Euro Area

Highlights Even isolated North Korean attacks are unlikely to lead to a full-scale war; The USD sell-off will start to reverse once Trump makes Gary Cohn his official pick for Fed chairman; Europe is not a risk for investors ... even Italy is only a longer-term risk; France is reforming; stay long French industrials versus German. Feature Last week, in London, we were scheduled to give a talk on Sino-American tensions, East Asian geopolitical risks, and North Korea specifically. We submitted our topic of choice about a month ahead of the event, when tensions between Pyongyang and Washington were at their height. As tensions temporarily subsided following Supreme Leader Kim Jong-Un's decision to delay the planned missile launch towards Guam, several colleagues wondered if the topic was still a pertinent one. We stressed in our research that tensions would not dissipate and would continue to be market-relevant, if not critical for S&P 500.1 Unfortunately, we have been proven right. Forecasting geopolitics requires insight, multi-disciplinary methodology, and a treasure trove of empirical knowledge. But sometimes it also just comes down to using Google and looking at a calendar. For example, given the present context of heightened tensions, the annual U.S.-South Korean military exercises - Key Resolve, which occurs normally in the spring, and Ulchi-Freedom Guardian, which occurs in August - are obvious dates to monitor. They are provocations that North Korea has to respond to for both foreign and domestic audiences. Pyongyang has chosen to do so by firing an ICBM across Japan and testing a sixth nuclear device, allegedly a miniaturized hydrogen bomb. While both these actions qualitatively expand on previous acts (missile and nuclear tests), neither cross a threshold. We are still in the realm of "territorial threat display." President Trump and Supreme Leader Kim are angling their "swords," but have not dared to cross them yet. Nonetheless, our clients have pointed out that our "arch of diplomacy" approach leaves a lot to imagination. Therefore, the first insight from the road of this week is that we need to put our thinking cap on and imagine a scenario where tensions do blow over into open conflict. How do we imagine such a scenario occurring and why would it not devolve into full out war that forces the U.S. to attack the North Korean mainland? Is North Korea About To Become A Praying Mantis? We can imagine a scenario where North Korea commits an act that takes us beyond the nuanced thresholds set by recent history (Chart 1). For example, we have cited to clients that an attack against international shipping in the Yellow Sea or Sea of Japan by North Korean submarines would be an unprecedented act that the U.S. and Japan would likely retaliate against.2 We could see the U.S. following the script from 1988 Operation Praying Mantis in the Persian Gulf - the largest surface engagement by the U.S. Navy since the Second World War - when the U.S. sunk half of Iran's navy in retaliation for the mining of the guided missile frigate USS Samuel B. Roberts. In the case of North Korea, this would primarily mean taking out its approximately 20 Romeo-class submarines and an unknown number of domestically-produced - Yugoslav-designed - newly built submarines.3 Chart 1North Korean Provocations Rarely Affect Markets For Long Such an increase in tensions is not our baseline case, but we assign much higher probability to it than to an all-out war on the Korean Peninsula (which we still see as highly unlikely). How would the markets react to the sinking of North Korean submarines? How would Pyongyang react? The answer to the former (market's reaction) depends on the answer to the latter (what does Pyongyang do?). Our best guess is that Pyongyang would do nothing. In fact, we may never know that North Korean submarines were sunk. We would suspect that North Korean military strategists would chalk the subs as a loss and quietly move on to more missile tests. Leadership in Pyongyang is massively constrained by its quantifiable military inferiority. This part requires a bit of "order-of-battle" analysis, so bear with us for a few paragraphs. North Korea has around 6 million military personnel, about 25% of the total North Korean population, ready to fight. Which would be great if it were preparing to charge Verdun in WWI. Unfortunately for Pyongyang, it is arrayed against one of the most sophisticated defenses ever constructed by man. To burst through the Demilitarized Zone (DMZ), its mammoth ground forces would have at their disposal about 2000 T-55s (designed in the 1950s) and an unknown number of T-72s (designed in the 1970s). The former are obsolete, but the latter are solid main battle tanks that could do damage ... that is, in a world where war was not airborne. The problem is that North Korea would lose air superiority within hours of any serious engagement leaving its tanks and ground troops vulnerable to death-from-above. Since North Korean troops would have to enter about 20 miles into South Korea to threaten Seoul with occupation, they would have to exit the range of most of their air defenses. Choosing to turn on the most powerful of their systems - such as the KN-06 with a 150km range - would leave them vulnerable to the U.S. AGM-88 HARM missiles that sniff out active radar antenna or transmitters. To protect its invading forces, North Korea would have at its disposal only about 20-30 Mig-29s. Countering two dozen jets would be South Korea's combined 177 F-15 and F-16s, plus American forces that would vary in size depending how many aircraft carriers were deployed in the vicinity and whether U.S. forces in Japan were deployed to counter the attack. Given that a single American aircraft carrier holds up to 48 fighter jets, North Koreans would likely quickly find themselves fighting a losing battle. Once the North Korean fighter jets were destroyed, the South Korean air force would turn the invasion into a massacre. The reality is that North Korea's ground forces are just for show. Its tanks and fighter jets will never see battle. North Korea really only has two gears: P & N. The first is for "Provocation" and the second is for "Nuclear Armageddon." This is why we highly doubt that we will see our Praying Mantis scenario play out, or lead to full-scale war if it does. North Korea is constrained by its technological inferiority. It does not have the ability to conduct war across a full spectrum of engagement. Neither did Iran in 1988, which is why it never retaliated for the loss of its navy, put all its revolutionary zeal and chest-thumping aside, and sued the U.S. at the International Court of Justice instead.4 The U.S. has a range of limited military engagements, particularly at sea, that could hurt Pyongyang's ability to project what little power it has. Given our constraint-based methodology, which requires one to have some understanding of military affairs, we have a fairly high conviction view that North Korea will continue to toe-the-line of the expected and thus accepted provocations along the lines of the history surveyed in Chart 1. Going beyond that list would threaten to expose the paucity of North Korea's military capabilities. Bottom Line: We are still in for a wild ride with North Korea. As we expected, regional safe haven assets continue to perform well. We will hold on to our safe haven basket of Swiss bonds and gold, up 2.6% since August 16. Nonetheless, we expect North Korea to steer clear of provoking a war. Gary Cohn Will Collapse The USD! (But What If He Already Did?) Several fast-money clients - both in the U.S. and Asia - have a theory for why the greenback continues to suffer: Gary Cohn. The theory goes that Cohn is an ultra-dove whose job as the next Fed Chair will be to stay "behind the curve" and drive down the USD. This would accomplish President Trump's lofty nominal GDP growth goals despite legislative hurdles to his fiscal policy. It would also keep risk assets well bid and help begin rebalancing the U.S. trade deficit. What do we know of Mr. Cohn's views on monetary policy? Not much: He defended the Trump administration goal of a 3% GDP growth target, suggesting that he has a far more optimistic view of U.S. growth than the current Fed projection;5 He believes that monetary policy is "globalized," intoning at a conference in Florida quickly after the election that the Fed policy of raising rates before the rest of the world is ready to do the same would be a mistake;6 In a January 2016 Bloomberg TV interview, he said that both the U.S. and Chinese currencies were overvalued and would both have to devalue.7 People who know and have worked with Gary Cohn (including one colleague at BCA!) speak highly of his pragmatism, work ethic, and focus. Most agree that he would likely be dove-ish, but there is not a single person we have spoken to who thinks that he will be Trump's puppet. As such, his disconnected statements largely say nothing about his potential style of leadership. His most ultra-dovish, USD-slaying comment comes from January 2016, with DXY 6.9% down since then (Chart 2). Mission Accomplished Mr. Cohn? The real reason for the USD slide, aside from a persistently disappointing inflation print, has been a realization by the market that President Trump's bark has no bite. On a slew of measures, President Trump's initial bravado has dissipated into flabby rhetoric. Chart 3 shows the initial surge in optimism regarding growth, tax reform, infrastructure spending, Mexico's comeuppance, and bi-partisanship (measured as support among independents). Each data point has not only fallen back to pre-election levels, but appears to have now been desensitized to any news that would have excited it in the past. For example, NAFTA negotiations are off to a poor start, President Trump continues to bash the trade deal, and yet the peso has rallied since Trump's inauguration! Chart 2Mission Accomplished, Mr. Cohn? Chart 3Trump's Bark Has No Bite? The Fed itself has lost faith in the president. The number of FOMC members who see upside risks to inflation and GDP growth, not unrelated to fiscal policy, has fallen after a brief surge after the election (Chart 4). Chart 4The Fed Also Doubts Trump What chances are there for the White House and Congress to re-write the fiscal narrative over the final quarter of 2017? As we wrote last week, Hurricane Harvey will ensure that a debt ceiling breach and government shutdown are avoided. However, Congress is likely to spend September making one last attempt at Obamacare repeal and replace, thus largely wasting the month before returning to tax reform in earnest in the new fiscal year. We expect some form of tax legislation to take shape by the end of December. Will it be comprehensive tax reform? Unlikely. It will now almost certainly be merely a tax-cutting exercise, with some revenue offsets attached to it. With the Republicans in Congress now leading the tax reform effort, it is unlikely that the budget deficit hole will be as wide as President Trump would have wanted. The problem is that both Trump's July tax reform proposal and the House GOP August plan come short of revenue-neutrality by around $3-3.5 trillion (over the decade-long period) (Table 1). Given that such a massive increase in the deficit would be unacceptable to fiscal hawks (or Democrats) in the House, we would expect tax rates to be cut by a much more modest degree. Table 1By How Much Will Republican Tax Cuts Widen The Deficit? Table 1 gives a detailed survey of the preferences (Tax Cuts) and constraints (Revenue Offsets). It is difficult to see how all the constraints are overcome through the legislative process. This will force Republicans to modify their preferences on the scale of tax cuts. We would expect that a corporate tax cut from 35% to around 27-28% could be possible, along with a minimal middle-class tax cut. Anything beyond that would be overly complicated. Therein lies the paradox for Chair Cohn. The only way that he can be "behind the curve" is if the curve gets "in front of him." But why would it if any coming tax legislation has very little stimulative effect on the economy? Currently, the expected change in the Fed Funds Rate over the next two years stands at a measly 40 bps (Chart 5). That is just barely two rate hikes until September 2019. How can Mr. Cohn get the expectations any lower at this point? Bottom Line: The appointment of Gary Cohn will be a classic "sell the (USD on the) rumor, buy (the USD) on the news." We expect his appointment in late November or early December, if President Trump goes by the lead time from the past two nominations (Chart 6). That may be the time to pare back USD shorts for those investors who have been bearish on the greenback. Chart 5Hard To Drive Expectations##BR##Lower For Rate Hikes Chart 6How Long Does It Take To##BR##Confirm The Fed Chair? Europe Is Not A Risk Chart 7Europe's Economy Zooming Along One clear insight from our five weeks on the road this summer is that Europe is no longer on anyone's radar. We had hardly any questions regarding the upcoming German or Italian elections. And while most investors were somewhat pessimistic regarding French structural reforms, none expressed any interest in betting against them either. The obvious reason is that Europe's economy has genuinely recovered (Chart 7). Consumer and business confidence are holding up while the manufacturing PMI and industrial production remain strong. That said, uniformity of view among clients across several geographies makes us nervous. On the future of the Euro Area, investors have swung wildly from morose to resigned that it is here to stay. Nonetheless, we generally agree with the consensus. Unlike at the beginning of this year, when we boldly claimed that European risks would turn out to be a "trophy red herring," we have no alpha to generate by disagreeing with the market.8 Here is why: German Election: We have a policy of not wasting our client's time by covering major geopolitical events that have no market-relevance. Germany is the world's fourth-largest economy and it will hold an election on September 24. However, we see no investment relevance in the election and therefore no reason to spend time covering it. Polls show that the center-left opposition Social Democratic Party (SPD) has arrested its decline and may force another Grand Coalition (Chart 8). The only moderately interesting question is whether Chancellor Angela Merkel's Christian Democratic Union (CDU) will be able to get its favored coalition ally, the Free Democratic Party (FDP), into government instead. The FDP has turned towards soft Euroskepticism since 2009. Its parliamentarians voted against several bills dealing with the Euro Area crisis during their 2009-2013 coalition with the CDU. That said, Chancellor Merkel has turned much more forcefully pro-Europe since the dark days of Greek bailouts and bond market rioting. The Chancellor can read the polls: Germans support the common currency at 81%, compared to 66% average between 2009-2013 (Chart 9). We expect the FDP to play along with the Europhile conversion by the CDU. Chart 8Another Grand Coalition? Chart 9Merkel Knows Germans Support The Euro If there is any significance to the calm ahead of the German election, it is that the country is at "peak normal." Its policymakers have dealt with a massive migration crisis, geopolitical crises to the East, terrorist attacks, and severe political and economic stresses in its sphere of influence, all with a near-complete absence of internal drama. This looks like either "as good as it gets," or the start of a new Golden Age in Europe, with Berlin in the lead. It is probably neither, but given European asset prices, and gearing to the growing global economy, we would remain overweight Euro Area equities going forward. Italian Election: Polls remain too-close-to-call in the upcoming Italian election, with Euroskeptic parties continuing to poll well (Chart 10). However, we are not sure one can truly call these parties Euroskeptic anymore. Despite a high level of Euroskeptic sentiment in the country (Chart 11), its Euroskeptic parties have been scared off by the failures of peers in Austria, the Netherlands, and France. Chart 10Italy: Euroskeptic Parties Poll Well... Chart 11...Reflecting Broader Euroskepticism Luigi Di Maio, leader of the anti-establishment Five Star Movement (M5S) in the Italian Chamber of Deputies, and Matteo Salvini, head of the right-wing, populist Lega Nord, both reversed positions on the euro this month. Di Maio will be 5SM candidate for prime minister in the upcoming elections - which must be held by May and will likely take place in February or March. He reiterated a position, which 5SM hinted at in the past, that leaving the Euro Area would only be the "last resort" if Brussels refused to relax strict budget rules. Meanwhile, the firebrand, populist, Salvini hid behind Italy's constitution, claiming that a referendum on the euro would be illegal. In the short term, this means that the election in 2018 is no longer a risk. In the long term, it does not change the fact that Italy is ripe for a bout of Euroskeptic crisis at some later stage. Migration Crisis: Bad news for right-wing populists everywhere: the migration crisis is over and in quite a dramatic fashion. This is an empirical fact (Chart 12). Europe's enforcement efforts and collaboration with Libyan authorities (such as they are) have now forced even the humanitarian agencies to abandon the Mediterranean route. One of the largest such agencies - the Migrant Offshore Aid Station (MOAS) - recently announced that it was packing its mothership, the Phoenix, for Myanmar. The group is the fourth to stop patrols for migrants. Medecins sans Frontieres, Save the Children, and Germany's Sea Eye all cited hostile actions taken by Libyan authorities towards their vessels as the main reason to stop rescuing migrants in Libyan waters. Chart 12The 'Migration Crisis' Is Definitively Over To be clear, what is happening in the Mediterranean is a result of European enforcement efforts, not any sudden awakening of Libyan capacity or sovereignty. The European Union and Italy are training and funding the Libyan Coast Guard, which has started to intercept humanitarian vessels, threaten them with force (often right in front of the Italian Navy!), and force them to return migrants to Libya, where they are subjected to extremely cruel internment. Prior to this development, human smugglers would launch barely seaworthy "crafts" towards humanitarian ships waiting literally yards away in Libyan waters to "rescue" the "migrants" to Europe. As such, humanitarian agencies were aiding and abetting human smuggling, by making it a lucrative enterprise with no downside risk for the smugglers. We expect the step-up in enforcement in Libyan waters to severely impair the cost-benefit calculus of attempting a Mediterranean crossing for a would-be migrant. Instead of a welcoming NGO vessel many will find themselves in Libyan Internment camps. Word will spread fast and the migration crisis will abate further. We have now come full circle on the migration crisis, which we predicted back in September 2015 would end precisely in such an illiberal fashion.9 Europe has a vicious streak ... who knew? Structural Reforms In France: In February, we penned a bullish report on France, arguing with high conviction that Marine Le Pen would lose and that structural reforms would follow.10 What is the status of the latter forecast? Despite a decline in President Emmanuel Macron's popularity (Chart 13), he is expending his political capital early in his term. He understands our "J-curve of Structural Reform" (Diagram 1). Policymakers who understand how the reform J-curve works know that they have to spend their political capital while they have it, at the beginning of their term, in order to reap the benefits, if there are any, while they are still in power. Chart 13Macron's Popularity Slips Diagram 1The J-Curve Of Structural Reform How do Macron's reforms compare with previous efforts? Generally speaking, Macron's reforms (Table 2) compare favorably with both the 2012 Mariano Rajoy reforms in Spain and the 2003 Hartz reforms in Germany. The Hartz reforms were instrumental in expanding temporary work contracts and restructured generous unemployment benefits. Similarly, the Rajoy reforms in Spain clarified economic grounds for dismissal and created more flexible "entrepreneur contracts." Macron's reforms fit these efforts, especially the proposals to put in place "project contracts" - an open-ended contract lasting for the duration of a project - and to establish a floor and a ceiling for allowances in cases of unfair terminations, and make termination for economic reasons easier. Table 2French Labor Reforms: The Key Bits The two criticisms of the reform efforts we most often hear are that France has not had a crisis to spur reforms and that unions will launch vicious protests. The first criticism is dubious, given that France is itself emerging from the low-growth doldrums of the post-Great Financial Crisis. It is simply false to say that France has had no crisis. The French public is acutely aware that its real per-capita GDP growth has been closer to Greek levels than German ones over the last two decades (Chart 14) and that it has lost competitiveness in the global marketplace (Chart 15). One cannot have a conversation with a French friend, colleague, or client without wanting to order a strong drink!11 Chart 14France's Lost Millennium Chart 15France's Lost Competitiveness Besides, what monumental crisis was it that propelled Germany into reforms in the early 2000s? A vicious recession? A massive bank crisis? It was neither. Germany was simply weighed down for a decade by fiscal transfers to East Germany and sensing that its export-oriented industry was facing a massive challenge from the Asian move up the value chain. It was this acute sense of competitive pressure, of falling behind, that spurred Germany to reform. With France, the acute sense of falling behind Germany (Chart 16) is at the heart of today's effort. Chart 16German Competition Puts A Fire Under France The second criticism, that the unions will hold protests, misjudges the political capital arrayed behind Macron. Despite his sagging popularity, 85.9% of the seats in the National Assembly are of pro-reform orientation (Diagram 2). The second-largest party in the parliament is Les Republicains, an even more zealously pro-reform group. This is a unique situation in French history and will allow the government to ignore protests on the street. Diagram 2The Balance Of Power In France's National Assembly In fact, two of the largest unions in France - Force Ouvrière and CFDT - have both said they would not protest the labor reforms. This leaves only the more militant CGT to protest, along with the left-wing presidential candidate Jean-Luc Mélenchon. The reason investors will still fret about protests this month is because CGT retains a strong representation in heavy industry and infrastructure sectors like energy and railways. As such, their industrial action could grind the country to a halt. We suspect that a repeat of the 1995 general strike or the 2010 French pension reform unrest - both of which CGT spearheaded - will be the final nail in the coffin of "Old France." Unlike those previous reform efforts, President Macron's effort has been clearly signaled ahead of the election and thus retains considerable democratic legitimacy. As such, any repeat of the 1995 or especially 2010 unrest would delegitimize the unions and give President Macron even more political capital. Bottom Line: We agree with the now conventional view that all is well in Europe. Stability ahead of the German election reminds investors of what a healthy country is supposed to look like. Italian election risks have dissipated. And our French structural reforms call remains on track. This gives us an opportunity to do some house-cleaning regarding our calls. First, we are closing our long French 10-year bond / short Italian 10-year bond trade for a gain of only 1 bps. Second, we are closing our overweight Euro Area equities relative to U.S. equities call for a gain of 7.88%. Given our euro-bullishness, we never recommended that this call be currency hedged. We are now reinstating it with a currency hedge. We are also closing our long German 10-Year CPI Swap for a gain of 45.5 bps. We will stick with our long French industrial equities / short German industrials, which is currently up 9.25%. This is a way we have chosen to articulate our bullish view on the reforms, although clients with greater sophistication in European sectors could come up with a more direct way to articulate the view. Separately, we are also booking profits on our long China volatility trade (CBOE China ETF Volatility Index) for a gain of 16.82%. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 2 A North Korean submarine sank the South Korean corvette Cheonan in 2010, but that was still within the norm of behavior for the two countries that are still effectively at war and have contested maritime borders. 3 Romeo-class submarines are nearly 70 years old. As much as we harken back to Yugoslav engineering with pride at BCA's Geopolitical Strategy, Belgrade was never much of a naval power. Nonetheless, diesel-powered submarines are quite proficient in staying undetected and could present a problem for the U.S. Navy. At least until they had to resurface or get back to base, where nuclear-powered U.S. Virginia-class attack-subs would lie in wait for them. 4 Tehran won the court case in 2003! And the ICJ forced the U.S. to compensate Iran for its lost ships or else face invasion by the United Nations army. (We are just kidding obviously. Iran did win, but it got nothing.) Please see Pieter H.F. Bekker, "The World Court Finds that U.S. Attacks on Iranian Oil Platforms in 1987-1988 Were Not Justifiable as Self-Defense, but the United States Did Not Violate the Applicable Treaty with Iran," American Society of International Law Volume 8, Issue 25, dated November 11, 2003, available at: asil.org. 5 Please see CNBC, "Tax reform is coming in September, Trump economic advisor Gary Cohn says," dated June 29, 2017, available at cnbc.com. 6 Please see Wall Street Journal, "How Donald Trump's New Top Economic Adviser Views the World," dated December 14, 2016, available at wjs.com. 7 Please see Business Insider, "Trump and his top economic adviser have had completely different views on China," dated January 3, 2017, available at businessinsider.com. 8 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 11 Thankfully for France, the choice would still be French wine!

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 30th, 2017. The model has continued to reduce its allocation to the U.S. driven by worsening liquidity condition, and it's the second consecutive month that the U.S. allocation is the largest underweight. Australia is downgraded to neutral on concern of valuation. Germany and Netherland continued to receive more allocation and Canada's underweight is reduced as well, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 18 bps in August, entirely due to the 43 bps outperformance of Level 2 model where the overweight in Italy and Germany versus the underweight in Japan, Spain and Canada worked very well. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of August 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model is optimistic on global growth and maintains in cyclical tilt. However, the magnitude of overweight in cyclical sectors has reduced on the back of momentum indicators. The biggest change has been utilities which has moved from a 2% underweight to a 1.7% overweight. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights The ECB defines a euro overshoot as EUR/USD in the high 1.20s. Until then, remain cyclically long both EUR/USD and the associated SEK/USD. EUR/USD is a function of expected terminal interest rates in the euro area and U.S. Whether the Fed hikes in December or whether the ECB hikes next year is largely irrelevant. Global investors should be long the euro, but underweight the Euro Stoxx 50. European equity investors should prefer the broader based 300-constituent Euro Stoxx over the 50-constituent Euro Stoxx 50.1 And prefer the FTSE100 over the Euro Stoxx 50. Feature Arguably the biggest macro trade of 2017 has been to own the euro. Year to date, the big winner is EUR/USD, which is up 15%, but even EUR/GBP is up an impressive 9%. An additional merit is that the euro has behaved like a haven currency. When risk assets have sold off sharply, EUR/USD has tended to strengthen.2 The Euro Is Stronger, But It Is Not Strong Although the euro is stronger, the ECB's own indicators for euro area competitiveness3 suggest that the euro is not yet strong. The euro needs to appreciate by at least another 5%4 to cancel the euro area's over-competitiveness versus its top 19 trading partners (Chart of the Week). Translated to EUR/USD this implies a fair value in the 1.25-1.30 range. Chart of the WeekThe Euro Is Stronger, But It Is Not Yet Strong To be clear, the ECB's competitiveness analysis assumes that the euro started its life in 1999 close to fair value. This assumption seems reasonable. In 1999, the euro area's constituent economies were broadly in internal balance with each other and had much in common. Hard as it is to believe today, in 1999 Germany and Italy scored identically on total debt as a share of GDP (Chart I-2) as well as on exports as a share of GDP (Chart I-3). Chart I-2At The Euro"s Birth, Germany And##br## Italy Had The Same Debt To GDP... Chart I-3...And Exports##br## To GDP Perhaps more significantly, euro area trade was in external balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. But after its birth, the euro became extremely undervalued in the dot com bubble, then extremely overvalued in the global credit boom, and most recently, extremely undervalued again - as a direct result of the ECB's extreme monetary easing. Seen in this bigger picture, the euro's recent rally is just a recovery from this most recent undervaluation, an argument that the ECB itself made at its last monetary policy meeting: "Regarding exchange rates, the appreciation of the euro to date could be seen as reflecting changes in relative fundamentals in the euro area vis-à-vis the rest of the world." At the same time: "Concerns were expressed about the risk of the exchange rate overshooting in the future." What would constitute such an overshooting? Based on the ECB's own analysis, we can deduce that it would occur if EUR/USD broke into the high 1.20s (Chart I-4). This is the level at which we would consider removing our cyclical overweight. Until then, remain cyclically long both EUR/USD and the associated SEK/USD. Chart I-4The Euro Needs To Rally Another 5% To Cancel The Euro Area"s Over-Competitiveness Explaining The Stronger Euro The explanation for the euro's impressive rally starts with central banks' strong commitment to 'data-dependency'. Over short periods, economic data can be noisy or "transient" giving central banks an excuse to look through the data. But over periods of 6 months and longer, the noise cancels out. So unless central banks break their commitment to data-dependency - which would mark a big shift in transparency and communication - the markets know that central bank policy must ultimately follow the hard data on GDP growth, inflation, and job creation. This necessarily means that the evolution of relative interest rate expectations and bond yields must also ultimately follow relative economic performance. Which they have done perfectly (Chart I-5). The next part of the explanation is the so-called fixed income portfolio channel (Chart I-6). The key point is that international fixed income investors make their allocations based on both bond valuations and currency valuations. Chart I-5Bond Yield Spreads Follow Relative##br## Economic Performance Chart I-6Fixed Income Flows Are The Most Volatile##br## Part Of Currency Demand When the expected interest rate in the euro area rises relative to that in the U.S., the euro bond becomes de facto relatively cheaper. As an example, let's say 1% cheaper. In this case, the international fixed income investor will shift into the euro bond until the flow makes EUR/USD symmetrically 1% more expensive. At this point, the fixed income portfolio flow will stop, and an equilibrium will reestablish at the new higher level for EUR/USD. This is because the international investor now has 1% more upside from the cheaper bond, but 1% less upside from the more expensive currency - and the two cancel out. Finally, at major turning points in monetary policy such as now, the expected interest rate that matters is the so-called terminal rate. At such major turning points, the issue for the largest fixed income portfolio flows is not the exact timing of rate hikes. Whether the Fed hikes in December or whether the ECB hikes next year is largely irrelevant. The big issue is: at what level of rates will the respective tightening cycles ultimately end many years from now? Chart I-7 and Chart I-8 illustrate that EUR/USD has recently been tracking the expected policy rate differential not in 2018 or 2019, but in 2022! Chart I-7EUR/USD Is Not Tracking Policy ##br##Rate Differentials In 2019... Chart I-8...But Rather Policy Rate ##br##Differntials In 2022 Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses which lead activity, euro area hard data will continue to perform at least in line with those in other major economies. In which case, relative expectations for the terminal policy interest rate will continue to converge, long-dated bond yield spreads will continue to compress, and the euro has further cyclical upside. Losers And Winners From The Stronger Euro A stronger euro creates both losers and winners. A stronger euro hurts the competitiveness of firms selling euro priced products in international markets. Therefore, firms exporting discretionary goods and services which are price elastic could suffer a drop in sales. Against this, a stronger euro makes everyone in the euro area richer in terms of the goods and services they can buy from outside the euro area. This is particularly significant for non-discretionary items - food and energy - of which Europe is a large importer. Given that the volumes of these purchases tend to be inelastic, their price decline in euro terms significantly boosts the real spending power of euro area consumers. Chart I-9The Stronger Euro Weighs##br## On The Eurostoxx 50 (As an aside, the exact opposite applies in the U.K. The post Brexit vote slump in the pound - and the associated rise in prices - has depressed U.K. consumers' real spending power. And likely explains why the U.K. economy is now slowing.) A stronger euro also reflects a steeper yield curve, and its associated boost to bank profit margins, solvency, and credit creation. The important point is that the stronger euro's aggregate impact on an economy depends on how the losers and winners net out. For example, many people will worry that the stronger euro has made Italy 5% under-competitive versus its major trading partners. However, the drag on Italy's price-sensitive exporters could be less significant than the boost to real consumer spending and bank credit creation - netting out as a positive for Italy. Equity investors should note that most exporters in the Euro Stoxx 50 tend to be multinationals whose sales and costs are currency diversified and/or hedged. So a stronger euro should not hurt operationally. But it does hurt in the translation of multi-currency profits back into euros - the base currency of the Euro Stoxx 50. This drags down (local currency) index performance. Hence, global investors should be cyclically long the euro, but underweight the Euro Stoxx 50. European equity investors should prefer the broader based 300-constituent Euro Stoxx5 over the 50-constituent Euro Stoxx 50 (Chart I-9); and prefer the FTSE100 over the Euro Stoxx 50. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Not to be confused with the Stoxx Europe 600 2 Global equities assets have suffered 11 sharply down days this year - defined as the MSCI World index (in local currency terms) down more than -0.5%. And on 9 of those 11 days, EUR/USD has rallied 3 Available at https://www.ecb.europa.eu/stats 4 The ECB calculates three Harmonised Competitiveness Indicators for the euro area versus its top 19 trading partners based on unit labour costs, GDP deflators, and consumer price indices. Updated to August 29 2017, the three indicators suggest that the trade-weighted euro is still undervalued by 5%, 11% and 6% respectively. 5 Not to be confused with the Stoxx Europe 600 Fractal Trading Model* This week we are initiating a short nickel / long silver commodity pair trade with a profit target / stop loss at 8%. In other trades, short MSCI Turkey / long Eurostoxx600 hit its stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Dear Client, The Global Fixed Investment Strategy will not be publishing next week. Our regular publishing schedule will resume on September 12, 2017. Jackson Hole: Last week's Fed conference did not produce any signals on policy shifts from the Fed or ECB. Yet the outlook for either central bank over the next year has not changed. The Fed will deliver more hikes than currently discounted by the market, while the ECB will taper the pace of its asset purchases. A below-benchmark duration stance is warranted on a 6-12 month horizon. IG Sector Performance: Our Investment Grade (IG) corporate sector allocations for the U.S., Euro Area and U.K., taken from our relative value models, have generated outperformance versus the regional benchmarks since the beginning of the year, led by overweights to Banks. The alpha of sector selection should start to outweigh the beta of owning corporates in the next 6-12 months, given the tight overall level of spreads and flat credit curves. Feature Markets Were Too Jacked Up For Jackson Hole Well, so much for that. The highly anticipated Federal Reserve symposium in Jackson Hole last weekend provided little in the way of guidance on the future monetary policy moves in the U.S. or Europe. The speakers at Jackson Hole, including Fed Chair Janet Yellen and ECB President Mario Draghi, instead chose to focus more on factors that they cannot directly control, such as trade protectionism, income inequality and technological change. Chart of the WeekTougher Regulations Or Just Easy Money? The market reaction was interesting. Bond yields and equities were essentially unchanged on the day last Friday, but the U.S. dollar ended softer, especially versus the euro. Perhaps this was simply a function of very short-term positioning in currency markets. The speculation prior to Jackson Hole was that Yellen might talk up another Fed rate hike to offset to stimulative effects of booming financial asset prices, perhaps in the absence of any renewed pickup in U.S. inflation. At the same time, there were expectations that Draghi could use his speech to dial back expectations of a reduction in ECB asset purchases, which have helped fuel the strong rally in the euro. With both central bankers delivering a big "nothing burger" with regards to policy changes, speculators likely covered their positions. The speeches from Yellen and Draghi were not totally without meaningful content, however. They both warned about the potential risks from dialing back some of the post-crisis regulatory changes to the infrastructure of the global financial system. Both of them went as far as stating that the stronger regulatory backdrop has been a major factor behind the current health of the global economy: Yellen: "Our more resilient financial system is better prepared to absorb, rather than amplify, adverse shocks, as has been illustrated during periods of market turbulence in recent years." Draghi: "[...] lax regulation runs the risk of stoking financial imbalances. By contrast, the stronger regulatory regime that we now have has enabled economies to endure a long period of low interest rates without any significant side-effects." This is an interesting way to spin the events of the past decade. Yes, regulatory reforms have forced global banks to hold higher levels of capital. This should, in theory, help mitigate the spillover effects on the real economy from periodic financial market sell-offs that could make banks more risk-averse. Yet central banks have, at the same time, maintained incredibly loose monetary policies that have helped support both global growth and bull markets in risk assets (Chart of the Week). It is, at best, complacency and, at worst, hubris for Yellen or Draghi to say that the financial system can handle market shocks better when their own hyper-easy monetary policies are a big reason why asset markets have avoided protracted sell-offs. "Buy the dip" is an easy investment strategy when central banks are providing a liquidity tailwind while keeping risk-free interest rates at unattractive levels. Yet market valuations are now at the point where the payoff to buying the dips will be much lower than in recent years, presenting a challenge to financial stability for policymakers looking to incrementally become less accommodative. In Charts 2A & 2B, we show the range of asset prices and valuations for key fixed income and equity markets since 1990. The blue dots in each panel represent the latest reading, while the historical ranges are the thick lines. The benchmark 10-year government bond yields for the U.S., Germany, Japan and the U.K. are shown in Chart 2A, both in nominal and inflation-adjusted terms.1 In Chart 2B, the trailing price-earnings multiples for global equity markets and option-adjusted spreads for the major global credit sectors (corporate bonds and Emerging Market debt) are displayed. Chart 2AGlobal Asset Valuations, 1990-2017 Chart 2BGlobal Asset Valuations, 1990-2017 Within fixed income, nominal government bond yields and credit spreads are trading at the low end of the historical ranges. Equity valuations are not yet at the stretched extremes seen during the late 1990s dot-com bubble, although longer-term measures like the CAPE (cyclically-adjusted price earnings) ratio are much closer to all-time highs. By any measure, most financial assets are not cheap, thanks in large part to the easy monetary backdrop. Right now, the current tranquil market backdrop is increasingly at risk from a shift in monetary policies. The Fed and ECB are still confronted with the problem of tight labor markets alongside tame inflation (Chart 3). While there has been a much more vigorous debate among central bankers on the effectiveness of using a Phillips Curve framework for forecasting inflation, the plain truth is that policymakers do not have any reliable alternative. The best they can do is stick with the unemployment-versus-inflation trade-off and go more slowly on policy adjustments when inflation undershoots levels suggested by strong labor markets. At the moment, there is no immediate need for either the Fed or ECB to tighten monetary policy. Realized inflation rates on both sides of the Atlantic are still below the 2% target. Our Central Bank Monitors for the U.S. and Euro Area are both hovering around the zero line (Chart 4), also indicating that no imminent changes in the policy stance are required. Chart 3Fed & ECB Facing The Same##BR##Phillips Curve Dilemma Chart 4Bond & FX Markets Look Fully##BR##Priced For A Stronger Europe The improvement in the Euro Area Monitor is related to both faster domestic economic growth and a slow-but-steady rise in inflation, trends that are likely to be maintained over at least the next 6-12 months given the strength of European leading economic indicators. However, the decline in the U.S. Monitor is largely a function of the recent surprising dip in U.S. inflation (both prices and wages) over the past few months. We expect that to soon begin to reverse on the back of reaccelerating U.S. growth and a rebound in inflation fueled in part by the lagged impact of the weaker U.S. dollar. The greenback's decline this year versus the euro has been a reflection of a more rapid improvement in European economic growth (3rd panel). Although this looks to have overshot with the EUR/USD exchange rate rising far more rapidly than implied by interest rate differentials between the U.S. and Europe (bottom panel). This either suggests that European bond yields must rise relative to U.S. yields to justify the current level of EUR/USD (a UST-Bund spread close to 100bs based on the relationship over the past three years), or that the currency must pull back to valuations more consistent with interest rate differentials (around 1.10, also based on the post-2014 correlations). The easier path is for the currency to soften up rather than European bond yields rising faster than U.S. Treasuries. The ECB is still far from contemplating an actual interest rate hike, and is only debating the need to continue buying European bonds at the current pace. At the same time, there is now barely one full 25bp Fed rate hike discounted by the market, which makes Treasuries more vulnerable to the rebound in U.S. growth and inflation that we expect. That outcome is not conditional on any easing of U.S. fiscal policy, but any success by the Trump White House in delivering tax cuts would only force the Fed to hike rates to offset the stimulus to an economy already at full employment. In other words, we see more reasons for both U.S. Treasury yields and the U.S. dollar to go up from current levels versus European equivalents. Bottom Line: Last week's Fed conference at Jackson Hole did not produce any signals on policy shifts from the Fed or ECB. Yet the outlook for either central bank over the next year has not changed. The Fed will deliver more hikes than currently discounted by the market, while the ECB will taper the pace of its asset purchases. A below-benchmark duration stance is warranted on a 6-12 month horizon. A Brief Update On The Performance Of Our Corporate Bond Sector Allocation Recommendations Chart 5Performance Of Our IG Sector Allocations We last published an update of our Investment Grade (IG) sector valuation models for the U.S., Euro Area and U.K. back on June 6th.2 This followed up on our report from January 24th of this year where we added our IG sector recommendations to our model bond portfolio.3 That meant putting actual weightings to each sub-sector within the overall IG index for each region, rather than a more nebulous "overweight", "underweight" or "neutral" recommendation. This was in keeping with the spirit of our overall model bond portfolio framework, which is to present a more transparent measure of how our recommended tilts would perform as a hypothetical fully-invested fixed income portfolio. Our IG sector allocations come from our IG relative value model, which is designed to measure the valuation of each sector relative to the overall Barclays Bloomberg corporate bond index for each region. The latest output of the model can be found in the Appendix on page 14. The current valuations have not changed material from that June 6th report, suggesting that the rally in corporate bond markets has been more about beta driving the valuations of all sectors. In other words, the sectors have maintained their value relative to each other and to the overall IG index over the past few months. Having said that, our sector allocations have still been able to deliver some extra return versus the regional benchmarks since we started putting specific weights to our sector tilts back in January. Since then, our sector tilts have added +3bps of "active" excess return (i.e. returns over duration-matched government bonds) versus the IG benchmark in the U.S., +9bps in the Euro Area and an impressive +32bps in the U.K. (Chart 5). Most of that outperformance came between January and our last update, with only the U.K. showing gains since June. The specifics of the returns can be found in Table 1 for the U.S., Table 2 for the Euro Area and Table 3 for the U.K. For all three regions, the biggest source of the outperformance of our allocations has come from the overweight positions in Financials, specifically Banks. As any corporate bond portfolio manager will attest, the large weighting of Financials in IG bond indices makes the Financials versus Non-Financials decision the most important one to make. Our model bond portfolio is no different. Table 1U.S. Investment Grade Performance Table 2Euro Area Investment Grade Performance Table 3U.K. Investment Grade Performance Looking ahead, we expect that sector allocations may soon begin to have a greater impact on the performance of IG corporate bond portfolios, given how flat credit curves have become (Chart 6). The spread between BBB-rated corporates and A-rated corporates is at historically narrow levels in all regions. The flattening of credit curves may be reaching a resistance level in the U.S. and U.K., but not so in the Euro Area where the gap between BBB-rated and A-rated corporates is now a mere 34bps. Chart 6Credit Quality Curves Are Very Flat The combination of a solid Euro Area economic upturn and persistent ECB buying of corporates as part of its asset purchase program has driven a reduction of risk premiums throughout the Euro Area credit markets. Given our expectation that the ECB will be forced to begin tapering its asset purchase program in 2018, including the pace of corporate buying, we continue to maintain an underweight allocation to Euro Area IG corporates in our overall model portfolio. We are also seeking to limit our overall recommended spread risk to around index levels using our preferred metric, Duration Times Spread (DTS). At the same time, we are maintaining our recommended overweights to U.S. IG and U.K. IG, sticking with above-benchmark tilts in the Banks, while maintaining a portfolio DTS close to the overall index DTS. In the U.S., we are also keeping an overweight bias on Energy-related sectors, which offer the most attractive valuations despite having a higher DTS than the overall benchmark index. Our underweights in higher DTS U.S. sectors, specifically in the Consumer Non-Cyclicals and Utilities groupings, offset the DTS exposure from our recommended Energy overweight. Bottom Line: Our Investment Grade (IG) corporate sector allocations for the U.S., Euro Area and U.K., taken from our relative value models, have generated outperformance versus the regional benchmarks since the beginning of the year, led by overweights to Banks. The alpha of sector selection should start to outweigh the beta of owning corporates in the next 6-12 months, given the tight overall level of spreads and flat credit curves. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 In the bottom panel of Chart 2A, we deflate nominal 10-year bond yields by a 3-year moving average of realized headline inflation to smooth out the fluctuations in inflation. 2 Please see BCA Global Fixed Income Strategy Special Report, "Updating Our Investment Grade Corporate Bond Sector Allocations", dated June 6th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Special Report, "Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework", dated January 24th 2017, available at gfis.bcaresearch.com. Appendix Appendix Table 1U.S. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Mario Draghi will signal the ECB's intention to further taper asset purchases during his Jackson Hole address later today, while cautioning that rate hikes remain a way away. The spread between long-term U.S. and euro area bond yields is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area. The upswing in Japanese growth is unlikely to prompt the BoJ to abandon its yield- curve targeting regime. Japanese stocks are cheap and corporate profits are rebounding smartly. Stay overweight Japanese equities in currency-hedged terms for the next 12 months. As one looks further ahead to the next decade, Japanese inflation will likely break out as labor shortages intensify. This will be part of a broad-based increase in global inflation. Stay long Japanese inflation protection and go short 20-year JGBs relative to their 5-year counterparts. Feature Mario Draghi: Action Jackson, The Sequel? Mario Draghi made shockwaves the last time he spoke at Jackson Hole on August 22, 2014. Draghi used that occasion to lay out the case for additional monetary easing. This paved the way for the ECB's own QE program. From that fateful speech to March 2015, EUR/USD fell from 1.33 to 1.05. Three years later, investors are anxious to hear what Draghi has to say, but this time around the expectation is that he will discuss plans for winding down QE. We agree that Draghi will signal the ECB's intent to further taper asset purchases. Growth is currently strong and the risk of a euro area breakup has all but disappeared. Nevertheless, although he may not publicly admit it, Draghi is cognizant of the fact that euro area financial conditions have tightened on the back of a strong euro, while U.S. financial conditions have continued to ease (Chart 1). Mario Draghi also knows that both inflation and wage growth remain depressed across the euro area, and that labor market slack outside Germany is still 6.7 percentage points higher than in 2008 (Chart 2). In addition, Draghi is undoubtedly aware of the likelihood that the neutral rate of interest is extremely low in the euro area, implying that the ECB would be constrained in raising rates even if the region were close to full employment.1 The spread between the 30-year U.S. Treasury yield and the 30-year GDP-weighted euro area bond yield - a reasonable proxy for the market's estimate of the difference in neutral rates between the two regions - currently stands at 86 basis points in nominal terms and 56 basis points in real terms. This is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area (Chart 3).2 Chart 1Diverging Financial Conditions Favor U.S. Over The Euro Area Chart 2Draghi Is Paying Attention Chart 3The State Of Fiscal Policy In The G4 We expect EUR/USD to pare back its gains, dropping to $1.05 by the end of 2018. However, most of the dollar's rebound is likely to occur next year, when it becomes apparent that the U.S. unemployment rate will fall well below the Fed's 2018 projection of 4.2%. This will force the Fed to step up the pace of rate hikes. For the time being, we see EUR/USD fluctuating within a broad range of $1.10-to-$1.20. BoJ: Time To Remove The Sake Bowl? Could the Bank of Japan follow in the Fed's and ECB's footsteps by signaling the desire to slowly withdraw monetary accommodation? On the surface, there are certainly some reasons to think so. Japanese growth has picked up recently, with real GDP rising at a blistering annualized pace of 4% in the second quarter (Chart 4). The acceleration in growth was driven entirely by stronger domestic demand. Consumer spending increased by 3.7%, while private nonresidential investment jumped by 9.9%. Inflation appears to be bottoming. The national core CPI index, which excludes fresh food prices but includes energy costs, rose for the seventh straight month in June to 0.4% on a year-over-year basis. Corporate goods inflation has reached 2.6%, up from a low of -4.6% in May 2016. Corporate service inflation moved to 0.8% this spring, the highest rate since 1993 (Chart 5). Nominal wage growth has also accelerated. Our Wage Trend Indicator, which uses statistical techniques applied to three separate data series to extract the underlying trend in Japanese wages, is now close to its 2007 highs (Chart 6). Chart 4GDP Growth Has Perked Up In Japan Chart 5Corporate Pricing Power Has Improved Chart 6Japanese Wages Are In An Uptrend The recovery in Japanese wage growth has occurred alongside a tightening of the labor market. The latest Economy Watchers Survey featured a litany of companies complaining of worsening labor shortages (Table 1). This is confirmed by the job openings-to-applicants ratio, which has surged to the highest level since 1974 (Chart 7). Table 1Japan: Evidence Of Shortages Of Workers, Part I Chart 7Japan: Evidence Of Shortages Of Workers, Part II Easy Does It, Kuroda-san Despite the good news on the economy, it is highly unlikely that the Bank of Japan will abandon its ultra-accommodative stance any time soon. There are a number of reasons for this: While inflation is rising, it is coming off a very low base, and is nowhere near the BoJ's 2% target. A deflationary mindset also remains firmly entrenched, as highlighted by both survey data and market expectations (Chart 8). Much of the recent pickup in inflation is attributable to higher energy prices and the lagged effects of a weaker yen. Excluding energy prices, core inflation has barely risen. The increase in corporate goods prices has also closely tracked the price of imports. Considering that the trade-weighted yen has appreciated of late, it is reasonable to assume that import price inflation will dissipate. This spring's annual shunto wage negotiations yielded smaller wage hikes among large companies than in 2016. This suggests that further near-term gains in wages will be hard to come by. Fiscal policy may turn less accommodative. The government passed a supplementary budget last summer (worth 1.5% of GDP according to the IMF). The effects of this package are being felt now. Public fixed investment surged by 21.9% in Q2. Under current law, however, fiscal policy is set to turn contractionary again over the next few years. Leading economic indicators are pointing to a modest slowdown in growth over the coming months (Chart 9). Chart 8Deflationary Mindset Has Been Hard To Shake Off Chart 9LEIs Pointing To Modest Slowdown The BoJ is not the same central bank that it was five years ago. The last two hawkish dissenters, Takehiro Sato and Takehide Kiuchi, both stepped down in July when their terms expired. They were replaced by Goshi Kataoka and Hitoshi Suzuki, neither of whom are expected to oppose Governor Haruhiko Kuroda's dovish approach. As such, it is highly likely that the BoJ will continue to anchor the 10-year yield at close to zero for at least the next 12 months. If bond yields elsewhere rise over this period - as we expect will be the case - the yen will weaken. Good News For Japanese Stocks... For Now A weaker yen is, of course, good news for Japanese stocks. Japanese equities are currently trading at a 16% discount to the MSCI World index based on forward earnings (Chart 10). Moreover, unlike in the past, both earnings and dividend growth have been strong, averaging 19% and 9%, respectively, over the last five years (Chart 11). Corporate governance reform - a key element of Abenomics - can take some credit for this. The share of companies with at least two independent directors rose from 18% in 2013 to 78% in 2016. The number of companies with performance-linked pay increased from 640 to 941, while the number that publish disclosure policies jumped from 679 to 1055. Analysts have been slow to factor in these positive developments. Chart 12 shows that Japan leads all other major stock markets in positive earnings surprises in the second quarter. We remain overweight Japanese equities in currency-hedged terms. Chart 10Good Value In Japanese Stocks Chart 11Solid Earnings And Dividend Growth Chart 12Japan And Positive Earnings Revisions: Follow The Leader . The Longer-Term Outlook: Japan (Eventually) Escapes Deflation As we discussed last week, it is likely that the U.S. will fall into recession in 2019 or 2020, dragging the rest of the world down with it.3 As a risk-off currency, the yen will strengthen, potentially reigniting deflationary forces. This will make it impossible for the BoJ to abandon its yield-curve targeting regime. Does that mean that Japan is condemned to a never-ending cycle of reflation/deflation? Not necessarily. As one looks at a longer-term horizon of 5-to-10 years, it is likely that Japan will finally escape deflation. This is because many of the structural forces that have sustained deflation will have either receded or reversed course by then. The simultaneous bursting of Japan's real estate and stock market bubbles in the early 1990s ushered in a prolonged period of falling property prices and corporate deleveraging. This suppressed both household consumption and business investment, leading to a persistent shortfall in aggregate demand. The latest data suggests that property prices are bottoming and corporate balance sheets have finally improved to the point where further aggressive cost-cutting is no longer necessary (Chart 13). Demographic trends are also likely to fuel higher inflation over the long haul. The deceleration in population growth in the early 1990s reduced the need for everything from new homes to new cars, shopping malls, and factories. This weighed on business capex and consumer durable spending, thereby exacerbating the deflationary forces that were already in place. In addition, a surge in the share of the population in their peak saving years - ages 30 to 50 - led to an increase in desired savings throughout the economy. More savings means less spending, so this also contributed to deflation. Looking out, population growth will remain anemic. However, two important developments will occur. First, the biggest cohort of Japanese baby boomers - those born in 1947-52 - will hit 70, the age at which most Japanese workers retire. Second, the secular rise in female labor force participation will plateau. Chart 14 shows that a larger percentage of Japanese women between the ages of 25 and 54 are employed than in the U.S., a massive shift from 20 years ago. Both these changes will exacerbate labor shortages, while further reducing national savings. Chart 13Deflationary Headwinds Are Abating Chart 14Female Employment In Japan Has Surpassed The U.S. Concluding Thoughts Contrary to popular belief, the Phillips curve remains intact, even in Japan (Chart 15). The market is not at all prepared for the prospect of higher Japanese inflation, as evidenced by the fact that CPI swaps are pricing in inflation of only 0.5% over the next two decades. As inflation picks up in the 2020s, nominal GDP will rise (even if real GDP growth remains anemic due to a shrinking labor force). The Bank of Japan will keep nominal rates low during the first half of the 2020s, ensuring that real rates sink further into negative territory. This will be the way by which Japan reduces its debt burden. Older savers may not like it, but the alternative of pension and health care cuts will be seen as even worse. We are currently long Japanese inflation protection through the CPI swaps market. As of today, we are adding a new long-term trade recommendation: Go short 20-year JGBs relative to their 5-year counterparts. The potential upside from this trade easily compensates for the negative carry of 66 bps. An upswing in Japanese inflation in the 2020s is very much in line with our secular view that global inflation will trend higher over the long haul, as articulated in a recent report.4 This will have a profound impact on fixed-income markets. While Japan's demographic transition has been and will continue to be more extreme than elsewhere, population aging is something that will affect all major economies. Chart 15Japan's Phillips Curve Is Alive And Well Chart 16Demographic Shifts: From Highly Deflationary To Highly Inflationary Chart 16 shows the IMF's estimate of how projected changes in the age structure of the population will affect inflation over the next few decades. The Fund's calculations suggest that demographic shifts will go from being very deflationary to very inflationary in every major economy. This will translate into significantly higher long-term nominal bond yields. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Future Of The Neutral Rate," dated August 4, 2017. 2 We calculate this number by taking the difference between the structural primary budget balance in the euro area (roughly 1.5% of GDP) and the U.S. (roughly -2.5% of GDP). The claim that this will translate into 4% more in aggregate demand in the U.S. implicitly assumes a fiscal multiplier of one. A larger multiplier would generate an even bigger gap in demand. 3 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?" dated August 18, 2017. 4 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Your portfolio cash weighting should be at least in the middle of its range, until the observed volatility of risk assets rises meaningfully from its record low. Cyclically add long SEK/USD to long EUR/USD. Within a European equity portfolio, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Go underweight Swedish real estate equities; overweight Spanish real estate equities. Within a global equity portfolio, overweight euro area banks versus U.S. banks. Feature Great expectations for Mario Draghi's appearance at the Jackson Hole Symposium have been dampened, and understandably so. After the last monetary policy meeting, Draghi emphasised that ECB discussions about policy direction would take place in the autumn. It would undermine this decision making process if Draghi's Jackson Hole speech front ran the ECB discussions. Nonetheless, twitchy markets will inevitably read the tone of Draghi's observations on the global and euro area economies. Chart of the WeekSwedish House Prices Are Up 50% In Just Four Years...Thanks To Negative Interest Rates But the more market-relevant presentation might come five hours earlier on Friday at 3pm London time, when Janet Yellen gives a keynote speech on the market's latest meme - financial stability. Three months ago in Madrid, Draghi delivered a keynote speech1 on the very same topic - The interaction between monetary policy and financial stability - available here https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp170524_1.en.html and well worth reading as a prelude to Yellen's presentation. Draghi explained that ultra-accommodative monetary policy endangers financial stability through three potential channels: Distorting investor behaviour. Generating credit-fuelled bubbles, especially in real estate. Squeezing bank profitability. Do any of these three channels give ground for concern today? Yes. Distorting Investor Behaviour In our view, central banks' distortive impact on investor behaviour is the single biggest source of financial instability today. Yet Draghi devoted only a cursory mention of this danger, noting that investors "could be prone to engage in search-for-yield behaviour and take on excessive risks." The difficulty is that the psychological and behavioural finance biases creating the current distortions lie outside central bankers' natural area of expertise. Nevertheless, we hope that Yellen develops this topic much further at Jackson Hole. Specifically, the behavioural finance distortion known as Mental Accounting Bias describes the irrational distinction between the part of an investment's return that comes from its income, and the part that comes from its capital growth. Rationally, people should not care about this distinction because the money that comes from income and the money that comes from capital growth is perfectly fungible.2 But in practice, many people want a minimum investment income - because they wish to match their known spending outlays with their known income. While they could meet their spending needs by crystalizing capital growth, many people create psychologically separate 'mental accounts': spending from investment income and saving from capital growth. This is especially true for retirees whose main or only income might come from accumulated assets. Traditionally, this psychological mental accounting bias would be unnoticeable because investors could easily match their spending needs with the safe income generated by cash and government bonds. But in recent years, central banks' extended experiments with zero and negative interest rates and QE have forced the 'income mental account' to chase the higher but much more risky income streams from high-yield bonds and equities (Chart I-2 and Chart I-3). To the point where these risk assets no longer offer a sufficient risk premium. Chart I-2A Positive Yield On Equities Can Produce##br## A Negative 5-Year Return... Chart I-3...And Even A Negative##br## 10-Year Return The search-for-yield pushed up the prices of these risk assets. Now add to the mix the phenomenon known as negative skew.3 Risk asset advances tend to be gradual and gentle, and the longer and more established the advance becomes, the lower the observed volatility goes. Some investors then mistakenly interpret lower observed volatility as justification for a lower risk premium, which warrants a further price advance. And so on, in a self-reinforcing feedback. Today, this has left us with a bizarre and unprecedented situation in which the observed volatility of the Eurostoxx50 equity index is a fraction of the observed volatility of the long-dated German bund! (Chart I-4) Chart I-4Unprecedented: The Observed Volatility Of The Eurostoxx50 ##br## Is Now Lower Than That On The German Bund! But given the strong inverse relationship between observed volatility and price, record low observed volatility categorically does not mean that prospective risk of a drawdown is low. Quite the reverse, the lower the observed volatility, the higher the prospective risk. And vice-versa. Investment bottom line: Your portfolio cash weighting should always be inversely proportional to the observed volatility of risk assets. Today, with observed volatility still near a record low, your cash weighting should be at least in the middle of its range. Generating Credit-Fuelled Bubbles... In Sweden Turning to the second channel of financial instability, the ECB sees no evidence of credit-fuelled bubbles. Banks are extending credit, but at a fraction of the rate seen prior to 2007 (Chart I-5). And although house prices are rising, the ECB claims that its ultra-accommodative monetary policy has not created imbalances in real estate markets in the euro area. Taken at face value, this claim might be true. Chart I-5Euro Area Banks Are Extending Credit... But At A Modest Rate But look across the Baltic Sea. Chart I-6Swedish House Prices Accelerated##br## After ZIRP And NIRP Sweden's Riksbank has had to shadow the ECB's ultra-loose policy, to prevent a sharp appreciation of the Swedish krona versus the euro. The trouble is that negative interest rates have been wholly inappropriate for an economy that has recently been growing at 4.5%. One worrying consequence is that Swedish house prices have gone up by 50% in just four years (Chart of the Week), with the bulk of the boom happening after ZIRP and NIRP (Chart I-6). Also, bear in mind that the Swedish real estate market did not suffer a meaningful setback in either 2008 or 2011, meaning the recent boom is not a corrective rebound - like say, in Spain and Ireland. So the ECB's ultra-loose policy may indeed have generated a credit-fuelled bubble... albeit in Sweden! Fortunately, as the ECB ends its ultra-accommodation, it will also liberate the Riksbank to end its incongruous and dangerous NIRP policy. Investment bottom line: Cyclically add long SEK/USD to long EUR/USD. For European equity investors, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Also, go underweight Swedish real estate equities which are now approaching peak price-to-book multiples (Chart I-7). Prefer to overweight Spanish real estate equities which offer much more attractive valuations (Chart I-8). Chart I-7Swedish Real Estate Equities ##br##Are Close To Peak Valuation Chart I-8Spanish Real Estate Equities ##br##Offer Better Value Squeezing Bank Profitability For the third channel of financial instability, the ECB concedes that ultra-loose monetary policy compresses banks' net interest margins and thus exerts pressure on their profitability. "Since banks carry out maturity transformation by borrowing short and lending long-term, both the slope of the yield curve and its level matter for profitability." In turn, lower retained profits means lower accumulation of capital, making banks more fragile. The evidence strongly supports this logic. Since the start of the ECB's asset-purchase program, euro area bank valuations - a good proxy for profitability - have formed a perfect mirror-image of the expected intensity of QE (Chart I-9). Chart I-9Bank Valuations Have Been A Mirror-Image Of QE It follows that as the ECB dials back accommodation, the valuations of euro area banks will continue to recover - at the very least, in relative terms versus banks elsewhere in the world. Investment bottom line: Global equity investors should stay overweight euro area banks versus U.S. banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 At the First Conference on Financial Stability, May 24 207. 2 Assuming the tax treatment of income and capital growth is equal. 3 Please see the European Investment Strategy Weekly Report titled 'Negative Skew: A Ticking Time-Bomb' dated July 27, 2017 available at eis.bcaresearch.com Fractal Trading Model* We are monitoring the Italian stock Tenaris which is approaching a point of being technically oversold. We are also monitoring a commodity pair-trade, short nickel / long silver which is also approaching a potential entry point in the coming days. But we have not yet opened either trade. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Highlights U.S. Tax Cuts: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. Fed vs. ECB: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. We expect a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. U.S. Corporates vs. EM: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Feature Who's In Charge Here? Table 1A Rough Month For Risk Financial markets are sailing without a rudder at the moment. A clear risk-off flavor has swept over most risk assets, as can be seen in the returns seen so far in August in so many asset classes (Table 1). There have been a number of negative news events for investors to process, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to the North Korean tensions to last week's terror attack in Spain. On top of that, some of the major central banks have become a bit more wishy-washy in their guidance to the markets, even going as far as questioning their own understanding of the inflation process (does the Philips curve even work anymore?). Investors always prefer a clean narrative when it comes to the "big picture" macro backdrop. Right now, they are not getting that from political leaders and policymakers, especially in the U.S. (Chart of the Week). Trump's popularity rating is steadily declining, even now among Republican voters. This has raised concerns that any of his business-friendly policies tax cuts or initiatives to boost growth like infrastructure spending can be successfully enacted. At the same time, and perhaps for similar reasons, the gap between the market expectation and the Fed's projection for the funds rate is widening with only 24bps of hikes priced over the next year. This is driven largely by investors' persistent lack of belief that U.S. inflation will hit to the Fed's target in the next few years. Simply put, the market is saying that the Fed's current tightening cycle is essentially complete unless there is a turnaround in U.S. inflation and/or a sizeable fiscal stimulus enacted in D.C. On that latter point, we think it is critical to monitor measures of U.S. business confidence. The current cyclical upturn in global growth and corporate profits has certainly lifted optimism among business leaders. Yet it is clear that there was also a boost to business sentiment after the U.S. election (Chart 2) last November as it was believed that Trump's victory, and the likely policies that would follow, would be good for American companies. Right now, business optimism remains at strong levels whether looking at small business measures like the NFIB survey (top panel) or the