Market Returns

Highlights The risk to EM currencies is to the downside over the next 12 months - i.e., they will depreciate more than their carry. In this context, investors in local currency bonds should consider hedging against currency depreciation. The cross-currency basis spread can be used to calculate exchange rate-hedged yield on local currency bonds for U.S. dollar and euro-based investors. On a currency-hedged basis, Korean, Russian and Mexican local bonds offer the highest yield, while Turkish, South African and Chinese fixed-income securities stand at the opposite end of the spectrum. Feature The Big Picture: A Stampede Into EM Bonds There has been a stampede into EM risk assets since early this year. Fixed-income investors' search for yield is understandable, given DM bond yields are very low. However, we believe investors are underappreciating currency and other risks embedded in EM that are likely to manifest in the next 6-12 months. In other words, the fact that DM bond yields are low in of itself does not justify chasing EM bonds and currencies. Investment in EM should primarily be based on the merits of EM fundamentals. With respect to EM local bonds, total returns for international investors are greatly influenced by exchange rate moves. Not only does currency depreciation undermine returns for foreign investors, but in many high-yielding fixed income markets, bond yields also rise when their respective country's currency depreciates, and vice versa (Chart I-1). Furthermore, Chart I-2 demonstrates that high or rising interest rates historically have not precluded bear markets in EM currencies. On the contrary, historically, it was exchange rate that determined the direction and level of local interest rates: a strong currency led to lower interest rates and a weak currency warranted rising interest rates. This was especially true with the recent darlings of investors, the Brazilian real and South African rand. Chart I-1EM Local Bond Yields And ##br##Currencies: Negative Correlation EM Local Bond Yields And Currencies: Negative Correlation EM Local Bond Yields And Currencies: Negative Correlation Chart I-2In EM, Currencies Drive ##br##Interest Rates Not Vice Versa In EM, Currencies Drive Interest Rates Not Vice Versa In EM, Currencies Drive Interest Rates Not Vice Versa In our weekly reports, we have argued at length why EM currencies are set to depreciate considerably, and we will not repeat the rationale in this report. Instead, our focus this week is on hedging mechanisms and the concept of cross-currency basis swap. Specifically, we calculate what yields would be on offer to U.S. dollar- and euro-based investors in EM local currency bonds after hedging the EM exchange rate risk. This can be done via cross-currency basis swaps. We also demonstrate the mechanism behind the hedge, and present the relative attractiveness of local yields across the EM universe after hedging. EM local currency bonds are only comparable to each other as well as to U.S. Treasurys and German bunds after hedging exchange rate risk. We conclude that Korea, Russia and Mexico local bond markets offer the highest hedged yields, while Turkey, South Africa and China provide the lowest hedged yield. Bottom Line: The risk to EM currencies is to the downside in the next 12 months - i.e., they will depreciate more than their carry. In this context, investors in local currency bonds should consider hedging against currency depreciation. Cross-Currency Basis Swap The cross-currency basis spread is the price of a cross-currency basis swap. This spread is directly quoted in the marketplace. The swap allows two parties involved to temporarily access each other's currencies without having to take on foreign currency exposure. Chart I-3 demonstrates an equal-weighted average basis spread for nine EM currencies (Mexico, Russia, Korea, Malaysia, Turkey, South Africa, China, Hungary, Poland) and the aggregate EM exchange rate versus the greenback. Chart I-4 does the same but against the euro - i.e., EM cross-currency basis spread versus the euro, and the EM aggregate exchange rate against the euro. Chart I-3EM Versus U.S. Dollar And Cross-Currency Basis Swap With Dollar EM Versus U.S. Dollar And Cross-Currency Basis Swap With Dollar EM Versus U.S. Dollar And Cross-Currency Basis Swap With Dollar Chart I-4EM Versus Euro And Cross-Currency Basis Swap With Euro EM Versus Euro And Cross-Currency Basis Swap With Euro EM Versus Euro And Cross-Currency Basis Swap With Euro A few considerations are in order: A negative basis spread means that U.S. dollar investors are paid to hedge their EM currency exposure - i.e., they can enhance their U.S. dollar yield by forgoing their EM local yield and hedging their EM exchange rate risk. The aggregate EM basis spread was very wide in 2011 before the EM bear market began. This meant that not many investors hedged their EM currency exposure before the second half of 2011. From 2011 through to mid-2016, various EM cross-currency basis spreads narrowed. The narrowing occurred at an uneven pace, at times in sync with EM rallies and at other times with EM selloffs. This suggests that fixed-income investors were periodically hedging their EM currency exposure via basis swaps until the middle of 2016. Since the middle 2016 - the point when confidence in EM fixed-income rally was cemented - the basis swap spread has widened. This entails that EM fixed-income investors have been reluctant to hedge their currency risk via basis swaps. This corroborates the lingering complacency among the investment community with respect to EM risk. Chart I-5EM Domestic Bond Yields ##br##Over U.S. Treasurys Are Low EM Domestic Bond Yields Over U.S. Treasurys Are Low EM Domestic Bond Yields Over U.S. Treasurys Are Low There is no strong and stable correlation between the EM basis swap spread and EM exchange rate moves (appreciation/depreciation). However, the persisting negative sign of the basis spread implies stronger secular demand for hedged U.S. dollar funding from EM companies and banks than demand for hedged EM currency exposure among foreign investors and companies. Remarkably, the spread of EM local bond yields over 5-year U.S. Treasurys is at the bottom of the trading range that has prevailed over the past seven years (Chart I-5). Provided that EM exchange rate risk is currently considerable, the current level of EM local yields does not warrant blind yield chasing. Hedging Mechanism While obtaining funds in the spot foreign exchange market and hedging via forwards is possible, liquidity in forwards becomes very poor beyond 12 months. Cross-currency basis swaps allow hedging up to multiple years, effectively locking in yields until the maturity of the bond. The following illustrates the transactions involved in the hedging process. A fixed-income portfolio manager (PM) starts with $1 U.S. dollar. This investor enters into a cross-currency basis swap with Counterparty A who, let's say, owns Malaysian ringgits. The PM gives $1 and receives 4.3 MYR, where 4.3 is the spot exchange rate. The PM also agrees to swap back 4.3 MYR for $1 at maturity. The PM then takes the 4.3 MYR and purchases a Malaysian 5-year local currency government bond yielding 3.7% (Chart I-6). During the lifetime of the swap, the PM receives U.S. LIBOR from Counterparty A. In return, she/he must pay Counterparty A KLIBOR (the Kuala-Lumpur interbank offered rate, presently 3.9%) plus the basis spread, which is currently -50 basis points. The PM collects 3.7% yield from the ownership of Malaysian government bonds (Chart I-7). Thus, a negative basis spread of 50 basis points implies that the PM would be paying less than KLIBOR, which is the ordinary rate for borrowing ringgits. At the maturity of the swap contract, the PM redeems the bond and pays 4.3 MYR back to Counterparty A. In exchange, Counterparty A returns $1 U.S. dollar (Chart I-8). Chart I-6Hedging Mechanism: Step 1 EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields Chart I-7Hedging Mechanism: Step 2 EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields Chart I-8Hedging Mechanism: Step 3 EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields The transaction allowed the international fixed-income investor to gain exposure to local currency Malaysian government bonds with almost no currency risk, as the PM received all of the payments in U.S. dollars. On a net basis, the investor receives the following yield: U.S. LIBOR + local yield - (KLIBOR + BASIS), or 2.3% = 2.0% + 3.7% - (3.9%-0.5%). Importantly, this yield is in U.S. dollars, meaning the PM has secured the principal investment and the yield on it in U.S. dollars while gaining exposure to Malaysian local currency sovereign bonds. The latter entails that the portfolio will gain/lose from changes in prices of Malaysian government bonds. Besides, the investor still has some currency exposure on the quarterly flows of interest payments. However, this is miniscule in comparison to the notional. Currency-Hedged Local Bond Yields Using the method described above to calculate hedged returns for individual countries, we ranked the resulting yields for EM countries with available data. Unfortunately, some markets like Brazil do not have a cross-currency basis swap market. Chart I-9 ranks currency-hedged yield for U.S. dollar investors for investments in 5-year local currency fixed-income bonds. Chart I-9EM Local Bonds: Currency-Hedged Yields For U.S. Dollar Investors EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields We also did the same calculation for the euro using German bunds as a proxy. For pairs that do not have direct cross-currency basis swaps with the euro or U.S. dollar, we use the euro/U.S. dollar cross-currency basis to do the conversion. Chart I-10 classifies EM countries according to their hedged euro yield for euro-based international fixed-income investors. Chart I-10EM Local Bonds: Currency-Hedged Yields For Euro-Based Investors EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields For 5-year local bonds, the highest hedged yields are offered by Korea, Russia and Mexico. In contrast, the lowest hedged yields for 5-year domestic local bonds are offered by Turkey, South Africa and China. These hedged yields are calculated on our best estimate of transactions happening at the mid-point of the bid-ask spread. The EM cross-currency swap market is often illiquid. Coupled with the fact that the hedging process requires multiple transactions, the hedged return can be quite lower. To conclude, the highest-yielding local bond markets do not always offer the highest yield when taking currency hedging into account. A caveat is in order: Applying hedging via basis swaps eliminates exchange rate risk, but it does not eliminate risk from fluctuations in bond prices (capital gains/losses). Therefore, in the event that EM local bond yields rise as their currencies depreciate, hedging via basis swaps will not protect against capital losses. Therefore, basis swap hedging should be used by long-term fixed-income investors who have deployed a lot of capital in EM local bond markets and share our concerns on EM exchange rates. These investors typically have a higher tolerance for asset price swings compared with traders who have little tolerance for short-term losses. The latter should sell out of EM domestic bonds altogether. Investment Implications This exercise reinforces our existing overweights in Korean, Russian and Mexican bonds within the EM local currency bond universe. Similarly, it also corroborates our underweights in Turkish and South African domestic bond markets. Although we expect most EM currencies will depreciate versus both the U.S. dollar and the euro in the next 12 months, the Korean won (as well as other low-yielding Asian currencies such as the TWD and the SGD), the Russian ruble and the Mexican peso are less vulnerable, and will outperform other EM currencies. By contrast, the TRY and the ZAR are among the most vulnerable, even after adjusting for their high carry. A plunge in these currencies will also force their local bond yields higher. Hence, capital losses on local bonds even after hedging exchange rate risk could be substantial in these countries. Furthermore, we also continue to recommend overweight positions in local currency bonds in Poland, Hungary, India and Chile within the EM universe. Henry Wu, Research Analyst henryw@bcaresearch.com

Highlights Portfolio Strategy Any advance in Treasury yields should be gradual and more reflective of an improving global economy than it would be restrictive for equities. Book profits in homebuilders and downgrade to neutral. Rising lumber prices will do more harm than good. In contrast, home improvement retailers are in a sweet spot. We reiterate our high-conviction overweight stance. Recent Changes S&P Homebuilding - Downgrade to neutral. Table 1 Awaiting A Catalyst Awaiting A Catalyst Feature Equities marked time at the top end of their range last week. A catalyst may be required to sustain a breakout to new highs, as robust corporate profitability and forward guidance, coupled with tame monetary conditions, are battling against a spate of economic disappointments and soft commodity prices. Financial conditions remain sufficiently easy that economic growth should rebound in the back half of the year. The Fed is in no hurry to aggressively tighten monetary policy, owing to the lack of a serious inflation threat. If hard data begin to firm, then investors will gain confidence in the durability of the profit recovery, powering a further share price advance. While there may be some concern that stronger growth will simply embolden the Fed and push up Treasury yields, we doubt that the latter will become a roadblock just yet. Last week we highlighted that it typically takes a rise to at least one standard deviation above the mean in BCA's Treasury Bond Valuation Indicator to warn that the economy and stocks are at risk of a major downturn. That level would equate to 3.3% on the 10-year Treasury yield (Chart 1). Such large moves in Treasury yields do occur occasionally, (Nov/2010-Feb 2011, summer of 2013 and winter of 2016) and have sometimes preceded/caused economic slowdowns and/or financial accidents. The speed of the adjustment clearly plays a role, as short-term spikes are much harder to digest than gradual yield advances. Nominal GDP growth is comfortably above the 10-year Treasury yield, signaling that financial conditions will stay sufficiently easy for some time, barring a major bond selloff (second panel, Chart 2). Chart 1Yields Have Room To Rise##br## Before Becoming Restrictive Yields Have Room To Rise Before Becoming Restrictive Yields Have Room To Rise Before Becoming Restrictive Chart 2Sales Will Support##br## The Overshoot Sales Will Support The Overshoot Sales Will Support The Overshoot In other words, any advance in yields should be gradual and more reflective of a better global economy than restrictive, especially given the ongoing gentle softening in the U.S. dollar. The upshot is that the string of economic disappointments should begin to fade. In recent research, we have stressed the importance of a meaningful revival in corporate sector revenue growth in order to sustain sky-high valuations (top panel, Chart 2). Encouragingly, inflation expectations are recovering globally. A whiff of inflation is a positive omen for top line growth prospects. Inflation and economic growth expectations have firmed around the world. Chart 2 shows that euro area sales per share are on track to exit deflation after a multiyear slump, based on the message from the bond market. The same is true for emerging markets. If companies outside the U.S. finally enjoy renewed top-line growth, that would bode well for a continued recovery in U.S. business sales, especially if the U.S. dollar weakens. Chart 3 shows that both EM currencies and regional confidence surveys are heralding ongoing gains in U.S. profits sourced from overseas. Nevertheless, it is critical to keep the backdrop in a longer-term context. BCA's Equity Speculation Index (ESI) signals that the advance is at a very high risk stage (Chart 4). The ESI can stay in elevated territory for a prolonged period, as occurred in 2014/2015, before a correction unfolds. But, investors should maintain some non-cyclical exposure even if the market continues its advance in the short run. Chart 3Foreign-Sourced Profit Support Foreign-Sourced Profit Support Foreign-Sourced Profit Support Chart 4The Rally Is Very High Risk The Rally Is Very High Risk The Rally Is Very High Risk This week we are updating our overall view of the consumer discretionary sector and tweaking our housing-related equity positioning. Consumer Discretionary: On The Way To All-Time Highs Consumer discretionary stocks have been portfolio stalwarts in 2017 (outside of autos and select media), advancing by over 10% and besting the S&P 500 by about 400bps. The heavyweight media sub-group (ex-cable and satellite) has come under scrutiny recently, as fears that ad spending will endure a deep slump have resurfaced. However, most of our indicators suggest that ad spending, at least outside of autos, will not suffer a major downturn, given our upbeat outlook for consumption and profits. Cord-cutting is not a new phenomenon, and is already reflected in very washed out profit expectations, both on a cyclical and structural horizon (we will be covering media in more detail in an upcoming Report). Consequently, there are good odds that this impressive consumer discretionary showing will remain intact especially as last Friday's payrolls bounced smartly. Two key drivers have added fuel to this fiery performance: border adjustment tax fears have subsided and soft economic data have given the Fed enough breathing room to continue erring on the dovish side. Importantly, leading indicators of discretionary spending are heralding a solid recovery in consumer outlays. Interest rates remain near generationally low levels and oil price inflation has peaked. The economy is near full employment, signaling that wage inflation will quicken. According to BCA's Income Indicator1, consumer income growth is expected to reaccelerate imminently (bottom panel, Chart 5). While consumers have demonstrated a preference for saving vs. spending, several factors suggest that purse strings should soon loosen. Consumer confidence has soared, buoyed by income gains (third panel, Chart 5). Moreover, new highs in household net worth as a percent of disposable income signal that the upward pressure on the personal savings rate should diminish (second panel, Chart 5). The implication is that recent disappointing consumer spending data should prove transitory. While these factors could ultimately put upward pressure on interest rates, there may be a window where limited inflation pressures and weak credit growth permit only a gradual upshift in the Treasury curve. Regardless, there are other indicators pointing to additional outperformance. For instance, there is still a wide gap between forward earnings breadth and washed-out technical conditions. Roughly 75% of consumer discretionary sub-groups have rising 12-month forward profit estimates. This is sustainable as long as consumers have an incentive to spend. In contrast, the proportion of consumer discretionary sub-indexes with a positive 52-week rate of change and/or are trading above their 40-week moving average remains well below 50%. This divergence between fundamentals and technicals is an exploitable gap, which should narrow via a sustained rise in relative share prices (Chart 6). Chart 5Upbeat Consumption Outlook Upbeat Consumption Outlook Upbeat Consumption Outlook Chart 6Exploitable Gap Exploitable Gap Exploitable Gap Finally, consumer discretionary stocks are no longer expensive. On a relative forward P/E basis they trade below the historical mean and at a discount to the S&P 500. Consumer discretionary EV/EBITDA is also trailing the broad market, as well as its long-term average. If a recovery in consumer outlays pans out in the back half of the year, as we expect, then a re-rating phase is likely. However, not all sub-groups are created equal. This week we are tweaking our housing-related consumer discretionary exposure. Homebuilders' Pain... Homebuilding stocks have been moving sideways for the better part of the past four years in a narrow trading range. They are currently sitting near the top of this range. Is it time to book profits? The short answer is yes. The recent confirmation of U.S. tariffs on Canadian lumber imports represents a source of cost inflation that may embed a risk premium in share prices until a new trade deal can be worked out. Lumber prices have nearly doubled during the past sixteen months and remain the best performing commodity in 2017 (bottom panel, Chart 7). Lumber comprises anywhere between 10%-20% of the cost of a new home, underscoring that a 20% lumber tariff will add to the cost of building a new home, squeezing margins unless homebuilders can pass this cost on via increased house prices. However, we are skeptical that there is a lot of room for new house price increases given that it would make it more difficult to compete with existing house sales. While new homes have taken market share from existing homes since the residential housing market trough earlier in the decade (Chart 8), market share gains have come at the expense of profit margins. Homebuilders have been aggressively discounting properties in order to lure new buyers. Given the buildup in new home inventories, further market share gains are at risk, unless additional selling price concessions materialize. Chart 7Elevated Lumber Prices... Elevated Lumber Prices... Elevated Lumber Prices... Chart 8...Spell Trouble For Homebuilding Margins ...Spell Trouble For Homebuilding Margins ...Spell Trouble For Homebuilding Margins The implication is that builders would likely have to absorb any input cost inflation, to the detriment of margins. Indeed, homebuilder sales are already decelerating as a consequence of pricing pressure (second panel, Chart 7). A simple homebuilder profit margin proxy (comprising new house price inflation minus the residential construction wage bill) warns that operating margins will compress, irrespective of the path of lumber prices (bottom panel, Chart 8). Nevertheless, there are some positive offsets that prevent us from turning outright bearish on the niche S&P homebuilding index. These counterbalances are related to the stage of the housing recovery. Homebuilders' sales expectations have surged, nearing the previous cycle's peak, according to the NAHB survey (Chart 9). Similarly, overall housing market conditions are probing multi-year highs and buyer traffic has vaulted to the highest level since mid-2005. Homebuilders remain optimistic about new housing demand. Household formation is still running higher than housing starts, representing a bullish backdrop for future new home construction. Rising incomes and a firming job market also bode well for the prospects of residential real estate. In aggregate, house prices are still expanding according to the Case-Shiller indexes and there are pockets of frothiness in select markets. The thirty year fixed mortgage rate recently broke back below 4% (Chart 10) and banks are willing extenders of mortgage credit, allaying fears that the price of credit will undermine housing affordability. According to our updated estimates (not shown), even if mortgage rates spiked 200bps from current levels, neither affordability nor mortgage payments as a percent of median incomes would return to their respective long-term average. Chart 9Housing Market Remains Firm... Housing Market Remains Firm... Housing Market Remains Firm... Chart 10...Warranting A Neutral Stance ...Warranting A Neutral Stance ...Warranting A Neutral Stance Still, these positives are already reflected in expectations, as the sell side has aggressively upgraded homebuilding profit estimates. The net earnings revisions ratio has catapulted to a 12-year high (Chart 10). Given our more balanced outlook for homebuilding earnings, we are leaning against this exuberance. Bottom Line: Book profits of 3.4% in the S&P homebuilding index and downgrade to neutral. The ticker symbols for the stocks in this index are: DHI, LEN, PHM. ...Is Home Improvement Retailers' Gain While our confidence in further homebuilding outperformance has ebbed, the opposite is true for the S&P home improvement retail (HIR) index. We put the S&P HIR index on our high-conviction overweight list at the beginning of the year, and so far, so good. HIR stocks have outperformed the broad market and the S&P consumer discretionary sector year-to-date. There are good odds that more gains lie ahead. Industry retail sales are running at a mid-single digit rate, surpassing lackluster overall retail sales (second panel, Chart 11). Importantly, household appliance and furniture selling prices have surged, reinforcing that demand is robust and signaling that HIR same-store sales growth will likely accelerate in the busy spring selling season, and beyond (middle panel, Chart 11). Unlike homebuilders, home improvement retailers benefit from rising lumber prices. HIR companies typically earn a set margin on lumber-related sales. Thus, any absolute increase in lumber prices boosts top line growth, and profit margins (bottom panel, Chart 11). The industry's disciplined approach to store additions in the aftermath of the GFC has set the stage for ongoing selling price gains. Chart 12 shows that while house prices have overtaken the 2006 highs, increasing the incentive for homeowners to remodel and invest in this key asset, building and supply store construction activity has remained depressed. Easier mortgage lending standards should ensure that total home sales activity remains elevated, to the benefit of home prices, and provide the necessary financing needed for large projects (Chart 12). Tight labor markets, rising wages and surging consumer confidence are signaling that consumers have an appetite to re-lever and space to take on more debt (Chart 12). With store capex budgets under tight control, same-store sales and cash flow growth are bound to sustain their solid advance as renovation activity accelerates. All of this is best encapsulated by our HIR model. The model has recently soared, driven by the drop in fixed mortgage rates and surge in lumber prices, signaling that the path of least resistance is higher for relative share prices (top panel, Chart 11). Indeed, relative profits have already soared to fresh highs, also signaling the same for relative share prices (top panel, Chart 13). Oddly, analysts are overly pessimistic about the industry's sales and earnings growth prospects. In fact, top line growth estimates are trailing those of the broad market, and the 12-month forward relative profit growth hurdle is set very low at 2% (middle panel, Chart 13). Chart 11All Signals Flashing Green All Signals Flashing Green All Signals Flashing Green Chart 12Capacity Restraint Is Paying Dividends Capacity Restraint Is Paying Dividends Capacity Restraint Is Paying Dividends Chart 13Earnings Led Advance Earnings Led Advance Earnings Led Advance Given the positive message from leading indicators of remodeling activity we are far more optimistic, and expect both relative top and bottom line growth numbers to overwhelm. Bottom Line: The re-rating phase in the S&P home improvement retail index has room to run. We reiterate our high-conviction overweight stance. The ticker symbols for the stocks in this index are: HD, LOW. 1 Please see Foreign Exchange Strategy Weekly Report, "U.S. Households Remain In The Driver's Seat," dated March 31, 2017, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The headwinds against commodity currencies are still brewing, the selloff is not over. Global liquidity conditions are deteriorating and EM growth will disappoint. The valuation cushion in commodity currencies and EM plays is not large enough to compensate for the red flags emanating from financial markets. The euro is peaking. A capitulation by shorts is likely early next week. A move to 1.12 should be used to sell EUR/USD. Feature Commodity currencies have had a tough nine weeks, weakening by 5% in aggregate, helping boost our short commodity currency trade returns to 3.8%. At this juncture, the key questions on investors' minds is whether or not this trend will deepen and if this selloff will remain playable. We believe the answer to both questions is yes. A Less Friendly Global Backdrop When observed in aggregate, the past 12 months represented a fertile ground for commodity currencies to perform well as both global liquidity and growth conditions were on one of the most powerful upswings in the past two decades, lifting risk assets in the process (Chart I-1). Chart I-1The Zenith Is Passing The Zenith Is Passing The Zenith Is Passing Global Liquidity Is Drying When we look at the global liquidity picture, the improvement seems to be over, especially as the Fed, the key anchor to the global cost of money, is more confidently embracing its switch toward a tighter monetary policy. It is true that U.S. Q1 data has been punky at best; however, like the Fed, we think this phenomenon will prove to be temporary. Recently, much ink has been spilled over the weakness in the auto sector. However, when cyclical spending is looked at in aggregate, the picture is not as dire and even encourages moderate optimism. Driven by both corporate and housing investment, cyclical sectors have been growing as a share of GDP (Chart I-2). This highlights that poor auto sales may have been a sector specific development and do not necessarily provide an accurate read on the state of household finances. Chart I-2Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Moreover, the outlook for household income is still positive. Our indicator for aggregate household disposable income continues to point north (Chart I-3). As we have highlighted in recent publications, various employment surveys are suggesting that job growth should improve in the coming months.1 Also, this week's productivity and labor cost report showed that compensation is increasing at a nearly 4% annual pace. This healthy outlook for household income, combined with the consumer's healthy balance sheets - debt to disposable income stands near 14 year lows while debt-servicing ratios are still near 40 year lows - and elevated confidence suggests that house purchases can expand. With the inventory of vacant homes standing at 11 year lows, this positive backdrop, along with the improving household-formation rate, is likely to prompt additional housing starts, lifting residential investment (Chart I-4). Chart I-3Bright U.S. Household ##br##Income Prospects Bright U.S. Household Income Prospects Bright U.S. Household Income Prospects Chart I-4As Households Get Formed,##br## Housing Starts To Pick up As Households Get Formed, Housing Starts To Pick up As Households Get Formed, Housing Starts To Pick up For the corporate sector, the strength in survey data is also likely to result in growing capex (Chart I-5). Not only have "soft" data historically been a good leading indicator of "hard" data, but the outlook for profit growth has also improved substantially. Profit growth is the needed ingredient to realize the positive expectation of business leaders embedded in "soft" data. Profit itself is very often dictated by the trend in nominal revenue growth. The fall in profits in 2016 mostly reflected the fall in nominal GDP growth to 2.5%, which produced a level of revenue growth historically associated with recessions (Chart I-6). As such, the recent rebound in nominal GDP growth, suggests that through the power of operating leverage, profit should also continue to grow, supporting capex in the process. Chart I-5Business Confidence Points ##br##To Better Growth And Capex... Business Confidence Points To Better Growth And Capex... Business Confidence Points To Better Growth And Capex... Chart I-6...Especially As A Key Profit##br## Driver Is Improving ...Especially As A Key Profit Driver Is Improving ...Especially As A Key Profit Driver Is Improving With the most cyclical sector of the U.S. economy still on an upswing, the Fed will continue to increase rates, at least more aggressively than the 45 basis points of tightening priced into the OIS curve over the next 12 months. With liquidity being sucked into the U.S. economic machine, international dollar-based liquidity, which is already in a downtrend, is likely to deteriorate further (Chart I-7). Moreover, global yield curves, which were steepening until earlier this year, have begun flattening again, highlighting that the tightening in global liquidity conditions is biting (Chart I-8). This will represent a continuation of the expanding handicap against global growth, and EM growth in particular. Chart I-7Global Dollar Liquidity Is Already Poor Global Dollar Liquidity Is Already Poor Global Dollar Liquidity Is Already Poor Chart I-8A Symptom Of The Tightening In Liquidity A Symptom Of The Tightening In Liquidity A Symptom Of The Tightening In Liquidity Global Growth Conditions Are Also Past Their Best, Especially In EM Global growth conditions are already showing a few troubling signs, potentially exerted by the tightening in global liquidity. To begin with, while our global leading economic indicator is still pointing north, its own diffusion index - the number of nations with improving LEIs versus those with deteriorating ones - has already rolled over. Normally, this represents a reliable signal that growth will soon peak (Chart I-9). For commodity currencies, the key growth consideration is EM growth. Here too, the outlook looks precarious. The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing. Chinese monetary conditions have been tightening abruptly (Chart I-10, top panel). Moreover, this tightening seems to be already yielding some results. The issuance of bonds by smaller financial firms has been plunging, which tends to lead the growth in aggregate total social financing (Chart I-10, bottom panel). This is because the grease in the shadow banking system becomes scarcer as the cost of financing rises. Chart I-9Deteriorating Growth##br## Outlook Deteriorating Growth Outlook Deteriorating Growth Outlook Chart I-10Chinese Monetary Conditions ##br##Are Tightening Chinese Monetary Conditions Are Tightening Chinese Monetary Conditions Are Tightening This situation could continue. Some of the rise in Chinese interbank rates to two-year highs reflects the fact that easing capital outflows have meant that the PBoC can tighten monetary policy through other means. However, the recent focus by the Beijing and president Xi Jinping on financial stability and bubble prevention, suggests that there is a real will to see tighter policy implemented. This means that the decline in total credit growth in China should become more pronounced. As a result, this will weigh on the country's industrial activity, a risk already highlighted by the decline in Manufacturing PMIs (Chart I-11). Additionally, this decline in credit growth tends to be a harbinger of lower nominal GDP growth, and most importantly for EM and commodity producers, a foreboding warning for Chinese imports (Chart I-12). Chart I-11China Industrial ##br##Growth Worry China Industrial Growth Worry China Industrial Growth Worry Chart I-12Slowing Chinese Credit Impulse ##br##Will Weigh On EM Growth Slowing Chinese Credit Impulse Will Weigh On EM Growth Slowing Chinese Credit Impulse Will Weigh On EM Growth Financial markets are already flashing red signals. The Canadian Venture exchange and various coal plays have historically displayed a tight correlation with Chinese GDP growth.2 Today, they are breaking below key trend lines that have defined their bull markets since the February 2016 troughs (Chart I-13). This message is corroborated by the recent weakness in copper, iron ore, and oil prices. Additionally, the price of platinum relative to that of gold is also breaking down. While the VW scandal has a role to play, this breakdown is also a symptom of the pain on growth created by the tightening in global liquidity conditions. In the past, the message from this ratio have ultimately been heeded by EM stock prices, suggesting that the recent divergence is likely to be resolved with weaker EM asset prices (Chart I-14). Confirming this risk, the sectoral breadth of EM equities has also deteriorated, and is already at levels that in the past have marked the end of stock advances (Chart I-15). At the very least, the narrowing of the EM bull market should prompt investors in EM-related plays to pause and reflect. Chart I-13Two Worrisome Breakdowns##br## On Chinese Plays Two Worrisome Breakdowns On Chinese Plays Two Worrisome Breakdowns On Chinese Plays Chart I-14Platinum's Dark##br## Omen For EM Platinum's Dark Omen For EM Platinum's Dark Omen For EM Chart I-15The Falling Participation ##br##In The EM Rally The Falling Participation In The EM Rally The Falling Participation In The EM Rally This moment of reflection seems especially warranted as EM assets do not have much cushion for unanticipated growth disappointment. The implied volatility on EM stocks is near cycle lows, so are EM sovereign CDS and corporate spreads (Chart I-16). This picture is mimicked by commodity currencies. Even after the recent bout of weakness, the aggregate risk-reversal in options points to a limited amount of concern, and therefore, a growing risk of negative surprises (Chart I-17). Chart I-16Little Cushion##br## In EM Assets Little Cushion In EM Assets Little Cushion In EM Assets Chart I-17Commodity Currency Options##br## Turn Optimistic As Well Commodity Currency Options Turn Optimistic As Well Commodity Currency Options Turn Optimistic As Well If commodity currencies have already depreciated in the face of a slightly soft dollar and perky EM asset prices, we worry that further weaknesses will emerge if the dollar strengthens again and EM assets self-off on the back of less liquidity and more EM growth disappointment. If the price of platinum relative to that of gold was a signal for EM assets, it is also a good indicator of additional stress in the commodity-currency space (Chart I-18). Chart I-18Platinum Raises Concerns ##br##For Commodity Currencies As Well Platinum Raises Concerns For Commodity Currencies As Well Platinum Raises Concerns For Commodity Currencies As Well We remain committed to our trade of shorting a basket of commodity currencies. AUD is the most expensive and most exposed to the Chinese tightening of the group, but that doesn't mean much. The Canadian housing market seems to be under increased scrutiny thanks to the combined assault of rising taxes on non-residents and growing worries about mortgage fraud, which is deepening the underperformance of Canadian banks relative to their U.S. counterparts. If this two-front attack continues, the housing market, the engine of the domestic economy, may also prove to weaken faster than we anticipated. Finally, the New Zealand dollar too is expensive even if domestic economic developments suggest that its fair value may be understated by most PPP metrics. Bottom Line: The outlook for the U.S. economy remains good, but this will deepen the tightening in global liquidity. When combined with the tightening of monetary conditions in China, this suggests that global industrial activity and EM growth in particular could disappoint, especially as cracks in the financial system are beginning to appear. Moreover, EM assets and commodity currencies do not yet offer enough of a valuation cushion to fade this risk. Stay short commodity currencies. Macron In = Buy The Euro? The euro has rallied a 3.6% since early April, mostly on the back of Emmanuel Macron's electoral victories. Obviously, the last big hurdle is arriving this weekend with the second round. The En Marche! candidate still leads Marine Le Pen by a 20% margin. Wednesday's bellicose debate is unlikely to overturn this significant lead. The Front National candidate's lack of substance seems to have weighed against her in flash polls. If anything, her performance might have prompted some undecided Mélanchon voters to abstain or cast a "vote blanc" this weekend instead of picking her. This was her loss, not Macron's win. Does this mean that the euro has much upside? A quick rally toward 1.12 early next week still seems reasonable. New polls are beginning to show that En March! might perform much better than anticipated in the legislative election. Also, the center-right Les Républicains should also perform very well, resulting in the most right wing, pro-market Assemblée Nationale in nearly 50 years. While these polls are much too early to have any reliability, they may influence the interpretation by traders of Sunday's presidential election. However, we would remain inclined to fade any such rally. As we highlighted last week in a Special Report, our EUR/USD intermediate-term timing model shows that the euro is becoming expensive tactically, and that much good news is now in the euro's prices (Chart I-19).3 Additionally, investors have been excited by the rebound in core CPI in the euro area, a development interpreted as giving a carte-blanche to the ECB to hike rates sooner than was anticipated a few months ago. Indeed, currently, the first hike by the ECB is estimated to materialize in 27 months, versus the more than 60 months anticipated in July 2016. We doubt that market participants will bring the first rate hike closer to the present, a necessary development to prompt the euro to rally given our view on the Fed's tightening stance. We expect the rebound in the European core CPI to prove transient. Not only does European wage dynamics remain very poor outside of Germany, our country-based core CPI diffusion index has rolled over and points to a decelerating euro area core CPI (Chart I-20). Chart I-19EUR/USD: ##br##Good News In The Price EUR/USD: Good News In The Price EUR/USD: Good News In The Price Chart I-20European Core CPI Rebound ##br##Should Prove Transient European Core CPI Rebound Should Prove Transient European Core CPI Rebound Should Prove Transient Additionally, as we argued four weeks ago, tightening Chinese monetary conditions and EM growth shocks weigh more heavily on European growth than they do on the U.S.4 As such, our EM view implies that the euro area's positive economic surprises might soon deteriorate. Therefore, the favorable growth differential between Europe and the U.S. could be at its zenith. Shorting the euro today may prove dangerous, as a violent pop next week is very possible if the last euro shorts capitulate on a positive electoral outcome. Instead, we recommend investors sell EUR/USD if this pair hits 1.12 next week. Moreover, for risk management reasons, despite our view on the AUD, we are closing our long EUR/AUD position at a 6.9% gain this week. Bottom Line: Emmanuel Macron's likely victory this weekend could prompt a last wave of euro purchases. However, we are inclined to sell the euro as economic differentials between the common currency area and the U.S. are at their apex. Moreover, European core CPI is likely to weaken in the coming quarters, removing another excuse for investors to bid up the euro. Close long EUR/AUD. A Few Words On The Yen The yen has sold-off furiously in recent weeks. The tension with North Korea and the rise in the probability of a Fed hike in June to more than 90% have been poisons for the JPY. We are reluctant to close our yen longs just yet. Our anticipation that EM stresses will become particularly acute in the coming months should help the yen across the board. That being said, going forward, we recommend investors be more aggressive on shorting NZD/JPY than USD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "Healthcare Or Not, Risks Remain", dated March 24, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report titled "Updating Our Intermediate Timing Models", dated April 28, 2017, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The Fed decided to keep the federal funds rate unchanged at the 0.75% - 1% range. The Committee highlighted the Q1 GDP weakness as transitory, as the labor market has tightened more since their last meeting, inflation is reaching its 2% target, and business investment is firming. Continuing and initial jobless claims both beat expectations; However, ISM Manufacturing PMI came in less than expected at 54.8; PCE continues to fluctuate around the 2% target, coming in at 1.8% from 2.1%; ISM Prices Paid came in at 68.5, beating expectations. Furthermore, the Committee expects that "near-term risks to the economic outlook appear roughly balanced", and that "economic activity will expand at a moderate pace". The market is now pricing in a 93.8% probability of a hike. We therefore expect the dollar to continue its appreciation after the French elections. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Macron's lead over Le Pen has risen after the heated debate between the two rival candidates. We believe these dynamics were a key bullish support for the euro in the run up to elections as the possibility of a Le Pen victory is being completely priced out. Adding to this optimism is a plethora of positive data from Europe. Business and consumer confidences have both pick up. German HICP came in at 2% yoy; Overall euro area headline CPI came in at 1.9%, and core at 1.2%. Nevertheless, labor market data in the peripheries, as well as the overall euro area, was disappointing. We believe this highlights substantial slack in the economy, and will keep the ECB from increasing rates any time soon. We expect the euro to climb in the short run, but the longer-run outlook remains bleak. Look to short EUR/USD at 1.12. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Economic data in Japan has been positive this past week: The unemployment rate went down to 2.8%, outperforming expectations. Retail trade annual growth came in 2.1%, also outperforming expectations. The jobs offer-to-applicants ratio came in at 1.45. This last number is significant, as this ratio has reached it 1990 peak, and it provides strong evidence that the Japanese labor market is very tight. Eventually, this tight labor market will exert pressures on wage inflation. In an environment like Japan, where nominal rates are capped, rising inflation would mean a collapse in real rates and consequently a collapse on the yen. Thus, we are maintaining our bearish view on the yen on a cyclical basis. On a tactical basis, we continue to be positive on the yen, given that a risk-off period in EM seems imminent. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 In spite of the tougher rhetoric coming from Brussels recently, the pound has maintained resilient and has even gain against the U.S. dollar. Indeed, recent data from the U.K. has been positive: Markit Services PMI came in at 55.8, outperforming expectations. Meanwhile, Markit Manufacturing PMI came in at 57.3, crushing expectations. Additionally, both consumer credit and M4 money supply growth also outperformed. Overall we continue to be positive on the pound, particularly against the euro, as we believe that expectations on Britain are too pessimistic, while the ability for the ECB to turn hawkish limited given that peripheral economies are still too weak to sustain tighter monetary conditions. Against the U.S. dollar the pound will have limited upside from now, given that it has already appreciated substantially. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The RBA left its cash rate unchanged at 1.5%. The Bank also stated that its "forecasts for the Australian economy are little changed." It remains of the opinion that the low interest rate environment continues to support the outlook. This will also be a crucial ingredient to generate a positive outcome in the labor market in the foreseeable future. This past month has been very negative for the antipodean currency, with copper and iron ore prices displaying a similar behavior, losing almost 10% and 25% of their values since February, respectively. With China tightening monetary policy, and dissipating government spending soon to impact the Chinese economy, we remain bearish on AUD. In brighter news, the Bank's trimmed mean CPI measure increased by 1.9% on an annual basis, beating expectations of 1.8%. This is definitely a positive, but economic slack elsewhere could limit this development. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Data for New Zealand was very positive this week: The participation rate came in at 70.6%, outperforming expectations. Employment growth outperformed expectations substantially in the first quarter of 2017, coming in at 1.2%. The unemployment rate also outperformed coming in at 4.9% This recent data confirms our belief that inflationary pressures in New Zealand are stronger than what the RBNZ would lead you to believe. Indeed, non-tradable inflation, which measures domestically produced inflation is at its highest since 2014. Eventually, this will lead the RBNZ to abandon its neutral bias and embrace a more hawkish one, lifting the NZD in the process, particularly against the AUD. Against the U.S. dollar the kiwi dollar will likely have further downside, as the tightening in monetary conditions in China should weigh on commodity prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The oil-based currency has once again succumbed to fleeting oil prices, depreciating to a 1-year low. U.S. crude inventories have recently been declining by less than expected and production in Libya has been increasing. Moreover, headline inflation dropped 0.5% from its January high of 2.1%. The Bank of Canada acknowledged the weak core CPI data in its last monetary policy meeting, but instead chose to focus on stronger economic data to change their stance to neutral. As the weakness in oil prices proves temporary due to another likely OPEC cut, headline inflation should pick up again. However, labor market conditions and economic activity remain questionable based on the weakness of recent data: retail sales are contracting 0.6% on a monthly basis, and the raw materials price index dropped 1.6%. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 AUD And CAD: Risky Business - March 10, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales growth came in at 2.1%, crushing expectations. However, Aprils PMI underperformed coming in at 57.4 against expectations of 58.3. Additionally, the KOF leading indicator came in at 106, al coming below expectations. EUR/CHF now stands at its highest level since late 2017 and while data has not been beating expectations it still very upbeat. We believe that conditions are slowly being put into place for the SNB to abandon its implied floor, given that core inflation is approaching its long term average. Therefore, once the French elections are over, EUR/CHF will become an attractive short, given that the euro will once again trade on economic fundamentals rather than political risks. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The krone continues to depreciate sharply. This comes as no surprise given that oil is now down 13% in 2017. Overall we expect that oil currencies will outperform metal currencies given that oil prices will have less sensitivity to EM liquidity and economic conditions. That being said, it is hard to be too bullish on oil if China slows anew, even if one believe that the OPEC deal will stay in place . This means that USD/NOK could have additional upside. On a longer term basis, there has been a slight improvement in Norwegian data, as nominal retail sales are growing at a staggering 10% pace, while real retail sales are growing at more than 2%, which are a 5-year and a 2-year high respectively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The April Monetary Policy meeting delivered an unexpected decision, with members deciding to extend asset purchases till the end of the year, while delaying the forecast for a rate hike to mid-2018. Recent inflationary fluctuations and weak commodity prices support the Riksbank's actions. Forecasts for both inflation and the repo rate were lowered for 2018 and 2019. The Riksbank highlighted that "to support the upturn in inflation, monetary policy needs to be somewhat more expansionary", and is prepared to be more aggressive if need be. This increasingly dovish rhetoric by the Riksbank contrasts markedly with the FOMC's hawkish tilt, a dichotomy that will prove bearish for the krona relative to the greenback. Implications for EUR/SEK are a little more blurred, as the ECB will also remain dovish for the foreseeable future. However, Sweden's attentive and cautious stance on its currency's strength will cap any downside in EUR/SEK. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Chart 1Rate Hikes Lagging Wage Growth Rate Hikes Lagging Wage Growth Rate Hikes Lagging Wage Growth Last Friday's GDP report showed that the U.S. economy grew a meagre 0.7% (annualized) in the first quarter of 2017, well below levels necessary to sustain an uptrend in inflation. However, our forward looking indicators still point to U.S. growth of around 2% during the next few quarters. It is likely that faulty seasonal adjustments suppressed Q1 GDP growth. Q1 growth has averaged -0.1% during the past 10 years, while Q2 growth has averaged more than 2%. Q2 growth has also exceeded Q1 growth in 8 of the last 10 years. For its part, the Bloomberg Barclays Treasury index has provided an average return of close to 1% during the past 10 Q1s and an average return of 0.4% during the past 10 Q2s. Treasury returns have been greater in the first quarter than in the second quarter in 6 out of the past 10 years. Investors would be wise to ignore Q1 GDP and stay focused on the uptrends in wage growth and inflation that are likely to persist (Chart 1). With the market priced for only 38 bps of rate hikes between now and the end of the year, there is scope for the Fed to send a hawkish surprise. Stay at below-benchmark duration and short January 2018 Fed Funds Futures. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 23 basis points in April. The index option-adjusted spread tightened 2 bps on the month and, at 116 bps, it remains well below its historical average (134 bps). While supportive monetary policy will ensure excess returns consistent with carry, investors should not bank on further spread compression as spreads have already discounted a substantial improvement in leverage (Chart 2). In a recent report,1 we noted that net leverage (defined as: total debt minus cash, as a percent of EBITD) is positively correlated with spreads, and also that it has never reversed its uptrend unless prompted by a recession. In other words, the corporate sector never voluntarily undertakes deleveraging, it only starts to pay down debt when forced by a severe economic contraction. We conclude that debt growth will likely continue to outpace profit growth (panel 4), even as profits rebound over the course of this year. If our anticipated timeline plays out, we will be looking to scale back on credit risk in 2018, when inflationary pressures are more pronounced and the Fed steps up the pace of tightening. Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3). Further, our commodity strategists expect OPEC production cuts will be extended through to the end of the year, and that $60/bbl remains a reasonable target for oil prices. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Time Of The Season Time Of The Season Table 3BCorporate Sector Risk Vs. Reward* Time Of The Season Time Of The Season High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 62 basis points in April. The index option-adjusted spread tightened 12 bps on the month and, at 371 bps, it is currently 27 bps above its 2017-low. Wider junk spreads in recent months appear to be largely related to flight-to-safety flows driven by elevated global political uncertainty. We find it notable that spreads tightened following the market-friendly result of the first round of the French election. While political uncertainty remains, we view current spreads as attractive on a 6-12 month horizon. In a recent report,2 we tested a strategy of "buying dips" in the junk bond market and found that it produced favorable results in a low-inflation environment. With the St. Louis Fed's Price Pressures Measure still suggesting only a 6% chance of PCE inflation above 2.5% during the next 12 months, we think this strategy will continue to work. Moody's recorded 21 defaults in Q1 (globally) down from 41 in the first quarter of 2016, with the improvement attributable to recovery in the commodity sectors. While commodity sectors still accounted for half of the defaults in Q1, Moody's predicts that the retail sector will soon assume the mantle of "most troubled sector." According to Moody's, nearly 14% of retail issuers are trading at distressed levels. Moody's still expects the U.S. speculative grade default rate to be 3% for the next 12 months, down from 4.7% for the prior 12 months. Based on this forecast we calculate the High-Yield default-adjusted spread to be 207 bps (Chart 3), a level consistent with positive excess returns on a 12-month horizon more than 70% of the time. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in April. The conventional 30-year MBS yield fell 10 bps on the month, driven by an 11 bps decline in the rate component. The compensation for prepayment risk (option cost) rose by 2 bps, but this was partially offset by a 1 bp tightening in the option-adjusted spread (OAS). Since the middle of last year the MBS OAS has widened alongside rising net issuance, but this has been offset by a falling option cost (Chart 4). This is exactly the price behavior we would expect to see in an environment where mortgage rates are moving higher and the market is starting to discount the Fed's eventual exit from the MBS market. Higher mortgage rates suppress refinancings, and this will ensure that the option cost component of spreads remains low. However, higher mortgage rates are also unlikely to halt the uptrend in net MBS issuance, since the main constraint on housing demand this cycle has been insufficient household savings, not un-affordable mortgage payments.3 This means that OAS still have room to widen alongside greater net issuance. The winding down of the Fed's mortgage portfolio - a process that is likely to begin later this year - will only add to the supply that the market needs to absorb. How will the opposing forces of low option cost and widening OAS net out? The option cost component of spreads is already close to its all-time low, while the OAS is still 16 bps below its pre-crisis mean. We think it is unlikely that a lower option cost can fully offset OAS widening. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 2 basis points in April, bringing year-to-date excess returns up to 75 bps. The high-beta Sovereign and Foreign Agency sectors outperformed by 8 bps and 1 bp, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors outperformed by 7 bps each. Local Authorities underperformed the Treasury benchmark by 23 bps. Since the beginning of the year, excess returns from the Sovereign sector have been supported by a weakening U.S. dollar (Chart 5). Mexican debt, in particular, has benefited from a 10% appreciation of the peso relative to the U.S. dollar (panel 3). A stronger peso obviously makes Mexico's USD-denominated debt easier to service and has led to year-to-date excess returns of 402 bps for Mexican sovereign debt relative to U.S. Treasuries. Mexican debt accounts for 21% of the Sovereign index. Our Emerging Markets Strategy service thinks that Mexico's central bank could deliver another 50 bps of rate hikes, because inflation is above target, but also maintains that further rate hikes will soon start to squeeze consumer spending.4 Conversely, the Fed has scope to hike rates much further. Sovereigns no longer appear expensive on our model, relative to domestic U.S. corporate sectors. But we still expect them to underperform as the dollar resumes its bull market. Local authorities and Foreign Agencies still offer lucrative spreads on our model, and we remain overweight those spaces within an overall underweight allocation to the Government-Related index. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in April (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio was flat on the month, but has fallen 15% since peaking shortly after the U.S. election (Chart 6). The sparse details of the Trump administration's proposed tax reform plan, released last week, did not include any specific mention of the municipal bond tax exemption, but did call for the elimination of "targeted tax breaks" leaving some to wonder if the tax exemption is in play. It is too soon to tell whether repealing the tax exemption will be part of the final tax reform plan, although its repeal would be at odds with the President's stated desire to spur infrastructure spending. For this reason, we suspect the tax exemption will ultimately survive. Assuming the tax exemption survives, the proposed repeal of the Alternative Minimum Tax and of the state & local government income tax deduction should both increase demand for tax-exempt municipal bonds. However, this positive impact will be offset by lower tax rates. All in all, it is too soon to know how this will all shake out, but the considerable uncertainty makes us reluctant to take strong directional bets in the municipal bond market for now. Meanwhile, Muni mutual fund inflows have totaled more than $9 billion since the beginning of the year, while total issuance is at a 12-month low. Strong inflows and low supply likely explain why yield ratios are testing the low-end of their post-crisis trading range. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve shifted lower in April, with the 2/10 slope flattening by 12 basis points and the 5/30 slope steepening by 6 bps. The 5-year Treasury yield declined 12 bps on the month, while the 10-year yield fell 11 bps. The 2-year yield actually ticked 1 bp higher. Significant outperformance in the 5-year part of the curve means that our recommendation to favor the 5-year bullet over a duration-matched 2/10 barbell has returned 27 bps since inception on December 20, 2016. This 5-year bullet over duration-matched 2/10 barbell trade is designed to profit from 2/10 curve steepening, which has not yet materialized. Instead, the trade has performed well because the 2/5/10 butterfly spread has moved much closer to our estimate of fair value (Chart 7). The 5-year bullet still looks moderately cheap on the curve, but no longer offers an exceptional valuation cushion. For our trade to outperform from here we will likely need to see some 2/10 curve steepening. We continue to hold the 5-year bullet over duration-matched 2/10 barbell trade, because we still expect the 2/10 slope to steepen. This steepening will be driven by wider long-maturity TIPS breakevens which should eventually catch up to leading pipeline inflation measures (see next page). In a recent report,5 we outlined the main drivers of the slope of the yield curve on a cyclical horizon and concluded that wider breakevens can cause the nominal curve to steepen even with the Fed in the midst of hiking rates. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 25 basis points in April. The 10-year TIPS breakeven rate declined 5 bps on the month and, at 1.92%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Our Financial Model of TIPS breakevens - which models the 10-year TIPS breakeven rate using the stock-to-bond total return ratio, the price of oil and the trade-weighted dollar - attributes the recent decline in breakevens to weakness in the stock-bond ratio and the fact that the 10-year breakeven rate was already quite elevated compared to fair value (Chart 8). Both core and trimmed mean PCE inflation dropped sharply in March, and are now running at 1.6% and 1.8% year-over-year, respectively (bottom panel). This decline is likely to reverse in the coming months. Crucially, pipeline inflation measures, such as the ISM prices paid index, are holding firm at high levels (panel 4). We remain overweight TIPS versus nominal Treasuries on the view that growth will be strong enough to keep measures of core inflation on a steady upward trajectory, eventually converging with the Fed's 2% inflation target. In that environment, TIPS breakevens should eventually return to their pre-crisis range. In last week's report,6 we considered the possibility that TIPS breakevens might not return to their pre-crisis trading range, even if measures of core inflation remain strong. The most likely reason relates to structural rigidities in the repo market that have made it more costly to arbitrage the difference between real and nominal rates. For now, we consider this simply a risk to our overweight view. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in April, bringing year-to-date excess returns up to +33 bps. Aaa-rated issuers outperformed the Treasury benchmark by 10 bps on the month, while non-Aaa issues outperformed by 13 bps. The index option-adjusted spread for Aaa-rated ABS tightened 1 bp on the month, and remains well below its average pre-crisis level. Banks are now tightening lending standards on both auto loans and credit cards. While we do not expect this recent development to have much of an impact on consumer spending,7 it is usually an indication that there is growing concern about ABS collateral credit quality. This concern is echoed by the fact that net losses on auto loans are trending sharply higher (Chart 9). Credit card charge-offs remain subdued for now - and we continue to recommend that investors favor Aaa-rated credit cards over Aaa-rated auto loans - but even in the credit card space quality concerns are starting to mount. Capital One reported a 20% drop in earnings in Q1 versus the same quarter in 2016, and noted that it has been tightening underwriting standards against a back-drop of credit card loans growing faster than income. We remain overweight ABS for now, as the securities still offer attractive spreads compared to other high-quality spread product, but we are closely monitoring credit quality metrics for signs of rising stress. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in April, bringing year-to-date excess returns up to +19 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month, and is fast approaching its average pre-crisis level. Apartment and office building prices are growing strongly, but as in the corporate space, the retail sector is a major drag (Chart 10). Tighter lending standards and falling demand also suggest that credit stress is starting to mount, but while office and retail delinquencies are rising multi-family delinquencies remain low (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in April, bringing year-to-date excess returns up to +19 bps. The index option-adjusted spread for Agency CMBS widened 1 bp on the month, and currently sits at 54 bps. The option-adjusted spread on Agency CMBS looks attractive compared to other high-quality spread product: Agency MBS = 35 bps, Aaa consumer ABS = 46 bps, Agency bonds = 17 bps and Supranationals = 20 bps. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.59% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.43%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we are inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. It should also be noted that the fair value readings from both the 2-factor and 3-factor models are calculated using FLASH PMI estimates for April. These estimates will be revised later today when the actual PMI data are released. 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 2.32%. 1 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 4 Please see Emerging Markets Strategy Weekly Report, "A Time To Be Contrarian", dated April 5, 2017, available at ems.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 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 April 30, 2017. The model has increased its allocation to Spain at the expenses of Germany largely driven by changes in the value and technical indicators, compared to previous month as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, Level 2 model (the allocation among the 11 non-U.S. DM countries) outperformed its benchmark by 99 basis points (bps) in April, largely a result from the overweight of the euro area versus the underweight in Japan, Canada and Australia. Level 1 model, the allocation between U.S. and non-U.S., underperformed by 13 bps in April due to the large overweight in the U.S. Overall, the aggregate GAA model outperformed its MSCI World benchmark by 15 bps in April and by 138 bps since going live. 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. Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of April 30, 2017. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates The growth component has become more bullish on global growth. The model has now turned overweight on materials & consumer discretionary, and underweight on utilities & healthcare. 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 Patrick Trinh, Associate Editor patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights Portfolio Strategy Upgrade the financials sector to overweight. This year's consolidation phase is drawing to a close as inflation expectations stabilize. Lift the S&P banks index to overweight. Leading indicators of credit creation are signaling a reacceleration as the year progresses. Trim the S&P health care sector to neutral via profit-taking in medical equipment stocks. Recent Changes S&P Financials - Upgrade to overweight from neutral. S&P Banks Index - Upgrade to overweight from underweight. S&P Health Care - Downgrade to neutral. S&P Health Care Equipment - Downgrade to neutral. Table 1 Girding For A Breakout? Girding For A Breakout? Feature Chart 1Yields Are Not Yet Restrictive Yields Are Not Yet Restrictive Yields Are Not Yet Restrictive The S&P 500 is challenging the top end of its range. A playable breakout looks increasingly probable, albeit the exact timing is difficult. First quarter profit results have been strong, corporate guidance has been solid and monetary conditions are unlikely to become tight enough in the short run to dent renewed profit optimism. The latest string of economic disappointments is seen as providing the Fed with ample leeway, and investors are willing to overlook ongoing sluggishness because earnings are outperforming the economy via margin expansion. As discussed in detail in recent weeks, earnings growth is supported by a broad-based recovery in sales and pricing power. Top-line growth is critical to sustaining the overall equity market overshoot given sky-high valuations. Indeed, the appeal of equities stems from their attractiveness relative to other asset classes rather than in absolute terms. History shows that an asset preference shift can take time to play out, and push valuations higher than seems justified on fundamentals alone as long as recession is not an imminent risk. The Treasury market can provide clues as to when vulnerabilities will intensify. According to BCA's Treasury Bond Valuation Model, yields usually need to be at least one standard deviation above normal before stocks, and the economy, are at risk of a major downturn (Chart 1). At those turning points, inflation concerns are typically running hot, forcing the Fed to tighten enough to slow growth and undermine economic activity. This simple rule of thumb warned of the most recent stock market peaks, as well as equity slumps in the early-1990s, 1987, and the early-1980s, and supported bond vs. equity outperformance. Recently, the 10-year Treasury yield has returned to fair value, and the U.S. dollar has come off the boil. The implication is that there is no monetary roadblock to halt the upward momentum in equities at the moment. There is ample room for yields to rise before becoming restrictive, especially if the primary driver is the real component. In this light, we will continue with our program of transitioning to a more balanced equity portfolio from its previous defensive tilt. This week we downgrade a defensive sector to neutral and redeploy capital into the financials sector. Upgrade The Financials Sector... The financials sector has given back roughly 50% of its post-election surge this year. The main culprits have been a calming in Fed interest rate hike expectations, a flattening yield curve and softening inflation expectations. Moribund credit creation has also created earnings uncertainty (Chart 2). Nevertheless, the corrective phase appears to be drawing to a close, because financials sector profits are increasingly likely to surpass those of the overall corporate sector going forward. Traditionally, the financials sector benefited from a strong U.S. dollar. A strong dollar exerted downward pressure on interest rates, which spurred domestic economic strength, loan demand and a steepening yield curve. However, since the GFC, the opposite has been true. Zero interest rates and intense deflationary risks were exacerbated by U.S. dollar appreciation, as the corporate sector and commodities suffered. In other words, with the economy operating on a knife's edge between deflation and inflation, a strong currency weighed heavily on financial shares. Thus, the hiatus in the U.S. dollar bull market is a significant positive catalyst, if it arrests the decline in inflation expectations. The yield curve is making an effort to stabilize, suggesting that the risks of falling back close to the deflationary precipice are low. There are already signs of a positive reversal in euro area financials, which had led the U.S. financial sector on the way down after peaking late last year (Chart 2). The euro area has been in a deleveraging phase with acute deflationary risks, underscoring that the signal from share price stabilization in this region is worth noting. The key to a sustained recovery in sector profits is economic reacceleration. Corporate sector profits are healing as a consequence of the pickup in global final demand and the peak in the U.S. dollar, which should ensure that labor market slack does not imminently build. That is necessary to sustain credit quality and generate faster credit demand, and can be illustrated through the positive correlation between the output gap and relative share price performance (Chart 3), at least until the gap grows too large to generate inflationary pressures and by extension, tight monetary policy. Chart 2Earnings Uncertainty... Earnings Uncertainty... Earnings Uncertainty... Chart 3...But A Narrowing Output Gap... ...But A Narrowing Output Gap... ...But A Narrowing Output Gap... Leading economic indicators are consistent with erring on the side of optimism (Chart 4). Our proxy for the supply/demand balance for C&I loans confirms a positive bias for future loan growth (Chart 4). The upturn in the financial sector sales/employment ratio is encouraging (Chart 4). Productivity improvement has begun prior to a reacceleration in loan creation, suggesting that additional upside looms as balance sheets expand. Any unlocking of the regulatory shackles would be a bonus. Strength in our Financials Cyclical Macro Indicator confirms that profits should best those of the overall corporate sector. The financial sector is contributing more to overall GDP growth than it did even during the credit binge/housing bubble (Chart 5), despite the headwind of ultralow interest rates. Chart 4...And Leading Indicators ##br##Are Positive Offsets ...And Leading Indicators Are Positive Offsets ...And Leading Indicators Are Positive Offsets Chart 5Market Cap ##br##Gains Loom Market Cap Gains Loom Market Cap Gains Loom Even though financials represent an ever increasing share of the broad economy, the sector still garners less than its historic median market cap weight (Chart 5). The upshot is that if the economy stays resilient, the correction in relative share price performance should fully reverse, and we recommend further upgrading allocations to overweight via the heavyweight bank group. ...And Bank On Faster Growth Bank profit growth is supported by three main pillars: the quantity, price and quality of credit. All three are set to improve. While seven out of eight lending categories are experiencing a negative credit impulse, forward looking indicators are sending a more positive message. Business and consumer confidence have skyrocketed (Chart 6). If the revival in animal spirits lifts real economic activity later this year, capital demands could finally break out of their slump and reinvigorate moribund loan growth (Chart 6). Importantly, our U.S. Capital Spending Indicator (CSI) snapped back into positive territory. This primarily reflects both the firming in the ISM manufacturing survey and tightness in the labor market. Credit growth has not yet troughed, but should recover in the second half of the year based on our CSI's reading (Chart 6, top panel). Other leading indicators are heralding a pickup in credit demand. A steepening yield curve and the soaring ISM new orders index have an excellent track record in leading the Fed's Senior Loan Officer Survey for overall credit demand (Chart 6). Solid house price inflation and a tight labor market should ensure that consumer credit growth also firms (Chart 7), pointing to the potential for a broad-based bank balance sheet expansion. Overall household leverage has fallen back to 2003 levels and the household debt-service ratio is at multi-decade lows. Chart 6A Turning Point For Loans... A Turning Point For Loans… A Turning Point For Loans… Chart 7...As Demand Recovers …As Demand Recovers …As Demand Recovers Bank deposits are still growing, outpacing nominal GDP by 200bps, and the sector is extremely well capitalized. The loan-to-deposit ratio remains low by historical standards (Chart 8). Bank holdings of risk free securities comprise about 15% of the sector's assets, well above the historic average (Chart 8). The upshot is that there is plenty of firepower to crank up credit creation. True, a rundown in Treasury holdings would result in mark-to-market losses, but banks are well positioned to navigate through rising interest rates. According to the FDIC, net interest income as a share of total revenue has climbed steadily at commercial banks with assets greater than $1bn (Chart 9). Thus, if a better economy and rising inflation materialize in the back half of the year, then higher interest rates will boost profitability (Chart 9). Chart 8Banks Have Dry Powder Banks Have Dry Powder Banks Have Dry Powder Chart 9A Durable NIM Expansion A Durable NIM Expansion A Durable NIM Expansion Table 2 shows a sample of the four largest U.S. banks' earnings sensitivity to interest rate changes. Banks profit from overall rising interest rates in two ways: reinvesting at higher yields and assets repricing at a faster pace than deposits. Table 2Top Four Banks' Interest Rate Sensitivities Girding For A Breakout? Girding For A Breakout? Thus, a steepening yield curve would signal that bank profit estimates should experience a re-rating, provided the yield lift at the long end of the curve was gradual and did not choke off growth via a sudden spike (Chart 9). In terms of credit quality, non-performing loans and charge-offs are sinking from already low levels. It would take a significant deterioration in the labor market to warn that credit quality was about to become a profit drag (Chart 10). Chart 10Credit Quality Is Not An Issue, For Now Credit Quality Is Not An Issue, For Now Credit Quality Is Not An Issue, For Now Importantly, the reserve coverage ratio has climbed to near 100%, as non-current loans have fallen faster than banks have released reserves. Historically, credit quality improvement has been positively correlated with rising valuations (Chart 10). This message is corroborated by return on equity (ROE). Bank ROE has recouped most of the losses since the GFC on the back of recovering productivity gains. However, valuations do not yet reflect the ROE improvement. History shows that after a financial crisis, it can take a prolonged period of improved ROE before investors reward the sector with a valuation expansion, as occurred in the early-1990s (Chart 7, bottom panel). Bottom Line: Boost the S&P financials sector to overweight from neutral. Lift the S&P banks index to overweight. The ticker symbols for the stocks in the S&P banks index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Take Health Care Equipment Down A Notch We are making room for the financials sector upgrade by trimming the health care sector to neutral. As discussed in recent weeks, a modest shift away from a defensive to a more balanced portfolio has been on our radar and the surge in equities over the past week suggests that the consolidation phase is now ending in a bullish fashion, as expected. At the beginning of the year we added the S&P health care equipment (HCE) index to our high-conviction overweight list for three main reasons: valuations had undershot owing to health care reform uncertainty, domestic sales were set to improve and leading indicators of foreign sourced revenue also painted a rosy picture. What has changed? Relative share prices have undergone a V-shaped snapback, all of which can be attributed to a valuation expansion. A flurry of recent M&A activity has also buoyed relative valuations, as takeover premiums have been significant. Relative performance is now at a natural spot to expect a breather. On the operating front, a number of positive profit drivers are still intact. The industry's shipments-to-inventories ratio remains at multi-decade highs and the backlog of medical equipment orders is robust (top and bottom panels, Chart 11). HCE exports are primed to accelerate in the coming months likely irrespective of the U.S. dollar's move. In particular, Europe matters most to S&P HCE constituents, as roughly half of international sales originate in the old continent. Forward-looking indicators of European demand are upbeat, especially with the surge in German medical equipment orders (Chart 11). However, domestic sales indicators have downshifted. New health care facility construction has dropped sharply, warning that investment in medical equipment may soon follow suit (Chart 12, second panel). Consumables demand growth may also take a breather. Consumer outlays at hospitals have nosedived on a growth rate basis. This suggests that the growth in patient visits has dried up, and may be a warning that medical equipment new order growth will also decelerate (Chart 12). Moreover, as outlined in recent Weekly Reports, the broad corporate sector has regained pricing power, but medical equipment suppliers have lagged. Chart 12 shows that relative selling prices are contracting at an accelerating pace. This is significant, as deflation concerns could undermine revenues, and halt the valuation expansion. If domestic medical equipment demand cools, then it will sustain downward pressure on industry activity (Chart 13). Already, medical equipment industrial production (IP) has collapsed, in marked contrast with the expansion in overall IP. Chart 11Export Prospects Are Positive... Export Prospects Are Positive... Export Prospects Are Positive... Chart 12...But Domestic Blues... ...But Domestic Blues... ...But Domestic Blues... Chart 13...Will Weigh On Activity ...Will Weigh On Activity ...Will Weigh On Activity Worrisomely, the HCE new orders-to-inventories ratio has also lost steam, warning that a recovery in future production growth may not be imminent. The implication is that productivity gains are petering out, denting our confidence in a further valuation re-rating. Bottom Line: Downgrade the S&P health care equipment index and remove it from the high-conviction overweight list for an 9% gain. This also pushes the broad health care index to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HCEP: MDT, ABT, DHR, SYK, BDX, BSX, ISRG, BAX, ZBH, EW, BCR, IDXX, HOLX, VAR. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Portfolio Strategy The consumer staples recovery is sales-driven, underscoring that additional outperformance lies ahead. The lagging hypermarkets and retail food industries are starting to play catch up, reflecting a shift in consumer spending patterns. Use the drubbing in air freight shares to upgrade to overweight. Recent Changes S&P Air Freight & Logistics - Upgrade to overweight from neutral. Table 1Sector Performance Returns (%) Pricing Power Comeback Pricing Power Comeback Feature Equities caught a bid last week, after holding at the bottom end of their tactical trading range. The overall consolidation phase likely has further to run, but should ultimately be resolved in a positive fashion. Chart 1Ongoing Margin Expansion Ongoing Margin Expansion Ongoing Margin Expansion Real economic performance continues to lag relative to exuberant 'soft' economic survey data, while the odds of meaningful pro-cyclical U.S. fiscal largesse fade. Inflation expectations are softening as commodity prices dip, while the yield curve is narrowing. These factors are likely to sustain ambiguity about the durability and strength of the expansion. But in the background, the corporate sector continues to heal slowly, aided by the hiatus in the U.S. dollar bull market. The latter is enabling some corporate pricing power revival. Our pricing power diffusion index has surged alongside our pricing power proxy (Chart 1, second panel). The broadening of selling price inflation bodes well for the sustainability of corporate sector pricing power gains. We have updated our industry group pricing power gauges (see Table 2), comprising the respective CPI, PPI, PCE and commodity year-over-year changes for 60 industry groups. The table details the most recent annual and 3-month pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Our analysis reveals that ¾ of the industries tracked are experiencing rising selling prices, and half are also besting overall inflation rates. Only 14 of 60 industries are in outright deflation, versus 19 in January and 23 last September. Importantly, 31 of 60 industry groups are enjoying a rising pricing trend, a 50% increase from last quarter, 9 are moving laterally and only 20 are fading. The implication is that upward momentum in pricing power is gathering steam. Importantly, the rate of selling price inflation is outpacing wage bill growth, which heralds some incremental near-term torque for profit margins (Chart 1, bottom panel). Are there any themes of note? Cyclical sectors continue to dominate the table with energy and materials taking the top two spots, although recent corrective action in the commodity pits suggests that these gains may peter out. The technology sector is a notable exception within deep cyclicals, as most tech sub-groups still have to slash prices (Table 2). Early cyclicals (or interest rate-sensitives) also show strength, with banks, insurers, and media-related groups managing to lift selling prices at a decent rate. Select defensives like health care and utilities are expanding pricing power, but the overall consumer staples and telecom services sectors are lagging. Table 2Industry Group Pricing Power Pricing Power Comeback Pricing Power Comeback Adding it all up, there are tentative signs that the profit advantage may be starting to slowly shift away from defensives. In that light, we are closely monitoring several factors that could expedite a transition to a more balanced portfolio from our current defensive bias. First, the gap between hard and soft data remains unusually wide (Chart 2). The longer hard data takes to play catch up, the less likely the Fed will be re-priced more aggressively. History shows that until this gap narrows, defensive sectors are likely to retain the upper hand in terms of relative performance (Chart 2), while financials could continue to languish owing to uncertainty about the path of future Fed policy. Second, commodity prices and the U.S. dollar - especially versus emerging market (EM) currencies - are still signaling that the cyclical/defensive ratio has more downside (Chart 3). Finally, within the context of the current broad equity market consolidation, it should continue to pay to remain with a defensive over cyclical portfolio tilt for a little while longer (Chart 4, top panel). Chart 2The Gap ##br##Is Closing The Gap Is Closing The Gap Is Closing Chart 3Monitoring The U.S. ##br##Dollar And Commodities1 Monitoring The U.S. Dollar And Commodities Monitoring The U.S. Dollar And Commodities Chart 4Stick With Defensives##br## For A While Longer Stick With Defensives For A While Longer Stick With Defensives For A While Longer Nevertheless, we will likely use this phase to make additional portfolio adjustments. The wide gap between emerging/developing markets performance and the cyclical/defensive share price ratio has narrowed significantly year-to-date, suggesting that defensive outperformance may be in the late stages. In sum, equity markets are in a transition phase and we are further tweaking our intra-industrials positioning after using recent underperformance to upgrade to neutral. We are also updating our high-conviction consumer staples view, and two unloved staples sub-groups. The Consumer Staples Sector Remains Appealing As part of this year's defensive sector leadership, the consumer staples sector has confounded its critics and registered a solid year-to-date relative performance gain. We expect additional near-term upside on the back of both internal and external drivers. Consumer staples companies are enjoying a revenue renaissance. Domestically, non-discretionary retail sales are gaining market share from discretionary outlays (Chart 5), reflecting consumers structurally ingrained propensity to save vs. spend since the financial crisis. Even exports are contributing to rising revenues, despite the U.S. dollar's appreciation (Chart 5). Easing monetary conditions in the emerging markets are underpinning domestic demand, benefiting U.S. staples exporters. Improving demand and cost containment are boosting operating profit margins (Chart 5, fourth panel). This should ensure that the sector continues to register meaningful free cash flow growth, a refreshing difference with the overall corporate sector. Meanwhile, external factors also point to a further relative performance recovery. The bond-to-stock ratio is joined at the hip with relative performance momentum, and a mean reversion phase is unfolding (Chart 6). Geopolitical uncertainty, the risk of a cooling in economic momentum following the downturn in the Economic Surprise Index could fuel flows into this non-cyclical sector. Chart 5Domestic And International##br## Positive Demand Drivers Domestic And International Positive Demand Drivers Domestic And International Positive Demand Drivers Chart 6Financial Variables ##br##Reinforce Staples Bid Financial Variables Reinforce Staples Bid Financial Variables Reinforce Staples Bid There is both valuation and technical motivation for capital inflows. Chart 6 shows that our Technical Indicator has troughed near one standard deviation below the historical mean. Every time this has occurred in the last decade, a sizable relative share price recovery has ensued. There are no valuation roadblocks, countering the assertion that defensive sectors are all overvalued in relative terms (Chart 6). As a result, this sector remains a high-conviction overweight, especially with two previous lagging groups now exhibiting signs of a recovery. Hypermarket Green-Shoots The hypermarkets industry is sprouting a number of green-shoots that should further propel the recent advance in relative share price performance. The industry is enjoying profit margin support on two fronts. Import prices are still deflating (Chart 7), and the nascent rebuilding in Asian manufacturing inventories suggests that pricing pressure will persist. On the revenue front, Wal-Mart recently noted that store traffic continues to improve, albeit aided by discounting. A tight labor market is supporting aggregate wage growth, especially those in lower income brackets, which is supportive of total hypermarkets sales. Importantly, the need to slash prices to attract more customers should abate courtesy of improving demand. The overall retail sales price deflator has climbed into positive territory. Hypermarket sales growth is highly correlated with overall retail selling price inflation (Chart 8). Chart 7Input Costs Will Remain Contained Input Costs Will Remain Contained Input Costs Will Remain Contained Chart 8Low Profit Hurdle Low Profit Hurdle Low Profit Hurdle At least some of the improvement in pricing power reflects an easing in food industry deflation, which implies that the intensity of price wars with food retailers will diminish. Total outlays on food and beverages are climbing as a share of total consumer spending after falling for six consecutive years (Chart 8). These elements are captured by our hypermarkets earnings pressure gauge, which is signaling a rosier sales and EPS growth backdrop (Chart 8, fourth panel). If the border adjustment tax continues to lose momentum, the risk premium for this group should narrow. Food Retailers Are Down, But Not Out Elsewhere, the drubbing in food retailers looks overdone. The relative share price ratio is at a multi-decade low. Investor fears have concentrated on industry selling price deflation, which has weighed on already razor thin profit margins. Nevertheless, a turnaround is afoot, and we would lean against extreme bearishness. As noted previously, consumer spending on food and beverages are gaining a foothold relative to overall outlays. That is supporting a reacceleration in grocery store same-store sales. With the unemployment rate this low, wage inflation is expected to sustain recent gains. Rising incomes are synonymous with higher consumer spending power. Thus, the rebound in industry sales has more upside (Chart 9). The upshot of consumers' increased food appetite is that the food CPI is exiting deflation (Chart 10). That should go a long way in allaying investor profit margin concerns. Chart 9Buy The Wash ##br##Out In Food Retailers... Buy The Wash Out In Food Retailers... Buy The Wash Out In Food Retailers... Chart 10...Because The Deflation##br## Threat Is Diminishing ...Because The Deflation Threat Is Diminishing ...Because The Deflation Threat Is Diminishing Previous pricing pressure forced grocers to refocus on productivity. The industry's total wage bill has cooled significantly. Our productivity proxy, defined as sales/employee, is accelerating, hitting growth rates last seen more than five years ago, when share prices were trading at much higher valuations (Chart 10). Bottom Line: We reiterate our overweight stance both in the S&P hypermarkets and the compellingly valued S&P food retail index. The ticker symbols for the stocks in these indexes are: WMT, COST and KR, WFM, respectively. Air Freight Stocks Will Spread Their Wings The sell-off in transportation stocks has progressed to the point where pockets of value are materializing. Specifically, air freight and logistics stocks have been pummeled, trading down to the bottom of their post-GFC trading range (Chart 11). This is a playable opportunity. Relative performance has returned to levels first reached in the depths of the GFC. Bears have pushed valuations and technical conditions to extremely washed out levels. Both the forward P/E and price-to-sales ratios have collapsed, trading significantly below their historical means and at a steep discount to the S&P 500 (Chart 11). To be sure, a number of forces have fueled the selling. Industry activity is running below capacity, as evidenced by weakness in industry average weekly hours worked (Chart 11). The loss of momentum in internet sales compared with bricks and mortar retail sales may be causing some concern about the pace of future land deliveries (Chart 11). Walmart's news that it is offering an in-store pick up option for online orders has also spooled investors. Amazon's push for its own delivery service is a longer-term yellow flag. Nevertheless, deeply discounted valuations and depressed earnings growth expectations imply that these drags are already reflected in prices. In fact, more recently analysts have pushed the net earnings revision ratio back into positive territory. We expect additional upside as global trade improves. While we were concerned about global trade last November when we downgraded to neutral, there is more evidence now that global revenue ton miles will reaccelerate. The surge in BCA's boom/bust indicator and advance in the business sales-to-inventories (S/I) ratio are both signaling that global trade will continue to recover (Chart 12). The sustainability of the S/I improvement looks solid. The global manufacturing PMI has shot higher on the back of a synchronized developed and emerging market final demand improvement, which heralds accelerating global export volumes (Chart 12). hiatus in the U.S. dollar bull market has also provided much needed reflationary relief to the emerging world. We expect these global forces to overwhelm recent domestic freight demand concerns. Importantly, global exports have been positively correlated with air freight pricing power and the current message is to expect price hikes to stick (Chart 13, third and fourth panels). Keep in mind that air freight companies typically command greater pricing power when the supply chain is lean and lead times begin to lengthen, because companies will pay up to ensure product/parts availability. Chart 11Grim News Is Well Discounted Grim News Is Well Discounted Grim News Is Well Discounted Chart 12Recovering Global Trade... Recovering Global Trade... Recovering Global Trade... Chart 13...Is A Boon To Air Freight Pricing Power ...Is A Boon To Air Freight Pricing Power ...Is A Boon To Air Freight Pricing Power In sum, a durable recovery in global trade should ignite an earnings led relative outperformance phase in the S&P air freight & logistics index. Bottom Line: Boost exposure to overweight in the S&P air freight & logistics sub-group. The ticker symbols for the stocks in this index are: BLBG: S5AIRFX - UPS, FDX, CHRW, EXPD. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The U.S. dollar correction is entering its last innings as investors now only discount marginally more than one rate hike by the Fed over the next 12 months. The last leg of the USD's weakness is likely to be prompted by technical and political factors. Beyond this, the outlook for the U.S. economy remains healthy, yet investors have pared down their expectations, suggesting that positive surprises should emerge. The conciliatory tone of the so-called currency manipulator report suggests that the hopes of a Plaza 2.0 accord should get dashed. EUR/GBP has downside. Feature The dollar continues to decline. Doubts about President Trump's pro-growth agenda and higher borrowing costs are creating worries about future economic growth. Treasury Secretary Mnuchin's admonition that fiscal reform may be delayed only added fuel to the fire. The reality is a bit more nuanced than this. The global economy just experienced one of its most broad-based periods of improvement in decades. Earlier this year, our global economic and financial diffusion index, based on 106 indicators, hit its highest level since 1999 (Chart I-1). This upswing caused global growth expectations to surge, as highlighted by large moves in the global and U.S. stock-to-bond ratios. Chart I-1Broad-Based Economic Upswing Has Lifted Growth Expectations Broad-Based Economic Upswing Has Lifted Growth Expectations Broad-Based Economic Upswing Has Lifted Growth Expectations Still, such a pace of improvement is hard to maintain. The handicap is even greater given one of the sharpest increases in global borrowing costs of the past thirty years. Thus, an almost unavoidable growth disappointment is currently underway, as illustrated by the sudden swoon in global economic surprises. As negative surprises accumulate, it is natural for investors to tame their growth expectations, and in the process, to have pulled down their expectations for the level of the Fed funds rate 12 months out (Chart I-2). Unsurprisingly, the dollar has corrected in the process. Going forward, the flattening yield curve and weak inflation expectations could cause market expectations for the Fed Funds rate to fall further (Chart I-3). A downgrade in Fed expectations could push the DXY toward 97 - particularly given that the greenback currently stands at a crucial support (Chart I-4). Chart I-2A Full Rate Hike Has Been ##br##Purged From Expectations A Full Rate Hike Has Been Purged From Expectations A Full Rate Hike Has Been Purged From Expectations Chart I-3The Source Of ##br##The Worry The Source Of The Worry The Source Of The Worry Chart I-4Dollar At ##br##Crucial Spot Dollar At Crucial Spot Dollar At Crucial Spot Moreover, while our dollar capitulation index is already flirting with oversold readings, it can remain in that territory for extended periods of time. In fact, as long as this indicator stays below its 13-week moving average, the dollar tends to remain under downward pressure (Chart I-5). This would suggest that the window of weakness in the dollar has yet to be closed and that a break toward 98-97 in DXY is still very likely. Chart I-5Momentum Still A Headwind For The Dollar Momentum Still A Headwind For The Dollar Momentum Still A Headwind For The Dollar Outside of growth considerations, politics could also contribute to a last wave of selling in the dollar against the euro. Macron, the centrist candidate for the French presidency, is currently polling 25% of voting intentions for the first electoral round this weekend, ahead of Marine Le Pen. Yet the press continues to focus on Jean-Luc Mélanchon's surge in the polls, despite the fact that his popularity gains have stalled at 19%. This means that markets may get positively surprised Sunday night when French electoral results come in as the implied probability of a Le Pen / Mélanchon second round has risen. If as is more likely, Macron, not Mélanchon, makes it to the second round, it is important to remember that in head-to-head polls, he currently scores 64% vs 36% for Marine Le Pen (Chart I-6). Beyond these short-term dynamics, the outlook for the dollar continues to look brighter. To begin with, major leading indicators of the U.S. economy still point to a rebound later this year: The ISM manufacturing highlights that the decline in credit growth may be a temporary episode (Chart I-7). Chart I-6Positive Euro Stock This Weekend? Positive Euro Stock This Weekend? Positive Euro Stock This Weekend? Chart I-7U.S. Credit Growth Will Pick Up U.S. Credit Growth Will Pick Up U.S. Credit Growth Will Pick Up The U.S. CEO Confidence survey is at a 12 year high, and points toward both stronger capex and GDP growth (Chart I-8). The soft job number in March is likely to have been an aberration, as various indicators suggest that job growth will remain perky (Chart I-9). Moreover, this is happening in an environment where labor market slack is likely to prove limited. Not only is the headline U-3 unemployment rate now in line with NAIRU, but also hidden labor market slack - as approximated by discouraged workers and part-time workers for economic reasons - has greatly normalized (Chart I-10), suggesting that healthy job creation should result in accelerating wage growth this year. The elevated level of consumer confidence along with the healthy state of household finances - debt to disposable income still stands near 15-year lows and debt-service payments are at multi-generational lows - are together pointing toward stronger consumer spending. Chart I-8When CEOs Are Happy, ##br##So Is The Economy When CEOs Are Happy, So Is The Economy When CEOs Are Happy, So Is The Economy Chart I-9Soft March Payrolls: ##br##An Aberration Soft March Payrolls: An Aberration Soft March Payrolls: An Aberration Chart I-10U.S. Labor Market ##br##Slack Is Limited U.S. Labor Market Slack Is Limited U.S. Labor Market Slack Is Limited U.S. Labor Market Slack Is Limited U.S. Labor Market Slack Is Limited These developments are important as our Composite Capacity Utilization Gauge for the United States has now firmly moved into no-slack territory (Chart I-11). As such, improvements in the U.S. economy later this year will give the Fed plenty of ammunition to increase rates. Thus, we think that markets are ultimately underestimating the FOMC's capacity to lift rates by only anticipating marginally more than one rate hike over the next 12 months. Chart I-11U.S. Capacity Constraints Are Getting Hit U.S. Capacity Constraints Are Getting Hit U.S. Capacity Constraints Are Getting Hit As a result, buy any further dips in the dollar. We are already long the USD against commodity currencies, but will use any weakness to close our short USD/JPY trade and begin accumulating the dollar against the euro. In terms of level, we will close our short USD/JPY position at 107 and look to open a short EUR/USD bet at 1.10. Bottom Line: Markets are revising down their expected path for U.S. interest rates, causing a correction in the dollar in the process. After a period of robust and widespread growth improvement, expectations had become lofty and a period of indigestion was all but inevitable. However, forward looking indicators for U.S. growth are still healthy. With U.S. spare capacity becoming increasingly limited, investors are in the process of overdoing their downward adjustment in future U.S. rates. Use any further pull back in the U.S. dollar to buy the greenback. Currency Manipulators On Notice? Not Really This week, the U.S. Treasury published its annual report on Forex policies for the U.S.'s major trading partners, the so-called currency manipulator report. This time around, the report was especially interesting in light of the aggressive campaign rhetoric from President Trump. Chart I-12Conditions For Inflation Are ##br##Emerging In Japan Conditions For Inflation Are Emerging In Japan Conditions For Inflation Are Emerging In Japan Six countries were highlighted as hitting two of the three criteria necessary to be labeled currency manipulators. These were China, Germany, Japan, South Korea, Switzerland, and Taiwan. Most interesting was the tone of the discussion around China and Japan. Regarding China, the Treasury acknowledged that the PBoC is intervening in the currency market, however not to depress the value of the yuan, but to support it. The discussion was centered on the need for China to ease import restrictions and promote household consumption in order to narrow both the overall current account surplus and the bilateral trade surplus with the United States. These would be steps in the right direction to normalize the Sino-U.S. trade disequilibrium without entering in an all-out trade war. The discussion vis-à-vis Japan was also nuanced. Obviously, Japan's US$69 billion trade surplus with the U.S. was flagged, but the Treasury also acknowledged that the country's 3.7% current account surplus mostly reflected a very large positive income balance. Additionally, the Treasury also recognized that the large surplus was a reflection of Japan's poor domestic demand and that Japan needed to complement its very accommodative monetary policy with further fiscal boost and reforms. We interpreted this comment as a tacit acceptance that Abenomics and the BoJ's policy were squarely domestically focused and that the weak yen was a casualty, not the ultimate end-goal of these policies. With this recognition, it seems unlikely that the calls for a Plaza 2.0 accord would go anywhere. Instead, we expect similar demands to the one exerted on China to take precedence: more opening of the domestic market to imports and more Japanese FDI in the U.S. With this, the U.S. will live with a very dovish BoJ. In this optic, a key development emerged this week in Japan. Two BoJ governors have been replaced by two Abe philosophical allies, Mr. Hitoshi Suzuki and Mr. Goshi Kataoka. Therefore, Japan's monetary policy will remain very accommodative going forward as the near total control of the board by ultra-doves reinforces the institution's commitment to "irresponsible" monetary policy. Most importantly, our Composite Capacity Utilization Gauge for Japan is now in the zone where core inflation should accelerate (Chart I-12). This suggests that inflationary dynamics are likely to emerge after the current wave of global negative economic surprises abates. This should result in exactly what the BoJ wants: lower real rates and higher inflation expectations. This would be poisonous for the yen. Any further yen rally should be used to once again short the JPY. With regards to Germany, the Treasury acknowledged that ECB monetary policy is out of Berlin's control, but it would like to see more efforts to boost domestic demand, and a higher real exchange rate. In other words, at this point the Treasury seems to be hoping for higher German inflation more than for a higher euro. This too is re-assuring considering the initial aggressive stance of the Trump administration toward Germany. Switzerland, Korea, and Taiwan are in slightly more precarious conditions as all have been engaging in open market operations to depress the value of their currencies in recent years. However, with the softened tone exhibited toward China, Japan, and Germany, there is a high chance that the Treasury will find ways to turn a blind eye on these countries going forward. Bottom Line: The current U.S. administration is softening its tough rhetoric on trade and it is coming to grips with the reality that it may not be able to bully its trading partners into appreciating their currencies. Instead, Trump is likely to have to be content with fewer trade barriers to access these nations, and further efforts to stimulate domestic demand, which indirectly may help U.S. exports to these countries. We see these developments as steps in the right direction that should decrease the risks currently hanging over global trade. Politics Abound: What To Do With The Euro And The Pound? This week, Theresa May called for a snap election on June 8. The market perceived this announcement as very positive for the U.K.: it will decrease the risk of a very harsh form of Brexit. A larger Conservative victory, which seems highly likely based on current polls, implies that May will be less reliant on the most extremist Brexiters to govern. As such, the U.K. is perceived to be more likely to concede on some key EU demands such as Brussels's request that London pays the GBP 60 billion it owes to the EU's 2014-2020 budget. If these demands are met by the U.K., it is expected that the EU will be less intransigent when it comes to negotiating transitional agreements. On these dynamics, GBP/USD rallied 2.2% on Tuesday and now stands above its 200-day moving average for the first time since that fateful June 2016 night. EUR/GBP too was hurt by the pound rally, retesting its post referendum lows. What is the outlook for GBP/USD and EUR/GBP? The picture for EUR/GBP is the cleanest. A quick rally next week if Macron clenches a spot in the second round of the French election is very likely, especially as investors might have discounted the positive implications of the election on the pound too quickly. Any such rally should be used to begin building short EUR/GBP positions. EUR/GBP is currently trading 12% above its PPP fair value, but it is also trading at a large premium to real interest rate differentials (Chart I-13, top panel). Moreover, investors are starting to adjust upward the expected path of short rates in the U.K. relative to the euro area. This historically has been associated with a stronger pound (Chart I-13, bottom panel). Additionally, as we have argued, the negative factors affecting the U.K. economy are well known. Yet, the stability of long-term U.K. household inflation expectations suggests that the adjustment in consumption in response to high inflation caused by the lower pound could be limited as households may look through any temporary bump in inflation.1 Finally, positioning and sentiment on EUR/GBP are extremely stretched. Historically, such extended levels of bullishness toward the euro relative to the pound have been followed by sharp sell-offs in EUR/GBP (Chart I-14). Chart I-13Real Rates Points To ##br##EUR/GBP Downside Real Rates Points To EUR/GBP Downside Real Rates Points To EUR/GBP Downside Chart I-14Investors Are Positioned For##br## Further Euro Strength Investors Are Positioned For Further Euro Strength Investors Are Positioned For Further Euro Strength When it comes to the GBP/USD, the pound may continue to rebound in the short term toward 1.35. However, the upside in GBP/USD is likely to be capped if our bullish view on the dollar does pan out. This is why we prefer to express positive views on the pound via a short position in EUR/GBP. Bottom Line: The June 8 U.K. general election is important as it does increase the probability that Theresa May will be able to soften the U.K.'s negotiating stance on key budgetary points regarding Brexit. This means that longer and smoother transitional agreements between the U.K. and the EU are likely to emerge at the end of the Article 50 negotiations. Meanwhile, EUR/GBP is expensive relative to PPP metrics and rate differentials. The risk of a breakdown below 0.83 is growing, especially as investors are not positioned for a rally in the pound against the euro. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the U.K. economy, please refer to the Foreign Exchange Strategy Special Report titled "GBP: Dismal Expectations", dated January 13, 2017 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The greenback's weakness has been a result of declining price and wage pressures this month. A weaker than expected jobless claims and Philadelphia Fed Manufacturing Survey are both indications of the current economic soft patch. However, this is a temporary setback that will do little to alter the Fed's intended hiking cycle. The DXY is currently at a crucial technical level and could face significant pressure from an appreciating euro in the run-up to the French elections. After the outcome of these elections is digested, a return to robust U.S. data will likely propel the greenback upwards as the Fed will keeping lifting rates relative to the rest of the G10. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro strengthens on the back of an optimistic interpretation of Praet's speech in New York. The central banker alluded to diminishing growth risks, but pointed out that short-term risks still remain. It seems that markets have priced in the end of the ECB's easing cycle. Further lifting the euro is expectations that Emmanuel Macron is on his way to the second round of the French election. However, it remains true that peripheral economies are stumbling along with high unemployment and little-to-no wage growth, which points toward widening U.S./European real rate differentials in the longer term. Inflation figures remained unchanged in March both in monthly and annual terms. An annual core inflation figure of 0.7% implies that inflationary pressures remain muted. A bearish outlook on the euro after the French elections is warranted. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 ECB: All About China? - April 7, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 On Tuesday the Japanese parliament nominated Hitoshi Suzuki and Goshi Kataoka to replace two members of the BoJ who had been serial dissenters of Governor Kuroda. This development is important as both of the nominees are known reflationists, which confirms our thesis that the Abe government is committed to support Kuroda's agenda. As the BoJ becomes increasingly dominated by doves, Kuroda will have more leeway in implementing radical reflationary measures, which is bearish for the yen on a cyclical basis. On a tactical basis, we believe the downtrend in USD/JPY might be approaching its last legs, given that we expect the dollar correction to end soon. On the other hand, a risk-off period in the markets seems probable, thus we will stay short NZD/JPY to capture investor's risk aversion. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Cable surged following Theresa May's call of a snap election as the market became less bearish on the U.K. economy given that the election provides an opportunity for the Prime Minister to assert her power over the more radical MPs, and thus set the stage for a softer Brexit. We continue to be relatively optimistic on the pound, particularly against the euro, as we believe that the market is too pessimistic on the U.K. economy. Furthermore, the BoE has shown much less dovish than the ECB as Governor Carney has stated that they will undergo "some modest withdrawal of stimulus" in the next few years, while many members seem to be leaning towards a rate hike. Taking these factors into account, as well as the overly bullish positioning on the euro relative to the pound, we are now confident in shorting EUR/GBP. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The antipodean currency experienced significant downside amidst dovish remarks by the RBA. Highlighted in the minutes were worries associated with the labor market, with members citing higher unemployment and underemployment as contributors to faltering wage growth. As a corollary, the rise in underlying inflation is expected to be "more gradual", with headline inflation expected to reach its 2% target sometime this year. However, members also stressed the role of energy prices, which could complicate the process. An important observation is the adverse impact of Hurricane Debbie on coal production, a major export for Australia. In merrier news, China's economy outperformed expectations, achieving a growth rate of 6.9% in Q1. However, this is a backward looking indicator and likely corroborates the AUD's strength in Q1, while the recent weakness in Chinese capital spending plans and residential property prices are more accurate indicators of future AUD development. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 This week, kiwi headline inflation came at 2.2%, not only surpassing expectations but also reaching the upper half of the 1%-3% target inflation range for the RBNZ. This confirms our suspicion that inflationary pressures in New Zealand are much stronger than what the RBNZ would lead you to believe, and opens the possibility that the RBNZ could abandon its neutral bias for a more hawkish one. This should help the NZD outperform the AUD on a cyclical basis, given that the Australia's domestic inflationary pressures are much weaker. On a tactical basis, we continue to be short the NZD relative to the JPY, given that a China induced risk-off episode will boost safe heavens and hurt carry currencies. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Within the commodity space, CAD should benefit against other commodity currencies. Oil is likely to face relatively consistent global demand vis-a-vis other commodities, such as industrial metals, as it is more insusceptible to the "unwinding of the Trump trade". Moreover, BCA foresees an extension of the OPEC production cuts for the remainder of the year, which will support oil-based currencies. Faltering capital expenditure in China will work against industrial metal demand, further accentuating this development. Limiting the CAD's upside, however, is a stronger USD this year, most probably after April is over. Real rate differentials will evolve in favor of the USD, limiting the upside to commodity prices in general. The result will be an outperformance of CAD relative to AUD and NZD. Finally, the recent non-resident tax implemented by Ontario my cause hick-ups in Canada's largest housing market. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Economic data in Switzerland continues to improve as various measures such as manufacturing PMI, employment PMI and purchase prices have reached 2011 highs. These developments along with rising inflation, will reassure the SNB that the unofficial floor under EUR/CHF has been effective. Nevertheless, we expect the SNB to keep this floor in place until the end of the year, as not only do French elections pose a short term risk, but core inflation and wage growth would have to stay high for a sustainable period of time for the SNB to consider removing accomodation. Moreover, the removal of the floor would likely be gradual, as the SNB has learned from 2015 that a sharp appreciation in the franc could quickly undo any economic progress. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Although USD/NOK has been quite uncorrelated with oil in recent months, EUR/NOK continues to be highly correlated with oil prices. Overall, we expect the NOK to exhibit weakness against the dollar on a cyclical basis given that dollar bull markets tend to weigh on this cross. Moreover, the Norges Bank will continue to have a dovish bias, given that inflation is falling sharply and economic conditions remain weak. However, on a tactical basis, it is possible that the NOK outperforms the AUD, given that base metals are more sensitive to weaknesses in the Chinese economy. Oil, on the other hand, should stay relatively resilient, given that an extension of the OPEC deal until the end of the year seems very likely. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The SEK has largely been trading on the news flow from the U.S. and the euro area following a quiet week in Sweden. Similar to the DXY, USD/SEK is at a crucial technical spot, and EUR/SEK is likely to continue its uptrend in the run-up to the French election. Next week's Riksbank meeting is the last meeting before asset purchases end in June. As inflationary pressures are unlikely to subside substantially, we firmly believe that asset purchases will not be extended further. Nevertheless, while not shifting the policy rate, the Riksbank is likely to reiterate that a future cut is more likely than a future hike, especially as recent inflation figures have disappointed. This is likely to help USD/SEK in the longer run. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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

Highlights Expanded data availability and increasingly systemized investment processes have powered a surge of interest in factor attribution among academics, quants and ordinary investors. Momentum has long been recognized as a proven factor. Kenneth French's database shows that a zero-net-exposure strategy of shorting the stocks with the weakest momentum to fund the purchase of their strong-momentum counterparts yielded over 10% per year from 1939-1999. Since the crisis, however, momentum has lost its magic touch. As in the 1930s, Fama and French's long/short momentum strategy has stumbled following a crash. The long leg of the strategy's outperformance record remains intact, though, just as it has across the 90 years covered by the Fama-French database. In this Special Report, we examine some hypotheses for why momentum has lost some of its edge and consider the conditions under which it might fully regain it. We then consider the current crop of smart-beta momentum funds based on the features we would like to have in a momentum fund once the factor fully recovers its footing. Feature Regular readers will recognize this installment of our smart-beta ETF series as a departure. Unlike the Value and Dividend Special Reports, this one does not employ the relevant metrics from our Equity Trading Strategy's ("ETS") proprietary multi-factor model to evaluate single-factor ETFs. The momentum factor's post-crisis stumbles may indicate that the classic momentum yardsticks are in need of realignment, and the modest pool of smart-beta momentum ETFs can be winnowed without them. We instead use this Special Report to explore the momentum factor: its empirical history, potential explanations for its long success and current slump, and its interaction with the fed funds rate cycle. We will examine the links between the big picture and factor performance next month, with a particular focus on monetary policy settings. Careful study of the relationship between macro variables and equity factors may shed some light on the most opportune cycle phases for seeking particular factor exposures. It will also illustrate how individual factors could interact within a portfolio to boost risk-adjusted returns. The series' primary goal is still to provide our clients with a solid grounding in the basics of factor investing and the smart-beta process. It is our hope that the addition of macro-level guidance to help recognize the best cyclical backdrops for taking on factor exposures will enhance the micro-level guidance to help choose the optimal ETFs for gaining exposure to a particular factor. The Momentum Paradox Traders are a famously empirical breed with little use for fancy theories. Their common-sense mantras that survive long enough to pass into general use are based on steady observation and hard-won experience. Two of our favorites sum up the duality at the heart of momentum investing: The trend is your friend. Trees don't grow to the sky. Trader intuition is valid: academic research has repeatedly confirmed the existence and persistence of momentum. Alas, it doesn't last forever. The challenge at the heart of developing a working momentum strategy is determining how long the typical trend runs before it reverses. Investors have much longer timeframes than traders, but they would do well to heed traders' warning about overstaying one's welcome when they plot their course: Bulls make money; bears make money; pigs get slaughtered. A History Of Momentum In Five Chapters The Golden Age, 1939-1999 Momentum shot the lights out for 60 years. From late 1939, when it finally threw off the lingering effects of the Great Depression, until the peak of the tech bubble in early 2000, a simple zero-net-exposure strategy developed by Fama and French (please see Box 1 for the parameters of the strategies referenced herein) generated a whopping 10.4% compound annualized return (Chart 1, Phase 3). The strategy's consistency may have been even more remarkable. The 60-year golden age included just one bear event (a peak-to-trough decline of at least 20%),1 and a mild and brief one at that.2 Data from Jegadeesh and Titman, co-authors of the seminal momentum-focused paper,3 corroborate Fama and French's findings. Tracking the results of 32 separate strategies from 1965 to 1989 (Box 1), Jegadeesh and Titman definitively established that the momentum factor generates statistically significant excess returns. The 6-month, 6-month strategy on which they focused (shorting the last six months' biggest laggards to fund the purchase of its biggest outperformers, and holding the portfolio for six months) generated an average compound annual return of 12%.4 The Roaring Twenties, 1927-1932 The Fama-French momentum strategy blasted out of the gate with compound annual returns of 29% through June 1932 (Chart 1, Phase 1). Full year returns were at least 20% every year from 1927 through 1931, as momentum was impervious to the 1929 Crash. This chapter illustrates that stock-price momentum is hardly a new phenomenon, and that momentum strategies, which often zig when the broad market zags, can contribute welcome diversification to a portfolio. The First Failure, 1932-1939 The party came to an abrupt end in July and August 1932, when the strategy lost three-quarters of its value in two months (Chart 1, Phase 2). As the financial crisis would reiterate seven decades later, momentum crashes can be vicious and swift. This one was followed by several years of listless performance, capped by a brutal coda. The aftershocks can be much worse for momentum than the earthquake itself, and it only hit bottom after September 1939's 30% decline. The Wobbly Years, 2000-2008 The end of the tech bubble marked a watershed for momentum. Although the strategy generated hearty positive returns given its zero net exposure (4.7% CAGR from March 2000 through November 2008), its return profile became uncharacteristically volatile (Chart 1, Phase 4). Momentum bear markets became a regular feature, with three separate declines of 23% to 32% occurring between February 2000 and August 2004. Academic research into the momentum factor became a veritable cottage industry after its discovery in the early 1990s, making this the first chapter to unfold against a backdrop of wide investor awareness of its existence. The Crisis and Its Aftermath, 2008-2017... The spring of 2009 witnessed the second great momentum crash, with the strategy losing 58% from its November 2008 peak to its September 2009 trough, sustaining a 49% loss over just the three months of March (-11.5%), April (-34.6%) and May (-12.3%) (Chart 1, Phase 5). The strategy has crept back to post a 3% compound annualized return since the trough, but it has recovered just 18% of its peak-to-trough decline in the ensuing seven-and-a-half years,5 and it just entered a bear market for the first time since the '08-'09 crash. Highlighting its extended slump, the strategy now trades at a level it first reached in December 1999. What Makes Momentum Tick? As with all factors, the jury is out on just what drives momentum's performance. Some researchers have argued for a risk-based explanation, but we do not see momentum as especially risky, relative to other strategies6 (Table 1), and therefore have more sympathy for the behavioral hypotheses advanced by the academic consensus. These hypotheses coalesce around the sense that markets systematically underreact to information, perhaps because of the time required to fully digest it or because the disposition effect lures investors into parting with winning positions too quickly and holding onto losing positions too long. As the built-in lags between portfolio formation and activation described in Box 1 recognize, however, the medium-term underreaction reliably follows an immediate overreaction. Table 1Market-Neutral Momentum Versus The Broad Market Smart-Beta ETF Selection, Part III - Momentum Funds Smart-Beta ETF Selection, Part III - Momentum Funds BOX 1 Momentum Strategy Parameters We refer to two distinct approaches to building momentum portfolios in this Special Report: Fama and French's single long/short strategy and Jegadeesh and Titman's matrix of sixteen long/short strategies. Both approaches attempt to exploit the observed tendency for outperforming stocks to continue to outperform and underperforming stocks to continue to underperform. Each strategy starts by ordering stocks based on their trailing returns over a stated period (the lookback period) to determine their relative price momentum. Each strategy creates its portfolio after a short lag following the lookback period to evade relative performance's tendency to mean revert over the short term. Each strategy maintains its portfolio for a stated holding period before reshuffling the deck. Fama and French's lookback period is the first eleven months of the preceding twelve-month period, with the twelfth month serving as the lag between portfolio definition and formation. Fama and French form their market-neutral portfolio by buying the top three relative-performance deciles and shorting the bottom three. The portfolio is reconstituted monthly and its sample period extends from 1927 to today. By using four different lookback and holding periods (three, six, nine and twelve months), Jegadeesh and Titman formed sixteen different market-neutral portfolios with a one-week lag. Jegadeesh and Titman's portfolios buy the top, and short the bottom, deciles. They offer a more concentrated take on a long/short momentum strategy than Fama and French's. The near-term overreaction/medium-term underreaction response is additionally complicated by the tendency for relative performance to mean revert over long periods. Trees don't grow to the sky. Over time, investors may unduly extrapolate past surprises into the future, or mean-reversion may impede continued growth surprises via adaptive expectations and/or the law of large numbers. Whatever the cause, our Equity Trading Strategy model navigates the oscillating reaction gauntlet by betting on mean reversion over one- and 36-month timeframes and on momentum over a twelve-month timeframe. Why Isn't Momentum Working Like It Used To? Advances in communications and computing technology may have compressed the timeframes over which the overreaction/underreaction/overreaction pattern unfolds. Information travels faster in a wired world, and enhanced computing power allows it to be digested more rapidly after it's disseminated. Once digested, investors are able to act upon it in milliseconds. Reduced frictions in terms of commission costs and bid-ask spreads (as stocks have gone from being quoted in eighths, to sixteenths to pennies) have made it feasible to capture profits that couldn't be captured before. Specific to the post-crisis landscape, momentum portfolios are particularly susceptible to the whipsawing that can occur in the wake of once-in-a-generation bear markets. Momentum strategies tend to weather the initial storms quite well by steadily migrating to lower-beta stocks and shunning higher-beta ones. Eventually, however, their lopsided beta profiles turn momentum portfolios into sitting ducks for the violent snapback rallies that originate among the most down-and-out stocks. Those rallies inflicted heavy casualties after the Depression, when the bottom three deciles surged by 200% in July and August 1932, versus the top three deciles' 60%, and after the crisis, when the bottom three deciles nearly doubled in March, April and May 2009 while the top three deciles gained just 15%. The gory particulars behind momentum's biggest setbacks illustrate why investors shouldn't write the factor off just yet. Its crashes - and the reason it takes so long to recover from them - are a function of runaway shorts. Table 2 shows the Fama-French momentum portfolio separated into its long (Up Basket) and short (Down Basket) components. As one would expect in a market that's trended steadily higher ever since the Depression, the shorts are volatile and lag both the overall market and the long basket. Jegadeesh and Titman's more concentrated portfolios (confined to stocks in the top and bottom deciles) have struggled mightily in the out-of-sample period, losing money across the board (Chart 2). Table 2Full Speed Ahead For Long-Only Momentum Strategies Smart-Beta ETF Selection, Part III - Momentum Funds Smart-Beta ETF Selection, Part III - Momentum Funds Chart 2The Last Shall Be First (After A Crash, Anyway) Smart-Beta ETF Selection, Part III - Momentum Funds Smart-Beta ETF Selection, Part III - Momentum Funds But the real news is in the Up Basket's performance, which has pounded the overall market on both a nominal and a risk-adjusted basis for the entirety of the pre-crisis history and has fought it to a risk-adjusted draw since the crisis (while winning again on a nominal basis). Momentum still works, even now. We like to test factor performance on a market-neutral basis to gauge how well it stratifies a population from top to bottom, but we are sensitive to the fact that the majority of our clients are long-only investors. It is gratifying to see the factor's favored stocks consistently outperforming by a wide margin because it means alpha-generation is available to all investors. The potential excess returns to overweighting the winners and under- or zero-weighting the losers may be limited relative to overweighting the winners and shorting the losers, but they are excess returns nonetheless. We are unwilling to conclude that a factor as persistently robust as momentum is dead. It is simply hibernating, in our view, until the rising tide of extraordinarily accommodative monetary policy stops lifting all boats. ZIRP (and NIRP) have helped enable a bull market that has muffled the distinctions between individual stocks and other risk assets. That's unhelpful for relative value strategies, which feed on wide spreads, but the inflection in Fed policy may soon help mo-mo recover its missing mojo. Momentum And The Fed Funds Rate Cycle We have found that the fed funds rate cycle can provide an excellent guide to broad equity movements. As our U.S. Investment Strategy service has shown, the level of the fed funds rate has exerted a powerful pull on equities, with all of the S&P 500's price returns over 55 years having accumulated in periods when policy settings were accommodative.7 As Table 3 shows, Fama and French's momentum strategy turns that rule on its head, posting its strongest returns during periods when policy settings are restrictive. Table 3Fama French Momentum Portfolio Returns During Rate Cycle Phases From August 1961 Smart-Beta ETF Selection, Part III - Momentum Funds Smart-Beta ETF Selection, Part III - Momentum Funds The results are not as counterintuitive as they seem when one recalls that they are generated by long/short portfolios. As noted above, accommodative policy could act to narrow the gap between winners and losers. Restrictive policy may have the opposite effect, as reduced liquidity and higher yields make borrowing more fraught and debt service more onerous. It's only when the tide goes out that markets see who was swimming naked. Isolating Fama and French's Up- and Down-Basket returns supports this reading. Average return spreads between the long and short positions widen when policy is restrictive and narrow when it's accommodative (Tables 4A and 4B). Restrictive policy brings internal stresses to the fore, even to the point of inducing recessions (all of the recessions since the inception of our equilibrium fed funds rate model have begun in Phase II or Phase III of the policy cycle). Table 4AFama French Down-Basket Returns During Rate Cycle Phases From August 1961 Smart-Beta ETF Selection, Part III - Momentum Funds Smart-Beta ETF Selection, Part III - Momentum Funds Table 4BFama French Up-Basket Returns During Rate Cycle Phases From August 1961 Smart-Beta ETF Selection, Part III - Momentum Funds Smart-Beta ETF Selection, Part III - Momentum Funds The empirical evidence suggesting that restrictive policy settings are more conducive to momentum factor outperformance than accommodative ones carries tactical and strategic implications. The tactical implication suggests there's no rush to assume standalone momentum exposure even though it has distinguished itself over time. The strategic implication suggests that momentum exposure, in conjunction with other factor exposures, could help to reduce portfolio volatility for any given level of expected returns, or increase expected returns for any given level of volatility. The Smart-Beta Momentum Menu The same considerations involved in setting momentum model parameters bear on the choice of smart-beta momentum ETFs (Table 5). What is the optimal lookback period, the optimal rebalancing frequency and portfolio-formation lag? What tweaks might help avoid drawdowns and boost risk-adjusted performance over time? The sponsors of the ETFs tend to keep their lookback-period cards close to the vest, but six- and twelve-month lookback periods seem to be the standard. Lag periods are also treated like competitive secrets, except at the major index providers, where one- and two-month lags are the norm. Table 5The Current Universe Of U.S. Equity-Focused Smart-Beta Momentum ETFs Smart-Beta ETF Selection, Part III - Momentum Funds Smart-Beta ETF Selection, Part III - Momentum Funds The funds distinguish themselves more clearly in their rebalancing frequencies. Quarterly rebalancings are the standard, but MTUM, ONEO and SPMO, based on benchmarks from established index families, roost at the more patient semi-annual end of the continuum. EEH has the shortest attention span, pursuing its sector rotation strategy with daily rebalancing, and fund-of-funds DWTR rebalances monthly. We note that EEH is an ETN representing an obligation of a Swedish bank and that, all else equal, we prefer ETFs since they carry no credit risk. QMOM recently shifted its registration from Active to Passive, along with three other Alpha Architect funds. Alpha Architect is a quant shop run by a Finance PhD and we have noticed that its funds tend to cluster at the top of our ETS model rankings. It would appear that its portfolio construction models share several factors with the ETS model, and we will be keeping an eye on its funds' performance. Doug Peta, Senior Vice President Global ETF Strategy dougp@bcaresearch.com Philippe Morissette, Associate Vice President Equity Trading Strategy philippem@bcaresearch.com 1 Based on a manual review of the data using month-end closing prices. 2 The strategy lost 20.4% from December 1980 through August 1981 at the beginning of the Volcker bear market. 3 Jegadeesh, Narasimhan and Titman, Sheridan, "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," Journal of Finance, Volume 48, Issue 1 (March 1993), p.70. 4 Ibid, p. 89. 5 Through the end of February. 6 Asness, Clifford S. and Frazzini, Andrea and Israel, Ronen and Moskowitz, Tobias J., "Fact, Fiction and Momentum Investing," Journal of Portfolio Management, Fall 2014 (40th Anniversary Issue); Fama-Miller Working Paper. Asness et al demonstrate that momentum's risk-adjusted returns have outpaced those of more widely celebrated factors and the overall market. 7 Please see U.S. Investment Strategy Special Report, "Stocks And The Fed Funds Rate Cycle," published December 23, 2013, available at usis.bcaresearch.com.