Valuations

Highlights Chart 1Upside Risks & Uncertainty Upside Risks & Uncertainty Upside Risks & Uncertainty The evidence of economic acceleration continues to pile up and we maintain our view that bond yields will be higher than current forwards by the end of 2017. In the near-term, however, the bond market has been too quick to discount a more positive growth outlook, especially considering still-elevated levels of economic policy uncertainty. Our cautious optimism is echoed by the readings from our global PMI models and also by the Fed. The minutes from December's FOMC meeting revealed that more participants saw upside risks to growth and inflation than saw downside risks, but also that this improved economic forecast was judged to be more uncertain than any Fed forecast since 2013 (Chart 1). We remain bond bears on a 12-month horizon, but advocate a benchmark duration stance in the near term. A period of flat bond yields is the most likely outcome until elevated uncertainty levels revert to a more normal range (see the global economic policy uncertainty index). Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 82 basis points in December and by 478 basis points in 2016. The index option-adjusted spread tightened 6 bps on the month and 42 bps on the year. At 122 bps, the spread is currently well below its historical average (134 bps). Corporate spreads have tightened substantially since last February despite elevated gross leverage (Chart 2).1 As we pointed out in our end-of-year Special Report titled "Seven Fixed Income Themes For 2017",2 it is very rare for spreads to tighten when leverage is in an uptrend. While a rebound in profit growth will likely cause the uptrend in leverage to abate this year, spreads have already moved to discount a significant reversal. Although valuations are by no means attractive, accelerating economic growth and still-accommodative Fed policy will keep spreads at tight levels during the first half of this year. This sweet spot will persist at least until TIPS breakeven inflation rates return to pre-crisis levels, which would likely presage a hawkish shift in Fed policy. Energy sector debt returned 12.5% in excess of duration-equivalent Treasuries in 2016, compared to excess returns of under 5% for the overall corporate index. Despite this large outperformance, energy credits still appear attractive according to our model (Table 3), and should continue to outperform into the New Year. Table 3ACorporate Sector Relative Valuation##br## And Recommended Allocation* Cautious Optimism Cautious Optimism Table 3BCorporate Sector##br## Risk Vs. Reward* Cautious Optimism Cautious Optimism High-Yield: Underweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 188 basis points in December and by 1539 basis points in 2016. The index option-adjusted spread narrowed 46 bps on the month and 251 bps on the year. At 383 bps, it is currently 137 bps below its historical average. As we highlighted in our year-end Special Report,3 the uptrend in defaults is likely to reverse this year, mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Given the improving default backdrop, we are actively looking to upgrade our allocation to high-yield debt. However, valuations do not present a sufficiently compelling opportunity at the moment. Our estimate of the default-adjusted high-yield spread - the average spread of the junk index less our forecast of 12-month default losses - is below 150 bps (Chart 3). This is close to one standard deviation below the long-run average. Historically, we have found that a default-adjusted spread between 100 bps and 200 bps is consistent with positive 12-month excess returns 65% of the time, but with an average 12-month excess return of close to zero. With the spread in this range, a 90% confidence interval would place 12-month excess returns between -3% and +4%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in December, but underperformed by 11 bps in 2016. The conventional 30-year MBS yield rose 5 bps in December, completely driven by a 5 bps increase in the rate component. The compensation for prepayment risk (option cost) and option-adjusted spread were both flat on the month. In 2016, the conventional 30-year MBS yield rose 6 bps. This was driven by a 12 bps increase in the rate component that was partially offset by a 9 bps decline in the option-adjusted spread. The option cost increased 3 bps on the year. Our underweight in MBS is predicated upon very low option-adjusted spreads, relative both to history and other comparable spread product (Chart 4). Historically, the option-adjusted spread is correlated with net MBS issuance and eventually we expect rising net issuance to lead the option-adjusted spread wider. Importantly, purchase applications have remained firm in the face of higher mortgage rates even though refinancings have collapsed (bottom panel). Another tail risk for the MBS market is the possibility that the Fed ceases the reinvestment of its mortgage portfolio. While we do not expect this to occur in 2017, with two rate hikes now in the bank the fed funds rate is approaching levels where the Fed might begin to consider it. A new Fed Chair in early 2018 might also be more inclined to wind down the balance sheet. Government Related: Overweight Chart 5Government Related Market Overview Government Related Market Overview Government Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 27 basis points in December. Foreign Agency and Sovereign bonds outperformed by 84 bps and 83 bps respectively, while Local Authorities outperformed by 22 bps. Domestic Agency bonds and Supranationals were a drag on performance during the month, underperforming the Treasury benchmark by 10 bps and 7 bps respectively. The government-related index outperformed the duration-equivalent Treasury benchmark by 150 bps in 2016. The best performing sub-sectors for the year were Sovereigns (outperformed by 322 bps), Local Authorities (outperformed by 286 bps) and Foreign Agencies (outperformed by 258 bps). Domestic Agency bonds outperformed Treasuries by 38 bps, while Supranationals underperformed by 11 bps. Foreign Agency bonds and Local Authority bonds continue to appear attractive relative to U.S. corporate credit, after adjusting for credit rating and duration. We recommend focusing our government related allocation in these two sectors. In contrast, Sovereigns and Supranationals both appear expensive relative to U.S. corporate credit, and we recommend avoiding these sectors. Spreads on Domestic Agency debt have room to tighten in the near-term (Chart 5). Spreads widened to the top of their recent range last month on rumors that the new government could seek to speed up the process of GSE reform. We view these concerns as premature. This week we also remove our recommendation to favor callable agencies over bullets. Bullets have tended to outperform when the 2/5 Treasury slope steepens (bottom panel). We expect the 2/5 curve to be biased steeper in the first half of this year. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 134 basis points in December, but underperformed the index by 103 basis points in 2016 (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio fell 8% in December, but increased 13% during 2016. At present the average M/T ratio is 98%, only slightly below its post-crisis average (Chart 6). Although M/T ratios moved higher last year, trends in issuance and fund flows suggest they are still too low. As we noted in our year-end Special Report,4 our tactical model of the M/T yield ratio - based on issuance, fund flows, ratings changes and economic policy uncertainty - pegs current fair value for the average M/T yield ratio at 112%. Further, as was also highlighted in our year-end report, the municipal credit cycle is likely to take a turn for the worse in late 2017, with muni downgrades starting to outpace upgrades. This analysis is based on indicators of state & local government budget health that tend to follow our indicators of corporate sector health with a two year lag. Just last month Moody's downgraded $1.6 billion worth of the City of Dallas' general obligation debt from Aa3 to A1. The downgrade was justified based on the city's poorly funded public safety pension plan. Attention will increasingly turn to underfunded public pensions when state & local government budget health starts to deteriorate later this year. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve shifted higher and flattened in December. The 2/10 slope flattened by 1 basis point on the month and the 5/30 slope flattened 6 bps. For 2016 as a whole, the Treasury curve bear-steepened out to the 10-year maturity. The 2/10 slope steepened 4 bps and the 5/30 slope flattened 12 bps. In our year-end Special Report,5 we detailed how the combination of accelerating economic growth and still-accommodative Fed policy will cause the Treasury curve to bear-steepen in the first half of 2017. This steepening will be driven by continued, but gradual, recovery in long-dated TIPS breakeven inflation back to pre-crisis levels (2.4% to 2.5%). Once inflation expectations return to pre-crisis levels, it is possible that the Fed will shift to a monetary policy that is focused more on tamping out inflation than supporting growth. At that point the curve will shift from a bear-steepening to a bear-flattening regime. A steepening curve environment will cause bullet trades to outperform barbells. On top of that, the 5-year bullet is currently extremely cheap on the curve (Chart 7). For these reasons we recommended entering a long 5-year bullet, short 2/10 barbell trade on December 20. This trade has already returned 8 bps since initiation, even though the 2/10 slope has flattened 10 bps during this period. A resumption of curve steepening will cause our long 5-year bullet, short 2/10 barbell trade to perform even better in the months ahead. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 6 basis points in December, and by 331 bps in 2016. The 10-year TIPS breakeven rate increased by 1 bp in December and by 41 bps in 2016. At present it sits at 1.96%, still well below the 2.4% to 2.5% range that is consistent with the Fed's 2% inflation target. As we explained in our year-end Special Report,6 the Fed will be keen to allow TIPS breakevens to rise toward levels more consistent with its inflation target, and will quickly back away from a hawkish policy stance should breakevens fall. But while breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. It is difficult for the Fed to drive long-dated inflation expectations higher while it is in the midst of a tightening cycle. For this reason, trends in actual inflation will be a more important determinant of TIPS breakevens than in the past. And while there are indications that the uptrend in realized inflation will persist, notably recent accelerations in wage growth and survey measures of prices paid (Chart 8). There is currently no indication that core and trimmed mean inflation are breaking out to the upside (bottom panel). We remain overweight TIPS relative to nominal Treasuries on the expectation that long-dated breakevens reach the 2.4% to 2.5% range in the second half of 2017, and that core PCE inflation reaches the Fed's 2% target by the end of the year. ABS: Maximum Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 17 basis points in December but outperformed the Treasury benchmark by 94 bps in 2016. Aaa-rated ABS underperformed Treasuries by 21 bps in December but outperformed by 75 bps in 2016, while non-Aaa ABS outperformed the benchmark by 13 bps in December and by 257 bps in 2016. The index option-adjusted spread for Aaa-rated ABS widened by 11 bps in December, but tightened by 10 bps in 2016. Further, the spread differential between Aaa-rated auto ABS and Aaa-rated credit card ABS narrowed substantially in 2016. The option-adjusted spread for Aaa-rated auto loan ABS has tightened by 20 bps since the end of 2015, while the option-adjusted spread for Aaa-rated credit card ABS has tightened by 10 bps. We have previously noted that, after adjusting for spread volatility, Aaa-rated auto loan ABS no longer offer an attractive opportunity relative to Aaa-rated credit cards (Chart 9). We continue to favor Aaa-rated credit cards over Aaa-rated auto loans, given the low spread differential and divergences in collateral credit quality (bottom panel). As was noted in the Appendix to our year-end Special Report,7 consumer ABS provided better volatility-adjusted excess returns than all fixed income sectors except for Baa-rated corporates and Caa-rated high-yield in 2016. With spreads still elevated relative to other similarly risky fixed income sectors, we expect this risk-adjusted performance to continue. Non-Agency CMBS: Underweight Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Agency CMBS underperformed the duration-equivalent Treasury index by 40 basis points in December, but outperformed by 117 bps in 2016. The index option-adjusted spread for Agency CMBS widened 10 bps in December but tightened 6 bps in 2016. Agency CMBS still offer 50 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (51 bps) and greater than what is offered by conventional 30-year MBS (26 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 19 basis points in December, but outperformed by 313 bps in 2016. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 7 bps in December but tightened 48 bps in 2016. It has recently moved well below its average pre-crisis level (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Treasury Valuation Chart 11Global PMI Model Global PMI Model Global PMI Model The current reading from our 2-factor Global PMI model (which includes the global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.31% (Chart 11). Our 3-factor version of the model, which also incorporates the global economic policy uncertainty index, places fair value at 2.02%. The lower fair value is the result of a large spike in the global economic policy uncertainty index in November that barely reversed in December (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. However, unusually high uncertainty is one reason we are reluctant to adopt a below benchmark duration stance for the time being even though we expect yields to be higher in 12 months. At the time of publication the 10-year Treasury yield was 2.37% For further details on our Global PMI models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). With the MCI having just reached this estimate of equilibrium, the shaded region in Chart 13 shows the expected path of the federal funds rate assuming that the MCI remains at its equilibrium level. The upper-end of the shaded region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the shaded region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Monetary Conditions Vs. Equilibrium Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios Fed Funds Rate Scenarios Fed Funds Rate Scenarios As can be seen in Chart 13, both the market and Fed are discounting a move in the MCI above its equilibrium level. This would be consistent with behavior witnessed in past cycles when the MCI broke above its equilibrium level several years before the next recession. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Portfolio Strategy A battle between tighter monetary conditions and the anticipation of fiscal largesse will be a dominant market theme this year. Our high-conviction equity allocation calls do not require making a major directional global economic bet, or second guessing the Fed's desire to continue tightening. The bulk of our calls could currently be considered contrarian, based on recent market momentum and sub-surface relative valuation swings. Recent Changes S&P Insurance Index - Downgrade to high-conviction underweight. Nasdaq Biotech Index - Downgrade to high-conviction underweight. Feature Stocks have already paid for a significant acceleration in earnings and economic growth this year and beyond. Fourth quarter earnings season will be the first real test of investor expectations since the post-election market surge. While recent data have been encouraging, forward corporate profit guidance is unlikely to be robust in the face of the U.S. dollar juggernaut. Currently, the hope is that fiscal stimulus will offset tighter monetary settings, ultimately delivering a higher plane of economic activity. The major risks are that the economy loses momentum before fiscal spending cranks up, and/or that profits diverge from a more resilient economic performance than liquidity conditions forecast. Indeed, fiscal stimulus isn't slated to accelerate until next year (Chart 1), while the impact of anti-growth market moves is far more imminent. Our Reflation Gauge has plunged, heralding economic disappointment (Chart 1). With the economy near full employment, Fed hawkishness could persist even in the face of any initial evidence of economic cooling. Under these conditions, the gap between nominal GDP and 10-year Treasury yields could turn negative in the first half of the year (Chart 2), which would be a major warning sign for stocks. Chart 1Fiscal Stimulus Is Still A Long Way Off Fiscal Stimulus Is Still A Long Way Off Fiscal Stimulus Is Still A Long Way Off Chart 2Warning Signal Warning Signal Warning Signal As a result, while the market has recently been focused almost solely on return, our emphasis at this juncture is on minimizing risk. That is consistent with the historic market performance during Fed tightening cycles. Going back to the early-1970s and using the last seven Fed interest rate hiking periods, it is evident that non-cyclical sector relative performance benefits immensely on both a 12 and 24 month horizon from the onset of Fed tightening (Charts 3 and 4). Cyclical sectors typically lag the broad market, while financials generally market perform1. Chart 312-Month Performance After Fed Hikes 2017 High-Conviction Calls 2017 High-Conviction Calls Chart 424-Month Performance After Fed Hikes 2017 High-Conviction Calls 2017 High-Conviction Calls Some of the other major macro forces that are likely to influence the broad market and sectoral trends are: Ongoing strength in the U.S. dollar and its drag on top-line growth: loose fiscal policy and tight monetary policy is a classic recipe for currency strength. Tack on high and rising interest rate differentials due to policy divergences with the rest of the world (Chart 5), and exchange rate strength is likely to persist in the absence of a major domestic economic downturn. A tough-talking Fed. Wage growth is accelerating and broadening out, and will sharpen the Fed's focus on inflation expectations. With dollar strength constraining revenue growth potential, strong wage gains are profit margin sapping (Chart 2). A divergence between economic growth and profit performance, i.e. stronger growth is unlikely to feed into equal growth in corporate sector earnings given the squeeze on profit margins from a recovery in labor's ability to garner a larger share of aggregate income. Disappointment and/or uncertainty as to the timing and rollout of the much anticipated fiscal spending programs and unfunded tax cuts. Favoring domestic vs. global exposure will remain a key theme. Emerging markets (EM) have not validated the sharp jump in the global vs. domestic stocks, nor cyclical vs. defensives (Chart 6). Chart 5Greenback Is A Drag##br## On S&P 500 Top Line Growth Greenback Is A Drag On S&P 500 Top Line Growth Greenback Is A Drag On S&P 500 Top Line Growth Chart 6Mind##br## The Gap Mind The Gap Mind The Gap EM stocks are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. The surging U.S. dollar is a growth impediment for many developing countries with large foreign liabilities to service. The U.S. PMI is gaining vs. the Chinese and euro area PMI (Chart 7, second panel), heralding a rebound in cyclical share price momentum. World export growth remains anemic and will remain so based on EM currency trends (Chart 7). When compared with the reacceleration in U.S. retail sales, the outlook for domestically-sourced profits is even brighter. The other key sectoral theme is to favor areas geared to the consumer rather than the corporate sector. Consumer income statements and balance sheets are far healthier than those of the corporate sector (Chart 8). As a result, they are in a more propitious position to spend and expand. Chart 7Domestics Will Rise To The Occasion Domestics Will Rise To The Occasion Domestics Will Rise To The Occasion Chart 8Consumers Trump The Corporate Sector Consumers Trump The Corporate Sector Consumers Trump The Corporate Sector We expect all of these forces to truncate rally attempts in 2017. The market is already stretching far enough technically to flag risk of a potentially sizeable correction in the first quarter, i.e. greater than 10%, particularly given the significant tightening in monetary conditions and overheating bullish sentiment that have developed. In other words, it is not an environment to chase the post-election winners, nor turn bearish on the losers that have been eschewed. Against this backdrop, we are introducing our top ten high-conviction calls for 2017. As always, these calls are fundamentally-based and we expect them to have longevity and/or meaningful relative return potential, rather than just reflect recent momentum trends. We recognize the difficulty of trading in and out of positions on a short-term basis. Energy Services - Overweight Chart 9Playable Rally Playable Rally Playable Rally The energy sector scores well in relative performance terms when the Fed is hiking interest rates2, supporting a high-conviction overweight in the energy services group. OPEC's agreement to curtail production should hasten supply/demand rebalancing that was already slated to occur via non-OPEC production declines through 2017. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies reduced capital expenditures by 40% over the same period. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to restore capital availability to the sector. With easier access to capital, producers, especially shale, will be able to accelerate drilling programs in a stable commodity price environment. The three factors traditionally required to sustain a playable rally are now in place. The rig count has troughed. The growth in OECD oil inventories has crested. The latter is consistent with a gradual rise in the number of active drilling rigs. Finally, global oil production growth is falling steadily. Pricing power is likely to be slow to recover this cycle given the scope of previous capacity excesses, but even a move to neutral would remove a major drag and reduce the associated share price risk premium (Chart 9). Consumer Staples - Overweight 2016 delivered a number of company specific body blows to the consumer staples sector, most notably concerns about the pharmacy benefit manger pricing model, which undermined the retail drug store group. Thereafter, the sector was shunned on a macro level following the election, as it was used as a source of capital to fund aggressive purchases in more cyclical sectors. This has set the stage for a contrarian buying opportunity in a high quality, defensive sector with one of the best track records during Fed tightening cycles3. The sector is now closing in on an undervalued extreme, in relative terms, having already reached such a reading in technical terms (Chart 10). Our Cyclical Macro Indicator is climbing, supported by the persistent rise in consumers' preference for saving. The latter heralds an increase in outlays at non-cyclical retailers relative to sales at more discretionary stores. Importantly, consumer staples exports have reaccelerated, despite the strong U.S. dollar, pointing to a further acceleration in sector sales growth, and by extension, free cash flow. The strong U.S. dollar is a major boon, from an historical perspective, given that it typically creates increased global economic and market volatility. The latter is starting to pick up (Chart 10). A strong currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and heralds a relative performance rebound (Chart 11). Chart 10Contrarian Buy Contrarian Buy Contrarian Buy Chart 11China To The Rescue? China To The Rescue? China To The Rescue? Home Improvement Retail - Overweight Enticing long-term housing prospects argue for looking through the recent rise in mortgage rates. Household formation is reaccelerating, as full employment is boosting consumer confidence, and clocking at a higher speed than housing starts. The implication is that pent-up housing demand will be unleashed. In fact, consumers have only recently started re-levering, with banks more than willing to facilitate renewed appetite for mortgage debt. Remodeling activity is booming and anecdotes of house flipping activity picking up steam are corroborating that the housing market is vibrant. Now that house prices have recently overtaken the 2006 all-time highs, the incentive to upgrade and remodel should accelerate. While the recent backup in bond yields has been a setback for housing affordability, the U.S. consumer is not priced out of the housing market. Yields are rising in tandem with job security and wages. Mortgage payments remain below the long-term average as a share of income and effective mortgage rates remain near generationally low levels. Building supply store construction growth has plumbed to the lowest level since the history of the data. Historically, capacity restraint has represented a boost to home improvement retail (HIR) profit margins and has been inversely correlated with industry sales growth. Stable housing data and improving operating industry metrics entice us to put the compellingly valued S&P HIR on our high-conviction buy list for 2017 (Chart 12). Chart 12Benefiting From Enticing##br## Long-Term Housing Prospects Benefiting From Enticing Long-Term Housing Prospects Benefiting From Enticing Long-Term Housing Prospects Chart 13Healthy Consumer Is A Boon##br## To Consumer Finance Stocks Healthy Consumer Is A Boon To Consumer Finance Stocks Healthy Consumer Is A Boon To Consumer Finance Stocks Consumer Finance - Overweight We are focusing our early-cyclical exposure on overweighting the still bruised S&P consumer finance index. This group is levered to the rising interest rate environment and debt-financed consumer spending. The selloff in the 10-year Treasury bond has been closely correlated with relative performance gains and the current message is to expect additional firming in the latter (Chart 13, top panel). Importantly, higher interest rates have boosted credit card interest rate spreads (the industry's equivalent net interest margin metric), underscoring that the next leg up in relative share prices will be earnings led (Chart 13, bottom panel). On the consumer front, consumer finances are healthy, the job market is vibrant and consumer income expectations are on the rise. In addition, house prices have vaulted to fresh all-time highs and are still expanding on a y/y basis. The positive wealth effect provides motivation for consumers to run down savings rates (Chart 13, second & third panels). Health Care Equipment - Overweight Health care equipment (HCE) stocks have been de-rated alongside the broad health care index, trading at a mere market multiple and below the historical mean, representing a buy opportunity. Revenue growth has been climbing at a double digit clip (Chart 14, third panel) and the surging industry shipments-to-inventories ratio is signaling that still depressed relative sales growth expectations will surprise to the upside (Chart 14, top panel). Synchronized global growth is also encouraging for U.S. medical equipment exports, despite the U.S. dollar's recent appreciation. The ageing population in the developed markets along with pent up demand for health care services in the emerging markets where a number of countries are developing public safety nets, bode well for HCE long-term demand prospects. The bottom panel of Chart 14 shows that the global PMI has been an excellent leading indicator of HCE exports and the current message is positive. The recent contraction in valuation multiples suggests that sales are expected to disappoint in the coming year, an outlook that appears overly cautious, especially within the context of the nascent improvement in industry return on equity (Chart 14, second panel). Chart 14HCE Stocks Are Cheap Given##br## Improving Final Demand Outlook HCE Stocks Are Cheap Given Improving Final Demand Outlook HCE Stocks Are Cheap Given Improving Final Demand Outlook Chart 15More Than##br## Meets The Eye More Than Meets The Eye More Than Meets The Eye REITs - Overweight REITs have traded as if the back up in global bond yields will persist indefinitely, and that the level of interest rates is the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin. The RDI is also positively correlated with commercial property prices, implying more new highs ahead. That will support higher net asset values. While increased supply is a potential sore spot, particularly in the residential space, multifamily housing starts have rolled over relative to the total, suggesting that new apartment builds are diminishing. As discussed in previous research reports, contrary to popular perception, relative performance is also depressed from a structural perspective. REIT relative performance is trading well below its long-term trend, a starting point which has historically overwhelmed any negative pressure from a Fed tightening cycle (Chart 15). Tech Hardware Storage & Peripherals - Underweight The S&P technology hardware storage & peripherals (THSP) sector is a disinflationary play (10-year treasury yield change shown inverted, second panel, Chart 16) and benefits when prices are deflating, not when there are whiffs of inflation4. The tech sector has the highest foreign sales/EPS exposure among the top 11 sectors, and the persistent rise in the greenback is weighing on export prospects for the THSP sub-index (Chart 16, third panel), and by extension top and bottom line growth. Computer and electronic products new order growth has fallen sharply recently, warning that THSP sales growth will remain downbeat. Industry investment is also probing multi-year lows (not shown). Asian inventory destocking is ongoing, which will pressure selling prices, but the end of this liquidation phase would be a signal that the worst will soon be over. Technical conditions are bearish. A pennant formation signals that a breakdown looms. Chart 16Tech Stocks Hate Reflation Tech Stocks Hate Reflation Tech Stocks Hate Reflation Chart 17Shy Away, Don't Be Brave Shy Away, Don’t Be Brave Shy Away, Don’t Be Brave Biotech - Underweight The Nasdaq biotech index is following the BCA Mania Index, which includes previous burst bubbles in a broad array of asset classes. The top panel of Chart 17 shows that if history at least rhymes, biotech bubble deflation is slated to continue. Only 45 stocks in the NASDAQ biotech index have positive 12-month forward earnings estimates, comprising 27% of the 164 companies in the index according to Bloomberg. There is still a lot of air to be taken out of the biotech bubble. Historically, interest rates and relative performance have been inversely correlated. The back up in bond yields and Fed tightening represent a draining in liquidity conditions which bodes ill for higher beta and more speculative investments. The biotech derating has been earnings driven and a sustained multiple compression period looms, especially given the sector's poor sales prospects (Chart 17, bottom panel) Worrisomely, not only have biotech stocks fallen despite Trump's win, but recent speculative zeal (buoyant equity sentiment and resurging margin debt, not shown) has also failed to reinvigorate biotech equities. The NASDAQ biotech index is a sell (ETF ticker: IBB:US). Industrials - Underweight The industrials sector was added to our high-conviction underweight list late last year so the turn in calendar does not require a change in outlook. The sector has discounted massive domestic fiscal stimulus and disregarded the competitive drag on earnings from the U.S. dollar, trading as if a profit boom is imminent. Recent traction in surveys of industrial activity is a plus, but is more a reflection of an improvement in corporate sentiment and is unlikely to translate into imminent industrials sector profit improvement. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure or private sector investment spending. Commodity prices and EM drag when the dollar is strong. Chronic surplus EM industrial capacity remains a source of deflationary pressure for their currencies, economies and U.S. industrial companies. U.S. dollar strength warns of renewed pricing power pressure (Chart 18). Non-tech industrial capacity is growing faster than output, and capital goods imports prices are contracting (Chart 18). Tack on the relentless surge in the U.S. dollar, and a new deflationary wave appears inevitable. Relative forward earnings momentum is already negative, and is likely to remain so given the barriers to a top-line recovery, and a soaring domestic wage bill. The sector is not priced for lackluster earnings. Chart 18Fade The Bounce Fade The Bounce Fade The Bounce Chart 19Advance Is Precarious Advance Is Precarious Advance Is Precarious Insurance - Underweight Insurance stocks have benefited from the upward shift in the yield curve and the re-pricing of the overall financials sector, but the advance is precarious. Previously robust insurance pricing power has cracked. The CPI for household insurance is barely growing. The latter is typically correlated with auto premiums, underscoring that they may also slip (Chart 19). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios and incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and less pricing power. Insurance companies have added massively to cost structures in recent years (Chart 19), while the rest of the financials sector was shedding labor costs. Relative valuations have enjoyed a step-function upshift, but the path of least resistance will be lower for as long as relative consumer spending on insurance products retreats on the back of pricing pressure (Chart 19). 2016 Review... Last year's high-conviction calls were hot out of the gate, and generally had very strong gains until the late-summer/early-fall, but were hijacked by the post-election surge in a few sectors. As a result of the end of year fireworks, our high conviction calls trailed the market by just under 2% for the year ending 2016. Had we had the foresight to predict a Trump win and a massive market rally, we could have closed our positions in early November for comfortably positive gains. In total, our average booked gains in the year were 3% in excess of the broad market since the positions were initiated. We are also closing our pair trades, and will re-introduce a number of new trades in the near future. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see the U.S. Equity Strategy Special Report titled: "Sector Performance And Fed Tightening Cycles: An Historical Roadmap", available at uses.bcaresearch.com. 2 Ibid 3 Ibid 4 Please see the U.S. Equity Strategy Special Report titled: "Equity Sector Winners And Losers When Inflation Climbs", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights The U.S. growth outlook has improved but markets already reflect this reality. The U.S. dollar is losing momentum despite healthy economic releases, highlighting the risk of a pullback. EUR and JPY should be the prime beneficiaries of a dollar correction as commodity currencies are exposed to brewing Chinese risks. Short CAD/NOK and AUD/JPY. Happy New Year! Feature A defensive posturing seems increasingly appropriate for currency investors in the coming months. While we continue to expect U.S. growth to strengthen toward 3% this year, asset prices have already discounted a very positive economic outcome. As Chart I-1 illustrates, the ratio of metal to bond prices (adjusted for relative return volatilities) tends to be a good leading indicator of U.S. growth. However, this indicator clearly shows that investors are already positioned for solid growth. Chart I-1The Economic Outlook Has Improved, But Markets Are Aware The Economic Outlook Has Improved, But Markets Are Aware The Economic Outlook Has Improved, But Markets Are Aware Moreover, bond prices have uniformly discounted good news. Both our composite sentiment indicator and the bonds' fractal dimension - a measure of groupthink - highlight that investors are collectively positioned for a bearish Treasury outcome (Chart I-2). This raises the risk that even a good growth number out of the U.S. will disappoint investors. Lofty expectations are not confined to bonds and metals, however. DXY and the broad trade-weighted dollar are also displaying some groupthink, another troubling sign for dollar bulls like us (Chart I-3), who find our side of the ledger increasingly crowded. Chart I-2Buying Bonds Is A Contrarian Play Buying Bonds Is A Contrarian Play Buying Bonds Is A Contrarian Play Chart I-3Dollar Could Pull Back Dollar Could Pull Back Dollar Could Pull Back What does this all mean? In our 2017 outlook, we mentioned that while the risk of a dollar correction was rising, the dollar's momentum was too strong to fight at this point in time.1 Moreover, historically, January tends to be a strong month for the dollar (Chart I-4). A window of opportunity to get short may be opening up. For one, the dollar has been losing momentum in the past few weeks, shown by the divergence that is emerging between prices and momentum (Chart I-5). Additionally, net speculative positions on the dollar are near record highs but, more importantly, are not making new highs (Chart I-6). Chart I-4The Greenback Likes The New Year The Greenback Likes The New Year The Greenback Likes The New Year Chart I-5Dollar Momentum Is Weakening Dollar Momentum Is Weakening Dollar Momentum Is Weakening Chart I-6Long Dollar: A Crowded Trade Long Dollar: A Crowded Trade Long Dollar: A Crowded Trade Interestingly, the Swedish krona, the currency with the most negative beta to the dollar is now showing surprising signs of strength (Chart I-7). This is particularly remarkable as this week the Riksbank announced it would pursue currency-market interventions if it judges that a strong currency threatens its inflation target. Hence, if the krona's underperformance was a harbinger of dollar strength this past fall, the SEK's current resilience may foreshadow a correction in the greenback. In terms of the dollar's reaction to recent economic data, the greenback has been unable to rally on strong fundamentals this week. Instead, the dollar softened despite healthy readings from the ISM manufacturing survey, with the headline measure rising to 54.7 and the new orders component surging to 60.2. Relatively hawkish FOMC minutes couldn't even support DXY. In fact, European PMIs seem to have overshadowed U.S. economic data. The European Manufacturing PMI is at a six year high (Chart I-8). Even the French consumer is feeling perky, with the consumer confidence hitting a nine year high. Chart I-7SEK Upside Equals USD Downside SEK Upside Equals USD Downside SEK Upside Equals USD Downside Chart I-8Good Numbers In Europe Good Numbers In Europe Good Numbers In Europe The absence of U.S. dollar strength in response to strong economic news at a time of seasonal strength for the USD raises the risk of a dollar correction in the coming weeks. We expect the yen and the euro to be the prime beneficiaries of such moves. Commodity currencies, on the other hand, might be unable to take advantage of any dollar weakness. Too much good news have been priced in. Commodities have been lifted by the perception of stronger growth in the U.S., but also by the common refrain among investors that the Chinese authorities will continue to reflate the economy in the run up to the Communist Party Congress this autumn. We worry that China is likely to be a source of negative shock. Investors are increasingly likely to see their hopes of stimulus dashed, particularly since the Chinese economy does not look like it needs much stimulus right now. The Keqiang index - a comprehensive measure of industrial activity - is at post-2010 highs and real estate markets have become very frothy (Chart I-9). Moreover, the recent surge in bitcoin prices - despite a strong dollar - suggests that capital outflows out of China are intensifying despite tightening capital account restrictions (Chart I-10). Indeed, bitcoin prices started their recent ascent as talks of capital controls in China grew in late 2015. The result has been higher interest rates and a tightening of Chinese financial conditions. This also gives the authorities an impetus to let the RMB fall - representing another deflationary shock for EM economies and commodity producers. Chart I-9China Doesn't Need Reflation China Doesn't Need Reflation China Doesn't Need Reflation Chart I-10Symptoms Of Chinese Outflows Symptoms Of Chinese Outflows Symptoms Of Chinese Outflows In this environment, oil prices are likely to fare better than metal prices, one of the key themes we highlighted in our 2017 outlook, which should benefit our short AUD/CAD trade. In addition, we are reopening our short CAD/NOK position. CAD/NOK is trading 15% over its fair value (Chart I-11), and would benefit in the event of a USD correction. Moreover, the Canadian surprise index, which had surged relative to that of Norway has now rolled over, pointing toward weaknesses for this cross (Chart I-12). Chart I-11CAD/NOK Is Overvalued ##br##CAD/NOK Is Expensive CAD/NOK Is Expensive CAD/NOK Is Expensive Chart I-12Economic Momentum ##br##Moving Against CAD/NOK Economic Momentum Moving Against CAD/NOK Economic Momentum Moving Against CAD/NOK Another opportunity seems to be emerging in the yen. Speculators are massively short the yen and our yen capitulation index continues to hover near 22-year lows (Chart I-13). From current levels, the yen could easily move toward 110, especially if our view on the dollar and Chinese policy risks is correct. That being said, the more than 1% fall in USD/JPY yesterday suggests that investors may want a more attractive entry point. Investors should also consider shorting AUD/JPY. Not only is this cross very sensitive to movements in the yen, but it also provides a direct way to capitalize through the currency market on falling metal prices and rebounding bond prices (Chart I-14). Moreover, AUD is very sensitive to Chinese economic conditions, and tightening Chinese liquidity along with a falling RMB would do great damage to the Aussie. Chart I-13JPY Has ##br##Upside JPY Has Upside JPY Has Upside Chart I-14Short AUD/JPY Equal ##br##Short Metals / Long Bonds Short AUD/JPY Equal Short Metals / Long Bonds Short AUD/JPY Equal Short Metals / Long Bonds Bottom Line: Financial markets have priced in a lot of good news in a short amount of time. Investors are now vulnerable to a pullback in risk assets and a rebound in bond prices. This process is likely to support the European currencies and the yen against the dollar, but hurt commodity currencies. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Outlook: 2017's Greatest Hits", dated December 16, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The minutes from the December 14 FOMC meeting highlighted that Trump's fiscal proposal still lacks clarity, but the Fed's hawkish shift remains in place despite the tightening conditions brought about by a rising dollar. Anxiety about future growth may have resurfaced from this realization, prompting dollar bulls to close some of their bets: the DXY plunged 1.7% in just two days. Alongside this, Treasurys have rallied 1.7% and the 10-year yield has dropped 8 bps. Data from the U.S. in the past few months has been consistently positive, with this week also showing an uptick in Manufacturing PMI to 54.7 from 53.2, and prices paid increasing by 11 points to 65.5. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The Euro Area ended the year on an up note, as manufacturing, service and composite PMIs all outperformed consensus and preceding figures for most of the major euro countries. The resulting effect was a pickup in CPI, as headline inflation for the Euro Area came in at 1.1% YoY, and core at 0.9%. The labor market continues to make steady progress as Germany recorded a decrease in unemployed people by 17,000, and Spain, a decrease of 86,800. It is too early to tell whether this data will affect the ECB's next monetary policy stance. However, what is evident is that EUR/USD is more likely to move on U.S. economic surprises than anything else. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 On December 20th the BoJ left rates unchanged and maintained its yield curve control program that keeps 10-year rates near 0%. In its statement, the bank admitted that it expects a moderate expansion on 2017 as Japan continues to recover. We are sympathetic to this view. With the yen and Japanese real rates falling, the economy should be able to get out of its deflationary trap. Indeed, recent data shows that things might be turning for Japan: Both Services and Manufacturing PMI increased last month and are now at 52.3 and 52.4 respectively. Retail trade growth came at 1.7% YoY, beating expectations. We maintain that the yen should see more downside on a cyclical basis, given that the BoJ will maintain their yield curve control program until inflation overshoots their 2% target. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The pound has remained relatively unchanged against the dollar since the start of the year. The decision by the Supreme Court will be a key event to watch as it will determine whether the U.K. parliament has authority in determining how Britain exits from the European Union. Aside from political risks, The British Economy has remained resilient despite the uncertainty unleashed by last year's referendum. Recent data confirms this: Markit Manufacturing PMI came in at 56.1 versus expectations of 53. Surprisingly, Markit Services PMI reached 56.2, marking the biggest expansion of the service sector in a year. Despite much fear about the effects that the fear of Brexit would have on property prices, house prices continue to rise at a healthy 4.5% pace, beating expectations. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 AUD/USD has enjoyed a recent rally on the back of the greenback's decline. Additionally, the Australian services sector has improved considerably with the AiG Performance of Services Index recording a 6.6 point increase in November to 57.7. Although this may have contributed to the AUD bump, it is important to not look too much into this data as the Australian economy looks questionable - something we have discussed on several occasions. Australia's mining sector, China and emerging market uncertainty, a bearish outlook for commodity currencies and a USD bull market are all factors which will put downward pressure on AUD in the future. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The kiwi reached its lowest level since June right before the New Year, dipping slightly below 0.69. Indeed some recent developments have proved negative for the NZD: Dairy prices have slowed down after their meteoric growth in the last half of 2016. GDP growth came at 3.5%, below expectations of 3.7%. Nevertheless structural forces appear to favor the Kiwi economy. First, permanent long-term migration in Auckland is at a 24-year high. Although, in the short term this should contain inflation as the supply of workers increases, in the long term the additional demand should boost the economy. Moreover, household credit growth continues to be healthy at almost 10% without being excessive, as it still is well below pre-2008 levels. These factors should boost the kiwi economy and provide long-term support for the NZD, at least compared to the AUD. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The Canadian dollar failed to appreciate against the dollar alongside rising oil prices after the Fed's December 14 monetary policy decision. For a moment, the Canadian dollar seemed to be more a function of the dollar than of oil. However, this decoupling is historically unprecedented and USD/CAD will soon revert back to its negative association with oil prices, especially due to the likely subdued movements in the dollar in the near future. A longer term outlook for CAD entails moderate downside. A dollar bull market will keep a lid on oil prices and be bullish for USD/CAD. Shorter-term momentum points to some strength in the CAD, with the MACD line surpassing the signal line and the 14-day RSI approaching oversold levels. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 USD/CHF should continue to mirror the behavior of the euro against the U.S. Dollar. While it is true that the euro area had strong data at the end of the year, continued dollar strength should cap any rally in the euro. Thus, USD/CHF should remain relatively unchanged. On the other hand, EUR/CHF is currently at 1.07, a level at which the SNB is very likely to intervene if it drifts any lower. The SNB has been very explicit that they will not tolerate any further currency appreciation, until deflationary pressures have started to dissipate. Given that inflation finished 2016 with a yearly growth of 0%, the SNB will not stop intervening any time soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 In a recent speech, Norges Bank Governor Oystein Olsen asserted that the economy has turned the corner, projecting real GDP growth of 1.5% in 2017 and above 2% in 2018 and 2019. He also pointed to the solid growth experienced by the non-oil sector. Wage growth, after falling for the past 8 years, also appears to have bottomed at around 2% and is now picking up. More importantly, leverage in the economy is very high and continues to grow, with debt as a percent of disposable income projected to reach close to 250% by the end of 2018. All of these factors could fortify already present inflationary pressures in the Norwegian economy. This will push the Norges Bank off its dovish bias, and consequently, thrust the NOK higher, particularly against its crosses. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The Riksbank's monetary policy meeting on Wednesday concluded with an unexpected outcome -the board considered the option to be able to immediately intervene on the market if necessary. It is clear that Swedish officials are making an adamant attempt in achieving their inflation target, clearing out any obstructions that may slow down inflation. It must be highlighted however that Governor Martin Flodén is reticent on this policy in the current situation, suggesting that intervention risk is not looming for the time being. Nevertheless, it is important to note that this instrument has been added to their toolkit. This decision most likely stems from the 4.5% decline in EUR/SEK since November 8 of last year. Since Europe represents 82% of Sweden's imports, a risk of importing deflation exists. We believe a level of around 9.000 to 9.1000 for EUR/SEK seems like a potential intervention trigger. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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 December, the model underperformed global equities and the S&P in USD and local-currency terms. For January, the model increased its allocation to stocks and reduced its allocation to bonds (Chart 1). Within the equity portfolio, the weighting to euro area stocks was increased. The model boosted its allocation to Canadian and Swedish bonds at the expense of other European markets. The risk index for stocks deteriorated in December, as did the bond risk index. Feature Performance In December, the recommended balanced portfolio gained 2.1% in local-currency terms and 0.8% in U.S. dollar terms (Chart 2). This compares with a gain of 2.9% for the global equity benchmark and a 3.4% gain for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide other suggestions on currency risk exposure from time to time. The continued bonds selloff was a drag on the model's performance in December. Chart 1Model Weights bca.gis_taami_2016_12_23_c1 bca.gis_taami_2016_12_23_c1 Chart 2Portfolio Total Returns bca.gis_taami_2016_12_23_c2 bca.gis_taami_2016_12_23_c2 Weights The model increased its allocation to stocks from 53% to 57%, and trimmed its bond weighting from 47% to 43% (Table 1). The model boosted its equity allocation to Spain by 3 points, Germany by 2 points, Italy by 1 point, Japan by 1 point and France by 1 point. Meanwhile, weightings were reduced in Sweden by 3 points and New Zealand by 1 point. In the fixed-income space, the allocation to Canadian paper was boosted by 5 points, Sweden by 3 points, New Zealand by 2 points. The allocation to Italian bonds was reduced by 6 points, France by 4 points, U.K. by 3 points, and U.S. Treasurys by 1 point. Table 1Model Weights (As Of December 22, 2016) Tactical Asset Allocation And Market Indicators Tactical Asset Allocation And Market Indicators 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 dollar's attempt at consolidating its gains was cut short by the hawkish Fed. As a result, our Dollar Capitulation Index is back to levels that indicate the rally in the broad trade-weighted dollar could pause. However, unless the new administration pours cold water on expectations of a major fiscal boost, monetary policy divergence will underpin the dollar bull market (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 improved slightly reflecting a better reading from the momentum indicator. However, this asset class remains excluded from the portfolio (Chart 4). The risk index for global equities remains at the highest level in over two years. Despite this, our model slightly increased its allocation in equities following four consecutive months of reductions (Chart 5). Chart 4Commodity Index And Risk bca.gis_taami_2016_12_23_c4 bca.gis_taami_2016_12_23_c4 Chart 5Global Stock Market And Risk bca.gis_taami_2016_12_23_c5 bca.gis_taami_2016_12_23_c5 The deterioration in the value and liquidity indicators for U.S. stocks was offset by some improvement in the momentum reading. As a result, the risk index for U.S. stocks was flat in December (Chart 6). The risk index for euro area equities increased in December and is now at neutral levels. However, even after the latest increase, the risk index for euro area stocks is noticeably lower than the U.S. measure (Chart 7). Positive growth momentum and a weaker currency could provide support for the euro area equities. Chart 6U.S. Stock Market And Risk bca.gis_taami_2016_12_23_c6 bca.gis_taami_2016_12_23_c6 Chart 7Euro Area Stock Market And Risk bca.gis_taami_2016_12_23_c7 bca.gis_taami_2016_12_23_c7 The model slightly increased its allocation to German equities despite the deterioration in the risk index (Chart 8). Unlike most of the equity risk indexes in the model's universe, the one for Emerging Asian stocks improved in December. The model kept its allocation to this asset unchanged (Chart 9). Chart 8German Stock Market And Risk bca.gis_taami_2016_12_23_c8 bca.gis_taami_2016_12_23_c8 Chart 9Emerging Asian Stock Market And Risk bca.gis_taami_2016_12_23_c9 bca.gis_taami_2016_12_23_c9 The risk index for bonds deteriorated in December, but remains at a historically low-risk level reflecting oversold readings from the momentum indicator. The model has trimmed its allocation to bonds a touch (Chart 10). The risk index for U.S. Treasurys was little changed in December. Despite its very low risk reading, the model is adding allocation to bond markets that feature more oversold conditions. (Chart 11). Chart 10Global Bond Yields And Risk bca.gis_taami_2016_12_23_c10 bca.gis_taami_2016_12_23_c10 Chart 11U.S. Bond Yields And Risk U.S. Bond Yields And Risk U.S. Bond Yields And Risk Canadian bonds remain massively oversold based on our momentum measure, and the overall risk index is at extremely low-risk levels. The model boosted its allocation to this asset (Chart 12). With oversold conditions unwinding and the cyclical indicator moving in a more bond-negative direction, the overall risk index for Italian bonds has shifted back to neutral levels. The model has excluded this asset class from its allocation (Chart 13). Chart 12Canadian Bond Yields And Risk Canadian Bond Yields And Risk Canadian Bond Yields And Risk Chart 13Italian Bond Yields and Risk bca.gis_taami_2016_12_23_c13 bca.gis_taami_2016_12_23_c13 U.K. bonds remain deeply in low-risk territory, despite a small deterioration in its risk index. The oversold reading in the momentum measure is completely overshadowing the negative signal from the cyclical indicator. Allocation to gilts remains one of the highest in the bond universe, even after the model trimmed its exposure to this market (Chart 14). The risk index for Swedish bonds fell once again in December reflecting improved readings in all of its components. Extremely oversold conditions dominate the overall risk index and suggest that a pullback in yields is overdue. The model boosted its allocation to Swedish paper. (Chart 15). Chart 14U.K. Bond Yields And Risk U.K. Bond Yields And Risk U.K. Bond Yields And Risk Chart 15Swedish Bond Yields And Risk bca.gis_taami_2016_12_23_c15 bca.gis_taami_2016_12_23_c15 Currency Technicals The 13-week momentum measure indicates that the dollar's ascent could face near-term resistance. However, the continued recovery in the 40-week rate of change measure suggests that the dollar bull market has more upside. The latest round of central bank meetings reinforces the monetary divergence between the Fed on one side, and the ECB and BoJ on the other (Chart 16). With the prospect of the Bank of Canada staying put, while its southern peer gradually raises rates, the rate differential should exert downward pressure on the CAD/USD. Technically, the breakdown of the longer-term rate-of-change measure is pointing in that direction. In addition, the short-term rate of change metric is not stretched. However, the risk to this view is that the headwinds for the loonie arising from monetary policy divergences can be mitigated by higher oil prices (Chart 17). With the BoJ pegging nominal JGB yields, the differential in real rates is supportive of a stronger USD/JPY. This cyclical outlook for the yen is being confirmed by the 40-week rate of change measure. That said, the 13-week momentum measure is at levels that have signaled a pause in the yen weakening trend in both 2013 and 2015 (Chart 18). Chart 16U.S. Trade-Weighted Dollar* bca.gis_taami_2016_12_23_c16 bca.gis_taami_2016_12_23_c16 Chart 17Canadian Dollar Canadian Dollar Canadian Dollar Chart 18Yen bca.gis_taami_2016_12_23_c18 bca.gis_taami_2016_12_23_c18 Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Highlights BCA's U.S. Equity Strategy team would like to wish our clients a healthy, happy and prosperous New Year. Portfolio Strategy The growth vs. value style bias is due for a bounce, but beyond the near run, the outlook has become more balanced. Stick with a small vs. large cap bias for the time being, but get ready to book profits if domestic wage inflation continues to accelerate. Buy into the health care facilities sell-off. Value is surfacing as profit margin pressures subside. Recent Changes S&P 1500 Health Care Facilities - Boost to overweight today. Downgrade Alert Growth vs. Value - Downgrade alert. Table 1Sector Performance Returns (%) Contrarian Alert: Reflation Is Reversing Contrarian Alert: Reflation Is Reversing Feature Stocks look poised to maintain their momentum-fueled march higher into yearend, seemingly impervious to potential profit backlash from tightening monetary conditions, a more hawkish Fed and/or overheating sentiment. Sellers are holding back in anticipation of lower tax rates next year. In fact, our Composite Sentiment Gauge has surged to extremely bullish levels (Chart 1). This gauge comprises surveys of traders, individuals and investment professional sentiment. Overtly bullish readings have been a reliable contrary indication of building tactical risks, although not foolproof. The broad market has returned nearly 80%, excluding dividends, since the beginning of 2012, and over 5% since election night in November. Lately, earnings expectations have increased their contribution to the market's return, but the vast majority of the gains over the last five years can be explained by multiple expansion. Soaring median industry price/sales ratios are consistent with lopsidedly optimistic sentiment (Chart 1). Now that the Fed has signaled its intention to steadily raise interest rates in 2017, a critical question is whether profits can take over the reins from liquidity as the main market driver, at least partially validating the valuation increase? On this front, our confidence level is low. Profit margins are steadily narrowing. Our profit margin proxy is not signaling any imminent relief (Chart 2). With labor costs rising, faster sales are needed to halt the squeeze. But U.S. dollar appreciation is a significant headwind to top-line performance, given that 45% of sales come from abroad. As hedges fall off, the impact on 2017 revenue will become increasingly meaningful. Corporate debt levels are disturbingly high, in absolute terms and as a share of GDP (Chart 2, bottom panel). If borrowing costs continue to climb, then it will be hard for companies to turn expansionist, potentially offsetting any benefit from a reduced tax rate. Against this backdrop, it is difficult to envision a robust rebound in corporate profits. Our confidence level would be higher if monetary conditions were still reflationary. Instead, our Reflation Gauge (RG), a combination of oil prices, Treasury yields and the U.S. dollar, has plummeted at its fastest rate ever (Chart 3)! The speed and ferociousness of the plunge underscores the economic need for a massive and imminent fiscal offset. Chart 1Sentiment Is Overheating Sentiment Is Overheating Sentiment Is Overheating Chart 2Stiff Headwinds For The Corporate Sector Stiff Headwinds For The Corporate Sector Stiff Headwinds For The Corporate Sector Chart 3Reflation Is Dead Reflation Is Dead Reflation Is Dead The RG leads both equity sentiment and the U.S. Economic Surprise Index (ESI, Chart 3). If economic activity begins to disappoint in the coming months, i.e. before any meaningful fiscal stimulus arrives, there is a window of risk for the equity market because valuations will narrow as optimism fades, especially in those sectors that have gone vertical since the U.S. election. Keep in mind, last week we showed that typical Fed tightening cycles augur well for non-cyclical sector relative performance on a 12 and 24 month horizon. Surprisingly, financials and utilities have also managed to at least keep pace with the broad market, with cyclical sectors lagging behind overall market returns. The bottom line is that a number of objective indicators are signaling that the post-election rally will hit turbulence, perhaps in the first quarter of the New Year. Investors would be well served from a cyclical perspective to take advantage of value creation in defensive sectors while reaping any windfalls received in deep cyclical sectors. Will Growth Vs. Value Recover? The sudden surge in the financials and industrials sector has caused a sharp correction in the growth vs. value (G/V) share price ratio. The scope of the move has been both powerful and unnerving, catching many off guard, including us. Is this the start of a value renaissance after nearly eight years of growth stock dominance? History shows that sustained rotations into the value complex require validation from strengthening global economic growth. We have shown in previous research that G/V share price momentum is negatively correlated with the growth in durable goods orders, house prices and profits, i.e. when these variables accelerate, growth underperforms value. By virtue of the improvement in our global PMI composite (Chart 4), it would be easy to conclude that value stocks are coming back in vogue. Financials, energy and industrials account for over 50% of the value composite. These sectors only comprise roughly 15% of the growth benchmark. In addition, the technology sector weighs in at one third of the growth index, while representing only 8% of the value cohort. In addition, consumer discretionary and health care also represent about the same weight as technology in the growth composite, but only contribute about half that in the value index. It is no wonder that rising bond yields and hopes for a fiscal stimulus bonanza have triggered such a violent G/V reaction. While we are sympathetic to this view, extrapolating the last six weeks to continue over the next six months is dangerous. Much of the Treasury yield advance has been driven by inflation expectations. Global real yields are up, but not by as much as share prices have discounted (Chart 5). That is not surprising, as the soaring U.S. dollar is a deflationary force, and heralds a sharp rebound in the G/V ratio (Chart 5, top panel). Chart 4A Vicious Correction... A Vicious Correction... A Vicious Correction... Chart 5... That May Soon Reverse ... That May Soon Reverse ... That May Soon Reverse U.S. currency strength will make it difficult for developing economies to service large foreign debt obligations and could drain domestic liquidity if they are forced to sell foreign exchange reserves to defend their currencies. It is notable that EM capital spending is virtually nil in real terms, and their share prices are underperforming the global benchmark by a wide margin (Chart 5). Our Global Economic Diffusion Index has crested (Chart 5, shown inverted), perhaps picking up emerging market sluggishness. Unless the U.S. dollar begins to weaken, it is premature to forecast robust economic growth in the coming quarters, thereby raising some skepticism about the durability of the value stock rebound. The objective message from our Cyclical Macro Indicators for the growth vs. value style is slowly shifting from bullish to neutral, and the pricing power advantage no longer exists (Chart 6). However, the latter is an unwinding of the rate of change shock in the commodity complex rather than renewed demand-driven pricing power gains in the deep cyclical space. From a longer-term perspective, growth stocks should stay well supported by the increase in long-term earnings growth expectations (Chart 7). When the latter are rising, growth stocks tend to enjoy multiple expansion relative to value shares. Moreover, if equity volatility perks up on uncertainty over the path and pace of future fiscal policy and a more hawkish Fed, then growth stocks should receive another source of natural support. The VIX and G/V indices tend to correlate positively over time (Chart 7). Chart 6Mixed Signals Mixed Signals Mixed Signals Chart 7Structural Supports Structural Supports Structural Supports In sum, choosing value over growth is not a slam dunk, nor is forecasting a recovery to new highs in the G/V ratio given the large sector weightings discrepancies. Rather, a reflex rally in the G/V ratio is probable as post-election financials/industrials sector enthusiasm wanes, with a lateral move thereafter. Bottom Line: We will likely recommend moving to a neutral style bias over the coming weeks/months from our current growth vs. value stance, but expect to do so from a position of strength. A Revival In Small Business Animal Spirits? A broad-based and powerful rotation into small caps has occurred, as all the major small cap sectors have surged relative to their large cap counterparts (Chart 8), flattering our current stance. Small caps fit nicely into one of our overriding longer-term themes, namely favoring domestic over global industries. Small companies are typically domestically-geared regardless of geography, underscoring that if anti-globalization trends pick up steam, this theme could gain traction around the world. The potential for U.S. corporate tax cuts has provided another source of domestic company enthusiasm, because multinationals already have low effective tax rates. However, these developments are not assured, details remain scant, and chasing small cap relative performance on that basis alone could be a mistake from a tactical perspective. We have noted that we would recommend profit taking if evidence of a reversal in the small vs. large cap profit outlook materialized. Recent labor market and pricing power data are slightly worrying. The NFIB survey of the small business sector showed that planned labor compensation is still diverging markedly from the overall employment cost index (Chart 9, second panel). While reported price changes have also nudged higher, the discrepancy in labor cost gauges may be signaling that the massive profit margin gap between small and large companies will not be quick to close (Chart 9, bottom panel). Still, the overall NFIB survey was strong, and suggests that animal spirits in the small business sector may finally be reawakening (Chart 10, second panel). The latter may reflect an easing in worries about government red tape, excessive bureaucracy and health care costs. Chart 8Broad-based Small Cap Outperformance Broad-based Small Cap Outperformance Broad-based Small Cap Outperformance Chart 9Yellow Flag For Margins Yellow Flag For Margins Yellow Flag For Margins Chart 10Overbought, But Not Overvalued Overbought, But Not Overvalued Overbought, But Not Overvalued These sentiment shifts may allow extremely overbought technical conditions for the relative share price ratio to persist for a while longer (Chart 10, middle panel), particularly if the Trump honeymoon phase for the overall market lasts until early in the New Year. Importantly, there is no meaningful valuation roadblock at the moment (Chart 10). From a longer-term perspective, however, it is notable that the share price ratio is trading well above one standard deviation from its mean. Such a stretched technical level warns against getting too comfortable with small caps. In fact, the share price ratio is tracing out a pattern similar to the early-1980s (Chart 11), when it enjoyed a brief run to new highs in 1983 on the back of similar aspirations of meaningful fiscal thrust and as the U.S. dollar sprang higher. However, that surge was short-lived and in hindsight, was a blow-off top that marked the beginning of a massive underperformance phase. Chart 11The Big Picture The Big Picture The Big Picture Bottom Line: Stick with a small/large cap bias for now, but get ready to take profits if the relative profit margin outlook does not soon improve. Buy Into Health Care Facilities Weakness Rapid sub-surface market gyrations are creating attractive value in a number of areas, particularly in the defensive health care sector. In particular, we downshifted our view on the S&P health care facilities index at mid-year, because consumer spending on health care was decelerating, which favored moving into equities that paid for medical services (managed care) vs. those that provided them. While that trend remains intact, health care facilities stocks appear to be discounting an extreme scenario. The current concern is that the Affordable Care Act (ACA) will be repealed, leaving hospitals to foot the bill for uninsured patients. While such a scenario would potentially reverse the decline in the provision for doubtful accounts (PDA, Chart 12), a major profit margin support, the ACA is more likely to be reworked than repealed especially in the absence of a replacement plan. Importantly, there are other offsets. PDA follows the unemployment rate, which is signaling that the former will decline further. Hospital cost inflation is beginning to recede, led by drug costs (Chart 12). Physician services costs and inflation in other medical supplies is also subsiding. Health care facilities have also reduced capital spending in a bid to protect profit margins. Construction data show that hospitals have eased back on the throttle significantly (Chart 13). A shift to a profit margin preservation mentality is confirmed by the sharp reduction in headcount growth and decline in total wage inflation (Chart 13). Labor cost control provides another positive profit margin support, over and above the fillip from the reacceleration in hospital pricing power (Chart 13). Consumers are allocating an increasing portion of their spending to hospitals, which provides confidence that pricing power gains will stick. It would take massive earnings downgrades to validate the pessimism embedded in current valuations (Chart 14). Technical conditions argue that the sell-off is overshooting. The share price ratio has made new lows, but cyclical momentum is diverging positively. Given that this group is traditionally a strong U.S. dollar winner (Chart 14, top panel), there is scope for a playable relative performance rally in the coming six months. Chart 12Hospital Costs Are Easing... Hospital Costs Are Easing... Hospital Costs Are Easing... Chart 13... While Sales Improve ... While Sales Improve ... While Sales Improve Chart 14Dirt Cheap Dirt Cheap Dirt Cheap Bottom Line: Augment the S&P 1500 health care facilities index (BLBG: S15HCFA - HCA, UHS, WOOF, HLS, LPNT, SEM, SCAI, THC, ENSG, USPH, KND, CYH, QHC) to overweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Duration: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. Corporate Bonds: The macro back-drop is turning marginally more positive for corporate spreads. C&I lending standards are no longer tightening and bank stocks have rallied significantly. Corporate Bonds: Spreads are too tight at the moment, even for an improving economic environment. Remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now. We are actively looking to add exposure to corporate credit from more attractive levels. Feature There is no question that the U.S. economy is on a firm footing heading into the New Year. Third quarter real GDP growth came in at a robust 3.2%, and the Atlanta and New York Fed tracking models currently forecast fourth quarter growth of 2.6% and 2.7%, respectively. This represents a marked acceleration from the average growth rate of 1.1% witnessed during the first two quarters of 2016. Forward-looking survey data are also pointing in the right direction. The ISM non-manufacturing survey reached 57.2 in November, its highest level since October 2015, while the expectations component of the University of Michigan Consumer Sentiment survey reached 88.9 in December, its highest level since January 2015 (Chart 1). The question for bond investors is how much of this good news is already reflected in Treasury yields. Higher Treasury yields and a stronger dollar have already led to a material tightening in some broad indexes of financial conditions, enough to exert a meaningful drag on U.S. growth (Chart 2). In fact, according to the Fed's FRB/US model, the recent interest rate and dollar moves could be expected to shave 1% from GDP over the next eight quarters. Chart 1Economic Tailwinds Economic Tailwinds Economic Tailwinds Chart 2Financial Conditions Must Ease bca.usbs_wr_2016_12_13_c2 bca.usbs_wr_2016_12_13_c2 The natural conclusion is that while some upside in Treasury yields is justified by an improving economic outlook, the bond selloff has proceeded too quickly and must pause in the near-term to prevent financial conditions from exerting an excessive drag on growth. Sentiment and positioning indicators also confirm that the uptrend in yields appears stretched (Chart 2, bottom two panels). As such, last week we tactically shifted our recommended portfolio duration allocation from 'below benchmark' to 'at benchmark'.1 We expect Treasury yields will grind higher next year, reaching a range of 2.8% to 3% by the end of 2017, but the selloff will proceed more gradually, in line with the acceleration in economic growth. A More Uncertain World The premise that the bond selloff has proceeded too quickly is confirmed by our Global PMI models of the 10-year Treasury yield. We track two versions of our Global PMI model. One is a 2-factor model based only on the Global PMI index and a survey of bullish sentiment toward the U.S. dollar. The intuition behind this model is that improving global growth contributes to a higher fair value Treasury yield. However, for a given level of global growth, increasingly bullish dollar sentiment applies downward pressure to yields. This is because a stronger dollar represents a tightening of monetary conditions, so that all else equal, a stronger dollar means we should expect fewer Fed rate hikes. The current fair value reading from this 2-factor model is 2.26%, meaning that the 10-year Treasury yield at 2.49% appears somewhat cheap (Chart 3). The second version of our Global PMI model is a 3-factor model which adds the Global Economic Policy Uncertainty Index (EPUI) as a third independent variable. All else equal, an increase in uncertainty about the economic outlook should depress the term premium in long-dated Treasury yields. The data appear to back-up this assertion, as the EPUI is negatively correlated with the 10-year Treasury yield over time. With the addition of the EPUI, our 3-factor model explains 84% of the variation in the 10-year Treasury yield since 2010, compared to 80% from our 2-factor model. The EPUI spiked last month, and as such, this version of the model suggests that fair value for the 10-year Treasury yield is only 1.82% (Chart 4). Chart 32-Factor Global PMI Model bca.usbs_wr_2016_12_13_c3 bca.usbs_wr_2016_12_13_c3 Chart 43-Factor Global PMI Model bca.usbs_wr_2016_12_13_c4 bca.usbs_wr_2016_12_13_c4 There are probably good reasons to overlook last month's spike in policy uncertainty. For one, the EPUI, created by Baker, Bloom and Davis,2 is largely constructed from algorithms that scan newspaper articles for keywords. They do not attempt to distinguish between economic news with bond-bearish or bond-bullish implications. Second, we have found that large spikes in uncertainty that do not coincide with deterioration in economic growth tend to mean-revert fairly quickly. This past summer's Brexit vote being a prime example. As a counterpoint, however, the negative correlation between the EPUI and the 10-year Treasury yield is quite robust (Chart 5), and historically, incidents of spiking policy uncertainty and rising Treasury yields have been few and far between. Since 1991, there have been 42 instances when the monthly increase in the EPUI exceeded one standard deviation. In those 42 months, the 10-year Treasury yield increased only 36% of the time, with last month's 53 basis point rise being by far the largest on record. We tend to view the reading from the 2-factor model as the more reasonable assessment of fair value in the current environment. But the spike in policy uncertainty does underscore why we should view the recent bond selloff skeptically. The recent selloff has, to a large extent, been predicated upon promises of fiscal stimulus that have yet to be delivered, from a President-elect who has shown himself to be highly unpredictable. In this environment, near-term caution is clearly warranted. Of course, this week the market's focus will at least temporarily turn away from fiscal policy and toward the Fed. We expect that the Fed will announce a 25 basis point increase in the fed funds rate tomorrow, but also that participants' interest rate projections will not change meaningfully. The FOMC will likely be much slower to react to promises of fiscal stimulus than the market. With the Fed's projected near-term path for interest rates already mostly discounted by the market (Chart 6), we could see a "dovish hike" from the Fed tomorrow coinciding with the near-term top in Treasury yields. Chart 5Economic Policy Uncertainty & Treasury Yields bca.usbs_wr_2016_12_13_c5 bca.usbs_wr_2016_12_13_c5 Chart 6A "Dovish Hike" Is In The Price bca.usbs_wr_2016_12_13_c6 bca.usbs_wr_2016_12_13_c6 Bottom Line: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. A More Favorable Environment For Credit We frequently point to three main indicators that we use to assess the current stage of the credit cycle: Our Corporate Health Monitor (CHM) Monetary conditions relative to equilibrium C&I bank lending standards In a report3 published earlier this year we found that the performance of bank stocks relative to the overall market is another useful indicator (Chart 7). While the credit cycle is still very much in its late stages, recently, our indicators have been sending marginally more positive signals. The CHM remains deep in 'deteriorating health' territory and non-financial corporate balance sheets continue to lever-up aggressively. However, the indicator did inch slightly closer to 'improving health' territory in the third quarter due to an improvement in all six of its components (Chart 8). Make no mistake, trends in corporate balance sheet leverage are not supportive for corporate spreads. In fact, as we will explore in a future report, the recent divergence between rising leverage and tightening spreads is nearly unprecedented during the past 40 years. But at the margin, recent trends are less worrisome. Chart 7Credit Cycle Indicators Credit Cycle Indicators Credit Cycle Indicators Chart 8Corporate Health Monitor Components Corporate Health Monitor Components Corporate Health Monitor Components Box1: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole. These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets Second, although monetary conditions appear very close to our estimate of equilibrium, the recent steepening of the yield curve suggests that the market is revising its estimate of monetary equilibrium higher, leading to a de-facto easing of monetary conditions. In the long-run, with the Fed in the midst of a hiking cycle, this sort of easing is unlikely to persist. But, as we argued in a recent report,4 the bear steepening curve environment could continue in the first half of next year as the Fed is slow to respond to an improving economy. Third, C&I bank lending standards have fallen back to unchanged after having tightened for four consecutive quarters. This likely reflects less stress in the energy sector now that oil prices have rebounded. Fourth, bank stocks have rallied strongly alongside the steepening yield curve. To the extent that higher bank stock prices reflect lower future commercial loan delinquencies, then this trend should be viewed positively from the perspective of credit investors. To test the idea that bank stock performance might help us trade the corporate bond market, we take a look at the past six credit cycles, going back to 1975 (Chart 9). The bottom panel of Chart 9 shows the percent drawdown in relative bank equity performance from its peak during the most recent credit cycle. We define credit cycles as the periods between when the CHM crosses into 'improving health' territory. For example, we define the most recent credit cycle as beginning when the CHM fell into 'improving health' territory in 2002 and ending when it fell into 'improving health' territory in 2009. Shaded regions in Chart 9 show periods when the CHM is in 'deteriorating health' territory. Chart 9Bank Equity Drawdown & Corporate Bond Performance bca.usbs_wr_2016_12_13_c9 bca.usbs_wr_2016_12_13_c9 If we construct a trading strategy using the CHM alone, we can get fairly good results. We find that investment grade corporate bonds underperform duration-equivalent Treasury securities in 3 out of 6 instances, over a 12-month investment horizon, following the time when the CHM first crosses into deteriorating health territory, for an average excess return of -1.2% (Table 1). Table 1Corporate Bond Trading Rules: 12-Month Investment Horizon A Positive Signal From Bank Stocks A Positive Signal From Bank Stocks However, we find that this result can be improved if we also incorporate bank stock price performance. If we were to only reduce corporate bond exposure when the CHM was in deteriorating health territory and after the drawdown in bank equities exceeded 20%, then the position is still profitable in 3 out of 6 instances, but for a more negative average return of -1.9%. Further, if we were to wait for the drawdown in bank equities to surpass 30%, then the hit rate on our position improves to 3 out of 5 and the average return falls to -4.6%. We find similar results if we use a 6-month investment horizon (Table 2). In the current cycle, the drawdown in bank stocks breached 25% in February but has since reversed course, and it has not yet reached the 30% threshold. Our analysis suggests that corporate bond underperformance tends to persist for some time even after the drawdown in bank stocks exceeds 30%. Table 2Corporate Bond Trading Rules: 6-Month Investment Horizon A Positive Signal From Bank Stocks A Positive Signal From Bank Stocks Chart 10Corporate Spreads Are Too Low Corporate Spreads Are Too Low Corporate Spreads Are Too Low Bottom Line: The macro back-drop is turning marginally more positive for corporate spreads. We remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now, due to poor starting valuation (Chart 10). But we are looking for an opportunity to upgrade from more attractive spread levels in the next couple of months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Too Far Too Fast, But The Bond Bear Is Still Intact", dated December 6, 2016, available at usbs.bcaresearch.com 2 For further details on the construction of this index please see www.policyuncertainty.com 3 Please see U.S. Bond Strategy Weekly Report, "Lighten Up On Duration", dated February 16, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy If the Fed is about to begin interest rate re-normalization in earnest, then investors should heed the message from historic sector performance during tightening cycles. The tech sector remains vulnerable to tighter monetary conditions. Downshift communications equipment to neutral and stay clear of software. The OPEC supply agreement reinforces our current energy sector bias, overweight oil services and underweight refiners. Recent Changes S&P Communications Equipment - Reduce to neutral. Table 1 Prepare For The Return Of Equity Volatility Prepare For The Return Of Equity Volatility Feature Chart 1Why Is Equity Vol So Low? bca.uses_wr_2016_12_12_c1 bca.uses_wr_2016_12_12_c1 The equity market has been in a remarkably low volatility uptrend in recent weeks, powered by hopes that political regime shifts will invigorate growth. Signs of economic life have also played a role. The risk is that investors have pulled forward profit growth expectations on the basis of anticipated fiscal stimulus that may disappoint. In the meantime, the tighter domestic monetary conditions get, the less likely equity resilience can persist, especially in the face of rising instability in other financial markets. Volatility has jumped across asset classes, with the bond market leading the charge. The MOVE index of Treasury bond volatility has spiked. Typically, the MOVE leads the VIX index of implied equity market volatility (Chart 1, second panel). Currency and commodity price volatility has also picked up. It would be dangerous to assume that the equity market can remain so sedate. If the economy is about to grow in line with analysts double-digit profit growth expectations and/or what the surge in some cyclical sectors would suggest, then a re-pricing of Fed interest rate hike expectations is likely to persist. Against this backdrop, it is instructive to revisit historic sector performance during past Fed tightening cycles. If one views the next interest rate hike as the start of a sustained trend based on the steep trajectory of expected profit growth embedded in valuations and forecasts, then it is useful to use that as a starting point rather than last year's token 'one and done' interest rate hike. Charts 2 and 3 show the one-year and two-year average sector relative returns after Fed tightening cycles have commenced. A clear pattern is evident: defensive sectors have been the best performers by a wide margin, followed by financials, while cyclical sectors have underperformed over both time horizons. To be sure, every cycle is different, but this is a useful frame of reference for investors that have ramped up growth and cyclical sector earnings expectations in recent months. There has already been considerable tightening based on the Shadow Fed Funds Rate, a bond market-derived fed funds rate not bound by zero percent (Chart 4, shown inverted, top panel). The latter foreshadows a much tougher slog for the broad market. The point is that tighter monetary conditions can overwhelm valuation multiples and growth expectations. Chart 212-Month Performance After Fed Hikes Prepare For The Return Of Equity Volatility Prepare For The Return Of Equity Volatility Chart 324-Month Performance After Fed Hikes Prepare For The Return Of Equity Volatility Prepare For The Return Of Equity Volatility Chart 4A Blow-Off Top? A Blow-Off Top? A Blow-Off Top? The violent sub-surface equity rotation has presented a number of rebalancing opportunities. The defensive health care and consumer staples sectors have been shunned in recent weeks, with capital rotating into financials and industrials. As discussed previously, the industrials and materials sectors cannot rise in tandem for long with the U.S. dollar. These sectors should be used as a source of funds to take advantage of value creation in consumer discretionary, staples and health care where value has reappeared. Chart 5It's Not A ''Growth'' Trade bca.uses_wr_2016_12_12_c5 bca.uses_wr_2016_12_12_c5 Indeed, the abrupt jump in the cyclical vs. defensive share price ratio appears to have been driven solely by external forces, i.e. the sell-off in the bond market, rather than a shift in underlying operating profit drivers. For instance, emerging market (EM) equities and the cyclical vs. defensive share price ratio have tended to move hand-in-hand (Chart 5). The former are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the U.S. cyclical vs. defensive share price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debt liabilities, and the lack of EM equity participation reinforces that the recent rise in industrials is not a one way bet. As a result, our preferred cyclical sector exposure lies in the consumer discretionary sector, and not in capital spending-geared deep cyclical sectors. A market weight in financials, utilities and energy is warranted, as discussed below, while the tech sector is vulnerable. A Roundtrip For The Tech Sector? After a semiconductor M&A-driven spurt of strength, the S&P technology sector has stumbled. As a long duration sector, technology has borne a disproportionate share of the backlash from a higher discount rate, similar to the taper-tantrum period in 2013. Then, bond yields soared as the Fed floated trial balloons about tapering QE. Tech stocks did not trough until yields peaked (Chart 6). In addition, a recovery in tech new orders confirmed that the sales outlook had brightened. Now, the capital spending outlook remains shaky, and tech new order growth is nil (Chart 6). Meanwhile, tech pricing power has nosedived (Chart 6). Domestic deflationary pressures are likely to intensify as the U.S. dollar appreciates, particularly against the manufacturing and tech-sensitive emerging Asian currencies. Tech sales growth is already sliding rapidly toward negative territory (Chart 7), with no reprieve in sight based on the contraction in emerging market exports, as well as U.S. consumer and capital goods import prices. Chart 6Tech Doesn't Like Rising Bond Yields bca.uses_wr_2016_12_12_c6 bca.uses_wr_2016_12_12_c6 Chart 7No Sales Growth bca.uses_wr_2016_12_12_c7 bca.uses_wr_2016_12_12_c7 True, tech stocks have a solid relative performance track record when the U.S. dollar initially embarks on a long-term bull market (Chart 8). Why? Because tech business models incorporate deflationary conditions, investors have been comfortable bidding up valuations in excess of the negative sales impact from a stronger U.S. dollar. Nevertheless, history shows that this relationship becomes untenable the longer currency appreciation persists. Chart 8 shows that in the final phase of the past two U.S. dollar bull markets, tech stocks have abruptly reversed course, rapidly ceding the previously accrued gains. Apart from a loss of competitiveness from currency strength, the new anti-globalization trend is bad for tech as it has the highest foreign sales exposure. The bottom line is that there is no rush to lift underweight tech sector allocations. In fact, we are further tweaking weightings to reduce exposure. For instance, software companies are worth another look through a bearish lens. Software sales growth is at risk from pricing power slippage amidst cooling final demand (Chart 9). Chart 8Beware Phase II Of Dollar Bull Markets bca.uses_wr_2016_12_12_c8 bca.uses_wr_2016_12_12_c8 Chart 9Sell Software... bca.uses_wr_2016_12_12_c9 bca.uses_wr_2016_12_12_c9 The financial sector is an influential technology sector end market. On the margin, financial companies are likely to reduce capital spending on the back of deteriorating credit quality. Chart 9 demonstrates that when financial sector corporate bond ratings start to trend negatively, it is a sign that software investment will stumble. A similar message is emanating from the decline in overall CEO confidence (Chart 10), which mirrors the relentless narrowing in the gap between the return on and cost of capital (Chart 8, bottom panel). Even C&I bank loans, previously an economic bright spot, are signaling that corporate sector demand for external funds and working capital are softening, consistent with slower capital spending. Against a backdrop of fading software M&A activity, we are skeptical that the S&P software index can maintain its premium valuation (Chart 11). Chart 10... Before Sales Erode bca.uses_wr_2016_12_12_c10 bca.uses_wr_2016_12_12_c10 Chart 11Not Worth A Premium bca.uses_wr_2016_12_12_c11 bca.uses_wr_2016_12_12_c11 Elsewhere, the communications equipment industry will have trouble sustaining this summer's outperformance. Communications equipment stocks broke out of a long-term downward sloping trend-line on the back of productivity improvement. Chart 12 shows that after a period of intense cost cutting, wage inflation was negative. Our productivity proxy, defined as sales/employment, is growing rapidly. These trends are supportive of profit margins, and at least a modest valuation re-rating from washed out levels. Nevertheless, our confidence that a major bullish trend change has occurred after years of underperformance has been shaken. The budding reacceleration in top-line growth has hit a snag. New orders for communications equipment have rolled over relative to inventories. Investment in communications equipment has dipped (Chart 13). The telecom services sector has scaled back capital spending (Chart 13, third panel), suggesting that final demand will continue to soften. It will be difficult for companies to maintain high productivity if revenue growth stagnates. Chart 12Productivity Strength... bca.uses_wr_2016_12_12_c12 bca.uses_wr_2016_12_12_c12 Chart 13... May Be Pressured bca.uses_wr_2016_12_12_c13 bca.uses_wr_2016_12_12_c13 Consequently, the most likely scenario is that relative performance is entering a base-building phase rather than a new bull market, warranting benchmark weightings. Bottom Line: Reduce the S&P communications equipment index (BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV) to neutral, in a move to further reduce underweight tech sector exposure. Stay underweight software (BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, ATVI, EA, ADSK, SYMC, RHT, CTXS, CA). Energy Strategy Post-OPEC Production Cut Chart 14Energy Stocks Need Rising Oil Prices bca.uses_wr_2016_12_12_c14 bca.uses_wr_2016_12_12_c14 The energy sector continues to mark time relative to the broad market, but that has masked furious sub-surface movement. We have maintained a benchmark exposure to the broad sector since the spring, but shifted our sub-industry exposure in October to favor oil field services over producers, while underemphasizing refiners. OPEC's recent agreement to trim flatters this positioning. Whether OPEC's announcement actually feeds through into meaningfully lower production next year and higher oil prices remains to be seen, but at a minimum, supply discipline should put a floor under prices. Rather than expecting the overall energy sector to break out of its lateral move relative to the broad market, we continue to recommend a targeted approach. The energy sector requires sustained higher commodity prices to outperform, and our concern is that a trading range is more likely (Chart 14). OPEC producers suffered considerable pain over the last two years as they overproduced in order to starve marginal producers of the capital needed for reinvestment. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies (IOCs) cut capital expenditures by 40% over the same period. Chart 15 shows that only OPEC has been expanding production. That has set the stage for limited global production growth, allowing for demand growth to eat into overstocked crude inventories in the coming years. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to increase capital availability to the sector. With a lower cost and easier access to capital, producers, especially shale, will be able to accelerate drilling programs. The rig count has already troughed. The growth in OECD oil inventories has crested, which is consistent with a gradual rise in the number of active drilling rigs. As oversupply is absorbed, investment in oil field services will accelerate, unlocking relative value in the energy services space (Chart 16). Chart 15OPEC Cuts Would Help... bca.uses_wr_2016_12_12_c15 bca.uses_wr_2016_12_12_c15 Chart 16... Erode Excess Oil Supply bca.uses_wr_2016_12_12_c16 bca.uses_wr_2016_12_12_c16 This overweight position is still high risk, because it will take time to absorb the excesses from the previous drilling cycle. There is still considerable overcapacity in the oil field services industry, as measured by our idle rig proxy. Pricing power does not typically return until the latter rises above 1 (Chart 17). Companies will be eager to put crews to work and better cover overhead, and may accept suboptimal pricing, at least initially. Meanwhile, if EM currencies continue to weaken, confidence in EM oil demand growth may be shaken, eroding valuations. Still, we are willing to accept these risks, but will keep this overweight position on a tight leash and will take profits if OPEC does not follow through with plans to limit production. On the flipside, refiners will not receive any relief in feedstock prices, which should ensure that the gap between Brent and WTI prices remains non-existent (Chart 18). That is a strain on refining margins. Our model warns that there is little profit upside ahead. That is confirmed by both domestic and global trends. Chart 17Risks To A Sustained Rally bca.uses_wr_2016_12_12_c17 bca.uses_wr_2016_12_12_c17 Chart 18Sell Refiners bca.uses_wr_2016_12_12_c18 bca.uses_wr_2016_12_12_c18 Chart 19Global Capacity Growth bca.uses_wr_2016_12_12_c19 bca.uses_wr_2016_12_12_c19 Refiners have continued to produce flat out, even as domestic crude production has dropped (Chart 18). As a result, inventories of gasoline and distillates have surged, despite solid consumption growth. In fact, refined product output is about to eclipse the rate of consumption growth, which implies persistently swelling inventories. There is no export outlet to relieve excess supply. U.S. exports are becoming much less competitive on the back of U.S. dollar strength and the elimination of the gap between WTI and Brent input costs (Chart 19). Moreover, rising capacity abroad has trigged an acceleration of refined product exports in a number of low cost producer countries, including India, China and Saudi Arabia (Chart 19). Increased global refining capacity is a structural trend, and will keep valuation multiples lower than otherwise would be the case. The relative price/sales ratio is testing cyclical peaks, warning that downside risks remain acute. Bottom Line: Maintain a neutral overall sector weighting, with outsized exposure to the oil & gas field services industry (BLBG: S5ENRE - SLB, HAL, BHI, NOV, HP, FTI, RIG), and undersized allocations to the refining group (BLBG: S5OILR - PSX, VLO, MPC, TSO). Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Highlights The recent tightening in U.S. monetary conditions increases the risk of a pause in the dollar bull market. The yen is in a strong cyclical bear market, but it is best placed to benefit from a dollar correction. The ECB just eased policy; monetary divergences between the euro area and the U.S. will only grow wider, hurting the cyclical prospects for EUR/USD. We are opening a short EUR/JPY tactical trade. The SNB's EUR/CHF floor is firmly in place. USD/CHF will continue to mirror EUR/USD until Switzerland's output gap is fully closed. Feature The dollar will make new cyclical highs against all currencies, but the short-term outlook for the greenback is poor. The 7% appreciation in the dollar and the 100 basis point move in 10-year Treasury yields have tightened U.S. monetary conditions considerably. This development would be manageable in the face of actual stimulus, but it is a much greater handicap when the economy has not yet received any shot in the arm. Tactically, the yen is well positioned to benefit from a dollar correction as the ECB just deepened its easing bias. The Dollar Faces Short-Term Headwinds The dollar is extremely overbought, as our Capitulation Index warns of an imminent correction (Chart I-1). The likelihood that the dollar weakens further around the Fed's meeting is growing. Our discounter suggests the market is already expecting rates to be 60 basis points higher a year from now. While we do think this hurdle will ultimately be beaten, the move has been too fast. The U.S. economy has surprised to the upside, a reality highlighted by the strong rebound in the U.S. surprise index. However, this development is backward looking. While the economy has yet to receive the benefit of the potential Trump stimulus, it still has to contend with large adjustments in financial variables. Take mortgage rates as an example. They have risen by 70 basis points since July to 4%; however federal income tax withholdings - a proxy for income growth - have plunged (Chart I-2). Falling income growth and rising financing costs create a major tightening of U.S. household financial conditions. Chart I-1Overbought Dollar bca.fes_wr_2016_12_09_s1_c1 bca.fes_wr_2016_12_09_s1_c1 Chart I-2Tightening The Screw On Households bca.fes_wr_2016_12_09_s1_c2 bca.fes_wr_2016_12_09_s1_c2 On the corporate front, while the ISMs paint a very upbeat picture, the shock from the dollar's surge is large. The 7% increase in the broad trade-weighted dollar since August could curtail profits growth by 15%. This could lead to additional weakness in capex and a slowdown in employment. Altogether, based on the Fed FRB model, the recent interest rate and dollar moves could shave 1% from GDP over the next 8 quarters. This is not a trivial amount when trend growth is around 1.5%. This reality is unsustainable. As such, we agree with our U.S. Bond Strategy service that a temporary pullback in yields is likely. As we argued three weeks ago, this would mean a correction in the overbought dollar.1 Ultimately, this correction should prove temporary. The U.S. economy was on a strong footing before liquidity conditions tightened. A reversal of the recent dollar and bond moves will only solidify this economic trend. And exactly as the economy's strength redoubles, Trump's fiscal stimulus will take shape. The timing of this development is uncertain. Our current bet is that this will happen in late Q1 2017. Once our Composite Capacity Utilization Gauge moves back into "no-slack" territory, the market's now-premature Fed pricing will be warranted (Chart I-3). This is when the USD can rise again. Chart I-3Conditions For Repricing The Fed: Almost There bca.fes_wr_2016_12_09_s1_c3 bca.fes_wr_2016_12_09_s1_c3 Bottom Line: The dollar is in the midst of a cyclical bull market. However, markets rarely move in a straight line. This time is not different. The recent surge in the dollar and bond yields hurt the very fundamentals that have supported these moves in the first place. With the pain being inflicted on the economy before the benefits of any Trump stimulus package are felt, the likelihood of a partial reversal of recent trends is growing. The Yen: A Vehicle To Play A Dollar Correction The yen should be the key beneficiary of a dollar counter-trend fall. Our yen Capitulation Index shows that USD/JPY has not been as overbought as it is now in 21 years (Chart I-4). Moreover, bond yields continue to correlate tightly with the yen (Chart I-5). This simply reflects the low beta of Japanese yields. When global rates move up, JGB yields rise less, implying widening rate differentials in favor of USD/JPY. The opposite is also true. Chart I-4Yen Is Massively Oversold bca.fes_wr_2016_12_09_s1_c4 bca.fes_wr_2016_12_09_s1_c4 Chart I-5Yen And Bonds: Brothers In Arms bca.fes_wr_2016_12_09_s1_c5 bca.fes_wr_2016_12_09_s1_c5 While we continue to hold our short USD/JPY tactical trade, we remain very worried over the long-term outlook for the yen. The old policy of the Bank of Japan, targeting the quantity of money, was a failure. The monetary base increased by 220% between December 2012 and today, but M2 only grew 15% or so. In effect, the BoJ changed the composition of Japanese money, skewing it toward bank reserves as the money multiplier collapsed by 65% (Chart I-6). However, the new policy of targeting the price of money - interest rates - should deliver a higher growth dividend. As the economy improves, inflation expectations perk up (Chart I-7). But with the BoJ keeping nominal rates capped near 0%, this depresses real rates, further stimulating the economy and boosting inflation expectations. This also hurts the yen. Chart I-6Targeting The Quantity Of ##br##Money Was A Failure bca.fes_wr_2016_12_09_s1_c6 bca.fes_wr_2016_12_09_s1_c6 Chart I-7Stronger Japan = Higher##br## Inflation Expectations Stronger Japan = Higher Inflation Expectations Stronger Japan = Higher Inflation Expectations \ Additionally, by capping JGB yields at 0%, the BoJ accentuates the upward pressure on yield differentials between the rest of the globe and Japan that naturally occurs when global yields move up. This means that an upward move in global rates is even more harmful to the yen than before. Finally, the Abe administration is ramping up its fiscal stimulus rhetoric as the job-opening-to-applicants-ratio hits its highest level since 1991. Stimulating the economy in the face of labor market tightness is inflationary. With the BoJ committing to an accommodative policy stance until inflation overshoots by a wide margin, this policy is tantamount to willingly crush real rates and the yen.2 Bottom Line: The yen cyclical bear market is intact. However, if the dollar corrects and Treasurys temporarily rally, the extremely oversold yen will be the prime beneficiary. The Euro: This Is Not Tapering Mario Draghi managed to please both the hawks and the doves on the ECB's governing council. But once the dust settles, this week's policy move represents an important easing. While the ECB's purchases will be curtailed to EUR60 billion from EUR80 billion in April 2017, the asset purchase program now has an unlimited time frame. Additionally, not only can the ECB buy securities with a maturity of 1-year, the -40 basis-point floor on eligible securities has been scrapped. The staff forecasts reinforced a dovish message. Inflation expectations have been revised down, from 1.6% to 1.3% in 2017, despite an acknowledgement that energy prices will positively contribute to inflation. Furthermore, when a journalist asked President Draghi if the 2019 HICP forecast of 1.7% was in line with the ECB's target of "close but under 2%", Draghi squarely responded that 1.7% was not within the target; and therefore, the ECB would persist in maintaining its monetary accommodation. Moreover, the market responded with all the signs that the ECB had eased policy. The yield curve steepened by 11 basis points - its sharpest daily move since mid-2015, the euro plunged 1.3%, and European stocks, led by financials, rallied. With regards to the economic outlook, recent survey data have improved, with eurozone manufacturing and service PMIs rising to 53.7 and 53.8, respectively. However, worrying signs highlight the persistence of the euro area output gap. Euro area core CPI has rolled over and wage growth is slowing, despite the falling unemployment rate (Chart I-8). Additionally, broad money supply growth has rolled over sharply, seconding the omen bank equities have flashed for future credit growth (Chart I-9). Therefore, the European credit impulse could wane in the coming quarters. Chart I-8European Labor Market Slack Is Evident ##br##Signs Of European Excessive Slack bca.fes_wr_2016_12_09_s1_c8 bca.fes_wr_2016_12_09_s1_c8 Chart I-9Money, It's ##br##A Crime bca.fes_wr_2016_12_09_s1_c9 bca.fes_wr_2016_12_09_s1_c9 Going forward, monetary divergence between the euro area and the U.S. will grow further, supporting our bearish EUR/USD stance and our bullish dollar view. We are closing our long EUR/AUD trade as the ECB is clearly bent on goosing the European economy. Tactically, the outlook is much trickier and the euro could rebound. The euro capitulation index is oversold and relative positioning between the EUR and the USD is skewed (Chart I-10). For now, we are expressing our negative view on the euro by shorting EUR/JPY. Being in place since late September, the dovish implications of the BoJ's policy are much better appreciated by the market than the recent ECB's move. Moreover, short-term technicals for EUR/JPY are stretched and are beginning to roll over (Chart I-11). A pull back in EUR/JPY toward 116.5 is likely. Chart I-10Euro: Oversold... bca.fes_wr_2016_12_09_s1_c10 bca.fes_wr_2016_12_09_s1_c10 Chart I-11...But Overbought Against The Yen bca.fes_wr_2016_12_09_s1_c11 bca.fes_wr_2016_12_09_s1_c11 Bottom Line: The ECB eased policy this week. With the European economy exhibiting fewer signs of an impending pickup in inflation than the U.S., monetary divergences between the Fed and the ECB will only grow wider in the future. This will weigh on EUR/USD. In the short-term, risks to the USD could help the euro. Thus, we elect to express our bearish view on the euro by shorting EUR/JPY for now. The Swiss Franc: A Floor Is A Floor The SNB unofficial floor below EUR/CHF 1.06 is firmly in place. The Swiss economy sports a negative output gap of around 2.5% of GDP according to the IMF and OECD. Even after recent improvements, headline and core CPI remain below 0%. Both nominal and real Swiss retail sales are contracting at a 2.5% annual pace. This fits with wage growing near 0%, with consumer confidence hovering near levels last registered when the euro crisis was raging, and with house price annual growth falling to 1%. Unsurprisingly, Swiss business confidence is below its post-crisis average and business investment is tepid. In line with this poor corporate and consumer backdrop, Swiss non-financial credit growth has fallen to near 0% - among the lowest readings in the past 20 years, and the money multiplier remains depressed (Chart I-12). This suggests that the output gap will continue to narrow only slowly. Interestingly, the outlook for Switzerland was on a definite upswing in 2014, but the botched CHF unpegging of January 2015 caused the economic relapse witnessed in 2015 and 2016. With Swiss stocks - financials and exporters particularly - underperforming global averages, financial markets are still flashing a red flag for the SNB. This means USD/CHF will continue to mirror EUR/USD. Moreover, positioning on the CHF is at oversold extremes, highlighting the risk of a correction in USD/CHF (Chart I-13). Chart I-12No Credit Growth In Zurich bca.fes_wr_2016_12_09_s1_c12 bca.fes_wr_2016_12_09_s1_c12 Chart I-13Swissie Is Oversold bca.fes_wr_2016_12_09_s1_c13 bca.fes_wr_2016_12_09_s1_c13 On a structural basis, the outlook for the CHF is much brighter. The Swiss economy will firm as the SNB keeps the EUR/CHF floor in place. Employment growth is strong, real exports are healthy, and financial as well as monetary conditions are very supportive. Money supply should ultimately pick up. The SNB is expanding its balance sheet through the reserve accumulation required to maintain the peg. In due time, inflationary pressures and wage growth will re-emerge in Switzerland. In terms of signal, once we see Swiss inflation and wage growth back above 1%, as well as non-financial private-credit growth moving back to its post-2010 average, the SNB should abandon its peg. Supported by a net international investment position of 120% of GDP and a current account surplus of 11% of GDP, the long-term equilibrium exchange rate for CHF will continue to rise, lifting the Swiss franc in the process (Chart I-14). Chart I-14The CHF Has A Long Term Positive Bias bca.fes_wr_2016_12_09_s1_c14 bca.fes_wr_2016_12_09_s1_c14 Additionally, the inflationary consequences of Trump's policies may take time to emerge, but U.S. inflation could rise markedly when the USD cyclical rally ends.3 Because Switzerland is structurally a low-inflation economy and a net creditor to the world, the long-term appeal of the Swiss franc will only increase. Bottom Line: The SNB unofficial floor under EUR/CHF is alive as the Swiss economy still exhibits deflationary tendencies. On a 12-18 months basis, USD/CHF will move higher as the CHF will be dragged down by EUR/USD. Structurally, the Swiss franc will become a buy only once the SNB abandons its current policy. We are monitoring inflation, wages, and credit growth to judge when this will become a reality. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "One Trade To Rule Them All", dated November 18, 2016, available at fes.bcaresearch.com 2 For a more detailed discussion of the BoJ's policy, please see Foreign Exchange Strategy Weekly Report, "How Do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Trump: No Nixon Redux", dated December 2, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 bca.fes_wr_2016_12_09_s2_c1 bca.fes_wr_2016_12_09_s2_c1 Chart II-2USD Technicals 2 bca.fes_wr_2016_12_09_s2_c2 bca.fes_wr_2016_12_09_s2_c2 The dollar rose substantially on Thursday after the ECB policy decision. Before this, DXY had already hit overbought levels, as shown by the RSI. Currently, the capitulation index is also in overbought territory, suggesting that a correction is to come. Moreover, it is likely that the market had overpriced Trump's fiscal proposals, as details have yet to be released. The U.S. economy remains strong for now. The ISM Manufacturing and Non-Manufacturing hit 53.2 and 57.2, respectively. The labor market remains healthy despite the recent disappointing job reports. However, the tightening in U.S. financial conditions represents a short-term hurdle. Report Links: Party Likes It's 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_12_09_s2_c3 bca.fes_wr_2016_12_09_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_12_09_s2_c4 bca.fes_wr_2016_12_09_s2_c4 The euro encountered significant volatility following the ECB's decision. Although the interest rates were left unchanged, the ECB put forth an extension of the asset purchase program (APP) at the current pace of EUR 80 billion, but plan to reduce purchases to EUR 60 billion by April 2017. The euro declined on the news, and on a possible increase of the purchases if "the outlook becomes less favorable". Recent data reflects a strong economy overall, as well as strong performances from its participants. This will limit the euro's downside. However, the euro may encounter some volatility in the long run as potential political risks begin to be priced in, and stimulating monetary policy continues. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_12_09_s2_c5 bca.fes_wr_2016_12_09_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_12_09_s2_c6 bca.fes_wr_2016_12_09_s2_c6 The oversold U.S. bond market is finally stabilizing, a development that has also put a halt on the rapid yen sell-off of the past month, with USD/JPY encountering resistance at around 114.5. We are of the view that then yen downturn is overdone, as USD/JPY currently stands at highly overbought levels. That being said we continue to reiterate that past the short term, the outlook for the yen remains extremely bearish. The BoJ will continue to implement radical measures until it sees any signs of life in Japanese inflation. Recent data suggest this is not likely to happen any time soon: Japanese consumer confidence continues to be very depressed, standing at 40.9. Japanese GDP grew by a measly 1.3% YoY in Q3, underperforming expectations. Industrial production continues to contract, declining by 1.3%. Report Links: Party Likes It's 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_12_09_s2_c7 bca.fes_wr_2016_12_09_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_12_09_s2_c8 bca.fes_wr_2016_12_09_s2_c8 GBP/USD has rallied by about 4% from its end of October lows, being the best performer against the U.S. dollar among G10 currencies in this time period, in part because the U.K. economy has consistently beaten expectations. Nevertheless, recent data has been a mixed bag: while both construction PMI and Markit Services PMI outperformed expectations, Industrial and manufacturing production underperformed them, contracting by 1.1% and 0.4% respectively. We have often pointed to the cable as an attractive buy given that it is very cheap and fears of a significant slowdown in the British economy have been overblown. However it is important to point out that at levels near 1.30 the pound is no longer such a bargain, as the potentially damaging effects of Brexit still have to be taken into account. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_12_09_s2_c9 bca.fes_wr_2016_12_09_s2_c9 Chart II-10AUD Technicals 2 bca.fes_wr_2016_12_09_s2_c10 bca.fes_wr_2016_12_09_s2_c10 Recent data paint a dull picture for the Australian economy, the most concerning of which is the quarterly contraction in GDP of -0.5%, and an annual growth of 1.8%, below expectations of 2.5%. Before GDP was published, the RBA left its cash rate unchanged at 1.5% on the basis of a weak labor market and poor investment prospects. With only part-time employment growing, and full-time employment contracting, it is unlikely that this growth will translate into improving consumer spending or inflation. RBA Governor Philip Lowe also highlighted that tightening monetary conditions and uncertainty have subdued business investment. We remain bearish on the AUD. The recent GDP figures may also cause the RBA to become slightly dovish in the future if data does not compensate for current weaknesses. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 bca.fes_wr_2016_12_09_s2_c11 bca.fes_wr_2016_12_09_s2_c11 Chart II-12NZD Technicals 2 bca.fes_wr_2016_12_09_s2_c12 bca.fes_wr_2016_12_09_s2_c12 We continue to be bearish on the kiwi on the short term, given that dollar strength will continue to weigh on this currency. That being said, some factors make this currency attractive against its crosses. While it is true that inflation is very low, this is mostly due the price of tradable goods falling by 2.1% YoY, which reflects the fall in commodity prices. Non-tradable inflation on the other hand stands at a healthy 2.4%. With base effects taking hold, inflation should pick up again, a development which could put upward pressure on rates and support the NZD on its crosses. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 bca.fes_wr_2016_12_09_s2_c13 bca.fes_wr_2016_12_09_s2_c13 Chart II-14CAD Technicals 2 bca.fes_wr_2016_12_09_s2_c14 bca.fes_wr_2016_12_09_s2_c14 Canada's export sector has recently come into light as a factor hurting the economy. Although export figures for October increased by 0.5% on a monthly basis, this reflected a 1.2% increase in energy export prices offsetting a 0.7% decline in volume, and this was despite a stronger U.S. economy and a weaker CAD. Recent news highlights that Mexico has overtaken Canada as the second biggest exporter of goods to the U.S, reflecting rising Canadian unit labor costs and declining productivity, as well as the recent appreciation in CAD/MXN. Domestically, Canada continues to be mired by a bleak outlook. Wednesday's monetary policy statement highlights that uncertainty and tightening monetary conditions are hampering business confidence and investment. The BoC, therefore, kept rates unchanged at 0.5%. Rate divergences will lift USD/CAD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 bca.fes_wr_2016_12_09_s2_c15 bca.fes_wr_2016_12_09_s2_c15 Chart II-16CHF Technicals 2 bca.fes_wr_2016_12_09_s2_c16 bca.fes_wr_2016_12_09_s2_c16 USD/CHF will continue to mirror the Euro as the unofficial peg by the SNB is likely to stay enforced. The Swiss economy continues to be plagued by deflationary pressures. Additionally, Switzerland's real retail sales continue to contract by 2.5%YoY, while wage growth remains at 0% and consumer confidence is hovering near 2010/2011 lows. The SNB will try to avoid their 2015 blunder, where they unpegged the currency, and derailed the economic recovery that Switzerland was experiencing. On a longer time basis the outlook for the franc is very positive. This currency continues to be supported by a current account surplus of 11% of GDP and monetary conditions are as accommodative as they can be, which means that eventually SNB will have to break the floor under EUR/CHF, letting the Swiss Franc follow rising fair value. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 bca.fes_wr_2016_12_09_s2_c17 bca.fes_wr_2016_12_09_s2_c17 Chart II-18NOK Technicals 2 bca.fes_wr_2016_12_09_s2_c18 bca.fes_wr_2016_12_09_s2_c18 We are bearish on the NOK versus the dollar, yet we are positive on this currency on its crosses, as oil should outperform other commodities. Moreover, Norway is the only country in the G10 where inflation is above target, which should put pressure on the Norges Bank to abandon its easing bias. The housing sector is also in dire need of higher rates. However, a big portion of household indebtedness in Norway is in adjustable rate mortgages. As house prices and household debt keeps rising, rising rates will become more dangerous as an ever larger pool of fragile debt would be at risks. Thus, it is imperative for the Norges Bank to not keep monetary policy too accommodative for too long in order to avoid further excess in household debt and in the housing market. This will eventually prove bullish for the NOK. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 bca.fes_wr_2016_12_09_s2_c19 bca.fes_wr_2016_12_09_s2_c19 Chart II-20SEK Technicals 2 bca.fes_wr_2016_12_09_s2_c20 bca.fes_wr_2016_12_09_s2_c20 Despite recent resilience in the consumer sector, a risk is looming. Rising house prices and increased mortgages have become a notable issue, as Riksbank research points out. Low rates have allowed households to finance their mortgages at a low cost and markets are worrying about household indebtedness, with around 35% of new borrowers burdened with debt above 650% of their disposable income, according to an IMF study. This may be a potential danger as consumers substitute consumption for debt-servicing, limiting the upside for Swedish interest rates. In the short run, the outlook remains more upbeat for the SEK as the dollar will swap overbought optimism for economic reality. But longer term, USD/SEK has more upside. Report Links: One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades