Policy

Highlights Coordinated Hawkishness: Central bankers are in the process of taking back the easier monetary policy that followed the deflationary 2014/15 oil shock. Bond yields still have more upside to catch up to the solid pace of global growth and diminishing economic slack. Maintain a below-benchmark stance on overall portfolio duration. ECB Taper Tantrum: The recent European bond sell-off is following a similar pattern to both the 2013 Fed Taper Tantrum and the 2015 Bund Tantrum, suggesting a potential target of 1% on the benchmark 10-year German Bund yield by year-end. Stay underweight Euro Area government bonds. Canada: With the Canadian economy looking very strong, and with the Bank of Canada signaling a desire to begin normalizing monetary policy, the current underperformance of Canadian government bonds will continue. We are maintaining our tactical bearish positions on Canadian bonds, and are also adding a new strategic underweight position (2 out of 5) in our model bond portfolio. Feature A Regime Shift, Not A Regime Change Interest rate risk has returned with a vengeance in global fixed income markets over the past couple of weeks. A string of relatively hawkish policymaker comments has triggered a quick and sharp bond sell-off, as investors reprice the odds of what is looking now like a coordinated recalibration of global monetary policies. Longer-dated bonds have gotten pummeled as yield curves have bear-steepened in most countries, with 30-year government bond prices falling between -5% and -7% in a matter of days (Chart of the Week). With global growth looking very strong at the moment, policymakers are being forced to respond by looking to unwind some of the easing that took place after the crash in oil prices in 2014/15. With that deflation scare now firmly in the rearview mirror, central bankers are having to signal a move away from the emergency stimulus from 2015. The rapid yield responses seen so far suggest that the communication of that subtle policy shift - becoming "less dovish" rather than "more hawkish" - must be handled delicately, or else financial markets may riot and possibly short-circuit the current economic upturn. This yield surge has done very little to dampen investor enthusiasm for risk assets, so far. Equity prices and corporate credit spreads, both in the developed world and emerging markets (EM), have only moved modestly despite the large move in government bond yields (Chart 2). This suggests that the latter was most mispriced compared to the current solid pace of global economic growth. Chart of the WeekA Painful Repricing Chart 2Risk Assets Remain Unfazed With the benefit of hindsight, it now appears that the decline in global bond yields in the spring was an outsized response to a few below-consensus data prints on U.S. economic growth and inflation. Importantly, the numbers in the U.S. are starting to improve again, as indicated by the strong jump in the ISM indices and employment (+220k) in June. Many of our most reliable leading indicators and models are all pointing to further acceleration in U.S. growth in the next few quarters (Chart 3). The U.S. inflation data continues to disappoint, both in terms of price indices and wage growth. Growth in Average Hourly Earnings has drifted lower since the most recent peak, while core PCE inflation is only 1.4%. The latest commentary from the Fed, including the minutes from the June FOMC meeting released last week, suggests that this downdraft in inflation should prove to be temporary and stronger growth should lead to faster inflation. We would agree with that assessment. The U.S. unemployment rate at 4.4% remains below most measures of full employment, while other reliable indicators of labor market tightness, such as the spread between the "jobs plentiful" and "jobs hard to get" components of the U.S. consumer confidence report, are also pointing to an eventual reacceleration of wages (Chart 4, top panel). Meanwhile, the Cleveland Fed Median CPI is hovering around 2.5%, well above the current 5-year/5-year forward cost of inflation compensation embedded in U.S. TIPS prices of 1.83% (middle panel). Furthermore, the Phillips Curve based core PCE inflation model developed by our colleagues at U.S. Bond Strategy is signaling a rebound of core PCE inflation back above 1.9% by year-end, in a scenario of no change in the unemployment rate or U.S. dollar from current levels (bottom panel). Chart 3U.S. Growth Will Rebound Chart 4U.S. Inflation Will Rise Our base case scenario for the Fed is that additional tightening will come in 2017. First through an announcement on starting the process of reducing the Fed's balance sheet, through "tapering" the reinvestment of proceeds from maturing bonds held by the Fed, at the September FOMC meeting. After that, the next rate hike will not be until December. This will allow the Fed to see more inflation prints to confirm its own expectation that inflation will soon rebound before delivering more policy tightening. Of course, if the next couple of inflation releases surprise to the upside, then perhaps a rate hike is possible at the September meeting alongside the announcement on the Fed's balance sheet (which is basically a done deal, at this point). For now, we see the Fed staying cautious, especially given the increasing number of FOMC members who are becoming concerned with the lack of U.S. inflation, according to the June minutes. As for the other major developed economy central banks, this "old-school" cyclical upturn is boosting both capacity utilization and pipeline inflation (Chart 5). Combined with the other measures that have been showing diminished economic slack, like unemployment rates and output gaps, this will give policymakers confidence in their own medium-term growth and inflation forecasts. This will also embolden central bankers to remove some policy accommodation. Our own Central Bank Monitors are indicating a need for tighter monetary policy in every major developed economy except Japan. That is confirmed by Taylor Rule estimates for interest rates. In Chart 6, we present simple Taylor Rule projections for the policy rate in the U.S., Euro Area, U.K., Japan, Canada and Australia. The formula takes potential GDP growth (OECD estimates) and then adds current realized inflation, ½ of the deviation of inflation from the central bank target and ½ of the output gap.1 We also show projections for the Taylor Rule over the next two years, using individual central bank forecasts for inflation and IMF projections for potential growth and the output gap. We then compare those Taylor Rule forecasts with the rate expectations priced into Overnight Index Swap (OIS) curves. Chart 5An "Old-School" Cyclical Upturn Chart 6Rates Too Low, According To The Taylor Rule The first point to note is that policy rates are below the Taylor Rule "equilibrium" level everywhere except Japan, where the 0% interest rate looks appropriate given the lack of actual inflation. Secondly, the Taylor Rule rates are projected to rise in the U.S., Euro Area, Japan and Canada, while remaining around current levels in the U.K. and Australia. Thirdly, the projected rates using Taylor Rule estimates are well above the current path of rates discounted in OIS curves. We do not expect central banks to deliver anywhere near the amount of tightening suggested by these simple Taylor Rules over the next couple of years. Policymakers will likely tolerate some degree of higher realized inflation to ensure that inflation expectations can return to, and sustainably stay at, central bank target levels. This means keeping interest rates below equilibrium levels for as long as possible. However, if central banks believe their own current inflation forecasts (which we have used in our Taylor Rule estimates), then policy rates do have room to move higher without becoming restrictive (i.e. above the Taylor Rule estimates). The markets clearly disagree with these Taylor Rule projections, with much lower OIS rates expected in the next few years. The markets may turn out to be correct. At the moment, however, the gap between the Taylor Rule rate forecasts and market pricing is too large, which suggests there is additional scope for bond yields to rise. Even if central banks ignore their own forecasts of higher inflation and keep rates on hold, this will put upward pressure on bond yields via higher inflation expectations. In other words, the path of least resistance for bond yields is up - at least until there is a major financial market event, like a big pullback in equity prices or widening of corporate bond spreads. Yet until there is evidence that global growth is rolling over and decelerating, a "risk-off" event like that is unlikely. Investors should maintain below-benchmark duration exposure, and overweight allocations of corporate debt to government bonds, in the next 3-6 months. Watch the path of leading economic indicators before looking to reverse those positions. Bottom Line: Central bankers are in the process of taking back the easier monetary policy that followed the deflationary 2014/15 oil shock. Bond yields still have more upside to catch up to the solid pace of global growth and diminishing economic slack. If It Walks Like A Tantrum And Talks Like A Tantrum ... The spike in Euro Area bond yields since June 26th has raised concerns that another bond "tantrum" is unfolding, similar to U.S. Treasury sell-off in 2013 and the German Bund sell-off in 2015. In both cases, bond yields jumped rapidly as investors repriced the outlook for central bank policy. The recent comments from the European Central Bank (ECB) are signaling that a change in its asset purchase program, which is set to end on December 31st, is highly likely and were the trigger for the backup in European yields. We have already shown in previous reports how the benchmark 10-year German Bund yield has been following the same directional path as the 10-year U.S. Treasury yield in the months leading up to the 2013 Taper Tantrum.2 We benchmarked the two markets for the peak in our Months-to-Hike indicator for the timing of the first rate hike priced into OIS curves. In Chart 7, we show the same comparison for the various slopes of yield curves for U.S. Treasuries and German government bonds. Again, the German curve is following the Fed Taper Tantrum experience, which implies more bear-steepening pressure on yields over the rest of 2017. In Chart 8, we show a similar "cycle-on-cycle" comparison of German bonds today compared to the spring of 2015 during the Bund Tantrum episode. That sell-off took place over a much shorter time horizon than the U.S. Taper Tantrum, with the entire sell-off condensed to just over a month. The current backup in German yields looks to be following a similar pattern to the Bund Tantrum, suggesting that this move could take the benchmark 10-year yield back to 1% before it is done. Chart 7Taper Tantrum 2.0?... Chart 8...or Bund Tantrum 2.0? There are major differences between today and the 2015 episode - European economic growth is much faster, the output gap is narrower, and realized inflation is higher than it was two years ago (bottom two panels). The 2015 Tantrum was triggered by two events: a rise in European inflation back above 0% that led to a (misguided) belief among investors that the ECB, which had just started its asset purchase program, would quickly look to exit that program; a massive unwind of long positions in core European bond markets, made worse as speculators who were betting on a reversal of the initial jump in Bund yields got stopped out as yields continued to climb. Roll the tape to 2017, and the growth and inflation backdrop is much different. Now, the ECB is indeed talking openly about exiting/tapering its asset purchase program, supported by a solid European growth backdrop. There is likely less speculative positioning in European markets given the painful experience of the Bund Tantrum. However, with the ECB now owning significant shares of European bonds after two years of steady buying, the potential for a jump in yields driven by less-liquid markets may still be there. Net-net, the current Bund sell-off has additional upside when compared to the previous Tantrums, suggesting the Bund yield could rise to 1% before this move is done. Watch the performance of European equities and the euro for signs that the pain trade in Bunds could stall before 1%. If equities break lower or the Euro breaks higher (or both), the ECB commentary about the timing of a taper could take a more dovish turn. This is not our base case, though. Bottom Line: The recent European bond sell-off is following a similar pattern to both the 2013 Fed Taper Tantrum and the 2015 Bund Tantrum, suggesting a potential target of 1% on the benchmark 10-year German Bund yield by year-end. Stay underweight European government bonds. Move To An Underweight Stance On Canada This week, the Bank of Canada (BoC) meets to determine the next move for Canadian monetary policy. For the first time since 2010, that move will likely be a rate hike. The Canadian economy is booming, and the strength is starting to bump up against capacity constraints. The strong performance of real GDP growth in Q1 (+3%) looks to be followed up by a similar growth rate in Q2. The BoC's latest 2017 Business Outlook Survey made for great summer reading, as expectations for sales, capital spending and employment all remained quite strong (Chart 9). Firms were reporting that an increasing share of capital spending intentions were for the purposes of increasing capacity to accommodate stronger demand, a sign that Canadian businesses are becoming more optimistic that the economic upturn is sustainable. Hiring intentions hit the highest level ever recorded in the Survey, with firms also reporting an increase in employment to meet up with stronger demand. Current Canadian inflation rates remain subdued, but a pickup in output prices is expected over the next 12 months according to the Business Outlook Survey (bottom panel). A net positive number of respondents reported capacity constraints and labor shortages for the first time in the three years that those questions have been asked as part of the Survey. The BoC's growth forecasts are clearly too low and will likely be revised upward at this week's policy meeting, when a new Monetary Policy Report will be presented. This will likely be the reason for a rate hike to either be delivered this week, or strongly hinted at for the next policy meeting. Given the recent comments from BoC Governor Stephen Poloz and other BoC officials discussing the improving health of the economy and the need to "take back" the 50bps of rate cuts in 2015 as oil prices were collapsing, a rate hike is the more likely outcome this week. Already, the markets have moved to price in a more hawkish BoC, with a full 75bps of hikes expected over the next 12 months. This has helped out bearish Canadian rates trades in our Tactical Overlay Portfolio (see Page 15 and Chart 10), which were positions that benefitted from a stronger Canadian economy and more hawkish BoC. With Canadian policy rates still well below equilibrium (see our Taylor Rule estimates shown earlier), and with leading economic indicators still pointing towards accelerating Canadian economic growth in the coming quarters, the case for the BoC to leave rates at these current depressed levels is not a strong one. Chart 9A Robust Canadian##BR##Growth Upturn Chart 10Sticking With Our Winning##BR##Tactical Canadian Trades We see the recent underperformance of Canadian government bonds as the start of a more prolonged trend, thus we are opening up a new strategic position in our model bond portfolio: cutting our Canada country allocation to underweight (2 out of 5). As Canada is only a small part of our benchmark index (only 1%), we are increasing our U.S. exposure as an offset to our lower Canadian weighting. This will not change our below-benchmark allocation to U.S. Treasuries, while making our new position a more explicit bet on additional widening of the Canada-U.S. bond spread. Chart 11Canada Rates Strategy Summary:##BR##Move To Underweight If the economy improves enough to continue absorbing economic slack and put upward pressure on inflation, both realized and expected, then the potential for higher Canadian yields and a flatter Canadian curve - as the BoC becomes even more hawkish - will also increase (Chart 11). One huge caveat to this trade is the state of the Canadian housing market. Even a small move in policy interest rates could have a huge impact on the demand for Canadian housing and the health of Canadian household finances. A recent private-sector survey showed that 70% of Canadian homeowners could not manage even a 10% rise in their interest payments.3 Given the extreme valuations in the Canadian housing market, and some of the recent macro-prudential measures taken to deter speculation in the booming Vancouver and Toronto markets, there is potential for a larger housing downturn after a few BoC rate hikes. This will not prevent the BoC from normalizing rates, but if the housing market responds poorly and there is a spillover into concerns about the state of Canadian banks, then any backup in Canadian bond yields will be short-lived. This is a risk and not our base case over the next year, however. Bottom Line: With the Canadian economy looking very strong, and with the Bank of Canada signaling a desire to begin normalizing monetary policy, the current underperformance of Canadian government bonds will continue. We are maintaining our tactical bearish positions on Canadian bonds, and are also adding a new strategic underweight position (2 out of 5) in our model bond portfolio. Tactical Trade Update We have been recommending a position in our Tactical Overlay Table since March to position for additional Fed rate hikes, shorting the January 2018 fed funds futures contract. That contract is now priced for the fed funds rate to increase 15bps between now and the end of the year. Given that even an optimistic economic scenario would likely only result in one more 25bp increase in the funds rate by year-end, there is no longer much potential for further gains in this trade. We are closing the position this week, taking a tiny profit of +1bp. Chart 12Roll Our Short Fed Funds##BR##Futures Trade To July 2018 Looking further out, we now see an attractive new opportunity to short the July 2018 fed funds futures contract. That contract is currently priced for only 32bps of rate hikes between now and next June (Chart 12), and would therefore turn a profit in the event of two or more rate hikes during that timeframe. We are opening the new trade today, shorting the July 2018 contract. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 We show the inflation gap as the difference between realized inflation and the inflation target, using the actual inflation rate that the central bank is targeting. This could be headline inflation, as in the U.S. and Euro Area, or core inflation, as in Japan. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up", dated July 4 2017, available at gfis.bcaresearch.com. 3 http://www.newswire.ca/news-releases/the-debt-truth-unexpected-expenses-could-spell-big-trouble-for-millennial-homeowners-623825354.html Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

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

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

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

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

Highlights Central Banks: The sharp sell-off in global bond markets last week was triggered by more upbeat comments on growth and inflation by several major central bankers, most notably ECB President Mario Draghi. ECB Tapering: Draghi's positive views on the European economy are generally accurate, which puts the ECB on a path to taper its asset purchases next year. Bunds vs. JGBs: Bund yields have more upside in the next 3-6 months as the market reprices a smaller amount of ECB bond buying. Downgrade core European government bonds to underweight (2 out of 5) and upgrade low-beta Japan to maximum overweight (5 out of 5). Feature "The threat of deflation is gone and reflationary forces are at play." - Mario Draghi Chart of the WeekA Co-Ordinated Tightening On The Horizon? Bond market volatility awoke with a vengeance last week, as investors digested a string of hawkish comments from previously dovish central banks. A surprisingly optimistic speech from European Central Bank (ECB) President Mario Draghi set the tone, triggering the biggest single day rise in German bond yields in over two years. This was followed up by comments from Bank of England (BoE) Governor Mark Carney and Bank of Canada Governor Stephen Poloz suggesting that higher rates may be needed soon in the U.K. and Canada, triggering sell-offs in Gilts and Canadian bonds. Even U.S. Treasury yields rose alongside the global move, without any positive U.S. data or more hawkish Fed commentary. This move to a more hawkish tone - or, at least, a less dovish message - is consistent with the current strength of the global economy, as well as the robust performance of risk assets so far in 2017. Policymakers are now being forced to adjust their biases to reflect the more positive backdrop, forcing a repricing of interest rate expectations with most developed economies hovering around full employment (Chart of the Week). A "coordinated" move to tweak policy rates higher suggests bond yields have more room to rise - especially after the decline since March that has driven most government bond yields to expensive levels. The bigger risk for global bonds, however, will come from a likely shift in ECB policy towards a reduction in the size of their current bond purchase program. As we saw last week, even a mere mention of a need to shift to a less accommodative monetary stance was enough to cause Bund yields to nearly double in a matter of days. We have been positioned for a renewed rise in bond yields through our recommended below-benchmark portfolio duration stance. We are also positioned for a bear-steepening of government bond yield curves in our model bond portfolio, as our recommended duration exposures are concentrated in shorter-maturity bonds. With central banks only looking to catch up to the underlying state of the global economy, rather than aiming to more aggressively tighten policy to cool off growth, there is more potential for longer-dated bond yields to rise relative to shorter-maturity debt - especially with market-based inflation expectations now looking too low in most countries. In other words, expect more bear-steepening of global yield curves (ex-Japan) in the next few months. Dissecting Draghi's Speech The jump in global yields last week was broad based, both across countries and when broken down into valuation components. The "high-yielders" among developed markets (U.S., Canada, U.K.), saw modest increases in inflation expectations and term premia, while rate hike expectations jumped sharply in Canada and the U.K. (Chart 2). Among the "low-yielders" (Germany, Japan), the 22bps jump in Bund yields came through higher term premia, with only very modest moves higher in rate hike or inflation expectations (Chart 3). Japanese yields didn't move at all, consistent with the view that the Bank of Japan is the one central bank that does not need to become less accommodative with Japanese core inflation back down to 0%. Chart 2Global Yields Starting To Perk Up A Bit... Chart 3...Led By Europe Mario Draghi's speech, which set off last week's yield spike, was such a shock to markets because of the upbeat description of the underlying strength of the Euro Area economy. It is important to consider where this speech was given - in front of global policymakers at the annual ECB Forum on Central Banking in Portugal (the ECB equivalent to the Fed's annual Jackson Hole conference). The head of the central bank that has been providing the highest degree of monetary stimulus among the major economies over the past couple of years told his global peers that the need for such an extreme accommodative policy stance was now diminished. This is a message shared by the BCA Central Bank Monitors, which are pointing to a need for tighter monetary policy everywhere except Japan (Chart 4). Chart 4Tighter Monetary Policy Is Required Is such a high-conviction view from the ECB justified? Let's do a little "truth check" on some of Draghi's most relevant comments from his speech: "All the signs now point to a strengthening and broadening recovery in the Euro Area." TRUE. Most reliable cyclical indicators - PMIs, consumer confidence, business confidence - are all at, or beyond, pre-2008 crisis levels (Chart 5). The German IFO index hit a record high in June, while data has been strengthening across all the major Euro Area economies (even Italy). "We can be more assured about the return of inflation to our objective than we were a few years ago. [However,] inflation dynamics are not yet durable and self-sustaining. So our monetary policy needs to be persistent." TRUE. The Euro Area unemployment rate at 9.5% now sits within hailing distance of the OECD's estimate of the full employment "NAIRU" rate of 9%. Already, core inflation and wage growth are stabilizing in the Euro Area (Chart 6), suggesting that the estimated full employment rate may be an accurate measure. The ECB is forecasting that the unemployment rate will fall to 8.4% by 2019, which would be below the OECD NAIRU level, and the ECB is now forecasting that Euro Area core inflation will rise to 1.8% within two years. That would likely be close enough to the ECB's official inflation target (headline inflation at or just below 2%) for a potential rate hike by then, but not before. Chart 5European Growth Looks Very Healthy Chart 6Full Employment Is In Sight "The past period of low inflation is [...] on the whole temporary and should not cause inflation to deviate from its trend over the medium term." MOST LIKELY TRUE. The steep fall in European inflation in 2014 triggered deflation fears, and prompted the ECB to finally engage in an asset purchase program just as the Fed was ending its' own "QE". Much of that decline was related to the sharp downturn in global energy prices. Draghi also noted in his speech that, by the ECB's own estimates, around two thirds of the undershoot of Euro Area inflation in 2015/16 came from the impact of lower energy prices. He also mentioned that past fall in oil prices and other "global shocks" are likely to still be restraining core inflation to some degree via pass-through effects in parts of the economy that are more energy-intensive. Draghi did also point out that the current low oil prices are mainly supply driven (a view that BCA's commodity strategists whole-heartedly agree with) and, therefore, can be "looked through" by a central bank. That may be dangerous view to take with wage inflation still subdued in Europe, but it seems clear that core inflation has indeed bottomed out and is in the process of a slow grind higher (Chart 7). This is also helping to stabilize inflation expectations in Europe to some degree, although it is far too early for the ECB to declare victory over "low-flation." "Political winds are becoming tailwinds. There is newfound confidence in the reform process, and newfound support for European cohesion, which could help unleash pent-up demand and investment." TRUE. The 2017 political calendar appeared daunting at the start of the year, with elections scheduled in the Netherlands, France and Germany anti-euro candidates scoring better-than-expected in the polling data. The ECB even cited political uncertainty as one of the reasons for extending its asset purchase program to the end of 2017, in case there was a surprise win by a "Euro-skeptic" party. The electoral losses by Geert Wilders in the Netherlands and Marine Le Pen in France were strong signals that the anti-establishment wave that had washed over the U.K. and U.S. last year would not spill over into Europe. There is a new potential risk in Italy, where fresh parliamentary elections are expected to be called sometime in the first half of 2018. The polling numbers are tight there, with pro- and anti-euro parties showing roughly equal levels of support. Yet with the Italian economy showing some improvement alongside the rest of Europe, and with Italian banks under less immediate pressure after some successful recent rescue packages for struggling lenders (Chart 8), there is less risk of an anti-euro uprising in the polls in Italy next year. Chart 7From Deflation Fears To Reflation Cheers Chart 8Italy Is No Constraint To An ECB Taper At a minimum, the ECB likely would not factor politics into any decision on tapering its asset purchases starting in 2018. Chart 9Taper Tantrum 2.0? "As the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments - not to tighten the policy stance, but to keep it broadly unchanged." TRUE. The Fed was making similar arguments when they moved away from QE bond purchases and, eventually, the timing of the first rate hike. Using words like how the U.S. economy had "healed" from the financial crisis by enough to start removing some policy accommodation. In some respects, the European economy is in much better shape than when the Fed began its own taper in 2014. In Chart 9, we present an idea that we published earlier this year, showing the comparison of Europe now versus the U.S. pre-Fed taper. This is a "cycle-on-cycle" analysis, where the European and U.S. data are lined up to the peak of our months-to-hike indicator, noting the timing of the first rate hike priced into OIS curves after the period of 0% policy rates. The chart shows that the current Euro Area economy is about two percentage points closer to full employment than the U.S. was just before the infamous 2013 Taper Tantrum. The Fed began signaling that major policy shift with core inflation below its 2% target, at similar levels to the current European core inflation rate. A look at the subsequent moves in bond yields and term premia (bottom two panels) suggests that Europe could be on the verge of its own Taper Tantrum in the next few months. Summing it all up, we conclude that the optimism on the European growth and inflation outlook expressed by Draghi is justified. Barring a sudden collapse in the economy or inflation over the summer, the ECB looks to be on course to announce a tapering of its bond purchases, starting in 2018, at the upcoming September policy meeting. Bottom Line: The sharp sell-off in global bond markets last week was triggered by more upbeat comments on growth and inflation by several major central bankers, most notably ECB President Mario Draghi. We see Draghi's positive views on the European economy to be generally accurate, which puts the ECB on a path to taper its asset purchases next year. Downgrade Core European Government Bonds To Underweight Our expectation heading into 2017 was that core European bonds would outperform U.S. Treasuries in the first half of the year as the Fed delivered more rate hikes and the ECB maintained a highly dovish tone at least through the April/May French presidential elections.1 After that, assuming the French election went according to our expectations with a Le Pen loss, the ECB would then turn its attention to potential "taper talk" that would trigger an underperformance of core Europe versus Treasuries. The U.S. Treasury rally since March defied our forecast, even though the Fed did actually hike rates twice! While we still see more Fed tightening and higher U.S. yields as the base case in the latter half of the year, the European story is playing out as we expected. We are sticking to our plan after last week's developments, and we are downgrading core European bonds (Germany, France, Italy) to a recommended underweight ranking (2 out of 5). Importantly, we've likely seen the low in European yields even if there is no tapering in 2018. In Chart 10, we update an analysis we did earlier this year, looking at the projected size of the ECB's monetary base under various asset purchase scenarios for next year: The ECB stops "cold turkey" on December 31 and buys no additional bonds in 2018; The ECB tapers its €60bn/month of bond buying to zero by June 2018; The ECB tapers its €60bn/month of bond buying to zero by December 2018; The ECB announces no taper and keeps on buying at €60bn/month throughout 2018. In the bottom two panels of Chart 10, we show the growth rate of the ECB's monetary base versus the German Bund yield and the term premium. The projections for the growth rates are based off the four scenarios laid out above. In all cases, the growth in the expansion of the ECB monetary base (and its balance sheet) will slow next year - even if there is no tapering. Importantly, the euro is unlikely to spike versus the U.S. dollar in the event of a tapering, as relative money supplies and policy interest rates will remain USD-bullish (Chart 11). Chart 10The ECB Effect On Bunds Will Soon Fade Chart 11A Taper-Fueled Rise In The Euro Has Its Limits This is the dirty little secret about central bank asset purchase programs. They must be delivered in even bigger sizes than before to have the same impact on asset prices and, eventually, economic growth and inflation. Chart 12UST-Bund Spread Looks Too Low We now feel comfortable shifting to a reduced recommended country allocation to core Europe in our model bond portfolio. We have been maintaining a below-benchmark duration stance in core Europe for the past couple of months, by placing less recommended exposure in the longer maturity "buckets" in our portfolio and overweighting the shorter-maturity buckets. Now, we are comfortable cutting the allocation to core Europe across all buckets based on our views on the ECB. What should be upgraded if we are downgrading Europe? As mentioned, we had expected to upgrade U.S. Treasuries at this point in the year, but the disappointing run of U.S. data (especially versus Europe) drove the Treasury-Bund spread sharply lower (Chart 12). Given our view that the U.S. economy and inflation will rebound in the latter half of this year and prompt the Fed to deliver more hikes, we see the Treasury-Bund spread as too low to recommend shifting out of core Europe into the U.S. Instead, we see a better case to upgrade the most defensive country in the developed bond universe - Japan. There is a clear divergence between recent growth and inflation data in the Euro Area versus Japan, most notably with core inflation returning to 0% in Japan (Chart 13). The JGB-Bund spread looks to be at critical support levels that could trigger a quick tightening, especially if there are more upside data surprises in Europe or disappointments in Japan (Chart 14). Chart 13Europe & Japan Are Diverging Chart 14Reduce Core European Exposure In Favor Of JGBs Bottom Line: Bund yields have more upside in the next 3-6 months as the market reprices a smaller amount of ECB bond buying. Downgrade core European government bonds to underweight (2 out of 5) and upgrade low-beta Japan to maximum overweight (5 out of 5). Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "How To Think About Global Bond Investing In 2017", dated December 20 2016, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights The Q2 earnings season will be above average and the BCA Earnings model predicts EPS growth to hit 18% later this year before moderating in 2018. Are the NIPA and S&P profit measures sending different signals? Business capital spending remains in an uptrend despite businesses' reluctance to spend ahead of changes in corporate tax policy. The commercial real estate sector (CRE) is beginning to show early signs of stress. Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits, even for Republicans in an environment of populism. Feature Q2 Earnings Season Is Here Chart 1Strong Earnings Growth##BR##In 2017 Will Support Equities The Q2 earnings season will be above average and the BCA Earnings model predicts EPS growth to hit roughly 18% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 1). The consensus is anticipating an 8% year-over-year increase in EPS in Q2 2017 versus Q2 2016, and 11% for 2017. Energy, technology, and financials, all are forecast to lead the way in earnings growth in Q2, but utilities and telecom will be the laggards. The favorable profit picture for Q2 and the rest of the year reflects the rebound in oil prices, which are expected to boost energy sector EPS by 671%. The positive picture also mirrors the sweet spot of rising top-line growth and still muted labor costs, which are driving a countercyclical rally in profit margins. The focus in Q2 for investors and corporate executives will be on the improving economic conditions in Europe and EM, the U.S. dollar and the sustainability of margins. Guidance from CEOs and CFOs on trends in 2H 2017 and beyond are more important than the actual Q2 results. Note that guidance can be tracked using Chart 2. Investors should guard against managements' over-optimism because earnings growth forecasts almost always move lower over time. Chart 22017 EPS Estimates Rebounding And 2018 Stable In Q2, firms with high overseas sales should benefit from the improved growth profile in Europe and Japan. Global GDP growth projections for this year and next have steadily escalated, in sharp contrast with prior years when forecasters have relentlessly lowered GDP estimates. On the other hand, the U.S. dollar should be a modest drag on earnings in Q2; the dollar is up 2% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (May 31) mentions of a "strong dollar" were unchanged compared with a year ago, indicating that the stronger currency has faded as a primary concern of managements in recent months. Our view is that the dollar will appreciate by another 10%. This appreciation would trim EPS growth by roughly 2.5 percentage points, although most of this would occur in 2018 due to lagged effects. Another upleg in the dollar, on its own, should not provide a substantial headwind for the stock market. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. Investors are skeptical that margins can advance for the fourth consecutive quarter in Q2. Our view is that we are in a temporary sweet spot for margins and that should continue for the next quarter or two, but the secular "mean reversion" of margins will resume beyond that time. Bottom Line: Look for another solid performance for earnings and margins in Q2 and the rest of 2017, supporting our stocks-over-bonds stance for this year. However, investors should position their portfolios for decelerating earnings and compressed profit margins in 2018. Will The Real Profit Margin Stand Up While the markets focus on Q2 earnings, margins and corporate guidance for the next month or so, we take a broader view. For some time we have highlighted the importance of the mini-cycle in U.S. earnings growth; the corporate sector is in a catch-up phase following last year's profit recession, a trend that extends beyond the energy patch. EPS growth has surged this year on the back of slightly stronger sales and rising S&P 500 margins. The National Accounts (NIPA) data, on the other hand, paint a different picture. Earnings growth for the entire corporate sector fell sharply in the first quarter and margins continued to slide. If the NIPA data are telling the true story, then the equity market is in trouble because it suggests that the earnings outlook is much weaker than what is discounted in stock prices. There are many definitional differences that make it difficult to reconcile the NIPA and S&P data.1 Nonetheless, we can make some general observations. Chart 3 presents the four-quarter growth rate of NIPA profits2 and a proxy for aggregate S&P earnings. For the latter, we multiplied earnings-per-share by the divisor to obtain an estimate of the level of aggregate earnings in dollar terms (i.e. not on a per-share basis). The bottom panel of Chart 3 compares the level of profits, each indexed to be 100 in 2011 Q1. The charts highlight that while there have been marked differences in annual growth rates between the two measures, the levels were close to the same point in the first quarter of 2017. The dip in NIPA profit growth in Q1 was not reflected in the S&P measure. It appears that this is partly due to different profiles for profit growth in the energy and financials sectors. However, it does not appear that the difference in margins is linked to a significant divergence in aggregate profits. Most of the margin divergence is related to the denominator of the calculation (Chart 4). The NIPA denominator is corporate sector Gross Domestic Product (GDP). This is a value-added concept that is different from sales. It is not clear why, but GDP has grown much faster than sales since the end of 2014. We believe that the S&P data are painting a more accurate picture because sales are straight forward to measure, while value-added is complicated to construct. The slow growth of sales is not a bullish point for stocks. Nonetheless, it does not appear that financial engineering has distorted bottom-up company data to such an extent that the S&P data are falsely signaling strong profit growth. We expect the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the profit backdrop remains positive for stocks for now. The same is true in the Eurozone and Japan, where margins are also rising. It is worrying that a much of this year's advance in U.S. equity markets has been concentrated in only a few stocks, but that belies the breadth of the profit recovery (Chart 5). The proportion of S&P industry groups with rising earnings estimates is 75%, reflecting broad-based upgrades. Chart 3S&P And NIPA##BR##Profit Comparison Chart 4Denominator Explains##BR##S&P/NIPA Margin Divergence Chart 5Positive Earnings Revisions##BR##Are Broadly Based Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates. Bottom Line: The solid earnings backdrop is why we remain overweight stocks versus bonds and cash. Stay extra vigilant for warning signs of a bear market in view of the poor valuations. Valuation has never been good leading indicator for bear markets, but it may provide information on the risks. Capital Spending Check Up Business capital spending remains in an uptrend. Investors are concerned that the below expectations readings on capex in recent months may be the start of a new trend for a significant part of the economy. We look at it another way. Managements are postponing investment decisions until they get more clarity on federal tax policy. In short, corporations are struggling with how much and when spend, rather than whether to invest at all. The key supports for sustained corporate spending remain despite the tepid May durable goods report. C&I loan growth has ticked back up and our model (based on non-residential fixed investment, small business optimism and the speculative-grade default rate) suggests lending is poised to move higher on a 12-month basis (Chart 6). Our research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. While consumer expenditures were soft (+1.1% annualized gain) in Q1, household spending in Q2 accelerated and is on track to post 3%+ growth. We expect household spending to continue to improve in the second half of 2017.3 Moreover, the recent readings on core durable goods orders and shipments show that the uptrend that began in mid-2016 persists, despite the recent monthly wiggles in the data (Chart 7). Chart 6Model Points To##BR##Further Improvement Chart 7Capital Spending##BR##Remains In An Uptrend CEO confidence recently soared to a 13-year high in Q1, adding to the positive backdrop for capex. The last reading on this survey was taken in the first quarter of 2017 when managements eagerly anticipated that business-friendly legislation was pending. The next survey (due in mid-July) may show a bit more restraint from CEOs given the lack of legislative progress in Washington (Chart 7, top panel). Bottom Line: The fundamentals supporting solid business spending remain in place. However, our positive capex outlook in the U.S. could be blemished if the Republicans fail to deliver on their promises to cut taxes and boost infrastructure spending. Stressing The Commercial Real Estate Market The commercial real estate sector (CRE) is beginning to show early signs of stress. The recent softening in CRE does not suggest that recession is imminent, but investors should understand whether a sustained drop in CRE prices poses a risk to the global financial system. At best, business spending on construction is coincident with the overall economy, but most often lags due to long lead times required on projects (Chart 8). Chart 8Commercial Real Estate Lags Our colleagues in the Global Investment Strategy service4 highlighted the risks to the CRE market, noting that CRE-related debt is rising, prices have surpassed pre-recessionary levels, vacancy rates outside of the industrial sector are bottoming, and rent growth is losing steam (Chart 9). Likewise, we share Boston Fed President Rosengren's5 concern that if CRE's recent tailwinds (muted inflation, low financing rates, declining unemployment rate, robust economic growth in the U.S. relative to overseas developed economies, and favorable demographics) turn to headwinds, then the impact on the market and the wider economy may have a disproportionate impact on CRE. The BCA Beige Book Real Estate Monitor corroborates a softening in recent quarters. The monitor takes the real estate (both commercial and residential) comments from each Beige Book and uses the approach outlined in our April 17 publication6 (Chart 10). Chart 9Commercial Real Estate##BR##Indicators Softening Chart 10Introducing The##BR##Beige Book CRE Monitor Stretched CRE valuations may exacerbate any price declines in CRE if the markets sense that the tide is turning. Falling prices may lead to a drop in the value of collateral-backing CRE loans, which in turn, could cause lenders to restrict credit in the sector and spark an additional downturn in prices. Moreover, Table 1 highlights the risk that GSE reform may cause two large holders of CRE debt to begin to curtail lending. Small banks have more absolute exposure to CRE loans than large banks, according to the table, and overall, banks' share of CRE lending (53%) is nearly four times as high as GSE's exposure. Table 1Holders Of Commercial Real Estate Loans CRE's risks are evident in the latest round of bank CCAR stress tests. The Fed modeled a 15% drop in CRE prices through Q4 2018 in its "adverse" scenario and a 35% drop in the same period in its "severely adverse" scenario. The Fed7 found that under these scenarios, common equity Tier 1 capital ratio at the participating firms would drop from 12.5% (Q4 2016) to 9.2% and 7.2% respectively by Q1 2019. Bottom Line: Commercial real estate has benefitted from a Fed-led tailwind since the end of the 2007-2009 recession. That said, some of the tailwinds are turning to headwinds and investors should be prepared for a reversal in this sector sometime in the second half of 2018 as economic and earnings growth slows, which could set the stage for a recession in 2019. That said, it is a positive sign for the economy that the commercial real estate sector is one of the few areas showing any signs of stress, implying that the conditions for a recession in the next 6 to 12 months remain low. Is Dodd-Frank Dead? The Republicans' Financial CHOICE Act, which would roll back key aspects of the landmark Dodd-Frank Wall Street reform, has hurdles to overcome before its passage through the U.S. Senate. Two of BCA's publications have examined the impact on consumers, investors and financial markets. BCA's Geopolitical Strategy8 service noted that Republicans want to overturn Dodd-Frank to increase the financial sector's profits, credit growth, economic growth and animal spirits. A repeal would also satisfy the Republicans' ideological goal to reduce state involvement, which grew due to the law. Also, the CBO estimates that the proposed rewrite would cut the budget deficit by a net $22.3 billion over 10 years, in line with the GOP's political bent. The CHOICE Act would create an "escape hatch" to allow banks to maintain a capital-to-asset ratio of over 10% to bypass Dodd-Frank regulations. Financial companies that do not meet the 10% leverage ratio could either raise funds or remain subject to Dodd-Frank oversight, including required capital ratios, stress tests, living wills and other regulations. Critically, the 10% leverage ratio for those banks that opt out of Dodd-Frank would not be calculated using risk-weightings for different assets (whereas Dodd-Frank requires both risk-weighted and non-risk-weighted capital ratios to be maintained). Therefore, banks that opt out would be able to take on greater risk while still fulfilling minimum capital requirements. The intent is to boost lending, earnings and growth. According to the Geopolitical Strategy, if the bill becomes law, U.S. banks comprising an estimated $1.5 trillion in assets would become less restricted and eligible to adopt riskier trading practices. The greatest impact will be in areas with a higher concentration of small community banks and credit unions. These banks, with under $10 billion in assets, face the most difficulty in meeting Dodd-Frank's requirements and yet tend to meet the 10% leverage ratio (Chart 11). Chart 11Banks With $1.5 Trillion Could Gain Risk Appetite Other aspects of the bill would: Repeal the FDIC's liquidation fund: The private sector would take over responsibility for managing liquidations. Eliminate the Volcker Rule: Banks would be able to trade riskier assets on their own accounts and forge closer relationships with private equity and hedge funds. Audit the Fed: The Government Accountability Office (GAO) would audit the Fed's board of governors and regional banks, including their handling of monetary policy. Reshape the Consumer Financial Protection Board: The agency would have its powers neutered and funding dependent on the Congress, rather than transfers from the Fed. Cut penalties for violating regulations. Chart 12Small Banks Benefit##BR##From Bank Deregulation Investors could capitalize on financial sector reform by favoring small U.S. bank equities over large bank stocks. The share price of small banks relative to large banks, which rallied in the aftermath of Trump's election only to subsequently fall back, has recently perked up (Chart 12). Relative earnings have been flat in the same period. If Dodd-Frank is partially watered down, then these banks should see earnings improve, and drive up their share prices. BCA's U.S. Equity Strategy is positive on global bank equities. In particular, U.S. banks have better fundamentals than their counterparts in Europe and Japan - more capital, higher net interest margins, lower or equal NPL ratios. They also stand to benefit from relatively faster rising interest rates. BCA's Fiscal Note Financial Sector Index suggests that the flow of legislative and regulatory proposals is becoming less onerous on the financial sector. Chart 13 is an aggregation of the favorability scores, which assess whether the bill would be favorable to the financial sector. It provides a snapshot of the regulatory environment for the financial sector at any point. Chart 13Financial Sector Scrutiny Softening Bottom Line: Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits, even for Republicans in an environment of populism. However, a bill focused on lightening the regulatory load on small banks has a chance of passing if tacked on to the budget process. Large banks would remain subject to closer scrutiny and stricter international standards. The post-election rally for bank stocks is mostly over. Investors have an opportunity to favor small banks versus large ones. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 The first problem is that the S&P data are expressed on a per-share basis. Moreover, the NIPA data adjusts for inventory and depreciation allowance. S&P margins are calculated using sales in the denominator, while we generally use GDP as the denominator for calculating NIPA profits. 2 The NIPA data shown include financials and profits earned overseas, as is the case for the S&P. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Still In The Sweet Spot", June 19, 2017, available at usis.bcaresearch.com. 4 Please see BCA's Global Investment Strategy Weekly Report "The Timing Of The Next Recession," published June 16, 2017, available at gis.bcaresearch.com. 5 "Trends In Commercial Real Estate", Eric S. Rosengren, at Risk Management for Commercial Real Estate Financial Markets Conference, NYU Stern School of Business, May 9, 2017. 6 Please see BCA's U.S. Investment Strategy Weekly Report, "The Great Debate Continues", published April 17, 2017, available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/publications/files/2017-ccar-assessment-framework-results-20170628.pdf 8 Please see BCA's Geopolitical Strategy Weekly Report "How Long Can The "Trump Put" Last?," published June 14, 2017, available at gps.bcaresearch.com.

Feature Chart 1Global Growth Pick Up As a whole, G10 economies have been in expansion for more than seven years now. Moreover, after a near-recessionary episode in late 2015 / early 2016, the global economy is on a renewed upswing, with global trade and capex having regained vigor (Chart 1). Similar upswings in aged economic expansions have historically been the ideal breeding ground for global monetary tightening. However, the world economy is still dealing with two deflationary anchors: two decades of over-investment in emerging markets that have led to chronic overcapacity globally, and a strong preference for savings - a legacy of the great financial crisis (GFC) in the West and of financial repression in China. Thanks to this confluence of forces, global central banks have been fearful of tightening policy, hence, global policy rates continue to hover near multi-generational lows. Yet, now that the Federal Reserve has opened Pandora's box and raised rates four times, the question on every investor's mind is who is next. In this piece, we examine a few key domestic indicators for each G10 central bank (CB), and try to categorize CBs according to their likelihood of being the next one to tighten policy. We find three groups. The first one with the highest likelihood of hiking includes New Zealand, Sweden, and Canada. We place Australia, the U.K., and the Euro Area in the somewhat-likely-to-tighten camp. Finally, among the economies where we see little scope for tighter policy are Norway, Switzerland, and Japan. Using this ranking, we examine the implications for these countries' respective currencies and equity markets' relative performance. In this optic, it is important to remember that while conventional wisdom dictates that the stock market needs a depreciating currency in order to advance, empirically, countries with appreciating exchange rates have tended to outperform the global equity benchmark, reflecting the effect of international flows into these economies and markets.1 Finally, we look forward to publish in the coming months a quantitative model based on the indicators used in this report. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com Most Likely To Increase Rates First: 1) New Zealand Chart 2New Zealand The real Official Cash Rate has never been at such a discount to trend real GDP growth (Chart 2). As a result, nominal GDP is growing at a strong 6% a year, and core inflation is moving back toward 2%. Additionally, nominal retail sales are expanding at nearly 8% per year, the highest pace since 2007. According to the OECD, GDP is now nearly 2% above trend, which highlights the inflationary nature of New Zealand's economy. Supporting that, capacity constraints are becoming rampant, despite strong immigration into the country, unemployment is now nearly 1% below equilibrium, further confirming that the Reserve Bank of New Zealand is keeping policy at too-stimulative levels. This time around, hiking rates will not be a policy mistake as it was in both 2010 and 2014. In 2010, the difference between real rates and trend real GDP growth was much narrower than today, and the output gap was still very negative. In 2014, measures of slack were also not supportive of higher rates, and a rollover in core inflation as well as muted retail sales growth created additional headwinds. Most Likely To Increase Rates First: 2) Sweden Chart 3Sweden The Riksbank's repo rate has been driven lower in response to the European Central Bank's own bias, resulting in a Swedish repo rate of -0.5%. The gap between the real policy rate in Sweden and trend GDP growth is hovering around record-low levels (Chart 3). Supported by such a stimulative policy setting, Swedish non-financial private credit has expanded massively, hitting 230% of GDP. Today, the output gap is in positive territory and the unemployment gap indicates that the labor market has tightened considerably. In fact, both measures are congruent with the levels recorded during prior rate-tightening cycles. Core inflation is still below the central bank's 2% target, but is accelerating higher. The Riksbank's resource utilization indicator is further confirming this trend and points toward much higher inflation in the second half of 2017.2 Retail sales have been soggy, but they are picking up anew, clearing the way for a rate hike. Crucially, under the tutelage of Stefan Ingves, the Riksbank has been extremely dovish, but his second term as head of the institution ends this year. For now, he does not look set to be re-appointed. His re-appointment constitutes the greatest risk to our Riksbank view. Most Likely To Increase Rates First: 3) Canada Chart 4Canada The gap between the real policy rate and trend real GDP growth is still very negative, much more so in fact than was the case in 2010, the last time the Bank of Canada (BoC) tried to hike interest rates. The output gap and the unemployment gap continue to point toward a small degree of slack in the Canadian economy (Chart 4). Nonetheless, the BoC expects the output gap to close in 2018. However, the amount of slack in the economy remains very low compared to what prevailed in 2010. Like in the U.S., core inflation has recently sagged, but retail sales continue to grow at a healthy pace. Canadian policy rates have rarely diverged from those in the U.S. for long as the Canadian economy is deeply integrated in the U.S. supply chain. This means that economic impulses in the U.S. are often transferred to Canada. The Fed increasing rates in the U.S. puts pressure on the BoC. If rates diverge for too long, the Loonie will weaken considerably, exacerbating inflationary pressures in Canada. Recent communications of the BoC's most senior staff indicate a very sharp move away from dovishness. Middle Of The Pack: 1) Australia Chart 5Australia The gap between real policy rates and trend real GDP growth is in stimulative territory, but it is not at the level seen in New Zealand, Sweden or Canada. While the unemployment gap suggests the labor market is becoming increasingly tight, the OECD's measure of the output gap still stands near record lows, suggesting that in aggregate there remains substantial slack in Australia (Chart 5). This paints a mixed picture rather than an indubitably good or bad one. Core inflation remains in a downtrend and nominal retail sales are growing at very low rates, further highlighting that monetary policy is not as accommodative as in New Zealand or Canada. Improvement in global trade continues to support the Australian economy, and strong real estate activity suggests that policy is too easy for domestic asset prices. These two forces are critical in preventing Australia from falling into the bottom basket of central banks. Even if a small deceleration in global activity emerges, so long as it does not degenerate into the kind of vicious commodity selloff experienced in the second half of 2015 and early 2016, the Australian economy will be able to avoid another deceleration. Middle Of The Pack: 2) The U.K. Chart 6U.K. On many fronts, the U.K. looks ripe for an imminent rate hike. The gap between the real policy rate and trend real GDP growth is as depressed as the levels recorded in the countries in the first bucket, suggesting that the Bank of England's policy stance is extremely accommodative (Chart 6). However, like in Australia, measures of economic slack paint a mixed picture. The unemployment gap points to an absence of slack, while the output gap remains negative and indicative of some slack in the U.K. Retail sales have been lifted by the recent surge in inflation, with core consumer prices now growing at a 2.6% annual rate. However, this picture is distorted. Real retail sales have massively decelerated, and the surge in inflation has had nothing to do with domestic conditions but has been entirely due to the pass-through associated with the near-20% collapse in the trade-weighted pound since November 2015. Beyond the negative output gap, the key reason why the BoE is not at the top of the list of potential hikers is because U.K. household inflation expectations remain well behaved, and the economy could continue to decelerate in the face of uncertainty associated with Brexit. This could even prompt Mark Carney to keep an even more dovish stance that we or the market currently anticipate. Middle Of The Pack: 3) The Euro Area Chart 7Euro Area The gap between the real policy rate and trend real GDP growth in the euro area is actually also at extremely stimulative levels (Chart 7), partly explaining why the European economy has been able to generate so many positive data surprises. However, the euro area economy still needs easy policy. The output gap remains very negative and unemployment is still below equilibrium. In fact, as we have argued, this latter indicator may even underestimate the amount of labor market slack in Europe, as measures of labor underutilization remain very elevated. Euro area core inflation has been moving up, but at around 1% remains well shy of the ECB's objective of close to but below 2%. True, officially the ECB targets headline inflation, but Draghi's emphasis on underlying domestic inflation trends belies a focus on core inflation. Ultimately, the combination of labor underutilization, simmering political risk in Italy and a still-negative output gap suggests the ECB in unlikely to lift interest rates until at least late 2018. The biggest risk to our view would be for the ECB to tighten policy more than we or even the market anticipate. This would put the ECB ahead of the BoE. The Laggards: 1) Norway Chart 8Norway The gap between Norway's real policy rate and trend real GDP growth is still indicative of an easy policy stance. However, the recent dip in core inflation has caused an inadvertent policy tightening, as illustrated by the gap's sharp narrowing (Chart 8). The OECD's measure of Norway's output gap is very negative, and the unemployment rate has not been this deeply above equilibrium in more than 20 years. As such, there seems to remain large amounts of slack in the Norwegian economy. Corroborating this assessment, Norwegian wages are contracting at a 4% annual pace. Norwegian retail sales have been very weak, and core inflation has collapsed from 4% to 1.5%. This easing in inflation is a blessing for the Norges Bank as this allows it to focus on the large amount of slack still present in the economy. The Laggards: 2) Switzerland Chart 9Switzerland Despite a deeply negative nominal policy rate and a continuously expanding central bank balance sheet, Switzerland monetary policy does not seem to be very easy, as the gap between the real policy rate and the trend real GDP growth rate is in neutral territory (Chart 9). The OECD's output gap and the difference between the headline unemployment rate and equilibrium unemployment rate both point toward plentiful slack in the Swiss economy. Swiss wage growth also remains quite tame, only hitting 0.1% last quarter. Core inflation remains well below target as it only modestly moved back into positive territory three months ago. The confluence of not-so-easy monetary policy and plentiful excess capacity suggests that despite the challenging conditions for Swiss pension plans and insurance companies created by deeply negative rates the Swiss economy is not yet ready to handle tighter monetary policy. The Laggards: 3) Japan Chart 10Japan Japan might be the most perplexing economy in the G10 right now, and the Bank of Japan is in the toughest position of all the major central banks in the advanced economies. Like Switzerland, despite negative nominal short-term interest rates and large asset purchases by the BoJ, the gap between Japan's real policy rates and trend real GDP growth suggests that policy is only at a neutral setting (Chart 10). This would seem appropriate given that both the output gap and the unemployment gap point to little spare capacity in Japan. However, this does not square with core inflation moving back into negative territory and barely expanding retail sales. Ultimately, Japan's problem is two-fold. First, the unemployment gap underestimates the amount of labor underutilization in Japan, as output per hour worked remains 11% and 34% behind that of the OECD and the U.S, respectively. Second, extremely depressed Japanese inflation expectations continue to result in an extraordinarily flat Philips curve. Due to these dynamics, we expect that it will take continued sustained efforts by the BoJ to overheat the economy before any signs of inflation emerge. FX Implications Based on our assessments, we would expect the RBNZ, the Riksbank and the BoC to be the first central banks to hike now that the Fed has blazed the trail. Within this group, the RBNZ is potentially the cleanest story, as all factors are aligned. We would expect the RBNZ to hike late summer / early fall 2017. Technically, the Riksbank seems in a better place to hike rates than the BoC. However, the leadership of the BoC is already preparing the market for higher rates. Canadian rates could also rise as soon as late summer / early fall 2017. Meanwhile, so long as Ingves remains head of the Riksbank, the Swedish central bank will likely stand pat. Thus, we would expect the first hike to materialize early next year, as soon as a new governor takes the helm, although, we believe markets will begin pricing in such a hike as soon as his replacement is announced. In the second group of central banks, we expect the RBA to be the first to increase rates. The BoE does face a much more inflationary environment than the RBA, but the U.K.'s economic uncertainty remains such that the BoE is likely to tread carefully and wait to see how the economy handles the new wave of political trauma unleashed by this month's election. The ECB is likely to begin tapering its own purchases at the end of 2017, but our base case anticipates that it will not touch policy rates until well into 2018. Among the laggards, the Norges Bank will most likely be the first to push up rates - something we do not anticipate until late 2018. While BCA expects oil prices to rebound, this is unlikely to boost the economy fast enough to close the output gap for at least 18 months. Switzerland and Japan need to do a lot of work before their respective economies generate any kind of inflationary pressures. We do not anticipate any tightening for Switzerland until well after the ECB has moved. The BoJ may not tighten policy for the remainder of this decade. This means that the CAD and the NZD are likely to prove to be the best-performing currencies in the dollar bloc. Investors should stay short AUD/NZD and AUD/CAD. CAD/NOK also possesses more upside. The SEK could prove to be the best performing European currency. Swedish money markets are pricing in only 40 basis points of hikes over the next 12 months, something that seems too low considering the inflationary risk in that country. Stay short EUR/SEK. The EUR/USD rebounded this week on the back of seemingly hawkish comments by Draghi. Even when the ECB somewhat backtracked and communicated that the market had misinterpreted the speech, EUR/USD looked the other way. This confirms our fear that the momentum in this pair is too strong to fight. EUR/USD should retest 1.15-1.16, the upper bound of its trading range put in place since March 2015. Based on our economics work, any move above 1.15 should be used to short the euro. The pound will continue to suffer from a political discount, however, because our base case expects the BoE to tighten policy before the ECB, we continue to recommend that investors use moves above 0.88 to begin shorting EUR/GBP. The SNB is unlikely to remove its cap on the Swiss franc, which means the natural upward pull created by the large net international position of Switzerland will be of little solace for investors. Finally, the JPY should be the worst performing currency in the G10 as the BoJ will not be able to lift rates - a great handicap when, as BCA expects, global bond yields are likely to enjoy more upside than downside over the next 12 months. Equity Implications U.S. Equities Chart 11U.S. Contrary to popular belief equities and the currency are joined at the hip especially during currency bull markets. A rising currency tends to attract flows and equities outperform in common and local currency terms. Keep in mind that domestic equity exposure dominates stock market weightings, further solidifying the positive currency and equity correlation. The top panel of Chart 11 shows that this relationship is extremely tight in the U.S. with equities outperforming the MSCI ACWI when the dollar advances and suffering a setback when the greenback depreciates. The Fed has raised rates three times since December 2015 and is slated to tighten monetary policy one more time later this year. This is well telegraphed to the markets, and thus the U.S. dollar has been in sell off mode for the past 6 months, weighing on relative equity performance. The relative economic surprise indexes also have an excellent track record in forecasting relative equity momentum, and the current message is grim for relative share prices. We expect the U.S. to continue to trail other G10 bourses in the coming months and the MSCI ACWI as other CBs have more scope to tighten monetary policy, and recommend an underweight stance in global equity portfolios. Bank/financials performance is also closely linked to monetary policy. While the yield curve flattening tends to suppress net interest margins (NIM), the recovery in loan volumes and drop in NPLs owing to a pickup in economic growth more than offsets the fall in NIMs. We continue to recommend overweight exposure in U.S. banks/financials both in global and U.S. only portfolios.3 New Zealand Equities Chart 12New Zealand The positive stock and currency correlation exists in New Zealand. Currently, the Kiwi has been rising, but relative equities have not followed suit. If our analysis proves prescient and the RBNZ becomes the next G10 CB to hike, then a playable relative equity catch up phase will materialize (Chart 12). The relative surprise index is firing on all cylinders and corroborates the bullish economic message from our macro analysis and hints that New Zealand equities are a buy. We recommend an overweight stance in New Zealand stocks in global equity portfolios. While all the rest of the G10 have a domestic banking sector, New Zealand is the exception. Australian banks dominate the banking scene in New Zealand, and thus serve as a good proxy. We are comfortable to have a modest Australian banks/financials exposure in New Zealand only portfolios. However, there is one caveat: the housing market is bubbly. While excesses are well documented, we doubt that the housing markets would burst either in Australia or in New Zealand in the coming 6-12 months and bring down the Australian banking sector. In such a time frame, both CBs will still be early in their respective tightening cycles. Swedish Equities Chart 13Sweden The Swedish krona moves in lockstep with relative share prices, a relationship that has been in place for the better part of the past two decades (Chart 13). Were the Riksbank to raise the policy rate from deeply negative territory, as our macroeconomic analysis pegs it as second most likely, then equities will outperform the MSCI ACWI, and we recommend an above benchmark allocation in global equity portfolios. Economic surprises in Sweden continue to outnumber the G10, heralding additional momentum gains in relative share prices (bottom panel). The elimination of NIRP would also benefit the banking sector. NIRP serves as a noose around banks' necks, as bankers cannot pass on NIRP to retail depositors weighing on NIMs. Chart 21 in the Appendix shows that Swedish financials comprise over 30% of the overall Swedish market and drive overall market performance. Thus, we are comfortable with an overweight stance in financials in Swedish only equity portfolios given the prospects of tighter monetary policy in the coming quarters. Canadian Equities Chart 14Canada The Loonie and relative equity performance also move in tandem (Chart 14). At the current juncture the bear market in oil prices has dampened both the currency and equities, as Canada is an excellent proxy for commodity prices in general and oil prices in particular. The BoC is the third most likely CB to raise interest rates in the coming months according to our analysis, raising the odds of a reversal of fortunes for Canadian equities. The relative economic surprise index is surging, opening a wide gap with relative share price momentum. If our thesis proves accurate and the BoC pulls the trigger soon, then Canadian equities will gain some traction. Under such a backdrop we recommend an overweight stance in global equity portfolios. In terms of financials, Canadian financials' market capitalization weight is the second largest in the G10, exerting significant influence in overall equity direction. If the commodity complex is healthy enough for the BoC to tighten monetary policy, then banks will outperform on the back of firming loan growth and receding commodity related NPLs. Nevertheless, the housing market poses a clear risk. Were a housing crisis to grip the Canadian economy, bank earnings and thus performance would suffer a sizable blow. Our sense is that such an outcome is highly unlikely in the next year, making us comfortable recommending overweight financials exposure in Canadian only equity portfolios. Australian Equities Chart 15Australia The positive correlation between FX rates and relative equity performance is prevalent in Australia (Chart 15). Currently, the Aussie has stayed resilient, but equities have given way suffering alongside commodities in general and iron ore prices in particular. The RBA sits in the middle of the pack in terms of hiking interest rates next according to our thesis, but still remains the fourth most likely CB in the G10 to pull the trigger ahead of the BoE and the ECB. As such, we recommend a neutral weight in global equity portfolios. While the relative economic surprise index has vaulted higher, the positive correlation with relative share price momentum seems to have broken down in recent years. Similar to Canada, Australian financials comprise a large chunk of the broad equity market (see Chart 21 in the Appendix on page 24), setting the tone for overall equity returns. If Canada's housing market is frothy, then Australia is a definite bubble and poses a significant risk to the banking sector. The APRA is breathing down banks' necks and that is reflected in recent bank underperformance. As we mentioned earlier, we doubt the Australian housing market blows up in the next 6-12 months as the RBA will be in the early innings of a tightening cycle. As a result, only a benchmark allocation is warranted in Australian banks in Australian only portfolios. U.K. Equities Chart 16U.K. Cable and relative U.K. equity performance also follow our currency/FX positive correlation playbook (Chart 16). Relative share prices have ticked up recently taking cue from the rebound in sterling. British economic surprises have been outnumbering the G10 post Brexit, and sport a positive correlation with relative share price momentum. Our U.K. macroeconomic analysis highlights that the BoE stands right in the middle of the CB pack. Importantly, the BoE is our "surprise risk" of staying easy for longer than the economic variables would suggest as the dust clears from the Brexit aftermath. Under such a backdrop we recommend a modest underweight in U.K. equities in global equity portfolios. Similarly, U.K. banks also warrant a slight underweight stance in U.K. only equity portfolios. Eurozone Equities Chart 17Euro Area Euro area stocks and the euro have been positively correlated especially since 2003. Year-to-date EUR/USD is up roughly 10% and Eurozone equities have been stellar outperformers. The catalyst for the euro's sizable gains has been the market's realization that the ECB passed its maximum easing in Q1/2017. Receding geopolitical uncertainty has also played a key role. In addition, the economy has responded well both to the extraordinarily easy monetary policy measures and move away from austerity. The bottom panel of the Chart 17 shows that relative economic surprises are probing 5-year highs pulling relative equity momentum higher. While our macro analysis suggests that the ECB stays pat for a while longer, our "surprise risk" is that the ECB moves earlier than we expect and removes some of the extreme monetary accommodation. As a result we continue to recommend above benchmark exposure both in Eurozone equities and banks/financials. Importantly, not only will euro area banks benefit from the eventual ECB's removal of NIRP and the related boost to NIMs, but also NPLs have peaked and will continue to drift lower along with the unemployment rate. More recently, the speedy and contained resolution of two Italian bank failures along with the absorption of two Spanish banks by Santander and Bankia are a giant step in the right direction. These moves also suggest that there is political will to overcome the banking issues in the euro area. Additional bank cleanup is likely and this is a welcome development in the Eurozone that should entice healthier banks to extend credit to the economy. Norwegian Equities Chart 18Norway Over the past two decades, the Norwegian krone and relative equity performance have moved in lockstep (Chart 18). Year-to-date, relative Norwegian equities have fallen to fresh cycle lows. Similar to Canada, the country's substantial oil dependency has weighed on relative share prices and also knocked down the krone. Our macro analysis concluded that the Norges Bank will be late in lifting interest rate and sits at the bottom of the G10 CBs. As a result, we recommend underweight exposure in Norwegian stocks in global equity portfolios. Financials in Norway comprise one fifth of the stock market's capitalization (Chart 21 in the Appendix on page 24) and have been on a nearly uninterrupted run since the end of the GFC and catapulted to multi-decade highs. Given our thesis of the Norges Bank staying late in raising rates we recommend lightening up on financials equities in Norwegian only equity portfolios. Swiss Equities Chart 19Switzerland Since the late 1990s relative Swiss share prices and the CHF have been enjoying an almost perfect positive correlation (Chart 19). At the current juncture Swiss stocks have been propelling higher versus the MSCI ACWI as the franc has been appreciating. There are extremely low odds that the SNB would move the needle in terms of normalizing interest rates any time soon, according to our analysis. Keep in mind that the SNB is conducting the ultimate QE experiment by purchasing U.S. stocks, underscoring that there are a lot of layers/levers of momentary policy easing that it will have to eventually to unwind. The implication is that we would lean against recent strength in the Swiss equity market and recommend a below benchmark allocation. Switzerland financials have the third lowest market cap weight in the G10 as UBS and CS are still licking their wounds from the aftermath of the GFC. Relative financials performance has been soft and taken a turn for the worse recently in marked contrast with global financials exuberance since Brexit. Our macro analysis suggests that a below benchmark allocation is warranted in financials in Swiss only portfolios. Japanese Equities Chart 20Japan The Japanese yen and relative equity performance were joined at the hip from the mid-1990s until 2009. From the end of the GFC until 2015 this correlation broke down as Japan has been in-and-out of recession. Since then however, there is tentative evidence that Japanese equities and the yen have resumed moving in tandem (Chart 20). Our macroeconomic analysis suggests that Japan will be the last G10 CB to lift interest rates. While our study would signal that investors should avoid Japanese equities, we do not have high confidence in that view. The break and resumption in the equity/currency correlation is worrisome and suggests that other more important factors are in play dictating relative share price performance. As a result, we would modestly overweight Japanese equities in global equity portfolios in line with BCA’s Global Investment Strategy service view.4 On the financials front, relative performance in Japan has fallen into oblivion. NIRP is anchoring NIMs. But, an extremely low unemployment rate suggests that NPLs will continue to probe multi decade lows and provide an offset to bank EPS. Thus, we would stick with a neutral weighting in Japanese financials.5 Appendix Chart 21G10 Financial Market Cap Weights 1 For a more detailed discussion on the correlation between equity prices and the currency market, please see Global Alpha Sector Strategy Special Report titled, "Can The S&P 500 Rise Alongside The U.S. Dollar?", dated October 7, 206, available at gss.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 16, 017, available at fes.bcaresearch.com 3 Please see U.S. Equity Strategy Weekly Report titled, "Girding For A Breakout?", dated May 1, 2017, available at uses.bcaresearch.com 4 Please see Global Investment Strategy - Strategy Outlook "Third Quarter 2017: Aging Bull", June 30, 2017, available at gis.bcaresearch.com 5 Please see Global Alpha Sector Strategy Weekly Report titled "The Year Of The Letter "R"", January 13, 2017, available at gss.bcaresearch.com

Highlights Economic Outlook: Global growth will remain strong over the next 12 months, but will start to slow in the second half of 2018, potentially setting the stage for a recession in 2019. Overall Strategy: Investors should overweight equities and spread product for now. However, be prepared to pare back exposure next summer. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S. Treasurys, stay neutral Europe, and overweight Japan. Equities: Remain overweight developed market equities relative to their EM peers. Within the DM sphere, favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares have significant upside. Currencies: The selloff in the dollar is overdone. The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar, as does the euro. Commodities: Oil will rally over the coming months as global inventories decline. Gold will continue to struggle, before exploding higher towards the end of this decade. Feature I. Global Macro Outlook End Of The Global Manufacturing Recession Global growth estimates have been trending higher over the past 12 months, having bottomed last summer. Ironically, the collapse in oil prices in late 2014 was both the main reason for the deterioration in global growth as well as its subsequent rebound. Plunging oil prices led to a massive decline in capital spending in the energy sector and associated industries. In the U.S., energy capex dropped by 70% between Q2 of 2014 and Q3 of 2016. The economic fallout was even more severe in many other economies, especially emerging markets such as Russia and Brazil. The result was a global manufacturing recession and a pronounced slump in international trade (Chart 1). When thinking about oil and the economy, the distinction between levels and rates of change is important: While rapidly falling oil prices tend to be bad for global growth, lower oil prices are good for it. By the middle of 2016, the damage from the oil crash had largely run its course. What was left was a massive windfall for households, especially poorer ones who spend a disproportionate share of their paychecks at the pump. Industries that use oil as an input also benefited. Simply put, the oil crash went from being a bane to a boon for the global economy. A Solid 12-Month Outlook We expect global growth to remain firm over the next 12 months. Financial conditions in most countries have eased substantially since the start of the year thanks to rising equity prices, lower bond yields, and narrower credit spreads (Chart 2). Our empirical analysis suggests that easier financial conditions tend to lift growth with a lag of 6-to-9 months (Chart 3). This bodes well for activity in the remainder of this year. Chart 1The Manufacturing Recession Has Ended Chart 2Financial Conditions Have Eased Globally A number of "virtuous cycles" should amplify the effects of easier financial conditions. In the U.S., a tight labor market will lead to faster wage growth, helping to spur consumption. Rising household spending, in turn, will lead to lower unemployment and even faster wage growth. Strong consumption growth will also motivate firms to expand capacity, translating into more investment spending. Chart 4 shows that the share of U.S. firms planning to increase capital expenditures has risen to a post-recession high. Chart 3Easier Financial Conditions Will Support Growth Chart 4U.S. Firms Plan To Boost Capex The euro area economy continues to chug along. The purchasing manager indices (PMIs) dipped a bit in June, but remain at levels consistent with above-trend growth. The German Ifo business confidence index hit a record high this week. Corporate balance sheets in the euro area are improving and credit growth is accelerating. This is helping to fuel a rebound in business investment (Chart 5). The fact that the ECB has no intention of raising rates anytime soon will only help matters. As inflation expectations begin to recover, short-term real rates will fall. This will lead to a virtuous circle of stronger growth, and even higher inflation expectations. The Japanese economy managed to grow by an annualized 1% in the first quarter. This marked the fifth consecutive quarter of positive sequential growth, the longest streak in 11 years. Exports are recovering and both the manufacturing and non-manufacturing PMIs stand near record-high levels (Chart 6). Chart 5Euro Area Data Remain Upbeat Chart 6Japanese Economy Is Rebounding Chart 7China: Slight Slowdown, But No Need To Worry The Chinese economy has slowed a notch since the start of the year, but remains robust (Chart 7). Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production are rising at a healthy clip. Exports are accelerating thanks to a weaker currency and stronger global growth. Retail sales continue to expand, while the percentage of households that intend to buy a new home has surged to record-high levels. The rebound in Chinese exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 8). A better profit picture should support business capital spending in the coming months. Meanwhile, the Chinese government's "regulatory windstorm" - as the local press has called it - has largely bypassed the real economy. In fact, medium and long-term lending to nonfinancial corporations, a key driver of private-sector capital spending and physical commodity demand, has actually accelerated over the past eight months (Chart 9). Chart 8China: Higher Selling Prices Fueling A Rebound In Profits Chart 9China: Credit To The Real Economy Is Accelerating All Good Things Must Come To An End We remain optimistic about global growth over the next 12 months. Unfortunately, things are likely to sour in the second half of 2018, possibly setting the stage for a recession in the U.S. and several other countries in 2019. The odds of a recession rise when economies approach full employment (Chart 10). The U.S. unemployment rate now stands at 4.3% and is on track to break below its 2000 low of 3.8% next summer. A cursory look at the data suggests that the unemployment rate is usually either rising or falling (Chart 11). And once it starts rising, it keeps rising. In fact, there has never been a case in the postwar era where the three-month average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing. Chart 10Recessions Become More Likely When The Labor Market Begins To Overheat Chart 11Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Modern economies contain numerous feedback loops. When unemployment starts increasing, this fuels a vicious cycle where rising joblessness saps confidence and incomes, leading to less spending and even higher unemployment. History suggests that it is almost impossible to break this cycle once it starts. The Fed is well aware of the risks of letting the unemployment rate fall to a level where it has nowhere to go but up. Unfortunately, calibrating monetary policy in a way that achieves a soft landing is easier said than done. Changes in monetary conditions affect the economy with a lag of about 12-to-18 months. Once it has become obvious that a central bank has either loosened or tightened monetary policy too much, it is often too late to right the ship. The risks of a policy error are particularly high in today's environment where there is significant uncertainty about the level of the long-term neutral rate. Question marks about the future stance of fiscal policy will also complicate the Fed's job. We expect the Trump administration to succeed in passing legislation that cuts both personal and corporate income taxes later this year or in early 2018. The bill will be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This will generate a modest amount of fiscal stimulus over the next few years. That being said, the proposed changes to health care legislation could more than neutralize the effects of lower tax rates. The Senate bill, as currently worded, would lead to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Our base case is that Republicans in Congress fail to pass a new health care bill, thus leaving the Affordable Care Act largely unscathed. However, if they succeed, the overall stance of federal fiscal policy would likely shift from being somewhat accommodative, on net, to somewhat restrictive. This would expedite the timing of the recession. How Deep A Recession? If the U.S. does succumb to a recession in 2019, how bad will it be? Here, there is both good news and bad news. The good news is that financial and economic imbalances are not as severe today as those that existed in the lead-up to the past few recessions. The Great Recession was preceded by a massive housing bubble, associated with overbuilding and a sharp deterioration in mortgage lending standards (Chart 12). Today, residential investment stands at 3.9% of GDP, compared to a peak of 6.6% of GDP Q1 of 2006. Lending standards, at least judging by FICO scores, have remained fairly high over the course of the recovery. In relation to income and rents, home prices are also much lower today than they were a decade ago. Likewise, the massive capex overhang that preceded the 2001 recession is largely absent at present. Chart 12No New Bubble In The U.S. Housing Sector Chart 13Consumer Credit: Making A Comeback... The bad news is that cracks in the economy are starting to form. In contrast to mortgage debt, student debt has gone through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 13). Not surprisingly, this is starting to translate into higher default rates (Chart 14). The fact that this is happening when the unemployment rate is at the lowest level in 16 years is a cause for concern. Meanwhile, the ratio of corporate debt-to-GDP has risen above 2000 levels and is closing in on its 2007 peak (Chart 15). Chart 14...With Defaults Starting To Rise In Some Categories Chart 15U.S. Corporate Sector Has Been Feasting On Credit We are particularly worried about the health of the commercial real estate (CRE) market. CRE prices currently stand 7% above pre-recession levels in real terms, having risen by a staggering 82% since the start of 2010 (Chart 16). U.S. financial institutions hold $3.8 trillion in CRE loans, $2 trillion of which are held by banks. As a share of GDP, the outstanding stock of CRE bank loans in most categories is near pre-recession levels (Chart 17). Chart 16Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 17CRE Debt Is Rising The retail sector is already under intense pressure due to the shift in buying habits towards E-commerce. Vacancy rates in the apartment sector have started to tick higher and rent growth has slowed (Chart 18 and Chart 19). The number of apartment units under construction stands at a four-decade high, despite a structurally subdued pace of household formation (Chart 20). Most of these units are likely to hit the market in 2018, which will result in a further increase in vacancy rates. Vacancies in the office sector are also likely to rise, given the recent increase in the number of new projects in the pipeline. On the flipside, demand growth for new office space is set to weaken, as a tighter labor market leads to slower payroll gains. Chart 18Vacancy Rates Are Bottoming Outside The Industrial Sector... Chart 19...While Rent Growth Is Losing Steam If vacancy rates across the CRE sector start rising in earnest, real estate prices will fall, leading to a decline in the value of the collateral backing CRE loans. This could prompt lenders to pull back credit, causing prices to fall further. Seasoned real estate investors are no strangers to such vicious cycles, and if the next one begins late next year when growth is slowing because the economy is running out of spare capacity and financial conditions are tightening, it would further add to the risks of a recession. Chart 20Apartment Supply Is Surging, But Will There Be Enough Demand? Gauging The Global Spillover Effects What repercussions would a U.S. recession have for the rest of the world? Simply based on trade flows, the answer is "not much." U.S. imports account for less than 5% of global ex-U.S. GDP. Thus, even a significant decline in U.S. spending abroad would not make much of a dent in overseas growth. More worrisome are potential financial spillovers. As the IMF has documented, these have been the dominant drivers of the global business cycle in the modern era.1 Chart 21Global Debt Levels Are Still High Correlations across global markets tend to increase when risk sentiment deteriorates. Thus, if U.S. stocks buckle in the face of rising recessionary risks, risk assets in other economies are sure to suffer. The fact that valuations are stretched across so many markets only makes the problem worse. A flight towards safety could trigger a pronounced decline in global equity prices, wider credit spreads, and lower property prices. This, in turn, could lead to a sharp decline in household and corporate net worth, resulting in tighter financial conditions and more stringent lending standards. Elevated debt levels represent another major source of vulnerability. Total debt as a share of GDP is greater now than it was before the Great Recession in both advanced and emerging markets (Chart 21). High debt burdens will prevent governments from loosening fiscal policy in countries that are unable to issue their own currencies. The monetary transmission mechanism also tends to be less effective in the presence of high debt. This is especially the case in today's environment where the zero lower-bound on nominal interest rates remains a formidable challenge. The presence of these fiscal and monetary constraints implies that the severity of the next recession could be somewhat greater than one might expect based solely on the underlying causes of the downturn. II. Financial Markets Overall Strategy The discussion above implies that the investment outlook over the next few years is likely to be of the "one step forward, two steps back" variety. The global economy is entering a blow-off stage where growth will get better before it gets worse. We are bullish on global equities and spread product over the next 12 months, but expect to turn bearish on risk assets next summer. Until then, investors should position for a stronger dollar and higher bond yields. We recommend a slight overweight allocation to developed market equities over their EM peers. Within the DM sphere, we favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares stand out as offering an attractive risk-reward profile. Comparing government bonds, we are underweight U.S. Treasurys, neutral on European bonds, and overweight Japan. These recommendations are broadly in line with the output of our in-house quantitative models (Table 1 and Chart 22). Table 1BCA's Tactical Global Asset Allocation Recommendations* Chart 22Message From Our U.S. Stock Market ##br##Timing Model Equities Earnings Are Key Earnings have been the main driver of the global equity bull market. In fact, the global forward P/E ratio has actually declined slightly since February, despite a 3.9% gain in equity prices (Chart 23). Strong global growth should continue to boost corporate earnings over the next 12 months. Consensus bottom-up estimates call for global EPS to expand by 14% in 2017 and a further 11% in 2018. The global earnings revision ratio moved into positive territory earlier this year for the first time in six years (Chart 24). Chart 23Earnings Have Been The Main Driver ##br##Of The Global Equity Bull Market Chart 24Global Earnings Picture ##br##Looks Solid Global monetary conditions generally remain favorable. Our U.S. Financial Conditions Index has loosened significantly. Historically, this has been a bullish signal for stocks.2 Excess liquidity, which we define as M2 growth less nominal GDP growth, is also still well above the zero line, a threshold that has warned of a downturn in stock prices in the past. Chart 25Individual Investors Are Not Overly Bullish On U.S. Equities But... Sentiment is stretched, but not excessively so. The share of bullish respondents in the AAII's weekly poll of individual investors stood at 29.7% this week (Chart 25). This marked the 18th consecutive week that optimism has been below its long-term average. Market Vane's survey of traders and Yale's Investor Confidence index paint a more complacent picture, as do other measures such as the VIX and margin debt (Chart 26). Nevertheless, as long as earnings continue to grow and monetary policy remains in expansionary territory, sentiment can remain elevated without being a significant threat to stocks. Overweight The Euro Area And Japan Over The U.S. Regionally, earnings revisions have been more positive in Europe and Japan than in the U.S. so far this year. Net profit margins are also lower in Europe and Japan, which gives these two regions more room for catch-up. Moreover, unlike the Fed, neither the ECB nor the BoJ are likely to raise rates anytime soon. As we discuss in greater detail in the currency section of this report, this should lead to a weaker euro and yen, giving European and Japanese exporters a further leg up in competitiveness. Lastly, valuations are more favorable in the euro area and Japan than in the U.S., even if one adjusts for differing sector weights across the three regions (Chart 27). Chart 26...There Are Signs Of Complacency Chart 27U.S. Valuations Seem Stretched Relative ##br##To Other Bourses Mixed Outlook For EM Earnings growth in emerging markets has accelerated sharply. Bottom-up estimates imply EPS growth of 20% in 2017 and 11% in 2018 for the EM MSCI index. Our EM strategists believe this is too optimistic, given the prospect of a stronger dollar, high debt levels across the EM space, poor corporate governance, and the lack of productivity-enhancing structural reforms. These problems warrant a slight underweight to emerging markets in global equity portfolios. Nevertheless, considering the solid backdrop for global growth, EM stocks should still be able to deliver positive real total returns over the next 12 months. Within the EM space, we favor Russia, central Europe, Korea, Taiwan, India, Thailand, and China. Chinese H-shares, in particular, remain quite attractive, trading at only 7.1-times forward earnings and 1.0-times book value. Favor Cyclicals Over Defensives ... For Now Looking at global equity sectors, upward revisions have been largest for industrials, materials, financials, and real estate. Revisions for energy, health care, and telecom have been negative. We expect cyclical stocks to outperform defensives over the next 12 months. Energy stocks will move from being laggards to leaders, as oil prices rebound. Financials should also do well, as steeper yield curves, increased M&A activity, and falling nonperforming loans bolster profits. Equity Bear Market Will Begin Late Next Year As growth begins to falter in the second half of 2018, stocks will swoon. U.S. equities are likely to fall 20% to 30% peak to trough, marking the first sustained bear market since 2008. Other stock markets will experience similar declines. Global equities will eventually recoup most of their losses at the start of the 2020s, but the recovery will be a lackluster one. As we have argued extensively in the past, global productivity growth is likely to remain weak.3 Population aging will deplete savings, leading to higher real interest rates. The next recession could also propel more populist leaders into power. None of these things would be good for stocks. Against today's backdrop of lofty valuations, global stocks will deliver a total real return in the low single-digit range over the next decade. Fixed Income Bonds Have Overreacted To The Inflation Dip We turned structurally bearish on government bonds on July 5th, 2016. As fate would have it, this was the very same day that the U.S. 10-year Treasury yield dropped to a record closing low of 1.37%. The dramatic bond selloff that followed was too much, too fast. We warned at the start of this year that bond yields were likely to climb down from their highs. At this point, however, the pendulum has swung too far in the direction of lower yields. Chart 28 shows that almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained resilient, suggesting that investors' views of global growth have not changed much. This helps explain why stocks have been able to rally to new highs. The fall in inflation expectations has been largely driven by the decline in commodity prices. Short-term swings in oil prices should not affect long-term inflation expectations, but in practice they do (Chart 29). If oil prices recover in the second half of this year, as we expect, inflation expectations should shift higher as well. This will translate into higher bond yields. Chart 28Inflation Expectations Declined This Year, ##br##But Real Yields Remained Resilient Chart 29Low Oil Prices Drag Down##br## Inflation Expectations U.S. Treasurys Are Most Vulnerable Tightening labor markets should also boost inflation expectations. This is particularly the case in the U.S., where the economy is quickly running out of surplus labor. Some commentators have argued that the headline unemployment rate understates the true amount of economic slack. We are skeptical that this is the case. Table 2 compares a wide variety of measures of labor market slack with where they stood at the height of the business cycle in 2000 and 2007. The main message from the table is that the unemployment rate today is broadly where one would expect it to be based on these collaborating indicators. Table 2Comparing Current Labor Market Slack With Past Cycles 12-MONTH If the U.S. has reached full employment, does the absence of wage pressures signal that the Phillips curve is dead? We don't think so. For one thing, wage growth is not that weak. Our wage growth tracker has risen from a low of 1.2% in 2010 to 2.4% at present (Chart 30). In fact, real wages have been rising more quickly than productivity for the past three years (Chart 31). Unit labor cost growth is now just shy of where it was at the peaks of the last two business cycles (Chart 32). Chart 30Stronger Labor Market ##br##Is Leading To Faster Wage Growth Chart 31Real Wages Now Increasing Faster##br## Than Productivity Chart 32Unit Labor Cost Growth Close ##br##To Previous Two Peaks The evidence generally suggests that the Phillips curve becomes "kinked" when the unemployment rate falls towards 4%. In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 4.5% to 3.5% does. The experience of the 1960s is illustrative in that regard. Chart 33 shows that much like today, inflation in the first half of that decade was well anchored at just below 2%. However, once the unemployment rate fell below 4%, inflation took off. Core inflation rose from 1.5% in early 1966 to nearly 4% in early 1967, ultimately making its way to 6% by 1970. The Fed is keen to avoid a repeat of that episode. In a recent speech, New York Fed President and FOMC vice chairman Bill Dudley warned that "If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation ... Then the risk would be that we would have to slam on the brakes and the next stop would be a recession." If U.S. growth remains firm and inflation rebounds in the second half of this year, as we expect, the Fed will get the green light to keep raising rates in line with the "dots." The market is not prepared for that, as evidenced by the fact that it is pricing in only 27 basis points in rate hikes over the next 12 months. We are positioned for higher rate expectations by being short the January 2018 fed funds contract. The ECB And The BoJ Will Not Follow The Fed's Lead Could better growth prospects cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl? We doubt it. Investors are reading too much into Mario Draghi's allegedly more "hawkish" tone. There is a huge difference between removing emergency measures and beginning a full-fledged tightening cycle. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 34). Chart 33Inflation In The 1960s Took Off ##br##Once The Unemployment Rate Fell Below 4% Chart 34Euro Area: Labor Market Slack##br## Is Still High Outside Of Germany At this point, the market is pricing in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 25 months at present (Chart 35). Investors now expect real yields in the U.S. to be only 16 basis points higher than in the euro area in five years' time.4 This is below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 36). Chart 35ECB: Markets Are Pricing In Too Much Tighteninh Chart 36The Neutral Rate Is Lowest In The Euro Area As for Japan, while the unemployment rate has fallen to a 22-year low of 2.8%, this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Bank Of England's Dilemma Gilts are a tougher call. The equilibrium rate is higher in the U.K. than in most other developed economies. Inflation has risen, although that has largely been a function of a weaker currency. Fiscal policy is turning more accommodative, which, all things equal, would warrant a more bearish view on gilts. The big wildcard is Brexit. Chart 37 shows that the U.K. is the only major country where growth has faltered this year. Worries over Britain's future relationship with the EU have likely contributed to the slowdown. Ongoing Brexit angst will keep the Bank of England on hold, justifying a neutral weighting on gilts. Stay Short Duration ... For Now In summary, investors should keep global duration risk below benchmark levels over the next 12 months. Regionally, we recommend underweighting U.S. Treasurys, overweighting Japan, and maintaining a neutral position towards euro area and U.K. government bonds. Reflecting these recommendations, we are closing our short Japanese, German and Swiss 10-year bond trade for a gain of 5.3% and replacing it with a short 30-year U.S. Treasury bond position. As global growth begins to slow in the second half of next year, global bonds will rally. However, as we discussed at length in our Q2 Strategy Outlook, the rally will simply represent a countertrend move in what will turn out to be a structural bear market.5 The 2020s, in short, could end up looking a lot like the 1970s. Spread Product: Still A Bit Of Juice Left While we prefer equities to high-yield credit on a risk-adjusted basis over the coming months, we would still overweight spread product within a global asset allocation framework. The option-adjusted spread of the U.S. high-yield index offers 200 basis points above the Treasury curve after adjusting for expected defaults, roughly in line with the mid-point of the historical data (Chart 38). Corporate defaults are likely to trend lower over the next 12 months, spurred by stronger growth and a rebound in oil prices. Chart 37U.K. Is Lagging Its Peers Chart 38Default-Adjusted Junk Spreads Are At Historical Average As with all our other views, the picture is likely to change sharply in the second half of next year. At that point, corporate spreads will widen, warranting a much more defensive stance. Currencies And Commodities The Dollar Bull: Down But Not Out Our long-standing dollar bullish view has come under fire over the past few months. The Fed's broad trade-weighted dollar index has fallen 4.6% since December. Momentum in currency markets can be a powerful force, and so we would not be surprised if the dollar remains under pressure over the coming weeks. However, over a 12-month horizon, the greenback will strengthen, as the Fed raises rates more quickly than expected while most other central banks stand pat. When all is said and done, the broad-trade weighted dollar is likely to peak next summer at a level roughly 10% higher than where it is today. That would still leave it substantially below prior peaks in 1985 and 2000 (Chart 39). The U.S. trade deficit has fallen from a peak of nearly 6% of GDP in 2005 to 3% of GDP at present (Chart 40). Rising shale production has reduced the demand for oil imports. A smaller trade deficit diminishes the need to attract foreign capital with a cheaper currency. Chart 39The Dollar Is Below Past Peaks Chart 40The U.S. Trade Deficit Has Halved Since 2005 Sentiment and speculative positioning towards the dollar have swung from extremely bullish at the start of the year to being more neutral today (Chart 41). In contrast, long euro speculative positions and bullish sentiment have reached the highest levels in three years. Our tactical short euro/long dollar trade was stopped out this week for a loss of 1.6%. However, we continue to expect EUR/USD to fall back towards parity by the end of the year. We also expect the pound to weaken against the dollar, but appreciate slightly against the euro. Now that the Bank of Japan is keeping the 10-year JGB yield pinned to zero, the outlook for the yen will be largely determined by what happens to yields abroad. If we are correct that Treasury yields - and to a lesser extent yields in Europe - rise, the yen will suffer. Commodity Currencies Should Fare Well Higher commodity prices should benefit currencies such as the Canadian and Aussie dollars and the Norwegian krone. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. While shale output continues to rise, this is largely being offset by falling production from conventional oil fields. Consequently, oil inventories should fall in the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 42). Chart 41USD: Sentiment And Positioning ##br##Are Not Lopsided Anymore Chart 42Falling Oil Inventories Should Lead ##br##To Higher Crude Prices The outlook for industrial metals is not as upbeat as for oil, but metal prices should nevertheless rebound over the coming months. We suspect that much of the recent weakness in metal prices can be attributed to the regulatory crackdown on shadow banking activity in China. Many Chinese traders had used commodities as collateral for loans. As their loans were called in, they had no choice but to liquidate their positions. Today, speculative positioning in the commodity pits has returned to more normal levels (Chart 43). This reduces the risk of a further downdraft in commodity prices. BCA's China strategists expect the Chinese authorities to relax some of their tightening measures. This is already being seen in a decline in interbank lending rates and corporate bond yields (Chart 44). Chart 43Commodities: Long Speculative Positions Returning ##br##To More Normal Levels Chart 44China: Some Relief##br## After Recent Tightening Action? One key reason why the authorities have been able to let interest rates come down is because capital outflows have abated. Compared to late 2015, economic growth is stronger and deflationary pressures have receded. The trade-weighted RMB has also fallen by 7.5% since then, giving the economy a competitive boost. As such, the seeming can't-lose bet on further yuan weakness has disappeared. We still expect the RMB to depreciate against the dollar over the next 12 months, but to strengthen against most other currencies, including the euro and the yen. If the yuan remains resilient, this will limit the downside risk for other EM currencies. Nevertheless, at this point, much of the good news benefiting EM currencies has been priced in. Across the EM universe, in addition to the Chinese yuan, we like the Mexican peso, Taiwan dollar, Indian rupee, Russian ruble, Polish zloty, and Czech koruna. Lastly, a few words on the most timeless of all currencies: gold. We expect bullion to struggle over the next 12 months on the back of a stronger dollar and rising bond yields. However, once the Fed starts cutting rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For example, please see Box 4.1: Financial Linkages and Spillovers in "Spillovers and Cycles in the Global Economy," IMF World Economic Outlook, (April 2007). 2 Please see Global Investment Strategy Weekly Report, "The Message From Our Stock Market Timing Model," dated May 5, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; Global Investment Strategy - Strategy Outlook, "First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters), First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters)," dated January 6, 2017; and Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 U.S. minus euro area 5-year/5-year forward real bond yields. Real bonds yields are calculated as a difference between nominal yields and the CPI swap rate. Euro area yields refer to a GDP-weighted average of Germany, France, the Netherlands, Belgium, Austria, Italy, and Spain. 5 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Our new Revealed Preference Indicator (RPI) is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. The RPI borrows from Paul Samuelson's "revealed preference" theory of consumer behavior to market behavior. It combines the idea of market momentum with valuation and the monetary policy backdrop. A trading rule for the stock/bond allocation based on the RPI outperforms traditional technical, monetary, and valuation indicators. It provides a powerful bullish signal if positive equity market momentum lines up with positive signals from policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. This model adds value on its own, but we feel that it is best used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. In 1938, economist Paul Samuelson published a paper entitled, "A Note on the Pure Theory of Consumer's Behavior," in which he outlined an alternative to the well-known economic principle, utility theory. He dubbed his work "revealed preference theory."1 His goal was to redefine utility - a measure of consumer satisfaction with a good or service - by observing behavior. He posited that when consumers reveal their preferences by buying one item rather than another, they reveal the way in which they maximize happiness or satisfaction. For instance, one can measure preferences via experiments in which a subject is given $200 and the choice between two brands of shoes at different prices. Repeating the exercise at different levels of income and relative prices generates "preference axioms." Samuelson's theory has many more layers of complexity, but this Special Report focuses on modelling investors' preferences through observed behavior. Borrowing from Samuelson's reasoning, we developed a methodology to identify investors' axioms of preference for equities and bonds at different levels of incomes and prices. Then we compared investors' real actions with those anticipated by our methodology. This allowed us to generalize our findings and analyze the effects on a portfolio of equities and bonds. The main finding of our statistical exercise is that asset allocators can profit from understanding how short-term moves are linked to the market's revealed preferences at different times during the economic cycle. We then use the results to construct an indicator and a trading rule that not only outperforms a buy-and-hold strategy by a wide margin, it outperforms other traditional trading rules as well. Building A Revealed Preference Model Our primary objective in constructing a revealed preference indicator (RPI) is to understand: (1) how market preferences shape the behavior of investors; and (2) how they ultimately affect future returns. To do so, we broke down our analysis into three key areas: Part I identifies market preferences for different levels of income and price in the economy. Part II defines a general investment strategy that utilizes historic preferences and short-term market movements as a market timing tool. Part III optimizes the RPI and compares its historical track record with a buy-and-hold asset allocation and trading rules based on other indicators. Part I - Developing The Framework The first step in building the RPI is to establish the proper control variables. We limited our basket of investable "goods" to U.S. equities and 10-year Treasurys. We also need a variable that is analogous to the income measure that Samuelson used in his study. For the choice facing investors who are deciding between buying two financial assets, we believe that a measure of market "liquidity" is more appropriate than income. By this we do not mean the ease by which financial assets can be bought and sold. Rather, it is "funding liquidity", or how easily it is to borrow to invest. BCA often uses the four phases of the Fed cycle, as interest rates fluctuate around the equilibrium level, as a measure of funding liquidity (Chart II-1):2 Chart II-1Fed Funds Rate As A Proxy For Income Phase I = Policy is accommodative but the fed funds rate is rising. Phase II = Policy is tight and the Fed is still tightening. Phase III = Policy is tight but the Fed is cutting rates. Phase IV = Policy is easy and the Fed is cutting rates. The rationale for using the fed funds-rate cycle as a proxy for income is that, when interest rates are below equilibrium, monetary conditions are accommodative. Leverage is easy to obtain because there is plenty of liquidity (income) to fund investments. When conditions are tight, funding liquidity is relatively scarce. To measure relative prices, we first divided the S&P 500 price index by its 12-month moving average and second, we took the inverse of the 10-year Treasury yield divided by 12-month moving average.3 We then used the ratio of these two deviations-from-trend to construct a relative price measure (Chart II-2). This ratio provides a single measure of how expensive stocks and bonds are, not only to each other, but to their own history as well. We then grouped the relative price data into four sets of percentiles, or buckets, shown in Table II-1. Stocks are expensive and bonds cheap at the top of the table, while the reverse is true at the bottom. Chart II-2Constructing A Single Price Measure For Equities And Bonds Table II-1Distribution Of Relative Price Table II-2A presents the average historical monthly percent change in stock prices for each combination of the four relative price and liquidity buckets over the entire dataset. In the fourth phase of the Fed cycle (when monetary conditions are easy and the Fed is still cutting interest rates), and when relative prices are in the first bucket (i.e. stocks are expensive), the average stock price increase during the month was slightly above 1% percent. Table II-2B provides the same breakdown for the average change in bond yields (shown in basis points, not returns). Tables II-2A and II-2B are recalculated at each point in time - meaning that we used an expanding sample to calculate the price buckets, and updated the results for the ensuing price or yield movements as new data are added. That way, we completely avoid the advantage of hindsight. To simplify our methodology, we coded the results to end up with the stock and bond returns for the 16 different combinations of Fed and relative price buckets. Table II-3 uses the results from Tables II-2A and II-2B in the last period of history as an example. The "Liquidity" and "Price" columns indicate the bucket (e.g. price in bucket 1 and liquidity in bucket 1). The "Stocks" and "Bonds" columns are coded as "1" if the asset appreciated during the month given the indicated liquidity/price bucket, and a "0" if it depreciated that month. Table II-2AEquity Market Reactions At Given Levels Of Price And Liquidity Table II-2BTreasury Market Reactions At Given Levels Of Price And Liquidity Chart II-3Revealing What Investors Prefer Part II - Habits Create Expectations It is important to keep in mind that the objective of our revealed preference model is not to use the revealed market preferences as forecasts but rather to examine what happens when investors decide to follow or ignore them. Our hypothesis in building this model is that, when investors go against their historical preferences, the result should be interpreted as short-term noise. It is only when preferences and (subsequent) short-term market moves are aligned that we should heed the signal and invest accordingly. Table II-3 can be thought of as the market's revealed preference. Again, keep in mind that we allowed revealed preferences to change over time by recalculating it under our stretching-sample approach. The following steps detail how we used investor preferences to create a trading rule that verifies our hypothesis empirically: Step 1 - Expected vs. Actual: The first step is to examine how actual equity prices and bond yields behaved relative to their expected trajectory. We created two variables - one for equities and one for bonds. If revealed preference last month (t-1) suggested that the asset's return should be positive in the subsequent month (t), and it indeed turned out to be positive in period t, then we coded month t as "1." If both the revealed preference and the actual outcome were negative, we coded it as "-1." If they did not match, the code is "0" (in other words, the market did not follow the typical historical revealed preference). Thus we have two time series, one for bonds and one for stocks, which are made up of 1s, -1s and zeros. Step 2 - Bullish, Bearish, and Neutral: We combined the coded series for stocks and bonds to encompass the nine possible outcomes in our model (i.e. both bonds and stocks can have a value in any month of 1, 0 or -1, providing 9 different combinations). Table II-4 presents the nine outcomes along with the asset allocation that would have maximized investor returns based on our historical analysis. For example, investors were paid to be overweight equities when equities and bonds have a code of "1" and "-1," respectively (top row in Table II-4). In other words, stocks tended to outperform bonds when revealed preferences from the month before predicted rising stock prices and rising bond yields, and these predictions were confirmed. Table II-4Understanding The Signals From Preferences If revealed preference is not confirmed for both bonds and stocks, then it is best for investors to stand aside with a benchmark allocation. Step 3 - "If It Don't Make Dollars, It Don't Make Sense": To test whether our theory would add strategic value, we computed a trading rule to see how well it performed against a benchmark portfolio of 50% equities and 50% Treasurys. The trading rule was computed as follows: when the revealed preference for equities is positive (at time t-1) and this signal is confirmed in t, then in t+1 we allocate 100% to the S&P 500 and 0% to Treasurys. When the revealed equity preference signal is correctly bearish, we removed all exposure to equities and allocated 100% to Treasurys. When the signal was neutral, we kept a benchmark allocation of 50% equities and 50% Treasurys. Chart II-3 shows that this trading rule outperforms the benchmark, confirming our initial hypothesis - one should fade the short-term movements when investors go against their preferences, and only follow the signals when those movements align with historical preferences. History shows that investors tend to underperform in terms of the stock/bond allocation when they deviate from their revealed preference. Chart II-3Correctly Gauging How Investors Behave Pays Off Part III - Validating The Results One drawback is that this trading rule would require frequent portfolio allocation changes every month, as shown in Chart II-4. As such, we constructed a smoothed version by imposing the rule that asset allocation is unchanged unless the model provides a new signal for two months in a row (Chart II-5).4 These restrictions not only dramatically reduced the frequency of the asset allocation adjustments, but it also augmented historical cumulative excess returns (Chart II-6). Chart II-4Revealed Preference Indicator Is Inherently Volatile Chart II-5Removing Some Of The Noise Any new indicator of course must be able to outperform a buy-and-hold strategy to be useful but it is also interesting to see how its performance ranks compared to a set of random portfolios. This way, we can identify if the indicator truly provides additional information. Random portfolios are generated using a monthly allocations of 100% or 0% to equities, with the remainder in Treasurys. Chart II-7 shows the performance of the smoothed indicator versus a set of 1,000 randomly generated portfolios. Chart II-6Once Smoothed, The RPI Truly Shines Chart II-7The RPI Adds A Significant Amount Of Information We compared the indicator's trading rule to simple moving averages or BCA's other indicators. We also wanted to ensure that the RPI adds value beyond investing based strictly on the four phases of the liquidity cycle or based on relative value alone. We therefore compared the track record of the RPI trading rule to rules that are based on: (1) the deviation of the S&P 500 from its 12-month moving trend; (2) BCA's monetary conditions indicator; (3) BCA's valuation indicator; (4) BCA's technical indicator; (5) the four phases of the Fed cycle; and (6) the relative price index. Charts II-8A and II-8B highlights that RPI indeed impressively dominates the other trading rules. The one exception is that, during the Great Recession, the model's performance fell to roughly match the performance of a S&P 500 technical trading rule. Chart II-8AThe RPI Outperforms The Sum Of Its Parts... Chart II-8B...As Well As Other Indicators Part IV - Conclusions The RPI is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. This model adds value on its own, but we feel that it will best be used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. The indicator's current reading for stocks versus bonds, at benchmark, is more conservative than our official recommendation. The benchmark reading reflects the fact that equities are overvalued and that investors have deviated from their preferences in their past two quarters. David Boucher Associate Vice President Quantitative Strategist 1 For more information, please see P. A. Samuelson, "A Note on the Pure Theory of Consumer's Behavior," Economica 5:17 (1938), pp. 61-71. 2 Please see U.S. Investment Strategy Special Report "Stocks And The Fed Funds Rate Cycle," dated December 23, 2013, available at usis.bcaresearch.com 3 We tested a few other measures, most notably the stock-to-bond total return ratio (measured by comparing each asset's total returns), but the chosen measures provided the best and most robust results. 4 We conducted a statistical exercise to validate and optimize the allocations in Table 4 to provide a smoother performance.