Valuations

Highlights Portfolio Strategy A relapse in the global financials sector threatens to spill into U.S. financials as credit growth sinks. Bank equities are the most vulnerable to such a phase, given their reliance on rising interest rate expectations rather than increased lending. Take profits in the S&P health care facilities index and downgrade to neutral. Recent Changes S&P Health Care Facilities - Take profits of 12% and downgrade to neutral. Table 1Sector Performance Returns (%) As Good As It Gets? As Good As It Gets? Feature Momentum continues to trump all else, with the equity market surging to new all-time highs last week. However, in the background, the Fed is becoming steadily more hawkish, and the odds of a March rate hike have risen substantially. This should be cause for some trepidation. Chart 1Multiples Are Headed##br## Lower As The Fed Hikes Multiples Are Headed Lower As The Fed Hikes Multiples Are Headed Lower As The Fed Hikes The market advance since November has been supported primarily by valuation expansion, along with some improvement in corporate profits. The forward P/E has climbed to 18, its highest level in well over a decade. The scope for further expansion is limited. Importantly, if a transition to an earnings-led rally is in the offing, Fed funds expectations likely need to be ratcheted higher. Chart 1 shows that valuation multiples contract during Fed tightening cycles, using cycle-on-cycle analysis. Thus, the valuation expansion is inconsistent with a significant upgrade in the economic and profit outlook, particularly with return on equity so weak (Chart 1). In other words, the economy has good momentum, but that is not translating one for one to the corporate sector. Keep in mind that even a small two P/E multiple point decline requires 11% earnings growth for the market just to hold its ground. That is a tall order given the squeeze on profit margins from labor cost inflation and a strong U.S. dollar. Ironically, high multiples would be more durable if economic data softened enough for the Fed to hold its fire. Against this background, it is not surprising that a stealthy flight to safety has developed, although it is not uniform across asset classes. For instance, gold has outperformed most major currencies (note we recently upgraded the gold shares group as a portfolio hedge); global government yields have eased back while sovereign bond spreads have widened (Chart 2). In the U.S., the economically-sensitive transport group has rolled over in line with the yield curve narrowing (Chart 2), the equity SKEW index remains historically elevated, and a defensive vs. cyclical portfolio bias has outperformed handily since early December (Chart 2, bottom panel), on broad-based non-cyclical sector participation. These shifts, on the margin, signal that some investors are bracing for a bout of volatility. On the flipside, U.S. junk bond spreads have narrowed back to 2014 lows, and emerging market corporate bond spreads are testing similarly tight levels. The global purchasing manager survey recorded yet another monthly gain (Chart 3). Chart 2Contrarian##br##Alert... Contrarian Alert... Contrarian Alert... Chart 3... Defensives Can Outperform##br## When Growth Is Good ... Defensives Can Outperform When Growth Is Good ... Defensives Can Outperform When Growth Is Good Ergo, a systemic economic threat is not the main obstacle to further asset price appreciation. Rather, it is that expectations in some assets and sectors have become divorced from reality. Indeed, we have noted for the last two months the disturbing downtrend in bank credit growth and the unprecedented gap between strong 'soft' and pedestrian 'hard' economic data. Mixed economic and financial market messages suggest that any equity turbulence may be marked by a mostly rotational correction rather than a savage drawdown in the broad averages. Still, the latter cannot be ruled out given the high degree of complacency and buoyant profit and economic expectations. It is notable that defensive equities embarked on a massive outperformance phase when both U.S. and EM bond spreads were just as low as they are currently, i.e. they hit 'as good as it gets' levels (Chart 3). Any widening in corporate bond spreads would tighten financial conditions, spurring a slowdown in growth down the road. In sum, the odds of an equity market sweet spot extension beyond the very near run have diminished as a consequence of ongoing strong economic data, which reflects the easing in financial conditions a year ago. In terms of positioning portfolios, there is still a mismatch between developed and developing markets, as measured by the relative ISM indexes (Chart 3, fourth panel). The upshot is that defensives will continue to generate much more cash than their cyclical counterparts (Chart 3, bottom panel), supporting the nascent relative share price recovery. The financial sector could also be due for a correction. Financials And Banks: Where To Next? The global financials sector has cheered the firming in leading economic indicators and back up in bond yields since last autumn, but that celebration is likely drawing to a close. Euro area financials have rolled over, in line with renewed weakness in German government bond yields (Chart 4). Continued slippage in global yields could cap U.S. yields, thereby flattening the yield curve (Chart 5). U.S. financials are much more expensive than their euro area counterparts (Chart 5, bottom panel), suggesting heightened vulnerability. Chart 4Are EMU Financials ##br##Sending A Warning Signal? Are EMU Financials Sending A Warning Signal? Are EMU Financials Sending A Warning Signal? Chart 5Watch The##br## Yield Curve Watch The Yield Curve Watch The Yield Curve In our view, the S&P bank index contains the most downside vulnerability, in relative performance terms, of all the financial sector sub-components, especially if regulatory reform disappoints and/or is slow to evolve. True, as outlined in a Special Report published on October 3, 2016, interest rate expectations have a checkered history of predicting bank stock relative performance. When they do drive bank stocks, it is typically because most other profit drivers are lacking, as is currently the case (Chart 5, top panel). This cycle, interest rate spreads have been unduly suppressed by the zero lower bound. Under normal circumstances, when short-term interest rates are well above zero lower bound, banks can target a spread between rates on assets and liabilities. But when the fed funds rate is at zero, the spread is compressed, because banks generally cannot charge customers a penalty implied by negative interest rates on deposits (at least in the U.S.). As the Fed pushes interest rates back upward, banks may be able to return their spreads to their target levels, by raising deposit rates more slowly than loan rates. However, this dynamic has been fully priced in over the last few months and the risk is that higher net interest margins will not offset the lack of credit creation and/or that Fed funds rate expectations will level off if economic data start to disappoint. After all, Chart 6 shows that net interest margins can both widen and narrow when the Fed is hiking interest rates. Moreover, the yield curve is narrowing, after peaking two months ago. If rising fed interest rate expectations are the primary factor driving bank stock performance, then it follows that market expectations must continue to price in a much more hawkish rate environment in order to extend any rally in bank share prices. However, the global credit impulse is still negative, albeit less so, reflecting capital constraints and deleveraging. The Bank of International Settlements global credit impulse indicator has been an excellent leading indicator of relative bank profitability, and it is premature to expect earnings outperformance (Chart 7). U.S. credit data are also inconsistent with a major upshift in Fed funds interest rate expectations. Total loan growth is contracting, led by commercial & industrial loans (Chart 8). Commercial real estate loan growth has also turned lower. Chart 6Net Interest Margins And The Fed Net Interest Margins And The Fed Net Interest Margins And The Fed Chart 7Don't Chase Without Profit Support Don't Chase Without Profit Support Don't Chase Without Profit Support Chart 8Shrinking Balance Sheets Shrinking Balance Sheets Shrinking Balance Sheets The most recent Fed Senior Loan Officer Survey showed that banks are tightening lending standards in most categories, with the exception of mortgages (Chart 9). The number of banks reporting increased loan demand has also softened. Since the credit crisis, banks have shifted their balance sheet exposure toward businesses and away from consumers and residential mortgages, underscoring that a decent housing market is unlikely to provide an offset to lackluster corporate credit demand. Only mortgages have experienced an uptick in loan demand and availability of funds (Chart 9). This credit backdrop is not conducive to a much more aggressive Fed, reinforcing that it would be dangerous to discount a sustained and meaningful uptrend in net interest margins. To further confound the bank stock reward/risk profile, bank employment continues to rise steadily (Chart 10), even though balance sheet expansion is no longer a sure thing. We have shown in past Reports that bank stocks have almost always underperformed when bank employment is rising. Chart 9Credit Standars Are Tightening Credit Standars Are Tightening Credit Standars Are Tightening Chart 10Sagging Productivity Sagging Productivity Sagging Productivity The current combination of fading credit creation and rising employment has done a number on our bank productivity proxy. The latter is now contracting on a rate of change basis, warning that the expansion in bank stock valuations is due for a squeeze (Chart 10). Bottom Line: The run in bank stocks over the past few months is on the cusp of a reversal, based on the leading message from the euro area, sinking productivity and punk credit demand. Our financial sector preference remains skewed toward areas not dependent on credit creation, such as asset managers. Book Profits In Health Care Facilities We bought the S&P health care facilities index last December after a steep post-election sell-off created a valuation and technical undershoot relative to the fundamental outlook. The doomsday concern was that President Trump would tear up the Affordable Care Act (ACA), potentially leaving millions without insurance: treating the uninsured is the bane of any hospital's existence. At the time of purchase, the 52-week rate of change was diverging positively from the share price ratio after hitting deeply oversold levels, often a harbinger of a playable rally (Chart 11). That was particularly true given an historically high short position. The index has outperformed by 12% since then, encouraged by a jump in analyst net profit revisions following upbeat profit results and guidance from industry heavyweights such as HCA Holdings (Chart 11), and a realization that any ACA action is likely to be more of a rework than a total rebuild. Valuations remain appealing, but a technical breakout above key resistance levels requires increased confidence in the durability of profit outperformance. Is such a phase forthcoming? Our conviction level has decreased a notch. Our concern is primarily revenue based, rather than fear that provisions for doubtful accounts will suddenly deteriorate as a consequence of treating uninsured patients. Instead, the main push from the surge in the insured population and increase in procedures on the back of rising consumer confidence/job security is likely to peter out. Consumer spending on hospitals has already rolled over decisively on a growth rate basis (Chart 12, third panel), and is contracting compared with total consumer spending. The same is true of spending on physician visits. Fewer doctor visits mean a reduction in procedures performed at hospitals. Chart 11Hitting Resistance Hitting Resistance Hitting Resistance Chart 12Top-Line Trouble Ahead? Top-Line Trouble Ahead? Top-Line Trouble Ahead? Health care is a labor-intensive industry. Health care facilities staff up when they get busy and prune when capacity utilization slips. As such, slowing growth in hospital employment reinforces that patient volume growth is likely to ebb (Chart 12). In fact, the contraction in hospital hours worked signals the same ahead for hospital sales (Chart 12, bottom panel). The good news is that labor costs remain in check, as measured by the employment cost index for hospitals (Chart 13). Other input costs, such as the cost of medical equipment and supplies, have perked up (Chart 13), which may require increased pricing power in order to sustain profit margins. However, the revenue trends noted above suggest that hospitals may not experience a sufficient rise in patient volumes to the extent that restores pricing power to a more solid footing. Chart 14 shows that the consumer price index for hospitals is losing momentum relative to overall inflation. Durable outperformance phases require accelerating relative pricing power, in addition to a cooling in overall economic growth, as proxied by the ISM manufacturing index (see shading, Chart 14). Those conditions provide a durable competitive profit advantage. Chart 13A Mixed Picture For Costs A Mixed Picture For Costs A Mixed Picture For Costs Chart 14Shaky Long-Term Support Shaky Long-Term Support Shaky Long-Term Support Chart 15Macro Headwinds Macro Headwinds Macro Headwinds In addition, the ideal macro conditions for hospital stocks exist when consumer spending on overall health care services is accelerating relative to total spending. That implies that the providers of health care services have an advantage over those that pay for them, such as insurers. Total medical care spending is steadily decelerating (Chart 15), underscoring that investors are better off targeting investments in other parts of the sector. In sum, the forces required to sustain the oversold rally in the S&P 1500 health care facilities index are losing clout, so we recommend booking profits. Bottom Line: Downgrade the S&P 1500 health care facilities index to neutral, locking in a 12% profit since inception in December 2016. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Risk assets have rallied smartly, yet key indicators like the relative performance of Swedish stocks or the price of kiwi equities are not corroborating these moves. With the Fed now very likely to increase rates in March, the broad-trade-weighted dollar could be about to resume its rally. This would prompt a correction in metals, and EM as well as commodity currencies. We think the tactical correction in the broad-trade-weighted dollar is over, and the cyclical dollar rally can resume. EUR and JPY will not suffer as much as the commodity currencies, go long EUR/AUD, short NZD/JPY. Feature In the Roman calendar, the Ides of March corresponds to the 15th of that month. Consigning that date to posterity in the year 44 BCE, Julius Caesar was assassinated on the floor of the senate in Rome, with his adoptive son Brutus, being among the conspirators. This event prompted yet another round of civil war in the republic, and ultimately a regime shift: the end of the Roman Republic and the Beginning of Imperial Rome under Augustus in 27 BCE. Fast forward 2061 years to the present. March 15th will be the day when the FOMC meeting ends. Will the period around the Ides of March represent a regime shift once again - albeit on a much different scale - where risk assets finally correct? Can the dollar resume its ascent? We believe the answer to both questions is yes. Unusual Market Moves Strange market dynamics have piqued our interest. In recent weeks, DM stock prices, and bond yields have been moving up (Chart I-1). This is consistent with investors pricing in an improving growth outlook and a Fed moving toward a tighter policy. On the other hand, EM stocks, metals, and gold in particular have also been moving up (Chart I-2). This move is more disturbing as it tends to imply an easing in monetary conditions, especially the strength in gold, even if it may have ended yesterday. This strange performance could be explained if the dollar was weakening or inflation expectations were moving up. However, the dollar has been strengthening in recent days and inflation expectations have been flat. Additionally, the U.S. yield curve has flattened, suggesting that the adjustment in the Fed's expected rate path is beginning to have marginally negative implications for future growth (Chart I-3). Chart I-1More Growth, More Hikes More Growth, More Hikes More Growth, More Hikes Chart I-2More Reflation As Well More Reflation As Well More Reflation As Well Chart I-3No Sign Of A Fed Behind The Curve No Sign Of A Fed Behind The Curve No Sign Of A Fed Behind The Curve So based on current information, how are these market moves likely to resolve themselves? Let's look at indicators. In the past, we have followed the common-currency performance of Swedish relative to U.S. equities as a gauge for the global growth outlook, and particularly non-U.S. growth relative to U.S. growth. This reflects the fact that U.S. stocks tend to be defensive, while Swedish stocks are very pro-cyclical. This dynamic is accentuated by the nature of the Swedish economy. Sweden is a small open nation that trades heavily with EM. While its biggest trading partner is the euro area, where it tends to export many intermediate goods and machinery, which are then re-exported as finished products to the EM space. Currently, Swedish equities continue to underperform U.S. ones. What is most striking is that this underperformance has happened despite a strong performance in EM stocks and metals, a very rare divergence (Chart I-4). Another worrying signal comes from New Zealand stocks in USD terms. New Zealand is another small open economy with deep trade links to the EM space. It is therefore very sensitive to global growth dynamics. While Kiwi equities did flag the rebound in EM growth and global manufacturing activity that happened in 2016, since late January, they have stopped participating in the rally in global risk assets despite a booming New Zealand economy. They have even begun swooning in recent weeks (Chart I-5). Chart I-4A Strange Divergence A Strange Divergence A Strange Divergence Chart I-5Are Kiwi Stocks Telling Us Something? Are Kiwi Stocks Telling Us Something? Are Kiwi Stocks Telling Us Something? Finally, two other reliable indicators of global growth are also not corroborating any further improvement in global growth from here: Small caps are underperforming large caps and oil is underperforming gold (Chart I-6). Obviously the next question becomes: are all these indicators likely to converge back toward EM equities, the AUD and the BRLs of the world or are the risk assets mentioned above likely to be the ones experiencing a downward adjustment? Here economics should give us a clue. For one, the 2016 rally in EM and risk assets can be explained by the large improvement in economic conditions. G10 and EM surprise indexes have moved up vertically in recent months (Chart I-7). However, this move might reflect the past not the future. Chart I-6Some Growth Indicators Are##br## Not Doing Well Anymore Some Growth Indicators Are Not Doing Well Anymore Some Growth Indicators Are Not Doing Well Anymore Chart I-7Too Much Of##br## A Good Thing? Too Much Of A Good Thing? Too Much Of A Good Thing? China has been a key reason explaining why EM assets and economic activity have been so positive. However, the large dose of fiscal stimulus that has supported that economy has dissipated (Chart I-8). Based on the IMF's October Fiscal Monitor, the fiscal thrust in China was 1.7% of potential GDP in 2015 (heavily loaded to the second half of that year), and 0.3% in 2016. It is moving to 0% in 2017. This means that as the lagged effects of the late 2015 fiscal surge dissipate, a key reflationary wind behind the global economy will disappear. The Keqiang index is mirroring these dynamics. After flirting with cyclical highs, and therefore highlighting a sharp improvement in the Chinese industrial sector, it has begun to roll over (Chart I-9). More weakness is likely in the cards. Fiscal dynamics have followed a similar pattern on a global level. The overall EM fiscal thrust was at its strongest in 2015, at 0.6% of EM potential GDP, fell to 0.1% in 2016, and is expected to hit -0.2% in 2017. In the DM, the pattern is slightly different. The high point of fiscal stimulus was 2016, when the fiscal impulse hit 0.4% of potential GDP. However, this measure is moving back to -0.1% in 2017. Chart I-8Losing A Source ##br##Of Reflation Losing A Source Of Reflation Losing A Source Of Reflation Chart I-9Chinese Industrial Activity ##br##May Be Rolling Over Chinese Industrial Activity May Be Rolling Over Chinese Industrial Activity May Be Rolling Over Additionally, the monetary environment is not as stimulative as it once was. Bond yields have risen in the whole DM space, with Treasury yields now more than 110bps higher than in July, Bund yields having moved from -0.18% to 0.31%, and JGB yields having adjusted 37bp higher to 0.07%. High-frequency loan data out of the U.S. already shows some strains caused by this rise in borrowing costs (Chart I-10). This combination points toward a deceleration in the growth impulse, especially in the goods sector. As such, we do expect the EM and G10 surprise indexes to roll over in coming weeks. Even if this phenomenon may prove temporary, the market is not priced for this event. Highlighting this vulnerability is the high level of complacency we have already flagged last week, which suggests that global investors are positioned for a continuation of the improvement in the growth outlook (Chart I-11). So high seems the conviction that growth will continue to accelerate that it is outweighing the move toward a tighter Fed going forward. Finally, the implied correlation in the S&P 500 has fallen to post 2010-lows. This could incentivize investors to take on more leveraged bets on portfolios of stocks. A low correlation results into higher diversification benefits and therefore, a lower portfolio volatility (Chart I-12). A rise in correlation would cause volatility to rise and thus a mini-deleveraging and de-risking cycle to take hold amongst investors. Chart I-10Response To Higher Yields Response To Higher Yields Response To Higher Yields Chart I-11Lots Of Complacency Globally Lots Of Complacency Globally Lots Of Complacency Globally Chart I-12Correlation-Induced Derisking On Its Way? Correlation-Induced Derisking On Its Way? Correlation-Induced Derisking On Its Way? Bottom Line: DM stocks are up, yields are up, the dollar is firming, yet EM equities, metals and gold especially have risen as well, and the U.S. yield curve is flattening while inflation expectations have recently been stable. We expect risk assets to end up buckling. Some reliable indicators of the trend in risk assets are pointing south, global investors are expecting further growth improvement in the coming months while global growth may in fact temporarily decelerate, and finally, if the low level of implied correlation in stocks normalizes, a correction may be catalyzed. What About The Fed Because Lael Brainard has been such a reliable dove on the FOMC, when she says that a hike is coming soon, we must listen. The fact that the market has come to price in an 83% probability of a Fed hike in March will only give the FOMC more comfort in increasing interest rate when it meets in two weeks (Chart I-13). While we have been expecting the Fed to move in line with its Summary of Economic Projection's interest rate forecast, and thus increase three times this year, we are surprised by the fast change of tune in recent days. Nonetheless, we are acknowledging this reality. Is this publication moving toward expecting four rate hikes in 2017? Not yet. We want to see how the market handles the coming hike going forward. A correction in risk assets, commodities, and EM is likely to force the Fed to pause again before resuming its hiking path. We are clearly expecting such a development. The broad dollar is likely to be caught in a bullish cross current. However, differentiation between the minors vis-à-vis the EUR and JPY might be essential for investors. Chart I-14 shows that recently, the broad-trade-weighted dollar has not kept pace with the increase in interest rate expectations for the U.S. With our capitulation index for this measure of the dollar moving closer to "oversold" territory, the weeks leading up to the Fed meeting could witness a stronger broad trade-weighted dollar. We are therefore removing our tactical short bias and moving in line with our cyclical bullish dollar stance. Chart I-13The Fed Tends To Telegraph ##br##Its Intention To Hike Et Tu, Janet? Et Tu, Janet? Chart I-14The Dollar Should ##br##Catch Up The Dollar Should Catch Up The Dollar Should Catch Up We believe that in this process, the dollar will be strongest against EM and commodity currencies. To begin with, the USD is trading near 19, 18, and 17 months lows against the BRL, ZAR, and RUB respectively. As recently as Wednesday, the AUD was also trading near the top of its distribution of the past two years (Chart I-15). Moreover, EM and commodity currencies are heavily geared to global growth. As such, the combination of a tightening Fed, rising bond yields, and a potential roll-over in global economic surprises may weigh especially heavily on them. On the other hand, in 2015 and 2016, the dollar has tended to be softer against the EUR and the JPY in periods of market turbulence. Thus, the call on EM and commodity currencies seems much cleaner than on these two currencies. In this regard, two crosses have caught our eye. One is EUR/AUD. Not only is it at the bottom end of a trading range established since June 2013, it has only traded lower at the apex of the euro area crisis between 2011 and the first half of 2013 (Chart I-16). The recent rollover in French / German bund spreads is potentially a good signal to buy this cross. The picture for JPY is now muddied. While higher interest rates should hurt the JPY, a period of risk-asset selloff should support the JPY. To play the cross-current described above, we are opening a short NZD/JPY position, a cross historically levered to rising volatility (Chart I-17). Chart I-15AUD Is Elevated AUD Is Elevated AUD Is Elevated Chart I-16To Fall From Here, EUR/AUD Needs A Euro Crisis To Fall From Here, EUR/AUD Needs A Euro Crisis To Fall From Here, EUR/AUD Needs A Euro Crisis Chart I-17Short NZD/JPY: A Risk-Off Play Short NZD/JPY: A Risk-Off Play Short NZD/JPY: A Risk-Off Play Bottom Line: The Fed moving forward its planned rate hike to March could be the ultimate catalyst to prompt a correction in risk assets, especially the segment of the market most levered to EM and growth conditions: EM and commodity currencies. We are removing our tactical USD stance and we are moving in line with our bullish cyclical stance. We are also buying EUR/AUD and shorting NZD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar USD Technicals 1 USD Technicals 1 USD Technicals 1 USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data paints a healthy picture for the U.S. economy: Fourth quarter annualized GDP came in unchanged from the previous quarter at 1.9%; PCE Price Index increased at a 1.9% annual pace, near the Fed's target; Core PCE remained steady at 1.7% annually and increased to 0.3% monthly, indicative of a robust economy; ISM Manufacturing PMI went up to 57.7. The market is now pricing in an 83% probability of a rate hike. Further enhancing growth prospects were Trump's remarks at his Joint Address to Congress, where he stated that there will be a "big, big cut" in corporate tax, and that he will seek to gain approval for a $1 trillion infrastructure plan. Hawkish comments from the previous FOMC meeting strengthened the dollar in February; Trump's comments may be an additional tailwind to the dollar's upside this month. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 The Euro EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Fundamentally, the euro area economy remains resilient: Services sentiment, business climate, and industrial confidence all picked up in February, outperforming expectations; Germany recorded a decrease in unemployed persons of 14,000; German CPI picked up to a 2.2% annual pace, also beating expectations Nevertheless, EUR/USD is unlikely to see any substantive upside in the coming months. With the Dutch elections in around 2 weeks, considerable volatility could rise up, something which has not been priced in. The Euro Stoxx 50 Volatility Index is showing a low reading of 16.55, just above the all-time low of 12. The ECB will meet next week and is likely to display a dovish bias due to potential political turmoil. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 The Yen JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 On a cyclical basis we are still bearish on the yen, as the BoJ will continue to pursue radical measures to pull Japan out of its liquidity trap. Recent data seems to indicate that these measures have been somewhat successful: Retail trade YoY growth outperformed expectations coming in at 1%. Housing starts YoY growth also outperformed, coming in at 12.8%. On a tactical basis the picture is more nuanced. While it is very possible that the coming rate hike could lift rate expectations in the U.S., lifting USD/JPY, there is a risks that the hike might trigger a sell-off in risks assets, which could be very positive for the yen. For this reason we are shorting NZD/JPY, as this cross is very vulnerable to an increase in volatility. Report Links: JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 British Pound GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The past week has not been kind to the pound, with GBP depreciating by about 2% against both the Euro and the U.S. Dollar. This was in part due to the prospect of a Scottish Independence referendum. On the economic side, data for the U.K. continue to be mixed: House prices annual growth outperformed expectations coming in at 4.5% M4 broad money annual growth continues to climb higher and it is now at 7%. On the other hand manufacturing PMI, although still high, underperformed expectations, coming in at 54.6. Although the cyclical dollar bull market should continue to weigh on cable, we are more bullish on the pound, particularly against the euro, as expectations for the U.K. economy continue to be too pessimistic, while the dark cloud of this year's election cycle looms on the euro. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 AUD lost 1.3% of its value Thursday morning amid disappointing trade data. It seems that the market largely ignored stronger data this week: GDP grew at a 2.4% annual rate Q42016 and both NBS and Ciaxin Chinese Manufacturing PMI beat expectations. Exports, however, contracted at a 3% pace and the surplus missed expectations by 66%, most likely due to the AUD's strength this year, even alongside higher commodity prices. This is also particularly worrying seeing that exports failed to pick up despite a previously strong Chinese PMI reading. Now, alongside a Keqiang Index that is topping out, the future for Australian exports could be limited. Additionally, this outlook is further supported by investment diverting to the non-resource sector. It is difficult to see whether the RBA will respond to this export slump, as the contractionary Q32016 GDP data was largely overlooked and dismissed. Nevertheless, we stand by our bearish outlook on AUD. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 New Zealand Dollar NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The RBNZ continues to assert its neutral bias. On Wednesday, RBNZ Governor Graeme Wheeler stated that "there is an equal probability that the next OCR adjustment could be up or down". This caused the kiwi to come close to reaching 0.71, its lowest point since mid-January. We continue to believe that the RBNZ stance is not hawkish enough, as powerful inflationary forces continue to brew in New Zealand. That being said, it is very likely that the RBNZ will continue with its neutral tone up until the middle of the year, when we start to have a clearer picture about the outcome in European elections. Therefore, given that the Fed is likely to hike in March, diverging monetary policies should continue to weigh on NZD/USD until then. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Canadian Dollar CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The BoC left their overnight rate target unchanged at 0.5% despite a high CPI reading of 2.1% in January. A further surprise was a particularly dovish tone, highlighting that higher energy prices will have a temporary effect on inflation, and indicating "material excess capacity in the economy". Additional weaknesses were highlighted with regards to competitiveness challenges for the export sector and subdued wage growth accompanied by contracting hours worked. Trade developments are an additional headwind for the Canadian economy that the bank is monitoring and will continue to do so until the outlook clarifies. CAD has lost more than 2% of its value against the USD in 3 days due also to a stronger dollar based on Fed rate hike expectations and Trump's potential infrastructure spending and tax cuts. It is unlikely that CAD will see any strength in the near future as the Bank has set forth a rather cautious tone. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data has been mixed, which indicates that although economic activity in Switzerland is improving, it still is very tepid: The KOF leading indicator outperform expectations coming in at 107.2 Retail sales outperformed expectations. However they are still contracting by 1.4% GDP annual growth was 0.6%, falling significantly from last quarter reading of 1.4% The SNB is currently in a tight spot, as improvements are very marginal and it is evident that the economy is still plagued by strong deflationary forces. Meanwhile EUR/CHF is under 1.065 and has been unable to climb above this level this month, as the SNB continues to fight risk off flows coming into the franc due to the risks of the European election cycle. As these risks increase, the floor in this cross will continue to get tested. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Risks continue to point for further upside in USD/NOK. Oil is unlikely to rally much further from current levels, even if the OPEC agreement continues. Thus the movements in USD/NOK should be dominated by monetary divergences between the United States and Norway. These are likely to continue to favor the dollar, as the Fed should continue its hawkish tone. Meanwhile the Norges Bank is likely to stay dovish, as their economy has been to be very weak. GDP growth is negative, the output gap is over -2% of GDP and employment and real wages continue to contract. Meanwhile, the high inflation that Norway experiences last year is likely to continue its slowdown, as the effects of the currency depreciation should start to dissipate. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 In past reports, we have argued that the Swedish economy is robust and inflation is picking up. This has been corroborated by strong consumer and business confidence, and high resource utilization and inflation expectations. Recent data has supported this view: Retail sales picked up 2.2% annually; Producer price index was up 8.2% from last year in January; Annual GDP growth came in at 2.3% at the end of last year. Growth and inflation have been supported by expansionary monetary policy. With the Riksbank stating that "there is still a greater possibility that the rate will be cut than... raised in the near future", these conditions are unlikely to falter. Nevertheless, it is important to note that it is this cautionary stance by the Bank that is the reason for the SEK's recent weakness, not fundamentals. It is now the probable case that any upside in the SEK will be noted and limited by the Riksbank, capping the upside on the krona. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

How Long Is The Sweet Spot? Table 1Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update The sweet spot on a baseball bat, scientists find,1 is the small area about two inches (5 cm) long, some six inches from the tip. The sweet spot for global risk assets may not be much bigger. The 22% rise in global equities since February last year has been driven by a "goldilocks" combination of recovering economic activity, quiescent inflation, and still-accommodative monetary policy. But, after such a strong rally, markets must walk a fine line - no slowdown in growth and no surprising tightening of monetary conditions - for prices to rise further. Our analysis suggests that they can, but the risk of a correction is rising. A lot of the better news of the past year has already been priced in. The price-to-sales ratio for U.S. stocks is close to an all-time high, and even the plain-vanilla 12-month forward PE ratio has reached 17.5x, the highest since 2002 (Chart 1). Volatility has fallen to a low level, with the VIX not rising above 12 over the past month, and the S&P500 index going 98 days without a one-day decline of 1% or more, the longest such period since 1995 (Chart 2). To a degree, this is justified by the recent strong pick-up in global growth. Sentiment indicators have accelerated since the election of President Trump, and even hard data is now showing the first signs of recovery (Chart 3) with, for example, U.S. retail sales rising 5.6% year-on-year in January, and core durable goods orders starting to follow the rise in companies' capex intentions (Chart 4). Similar positive economic surprises are visible in Europe, Japan, China and elsewhere. The problem is that further upside surprises are likely to be limited. Regional Fed NowCast surveys for Q1 real GDP growth are already at 2.5-3.1%. Consensus forecasts for S&P500 earnings growth in 2017 look about right at 10.5% but, with a stronger dollar and rising wages, are unlikely to be beaten. Chart 1Historically High Valuations Historically High Valuations Historically High Valuations Chart 2Time For A Pull-Back? Time For A Pull-Back? Time For A Pull-Back? Chart 3Hard Data Starting To Recover Too Hard Data Starting To Recover Too Hard Data Starting To Recover Too Chart 4Orders To Follow Capex Intentions Orders To Follow Capex Intentions Orders To Follow Capex Intentions Headline inflation has picked up (to 2.5% in the U.S. and 1.9% in the Eurozone), mainly because of higher oil prices, but core inflation remains sufficiently under control that central banks don't need to slam on the brakes. The rise in unit labor costs in the U.S. suggests that core PCE inflation will gradually move up to 2% during the year (Chart 5). The latest FOMC minutes revealed that members want a further rate hike "fairly soon", and BCA expects the Fed to raise three times this year (to which the futures market ascribes only a 36% probability). But Fed policy remains very accommodative (Chart 6), the European Central Bank is unlikely to end its asset purchases soon on account of political and banking system concerns, and the Bank of Japan remains committed to its 0% yield target for 10-year government bonds until inflation is well above 2%. Absent a powerful fiscal stimulus in the U.S. or a move by the "hard money" advocates in the Trump administration to change the Fed's modus operandi, we think its unlikely that a tightening of monetary policy will drag down asset prices. Chart 5Labor Costs Putting Pressure On Prices Labor Costs Putting Pressure On Prices Labor Costs Putting Pressure On Prices Chart 6Fed Policy Still Accomodative Fed Policy Still Accomodative Fed Policy Still Accomodative Risks certainly abound. The Trump administration could start a trade war with China. Its proposals for corporate and personal tax cuts could disappoint both in terms of their details and the timing of Congress's passing them. European politics remain a concern, with the probability of Marine Le Pen becoming French President increasing recently (though it remains small). But risk markets tend to rise on a wall of worry. Investor sentiment is not particularly bullish at the moment, with the bull/bear ratio among individual investors barely above 1 (Chart 7) and flows into equity funds in recent months not reversing the outflows of last year (Chart 8). Chart 7Retail Investors Not So Bullish Retail Investors Not So Bullish Retail Investors Not So Bullish Chart 8Equity Flows Are Still Tepid Equity Flows Are Still Tepid Equity Flows Are Still Tepid After a year of a strong cyclical risk-on rally, progress from now on will get tougher. A short-term change of direction is quite possible (and has already happened in some assets, with the yen moving back to 112 and the 10-year Treasury yield to 2.3%). But we expect economic growth to remain robust this year - with U.S. real GDP growth likely to come in close to 3% on the back of surprises in capex - which will push the 10-year Treasury yield above 3% by year-end. In this environment, we continue to favor equities over bonds, and maintain our pro-risk tilt in equity sectors, credit and alternative assets. Equities: U.S. equities have outperformed Eurozone ones by 5% year-to-date, mainly because of worries about Europe's political risk and the fragility of its banking sector. Though we think the political risks are overstated (except perhaps in Italy), we continue to prefer the U.S. in common currency terms because of our expectations of further dollar appreciation and because the lower volatility of the U.S. helps reduce the beta of our recommended portfolio. Emerging markets have outperformed global equities by 3% YTD, mainly on the back of stronger commodities prices. But we remain underweight EM because of the risks from a stronger dollar and rising global rates, concerns about protectionism and debt refinancing, and because of the likelihood that China's rebound will run out of steam over the next 12 months (Chart 9). Fixed Income: Rates have pulled back recently: long-term institutional investors have begun to find attraction in the long end of the U.S. Treasury yield curve at 2-3%, though speculative investors remain short (Chart 10). With the Fed likely to raise rates three times this year, inflation expectations to pick up further, and nominal GDP growth in the U.S. to reach 4.5-5%, we expect the U.S. 10-year yield to rise above 3%. We therefore remain underweight duration and prefer inflation-linked over nominal bonds. In the improving economic environment, we continue to like credit, but find valuations more attractive for investment-grade bonds than for high-yield. Currencies: Dollar appreciation has been on hold since January but we think the long-term trend remains in place because of the probable direction of relative interest rates. Neither Japan nor the Eurozone is likely to move towards monetary tightening over the next 12 months. Even if the Trump administration were to want a weaker dollar, a few tweets would not be enough to offset monetary fundamentals. And, while it is true that sentiment towards the dollar is already bullish, this has historically not precluded further appreciation, for example in the late 1990s (Chart 11). Chart 9EM Equities Correlated With China PMIs EM Equities Correlated With China PMIs EM Equities Correlated With China PMIs Chart 10Divergent Views On U.S. Bonds Divergent Views On U.S. Bonds Divergent Views On U.S. Bonds Chart 11Optimism Need Not Stop USD's Rise Optimism Need Not Stop USD's Rise Optimism Need Not Stop USD's Rise Commodities: The oil price remains close to its equilibrium level at around $55 a barrel, with the OPEC agreement largely holding but being offset by a production increase from the U.S. shale drillers, whose rig count has doubled since last May. We are neutral on industrial commodities: Chinese demand resulting from last year's reflationary policy is likely to be offset by the stronger dollar. Gold remains a useful portfolio hedge in a world of elevated geopolitical worries and inflation tail-risk, but is also negatively correlated with the U.S. dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see, for example, "The Sweetspot of a Hollow Baseball or Softball Bat", by Daniel A. Russell, Pennsylvania State University, available at www.acs.psu.edu/drussell/bats/sweetspot.html Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights U.S. Treasuries - Fair Value: The 10-year U.S. Treasury yield now appears 7 bps expensive on our model. Investors should maintain below-benchmark duration and continue to monitor bullish sentiment toward the U.S. dollar for signals about the breadth of the global economic recovery. U.S. Treasuries - Technicals: Large net short bond positions are in the process of being unwound. A more balanced technical picture removes one of the key impediments to the bond bear market and possibly sets the stage for another leg higher in yields. China: Chinese monetary policy that is sufficiently accommodative to spur economic growth, but not so accommodative that it causes undue strength in the trade-weighted U.S. dollar, is the most bearish outcome for U.S. bonds. Feature Bonds rallied strongly late last week without any obvious economic catalyst. Now that the dust has settled we find the 10-year U.S. Treasury yield trading at 2.34%, 7 bps below our estimate of fair value (Chart 1). Chart 12-Factor U.S. Treasury Model 2-Factor U.S. Treasury Model 2-Factor U.S. Treasury Model Updating Our U.S. Treasury Model That fair value estimate comes from our 2-factor U.S. Treasury model, based on the Global Manufacturing PMI and bullish sentiment toward the U.S. dollar. In our view, these two factors capture the most important macro drivers of U.S. bond yields. Stronger global growth, as proxied by the Global Manufacturing PMI, tends to push yields higher. However, to the extent that stronger global growth coincides with an appreciating U.S. dollar, the amount of monetary tightening that needs to be achieved through higher interest rates is limited. This caps the upside in long-dated U.S. bond yields. Put differently, it is not just the magnitude of the global growth impulse that matters for U.S. bond yields, but also the breadth of the recovery. The more broad-based the recovery, the less upward pressure on the U.S. dollar and the higher U.S. Treasury yields can rise. Last week we received Flash PMI estimates for the U.S., Eurozone and Japan that we can use to estimate the Global PMI for February. According to the Flash estimates, the U.S. PMI declined slightly in February, but this was more than offset by accelerations in both the Eurozone and Japan. Altogether, these three regions account for 48% of the Global PMI and, assuming PMIs in all other countries remain flat, we can calculate that the global PMI will nudge higher from 52.7 in January to 52.9 in February. Of course one month of data is much less important than the longer run trend. Taking a step back, we see that manufacturing PMIs are trending higher in every major economic bloc (Chart 2). Our diffusion index also shows that the global manufacturing recovery is more broadly based than at any time during the past three years (Chart 2, top panel). The synchronized nature of the recovery is also reflected in the behavior of the U.S. dollar, which has not appreciated during the past month even though Fed rate hike expectations have shifted up (Chart 3). The message from the survey of bullish dollar sentiment - the series that is included in our Treasury model - is more mixed. Bullish dollar sentiment plunged from elevated levels in January but has recovered somewhat during the past few weeks (Chart 3, panel 2). Meantime, U.S. Treasury spreads over German bunds and JGBs are also sending mixed signals. Short-maturity spreads have widened alongside increased U.S. rate hike expectations, while long-maturity spreads have been well contained (Chart 3, bottom 2 panels). Chart 2Synchronized Global Recovery Synchronized Global Recovery Synchronized Global Recovery Chart 3Keep Watching The Dollar Keep Watching The Dollar Keep Watching The Dollar Global bond investors should closely monitor trends in the U.S. dollar, bullish sentiment toward the dollar, and U.S. Treasury spreads over bunds and JGBs. Each of these indicators provides information about the breadth of the economic recovery. If Fed rate hike expectations remain firm, or even move higher, and that trend is not matched by a stronger dollar or wider Treasury spreads, then that would signal that the global recovery is becoming more synchronized, suggesting additional upside for bond yields. Bottom Line: The 10-year U.S. Treasury yield now appears 7 bps expensive on our model. Investors should maintain below-benchmark duration and continue to monitor bullish sentiment toward the U.S. dollar for signals about the breadth of the global economic recovery. Chart 4Positioning Becoming More Balanced Positioning Becoming More Balanced Positioning Becoming More Balanced Treasury Technicals Less Stretched This brings us back to last Friday's bond rally. Puzzlingly, the 2-year U.S. Treasury yield declined 6 bps and the 10-year yield fell 7 bps on a day without any significant economic or political news. In fact, Treasury yields managed to decline even though rate hike expectations embedded in the overnight index swap curve were unchanged and the probability of a March rate hike priced into fed funds futures actually increased from 31% to 33%! The unusual disconnect between Treasury yields and rate hike expectations is probably related to the expiry of the March bond futures contracts. Last week, traders had to decide whether to let their March contracts expire or roll them over into June. Positioning data show that speculators carried large net short positions into last week (Chart 4), so it is possible that it was the capitulation of these large short positions that drove yields lower on Friday. More timely data from the skew between payer and receiver swaptions show that swaption investors are no longer betting on rising rates (Chart 4, panel 4). Net speculative positions in Treasury futures could follow suit when the data are released later this week. In addition, our composite sentiment indicator has just recently ticked back above the zero line (Chart 4, panel 2). Bottom Line: Large net short bond positions are in the process of being unwound. A more balanced technical picture removes one of the key impediments to the bond bear market, and possibly sets the stage for another leg higher in yields. China's Bond Market Balancing Act Chart 5Easy Money Spurs Chinese Growth Easy Money Spurs Chinese Growth Easy Money Spurs Chinese Growth In the context of the 2-factor U.S. Treasury model presented above, there are two reasons why developments in China matter for U.S. bond markets. The first is that China accounts for the single largest weighting in the Global Manufacturing PMI, so stronger growth in the Chinese manufacturing sector will pressure bond yields higher, all else equal. But the Chinese economy can also influence U.S. bond yields if changes in the RMB exert meaningful influence on the trade-weighted U.S. dollar. For example, faster Chinese growth pressures U.S. bond yields higher, but some of that upward pressure could be mitigated if that strong growth is engineered through a rapid depreciation of the RMB relative to the U.S. dollar. On the first point, China's manufacturing PMI is in a clear uptrend although the recent contraction in the government's fiscal expenditures is a potential warning sign (Chart 5). Our China Investment Strategy service views the fiscal contraction as a risk but still expects the Chinese economy to remain buoyant this year.1 This is because Chinese monetary conditions remain supportive of further gains in the manufacturing sector, and the rebound in China's PMI that began early last year is more tied to easing monetary conditions - a weaker exchange rate and falling real interest rates - than to increased fiscal spending. On the second point, while a weaker trade-weighted RMB has helped spur the recovery in Chinese manufacturing, the impulse from a weaker RMB has so far not been potent enough to move the needle on the trade-weighted U.S. dollar (Chart 6). From the perspective of U.S. fixed income markets a continuation of this trend would be the most bond-bearish outcome. Chinese monetary policy remains easy enough to spur economic growth but not so easy that it causes the U.S. dollar to spike. For the time being at least, China has been actively selling Treasuries in order to mitigate the extent of its currency depreciation (Chart 7). If China were to suddenly stop selling Treasuries, then the RMB would likely depreciate sharply. This would actually have an ambiguous impact on U.S. Treasury yields since it would probably lead to both a stronger U.S. dollar and faster global growth. Chart 6USD So Far Not Impacted By RMB USD So Far Not Impacted By RMB USD So Far Not Impacted By RMB Chart 7China Is A Treasury Seller China Is A Treasury Seller China Is A Treasury Seller More likely, however, is that China will continue to manage the gradual depreciation of its currency unless it is forced to take more dramatic action in the face of a negative growth shock. Our China Investment Strategy team notes that the annual People's Congress in early March should offer some important clues about the Chinese government's growth priorities and policy direction going forward. Bottom Line: Chinese monetary policy that is sufficiently accommodative to spur economic growth, but not so accommodative that it causes undue strength in the trade-weighted U.S. dollar, is the most bearish outcome for U.S. bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening", dated February 16, 2017, available at cis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy The market has quietly adopted a less cyclical sectoral tone since yearend, a trend that could amplify over the coming months, even if overall appreciation persists. Defense stocks have grown into previously extended valuations, warranting ongoing above-benchmark exposure. The opposite is true for aerospace equities. Data processing shares are more likely to roll over than break out and we recommend paring positions to underweight. Recent Changes S&P Data Processing - Downgrade to underweight from overweight. Table 1 Shifting Internal Dynamics Shifting Internal Dynamics Feature The stock market has cheered the broad-based rebound in earnings and improvement in corporate sector pricing power (Chart 1). Unbridled optimism about growth friendly policy tilts including potential tax reform and select regulatory relief combined with an easing in financial conditions have encouraged investors to make large down payments against expected future profit gains. Indeed, extreme economic and earnings bullishness is evident in record setting price/sales (P/S) multiples: Chart 1 shows that on a median basis, the industry group (P/S) ratio is far above the 2000 peak, providing yet another metric in a long list of yardsticks signaling that greed is the overriding market emotion. Nosebleed valuation levels are cause for significant cyclical concern, but as discussed last week, momentum and a valuation-agnostic transition from fixed income to equities are the dominant tactical forces at the moment. Since it is difficult to reconcile valuations at odds with realistic expectations about future earnings growth, we remain focused on sub-surface positioning to indemnify against disappointment. Since late last year, the market has adopted a more defensive than cyclically-oriented tenor. Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models (Chart 2). Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal (Chart 2). Chart 1Future Growth Has Been Paid For Already Future Growth Has Been Paid For Already Future Growth Has Been Paid For Already Chart 2The Market Tone Is Changing The Market Tone Is Changing The Market Tone Is Changing Contrarians should take note. These nascent trend changes have developed even though economic data have generally surprised on the upside, which may be an indication that a more forceful response will occur once the string of upside surprises loses momentum. The global PMI has been very strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive vs. cyclical stocks (Chart 3). The contraction in U.S. bank lending growth may be heralding slippage in hard economic data (Chart 3), to the benefit of defensive vs. cyclical sectors. Keep in mind that the market is priced for non-inflationary growth nirvana, such that even modest economic disappointment could short circuit the buying binge. The yield curve has stopped widening and financial conditions are no longer easing (Chart 3), providing additional confirmation that the defensive vs. cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend. A trend change is also consistent with the relentless downgrading in emerging market vs. developed country GDP growth expectations (Chart 4). Chart 3Forward Looking Yellow Flags Forward Looking Yellow Flags Forward Looking Yellow Flags Chart 4No EM Confirmation For Cyclicals No EM Confirmation For Cyclicals No EM Confirmation For Cyclicals The lack of a durable and credible growth thrust in EM is confirmed by regional share price performance, as EM equities have significantly lagged their developed country counterparts (Chart 4). Now that China's fiscal stimulus impulse has rolled over amidst ongoing currency depreciation, EM lacks a catalyst for incremental growth outperformance vs. developed markets. Adding it up, evidence of a sub-surface trend change continues to materialize, even in the face of upward momentum in the broad market. We expect a mostly defensive along with select interest rate-sensitive exposure to provide optimal portfolio performance in the next 3-6 months. Defense Stocks Will Continue To Protect Portfolios... A Special Report sent to clients on October 31 outlined the long-term appeal of defense stocks, prior to the installment of a new, bellicose U.S. Administration. If anything, the latter threatens to exacerbate the decline in globalization that was already in progress (as discussed since 2014 by BCA's Geopolitical Strategy Service), potentially creating a leadership vacuum that will raise the specter of open military conflict. More nationalistic foreign policies in a number of countries, i.e. moving away from collaboration and cooperation and toward isolationism and self-sufficiency, is a recipe for increased geopolitical instability. China's challenge to the status quo is also likely to motivate a boost to defense spending globally. The recent World Economic Forum estimates of global military spending by 2030 cite both China and India planning to quadruple military outlays over this time frame (Table 2). The U.S. Administration is already pressuring other NATO members to boost defense spending after a long contraction (Chart 5), which should eventually spillover into rising defense contractor sales. Reportedly, only 5 out of 28 NATO members reached the targeted goal of spending 2% of GDP on defense. Ergo, there is room for an increase, especially in some larger countries with fiscal room to maneuver. More imminently, the conditions that have created the gap between aerospace and defense relative performance are growing even stronger (Chart 6). Table 2A New Arms Race Underway Shifting Internal Dynamics Shifting Internal Dynamics Chart 5Lots Of Upside Lots Of Upside Lots Of Upside Chart 6A Growing Gap A Growing Gap A Growing Gap While U.S. defense spending has been through a soft patch for the past several years, new orders for defense goods have been one of the strongest components of overall durable goods orders (Chart 6). The unfortunate reality is that the incentive to boost defense and security spending has never been higher. Terrorist activity continues to proliferate around the world (Chart 7), raising a sense of geopolitical uncertainty and mistrust. With defense new orders continuing to make new cyclical highs, factory output should run at levels flattering operating margins. Shipments of defense goods are outpacing inventories by a wide margin, which is consistent with solid pricing power. Even exports of military goods are booming (Chart 7), despite the strong U.S. dollar, reflecting a strong undercurrent of global demand. Domestic defense spending has room to expand. Real defense outlays are only just starting to recover (Chart 8). President Trump ran on a campaign to protect the U.S. from terrorism. That should make it comparatively easy to increase defense spending in the years to come. It is normal for defense stocks to retain momentum as defense spending growth accelerates (Chart 8, top panel). Increased staffing at the U.S. Department of Defense (DOD) implies that purse strings may already be loosening in anticipation of heightened activity. DOD employment growth often provides a good leading indication for real defensive spending trends (Chart 8, bottom panel). Thus, while share prices have been on a tear and valuations are not cheap, rapid earnings growth has pushed down forward multiples to manageable, below-market, levels (Chart 9, shown as an average of the companies in the BCA Defense Index). Chart 7Powerful Momentum... Powerful Momentum... Powerful Momentum... Chart 8... With Long-Term Durability ... With Long-Term Durability ... With Long-Term Durability Chart 9Growing Into Valuations Growing Into Valuations Growing Into Valuations Prospects for strong multiyear growth should support a move to a premium valuation as margins expand (Chart 9), similar to what occurred during past defense spending booms, as chronicled in our October 31 Special Report. ...But Aerospace Stocks Are Out Of Fuel In terms of aerospace equities, the outlook is more challenging. New orders have been sinking steadily, reflecting a downturn in the commercial aerospace cycle. While long lead times and lengthy delivery schedules offer some earnings protection, dwindling order backlogs will ultimately undermine confidence in the long-term outlook. Chart 10 shows that aerospace unfilled orders are contracting, an environment typically associated with share price underperformance, or at least elevated volatility. Shipments of aerospace goods are falling, a rare occurrence (Chart 10). The implication is that aerospace industrial production is also shrinking (Chart 10). With a heavily unionized labor force, it will be difficult to maintain profitability. Will increased global growth translate into a recovery in aerospace new orders? Doubtful. Aerospace cycles tend to be long and are not always correlated with the business cycle. Aerospace new order growth has little correlation with the global leading economic indicator. In fact, if anything, it is more countercyclical. Ominously, there are signs of excess capacity. Our global airline consumer price index, a composite of airline pricing power in a number of major countries, is in negative territory. A negative CPI reflects excess capacity, and warns of grim prospects for a recovery in new airplane orders (Chart 11). Chart 10Running On Empty Running On Empty Running On Empty Chart 11Too Much Capacity Too Much Capacity Too Much Capacity Against this backdrop, aerospace profits will become increasingly reliant on maintenance, repair and consumables activity. However, weak pricing power suggests that this source of revenue is soft (Chart 11). Aerospace valuations are close to a par with those of defense stocks. Divergent profit outlooks imply that the latter should expand while the former get squeezed. Bottom Line: We remain confident that the BCA defense index (LMT, GD, RTN, NOC, LLL) will continue to generate above market returns, whereas the BCA aerospace index (BA, UTX, HON, TXT) exhibits asymmetric downside risk. Data Processors Are Losing Their Allure After a consolidation phase that restored value to a more neutral level, we upgraded the S&P data processing index to overweight in late-September, because it fit into our consumption vs. capital spending theme, outperforms in disinflationary environments and would benefit from a recovery in industry sales growth. While several of those factors still exist, the share price ratio has been unable to gain traction and the window for outperformance may be closing. The economic backdrop is no longer conducive to capital inflows. Data processing companies enjoy hefty recurring revenue and high returns on equity, warranting persistent above market valuations (Chart 12). However, the flipside of predictability is lower operating leverage than many other industries and a pattern of underperformance during periods of rising inflation expectations. Indeed, cyclical share price momentum tends to take its cue, inversely, from inflation expectations (inflation expectations shown inverted, middle panel, Chart 12). Renewed traction in global economic growth, as evidenced by the upturn in the global leading economic indicator (GLEI, shown inverted, top panel, Chart 13), represents a headwind to capital inflows and relative multiple expansion. The improvement in business sentiment has also boosted our capital spending model, albeit we are doubtful as to whether increased animal spirits will translate into much of a capital spending cycle in a world of deficient final demand and soft free cash flow. Still, any rise in capital spending would put the services-based data processing group at a disadvantage, in relative terms. The downturn in the ISM services index compared with the ISM manufacturing index reinforces that the external environment has become more challenging (Chart 13). All of these factors could be overcome if operating trends were set to improve. Data processing revenue trends are tightly linked with consumer spending (Chart 14). The personal savings rate has room to fall, facilitating an increase in outlays, particularly now that the labor market has tightened. Rising job security has buoyed consumer confidence, which has historically augured well for data processing sales growth. Chart 12The Window Has Closed The Window Has Closed The Window Has Closed Chart 13Sell Signals Sell Signals Sell Signals Chart 14Margin Squeeze Margin Squeeze Margin Squeeze But top-line growth has been in a funk of late, even with firming pricing power (second panel, Chart 14). Companies have made a significant investment to boost marketing, as evidenced by the surge in SG&A, but so far, this has sapped margins more than stoked revenue. Importantly, Visa has recently provided a fee break to retailers, who are increasingly banding together to put pressure on the industry to lower fees. Amidst increased competition on the payments processing side, this trend is likely to be structural and put downward pressure on profit margins. Thus, we are reluctant to embrace the jump in the producer price index, as future readings could be much weaker. The implication is that operating performance will not overcome macro hurdles. Bottom Line: Reduce the S&P data processing index (V, MA, PYPL, ADP, FIS, FISV, PAYX, ADS, GPN, WU, TSS) from overweight to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In February, the model underperformed global equities and the S&P 500 in USD and local-currency terms. For March, the model slightly increased its allocation to stocks and cut its weighting in bonds (Chart 1). Within the equity portfolio, the allocation to Europe was increased. The model boosted its weightings to French and Australian bonds at the expense of Canadian and Swedish paper. The risk index for stocks, as well as the one for bonds, deteriorated in February. Feature Performance In February, the recommended balanced portfolio gained 2.1% in local-currency terms, and 0.2% in U.S. dollar terms (Chart 2). This compares with a gain of 3% for the global equity benchmark and a 3.3% gain for the S&P 500. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide suggestions on currency risk exposure from time to time. The high allocation to bonds continued to hold back the model's performance. Chart 1Model Weights Model Weights Model Weights Chart 2Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Weights The model increased its allocation to stocks from 53% to 57%, and cut its bond weighting from 47% to 43% (Table 1). Table 1Model Weights (As Of February 23, 2017) Tactical Asset Allocation And Market Indicators Tactical Asset Allocation And Market Indicators The model increased its equity allocation to Dutch and Swedish equities by 4 points each, Germany and New Zealand by 2 points each, and France and Emerging Asia by 1 point each. Weightings were cut in Italy by 4 points, Latin America by 3 points, Spain by 2 points, and Switzerland by 1 point. In the fixed-income space, the allocation to Australia was boosted by 8 points, France by 6 points, and Germany by 4 points. The model cut its exposure to Swedish bonds by 9 points, Canadian bonds by 6 points, U.S. and U.K. bonds by 3 points each, and Kiwi bonds by 1 point. Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The most recent bout of dollar depreciation was halted in February. Our Dollar Capitulation Index is below neutral levels. However, it is not extended, meaning that it does not preclude renewed dollar weakness in the near term. That said, assuming no major negative economic surprises, a relatively more hawkish Fed versus its peers should provide support for the dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation U.S. Trade-Weighted Dollar* And Capitulation U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The risk index for commodities was little changed in February. The model continues to avoid this asset class (Chart 4). The risk index for global equities rose to its highest level since early 2010, mostly on the back of deteriorating value. Despite this, the model slightly increased its allocation to equities (Chart 5). Chart 4Commodity Index And Risk Commodity Index And Risk Commodity Index And Risk Chart 5Global Stock Market And Risk Global Stock Market And Risk Global Stock Market And Risk The rally in U.S. stocks - driven by optimism about the economic outlook - pushed the value component of the risk index into expensive territory. The model kept a small allocation in U.S. equities. A change in the perception about the ability of the new U.S. administration to boost growth remains a risk for this market (Chart 6). The risk index for euro area equities continues to deteriorate. However, it remains lower than its U.S. counterpart. The continued flow of solid economic data and a weaker currency should bode well for euro area stocks, although political uncertainty is a potential headwind (Chart 7). Chart 6U.S. Stock Market And Risk U.S. Stock Market And Risk U.S. Stock Market And Risk Chart 7Euro Area Stock Market And Risk Euro Area Stock Market And Risk Euro Area Stock Market And Risk All three components of the risk index for Dutch equities are close to neutral levels. As a result, despite the recent deterioration in the overall risk index, it remains one of the lowest among the markets the model covers (Chart 8). The risk index for Swedish stocks worsened. However, the model increased its allocation to this bourse. Swedish equities would be a beneficiary of the continued risk-on environment (Chart 9). Chart 8Netherlands Stock Market And Risk Netherlands Stock Market And Risk Netherlands Stock Market And Risk Chart 9Swedish Stock Market And Risk Swedish Stock Market And Risk Swedish Stock Market And Risk The momentum indicator for global bonds is less stretched in February. Meanwhile, despite its latest decline, the cyclical indicator continues to signal that the positive global economic backdrop is firmly bond-bearish. Taken all together, the risk index for bonds deteriorated in February, although it still remains in the low-risk zone (Chart 10). U.S. Treasury yields moved sideways in February as investors await more guidance from the Fed on the timing of the next hike. A bond-negative cyclical indicator coupled with the unwinding of oversold conditions - as per the momentum measure - led to a deterioration in the risk index for U.S. Treasurys. The latter is almost back to neutral levels. The model trimmed the allocation to this asset class (Chart 11). Chart 10Global Bond Yields And Risk Global Bond Yields And Risk Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk U.S. Bond Yields And Risk U.S. Bond Yields And Risk The momentum indicator remains the main driver of the risk index for Canadian bonds. As a result, the less extreme momentum reading translated into an increase in the risk index for this asset class. (Chart 12). The risk index for Australian bonds moved lower in February, reflecting improvements in all three of its components. The model included the relatively high-yielding Aussie bonds in the portfolio. (Chart 13). Chart 12Canadian Bond Yields And Risk Canadian Bond Yields And Risk Canadian Bond Yields And Risk Chart 13Australian Bond Yields And Risk Australian Bond Yields And Risk Australian Bond Yields And Risk The cyclical indicator for euro area bonds is near expensive levels, and the momentum indicator shows heavily oversold conditions. These two measures are offsetting the cyclical one that is sending a bond-bearish message. While the overall risk index for euro area bonds is in the low-risk zone, the country allocation is concentrated in French paper (Chart 14). The risk level for French bonds is seen as low thanks to oversold momentum. French presidential elections are probably the most important political event in Europe this year. Whether the models' heavy allocation to this asset pans out hinges to a certain extent on the reduction of investor anxiety about this political risk (Chart 15). Chart 14Euro Area Bond Yields And Risk Euro Area Bond Yields And Risk Euro Area Bond Yields And Risk Chart 15French Bond Yields And Risk French Bond Yields And Risk French Bond Yields And Risk The 13-week momentum measure for the dollar broke below the zero line, and is currently sitting on its upward-sloping trendline, drawn from the 2010 lows, that has been broken only once before. Meanwhile, the 40-week rate of change measure is still suggesting that the dollar bull market has more legs on a cyclical horizon. Monetary divergences should lend support to the dollar over the cyclical horizon, although the new administration's attempts to talk down the dollar as well as heightened policy uncertainty could translate into more volatility (Chart 16). The weakening trend in the yen hit a snag two months ago, as the 13-week momentum measure reached the lows that previously foreshadowed a consolidation phase after sharp depreciations. This short-term rate-of-change measure has bounced smartly this year reaching a critical level. Meanwhile, the 40-week rate-of-change measure is not warning of a major change in the underlying trend which remains dictated by BoJ's dovish bias (Chart 17). EUR/USD has been gravitating towards 1.05 over the course of February. The short-term rate-of-change measure seems to be holding at the neutral level, while the 40-week rate-of-change measure is in negative territory, but hardly stretched. Political uncertainty has the potential to drive the euro in near term, but the longer-term outlook is mostly a function of the monetary policy divergence between the ECB and the Fed (Chart 18). Chart 16U.S. Trade-Weighted Dollar* U.S. Trade-Weighted Dollar* U.S. Trade-Weighted Dollar* Chart 17Yen Yen Yen Chart 18Euro Euro Euro Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Highlights Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear as the U.S. equity market breaks out and other stock markets test the upside. Technical conditions are stretched and a correction is overdue, but investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. Upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. History shows that the risk of recession increases when the U.S. unemployment rate falls below its full employment level. Nonetheless, for extended "slow burn" expansions like the current one, inflation pressure accumulates only slowly. These late cycle phases can last for years and can be rewarding for equity investors. Stock markets are also benefiting from an earnings recovery from last year's profit recession in some of the major economies. Importantly, it is not just an energy story and is occurring even in the U.S., where companies are dealing with a strong dollar. The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. The probability of a watered-down border tax being passed as part of a broader tax reform package is higher than the market believes. Overall, tax reform should be positive for growth and profits in the medium term, but is likely to cause near-term turbulence in financial markets. Eurozone breakup risk has re-entered investors' radar screen. Most of the political events this year will end up being red herrings. However, we are quite concerned about Italy, where support for the euro is slipping. Our Duration Checklist supports our short-duration recommendation. The FOMC will hike three times this year, while the European Central Bank and the Bank of England will adopt a more hawkish tone later in 2017 (assuming no political hiccups). The policy divergence backdrop remains positive for the U.S. dollar. Technical and valuation concerns will be a headwind, but will not block another 5-10% appreciation. The Trump Administration is very limited in its ability to engineer a weaker dollar. The robust upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation for a signal to trim risk. Feature U.S. equity markets have broken out and stock indexes in the other major markets are flirting with the top end of their respective trading ranges. Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear. The latter is highlighted by the fact that our Complacency-Anxiety Indictor hit a new high for the cycle (Chart I-1). Chart I-1Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability It is disconcerting that there has been no 15-20% equity correction for six years and that technical conditions are stretched. Nonetheless, investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. As we highlight in this month's Special Report, beginning on page 22, upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. The economic and profit data are thus providing stocks with a solid tailwind at the moment. Unfortunately, the noise surrounding the Trump/GOP fiscal policy agenda is no less than it was a month ago. Investors are also dealing with another bout of euro breakup jitters ahead of upcoming elections. While most of the European pressure points will turn out to be red herrings in our view, Italy is worrisome (see below). Investors are also concerned that, even if the geopolitical risks fade and Trump's protectionist proposals get watered down, the U.S. is nearing full employment. This means that any growth acceleration this year could show up in rising U.S. wages, a more aggressive Fed and a margin squeeze. In other words, the benefits of growth could go to Main Street rather than to Wall Street. This month we research past cycles to shed some light on this concern. We remain overweight stocks versus bonds, but are watching Italy's political situation, U.S. core inflation and our leading economic indicators for signs to take profits. On a positive note, we are not concerned that the U.S. is "due" for a recession just because it has reached full employment. Late Cycle Economic And Equity Dynamics Previous economic cycles are instructive regarding the recession and margin pressure concerns. In our December 2016 issue, we presented some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart I-2 and Chart I-3 compare the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. Chart I-2Long Expansion Comparison (I) Long Expansion Comparison (I) Long Expansion Comparison (I) Chart I-3Long Expansion Comparison (II) Long Expansion Comparison (II) Long Expansion Comparison (II) We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart I-2 and Chart I-3). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Some studies have demonstrated that the probability of recession rises once full employment is reached. We agree with this conclusion when looking across all the post-war cycles.1 However, recessions are almost always triggered by Fed tightening into rising inflationary pressures. Such pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed gradually. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat (not shown). Wage growth accelerated in both cases, but healthy productivity growth kept unit labor costs in check. The result was an extended late-cycle phase that allowed profits to continue growing. Earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. Of course, no two cycles are the same. Both the 1980s and 1990s included a financial crisis in the second half that interrupted the Fed's tightening timetable, which likely extended the expansion phases (the 1987 crash and the 1998 LTCM financial crisis). Today, unit labor costs are under control, but wage and productivity growth rates are significantly lower. The implication is that nominal GDP is expanding at a significantly slower underlying pace in this cycle, limiting the upside for top line growth in the coming years. In terms of valuation, stocks are more expensive today than they were in the second half of the 1980s. Stocks were even more expensive in the late 1990s, but that provides little comfort because the market had entered the 'tech bubble' that did not end well. We are not making the case that the current late-cycle phase will be as long or rewarding for equity holders as it was for the two previous slow-burn expansions. Indeed, fiscal stimulus this year could lead to overheating and a possible recession in late 2018 or 2019. Our point is that reaching full employment does not condemn the equity market to flat or negative returns. Indeed, the previous cycles highlight that earnings growth can be decent even with the twin headwinds of narrowing margins and a strengthening dollar. The Earnings Mini-Cycle Another factor that distinguishes the current late-cycle phase from the previous two is that the main equity markets endured an earnings recession last year that did not coincide with an economic recession. Since the mid-1980s, there have been three similar episodes (shaded periods in Chart I-4). Bottom-up analysts failed to see the profit recession coming in each case, such that actual EPS fell well short of expectations set 12 months before (the 12-month forward EPS is shown with a 12-month lag to facilitate comparison). In each case, forward EPS estimates trended sideways while actual profits contracted. Chart I-4Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) This was followed by a recovery in profit growth that eventually closed the gap again between actual and (lagged) 12-month forward EPS. This 'catch up' phase coincided with some multiple expansion and a total return to the S&P 500 of about 8% in the late 1990s and 20% in 2013/14.2 The starting point for the forward P/E is elevated today, which means that double-digit returns may be out of reach. Nonetheless, stocks are likely to outperform bonds on a 6-12 month view. A Bird's Eye View Of The Trump Agenda The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. We have no doubt that some sort of tax bill will be passed in 2017. The GOP faces few constraints to cutting corporate taxes and there is every reason to believe it will occur quickly. The major question is whether a broader tax reform will be passed. Trying to understand all the moving parts to tax reform is a daunting task. In order to simplify things, Table I-1 lists the main policies that are being considered, along with the economic and financial consequences of each. Some policies on their own, such as ending interest deductibility, would be negative for the economy and risk assets. However, the top three items in the table will likely be combined if a broad tax reform package is passed. Together, these three items define a destination-based cash-flow tax, which some Republicans would like to replace the existing corporate income tax. The aim is to promote domestic over foreign production, stimulate capital spending and remove a bias in the tax system that favors imports over exports. Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Perhaps the most controversial aspect is the border-adjustment tax (BAT), which would tax the value added of imports and rebate the tax that exporters pay. We will not get into the details of the BAT here, but interested readers should see two recent BCA reports for more details.3 The implications of the BAT for the economy and financial markets depend importantly on the dollar's response. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. This is because a full dollar adjustment would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field. In reality, much depends on how the Fed and other countries respond to the BAT. We believe the dollar's rise would be less than fully offsetting, but would still appreciate by a non-trivial 10% in the event of a 20% border tax. If the dollar's adjustment is only partially offsetting, then it would have the effect of boosting exports and curtailing imports, thereby adding to GDP growth and overall corporate profits. It would make it more attractive for U.S. multinational firms to produce in the U.S., rather than produce elsewhere and export to the U.S. A partial dollar adjustment would also be inflationary because import prices would rise. The smaller the dollar appreciation, the more inflationary the impact. The result would be dollar strength coinciding with higher Treasury yields, breaking the typical pattern in recent years. The impact on the U.S. equity market is trickier. To the extent that dollar strength is not fully offsetting, then the resulting economic boost will lift corporate earnings indirectly. However, the BAT will reduce after-tax profits directly. One risk is that the FOMC slams the brakes on the economy in the face of rising inflation. Another is that, with the economy already operating close to full employment, faster growth might be reflected in accelerating wage inflation that eats into profit margins. However, our sense is that the labor market is not tight enough to immediately spark cost-push inflation. As noted above, it usually takes some time for wage inflation to get a head of steam once the labor market gap is closed in a slow-burn expansion. Full employment is not a hard threshold beyond which the economy suddenly changes. Moreover, the Phillips curve has been quite flat in this recovery, suggesting that it will require significant levels of excess demand to move the dial on inflation. More likely, a slow upward creep in core PCE inflation will allow the Fed to err on the side of caution. Unintended Consequences There are a number of risks and unintended consequences associated with the border tax. One major drawback of the BAT is that, to the extent that the dollar appreciates, it reduces the dollar value of the assets that Americans hold abroad. We estimate that a 25% appreciation, for example, would impose a whopping paper loss of about 13% of GDP. Moreover, a partial dollar adjustment could devastate the profits of importers, while generating a substantial negative tax rate for exporters. It would also be disruptive to multinational supply chains and to the structure of corporate balance sheets (debt becomes more expensive relative to equity finance). Partial dollar adjustment would also be bad news for countries that rely heavily on exports to the U.S. to drive growth, especially emerging economies that have piled up a lot of dollar-denominated debt. An EM crisis cannot be ruled out. Finally, it is unclear whether or not a border tax is consistent with World Trade Organization Rules. At a minimum, it will be seen as a protectionist act by America's trading partners and could trigger a trade war. President Trump has sent conflicting views on the BAT and there has been a wave of criticism from sectors that will lose from such legislation. However, the House GOP leaders signaled a greater flexibility in drafting the law so as to win over various stakeholders. Our Geopolitical Strategy team believes that Trump will ultimately hew to the Republican Party leadership on tax reform, largely because his protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT. Critics will be won over by the use of carve-outs and/or phased implementation for key imports like food, fuel and clothing. Interestingly, the sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart I-5). Finally, the BAT would raise revenue that can be used to offset the corporate tax cuts, helping to sell the package to Republican deficit hawks. Chart I-5Cuts In Tax Rates Mitigate A New Import Tax Somewhat March 2017 March 2017 But even if the border adjustment never sees the light of day, there will certainly be tax cuts for both corporations and households, along with specific add-ons to deal with concerns like corporate inversions and un-repatriated corporate cash held overseas. An infrastructure plan and cuts to other discretionary non-defense government spending also have a high probability, although the amounts involved may be small. An outsourcing tax has a significant, though less than 50%, chance of occurring in the absence of a border tax. On its own, an outsourcing tax would be negative for growth, profits and equity returns. We place a 50/50 chance on a broad tax reform package that includes the border adjustment. We believe that a broad tax reform package will ultimately be positive for the bottom line for the corporate sector as a whole, although unintended consequences will complicate the path to higher stock prices. Eurozone: Breakup Risk Resurfaces Investors have lots to consider on the other side of the Atlantic as well. The European election timetable is packed and plenty is at stake. Could we see a wave of populism generate game-changing political turmoil in the E.U., as occurred in the U.S. and U.K.? Our geopolitical strategists believe that European risks are largely red-herrings for 2017. Investors are overestimating most of the inherent risks:4 In the Netherlands, the Euroskeptic Party for Freedom is set to capture about 30 out of 150 seats in the March election. However, that is not enough to win a majority. Dutch support for the euro is at a very high level, while voters lack confidence in the country's future outside of the EU. Support for the euro is also elevated in France, limiting the chance that Le Pen will win the upcoming presidential election. Even if she is somehow elected, it is unlikely that she would command a majority of the National Assembly. Exiting the Eurozone and EU would necessitate changing the constitution, possibly requiring a referendum that Le Pen would likely lose. That said, these constraints may not be clear to investors, sparking a market panic if Le Pen wins the election. The German public is not very Euroskeptic either and anti-euro parties are nowhere close to governing. Markets may take a Merkel loss at the hands of the SPD negatively at first. However, the new SPD Chancellor candidate, Martin Schulz, is even more supportive of the euro than Merkel and he would be less insistent on fiscal austerity in the Eurozone. A handover of power to Schulz would ultimately be positive for European stocks. The Catlan independence referendum in September could cause knee-jerk ripples as well. Nonetheless, without recognition from Spain, and no support from EU and NATO member states, Catlonia cannot win independence with a referendum alone. Greece faces a €7 billion payment in July, by which time the funding must be released or the government will run out of cash. The IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. If a crisis emerges, the likely outcome would be early elections. While markets may not like the prospect of an election, the pro-euro and pro-EU New Democratic Party (NDP) is polling well above SYRIZA. The NDP would produce a stable, pro-reform government that would be positive for growth and financial markets. It is a different story in Italy, where an election will occur either in the autumn or early in 2018. Support for the common currency continues to plumb multi-decade lows, while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart I-6 and Chart I-7). Euroskeptic parties are gaining in popularity as well. The possibility of a referendum on the euro, were a Euroskeptic coalition to win, would obviously be very negative for risk assets in Europe and around the world. Chart I-6Italians Turning Against The Euro Italians Turning Against The Euro Italians Turning Against The Euro Chart I-7Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU The implication is that most of the risks posed by European politics should cause no more than temporary volatility. The main exception is Italy. We will be watching the Italian polls carefully in the coming months, but we believe that the widening in French/German bond spreads presents investors with a short-term opportunity to bet on narrowing.5 Bond Bear Market Is Intact These geopolitical concerns and uncertainty over President Trump's policy priorities put the cyclical bond bear market on hold early in the New Year, despite continued positive economic surprises. Even Fed Chair Yellen's hawkish tone in her recent Congressional testimony failed to move long-term Treasury yields sustainably higher, after warning that "waiting too long to remove accommodation would be unwise." In the money markets, expectations priced into the overnight index swap curve have returned to levels last seen on the day of the December 2016 FOMC meeting (Chart I-8). The market is priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. March is too early to expect the next FOMC rate hike. One reason is that core PCE inflation has been stuck near 1.7% and we believe it will rise only slowly in the coming months. Even though the strong January core CPI print seemed to strengthen the case for a March hike, the details of the report show that only a few components accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in negative territory, inflation may even soften temporarily in the coming months. This would take some heat off of the FOMC (Chart I-9). Chart I-8Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Chart I-9U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily Second, Fed policymakers will want to see how the Trump policy agenda shakes out in the next few months before moving. We still expect three rate hikes this year, beginning in June. The stance of central bank policy is on our Duration Checklist, as set out by BCA's Global Fixed Income Strategy service (Table I-2). We will not go through all the items on the checklist, but interested readers are encouraged to see our Special Report.6 Table I-2Stay Bearish On Bonds March 2017 March 2017 Naturally, leading and coincident indicators for global growth feature prominently in the Checklist. And, as we highlight in this month's Special Report, a synchronized global growth acceleration is underway that is broadly based across economies, consumer and business sectors, and manufacturing and services industries. Our indicators for private spending suggest that real GDP growth in the major countries accelerated sharply between 2016Q3 and the first quarter of 2017, to well above a trend pace. In the Euro Area, jobless rate has been declining quickly and reached 9.6% in January, the lowest level in nearly eight years. Even if economic growth is only 1½% in 2017 (i.e. below our base case), the unemployment rate could reach 9% by year-end, which would be close to full employment. Core inflation already appears to be bottoming and broad disinflationary pressures are abating. When the ECB re-evaluates its asset purchase program around the middle of this year, policymakers could be faced with rising inflation and an economy that has exhausted most of its excess slack. At that point, possibly around September, ECB members will begin to hint that the asset purchases will be tapered at the beginning of 2018. Moreover, the annual growth rate of the ECB's balance sheet will peak by around mid-year and then trend lower (Chart I-10). This inflection point, along with expectations that the ECB will taper further in 2018, will place upward pressure on both European and global bond yields. The Bank of England (BoE) may become more hawkish as well. At the February BoE meeting, policymakers re-iterated that they are willing to look through a temporary overshoot of the inflation target that is related to pass-through from the weak pound and higher oil prices. However, the BoE has its limits. The Statement warned that tighter policy may be necessary if wage growth accelerates and/or consumer spending growth does not moderate in line with the BoE's projection. In the absence of Brexit-related shocks, the BoE is unlikely to see the growth slowdown it is expecting, given healthy Eurozone economic activity and the stimulus provided by the weak pound. Investors should remain positioned for Gilt underperformance of global currency-hedged benchmarks (Chart I-11). Chart I-10Bond Strategy And ##br## The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Chart I-11Gilts To Underperform Gilts To Underperform Gilts To Underperform Outside of central bank policy, a majority of items on the Duration Checklist are checked at the moment, indicating that investors with a 3-12 month view should maintain below-benchmark duration within bond portfolios. That said, technical conditions are a headwind to higher yields in the very near term. Oversold conditions and heavy short positioning suggest that yields will have a tough time rising quickly as the market continues to consolidate last year's sharp selloff. Can Trump Force Dollar Weakness? Chart I-12Trump Can't Weaken ##br## Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long The U.S. dollar appears to have recently decoupled from shifts in both nominal and real interest rate differentials this year (Chart I-12). The dollar is expensive, but we do not believe that valuation is a barrier to an extended overshoot given the backdrop of diverging monetary policies between the U.S. and the other major central banks. The dollar's recent stickiness appears to be driven by recent comments from the new Administration that the previous 'strong dollar' policy is a relic of the past. Let us put aside for the moment the fact that expansionary fiscal policy, higher import tariffs and/or a border tax would likely push the dollar even higher. "Tweeting" that the U.S. now has a 'weak dollar' policy will have little effect beyond the near term. A lasting dollar depreciation would require changes in the underlying macro fundamentals and policies. President Trump would have to do one of the following: Force the Fed to ease policy rather than tighten. However, the impact may be short-lived because accelerating inflation would soon force the Fed to tighten aggressively. Convince the other major central banks to tighten their monetary policies at a faster pace than the Fed (principally, the People's Bank of China, the BoJ, the ECB, Banco de Mexico, and the Bank of Canada). Again, the impact on the dollar would be fleeting because premature tightening in any of these economies would undermine growth and investors would conclude that policy tightening is unsustainable. Convince these same countries to implement very expansionary fiscal policies. This has a better chance of sustainably suppressing the dollar, but foreign policy would have to be significantly more stimulative than U.S. fiscal policy. The U.S. Administration will not be able to force the Fed's hand or convince other countries to change tack. President Trump has an opportunity to stack the FOMC with doves if he wishes next year, given so many vacant positions. Nonetheless, Trump's public pronouncements on monetary policy have generally been hawkish. It will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans would likely resist. This means that the path of least resistance for the dollar remains up. Dollar valuation is stretched and market technicals are a headwind to the rally. However, valuation signals in the currency market have a poor track record at making money on a less than 2-year horizon. The dollar is currently about 8% overvalued by our measure, which is far from the 20-25% overvaluation level that would justify short positions on valuation grounds alone (Chart I-13). What is more concerning for dollar bulls is that there is near universal unanimity on the trade. Nonetheless, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-14). Moreover, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. We believe that the dollar will appreciate by another 5-to-10% in real trade-weighted terms by the end of the year, despite lopsided market positioning. The appreciation will be even greater if a border tax is implemented. Chart I-13Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Chart I-14In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right Conclusions Many investors, including us, have been expecting an equity market correction for some time. But the longer that the market goes without a correction, the "fear of missing out" forces more investors to throw in the towel and buy. This market backdrop means that now is not the best time to commit fresh money to stocks, but we would not recommend taking profits either. On a positive note, the U.S. economy is not poised on the edge of recession just because it has reached full employment. Indeed, a synchronized growth acceleration is underway across the major countries that is broadly based across industries. Inflationary pressure is building only slowly in the U.S., which gives the Fed room to maneuver. Moreover, the Trump Administration has not labelled China a currency manipulator, and has sounded more conciliatory toward NATO and the European Union in recent days. This is all good news, but the direction of U.S. fiscal policy remains highly uncertain. Moreover, investors must navigate a host of geopolitical landmines in Europe this year, most important of which is an Italian election that may occur in the autumn. The ECB and the BoE will likely become more hawkish in tone later this year. The impressive upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier for risk assets in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation among other factors for a signal to trim risk. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Overweight Eurozone government bonds relative to the U.S. and U.K. in currency-hedged portfolios. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks versus bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues, but stay underweight high-yield where value is very stretched. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. We are bullish on oil prices in absolute terms on a 12-month horizon, and recommend favoring this commodity relative to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst February 23, 2017 Next Report: March 30, 2017 1 Indeed, this must be true by definition. 2 The S&P 500 contracted during 1987 because of the market crash. 3 Please see BCA Global Investment Strategy "U.S. Border Adjustment Tax: A Potential Monster Issue for 2017," dated January 20, 2017. Also see: BCA Geopolitical Strategy "Will Congress Pass The Border Adjustment Tax?", dated February 8, 2017. 4 Please see Global Political Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017. 5 Please see Global Political Strategy Special Report, "Our Views On French Government Bonds," dated February 7, 2017. 6 Please see Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017. II. Global Growth Pickup: Fact Or Fiction? Risk assets have discounted a lot of good economic news. There is concern that the growth impulse evident in surveys of business activity and confidence has been slow to show up clearly in the "hard" economic data related to final demand. If the optimism displayed in the survey data is simply reflecting "hope" for less government red tape, tax cuts and infrastructure spending in the U.S., then risk assets are highly vulnerable to policy disappointment. After a deep dive into the economic data for the major countries, we have little doubt that a tangible growth acceleration is underway. Momentum in job creation has ebbed, but retail sales, industrial production and capital spending are all showing more dynamism in the advanced economies. Evidence of improving activity is broadly-based across countries and industrial sectors (including services). Orders and production are gaining strength for goods related to both business and household final demand. Inventory rebuilding will add to growth this year, but this is not the main story. The energy revival is not the main driver either. Indeed, energy production has lagged the overall pick-up in industrial production growth. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our models, based largely on survey data, point to a significant acceleration in G7 real GDP growth in early 2017. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. A return of animal spirits could prolong a period of robust growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts. This economic backdrop is positive for risk assets and bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this current cyclical upturn will be any more resilient and enduring than previous mini-cycles in this lackluster expansion. Much depends on U.S. policy and European politics in 2017. The so-called Trump reflation trades lost momentum in January, but the dollar and equity indexes are on the rise again as we go to press. A lot of recent volatility is related to the news flow out of Washington, as investors gauge whether President Trump will prioritize the growth-enhancing aspects of his policy agenda over the ones that will hinder economic activity. Much is at stake because it appears that risk assets have discounted a lot of good economic news. Investors have taken some comfort from the fact that leading indicators are trending up across most of the Developed Markets (DM) and Emerging Markets (EM) economies. In the major advanced economies, only the Australian leading indicator is not above the boom/bust mark and rising. Our Global Leading Economic Indicator is trending higher and it will climb further in the coming months given that its diffusion index is well above 50 (Chart II-1). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook (although the former ticked down in February). Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart II-2). The improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Surveys (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. Chart II-1A Consistent, Positive ##br## Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Chart II-2Surging Confidence, ##br## Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. Could it be that the bounce in confidence is simply based on faith that U.S. fiscal policy will be the catalyst for a global growth acceleration? Could it be that, beyond this hope, there is really nothing else to support a brighter economic outlook? Is it the case that the improved tone in the survey data only reflects the end of an inventory correction and a rebound in energy production? If the answer is 'yes' to any of these questions, then equity and corporate bond markets are highly vulnerable to U.S. policy disappointment. This month we take deep dive into the economic data for the major economies. The good news is that there is more to the cyclical upturn than hope, inventories or energy production. The improved tone in the forward-looking data is now clearly showing up in measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, the bad news. There has been a worrying loss of momentum in job creation, although the data releases lag by several months in the U.K. and the Eurozone, making it difficult to get an overall read on payrolls into year-end (Charts II-3 and II-4).1 Job gains have accelerated in recent months in Japan, Canada and Australia. The payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart II-3Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Chart II-4Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) On the positive side, households are opening their wallets a little wider according to the retail sales data (Chart II-5 and Chart II-6). Year-over-year growth of a weighted average of nominal retail sales for the major advanced economies (AE) has accelerated to about 3%, and the 3-month rate of change has surged to 8%. Sales growth has accelerated sharply in all the major economies except Australia. The retail picture is less impressive in volume terms given the recent pickup in headline inflation, but the consumer spending backdrop is nonetheless improving. The major exception is the U.K., where inflation-adjusted retail sales have lost momentum in recent months. Chart II-5On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) Chart II-6On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart II-7). Order books began to fill up in the second half of 2016 and the year-over-year growth rate appears headed for double digits in the coming months. The pickup is fairly widespread across industries in Germany and the U.S., although less so in Japan. The acceleration of imported capital goods for our 20 country aggregate corroborates the stronger new orders reports (Chart II-7, bottom panel). Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across most of the major advanced economies (Chart II-8 and Chart II-9). Chart II-7Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Chart II-8...Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn Chart II-9Global Manufacturing Upturn Global Manufacturing Upturn Global Manufacturing Upturn The fading of the negative impacts of the oil shock and last year's inventory correction are playing some role in the manufacturing rebound, but there is more to it than that. The production upturn is broadly-based across sectors in Japan and the U.K., although less so in the Eurozone and the U.S. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart II-10). Interestingly, energy-related production is not a driving force. Indeed, energy production is lagging the overall improvement in industrial output growth, even in the U.S. where the shale oil & gas sector is tooling up again (Chart II-11). Chart II-10A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration Chart II-11Energy Is Not The Main Driver Energy Is Not The Main Driver Energy Is Not The Main Driver The Boost From Inventories And Energy Some inventory rebuilding will undoubtedly contribute to the rebound in industrial production and real GDP growth in 2017. The inventory contribution has been negative for 6 quarters in a row for the major advanced economies, which is long for a non-recessionary period (Chart II-12). We estimate that U.S. industrial production growth will easily grow in the 4-5% range this year given a conservative estimate of manufacturing shipments and a flattening off in the inventory/shipments ratio (which will require some inventory restocking; Chart II-13). Chart II-12Global Inventory Correction Is Over Global Inventory Correction Is Over Global Inventory Correction Is Over Chart II-13U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish Nonetheless, the inventory cycle is not the main story for 2017. The swing in inventories seldom contributes to annual real GDP growth by more than a tenth of a percentage point for the major countries as a whole outside of recessions. Moreover, inventory swings generally do not lead the cycle; they only reinforce cyclical upturns and downturns in final demand. U.S. industrial production growth this year will undoubtedly exceed the 4-5% rate discussed above because that estimate does not include a resurgence of capital spending in the energy patch. BCA's Energy Sector Strategy service predicts that energy-related capex will surge by 40% in 2017, largely in the shale sector (Chart II-13, bottom panel). Even if energy capital spending outside the U.S. is roughly flat, as we expect, this would be a major improvement relative to the 15-20% contraction last year. According to Stern/NYU data, energy-related investment spending currently represents about a quarter of total U.S. capital spending.3 Thus, a 40% jump in energy capex would boost overall U.S. business investment in the national accounts by an impressive 10 percentage points. This is a significant contribution, but at the moment the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. Soft Survey Data Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey all include measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. We analyzed a wide variety of survey data and combined the ones that best lead (if only slightly) consumer and capital spending into indicators of private final demand (Chart II-14 and Chart II-15). A wide swath of confidence and survey data are rising at the moment, with few exceptions. Moreover, the improvement is observed in both the manufacturing and services sectors, and for both households and businesses. We employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart II-16). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter, from 1½% in 2016 Q3. We expect growth of close to 3% in the U.S. and about 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 1.7% in the first quarter based on these indicators. Chart II-14Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Chart II-15...Our Capex Indicators Too ...Our Capex Indicators Too ...Our Capex Indicators Too Chart II-16Real Growth To Accelerate Real Growth To Accelerate Real Growth To Accelerate The outlook is less impressive for the U.K. While the survey data have revealed the biggest jump of the major countries in recent months, this represents a rebound from last years' Brexit-driven plunge. Nonetheless, current survey levels are consistent with continued solid growth. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Infrastructure spending in the state-owned sector is slowing, but overall industrial capital spending growth has turned up because of private sector activity. An easing in monetary conditions last year is lifting growth and profitability which, in turn, is generating an incentive for the business sector to invest. There are also budding signs of recovery in housing-related investment. Stronger Chinese capital spending in 2017 will encourage imports and thereby support activity in China's trading partners, particularly in Asia. Will The Growth Impulse Have Legs? The cyclical dynamics so far appear a lot like the rebound in global growth following the 2011/12 economic soft patch and inventory correction (Chart II-17). That mini cycle was caused by a second installment of the Eurozone financial crisis. The damage to confidence and the tightening in financial conditions sparked a recession on the European continent and a loss of economic momentum globally. The financial situation in Europe began to improve in 2013. Consumer spending growth in the major advanced economies was the first to turn up, followed by capital spending, industrial production and, finally, hiring. Then, as now, the upturn in the surveys led the hard data. Unfortunately, the growth surge was short-lived because the 2014/15 collapse in oil prices undermined confidence and tightened financial conditions once again. The result was a manufacturing recession and inventory correction in 2016. There are reasons to believe that the cyclical upturn will have legs this time. It is good news that the growth impetus is observed in both the manufacturing and service sectors, and that it is widespread across the major advanced economies. Fiscal policy will likely be less restrictive this year than in 2014/15, and our sense is that some of the lingering scar tissue from the Great Recession is beginning to fade. The latter is probably most evident in the case of the U.S.; a Special Report from BCA's U.S. Investment Strategy service highlighted that the U.S. expansion has become more self-reinforcing.4 In the U.S. business sector, it appears that "animal spirits" have been stirred by the promise of less government red tape, lower taxes and protection from external competitive pressures. Regional Fed surveys herald a surge in capital spending plans in the next six months (Chart II-18). The rebound in corporate profitability also bodes well for capital spending. Chart II-17Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Chart II-18...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now Conclusions: We have little doubt that a meaningful global growth acceleration is underway. It is possible that consumer and business confidence measures are contaminated by hopes of policy stimulus in the U.S., but there is widespread verification from survey data of current spending that real final demand growth accelerated in 2016Q4 and 2017Q1. In terms of the hard data, evidence of improving manufacturing output and capital spending is broadly-based across industrial sectors and countries, suggesting that there is more going on than the end of an inventory correction and energy rebound. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, which would be positive for risk assets and the dollar, but bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles in this lackluster expansion. The economy may be just as vulnerable to shocks as was the case in 2014. As discussed in the Overview, there are numerous risks that could truncate the economic and profit upswing. On the U.S. policy front, tax cuts and some more infrastructure spending would be positive for risk assets on their own. However, the addition of the border tax or the implementation of other trade restrictions would disrupt international supply chains, abruptly shift relative prices and possibly generate a host of unintended consequences. And in Europe, markets have to navigate a minefield of potentially disruptive elections this year. Any resulting damage to household and business confidence could short-circuit the upturn in growth. For now, we remain overweight equities and corporate bonds relative to government bonds in the major countries, but political dynamics may force a shift in asset allocation as we move through the year. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Note that where only non-seasonally adjusted data is available, we have seasonally-adjusted the data so that we can get a sense of short-term momentum via the annualized 3-month rate of change. 2 Machinery orders used for Japan. 3 Please see http://www.stern.nyu.edu/ 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017. III. Indicators And Reference Charts The breakout in the S&P 500 over the past month has further stretched valuation metrics. The Shiller P/E is very elevated, and the price/sales ratio is almost back to the tech bubble peak. However, our composite valuation indicator is still slightly below the one sigma level that marks significant overvaluation. This composite indicator comprises 11 different measures of value. The monetary indicator is slightly negative, but not dangerously so for stocks. Technical momentum is positive, although several indicators suggest that the equity rally is stretched and long overdue for a correction. These include our speculation indicator, composite sentiment and the VIX. Forward earnings estimates are still rising, although it may be a warning sign that the net earnings revisions ratio has rolled over. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The WTP indicators have turned up for the Japanese, Eurozone and U.S. markets, although only the latter is sending a particularly bullish message at the moment. The U.S. WTP has risen above the 0.95 level that historically provides the strongest bullish signal for the stock-to-bond total return ratio. The WTP indicator suggests that, after loading up on bonds last year, investors still have "dry powder" available to buy stocks as risk tolerance improves. Bond valuation is roughly unchanged from last month at close to fair value, as long-term yields have been stuck in a trading range. The Treasury technical indicator suggests that oversold conditions have not yet been fully unwound, suggesting that the next leg of the bear market may take some time to develop. The dollar is extremely expensive based on the PPP measure shown in this section. However, other measures suggest that valuation is not yet at an extreme (see the Overview). Technically overbought conditions are still being unwound according to our dollar technical indictor. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights The Fed & Yields: Positive U.S. growth and inflation momentum is maintaining the credibility of the Fed's 2017 rate hike plans. U.S. bond yields, in particular, and global yields, in general, will remain under upward pressure in this environment, despite the aggressive short positioning in the U.S. Treasury market. Maintain a below-benchmark portfolio duration stance. "Soft" vs. "Hard" Data: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The cyclical outlook Down Under has become murkier of late, even with the RBA starting to shift in a more hawkish direction. We are taking profits on our recommended pro-growth tilts in Australia. Feature The positive momentum on global growth continues to put upward pressure on bond yields, despite the large short positioning already in place in the government bond markets. The benchmark 10-year U.S. Treasury yield returned to 2.5% at one point last week, led by a rash of better-than-expected data on U.S. retail sales and inflation, combined with hawkish comments from numerous Fed officials (Chart of the Week). Markets started to more seriously consider a March Fed rate hike, although we still see June as the more likely date for the Fed's next tightening move. As we have discussed in several recent reports, it is a surge in global economic survey data that suggests that a broad-based upturn currently underway. While this is all good news for risk assets, there is some concern among investors that a pick-up in growth has been slow to appear clearly in the "hard" economic data related to final demand. Without a boost in actual economic activity, and not just "feel good" surveys, the pro-growth momentum currently embedded in equity and bond markets may melt away as rapidly as it was built up. Mark McClellan, the Chief Strategist at BCA's flagship publication, The Bank Credit Analyst, is releasing a report this week that digs into the differences between "soft data" (i.e. surveys) and "hard data" (i.e. employment and production).1 We present some excerpts from that report in the following section. Global Growth Pickup: Fact Or Fiction? Investors have taken some comfort from the fact that leading indicators are trending up across most of the developed and emerging economies. BCA's Global Leading Economic Indicator is moving higher and will climb further in the coming months given that its diffusion index is well above 50 (Chart 2). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook. Chart of the WeekNo Bond-Bearish Data In The U.S. No Bond-Bearish Data In The U.S. No Bond-Bearish Data In The U.S. Chart 2A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart 3). Importantly, the improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Indices (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. The good news is that there is more to the cyclical upturn than hope. The improved tone in the forward-looking data is now clearly showing up in some measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, we start with some bad news. There has been a worrying loss of momentum in job creation in recent months (Chart 4). While employment gains have accelerated in Japan, Canada and Australia, the payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart 3Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit Chart 4Global Employment Growth Cooling Off Global Employment Growth Cooling Off Global Employment Growth Cooling Off Also on the positive side, households are opening their wallets a little wider according to the retail sales data (Chart 5), where growth has accelerated sharply in all the major economies except U.K. and Australia (NOTE: we discuss the Australian bond outlook later in this Global Fixed Income Strategy report). Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart 6). The acceleration of imported capital goods for our 20-country global aggregate corroborates the stronger new orders reports (bottom panel). Chart 5On Your Mark, Get Set, Shop!! On Your Mark, Get Set, Shop!! On Your Mark, Get Set, Shop!! Chart 6Global Capex Cycle Turning Positive Global Capex Cycle Turning Positive Global Capex Cycle Turning Positive Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across all of the major advanced economies (Chart 7). Production growth has been particularly robust in the Eurozone, U.K. and Japan. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart 8). Chart 7A Global Manufacturing Upturn A Global Manufacturing Upturn A Global Manufacturing Upturn Chart 8A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration At the moment, the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. The Soft Data Chart 9Global GDP Growth Is Accelerating Global GDP Growth Is Accelerating Global GDP Growth Is Accelerating Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that President Trump's election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey are all measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. To test the reliability of the growth message from the "soft data", we employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart 9). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter of 2017. We expect growth of close to 3% in the U.S. and a little over 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 2% in the first quarter based on these indicators. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Stronger Chinese capital spending in 2017 will boost imports and thereby support activity in China's trading partners, particularly in Asia. Conclusions We have little doubt that a meaningful global growth acceleration is underway. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. American CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts or trade wars. This economic backdrop is positive for risk assets and bearish for government bonds. Bottom Line: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The Equation Gets More Complicated Two weeks ago, the Reserve Bank of Australia (RBA) unsurprisingly left its cash rate unchanged at 1.5%. The post-meeting statement by RBA Governor Philip Lowe was considered hawkish by economic analysts. Nonetheless, the market reaction has been relatively muted, with the Australian government bond yield curve steepening by only 5 bps, and the Aussie dollar remaining stable, since the meeting. Pricing in the OIS curve suggests that the RBA will probably remain on hold throughout 2017, but the implied odds of a rate hike are rising, standing now at 20%. The RBA's assessment of the current global economic backdrop was relatively constructive, pointing to above-trend growth expectations in a number of advanced economies. Domestically, the RBA foresees a boost to Australian export growth from the resource sector, an end to the decline in mining investment and a pick-up in non-mining capital spending.3 With such a tone, the central bank might have set up the market for some disappointments. The new forecast of economic growth around 3% for the next couple of years seems overly optimistic. This is higher than the median expectation of economists surveyed by Bloomberg, who foresee 2.5% and 2.8% growth for 2017 and 2018, respectively. The IMF does not expect growth to reach 3% until 2019. Granted, several parts of the economy have shown very robust performances of late. The service sector PMI has surged to pre-crisis levels. The NAB survey of business conditions also shot higher last week. Goods exports have exploded at a 40% annual growth rate, causing the December trade balance to jump to $3.5bn, nearly double the consensus $2.0bn estimate (Chart 10). Those jumps in activity are hard to ignore. From a big picture perspective, however, Australian economic data has not been surprising to the upside, unlike the trend in in the rest of the world over the past few months (Chart 11). This is intriguing, since an easy monetary policy, loose bank credit conditions, improving profit expectations and a reflationary impulse coming from China were all tailwinds that should have supported Australian growth; this was our view last year.4 Now, those favorable factors have started to reverse, raising the chances of a cyclical economic downturn. Chart 10Surging Numbers Surging Numbers Surging Numbers Chart 11Surprisingly Unsurprising Surprisingly Unsurprising Surprisingly Unsurprising Foremost, overall labor market conditions are uninspiring (Chart 12): Although the monthly employment change for January did positively surprise, at 13.3k versus an expected 10k, the pace of job creation remains under 1% year-over-year, which is low by historical standards. The diverging trend between plunging full-time and steady part-time job growth indicates a sub-optimal labor market. The labor force participation rate declined from 65.2 to 64.6 in 2016, suggesting an increasing amount of discouraged workers. Underemployment has not budged in the last two years and is stuck at historically high levels. As result, a rise in labor market slack poses a risk for the Australian consumer; wage growth has already been in a downtrend since 2011 (Chart 12, bottom panel). The construction sector further confirms our apprehensions on the true strength of the economy. Households believe that it is not a good time to buy a home, while building approvals for new dwelling units fell from bubbly levels at the end of last year. At the same time, speculative money, which was supposed to have been curbed by macroprudential policy measures, has returned to the housing market (Chart 13). Lower supply and increased speculation could push residential prices even higher, inflating debt burdens, and leaving households with fewer dollars to consume. Chart 12Consumption: Set To Deteriorate Consumption: Set To Deteriorate Consumption: Set To Deteriorate Chart 13The Foundations Are Shaking The Foundations Are Shaking The Foundations Are Shaking Externally, the Chinese reflationary mini-boom - which boosted the prices of iron ore and other commodities exported by Australia last year - will probably retreat to some extent in 2017. Although China's overall cyclical momentum remains solid, according to our GFIS China Checklist,5 government spending growth has severely relapsed, potentially signaling an end to last year's largesse (Chart 14). With that in mind, it has become difficult to envision a continuation of the positive effects from the terms of trade shock experienced by Australia in 2016. In a similar vein, but domestically-driven, Australia's credit growth has become a headwind. Between 2013 and 2015, business credit growth was expanding, creating a positive impulse for the economy. Unfortunately, this trend changed tack in 2016, with slowing credit growth now representing a negative economic force (Chart 15). With Australian banks having suffered declining profits and rising bad debt charges in the last few quarters, credit conditions could tighten going forward. This is especially worrisome since personal credit was already contracting in 2016. Chart 14China Mini-Boom Could Be Over China Mini-Boom Could Be Over China Mini-Boom Could Be Over Chart 15Negative Credit Impulse Negative Credit Impulse Negative Credit Impulse top of all this, the IMF is projecting that Australia's fiscal thrust - the change in the primary government budget balance - will be negative in each of the next five years (Chart 16). As such, this economy could run out of supporting impulses in the short to medium term. Summing it all up, we agree with the current market pricing of interest rates, given the economic uncertainties. The RBA will most likely remain on hold for the foreseeable future. The story remains the same; the central bank wants to depreciate the overvalued Aussie dollar, but excesses in the housing market prevent them from weakening the currency through interest rate cuts (Chart 17). Now, the declining cyclical outlook will only complicate the equation. Chart 16Negative Fiscal Impulse Negative Fiscal Impulse Negative Fiscal Impulse Chart 17The RBA Has Little Room To Maneuver The RBA Has Little Room To Maneuver The RBA Has Little Room To Maneuver Investment Implications Our updated and more balanced economic view of Australia leads us to neutralize our recommended pro-growth Australia bond tilts: Asset allocation. As discussed above, the previously favorable factors supporting the Australian economy are progressively reversing. This is not the case in most of the other bond markets where additional cyclical upward pressure on global yields is anticipated. To reflect this view, today we are upgrading our recommended Australian bond exposure to neutral, from below-benchmark, within global hedged bond portfolios. This underweight position produced +188bps of excess return versus the global benchmark since inception in June 2016. Duration. The 10-year Australian government bond yield, 1-year forward, is 3.04%, 25bps above the current yield of 2.79%. There is a good chance that yields will rise at a faster pace than implied by the forwards at times over the course of the year, given the improving global growth and inflation backdrop. However, these instances will be opportunities to extend duration within dedicated Australian fixed income portfolios. Current Australian government bond valuation has become very cheap and is now at a level that has been associated with the beginning of positive absolute performance in the past. Moreover, the 10-year inflation breakeven is already pricing in a fair amount of inflation increases; those expectations will be hard to surpass, especially considering the low starting point (Chart 18). Curve. In May 2016, we initiated an Australian butterfly curve trade, going long the 2-year/6-year barbell versus the 4-year bullet. At the time, the 2/4/6 part of the government bond yield curve was kinked, with the 4-year sector trading very expensive versus the 2-year and 6-year maturities, reflecting the perception of a dovish stance by the RBA. then, the market has priced out these rate cut expectations, as we expected, and this part of the curve has bear steepened (Chart 19). Today, we close this trade at a +36bps profit. The RBA's future potential actions - or, more likely, inaction - are now properly discounted in the curve and reflect our neutral stance on the RBA. Chart 18Time To Buy Australian Bonds Time To Buy Australian Bonds Time To Buy Australian Bonds Chart 19Taking Profits On Our 2/4/6 Butterfly Trade It's Real Growth, Not Fake News It's Real Growth, Not Fake News Credit trades. Developing economic uncertainties warrant more cautiousness towards Australian credit. In March 2016, we recommended going long Australian semi government debt versus federal government bonds as an initial way to play what was, at the time, a relatively constructive view on the Australian economy.6 Now, given the increased economic risks, we are closing this relative value trade with a +133bps profit. Mark McClellan, Senior Vice President markm@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President rrobis@bcaresearch.com 1 Please see The Bank Credit Analyst, Section II, "Global Growth Pickup: Fact Or Fiction?," dated March 2017, available at bca.bcaresearch.com 2 Machinery orders used for Japan 3 http://www.rba.gov.au/media-releases/2017/mr-17-02.html 4 For details, please see BCA Global Fixed Income Strategy Weekly Report, "Last Minute Recommendations Before The Brexit Vote," dated June 21, 2016, available at gfis.bcaresearch.com 5 For details concerning this indicator, please see BCA Global Fixed Income Strategy Weekly Report, "How To Assess The "China Factor" For Global Bonds," dated November 11, 2016, available at gfis.bcaresearch.com 6 Please see BCA Global Fixed Income Strategy Special Report, "Australian Credit: Time To Test The Waters," dated March 29, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index It's Real Growth, Not Fake News It's Real Growth, Not Fake News Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Monetary Policy: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Economy: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. High-Yield: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Feature Chat 1A Hawkish Market Reaction A Hawkish Market Reaction A Hawkish Market Reaction After having been relatively subdued in the two months since the Fed's last rate increase, rate hike expectations priced into money market curves awakened last week following Janet Yellen's semi-annual Congressional testimony. Expectations priced into the overnight index swap curve have returned close to levels last seen on the day of the December 2016 FOMC meeting (Chart 1). As of last Friday's close, the market was priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. The implied probability of a March hike peaked at 34% last Wednesday.1 In this week's report we discuss why a March rate hike is unlikely. We also consider the outlook for U.S. economic growth in 2017, which we expect will remain decidedly above trend. Above-trend growth will allow the gradual increase in core inflation to persist, reaching the Fed's target by the end of the year. As a result, the Treasury curve will bear-steepen during this timeframe. To position for this outcome, investors should maintain below-benchmark duration and favor the belly (5-year bullet) of the curve relative to the wings (2/10 barbell) in duration-matched terms.2 Yellen's Hawkish Turn? Most news reports of Janet Yellen's testimony last week perceived a hawkish tone in her remarks and focused specifically on the following sentence: As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.3 However, more important than the above boilerplate is the simple fact that inflation remains below target and the Fed has an incentive to tread cautiously to support its eventual recovery. There is no pressing need to move quickly on rate hikes and we expect that the next rate increase will not occur until June. One reason is that, in the current cycle, the Fed has not lifted rates without having first guided market expectations in the months leading up to the hike. As can be seen in Chart 2, rate hike probabilities implied by fed funds futures were already well above 50% one month prior to each of the last two rate hikes. If there was a strong desire to lift rates in March, Yellen would have likely sent a more powerfully hawkish signal in her testimony last week. Instead, Yellen chose not to mention the March meeting specifically and said only that the Fed would continue to evaluate the case for further rate hikes at its upcoming "meetings". Chart 2Market-Implied Rate Hike Probabilities: March Looks Too High Market-Implied Rate Hike Probabilities: March Looks Too High Market-Implied Rate Hike Probabilities: March Looks Too High Second, as was alluded to above, core PCE inflation is running at 1.7% year-over-year, still below the Fed's 2% target. What's more, long-dated TIPS breakeven inflation rates are also below levels that are consistent with inflation being anchored near the Fed's target (Chart 3). At present, the 5-year/5-year forward TIPS breakeven rate is 2.17%. Historically, a range of 2.4% to 2.5% is consistent with inflation at the Fed's target. Further, even though a strong January core CPI print, released last week, seemed to strengthen the case for a March hike, the details of the report show that only a few components (new cars +0.9% m/m, apparel +1.4% m/m, and airline fares +2.0% m/m) accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in contractionary territory (Chart 4), it is very likely that inflation will soften in the coming months. Chart 3Inflation Still Too Low Inflation Still Too Low Inflation Still Too Low Chart 4Inflation Recovery Not Broad Based Inflation Recovery Not Broad Based Inflation Recovery Not Broad Based Both our own and the Fed's forecasts for continued inflation increases are contingent on the view that tight labor markets are causing wage pressures to mount, and certainly wages have accelerated during the past few years. However, wage growth in both real and nominal terms is still below where the Fed would like it to be, and there has been scant evidence of wage acceleration during the past few months. While the Atlanta Fed's Wage Growth Tracker remains strong in nominal terms, it has leveled off in real terms, and both the Employment Cost Index and Average Hourly Earnings have recently been flat (Chart 5). A final factor that will prevent the Fed from lifting rates in March is the extremely high degree of policy uncertainty. As shown in Chart 6, economic policy uncertainty traditionally correlates with financial conditions. With financial markets having already discounted a very positive fiscal policy outcome, there is a heightened risk that some disappointing news on the fiscal front will lead to a sharp tightening of financial conditions in the near term. Such an event would definitely put the Fed on hold until financial markets recovered. Chart 5Fed Needs Wage Growth To Pick Up Fed Needs Wage Growth To Pick Up Fed Needs Wage Growth To Pick Up Chart 6Policy Uncertainty Remains Elevated Policy Uncertainty Remains Elevated Policy Uncertainty Remains Elevated Bottom Line: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Policy Aside, U.S. Growth Is Heating Up Chart 7ISM Surveys Point To Strong Growth ISM Surveys Point To Strong Growth ISM Surveys Point To Strong Growth Most recent economic discussion has focused on when President Trump will get around to enacting some of the more stimulative parts of his policy agenda, and whether or not the impact of these policies (tax cuts, infrastructure spending) will ultimately be offset by other spending cuts. But in the meantime, leading indicators of GDP growth have been picking up steam. Both the manufacturing and non-manufacturing ISM surveys point to an increase in GDP growth in the first quarter (Chart 7), and consistently, the New York Fed's tracking model suggests Q1 GDP will grow by 3.1%. The Atlanta Fed's GDP tracking model pegs Q1 growth slightly lower at 2.4%. Our own sense is that GDP growth will remain solidly above trend this year, in the range of 2.5% to 3%, even in the absence of major fiscal stimulus. This forecast hinges on the view that both residential and non-residential investment will rebound from the depressed levels seen last year and that consumer spending will remain strong. Residential Investment Chart 8Residential & Non-Residential Investment Residential & Non-Residential Investment Residential & Non-Residential Investment Residential investment was actually a drag on GDP growth for two quarters in 2016, even though leading indicators such as the months supply of new homes and homebuilder confidence remained supportive (Chart 8, panels 1 & 2). The progress made on foreclosures since the financial crisis has driven housing inventory to its lowest level since the mid-1990s,4 meaning that housing supply no longer poses a headwind to construction. Further, demographics should also help boost the housing market during the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the Millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.5 While rising mortgage rates will be a drag on housing at the margin, they will not pose a significant headwind to residential investment in 2017. At least so far, mortgage purchase applications have been resilient in the face of rising rates (Chart 8, panel 3). Non-Residential Investment Non-residential investment was a small drag on growth in 2016, but this was largely related to depressed investment in the energy sector (Chart 8, panel 4). Now that the oil price has recovered, non-residential investment should return to being a small positive contributor to growth. Our composite indicator of New Orders surveys also suggests that non-residential investment will trend higher this year (Chart 8, bottom panel). While there is some concern that the optimism displayed in these survey measures may not filter through to the "hard" economic data, a Special Report from our Bank Credit Analyst publication that will be published on Thursday concludes that a tangible growth acceleration is indeed underway throughout the G7. Consumer Spending As always, the consumer is the main driver of U.S. growth and we expect consumer spending will remain firm in 2017. Our U.S. Investment Strategy service recently undertook a detailed analysis of consumer spending,6 focusing on its two main drivers - income growth and the savings rate (Chart 9). A look at past cycles suggests that income growth can remain strong even after the economy reaches full employment as rising wages compensate for decelerating payroll growth (Chart 10). The recent spike in consumer income expectations suggests that the impact from rising wages might be particularly important in the current cycle (Chart 10, panel 1). Chart 9Consumer Spending Is Driven By Income Growth And The Savings Rate Consumer Spending Is Driven By Income Growth And The Savings Rate Consumer Spending Is Driven By Income Growth And The Savings Rate Chart 10Wages Can Drive Income Growth Wages Can Drive Income Growth Wages Can Drive Income Growth Another benefit of the economy reaching full employment is that increased job security can translate into greater consumer confidence and a lower savings rate (Chart 9, bottom panel). Confidence trends suggest that the savings rate has scope to decline during the next few months. One possible headwind to consumer spending is the recent tightening of consumer lending standards. The Fed's Senior Loan Officer Survey for the fourth quarter of 2016 shows that lending standards on auto loans have tightened for three consecutive quarters and that credit card lending standards also recently spiked into "net tightening" territory. In other words, more banks are now tightening lending standards on consumer loans than easing them. Prior to the financial crisis, consumer lending standards were strongly correlated with the savings rate (Chart 11). More stringent lending standards slowed the pace of consumer credit growth and led to reduced consumer spending. But this relationship broke down following the financial crisis. After the housing bust, households were no longer eager to supplement their consumption with as much credit as possible. Their chief concern became repairing their own balance sheets. As such, the supply of credit is no longer the most important driver of the savings rate. In the data, we observe that the savings rate did not fall by as much as would have been predicted by easing lending standards in the early years of the recovery. As a result, we do not think that modestly tighter lending standards will have much of an impact either. The Fed's latest Senior Loan Officer Survey also showed that demand for consumer credit declined sharply in 2016 Q4. This is potentially more worrisome for the savings rate since lower credit demand may still suggest a reduced appetite for spending, even in the wake of the Great Recession. However, a look back at prior cycles shows that loan demand from the Senior Loan Officer Survey tends to decline several years prior to the next recession, but the savings rate has tended to stay low until the next recession actually hits (Chart 11, bottom panel). We would not be surprised to see the same dynamic play out again. Bottom Line: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. Chart 11Lending Standards Less Of A Risk Lending Standards Less Of A Risk Lending Standards Less Of A Risk Chart 12Default-Adjusted Spread Default-Adjusted Spread Default-Adjusted Spread A High-Yield Valuation Update With the release of the Moody's default report for January we are able to update our forecast for High-Yield default losses during the next 12 months, and also our High-Yield default-adjusted spread. The default-adjusted spread is our preferred valuation indicator for both High-Yield and Investment Grade corporate bonds. It is calculated by taking the option-adjusted spread from the Bloomberg Barclays High-Yield index and subtracting an estimate of expected default losses during the next twelve months (Chart 12). Default loss expectations are calculated using the Moody's baseline forecast for the 12-month High-Yield default rate and our own forecast of the recovery rate based on its historical relationship with the default rate (Chart 12, bottom two panels). The current reading from our default-adjusted spread is 152 basis points. Most of the time, a reading of 152 bps on the default-adjusted spread is consistent with small positive excess returns for both High-Yield and Investment Grade corporate bonds (Chart 13 & Chart 14). This is also consistent with the excess returns we expect from corporate credit this year. Chart 1312-Month Excess High-Yield Returns Vs. Ex-Ante ##br##Default-Adjusted Spread (2002 - Present) The Odds Of March The Odds Of March Chart 1412-Month Excess Investment Grade Returns Vs. Ex-Ante High-Yield##br## Default-Adjusted Spread (2002 - Present) The Odds Of March The Odds Of March In fact, when the default-adjusted spread is between 150 bps and 200 bps, 12-month excess returns to High-Yield have been positive in 65% of cases, with a 90% confidence interval placing 12-month excess returns in a range between -5.0% and +1.7%. Given the favorable economic back-drop of strong economic growth and accommodative Fed policy, we would expect High-Yield excess returns to be positive during the next 12 months. But given the tight starting valuation, probably not above +1.7%. Bottom Line: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculations of rate hike probabilities implied by fed funds futures are lower than those shown on Bloomberg terminals. Our measure differs because we use the actual data for the effective fed funds rate and also adjust for the well-known fact that the effective fed funds rate tends to fall by approximately 10 basis points on the last day of the month. 2 For further details on our recommended yield curve trade please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/testimony/yellen20170214a.htm 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see "The State Of The Nation's Housing 2016", Joint Center for Housing Studies of Harvard University. 6 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Add the S&P asset manager & custody banks index to the high-conviction overweight list. Prospects for higher interest rates bode well for a catch up phase with the rest of the financials sector. Initiate a long S&P consumer staples/short S&P technology pair trade, a truly out of consensus call. Housing-related equities are likely to gain ground as housing activity should stay resilient amidst rising borrowing costs. Recent Changes S&P Asset Managers & Custody Banks - Added to our high-conviction overweight list on February 16th. Long S&P Consumer Staples/Short S&P Technology - Initiate this pair trade today. Table 1Sector Performance Returns (%) Overbought, But... Overbought, But... Feature Momentum continues to drive the broad market trend. The drag from a reduction in global liquidity courtesy of depleting foreign exchange reserves continues to be overwhelmed by economic optimism. The latter is fueling a major rotation from bonds to stocks, which is the dominant market force. Valuations have taken a backseat, emblematic of blow-off phases. Two weeks ago we introduced our Complacency-Anxiety Indicator, which hit a new high. Another way to measure greed overwhelming fear is the relentless rise of the forward P/E over the VIX. The spread between these two measures can also gauge complacency. This Indicator has also soared to an all-time high (Chart 1). Chart 2 applies this methodology for the broad S&P sectors, using forward P/E and implied equity volatility, and then standardizes the result to remove biases from perennially low and high P/E sectors. A low reading suggests lower risk, and vice versa. Chart 1Buy At Your Own Risk Buy At Your Own Risk Buy At Your Own Risk Chart 2Sector Vulnerabilities And Opportunities Overbought, But... Overbought, But... At the moment, financials, telecom, utilities, REITs and health care have the lowest implicit vulnerability, while cyclical sectors carry the most risk. How long can this overshoot phase last? There are obviously no easy answers. However, from a purely technical perspective and in the absence of any major monetary, economic and/or geopolitical shocks, an examination of our Composite Technical Indicator (CTI) suggests some running room remains. Our CTI is driven primarily by momentum components. Overbought conditions are signaled once it hits one standard deviation above the mean. Currently, the TI remains slightly below this threshold (Chart 3). Even then, it can cross decisively into the danger zone before the S&P 500 eventually sells off in a meaningful fashion. Chart 3Overbought Conditions Can Persist Overbought Conditions Can Persist Overbought Conditions Can Persist Importantly, when the CTI swings quickly from deeply oversold to overbought levels, there can be a multi month lead before the broad market crests or suffers a sustained setback (Chart 3), and the bulk of those moves are associated with economic recessions and/or growth disappointments. The implication is that even though extended broad market valuations virtually guarantee paltry long-term returns and economic expectations are now sky-high, technical conditions suggest that momentum may continue to carry the day for a while longer. That does not mean investors should abandon a largely defensive portfolio structure, given that this is where the reward/risk tradeoff is most attractive and timing corrections is inherently difficult. Two weeks ago we recommended buying both gold and packaging stocks. As part of our ongoing rebalancing, this week we are further tweaking our portfolio. We recommend a pair trade to position for the inevitable sub-surface mean reversion heralded by our Indicators in the coming 3-6 months. Asset Managers: Shifting To High-Conviction Status The interest rate and market-sensitive S&P asset managers & custody banks index (AMCB) has lagged most other financials sub-indexes at a time when macro forces are lining up bullishly, particularly in view of the sector's attractive ranking on a forward P/E to volatility basis. While the capital markets and banks groups are seen as having higher torque to these positive forces, these three groups tend to move together. Lately, a divergence has opened, but a number of factors point to an imminent AMCB catch up phase (Chart 4), especially given that AMCB is not levered to overall credit growth, which has dried up. Fed Chair Yellen's testimony last week was interpreted to be slightly more on the hawkish side. That, coupled with the recent upside surprise in core inflation, raises the possibility of more 2017 tightening than currently discounted. That would provide further relief for custody banks, as ultra-low interest rates have been an anchor on this group's profitability as fees earned on funds held in trust have been minimal. The increase in short-term Treasury yields heralds a share price rally (Chart 5, top panel). Chart 4Catch Up Ahead Catch Up Ahead Catch Up Ahead Chart 5Time To Rally Time To Rally Time To Rally Moreover, the boost in economic expectations signals scope for an increase in fee generating activity, such as M&A, stock issuance and even stock lending. BCA's Global Economic Sentiment Index also indicates that the share price ratio has undershot (Chart 5). Most importantly, the asset preference shift from bonds to stocks reverses another major drag on profitability (Chart 5, third panel). Fixed income products carry lower margins than equity products, so as equity assets under management grow, profit margins should expand. If so, then we would anticipate a relative valuation re-rating, especially if the pace and scale of financial sector deregulation disappoints. The latter has been a key factor propelling capital markets and banks, and any disappointment could cause a capital rotation into the lagging AMCB index. Bottom Line: We are already overweight the S&P asset management & custody banks index, and added it to our high-conviction list in a daily Sector Insight on February 16th. New Pair Trade This week we are recommending what can be considered a highly contrarian pair trade: long the S&P consumer staples sector and short the S&P technology sector. It may be difficult to swallow executing such a non-consensus position while the broad market is going gangbusters. However, the objective message from our Indicators and increasing odds of a vicious, un-telegraphed correction, argue that the reward/risk trade-off is too attractive to ignore. As outlined in last week's Cyclical Indicator Update, the technology sector's relative earnings profile has deteriorated, because the corporate sector is not spending much yet and tech companies have suffered a serious loss of pricing power. Conversely, the consumer staples sector has a better chance of earnings outperformance, according to our model (Chart 6). Both sectors appear to have discounted the opposite outcome. Moreover, from a technical perspective, tech stocks are overbought and consumer staples are extremely oversold (Chart 6). Even a simple technical/momentum renormalization would imply a sharp jump in the share price ratio. Both sectors lose competitiveness when the U.S. dollar rise, but given that the technology sector's share of foreign sales (58%) is much higher than that of consumer staples (28%), the pain is disproportional. Importantly, consumer staples exports are accelerating, whereas tech exports are shrinking (Chart 7). Chart 6Contrasting Profiles Contrasting Profiles Contrasting Profiles Chart 7The Strong Dollar Is Worse For Tech The Strong Dollar Is Worse For Tech The Strong Dollar Is Worse For Tech Non-durable consumer goods are less sensitive to emerging market prospects, and thus when their currencies weaken, momentum in the consumer staples/tech share price ratio tends to accelerate (EM currencies shown inverted and advanced, bottom panel, Chart 7). Moreover, a strong U.S. dollar tends to reduce input costs for many consumer staples vendors, both through lower commodity prices and a reduced cost of imported goods sold. We have shown that tech stocks fare poorly toward the latter stages of a U.S. dollar bull market, when consumer staples start to shine. This dynamic reflects the economic fallout abroad from a strong U.S. dollar, particularly on developing economies, as well as the drag on U.S. corporate profits, and by extension, capital spending. While the U.S. dollar and stocks have risen in tandem in recent months, that cannot continue indefinitely, and when the correlation breaks down, the defensive consumer staples sector should outperform. In terms of economic dynamics, this share price ratio tends to accelerate when consumer spending outperforms capital spending. Consumer confidence is outpacing business confidence (Chart 8, top panel), signaling such an environment ahead. That sentiment mismatch has already translated into faster consumption than business investment on tech goods (Chart 8, second panel). Unless the gap between the return on and cost of capital reverses course and widens anew, then this trend is likely to persist. As a result, the surge in consumer staples vs. technology pricing power will continue, ultimately flattering the share price ratio through relative profit performance (Chart 8, bottom panel). The message is that consumer staples profits can have the upper hand over tech even when overall GDP growth is positive, provided the underlying driver is consumption rather than capital spending. From an external standpoint, it is notable that consumer staples have a better track record than tech stocks during inflationary periods. Chart 9 shows that the uptrend in long-term inflation expectations and increase in actual inflation both forecast a revival in this pair trade. Chart 8Unsustainable Divergences Unsustainable Divergences Unsustainable Divergences Chart 9Inflation Pressures? Buy This Ratio Inflation Pressures? Buy This Ratio Inflation Pressures? Buy This Ratio Rising inflation ultimately heralds tighter monetary policy, which is a precursor to elevated broad market volatility and a rise in the discount rate, to the detriment of long duration sectors. History shows that the high priced tech sector is more vulnerable than the safe haven staples sector in such an environment. In sum, the time is ripe for a contrary pair trade favoring consumer staples vs. technology. Notable risks to this trade are that the U.S. dollar weakens meaningfully and/or global capital spending re-accelerates decisively, relative to consumer spending. Bottom Line: We recommend a market neutral long consumer staples/short technology pair trade. The time horizon for this trade is 3-6 months. Will Housing Stocks Go Through The Roof? Housing-related stocks have delivered positive earnings surprises, but anxiety about rising mortgage rates challenges the outlook. While the latter is a risk, cheap valuations and consumers' underappreciated ability to absorb rising borrowing costs offset these concerns. Sensitivity analysis shows that even a 200 basis point (bps) spike in interest rates from current levels would fail to push housing affordability back to the long-term average (Chart 10). Moreover, mortgage payments as a percentage of incomes and effective borrowing costs would also remain below their respective historic means even with such a spike. Importantly, housing market fundamentals are improving. Lumber prices are on fire. Lumber has been the best performing commodity year-to-date. This is a real time indicator of housing demand (Chart 11). Similarly, railroad carloads of lumber are also firming, signaling that the price rise is demand-driven rather than a speculative bet in the trading pits. Sustained house price inflation, solid housing turnover and the acceleration in building permits reinforce that housing activity remains robust (Chart 11). Chart 10Higher Rates Are Not A Show Stopper Higher Rates Are Not A Show Stopper Higher Rates Are Not A Show Stopper Chart 11Lumber Strength Is Housing Bullish Lumber Strength Is Housing Bullish Lumber Strength Is Housing Bullish The credit tap to sustain strong activity is still open. According to the latest Fed Senior Bank Loan Officer Survey, banks are willing and able to extend residential mortgage credit (bottom panel, Chart 11). This contrasts with many other credit categories, where banks are tightening the screws and credit demand is faltering: C&I loans have shrunk over the past three months, as has total bank credit. First time home buyers are also reappearing and anecdotes of increased house flipping activity signal a vibrant market with unobstructed access to credit. All of this should continue to support earnings-led outperformance from both homebuilders and home improvement retailers (HIR). The bullish outlook for the S&P homebuilding index rests on four pillars. The latest National Association of Home Builders (NAHB) survey revealed that sales expectations remain over 20 points above the boom/bust line and just shy of recent cyclical highs (Chart 12). Homebuilders are clearly still seeing strong traffic. New home prices are still expanding at a healthy clip (Chart 12). Sales growth and new home price inflation are tightly linked. The mortgage application purchase index has picked up steam despite the mortgage rate increase, confirming that first time homebuyers are entering the market after a long hiatus as the financial motivation to buy vs. rent has improved. This optimism is causing an aggressive re-rating in earnings estimates from chronically bearish levels (Chart 12), a harbinger of further gains in relative share prices. The S&P HIR index also has a concrete foundation. Higher lumber prices flow straight to the bottom line, because HIR companies typically earn a set margin on lumber-related sales. Moreover, higher housing turnover is a boon for industry sales volumes (Chart 13). Historically, home sales momentum has been an excellent leading indicator of renovation activity. Chart 12Buy Homebuilders... Buy Homebuilders... Buy Homebuilders... Chart 13... And Building Supply Retailers ... And Building Supply Retailers ... And Building Supply Retailers Encouragingly, the NAHB remodeling survey is still in expansion territory, and tends to follow the trend in home sales, underscoring that home renovation activity is set to improve (Chart 13). Our HIR model encapsulates many of these key drivers, and has climbed anew (Chart 13). The message is that profits, and share prices, are on track to outperform. Adding it all up, the housing backdrop remains attractive, and even a steady increase in borrowing costs should not disrupt momentum. The time to become concerned will be if inflation becomes a serious risk, causing the Fed to get 'tight' and credit availability to dry up. The next few interest rate hikes won't move the monetary settings to that phase yet. Until then, we recommend erring on the bullish side. Bottom Line: We reiterate our high-conviction overweight in the S&P home improvement retail index (HD, LOW) and continue to recommend an above benchmark allocation in the S&P homebuilding index (PHM, DHI, LEN). Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).