big business series like the Conference Board CEO confidence index of the Duke University/CFO Magazine indicator for confidence among chief financial officers (middle panel). There has been a slight recent pullback from the post-election peak in all the business sentiment indicators, however, and any sign that Trump will have difficulty pushing his tax cuts through Congress could result in a bigger loss of confidence that could impact future hiring and capital spending activity. Our colleagues at BCA Geopolitical Strategy continue to believe that a tax reform package, including significant tax cuts, is still the most likely outcome. Congressional Republicans will not want to go into the 2018 U.S. mid-term elections "empty-handed". With Congress and the White House on the same page, focused by fears of losing seats next year, even an embattled and unpopular president should be able to get his tax cuts implemented. Any fiscal boost in the U.S. can only help to support the current global cyclical economic upturn. While growth indicators like our global PMI index have come off the highs a bit (Chart 3), the OECD's global leading economic indicator is still rising and pointing to rising real developed market bond yields (middle panel). In addition, the global data surprise index has bottomed out, leaving global bond yields exposed to any improvement in economic momentum (bottom panel). Chart of the WeekLosing Faith In##BR##Trump & The Fed Chart 2U.S. Businesses##BR##Are Still Confident Chart 3Global Bond Yields Are##BR##Vulnerable To Faster Growth The fiscal news flow out of D.C. is likely to remain volatile once Congress returns from its summer recess, particularly with regards to tax cut negotiations and the looming debt ceiling. Yet the big news that investors want to hear, regarding U.S. tax cuts, is more likely to be positive for growth and risk assets and negative for bond yields. Bottom Line: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. The Fed & ECB: Still Sticking To Their Script Chart 4Inflation Expectations Are##BR##Stable In The U.S. & Europe The markets continue to underestimate the likelihood of more Fed rate hikes in the next year. The odds of a hike in December now sit at only 32%, while essentially no hikes in 2018 are currently discounted. This is far too low, given the steady (if unspectacular) growth in the U.S. and tightening labor conditions. The market has clearly responded to the dip in realized U.S. inflation since March as a sign that the real fed funds rate is now close to equilibrium - a point that has also been suggested by some FOMC members - and that the Fed's inflation forecasts are hence unlikely to be realized. Yet measures of U.S. inflation expectations, both survey-based and market-based, have been fairly stable at levels consistent with the Fed's inflation target in recent months, even as headline U.S. inflation has slowed (Chart 4, 2nd panel).1 A similar dynamic is playing out in Europe. Both survey-based and market-based measures of inflation expectations have been stable at levels close to the ECB's inflation target of "just below" 2% on headline inflation (bottom panel), despite the dip in realized inflation. Stable inflation expectations are something that central bankers take very seriously as a sign that their monetary policies are seen as credible. If the recent dip in realized inflation also showed up as an equivalent decline in expected inflation, this would give policymakers in D.C. and Frankfurt second thoughts about making any policy changes in a less dovish/more hawkish direction. The latest readings on realized inflation in both the U.S. and Euro Area suggest some stabilization of the current downturn may be underway. Headline CPI inflation ticked higher from 1.6% to 1.7% in July, ending a streak of four consecutive months of deceleration since March. Core CPI inflation has been stable at 1.7% for three consecutive months up to July, after falling for four consecutive months from January. Data released last week for July inflation in Europe showed a similar dynamic, with core HICP inflation ticking up to 1.2%, the third consecutive month of faster year-over-year inflation. With growth on both sides of the Atlantic maintaining a steady, above-potential pace, amid stable inflation expectations and with realized inflation showing signs of bottoming out, we see both the Fed and the ECB sticking with their current messaging and forward guidance. That means one more rate hike this year by the Fed, most likely in December, following an announcement on beginning the process of reducing the Fed's balance sheet at the September FOMC meeting. After that, at least another 25-50bps of hikes in 2018 will be delivered, which is currently not discounted by the market. As for the ECB, expect a shift to a slower pace of asset purchases for 2018, to be announced at either the September or October monetary policy meetings. Chart 5Has The Euro Already Overshot? The Kansas City Fed's annual Jackson Hole conference, set to take place this weekend, is unlikely to produce any major surprises for investors. Both Fed Chair Janet Yellen and ECB President Mario Draghi will give speeches to an audience of their peers - other global central bankers. Much is being made of Draghi's speech, since he has not spoken at Jackson Hole since 2014 when he gave strong indications of the introduction of the ECB's asset purchase plan in 2015. After his speech at the ECB Forum in Portugal in late June of this year - also to an audience of central bankers - where he mentioned a "reflationary" impulse in Europe that could require some "adjustments" to the ECB's policy settings, investors will be on high alert for any indications that the ECB is about to announce a tapering of its asset purchases. The Account of the July ECB meeting released last week suggested some concern within the ECB Governing Council regarding the potential for an "overshoot" of the euro in response to any policy shift.2 Some are interpreting those comments as a sign that the ECB might be getting cold feet over making any changes to its asset purchase program given the 11% rise in the euro seen this year. However, we think that there was too much attention focused on the fears that a strong euro could derail any plans for an ECB taper, for two reasons: The ECB did note in the July Account that the rise in the euro was a reflection of both the relatively stronger growth seen in the Euro Area this year and the reduction in political risk premia after the French presidential elections in the spring. The Account also noted that the ECB was looking at the totality of its monetary policy measures - policy rates, forward guidance & asset purchases - when assessing its policy stance. This specific quote from the Account, shown with our emphasis on the key passages, highlights that the ECB thinks that a tapering of asset purchases, done on its own with no hikes in short-term interest rates, will still leave monetary policy at very accommodative settings: "...the point was made again that the overall degree of accommodation was determined by the combination of all the monetary policy measures implemented by the ECB, and that the Governing Council's assessment of progress regarding a sustained adjustment in the path of inflation should apply to the overall design and direction of the ECB's monetary policy stance as a whole, and not with reference to any particular instrument in isolation, such as the duration and pace of APP asset purchases." Investors should understandably be worried about the impact of the rising in the euro, which was one of the fastest rates of acceleration seen in the currency's history (Chart 5). Yet given that extreme in price momentum, the lack of support from higher short-term Euro Area interest rates, and with speculative positioning on the euro at very bullish levels, it is unlikely that much further gains in the currency can be expected. This is especially true for the euro versus the U.S. dollar if the Fed delivers additional rate hikes, as we expect. Unless there is decisive evidence that the latest rise in the euro was seriously dampening Euro Area economic growth or inflation, which is not currently visible in the data (bottom panel), then the ECB is still likely to downshift to a slower pace of asset purchases in 2018. Bottom Line: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. The Fed and ECB remain on course to shift to a less accommodative policy stance towards year-end. That means a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. Trim EM Debt Exposure Versus U.S. Investment Grade Corporates Emerging market (EM) debt has been one of the strongest performing asset classes so far in 2017. EM USD-denominated sovereign bonds have delivered a total return of 7.5%, while USD-denominated EM corporates have returned 8.7%, according to Bloomberg Barclays index data. These returns have handily surpassed the majority of all other major USD-denominated fixed income sectors. A robust pace of inflows into EM debt, a record $48.6 billion year-to-date to August 9th according to the Wall Street Journal, has helped drive EM debt spreads to tight levels (Chart 6).3 The outperformance of EM debt, both versus its own history and compared with other pro-risk fixed income classes like U.S. corporates, would be justified if EM economic growth was faster than that seen in developed markets. Yet that is not currently the case. An EM (excluding China) PMI Index put together by our colleagues at BCA Emerging Markets Strategy has shown a sharp deceleration of EM growth for most of 2017 (Chart 7, top panel). This stands in sharp contrast to the improving growth seen in both the U.S. and Europe. Chart 6EM Debt Looks##BR##Fully Valued Chart 7Stronger U.S. Growth Favors##BR##U.S. IG Vs EM Sovereigns... The gap between the U.S. and EM (ex China) PMIs has widened to the largest level since 2014. This PMI gap has been a good directional indicator for the spread between U.S. corporate bond spreads (both for Investment Grade and High-Yield) and EM debt spreads (bottom two panels). Right now, it appears that U.S. High-Yield looks fairly valued versus EM USD-denominated sovereign debt but U.S. Investment Grade spreads still look a bit too wide relative to EM sovereigns. A similar story can be told when comparing U.S. corporates to EM USD-denominated corporate debt (Chart 8). Arthur Budaghyan, BCA's Chief Emerging Market strategist, recently made a trade recommendation to go short EM sovereign and corporate debt versus U.S. Investment Grade corporate debt.4 His argument was based on the relatively expensive valuations on EM debt, coming at a time when the outlook for economic growth and corporate profits looks healthier in the U.S. We could not agree more - especially if the Fed begins to hike rates, as we expect, and the U.S. dollar begins to strengthen anew, potentially triggering outflows from EM. Arthur has also pointed out that the gap between the option-adjusted spread (OAS) on EM corporates and U.S. corporates (both Investment Grade and High-Yield) has been an excellent leading indicator of the total return differential between the asset classes (Chart 9). The current relationships show that there is upside potential for U.S. Investment Grade versus EM corporates over the next 12 months, but not for U.S. High-Yield versus EM. Chart 8...And Vs. EM Corporates Chart 9Downgrade EM Debt Vs U.S. IG Corporates Thus, this week, we are cutting our allocations to both EM sovereign and corporate debt in our model bond portfolio, and increasing our allocation to U.S. Investment Grade corporates (see page 12). While this does move us into an asset class with a longer duration, the increase in our overall portfolio duration from this shift is very small given the small weight of EM debt in our custom benchmark. More importantly, U.S. Investment Grade is less risky than EM corporates using the duration-times-spread metric - our preferred measure for spread product risk. Bottom Line: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. We see better value in U.S. higher-quality corporates vs. EM debt at current spread levels. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The inflation expectations data shown in Chart 4 is based off the U.S. Consumer Price Index (CPI) measure of inflation, while the Fed targets growth in the headline Personal Consumption Expenditure (PCE) deflator of 2%. The spread between the two measures have averaged around 50bps in recent years, which suggests that the current CPI-based inflation expectations around 2.5% are in line with the Fed's 2% PCE inflation target. 2 https://www.ecb.europa.eu/press/accounts/2017/html/ecb.mg170817.en.html 3 https://blogs.wsj.com/moneybeat/2017/08/17/emerging-market-bonds-attract-record-inflows/?mg=prod/accounts-wsj 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Focus Is On Profits", dated August 16th 2017, available at ems.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Mantra 1 - Europe: First Among Equals - instils awareness that the euro area's long-term growth prospects and 'neutral' real interest rate are not meaningfully different to those in other developed economies. Mantra 2 - Mission Impossible: 2% Inflation - instils awareness that central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. Mantra 3 - Negative Skew: A Ticking Time-Bomb - instils awareness that low observed volatility categorically does not mean that equity market risk has diminished. If anything, it means the exact opposite. Feature The titles of three of our recent reports - Europe: First Among Equals,1 Mission Impossible: 2% Inflation,2 and Negative Skew: A Ticking Time-Bomb3 - can be regarded as mantras instilling awareness of major investment opportunities and threats. This week's report is a recap of the messages encapsulated within these three mantras. Mantra 1 - Europe: First Among Equals Mantra 1 instils awareness that long-term growth in the euro area, adjusted for population, is not meaningfully different to that in other developed economies (Chart of the Week). Through the past 20 years, the euro area has underperformed through multi-year periods encompassing around half the time; but it has outperformed through the multi-year periods encompassing the other half. Chart of the WeekThe Euro Area Is An Economic Equal Seen in this wider context, the euro area's 2008-14 phase of poor economic performance was not structural, it was cyclical - the impact of back to back recessions separated by an unusually short gap. And if the euro area continues its recovery to just the mid-point of its long-term relative cycle, then recent investment trends in the bond and currency markets have much further to run. Bond yield spreads closely follow relative real GDP per head (Chart I-2). As they must, given central banks' self-professed 'data-dependency'. Although nobody expects the ECB to hike interest rates any time soon, expectations for the long-term 'neutral' rate are correctly rising from overly-depressed levels. Hence, the yield spread between long-dated bonds in the euro area4 and the U.S. has compressed from -175 bps last year to -125 bps today. Still, to reach the mid-point of its long-term cycle, this yield spread must ultimately converge to around -40 bps. But why is the mid-cycle yield spread -40 bps? The simple answer is that, over this 20-year period, the euro area versus U.S. inflation differential has averaged -40bps (Chart I-3). In other words, the mid-cycle real yield spread is zero. Chart I-2Bond Yield Spreads Just Follow ##br##Relative GDP Per Head Chart I-3The Euro Area - U.S. Inflation Differential ##br##Has Averaged -40 Bps This leads to a very important empirical observation. The mid-cycle or 'neutral' real interest rates in the euro area and U.S. have been near-identical over the past 20 years. Bear in mind that the past 20 years captures a very wide spectrum of economic and financial backdrops: the launch of the euro, the dotcom bubble and bust, the U.S. subprime credit boom and financial crisis, the euro debt crisis, QE. If this disparate past is a reasonable representation of the disparate future, we should expect the neutral real interest rate in the euro area to remain broadly similar to that in the U.S. The implication is that the yield spread between long-dated bonds in the euro area and the U.S. can compress much more. On a 2-year horizon, stay underweight euro area bonds - especially German bunds - in a European and global bond portfolio. And expect euro/dollar eventually to break through 1.30. Mantra 2 - Mission Impossible: 2% Inflation Mantra 2 instils awareness that central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. The crux of the matter is that the monetary system and inflation form a classic non-linear system. A defining feature of a non-linear system is that it can be very difficult, even impossible, to achieve an arbitrary point target output like '2%' (Chart I-4). Chart I-4Non-Linear: Inflation Flipped From One Mode To A Completely Different Mode In a linear system, if a small input produces a small output, then double the input will produce double the output and triple the input will produce triple the output. But in a non-linear system, double the input could produce no output, half the output, or ten times the output. To be clear, we have no doubt that a fiat monetary system makes it possible to generate rampant inflation, should policymakers be absolutely determined to create it. But central banks are now starting to ask. At what cost? And for what benefit? Central banks are realising that in the struggle to achieve 2% inflation, persistent ultra-accommodative policy endangers the healthy functioning of markets and poses a risk to financial stability. At the same time, the continued undershoot of 2% inflation is not such a terrible thing when the economy is growing well. Chart I-5Relative Interest Rate Expectations##br## Just Follow Relative GDP Per Head The latest to admit this is Kasumasa Iwata, a leading candidate to become the next governor of the Bank of Japan. With the demerits of extraordinary stimulus becoming clearer, the BoJ should slow purchases of government bonds and ETFs even though inflation is nowhere near its target, he said. This follows hot on the heels of respected and influential ECB Governing Council member, Ewald Nowotny, who recently asked whether there should "be an easing of the 2% inflation goal in the sense of setting a range instead of a clear-cut target." And in Sweden, even though inflation has just hit 2% for the first time in six years, the Riksbank has suggested (re)introducing a variation band of 1% either side of the target5 to acknowledge that persistent 2% inflation is very difficult, or impossible, to achieve. Additionally, Riksbank Governor, Stefan Ingves, proposed that "central banks should also have the explicit responsibility for financial stability." The direction of travel is very clear. The most accommodative central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. These central banks are set to dial back accommodation. Hence, the multi-year phase of divergent monetary policies across developed economies is over. The new multi-year phase is re-convergence of monetary policy, and specifically the ECB and Riksbank versus the Fed (Chart I-5). Therefore, mantra 2 - Mission Impossible: 2% Inflation - reinforces the investment conclusions that stem from mantra 1 - Europe: First Among Equals. Mantra 3 - Negative Skew: A Ticking Time-Bomb Mantra 3 instils awareness that low observed volatility categorically does not mean that equity market risk has diminished. If anything, it means the exact opposite. When the equity market is advancing, its observed volatility is low. But this is just a property of so-called 'negative skew'. Up weeks tend to generate small and regular positive returns which means that advances tend to be gradual and gentle. And the longer and more established the advance becomes, the lower the observed volatility goes. Unfortunately, some investors and risk-control algorithms mistakenly use the observed volatility of an investment as a gauge of its riskiness. They incorrectly equate low observed volatility with a lower risk premium, which justifies an additional advance in the market. The additional advance then takes observed volatility even lower - which justifies a further market advance. And so on, in a self-reinforcing positive feedback. Eventually, the truth dawns. Equity market risk hasn't actually declined, but the equity risk premium - the excess prospective return that equities offer over bonds - has almost disappeared. And suddenly, the self-reinforcing feedback phase-shifts from positive to negative. The equity risk premium is the excess prospective return that equities offer over bonds, but a good working approximation is the difference between the equity index earnings yield and the bond yield. The concerning thing is that this measure of the equity risk premium is moving exactly in line with the equity market's observed volatility (Chart I-6), when it shouldn't. Admittedly, it is difficult to know when the time-bomb will go off. But the good news is that when observed volatility is very low - as it is now - options become very cheap. And a long index plus at-the-money put option becomes an excellent absolute return strategy.6 Chart I-6The Equity Risk Premium Is Tracking The##br## Equity Market's Observed Volatility Chart I-7Record Low Observed Volatility ##br##Doesn't Last For those that cannot buy options, record low observed volatility tends to signify a good time to raise a little bit of cash. This should be set aside for reinvestment in the equity market when observed volatility spikes (Chart I-7), as it always ultimately does. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Published on August 3 2017 and available at eis.bcaresearch.com 2 Published on July 20 2017 and available at eis.bcaresearch.com 3 Published on July 27 2017 and available at eis.bcaresearch.com 4 Euro area average over 10-year sovereign yield, weighted by sovereign issue size. 5 The Swedish FSA has said that the Riksbank should delay the change until a parliament review of Riksbank policy rules is completed in about 2 years. 6 For more details of the absolute return strategy, please see the European Investment Strategy Special Report titled "Negative Skew: A Ticking Time-Bomb", dated July 27, 2017 and available at eis.bcaresearch.com Fractal Trading Model Long USD/CAD successfully hit its 2.5% profit target and is now closed. This week's new trade is to short MSCI Turkey versus the Eurostoxx600 with a profit target and symmetric stop-loss set at 5%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Highlights Duration: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. The Fed & The Dollar: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. USD Sovereigns: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Feature Please note there will be no U.S. Bond Strategy report next week. Our regular publishing schedule will resume on August 29, 2017. Chart 1Firm Growth, Despite Weaker $ Escalating tension between the U.S. and North Korea captured the market's attention during the past week, causing investors to ignore what in our view is a more important economic development: Global growth has managed to stay firm even in the face of significant dollar depreciation. Not only does this break the pattern of the past few years when periods of substantial dollar weakness were associated with slowing global growth (Chart 1), but in our view it sends a very bearish signal for U.S. bonds. Above all else, a weak dollar amidst strong global growth suggests that the breadth of the economic recovery is improving. This intuition is confirmed by the fact that our Global Manufacturing PMI Diffusion Index, which measures the net percentage of countries with PMIs above the 50 boom/bust line, is fast approaching 90% (Chart 2). Not only that, but PMIs from the four most important economic blocs are all showing signs of strength. Both the Eurozone and Japanese PMIs are holding firm at high levels, while the U.S. and Chinese PMIs have recently reversed their year-to-date downtrends (Chart 2, bottom two panels). Why is the breadth of the global recovery important? Precisely because a more synchronized recovery prevents the dollar from appreciating too quickly. All else equal, a stronger dollar causes investors to reduce their forecasts for future U.S. growth and inflation. This implies a slower expected pace of rate hikes and lower Treasury yields. Conversely, a weaker dollar causes investors to revise up their growth and inflation forecasts, leading to a quicker expected pace of rate hikes and higher yields. To capture the importance of both global growth and the exchange rate we turn to our 2-factor Treasury model (Chart 3). This is a simple model of the 10-year Treasury yield based on the Global PMI and bullish sentiment toward the dollar. A stronger Global PMI pressures the model's fair value higher, as does increasingly bearish dollar sentiment. Chart 2Synchronized Global Growth Chart 310-Year Treasury Yield Fair Value At present, the model pegs fair value for the 10-year Treasury yield at 2.6%, meaning the current 10-year Treasury yield of 2.22% is 38 bps below fair value. This is the most expensive Treasuries have appeared on our model since the immediate aftermath of last year's Brexit vote. Political Uncertainty & Flights To Quality While our 2-factor model does a good job, there is one important driver of Treasury yields it does not capture. That is the tendency for political events to drive a flight to safety into Treasuries (Chart 4). Typically, if it is possible to identify a purely politically-driven flight to safety - one that is unlikely to exert a meaningful economic impact during the next 6-12 months - then the correct strategy is to heed our model's message and position for higher yields. This strategy worked out perfectly following the Brexit vote, and we anticipate it will work again this time around. Chart 4Policy Uncertainty Is A Driver Of Bond Yields With regards to the catalyst for last week's flight to safety, our Geopolitical Strategy service wrote in a recent Special Report1 that a pre-emptive strike by the U.S. on North Korea is extremely unlikely. The theatrics of the past week demonstrate only that the U.S. needs to establish a "credible threat" if it wants to eventually open a new round of negotiations over North Korea - not unlike the Iranian nuclear negotiations of the past decade. Looking further down the road, if those talks eventually fail then the potential for military conflict is high. We therefore conclude that there is not much potential for U.S. / North Korean tensions to exert a meaningful economic impact during the next 6-12 months, and view the recent bond rally as an opportunity to position for sharply higher yields in the near-term. Bottom Line: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. How The Fed Views A Weaker Dollar Financial Conditions Chart 5Weak $ Eases Financial Conditions The Fed views the 7% year-to-date depreciation of the dollar as a significant easing of financial conditions. In fact, most broad indicators of financial conditions have eased this year, even though the Fed has lifted rates by 75 bps since December (Chart 5). In the Fed's framework, this means that the pace of rate hikes might need to increase in order to tighten financial conditions as much as desired. New York Fed President William Dudley summed up this approach in a 2015 speech:2 All else equal, if financial conditions tighten sharply, then we are likely to proceed more slowly. In contrast, if financial conditions were not to tighten at all or only very little, then - assuming the economic outlook hadn't changed significantly - we would likely have to move more quickly. In the end, we will adjust the policy stance to support financial market conditions that we deem are most consistent with our employment and inflation objectives. Of course, all else is not equal. Core inflation has disappointed so far this year and our current assessment of monetary policy is that while the Fed will take action to start shrinking its balance sheet next month, rate hikes are on hold until inflation turns higher. We remain optimistic that inflation will show sufficient strength in time for the Fed to lift rates in December.3 Inflation Chart 6Weak $ = Higher Inflation A weaker dollar also increases the Fed's confidence that inflation will head higher. Although so far we have not seen much evidence that this is occurring. Last Friday's July CPI report showed that core CPI rose only 0.1% month-over-month, while the year-over-year growth rate held flat at 1.7%. However, evidence is mounting that core inflation will soon put in a bottom. Our CPI diffusion index bounced back into positive territory in July (Chart 6) and our PCE diffusion index is at its highest level since last October.4 Both of these measures have excellent track records capturing the near-term swings in core inflation. The year-to-date weakness in the dollar has led to a surge in import prices. Stronger import prices will soon translate into higher core goods inflation (Chart 6, panels 2 and 3). Unfortunately, any increase in core goods inflation is unlikely to be sustained beyond the next 12 months. If the year-to-date dollar weakness starts to reverse, as our currency strategists anticipate,5 then import prices will decline anew. Eventually, this will translate into a deceleration in core goods inflation. For core inflation to sustainably reach the Fed's target, improvement in the lagging core services (excluding shelter and medical care) component will be required. Historically, this component is the most tightly linked to wage growth (Chart 6, bottom panel). A Rising Wage Growth Environment Two related methods do an excellent job predicting the direction of wage growth on a cyclical horizon. First, wages accelerate when the unemployment rate is falling, and second, wages accelerate when the prime-age (25-54) employment-to-population ratio is increasing. The top two panels of Chart 7 show the relationship between wage growth and the unemployment rate. The shaded regions in both panels correspond to periods when the unemployment rate is falling. As can be seen, wage growth always rises during these periods. That being the case, we calculate that non-farm employment needs to grow by more than 125k per month (on average) for the unemployment rate to continue its downtrend, assuming the labor force participation rate remains flat. Chart 7A Rising Wage Environment Of course it is not guaranteed that the labor force participation rate will stay flat. In a recent report we discussed the risk that a large cyclical increase in the participation rate might cause the unemployment rate to rise even as the economy continues to recover.6 This is why we also look at the shaded regions in the bottom two panels of Chart 7 and see that wages always rise during periods when the prime-age employment-to-population ratio is rising. By looking at the employment-to-population ratio instead of the unemployment rate we do not need to make an assumption about the trend in labor force participation. Using this method, we calculate that monthly employment growth must exceed 140k (on average) for the prime-age employment-to-population ratio to keep increasing. Non-farm payroll growth has averaged 184k per month so far in 2017 and averaged 187k per month in 2016. In other words, the U.S. jobs machine is running at a fairly steady pace, well above the thresholds we see as necessary for the recovery in wage growth to continue. Bottom Line: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. Sovereigns Not Buying The Weak Dollar USD-denominated sovereign bonds should benefit from a falling dollar. A weaker U.S. dollar makes the debt obligation cheaper in the issuing nation's local currency. However, the USD Sovereign index has actually underperformed the duration-matched Baa U.S. Credit index during the past six months, despite a depreciating U.S. currency (Chart 8). The duration-matched Baa-rated U.S. Credit index is the closest comparable we can find for the Sovereign index. It matches the Sovereign index in terms of duration and average credit rating, although historically it also delivers less excess return volatility (Chart 8, bottom panel). The two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the dollar. Historically, spread differential has been an important driver of relative returns. Attractive starting valuations even allowed sovereigns to outperform credit in 2014 and 2015 despite the dollar's surge. But at the moment, relative value is skewed heavily in favor of domestic U.S. credit (Chart 8, panel 1). Chart 8Sovereigns Too Expensive Added to that, with U.S. growth likely to remain strong and U.S. inflation poised to rebound, we think there is a high likelihood that the Fed will deliver more rate hikes than are currently priced in. This will make it difficult for the dollar to decline further from current levels. Taken together, poor relative valuation and a bullish outlook for the dollar lead us to continue underweighting USD-denominated sovereigns in our portfolio. The Sovereign Index: Country Breakdown Even though the overall index is unappealing, opportunities might still exist at the country level. Chart 9 shows a risk/reward picture for each country in the Bloomberg Barclays Sovereign index. The upper panels show the option-adjusted spread for each country relative to its duration and credit rating. The lower panels show a risk-adjusted spread on the y-axis. This risk-adjusted spread is the excess spread that remains after we adjust for differences in credit rating and duration using a cross-sectional model. What sticks out immediately is that Finland, Colombia and Mexico all offer compelling spreads after adjusting for differences in credit rating and duration. The outlook for each country's currency versus the U.S. dollar is obviously also important. And in fact, the lower-right panel of Chart 9 shows that exchange rate volatility is positively correlated with the risk-adjusted spreads from our cross-sectional model. This implies that the extra compensation available in Mexican and Colombian sovereigns is probably compensation for assuming highly volatile currency risk. By this measure, Finland looks even more attractive given the euro's slightly lower volatility. Chart 9USD Sovereign Index: Country Breakdown Bottom Line: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. Remain underweight. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire", dated April 19, 2017, available at gps.bcaresearch.com 2 https://www.newyorkfed.org/newsevents/speeches/2015/dud150605 3 For further details on our outlook for the near-term path of monetary policy please see U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 4 For a chart of the PCE diffusion index please see page 11 of U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Feature Visions abound of a dystopia in which Artificial Intelligence (AI) obsoletes all human jobs. In these visions, mankind becomes a subservient sideshow in a world run by robots. But while such dystopian visions make excellent narratives for Hollywood blockbusters, the chance they become a reality is nil. Technological progress is nothing new. Each generation feels it is experiencing unprecedented disruptive changes, but the constant march of technological progress has defined humanity for centuries, or even millennia. In the process, innovation has already obsoleted countless occupations. Where are today's lamplighters, ostlers,1 livery-stable keepers, newspaper criers and boiler firemen? In 1910, one third of the labour force worked on farms,2 with many of these workers tending animals; today, those proportions are near zero. In 1950, one fifth of the workforce was a machine or vehicle operative; today, that proportion is less than a tenth. More recently, in 1970, over 5% of workers were 'stenographers, typists or secretaries'; again today, most of those jobs have vanished. Yet this mass of job obsolescence has not created mass unemployment. The reason is that an advancing economy creates as many new jobs to replace the obsoleted jobs (Feature Chart and Chart I-2). In 1910, less than 5% of workers were in 'professional or technical' jobs; today the category employs over a quarter of workers. In 1950, healthcare employed 2% of workers; today it employs 8%. Moreover, the nature of many of today's jobs might have been unimaginable just a few decades ago. The rapidly growing employment sector 'medical and dental technicians' did not even exist before 1950. In the same way, the precise type of jobs that will see very strong growth in the coming years and decades might be unimaginable today. Feature ChartTechnological Progress In The 20th ##br##Century Destroyed Many Jobs... Feature Chart...But Created As ##br##Many New Jobs Chart I-2Nothing New: Technological Progress Always ##br##Involves Job Destruction And Creation Say's Law Tells Us That Robots Will Not Kill Job Growth Technological progress has not killed job growth. Nor will it. This is because firms choose to replace human workers with machines only if it increases their productivity and profitability (Charts I-3, Chart I-4, Chart I-5). The higher productivity increases the ability to purchase other goods and services - thereby creating jobs elsewhere in the economy (Chart I-6), often in new and surprising industries. Chart I-3Machine And Vehicle Operative ##br##Work Peaked In The 50s Chart I-4Secretarial Work Peaked ##br## In The 70s Chart I-5Clerical Work Peaked##br## In The 80s Chart I-6Healthcare Work Is In##br## A Strong Uptrend This is the idea introduced in 1803 by French economist Jean-Baptiste Say, called Say's Law: The producer of X is able to buy Y, if his products are demanded. Thereby, supply of X creates demand for Y, as long as people wish to buy X. A producer replaces human workers with machines to generate his output at higher profit, enabling him to demand new goods and services that he desires. Crucially, human desires are varied, ever changing and ultimately unlimited. Satisfying those unlimited desires creates new economies and jobs. In this way, technological progress often paves the way for completely new and unrelated goods and services. It creates whole new industries. To give just one example, railways spawned the frozen food industry. The frozen food industry satisfied the human desire to eat fresh food - which railways could now transport (frozen) to cities from distant farms and fisheries. In real time though, it was difficult to connect the advent of railways with the birth of the frozen food industry. Likewise, today it is hard to know precisely which new economies, markets and associated jobs the current new technologies will spawn. Nevertheless, a new technology's disruptive effect on an economy does depend on the broad type of job it destroys versus the broad type of job it creates. Consider a stylized economy with three types of job: a high-income innovator, a middle-income manufacturer, and a low-income animal tender. And imagine two scenarios. Scenario 1: the innovator invents a machine that obsoletes the low-income animal tender. Having replaced the animal tender with a more productive machine, the innovator will use his higher income to satisfy additional desires for manufactured goods. This enables the obsoleted animal tender to retrain and make a better living as a middle-income manufacturer. Scenario 2: the innovator instead invents a machine that obsoletes the middle-income manufacturer. In this case, the innovator will use his higher income to satisfy additional desires for animal tending services. The obsoleted manufacturer must now make a living as a low-income animal tender. So while the innovator sees a rise in his standard of living, the outcome for the unfortunate middle-income manufacturer is a massive deflation in pay. It is our strong contention that whereas previous waves of technological progress looked like scenario 1, the current and forthcoming impact of AI looks more like scenario 2. In other words, robots will kill middle-income jobs rather than low-income jobs. And the reason comes from a discovery called Moravec's Paradox.3 Moravec's Paradox Tells Us That Robots Will Kill Middle Income Jobs Moravec's Paradox is a counterintuitive discovery by robotics researchers that, for AI, the hard problems are easy and the easy problems are hard: High-level reasoning - such as logic and algebra - requires very little computation, but supposedly low-level sensorimotor skills - such as mobility and perception - require vast computational resources. Logic and algebra are considered difficult for humans, a supposed sign of intelligence. Jobs that require them are relatively well paid. Conversely, basic mobility and perception are considered innate. Jobs that rely on them are relatively poorly paid. But from an evolutionary perspective, high-level reasoning is very recent, maybe less than 100 thousand years old. This explains why it seems un-mastered and requires conscious effort. Conversely, evolution has honed and perfected our mobility and perception skills over tens of millions of years. So those low-level skills are subconscious and effortless. As AI is, in effect, just reverse-engineering the brain, the difficulty of any task for AI is roughly proportional to the amount of time it has taken for nature to evolve and encode it in the human brain. Therefore, the 100 thousand year old 'high-level' skills like logic and algebra are relatively easy for AI to replicate and even surpass, whereas the 10 million year old 'low-level' skills like mobility and perception are extremely difficult to replicate. It follows that the jobs that AI can easily replicate and replace are those that require recently evolved skills like logic and algebra. They tend to be middle-income jobs. Conversely, the jobs that AI cannot easily replicate are those that rely on the deeply evolved skills like mobility and perception. They tend to be lower-income jobs. Hence, the current wave of technological progress is following scenario 2. AI is hollowing out middle-income jobs and creating lots of lower-income jobs. Put another way: Say's Law + Moravec's Paradox = Strong Job Creation + Middle Income Wage Depression Is there any evidence of this? Yes, in the United States where the job creation data is a lot more granular than in Europe, the strongest growing employment sub-sector for many years has been 'Food Services And Drinking Places' (Table I-1 and Chart I-7). In other words, bartenders and waiters - classic low-income jobs requiring mobility and perception. Meanwhile, job losses have been concentrated in middle-income occupations. Table I-1Which Sectors Are Seeing ##br##The Job Growth? Chart I-7Bartenders And Waiters Is The Fastest ##br##Growing Employment Sector! Stronger evidence comes from the weakening Phillips curve relationship between unemployment and wage inflation. In many economies, unemployment rates are hitting multi-decade lows, yet wage inflation remains dormant. This has baffled many economists, but it shouldn't. Moravec's Paradox tells us that strong job creation is at the lower-income end of the employment distribution. So a weakening Phillips curve relationship is exactly what we should see. Moreover, as the economic impacts of AI are still in their infancy, the trends we are seeing now have much further to run. The major investment takeaway is that the structural backdrop for bonds is benign. But with the ECB about to end its ultra-accommodation, bond investors should tilt their long-term exposure towards non-euro area government bonds. A New Investment Theme: Animal Care Chart I-8Animal Care: Strong And Steady Growth Despite the on-going disruption to many middle-income jobs, developed economies have grown and will continue to grow. But as we said, economic growth can come through new and surprising industries. The early identification of such industries can create excellent investment opportunities. So we will end this report by introducing an idea. In our stylized scenario 2 we said that the innovator would use his higher income to satisfy additional desires for animal tending services. As it happens, we are witnessing this precise phenomenon today. The demand for animal tending services, such as dog walking, is booming. We fully expect the animal and pet care industry to remain one of the strongest growth sectors in developed economies (Chart I-8). The strong uptrend will be supported by three sub-themes. First, increased pet ownership among wealthy retiring baby boomers. Second, a lower birth rate means that pets are becoming a substitute for a child. Third, the 'humanization of animals': as pets become regarded as equal members of the family, spending on their welfare rises accordingly. We expect to develop this long-term theme in future reports. But today, we are starting our Animal Care basket with 3 initial stocks (Table I-2). Table I-2The Animal Care Basket Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 An ostler was a man employed to look after the horses of people staying at an inn. 2 Based on U.S. data. 3 Named after the robot engineer Hans Moravec. Fractal Trading Model There are no new trades this week. The short CAC40 / long Eurostoxx600 position reached the end of its 65 day term achieving half of its profit target, while the long DM / short EM position hit its stop-loss. This leaves three open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations