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Highlights EM equity breadth has moved into negative territory, DM-based excess liquidity measures are set to roll-over, and China-based liquidity measures are also weak. Individually, each of these factors are not enough to raise alarm bells, but together they point to a period of heightened risks for EM assets and commodity currencies. AUD/CAD and NZD/JPY are set to suffer in this environment. EUR/USD will rise to 1.15-1.16, but unlike in 2015, it should not receive much of a fillip from EM volatility. Feature Chart I-1Technical Risk In EM An interesting development has unfolded in emerging markets. While the pause in the EM rally has hit investors' radar screens, the more puzzling event concerns breadth. Not only has the advanced/decline line rolled over, but more worrisomely, it has recently moved into negative territory. Historically, when more stocks are declining rather than advancing, EM equities tend to experience sharp selloffs (Chart I-1). This development is important when put into a global context. EM stocks and related assets like commodity currencies have been buoyed by plentiful global liquidity conditions. However, global liquidity is set to deteriorate. A rocky second half may emerge in EM assets. Global Liquidity Is Slowing Following in the Federal Reserve's footsteps, DM central banks are moving away from monetary accommodation. Last week, European Central Bank President Mario Draghi made a speech that was interpreted as representing an abandonment of the ECB's dovish bias. With the anticipation that its bond-buying program will be tapered early in 2018 and reports that the ECB is having problems buying its quota of German and Finnish bonds, global bonds suffered, with Bund and T-Note yields moving up 33 and 23 basis points since June 27, respectively. The ECB is not the only central bank to have changed its tack. The Bank of Canada's communications have been crystal clear that it intends to increase rates this summer, or early fall at the latest. Even the perennially dovish Riksbank is moving away from its easy bias, as Sweden's resource utilization points to a continued acceleration in core inflation. But does this even matter? The global economy is strong, and beginning to remove accommodation is not quite the same thing as pushing rates into tight territory. The advanced economies are unlikely to suffer much from this development. However, the picture for EM is more concerning. Some key leading indicators of EM activity have already begun to roll over. For example, Taiwanese IP, a key bellwether of overall EM strength, is now contracting on a year-on-year basis (Chart I-2, top panel). Meanwhile EM PMIs rolled over three months ago and EM narrow money growth, a key forecaster of EM profits, is slowing sharply (Chart I-2, bottom panel). Despite these negative developments, EM stocks have remained resilient. The factor underpinning this impressive performance has been the rise in global liquidity. More technically, the rise in the global Marshallian K - the ratio of money to nominal GDP - over the past six months. Excess money has had to go somewhere. Among the many refuges, EM has been a key pole of attraction, with massive inflows supporting assets prices. The 8% appreciation in EM currencies versus the dollar since their January 2016 trough has been a vivid illustration of this phenomenon. The driver of the rise in excess money has been the ratio's numerator, dollar-based liquidity. The Fed's various QE programs were key determinants of dollar-based liquidity (Chart I-3). However, its tapering in late 2014 was enough to prompt a contraction of the measure. Now that the Fed is intent on decreasing its balance sheet while the ECB tapers and other smaller DM central banks begin increasing rates, the small improvement witnessed in the past three months is likely to end. The recent weakness in gold prices, despite the softness in the dollar, could be a sign that markets are beginning to sniff out the imminent tightening of global liquidity conditions. Chart I-2EM/China Profits Growth To Roll Over (I) EM Growth ##br##Has Deteriorated, Profits Will Suffer Chart I-3The Fed Balance Sheet Runoff ##br##Will Hurt Global Liquidity Additionally, not only are global central banks, led by the Fed, tightening or looking to tighten policy, they are doing so despite an absence of actual inflation. As a result, this means DM real yields are set to rise. As Chart I-4 illustrates, rising real DM yields have historically been a harbinger of poor EM bond performance. In fact, the action in DM real yields since mid-2016 already points to a problematic second half for EM bonds. As a result, EM bond investors are likely to suffer some losses in the coming months. Such losses would not only tighten EM financial conditions, but would also be symptomatic of capital leaving the region. Less money in those markets simply means less liquidity. With EM corporate spreads near historical lows, a repricing of credit risk on the back of softening global and EM liquidity is likely to prompt both a selloff in EM stocks and in EM currencies (Chart I-5). As a result, DM commodity currencies, the NZD and AUD in particular, could suffer. Chart I-4EM Financial Conditions##br## Are Set To Deteriorate Chart I-5If Liquidity Dries, Spreads Widen ##br##And EM Stocks Fall Bottom Line: In November 2016, a new leg of the EM rally began - a move driven by an expansion in global liquidity, even as a key bellwether of EM economic activity rolled over in the interim. Global excess liquidity is set to roll over as DM central banks abandon their dovish biases and the Fed begins to let its balance sheet run off. With EM weaker from a technical perspective, the second half of 2017 could be a tough environment for EM plays. Chinese Liquidity Joins The Fray In May 2015, EM equities in U.S.-dollar terms peaked just before global liquidity began to roll over. Compounding the risks, back then Chinese economic conditions were also problematic. Excess capacity and massive deflationary forces were wearing down on profits and investment. China is thus another key factor to watch. In this optic, beyond DM liquidity, a key driver of the rebound in EM last year was actually Chinese liquidity conditions. In the second half of 2015, China's own Marshallian K - based on M2 relative to nominal GDP growth - was rebounding sharply, as the PBoC was easing policy and the fiscal authorities were pressing on the gas pedal, expanding both public expenditures and pushing credit growth through the economy. However, that was then. Today, China has joined the tightening party. The quarterly moving average of Chinese interbank rates has increased by 100 basis points over the past year. Crackdowns on real estate and excess leverage have also resumed. Most importantly, the issuance of bonds by small and medium banks - a key source of grease to total social financing - has also massively decelerated, which points to a sharp slowdown and even a contraction in the Chinese credit impulse (Chart I-6). Thanks to this development, the Chinese Marshallian K is now in negative territory. The global impact of tighter Chinese monetary conditions is also flashing a red flag. Our indicator is based on the relative performance of Chinese bank stocks and USD/HKD. Underperformance of Chinese banks tends to send warning signs that tightening policy is beginning to negatively affect the outlook for Chinese credit growth. Additionally, USD/HKD is at an 18-month high because Hong Kong interest rates have not been able to follow U.S. ones, as loan demand by mainland-China entities has been poor. Most of the time, this indicator tends to move with EM stock prices, providing very little information. However, as Chart I-7 illustrates, this gauge is at its most useful when it diverges from EM equity prices. In each case, such as in 2007, 2011, and 2014, the divergences between the falling price-based Chinese liquidity indicator and rising EM stock prices was resolved by a correction in the latter. Today, the indicator points to a large amount of downside risk for EM stocks. Chart I-6Chinese Credit Impulse Will Slow Chart I-7A Worrying Divergence Again, it is important to reiterate that in and of itself, such a divergence is not enough to prompt investors to run for the hills and ditch EM stocks and related plays. However, when this happens as DM liquidity is also set to deteriorate, and most crucially, when EM breadth turns negative, decreasing EM exposure makes sense. Bottom Line: Chinese liquidity conditions are also deteriorating. The People's Bank of China may not want to push the economy into another slowdown cycle, which will most likely limit how far the Chinese central bank will tighten policy. However, this tightening has not been priced in by EM equities, and is happening as DM central banks are also reducing accommodation and as EM breadth has greatly deteriorated. A sizeable correction in EM plays is becoming increasingly likely. Investment Implications Chart I-8Global Liquidity Leads EM ##br##By More Than A Year A tightening of dollar-based liquidity and Chinese-based liquidity is a big problem for non-China EM economies. EM economies outside of China and OPEC nations still run an annual current account deficit of more than US$200 billion. They need liquidity. Moreover, they still have at least US$3.6 trillion in foreign-currency debt. With liquidity conditions deteriorating, we should expect a widening of EM spreads, falling EM stock prices and falling commodity currencies. In fact, we are today in the window of maximum risk. Chart I-8 shows the combined G7 and Chinese Marshallian K, standardized. This indicator tends to have long leads over EM equity prices. It turned negative in the summer of 2006, though EM stock prices did not peak until the fourth quarter of 2007. It turned negative again in the early days of 2010, but EM equity prices did not peak until April 2011. The indicator moved below zero in mid-2014, yet EM equities only sold off in the second quarter of 2015. This time around, the combined liquidity indicator became negative in early 2016, suggesting great risks for EM assets and related plays in the second half of 2017. High carry EM currencies like the BRL or the TRY are at risk. The ZAR looks especially poorly positioned as well but the RUB seems better cushioned against these risks. The MXN could suffer too as Mexico has a lot of U.S. dollar-denominated debt. Nonetheless, MXN remains much cheaper than the BRL and could still outperform its Brazilian brethren. The SGD is very sensitive to global liquidity conditions, as Singapore is a key banking center for EM, and could also suffer substantially against the USD. In terms of timing for the G10 currency markets, the deterioration of EM breadth has historically been a dangerous sign for commodity currencies (Chart I-9). This combination of deteriorating liquidity and breadth is often associated with a sharp selloff in NZD/JPY (Chart I-10). Investors should short this cross, and we are re-opening this trade this week. Chart I-9Commodity Currencies##br## Prefer A Fresh Breadth... Chart I-10...So Does ##br##NZD/JPY The dynamics highlighted above also explain why despite our positive stance on Canada and the CAD, we are not willing to chase the selloff in USD/CAD further, and prefer to play the CAD's strength through its crosses. The risk-reward ratio seems better this way, as we are not as negatively exposed to an EM selloff as we would be buying the CAD against the USD. Indeed, a cleaner way to play the BoC's change of tone while gaining exposure to an EM-risk off theme, is to short AUD/CAD, a trade that is already on our book. On the domestic front, this week the Reserve Bank of Australia disappointed markets and did not try to indicate a change in stance away from its dovish bias. Markets have taken notice, with the AUD incapable of rallying against a weak USD, despite very strong trade data yesterday. Meanwhile, the BoC is telegraphing a rate hike in the very near future. Additionally, an abnormal gap has emerged between AUD/CAD and AUD/USD. As Chart I-11 shows, historically, AUD/CAD and AUD/USD have tracked one another. This makes sense. The Australian economy is very levered to Asian growth and liquidity dynamics, while Canada is a crucial link in the North American supply chain. With the U.S. and Canadian business cycles so tightly integrated, the CAD tends to mimic the greenback when compared to non-USD currencies. Chart I-11AUD/CAD Is A Short The points in time when AUD/CAD has been much stronger than the AUD/USD deserve closer attention. They are periods of booms in EM Asia, such as the middle of the 1990s, or 2004 to 2005. Today, AUD/CAD is again out of line with AUD/USD, reflecting the boom in EM assets prices in 2016 and in the first half of 2017. However, if our view is correct that EM is entering a dangerous zone, AUD/CAD should weaken further. Chart I-12When Investors Are Short, ##br##EUR/USD Likes EM Selloffs Last but certainly not least the euro. EUR/USD has much momentum and could continue to rally into the 1.15-1.16 zone. In fact, historically, EM shocks have been able to lift the euro, albeit temporarily. This definitely was the case in 2015 when EM sold off: in April 2015, when EM began to weaken, in August 2015, when a temporary selling climax emerged after the Chinese floated the CNY, and in December 2015, after the Fed hiked. The euro spiked in all three instances. However, investors were very short EUR/USD entering each of these periods, and the ensuing rallies were short-covering rallies (Chart I-12). This time around, investors are very long the euro, suggesting that the euro has not been used as a funding vehicle to the same extent as it was in 2015. Additionally, in all these previous episodes, EUR/USD traded at a small discount to the fair value implied by real rate differentials, today it is trading at a premium. Thus, the same kind of short-covering rally is unlikely. As a result, we do not anticipate EUR/USD to break out of its range on the back of an EM risk-off event. That being said, EUR could outperform GBP in this type of environment. The pound remains very dependent on global liquidity conditions to finance its current account deficit of more than 4% of GDP. With big financial institutions announcing more divesture from the U.K., these hot-money flows could prove even more crucial. As a result, we are removing our call to short EUR/GBP if it moves above 0.88, and expect a move in EUR/GBP toward 0.92-0.93 in the second half of 2017. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The greenback slipped on weak as the ADP employment, the ISM-non manufacturing employment component, and continuing as well as initial jobless claims all underperformed expectations. While the dollar reacted negatively to this news, the Fed's hawkish stance should ultimately help the USD. Supplementing the increases in interest rates, are plans to reverse the multi-year quantitative easing program.The FOMC is also increasingly worried about the "quite high" stock valuations which, could lead to financial instability. U.S. 10-year yields have gone up 4 basis points following the release of the minutes, after the 20 bps spike following initial Fed comments on June 27. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro's strength extends as the union experienced strong services and composite PMI measures this Wednesday. While it is true that the ECB may be looking to draw back its excessively easy monetary policy, Draghi and Praet have highlighted that accommodative policy is still needed as inflationary pressures are not yet entrenched. The euro's recent appreciation and weak producer price numbers could vindicate this view. The euro's strength has also weighed on manufacturing activity, as PMIs underperformed expectations. This is likely to weigh on EUR/USD going forward, especially as European stocks have been underperofming U.S. ones in recent weeks. EUR/SEK can face considerable pressure ahead due to the Riksbank's change in rhetoric. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Europe's Divine Comedy Part II: Italy In Purgatorio - June 21, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: National inflation came in at 0.4%, while Tokyo ex fresh food and energy inflation contracted by 0.2%. Both of these measures underperformed expectations. On the other hand, Japan's job-to-applicant ratio continues to climb, coming in at 1.49, and outperforming expectations. This last data point is key, as it highlights that the Japanese labor market is very tight, and that the stage is set for inflation to come back to Japan. However, as evidenced by the recent disappointments in data, the currency holds the key to unleash inflation in Japan. Thus, not only is a selloff in the yen needed for inflation to remerge, but this selloff would feed on itself, as a falling currency and a tight labor market would raise inflation (and thus lower real rates, as Japanese 10-year rates are anchored at 0), which would push the yen down further. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Markit manufacturing PMI declined from last month's reading and also came in below expectations at 54.3. Construction PMI also declined and came in below expectations at 53.4 However credit had a strong showing as net lending to individuals, consumer credit and mortgage approvals all came in above expectations at 5.3 billion pounds, 1.73 billion pounds and 65 thousand respectively. Various BoE members have stated that rising interest rates might be necessary to keep a lid on the island's high inflation. Although there are still some voices within the BoE who are more cautious, given the uncertainty that Brexit poses, overall the BoE has shown a much more hawkish tone in recent weeks. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has experienced considerable weakness this week, following a drawback in inflation estimates for June by the TD Securities measure, of 2.3% from 2.8% and a less hawkish than anticipated RBA. While retail sales beat expectations of 0.2% - coming in at 0.6% - the pace of appreciation in the RBA Commodity Index in SDR terms continues to slow Nevertheless, these factors were not the only contributors to the recent AUD weakness. Australia remains highly levered to emerging markets, and the Fed tightening remains a major risk for the AUD. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The annual trade balance underperformed expectations, coming in at a deficit of 3.75 billion U.S. dollars. However the ANZ business confidence index continued climbing, and now stands at the highest level in 8 months Overall the New Zealand economy continues to be one of the best performing in the G10. If one were to be guided merely by domestic factors, the RBNZ should be the next central bank to hike after the Fed. However the picture is slightly more nuanced, as the RBNZ is still worried about foreign developments, particularly EM weakness. This justifies why they continue to state that "monetary policy will remain accommodative for a considerable period". Thus, we continue to be bullish on the NZD against the AUD, while we are shorting it against the JPY, as a mean to benefit from a potential EM dislocation. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has broken down from a crucial technical level following Poloz's statements about the Canadian economy. He states that the "cuts have done their job". When asked about oil, the reply was reassuring, declaring that the expected level of WTI is at USD 40-50 bbl, which implies that fluctuations within that band should not influence movements the BoC path, helping the CAD in the process. He also suggested that "the adjustment we've been talking about... is largely complete now". While inflation is weak, the BoC governor highlighted that forward looking indicators for inflation should be monitored instead of current inflation. These variables are pointing to stronger growth, and are in line with the bank's expectations of a closing output gap in the first half of 2018. While this may be true, a strengthening CAD will remain a risk for inflation. Report Links: Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Although real retail sales yearly growth came in negative at -0.3%, it outperformed expectations and was better than last month. Additionally, the SVME PMI came also blew away expectations, increasing from last month's 55.6 reading to 60.1. However Consumer price inflation came in at -0.1%, underperforming expectations. The Swiss economy continues to be haunted by the ghost of deflation. Nonetheless, some economic indicators appear to be ticking up, most likely as a result of the sharp rally in EUR/CHF. We continue to believe that a rally of EUR/CHF beyond 1.1 is unlikely, as most of the good news in the euro area are already priced into the euro. Furthermore, any disappointments, particularly in EM could trigger a selloff in this cross. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Labor Force survey, which measures the number of unemployed people as a percentage of the total civilian labor force came in at 4.6%, increased since last month. This measure shows that despite the increase in oil prices the Norwegian labour market continues to be tepid. The Norges Bank agrees with our assessment, as it lowered its projected near term policy rate path. Furthermore, they projected that rates in Norway will not rise until the beginning of 2019. The reasons for this are two fold: first, inflation should continue to remain weak, as the pass through from the collapse in the currency has faded. Additionally, bubbly real estate prices, which were the only factor, which could incite the Norges Bank to become more hawkish, have gone down, following reform in lending standards. Thus, despite its good value, the NOK will continue to underperform amongst commodity currencies. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 It is true that the Riksbank recently hinted towards a more neutral stance, acknowledging "that inflation has recently been slightly higher than expected", which has made it "less likely than before that the Riksbank will cut the repo rate in the near term". However, the Riksbank also highlighted the fact that the bank is "prepared to implement further monetary policy easing if necessary to stabilize inflation". A very nuanced statement referred to the exchange rate, which "is important that [it] does not appreciate too rapidly", further stating that "this could happen if, for example, the Riksbank's monetary policy deviates clearly from that of other countries." This conclusively highlights that the bank is wary of diverging rates lifting undesirably on the krona, which is a limiting factor for substantial krona strength in the near term. However, the change of guard at the helm of this central bank in early 2018 could change all this caution. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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

Highlights With crude-oil inventory transfers from OPEC to western refining centers slowing, OPEC 2.0's production cuts will begin to show up in high-frequency OECD inventory data in the form of lower stock levels. The coalition has been bedeviled by higher production from Libya and Nigeria, and a push from Iraq asserting its right - in line with its huge reserves - to increase production. U.S. imports from Iraq are growing this year, even as other OPEC members slow shipments. In addition, Iraqi crude oil inventories also were increasing while other OPEC states were running their stocks down, which suggests Iraq may be preparing to lift production and exports in the near future. Energy: Overweight. Crude oil rallied sharply over the past week, despite reports of higher Libyan production. We remain long via Dec/17 $50/bbl vs. $55/bbl call spreads in Brent and WTI. Base Metals: Neutral. The U.S. reportedly is using a national security review of the U.S. steel industry, to determine whether it will impose tariffs on steel imports at this week's G20 meeting in Germany. Precious Metals: Neutral. Gold recovered after selling off last week on the back of more aggressive guidance from central bankers. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. The USDA's acreage reports for grains were less bearish than expected, rallying markets into this week. We remain bearish, but also recommend investors continue to avoid shorting these markets. Feature Chart of the WeekCrude Oil Prices Rally,##BR##Despite Reports Of Higher Production Oil rallied 9.6% over the past week from recent lows, despite news reports of Libya pushing crude oil production toward 1mm b/d by the end of this month, and further indications Iraq is gearing up to increase production and exports (Chart of the Week). We expect prices to continue to be well supported in 2H17, as the production cuts engineered by OPEC 2.0 - the OPEC and non-OPEC producers' coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, respectively - finally begin showing up in the high-frequency storage data for the U.S. and the OECD. This is because, we believe, the massive crude-oil inventory transfers between OPEC and OECD refining centers is winding down. OPEC Inventory Transfer Winding Down Crude oil inventories in major oil importers with significant refining capabilities - in particular, the U.S. and the Amsterdam-Rotterdam-Antwerp (ARA) refining center in the Netherlands and Belgium - grew by a bit more than 35mm barrels (bbl) year-on-year (yoy) on average over the January - April period, based on data from the Joint Organisations Data Initiative (JODI), a transnational group made up of producing and consuming interests headquartered in Riyadh, Saudi Arabia. The January - April period marked the first four months of the OPEC 2.0 production-cutting Agreement, in which OPEC pledged to reduce output by 1.2mm b/d, and non-OPEC obliged itself to cut an additional 600k b/d of production. The yoy builds in the U.S. and ARA inventories were a mirror-image of the average yoy inventory withdrawals occurring in OPEC states that reported their stock levels to JODI in the first four months of this year (Chart 2). The JODI inventory data indicates that even as OPEC 2.0 was cutting production in the first four months of the year - by some estimates by more than 100% of the pledged 1.8mm b/d of reductions - these states were draining stocks from inventories during this period to maintain sales to key clients. The declining trend in high-frequency U.S. inventory data from the EIA for the U.S. East coast (PADD 1), the Midwest (PADD 2), and the U.S. Gulf (PADD 3), and declining weekly import estimates support our contention that OPEC inventories will continue to decline, and that the production surge by OPEC in 4Q16 will finally be worked off (Chart 3). Given the downtrend in the weekly high-frequency crude oil import data for the U.S., we expect crude-oil shipments from OPEC to continue to slow as production cuts no longer are masked by inventory draws (Chart 4). Among the top 10 crude oil exporters to the U.S., KSA shipments are down an average 55k b/d in yoy 2Q17 vs. an increase of slightly more than 150k b/d in 1Q17. KSA shipped 1.09mm b/d to the U.S. in 2Q17 vs. 1.23mm b/d in 1Q17. The rates at which Iraq and Nigeria were shipping oil to the U.S. also slowed, but are still above year-ago levels, as is to be expected given the civil strife from which both are recovering - Iraq's 2Q17 exports to the U.S. were up 279k b/d vs. 316k in 1Q17 yoy at 663k and 592k b/d, while Nigeria's exports to the U.S. were up 67k b/d yoy in 2Q17 and 69k b/d in 1Q17, at 286k b/d and 270k b/d, respectively. Chart 2OPEC Inventory Transfer##BR##Winds Down In 2017 Chart 3Surge In 2H16 OPEC Production##BR##Is Being Worked Off Continued high levels of U.S. refining runs and exports of crude and products also will accelerate draws in the U.S., even though refining runs are not growing at rates seen last year when the overall level of refining was lower (Chart 5). Chart 4OPEC Exports To##BR##The U.S. Are Slowing Chart 5U.S. Refinery Runs And Exports##BR##Remain High Watch Iraq Chart 6Libya, Nigeria Increase Production,##BR##But The Big Story Will Be Iraq The OPEC 2.0 agreement has been bedeviled by higher-than-expected production from Libya, where officials claim they will be producing at 1.0mm b/d by the end of July, and Nigeria.1 In our balances, we have Libyan production up some 100k b/d from last month at ~ 800k b/d. Nigeria currently is producing ~ 1.5mm b/d, after falling to as low as 1.2mm b/d due to sabotage of its export facilities. But, without doubt, the OPEC state with the greatest potential for production growth is Iraq, which currently is producing ~ 4.5mm b/d (Chart 6). Iraqi local inventories were up 43% yoy in April at just over 11mm bbl. Iraqi exports to the U.S. were up more than 50% yoy to just over 640k b/d in June. Ordinarily, this would not warrant much attention, given the harmony that so far has characterized OPEC 2.0's performance since year-end 2016. However, Iraqi officials have begun advocating for higher production levels, which, in their protestations, would be consistent with their high reserve levels. Just this week, the country's oil minister, Jabar al-Luaibi, asked rhetorically, "Why should Iraq be deprived from increasing its production? Not to disturb or disrupt OPEC at all, or the prices, but it is our right to have our production that corresponds to our reserves."2 He observed, "We have gas, we have oil. We have the right to do well. As simple as that." Iraq certainly has the reserves necessary to increase production significantly, but would require significant time and capital to grow production materially above the record levels reached in Q4 2016, which were about 200,000-300,000 b/d above current levels. "Whatever It Takes" May Require KSA To Cut Again If Libya can hold to its higher production level, and even reach 1mm b/d, and Iraq decides to exercise its "right" to produce more, OPEC 2.0 will have to cut additional barrels from the coalition's production to accommodate the higher output. Given Russia's apparent reluctance to do so, this could mark the first significant test of the durability of the agreement that created OPEC 2.0. The stakes are high if these production cuts are not addressed. As Russians go to the polls in March 2018, and, later in the year, KSA seeks to IPO Aramco, multiple problems will present themselves: Another production free-for-all that collapses prices would trigger another round of high consumer-level inflation in Russia, as the rouble falls once again, and KSA's IPO would value Aramco far below the $2 trillion Saudi officials are hoping for. Our bullish price view - we're expecting Brent to trade to $60/bbl by year-end - will be deep-sixed if production cannot be controlled. As it stands, we have total OPEC crude production just over 32mm b/d in 2017, and slightly over 32.5mm b/d in 2018. Given the stout demand growth we expect this year and next, we expect close to 900k b/d more demand growth over supply growth, based on our modelling. Next year, we expect supply growth of 2.25mm b/d, and demand growth of 1.62mm b/d, so supply growth exceeds demand growth in 2018 by 630k b/d, moving oil markets from undersupplied to balanced/slightly over-supplied. Obviously, higher production would change these balances. The big questions for the market going forward: Will OPEC states that have drained inventories supporting sales to key clients maintain production discipline, allowing inventories in the U.S. and ARA to drain? Will OPEC 2.0 unravel under pressure from Russia and KSA assessments of the need for additional cuts? Can Libya and Nigeria maintain higher output? Libya is a failed state, and warring tribes almost surely will seek to take control over as much of the revenue-generating capacity of the oil-export facilities in the East and West of the country as possible. Nigeria, although not a failed state, faces similar difficulties containing the sabotage that has disabled export capacity on and off for the past few years. Whither Iraq? A price collapse would definitely reduce U.S. shale output, as the 2015 - 1H2016 experience demonstrated. If domestic U.S. prices stayed lower for longer, we would expect rig counts to decline, reducing the rate of growth in U.S., supply. Right now, we expect U.S. shale output to grow 340k b/d this year and by ~ 1mm b/d next year based on earlier, higher price levels. Our research has shown the very high correlation between U.S. shale output and WTI prices along the forward curve out to 3 years forward, and a low price definitely will lead to lower rig counts. Bottom Line: OPEC 2.0 still is holding together. Going into its ministerial meeting at the end of this month, it must provide clear guidance to the market over how it will handle a sustained increase in Libyan production. In addition, Iraq's intentions must be clear - otherwise, the market will assume the worst. We remain bullish, and continue to recommend low-risk long positions - we are long Dec/17 $50 vs. $55/bbl call spreads in Brent and WTI. Once markets are given greater clarity, we will look for higher-risk alternatives for putting new length on. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Libya's Oil Production Nears 4 Year High," in oilprice.com's June 29, 2017, online edition. 2 The minister's remarks were reported in the July 5, 2017, issue of, Iraq Daily Journal's online edition. Please see "Iraq Has Right To Achieve Oil Output In Line With Reserves - Minister." Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Highlights Chart 1Too Pessimistic On Growth Treasury yields bounced sharply last week and the yield curve steepened. As a result the Bloomberg Barclays Treasury index posted a negative return in June, only the second month of negative Treasury returns so far in 2017. Last week's increase in yields could signal that growth expectations have finally become overly pessimistic. Our U.S. Investment Strategy service has calculated that after the U.S. Economic Surprise Index rises above 40, its average peak to trough decline lasts 90 days. Given that the surprise index peaked above 40 in mid-March, a bottoming-out in the coming weeks would be right on schedule (Chart 1). Net speculative positioning in the futures market has also capitulated, swinging sharply from net short to net long. In recent years, extreme net long positioning has led to higher Treasury yields during the following three months (bottom panel). Our assessment is that U.S. growth will remain above trend for the remainder of the year, and the Treasury curve will continue to bear-steepen as the economic data start to outperform downbeat expectations. Stay at below-benchmark duration, in curve steepeners, overweight spread product versus Treasuries, and overweight TIPS versus nominals. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 50 basis points in June. The index option-adjusted spread tightened 4 bps to end the month at 109 bps. Though below its historical mean, the investment grade spread is actually somewhat elevated compared to the early stages of prior Fed tightening cycles (Chart 2). We calculate that in the early stages of the past two tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 90 bps and traded in a range between 66 bps and 107 bps. While spreads are currently more attractive than is typical for this stage of the cycle, there is good reason for investors to demand some extra risk premium. In a recent report1 we observed that non-financial corporate debt as a percent of GDP is already as high as it was during the past two recessions. Further, the majority of this debt has been issued to finance direct payments to shareholders (dividends & buybacks) as opposed to capital investment. This unfavorable shift in corporate capital structures means that bond investors should demand somewhat greater compensation. All in all, we do not see potential for much spread tightening from current levels. However, a large spread widening would be equally unlikely given the favorable back-drop of steady growth and muted inflation. Small positive excess returns, consistent with carry, remains the most likely scenario. Energy debt underperformed duration-matched Treasuries by 12 bps in June. The sector still looks cheap after adjusting for credit rating and duration (Table 3), and our commodity strategists remain bullish on oil. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 35 basis points in June. The index option-adjusted spread widened 1 bp to end the month at 364 bps, 20 bps above its 2017 low. Energy sector spreads widened sharply in June, alongside falling oil prices, once again de-coupling from the overall index spread (Chart 3). Junk-rated energy credits underperformed the duration-equivalent Treasury index by 190 bps in June, while the High-Yield index excluding energy outperformed by 70 bps. In a report published today,2 our Energy Sector Strategy service takes a detailed look at credit risk among high-yield energy issuers, concluding that while the worst of the energy bankruptcy cycle is behind us, $23 billion of high-yield energy debt remains in distress. 91% of that distressed debt is in the Exploration & Production and Offshore Drilling & Transportation sectors. The continued moderation in energy sector defaults will ensure that the overall speculative grade default rate trends lower for the rest of the year, probably settling below 3% (bottom panel). The decline in defaults means that the current compensation offered by junk spreads in excess of expected default losses stands at 221 bps, right in line with its historical average (panel 3). In last week's report,3 we showed that a default-adjusted spread of 221 bps is consistent with excess returns close to 150 bps during the next 12 months. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 20 basis points in June, dragging year-to-date excess returns down to -20 bps. The conventional 30-year MBS yield rose 11 bps on the month, driven by a 7 bps increase in the rate component and a 6 bps widening of the option-adjusted spread (OAS). This was partially offset by a 2 bps decline in the compensation for prepayment risk (option cost). In last week's report,4 we examined the risk/reward trade-off in different Aaa-rated spread products. We found that despite some recent widening in MBS OAS, you still need to move into 4% coupons or higher to find competitive spreads relative to Aaa-rated corporates, consumer ABS, agency CMBS and non-agency CMBS. Further, MBS OAS are still too tight compared to the trend in net issuance (Chart 4), and even though depressed refi activity will continue to hold down the option cost component of spreads, it is unlikely that a lower option cost will be able to completely offset wider OAS during the next 12 months. The Fed released more details about its balance sheet run-off plan at the June FOMC meeting. We now know that the Fed will start by allowing only $4 billion of MBS per month to run off its balance sheet, but this cap will increase by $4 billion every 3 months until it reaches $20 billion per month. This means that even if the Fed starts to wind down its balance sheet following the September meeting, which is our base case expectation, then it will still be some time before a significant amount of extra supply shifts into the private market. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 21 basis points in June, bringing year-to-date excess returns up to +107 bps. Sovereigns and Local Authorities outperformed the Treasury benchmark by 65 bps and 73 bps, respectively. The low-beta Supranational and Domestic Agency sectors outperformed by 2 bps and 10 bps, respectively. The Foreign Agency sector underperformed duration-matched Treasuries by 4 bps, alongside the dip in oil prices. A weakening U.S. dollar has led to the outperformance of USD-denominated sovereign debt so far this year. Year-to-date, the Sovereign index has outperformed the duration-equivalent Treasury index by 300 bps. This is better than the equivalently-rated Baa U.S. Corporate index, which has outperformed by 195 bps year-to-date. However, there are already signs that the trade-weighted dollar is starting to moderate its downtrend (Chart 5), and we expect the trade-weighted dollar will strengthen as the economic data surprise to the upside in the back half of the year, as discussed on the first page of this report. Granted, the Mexican peso continues to strengthen versus the dollar (panel 3) and this currency pair is particularly important since Mexico is the largest issuer in the Sovereign index. On the heels of its recent outperformance, the Sovereign sector once again looks expensive compared to U.S. corporate sectors, after adjusting for credit rating and duration. Meanwhile, the Local Authority and Foreign Agency sectors continue to look cheap. Supranationals and Domestic Agencies offer very little additional compensation relative to Treasuries, and as we discussed last week,5 there are better options available for investors in need of high-quality spread product. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 18 basis points in June (before adjusting for the tax advantage). Last month we observed that Municipal / Treasury (M/T) yield ratios had become very tight, and we advised reducing municipal bond exposure to underweight. The average M/T yield ratio ticked higher in June, but at 85%, it remains more than one standard deviation below its post-crisis average (Chart 6). There is more compensation available at the long-end of the muni curve than at the short-end (panel 2), and investors should continue to favor long maturities over short maturities on the Aaa Muni curve. The National Association of State Budget Officers recently released its Fiscal Survey of the States and it showed that overall general fund expenditures are expected to increase by only 1% in the 2018 fiscal year, the slowest rate of growth since 2009/10. Meanwhile, 23 states have already enacted mid-year budget cuts in 2017. Budget cutting measures are clearly a response to disappointing tax revenues, which should bounce back somewhat in fiscal year 2018.6 This will help reduce net borrowing, though probably not by enough to justify current municipal bond valuations (panel 3). The state of Illinois avoided a ratings downgrade to junk this week, as the State House of Representatives voted to approve an income tax increase. This measure will keep the rating agencies at bay for now, but a downgrade is still possible in the coming months if the state fails to pass a budget for fiscal year 2018. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened for most of June, before suddenly reversing course and bear-steepening late in the month. The 2/10 slope flattened 15 basis points between the end of May and June 26, and then steepened 15 bps between June 26 and the end of the month. All told, the 2/10 slope was unchanged in June, while the 5/30 slope flattened 17 bps. The abrupt transition from bull-flattening to bear-steepening was prompted by comments from European Central Bank (ECB) President Mario Draghi that suggested a much more hawkish bias from the ECB. Higher rate expectations in the rest of the world should put downward pressure on the U.S. dollar, and historically, bearish sentiment toward the U.S. dollar has led to a steeper U.S. yield curve (Chart 7, bottom panel). This correlation has not held up so far this year, and we suspect this is because a weaker dollar has not translated into higher U.S. inflation and inflation expectations, as it usually does. We have previously made the case that inflation and inflation expectations, and not Fed tightening, are the main determinants of the slope of the yield curve (panel 4).7 As such, we attribute the bulk of this year's curve flattening to disappointing core inflation which has dragged TIPS breakevens lower. This should reverse in the coming months.8 Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 86 basis points in June. The 10-year TIPS breakeven rate fell 8 bps on the month and, at 1.75%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. In a recent report9 we outlined three possible scenarios for Treasury yields between now and the end of the year based on the interaction between incoming inflation data and Fed policy. In our base case scenario inflation will start to rebound in the coming months, heeding the message from our Phillips Curve model (Chart 8), leading to wider TIPS breakevens and keeping the Fed on its current tightening path. Even if realized inflation remains depressed, the next most likely scenario is that the Fed will capitulate later this year and adopt a shallower expected rate hike path. Such a dovish reaction from the Fed would lend support to long-maturity breakeven wideners, even though real yields would decline. The least likely scenario, in our view, is one where realized inflation remains low but the Fed sticks to its hawkish rhetoric. This is also the scenario that would lead to the most downside in the cost of inflation protection. May PCE inflation data were released last Friday, with year-over-year core PCE decelerating from 1.50% to 1.39%, and trimmed mean PCE decelerating from 1.70% to 1.66% (panel 4). One bright spot is that our PCE Diffusion Index swung sharply into positive territory. Historically, this index has a strong track record signaling turning points in core inflation (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in June, bringing year-to-date excess returns up to +54 bps. The index option-adjusted spread for Aaa-rated ABS tightened 2 bps on the month, and remains well below its average pre-crisis level. Despite low spreads relative to history, in a recent report10 we showed that Aaa-rated ABS appear quite attractive compared to other Aaa-rated spread product. Specifically, Aaa consumer ABS offer greater compensation per unit of duration than Agency bonds, agency MBS and Aaa Credit. They offer similar compensation per unit of duration to Agency CMBS, but less than non-Agency Aaa CMBS. Within consumer ABS, auto loan-backed securitizations offer slightly greater compensation than the credit card-backed variety (Chart 9). However, we still prefer credit card ABS over auto loan ABS. While credit card charge-offs remain historically low, auto net loss rates are rising. Auto lending standards also moved deeper into "net tightening" territory in the first quarter, according to the Fed's Senior Loan Officer Survey, while credit card lending standards dipped back into "net easing" territory (bottom panel). We continue to recommend that investors favor Aaa-rated credit cards over Aaa-rated auto loans within an overall overweight allocation to consumer ABS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in June, bringing year-to-date excess returns up to +57 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 1 bp on the month, and remains below its average pre-crisis level (Chart 10). In last week's report,11 we showed that non-agency CMBS offer by far the most compensation per unit of duration of any Aaa-rated spread sector. However, we are concerned that non-agency CMBS spreads will widen on a 6-12 month horizon. Commercial real estate lending standards are tightening and property prices are decelerating. Both of these developments tend to correlate with wider spreads. Despite lower spreads, we are much more comfortable in the Agency CMBS market. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 4 basis points in June, bringing year-to-date excess returns up to +54 bps. Agency CMBS offer somewhat lower spreads than their non-agency counterparts, but this sector should be more insulated from spread widening in the months ahead. Not only do these securities benefit from agency backing, but they also mostly comprise multi-family loans. Multi-family property prices have been stronger than those in the retail and office sectors, and delinquencies have been lower (bottom 2 panels). Treasury Valuation Chart 11Treasury 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 2.52% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.45%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound. The U.S. PMI has dipped lower in recent months, but remains firmly entrenched above the 50 boom/bust line. Meanwhile, the Eurozone PMI continues to surge ahead. China's PMI sent a worrying signal when it dipped below 50 in May, but it bounced back to 50.4 last month (bottom panel). Overall, the Global PMI came in at 52.6 in June, no change from the prior month. 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 2.35%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 2 Please see Energy Sector Strategy Weekly Report, "HY Debt Update: Offshore Drilling & Transportation Getting Left Behind", dated July 5, 2017, available at nrg.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 For further details please see U.S. Bond Strategy Weekly Report, "Will The Fed Stick To Its Guns?", dated May 16, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of June 30th, 2017. The model has continued to reduce its allocation to the U.S. and now for the first time the U.S. allocation is slightly below benchmark. Within the non-U.S. universe of the 11 countries, the model has also made significant adjustments to shift weights to Italy (now the largest overweight) and Australia (now for the first time it is overweight by the model), while underweight Germany and France. These adjustments are mainly due to liquidity and technical indicators, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 14 bps in June, largely due to the underperformance of Level 2 model where the overweight of the Euro area v.s. the underweight of Australia and Canada hurt the performance. Since going live, the overall model has outperformed its benchmark by 139 bps. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) 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. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of June 30, 2017. Chart 3GAA Non U.S. Model (Level 2) Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model continues to overweight cyclicals versus defensives. Additionally, the model has turned overweight financials and underweight consumer discretionary on the back of momentum. This overweight in financials is now in line with our global sector recommendations published yesterday. 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 Expanding trade volumes - led by EM growth - will continue to support commodity demand, particularly for base metals. In the first four months of this year, EM import growth averaged 8.4% year-on-year (yoy), led by an expansion of almost 13% in EM Asia. This compares with yoy growth averaging just 0.3% in the DM imports over the January - April period. EM exports grew 5.1% yoy in this interval vs. 2.7% for DM outbound trade. Overall, EM growth led world trade volumes 4% higher yoy, versus 0.8% growth over the January - April interval last year. We expect trade volumes to continue to grow as long as the Fed doesn't tighten monetary conditions too much in the U.S. Energy: Overweight. Benchmark crude oil prices continue their lackluster performance, as high-frequency inventory data in the U.S. fail to convince markets OPEC 2.0 cuts are succeeding in draining global inventories. We expect this to reverse, and remain long Dec/17 $50 vs. $55/bbl call spreads in WTI and Brent. Base Metals: Neutral. Expanded global trade, led by EM Asia, will be supportive of base metals prices. However, we do not expect higher trade volumes to prompt a surge in base metals. We remain neutral base metals generally. Precious Metals: Neutral. Palladium has consistently outperformed platinum in post-GFC markets, as has gold (see below). We remain neutral the precious-metals complex, but are keeping our long gold portfolio hedge in place. Ags/Softs: Underweight. The USDA's crop report will be released Friday. Weather-related crop distress in the grains could start showing up in the data. We remain bearish, but recommend staying on the sidelines. Feature Chart of the WeekStrong Growth In Global Trade Volumes##BR##Will Be Supportive Of Base Metals Growth in EM imports and exports continues to lead the expansion of global trade volumes. This is important, as the growth in trade supports EM income growth, which, in turn, supports commodity demand. EM growth is the principal source of commodity demand growth globally, particularly for oil and base metals. Global trade volumes expanded yoy in April, with imports up 3.7% and exports up 3.2%, down slightly from the pace in 1Q17, according to the CPB World Trade Monitor (Chart of the Week). The notional value of trade for the year ended in April was $16.3 trillion. The uptrend in global trade begun in 4Q16 continues, however, which we noted earlier this month. As was the case with oil, this expansion of global trade volumes, particularly out of the EM economies, will be supportive of base metals demand generally.1 Similar to EM oil demand, we find EM exports and imports are highly correlated with world base metals demand post-GFC (Chart 2). This is not unexpected, given the prominence of Chinese base metals demand, which accounts for roughly half of base metals demand globally. Given the low level of growth in DM imports and exports, we conclude that the bulk of the increase in global trading volumes is increasingly accounted for by trade within the EM economies with each other. This can be seen in Chart 3, which shows growth of EM imports and exports surpasses DM trade performance, shown in Chart 4. Chart 2World Base Metals Demand,##BR##Highly Correlated With EM Trade Volumes Chart 3Increased Trade Within##BR##EM Economies Powers Global Trade Growth Chart 4DM Growth Not##BR##Keeping Up With EM Growth Going Through The Trade Numbers For the year ended in April 2017, yoy world import levels grew 2.5% on average each month. DM imports averaged 1.8% yoy growth, while EM imports grew at twice that level. The notional value of DM imports was $9.6 trillion for the year ended in April. EM notional imports were $6.7 trillion, with EM Asia accounting for $4.7 trillion of this. For exports, world trade volumes grew at an average rate of 2.3% yoy each month for the 12 months ending in April, with DM growth coming in at 1.6%, and EM growth clocking in at 3.1% on average, just shy of double the rate of DM growth. The notional value of DM exports was $8.8 trillion for the year ended in April. EM notional exports were $7.4 trillion, with EM Asia responsible for $4.9 trillion of this. For April alone, DM imports were up 1.8% yoy, while EM imports were up 6.5%, down from a 9.1% average rate in 1Q17. DM exports in April were up 1.7% yoy, down from a 3% average rate in 1Q17, while EM exports rose 5%, equal to the 1Q17 average rate. Import volumes for EM Asia led global growth by a wide margin vs. other EM markets, particularly in Latin America and the Middle East (Chart 5). Average yoy import growth for the year ended in April was 6.6% for EM Asia, with yoy growth for April alone registering 10.4%. EM Asia also leads export volume growth (Chart 6), with average yoy outbound trade up 7.1% yoy. Chart 5EM Asia Dominates Import Growth YoY... Chart 6...And EM Export Growth As always, the evolution of China's economy will have an outsized influence on trade and EM growth. We continue to expect China's growth to moderate but not slow sharply, in line with our colleagues at our sister publication China Investment Strategy. The recent credit tightening likely will abate, given the central bank has reversed its credit contraction and injected liquidity into the interbank system in recent weeks, according to BCA's China Investment Strategy service.2 We agree with China Investment Strategy's assessment that, "The Chinese economy will likely continue to moderate, but the downside risk appears low at the moment and overall business activity will remain buoyant."3 Update On Global Inflation Vs. EM Trade Volumes World base metals demand is highly correlated with global consumer price inflation. In fact, these variables are cointegrated, meaning they share a common long-term trend. A 1% increase in world base metals demand can be expected to produce a 0.32% increase in U.S. CPI, a 0.25% increase in the Euro Area Harmonized CPI, and a 0.43% increase in China's CPI. Like the relationships between EM oil demand and EM trade volumes, which we presented earlier this month, the relationships between world base metal demand and EM trade volumes also allows us to track EM income levels. This is because the income elasticity of base metals demand also is ~ 1.0 for EM economies, according to the OECD, meaning a 1% increase in EM income can be expected to produce an increase in base metals demand of ~ 1%.4 Likewise, consumer inflation worldwide also is highly correlated with EM trade volumes post-GFC.5 In the regressions we ran for U.S., Euro Area and China CPI as a function of EM trade volumes, we find a 1% increase in EM imports can be expected to produce a 0.51% increase in the U.S. CPI, a 0.41% increase in the Euro Area harmonized CPI, and a 0.67% increase in the China CPI. A 1% increase in EM exports produces increases of 0.47%, 0.35% and 0.65%, respectively. These relationships can be seen in Charts 7, 8, and 9. Chart 7U.S. CPI Highly Correlated##BR##With EM Trade Volumes... Chart 8...Along With The Euro Area##BR##Harmonized CPI... Chart 9...And##BR##China's CPI Bottom Line: World base metals demand will continue to be supported by continued growth in EM trade volumes this year. While these volumes are up nicely, the rate of growth is moderating somewhat, suggesting global base metals demand will hold up this year, but won't surge ahead. We certainly do not see base metals prices falling precipitously this year, given the growth in EM imports and exports, which started to revive toward the end of last year. We remain neutral base metals, but will be watching the interplay between base metals demand and EM trade volumes for any sign global demand is being re-ignited. Inflation appears to be quiescent globally, but we would expect it to start ticking up if we see an uptick in base metals demand and EM trade volumes. Precious Metals Update PGM Notes Price relationships within the precious-metals complex, particularly vis-à-vis Platinum Group Metals (PGMs), have undergone profound transformations since the end of the Global Financial Crisis (GFC). These changes have been bolstered by technology shifts in the automotive sector as well. Two trading relationships - palladium's relationship to platinum, and platinum's relationship to gold - best illustrate these changing fundamentals. Unlike gold and platinum prices, palladium is heavily influenced by automotive sales, in this case, gasoline-powered automobile sales. Gasoline-powered cars use palladium in their pollution-control catalysts. Such usage was up 5% last year to 7.4mm oz, according to Thomson Reuters GMFS data.6 Autocatalyst demand accounts for slightly more than three-quarters of palladium demand, according to GFMS data.7 Importantly, the two largest car markets in the world - the U.S. and China - are predominantly gasoline-powered, and sales in both have been strong, although the rate of growth has slowed (Chart 10). This is supportive of palladium prices, particularly as the metal registered a 1.2mm physical deficit last year. There is an increase in Chinese platinum-based auto catalyst demand for diesel cars, due to tightening regulation on emissions, but still is a small share of the total demand for platinum. Post-GFC, the value of palladium relative to platinum has consistently strengthened (Chart 11). Chart 10U.S. Sales Growth Down,##BR##But China Remains Strong Chart 11Platinum Eclipsed By##BR##Palladium And Gold Platinum's Discount To Gold Endures Platinum traded premium to gold until the GFC (Chart 11). Since then, gold has behaved more like a currency, with its price mostly dependent on financial variables (USD, real U.S. interest rates, and equity risk premium). Importantly, the yellow metal has traded premium to platinum since the GFC ended. While platinum prices are somewhat sensitive to the same financial factors as gold, and also can be modeled as a function of these financial variables, the metal also has a real-demand driver: diesel-powered car sales. These vehicles use platinum in their pollution-control catalysts. Autocatalysts accounted for 3.3mm oz of platinum sales last year, or 42% of demand, according to Thomson Reuters GFMS. Most of this goes to diesel catalysts, which are mainly sold in Europe. Diesel-powered car sales have been trending lower (Chart 12) in Europe, where they are the dominant type of car sold. The second largest demand segment for platinum is jewelry sales, which fell 12% last year to 2.2mm oz, following a 3.6% decline the prior year. Both gold and platinum will be responsive to the same set of financial variables, meaning a stronger USD along with higher real rates will be bearish for both, and vice versa. However, given platinum is also sensitive to the diesel-powered auto market, its price evolution has a component strongly influenced by physical platinum demand and supply. Supply comes from mines and recycling, which increases when steel prices rise. Sales of diesel-powered cars are falling in Europe partly due to the Volkswagen emissions-testing scandal and a longer-lasting trend of cities attempting to lower pollution by restricting where diesel-powered vehicles can drive (e.g., Athens, Madrid, Paris and Mexico City are eliminating diesel traffic by 2025).8 In addition, high steel prices will increase platinum recycling volumes this year (people scrap their cars more when steel prices are high). High steel prices also incentivize the scraping of gasoline-powered vehicles, which use palladium in their pollution-control catalysts. Platinum competes at the margin in the pollution-control catalyst market with palladium. The ratio between palladium and platinum is at its highest level since 2002 (Chart 11). The premium of platinum against palladium (platinum minus palladium) went from $1200/oz. in 2010 to close to parity recently (Chart 13). Chart 12EU Sales Still Growing,##BR##But Diesel Loses Share Chart 13Platinum's Premium To##BR##Palladium Disappears Continue To Favor Palladium We are more favorably disposed toward palladium than platinum. Given palladium's price is dominated by sales of gasoline-powered cars, which should, all else equal, do well relative to diesel-powered auto sales, even with a globally synchronized economic upturn. With the U.S. Fed expected to continue tightening, gold and platinum will face financial headwinds that will restrain price appreciation. Palladium, on the other hand, will be less sensitive to these headwinds, although higher interest rates in the U.S. relative to the rest of the world will restrain demand for goods purchased on credit like autos. While we remain neutral the precious metals complex generally, we recently recommended a long spot-gold position as a portfolio hedge against rising inflation and inflation expectations.9 Even though inflation has remained quiescent, and markets are trading as if the odds of a return of inflation are extremely low, BCA's Global Investment Strategy argues "the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment."10 We believe the strengthening of household incomes resulting from the tight U.S. labor market likely will keep the Fed on track to continue with its rates-normalization policy, vs. market expectations of a mere 21 basis points in cumulative Fed rate hikes over the next 12 months. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, available at ces.bcaresearch.com. The CPB World Trade Monitor is published monthly by the CPB Netherlands Bureau for Economic Policy Analysis. Please see https://www.cpb.nl/en/worldtrademonitor for data and documentation. We use CPB's volumetric data for imports and exports in our analysis, which are indexed to 2010 = 100; we converted these data to USD values to see how the composition of imports and exports is changing so as to better see how the relative shares of EM and DM are evolving. 2 Please see BCA Research's China Investment Strategy Weekly Report "Chinese Financial Tightening: Passing The Phase Of Maximum Strength," published by on June 22, 2017, available at cis.bcaresearch.com. 3 Please see BCA Research's China Investment Strategy Weekly Report "A Chinese Slowdown: How Much Downside," published on June 8, 2017, available at cis.bcaresearch.com. 4 As we noted in our research earlier this month, the read-through on this is EM trade volumes are closely tied to income levels, given this income elasticity in non-OECD economies. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). In our modeling, we assume the GFC ended in 2010. Our oil results vis-à-vis EM income elasticities can be found in BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, available at ces.bcaresearch.com. 5 We originally published these results for EM oil demand vs. EM trade volumes in the June 8, 2017 article referenced above in footnote 1, in BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," available at ces.bcaresearch.com. The average R2 coefficient of determination for the regressions on imports was 0.89, while the average for the regressions on exports was 0.89. 6 Palladium supply totalled 8.6mm oz, while demand came in at 9.8mm oz, according to the Thomson Reuters - GFMS Platinum Group Metals Survey 2017. 7 In our modelling, we treat palladium as an industrial metal, given the overwhelming influence auto demand - particularly gasoline-powered vehicles - has on its price. Please see BCA Research's Commodity & Energy Strategy Weekly Report "2016 Commodity Outlook: Precious Metals," published by December 3, 2015, available at ces.bcaresearch.com. 8 A number of cities are looking to ban diesel cars entirely from their central districts. Please see https://www.theguardian.com/environment/2016/dec/02/four-of-worlds-biggest-cities-to-ban-diesel-cars-from-their-centres. 9 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Go Long Gold As A Strategic Portfolio Hedge," published May 4, 2017, available at ces.bcaresearch.com. 10 Please see BCA Research's Global Investment Strategy Weekly Report "Stocks Are From Mars, Bonds Are From Venus?," published June 23, 2017, available at gis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Special Report

Highlights The EM carry trade - supported by a commodity price rally, falling bond yields, and a weak USD - have propped up South African assets; Investors have largely ignored politics and focused on personalities instead of political fundamentals; South Africa's socio-economic factors - governance, middle class wellbeing, productivity, and unemployment - have all regressed; The "median voter" has therefore turned more radical and left-wing; Stay short ZAR versus USD and MXN, stay underweight stocks, sovereign credit, and domestic bonds, and bet on yield-curve steepening. Feature Why do investors in Europe and the U.S. continue to invest in South Africa? - Every client in South Africa Our recent week-long trip to South Africa was revealing for two reasons. First, it reminded us of the promise and opportunity of this amazing country and its people. Second, it impressed upon us the deep pessimism of its entire financial community. As the quote at the top of this report suggests, every client we met over seven days was deeply puzzled by continued resilience of foreign inflows. Clients were surprised that foreign investors continued to find value in South Africa's fixed income and currency markets amidst a continued growth downtrend, soft commodity prices, and the ongoing political imbroglio (Chart I-1). The answer to the puzzle is simple: the main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart I-2). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart I-1ZAR Rally Amidst Economic##br## And Commodity Downturn Chart I-2EM Carry Trade Is ##br##Alive And Well How likely is it that the carry trade can continue? BCA's Global Investment Strategy and Emerging Markets Strategy both argue that U.S. growth will soon accelerate.1 The U.S. financial conditions have eased thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart I-3). Historically, an easing in financial conditions has foreshadowed faster growth (Chart I-4). Meanwhile, the relative U.S. growth underperformance versus DM is late and will turn around very soon (Chart I-5). As U.S. economic growth surprises pick up, investors will bid up the 10-year Treasury yield and the greenback, ushering in the end of the carry trade. Chart I-3U.S. Financial Conditions Have Eased... Chart I-4...U.S. Growth Should Therefore Sharply Rebound Chart I-5U.S. Underperformance Is Long-In-The-Tooth How resilient are South Africa's economic fundamentals and politics? In this report, we argue that they are not resilient at all. The country is facing considerable structural problems on both economic and political fronts. Even its sole silver lining - that it retains cyclical maneuvering room, i.e., it can adopt fiscal stimulus - will only encourage its leaders to double-down on a populist growth model that has already run out of steam. Cyclical Outlook: A Dark Cloud With A Silver Lining The cyclical outlook for South Africa has darkened as of late. All the drivers that pushed the rand to appreciate over the last 12 months are now showing signs of a reversal: The rand's rally in the past six months or so - a period when it decoupled from commodities prices - is often attributed to its higher interest rates. However, Chart I-6 demonstrates that higher local interest rates historically did not prevent the rand's selloff when metal prices fell. In short, we believe the last six months is an aberration rather than a new norm. Remarkably, hedged yields in South Africa are no longer attractive within the EM space. South Africa already offers the worst hedged returns, after Turkey and China, for the U.S. dollar and euro-based investors (Chart I-7 and Chart I-8).2 The situation will only get worse as the U.S. dollar appreciates and Treasury yields rise. Chart I-6High Local Interest Rates ##br##Are No Panacea For ZAR The drop in precious metal prices will force the rand to selloff (Chart I-9). The unprecedented resilience in the rand was supported by increasing financial flows. Now that these are decreasing, the historic correlation with precious metals should reemerge. The decoupling between the ZAR and AUD since early this year is unprecedented (Chart I-10). Both economies are leveraged to industrial and precious metals as well as coal prices, making both exchange rates correlated. Needless to say, Australia commands much better governance and politics than South Africa. In fact, higher interest rates in South Africa have never precluded the rand's depreciation when the AUD dropped. Chart I-9Is The Divergence With Precious Metals... Chart I-10...And AUD Sustainable? Therefore, we conclude that the rand's strength has not been warranted by any of its historic drivers. It has been due to nothing else than the blind search for yield. Over the medium and long run, the outlook for the rand remains bleak. The ongoing dynamic of high wage growth and negative productivity growth will assure a lingering stagflationary environment (Chart I-11). This is bearish for the rand. Surprisingly, despite a rising currency and falling bond yields over the last 12 months, the South African economy is still showing signs of weakness. The household sector, which represents 61% of the economy, is not showing signs of a recovery yet. Credit growth to households is still falling and private consumption is abysmal. (Chart I-12). On the corporate side, the situation is not reassuring either. Firms are not investing and business confidence has not shown any signs of a significant recovery (Chart I-13). Chart I-11Productivity Is Weak But Wages Are Strong Chart I-12Household Consumption Is Declining Chart I-13No Confidence, No Investment The one positive is that the government has fiscal room to maneuver. South African gross government debt is at a comfortable 51% of GDP. However, we suspect that the nature of fiscal spending will likely result in transfers to appease the population - especially ahead of key elections in late 2017 and 2018 - rather than investments that can genuinely improve productivity. In fact, fiscal spending in the form of transfers could very well entice consumers to import more and consequently widen the current account deficit, putting more downward pressure on the rand. Bottom Line: The commodity price rally in 2016 and falling bond yields failed to buoy the economy. While policymakers do retain fiscal room to stimulate, the problem is that such efforts will likely merely rekindle populist policies that have failed South Africa thus far. Structural Outlook: Late Innings Of The Crisis Of Expectations South Africa is not alone in the EM universe in having failed to improve governance over the past decade. Most EM economies have squandered the commodity bull market and Chinese industrialization, allowing their governance to stagnate or even worsen during the good times (Chart I-14).3 However, South Africa does stand alone when it comes to a tepid rise in middle class, as percent of total population (Chart I-15), and continued high income inequality (Chart I-16). Chart I-14Quality Of EM Governance Declined##br## Amidst The Good Times Chart I-15Middle Class Has ##br##Barely Budged... The data is clear: South Africa is as unequal overall, and its middle class unchanged relative to overall population, as it was at the end of apartheid in the early 1990s. Governance in the country has continued to deteriorate, and while it remains higher than in Sub-Saharan Africa, the gap has astonishingly begun to narrow from both ends (Chart I-17). Chart I-17Governance Gap With Sub-Saharan ##br##Africa Is Closing! A major reason for the deterioration in governance is the "state capture" thesis that has become a popular one in characterizing President Jacob Zuma's rule.4 This process began early, as the country shifted its developmental program in 1996 away from a top-down, state-led, developmental model to one that encouraged a free-market economy balanced with welfare spending. This was a natural result of the global rise of laissez-faire capitalism, the Washington Consensus, and "Third Way" politics of left-leaning parties. A commitment to laissez-faire capitalism and free markets, combined with a strong welfare state, were seen as hallmarks of a successful economy. The problem with this approach is that it confused the symptoms of developed economies with their catalysts. South Africa needed a much more state-led approach to development, one that would have harnessed the resources of the state for productivity-enhancing investments. As such, the laissez-faire approach unsurprisingly failed to address the inequalities of the apartheid system and the country saw a decline in the middle class as percent of total population under both Presidents Nelson Mandela and Thabo Mbeki. This pivot towards free-market capitalism ended with the 2007 "Polokwane moment," which saw President Mbeki's free-market, reactive, attempt to address inequality between the white and black populations replaced with the proactive policy of Jacob Zuma. Zuma's more radical approach was to complement welfare transfers and high wage growth with an activist use of state owned enterprises (SOEs) as a vehicle for redistribution. This proactive policy meant using the government's tender system to doll out lucrative contracts to well-connected insiders, under the auspices of helping enfranchise black entrepreneurs and businesses. While the media has focused on the role that the Indian-born Gupta family has played in this process, it is highly unlikely that they are the only beneficiaries. Zuma's administration has, in the name of black enfranchisement and the fight against inequality, essentially rigged the entire government tender system for the sake of its own political preservation. The results of this process are unsurprising. First, government wages have outpaced those in both manufacturing and mining sectors (Chart I-18). Meanwhile, productivity has declined precipitously since 2007 and has been negative since 2012. South Africa has a lower productivity rate than both Latin American EM economies and its neighbors in sub-Saharan Africa (Chart I-19). Chart I-18Government Wages Have Outpaced All Others Chart I-19South African Productivity Has No Peer Financial media and investment research have continued to focus on the intricacies of the ruling African National Congress (ANC) politics. And we do so as well below. However, investors have to understand that South Africa's ills will not be fixed by the appointment of a pro-market finance minister or even the removal of Jacob Zuma from rule. South Africa has failed to develop inclusive economic institutions that engender creative destruction, which is at the heart of all successful development stories.5 South Africa ranked 74th in the World Bank's annual Doing Business report in 2017, an astonishing fall from grace over the past decade (Chart I-20). Compared to regional averages, South Africa barely beats the Sub-Saharan "distance to frontier" scores in several World Bank categories (Chart I-21). This is not due to the gross failure of the Zuma administration to do the "right thing." Rather, it exhibits a structural failing of South African political institutions. This development path is not unique to South Africa. Most sub-Saharan African states experienced a similar regression within 10-20 years of decolonization. Political scientist Robert Bates famously documented how African leaders co-opted colonial-era extractive economic institutions - such as the state marketing boards that purchased all cash crops and exported them on the global market - in order to generate enough revenue to industrialize their economies.6 While their intentions may have originally been noble, if misplaced, they quickly began to use control over marketing boards for political purposes. The rent generated from marketing boards became an immense source of political power for African leaders and they held on to it to the detriment of the economic development of their state. South Africa is far more developed than its sub-Saharan peers were in the 1970s. Nevertheless, its leaders are exhibiting similar rent-seeking behavior, albeit at a much higher level of development. It is also entering a dangerous period in its post-apartheid history: it has now been twenty years since South Africa's effective decolonization and it is facing its first serious economic downturn. Bottom Line: We doubt that anyone in the current leadership elite will be able to fully abandon the rent-seeking behavior of the Zuma administration and improve South Africa's economic institutions. The crisis of expectations among the country's voters is palpable and demands for greater redistribution are rising. This is not a context for pro-market reforms that will encourage creative destruction. Instead, we would expect a doubling-down of populism and greater emphasis on proactive redistribution, which will, at the same time, encourage greater out-migration of talent out of the country and rent seeking behavior from political elites. Can Any One Man Or Woman Fix South Africa? The African National Congress (ANC) will meet in December 2017 to decide the party candidate that will contest the 2019 general election (Diagram I-1). Given the ANC's stranglehold on the country's politics, it is likely that whoever emerges at the upcoming ANC Congress will be the next president of South Africa. BCA's Geopolitical Strategy subscribes to the idea that policymakers are price takers in the political marketplace, not price makers. This is particularly the case in democracies, but it is also the case in some authoritarian regimes where public opinion is relevant. As such, the puzzle investors have to resolve is not what policymakers stand for, but rather what the median voter wants. In South Africa, the median voter lives in a rural area, works in the agriculture or service industry, and is a black citizen. The polls indicate that the main concerns of the median voter are a high structural unemployment rate (Chart I-22), endemic corruption (Chart I-23), poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. Chart I-22Crisis Of Expectations Is this the profile of a median voter about to elect a pro-market reformer willing to pursue painful structural reforms? We do not think so. The two candidates vying for the ANC presidency are the ex-wife of Jacob Zuma and former Chair of the African Union, Nkosazana Dlamini-Zuma, and former Deputy President, Cyril Ramaphosa. Ramaphosa is the darling of the international investment community. This is because he has abandoned his previous union credentials - he founded the country's largest trade union, the National Union of Mineworkers in addition to founding the Congress of South African Trade Unions (COSATU) - and turned into a successful businessman. As such, the narrative among South Africa bulls (who are exclusively found in Europe and the U.S.) is that he would be able to bridge the divide between the demands for redistribution and pro-market reforms. To the median voter, however, Ramaphosa is alleged to be involved in the Marikana Massacre. Acting as the Deputy President, he ordered increased police presence at the mines and called for the use of force, which resulted in 47 deaths in August-September 2012. Dlamini-Zuma, on the other hand, speaks the language of the median voter while also not being seen as part of Zuma's corrupt entourage. Her credentials are bolstered by a successful tenure as Chair of the African Union and as a woman independent and strong enough to divorce President Zuma. She has not amassed personal wealth and does not hold strong loyalties to a particular faction within the ANC. However, she has begun to parrot Zuma's line that the country requires "radical economic transformation," which is a signal to left-leaning members of the ANC that she will continue much of economic policies begun under Zuma. Both the ANC Youth and Women's Leagues, which are left leaning, support her. The problem that investors face in South Africa is that there is no clear demand for pro-market reforms. Investors cheered the results of the August 2016 municipal election, for example, because the ANC lost in several key cities and saw its total vote share fall by 8%. However, few in the media or investment research community raised the obvious point that the centrist Democratic Alliance only saw its vote total rise by 3% compared to the 2011 election. It was the radically left-wing Economic Freedom Fighters, led by ex-Youth League leader Julius Malema, which saw the largest increase in vote share, by over 8%. In other words, ANC voters that did abandon Zuma most likely fell behind Malema, who is far more redistributionist. As such, we stick to our long-held view that Zuma and the ANC leadership are unlikely to do what investors want them to do given that the South African median voter is swinging further to the left. There is no demand for pro-market reforms and thus policymakers are more likely to double-down on populism. Bottom Line: Dlamini-Zuma is the likely winner of the upcoming ANC Congress, which will effectively decide the next president of South Africa. She has the sufficient left-leaning economic credentials to satisfy the demands for redistribution of the median voter. There is also a chance that she will attempt to clean up the corruption that has become endemic under Zuma, which would undoubtedly be a good thing for the country. However, it is unlikely that the macroeconomic context she will face will be positive, or that she will have the mandate to balance redistributive policies with painful pro-market reforms that would rebuild institutions required for creative destruction. Investment Implications South African assets are ultimately at the mercy of foreign inflows. When the dollar is weakening, U.S. bond yields falling, and Chinese growth stable, even the election of Julius Malema to the presidency would not dent foreign enthusiasm for yield in South African assets. Given the expected improvement in U.S. growth and the transitory nature of the drop in the U.S. inflation rate, we expect the global macro backdrop to worsen substantially for carry trades in general, and for South Africa in particular. China remains the wild card in our analysis, but its credit and fiscal impulse has rolled over, suggesting slower import growth over the next six months (Chart I-24). Even if Chinese policymakers react by re-stimulating the economy, the effects will only be felt in early 2018 given lead times. When the global carry trade reverses, it will not matter who is in charge of South Africa. Investors will realize that the country has failed to address serious socio-economic ills that have plagued South Africa since the end of apartheid. BCA's Emerging Markets Strategy continues to recommend the following investment positions: Chart I-24China Slowdown Is A Risk To EM Chart I-25Yield Curve Will Steepen Continue shorting ZAR versus USD and MXN. Underweight South African stocks, sovereign credit and domestic bonds relative to their respective EM benchmarks. A new trade: bet on yield-curve steepening (Chart I-25). The short end of the curve will be steady but populist politics, larger fiscal deficits/higher public debt, and an inflationary backdrop will push up long-end yields. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Beement Alemayehu, Research Assistant beementa@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "Stocks Are From Mars, Bonds Are From Venus?" dated June 23, 2017, available at gis.bcaresearch.com, and BCA Emerging Market Strategy Weekly Report, "EM: Contradictions And A Resolution," dated June 14, 2017, available at ems.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Local Bonds: Looking At Hedged Yields," dated May 10, 2017, available at ems.bcaresearch.com. 3 'Governance' is a catchall term that attempts to capture the quality of public service delivery, broadly defined. In essence, investors can consider governance as a factor that underpins the quality of political institutions. We rely on the World Bank's Development Indicators because the World Bank aggregates the work of several credible surveys on governance. These indicators are also useful because the World Bank standardizes the results in a way that allows cross-country/region comparisons. We then aggregate the scores across five different variables and look for trends and changes over time. 4 Please see State Capacity Research Project, "Betrayal Of The Promise: How South Africa Is Being Stolen," dated May 2017, available at pari.org.za. 5 Please see Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 6 Please see Robert H. Bates, Markets and States in Tropical Africa: The Political Basis of Agricultural Policies (Berkeley, University of California Press, 2014 edition). Geopolitical Calendar

Special Report

Highlights The EM carry trade - supported by a commodity price rally, falling bond yields, and a weak USD - have propped up South African assets; Investors have largely ignored politics and focused on personalities instead of political fundamentals; South Africa's socio-economic factors - governance, middle class wellbeing, productivity, and unemployment - have all regressed; The "median voter" has therefore turned more radical and left-wing; Stay short ZAR versus USD and MXN, stay underweight stocks, sovereign credit, and domestic bonds, and bet on yield-curve steepening. Feature Why do investors in Europe and the U.S. continue to invest in South Africa? - Every client in South Africa Our recent week-long trip to South Africa was revealing for two reasons. First, it reminded us of the promise and opportunity of this amazing country and its people. Second, it impressed upon us the deep pessimism of its entire financial community. As the quote at the top of this report suggests, every client we met over seven days was deeply puzzled by continued resilience of foreign inflows. Clients were surprised that foreign investors continued to find value in South Africa's fixed income and currency markets amidst a continued growth downtrend, soft commodity prices, and the ongoing political imbroglio (Chart I-1). The answer to the puzzle is simple: the main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart I-2). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart I-1ZAR Rally Amidst Economic##br## And Commodity Downturn Chart I-2EM Carry Trade Is ##br##Alive And Well How likely is it that the carry trade can continue? BCA's Global Investment Strategy and Emerging Markets Strategy both argue that U.S. growth will soon accelerate.1 The U.S. financial conditions have eased thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart I-3). Historically, an easing in financial conditions has foreshadowed faster growth (Chart I-4). Meanwhile, the relative U.S. growth underperformance versus DM is late and will turn around very soon (Chart I-5). As U.S. economic growth surprises pick up, investors will bid up the 10-year Treasury yield and the greenback, ushering in the end of the carry trade. Chart I-3U.S. Financial Conditions Have Eased... Chart I-4...U.S. Growth Should Therefore Sharply Rebound Chart I-5U.S. Underperformance Is Long-In-The-Tooth How resilient are South Africa's economic fundamentals and politics? In this report, we argue that they are not resilient at all. The country is facing considerable structural problems on both economic and political fronts. Even its sole silver lining - that it retains cyclical maneuvering room, i.e., it can adopt fiscal stimulus - will only encourage its leaders to double-down on a populist growth model that has already run out of steam. Cyclical Outlook: A Dark Cloud With A Silver Lining The cyclical outlook for South Africa has darkened as of late. All the drivers that pushed the rand to appreciate over the last 12 months are now showing signs of a reversal: The rand's rally in the past six months or so - a period when it decoupled from commodities prices - is often attributed to its higher interest rates. However, Chart I-6 demonstrates that higher local interest rates historically did not prevent the rand's selloff when metal prices fell. In short, we believe the last six months is an aberration rather than a new norm. Remarkably, hedged yields in South Africa are no longer attractive within the EM space. South Africa already offers the worst hedged returns, after Turkey and China, for the U.S. dollar and euro-based investors (Chart I-7 and Chart I-8).2 The situation will only get worse as the U.S. dollar appreciates and Treasury yields rise. Chart I-6High Local Interest Rates ##br##Are No Panacea For ZAR The drop in precious metal prices will force the rand to selloff (Chart I-9). The unprecedented resilience in the rand was supported by increasing financial flows. Now that these are decreasing, the historic correlation with precious metals should reemerge. The decoupling between the ZAR and AUD since early this year is unprecedented (Chart I-10). Both economies are leveraged to industrial and precious metals as well as coal prices, making both exchange rates correlated. Needless to say, Australia commands much better governance and politics than South Africa. In fact, higher interest rates in South Africa have never precluded the rand's depreciation when the AUD dropped. Chart I-9Is The Divergence With Precious Metals... Chart I-10...And AUD Sustainable? Therefore, we conclude that the rand's strength has not been warranted by any of its historic drivers. It has been due to nothing else than the blind search for yield. Over the medium and long run, the outlook for the rand remains bleak. The ongoing dynamic of high wage growth and negative productivity growth will assure a lingering stagflationary environment (Chart I-11). This is bearish for the rand. Surprisingly, despite a rising currency and falling bond yields over the last 12 months, the South African economy is still showing signs of weakness. The household sector, which represents 61% of the economy, is not showing signs of a recovery yet. Credit growth to households is still falling and private consumption is abysmal. (Chart I-12). On the corporate side, the situation is not reassuring either. Firms are not investing and business confidence has not shown any signs of a significant recovery (Chart I-13). Chart I-11Productivity Is Weak But Wages Are Strong Chart I-12Household Consumption Is Declining Chart I-13No Confidence, No Investment The one positive is that the government has fiscal room to maneuver. South African gross government debt is at a comfortable 51% of GDP. However, we suspect that the nature of fiscal spending will likely result in transfers to appease the population - especially ahead of key elections in late 2017 and 2018 - rather than investments that can genuinely improve productivity. In fact, fiscal spending in the form of transfers could very well entice consumers to import more and consequently widen the current account deficit, putting more downward pressure on the rand. Bottom Line: The commodity price rally in 2016 and falling bond yields failed to buoy the economy. While policymakers do retain fiscal room to stimulate, the problem is that such efforts will likely merely rekindle populist policies that have failed South Africa thus far. Structural Outlook: Late Innings Of The Crisis Of Expectations South Africa is not alone in the EM universe in having failed to improve governance over the past decade. Most EM economies have squandered the commodity bull market and Chinese industrialization, allowing their governance to stagnate or even worsen during the good times (Chart I-14).3 However, South Africa does stand alone when it comes to a tepid rise in middle class, as percent of total population (Chart I-15), and continued high income inequality (Chart I-16). Chart I-14Quality Of EM Governance Declined##br## Amidst The Good Times Chart I-15Middle Class Has ##br##Barely Budged... The data is clear: South Africa is as unequal overall, and its middle class unchanged relative to overall population, as it was at the end of apartheid in the early 1990s. Governance in the country has continued to deteriorate, and while it remains higher than in Sub-Saharan Africa, the gap has astonishingly begun to narrow from both ends (Chart I-17). Chart I-17Governance Gap With Sub-Saharan ##br##Africa Is Closing! A major reason for the deterioration in governance is the "state capture" thesis that has become a popular one in characterizing President Jacob Zuma's rule.4 This process began early, as the country shifted its developmental program in 1996 away from a top-down, state-led, developmental model to one that encouraged a free-market economy balanced with welfare spending. This was a natural result of the global rise of laissez-faire capitalism, the Washington Consensus, and "Third Way" politics of left-leaning parties. A commitment to laissez-faire capitalism and free markets, combined with a strong welfare state, were seen as hallmarks of a successful economy. The problem with this approach is that it confused the symptoms of developed economies with their catalysts. South Africa needed a much more state-led approach to development, one that would have harnessed the resources of the state for productivity-enhancing investments. As such, the laissez-faire approach unsurprisingly failed to address the inequalities of the apartheid system and the country saw a decline in the middle class as percent of total population under both Presidents Nelson Mandela and Thabo Mbeki. This pivot towards free-market capitalism ended with the 2007 "Polokwane moment," which saw President Mbeki's free-market, reactive, attempt to address inequality between the white and black populations replaced with the proactive policy of Jacob Zuma. Zuma's more radical approach was to complement welfare transfers and high wage growth with an activist use of state owned enterprises (SOEs) as a vehicle for redistribution. This proactive policy meant using the government's tender system to doll out lucrative contracts to well-connected insiders, under the auspices of helping enfranchise black entrepreneurs and businesses. While the media has focused on the role that the Indian-born Gupta family has played in this process, it is highly unlikely that they are the only beneficiaries. Zuma's administration has, in the name of black enfranchisement and the fight against inequality, essentially rigged the entire government tender system for the sake of its own political preservation. The results of this process are unsurprising. First, government wages have outpaced those in both manufacturing and mining sectors (Chart I-18). Meanwhile, productivity has declined precipitously since 2007 and has been negative since 2012. South Africa has a lower productivity rate than both Latin American EM economies and its neighbors in sub-Saharan Africa (Chart I-19). Chart I-18Government Wages Have Outpaced All Others Chart I-19South African Productivity Has No Peer Financial media and investment research have continued to focus on the intricacies of the ruling African National Congress (ANC) politics. And we do so as well below. However, investors have to understand that South Africa's ills will not be fixed by the appointment of a pro-market finance minister or even the removal of Jacob Zuma from rule. South Africa has failed to develop inclusive economic institutions that engender creative destruction, which is at the heart of all successful development stories.5 South Africa ranked 74th in the World Bank's annual Doing Business report in 2017, an astonishing fall from grace over the past decade (Chart I-20). Compared to regional averages, South Africa barely beats the Sub-Saharan "distance to frontier" scores in several World Bank categories (Chart I-21). This is not due to the gross failure of the Zuma administration to do the "right thing." Rather, it exhibits a structural failing of South African political institutions. This development path is not unique to South Africa. Most sub-Saharan African states experienced a similar regression within 10-20 years of decolonization. Political scientist Robert Bates famously documented how African leaders co-opted colonial-era extractive economic institutions - such as the state marketing boards that purchased all cash crops and exported them on the global market - in order to generate enough revenue to industrialize their economies.6 While their intentions may have originally been noble, if misplaced, they quickly began to use control over marketing boards for political purposes. The rent generated from marketing boards became an immense source of political power for African leaders and they held on to it to the detriment of the economic development of their state. South Africa is far more developed than its sub-Saharan peers were in the 1970s. Nevertheless, its leaders are exhibiting similar rent-seeking behavior, albeit at a much higher level of development. It is also entering a dangerous period in its post-apartheid history: it has now been twenty years since South Africa's effective decolonization and it is facing its first serious economic downturn. Bottom Line: We doubt that anyone in the current leadership elite will be able to fully abandon the rent-seeking behavior of the Zuma administration and improve South Africa's economic institutions. The crisis of expectations among the country's voters is palpable and demands for greater redistribution are rising. This is not a context for pro-market reforms that will encourage creative destruction. Instead, we would expect a doubling-down of populism and greater emphasis on proactive redistribution, which will, at the same time, encourage greater out-migration of talent out of the country and rent seeking behavior from political elites. Can Any One Man Or Woman Fix South Africa? The African National Congress (ANC) will meet in December 2017 to decide the party candidate that will contest the 2019 general election (Diagram I-1). Given the ANC's stranglehold on the country's politics, it is likely that whoever emerges at the upcoming ANC Congress will be the next president of South Africa. BCA's Geopolitical Strategy subscribes to the idea that policymakers are price takers in the political marketplace, not price makers. This is particularly the case in democracies, but it is also the case in some authoritarian regimes where public opinion is relevant. As such, the puzzle investors have to resolve is not what policymakers stand for, but rather what the median voter wants. In South Africa, the median voter lives in a rural area, works in the agriculture or service industry, and is a black citizen. The polls indicate that the main concerns of the median voter are a high structural unemployment rate (Chart I-22), endemic corruption (Chart I-23), poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. Chart I-22Crisis Of Expectations Is this the profile of a median voter about to elect a pro-market reformer willing to pursue painful structural reforms? We do not think so. The two candidates vying for the ANC presidency are the ex-wife of Jacob Zuma and former Chair of the African Union, Nkosazana Dlamini-Zuma, and former Deputy President, Cyril Ramaphosa. Ramaphosa is the darling of the international investment community. This is because he has abandoned his previous union credentials - he founded the country's largest trade union, the National Union of Mineworkers in addition to founding the Congress of South African Trade Unions (COSATU) - and turned into a successful businessman. As such, the narrative among South Africa bulls (who are exclusively found in Europe and the U.S.) is that he would be able to bridge the divide between the demands for redistribution and pro-market reforms. To the median voter, however, Ramaphosa is alleged to be involved in the Marikana Massacre. Acting as the Deputy President, he ordered increased police presence at the mines and called for the use of force, which resulted in 47 deaths in August-September 2012. Dlamini-Zuma, on the other hand, speaks the language of the median voter while also not being seen as part of Zuma's corrupt entourage. Her credentials are bolstered by a successful tenure as Chair of the African Union and as a woman independent and strong enough to divorce President Zuma. She has not amassed personal wealth and does not hold strong loyalties to a particular faction within the ANC. However, she has begun to parrot Zuma's line that the country requires "radical economic transformation," which is a signal to left-leaning members of the ANC that she will continue much of economic policies begun under Zuma. Both the ANC Youth and Women's Leagues, which are left leaning, support her. The problem that investors face in South Africa is that there is no clear demand for pro-market reforms. Investors cheered the results of the August 2016 municipal election, for example, because the ANC lost in several key cities and saw its total vote share fall by 8%. However, few in the media or investment research community raised the obvious point that the centrist Democratic Alliance only saw its vote total rise by 3% compared to the 2011 election. It was the radically left-wing Economic Freedom Fighters, led by ex-Youth League leader Julius Malema, which saw the largest increase in vote share, by over 8%. In other words, ANC voters that did abandon Zuma most likely fell behind Malema, who is far more redistributionist. As such, we stick to our long-held view that Zuma and the ANC leadership are unlikely to do what investors want them to do given that the South African median voter is swinging further to the left. There is no demand for pro-market reforms and thus policymakers are more likely to double-down on populism. Bottom Line: Dlamini-Zuma is the likely winner of the upcoming ANC Congress, which will effectively decide the next president of South Africa. She has the sufficient left-leaning economic credentials to satisfy the demands for redistribution of the median voter. There is also a chance that she will attempt to clean up the corruption that has become endemic under Zuma, which would undoubtedly be a good thing for the country. However, it is unlikely that the macroeconomic context she will face will be positive, or that she will have the mandate to balance redistributive policies with painful pro-market reforms that would rebuild institutions required for creative destruction. Investment Implications South African assets are ultimately at the mercy of foreign inflows. When the dollar is weakening, U.S. bond yields falling, and Chinese growth stable, even the election of Julius Malema to the presidency would not dent foreign enthusiasm for yield in South African assets. Given the expected improvement in U.S. growth and the transitory nature of the drop in the U.S. inflation rate, we expect the global macro backdrop to worsen substantially for carry trades in general, and for South Africa in particular. China remains the wild card in our analysis, but its credit and fiscal impulse has rolled over, suggesting slower import growth over the next six months (Chart I-24). Even if Chinese policymakers react by re-stimulating the economy, the effects will only be felt in early 2018 given lead times. When the global carry trade reverses, it will not matter who is in charge of South Africa. Investors will realize that the country has failed to address serious socio-economic ills that have plagued South Africa since the end of apartheid. BCA's Emerging Markets Strategy continues to recommend the following investment positions: Chart I-24China Slowdown Is A Risk To EM Chart I-25Yield Curve Will Steepen Continue shorting ZAR versus USD and MXN. Underweight South African stocks, sovereign credit and domestic bonds relative to their respective EM benchmarks. A new trade: bet on yield-curve steepening (Chart I-25). The short end of the curve will be steady but populist politics, larger fiscal deficits/higher public debt, and an inflationary backdrop will push up long-end yields. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Beement Alemayehu, Research Assistant beementa@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "Stocks Are From Mars, Bonds Are From Venus?" dated June 23, 2017, available at gis.bcaresearch.com, and BCA Emerging Market Strategy Weekly Report, "EM: Contradictions And A Resolution," dated June 14, 2017, available at ems.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Local Bonds: Looking At Hedged Yields," dated May 10, 2017, available at ems.bcaresearch.com. 3 'Governance' is a catchall term that attempts to capture the quality of public service delivery, broadly defined. In essence, investors can consider governance as a factor that underpins the quality of political institutions. We rely on the World Bank's Development Indicators because the World Bank aggregates the work of several credible surveys on governance. These indicators are also useful because the World Bank standardizes the results in a way that allows cross-country/region comparisons. We then aggregate the scores across five different variables and look for trends and changes over time. 4 Please see State Capacity Research Project, "Betrayal Of The Promise: How South Africa Is Being Stolen," dated May 2017, available at pari.org.za. 5 Please see Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 6 Please see Robert H. Bates, Markets and States in Tropical Africa: The Political Basis of Agricultural Policies (Berkeley, University of California Press, 2014 edition). Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

Dear client, This week, we are sending you an abbreviated Weekly Report as we co-authored a Special Report on Wednesday with our sister Geopolitical Strategy service. In our Special Report, available on our website, we argue that Italy's flirtation with leaving the euro area is rooted in its positive experience with devaluations in the 1990s. However, we note that this time is different and devaluing the euro through exit will not be a panacea, as financial market linkages would cause a deep domestic recession that could be brought forward by the mere reality of a referendum on the topic. As such, we think that Italy is unlikely to leave the Euro Area, but that it will remain a drag on the Eurozone - one that will force the European Central Bank to stay a bit more dovish than warranted by conditions in the broader Euro Area. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature Chart I-1The Dollar At A Critical Spot Since the end of last week, the dollar has staged a small rebound. This rebound was of the utmost importance as it materialized at an important level. Had DXY punched below the 96 level, the dollar could have sold off toward 93 in a matter of weeks. However, if the dollar can remain above 96, the greenback is likely to have formed a trough for the remainder of 2017 as it will rest above an important congestion zone that has been in place since early 2015 (Chart I-1). What are the odds of the greenback moving back to 93? We think that right now the balance of probability is in favor of a continued rebound. A call on DXY is first and foremost a call on the euro, as EUR/USD represents 60% of this index. We'll thus focus on the dynamics in this pair. Currently, nominal short rate differentials remain in the dollar's favor. As Chart I-2 illustrates, interbank rate spreads between the Euro Area and the U.S. are broadly supportive of the USD. Additionally, in both the late 1990s and in 2005-06, this spread had been much more negative than at present. BCA still expects the spread to grow more negative as the Federal Reserve continues on its intended policy path, while we also believe it will take a few more years before the ECB can begin lifting rates.1 Real rate differentials paint a similar picture. The euro's strength in the second quarter has emerged in spite of a move in real rate spreads in favor of the USD. As Chart I-3 shows, this divergence has mostly reflected dynamics at the short end of the yield curve, but over the past month and a half the real interest rate difference at the 10-year maturity has also diverged from the EUR/USD's path. Chart I-2EUR/USD Short Rate Differentials ##br##Can Grow Deeper Chart I-3EUR/USD Has Dissociated##br## From A Key Driver Technically, the dollar is beginning to look attractive against the euro as well. Our positioning indicator - based on sentiment, net speculative positions, and the euro's advanced/decline line - shows that investors are already positioned the most euro bullish since 2012 (Chart I-4). Our intermediate-term technical indicator is also at highly overbought levels, highlighting the euro's limited upside potential. Most importantly though, these moves have happened as the Euro Area economic surprise index massively beat the U.S. one (Chart I-4, bottom panel). This means that Europe's economic outperformance has been driving the euro's strength, unlike in 2015 when the surge in the European surprise index relative to the U.S. was reflective of the euro's 2014 collapse. This paints a picture where much good European news has been priced into EUR/USD during the recent rally. At current levels, the mean-reverting nature of the relative surprise index suggests that European surprises are unlikely to continue to beat U.S. ones by such a margin going forward. This means that the already overbought euro is likely to lose a key support. Finally, as we highlighted two weeks ago, global analysts have already ratcheted up their year-end estimates for EUR/USD (Chart I-5). Not only are their forecasts at levels that have in recent years been indicative of a peak, but the speed and magnitude of their adjustments has also been exceptional. This corroborates that the positive momentum in the Eurozone vis-à-vis the U.S. has already been internalized by market participants. If anything, this favorable relative economic momentum must only grow going forward for the euro to rally further. However, European LEIs have already rolled over relative to the U.S. as the latter looks set to exit its soft patch in the coming months (Chart I-6). Chart I-4Good News Already ##br##In The Euro Chart I-5Investors Have Already##br## Bought The Euro Chart I-6The Economic Tailwinds For The ##br##Euro Are Beginning To Fade Bottom Line: DXY has rebounded at a crucial level. If it can stay above 96, this would suggest that its correction is over. We are willing to make this bet as the euro - the key component of the DXY - has dissociated from rate differentials on strong optimism toward the economic outlook for Europe - at the exact time that investors have become more incredulous of the Fed's intentions. Due to these dynamics, EUR/USD is now massively overbought and at risk of a further pullback. Cutting Loose Short USD/JPY Last week, we closed our short USD/JPY position at a 4.2% gain. We did so because we see an increasingly less-supportive environment for the yen. To begin with, the U.S. Treasury notes' fair-value model used by our U.S. Bond Strategy service highlights that U.S. bond yields are currently quite expensive, and could be set to rise anew (Chart I-7). Because JGBs possess a very low beta relative to U.S. yields, an environment where global rates rise tends to be associated with rate differentials moving in favor of USD/JPY, often prompting a rally in the latter. Also, the Bank of Japan is keenly aware that it will be very difficult to achieve its 2% inflation target. The yen's recent strength has exerted a significant tightening in Japanese financial conditions that will drag down inflation (Chart I-8). Hence, the BoJ will continue to be among the most dovish central banks in the world. Additionally, while Japanese industrial production has been strong, it looks set to soften in the coming months, which will give further reason to the BoJ to talk down the yen: Japanese industrial production is very much a function of financial conditions. We are entering a window where the recent tightening in Japanese financial conditions should begin to bite industrial production. The growth rate of the Japanese shipments-to-inventories ratio has rolled over, historically a precursor of a slowdown in industrial production (Chart I-9). Chart I-7T-Notes Are Expensive Chart I-8Japanese FCI Points To Lower Inflation Chart I-9Japanese IP Will Turn Finally, the annual growth rate of Japan's industrial production is heavily influenced by China's economic dynamics, as EM represents 43% of Japanese exports. Two months ago, the Keqiang index - a barometer of strength for the Chinese economy based on credit growth, railway freight volumes, and electricity production - hit its highest level since June 2010, levels only recorded in early 2007, early 2005, and early 2004. Even though we do not anticipate it to crater, we do expect its recent rollover to deepen further in response to the recent wave of policy tightening in China. This should result in some weakness for Japan's industrial production. In practice there is little additional actions the BoJ can implement to ease policy further. However, because investors are currently so negative on the prospects for further Fed rate increases, with only 40 basis points priced in over the next 24 months, a re-assurance by the BoJ that easy policy is here to stay could put upward pressure on USD/JPY. While we remain worried about EM assets, we think that shorting the AUD or the NZD against the yen represents better portfolio protection than shorting USD/JPY. Bottom Line: USD/JPY has a generous amount of upside from here. Investors are too pessimistic regarding the Fed's ability to increase rates over the next 24 months. Meanwhile, the recent tightening in Japanese financial conditions is a headache for the BoJ, as it points to weaker inflation and a slowdown in industrial production. Hence, we expect the BoJ will try to talk down the yen over the coming months. EUR/NOK At An Interesting Spot Chart I-10If Brent Doesn't Fall Below,##br## EUR/NOK Is A Short The price action in EUR/NOK caught our eye this week. EUR/NOK is at a critical level and has rallied as investor optimism toward the Euro Area economy continues to grow. Meanwhile, oil prices have collapsed to US$45/bbl. Since Norway is an economy heavily geared to oil-price gyrations, this bifurcation created an ideal combination to generate a EUR/NOK rally. However, by discounting these developments, EUR/NOK has now entered massively overbought territory. Additionally, as Chart I-10 illustrates, the cross has only traded at higher levels at the depth of the financial crisis in the first quarter of 2009 and the early days of 2016. In both instances, Brent was trading below US$40/bbl. A selling opportunity could soon emerge. Our Commodity And Energy Strategy service continues to expect a deepening of the adjustment in global oil inventories as the OPEC 2.0 deal remains in vigor and compliance stays in place.2 This means a move below US$40/bbl for Brent is very unlikely, and the upside in EUR/NOK is extremely limited. While in the coming weeks a move in Brent to between US$44/bbl and US$42/bbl could happen, we think this limited downside points to an attractive risk-reward ratio to shorting this cross. We are currently long CAD/NOK and short EUR/CAD, with the latter having greater potential downside than EUR/NOK. However, due to Canada's deep integration with the U.S. economy, the EUR/CAD trade is often affected by dynamics in the U.S. dollar. Shorting EUR/NOK is thus a cleaner play on oil and removes much of the risk associated with the greenback's fluctuations. Finally, yesterday, the Norges Bank policy release displayed less dovish tone than anticipated by the market. This kind of surprise would create an additional support to being short EUR/NOK. Bottom Line: EUR/NOK looks set to weaken. Over the past 10 years, it has only traded above current levels when Brent prices were below US$40/bbl. Based on our commodity team's analysis, such a move is very unlikely. Thus, any short-term weakness in oil prices should be used to sell EUR/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 6, 2017, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report titled "Time For "Whatever It Takes" In Oil?", dated June 2, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades