Euro Area

Highlights The equity risk premium (ERP) is distorted: too low. The Eurostoxx600 uptrend is reaching a technical limit according to its 130-day (6-month) fractal dimension. The U.S.-Euro area bond yield spread is distorted: too high. The Spain-France bond yield spread is distorted: too high. The Italy-Germany bond yield spread is not distorted. Feature Central banks' massive interventions in markets have left many investors wondering: has the market's price discovery mechanism become dysfunctional - and if so, where most severely? It is a good question because clearly, the prices that are most distorted are also the ones most likely to dislocate, and generate lucrative opportunities. This week's report assesses the distortion in three important relative pricings: the Italy-Germany sovereign yield spread; the U.S.-euro area sovereign yield spread; and the prospective excess return from equities over bonds, otherwise known as the equity risk premium. The Italy-Germany Bond Yield Spread Is Not Distorted We often hear the claim that the ECB's bond purchase program has compressed periphery bond yields relative to core yields. But we find no evidence for such a distortion. For example, relative to the ECB's capital key1 and other guidelines for bond purchase volumes, there is a larger ongoing supply of Italian BTPs than German bunds.2 So from a technical perspective, the ECB's interventions should have depressed German bund yields more than Italian BTP yields, thereby expanding the spread. Chart Of The WeekLow Volatility: We've Been Here Before... And It Didn't Last In fact, the technical distortion seems quite small because the Italy-Germany yield spread can be fully justified by its two underlying fundamentals: relative competitiveness (Chart I-2) and euro breakup probability (Chart I-3). Chart I-2Euro Area Yield Spreads Depend On Relative Competitiveness ... Chart I-3... And The Probability Of Euro Break-Up The premium on Italian BTP yields exists as a compensation for the expected redenomination loss in the tail-event of euro breakup. Assuming this currency depreciation would neutralize Italy's current 25% under-competitiveness versus Germany, we can infer that the 125 bps yield premium on 5-year BTPs is pricing a 5% annual probability of euro breakup (because 125 bps = 25% loss times 5% probability). The probability should account for an Italian election that is due within the next year, and Italian public support for the euro hovering at an unconvincing majority of around 55%. In this context, the probability should be somewhat elevated, though not alarming. So a 5% annual probability of euro breakup through the next five years seems reasonable within its post-crisis 2%-20% range. On this basis, the Italian-Germany yield spread is not distorted (Chart I-4). Instead, the real anomaly is the Spain-France (5-year) yield spread which stands at 50 bps (Chart I-5). There is now no difference in competitiveness between Spain and France, so there should be no redenomination premium on Spanish Bonos over French OATs, irrespective of the probability of euro break up. Stay structurally overweight Spanish Bonos versus French OATs. Chart I-4The Italy-Germany Yield Spread At 150 Bps Is Fair Chart I-5The Spain-France Yield Spread At 50 Bps Is Too High The U.S.-Euro Area Bond Yield Spread Is Distorted: Too High If bond price discovery were based solely on economic fundamentals, the U.S.-euro area yield spread would not be at a multi-decade extreme today. Such an extreme spread exists because the difference between Fed and ECB policy is much more polarized than is justified by the economic fundamentals. In this sense, the relative pricing is distorted. Consider the hard data. The percentages of the working age population in employment are at the same respective pre-crisis highs in both economies; the difference in wage inflation is closing; and the gap between core inflation in the U.S. and euro area has narrowed very sharply to just 0.6%. Indeed, excluding the cost of shelter - which is not represented in the euro area CPI - core inflation in the U.S. is now lower than in the euro area. Agreed, Fed policy should be tighter than ECB policy. But the expected difference should not be at a multi-decade extreme. Given the self-proclaimed 'data-dependency' of both the Fed and the ECB, the polarization of monetary policy expectations (Chart I-6) has to converge to the rapidly narrowing gap in the hard economic data, one way or another (Chart I-7). Chart I-6The U.S.-Euro Area Yield ##br##Spread Is Too High ... Chart I-7... And Will Gravitate To The Narrowing ##br##Gap In The Economic Data I conclude that: the U.S.-euro area (and U.S.-Germany) yield spread can close much further; euro/dollar can rise structurally; and the market neutral equity pair-trade long euro area Financials/short U.S. Financials can continue to outperform. The caveat is that these positions are just one big correlated trade (Chart I-8 and Chart I-9). Chart I-8Expected Monetary Policy Difference ##br##Is Driving The U.S.-Germany Yield Spread ... Chart I-9... And Therefore The Relative ##br##Performance Of Financials The Equity Risk Premium Is Distorted: Too Low Equity market behaviour is starkly asymmetric; market ascents tend to be gentle and drawn out, while descents tend to be violent and abrupt. By contrast, bond market behaviour is more symmetric; both upward and downward moves can be gentle or violent. The upshot is that when the equity market is ascending, its observed volatility declines. And the longer and more established the ascent becomes, the lower the observed volatility goes, both in absolute terms and relative to bonds. Crucially, this is just an observation of the inherent behaviour of equities: a low observed volatility simply tells us that equity ascents are gentle and drawn out (Chart I-10); it does not tell us that equity risk has diminished. Chart I-10Low Volatility Just Tells Us That Equity Ascents Are Gentle And Drawn Out. ##br##It Does Not Tell Us That Equity Risk Has Diminished! Unfortunately, the decline in the observed volatility may create the illusion that equity risk has diminished. In response, investors might demand a smaller (or no) equity risk premium (ERP) - the excess prospective long-term return over bonds - because they have falsely concluded that the risk of a large intermediate loss is vanishing. In turn, the shrinking ERP and lower required return justifies an even higher price today, allowing the market to continue its gentle ascent. So observed volatility falls even further, and the process feeds on itself in a self-reinforcing spiral. Readers might recognise this as the setup of the Minsky hypothesis in which the illusion of systemic stability breeds systemic instability and an eventual tipping point - a so-called 'Minsky Moment'. The Minsky hypothesis is an explanation for the boom bust cycle in the economy. It proposes that a credit boom initially generates strong and steady growth with low observed volatility. But the associated hubris - "no more boom and bust" - eventually encourages reckless lending and thereby sows the seeds of its destruction. When the misallocated loans cannot be repaid, the inevitable nemesis arrives. Likewise, in the case of the equity market, today's low observed volatility is absolutely not a reason for hubris. Yet as demonstrated in Markets Suspended In Disbelief,3 the low observed volatility has seduced investors into accepting a wafer-thin ERP. Today's low observed volatility is at the lower end of a range that has existed for at least 50 years (Chart of the Week). We have been here many times before. In each case, the low observed volatility did not last. And when it rose, so too did the ERP. As supporting evidence, observe that the 130-day (6-month) fractal dimension of the Eurostoxx600 is suggesting that the current uptrend is reaching its technical limit (Chart I-11). As a reminder, when an investment's fractal dimension approaches its natural lower bound, it signals that excessive trend following and groupthink have reached a natural point of instability. At which point the established trend is likely to break down with or without an external catalyst. Chart I-11The Current Uptrend In The Eurostoxx600 ##br##Is Reaching Its Technical Limit Before making a large absolute commitment to the equity asset class on a 6-12 month or longer horizon, I would first like to see both of these trustworthy signals stop flashing red. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 The capital key refers to the proportion of the ECB's capital owned by each of the euro area member states, and it is broadly pro-rata to the member state's GDP. 2 German GDP is 2 times the size of Italian GDP, but the stock of German sovereign debt is only 1.1 times the size of Italian sovereign debt. 3 Published on April 13 2017 and available at eis.bcaresearch.com Fractal Trading Model* The 65-day fractal dimension of nickel versus tin is approaching a level which has previously signaled an imminent trend-reversal. Go long nickel/short tin as this week's trade. Chart I-12 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. 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights U.S. Politics: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Duration Checklists: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Europe: Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Feature The Economy Trumps Politics Chart of the WeekHas Anything Really Changed? A whiff of panic swept across global financial markets last week, as the political risk bugaboo came back with a vengeance. In the U.S., the deepening morass surrounding President Trump's decision to fire former FBI Director Comey, and the potential links to the ongoing investigation of the White House's ties to Russia, raised concerns that Trump's ambitious pro-growth policy agenda would never make it out of Congress. Even this year's darling in the Emerging Markets, Brazil, suffered a huge financial rout after news broke of corruption allegations against the current president. Amid growing talk of a potential impeachment of Trump, the market action was a classic risk-off move, with equity markets falling, the VIX finally waking from its slumber and safe-haven assets like gold, U.S. Treasuries and the Japanese yen rallying. The euro climbed to new 2017 highs versus the U.S. dollar, without any changes in expectations about potential policy moves from the European Central Bank (ECB), as the market knocked down the probability of a June Fed rate hike (Chart of the Week). Some creative commentators called these market moves "the Trump fade" - the beginnings of a reversal of the so-called "Trump trade" that has sent U.S. equity prices and bond yields higher since the U.S. election on expectations of a large U.S. fiscal stimulus. We remain skeptical, however, that expectations of tax cuts and increased government spending have been the main drivers of the post-election boost in U.S. stock prices and Treasury yields, as the current cyclical upturn in global growth was already underway before Trump's election victory. Our colleagues at the BCA Geopolitical Strategy service note that, despite Trump's terrible overall approval ratings (Chart 2), his support among his Republican voters remains strong (Chart 3). Thus, an impeachment is only likely if the Republicans were to lose control of the House of Representatives in next year's U.S. midterm elections. Fear of that outcome should motivate the GOP to try and push through tax and healthcare reform well ahead of the 2018 midterms, in order to present a positive economic message to voters.1 Unless the evidence against Trump becomes so damning that even the Republicans in Congress have to focus on impeachment instead of policy, investors should ride out any market volatility associated with worries that the Trump economic agenda is at risk. Chart 2Trump's Support Abysmal Chart 3GOP Not Yet Willing To Impeach Trump Even without a boost to growth from D.C., however, we continue to expect the U.S. economy to grow above 2.5% in 2017. This above-trend pace will keep the Fed in play for at least two additional rate hikes before year-end, as it would give policymakers confidence that U.S. inflation expectations would return back the Fed's 2% target. In addition, as we discuss in the next section, the cyclical upturn in the Euro Area economy is showing no signs of cooling off, which will put more pressure on the ECB to begin preparing the markets for an eventual tapering of its asset purchases. The recent decline in bond yields is unlikely to persist much longer. Bottom Line: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Checking In On Our Duration Checklists In a Special Report published back in February, we introduced a list of indicators to follow to assess the likely direction of U.S. Treasury and German Bund yields.2 We called these our "Duration Checklists", incorporating data on economic growth, inflation, investor risk aversion and market technicals to judge whether our bias to maintain a below-benchmark duration stance should be maintained. This week, we provide an update on those Checklists. The current message from the Checklists is that there is reduced upward pressure on bond yields from the overall strength of the global economy than existed four months ago. Domestic forces, however, are still pointing to higher yields in the U.S. and, especially, the Euro Area (Table 1). Specifically: Table 1A More Bond-Bearish Backdrop For Bunds Than USTs Global economic activity indicators have lost some momentum. While the global leading economic indicator (LEI) is still rising, our global LEI diffusion index has fallen sharply and is now below the 50 line, indicating that a more countries now have a falling LEI. In addition, the global ZEW index has drifted a touch lower, global data surprises are no longer positive, and the global credit impulse has ticked downward (Chart 4). Only the rising LEI warrants a "check" in our Checklists (i.e. justifies our current below-benchmark duration stance). U.S. & European domestic economic activity remains in good shape. Consumer and business confidence remains at strong levels on either side of the Atlantic, with corporate profit growth still accelerating (Charts 5 & 6). Only the modest decline in the U.S. manufacturing purchasing managers' index (PMI) is worthy of an "x" in our U.S. Checklist, although the index remains well above 50 and is not pointing to a more serious deterioration in the U.S. economy. Chart 4Global Growth Backdrop Has##BR##Turned Less Bond-Bearish Chart 5U.S. Economic Strength##BR##Still Supports Higher UST Yields Chart 6Euro Area Growth Is##BR##Gaining Upward Momentum Inflation pressures have eased a bit, especially in the U.S. The slowing momentum in global energy prices has taken some of the steam out of headline inflation in both the U.S. and Europe. Wage inflation has eased up a bit in the U.S., even with the labor market running at full employment (Chart 7). Wage growth and core inflation have recently ticked higher in the Euro Area, however, while the unemployment rate there has fallen to within less than a percentage point away from the OECD estimate of the NAIRU (Chart 8).3 The only indicators worthy of a "check" are the unemployment gap in both the U.S. and Euro Area, although we will give a potential "check" (with a question mark) to European wage inflation. If the recent uptick gains additional momentum, the case for the ECB to begin moving to a less accommodative policy stance will be much stronger. Chart 7Inflation Pressures On UST Yields Have Eased Chart 8Core Inflation & Wages Bottoming Out In Europe? There is still a pro-risk bias among global investors. U.S. and Euro Area equity markets are still in bullish trends, trading well above their 200-day moving averages. At the same time, corporate credit spreads remain tight and option-implied equity volatility is very low (even after last week's pop in the U.S. on the Trump drama). All indicators are worthy of a "check", suggesting that easier financial conditions can lead to higher bond yields (Charts 9 & 10). We are, however, giving an "x" to the European Checklist for the deviation of the Stoxx 600 from its moving average, as it is now at the +10% extreme that we defined as being potentially bond-bullish as it could foreshadow a near-term correction of an overheated stock market. Chart 9Still Generally A Risk-Seeking Backdrop In The U.S. Chart 10Strong Risk-Seeking Behavior In Europe Bond markets no longer look technically stretched. The sharp move higher in yields at the end of 2016 left all our indicators of yield momentum at bearish extremes (for bond prices). With bond yields pulling back from 2017 highs, however, the momentum measures all look neutral at the moment and are not an impediment to higher yields (Charts 11 & 12). The same goes for duration positioning in the U.S., with the net longs on 10-year Treasury futures now at the highest level since 2007. All of the technical indicators in our Checklists warrant an "check". Chart 11UST Technicals No##BR##Longer Stretched Chart 12Technicals Are No Impediment##BR##To Higher Yields In Europe Summing it all up, our Duration Checklists show that the majority of indicators are still pointing to higher bond yields in the U.S. and Europe, although not as decisively as when we first published the Checklists in February. There are more "check" on the European side of the ledger, however, suggesting that there is more room for European government bond yields to rise relative to U.S. Treasuries. This would indicate a potential trade opportunity to cut allocations to Europe and raise allocations to the U.S. Chart 13UST-Bund Spread Is Now Too Low The recent decline in U.S. yields, however, has narrowed the U.S. Treasury/German Bund spread to levels that make putting on a tightening trade unattractive on a tactical basis. (Chart 13). The gap between the data surprise indices in the U.S. and Euro Area already reflects the recent soft patch for the U.S. economy (middle panel). That spread in the surprise indices now at historically wide levels, suggesting more potential for Treasury yields to rise if the U.S. data begins to rebound soon, as we expect. Also, the gap between U.S. and Euro Area inflation expectations has narrowed alongside the recent downtick in U.S. core inflation (bottom panel), although we expect the decline in U.S. core inflation to be short-lived given the persistent tightness of the U.S. labor market. Net-net, we would prefer to see a wider Treasury-Bund spread before making switching our country exposure out of Europe and into the U.S. We can, however, listen to the message from our Checklists and reduce our duration exposure in Europe. Specifically, we are cutting our allocations to the longer maturity buckets (5 years out to 30 years) by 50% in our model portfolio for Germany, France and Italy, putting the proceeds into the 1-3 year buckets (see the table on Page 12). This will reduce our overall recommended portfolio duration by just over 1/10th of a year, as well as put an additional bear-steepening curve tilt within our European government allocations. We are comfortable with that bias, given the growing risk that the ECB will soon begin signaling a tapering of asset purchases once the current program expires at the end of the year. Bottom Line: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment", dated May 17 2017, available at gfis.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15 2017, available at gfis.bcaresearch.com 3 Non-Accelerating Inflation Rate Of Unemployment. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Four separate indicators provide compelling evidence for a 'mini-cycle' in activity. 1. The bond yield. 2. The credit impulse. 3. The steel equity sector price. 4. The consumer price index (CPI). Right now, the mini-cycle is about 4 months into downswing whose average duration tends to be about 8 months. Hence, the surprise in the coming months could be that inflation comes in below expectations. Feature Central to our European investment philosophy is the existence of what we call a 'mini-cycle' in global activity. Right now, this cycle is about 4 months into a mini-downswing whose average duration tends to be about 8 months. Within this global mini-cycle the irony is that Europe itself has been a paragon of stability. Quarter on quarter growth has remained within a remarkably narrow 1.2-2.2%1 band for eight consecutive quarters. And the dispersion of growth across euro area countries now stands at a historical minimum. We expect the euro area's relative stability to persist given the recent bottoming of the euro area 6-month bank credit impulse. Nevertheless, for the European investment and inflation outlook, the global growth cycle is as important, or more important, than the domestic cycle. In highly integrated and correlated international markets, the absolute direction of European asset prices takes its cue from a global rather than a local conductor. The pace of consumer price inflation also tends to be a global rather than a local phenomenon. For example, through the past 10 years, the inflation cycles in the euro area, U.K. and U.S. have been near identical (Chart I-2). Chart Of the WeekThe Steel Sector Has A Clear Mini-Cycle Chart I-2The Inflation Cycle Is Global, Not Local In this light, the ECB now correctly assesses that "the risks surrounding the euro area outlook relate predominantly to global factors." As we go on to show below, the surprise in the coming months could be that inflation comes in below expectations. This would slow the ECB's exit from its current ultra-accommodative monetary policy. But because these downside inflation surprises were coming from outside the euro area, it would force other central banks to become even more dovish relative to current expectations. On this basis, we are very comfortable to maintain our relative return positions in European investments: expect euro currency outperformance; T-bond/German bund yield spread convergence; and euro area Financials outperformance versus global Financials. For absolute return positions, expect the relatively benign backdrop for bonds to continue into the summer months. Mini-Cycles: The Evidence Mounts In previous reports, we presented two pieces of evidence for economic mini-cycles. First, the global bond yield shows a remarkably regular wave like pattern with each half-cycle averaging about 8 months (Chart I-3). Second, the acceleration and deceleration of bank credit flows - as measured in the credit impulse - also exhibits a remarkably regular wave like pattern, with each half-cycle also lasting about 8 months (Chart I-4). Chart I-3The Bond Yield Has A Clear Mini-Cycle Chart I-4The Credit Impulse Has A Clear Mini-Cycle We proposed that the bond yield and credit impulse cycles are inextricably embraced in a perpetual feedback loop: a higher bond yield weighs on credit flows; this slows economic growth which then shows up in activity data; in response, the bond market lowers the bond yield; the lower bond yield boosts credit flows, which lift economic growth; and so on... But as each stage in the sequence comes with a delay, the bond yield and credit impulse mini-cycles should be 'out of phase'. And this is precisely what the empirical evidence shows (Chart I-5). Chart I-5The Bond Yield And Credit Impulse Mini-Cycles Are Out Of Phase Now, to build an even stronger case for mini-cycles we will add a third and fourth piece of compelling evidence. The third piece of evidence is the steel equity sector price, which is an excellent real-time indicator of the growth cycle, and shows exactly the same mini-cycle profile as the bond yield (Chart of the Week). The fourth piece of evidence is the consumer price index (CPI) which also presents an identical mini-cycle profile (Chart I-6). Chart I-6The Consumer Price Index Has A Clear Mini-Cycle As with the bond yield and the steel equity sector price, we have de-trended the CPI to better show the underlying cyclicality. But in the case of the CPI, our chosen de-trending rate of 2% has special significance: 2% is the inflation target for most central banks. Hence, if the de-trended CPI is rising, inflation is running above the 2% target; if the de-trended CPI is falling, inflation is running below the 2% target. In this regard, the mini-cycle in the CPI carries a disturbing asymmetry. Observe that in recent mini-upswings, inflation has just about reached the 2% target. But in each and every mini-downswing, inflation has substantially undershot the 2% target. Based on the regularity of the mini-cycle through the past 10 years, we can estimate that we are about half way into a mini-downswing. If so, the surprise in the coming months could be that inflation comes in below expectations, frustrating the ECB. Still, as the disinflationary surprises will emanate from outside the euro area, other major central banks might be even more frustrated. And this supports our aforementioned relative positions in European investments. What Is Your Most Provocative Non-Consensus View? The observation that inflation has struggled to reach 2% in mini-upswings, but substantially undershot 2% in each and every mini-downswing is very telling. The strong suggestion is that the recent modest uplift in inflation towards 2% could just be a mini-cyclical rather than structural phenomenon. The death of debt super-cycles combined with an incipient wave of Artificial Intelligence (AI) led automation still constitutes a very powerful structural deflationary force, which should not be underestimated. The technical pattern of bond yields also supports this thesis. Chartists will point out that the global bond yield is still in a well-defined pattern of lower highs and lower lows - which is to say a well-established downward channel (Chart I-7). And that it would take the yield to rise by a quarter (about 40 bps) to breach this channel. The German 30-year bund yield gives a very similar message (Chart I-8). Chart I-7Still In A Structural Downtrend: The Global Bond Yield... Chart I-8...And The German 30-Year Bund Yield At meetings, clients often ask for the most non-consensus investment view - something to which the street attributes a 10% chance, but to which I attribute a 50% or higher chance. Given the asymmetrical mini-cycle behaviour of both inflation and bond yields and the powerful structural forces of deflation shown in the preceding charts, here is my provocative answer: Perhaps the structural low in bond yields is not behind us; perhaps it is to come in the next major global downturn. But this is a personal view. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 At an annualized rate. Fractal Trading Model* There are no new trades this week, leaving us with four open trades. 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. Fractal Trading Model * 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 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. 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights Duration: The opposing forces currently pulling on global bonds - softer growth and core inflation readings vs. tightening labor markets - are keeping yields locked into narrow trading ranges. We expect the strength of the global upturn to reassert itself, leading to higher government bond yields and corporate credit outperformance over the balance of 2017. U.K./Canada/Australia: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a relatively flatter curve in Canada and a relatively steeper curve in the U.K. Portugal Trade Update: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Feature Chart of the WeekMarket Volatility Is Low For A Good Reason What was once a fairly straightforward narrative for global bond markets earlier this year is now being challenged. Growth data has cooled a bit in the U.S. and China, while commodity prices have fallen, suggesting that the global economy may be losing steam even with leading indicators still rising and the European economy looking robust. At the same time, core inflation measures have ticked lower despite the signs of tighter labor markets throughout the developed world. These moves on the margin have stalled the upturn in global bond yields, resulting in lower fixed income market volatility that is likely playing a role in keeping realized equity market volatility at depressed levels (Chart of the Week). We continue to see the recent pullback in U.S. data as being temporary in nature. The economy should improve in the coming months given the still-solid trends in U.S. corporate profits and household income and the still-low level of interest rates. The signs of a building China slowdown are potentially more worrisome, especially on the inflation front given how much Chinese demand has boosted commodities and overall traded goods prices over the past year. Although we are not expecting a major Chinese downturn that could spill over more broadly to the world economy, it is likely that the next leg up in inflation in the developed economies will come from diminished spare capacity and rising core inflation, rather than a commodity-driven reacceleration of headline inflation. We continue to recommend a strategic underweight overall portfolio duration stance, as we expect the Fed to deliver on its planned rate hikes before year-end and the European Central Bank (ECB) to soon begin signaling a tapering of its asset purchases next year. We continue to favor corporate credit over sovereign debt, particularly in the U.S., given the strength of the current global upturn, but staying up in credit quality (i.e. focusing on Investment Grade and higher-rated credit tiers in High-Yield). Stuck On Neutral: Considering Trades Between Canada, Australia & The U.K. Over the past few months, we have upgraded our stance on government bond exposure in the U.K., Canada and Australia - all to neutral and all for essentially the same reason. There was not a compelling enough case to expect any of the central banks in those countries to move interest rates before year-end, in either direction, given the lack of sustainable inflation pressures and mixed messages on growth. With policymakers stuck on hold for the foreseeable future, keeping our recommended bond weightings at benchmark was the logical (albeit unexciting) choice. Even the mixed messages sent by our own bond indicators highlight the difficulty in making a decisive market call at the moment. Our Central Bank Monitors for Canada and Australia have recently flipped into the "tighter policy required" zone, joining the U.K. Monitor which has been there for some time (Chart 2).1 This would suggest moving to an underweight stance in anticipation of tighter monetary policy in those countries that is currently not priced into money market curves (bottom panel). Yet the best performing bond market of the three over the past two years has been the U.K. - a trend that started before last year's Brexit vote when the U.K. economy was in relatively good shape and the Bank of England (BoE) was starting to send hawkish messages. Gilts now look the most overvalued judging by the current negative real yields on offer (Chart 3), yet our U.K. Central Bank Monitor is showing signs of topping out, further adding to the confusion. Chart 2Markets Don't Expect Anything From BoE/BoC/RBA Chart 3Gilts Look Most Expensive Having mixed directional signals, however, does not imply that there are not trade opportunities within these markets. Even if the BoE, the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) are not in a hurry to begin hiking interest rates, domestic growth and inflation pressures are building at a different pace within these economies, creating potential cross-market trade opportunities. Economic Growth: Canada has the strongest leading economic indicator, manufacturing PMI and consumer sentiment, but the softest business confidence (Chart 4) - perhaps because of concerns over the future protectionist trade policies of U.S. President Donald Trump. In the U.K., a combination of falling real wage growth and persistently high levels of political uncertainty after Brexit are weighing on consumer sentiment, yet business confidence is the strongest of the three countries. Meanwhile, overall confidence in Australia is the weakest, even with manufacturing in a strong upturn. Most worryingly, real consumer spending is slowing rapidly in all three countries, although it is holding up relatively better in Canada. Inflation: The differences in price pressures are less pronounced (Chart 5). Inflation rates are similar among the three economies as Australian core CPI inflation appears to have finally bottomed out in the first quarter of this year after falling steadily since 2014. All three countries are witnessing decelerating wage growth, however, even with solid job growth in Canada over the past year. Spare capacity measures like the output gap and unemployment gap show the U.K. economy being closest to full employment (Chart 6). Spare capacity is steadily being absorbed in Canada, although the BoC attributes this to a slower pace of potential GDP growth, according to last month's BoC Monetary Policy Report (MPR).2 Chart 4Canadian Economic Data Looks Strongest Chart 5No Major Inflation Differences Home Prices & Debt: The housing markets remain an issue in Canada and Australia, where home prices look severely overvalued with household debt at elevated levels (Chart 7). The governments in both countries are trying to use regulatory and macro-prudential solutions to cool red-hot housing demand, but rapid growth in housing wealth remains a source of stimulus for consumers at the moment. The situation is different in the U.K., where home valuations and debt levels are nowhere near as elevated as in the other two countries (although London homeowners may disagree). Chart 6No Spare Capacity In The U.K. Chart 7Household Debt A Concern In Canada & Australia Exports: Each country is also exposed to a different major economy via the export channel. The OECD leading economic indicators for the U.S., Euro Area and China (the largest export markets for Canada, the U.K. and Australia, respectively) are all ticking higher, suggesting that export demand should pick up for Canada, the U.K. and Australia in the near term (Chart 8). However, Australian exports to China have already expanded at a 60% annual rate and our Emerging Market and China strategists are expecting some cooling of Chinese growth in the latter half of this year; slower export growth should be expected. Chart 8An Unsustainable Surge In Aussie##BR##Export Demand From China After adding up all the pieces, it is still difficult to select one government bond market over the others in absolute terms. The U.K. would appear to have the least bond-friendly backdrop, with higher inflation and very low real interest rates. Yet the BoE is worried about many factors - Brexit uncertainties on trade and business confidence, declining real household income growth - that should prevent them from shifting to a less accommodative monetary stance before year-end that would involve reduced Gilt purchases and/or outright interest rate hikes. Conversely, Australia seems to have the most bond-bullish climate - a still-negative output gap, plunging consumer confidence, very low inflation and the heaviest exposure to a Chinese economy that is set to cool off. Yet while core inflation remains low at 1.5%, it appears to be bottoming out and the RBA is currently forecasting that its preferred measure of underlying inflation will move up to 2% - the low end of its 2-3% target range - by early 2018, according to their just-released Statement on Monetary Policy.3 In Canada, the BoC continues to take a very cautious view on Canadian growth, despite the robust 4% real GDP growth seen in the first quarter of this year. Sluggish growth in exports and capital spending is expected to be a drag on growth this year, according to the April BoC MPR. Yet the central bank is now "decidedly neutral" and is no longer considering a rate cut as it was earlier this year according to BoC Governor (and BCA alumnus) Stephen Poloz.4 Given all the various factors pushing and pulling on these three economies and central banks, it is perhaps no surprise that yield moves have been highly correlated across these bond markets over the past several months (Chart 9). The most attractive near-term risk/reward opportunities now appear to be in relative yield curve trades rather than directional allocations or cross-country spread trades. Specifically, we see an opportunity to play for a steeper Gilt curve, and a relatively flatter Canadian government bond curve, via a 2-year/30-year box trade. Given the strong readings on current and leading economic indicators in Canada, combined with our view that the recent patch of slower U.S. growth will prove to be temporary, we see the greatest potential for upside growth surprises in Canada. The BoC is likely to wait before delivering rate hikes until there is decisive evidence of accelerating inflation, especially given the potential economic risks deriving from the Canadian housing bubble. However, better-than-expected growth will exert more flattening pressure on the Canadian yield curve than the U.K. or Australian curves, where downside growth risks are greater. Already, the very front end of the Canadian curve is starting to disengage from the U.K. and Australian curves, with the 2-year/5-year flattening modestly in Canada and the other markets showing steepening curves at similar maturities (Chart 10, top panel). We expect that relative flattening pressure to exert itself further out the yield curve for Canadian government debt over the latter half of 2017. Chart 9Yields Are Highly Correlated... Chart 10...Curve Slopes, Slightly Less Correlated In the U.K., the long end of the Gilt curve has rallied to very rich levels, with the 10-year/30-year slope now trading near the bottom of the range that has prevailed since 2014 (bottom panel). Much of that has been driven by a decline in longer-term inflation expectations that has accompanied the more stable British Pound. While the uncertainty surrounding the upcoming Brexit negotiations with the European Union will likely weigh on business confidence and investment spending in the U.K., the immediate impact of the robust Euro Area economy on U.K. exports should provide a boost to U.K. economic growth. Coming at a time when the U.K. is at, or even beyond, full employment, this should put some mild upward pressure on inflation expectations further out the curve, leading to steepening pressures on a relative basis to Canada. This can already be seen in looking at the 2-year/30-year yield curve box between the Canada and the U.K. in Chart 11. In all three panels, we show the steepness of the Canadian bond curve minus that of the Gilt curve, alongside the differentials in actual inflation, and market-based inflation expectations from the index-linked markets, between Canada and the U.K. As can be seen in the top two panels, the Canadian curve looks too steep relative to the U.K. curve given the higher rates of headline and core inflation in the U.K. The bottom panel shows that the 2-year/30-year box is in line with the relative inflation expectations within the two countries. We see this as a sign that U.K. inflation expectations are too low relative to actual U.K. inflation, leaving the Gilt curve too flat relative to the Canadian curve. While this would appear to argue for a relative trade between inflation-linked bonds in Canada and the U.K., the poor liquidity of the small Canadian linker market makes this a difficult trade for most investors to put on. We prefer to express the view via yield curves, particularly with the 2-year/30-year Canada-U.K. box currently priced in the bond forwards to move sideways over the rest of the year (Chart 12). This means that betting on a steeper Gilt curve relative to Canada does not incur negative carry - important for a trade with a more medium-term horizon like this. Chart 11Gilt 2/30 Curve Too Flat Relative To Canada Chart 12Enter A 2/30 Canada-U.K. Box Trade This week, we are adding this 2-year/30-year Canada-U.K. position to our strategic model portfolio at -7bps. The initial target is for the box to return to -50bps - the bottom of the range that has prevailed since 2015. A deeper decline would occur if the BoC begins to signal a rate hike in Canada at some point that puts even more flattening pressure on the Canadian curve, although that is not our base case expectation over the rest of 2017. The risk to the trade would come from a deceleration of U.K. inflation that eliminates the current divergence between realized and expected inflation. What about Australia? We anticipate that there will be an opportunity to move to an eventual overweight position in Australian bonds in the coming months to position for the slowing of Chinese growth, and the related demand for Australian exports, that we expect. We are choosing to stay neutral for now, however, given the current uptick in Australian inflation that muddies the water on any call on RBA monetary policy. Bottom Line: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a flatter curve in Canada and a steeper curve in the U.K. Tactical Overlay Housekeeping: Cutting Losses On Portugal Shorts One of our long-held positions in our Tactical Overlay trade portfolio has been a short position in Portugal 10-year government bonds versus a long position in 10-year German Bunds. We put the trade on last summer as part of a broader allocation at the time out of Peripheral European sovereign debt into core European debt. The logic was straightforward - the combined stress of decelerating economic growth and struggling banking systems in the Periphery (made worse by the ECB's negative interest rate policies) would result in some spread widening in Italy, Spain and Portugal. While that story remains true in Italy, both leading economic indicators and measures of financial sector risk like credit default swap (CDS) spreads for senior banks have a decline in Spain and Portugal. While we have already upgraded our recommended allocation to Spanish debt in our model portfolio, we had been reluctant to consider a similar move in Portugal given our concerns about its economy and, more importantly, its banking system. But with leading economic indicators starting to perk up and bank CDS spreads in Portugal falling sharply, and with German Bund yields rising alongside growing market nervousness of a potential ECB taper, Portugal-Germany spreads have tightened sharply. We are belatedly cutting our losses on this position this week and closing out the position at a loss of -1.6%. We plan on publishing a deeper dive on Portugal in the coming weeks to update our views on the country and its bond markets. Bottom Line: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "BCA Central Bank Monitor Chartbook", dated March 28 2017, available at gfis.bcaresearch.com. 2 http://www.bankofcanada.ca/wp-content/uploads/2017/04/mpr-2017-04-12.pdf 3 http://www.rba.gov.au/publications/smp/2017/may/pdf/statement-on-monetary-policy-2017-05.pdf 4 https://www.bloomberg.com/news/articles/2017-04-12/poloz-sees-faster-canada-return-to-full-capacity-key-takeaways The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The U.S. unemployment rate stands 0.1 points below the FOMC's year-end projection and 0.4 points below its estimate of NAIRU. If the unemployment rate keeps falling, it will have nowhere to go but up - and the U.S. has never been able to avoid a recession whenever the unemployment rate has risen by more than one-third of a percentage point. So far the FOMC has failed in its efforts to tighten monetary policy. U.S. financial conditions have actually eased sharply since the Fed resumed hiking rates in December. The Fed will turn more hawkish over the coming months. Stay short the January 2018 fed funds futures contract and position for a stronger dollar. What happens in the euro area has become increasingly irrelevant for what happens to EUR/USD. Even if the ECB raises rates somewhat more rapidly than expected, this will be largely counterbalanced by hawkish actions by the Fed. Investors should stay cyclically overweight global equities, but be prepared to pare back exposure next summer. Feature Beware Of Full Employment Chart 1Recoveries Usually Lose Steam##br## WhenThe Unemployment Rate Falls Below NAIRU After eclipsing 10% in 2009, the U.S. unemployment rate fell to 4.4% in April, 0.1 points below the median end-2017 dot in the Fed's Summary of Economic Projections, and 0.4 points below the FOMC's estimate of NAIRU.1 The fact that most Americans who want to work are able to find jobs is obviously a good thing. However, today's increasingly tight labor market does have a dark side: As Chart 1 illustrates, recoveries have tended to run out of steam whenever the unemployment rate has fallen below its full employment level. Two points about the unemployment rate are worth keeping in mind: The unemployment rate has rarely been stable over time; usually, it is either rising or falling. The former tends to occur very quickly, while the latter is more drawn out. The unemployment rate displays momentum over short horizons, but is "mean-reverting" over the long haul (Chart 2).2 Since there is a limit to how low the unemployment rate can go, periods when it is below its full employment level typically do not last long. This is confirmed by Chart 3, which shows that there is a clear positive correlation between the degree of labor market slack and the onset of the next recession: High slack means that a recession is usually far away, whereas low slack means that a downturn is approaching. And it doesn't take much of an increase in the unemployment rate to sow the seeds for another recession - the U.S. has never escaped a recession in the postwar period whenever the three-month moving average of the unemployment rate has risen by a mere one-third of a percentage point (Chart 4). Chart 2The Unemployment Rate Is Mean-Reverting Over The Long Haul, But Displays Momentum In The Short Term Chart 3The Degree Of Labor Market Slack And The Onset Of The Next Recession: A Clear Positive Correlation Chart 4What Goes Down Must Come Up? Rising unemployment tends to generate all sorts of vicious cycles. When someone loses their job, they spend less. The resulting decline in aggregate demand forces firms to lay off workers, leading to even less spending throughout the economy. A weaker economy also makes it more difficult for borrowers to pay back loans, causing them to pare back spending. Falling asset prices only serve to exacerbate this problem. Threading The Needle Today's low unemployment rate puts the Federal Reserve in a bind. On the one hand, if the Fed raises rates too quickly, this could precipitate exactly the sort of downturn that it is trying to avoid. On the other hand, if the Fed fails to raise rates quickly enough, this could cause the economy to overheat. This, in turn, may force the Fed to raise rates aggressively - something that would destabilize both the economy and financial markets. The hope is that the Fed succeeds in threading the needle to ensure that the economy achieves a soft landing. There are some reasons to be optimistic about such an outcome, but also several reasons to be pessimistic. On the optimistic side, inflation expectations remain well anchored. This means that an overheated economy is unlikely to produce a powerful price-cost spiral such as the one that broke out in the 1970s. This limits the risk that the Fed will be forced to raise rates dramatically. The real economy is also not suffering from the sort of clear-cut imbalances that plagued the late innings of the last two business cycles - a massive capex overhang in the late 1990s, and an even larger housing overhang in the years leading up to the Global Financial Crisis. Private debt levels have also fallen as a share of GDP for most of the recovery, unlike in past cycles (Chart 5). On the pessimistic side, uncertainty about the level of the neutral rate - the interest rate consistent with full employment and stable inflation - will make it difficult for the Fed to calibrate monetary policy in a way that ensures a soft landing. It typically takes 12-to-18 months for changes in monetary conditions to fully make their way through the economy. Thus, if the Fed does end up either too far behind or too far ahead of the curve in normalizing monetary policy, it may not realize this until it's too late. Structurally slower potential GDP growth could also complicate matters. The Congressional Budget Office estimates that real potential GDP growth will average only 1.8% over the next 10 years, compared to 3.1% between 1980 and 2007 (Chart 6). Today's equity valuations are arguably pricing in faster GDP growth. Should growth settle below 2% - a rate that has often been associated with stall speed - risk assets could suffer, complicating the Fed's efforts in achieving a soft landing. Chart 5The Economy Is Not Showing ##br##Clear-Cut Signs Of Imbalances Chart 6Potential GDP Growth Is Not ##br##What It Used To Be The Fed's Choice Given the choice between erring on the side of raising rates too slowly or too quickly, the Fed has opted for the former. This is a quantitative statement, not a qualitative one. Chart 7 shows that U.S. financial conditions have eased considerably since the Fed resumed raising rates last December, thanks to a weaker dollar, tighter credit spreads, and a soaring stock market. If the whole point of hiking rates is to tighten financial conditions, then the Fed has not done enough. Worries that the headline unemployment rate may understate the true amount of labor market slack partly explain the Fed's angst in raising rates as quickly as it has in past cycles. While the headline rate has fallen back to its 2007 low, the broader U-6 unemployment rate - which incorporates people who are out of the labor market but claim to want a job, as well as those who are working part-time for economic reasons - is still 0.7 points above it. Likewise, the employment-to-population ratio for prime-age workers (ages 25-to-54) is 1.7 points below its pre-recession levels. The "quits rate" - a good measure of labor market confidence - also remains a notch below its pre-recession peak. Perhaps most glaringly, the median duration of unemployment has only fallen back to 10.2 weeks, which is still close to the high of the previous cycle (Chart 8). Chart 7Financial Conditions Have Been Easing Chart 8Headline Unemployment Rate ##br##Back To 2007 Levels, But Other ##br##Measures Still Point To Slack Each of these factoids has a counterargument: The elevated share of involuntary part-time workers may be partly due to the effects of Obamacare, which has made it burdensome for companies to add full-time workers to the payrolls;3 the low quits rate and the high median length of unemployment may reflect the aging of the population as well as lower gross job creation (Chart 9); and automation, globalization, and low-skilled immigration may have depressed real wages for less-educated workers, causing them to abandon the labor market (Chart 10). Nevertheless, with core inflation still below the Fed's 2% target, it is not hard to see why the Fed has elected to take a "go slow" approach so far. Chart 9The Labor Market Has Become Less Dynamic Chart 10Less-Educated Men Are Fleeing The Labor Market The Hawks Spread Their Wings That may be changing, however. The growth in nominal unit labor costs has already surpassed 2% and is close to the peaks reached in 2000 and 2007 (Chart 11). Most other measures of wage growth remain in a clear uptrend (Chart 12). If GDP growth accelerates over the remainder of the year, as we expect, the Fed will pursue a more aggressive tightening path than what the market is currently discounting. Chart 11Unit Labor Cost Inflation Close To Past Peaks Chart 12Most Measures Of Wage Growth Are In An Uptrend Recent communications from the Fed have revealed an increasingly hawkish bias. The latest Fed statement downplayed the slowdown in Q1 as "transitory." This follows Chair Yellen's comment that "waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession."4 Investment Conclusions Higher U.S. rate expectations should give the dollar a boost (Chart 13). We do not agree with the often-heard argument that the actions of foreign central banks will materially weaken the dollar. Consider the case of the ECB. There has been much speculation that the ECB will phase out some of its emergency measures. That may well happen, but even if it does, a full-fledged hiking cycle is nowhere on the horizon. According to a recent ECB study, the rate of labor underutilization still stands at 18% in the euro area, 3.5 points higher than in 2008 (Chart 14).5 Stripping out Germany, the rate of underutilization would be seven points higher (Chart 15). It is still too early for Mario Draghi to begin removing monetary accommodation in a concerted manner. Chart 13Higher U.S. Rate Expectations ##br##Should Give The Dollar A Boost Chart 14Labor Market Slack In The Euro Area Remains High... Chart 15...Especially Outside Of Germany Moreover, anything the ECB does which inadvertently leads to a stronger euro will likely be matched by offsetting hawkish actions by the Fed. Remember that the Fed needs to tighten financial conditions in order to prevent the unemployment rate from falling so much that it has nowhere to go but back up. A weaker dollar runs contrary to that strategy. The argument above can be applied more broadly. The euro rallied in the lead-up to the French election on the now-realized hope that Emmanuel Macron would prevail. Put aside the fact that Macron's platform calls for cutting the budget deficit from 3.2% of GDP this year to 1% of GDP in 2022 - something which, all things equal, would lead to less monetary tightening and a correspondingly weaker euro. Even if Macron's victory somehow did manage to allow the ECB to raise rates earlier than it would have otherwise, it is hard to believe that this would not influence the pace of Fed rate hikes. U.S. financial conditions could tighten through some combination of higher rates and/or a stronger dollar. The only way the Fed could engineer a tightening in financial conditions while the trade-weighted dollar still weakened would be to jack up interest rates by an inordinate amount. However, this outcome would require that other central banks raise rates even more. That's not going to happen. Stay short EUR/USD. We think the euro will reach parity against the dollar later this year. Where does this leave equities? So long as global growth remains solid and corporate earnings are in an uptrend, the path of least resistance for stocks is up. However, the risk is that the Fed overplays its hand and ultimately tightens monetary policy too much. This could lead to a broad-based global slowdown towards the end of 2018. Investors should stay cyclically overweight global equities, but be prepared to pare back exposure next summer. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The Non-Accelerating Inflation Rate of Unemployment (NAIRU) is the unemployment rate consistent with stable inflation. 2 An Ordinary Least Squares (OLS) regression using monthly data between 1960 and 2017 shows that the change in the unemployment rate over the coming three months is positively associated with a change in the unemployment rate over the prior three months, and negatively associated with the level of the unemployment gap. 3 See, for example: Marcus Dillender, Carolyn Heinrich, and Susan Houseman, "Effects of the Affordable Care Act on Part-Time Employment: Early Evidence," Upjohn Institute Working Paper, 2016. 4 Janet Yellen, "Semiannual Monetary Policy Report To The Congress," February 14, 2017. 5 Please see ECB, "Focus: Assessing Labour Market Slack," Economic Bulletin Issue 3, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights ECB policy is set to become less dovish relative to other central banks. Stay long the euro; stay underweight German bunds within a global bond portfolio; and overweight euro area Financials within a global Financials portfolio. Female labour participation is surging. The state of the euro area labour market is not nearly as bad as many pessimists would have you believe. Play the mega-trend of rising female labour participation with a structural overweight in the Personal Products sector. Allowing for euro break-up risk, European equities are fairly valued - rather than cheap - versus U.S. equities. Prefer to gain exposure via a 50:50 combination of Germany (DAX) and Sweden (OMX). Feature "Domestic sources of risk to euro area growth have diminished while global, geo-global sources of risk have increased." - Mario Draghi The Cleanest Dirty Shirt Since the end of 2014, an unspectacular 1.9% growth rate1 has been enough to make the euro area the world's top-performing major economy - bettering the U.S., U.K. and Japan (Chart I-2). Chart of the WeekThe Percentage Of The French Population In Employment Is At An All-Time High Chart I-2The Euro Area Is The Top-Performing Economy The euro area economy has achieved this outperformance with exceptionally low volatility. For eight consecutive quarters, growth2 has remained within a very tight 1.2-2.2% band, less than half of the equivalent volatility in the U.S., U.K. and Japan. And growth is now "solid and broad", meaning that it includes all countries. The ECB's dispersion index of value-added growth in different countries stands at a historical minimum. We expect the euro area to remain the cleanest dirty shirt. As Draghi points out, the ECB is less worried about domestic risks and more worried about global risks. Specifically: "Markets are in the course of reassessment of U.S. fiscal policy" - Trumponomics will not be nearly as stimulative as first thought. "How the U.K. economy does post-Brexit has a channel of economic consequences for the euro area." "Possible negative surprises in some emerging market economies" - notably China. If any of the global risks do flare up, the ECB will sit pat, but other central banks will have to become more dovish relative to current expectations. If the risks do not flare up, the ECB will start to reduce its own extreme dovishness - at least with words, if not actions. Either way, ECB policy is set to become less dovish relative to other central banks. And the investment implications are: stay long the euro; stay underweight German bunds within a global bond portfolio; and overweight euro area Financials within a global Financials portfolio. Female Labour Participation Is Surging Chart I-3Rising Participation Boosts Employment As Emanuel Macron prepares to become the twenty fifth President of the French Republic, he can take heart from a statistic which may surprise you: The percentage of the French population in employment has never been this high. (Chart of the Week). How can this be when the French unemployment rate is still hovering around 10%? The answer is: as millions of formerly inactive French citizens have entered the labour market, it has lifted the percentage of the population with jobs to an all-time high (Chart I-3). But the flip side of rising participation is that it has kept the unemployment rate elevated - because some citizens who were formerly 'uncounted inactive' are now 'counted unemployed'. Remember that to count as unemployed, a person has to be in the labour market available for work. Some argue that French citizens have simply flooded into the labour market to claim generous and long-lasting unemployment benefits. This argument might hold during downturns, but it cannot explain the 25-year uptrend which also includes economic booms. Unpalatable as it might be to the pessimists, we are left with a more optimistic explanation. France has raised activity levels in the working age population with policies that encourage much greater female participation in the labour market. The important lesson is that when labour participation is rising or falling, we must interpret the headline unemployment rate with extreme care.3 If a country's unemployment rate is high because labour participation has increased - as in France - the labour market is not quite as bad as the high unemployment rate might suggest.4 Conversely, if a country's unemployment rate is low because labour participation has decreased - as in the U.S. (Chart I-4) - the labour market is not quite as good as the low unemployment rate might suggest. Counted unemployment has just been replaced with uncounted inactivity. We propose that the percentage of the working age population in employment is the truer measure of labour utilisation. With surging female participation boosting employment in France and most other European countries (Chart I-5), the state of the euro area labour market is not nearly as bad as many pessimists would have you believe. Chart I-4Participation Down In The U.S.,##br## But Up In Europe... Chart I-5...Led By ##br##Women Play the mega-trend of rising female labour participation with a structural overweight in the Personal Products sector. Political Risk Is Correctly Priced Many people saw the Brexit and Trump victories as the leading edge of a wave of economic nationalism. However, subsequent election results in the Netherlands, Austria, Finland, Bulgaria and now France have seen economic nationalists consistently underperforming their expectations. In hindsight, the Brexit and Trump victories were idiosyncratic. Both the Remain and Clinton campaigns were lacking in personality or a strong emotional message, and this proved to be their undoing. Nowadays, many voters care about personalities more than policies; emotional appeal matters more than rational appeal. Behavioural psychologist and Nobel Laureate Daniel Kahneman calls the emotional way of thinking "System 1", and the colder rational way of thinking "System 2". Crucially, in a tight contest, both the Brexit and Trump campaigns resonated with the emotional System 1 with passionate pleas such as "Take Back Control" and "Make America Great Again". By contrast, the Remain and Clinton campaigns tried to appeal mainly to the rational System 2. But as Kahneman explains, when rational System 2 competes with emotional System 1, emotional System 1 almost always wins. Chart I-6Euro Break-Up Probability = 5% A Year In more recent elections, candidates and parties opposing the nationalists - including Emanuel Macron - have used a good balance of System 1 and System 2 arguments, thereby helping to prevent shock outcomes. This is also likely to be case in the two round French legislative elections on June 11 and 18 which we do not expect to impact financial markets significantly. Does this mean that political risk is over in Europe? No. Until the euro area turns into a permanent and irreversible political union, there has to be a probability of euro break-up. To value euro area assets, investors must ask: what is this break-up probability? The sovereign bond market says it is 5% a year (Chart I-6). This shows up in a discount on German bund yields, because after a euro break-up a new deutschmark would rise; and a symmetrical premium on Italian BTP yields, because a new lira would fall. For the aggregate euro area bond, the risk largely cancels out because intra-euro currency redenomination would be zero sum. But European equities must trade at a discount for this tail-event. At the peak of the euro debt crisis in 2011, the Eurostoxx600 underperformed the S&P500 by 25% in one year. In an outright break-up, the underperformance would almost certainly be worse, let's conservatively say 30-40%. So assuming the tail-event probability is 5% a year, European equities must compensate with a valuation discount which allows a 1.5-2.0%5 excess annual return over U.S. equities. Today, the valuation discount on European equities relative to U.S. equities implies an excess annual return of 1.8%.6 This makes European equities cheap versus U.S. equities only if the annual probability of euro break-up is less than 5%. Our assessment is that a 5% annual risk is about right. Therefore, European equities are fairly valued - rather than cheap - versus U.S. equities. But to avoid the undesirable sector skews in the Eurostoxx600, a much better way to gain long-term exposure to European equities is via a 50:50 combination of Germany (DAX) and Sweden (OMX) (Chart I-7). Chart I-7Prefer A DAX/OMX Combo To The Eurostoxx50 Or Eurstoxx600 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 At an annualized rate. 2 At an annualized rate. 3 Geek's note: the unemployment rate can be expressed as: 100*(participation rate - employment to population rate) / (participation rate). Hence, all else being equal, a rising participation rate will raise the unemployment rate and a falling participation rate will depress the unemployment rate. 4 This lesson applies equally to any studies of labour market slack such as this one: https://www.ecb.europa.eu/pub/pdf/other/ebbox201703_03.en.pdf that do not take into account the dynamics of participation rates. 5 5% multiplied by 30-40% equals 1.5-2.0% 6 Through the next ten years. Please see the European Investment Strategy Weekly Report titled "Markets Suspended In Disbelief" dated April 13, 2017 available at eis.bcaresearch.com Fractal Trading Model The rally in the CAC40 after the French election is technically extended. The recommended technical trade is to short the CAC40 versus the Eurostoxx600. 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 Macron has won in France; Economic reforms are forthcoming; Euroskeptic parties are moving to the center; Yet Italy remains a real risk; Stick to long French industrials versus German; stay long EUR/USD for now. Feature "A chair, a table, or a bench would be elected rather than her [Le Pen] in this country." - Jean-Luc Mélenchon Third-party candidate Emmanuel Macron is the new president of France following his win over populist and nationalist Marine Le Pen (Table 1). The victory was resounding, with polls underestimating support for the centrist, and vociferously Europhile, Macron (Chart 1). Macron's victory was all the more impressive given the low turnout, which should have favored Le Pen. Table 1Results Of French Presidential Election Chart 1Underestimating Emmanuel There are numerous narratives competing to make sense of the election in France. Our conclusion is simple: Marine Le Pen got trounced by a 39-year old political neophyte with no party organization and an investment-banking background. Le Pen wasn't so much defeated as she was routed, in a veritable Battle of Sedan for the European populists. What does this mean for investors? First, European assets are about to "rip." Second, the EUR/USD may have some more upside in the short term. Third, investors remain overly complacent about Italy, which we think has a good chance of breaking the trend of victories for the centrist forces in Europe. However, this is a story for 2018 and thus off the radar screen for investors at the moment. Le Pen Loses More Than Macron Wins Left-wing firebrand, and surprise first-round performer, Jean-Luc Mélenchon forecast in April that "a chair, a table, or a bench" would defeat Le Pen head-to-head. Naturally, the comment was self-serving for Mélenchon as he was trying to convince swing voters to support his campaign. Nonetheless, we fully agree with his assessment! Not only did Le Pen lose, but she lost to a political neophyte with investment banking on his resume. In France... In 2017... Chart 2Le Pen's Flaw Is The Euro So what happened? It is not a coincidence that Le Pen got precisely the same proportion of voters as the percent of the French public that does not support the euro, around 30-35%. Le Pen's popularity has in fact closely mirrored French Euroskepticism for years, peaking in 2013. Chart 2 essentially illustrates that Le Pen's ceiling is determined by the Euroskeptic mood of the country. We have stressed to clients since the December 2015 regional elections that Le Pen's Euroskpeticism is a major handicap to her political fortunes. In that election, her Front National (FN) was massacred in the second round despite a highly favorable context for an anti-establishment, nationalist party. The election took place on the heels of an epic migration crisis and a massive terrorist attack (which occurred just 23 days before the election).1 The Front National was defeated in all 13 mainland French regions, despite leading in six following the first round. As such, investors should ignore both the positive and negative hype surrounding the media coverage of Macron. The main lesson of the French election is that Euroskepticism does not pay political dividends, not that Le Pen still has a chance in the next election or that Macron has pulled off an extraordinary victory. The upcoming legislative elections - set for two rounds on June 11 and 18 - will cement our call on Le Pen and FN. Polls are sparse, but what we have thus far suggests that Macron's En Marche and the center-right Les Républicains will capture the vast majority of seats in the legislature (Table 2). We do not have enough polling data to gauge the reliability of this forecast, but it does make sense given FN's previously weak electoral performances in legislative and regional elections. In fact, following Macron's strong performance on May 7, we would be surprised if FN gets more than 15-20 seats in the National Assembly. Table 2Macron May Have To Work With The Republicans What matters for investors is the likely strong performance in the legislative elections for the center-right Les Républicains. Its presidential candidate François Fillon was the leading centrist candidate to get into the second round for most of early 2017 and only faded due to his corruption scandal (Chart 3). His primary challenger - Bordeaux mayor and former conservative Prime Minister Alain Juppé - in fact was comfortably leading all candidates before he was bested by Fillon in late November in party primaries (Chart 4). Chart 3Scandal, Not Policies, Killed Fillon Chart 4Juppe Led The Race Before Fillon Took Over A Macron presidency supported by Les Républicains in the National Assembly could be the best outcome for investors. On the international stage - where the president has no constraints - France will be led by a committed Europhile willing to push Germany towards a more proactive - rather than merely reactive - policy. On the domestic stage - where the National Assembly dominates - Macron's cautiously pro-growth agenda will be pushed further to the right by Les Républicains. In our view, the best outcome would be either genuine "cohabitation," where Macron's En Marche does not get a majority and he is forced to cohabitate with a center-right prime minister, or an En Marche sweep. The worst outcome would be a hung parliament, where Les Républicains refuse to cooperate with En Marche so as not to give Macron any further political wins. We continue to believe that the context is ripe for genuine structural reforms. We expanded on this topic in a February report titled "The French Revolution" and will not repeat the arguments here.2 Suffice it to say that a "silent majority" in France appears ready to incur the pain of reforms (Chart 5). As a play on the reform theme, we have been long French industrial equities / short German industrial equities on a long-term horizon (Chart 6). The idea is that French reforms should suppress wage growth and make French exports more competitive vis-à-vis their main competitor, Germany (Chart 7). Chart 5"Silent Majority" Wants Reform Chart 6France Will Revive, Germany Is Peaking Chart 7Reforms Could Close This Gap Bottom Line: As we have expected for years, Marine Le Pen is unelectable due to her opposition to European integration. At the minimum, this should allay the fears of many investors that Frexit is a possibility. It has never even been close.3 At its most optimistic, Macron's victory will usher in a period of economic reforms in France. The Big Picture: Europe's Populists Defeated In April 2016 - ahead of the U.K. EU referendum and the U.S. general election - we made a controversial call: Anglo-Saxon populists would surprise to the upside in the upcoming plebiscites, whereas continental European would underperform.4 The U.K. has subsequently chosen Brexit and the U.S. electorate has chosen Donald Trump, both outcomes that we noted were more likely than the consensus expected. On the other side of the ledger, populists were defeated in two Spanish elections (December 2015 and June 2016), the Austrian presidential election in December 2016, and the Dutch general election in April 2017. The latest defeat for the anti-globalization populists is surprising because it happened in France, a country with a long tradition of both. One cannot blame relative economic performance for the outcome, as France has clearly underperformed the U.S. on both the growth and employment fronts (Chart 8). Nor can it be blamed on a more sanguine security situation: since 2015, France has experienced far more tragedy due to terrorist attacks than the U.S. and has been in a state of emergency since the November 2015 terror attack (Chart 9). And while France has largely avoided the 2015 European migration crisis, it was at least far more threatened by it than the U.S. due to mere geography. Chart 8Economic Woes Not Lacking In France... Chart 9... Nor Is Threat Of Terrorism In our view, the long-term socio-economic context is more important than the day-to-day economic and security situation in explaining the success of populists. The French social welfare state - which is onerous, inefficient, and clearly in need of reform (Chart 10) - has nonetheless played a crucial role in tempering the appeal of anti-establishment politics. Chart 10France: Welfare State Needs Reform Chart 11Anti-Establishment Candidates Win... Unlike the U.S. - which has seen the real median household income decline over the past two decades and grow much slower than the economy (Chart 11) - European countries have redistributed the gains of globalization in such a way as to ensure that more people benefit from it (Chart 12). Income inequality has grown in Europe regardless, but to a much lower level - and by a lower magnitude - than in the U.S. (Chart 13). This is perhaps most pronounced in France, where the top 10% of households by income retain much the same share of the economy as they did in 1950 (Chart 14). Chart 12Redistributing Globalization's Gains Chart 13U.S. & U.K.: Outliers On Inequality Chart 14France: Inequality Flat For 70 Years Many of our clients in the U.S. and the U.K. have reacted negatively to our view above. Our analysis is not meant to endorse French levels of social welfare spending. In fact, we are bullish on France precisely because we expect Emmanuel Macron to reduce French state largesse over time. We merely point out that the political effect of a redistributive socio-economic system is greater stability and centrism of the voting public in the midst of a painful socio-economic context. The median voter in Europe is simply not as angry as the median voter in the U.S. This is not by chance, but rather by design. Europe's "socialism" is a relatively modern development and a product of Europe's disastrous inter-war period, which instilled a fear of a populist backlash against failed economic policies of the time. The inter-war period saw the rise of both left- and right-wing extremism, which fed on each other with increasing intensity. These included a failed communist revolution in Germany (1918-1919), a failed Nazi coup in Germany (1923), a fascist takeover of Italy (1925), a Nazi takeover in Germany (1933), far-right unrest in France (1934), and the Spanish Civil War (1936-1939). These political upheavals were a product of both the Great Depression and the First World War. But they were also colored by Europe's socio-economic context at the time: very high wealth inequality at the beginning of the twentieth century. In fact, Europe had a much higher starting level of wealth concentration than the U.S., resulting in a much sharper correction during the inter-war period (Chart 15). What most commentators who forecast Europe's doom after the Great Recession missed is that the socio-economic context matters. It is the reality through which voters filter contemporary events. In Europe's case, the median voter was in a much better place to deal with the post-2008 economic and financial crises because Europe's "socialism" had dampened the negative consequences of globalization. In the U.S., and we would argue in the U.K. to a much lesser extent, the median voter was far more exposed to the vagaries of globalization and thus was (and remains) more open to anti-establishment political outcomes. This is the great paradox of the past 18 months: that the two best performing economies in the developed world - the U.S. and the U.K. - experienced the greatest level of populism. To us, it is not much of a paradox. Economic performance is by nature a study of the mean performance, whereas political forecasting deals with the median outcomes. This is not to say that the French are not angry with elites. After all, nearly 50% of the votes cast in the first round of the election went to anti-establishment candidates (Chart 16). However, French voters are not angry enough to want a dramatic reordering of their society, particularly in terms of their support for European institutions. What about other countries in Europe? A trend is emerging across the continent where anti-establishment parties are retaining their commitment to economic redistribution, anti-immigrant sentiment, or unorthodox foreign policy, but abandoning their Euroskepticism for the sake of competitiveness. The best examples of this trend are Spain's Podemos and Greece's SYRIZA, which have evolved in a short period of time into mainstream left-wing parties. Meanwhile, parties that retain an official strategy of Euroskepticism are increasingly finding out that the "Euroskeptic ceiling" is real. As such, these parties are struggling between remaining politically competitive and staying true to their Euroskeptic ideals: Germany: The German Euroskeptic Alternative Für Deutschland (AfD) party has been beset by massive internal conflict and identity crisis. Ousted leader Frauke Petry tried to move the party towards the center, but was rebuked at an April party congress. The AfD is still polling just under 10% (Chart 17), and will therefore enter the Bundestag in the September 24 election, but its leadership is torn between openly embracing the German alt-right and setting a course as a conservative alternative to Angela Merkel's Christian Democratic Union. We would expect the party to enter the Bundestag, but only just, in the upcoming election. Chart 15U.S. And France: Different ##br##Starting Points Of Inequality... Chart 16French Voters##br## Are Angry Chart 17German Euroskeptics To ##br##Squeak Into Bundestag, At Best Austria: The presidential candidate of the anti-establishment Freedom Party of Austria (FPO), Norbert Hofer, tried mightily to soften his Euroskepticism ahead of the December 2016 elections. He failed and lost the election despite a solid lead in the polls for much of the year. Austria is set to hold general elections by October 2018 and support for the FPO has clearly peaked (Chart 18). Given that all other parties in Austria are pro-EU, the FPO is likely to remain isolated. Finland: The "True Finns," since rebranded as just "The Finns," were once the only competitive Euroskeptic party in northern Europe. They did very well in the 2015 general election and entered the governing coalition. To do so, they compromised on their Euroskeptic positions and became largely irrelevant, with a big dip in support (Chart 19). April municipal elections went terribly for The Finns, with the Europhile Green League emerging as the big winner. An upcoming party congress in June will determine the future of the party and whether it swings towards populism or centrism. Chart 18Austrian Anti-Establishment Has Peaked Chart 19Finnish Anti-Establishment Has Peaked Italy: The one party to watch over the next several months is Italy's Five Star Movement (5SM). There is evidence that 5SM is itself riven by internal conflict over how far to take its Euroskepticism. And several moves by party leadership - including attempting to leave the legislative alliance with UKIP at the European Parliament level - appear designed to pursue the political center. The problem, however, is that there is little evidence that the Italian median voter is as committed to European integration. This remains the key risk for Europe going forward. Bottom Line: Populism has underperformed in continental Europe, much to the surprise of most commentators. Europe's economic redistribution has dampened demands for anti-establishment outcomes. Evidence suggests that Euroskeptic parties will continue to migrate to the center, at least as far as European integration is concerned, in the near future. One outlier to this view is Italy, which we elaborate on below. Investment Implications European risk assets should continue to outperform the U.S. in the coming months. The European economy continues to fire on all cylinders, whereas the U.S. appears to have hit a soft patch, according to the sharply divergent Economic Surprise Indexes (Chart 20).5 The euro may benefit from the reduction in risk premia for the time being. We will retain our long EUR/USD for now, but look to close it over the summer as we doubt the ECB's commitment to a hawkish turn in monetary policy ahead of critical risks in 2018. At the forefront of those risks is the upcoming Italian election. As we have argued repeatedly for two years, the Italy's Euroskeptic turn is real and underpinned by data. Whereas the median European has been far less Euroskeptic than the conventional wisdom has held, the median Italian is becoming more Euroskeptic. We spent a week in Europe warning clients in London, Paris, and Zurich of the upcoming Italian risks. There was little appetite for our bearish view. Even clients in the U.K. who previously held deeply skeptical views of the Euro Area's ability to survive have changed their view on Italy. Why such complacency? The oft-repeated refrain was that Italian politics have always been a mess. The election, which is highly likely to produce either a weak coalition or a hung parliament, will therefore not produce a definitive outcome worthy of risk premia. We highly disagree with this view. Our concern with Italy is not the current polling of Euroskeptic parties, but rather the underlying turn in the Italian electorate towards greater acceptance of a future outside of Europe (Chart 21). If the median voter is more willing to entertain Euroskeptic outcomes, than the Euroskeptic parties will not be forced to adopt a centrist position, as they have done in the rest of Europe. Chart 20U.S. Economy Hits A Soft Patch Chart 21Italy: The Real Risk To Euro Area Nonetheless, investor complacency tells us that European asset outperformance could last well into late 2017. There will be no immediate risk rotation from the French election to the Italian one. The market will have to be shocked into pricing greater odds of Euro Area dissolution when Italy comes back into focus, likely in Q1 2018. Until then, the party will continue. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 5 Please see BCA Global Alpha Sector Strategy Weekly Report, "Buy The Breakout," dated May 5, 2017, available at gss.bcaresearch.com.

Highlights Duration: U.S. growth expectations have become overly pessimistic. A Q2 rebound will lead to higher global bond yields and a steeper U.S. Treasury curve. UST / Bund Spread: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. USD Hedging Costs: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Feature Chart 1Global Recovery Will Persist The synchronized global recovery that took hold in the second half of 2016 has stalled so far this year. Measures of economic sentiment, such as the Global ZEW survey and our own Boom/Bust Indicator, have rolled over from high levels and global bonds have clawed back some of last year's lost returns (Chart 1). Year-to-date, the Bloomberg Barclays Global Government Bond index has returned +3%, after having lost more than 9% between the July trough in the Global ZEW index and the end of last year. In our view, a repeat of early 2016's global growth slowdown and bond market rally, which saw the Global ZEW index fall below zero and the Global Government Bond index return 11.6% in 2016H1, is not in the cards. The global economy is on much firmer footing than at this time last year. U.S. Growth: Past Peak Pessimism First quarter U.S. GDP growth was a disappointing 0.7%, but is poised to bounce back strongly in Q2. The volatile inventories component subtracted 0.9% from overall Q1 growth, harsh weather wreaked havoc on the March employment report and there continue to be problems with residual seasonality depressing first quarter GDP data.1 The outlook is much brighter moving forward. The latest employment report showed that the U.S. economy added a healthy 211k jobs in April and our model is pointing toward a further acceleration (Chart 2). Economic growth can be thought of as a combination of aggregate hours worked and labor productivity (Chart 3). With aggregate hours worked growing at 1.7% year-over-year and labor productivity growth having averaged 0.6% (annualized) per quarter since 2012, real U.S. GDP growth of around 2.3% seems like a reasonable forecast. Chart 2Labor Market Still Strong Chart 3Look For Above 2% Growth There is even some reason to suspect that labor productivity could strengthen during the next few quarters. A recent IMF paper2 attributed weak post-crisis productivity growth to a combination of structural and cyclical factors, but also noted that weak investment in physical capital may be responsible for lowering total factor productivity growth by nearly 0.2 percentage points per year in advanced economies during the post-crisis period. With leading indicators pointing to still further gains in fixed investment (Chart 3, bottom panel), we would not be shocked to see productivity growth enjoy a modest late-cycle rebound. Chart 4Stronger Productivity = Steeper Curve All else equal, a late-cycle rebound in productivity growth would slow the increase in unit labor costs. Unit labor costs are a combination of wages (compensation-per-hour) and productivity (output-per-hour), and have historically tracked changes in the slope of the U.S. yield curve (Chart 4). Faster wage growth tends to coincide with Fed tightening, and slower wage growth with Fed easing. For this reason, all wage measures perform reasonably well tracking changes in the yield curve. But unit labor costs perform best because they also incorporate productivity growth, and low productivity growth can flatten the yield curve by pulling down long-dated yields. Rapid increases in compensation-per-hour and muted productivity growth have combined to give the yield curve a strong flattening bias during the past several years. Any increase in productivity growth would slow the uptrend in unit labor costs relative to other wage measures, allowing the yield curve to steepen. In fact, we continue to recommend that investors position for a steeper U.S. yield curve by going long the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This trade produces positive returns when the 2/10 slope steepens (Chart 4, panel 3), but has also returned +19 bps since we initiated the position last December, even though the curve has flattened since then. The reason for the trade's strong performance in an unfavorable curve environment is that the 5-year yield had been unusually elevated compared to the rest of the curve. Our model of the 2/5/10 butterfly spread versus the 2/10 slope showed that the 5-year note was one standard deviation cheap on the curve as recently as mid-March (Chart 4, bottom panel). This undervaluation has mostly dissipated and the 5-year note now appears only slightly cheap. For our curve trade to outperform from here, it will likely require the 2/10 slope to steepen.3 Bottom Line: With weak Q1 GDP now in the rearview mirror, we are likely past the point of peak pessimism on U.S. growth. Expect global bond yields to rise and the U.S. yield curve to steepen as the economic data start to reflect an environment of above-trend growth, in the neighborhood of 2% - 2.5%. European Growth & The Risk From China While the U.S. data have disappointed in recent weeks, as evidenced by the U.S. Economic Surprise Index having dipped below zero (Chart 5), the European economy has consistently bested expectations (Chart 5, panel 2). As a result, the Treasury / Bund spread has narrowed from high levels during the past few months. In practice, economic surprise indexes tend to mean revert because positive data surprises beget increasingly optimistic expectations. Eventually, overly optimistic expectations become too high a hurdle and the data start to disappoint. In our view, U.S. expectations have become unduly pessimistic while the Eurozone surprise index appears overdue for a correction. Against this back-drop, we expect the Treasury / Bund spread to widen in the near term as the large divergence between the U.S. and European surprise indexes starts to narrow. Further making the case for a wider Treasury / Bund spread is the recent performance of the Chinese economy. Our Foreign Exchange Strategy service recently observed that growth differentials between the U.S. and Europe are highly correlated with indicators of Chinese growth.4 This should not be overly surprising since Europe trades more with China and other Emerging Markets than does the United States. Along those lines, the IMF has calculated that a 1% growth shock to Emerging Markets impacts European growth by nearly 40 basis points, while it impacts U.S. growth by only 10 basis points.5 The worry at the moment is that Chinese monetary conditions have started to tighten, and China's Manufacturing PMI is rolling over alongside weaker commodity prices. These trends usually coincide with the underperformance of Europe relative to the U.S. (Chart 6). Chart 5Surprise Indexes Will Converge Chart 6Look To China To Trade UST / Bund Spread Our China Investment Strategy service highlights the importance of the trade-weighted RMB as a driver of Chinese growth.6 The RMB's 30% appreciation between 2012 and 2015 applied a massive deflationary force to China's economy, while its more recent depreciation helped boost producer prices, enhance profit margins and reduce the real cost of funding (Chart 7). Chart 7Monetary Conditions ##br##Still Fairly Stimulative More recently, the pace of the RMB's depreciation has slowed and this likely explains the weakness in China's Manufacturing PMI and commodity prices. Our China strategists are quick to note that while the pace of RMB depreciation has slowed, it is still not appreciating, and real interest rates deflated by the producer price index remain negative. In other words, monetary conditions have become somewhat less stimulative, but they should still be supportive of further economic growth. Although the Chinese economic data are likely to moderate in the coming months, barring the major policy mistake of aggressive tightening, Chinese growth will avoid a collapse and remain reasonably buoyant. Similarly, we would also expect European growth expectations to soften in the coming months, but growth is very likely to remain above trend and the ECB is still on track to adopt a less accommodative policy stance over the next year. In the most likely scenario, a few hints will be given at the June ECB meeting, and then an announcement that asset purchases will be tapered in 2018 will be made at the September meeting. The market will correctly assume that rate hikes will follow the taper, and this re-pricing of rate expectations will open up a window in the second half of this year when the Treasury / Bund spread can tighten. However, it is still too soon to adopt this position. Bottom Line: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. U.S. Bond Investors Should Expand Their Borders Divergences that have opened up between U.S. short-term interest rates and short-term rates in other developed countries mean that U.S. bond investors now face much lower currency hedging costs. In addition, increasingly negative cross-currency basis swap spreads have become a permanent feature of the post-crisis investment landscape, and unless significant regulatory changes occur, we expect they are here to stay. Combined, both of these factors make it incredibly attractive for U.S. bond investors to swap their U.S. dollars for foreign currencies and invest in foreign government bonds. In this week's report we explain why this is an attractive trade for U.S. investors and why it will likely remain so for quite some time. What Is The Basis Swap Spread? An excellent definition of the cross-currency basis comes from the Bank for International Settlements (BIS) who define it as "the difference between the direct dollar interest rate in the cash market and the implied dollar interest rate in the [currency] swap market".7 In essence, the existence of a negative basis swap spread should mean that there is an opportunity to arbitrage the difference between interest rates in the cash market and implied interest rates in the currency swap market. However, post-crisis regulatory constraints on bank balance sheets appear to have made this arbitrage prohibitive. Banks are either unable or unwilling to arbitrage the basis swap spread back to zero, and this increases the cost of U.S. dollars in FX swap markets. As a quick example, we can calculate the 10-year German Bund yield hedged into U.S. dollars using currency forwards. Hedged yield = Unhedged yield - Cost of hedging Where: Cost of hedging = forward exchange rate / spot exchange rate In this case, we define the exchange rates as euros per 1 U.S. dollar. By covered interest rate parity, we can also calculate the cost of hedging as: Cost of hedging = (1 + euro interest rate + basis swap spread) / (1 + USD interest rate) Using current 3-month interest rates, this means that the cost of hedging from euros into U.S. dollars is: Cost of hedging = (1 - 0.36% - 0.3%) / (1 + 1.18%) = -1.82% This means that the 10-year German Bund yield rises from 0.42% to 2.24%, from the perspective of a U.S. dollar investor, after hedging the currency on a 3-month horizon. In other words, U.S. investors can significantly increase the average yield of their portfolios by lending U.S. dollars over short time horizons and investing the proceeds into non-U.S. bonds. In Chart 8 we show the difference this currency hedging makes for German, Japanese and French 10-year government bonds. Current hedged 10-year yields for all the major bond markets are also shown on page 13 of this report. But for how long can this trade continue? In short, it can continue for as long as U.S. short-term interest rates increase relative to non-U.S. short-term interest rates and for as long as basis swap spreads move further into negative territory. At the moment there is no widespread agreement on what drives the day-to-day fluctuations in the basis swap spread. The BIS has posited a model where dollar strength weakens the capital positions of bank balance sheets, causing them to back away from providing liquidity to the FX swap market, and leading to increasingly negative basis swap spreads (Chart 9, top panel). Chart 8Higher Yields Via Currency Hedging Chart 9Basis Swaps, Reserves And The Dollar Meanwhile, Zoltan Pozsar from Credit Suisse has identified a link between basis swap spreads and reserves on the Fed's balance sheet (Chart 9, bottom panel).8 Specifically, as the Fed winds down its balance sheet it will be draining cash reserves from the banking system and replacing them with Treasury securities. This could cause money to leave the FX swap market and flow into Treasuries. The result is less liquidity in the FX swap market and increasingly negative basis swap spreads. Interestingly, the run-up to the debt ceiling in the U.S. has presented a test of this view. To stay under the debt ceiling the U.S. Treasury department has drawn down its cash account at the Fed and removed T-bill supply from the market. The result has been a temporary increase in reserve balances. As the theory would have predicted, basis swap spreads have moved closer to zero as reserves have increased. Going forward, the Fed is very likely to start winding down its balance sheet later this year. In all likelihood this will serve to pressure basis swap spreads even further below zero. Meanwhile, short-term interest rates in the U.S. will probably continue to rise more quickly than in most other developed markets. This means that the cost of hedging should become increasingly negative for U.S. investors. In Chart 10 we show that as the cost of hedging becomes more negative, total returns from a USD-hedged position in German bunds tend to outpace total returns from a position in U.S. Treasuries. Similarly, Chart 11 shows that USD-hedged Japanese government bonds (JGBs) also tend to outperform U.S. Treasuries when the cost of hedging falls. Chart 10Hedging Costs & Bond Returns: Germany Chart 11Hedging Costs & Bond Returns: Japan We should note that the relationships between hedging costs and relative total returns shown in Charts 10 & 11 are not perfect, and there will be instances when Treasuries can outperform even if hedging costs continue to decline. However, in the long run, as long as short-term U.S. interest rates continue to rise more quickly than short-term interest rates in the Eurozone or Japan, and especially if the Fed's upcoming balance sheet contraction leads to more deeply negative basis swap spreads, then U.S. investors should continue to boost their yields by lending dollars and investing in bunds and JGBs. Bottom Line: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our U.S. Investment Strategy service took up the issue of residual seasonality in a recent report. Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?", dated April 24, 207, available at usis.bcaresearch.com 2 IMF Staff Discussion Note, "Gone with the Headwinds: Global Productivity", https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/04/03/Gone-with-the-Headwinds-Global-Productivity-44758 3 Our outlook for the U.S. yield curve was discussed in detail in a recent report. Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com 5 IMF Multilateral Policy Issues Report: 2014 Spillover Report https://www.imf.org/external/np/pp/eng/2014/062514.pdf 6 Please see China Investment Strategy Weeky Report, "Has China's Cyclical Recovery Peaked?", dated May 5, 2017, available at cis.bcaresearch.com 7 http://www.bis.org/publ/work592.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ Fixed Income Sector Performance Recommended Portfolio Specification

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

Highlights The global credit impulse is 4 months into a mini-downswing, and it is too soon to position for the next mini-upswing. The euro area economy will remain one of the better performers in a global growth pause. Underweight German bunds in a global bond portfolio. Stay long the euro, especially euro/yuan. Go long euro area Financials versus U.S. Financials, currency unhedged, as a first foray into a beaten-up sector. Feature First the good news: the ECB's latest bank lending data indicate that the euro area 6-month bank credit impulse is stabilizing after a modest but clear decline in recent months (Chart I-2). Now the bad news: the global bank credit impulse continues to weaken. The upshot is that the euro area economy - even with 1.5% growth - will remain one of the better performers in what is now a very clear global growth pause. Chart of the WeekThe Global Bond Yield Has Shown ##br##A Regular Wave Like Pattern Chart I-2The 6-Month Credit Impulse Has Stabilized In The ##br##Euro Area... But Not In The U.S. Or China How To Play The Euro Area's Economic Outperformance In a global growth pause, the best way to play euro area economic outperformance is through relative positions in the bond markets and through currencies. Specifically, underweight German bunds in a global bond portfolio but stay long the euro, especially euro/yuan. The implication for euro area equities is more ambiguous. The Eurostoxx50 has a very low exposure to Technology, which tends to perform defensively in a growth pause. Conversely, the Eurostoxx50 has a high exposure to Financials, whose relative performance reduces to a play on the bond yield (Chart I-3). Given that the global credit impulse is still weakening, it is premature to expect a sustained absolute rally in Financials anywhere. Therefore, the strong knee-jerk absolute rally in European banks after the French election first round is unlikely to last. That said, with the euro area economy likely to outperform in a global growth pause, and euro area Financials still near a 50-year relative low versus U.S. Financials, euro area bank equities can now outperform banks in other markets (Chart I-4). Chart I-3Global Bond Yield = ##br##Financials Vs. Market Chart I-4T-Bond/German Bond Spread Compression =##br## Euro Area Financials Outperform U.S. Financials As a first foray into a beaten-up sector, go long euro area Financials versus U.S. Financials, currency unhedged. (Caveat: all of this assumes that Emanuel Macron beats Marine Le Pen to the French Presidency on Sunday, as we expect.) Don't Rely On Year On Year Comparisons Nature provides many of our units of time. The earth's orbit around the sun gives us a year; the moon's orbit around the earth gives us a month; the earth's rotation on its axis gives us a day. But there is absolutely no reason why economic and financial cycles should follow nature's cycles. Yet most analysts persist at looking for patterns and cycles in economic and financial data using yearly, monthly, or daily rates of change. Unfortunately, by focusing on years, months and days, they risk completely missing some of the strongest patterns and cycles in the economy and markets. Think about a clock pendulum. If you look at it once a second, it will always seem to be in the same position, motionless. You will miss the cycle. Likewise, if an economy regularly accelerates for 6 months and then symmetrically decelerates for 6 months, the yearly rate of change will be a constant, giving the false appearance that nothing is happening. It will miss the cycle. It turns out that the global economy does indeed regularly accelerate and decelerate - and that each half-cycle averages about 8 months. The strongest evidence of this very clear oscillation comes from the remarkably regular wave like pattern in the global bond yield, illustrated in the Chart of the Week and Chart I-5 and Chart I-6. Chart I-5The Global Bond Yield Has Shown A ##br##Regular Wave Like Pattern... Chart I-6...Which Is Easier To See ##br##When Detrended Furthermore, the acceleration and deceleration of bank credit flows - as measured in the global credit impulse - also exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months. But crucially, a half-cycle length of less than a year means that a year on year analysis would miss this very clear oscillation. Hence, our analysis always uses the 6-month credit impulse (Chart I-7). Chart I-7The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Mini Half-Cycles Average Eight Months It is not a coincidence that the bond yield and bank credit impulse exhibit near identical half-cycle lengths. The bond yield and credit impulse cycles are inextricably embraced in a perpetual feedback loop. A higher bond yield will initiate a mini down cycle. All else being equal, the higher cost of credit will weigh on credit flows. This will slow economic growth, which will then show up in GDP (and other hard) data. The bond yield will respond by readjusting down. In turn, a lower bond yield will then initiate a mini up cycle. And so on... But each stage in the sequence comes with a delay. For a change in the cost of credit to register with households and firms and fully impact credit flows, it clearly takes time. The credit flows do not generate instantaneous economic activity either. Fully spending the credit flows also takes time. Once you accept these assumptions of internal regulating feedback combined with delays in economic response, the economy has to be a naturally-oscillating system whose half-cycle length depends on the delays in economic response. And the important point is that these delays have little connection with nature's cycles. For those who are mathematically inclined, Box I-1 shows the differential equations which define the economic mini-cycle and its half-cycle length. Box 1The Mathematics Of Mini-Cycles Still, some commentators counter that credit flows don't just depend on the cost of credit. They also depend on so-called "animal spirits" - optimism or pessimism about the future. These commentators point to sentiment and survey data which show that animal spirits have soared. Our response is yes, for credit flows, heightened animal spirits in isolation are indeed a tailwind. But any rise in the cost of credit is a headwind. It follows that the net impact on credit flows depends on the relative strengths of the tailwind from heightened animal spirits and the headwind from the higher cost of credit. It is the net effect on the 6-month credit impulse - rather than heightened animal spirits per se - that determines the cyclical direction of the economy. We would suggest that the tailwind from heightened animal spirits has been countered by an even stronger headwind - the sharpest proportional rise in borrowing costs for at least 70 years (Chart I-8). Chart I-8The Sharpest Proportional Rise In Borrowing Costs For At Least 70 Years! As anticipated in our 16th February report The Contrarian Case For Bonds, incoming GDP data from the world's largest economies - the U.S., U.K. and France - now confirm this. First quarter growth (at annualised rates) sharply decelerated to 0.7%, 1.2% and 1.0% respectively. And this is not just about so-called first quarter "residual seasonality" as 6-month growth rates have also lost momentum. The global credit impulse is 4 months into a mini-downswing; the global bond yield is 2 months into a mini-downswing. Previous half-cycles have averaged 8 months, with the shortest at around 5 months. Hence, we feel it is somewhat premature to position for the next mini-upswing. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* The rally in Portuguese sovereign bonds appears technically overextended. Go short Portuguese sovereign 10-year bonds versus Spanish sovereign 10-year bonds with a profit target and stop loss of 2.5% . 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-9 * 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 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. 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