Market Returns

Highlights The ECB can talk down the euro, but not by much. The central bank has previously expressed comfort with EUR/USD at 1.15. The cyclical and structural direction of EUR/USD is higher... ...because the euro area versus U.S. long bond yield spread should ultimately compress to -40 bps from today's -130 bps. Remain neutral in Germany's DAX and underweight Sweden's OMX. Equity markets with a strong base currency and a large exposure to exporters will come under pressure. Overweight German consumer services equities versus German exporters and the DAX. Underweight U.K. consumer services equities versus the FTSE100. Feature When mariners know that a sea-change is coming, their concern is not whether it comes today, tomorrow or the day after tomorrow. The big issue is the sea-change itself - because it brings major implications for navigating the seas. In the same way, when currency markets know that a sea-change in monetary policy is coming, their concern is not whether the policy announcement comes on September 7, October 26 or December 141 - or indeed whether the sea-change will happen suddenly or gradually. At a sea-change, currency markets look much further ahead. Just as for mariners, the big issue is the sea-change itself. EUR/USD is now moving in lockstep with the expected differential between euro area and U.S. policy interest rates not next year, nor the year after next, but rather the differential five years out (Chart I-2). Chart I-1AA Strong Euro Is Good For ##br##German Consumer Services... A Strong Euro Is Good For German Consumer Services... A Strong Euro Is Good For German Consumer Services... Chart I-1B...A Weak Pound Is Bad For##br## U.K. Consumer Services ...A Weak Pound Is Bad For U.K. Consumer Services ...A Weak Pound Is Bad For U.K. Consumer Services Chart I-2EUR/USD Is Moving In Line With The Interest ##br##Rate Differential Expected In 2022 EUR/USD Is Moving In Line With The Interest Rate Differential Expected In 2022 EUR/USD Is Moving In Line With The Interest Rate Differential Expected In 2022 The ECB Can Talk Down The Euro, But Not By Much Chart I-3EUR/USD Might Find Support At 1.15 EUR/USD Might Find Support At 1.15 EUR/USD Might Find Support At 1.15 Therefore, if the ECB really wants to unwind the euro's sharp appreciation this year, the central bank must tell the market that the expectation for a sea-change is completely wrong. In other words, the ECB must indicate that it has no intention to dial back its emergency monetary accommodation. Such a volte-face is unlikely, for two reasons. First, the ECB likes to adjust market expectations incrementally rather than violently. The last policy meeting made the case "for proceeding gradually and prudently when approaching adjustments in the monetary policy stance and communication." Second, not to dial-back its emergency monetary accommodation flies in the face of a euro area economic expansion that is solid, broad, and among the strongest and best-established among major developed economies. "Postponing an adjustment for too long could give rise to a misalignment between the Governing Council's communication and its assessment of the state of the economy, which could (eventually) trigger more pronounced volatility in financial markets." Nevertheless, at the margin, dovish words from Draghi could pare back the euro. How much? Consider that at the last policy meeting EUR/USD stood at 1.15 and the ECB justified this level on the basis of the improved "relative fundamentals in the euro area vis-à-vis the rest of the world." (Chart I-3) Given that these relative fundamentals are still intact, 1.15 might provide a level of support in a technical retracement. Of course, EUR/USD also depends on the Federal Reserve and expectations for its policy rate five years out. EUR/USD would sink if the market became much more hawkish about where it sees the U.S. 'terminal' interest rate. However, for the terminal rate expectation to rise suddenly and sharply in the U.S. relative to the euro area would also fly in the face of the economic data on both sides of the Atlantic. Recently, there has been little difference in either economic growth or inflation rates. The 'Neutral' Real Interest Rates In The Euro Area And U.S. Are The Same More fundamentally, there is little difference in the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. Through the 19 years of the euro's life, the euro area versus U.S. long bond yield spread has averaged -40 bps2 (Chart I-4). Over this same period, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-5). Ergo, the real interest rate differential has averaged zero. Meaning, the neutral real interest rates in the euro area and the U.S. have been exactly the same. Chart I-4Euro-U.S.: Average Interest ##br##Differential = -40bps Euro-U.S.: Average Interest Differential = -40bps Euro-U.S.: Average Interest Differential = -40bps Chart I-5Euro Area-U.S.: ##br##Inflation Differential = -40bps Euro Area-U.S.: Inflation Differential = -40bps Euro Area-U.S.: Inflation Differential = -40bps Bear in mind that the 19 year life of the euro captures multiple manias and crises, some centred in Europe, some in the U.S. Hence, 1999-2017 is a good representation of what the future holds, at least in relative terms if not in absolute terms. With little difference in the neutral real rates over the past two decades, is there any reason to expect a big difference in the future? Our starting assumption has to be no. Chart I-6If Composition Differences Were Removed, ##br##Euro Area And U.S. Inflation Would Be Near-Identical If Composition Differences Were Removed, Euro Area And U.S. Inflation Would Be Near-Identical If Composition Differences Were Removed, Euro Area And U.S. Inflation Would Be Near-Identical In fact, even the -40 bps annual inflation shortfall in the euro area is due to a compositional difference in the consumer price baskets. The euro area does not include owner occupied housing costs, whereas the U.S. does at a hefty weighting.3 If this compositional difference were removed, inflation would also be near-identical (Chart I-6). Still, each central bank must target inflation as it is defined in its respective jurisdiction, so let's assume the annual inflation differential continues to average -40 bps. In this case, the long bond yield spread should also ultimately compress to -40 bps from today's -130 bps. The biggest risk to this view is if the existential threat to the euro resurfaced. Looking at the political calendar, the German Federal Election on September 24 poses no such threat. Meanwhile, ahead of the Italian general election to be held no later than May 20 2018, even the non-establishment Five Star Movement and Northern League are toning down their anti-euro rhetoric. As my colleague Marko Papic, our Chief Geopolitical Strategist, puts it: "euro area politics are a red herring." On this basis, our central expectation is that the euro area versus U.S. yield spread has the scope to compress much further from its current -130 bps. This means that after a possible near-term retracement, we expect the cyclical and the structural rally in the euro to resume. German Consumers Are Winners, U.K. Consumers Are Losers When European currencies strengthen, the big winners are European consumers because they become richer in terms of the goods and services they can buy in international markets. This is significant because Europe imports its food and energy in large (and inelastic) volumes. Hence, their price decline in local currency terms significantly boosts the real spending power of consumers. And vice-versa (Chart I-7). As if to prove the point, German consumer services equities have rallied strongly this year (Chart I-8). And their outperformance has closely tracked euro strength (Chart of the Week, left panel). Across the English Channel, it is the mirror-image story. The pound has slumped. And the big losers are U.K. consumers, whose real spending power is evaporating as food and energy prices - in pound terms - rise. Again, to prove the point, U.K. consumer services equities have struggled to make any headway this year (Chart I-9). And their underperformance has closely tracked the trade-weighted pound's weakness (Chart of the Week, right panel). Chart I-7German Consumption Accelerating,##br## U.K. Consumption Decelerating German Consumption Accelerating, U.K. Consumption Decelerating German Consumption Accelerating, U.K. Consumption Decelerating Chart I-8German Consumer Services ##br##Have Rallied German Consumer Services Have Rallied German Consumer Services Have Rallied Chart I-9U.K. Consumer Services ##br##Have Struggled U.K. Consumer Services Have Struggled U.K. Consumer Services Have Struggled If the euro has more cyclical and structural upside - as we anticipate - then these equity performance trends have further to run. Chart I-10The Exporter Heavy DAX And##br## OMX Have Struggled The Exporter Heavy DAX and OMX Have Struggled The Exporter Heavy DAX and OMX Have Struggled Remain overweight German consumer services equities versus German exporters and the DAX. And remain underweight U.K. consumer services equities versus the FTSE100. At the same time, equity markets with a strong base currency and a large exposure to exporters will come under pressure. Mostly, this is because the translation of multi-currency international earnings into a strengthening base currency hurts index profits. For the time being, this influences our allocation to Germany's DAX - in which we have been neutral relative to the Eurostoxx600 - and Sweden's OMX - in which we have been underweight (Chart I-10). Next week, we will update our overall European country allocation. Given the large sector skews in European equity indexes, this country allocation is heavily dependent on the stance towards Healthcare and Banks. Hence, we await any incremental communication from the ECB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 These are the dates of the ECB's three remaining monetary policy meetings in 2017. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 The imputed cost of owner occupied housing (owners' equivalent rent of residences) comprises 25% of the U.S. consumer price basket but 0% of the euro area consumer price basket. Fractal Trading Model Basic materials equities are technically overbought. Initiate a short position relative to the broad market with a profit target / stop loss at 2.5%. In other trades, long Mediaset Espana / short IBEX35 hit its stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Short Basic Materials Vs. Market Short Basic Materials Vs. Market The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Chart 1"Trump Trade" Progress Report "Trump Trade" Progress Report "Trump Trade" Progress Report One of our seven investment themes for 2017, published in a Special Report last December, is that the combination of strong U.S. growth and accommodative Fed policy creates a cyclical sweet spot in which risk assets will outperform. After last week's GDP revisions we now know that real growth averaged 2.1% in the first half of the year, solidly above the Fed's 1.8% estimate of trend. Meanwhile, weak inflation has caused markets to discount an exceptionally shallow path for Fed rate hikes - only 19 bps of rate hikes are priced for the next 12 months. This divergence between growth and inflation is reflected in Treasury yields. The real 10-year yield is 24 bps above its pre-election level, while the compensation for inflation protection is only 5 bps higher (Chart 1). Not surprisingly, the cyclical sweet spot has led corporate bonds to outperform duration-matched Treasuries by 296 bps since the election. The persistence of the cyclical sweet spot leads us to believe that last month's politically-driven spread widening should be seen as an opportunity to increase exposure to corporate bonds. Remain at below-benchmark duration and overweight spread product in U.S. fixed income portfolios. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 62 basis points in August, dragging year-to-date excess returns down to 146 bps. The average index option-adjusted spread widened 8 bps on the month to reach 110 bps. In last week's report,1 we demonstrated that to properly assess corporate bond valuations it is not sufficient to simply look at the average index spread. We need to adjust for the fact that both the average credit rating and duration of the index change over time. We also need to consider corporate spreads relative to other similar stages of the economic cycle, not relative to long-run averages. In this respect, considering the breakeven spread2 for each credit tier relative to where it traded in the early stages of prior Fed tightening cycles gives us the best sense of the value proposition in corporate bonds. At present, this analysis shows that while Aaa corporate spreads are expensive, the other investment grade credit tiers all appear fairly valued (Chart 2). Corporate profit data for the second quarter was released last week and showed a big jump in our measure of EBITD (panel 4). This makes it extremely likely that net corporate leverage declined in Q2. All else equal, this lengthens the window for corporate bond outperformance Table 3.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Cyclical Sweet Spot Rolls On The Cyclical Sweet Spot Rolls On Table 3BCorporate Sector Risk Vs. Reward* The Cyclical Sweet Spot Rolls On The Cyclical Sweet Spot Rolls On High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 67 basis points in August, dragging year-to-date excess returns down to 378 bps. The index option adjusted spread widened 26 bps to end the month at 378 bps, 55 bps above the mid-2014 cycle low. Back in March4 we tested a strategy of buying the High-Yield index relative to Treasuries whenever spreads widened by more than 20 bps in a single month, and then holding the trade for a period of one, two or three months. We found that this "buy the dips" strategy works very well when inflationary pressures are low, but performs poorly when inflation is high and rising. When inflation is low the Fed needs to support the recovery by adopting a more dovish posture whenever financial conditions tighten. With the St. Louis Fed Price Pressures Measure5 at only 6% (Chart 3), we expect a "buy the dips" strategy will continue to work for some time. In terms of valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6%, and an expected recovery rate of 49%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to -9 bps. The conventional 30-year MBS yield fell 13 bps in August, driven by an 18 bps decline in the rate component. This was partially offset by a 4 bps increase in the compensation for prepayment risk (option cost) and a 1 bp widening of the option-adjusted spread (OAS). The Fed is likely to announce the run-off of its balance sheet when it meets later this month. For its part, the market has been pricing-in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments (Chart 4). In this sense, the Fed's commitment to proceed with balance sheet normalization no matter the outlook for the future pace of rate hikes is doubly negative for MBS spreads. OAS are biased wider as Fed buying exits the market, while low rates encourage faster prepayments and a higher option cost component of spreads. Going forward, the option cost component of spreads will decline as mortgage rates cease their downtrend, but OAS still appear too tight relative to trends in net issuance. Despite robust issuance so far this year and the Fed backing away as a buyer, the conventional 30-year MBS OAS remains well below its pre-crisis mean (panel 2). While MBS are starting to look more attractive, especially relative to Aaa credit (panel 3), we think it is still too soon to buy. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 5 basis points in August, bringing year-to-date excess returns up to 154 bps. The Foreign Agency and Local Authority sectors drove the index outperformance in August. Both beat the duration-matched Treasury benchmark by 12 bps. Sovereigns outperformed the benchmark by 3 bps, Supranationals outperformed by 1 bp, and Domestic Agency bonds underperformed by 2 bps. We took a detailed look at the Sovereign index in a recent report,6 both at the aggregate and individual country levels. At the aggregate level, the two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the U.S. dollar (Chart 5). At present, relative valuation is skewed heavily in favor of domestic U.S. credit (panel 2). Added to that, given downbeat Fed rate hike expectations, we view further dollar weakness as unlikely on a 6-12 month horizon. Taken together, we continue to favor U.S. credit over USD-denominated Sovereign debt. At the country level, we identified several countries where USD-backed debt appears attractive. We found that Finland, Mexico and Colombia all offer attractive spreads. However, the spread pick-up available in Mexican and Colombian debt is compensation for heightened exchange rate volatility. Finnish debt appears the most attractive on a risk/reward basis. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 40 basis points in August (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 144 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio held flat in August, and it remains extremely tight relative to its post-crisis trading range (Chart 6). The M/T yield ratio remains very low despite the fact that state & local government net borrowing continues to rise. Net borrowing increased to $209 billion in Q2, the highest level since the second quarter of last year. Further, the Trump administration appears to be finally tackling the issue of tax reform. While comprehensive tax reform is probably too ambitious, some form of corporate and personal tax cuts seems likely, probably in the first half of next year. Lower tax rates are obviously a negative for municipal bonds, but some of the negative impact could be offset if current tax deductions (such as the deduction of state & local income tax) are removed. All else equal, fewer available tax deductions elsewhere makes the tax exemption of municipal bonds look more attractive. Of course, the municipal bond tax exemption itself could also be threatened, but at least so far this appears less likely. The bottom line is that current M/T yield ratios are far too low given the looming risks of rising state & local government borrowing and looming federal tax cuts. Remain underweight. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull flattened in August. The 2/10 slope flattened 17 bps and the 5/30 slope flattened 2 bps. The market moved to discount an even shallower path for Fed rate hikes in August. At the end of July the market had expected 27 bps of rate hikes during the next 12 months, and that number has now fallen to 19 bps (Chart 7). Consequently, our recommendation to short the July 2018 fed funds futures contract has suffered. The position is now 17 bps in the red, but we continue to believe that the market's expected rate hike path is too benign. From current levels, a position short the July 2018 fed funds futures contract will return 35 bps if there are two hikes between now and next July and 61 bps if there are 3 hikes. We also continue to recommend a position long the 5-year bullet versus a duration-matched 2/10 barbell on the view that the Treasury curve will steepen as inflation and TIPS breakevens move higher. This position has earned 28 bps since initiation last December, but valuation is starting to look less attractive. Our butterfly spread model7 suggests that the 5-year bullet is now slightly expensive compared to the 2/10 barbell (panel 3). Or put differently, that the 2/10 Treasury slope will have to steepen by more than 20 bps during the next 6 months for our trade to earn a positive return. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 36 basis points in August, dragging year-to-date excess returns down to -169 bps. The 10-year TIPS breakeven inflation rate fell 6 bps on the month and, at 1.76%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Despite robust growth, extremely weak realized inflation has caused breakevens to tighten this year. Last week's July PCE release was yet another disappointment. The year-over-year core inflation rate fell from 1.51% to 1.41% and the year-over-year trimmed mean rate fell from 1.68% to 1.64% (Chart 8). However, measures of pipeline inflation pressure such as the supplier deliveries and prices paid components of the ISM Manufacturing survey point towards higher inflation. The supplier deliveries component increased from 55.4 to 57.1 in August (panel 4) while the prices paid component held firm at an elevated 62 (panel 3). Adding it all up, and incorporating the fact that employment growth should stay strong enough to maintain downward pressure on the unemployment rate, we think it is very likely that core inflation will soon reverse course and resume the steady uptrend that began in early 2015. TIPS breakevens will widen alongside. At present, our TIPS Financial model suggests that breakevens are trading in line with other financial market instruments (panel 2). In other words, there is no apparent mis-valuation in breakevens relative to other financial markets, and higher realized inflation is likely required before breakevens move sustainably wider. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in August, bringing year-to-date excess returns up to 71 bps. Aaa-rated ABS outperformed the benchmark by 10 bps in August, bringing year-to-date excess returns up to 63 bps. Meanwhile, non-Aaa ABS outperformed by 26 bps in August, bringing year-to-date excess returns up to 147 bps. Credit card ABS outperformed the Treasury benchmark by 10 bps in August, bringing year-to-date excess returns up to 69 bps. Auto loan ABS outperformed by 12 bps, bringing year-to-date excess returns up to 71 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps on the month, and remains well below its average pre-crisis level (Chart 9). At 36 bps, the option-adjusted spread for Aaa-rated ABS is now the same as the option-adjusted spread for conventional 30-year Agency MBS. Meanwhile, lending standards are now tightening for both auto loans and credit cards. Further, the New York Fed's Household Debt and Credit Report for the second quarter revealed that "flows of credit card balances into both early and serious delinquencies climbed for the third straight quarter - a trend not seen since 2009."8 While overall credit card charge-offs in ABS collateral pools remain low (panel 4), it is clear that the cyclical winds are shifting against consumer ABS. If the trends of tightening lending standards and rising delinquencies continue, then it will soon be time to reduce consumer ABS exposure, possibly shifting into Agency MBS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in August, bringing year-to-date excess returns up to 116 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month, and is approaching one standard deviation below its average pre-crisis level (Chart 10). The combination of tightening lending standards and weaker demand for commercial real estate (CRE) loans (as evidenced by the Fed's Senior Loan Officer Survey) suggests that credit concerns are starting to mount in the CRE space. Meanwhile, CMBS delinquency rates have leveled-off during the past few months and remain much lower in the multi-family space (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in August, bringing year-to-date excess returns up to 79 bps. The average index option-adjusted spread for the Agency CMBS index held flat at 48 bps on the month. This compares favorably to the 36 bps offered by both Aaa-rated consumer ABS and conventional 30-year Agency MBS. Not only does the Agency CMBS sector continue to offer an attractive spread relative to both consumer ABS and Agency MBS, but its agency guarantee and concentration in the multi-family space (where delinquencies are still low) makes it look particularly attractive. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models 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 2.67% (Chart 11). Our 3-factor version of the model (not shown), which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.68%. The Global Manufacturing PMI rose to 53.1 in August, from 52.7 in July, reaching a 75-month high (panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (bottom panel). Taken together, these two factors suggest that not only is global growth accelerating but that the global economic recovery is increasingly broad based. This is an extremely bond-bearish development. A broad based global recovery means that when U.S. data finally start surprising positively, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.16%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Policy Reflections", dated August 29, 2017, available at usbs.bcaresearch.com 2 The 12-month breakeven spread is the basis point widening required over a 12-month period before a corporate bond delivers losses relative to a duration-matched Treasury security. We assume no impact from convexity and calculate the breakeven spread as OAS divided by duration. 3 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 5 The Price Pressures Measure is a composite indicator which shows the percent chance that PCE inflation will exceed 2.5% during the next 12 months. 6 Please see U.S. Bond Strategy Weekly Report, "The Upside Of A Weaker Dollar", dated August 15, 2017, available at usbs.bcaresearch.com 7 For further details on our models please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 8 https://www.newyorkfed.org/microeconomics/hhdc Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Feature Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report written by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst. Mark makes a compelling case that the deflationary effects of the "Amazon economy" are overstated. I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Chart 1September Is Generally ##br##Not A Good Time Of Year For Stocks Sticking With Bullish ... For Now Sticking With Bullish ... For Now My colleagues and I convened a meeting earlier this week to discuss whether to abandon our long-standing cyclically bullish view towards risk assets. Several of them felt it was time to turn more cautious. I am sympathetic to their concerns: Valuations are stretched, volatility is low, and geopolitical risks (most notably North Korea) are on the rise. Profit growth is likely to decelerate later this year, as the easy comps stemming from the depressed level of earnings in the first half of 2016 vanish. Meanwhile, stocks are entering the volatile early autumn months, a period which has historically seen poor returns (Chart 1). Nevertheless, at times like these, it is useful to fall back on our time-tested indicators. Bear markets have almost always coincided with economic recessions, with the latter usually causing the former (Chart 2). None of our recession-timing signals are flashing red: To cite just a few examples, ISM manufacturing new orders are strong, initial unemployment claims are low, core capital goods orders are accelerating, and the yield curve is not in any immediate risk of inverting (Chart 3). Chart 2Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Chart 3No Warnings Of Recession Here No Warnings Of Recession Here No Warnings Of Recession Here U.S. financial conditions have eased sharply this year, which should support growth over the next few quarters (Chart 4). A recent IMF report highlighted that easier U.S. financial conditions tend to generate positive spillovers onto other countries.1 The fact that all 45 countries monitored by the OECD are on track to grow this year - the first time this has happened since 2007 - is a testament to the strong fundamentals underpinning the global economy. Chart 4Easing Financial Conditions Bode Well For Growth Easing Financial Conditions Bode Well For Growth Easing Financial Conditions Bode Well For Growth The Fed's Dot Problem In this light, the Fed's projection that the unemployment rate will end this year at 4.3% and only fall to 4.2% by end-2018 no longer looks credible. If U.S. GDP growth remains above trend, as we expect, the unemployment rate could fall below its 2000 low of 3.8% by next summer. That will be enough to prompt investors to price in a few more rate hikes. Considering that the market expects just 22 basis points in hikes through to end-2018, this is not a high bar to clear. A bit more fiscal stimulus would add to the pressure to tighten monetary policy. While any meaningful progress on tax reform will be difficult to achieve, the odds are good that Congress will agree to cut statutory corporate and personal tax rates, with the latter focusing mainly on middle-income earners. Failure to raise the debt ceiling or extend federal spending authority beyond the current budget window could scuttle the benefits from lower tax rates. Fortunately, the risks of such an outcome have receded. If there is a silver lining from Hurricane Harvey, it is that the disaster could at least temporarily overcome the political impasse in Washington. Congress will need to appropriate additional disaster relief funds over the coming weeks. Politicians who are seen as creating roadblocks to such funding will face the electorate's wrath. The odds of an infrastructure bill passing through Congress have also risen. All recoveries eventually run out of steam, but this one can last at least until the second half of 2019, which will make it the longest U.S. expansion on record. As we discussed several weeks ago, the next recession is likely to be triggered by the Fed scrambling to hike rates in response to rising inflation.2 This is not an immediate concern, given that it usually takes a while for an overheated economy to generate inflation - especially since the U.S. currently can satisfy rising domestic demand with higher imports. However, the risks of overheating will increase as unemployment falls further and excess capacity elsewhere in the world is absorbed. Draghi After Jackson Hole Chart 5A Stronger Euro Is Deflationary A Stronger Euro Is Deflationary A Stronger Euro Is Deflationary Textbook economic theory states that a shift in consumption towards imported goods requires a real appreciation of the currency. The dollar, of course, has done exactly the opposite of that, depreciating by 6.6% in trade-weighted terms since the start of the year. The euro, in particular, has gained significant ground against the greenback, rising above $1.20 at one point this week. Mario Draghi's failure to express concerns about the resurgent euro during his Jackson Hole address was construed by many market participants as a green light for further currency strength. We are skeptical of this "saying nothing means you are saying something" interpretation. Draghi wanted to acknowledge (and partly take credit for) the recovery across the euro area, but he is cognizant of the problems posed by a stronger euro. The ECB's June forecast showed inflation rising to only 1.6% in 2019. In the period since those forecasts were compiled, the trade-weighted euro has appreciated by 3.9%, bringing the year-to-date gain to 6.2% (Chart 5). ECB staff calculations, which Draghi has approvingly quoted, show that a 10% appreciation in the euro would reduce inflation by 0.2 percentage points in the first year and 0.6-to-0.8 points in the subsequent two years.3 Better-than-expected growth since the June forecasts will offset some of the deflationary impact from the stronger euro, but probably not by much, given that the Phillips curve is quite flat at high-to-moderate levels of spare capacity. With labor market slack across the euro area still 3.2 percentage points higher today than in 2008 (and 6.7 points higher outside of Germany), it will be a while before stronger growth generates markedly higher inflation. We expect the ECB to reduce its 2018/2019 inflation forecast by 0.1-to-0.2 percentage points next week. It would be awkward for the central bank to play up the prospect of monetary policy normalization while it is simultaneously trimming its inflation projections. This suggests that the ECB's communications could turn more dovish, thereby limiting further upside for the euro. EUR/USD is currently trading near the top of the $1.10-to-$1.20 range that we foresee lasting for the next 10 months. Thus, our expectation is that the euro will weaken over the next few months, ending the year near $1.15, and potentially moving back towards its 2017 lows in the second half of next year, as an overheated U.S. economy forces the Fed to pick up the pace of rate hikes. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, (Chapter 3), (April 2017). 2 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery to Retro-Recession?" dated August 18, 2017. 3 Please see European Central Bank, "March 2017 ECB Staff Macroeconomic Projections For The Euro Area." APPENDIX 1 Tactical Global Asset Allocation Monthly Update To complement our analysis, we use a variety of time-tested models to assess the global investment outlook. At present, these models favor global equities over bonds over a three-month horizon (Appendix Table 1). Appendix Table 1BCA's Tactical Global Asset Allocation Recommendations* Sticking With Bullish ... For Now Sticking With Bullish ... For Now Our business cycle equity indicators remain in bullish territory, as reflected in strong global growth and rising corporate earnings. Our monetary and financial indicators are also generally supportive. In contrast, our sentiment readings are sending mixed signals. On the one hand, implied equity volatility remains low and institutional exposure to stocks is quite high. On the other hand, surveys of retail investors show a healthy skepticism towards the bull market, which is a positive contrarian indicator. As has been the case for some time, our valuation measures are signaling that stocks are expensive, but these are typically useful only over horizons beyond one or two years. As we flagged last month, stocks tend to do poorly in August and September, which may hurt returns over the next few weeks. The stronger euro will negatively impact earnings in the euro area. This has caused our models to suggest a slight downgrade to European equities. However, we are inclined to fade this signal, given our expectation that the euro will give up some of its recent gains. Japanese stocks continue to score well on our metrics, buoyed by strengthening corporate profits and attractive valuations. Emerging market equities are fairly valued, although China still appears cheap. The rally in U.S. Treasurys has caused the gap between the 10-year yield and our model's fair value estimate to widen to around 50 basis points, the highest since last September. European and Japanese bonds also look somewhat overvalued, although the latter will continue to receive support from the BoJ's yield curve targeting operations. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 30th, 2017. The model has continued to reduce its allocation to the U.S. driven by worsening liquidity condition, and it's the second consecutive month that the U.S. allocation is the largest underweight. Australia is downgraded to neutral on concern of valuation. Germany and Netherland continued to receive more allocation and Canada's underweight is reduced as well, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 18 bps in August, entirely due to the 43 bps outperformance of Level 2 model where the overweight in Italy and Germany versus the underweight in Japan, Spain and Canada worked very well. Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of August 30, 2017. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates The model is optimistic on global growth and maintains in cyclical tilt. However, the magnitude of overweight in cyclical sectors has reduced on the back of momentum indicators. The biggest change has been utilities which has moved from a 2% underweight to a 1.7% overweight. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights Yellen sidesteps monetary policy at Jackson Hole. The Fed raised rates in late 1990s before seeing any inflation. Tax cut deal is still likely... ..but a prolonged debt ceiling battle or government shutdown is not. Inflation surprise has not yet followed economic surprise higher. Earnings and earnings guidance matters more than politics. Feature Fed Chair Yellen's speech on financial stability at the Jackson Hole symposium on Friday, August 25 shed little light on the timing of the central bank's next policy move. Some investors were fearing that Yellen would give a nod to the hawks in her speech. Yellen did no such thing. She simply noted "that the core reforms we have put in place have substantially boosted resilience without unduly limiting credit availability or economic growth". Yellen made no comments to suggest that monetary policy needs to tighten in order to reduce financial froth and foster greater stability. Financial stability1 matters to the Fed almost as much as maintaining low and stable inflation, and full employment. In this week's report, we discuss the FOMC's deliberations when the economy was at full employment in the late 1990s, and note that the Fed was willing to raise rates even before inflation accelerated. Gary Cohn, a potential replacement for Yellen, suggested in an interview last week that tax cut legislation is on the way. We agree and discuss below. The economic surprise index is rebounding, but that has not yet led to positive surprises on inflation as it has in the past. We also examine what history says about earnings guidance, U.S. equities and the stock-to-bond ratios during and after earnings reporting season. Fed Deliberations At Full Employment Chart 1The Fed And Inflation At Full Employment The Fed And Inflation At Full Employment The Fed And Inflation At Full Employment Minutes from FOMC meetings in the late 1990s are instructive in understanding the central bank's reaction function due to a lack of inflation as the economy moves beyond full employment (Chart 1). The Fed cut rates following the LTCM financial crisis in late 1998 and subsequently held the fed funds rate at 4¾% until June 1999. Core inflation was roughly flat during the on-hold period, even as the unemployment rate steadily declined and various measures pointed to significant labor market tightness. The FOMC discussion in the late 1990s of why inflation was still quiescent sounds very familiar. Policymakers pointed to the widespread inability of firms to raise prices because of strong competitive pressures in domestic and global markets. In the Fed's view, significant cost-saving efforts and new technologies also contributed to the low inflation environment for both consumer prices and wages. Moreover, rapid increases in imports and a drawdown in the pool of available workers was also seen as satisfying growing demand and avoiding upward pressure on inflation. One difference from today is that productivity growth was solid at that time. The FOMC decided to hike rates in June 1999 by a quarter point, despite any indication that inflation had turned up. Policymakers described the tightening as "a small preemptive move... (that) would provide a degree of insurance against worsening inflation later". The Fed went on to lift the fed funds rate to 6½% by May 2000. Interestingly, the unemployment rate in June 1999 was 4.3%, the same as the current rate. There are undoubtedly important differences in today's macro backdrop. The Fed is also more fearful of making a policy mistake in the aftermath of the Great Recession and financial crisis. Nonetheless, the point is that the Fed has faced a similar low inflation / tight labor market environment before. Question marks regarding the structural headwinds to inflation will remain in place, but it will not take much of a rise in core inflation in the coming months for the Fed to deliver the next rate hike (most likely in December). Any fiscal stimulus, were it to occur, would reinforce the FOMC's bias to normalize interest rates. Is All Lost For U.S. Tax Cuts? Although tax reform was a major component of President Trump's legislative agenda, investors are skeptical that any fiscal stimulus or tax cuts will succeed (Chart 2). In our view, there is a high probability that at least a modest package will be passed. The reason is that, if it fails, Republicans will return empty-handed to their home districts to campaign for the November 2018 mid-term elections. Historically, Republican Presidents who have low approval ratings ahead of mid-term elections tend to lose a larger number of seats to Democrats (Chart 3). Chart 2Market Has Priced Out Trump's Economic Agenda Market Has Priced Out Trump's Economic Agenda Market Has Priced Out Trump's Economic Agenda Chart 3GOP Is Running Out Of Time Surprise, Surprise Surprise, Surprise Now that the border adjustment tax is officially dead, the GOP must either significantly moderate its tax cuts or add to the deficit. BCA's geopolitical strategists argue that regardless of which bill is passed by the GOP, the legislation will expire after a "budget window" of around 10 years.2 Tax cut plans ultimately will be watered down, but even a modest cut would be positive for the equity market. The dollar should also receive a boost, especially given that the Fed would have to respond to any fiscally driven growth impulse with higher interest rates. We expect Trump to ensure that the Fed retains its dovish bias when Chair Janet Yellen's term expires on February 3, 2018. He may favor a non-economist and a loyal adviser, such as Gary Cohn, over any of the more traditional and hawkish Republican candidates. Cohn could not single-handedly affect the course of monetary policy. The FOMC votes on rate changes, but decisions are formed by consensus (with one or two dissents). Cohn could implement an abrupt change in policy in the unlikely event that the Administration stacks the Fed Governors with appointees that are prepared to "toe the line." (The Administration does not appoint Regional Fed Presidents). Stacking the Governorships would take time. The FOMC has been very cautious in tightening policy and we do not see Trump taking an active role in monetary policy. The bottom line is that Cohn's possible appointment to the Fed Chair would not signal a major shift in monetary policy. Raising The Debt Ceiling Recent fights over Obamacare and tax reform have pitted fiscally conservative Republicans against moderates, with the debt ceiling used as a bargaining chip in the battles. While government shutdowns have occurred in the past, the debt ceiling has never been breached. At the end of the day, the debt ceiling will always be raised because government could not withstand the public pressure. Democrats can't be blamed because the Republicans control both chambers of Congress and the White House. Even the Freedom Caucus, the most fiscally conservative grouping in the House, is divided on the issue. This augurs well for a clean bill to raise the debt ceiling because the Republican majority in the House is 22 and the Freedom Caucus has 31 members. Democrats will not stand in the way of passage in the Senate. The worst-case scenario for the market would be a two-week shutdown, between October 1 when the current funding for the government will expire, and mid-October when the CBO predicts that the debt ceiling will be reached. Odds of such a scenario are probably around 25%. We would not expect a shutdown to have any lasting impact on the economy, although it could provide an excuse for the equity market to correct. The good news is that at least the economy is cooperating. Economic Surprise Versus Inflation Surprise Economic expectations are now low enough for the still-tepid activity data to beat, but this trend has not yet spilled over into the inflation data. Elevated economic expectations post-election led to a four-month period (early March-mid June) when the Citi Economic surprise index rolled over3 (Chart 4). In mid-July, the data began to top washed-out expectations and the surprise index accelerated. In the past two months, readings across a wide spectrum of economic indicators (consumer and business sentiment, consumer spending, home prices, manufacturing sentiment, and employment) have outpaced lowered expectations. Even so, inflation readings continue to disappoint relative to forecasts. Chart 4Inflation Surprise Usually Follows Economic Surprise Higher... But Not This Time Inflation Surprise Usually Follows Economic Surprise Higher... But Not This Time Inflation Surprise Usually Follows Economic Surprise Higher... But Not This Time After briefly moving above zero in early 2017 - indicating that inflation data was stronger than analysts projected- the Citi inflation surprise index rolled over again (Chart 4, bottom panel). Reports on the CPI, PPI, and average hourly earnings continued to fall short of consensus forecasts. This despite the rebound in the economic surprise index and the tightening of labor and product markets. The disappointment on price data relative to consensus forecasts is not new. Although there were brief periods where prices exceeded forecasts in 2010 and 2011, the last time that inflation exceeded market consensus in this business cycle was in late 2009 and early 2010. In the last few years of the 2001-2007 economic expansion through early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Moreover, the disconnect between economic surprise and inflation surprise has never been wider, but the inflation surprise index should follow the economic surprise index upward. In the past 13 years, there have been 15 periods when economic surprise has climbed after a trough. The inflation surprise index has temporarily increased in 13 of those episodes. For example, in the aftermath of the oil price peak in the U.S. in mid-2014, both economic surprise and inflation surprise diminished through early 2015 and then began moving up. However, today's inflation surprise index has rolled over while economic surprise has gained, but remember that inflation is a lagging indicator.4 Asset class performance since the economic surprise index formed a bottom in mid-June has run counter to history as risk assets have underperformed (Table 1). Returns on the S&P 500 have lagged Treasuries since the June 14 trough, driving down the stocks-to-bond ratio. U.S. large cap equities have outperformed Treasuries by an average of 290 basis points in the 11 prior episodes in this expansion as economic surprise climbed. Similarly, both high yield and investment-grade corporate bond returns have lagged Treasuries since mid-June. During previous episodes when the surprise index was climbing, credit outperformed Treasuries. Small caps have also lagged large caps, which is counter to the historical pattern, although oil and gold have both gained since the trough in economic surprise. The evidence is mixed for these two commodities after a bottom in economic surprise. Table 1Performance Of Risk Assets As Economic Surprise Rises Surprise, Surprise Surprise, Surprise BCA's view5 is that a Fed-led recession will begin in 2019. Nonetheless, markets were concerned about a recession occurring this year as the economic data underwhelmed in the first part of the year. Despite market fears, reliable leading indicators of a recession such as the LEI, the yield curve and the 26-week change in claims, are not signaling a recession (Chart 5). BCA does not expect the buildup of the types of imbalances that led to economic downturns in the past. Instead, a recession may be triggered by a Fed policy mistake, or a terrorist attack that disrupts economic activity over large area for an extended time, or a widespread natural disaster. Chart 5Data Suggest Low Odds Of A##BR##Recession In Next 12 Months Data Suggest Low Odds Of A Recession In Next 12 Months Data Suggest Low Odds Of A Recession In Next 12 Months Bottom Line: There are few imbalances in the economy and a recession in the U.S. is more than a year away. Although risk assets have not outperformed as is typical after a trough in economic surprise, we anticipate that stocks will beat bonds in the next 12-18 months. Inflation will surprise to the upside in the coming months, pressuring the Fed and the bond market. Stay short duration. Is Trump To Blame For The Stalled Stock Market Rally? Corporate earnings, not politics, drive equity prices. The S&P 500 has retreated from its all-time highs in early August despite another terrific earnings reporting season.6 Investors are concerned that Trump's erratic presidency may be to blame, but we take a different view Since the start of the economic expansion, the S&P 500 rose in 83% of the periods when large U.S. corporations provide results for the prior quarter and guidance on subsequent periods. (Table 2, bottom panel) U.S. equities increased only 66% of the time when managements were silent on profitability and future prospects (Table 3, bottom panel). However, there are periods when exogenous events like the 2011 U.S. debt downgrade and the 2015 Chinese devaluation that can disrupt the normal pattern, and we have excluded those from our calculations. Nevertheless, with the Q2 earnings reporting season over, the odds are less favorable for a rising U.S. equity market in the next few months. Table 2S&P 500, Stock-Bond-Ratio And Guidance During Earnings Season Surprise, Surprise Surprise, Surprise Table 3S&P 500, Stock-Bond-Ratio And Guidance Outside Of Earnings Season Surprise, Surprise Surprise, Surprise The stock-to-bond ratio also fares better during earnings season than during corporate quiet periods, and moves higher more often. When companies report profits, the stock-to-bond ratio increases 73% (Table 2, bottom panel) of the time versus just 65% outside of earnings season (Table 3, bottom panel). Since the start of 2010, the median return for the stock-to-bonds ratio is 0.046% per day during reporting season (Table 2, top panel) and 0.037% when it is not earnings season (Table 3, top panel). The implication is that the stock-to-bond ratio over the next two months may move higher, and at a faster rate than it did during the just completed Q2 earnings reporting season. Counter-intuitively, earnings guidance increases more often outside of earnings season (90% of the time and 0.04% per day, Table 3) than during it (77% of the time and 0.019% per day, Table 2). The top panels of Tables 3 and 2 respectively also show that the median daily return on stocks is higher outside of earnings reporting season (0.074% per day) than it is as earnings are being reported (0.054% per day). This is also somewhat counter-intuitive, as over the long term, earnings trends drive stock prices. We intend to examine the shorter term relationship between stock prices, the stocks to bond ratio and earnings guidance in a future Weekly Report. Bottom Line: The path of corporate earnings and not politics, ultimately drive stock prices. In the past eight years, the stocks to bond ratio during earnings season rises more and more often than when there was no new information on earnings. We remain upbeat on the earnings outlook for at least the remainder of this year, which will help the equity market weather the ongoing turbulence emanating from Washington. Next year, the earnings backdrop will not be as supportive. Stay overweight stocks versus bonds. 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, "The Fed's Third Mandate", dated July 24, 2017. It is available at usis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "Is The Trump Put Over" dated August 23, 2017. It is available at gps.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration", published July 17, 2017. It is available at usis.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?," August 18, 2017. It is available at gis.bcaresearch.com. 5 Please see BCA's Global Investment Strategy Weekly Report, "The Timing Of The Next Recession" published June 16, 2017. It is available at gis.bcaresearch.com. 6 Please see BCA's U.S. Investment Strategy Weekly Report, "The Stage Is Set For Jackson Hole", August 21, 2017. It is available at usis.bcaresearch.com.

Highlights Copper's impressive rally leaves prices out in front of fundamentals. We are expecting a correction going forward, given our view that reduced mine output results from transitory disruptions, and China's growth appears to be stalling: industrial output, investment, retail sales, and trade all grew less than expected last month. Energy: Overweight. Crude oil prices remain fairly well supported this week on signs U.S. production growth may not be as strong as expected, and continued production discipline by OPEC 2.0 keeps global inventories from building too rapidly. We remain long Brent and WTI $50/bbl vs. $55/bbl call spreads in Dec/17, which are up 99.1% and 18.9%, respectively. Base Metals: Neutral. Copper prices appear to be getting out ahead of fundamentals, particularly as regards Chinese demand, which could stall on the back of slower economic growth. Precious Metals: Neutral. In line with our House view, we expect the Fed to remain dovish on the inflation front, which, over time, will mean the central bank finds itself behind the curve on inflation. This means real rates remain relatively low for the foreseeable future, which will be supportive of gold. Ags/Softs: Underweight. We remain bearish, although we are not aggressively shorting any of the ags. Feature Chart of the WeekCopper 2017H1: Exceptional Performance Copper 2017H1: Exceptional Performance Copper 2017H1: Exceptional Performance Copper futures traded on COMEX rallied by almost 10% from the beginning of May, when spot was trading just under $2.50/lb, until late July, then shot up by an additional 9% on news of a potential ban on scrap imports by China; 4% of that increase was recorded on July 25 alone (Chart of the Week). Spot copper settled at $2.9865/lb Tuesday. Part of this rally can be put down to a renewed focus on China's environmental policies, which we expect to continue following the 19th National Congress of China's Communist Party later this year, and the better-than-expected performance of the Chinese economy in 2017H1. This occurred as supply side disruptions at some of the world's largest copper mines caused markets to discount possible near-term shortages, along with rumors of an import ban on so-called Category 7 scrap metals. These stories supercharged the copper market. Supply/Demand Imbalances Are Transitory While labor-related disruptions at major copper mines led to a production cutback in 2017H1, supply has, for the most part, recovered. Furthermore, these are one-off events that we do not foresee persisting or having a lasting impact on markets.1 Production of copper ores and concentrates fell a negligible 0.1% year-on-year (yoy) in H1, following a 6.7% yoy increase in global output in 2016. Year-to-date (ytd) production growth lies significantly below the 5.63% average for the same period 2013-2016 (Chart 2). Similarly, in a marked slowdown from the four-year average growth of ~ 4% yoy in refined copper production, output remained largely unchanged in the first 4 months of 2017 compared to last year. However, there is evidence of relief in May and June, which registered a 6.08% yoy increase in output. The slowdown in production is mainly driven by supply-side shocks at some of the world's largest mines in Chile, Peru, and Indonesia. Contract Renegotiations and Weather Disruptions in Chile: The respective 1% and 6.6% yoy fall in global ores and concentrates output in February and March can be attributed to a corresponding year-on-year 17% and 23% declines in production from Chile - the world's leading copper producer. At BHP Billiton's Escondida mine, the world's largest, 2,500 workers staged a 43-day strike over contract renegotiations, which ended without resolution in late March. Although the end of the strike has brought relief to copper output, talks will resume in 18 months, raising the possibility of another strike - and an accompanying production cut - in a year's time. However, President Marcelo Castillo has somewhat calmed these worries, expressing his intent to revise the mine's operating model so that it will be minimally impacted by such disputes in the future. The decline in Chilean output was compounded by heavy snow and rain in May, which forced the Caserones mine to halt production for three weeks. This was reflected in a ~ 1.7% yoy decline in national output in May. Caserones has since resumed production and is now reported to have reached 90% of capacity. Nationwide Strikes in Peru Not Expected to Show up in July Data: Labor reforms proposed at the end of July led to a three-day walk-out by unionized workers across Peru. The strike impacted operations at major deposits including Antamina, Cerro Verde, Cuajone among others. However, according to the National Society of Mining, Petroleum and Energy, absenteeism was insignificant and the impact on copper output was limited. This followed a five-day strike at Cerro Verde - Peru's second largest mine - in March due to dissatisfaction with labor conditions. Peru ramped up output by almost 25% in 2015, surpassing China as the second largest producer of copper, and accounted for 11.4% of global output in 2016. Dispute Over Export Rights and Worker Dissatisfaction at Grasberg: In an effort to promote its domestic smelting industry, Indonesian authorities imposed a temporary ban on exports of copper concentrates in January. However, in April, Freeport McMoRan was granted an eight-month license to resume exports from its Grasberg mine - the second largest in the world. Furthermore, CEO Richard Adkerson expressed confidence that Freeport will succeed in securing an agreement by October, allowing it to implement a major multi-billion-dollar underground mine development plan. Labor unrest remains a problem for the company, nonetheless. Angered by redundancies and enforced furloughs, a strike by 5,000 workers was extended for a fourth month, until the end of August. Output data until May shows production remained largely unchanged compared to last year and follows a 3.82% yoy increase in Q1. Indonesian output accounted for 3% of global copper production in 2016. This will have to be resolved for the company's development plans to proceed unchallenged. Despite these supply-side shocks and ensuing Q2 inventory draw, copper remains well stocked at the major warehouses (Chart 3). Furthermore, COMEX inventories are at their highest level since 2004. As long as the global market remains well stocked, we expect it will be capable of withstanding volatility induced by labor markets and government policy with minimal impacts on prices. Chart 2Supply Disruptions Subsiding,##BR##Copper Market Back In Balance Supply Disruptions Subsiding, Copper Market Back in Balance Supply Disruptions Subsiding, Copper Market Back in Balance Chart 3Copper Inventories##BR##Can Withstand Volatility Copper Inventories Can Withstand Volatility Copper Inventories Can Withstand Volatility Scrap Imports Kick In Amidst Elevated Prices Chart 4China Copper Demand Weakening China Copper Demand Weakening China Copper Demand Weakening A dip in Chinese demand was also partly to blame for the minimal impact of the production cutbacks on inventories. Chinese consumption single-handedly makes up ~ 50% of global copper demand. The 1.46% yoy decline in global refined copper consumption during 2017H1 is, in large part, due to a 4.57% yoy drop in Chinese consumption (Chart 4). In fact, consumption during February and April fell 10% and 11%, respectively. Weak demand is also evident in China's import of copper ores and concentrates data. Although imports grew by 2.72% yoy in 2017H1, this is a marked slowdown from the 33.66% growth rate witnessed during the same period last year, and the average H1 growth of 22.6% since 2012. Similarly, China's imports of refined copper, copper alloy, and products fell 18.32% yoy in 2017H1 before increasing by 8.33% yoy last month. However, it appears that scrap copper may have helped fill the void - China's imports of copper scraps and wastes increased by 18.56% in the first half of this year compared to the same period last year. This marks a turning point in the trend, as copper scrap imports have been on the decline since 2013, and is likely a direct result of speculation over the impact of China's environmental policies on base metals. China's Scrap Import Ban: Overplayed Last week, China confirmed intentions to ban some forms of scrap copper imports beginning as early as the end of the year. This is part of measures taken to support sustainable growth and environmental protection. While rumors swirled in late July suggesting "Category 7" (i.e. old) scrap copper would be included in the import ban, the list of banned waste imports released last week by the Ministry of Environmental protection did not include copper. However, copper scrap from automobiles, ships and electronic devices were included in a "limited import" category, with no further details of the import constraints to be imposed on these products. Scrap impacts the copper market in two main ways: It provides smelter-refineries an alternative input, in addition to ores and concentrates, thus enhancing total refined copper supply. The International Copper Study Group (ICSG) estimates global production of refined copper increased by 2% in January due to increased production from scrap, which rose by 13% yoy. It acts as a substitute for refined copper, providing first-stage manufacturers a lower-cost alternative input. This means that when prices are up, as they have been since late 2016, the impact on refined copper production is somewhat muted because scrap usage kicks in (Chart 5). Furthermore, because of this response, the effect of supply-side shocks on refined copper output are - to some extent - restrained. Chart 5Scrap Imports Kick In When Prices Are Up Scrap Imports Kick In When Prices Are Up Scrap Imports Kick In When Prices Are Up This explains why the market has been in somewhat of a frenzy since late July after hearing that the Chinese authorities will likely implement an import ban on some types of scrap copper, which caused copper prices to jump to levels last seen in 2015Q2. Copper futures traded on COMEX have rallied by 10% from the beginning of May to late July, then shot up an additional 9% on rumors of an import ban; 4% of that increase was recorded on July 25 alone. Markets are clearly buying into the news, and are optimistic the ban will hike demand for other forms of copper. However, we believe this optimism is unfounded, and that the impact on copper markets is overplayed. Although the ICSG estimates that ~ 30% of annual copper usage comes from 'secondary' or recycled sources, a much smaller ratio originates from 'old' scrap copper. This type of scrap is derived from end-of-life electronics, households, cars, and industrial products. While data on old-scrap copper supply is not readily available, researchers at Antaike estimated that out of the 3.35mm MT of scrap copper imports in 2016, old-scrap copper imports made up ~ 0.3mm MT of copper-equivalent. This accounts for a very small fraction of China's 17.05mm MT of imports of copper ores and concentrates and 4.94mm MT imports of refined copper last year. Thus, even if a ban on all old-scrap copper were to materialize, we do not believe it will create a supply deficit, or even threaten one. In addition, there has been speculation that a ban would reroute old scrap metal to other countries for dismantling and processing before being imported by China, diminishing its impact on the copper market. Given that the market's reaction to news of the ban has been favorable, we expect to see a correction as the market responds to information that the ban is less bullish than expected. Chinese Demand Will Ease As Tailwinds Die Down In 2017H1, China surprised with better-than-expected economic performance, which supported copper prices. China's infrastructure and equipment industries are especially important to the copper market, consuming, respectively, 43% and 19% of the red metal domestically. However, as our colleagues on BCA Research's China desk foresaw, recent data gives some early-warning signs of a slowdown in growth.2 Industrial output, investment and retail sales figures came in below expectations amid a cooling property market. Furthermore, restrictions on riskier types of lending will continue slowing credit growth going forward. The property market - residential and commercial construction - accounts for ~ one-third of copper consumption. After reaching three-year highs late last year, the official manufacturing PMI and the Keqiang index - both used as key measures of the state of China's economy - show evidence that the economy is stabilizing (Chart 6). In fact, the Keqiang index has come down significantly from its peak earlier this year. In particular, signs of cooling in China's property sector are playing into the possibility of weaker industrial metals generally. Steel-making commodities and base metals have been in high demand ever since China relaxed housing policies, reviving the property market. However, in an effort to cool this market, Chinese authorities announced measures to raise down payments and control speculative buying in 20 cities last September. These measures are beginning to show up in property-market construction and sales data (Chart 7). Chart 6Early Warning Signs Of China Slowdown Early Warning Signs of China Slowdown Early Warning Signs of China Slowdown Chart 7China Property Sector: Cooling China Property Sector: Cooling China Property Sector: Cooling New floor space started contracted by almost 5% yoy in July, potentially signaling early warning signs of what could come ahead. It marks a reversal of a 10.55% expansion in 2017H1. New floor space completed declined in July, registering a 13.54% fall yoy. This follows 5% growth in 2017H1 - a marked slowdown from the 20.05% pace of growth in 2016H1. Furthermore, floor space under construction has been steadily easing, growing just 3.17% yoy in July. In terms of floor space sold, July's yoy growth of 2% follows a 21.37% yoy growth rate in June, and marks a pronounced slowdown from the 15.82% average yoy growth rate in 2017H1. Chart 8China's Economic Structure##BR##Deviates From Trend China's Economic Structure Deviates From Trend China's Economic Structure Deviates From Trend While near term growth does not appear to be threatened, earlier this month the IMF warned against China's "reliance on stimulus to meet targets," and a "credit expansion path that may be dangerous," which could cause a medium-term adjustment. When this eventually weighs down on industrial activity - as we expect - it will reverberate throughout the economy, discouraging investment projects, and eventually taking its toll on commodities generally, base metals in particular. Even so, in a small change of pace, China's share of secondary sector (i.e. manufacturing) as a percent of GDP crept up in July (Chart 8). This is a deviation from the trend in the evolving structure of China's economy, where the tertiary sector (services) has been making up an increasing share of GDP. While it is still too early to determine whether this is the beginning of a change in trend, or a one-off case, this development is positive for metals short term, since manufacturing activity is industrial-metal intensive. Bottom Line: We expect a correction in copper prices near term, as markets adjust to revelations that the market impact of China's environmental policies is less than expected. Our longer-term outlook is neutral: The synchronized economic upturn in global demand will partially offset waning economic activity in China, as tailwinds from accelerating export growth and easing monetary conditions die down. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 We discuss some of these developments during 2017Q1 in BCA Research's Commodity & Energy Strategy Weekly Report "Copper's Price Supports Are Fading," published by March 23, 2017. It is available at ces.bacresearch.com. 2 Please see BCA Research's China Investment Strategy Weekly Report titled "China Outlook: A Mid-Year Revisit", dated July 13, 2017, It is available at cis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Copper's Getting Out Ahead Of Fundamentals, Correction Likely Copper's Getting Out Ahead Of Fundamentals, Correction Likely Commodity Prices and Plays Reference Table Copper's Getting Out Ahead Of Fundamentals, Correction Likely Copper's Getting Out Ahead Of Fundamentals, Correction Likely Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Beware of asset managers' and leveraged funds' large net long positions in EM currencies. Overextended net long positions in EM and commodities currencies signify overbought conditions in EM risk assets in general. This in tandem with the poor outlook for EM/China growth makes the risk-reward of EM financial markets unattractive. Downgrade Korean equities from overweight to neutral, but continue to overweight Korean technology stocks relative to the EM benchmark. Also, maintain the short KRW / long THB trade. Take profits on the long Indian / short Indonesian stocks position. Consistently, downgrade Indian stocks to neutral and upgrade Indonesian bourses to neutral within an EM equity portfolio. Feature Investor positioning in EM currencies is elevated. From a contrarian perspective, this at minimum warrants a correction. Chart I-1 illustrates that asset managers' and leveraged funds' combined net long positions in the Mexican peso, the Brazilian real, the Russian ruble and South African rand are very elevated.1 This aggregate is weighted by notional value of outstanding open interest of each currency, and is shown as a percentage of open interest. Importantly, we have refined positioning data to separate asset managers and leveraged funds from other non-commercial and commercial institutions. Asset managers and leveraged funds reflect investment community sentiment the best. Besides, they are the most inclined to scale back their net long positions if and when these currencies begin to depreciate, i.e., they are more momentum driven. By doing so, they will reinforce the selloff. Currently bullish sentiment on EM and commodities is corroborated by the fact that asset managers' and leveraged funds' aggregate net long positions in non-EM commodities currencies such as the CAD, the AUD and the NZD are at the highest level since 2011 (Chart I-2). Typically, these currencies are at risk of a correction when positioning reaches such excessive levels. Chart I-1Asset Manager's And Leveraged Funds' Net Long Positions In EM Currencies Are Large Asset Manager's And Leveraged Funds' Net Long Positions In EM Currencies Are Large Asset Manager's And Leveraged Funds' Net Long Positions In EM Currencies Are Large Chart I-2Asset Manager's And Leveraged Funds' Net ##br##Long Positions In Commodities Currencies Asset Manager's And Leveraged Funds' Net Long Positions In Commodities Currencies Asset Manager's And Leveraged Funds' Net Long Positions In Commodities Currencies Chart I-3A and Chart I-3B show the same for individual currencies such as the MXN, the BRL, the RUB, the ZAR, the CAD, the AUD and the NZD. The overarching message is that investors' net long exposure to both EM and commodities currencies is large and depreciation risk for these exchange rates is substantial, at least in the near term. Chart I-3AAsset Managers And Leveraged Funds' Net ##br##Long Positions In Select Currencies Asset Managers And Leveraged Funds' Net Long Positions In Select Currencies Asset Managers And Leveraged Funds' Net Long Positions In Select Currencies Chart I-3BAsset Managers And Leveraged Funds' Net ##br##Long Positions In Select Currencies Asset Managers And Leveraged Funds' Net Long Positions In Select Currencies Asset Managers And Leveraged Funds' Net Long Positions In Select Currencies Yet, these positioning data do not reveal whether potential weakness will be a bull market correction or the beginning of bear market. Our bias remains that the potential selloff will evolve into a new phase of the bear market in EM currencies that began in 2011. In turn, as EM currencies depreciate, they will erode foreign investors' returns and trigger a selloff in other EM risk assets such as stocks, domestic bonds and credit markets. In short, investor sentiment on EM risk assets correlates with sentiment toward both EM and commodities currencies. Hence, bullish sentiment and overextended net long positions in EM and commodities currencies signify overbought conditions in EM risk assets in general. The Cyclical Outlook Chart I-4EM Currency Valuations Are Close To Neutral EM Currency Valuations Are Close To Neutral EM Currency Valuations Are Close To Neutral We are negative on the cyclical outlook for EM currencies for the following reasons: With a few minor exceptions, EM currencies are not cheap; their valuations are close to neutral Chart I-4 demonstrates the real effective exchange rate for aggregate EM excluding China, Korea and Taiwan. This is an equity market cap-weighted aggregate. It shows that EM exchange rate valuations are not depressed. The reason why we remove China, Korea and Taiwan from the calculation is because their respective bourses have large equity market-cap weights in the MSCI EM stock index, and thereby dominate the EM aggregate. Excluding these three markets, we get a less skewed perspective on EM currency valuations and assign higher weight to the high-yielding ones. Importantly, the best measure of currency valuation is, in our opinion, the real effective exchange rate based on unit labor costs (ULC). The rationale is that this measure captures changes in wages and productivity. The latter two are critical to competitiveness and, hence, reveal the true valuation of currencies. Unfortunately, there is no available ULC-based real effective exchange rate data for all individual EM currencies. Chart I-5A and Chart I-5B presents the measure for countries where data from reputable sources are available. By and large, the message is that, with the exception of the Mexican peso, EM currencies are not particularly cheap. Chart I-5AReal Effective Exchange Rates ##br##Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Chart I-5BReal Effective Exchange Rates ##br##Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs The outlook for EM exchange rates has historically been contingent on growth and corporate profitability in developing economies. That said, EM exchange rate fluctuations have in recent years become dependent on U.S. real interest rates as the importance of portfolio fixed-income flows into EM has dramatically surged. Both drivers - EM growth and U.S. real yields - are likely to become headwinds for EM exchange rates going forward. EM growth will relapse anew as Chinese growth slows and EM shipments to China decline. Our new money impulse for China2 has historically been a good leading indicator for EM exchange rates, and it points to potentially considerable EM currency depreciation in the next six to nine months (Chart I-6). Meanwhile, U.S. interest rate expectations are very depressed. It will take only slightly stronger U.S. growth and inflation readings or some non-dovish guidance from the Federal Reserve for U.S. interest rate expectations to move higher. The latter will support the U.S. dollar and hurt EM currencies. Although industrial metals prices have recently spiked to new cyclical highs, we believe commodities prices - both for energy and industrial materials - will be lower in the medium term. Global oil stocks are breaking to new cyclical lows, heralding weakness in crude prices (Chart I-7). The fact that oil has failed to post gains amid a notable rally in the euro could be a sign of fundamental vulnerability. Chart I-6China's Money Impulse And EM Currencies China's Money Impulse And EM Currencies China's Money Impulse And EM Currencies Chart I-7Oil Prices Are Vulnerable Oil Prices Are Vulnerable Oil Prices Are Vulnerable As for industrial metals prices, our analysis has not changed: the considerable slowdown in China's broad money heralds a major top in industrial metals prices, as per Chart I-8. The mainland accounts for 50% of global industrial metals consumption, and its capex cycle is of critical importance. What explains the latest spike in base metals prices? Chart I-9 reveals that since early this year, iron ore prices have been negatively correlated with Chinese money market rates (interest rates are shown inverted and are advanced by 30 days Chart I-9). This year's correction and subsequent rebound in iron ore prices might be attributed to changes in mainland traders' positioning due to swings in domestic interest rates. Chart I-8China-Plays Are At Risk China-Plays Are At Risk China-Plays Are At Risk Chart I-9Chinese Interest Rates And Iron Ore Prices Chinese Interest Rates And Iron Ore Prices Chinese Interest Rates And Iron Ore Prices Going forward, either China's growth will decelerate sufficiently enough to weigh on industrial metals prices, or the authorities will resume policy tightening to rein in financial excesses. All in all, the risk-reward for iron ore and other industrial metals is negative. On the whole, lower energy and industrial metals prices will weigh on EM commodities currencies. As for Asian currencies, they are sensitive to global trade. We expect global trade and tradable goods prices to relapse due to the resumption of a slowdown in China/EM demand. Manufacturing-based Asian currencies will depreciate amid budding weakness in their manufacturing sector (Chart I-10). In addition, Chart I-11 shows global auto sales lead global semiconductor sales by several months. The basis for this correlation is that autos nowadays use a lot of semiconductors, and therefore auto cycles affect semiconductor demand. The boom in semi-cycle has been one of the pillars of Asian exports recovery. As the former moderates, the latter will relapse weighing on Asian non-commodities currencies. Chart I-10Asian Manufacturing ##br##And Exchange Rates Asian Manufacturing And Exchange Rates Asian Manufacturing And Exchange Rates Chart I-11Global Auto Sales Lead ##br##Global Semiconductor Sales Global Auto Sales Lead Global Semiconductor Sales Global Auto Sales Lead Global Semiconductor Sales Bottom Line: Our bet remains that EM currencies will depreciate versus both the U.S. dollar and the euro - and regardless of euro/U.S. dollar exchange rate fluctuations. We recommend a short position in a basket of the following EM currencies: ZAR, TRY, COP, CLP, BRL, IDR, MYR and KRW. For market-neutral portfolios, our currency overweights are MXN, RUB, PLN, CZK, TWD, INR and THB. Korean Equities: Downgrading To Neutral We recommend downgrading Korea to neutral from overweight within EM equity portfolios. North Korea will likely remain a source of uncertainty and volatility. BCA's Geopolitical Strategy service does not expect war on the Korean peninsula as long-standing constraints to conflict are still in place, starting with Pyongyang's ability to cause massive civilian casualties north of Seoul via an artillery barrage. As such, the ultimate resolution to the conflict will be a peaceful one. However, getting from here (volatility) to there (negotiated resolution) requires more tensions. The U.S. has to establish a "credible threat" of war in order to move China and North Korea towards a negotiated resolution.3 And that process could take more time, which means more volatility in the markets.4 The overwhelming portion of Korea's equity rally has been driven by a phenomenal surge in one company's share price: Samsung. Excluding technology companies, the performance of MSCI Korea stock prices and their EPS has been mediocre. Samsung's explosive rally has been partially due to the exponential surge in DRAM prices (Chart I-12). On a macro level, we cannot forecast prices of individual semiconductors (such as DRAM). Nevertheless, our assessment is that the global semi cycle is entering a soft patch as per Chart I-11 above. Furthermore, Korea's cyclical growth has already peaked, and will slow going forward (Chart I-13). Broad money growth is still decelerating, entailing that no turnaround is in the cards (Chart I-13, bottom panel). Chart I-12Samsung Share Prices And DRAM Samsung Share Prices And DRAM Samsung Share Prices And DRAM Chart I-13Korea: Cyclical Profile Korea: Cyclical Profile Korea: Cyclical Profile Importantly, the new government has enacted a law to boost minimum wages by 16% in January 2018 and would need to increase by a similar rate annually to reach its 2020 target. Even though there are fiscal subsidies for businesses and minimum wages affect smaller businesses much more than larger ones, odds are that this will still boost overall wage growth, and hence weigh on companies' profit margins. Chart I-14Korean Won Is Expensive Versus The Yen Korean Won Is Expensive Versus The Yen Korean Won Is Expensive Versus The Yen Finally, the Korean won is modestly expensive, based on the unit labor costs-based real effective exchange rate (Chart I-14, top panel). The won is especially expensive versus the yen (Chart I-14, bottom panel). This is negative for Korean manufacturers and the currency. Investment Recommendations Downgrade Korean stocks from overweight to neutral, but continue to overweight Korean technology stocks relative to the EM benchmark. Close long Korea / short EM equities and long Korean banks / short Indonesian banks positions. These positions have produced small gains since their initiation (details on all our open positions are available at the end of each week's report on page 17). Maintain a short KOSPI / long Nikkei in common currency terms trade: Either the won will depreciate substantially versus the yen or the KOSPI will underperform the Nikkei in local currency terms. In both cases, this trade will be profitable. Continue to bet on lower bond yields in Korea via receiving 10-year swap rates. Deflationary pressures from weaker exports - that make up 35% of GDP - will weigh on economic growth, and the central bank will be forced to cut rates. Maintain a short Korean won / long Thai baht position. The won is a high-beta currency and will underperform the Thai baht in a selloff / Asian exports slowdown. The Thai currency will likely trade in a low beta fashion due to the country's large current account surplus and low exposure to both China and commodities. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Take Profits On Long Indian / Short Indonesian Equities Position This recommendation has generated 8.4% gain since its initiation on July 30, 2014, and we recommend booking profits. Indian share prices have outperformed their Indonesian peers over the past year (Chart II-1) but the outlook for top line growth appears to be slightly better in Indonesia than in India. Specifically: We have combined bank credit to businesses and households with government expenditures to calculate a credit and fiscal spending impulse for both countries. Chart II-2 illustrates that this impulse heralds a more positive outlook for listed companies' revenues in the case of Indonesia than India. Chart II-1Book Profits On Long Indian / ##br##Short Indonesian Stocks Position Book Profits On Long Indian / Short Indonesian Stocks Position Book Profits On Long Indian / Short Indonesian Stocks Position Chart II-2Credit And Fiscal Spending ##br##Impulse Favor Indonesia Over India Credit And Fiscal Spending Impulse Favor Indonesia Over India Credit And Fiscal Spending Impulse Favor Indonesia Over India Other cyclical variables are mixed in both economies: vehicle and two-wheeler sales are sluggish, manufacturing PMIs have rolled over, but imports of capital goods are improving (Chart II-3). In regard to valuation and profitability, both bourses are expensive in absolute terms (Chart II-4, top panel) but India's return on equity (RoE) is well below Indonesia's (Chart II-4, bottom panel). Such a 14% premium of Indian stocks over Indonesian ones along with a poor revenue outlook and lower RoE might prevent further share price outperformance by India. Chart II-3Mixed Cyclical Growth Dynamics Mixed Cyclical Growth Dynamics Mixed Cyclical Growth Dynamics Chart II-4India And Indonesian Equities: P/E Ratios And RoEs India And Indonesian Equities: P/E Ratios And RoEs India And Indonesian Equities: P/E Ratios And RoEs Although our negative outlook for commodities prices and expensive equity valuations entail a negative stance on Indonesian risk assets in absolute terms, we believe this bourse's underperformance versus the EM overall equity index and Indian stocks is late. It makes sense to reduce/eliminate an underweight allocation to Indonesian equities. Bottom Line: We recommend booking gains on the long Indian / short Indonesia equity position initiated on July 30, 2014. Consistently, we downgrade Indian stocks from overweight to neutral and upgrade Indonesian ones from underweight to neutral within an EM equity portfolio. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 CFTC is the U.S. Commodity Futures Trading Commission. The data on South African rand is available from May 2015. 2 Presented and discussed in detail in July 26, 2017 and August 16, 2017 reports; the links are available on page 18. 3 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," April 19, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," August 16, 2017, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Despite a tightening in Chinese monetary conditions, dollar bloc currencies have continued to rally. Rising global reserves and strong carry inflows into EM prompted by low global financial volatility have created plentiful liquidity conditions in EM, supporting dollar-bloc currencies. The beginning of the Fed's balance-sheet runoff could reverse these dynamics, hurting the AUD, CAD and NZD in the process. Monitor U.S. inflation, cross-currency basis swap spreads, gold, EM currencies and Chinese monetary conditions to judge when a break in dollar-bloc currencies will materialize. Feature The rally in the dollar-bloc currencies since July 2016 has been nothing short of stunning. We did highlight in April last year that commodity currencies had room to appreciate, but we did not anticipate such a prolonged move.1 In fact, the up leg that began in April 2017 caught us by surprise. At this juncture, it is essential to analyze whether or not the bull move in commodity currencies has further to run, or whether it is in its final innings. A principal component analysis of the returns of the AUD, the CAD, and the NZD shows that despite differing central bank postures in the three countries, a simple common factor explains 86% of their variability against the USD since 2010 (Chart I-1). Because of this result, our focus in this week's report are the global forces that may be driving this factor. Today, the key risk to the dollar-bloc currencies is global liquidity tightening. Behind this danger lies the removal of policy accommodation in the U.S., and the risks to carry trades created by the already-very-low volatility of risk assets. A China-Fueled Rebound, But Something Is Amiss... The key reason behind the rally in commodity currencies has been improvement in EM growth relative to DM economies since 2016 (Chart I-2). This growth outperformance has been underpinned by a few factors. Chart I-1One Factor To Drive Them All One Factor To Drive Them All One Factor To Drive Them All Chart I-2Commodity Currencies And EM Growth Commodity Currencies And EM Growth Commodity Currencies And EM Growth China has played an essential role. As the Chinese economy decelerated in 2015, Beijing implemented a large amount of fiscal stimulus, which saw government spending grow at a 25% annual rate in November 2015. Due to the lags of stimulus on the economy, the full force of that stimulus was felt in 2016. Direct fiscal goosing was not the only road taken by Beijing. The Chinese authorities also applied a considerable amount of monetary pressure on China. After tightening massively through 2015, Chinese monetary conditions eased greatly in 2016 as real borrowing costs collapsed from a peak of 10.5% in the fall of 2015 to a trough of -3.5% earlier this year (Chart I-3). Directed expansion of credit through banking channels was also used to support the economy, resulting in a surge in the Chinese credit impulse. However, in recent months these positives have dissipated. Chinese money growth has slowed, and the combined credit and fiscal impulse has been lessened. Yet EM equity prices, copper prices and commodity currencies are all continuing their rally, and are now re-testing their May 2015 levels - levels last experienced right before EM assets and related plays entered a vicious tailspin that lasted all the way until January 2016 (Chart I-4). Chart I-3China: From Tailwind ##br##To Headwind China: From Tailwind To Headwind China: From Tailwind To Headwind Chart I-4EM, Copper, Dollar Bloc: ##br##Back To May 2015 Levels EM, Copper, Dollar Bloc: Back To May 2015 Levels EM, Copper, Dollar Bloc: Back To May 2015 Levels Bottom Line: The rally in dollar-bloc currencies that begun in January 2016 was powered by improving growth performance within EM economies. The original driver behind this move was Chinese monetary and fiscal stimulus. However, even once the easing faded, EM plays, including the AUD, the CAD and the NZD continued to appreciate. Another factor is currently at play. ...And This Something Is Global Liquidity Our view is that global liquidity is now the key factor supporting EM plays in general and dollar-bloc currencies in particular. Since the end of 2016, we have seen a rebound in the Federal Reserve's custody holdings - one that has happened as foreign central banks resumed their purchases of Treasury securities (Chart I-5). Fed custodial holdings for other monetary authorities are a key component of our dollar-based liquidity indicator. A rebound in this indicator tends to be associated with a surge in high-powered money globally. The capital outflows from China have dissipated, helping high-powered money find its way into EM plays and the commodity-currency complex. Private FX settlements - a proxy for the Chinese private sector's selling of yuan - was CNY -43 billion in July, a massive improvement compared to the CNY 800 billion in outflows experienced in August 2015 (Chart I-6). Through stringent administrative controls and a lessening of deflation, China gained the upper hand over its capital account. This development has two implications: it means that China does not need to sell reserves anymore, and in fact has been accumulating Treasurys since February 2017. It also means that investors are now less afraid of a sudden devaluation in the CNY, which has heartened risk-taking globally - especially in assets most exposed to China, which includes EM, commodities and dollar-bloc currencies. Chart I-5Easing Global Liquidty In 2017 Easing Global Liquidty In 2017 Easing Global Liquidty In 2017 Chart I-6Chinese Capital Account Under Control Chinese Capital Account Under Control Chinese Capital Account Under Control The collapse in the volatility of risk assets has been an additional element helping global liquidity make its way into EM plays and commodity currencies. As Chart I-7 illustrates, there is a relationship between the realized volatility of the U.S. stock market and the performance of dollar-bloc currencies. The first hunch is to dismiss the relationship as an artifact of the fact that both stock prices and commodity currencies are "risk-on" instruments. But there is an economic underpinning behind this relationship. As we argued in a Special Report on carry trades last year, the main reason carry trades have been able generate high Sharpe ratios since the 1980s is because they offer investors a risk premium for taking on exposure to unforeseen spikes in volatility.2 As a result, when the volatility of risk assets collapses, as has been the case recently, carry currencies outperform. The opposite holds true when volatility spikes back up. Chart I-7Dollar Bloc Currencies Like Low Vol Dollar Bloc Currencies Like Low Vol Dollar Bloc Currencies Like Low Vol When carry trades do well, investors end up aggressively buying EM currencies. As a result of these purchases, they inject funds - i.e. liquidity - into these economies. These injections of liquidity end up boosting money growth and supporting their economic activity, which stimulates global trade, commodity prices, and thus commodity currencies - even if these are not currently "high-yielders." Bottom Line: Chinese monetary conditions have deteriorated, creating a handicap for EM assets and the dollar-bloc currencies. Nonetheless, an increase in high-powered money growth, a decline in the risk premium to compensate investors for the risk of sudden new Chinese devaluation, and a collapse in global financial volatility have reinforced each other to create the ideal breeding ground for a rally in the AUD, the CAD and the NZD. The Sweet Spot Is Passing At the current juncture, the sweet spot for the dollar-bloc currencies may be passing. To begin with, commodity currencies are trading at a significant premium to underlying commodity prices, suggesting they are expensive and vulnerable to a decrease in global liquidity (Chart I-8). The AUD and the NZD stand out as especially expensive, while the CAD is only trading at a small premium to its long-term fair value (Chart I-9). This suggests that the Canadian dollar is likely to continue to outperform the Australian and New Zealand currencies, as it has been doing in choppy fashion since November 2016. Chart I-8Dollar Bloc Currencies Are Expensive Dollar Bloc Currencies Are Expensive Dollar Bloc Currencies Are Expensive Chart I-9AUD And NZD Are Expensive AUD And NZD Are Expensive AUD And NZD Are Expensive Another problem for dollar-bloc currencies is that they have greatly overshot global liquidity metrics. Historically, the commodity currencies have moved in lockstep with the evolution of global central bank reserves - a key measure of global liquidity (Chart I-10). While global reserves have improved, the average of the AUD, the CAD and the NZD has over-discounted this positive, pointing to potential vulnerability once liquidity ebbs. The problem with this overshoot is that liquidity is likely to decline with the imminent reduction in the Fed's balance sheet size. As Chart I-11 shows, the USD has been closely linked to changes in the reserves of commercial banks held at the Fed. As commercial banks accumulate excess reserves, this provides fuel for the repo market and the Eurodollar market, creating a supply of globally available USD for offshore markets. However, mechanically, once the Fed lets the assets on its balance sheet run off (its holdings of Treasurys), a liability will also have to decrease. This liability is most likely to be excess reserves as banks buy the Treasurys sold by the Fed. A fall in the accumulation of reserves of commercial banks in the U.S. is also directly linked with weaker dollar-bloc currencies (Chart I-12). This is because falling reserves push up the dollar and hurt commodity prices - a negative terms-of-trade shock for the AUD, the CAD and the NZD. Moreover, less reserves point to less liquidity making its way into EM economies. This also hurts the expected returns of holding assets in dollar-bloc economies. This therefore means that not only is there less liquidity available to move into these markets, the rationale to do so also dissipates. Without this dollar-based liquidity support, the tightening in Chinese monetary conditions could finally show its true impact on commodity currencies. Chart I-10Commodity Currencies Have##br## Overshot Global Liquidity Commodity Currencies Have Overshot Global Liquidity Commodity Currencies Have Overshot Global Liquidity Chart I-11Falling Excess Bank Reserves##br## Equals Strong Greenback Falling Excess Bank Reserves Equals Strong Greenback Falling Excess Bank Reserves Equals Strong Greenback Chart I-12Falling Excess Reserves Equals##br## Falling Commodity Currencies Falling Excess Reserves Equals Falling Commodity Currencies Falling Excess Reserves Equals Falling Commodity Currencies The last worrisome development for the dollar-bloc currencies is the volatility of financial assets. When volatility falls, it creates a wonderful environment for these currencies. But today, historical volatility is near the bottom of its distribution of the past 28 years. Being a highly mean-reverting series, it is thus more likely to rise than fall further going forward. There are three fundamental factors pointing to a potential reversal. First, share buyback activity has been declining, which historically points to rising volatility. Second, the U.S. yield curve slope also points toward a higher level of volatility. Volatility tends to bottom before the stock market peaks, and the stock market tends to peak before the economy enters recession. The yield curve itself tends to invert a year or so before a recession emerges. As a result, the yield curve begins to flatten around two years before volatility picks up (Chart I-13). Third, the anticipated decline in bank reserves - an important factor that has supported risk-taking around the globe - is likely to be the key catalyst supporting the relationship between the yield curve and volatility. If volatility increases, carry trades are likely to perform poorly, which will hurt EM currencies and result in outflows from these markets. This will cause liquidity conditions in EM economies to dry out, hurting their growth outlook. EM M1 growth has already weakened considerably, and is currently pointing to problems for commodity currencies (Chart I-14). The dry out in liquidity resulting from a reversal in carry trades will only amplify this phenomenon. Chart I-13Listen To The Yield Curve: ##br##Volatility Will Pick Up Listen To The Yield Curve: Volatility Will Pick Up Listen To The Yield Curve: Volatility Will Pick Up Chart I-14EM M1 Growth Is Becoming ##br##A Headwind For The Dollar Bloc EM M1 Growth Is Becoming A Headwind For The Dollar Bloc EM M1 Growth Is Becoming A Headwind For The Dollar Bloc Bottom Line: Global liquidity conditions are set to begin to tighten. While it is probably not enough to cause the bull market in stock prices to end now, it could be enough to affect the area of the global economy most exposed to this risk factor: carry trades and the dollar-bloc currencies. Specifically, commodity currencies are likely to be negatively affected by their elevated valuations, their strong sensitivity to excess bank reserves, and their high responsiveness to changes in financial market volatility. Key Indicators To Monitor After the surge that the dollar-bloc currencies have experienced since the spring and the large increase in the long exposure of speculators to these currencies, they are naturally at risk of experiencing a period of weakness. However, what worries us is not a retracement of 3-4%, but rather a 10-15% move. We suggest monitoring the following: First, watch U.S. inflation closely. The U.S. dollar is only likely to genuinely rally once the market believes the Fed can actually increase rates. So long as inflation remains tepid, investors will continue to second-guess the Fed. The market's response to this week's release of the most recent Federal Open Market Committee minutes only confirmed this. Mentions of debate on inflation within the FOMC was enough to send bond yields and the dollar reeling. However, based on the dynamics in the U.S. velocity of money, we continue to expect inflation to pick up in the second half of 2017 (Chart I-15).3 Second, follow cross-currency basis swap spreads. The cost of hedging U.S. assets back into euro or yen has normalized somewhat after hitting record levels in early 2016 (Chart I-16). If the removal of excess bank reserves in the U.S. system does affect global liquidity conditions, this market will be one of the first to be affected. Third, scrutinize the price of gold. The yellow metal remains a key gauge of global liquidity. Moreover, it is extremely sensitive to real rates and the dollar - two major determinants of the cost of global liquidity. In the summer of 2015, EM and dollar-bloc currencies severely suffered once gold broke below 1150. Today, a break below 1200 would be a sign of danger ahead. Fourth, watch EM currencies. A breakdown in EM currencies would be a key indication that carry trades are being reversed, and that global liquidity is no longer making its way into EM and EM-related plays. Commodity currencies are currently trading at a premium to their historical relationship with EM currencies, suggesting they would be highly vulnerable to such an event (Chart I-17). Chart I-15Watch U.S. Inflation Watch U.S. Inflation Watch U.S. Inflation Chart I-16Monitor Cross-Currency Basis Swap Spreads Monitor Cross-Currency Basis Swap Spreads Monitor Cross-Currency Basis Swap Spreads Chart I-17Dollar-Bloc Currencies At The Mercy Of EM FX Dollar-Bloc Currencies At The Mercy Of EM FX Dollar-Bloc Currencies At The Mercy Of EM FX Finally, keep an eye on Chinese monetary conditions. If Chinese monetary conditions improve from here, it would alleviate some of the negative pressure exercised on dollar-bloc currencies by the upcoming deterioration in global liquidity. However, if Chinese monetary conditions deteriorate further, this would negatively affect commodity prices, EM returns and the commodity currency complex. It would also hurt expected returns on Chinese assets, re-kindling outflows out of China and thus raising the risk premium associated with what would become a growing risk of CNY depreciation. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Pyrrhic Victories", dated April 29, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled, "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report titled, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data has been mixed this week: The Empire State Manufacturing Index increased to 25.2, a significant jump and beat Retail Sales increased at a 0.5% monthly pace, with the ex. Autos measure increasing at 0.5%, both beating expectations; The Import Price Index increased by 1.5% since last year; Initial jobless claims dropped to 232,000, beating expectations significantly; However, housing starts and building permits both underperformed expectations. While the DXY has rebounded, the FOMC's July minutes discussed the recent shortfall of inflation, which was interpreted bearishly by markets. The Fed is likely to begin normalizing its balance sheet very soon, as well as raising rates again by the end of this year. The greenback will likely continue its ascent when firmer inflation data emerges. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Improving euro area growth prospects have propelled the euro 12% higher since the beginning of the year. However, the market seems to begin questioning the ECB's hawkishness. In its minutes, the ECB expressed worries about a potential euro overshoot. Additionally, rumors emerged that Mario Draghi will not give much guidance in Jackson Hole. Together, these stories have reversed some of the euphoria that had engulfed the euro. The tightening in euro area financial conditions relative to the U.S. has prompted a roll over in relative economic and inflation surprises, justifying these budding doubts. Furthermore, U.S. inflation should begin to meaningfully accelerate in the fall. This is likely to add to the euro's weakness, as the greenback will resume its upward trend. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Data in Japan was mixed this week: Annualized gross domestic product growth grew by 4% on an annualized basis, crushing expectations. Additionally the month-to-month growth of industrial production came in at 2.2%, also beating expectations. However both export and import growth underperformed, coming in at 13.4% and 16.3% respectively. On cue, after we placed a long USD/JPY trade last week, USD/JPY rallied half percentage point, even if it gave up some of the gain now. We continue to be bearish on the yen as we expect U.S. yields to start picking up, in an environment where market expectations are very depressed. But could a correction in EM caused by the rise in the dollar help the yen? Not in the short term, given that historically the yen only gains in very sharp EM selloffs that themselves weigh on bond yields. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data in the U.K. was mixed this week: Retail sales prices increased by 3.6% year-on-year, outperforming expectations. However, The trade balance not only worsened since last month but also came in below expectations, at -4.564 Billion pounds Crucially, most inflation metrics came in below expectations, with headline inflation coming in at 2.6% while PPI core output inflation came in at 2.4%. Overall, we continue to believe that the market's rate expectations for the BoE remain too hawkish. As the pass through from the currency dissipates, inflation should also start to come down. Furthermore, one has to remember that the BoE has a higher hurdle for raising rates than other central banks due to the unique situation in which the U.K. is currently in. Lowered rate expectations will be negative for cable in the short term. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Despite initially weak data, a risk-on environment and increasing copper prices have fueled a rally in the AUD. Data from China has been soft, and Australian data has been neutral: Chinese retail sales increased annually by 10.4%, less than expected; Chinese industrial production also underperformed at 6.4%; Australian wages increased at a 1.9% annual pace, in line with expectations; Australian unemployment dropped to 5.6%; participation rate increased to 65.1%; and a net of 27,900 jobs were filled. However, full-time employment went down by 20,300 while part-time employment increased by 48,200, so hours worked contracted. This development is likely to comfort the RBA in its dovish stance. In its minutes, the RBA discussed its worries concerning the housing market, and that "borrowers investing in residential property had been facing higher interest rates". This further worries the RBA regarding the impact of higher interest rates, limiting the room for more hawkish speeches. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been positive: Retail sales and retail sales ex-autos Quarter-on-quarter growth strengthened relatively to the previous quarter, coming in at 2% and 2.1% respectively. Moreover quarter-on-quarter inflation both for producer prices in outputs and inputs outperformed expectations, coming in at 1.3% and 1.4%. Currently, differences in perception adjustment between the dovishness of the RBNZ and the RBA have pushed Australian rate expectations to the point that the market is now pricing a hike in Australia before New Zealand. Overall, this seems like a mispricing, as the kiwi economy is on a stronger footing than the aussie one. Moreover, a slowdown in China would be more harmful for Australia as iron ore is more sensitive to the Chinese industrial cycle than dairy products. Thus we remain bearish on AUD/NZD. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD has regained some composure despite weak oil prices. Even with the U.S. dollar weakening and inventories drawing massively, oil dropped. This dynamic is particularly worrying for oil, as the markets are doubting the durability of the curtailment in global oil production. While this could be worrying for the CAD, we still believe the USD 40-60/bbl equilibrium price level, as postulated by the BoC, will have a limiting effect on the oil-based currency, which has been driven by interest rate differentials. Both central banks are now hiking, but we believe that markets are underpricing Fed hikes. Thus, the CAD should weaken against USD. However, it will outperform other G10 currencies. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data has continued to show a mixed picture for the Swiss economy: Consumer prices inflation, increased slightly from the previous month, coming in at 0.3%, in line with expectations. The unemployment rate also came in in line of expectations at 3.2%, unchanged from the previous month. However, producer prices contracted by 0.1%, underperforming expectations. EUR/CHF has been weakening since its August second overbought extreme. For the moment, we expect the SNB to stand pat in its ultra-dovish monetary policy, at least until inflation and other economic indicators start to strengthen considerably. USD/CHF however might appreciate, given that the euro might fall the ECB minutes this week showed that the ECB is concerned by a potential euro overshoot. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Data in Norway this week was mixed: Headline inflation came in at 1.5% in July, outperforming expectations. However, it softened from June's 1.9% reading. Core inflation came at 1.2% in July, in line with expectations, decreasing from 1.6% in June. Moreover, manufacturing output contracted by 0.6% year-on-year. We continue to be bullish on USD/NOK, as the increasing gap in real rate differentials between the United States and Norway should outweigh any oil rally. Indeed, the recent numbers in Norway illustrate the lack of inflationary pressures in this Scandinavian country. This should keep a lid on rates, and thus help USD/NOK. On the other hand EUR/NOK should follow the path of oil. Thus, the OPEC supply cuts will ultimately support oil prices and thus, weigh on this cross. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The SEK has had a particularly strong week, as inflation surprised to the upside on both a monthly and a yearly basis, coming in at 0.5% and 2.2% respectively. While it initially appreciated against all currencies, the uptick in commodity currencies on Wednesday made it lose its gains against AUD, CAD, NZD and NOK. As inflationary pressures grow, the SEK is likely to appreciate further, especially against the EUR and GBP. Additionally, with current Riskbank governor Stefan Ingves' term coming to an end by the end of this year, the hawkish rhetoric is likely to only increase. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights Washington must establish a "credible threat" if it is to convince Pyongyang that negotiations offer the superior outcome; The process of establishing such a credible threat is volatile; U.S. Treasurys, along with Swiss and Japanese government bonds have been consistent safe haven assets; The risk of a U.S. attack against North Korea is a red herring, while the crisis itself is not; We suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Feature Brinkmanship between Pyongyang and Washington, D.C. has roiled markets over the past week. The uptick in rhetoric has not come as a surprise. Since last year, BCA's Geopolitical Strategy has stressed that souring Sino-American relations were the premier geopolitical risk to investors and that China's periphery, especially the Korean peninsula, would be the "decisive" factor for markets.1 North Korea's nuclear ambitions - which could be snuffed out immediately by a concerted and coordinated effort by China and the U.S. - are a derivative of the broader U.S.-China dynamic. The U.S. is unlikely to use military force to resolve its standoff with North Korea. There are long-standing constraints to war, ones that all of the interested parties know only too well from their experience in the Korean War of 1950-53. The first of these is that war is likely to bring a high death toll: Pyongyang can inflict massive civilian casualties in Seoul with a conventional artillery barrage; U.S. troops and Japanese troops and civilians would also likely suffer. Second, China is unlikely to remain neutral, given its behavior in the 1950s, its persistent strategic interest in the peninsula, and its huge increase in military strength relative to both the past and to the United States. However, the process by which the U.S. establishes a "credible threat" of military action is volatile.2 Such a credible threat is necessary if Washington is to convince Pyongyang that negotiations offer a superior outcome to the belligerent status quo. Viewed from this perspective - which is informed by game theory -President Donald Trump has not committed any grave mistakes so far, but has rather shrewdly manipulated the world's perception that he is mentally unhinged in order to enhance his negotiating leverage. It is unclear how long it will take Trump to convince North Korea that the threat of a U.S. preemptive strike is "credible." As such, it is unclear how long the current standoff will persist. From an investor perspective, it will be difficult to gauge whether the brinkmanship and military posturing are part of this "territorial threat display" or evidence of real preparations for an actual attack. As such, further volatility is likely. The ongoing crisis in North Korea is neither the first nor the last geopolitical crisis the world will face in today's era of paradigm shifts.3 We have long identified East Asia as the cauldron of investment-relevant geopolitical risks.4 This is a dynamic produced by the multipolar global context and the geopolitical disequilibrium in the Sino-American relationship. For now, investors have been able to ignore the rising global tensions (Chart 1) due to the ample liquidity emanating from central banks, but the day of reckoning is nigh (Chart 2). Chart 1Multipolarity Increases Conflict Frequency Multipolarity Increases Conflict Frequency Multipolarity Increases Conflict Frequency Chart 2Day Of Reckoning? Day Of Reckoning? Day Of Reckoning? Q&A On North Korea Back on April 19, we wrote a Special Report, "North Korea: Beyond Satire," which argued that North Korea had at last become a market-relevant geopolitical risk after decades of limited impact (Chart 3).5 Chart 3North Korean Provocations Rarely Affect Markets For Long North Korean Provocations Rarely Affect Markets For Long North Korean Provocations Rarely Affect Markets For Long Looking to the next steps, we introduced the "arc of diplomacy," a framework comparable to the U.S.-Iran nuclear negotiations from 2010-15 (Chart 4). We predicted that the U.S. would ultimately ramp up threats for the purpose of achieving a diplomatic solution. The U.S. was constrained and would only go to war if an act of war were committed, or appeared imminent.6 Chart 4Arc Of Diplomacy: Tensions Ramp Up As Nuclear Negotiations Begin Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? This assessment is now playing out. But not all clients are convinced of our logic, as we have found in our travels throughout Asia Pacific and elsewhere this month. Below we offer a short Q&A based on questions we have received from clients: Q: Diplomacy has already been tried, so why won't the U.S. attack? A: The U.S. public has less appetite for war, especially a preemptive strike, in the wake of the Iraq War, and has not suffered a 9/11 or Pearl Harbor-type catalyst. The U.S. will exhaust diplomatic options before joining a catastrophic second Korean War. And the diplomatic options are far from exhausted. The latest round of sanctions are tighter and more serious than past ones, but still leave categories untouched (like fuel supplies to the North) and are still very hard to enforce (like cutting illegal North Korean labor remittances). Enforcement is always difficult, and the U.S. is currently attempting to ensure that its allies enforce the sanctions strictly, not to mention its rivals (i.e. Russia and China). While we do not think China will ever impose crippling sanctions, we do think it can tighten them up considerably, which could be enough to change the North's behavior. Q: Why doesn't China just take North Korea out? A: China is a formal political, military, and ideological ally of North Korea, and has a strategic interest in maintaining a buffer space on the Korean peninsula - which it defended at enormous human cost in the Korean War. This interest remains in place. China is far more likely to aid and abet a nuclear-armed ally in North Korea than it is to endorse (much less participate in) regime change. The fallout from a new war, such as North Korean refugees flooding into China, is extremely undesirable for China, though it could handle the problem ruthlessly. China would also prefer not to have to occupy a collapsing North, which would be an extensive and dangerous entanglement. Therefore, expect China to twist Pyongyang's arm but not to break its legs. On a more topical note, China is consumed with domestic politics ahead of the nineteenth National Party Congress. It is perhaps more likely to take action after the congress in October-November. Q: Will U.S. allies cooperate with Trump? Why not bandwagon with China to gain economic benefit? A: South Korea is the best litmus test for whether Trump is causing U.S. allies to drift. The new South Korean President Moon Jae-In, who is politically left-of-center, has played his cards very carefully and started out on good footing with President Trump. A disagreement appears to be a likely consequence of Moon's agenda, which calls for extensive engagement with the North and a review of the U.S. THAAD missile defense deployment in Korea. So far, however, Moon is reaffirming the alliance, in his own way, and Trump has not (yet) expressed misgivings about him. If this changes significantly - as in, South Korea joining with China to give North Korea significant economic aid in defiance of U.S. sanctions efforts - then it would be a sign of division among the allies that would benefit North Korea and could even increase the risk of the U.S. taking unilateral action. The odds of that are still low, however. We have been short the Korean won versus the Thai baht since March 1, and the trade is up 6.03%. We also expect greater volatility and higher prices of credit default swaps to plague South Korea while the crisis continues over the coming months. We are closing our long Korean consumer stocks trade versus Taiwanese exporters for a loss of 4.24%. Q: What is Japan's role in the current crisis? What is the impact on Japan? A: Japan is one of the few countries whose relations with the U.S. have benefited under the Trump administration. The Japanese are in lock-step so far in reacting to North Korea. The government has been sounding louder alarms about North Korea for the past year, including by conducting evacuation drills in the case of attack. Japan has long been within range of North Korea's missiles, but its successes in nuclear miniaturization pose a much greater threat. Not only does North Korea pose a legitimate security risk, but Japanese Prime Minister Shinzo Abe also stands to benefit at least marginally in terms of popular support and support for his controversial constitutional revision. This will, in turn, feed into the region's insecurities. Yen strength as a result of the crisis, however, would be a headwind to Japan's economic growth. Thus Abe has a tightrope to walk. We expect him to take actions to ensure the economy continues to reflate. Q: Is Trump rational? How do we know he won't push the nuclear button? A: Ultimately this is unknowable. It also involves one's philosophical outlook. Josef Stalin and Mao Zedong both committed atrocities by the tens of millions but did not use nuclear weapons. Nikita Khrushchev practically wrote the playbook that North Korea's Kim dynasty has used in making its belligerent nuclear threats. Yet Khrushchev ultimately agreed to détente. Kim Jong Un makes Trump look calm. The combination of Kim and Trump is worrisome; but so was the combination of Eisenhower and Khrushchev, one believing nuclear weapons should be used if needed, the other threatening wildly to use them. It may be the case that the threat of an atrocity, or (in Kim's case) of total annihilation, is enough to keep decisions restrained. As we go to press, Kim has ostensibly suspended his plan to fire missiles around Guam and U.S. officials have repeatedly stated that they would not attack unless attacked. Stairway To (Safe) Haven Revisited In expectation of increased frequency of geopolitical risks, BCA's Geopolitical Strategy has produced two quantitative analyses of safe haven assets over the past two years. The first, "Geopolitics And Safe Havens," unequivocally crowned gold as the ultimate safe haven (Table 1), while showing that the USD is not much of a defense against geopolitical events (Chart 5).7 Table 1Safe-Haven Demand Rises During Crises Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Table 1Safe-Haven Demand Rises During Crises Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? As such, investors should fade the narrative that the failure of the USD to appreciate amidst the latest North Korean imbroglio is a sign of some structural weakness. The greenback continues to underperform due to weak inflation in the U.S., a fleeting condition that our macro-economist colleagues expect to reverse. Mathieu Savary, BCA's currency strategist, believes that more upside exists for the USD regardless of the geopolitical outcome: Chart 5Gold Loves Geopolitical Crises Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Chart 6DXY Is Cheap... DXY Is Cheap... DXY Is Cheap... Chart 7...But The Euro Is Not ...But The Euro Is Not ...But The Euro Is Not First, the dollar is currently trading at its deepest discount to the BCA Foreign Exchange Service augmented interest rate parity model since 2010 (Chart 6). The euro, which accounts for 58% of the DXY index, is its mirror image, being now overvalued by two sigma, the most since 2010 (Chart 7). Second, bullish euro bets will dissipate as Europe's economic outperformance versus the U.S. fades. Financial conditions have massively eased in the U.S., while they have tightened in Europe, resulting in the biggest upswing on euro area growth relative to the U.S. in over two years (Chart 8). Such an economic outperformance by the U.S. should lead to a strengthening greenback (Chart 9).8 Chart 8Easing Versus Tightening FCI Easing Versus Tightening FCI Easing Versus Tightening FCI Chart 9PMIs Point To USD Rally PMIs Point To USD Rally PMIs Point To USD Rally Our second attempt to quantify safe-haven assets, "Stairway To (Safe) Haven: Investing In Times Of Crisis," concluded that U.S. Treasurys, Swiss bonds, and Japanese bonds are the best performers in times of crisis.9 We considered 65 assets10 (Table 2) with five different methodologies and back-tested them empirically within the context of 25 financial and geopolitical events since January 1988. Some of these assets have been proven to perform as safe havens by previous academic research, some are commonly utilized in investment strategies, and others could provide alternatives (see Box 1 for further details). Table 2Scrutinizing The World For Safe Havens Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? This report demystifies four key issues related to safe havens: Part I identifies what qualifies as a safe-haven asset. Unsurprisingly, the best performers are U.S. Treasurys along with Swiss and Japanese bonds due to their currency effects. Part II examines if safe havens change over time. We find that gold and Treasurys have changed places as safe havens, and that JGBs and Swiss bonds have a long history as portfolio protectors. Part III breaks down safe havens through an event analysis. We look at the country of origin, the nature of the crisis, and whether the risk is a "black swan" or "red herring" - two classifications of events that BCA's Geopolitical Strategy has established - all of which have an impact on their performance. But red herrings or black swans are only defined after the fact, thus requiring geopolitical analysis or market timing indicators to be able to act on them. Part IV demonstrates that timing plays a crucial part when investing in safe havens as their performance is coincident with that of equities. Box 1 Safe Havens - A Literature Review In a previous Geopolitical Strategy Special Report published in November 2015, it was established that shifts in economic and political regimes alter investors' preferences for safe-haven assets, and that Swiss bonds and U.S. 10-year Treasurys were at the top of that list.11 Also, statistical methods were used to demonstrate that gold had acted as a safe haven from the 1970s to the early 90s, but has since lost its status due in part to a new era of looming deflationary risks. Li and Lucey (2013) have identified a pattern in precious metals, through a series of quarterly rolling regressions testing the significance of the 1st, 5th and 10th percentile movements in U.S. equity movements against safe-haven assets, catching extreme negative events. For instance, the 1st percentile captures the very worst corrections that have occurred, the one that represent the bottom 1% of the equity performances. The 5th and 10th percentiles represent the 5% and 10% lowest returns for equities, respectively. The authors demonstrated that silver, platinum and palladium act as safe havens when gold does not.12 Similarly, Bauer and McDermott (2013) examined the 1st, 5th and 10th percentile movements in U.S. equity movements and proved that both gold and U.S. Treasurys can serve as safe havens, but that gold has the best record in times of extreme financial stress.13 Baele et al. (2015) concentrated on flight-to-safety episodes, which they characterized as events in which the VIX, TED spreads and a basket of CHF, JPY, and USD all increased drastically.14 They found that during flight-to-safety episodes, large cap stocks outperform small caps, precious metal and gold prices (measured in dollars) increase slightly, while bond returns exceed those of the equity market by 2.5-4 percentage points. Baur and Glover (2012) provide further evidence that gold can no longer be utilized as a safe haven due to increased speculation and hedging. Their main finding is that gold cannot be both an investment and a safe-haven asset. That is, gold can only be effective as a safe haven if the periods prior to the event had not generated significant investment demand for gold.15 Using high-frequency exchange rate data, Ranaldo and Soederlind (2010) conclude that the CHF, EUR and JPY have significant safe-haven characteristics, but not the GBP.16 The strongest safe havens are identified as the CHF and JPY, but the returns are partly reversed after a day of safe-haven protection. They also find that the nature of the crisis has a significant effect on safe-haven properties. For instance, a financial crisis and a natural disaster produced drastically different outcomes for the yen. Part I - Safety In Numbers Our first step in identifying safe-haven assets was to review each asset's performance against equities in times of crisis. As such, we conducted a series of threshold regressions to generate a list of true safe-haven assets - assets that have a statistically significant positive performance in times of turmoil. Our method is explained as follows: Step 1 - Percentile Dummies: Following methods from Li and Lucey (2013) and Bauer and McDermott (2013), we created dummy variables for the 1st, 5th and 10th percentile of the S&P 500 daily total returns since 1988. We then multiplied each of these dummies by their corresponding stock returns (see Box 1 for further detail). Step 2 - Regressions: Using the 64 potential safe-haven assets, we ran a series of regressions both in USD and the local currency, testing each asset's returns explained by the three percentile dummies.17 Step 3 - Identifying Safe Havens: We then quantified strong safe-havens as assets having significant coefficients for all three return thresholds (1st, 5th and 10th percentile of the S&P 500 daily total returns). Results - Seek Refuge In Currencies And Government Bonds: Our quantitative results are mainly consistent with what others have found in the past: the Japanese yen and most G10 government bonds are safe havens. Table 3 shows the safe-haven assets that generated negative coefficients versus equities for all three threshold percentiles. Table 3Seeking Protection Against Corrections Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? In our threshold regressions expressed in USD terms, we found that the Japanese yen, Quality Stocks,18 and Japanese, Swiss and U.S. bonds acted as strong safe havens. Currencies play a crucial part in the performance of safe havens. In fact, in local-currency terms, a series of G10 government bonds (U.S., Canada, Belgium, France, Germany, Netherlands, Sweden, Switzerland, and the U.K.) proved to be the most useful safe havens. In sum, true or strong safe havens are government bonds that have currencies that add to positive returns during times of crisis. Unsurprisingly, this select group of strong safe-haven assets is comprised of U.S., Japanese, and Swiss government bonds. Quality Stocks did provide positive and statistically significant results, but the returns were very low - for this reason, we excluded them from our basket of strong safe havens. While gold, the Swiss franc, and the U.S. dollar did generate positive returns during times of crisis, they failed to generate statistically significant results at all three thresholds. Bottom Line: Based on our econometric work, most G10 government bonds can act as safe havens. But due to strong currency effects, our models favor what are already commonly known as safe havens: U.S., Japanese, and Swiss government bonds. Simply put, the difference between this select group and other G10 bonds is that their currencies rise or are stable during turmoil, while the currencies of the other G10 bonds do not. Part II - Are Safe Havens Like Fine Wines? U.S., Japanese, and Swiss government bonds were not always the top assets providing protection against the downside in equities, however. To determine whether safe-haven properties change, we examined the evolution of the relationship between safe havens and U.S. equity markets over time with the following model: Step 1 - Rolling Regressions: Considering the results obtained in Part I, we restricted our sample to G10 governments in USD and local-currency terms, Quality Stocks, gold, JPY, EUR, and USD for this statistical procedure. We put these remaining assets, both in USD and local-currency terms, through a series of 1-year rolling regressions.19 Step 2 - Identifying Trends: Each regression generated a coefficient that explained the relationship between equities and safe havens (B1). We created a new time series by collecting the coefficients for each data point and smoothing them using a five-year moving average, thus depicting a long-term pattern in the evolution of safe havens. Results - A Regime Shift In Gold And Treasurys: Our findings show that safe-haven assets fall in and out of favor through time (Charts 10A, B & C). Most striking are the changes in U.S. Treasurys and gold. Only after 2000 did Treasurys start providing a good hedge for equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. That said, gold's coefficient has been falling closer to zero lately, illustrating that it could soon resurface as a proper safe haven, especially if deflation risks begin to dissipate. Given that this is precisely the conclusion stated by our colleague Peter Berezin - BCA's Chief Global Strategist - and our own political analysis, we suspect that gold may be resurrected as a safe haven very soon.20 Chart 10ASafe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Chart 10BSafe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Chart 10CSafe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Safe Havens Don't Necessarily Age Well Another important finding is that the currency effect plays a key role during recent risk-off periods (Charts 11A & B). The best protector currencies are the ones that are negatively correlated with equity returns. According to our results, the CHF and the JPY have generally been risk-off currencies, while the USD has only been one since 2007, switching places with the euro. This reinforces the case for U.S., Japanese, and Swiss government bonds, which are supported by risk-off currencies. Chart 11ACurrencies Are Difference Makers Currencies Are Difference Makers Currencies Are Difference Makers Chart 11BCurrencies Are Difference Makers Currencies Are Difference Makers Currencies Are Difference Makers Bottom Line: Safe havens change over time. Gold fell out of favor due to global deflationary dynamics. With inflation on the horizon, we will keep monitoring the relationship between gold and equities for a possible return of the yellow metal as a safe haven. Since the July 4 North Korean ICBM test, for example, gold has rallied 4.8%. Part III - Red Herrings And Black Swans Since 1988, we identified 25 economic and (geo)political events that generated instant panic or acute uncertainty in the media and financial markets.21 We analyzed the short-term reactions of the safe-haven assets, both in USD and local-currency terms. This methodology allowed for the deconstruction of the impact of the events by the following factors: Country of origin of the crisis, the nature of the crisis, and whether the event was a "red herring" or a "black swan." Generally speaking, a red herring event is a crisis of some sort with little lasting financial impact. A black swan, on the other hand, is an event that has a very low probability of occurring but has a pronounced market impact if it does. Quantitatively, our definition of a black swan is an event that produces an immediate negative response in the S&P 500 below -1%, while creating a rise in either U.S., Japanese, or Swiss government bonds above 0% (Table 4). Of course, determining which event is a red herring or a black swan is only obvious post-facto and thus requires thorough geopolitical analysis. Table 4Understanding The Crises Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Results - Red Herrings And Black Swans Matter: Our event analysis solidifies our findings with regards to U.S., Japanese, and Swiss government bonds, but also builds a case for some European bonds as well as gold during black swan events. Our main findings can be summarized as follows. Fade The Red Herrings: Out of the sixteen geopolitical events, ten were identified as red herrings, in which safe havens underperformed the equity market. This, then, suggests that it is not always beneficial to buy safe-haven assets when tensions are rising. What is interpreted as a major geopolitical crisis - say, Ukraine in 2014 or Greece in 2015 - often ends up being a "red herring." Geopolitical Risk = Gold: Geopolitical black swan events, on the other hand, have a significant, negative impact on the market. During these events, gold emerges as the strongest hedge against a downturn in equities. U.S. Treasurys And The Swiss Franc Provide A Baseline: Under all black swan events considered - geopolitical and non-geopolitical - U.S. Treasurys and the Swiss franc had the strongest performance, generating positive returns on the day of the stock market crash in 85% of the cases. G10 Government Bonds Will Also Do: German, Dutch, Swiss and Swedish government bonds also provided protection during black swan events in local and common-currency terms, albeit to a lesser extent. U.S. And Swiss Bonds Outperform During Financial Episodes: During black swan financial crises, Swiss and U.S. government bonds stand out as the best safe havens due to their capacity to generate positive returns both in USD and local-currency terms in eight out of the nine examined crashes. Other findings that are interesting, yet less robust due to a limited sample size, include: When the crisis originated on U.S. soil, U.S. Treasurys and the dollar performed relatively poorly compared to other safe-haven assets. This is a somewhat surprising finding, as most investors believe that U.S. assets rally even at a time of U.S.-based crises, such as the 2011 budget crisis. We show that they may perform well, but in USD, non-U.S. based assets do better. When the crisis originated in Europe, European bonds performed very well both in USD and local-currency terms. When the crisis originated in Europe, Swiss and U.K. government bonds performed poorly in USD terms, but offered strong protection in local-currency terms. When the crisis originated in Russia, precious metals acted as a poor hedge. Bottom Line: It is crucial to gain an understanding of the nature of any potential crisis. Red herrings should always be faded, not hedged against, as they produce poor results in safe-haven assets. U.S. Treasurys, Swiss and Japanese government bonds have been very consistent safe-haven assets during previous periods of acute risk. Part IV: Timing Is Everything As a final step in our quantitative approach, we put our results through numerous timing exercises to test how the assets would perform in real time. Based on our Risk Asset Spectrum (Diagram 1), which summarizes our findings, one could argue that investing in times of crisis simply boils down to buying an equal-weighted basket of U.S. Treasurys, Swiss, and Japanese government bonds. Although this is technically true, such a strategy would require perfect foresight, unparalleled timing, or dumb luck - since black swan events are, by definition, very difficult to predict. Diagram 1Risk Asset Spectrum Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Proof Of The Ultimate Safe Haven: The first experiment we conducted was to illustrate how powerful safe havens can be when timed perfectly in a trading strategy. We started off by comparing two baskets. The first was a benchmark portfolio comprised of 60% U.S. equities and 40% U.S. bonds. The other contained the same two assets, but with 100% allocated to a basket comprised of U.S. Treasurys, Swiss, and Japanese government bonds during times of negative returns for equities. Of course, this strategy is not realistic and would be impossible to implement, since the trading rule depends on future events. But as Chart 12 shows, if one were able to predict every single period of negative returns for global equities and hold safe-haven assets instead, the trading rule would outperform almost 10-fold. Chart 12Safe Havens Work Wonders With Perfect Information... Safe Havens Work Wonders With Perfect Information... Safe Havens Work Wonders With Perfect Information... One-Month Lag Is Already Too Late: Repeating the same exercise, but with a one-month lag in the execution, produces drastically different results. More specifically, whenever the previous month's equity return is negative (t=0), the portfolio allocates 100% to a single safe-haven asset for the current month (t=1), otherwise it keeps the allocation identical to that of the benchmark. The rationale for using such a simple rule is that average investors are generally late in identifying a crisis and only react once they have validation that the market is in a correction. Chart 13 shows that being late by one month changes the performance of the safe haven basket from astronomically outperforming the benchmark to underperforming it. Chart 13... But Timing Is Everything ... But Timing Is Everything ... But Timing Is Everything Reaction Is Key: As a final timing exercise, we analyzed the reaction function of our assets to see how quickly they react after the correction in equities begins (Chart 14). Unsurprisingly, the top assets that we identified start appreciating as soon as the crisis hits (t=0). Gold is, on average, the quickest asset to react from investors seeking refuge. Swiss bonds come in as a close second, almost mirroring gold during the first few days of the correction. But both assets start to flatten out and even roll over after a few days. Japanese bonds react slightly later than gold and Swiss bonds, but keep increasing for a longer period of time and start plateauing around the 30th day after the crisis. U.S. Treasurys and Quality Stocks, on the other hand, remain rather flat and constant over the short term. These results attest to the importance of timing the crisis using the best safe-haven assets. Chart 14Safe Havens React Instantly Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? Bottom Line: Timing plays a crucial part in investing in safe-haven assets, as their performance is coincident to that of equities. Investment Implications: Is Pyongyang A Red Herring Or A Black Swan? The results of our quantitative analysis are clear: hedging geopolitical risk depends on whether it is persistent or fleeting. So, is Pyongyang a red herring or a black swan? From our geopolitical analysis we make three key conclusions: The U.S. is not likely to preemptively attack North Korea; However, the U.S. has an interest in signaling that it may conduct precisely such an attack; Brinkmanship could last for a long time. Even if the risk of a U.S. attack against North Korea itself is a red herring, the crisis itself is not. In fact, between now and when a negotiated solution emerges, investors may face several new crises, which may include limited military attacks or skirmishes. While markets have faded such North Korean provocations in the past, the current context is clearly different. As such, we would suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Even though a "buy and hold" strategy with such a "Doomsday Basket" will likely underperform the market if tensions with North Korea subside, we are betting that it may take time for the U.S. and North Korea to get to the negotiating table. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com David Boucher, Associate Vice President Quantitative Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 6, 2016, available at gis.bcaresearch.com. We upgraded North Korea to the status of a genuine market-relevant risk in "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2017 available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0," dated September 25, 2012, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. In particular, we argued, "the current saber-rattling is carefully orchestrated. But North Korea can no longer be consigned to the realm of satire. The very fact that the U.S. administration is adopting greater pressure tactics makes this year a heightened risk period. Investors should be especially wary of any missile tests that reveal North Korean long-range capabilities to be substantially better than is known to be the case today." Then, on May 13 and July 4, North Korea conducted its first ICBM launches; the UN Security Council agreed to a new round of even tighter economic sanctions on August 5; and the U.S. and North Korea engaged in an alarming war of words. 6 Specifically, we wrote: "Diplomacy is the only real option. And in fact it is already taking shape. The theatrics of the past few weeks mark the opening gestures. And theatrics are a crucial part of any foreign policy. The international context is looking remarkably similar to the lead-up to the new round of Iranian negotiations in 2012. The United States pounded the war drums and built up the potential for war before coordinating a large, multilateral sanctions-regime and then engaging in talks with real willingness to compromise." 7 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 8 Please see BCA Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen," dated August 11, 2017, available at fes.bcaresearch.com. 9 Please see BCA Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 10 Forty-one assets were denominated in USD only, while G10 bonds, Credit Suisse Swiss Real Estate Fund, and European 600 real estate were used both in local-currency terms and USD, for a total of 65 assets. 11 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 12 Sile Li and Brian M. Lucey, "What precious metals act as safe havens, and when? Some U.S. evidence," Applied Economic Letters, 2013. 13 Dirk G. Bauer and Thomas K.J. McDermott, "Financial Turmoil and Safe Haven Assets," 2013. 14 Lieven Baele, Geer Bekaert, Koen Inghelbrecht and Min Wei, "Flights to Safety," National Bank of Belgium Working Paper No. 230, 2015. 15 Dirk G. Baur and Kristoffer J. Glover, "The Destruction of Safe Haven Asset?,"2012. 16 Angelo Ranaldo and Paul Soederlind, "Safe Haven Currencies," Review of Finance, Vol. 10, pp. 385-407, 2010. Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? 18 Quality stocks are defensive equity plays with high, steady earnings with an elevated return on investments. They are estimated by Deutsche Bank's Factor Index Equity Quality Excess Return in USD. Can Pyongyang Derail The Bull Market? Can Pyongyang Derail The Bull Market? 20 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com, and BCA Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017, available at gis.bcaresearch.com. 21 Since we were interested in the immediate, often unexpected, response to the event, we did not include economic recessions in our event analysis.

Highlights GFIS Portfolio: The GFIS model bond portfolio has lagged its benchmark index since inception last September and since our previous performance update in April. All of that underperformance can be accounted for this month, however, given the risk-off moves seen in global financial markets. As investors begin to shift their attention away from the current geopolitical blustering over North Korea and back towards the solid global economic upturn, our current tilts should begin to outperform again. Risk Management: We have successfully raised the amount of overall portfolio risk (tracking error) since our last portfolio performance update in April. The tracking error remains below our self-imposed limit of 100bps, however, giving us the ability to make further adjustments to our tilts as opportunities arise. Tactical Overlay: Our Tactical Overlay trades have delivered a positive average return over the past year, led by the current open trades that have produced an average gain of +30bps. Feature In this Special Report, we are presenting a performance update for our Global Fixed Income Strategy (GFIS) model bond portfolio. We did the first such update back in mid-April, and we will continue to publish periodic portfolio reviews going forward. As a reminder to our readers, the GFIS model portfolio is intended to be a tool for us to both communicate and evaluate our fixed income investment recommendations. By putting actual weightings to each of our country and sector calls, against a bond benchmark index with an overall portfolio risk limit, we are aiming to express the convictions of our views in a manner more in line with the actual day-to-day portfolio trade-offs faced by bond managers. The model portfolio is a relatively new addition to the GFIS service, starting only in September 2016, thus the return history is still limited. We have built out several pieces of the GFIS model portfolio framework over the past year, and the process is nearing completion. We now have a custom performance benchmark index that reflects the universe of fixed income sectors that we regularly cover in GFIS (essentially, the Bloomberg Barclays Global Aggregate Index plus riskier fixed income classes like High-Yield corporates). We also have performance measurement metrics and a way to regularly present the portfolio returns, while we have also added a risk management (tracking error) element to help size our relative tilts. The final piece will be to incorporate our corporate bond sector recommendations within the model portfolio, both as a source of potential return and a use of our risk budget (tracking error). We intend to add that final element in the coming weeks. Overall Performance Review: Winners & Losers Chart 1GFIS Model Portfolio Performance GFIS Model Portfolio Performance GFIS Model Portfolio Performance As of August 11th, the GFIS model portfolio has produced a total return of +0.93% (hedged into U.S. dollars) since inception on September 20, 2016 (Chart 1). This has underperformed our custom benchmark index by -14bps. Since our last performance review on April 18th, the model portfolio has lagged the benchmark by -10bps. The portfolio has suffered in the risk-off environment seen so far in August, with a -14bp underperformance seen month-to-date, equal to the entire underperformance since inception. Our core structural positions of maintaining a below-benchmark duration stance, while staying underweight government bonds versus overweight spread product, have all suffered of late (bottom two panels). Our government bond country allocation has been the biggest overall drag on returns (Table 1) since last September (-26bps versus our benchmark). Japan (+5bps) and Spain (+3bps) have been the biggest positive contributors since inception, while Italy, the U.K. and France have a combined underperformance of -31bps. That more than accounts for the entire underperformance of the government bond sleeve of the model portfolio since inception (Chart 2). Since our last portfolio update in April, our government bond allocations have lagged our benchmark index by -29bps. Small gains in Spain and Germany (+2bps each) have been dwarfed by underperformance in the U.S. (-16bps), Italy (-10bps) and France (-5bps). Across almost every country, our below-benchmark duration positioning has translated into a bear-steepening yield curve bias, as we have been recommending substantially reduced exposure to the 10+ year maturity buckets in the major countries (U.S., Germany, France, Italy, and Japan). The bull-flattening of global yield curves between March and June, led by a downturn in inflation expectations, was more than large enough to offset any of the potential benefits from our country allocation. Yield curves did began to bear-steepen in July after the European Central Bank (ECB) sent signals that a tapering of its asset purchase program next year was increasingly likely. That move has quickly reversed this month, however, as financial markets have shifted to a risk-off stance on the back of rising geopolitical tensions on the Korean Peninsula. Table 1A Detailed Breakdown Of The GFIS Model Portfolio A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio Chart 2GFIS Model Portfolio Government Bond Performance Attribution By Country A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio The news is better with regards to our global spread product allocations. Those have delivered a total return of +1.41% since last September (beating the benchmark by +12bps) and +0.98% since the last performance review in April (+19bps versus the benchmark). Our allocations to U.S. Investment Grade (IG) and High-Yield (HY) have combined for a +30bps outperformance since September and a +23bps outperformance since April (Chart 3). Euro Area corporate debt has been a modest drag, with the combined allocation to IG and HY debt underperforming by -7bps since September and -3bps since April. Emerging Market corporate debt contributed -2bps of underperformance, while U.K. IG corporates added +1bp of excess return. Chart 3GFIS Model Portfolio Spread Product Performance Attribution A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio Among other spread sectors, U.S. Mortgage-Backed Securities (MBS) have generated a -12bps contribution to our excess return, although this entirely came from a period immediately after the inception of our model portfolio (Sept-Nov 2016) where we briefly moved to a tactical overweight stance. We have since maintained a structural underweight posture on U.S. MBS, but this has barely generated any relative performance (-1bp) since our last portfolio review in April. Net-net, the GFIS model portfolio has generally performed in line with where our recommendations are concentrated, both in absolute terms and on a relative basis between sectors. Our below-benchmark stance on overall duration has suffered as the government bond yield curves have exhibited more volatility than trend. At the same time, our structural overweights on global corporate debt, favoring the U.S. over non-U.S. equivalents, have contributed positively to the overall portfolio performance. In Charts 4-7, we show the relative performance of some individual countries and sectors that are part of our GFIS benchmark index. We specifically singled out our major asset allocation calls between sectors made over the past year, with a vertical line drawn at the date when the change was recommended. The data shown in all three charts is the relative performance of each tilt on a duration-adjusted basis and (where applicable) hedged back into U.S. dollars, indexed to 100 at the date of implementation in our model portfolio. Shown this way, we can evaluate the success of the timing of our calls. Our shift to an overweight stance on U.S. corporate debt versus U.S. Treasuries both for IG and HY in the first quarter of this year can be judged a success both in terms of timing and magnitude, with IG outperforming Treasuries by 217bps and HY outperforming by 826bps (Chart 4). Within our HY allocation, we left some performance on the table by concentrating our overweights on the higher-rated credit tiers (bottom panel), but this was a move we felt comfortable with (and still do) as a way of staying a bit up in quality at a time when lower-rated spreads were looking fully valued. In terms of our cross-Atlantic credit allocation, we shifted to an overweight stance on U.S. corporates versus Euro Area equivalents back on January 31st of this year (Chart 5). Since then, U.S. IG has underperformed Euro Area IG by -142bps, but U.S. HY has outperformed by a much larger 581bps. Taken together, these positions have contributed positively to the overall performance of the model portfolio. We continue to like U.S. corporates over Euro Area corporates from a valuation standpoint, thus we are keeping this tilt in the portfolio. Chart 4Our Overweights On##BR##U.S. Corporates Have Done Well Our Overweights On U.S. Corporates Have Done Well Our Overweights On U.S. Corporates Have Done Well Chart 5Our Combined Tilt Towards##BR##U.S. Corporates Has Outperformed Our Combined Tilt Towards U.S. Corporates Has Outperformed Our Combined Tilt Towards U.S. Corporates Has Outperformed With regards to our other major spread sector tilts, our shift to an underweight stance on U.S. MBS versus Treasuries back in November has essentially been a wash (Chart 6). Looking ahead, the combination of unattractive valuations and, more importantly, reduced buying of Agency MBS by the Federal Reserve as it begins to shrink its balance sheet will weigh on MBS performance in the next 6-12 months - we are staying underweight. At the same time, we are maintaining our long-held overweight stance on U.K. IG corporates versus Gilts (bottom panel). The Bank of England will be keeping interest rates unchanged over the next year given mixed readings on U.K. economic growth and the lingering uncertainties over the Brexit negotiations, thus going for the added carry of corporates versus expensive Gilts still makes sense. As for our cross-country government bond allocations, our underweight stance on Italy versus Spain, and our overweight stance on Japan versus Germany, have been volatile while delivering no excess performance (Chart 7). Chart 6Sticking With Our Tilts On##BR##U.S. MBS & U.K. IG Sticking With Our Tilts On U.S. MBS & U.K. IG Sticking With Our Tilts On U.S. MBS & U.K. IG Chart 7Our Cross-Country Government Bond##BR##Tilts Have Been Volatile Our Cross-Country Government Bond Tilts Have Been Volatile Our Cross-Country Government Bond Tilts Have Been Volatile Looking ahead, we continue to expect the global growth backdrop to be supportive of spread product over government debt over the next 6-12 months, particularly with central banks unlikely to shift to a restrictive monetary stance. At the same time, we should soon begin to claw back some of the underperformance of the government bond sleeve of the GFIS model portfolio coming from our below-benchmark duration stance, for several reasons: Our colleagues at BCA's Geopolitical Strategy service do not expect the current standoff between Pyongyang and Washington to devolve into a shooting war, even though the tough talk on both sides will likely continue for some time. As the military tensions begin to subside, this should reverse some of the safe-haven bid for government bonds seen in the past couple of weeks, causing yields to drift higher. The solid global growth backdrop, confirmed by the still-rising trend in leading economic indicators, will continue to force central banks to slowly shift to a less dovish policy stance. U.S. inflation will begin to rebound in the next few months, led by the lagged impact of the U.S. dollar weakness seen in 2017 and continued tightening of the U.S. labor market. This will prompt the Fed to hike rates in December and deliver more hikes in 2018, which is NOT currently priced into U.S. Treasuries. We expect the ECB to soon signal a reduction of the size of its asset purchase program starting in 2018, which will put upward pressure on core Euro Area bond yields, and widen Peripheral European spreads, as the market moves to price in a smaller amount of future bond supply that will be absorbed by the central bank. The combination of modest increases in global inflation, a rebound in investor risk sentiment, and an ECB taper announcement should all place bear-steepening pressures on developed market yield curves (ex-Japan). This will benefit the curve-steepening bias we have in the U.S., Euro Area and U.K., while also supporting our country allocation of a maximum overweight to low-beta Japanese Government Bonds (JGBs). Net-net, we see no reason to alter any of current portfolio tilts at the moment based on any change in our market views. Bottom Line: The GFIS model bond portfolio has lagged its benchmark index since inception last September and since our previous performance update in April. Our overweight credit allocations have performed well but our below-benchmark duration tilts have not. All of that underperformance can be accounted for this month, however, given the risk-off moves seen in global financial markets. As investors begin to shift their attention away from the current geopolitical blustering over North Korea and back towards the solid global economic upturn, our current tilts should begin to outperform again. A Very Brief Comment On Our Risk Management Framework In our prior portfolio update in April, we noted that the initial sizes we placed on the tilts in the GFIS model portfolio proved to be far too small to generate any meaningful outperformance.1 After that, we increased the sizes of our all our existing positions in the portfolio. We later introduced a "risk budget" into our framework that would allow us to measure the tracking error (excess volatility versus the GFIS benchmark index) of our portfolio to ensure that we were taking adequate levels of risk.2 So far, our changes have had the desired effect of raising the tracking error of the portfolio to more realistic levels to try and generate outperformance. The average allocations to our government bond underweights and our spread product overweights have increased since that April portfolio review (Chart 8). This has helped raise the tracking error of the model portfolio to 61bps from 25bps in April (Chart 9). This is still below our risk limit of 100bps of tracking error, giving us room to add positions to the model portfolio if we see opportunities come up. Chart 8We've Increased The Sizes Of##BR##Our Tilts Since April ... A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio Chart 9...Which Has Boosted The Tracking##BR##Error Of The Model Portfolio ...Which Has Boosted The Tracking Error Of The Model Portfolio ...Which Has Boosted The Tracking Error Of The Model Portfolio Bottom Line: We have successfully raised the amount of overall portfolio risk (tracking error) since our last portfolio performance update in April. The tracking error remains below our self-imposed limit of 100bps, however, giving us the ability to make further adjustments to our tilts as opportunities arise. Tactical Overlay Bets Have Been Helpful In addition to our GFIS model bond portfolio, we also are running recommended trades in our Tactical Overlay portfolio. These are positions that typically have a shorter-term investment time horizon (0-6 months) than those in the model portfolio. They can also be in less-liquid markets that are not included in the custom bond benchmark index for the model portfolio, like U.S. TIPS or New Zealand government bonds. The Overlay is intended to produce ideas for more tactical traders than portfolio managers, although the trades can also be viewed as a compliment to the model bond portfolio. The performance of our Tactical Overlay can be seen in Table 2 (for our current open trades) and Table 3 (for our past closed trades). We have shown the trade performance going back to the inception date of our model bond portfolio in September 2016, to facilitate apples-for-apples comparisons. We are currently working on developing a trade sizing and risk management framework along the lines of our model portfolio. For now, we can only present average return numbers and not a meaningful cumulative return measure. Table 2The Current Open GFIS Tactical Overlay Trades Are Performing Well A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio Table 3The Closed GFIS Tactical Overlay Trades Have Been A Mixed Bag A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio Our closed Overlay trades since last September generated only an average total return of a mere +1bp, but this weighed down by a large losing position on shorting Portuguese government bonds versus German Bunds. The average trade return would have been +21bps, on fifteen closed trades, excluding that Portuguese bet. The notable winners were long positions in 10-year French government bonds versus German Bunds (+130bps), a long position on Australian Semi-Government debt versus Federal government debt (+159bps) and a long positon on Korean 5-year government bonds vs. 5-year JGBs on a currency-unhedged basis (+195bps). The other notable loser besides the Portuguese trade was a failed long position on Japanese CPI swaps (-111bps). The current open Overlay trades have performed much better, delivering an average gain of +30bps. 14 of the current 16 open trades have a positive gain, thus the batting average is solid. Notable winners are an overweight on U.S. TIPS versus U.S. Treasuries (+197bps) and our Canada/U.K. 2-year/30-year yield curve box trade (+110bps). The only serious losing trade at the moment is our long position in 5-year New Zealand government bonds versus 5-year German debt (-123bps), although this is the only trade in the table that is currency UN-hedged and is a bet on a stronger New Zealand dollar versus the euro as well as a relative bond spread trade. Net-net, our Tactical Overlay trades have generated a positive average return since last September. In the next few months, we will look to introduce a weighting scheme and risk budget for the Overlay trades to better present these trades as a true complement to our model bond portfolio. Bottom Line: Our Tactical Overlay trades have delivered a positive average return over the past year, led by the current open trades that have produced an average gain of +30bps. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "An Initial Look At The Performance Of Our Model Bond Portfolio", dated April 18th 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "Adding A Risk Management Framework To Our Model Bond Portfolio", dated June 20th 2017, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio Appendix - Selected Sectors From The GFIS Model Portfolio Appendix 1 Appendix 1 Appendix 2 Appendix 2 Appendix 3 Appendix 3 Appendix 4 Appendix 4 Appendix 5 Appendix 5 Appendix 6 Appendix 6 Appendix 7 Appendix 7 Appendix 8 Appendix 8