Financial Markets

Special Report

Highlights EM stocks are about one standard deviation above their fair value, according to several valuation indicators. Provided EM equities are neither extremely overvalued nor undervalued, the key to their performance over the next 12 months will be corporate profits. Having missed this rally, we are reluctant to chase it at current levels amid the prevailing investor euphoria and overbought conditions. Compared with DM equities, EMs are not cheap - relative valuations are neutral. Meanwhile, the corporate profit outlook is better in DM than EM. As a result, we are reiterating our underweight stance on EM stocks versus DM bourses. Feature This week we delve into overall emerging markets (EM) stock valuations. Next month we will publish another report outlining a valuation ranking among individual EM bourses and equity sectors. After the significant share price run up, the question for investors is whether EM equities are still cheap or have become overvalued. Our composite valuation indicator based on trimmed-mean multiples suggests that EM equity valuations are one standard deviation above their fair value (Chart I-1). The message is the same when using the medians of various multiples for 50 sub-sectors (Chart I-2). Chart I-1EM Equity Valuations: ##br##Trimmed-Mean Multiples Chart I-2EM Equity Valuations: ##br##Medians Of Multiples These two composite valuation indicators are the averages of the trailing P/E, forward P/E, price-to-cash earnings,1 price-to-book value (PBV) and price-to-dividend ratios. The 20%-trimmed mean excludes the top 10% and bottom 10% of sub-sectors - i.e., it removes outliers and then calculates an equal-weighted average. Finally, the composite valuation indicator using equal-weights (not market-cap weights) for all 11 sectors also corroborates that the overall EM universe is somewhat overvalued (Chart I-3). Interestingly, based on Chart I-1 and I-2, EM stocks did not become cheap at their 2016 bottom - they were only fairly valued in early 2016. The individual components of the composite median valuation indicator - based on medians of 50 EM sub-sectors - are presented in Chart I-4. The top three panels reveal that the trailing P/E, forward P/E and price-to-cash earnings ratios are all well above their historical mean, and close to their previous peaks. The components that keep the composite indicator from being extremely overvalued are the PBV and price-to-dividend ratios. These two variables are close to their historical means (Chart I-4, bottom two panels). Chart I-3EM Equity Valuation: ##br##Equal-Weighted Sector Multiples Chart I-4Components of Median ##br##Valuation Composite As to qualitative assessment of EM valuations, our sense is that EM equity segments that have good fundamentals are currently overvalued, while those that feature low multiples are "cheap" for a reason. Bottom Line: According to valuation indicators based on various multiples, EM stocks are moderately overvalued. Relative Valuations To DM Relative to DM, EM equity valuations are neutral. Both relative composite valuation indicators computed using 20% trimmed-mean and the median are at the middle of their historical range (Chart I-5). This signifies there is presently no valuation gap between EM and DM stocks. All these measures are determined using the MSCI indexes, and utilize comparable data for both DM and EM across all companies, industry groups and sectors. Using equal weighted-sector multiples, the EM versus DM relative composite valuation indicator also upholds that relative equity valuations are neutral (Chart I-6). This measure uses equal weights for all sectors in both the EM and DM stock indexes. Hence, this composite removes sector weight differences among various equity indexes. EM equity valuations are also on par with the U.S. stock market, based on 20% trimmed-mean, median or equal sector-weighted multiples (Chart I-7). Chart I-5EM Versus DM: Relative Trimmed-Mean##br## And Median Multiples Chart I-6EM Versus DM: Relative Equal-Weighted ##br##Sector Multiples Chart I-7EM Versus U.S.: Trimmed-Mean, Median And ##br##Equal-Weighted Sector Multiples The takeaway from these relative valuation composites is that EM stocks are neither cheap nor expensive compared with U.S. or other DM equities. This is contrary to the widely held view among many investors and commentators that EM stocks are cheap versus DM in general, and the U.S. in particular. Additionally, in absolute terms, EM, DM and U.S. equities are all - about one standard deviation - expensive, according to these valuation yardsticks. Bottom Line: After removing outlier sub-sectors with the lowest and highest multiples and using equal weights for all sectors in the equity benchmarks, EM valuations appear comparable to those in the DM universe and the U.S. The CAPE Ratio: A Structural Valuation Perspective Our cyclically-adjusted P/E (CAPE) ratio for the EM equity universe currently stands at its fair value (Chart I-8). Due to the lack of historical data for EM, we were unable to use Robert Shiller's methodology for constructing the CAPE ratio for developing markets. The Shiller method uses a 10-year moving average of EPS to calculate the cyclically adjusted EPS. However, in the case of EM aggregate EPS, data go back only to 1986. If we were to calculate a 10-year moving average, we would lose 10 years of data, and the valuation indicator would only start in 1994. This is too short a time frame for a structural valuation indicator. Instead, we used the following methodology to construct the CAPE ratio: We deflated EM EPS and EM equity prices (both in U.S. dollar terms) by U.S. consumer price inflation (CPI) to get both EM EPS and EM share prices in real (inflation-adjusted) U.S. dollar terms. Then we regressed EM EPS in real U.S. dollar terms against a time trend. The resulting trend line represents the cyclically adjusted EPS in real U.S. dollar terms (Chart I-8, bottom panel). Finally, we divided EM stock prices in real U.S. dollar terms by the EM EPS trend line. The outcome is the EM CAPE ratio (Chart I-8, top panel). To be sure that our methodology produced a reasonable outcome, we computed a CAPE ratio using our methodology for the U.S. stock market and compared it with the Shiller CAPE ratio. Chart I-9 demonstrates that our methodology generated a CAPE ratio quite similar to Shiller's CAPE ratio from 1935 to the present. Consequently, we are comfortable that the results generated by our methodology are robust and sensible. When we calculate the EM versus U.S. relative CAPE ratio, the outcome is that EM appears cheap versus the U.S. stock market (Chart I-10). The degree of relative undervaluation is meaningful: one standard deviation. Chart I-8EM CAPE Ratio Is At Fair Value Chart I-9U.S. CAPE Ratio: EMS Vs. Shiller Chart I-10Relative CAPE Ratio: EM Versus U.S. The idea behind the CAPE model is to remove cyclicality of corporate profits when computing the P/E ratio. Our CAPE model gauges stock valuations under the assumption of EPS converging to their trend line. The latter is the cyclically adjusted EPS in real U.S. dollar terms. The slope of the time trend - the historical annual compound growth rate of EPS in inflation-adjusted U.S. dollar terms - is 2.8% for EM and 2% for the U.S. Please note that we determined the earnings time trend using the historical range of 1983-present for EM and 1935-present for the U.S. Hence, these CAPE models assume that EM EPS will grow 0.8% (2.8% - 2%) percentage points faster than U.S. corporate EPS in the inflation-adjusted U.S. dollar terms, as they have done historically. Under this assumption, EM stocks are materially cheaper than the U.S. market. Finally, the CAPE ratio is a structural valuation model, i.e., it works in the long term. Only investors with a time horizon greater than 3-5 years should use CAPE in their investment decisions. Bottom Line: According to our CAPE models, EM equities are fairly valued in absolute terms, but they are meaningfully cheaper than U.S. stocks. What About Interest Rates And Profits The above valuation measures did not incorporate one important variable: interest rates. The current high equity valuations in both DM and EM would in some way be justified if both global bond yields and EM local interest rates held at current low levels. Our bias is that U.S. bond yields will break out, dragging up other DM bond yields. DM government bond prices seem to be teetering on the edge of a technical breakdown (Chart I-11). The current robust growth in the U.S. and euro area justifies upward revisions to their interest rate expectations. In turn, higher U.S. bond yields will put a floor under the U.S. dollar. We anticipate that most of the potential U.S. dollar rally will occur versus EM and commodities currencies, and less so against the euro and other European currencies. Chart I-12 demonstrates that since January 2017, EM currencies have defied the rise in U.S. inflation-linked bond (TIPS) yields. We expect the negative correlation between EM currencies and U.S. TIPS yields - which existed from 2013 to 2017 - to re-establish itself. Chart I-11DM Bond Prices Are On Edge Of Breakdown Chart I-12EM Currencies And U.S. Real Yields This will likely occur as the recently approved tax cuts buoy the U.S. economy. Meanwhile, in China, regulatory tightening on banking and shadow banking as well as liquidity tightening will weigh on mainland growth. A shift in relative China-U.S. growth dynamics in favor of the U.S. will likely lead to a setback in the value of EM exchange rates. In turn, EM currency depreciation will produce higher local bond yields in a number of high-yielding developing markets (Chart I-13). Overall, the odds favor rising DM bond yields in the coming months. This, along with a slowdown in China, will trigger a selloff in EM currencies. The latter will produce widening EM credit (sovereign and corporate) spreads and lead to higher EM domestic bond yields. Altogether, this warrants a de-rating of EM versus DM equity multiples. On corporate profits, visible growth deceleration in China heralds a notable relapse in commodities prices and EM EPS growth. Our EM EPS model - based on narrow money (M1) growth - continues to flash red on the EM corporate profit outlook (Chart I-14). Chart I-13EM Currencies And Local Bond Yields Chart I-14EM EPS Is At Risk Investment Conclusions Chart I-15Bottom-Up Analysts Are ##br##Record Bullish On EM EPS Equity valuations matter most when valuations are at an extreme - two standard deviations overvalued or undervalued. This is presently not the case for EM stocks. Provided EM equities are neither extremely overvalued nor undervalued, the key to their performance over the next 12 months will be corporate profits. We expect EM corporate growth to downshift due to a slowdown in China and a setback in commodities prices. EM is more leveraged to China than to the U.S. or Europe. Hence, robust growth in DM is not inconsistent with our negative view on EM currencies and stocks. In the meantime, EM share prices continue to exhibit strong momentum. It is difficult to time a reversal amid such intense capital inflows. Nevertheless, from a big-picture perspective, such a stampede and the ensuing melt-up in stock prices typically precedes a major top. Having missed this rally, we are reluctant to chase it at current levels amid the prevailing investor euphoria (Chart I-15) and overbought conditions. Compared with DM equities, EMs are not cheap - relative valuations are neutral. Hence, there is no valuation justification to favor EM versus DM. Meanwhile, the corporate profit outlook is better in DM than in EM. As a result, we are reiterating our underweight stance on EM versus DM stocks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 MSCI defines cash earnings as earnings per share including depreciation and amortization as reported by the company. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Global Duration Strategy: Global bond yields continue to move higher, driven by rising inflation expectations and falling investor risk aversion. With global interest rates still not at levels that will restrict growth or draw capital away from booming equity markets, the path of least resistance for yields remains upward. Maintain a below-benchmark overall portfolio duration stance, with a bearish curve steepening bias in the U.S. and core Europe. U.K. Gilts: The momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. Stay overweight Gilts. Feature Revisiting Our Duration Strategy After The Rise In Yields Global government bond markets have started 2018 in a grumpy mood. The price return on the overall Barclays Global Treasury index is already down -0.6% so far in January, and yields are up for almost every country and maturity bucket within the developed market universe. Only longer-dated Peripheral European debt (Italy, Spain, Portugal, even Greece) has seen lower yields month-to-date, as the powerful growth upturn in the Euro Area has resulted in sovereign credit upgrades and narrowing spreads to core European bonds. The global sell-off has been led by the U.S., with the benchmark 10-year U.S. Treasury yield climbing all the way to 2.66% last week, already surpassing the 2016 high seen last March. Rising inflation expectations are the biggest culprit, with the 10-year TIPS breakeven rate climbing to 2.07%, the highest level since 2014. Chart of the WeekNo Good News For Bonds Right Now The relentless surge in global stock markets - driven by faster worldwide economic growth and an absence of volatility - is also helping fuel the bearishness in government bond markets. The economic growth momentum is showing no signs of abating. The IMF just raised its global growth forecast for both 2018 and 2019 to 3.9% in both years - the fastest pace since 2011 - largely because of the impact of the U.S. tax cuts but also because of much faster expected growth in Europe.1 The IMF noted that "the cyclical rebound could prove stronger in the near term as the pickup in activity and easier financial conditions reinforce each other." We could not agree more. With robust growth pushing a majority of economies to operate beyond full employment, and with financial conditions remaining highly accommodative, global bond markets are now pricing in both higher inflation expectations and less accommodative monetary policy (Chart of the Week). While we only expect actual rate increases in the U.S. and Canada in 2018, the pressures on global central banks to respond to the coordinated growth upturn with hawkish talk will keep government bond markets on the defensive - especially if global inflation rates are moving up at the same time. Diminishing demand for government bonds from recently reliable sources may also act to push up yields in the months ahead. A reduced pace of asset purchases from the European Central Bank (ECB) and Bank of Japan (BoJ), combined with the Fed reducing the reinvestments of its maturing Treasury holdings, means that the private sector must now absorb a greater share of bond issuance, on the margin. In the U.S. in particular, the biggest swing factor for the Treasury market could end up being the retail investor. Households have been notably risk-averse in the years since the Great Financial Crisis, keeping relatively high allocations to fixed income and relatively low allocations to equities after suffering such steep losses in the 2008 crash. Those attitudes are changing, however, with the U.S. equity market continuing to hit new all-time highs amid increased media coverage of the rally (as well as the bullish Tweets from the White House taking credit for it). The latest University of Michigan U.S. consumer confidence survey showed that the expected probability of another year of rising stock prices is now at the highest level (66%) in the fifteen years that question was asked. U.S. investment advisors are also very optimistic, with the Investors' Intelligence bull/bear ratio back to the highest level since 1987! (Chart 2) Yet actual equity returns over the past three years have lagged those seen during periods of elevated investor sentiment, like in 1987, 2005 and 2014 (Chart 2). What is missing now is a big surge of retail investor money into equities that can fuel the next leg of the equity rally, particularly through mutual funds and ETFs. Chart 2The Bond-Bearish Equity Party##BR##Is Just Getting Started This is starting to happen. The rolling 12-month total of net flows into U.S. equity mutual funds and ETFs is about to accelerate into positive territory for the first time since 2012, according to data from the Investment Company Institute (3rd panel). This could soon pose a problem for U.S. bond markets as, since 2008, there has been a reliable negative correlation between U.S. retail flows into equity funds and flows into fixed income funds, especially at major turning points (bottom panel). For example, after that 2012 bottom in net equity flows, the rolling total of net flows into bond funds collapsed from over $400bn to zero in a span of 18 months, with the vast majority of the outflow from bonds going into equities. An exodus of U.S. retail investors from fixed income would be a major problem for bond markets, especially at a time when net Treasury issuance is expected to increase due to wider fiscal deficits and the Fed will be buying fewer bonds as it begins to unwind its massive balance sheet. Other buyers like commercial banks and global reserve fund managers can pick up some of the slack if the retail bid fades from U.S. Treasuries. However, in an environment of strong global growth, rising inflation and more hawkish central banks, it may require higher yields to entice those buyers to ramp up their allocations. In the near-term, the next wave of global bond-bearish news will have to come from upside surprises in inflation, not growth. The Citi Global Economic Data Surprise index - which has historically correlated with swings in global bond yields - is now at elevated levels which should raise the odds of data disappointments as growth expectations get revised up (Chart 3). The Citi Global Inflation Data Surprise index, however, remains just below zero after last year's plunge, but is showing signs of stabilizing (bottom panel). U.S. inflation is already starting to bottom out, but Euro Area core inflation has been underwhelming of late. It will likely take a rise in the latter to trigger the next move higher in global yields, as the market will begin to more aggressively price in less accommodative monetary policy from the ECB. For now, U.S. Treasuries are driving the path of yields, with the "leadership" of the bond bear market expected to switch to Europe later on in 2018. In terms of our recommend duration strategy and country allocations, we are sticking with our current positions which are finally beginning to move in favor of our forecasts (Chart 4): Chart 3The Next Leg Higher In Global Yields##BR##Must Be Driven By Inflation Surprises Chart 4Our Recommended##BR##Country & Curve Allocations Underweights to countries where we expect central banks to hike rates (U.S., Canada) or more openly discuss a tapering of asset purchases (Germany, France). Overweights to countries where we expect no change in policy rates (U.K., Australia) or only modest changes to asset purchase programs (Japan). Positioning for steeper yield curves in countries where growth is strong, economies are at or beyond full employment, but where inflation expectations remain far enough below central bank targets to prevent policymakers from turning more hawkish faster than expected (U.S., Germany, Japan). Bottom Line: Global bond yields continue to move higher, driven by rising inflation expectations and falling investor risk aversion. With global interest rates still not at levels that will restrict growth or draw capital away from booming equity markets, the path of least resistance for yields remains upward. Maintain a below-benchmark overall portfolio duration stance, with a bearish curve steepening bias in the U.S. and core Europe. U.K. Gilts: The BoE's Hands Are Tied In our final report of 2017, we updated our recommended allocations in our Model Bond Portfolio based on the key views stemming from the 2018 BCA Outlook.2 We upgraded our country allocation to U.K. Gilts to overweight, primarily as a "defensive" position within a portfolio positioned for an expected rise in global bond yields. That may sound surprising given the current elevated level of inflation and low unemployment rate in the U.K. Yet our view is based on the notion that the Bank of England (BoE) will have a very difficult time trying to raise interest rates at all in 2018 when other major global central banks are likely to take a more hawkish turn. The main reason that the BoE will be unable to do much on the interest rate front is that the U.K. economy is likely to slow in the coming quarters. The OECD leading economic indicator is decelerating steadily, and is pointing to a real GDP growth rate below 2% in 2018 (Chart 5). The updated IMF forecast for the U.K. calls for growth to only reach 1.5% in both 2018 and 2019. The biggest factors that will weigh on growth will be a sluggish consumer and softer capex. Household consumption growth has already been slowing since early 2017, driven by diminishing consumer confidence (Chart 6, top panel). High realized inflation which has sapped the purchasing power of U.K. workers who have not seen matching increases in wages, is weighing on confidence (3rd panel). Consumers were able to maintain a decent pace of spending during a period of stagnant real income growth by drawing down on savings, but that looks to be tapped out now with the saving rate down to a 19-year low of 5.5% (bottom panel). Chart 5U.K. Growth Set To Slow Chart 6The U.K. Consumer Looks Tapped Out Making matters worse, U.K. consumers are not seeing much of a wealth effect from the housing market. The December 2017 readings of the year-over-year growth rate of U.K. house prices from the Halifax and Nationwide house prices came in at 1.1% and 2.5% respectively (Chart 7, top panel). In addition, the net balance of national house price expectations from the Royal Institution of Chartered Surveyors (RICS) survey has steadily declined since mid-2016 and now sits just above zero (i.e. equal number of respondents expecting higher prices and falling prices). The same indicator for London was a staggering -54% in November 2017. U.K. homeowners have had to take a lot of hits over the past couple of years. A 2016 hike in the stamp duty for second homes and buy-to-let properties prompted a plunge in more "speculative" property transactions. The squeeze on real household incomes that has damaged consumer spending has also made homes less affordable, even with very low mortgage rates. Most importantly, the 2016 Brexit vote and subsequent uncertainty over the U.K.'s future relationship with Europe has placed an enormous cloud over housing demand - both from potential reduced immigration to the U.K. and businesses and jobs potentially relocating to European Union countries. The Brexit uncertainty is also weighing on U.K. business investment spending. U.K. capital expenditure growth slowed to 4.3% year-over-year in nominal terms in Q3 2017, and is even lower in real terms (Chart 8, top panel). Capex is generally import-intensive, and the rise in import costs due to the depreciation of the Pound after the 2016 Brexit vote raised the cost of investment. Chart 7No Growth In##BR##U.K. Housing Chart 8Brexit Gloom Trumps Export##BR##Boom For U.K. Companies This explains why U.K. capital spending has lagged even with manufacturing indicators in decent shape, such as the Confederation of British Industry (CBI) survey which shows the highest readings on total industrial orders and export orders since 1988 and 1995, respectively (2nd panel). Yet non-financial credit growth stalled out in the latter half of 2017, while the CBI survey of business optimism has turned into negative territory. Brexit uncertainties are clearly trumping strong export demand, thus U.K. capital investment is likely to remain sluggish in 2018 even with robust global growth. With U.K. economic growth likely to slow in 2018, the lingering problem of high inflation should start to fade. Already, both headline and core CPI inflation have stabilized, with the latter actually drifting a touch lower in the latter half of 2017 (Chart 9). The small gap between the two can be explained by the rise in global oil prices seen over the past year. The impact of oil on U.K. inflation expectations is relatively modest compared to other countries with much lower realized inflation rates, as we discussed in last week's Weekly Report.3 What is far more relevant is the path of British pound. The 16% plunge in the trade-weighted sterling index after the 2016 Brexit vote was a major reason why U.K. realized inflation blew through the BoE's 2% target last year. The currency has since stabilized at a depressed level and traded in a relatively narrow range in 2017. The trade-weighted index is now 3% above year-ago-levels, which should help U.K. inflation rates drift lower in the next 6-12 months - especially if U.K. growth underwhelms at the same time. Already, the more stable currency has allowed the inflation rates of import prices and producer prices to fall sharply last year (bottom panel), which should soon start to feed through into overall inflation rates. Lower realized inflation would be a welcome boost for the spending power of U.K. households and businesses, but will likely be dwarfed by the impact of oil prices in the near term. More importantly, the slowing momentum of economic growth, now fueled more by Brexit uncertainty than high inflation, will limit the BoE's ability to continue normalizing the very low level of U.K. interest rates. Our 12-month U.K. discounter shows that markets are pricing in 25bps of rate hikes over the next twelve months (Chart 10). The forward path of interest rates shown in the U.K. Overnight Index Swaps curve suggests that the hike could come by October. That is unlikely to happen given the slump in leading economic indicators, and peaking in currency-fueled inflation, currently underway. Chart 9Currency-Fueled U.K. Inflation Is Peaking Out Chart 10Stay Overweight U.K. Gilts A stand-pat BoE, combined with more stable and potentially falling U.K. inflation, will limit the ability for U.K. Gilt yields to rise by as much as we are expecting in the U.S., and even core Europe, over the next 6-12 months. Gilts have become a relative safe haven within a global bond bear market in the developed markets, with a yield beta of around 0.5 to U.S. Treasuries and German government bonds. This has already allowed Gilts to outperform the Barclays Global Treasury index (in currency-hedged terms) since the most recent cyclical low in global bond yields last September (bottom panel). We continue to expect Gilts to outperform in 2018. Stay overweight. Bottom Line: The momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. Stay overweight Gilts. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 http://www.imf.org/en/Publications/WEO/Issues/2018/01/11/world-economic-outlook-update-january-2018 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Allocation In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Importance Of Oil", dated January 16th 2018, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Relative sector index composition, the macro backdrop, relative operating metrics along with compelling valuations and washed out technicals suggest that a value over growth style bias is warranted. Rising interest rates and a flattening yield curve, coupled with increasing relative indebtedness and lack of relative profit growth signal that the time is right to shift the capitalization bias to a neutral setting. Recent Changes Shift the style bias and favor value over growth today. Book profits in the small over large cap size bias of 2% since the mid-August 2016 inception. Table 1 Feature Equities catapulted to new all-time highs last week as earnings season got underway. Upbeat bank reports set the tone, and SPX profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS estimates have been aggressively ratcheted higher, on the back of the tax bill passage, rising from 12% to 16% in a mere three weeks, according to Thomson Reuters/IBES. Our SPX EPS growth model agrees that, cyclically, profits will continue to drift higher and a low-to-mid double-digit growth rate is likely for 2018, as we posited last week.1 While the synchronized and disinflationary global growth narrative continues to dominate, we are a bit uneasy. The eerie calm overtaking the markets, and headlines like this recent one from Bloomberg "The Stock Market Never Goes Down" give us cause for concern. As a reminder, the SPX is up 1000 points since the 1800 level registered in early-2016. Put differently, the SPX has been rising by roughly 25% per annum for the past two years. Such a breakneck pace is unsustainable. Our sense is that from a tactical perspective, equities are currently extremely stretched and warrant some caution. Therefore, this week we identify five key signposts we are closely monitoring that are sending clear warning signals (for a more comprehensive list please see the tactical section of our August 7th White Paper).2 First, our reflation gauge (RG) has taken a turn for the worse (Chart 1). At the margin, higher oil prices and interest rates may begin to bite. Historically, our RG has been an excellent leading indicator of both sentiment that has vaulted to multi-decade highs and CITI's economic surprise index. Our global reflation gauge emits a similar signal (not shown). Mean reversion is looming. Second, speculation runs rampant. Our Equity Speculation Index (ESI) is close to two standard deviations above the historical mean. Since the early-1960s, the ESI has only been higher during the dotcom bubble (Chart 2). While the ESI can rise further, it is at least waving a yellow flag. Investor sentiment has also gone parabolic with the bull/bear ratio reaching a level last seen right before the 1987 crash (third panel, Chart 2). Chart 1Yellow Flag Chart 2Extended Third, financial conditions are as good as they get. The St. Louis Fed Financial Stress Index recently hit an all-time low level. Similarly, Goldman Sachs' and the Chicago Fed's National Financial Conditions indexes are also near uncharted territory. This should be cause for some trepidation (Chart 3). Fourth, extended EPS breadth, all time highs in net earnings revisions, stretched median valuations and overbought technical conditions are near levels that have marked previous temporary broad market pullbacks (Chart 4). Finally, gold is behaving strangely. While the U.S. dollar's selloff explains part of the recent jump in the shiny metal, we think bullion may be sniffing out some trouble as it remains a true safe haven asset. Either real rates have to come down or gold has to reverse course; such a steep divergence is unsustainable (gold shown inverted, top panel, Chart 5). Chart 3As Good As It Gets Chart 4Peak Euphoria? Chart 5What's Gold Sniffing Out? Since December 18th our strategy has been to book gains in tactical trades and to refrain from altering our cyclical over defensive portfolio positioning bent,3 as we do not foresee a recession in the coming 9-12 months.4 We continue to pursue this strategy and were a 5-10% selloff to materialize, we would "buy the dip". In addition, this week we introduce/apply a risk management measure to our recently revealed high-conviction 2018 calls.5 Almost all of our calls are in the black outperforming the broad market on average by 640bps (Chart 6). While we are not compelled to change our views just yet, our confidence is not as high as two months ago, especially in the two calls that are registering double-digit relative returns. Thus, we suggest that clients institute a tight stop in these trades (please see the "Stop" column in the "Top High-Conviction Calls For 2018" table on page 15). Going forward, we will introduce such risk management trailing stops once a call clears the 10% relative return mark. This week we shift both our style and size biases. Chart 6Time To Set Stops Buy Value At The Expense Of Growth There is a once in a decade opportunity to prefer value over growth (V/G) stocks, and we recommend shifting our style bias in favor of value stocks. Typically, the V/G ratio moves in multi-year up and down cycles, and at the current juncture it is a screaming buy, if history at least rhymes. Chart 7 shows that relative share prices are not only near previous troughs, but also 1.5 standard deviations below the six-decade time trend. Chart 7Compelling Entry Point In fact we already have a flavor of this style preference in one of our market-neutral pair trades, long financials / short tech (for additional details on this trade please refer to our "Disentangling Pricing Power" early-summer report). Table 2 depicts why this is so: financials stocks dominate value indexes, while IT comprises 40% of growth indexes. Sector composition also suggests that a long energy / short health care trade would mimic this V/G preference, as energy stocks offer a lot of value, whereas health care stocks sit prominently in growth indexes (Table 2 & Chart 8). While we do not have this pair trade on per se, as a reminder we are overweight the energy sector and underweight health care stocks; we are also overweight financials and underweight tech (please see page 14 for a complete picture of our current sector recommendations). Table 2Sector Composition With regard to macro variables, these sector preferences would equate to a positive interest rate and oil price correlation. Indeed, the 10-year Treasury yield moves in lockstep with the V/G ratio and similarly oil prices are joined at the hip with relative performance (Chart 9). Chart 8Value/Growth Replicas Chart 9Rising Oil And Rates = Buy Value / Sell Growth One of BCA's themes for 2018 is higher interest rates, with our bond strategists still expecting an inflation-driven rise in the 10-year Treasury yield near 3%. Similarly, BCA' commodity strategists remain constructive on oil prices. Taken together, these BCA views warrant a value over growth preference. Importantly, since the depths of the GFC, value has underwhelmed growth by a wide margin. Likely, this growth over value preference reflected central bank interest rate suppression, which boosted the multiple investors were willing to pay for perceived growth at a time when growth was scarce. Now that the Fed has lifted rates five times since December 2015 and is on track to do so three more times this year, value should take the reins (Chart 10). Moreover, the Fed is unwinding its balance sheet and that tightening in monetary conditions, at the margin, favors value over growth (Chart 11). Chart 10Avoid Growth Stocks During Fed Tightening Cycles... Chart 11...And During Quantitative Tightening On the currency front, the V/G ratio has had a tight positive correlation with the EUR/USD foreign exchange rate (Chart 12). Once again sector composition has been underpinning this relationship. However, sector composition is constantly shifting. Currently, a larger percentage of growth stocks have international sales (especially tech) compared with more domestically-oriented value stocks. Thus, the depreciating U.S. dollar is a risk to our value over growth preference On the operating metric front, value stocks have the upper hand versus their growth siblings. Our relative composite pricing power gauge has swung by eight percentage points from trough-to-peak and heralds a deflation exit for relative top line growth (middle panel, Chart 13). Chart 12Depreciating U.S. Dollar Is ##br##Typically A Boon To The V/G Ratio Chart 13Relative Pricing Power ##br##Favors Value Over Growth Sell-side analysts have taken notice and have been aggressively bumping their net earnings revisions in favor of value versus growth indexes. As mentioned earlier, rising oil price inflation and better credit pricing power are a boon to V/G profit prospects (bottom panel, Chart 13). Valuations and technicals also suggest that investors should overweight value at the expense of growth. Our relative Valuation Indicator (VI) has recently sunk to a level last hit in the early-2000s, approaching one standard deviation below the historical mean. Similarly, the V/G ratio is oversold and our relative Technical Indicator (TI) has fallen to a level that has marked previous bull market phases (Chart 14). Finally, over the past thirty years V/G price moves have been a mirror image of both junk bond yields and vol. In other words, a value over growth preference has been synonymous with a "risk on" backdrop (junk yield and the VIX shown inverted, Chart 15). However, these close correlations appear to have broken down since the Great Recession as the Fed's unconventional monetary policies functioned well in keeping a lid on vol and suppressing bond yields across the fixed income spectrum. Chart 14Value Vs Growth Stocks Are Cheap And Oversold Chart 15Bet On Convergence As the Fed winds down its balance sheet there are good odds that volatility will make a comeback and interest rates will also shoot higher. The upshot is that these inverse correlations get reestablished in the coming quarters via a rise in the V/G ratio, an increase in vol and a selloff in the junk corporate bond market (Chart 15). Adding it up, relative sector composition, the macro backdrop, relative operating metrics along with a compelling VI reading and our washed out TI suggest that a value over growth style bias is warranted. Bottom Line: Boost value stock exposure at the expense of growth equities. The V/G ratio offers an excellent entry point with limited downside risk. Book Profits In Small Caps Vs. Large Caps And Move To The Sidelines In August 2016, we recommended a small over large cap (S/L) bias, predating the Trump election victory, on the back of five key drivers: non-inflationary growth would persist allowing central banks to stay incredibly accommodative, emerging market tail risks had eased taming equity market vol, small/large sector composition differentials, relative EPS fundamentals and restored relative valuations. Given that most of these factors have moved in favor of small versus large caps and some are starting to shift against the S/L ratio, does it still pay to have a small cap size bias? The short answer is no, and we now recommend investors book profits and move to the sidelines. While the euphoric tailwind surrounding the new administration and its promise to slash red tape and taxes tripped us up and we failed to monetize 10%+ gains, better late than never. First, from a big picture perspective, the near two decade S/L outperformance phase is running on fumes and it has likely put in a secular top in late-2016 (Chart 16). Similar to the style bias, this ratio also tends to move in long cycles. We are clearly in extended territory hovering at one standard deviation above the historical time trend. Chart 16Major Top? Second, interest rates bear close attention. Rising interest rates on the back of an inflationary impulse is BCA's view for the coming year and, coupled with the yield curve narrowing, are a harbinger of small cap trouble. Chart 17 shows the tight positive correlation between the S/L ratio and the yield curve, and the current message is to avoid small caps. Small caps are mostly domestically exposed and are ultra-sensitive to interest rate moves as small and medium businesses rely more heavily on their bankers for credit, rather than debt markets. When the yield curve flattens late in the cycle it is typically because the Fed is aggressively tightening monetary policy. While such a monetary backdrop is neither conducive to small nor to large firms, small caps suffer more, at the margin. Third, we are perplexed by the lack of profit growth in the small cap complex. It has now been over a year since Trump came into power and small cap EPS underperformance has been extremely prominent (top panel, Chart 18). The 12-month forward profit growth delta has also widened considerably over the past year to the detriment of small caps (middle panel, Chart 18). While the U.S. dollar's sizable depreciation explains part of the profit divergence, i.e. as the currency falls foreign sales exposed large caps enjoy a significant translation gain, relative indebtedness is also likely playing a key role. The bottom panel of Chart 19 shows the net debt-to-EBITDA ratio for the small cap and large cap indexes. The relative ratio has gone parabolic and is making all-time highs. Rising small cap indebtedness, at a time when cash flow growth is anemic, suggests that the S&P 600 is increasingly vulnerable. Not only are interest payments eating into income, but also refinancing risk is a threat in an era of rising interest rates. Under such a backdrop, small cap stocks should not trade at a valuation premium (bottom panel, Chart 18). Chart 17Yield Curve Blues Chart 18Small Cap Profit Trouble Chart 19Mind The Small Cap Indebtedness Bottom Line: The time is ripe to take profits of 2% and move to the sidelines in the capitalization bias. Were our indicators to further deteriorate, we would not hesitate to fully reverse course and prefer large to small caps. Stay tuned. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "White Paper: U.S. Equity Market Indicators (Part I)," dated August 7, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth and stay neutral small over large caps.

Highlights The Beige Book released on January 17 keeps the Fed on track to raise rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's Big 5 Bank Lending Beige Book highlights several of the positive trends supporting our view of the economy, the tax bill and the Fed. The Tax Cut and Jobs Act of 2017 has the potential to generate significant supply-side benefits for consumers, shareholders and the broad economy. We decided to stay long the dollar after a lengthy internal debate, although we have revised down our view on the upside potential. Feature U.S. risk assets continued to outperform last week outside of the dollar, as S&P 500 firms started to report Q4 2017 results and provide guidance for Q1 2018 and beyond. BCA's Bank Lending Beige Book summarizes the most optimistic comments from the Big 5 banks. The Fed's Beige Book captured comments on the broad economy in December and early January that were equally ebullient. Both Beige books suggested that firms were planning to return their tax savings to shareholders in the New Year, and to continue to boost capex, which was stout even before the law was passed. Yet, despite the upbeat news, the dollar broke down last week, as the ECB sounded a hawkish note and the Japanese economy continued to improve. On balance, the Beige Book, the Q4 earnings season, the health of the U.S. economy (notably capital spending), all support BCA's stance on the U.S. stock-to-bond ratio, the Fed, duration and the dollar. However, the dollar has not behaved as we would have expected. Beige Book Barometer Bounces The Beige Book released on January 17 keeps the Fed on track to raise rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's quantitative approach1 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market, but there is still a disconnect between the Beige Book's view of inflation and the market's stance. Moreover, references to the stronger dollar have disappeared from the Beige Book and business uncertainty is significantly reduced, reflecting the tax cut bill and President Trump's assault on regulation. Chart 1Latest Beige Book Supports##BR##The Fed's View On Rates, Economy Chart 1, panel 1 shows that at 66%, BCA's Beige Book Monitor stayed near its cycle highs in January, re-confirmation that the underlying economy was still upbeat in Q4 and early 2018. (The latest Beige Book covered the period from mid-November 2017 to January 8, 2018). The number of 'weak' words in the Beige Book returned to near four-year lows after ticking higher in the wake of last summer's hurricanes. Moreover, there were 12 mentions of the tax bill in the January Beige Book, up from only 3 in November (not shown). The tax bill was cast in a positive light in 75% of the remarks. In November, the references to either the tax bill (or tax reform) cited the consequent uncertainty as a constraint on growth. Based on the minimal references to a robust dollar in the past five Beige Books, the greenback should not be an issue in Q4 2017 or Q1 2018, which is in sharp contrast with 2015 and early 2016 when there was a surge in Beige Book mentions (Chart 1, panel 4). The last time that five consecutive Beige Books had so few remarks about a strong dollar was in late 2014. Business uncertainty over government policy (fiscal, regulatory and health) ticked up in the past few Beige Books as Congress debated the particulars of the tax bill. Nonetheless, comments of uncertainty in the Beige Book have dropped since Trump took office in early 2017. The implication is that the business community is correctly focused on policy and not politics in D.C. (Chart 1, panel 5). The disconnect with the Fed on inflation is evident in the Beige Book's number of inflation words (Chart 1, panel 3). Expressions regarding inflation rose to a four-month high in January and the disconnect persists between the still-elevated mentions of inflation and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The recent Beige Book backs BCA's view that the U.S. economy is poised to grow above its long-term potential in the first half of 2018. However, the Beige Book has done little to resolve the debate around why an economy growing above potential and a tightening labor market have not boosted inflation. Likewise, the latest Beige Book confirmed that at least initially, businesses and bankers across the U.S. welcomed the Tax Cut and Jobs Act. Bankers' Beige Book Returns Chart 2Banking System Shipshape BCA's Big 5 Bank Lending Beige Book highlights several of the positive trends supporting our view: Pristine credit quality, a positive U.S. credit impulse, loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities. We introduced the Big 5 Bank Lending Beige Book2 in early 2014 to interpret the health of the banking system based on comments from leaders of the Big Five banks during earnings season. Managements were upbeat on loan demand and credit quality as they unveiled Q4 results in the past two weeks, and most expressed optimism that the positive credit trends would continue to improve in 2018. Several bank executives shared their Fed rate hike expectations for this year, with most forecasting three or four increases. One institution planned for a flatter curve, while another noted that rising rates on both the short and long ends will benefit their operations. Chart 2 shows key banking related variables cited in the Bank Lending Beige Book. Appendix Table 1 shows the Big 5 Bank Lending Beige Book for Q4 2017. All five banks were uniformly upbeat in their assessments of the tax bill's impact on their operations, their customers' businesses or the overall economy. One bank noted that it took a repatriation charge in Q4, and another said it would return capital to shareholders via buybacks and dividends. A third said the bill will provide "immediate and ongoing benefit to our employees, customers, communities and our shareholders, as we invest a portion of our tax savings in each of these important constituencies." Bottom Line: The banking system is shipshape as 2018 begins and lenders are ready to extend credit to businesses and consumers to boost the economy despite higher rates. BCA's U.S. Equity strategists recommend an overweight position in the S&P 500's financial sector, with a high conviction overweight on banks.3 A Different Lens On Earnings Chart 3Corporate Health Has Improved##BR##Since Start Of 2017 The early December release of the U.S. flow of funds report allows us to update BCA's Corporate Health Monitor (CHM) (Chart 3). The CHM's level improved slightly between Q2 and Q3, but the overall reading remains in 'deteriorating health' territory. The marginal improvement in Q3 was driven by rising profit margins. In addition, profit growth surged while debt moved up modestly in Q3. The CHM is a reliable indicator of the trend in corporate bond spreads which supports our corporate bond overweight. Given that corporate balance sheets are declining, the sole supports for corporate spreads are low inflation and accommodative monetary policy. We anticipate spreads will start to widen later this year when inflation climbs and policy turns more restrictive. BCA's U.S. Bond strategists remain overweight the U.S. high-yield bond market.4 Although spreads appear a bit more attractive than for investment-grade corporates, there is still not much room for spread compression in high-yields. We calculate that if the high-yield index spread tightens by another 117 bps, then junk bonds will be the most expensive since 1995. In an optimistic scenario where the index spread tightens 100 bps, bringing it close to all-time expensive levels, then we would expect junk excess returns to be in the range of 600 bps (annualized). Nonetheless, in view of the trends in corporate leverage, it is unlikely that there will be another 100 bps of spread tightening. More realistically, we expect excess returns between 200 bps and 500 bps (annualized) between now and the end of the credit cycle. Bottom Line: BCA's indicators suggest that we are moving into the late stages of the credit cycle, but we retain an overweight cyclical stance on corporate bonds. A shift to a more restrictive monetary policy, tightening C&I bank lending standards and/or a continued uptrend in gross corporate leverage are the main catalysts we will monitor to gauge the end of the cycle. An abrupt end to the positive capex or earnings cycle would also be concerns for our upbeat view on credit. Repatriation Redux The Tax Cut and Jobs Act of 2017 has the potential to generate significant supply-side benefits for consumers, shareholders and the broad economy. There are several uses for corporate cash, including capital spending, M&A, increasing compensation to employees, paying down debt and returning capital to shareholders. Chart 4 shows that through Q3 2017, share buybacks and dividends ran slightly ahead of prior cycles, while capex was about average. Investors wonder how that mix may change under the new law. Corporate behavior in the wake of the 2004 overseas tax holiday5 provides some guidance. Chart 4Comparison Of Corporate Outlays Across Four Economic Expansion Phases Corporations used cash generated from the 2004 tax break to return capital to shareholders. However, we found scant evidence that firms who benefited from the tax holiday increased capital spending, raised wages or hired more workers. A study by the National Bureau of Economic Research (NBER) noted that a dollar increase in repatriations "was associated with an increase of almost $1 in payouts to shareholders."6 Moreover, a 2008 IRS paper7 concluded that nearly half of all the cash repatriated in 2004 and 2005 came from only the tech and pharma sectors. A Congressional Research Service (CRS) found that small firms tended to benefit less than large firms from the tax holiday.8 A paper9 by the left-leaning, U.S.-based think tank, the Center For Budget and Policy Priorities (CBPP), stated that several firms that benefitted the most from the 2004 law laid off workers soon after the tax law was enacted. In 2018, BCA expects firms to return capital to shareholders, boost capex and continue to bump up wages. Chart 5 shows that buybacks will probably augment S&P 500 EPS by around 2% this year, while panel 2 shows that there was a noticeable upswing to buyback announcements as 2017 ended. Aside from the post-recession bounce in buybacks in 2010, the last big swell in buyback announcements occurred in 2004 and 2005. That said, corporate balance sheets were in much better shape in 2004/2005 than they are today (Chart 3 again). The implication is that management teams may decide to pay down debt before returning the cash windfall back to shareholders. However, with rates still low, most firms will chose to distribute the cash to shareholders, despite high corporate debt levels. The positive reading on BCA's Capital Structure Preference Indicator supports our stance on buybacks (Chart 6, third panel). This Indicator is defined as the equity risk premium minus the default-adjusted yield in high-yield corporate bonds. When the indicator is above zero, there is financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The Indicator is currently positive, although not as high as it was in 2015. Moreover, Chart 7 shows that the dividend payout ratio rebounded from the 2007-2009 financial crisis, but has moved above its pre-crisis level. However, dividend distributions remain below their pre-crisis peak reached in the early 1990s. Chart 5Still Some Room##BR##To Run For Buybacks Chart 6Buybacks Adding Almost##BR##2 Percentage Points To EPS Growth Capital spending was already on a tear in late 2017, even before the tax bill passed. Industrial production, the PMI diffusion index and advanced-economy capital goods imports, all confirm strong underlying momentum in investment spending (Chart 8). Chart 7Corporations Poised To Return##BR##Capital To Shareholders Chart 8Capital Spending Helping##BR##To Drive Growth Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM data, roaring global exports and soaring sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters (Chart 9). CEO confidence soared to a 13-year high in Q4, according to the latest Duke's Fuqua School of Business/CFO Magazine Global Business Outlook (Chart 10, panel 1). Duke noted that "Among CFOs who responded to the survey after the Senate passed its version of the tax reform bill, optimism spiked to 73, which is the highest U.S. optimism ever recorded in the history of the survey."10 Chart 9Bright Outlook##BR##For Capital Spending Chart 10CEO Confidence And##BR##Capex Plans Surging Surveys by the Conference Board and Business Roundtable show a similar pattern. (panel 1 again). Notably, the soundings on all three surveys have climbed since Trump's election, but then retreated as his pro-business agenda stalled in the summer months. The dip in sentiment reflected the lack of legislative progress in Washington in the first 10 months of the Trump administration. The dip in CEO sentiment in Q2 and Q3 was in sharp contrast to the easing of policy concerns in the Fed's Beige Book (Chart 1, bottom panel). The upbeat numbers in the regional FRBs' surveys of capital spending intentions further support escalating capex spending in the next few quarters. The average readings from the New York, Philadelphia and Richmond Feds' capex survey plans are at an all-time high (Chart 10, panel 2). Moreover, the regional Feds' capex spending plans diffusion index is close to a cycle high, despite a modest pullback last summer (panel 3). Bottom Line: Stay overweight stocks versus bonds, and underweight duration. The tax bill will boost returns to shareholders via buybacks and dividends. In addition, rising capex will drive up GDP, employment and EPS in the coming quarters. Dollar View Revisited The dollar fell by 4% between mid-December and mid-January, amid a hawkish market interpretation of the ECB minutes, persistently strong growth in Japan and a key technical breakdown in the DXY index. The decline has some investors questioning BCA's bullish stance on the currency (Chart 11). We were correct on the direction of interest rate differentials vis-à-vis the other major economies, but this has not translated into a stronger dollar so far. We decided to stay long the dollar after a lengthy internal debate, although we have revised down our view on the upside potential. A lot of good news on the European and Japanese economies is now discounted and investors are quite pessimistic on the dollar (which is bullish the dollar from a contrary perspective) (Chart 12). Given this technical backdrop, we would expect at least a 5% rise in the trade-weighted dollar as expectations of Fed rate hikes rise this year. We are likely to exit our long dollar position if we get such an appreciation. Chart 11We Are Sticking With##BR##Our Long Dollar View Chart 12The Case For Crisis Era Monetary Stimulus##BR##In Europe And Japan Is Weakening Bottom Line: BCA's bullish dollar trade was initiated in October 2014 and although the DXY index is up 4% since that time, we are maintaining the trade. While downside risks remain, a unilateral decision by the Trump Administration to leave NAFTA will boost the U.S. dollar versus the Canadian dollar and the peso. Italy's upcoming spring Presidential election could prompt a rally in the dollar if the Eurosceptic parties outperform expectations. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues", published on April 17, 2017. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Commitments", published January 20, 2014. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "High Conviction Calls", published November 27, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "January Effect", published January 9, 2018. Available at usbs.bcaresearch.com. 5 https://www.congress.gov/bill/108th-congress/house-bill/4520 6 http://www.nber.org/papers/w15023 7 https://www.irs.gov/pub/irs-soi/08codivdeductbul.pdf 8 https://fas.org/sgp/crs/misc/R40178.pdf 9 https://www.cbpp.org/research/tax-holiday-for-overseas-corporate-profits-would-increase-deficits-fail-to-boost-the 10 http://www.cfosurvey.org/2017q4/press-release.html Appendix: Bankers Beige Book

Highlights Trade #1: Go Short The December 2018 Fed Funds Futures Contract. The trade has gained 64 bps since we initiated it. We are lifting the stop to 60 bps and targeting a profit of 75 bps. Trade #2: Go Long Global Industrial Stocks Versus Utilities. The trade is up 13.1%. We are targeting a profit of 15%, and are tightening the stop further to 12%. Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts. The trade is up 0.7%. We see this as a multi-year trade with significant upside potential. The unwinding of heavy short positions could cause the yen to strengthen temporarily. The euro is vulnerable to negative growth surprises. A retracement of some of its recent gains is likely. Feature Looking Back, Thinking Forward I had the pleasure of speaking at BCA's Annual Investment Conference held in New York on September 27th of last year where I offered three "tantalizing" trade ideas. Chart 1 reviews their performance. They were the following: Trade #1: Go Short The December 2018 Fed Funds Futures Contract We argued last summer that U.S. growth was likely to accelerate, taking rate expectations higher. That has indeed happened. Aggregate hours worked rose by 2.5% in Q4 over the previous quarter. Assuming that productivity increased by 1.5% in Q4 - equal to the pace recorded in Q3 - real GDP probably increased by nearly 4%. A variety of leading indicators point to continued above-trend growth in the months ahead (Chart 2). Chart 1Three Tantalizing Trades: ##br##An Update Chart 2Leading Indicators Pointing ##br##To Above-Trend U.S. Growth We think the Fed will raise rates four times this year, one more hike than projected by the dots and roughly 35 bps more in tightening than implied by current market expectations. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. We have been saying for a while that above-trend growth will take the unemployment rate down to a 49-year low of 3.5% by the end of this year. If the unemployment rate falls this much, the Fed will probably turn more hawkish. Stronger inflation numbers should also give the Fed confidence to keep raising rates once per quarter. Core inflation surprised on the upside in December. We expect this trend to continue in the coming months, as the ISM manufacturing index, the New York Fed's Inflation Gauge, and our own proprietary pipeline inflation index are already foreshadowing (Chart 3). Chart 3U.S. Inflation ##br##Should Accelerate Chart 4A Pick-Up In Wage Growth ##br##Would Put Upward Pressure On Service Inflation As we noted two weeks ago,1 service sector inflation should get a lift from faster wage growth this year (Chart 4). Goods inflation should also rise on the back of higher oil prices and the lagged effects of a weaker dollar (Chart 5). In addition, health care inflation is likely to pick up from its current depressed level, especially if the Congressional Budget Office is correct that insurance premiums will rise due to the elimination of the individual mandate (Chart 6). Housing inflation will moderate, but this is unlikely to stymie the Fed's tightening plans since excessively low interest rates could lead to even more overbuilding in the increasingly vulnerable commercial real estate sector. Chart 5Higher Oil Prices And A Weaker Dollar ##br##Are A Tailwind For Inflation Chart 6Health Care Inflation ##br##Should Move Higher Granted, four rate hikes equal four opportunities to defer raising rates. It is easy to imagine scenarios where the Fed stands pat, but hard to conjure scenarios where the Fed has to raise rates five times or more this year. Thus, the risk to our four-hike view is to the downside. As such, we will be looking to take profits of 75 bps on the trade, and are putting in a stop of 60 bps. Trade #2: Go Long Global Industrial Stocks Versus Utilities Capital spending tends to accelerate in the late innings of business-cycle expansions. We are in such a phase now, as evidenced by capital goods orders, capex intention surveys, and our global capex model (Chart 7). Increased capital spending will benefit industrial companies. Conversely, rising bond yields will hurt rate-sensitive utilities. Valuations in the industrial sector have gotten stretched, but are not at extreme levels (Chart 8). Based on enterprise value-to-EBITDA, industrials are still only slightly more expensive than utilities compared to their post-1990 average. Chart 7Capex Is Shifting Into ##br##Higher Gear Chart 8Industrial Stocks: Valuations Are Stretched, ##br## But Not Yet Extreme While we do think global growth will slow this year from the heady pace of 2017, it should remain firmly above-trend. A bigger-than-expected slowdown - especially if it is concentrated in China - would undoubtedly hurt industrials. A stronger dollar could also be a headwind. Thus, we are keeping this trade on a short leash, with a target of 15% and a stop of 12%. Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts The Japanese economy is on fire. Growth almost reached 2% in 2017 and leading indicators suggest a solid start to 2018 (Chart 9). The unemployment rate has fallen to 2.7%, a full point below 2007 levels. The ratio of job openings-to-applicants has surpassed its bubble peak. The Tankan Employment Conditions Index is pointing to an exceptionally tight labor market. Wages excluding overtime pay are rising at the fastest pace in twenty years (Chart 10). Chart 9Japanese Growth Momentum Is Positive Chart 10Signs Of A Tight Labor Market Inflation is low but is starting to edge up. The most recent release surprised on the upside. Inflation expectations moved higher on the news, benefiting our long Japanese 10-year CPI swap trade recommendation (Chart 11). A simple scatterplot between the unemployment rate and core inflation suggests the Phillips curve remains intact in Japan -- amazingly, it even looks like Japan (Chart 12)! Chart 11Inflation Expectations Have Edged Higher Chart 12The Phillips Curve In Japan Looks Like Japan Still, with core inflation excluding food and energy running at only 0.3%, there is a long way to go before inflation reaches the BoJ's target -- and even longer if the BoJ honours its promise to generate a meaningful overshoot to compensate for the below-target inflation of prior years. This suggests the BoJ will not meaningfully water down its Yield Curve Control regime anytime soon. As such, five-year yields are likely to stay put while yields with maturities in excess of ten years should move higher. Our "tantalizing trade" being short 20-year JGBs versus their 5-year counterparts still has a long way to run. Too Risky To Short The Yen The exceptionally strong correlation between USD/JPY and U.S. Treasury yields has broken down this year (Chart 13). Had the relationship held, the yen would have actually weakened against the dollar. Still, we are reluctant to get too bearish on the yen (Chart 14). The yen real effective exchange rate is close to multi-decade lows. Positioning on the currency is heavily short. The current account surplus has mushroomed from close to zero in 2014 to 4% of GDP at present. And even if the BoJ keeps the Yield Curve Control regime in place, investors may still anticipate its demise, leading to a temporary bout of yen strength. Chart 13Strong Correlation Is Broken Chart 14Too Risky To Short The Yen What's Propping Up The Euro? The euro has been on a tear since last week, egged on by the ECB minutes, which hinted at a faster pace of monetary normalization. Growing confidence that Angela Merkel will be able to form a grand coalition also helped the common currency, along with hopes that the new government will loosen the fiscal purse strings. The euro is often thought of as the "anti-dollar." And sure enough, the euro's strength has been reflected in a broad-based decline in the dollar index in recent days. BCA's Global Investment Strategy service went long the dollar on October 31, 2014. We "doubled up" on this call in the fall of 2016, controversially arguing that "Trump will win and the dollar will rally." Obviously, in retrospect, I should have rung the register and declared victory on our long dollar view when I had the chance. EUR/USD fell to 1.04 on December 2016, within striking distance of our parity target. Bullish dollar sentiment had reached unsustainably lofty levels. That was the time to sell the greenback. But hubris got the best of me. While our other currency trade recommendations have delivered net gains of 11% since the start of 2017, the long DXY trade has stuck out like a sore thumb. Hindsight is 20/20. The key question is what to do today. EUR/USD is still trading below the level it was at when we went long the DXY. Relative to the IMF's Purchasing Power Parity exchange rate of 1.32, the euro is 7% undervalued. That said, PPP exchange rates may not be a reliable benchmark in this case. Given current market expectations, EUR/USD would need to strengthen to 1.41 over the next ten years just to cover the carry cost of being short the dollar. Even assuming lower inflation in the euro area, that would still leave the euro trading above its long-term fair value. It is possible, of course, that rate differentials will narrow further, but the scope for this is more limited than it might appear. The market currently expects policy rates ten years out to be 95 basis points higher in the U.S., down from a spread of nearly 180 basis points in late December (Chart 15). Given that euro area inflation expectations are 40-to-50 bps lower than in the U.S., this implies a real spread of about 50 bps - broadly in line with our estimate of the real neutral rate gap between the two regions. Ultimately, the fate of the euro in 2018 will rest on the same question that drove the currency in 2017: Will euro area growth surprise on the upside, prompting investors to price in a faster pace of monetary normalization? The bar for success is certainly higher at present. Chart 16 shows that euro area consensus growth estimates have risen significantly since the start of last year. The expected lift-off date for policy rates has also shifted in by more than a year to mid-2019. Considering that Jens Weidmann stated earlier this week that he thinks current market pricing is broadly consistent with when the ECB expects to hike rates, there is little scope for the lift-off date to move forward. Chart 15Little Scope For Rate Differentials ##br## To Narrow Further Chart 16Euro Area Growth Estimates Have Been Revised Up ##br##Since The Start Of 2017 Meanwhile, financial conditions have tightened significantly in the euro area relative to the U.S., the euro area credit impulse has turned negative, and the U.S. economic surprise index has jumped above that of the euro area (Chart 17). Euro area inflation has also dipped. Especially worrying is that core inflation in Italy has fallen back to a near record-low of 0.4% (Chart 18). How is Italy supposed to navigate its way out of its debt trap if nominal growth stays this weak? On top of all that, long speculative euro positions have soared to record-high levels (Chart 19). Given the choice of betting whether EUR/USD will first hit 1.30 or 1.15, we would go with the latter. If our bet turns out to be correct, we will use that opportunity to shift to neutral on the dollar. Chart 17The Euro Is Vulnerable ##br##To Negative Growth Surprises Chart 18Euro Area Core Inflation ##br##Has Dipped Chart 19Euro Positioning: From Deeply Short ##br##To Record Long Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The euro is in a cyclical bull market. It is supported by attractive valuations, improving balance of payments dynamics, declining political risk, potential shifts in reserves preferences, and a re-rating of the European terminal rate. This positive cyclical backdrop hides a more treacherous short-term outlook. EUR/USD is vulnerable because ECB members are increasingly worried, the European periphery is displaying early strains, European inflation will slow versus the U.S., global industrial activity may experience a mini down cycle, and sentiment measures are massively stretched. Short EUR/JPY for now, and use any move in EUR/USD to 1.15 or lower to buy this pair. Feature The euro has undergone a major paradigm shift over the course of the past 16 months. In December 2016, the euro was trading near parity, and expectations were uniform that it would fall well below that threshold. The narrative was simple: Europe was turning Japanese, with inflation forever moribund; also, Europe was succumbing to the siren call of nationalism and populism, which meant the euro was bound to break up within the next five years. Meanwhile, the U.S. was on the rebound. Core consumer price inflation was above 2.2%, and U.S. President Donald Trump was set to massively stimulate the American economy, giving a free hand for the Federal Reserve to hike to its heart's content. Today, the picture could not be more different. Investors expect the European Central Bank's first hike to materialize in the summer of 2019, European growth is stellar, and European inflation is not low enough to warrant emergency-level policy rates. As a result, not only is EUR/USD trading above 1.20, but consensus forecasts increasingly see the euro trading into the 1.25 to 1.30 zone by year end. Is EUR/USD at 1.22 a buying or a selling opportunity? Short-term risks are currently elevated for the euro, but a move toward 1.15 would represent a buying opportunity, as the cyclical bear market in the euro is over. The Long-Term Bull Case A crucial long-term positive factor for the euro is that it is cheap. EUR/USD currently trades at a 10% discount to its purchasing-power-parity equilibrium, even after a nearly 17% rally since its December 2016 low. Encapsulating this concept, the real effective exchange rate for the euro remains well below equilibrium (Chart I-1). Additionally, our fundamental long-term fair value model pegs the euro as being almost 1-sigma undervalued. The euro area's balance of payment is also very favorable. It is well known among the investment community that the euro area sports a surplus of 3.5% of GDP, but significant changes are also materializing in the capital account. Portfolios outflows out of the euro area have begun to decrease, as equity inflows are rising and bond outflows are becoming smaller. Moreover, the euro area basic balance is moving into positive territory, which historically has been a precursor to sustainable euro rallies (Chart I-2). The supply of euro for international markets is therefore decreasing. Additionally, the euro area's net international investment position (NIIP), which was as low as -17% of GDP in 2014, will likely move into positive territory toward the end of the year. The NIIP has historically been a strong driver of long-term exchange rate moves.1 Chart I-1The Euro Is Still Cheap Chart I-2The European Balance Of Payments Has Improved Politics too have been moving in the right direction. Euro skepticism is not taking hold in the euro area: Last year's French election was a vivid demonstration that "more Europe" is not electoral poison. Even the Italian elections this coming March may not land much of a blow to the European project: The Five Star Movement is rapidly softening its anti-euro rhetoric, and support for centrist parties is strengthening (Chart I-3). Moreover, a German move toward a grand coalition means Angela Merkel's CDU is very likely to be governing along with a pro-euro SPD, whose campaign theme was "MEGA": Make Europe Great Again. Already, Germany is lending a listening ear to some of Macron's integrationist proposals, and fiscal stimulus could well be in the pipeline. Long-term reserves diversification is also in the euro's favor. A headline last week suggested that China would unload some of its vast holdings of Treasurys. This leak was soon condemned as "Fake News" by China's State Administration of Foreign Exchange. However, while the news clearly lacked substance, the reality remains that despite the euro area and the U.S. being similarly sized economies, the euro only represents 20% of allocated global reserves, compared to 65% for the greenback. The greater depth and liquidity of U.S. bond markets contributes to this discrepancy, but the ECB's bond buying, by creating a scarcity of euro denominated securities, has exacerbated the disparity. This latter handicap for the euro will end sometime next fall, and if Europe's integrates further, European bond markets will increasingly become alternatives to U.S. ones. A rebalancing of reserves would principally help the euro by hurting the U.S. dollar: It will become more tenuous for the U.S. to achieve a positive international income balance while sporting a NIIP of -40% of GDP if official international demand for dollars falls (Chart I-4). Chart I-3Italian Centrists Are Gaining Ground Chart I-4The USD Needs Its Reserve Status Finally, the terminal rates differential between the U.S. and the euro area remains well above its long-term average of 110 basis points. Thus, there is scope for a normalization of European terminal rates relative to the U.S. on a long-term basis (Chart I-5). However, an average is only a number. What forces could cause the terminal rate spread between the euro area and the U.S. to normalize over the coming years? European policy is currently very loose when compared to the U.S., which will enable the ECB to play catchup over the coming years. To make this judgment, we look at broad money supply in excess of money demand. Because money demand is an unobserved variable, we have to estimate it. Economic theory argues it should be a positive function of economic activity, wealth and uncertainty. Therefore, to get a sense of what money demand may be, we regress the real broad money aggregates of various countries on uncertainty indices and real wealth.2 The difference between real broad money supply numbers and these estimates represent excess money supply. If a country's excess money is being generated today, it ends up stimulating future economic activity and inflation. This increase in expected nominal growth should contribute to lifting expected interest rates at the long end of the yield curve - i.e. expected terminal rates. As Chart I-6 shows, the stock of excess money supply in the U.S. has stopped growing since 2015. However, it is currently exploding in the euro area as European commercial banks are regaining their health and lending again. The money supply dynamics in Europe signal that the easy policy of the ECB is finally bearing fruit. And as the bottom panel of Chart I-6 illustrates, when European excess money supply increases relative to the U.S., as is currently the case, EUR/USD experiences cyclical rallies.3 This counterinituitive result exists because previous ECB easing is bearing fruits, European asset returns are rising, and economic activity is increasing. As a result, the European terminal rate now has more scope to rise vis-à-vis the U.S. The steepening of the German yield curve relative to the Treasury curve only confirms this message (Chart I-7). Chart I-5The U.S. Terminal Rate Has Room To Fall##br## Against That Of Europe Chart I-6European Excess##br## Money Is Surging Chart I-7Listen To Yield ##br##Curves The five forces described above imply that the euro's move from 1.03 to 1.21 was the first salvo in what is likely to be a long cyclical bull market that could end up driving the euro above 1.40 over many years. However, these factors provide little insight regarding the euro's path over the next three to six months. Bottom Line: The euro is likely to have embarked on a cyclical bull market at the beginning of 2017. Five factors support this judgment: The euro is cheap, the European balance-of-payment backdrop is favorable, political winds in the euro area remain favorable to further European integration, global foreign exchange reserves are very underweight the euro, and the spread between U.S. and euro area expected terminal rates remains well above its long-term average, and has scope to narrow. Murkier Short-Term Outlook While the long-term outlook is very favorable for the euro, the shorter-term outlook is much more clouded. First, the chorus of complaints against the euro's strength is growing among European central bankers. In recent days, not only have Vitor Constâncio and Francois Villeroy voiced concerns over the euro's recent strength, but so has Ewald Nowotny, the rather hawkish Austrian central banker. Additionally, Bundesbank President Jens Weidmann stated that the market should not anticipate a rate hike before the summer of 2019, suggesting he would not want to see a more aggressive rate pricing than what is currently at play (Chart I-8). Second, the less competitive and more fragile European periphery is already showing early signs that the sharp appreciation in the euro is causing some pain. Peripheral equities have begun to underperform the stocks of core euro area nations, and are also sharply underperforming U.S. equities. This phenomenon tends to be associated with a weakening euro. Moreover, peripheral inflation excluding food and energy has already weakened to 1.3% from a high of 2% in February last year, the consequence of a tightening in financial conditions (Chart I-9). Chart I-8ECB Doesn't Want This To Change Chart I-9Peripheral Core Inflation In Free Fall Third, the economic environment points to underperformance of aggregate European inflation relative to the U.S. A fall in the gap between euro area and U.S. inflation tends to be associated with short-term gyrations in EUR/USD (Chart I-10). This is because a fall in relative inflation against the euro area causes investors to temporarily tweak the perceived path of future policy differentials. Over the course of 2018, U.S. inflation is set to increase. A simple model based on U.S. capacity utilization and the velocity of money shows that U.S. core CPI could hit 2.1% (Chart I-11). While this model has done a good job picking the turning points in U.S. core inflation, it has consistently overestimated inflation since 2013. Correcting for this bias, the model still forecasts a significant pick-up in inflation to 1.8% (Chart I-11, bottom panel). Chart I-10Higher European Inflation Equals Higher Euro Chart I-11A U.S. Inflation Pick Up Is Coming The same cannot be said for euro area inflation. Not only is the European periphery already feeling the pain caused by the euro's strength, but also we have entered the window of time where the previous tightening in euro area financial conditions vis-à-vis the U.S. puts a brake on euro area relative inflation.4 Moreover, the diffusion index of the components of the euro area core CPI index has been below 50% for four months in a row now. Historically, this has been associated with a fall in core CPI. Fourth, over the past year or so, EUR/USD has traded in line with risk assets. The euro area has benefited from EM growth improvement, which has lifted all corners of the global economy levered to the global industrial cycle. As a result, as investors become increasingly bullish on industrial metals, EM assets or momentum plays, so they have of the euro.5 However, clouds are slowly forming over the global economy, at the very least pointing to a mini-cycle downturn. For one, Chinese producer prices have rolled over, and Chinese import growth has significantly underperformed expectations in recent months, slowing to a 5% pace from a 20% pace as recently as September 2017. Essentially, industrial activity has slowed in response to a tightening in Chinese monetary conditions. This slowdown is already beginning to impact various corners of the globe: Korean and Taiwanese export growth continues to decelerate; BCA's Global LEIs Diffusion Index is well below the 50% mark, which normally precedes slowdowns in the global LEI itself; Our boom/bust and global growth indicators have slowed further - two precursors to global industrial production decelerations. Our global economic and financial A/D line, which tallies 100 pro-cyclical variables, has also rolled over sharply, another early warning sign for the global economy (Chart I-12). Finally, as we highlighted in December, EM/JPY carry trades, a canary for the global economy, have lost momentum - a signal that has normally preceded a slowdown in global industrial activity.6 All these signals only confirm the "Yellow Flags" we highlighted last October.7 In an environment where complacency is rampant and assets levered to growth are priced for perfection, this is worrisome. The euro's recent elevated correlation to such risk assets, along with the fact that the gap between European and U.S. core inflation is itself led by Chinese PPI, suggests that the euro is tactically vulnerable. Fifth, from a technical perspective speculators have never been this long the euro, which represents a significant danger as the euro is trading at a sharp premium to its short-term interest rate driver (Chart I-13). Moreover, risk-reversals for EUR/USD point to heightened susceptibility of a selloff if the bad omen on global growth and European inflation come to fruition (Chart I-14). Chart I-12Rising Risks For Global Growth Chart I-13The Euro Is Vulnerable Chart I-14Risk Reversals Point To Euro Downside This short-term picture suggests that the probability of a move in EUR/USD toward 1.15 is growing over the course of the next three to six months. Bottom Line: While the cyclical picture for the euro is bright, the short-term snapshot is much more dangerous. Not only are an increasing number of ECB officials weighing in on the impact of the euro's recent rally, but the European periphery is showing growing signs that the euro rally has indeed taken a bite. Additionally, European inflation is set to underperform U.S. inflation, and the global economic cycle could enter a short burst of disappointment. Finally, investors are not positioned for such developments, increasing the likelihood of a downward move in the euro. What To Do? Caught between a cyclically propitious backdrop and a tactically dangerous environment, EUR/USD presents a riddle for FX investors right now. The odds of a euro correction over the next three to six months are substantially greater than 50%. But as we highlighted last week, instead of taking a direct bet on EUR/USD, we recommend investors short EUR/JPY. Shorting EUR/JPY is an even cleaner way to take advantage of the cloudy weather building over the global economy.8 Moreover, in recent years, EUR/JPY has fallen when the 52-week rate-of-change of momentum trades began to weaken (Chart I-15). This highly mean-reverting indicator is currently in the 96th percentile of its distribution for the past 25 years, suggesting an imminent rollover. Additionally, EUR/JPY tends to perform well when the LIBOR-OIS spread widens. Today, the three-month FRA-OIS spread has been widening, even as the end-of-year dollar funding shortage has passed (Chart I-16). These kinds of dynamics point to a potential drying out in global liquidity, a phenomenon which historically hurts risk assets, especially when they are as frothy as they are now. This should once again hurt EUR/JPY. Chart I-15EUR/JPY And Momentum Stocks Chart I-16Funding Stresses Point To A Fall In EUR/JPY Thus, shorting EUR/JPY is our highest conviction trade for the next six months or so. If, as we foresee, EUR/USD weakens during the first half of 2018, we will look to buy this pair. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets" dated February 26, 2016 available at fes.bcaresearch.com 2 We do not include real GDP in the models because since wealth is affected by GDP, they are two co-integrated variables, which creates strong multi-collinearity in the regressions. Of the two variables, real wealth was the stronger explanatory variable. 3 While the focus of this report is on the euro, the relationship between relative excess money supply and currency performances works across many exchange rates. We will develop this theme over the coming weeks. 4 Please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets" dated February 26, 2016 available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "Euro: Risk On Or Risk Off" dated November 17, 2017 available at fes.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, "A Cold Snap Doesn't Make A Winter" dated January 5, 2018 available at fes.bcaresearch.com 7 Please see Foreign Exchange Strategy Weekly Report, "The Best Of Possible Worlds?" dated October 6, 2017 available at fes.bcaresearch.com 8 Please see Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Data out of the U.S. was strong this week: Industrial production increased by 0.9% on a monthly pace; Capacity utilization increased to 77.9% from 77.2%; Continuing jobless claims increased to 1.952 million from 1.876 million, beating expectations of 1.9 million; Initial jobless claims however decreased to 220K from 261K, beating expectations of 250K. We continue to expect the Fed to hike more than is priced by the market. A tightening labor market will eventually feed inflationary pressures, causing upward pressure on the dollar. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was decent: German CPI came in unchanged and at expectations, at 1.6%; European headline and core CPI also remained unchanged and at consensus, coming in at 1.4% and 1.1% respectively. However, the euro seems to be losing momentum his week. Comments by ECB board members such as Ewald Nowotny, Vitor Constâncio, and Francois Villeroy, all pointed to issues with the euro's sharp rise, and how they "don't reflect changes in fundamentals". Additionally, relapsing inflation data in the peripheries shows that the strength in the euro is beginning to cause strains and may even negatively affect the ECB's mandate. Report Links: The Unstoppable Euro - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Domestic corporate goods year on year inflation underperformed expectations, coming in at 3.1%. It also decreased substantially from November. Moreover, the Eco Watchers Survey for current conditions underperformed expectations, coming in at 53.9. It also decreased from the November reading. However, machinery orders yearly growth outperformed expectations substantially, coming in at 4.1%. USD/JPY is relatively flat from last week. Overall we expect upside to the yen to be limited against the U.S. dollar, given that bond yields are set to go up in the U.S. That being said, the yen has upside against the euro, as financial conditions have eased significantly in Japan relatively to the euro area. This should cause rate expectations in Japan to improve relative to those of Europe's, pushing EUR/JPY lower. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: The DCLG House Price Index yearly growth outperformed expectations, coming in at 5.1%. However, core consumer price inflation underperformed expectations, coming in at 2.5%. It also decreased from the 2.7% reading of November. Moreover, headline inflation came in line with expectations at 3%. This also marks the first decrease in inflation in the U.K. since July 2017. Lifted by the USD's weakness, cable has now reached the pre-Brexit low 1.38 hit in February 2016. However, GBP has been experiencing a downtrend versus the euro since last September Overall, we continue to be skeptical of the ability of the BoE to raise interest rates meaningfully. Thus, we would fade any further rally from GBP/USD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was strong this week: Home loans grew at a 2.1% annual pace in November, higher than the expected -0.2%; Employment grew by 34.7K, beating expectations of 9K. The part-time component increased by 19.5K, while the full-time component grew by 15.1K; The participation rate increased to 65.7% from 65.5%; Unemployment rate increased to 5.5% from 5.4%. Foreign exchange traders lifted the AUD further this week. While the headline employment data remains stellar, the heavy concentration part-time job creation means that overall labor utilization measures is staying low. This will cap wage and inflationary pressures, especially as the AUD is once again expensive, further exacerbating deflationary pressures. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: The month-on-month growth of food prices declined from -0.4% to -0.8%. Moreover, Electronic Card retail sales yearly growth slowed from 4.3% to 3.3%. Finally the ANZ Commodity Price Index year on year growth declined from -0.9% to -2.2%. The New Zealand Dollar has surges by almost 3% year to data against the U.S. dollar. This has been largely due to the depreciation of the greenback itself, as global growth continues to beat forecast. On a short term basis we are positive on the NZD relative to the AUD, as Chinese tightening should weigh more on Australia than New Zealand. However, the new populist government in New Zealand worsens the outlook of the kiwi on a long term basis. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Movements in the petrocurrency were muted following the 'dovish hike' by the Bank of Canada. Numerous factors were highlighted to justify the rate hike to 1.25%, such as: strong employment growth; higher wages; robust consumption; and exceptional GDP growth in 2017. While the Bank's Business Outlook Survey suggests the labor market is tightening due to labor shortages, the BoC underplayed this factor, pointing to much more muted overall labor utilization metrics. The BoC also noted the expected decline in the contribution of housing and consumption to growth this year due to higher mortgage and borrowing rates. While the economy is firing on all fronts, the spread between the West Canada Select and West Texas Intermediate oil prices continues to widen due to a lack of pipeline capacity to ship the oil out of Canada. According to the Bank, these bottlenecks should be temporary, which means that the CAD could catch up to oil later. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 On Tuesday, Thomas Jordan, the president of the SNB once again reiterated that the franc is still "highly valued", and thus interest rates need to stay low so as to prevent the franc from appreciating. Moreover, he emphasized that while expansionary monetary policy was necessary, it was important to not wait too long to normalize rates. Overall, we believe that the SNB will want to see sustained inflation at relatively high levels to justify an exit from their radical monetary policy. In the meantime the Swiss Central bank will stay accommodative, and thus, EUR/CHF is likely to have limited downside. If the mini down cycle takes hold of the global economy, this would temporarily weigh on EUR/CHF. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The krone continued to appreciate this week, and is now UP 3.3% year-to-date. The krone has been helped mostly by the surge in oil prices and by the fall in the dollar. Overall, we are bullish on this cross against the CAD, as there are 60 basis points of hiked priced in the Canadian curve, even after this week's hike. In the meantime, there are only 21 basis points in the Norwegian curve. We believe this spread is too high, and thus, that the krone should appreciate against the Canadian dollar. Moreover, further downside in EUR/NOK is limited, given that near 70 dollars, there is not much room for oil prices to go up. Thus, we are closing our EUR/NOK trade with a 3.40% gain but keep our long NOK/SEK call in place. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 In a recent speech in Uppsala, Sweden, Deputy Governor Henry Ohlsson reminded the audience of his view from the December meeting that it would have reasonable to hike rates in "early 2018". He pointed to Sweden's robust economic performance, highlighting population growth, migration into cities, and higher real wages. Inflation has also been on target since mid-2017. This assessment is in line with our view of the economy, however Governor Ingves consistently supported a strong dovish tone which undermined our view. Now that the ECB has begun tapering, the consensus within the Riksbank seems to also be shifting. Falling house prices need to be monitored closely, especially when one keeps in mind Governor Ingves dovish inclinations. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Our new pecking order for currencies is: yen first, euro second, pound third, dollar fourth. Long-term (real) interest rate differentials are the dominant driver of currencies right now. EUR/USD should continue to trend higher to around 1.30. Equity investors should prefer the broader based 300-constituent Euro Stoxx over the 50-constituent Euro Stoxx 50. Underweight Basic Materials equities versus Healthcare equities on a 6-9 month horizon. Feature Nine months ago, our report Euro First, Pound Second, Dollar Third 1 encapsulated our recommended pecking order for the three major currencies. Subsequent performance has fully justified the title. The euro has appreciated by 6% versus the pound, and by 13% versus the U.S. dollar (Chart I-2). Today we are tweaking our currency pecking order: yen first, euro second, pound third, dollar fourth. Chart of the WeekHigher Euro Area Inflation Has Strengthened The Euro Chart I-2Euro First, Pound Second, Dollar Third The Euro Has Moved The 'Right' Way, The Yen Has Moved The 'Wrong' Way The Chart of the Week illustrates an excellent explanation for the euro/dollar exchange rate. It shows euro area versus U.S. core inflation differentials, and provides a great rule of thumb. If the euro area's core inflation were underperforming by 2% vis-à-vis the U.S., EUR/USD should stand at 1.00. But thereafter, every half-percent of euro area inflation catch-up strengthens the euro by 10 cents. At the start of 2017, our thesis was that the underperformance of euro area inflation by almost 2% - and the associated EUR/USD rate near 1.00 - was an anomaly. And that core inflation in the euro area would converge with that in the U.S. Which it duly has. Still, if the euro area's inflation underperformance vis-à-vis the U.S. converges to its long run average of half a percent, EUR/USD should continue to trend higher to around 1.30. One equity market implication is to prefer the broader based 300-constituent Euro Stoxx over the 50-constituent Euro Stoxx 50 (Chart I-3). The puzzle is that for the yen, the same inflation relationship has worked the 'wrong' way. Through the past ten years, every half-percent of Japanese core inflation catch-up has weakened the yen by around 10 yen (Chart I-4). To complicate the puzzle, the relationship for the yen used to work the 'right' way. Through 1999-2008, every half-percent of Japanese inflation catch-up strengthened the yen by around 10 yen (Chart I-5). Chart I-3A Stronger Euro Favours The Euro Stoxx ##br##Over The Euro Stoxx 50 Chart I-4Through 2008-17 Higher Japanese##br## Inflation Weakened The Yen... Chart I-5...But Through 1999-2007 Higher Japanese##br## Inflation Strengthened The Yen! So higher relative inflation in the euro area has driven the euro up; whereas higher relative inflation in Japan has driven the yen down, but previously used to drive the yen up! How can we explain the puzzle? The answer is to think in terms of both inflation and its impact on long-term interest rate expectations. What Are The Drivers Of Currencies? Foreign exchange demand serves one of four broad purposes: To buy foreign exchange reserves. To buy foreign goods and services. To buy long-term investments denominated in a foreign currency, also known as foreign direct investment (FDI) To buy shorter-term financial investments like bonds and equities denominated in that currency, also known as portfolio flows.2 Of these four components, the demand for foreign exchange reserves tends not to suffer wild gyrations, except at the rare moment that a currency peg starts or ends.3 The net foreign demand for euro area goods and services and FDI are also not particularly volatile. Which means that the usual swing-factor in foreign exchange demand is portfolio flows (Chart I-6), and especially fixed income portfolio flows. Chart I-6Portfolio Flows Are The Swing Factor In Foreign Exchange Demand What causes swings in fixed income portfolio flows? The answer is expected changes in real interest rates. Fixed income investors gravitate to the bonds with the highest real yield adjusted for likely currency losses or hedging costs. So when the expected real interest rate in the euro area rises relative to that in the U.S., euro bonds becomes de facto relatively more attractive. Meaning that international fixed income investors will shift into euro bonds until the flow pushes up EUR/USD to make the currency valuation symmetrically less attractive. At this new higher level for EUR/USD, the fixed income portfolio flow will stop because a new equilibrium has been established. International investors now have more upside from the more attractive bonds, but symmetrically less upside from the less attractive currency valuation - and the two factors cancel out. Furthermore, at major turning points in monetary policy, the main issue for the largest fixed income investors is not the exact pattern of short-term interest rate changes. Whether the Fed hikes in March, June and December or whether the ECB hikes next year is largely irrelevant. The big issue centres on the so-called real terminal rate: the average real interest rate over the very long term. Solving The Currency Puzzle Let's now return to our currency puzzle. If core inflation increases, but the expected terminal interest rate increases more, it means that the expected real terminal rate will also increase - causing the exchange rate to rise. This is what tends to happen in the euro area versus U.S. comparison, and explains why the relationship between relative core inflation and EUR/USD movements works the 'right' way. In effect, the nominal terminal rate is the driving factor for the currency. It is also what tended to happen in Japan before 2008 (Chart I-7), and explains why the relationship between relative core inflation and the yen also used to work the 'right' way. However, if core inflation increases, and the expected terminal interest rate increases less, it means that the expected real terminal rate will decrease - causing the exchange rate to fall. Since 2008, this is what has happened in Japan (Chart I-8). The expected nominal terminal rate has gone into stasis, so higher core inflation has pulled down the real terminal rate. Which explains why the relationship between relative core inflation and the yen has worked the 'wrong' way. The key question is what happens next? Will the expected terminal rate in the euro area go into stasis, as it did in Japan? Almost certainly no. The euro area's expected terminal rate has already risen by over 0.5% in the past year (Chart I-9). Chart I-7Expectations For Japan's Terminal ##br##Rate Used To Fluctuate... Chart I-8...But After 2008, Expectations For Japan's ##br## Terminal Rate Have Gone Into Stasis Chart I-9The Terminal Interest Rate Differential##br## Is Driving EUR/USD More plausibly, the expected terminal rate in Japan could come out of its stasis. With every other major central bank backing away from ultra-accommodation, and Japanese growth and inflation now looking little different from other G10 economies, is it realistic - or indeed feasible - for the Bank of Japan to maintain its extreme policy? The slightest hint from the Bank of Japan that it is following other central banks out of its ultra-accommodation would cause the expected terminal rate - and the yen - to gap (up) sharply. On this basis, the one major currency that we would short the euro against is the Japanese yen. The Global Mini-Upswing Is Losing Steam Finally and briefly, an update to our 'mini-cycle' framework for global growth. Last week in The Cobweb Theory And Market Cycles, we explained the existence of these mini-cycles, and argued that the current mini-upswing - which started last May - is getting long in the tooth. Right on cue, the latest credit data out of both China and the U.S. show that their 6-month credit impulses are losing steam (Chart I-10). The implication is that global growth will experience a mini-downswing during the first half of 2018. In all of the last five such mini-downswings, cyclical sectors ended up underperforming defensive sectors (Chart I-11). Accordingly, on a 6-9 month horizon, equity investors should underweight Basic Materials versus Healthcare. Chart I-106-Month Credit Impulses Have Rolled##br## Over In The U.S. And China Chart I-11Expect A Mini-Downswing: Underweight ##br##Basic Materials Vs. Healthcare Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report 'Euro First, Pound Second, Dollar Third' published on April 27 2017 and available at eis.bcaresearch.com 2 In this discussion, portfolio flows include short-term speculative flows. 3 For example, when the Swiss National Bank broke the franc's peg to the euro, it just stopped buying euro reserves. Fractal Trading Model* There are no new trades this week, leaving two open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 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 Slower global demand growth, coupled with surging production from the U.S. shales and higher OPEC 2.0 production, risks reversing the progress made in draining global commercial oil storage and tanking prices in 2019.1 Our updated balances modelling is in agreement with the backwardation in forward Brent and WTI curves, but, if anything, indicates the backwardation should be more pronounced: We are forecasting Brent and WTI prices next year will average $55 and $53/bbl, respectively, vs. $62.80/bbl and $57.40/bbl average prices for 2019's forward curves. For 2018, we are maintaining our $67 and $63/bbl expectation for Brent and WTI, although our modelling indicates higher prices are a distinct possibility, given our fundamental assumptions of falling supply and rising demand this year (Chart of the Week). Energy: Overweight. We liquidated our May and July Brent and WTI $55 vs. $60/bbl call spreads last week with gains of 110.1% and 129.0%. We will be liquidating our Dec/18 Brent and WTI $55 vs. $60/bbl call spreads at tonight's close; they were up 62.3% and 82.1% as of Tuesday. We remain long Jul/18 vs. Dec/18 WTI (up 47.4%), and long the S&P GSCI (up 8.5%), expecting backwardation. We will get long $55 Brent Puts vs. short $50 Brent Puts in 4Q19 at tonight's close. Base Metals: Neutral. We continue to expect base metals to remain well supported in 1H18 by environmental reforms in China, and supply uncertainty around contract renegotiations at the copper mines. The global expansion underpinning demand will compensate for slower Chinese growth in 2H18. Precious Metals: Neutral. Our long gold portfolio hedge is up 8.5% since inception in May/17. Ags/Softs: Underweight. Soybean markets rallied following last week's USDA WASDE report, but grains fell amid data indicating these markets will remain oversupplied. Feature If there is one truth in commodity markets it is this: The best cure for high prices is high prices, and vice versa. This is being dramatically demonstrated by OPEC 2.0 in its collective action to remove 1.8mm b/d of production from the market following disastrously low prices in 2015 - 16. Higher prices in 4Q17 and 1H18 oil futures are incentivizing a surge in U.S. shale output, and will give OPEC 2.0 comfort in slowly feeding output taken offline at the beginning of 2017 back into the market in 2H18 and 2019 (Chart 2). Higher prices and tightening monetary conditions globally will slow the rate of growth in demand next year (Chart 3). Chart of the WeekFundamentals##BR##Support Oil In 2018 Chart 2Non-OPEC Production##BR##Will Surge Chart 3Strong Consumption Growth In 2018,##BR##Tempered By Higher Prices In 2019 Given these fundamental inputs, we expect to see Brent averaging $55/bbl next year, and WTI averaging $53/bbl next year. Our forecast is highly uncertain, given the actual evolution of prices will, once again, depend on actions taken by OPEC 2.0 and the forward guidance provided by its leadership, KSA and Russia. Our forecast for 2018 - $67/bbl for Brent and $63/bbl for WTI - remains unchanged. If anything, our unconstrained models (Chart of the Week) have more upside risk than our forecast suggests, largely from falling production and surging demand - not to mention unplanned production outages. Looking to the end of 2019 from today, the backwardation we expect is greater than what is being priced into the Brent and WTI forward curves presently. Growth In U.S. Shales Dominates Non-OPEC Gains We are expecting U.S. crude oil production growth will dominate the increase in non-OPEC output in 2018 and 2019 (Chart 2, top panel). U.S. shale-oil output rises by 970k b/d and another 1.18mm b/d, respectively, this year and in 2019. By our reckoning, this will lift total U.S. crude oil production to 10.22mm b/d this year, a record level of output, and to 11.44mm b/d on average next year. Total U.S. crude and liquids output therefore rises from just under 17mm b/d in 2018 to 18.5mm b/d by the end of 2019. If our estimates are correct, the U.S. will join Russia in producing more than 11mm b/d of crude oil next year, and may even exceed it. Russia is expected to raise production slightly. As one of the putative leaders of OPEC 2.0, we expect Russia to maintain its 300k b/d production cut in 1H18, which will keep its overall liquids production steady at ~ 11.17mm b/d through June. In 2H18, Russia will gradually restore production to an average of 11.24mm b/d, reaching 11.4mm b/d by December. For 2019, we expect total Russian liquids production to average 11.35mm b/d, up ~ 140k b/d yoy. OPEC's return will be led by the Cartel's Gulf producers, which are expected to raise crude production 450k b/d this year and 350k b/d next year (Chart 2, bottom panel). Total production in Gulf OPEC states will reach 25.25mm b/d on average in 2019. This will, of course, be dominated by KSA, which we expect will lift crude production to ~ 10.36mm b/d in 2H18 after holding crude output steady at ~ 10mm b/d in 1H18 over-delivering vs. its quota under the OPEC 2.0 Agreement. For 2019, we expect KSA to maintain production above 10.1mm b/d.2 Non-Gulf OPEC producers, on the other hand, will see their production fall 140k b/d this year, and another 240k b/d next year, leaving it at 7.49mm b/d on average in 2019, in our estimation. The contribution of these states to the OPEC 2.0 production cuts has been "managing" their respective decline curves. It is highly unlikely they will see production surge following the expiration of the OPEC 2.0 agreement at the end of this year. Overall, we expect global crude and liquids production to reach 100mm b/d this year, and 102.2mm b/d next year (Table 1). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Demand Surges This Year, But Slows In 2019 The global economic expansion will lift oil demand above 100mm b/d this year to 100.3mm b/d. This will be led, as always, by non-OECD growth, which we expect to increase 1.24mm b/d this year to 52.8mm b/d (Chart 3, top panel). DM demand - i.e., OECD consumption - will increase 440k b/d this year, to 47.5mm b/d, based on our estimates. Overall global demand rises 1.68mm b/d this year, by our reckoning (Chart 3). We expect tighter financial conditions this year and next will, with the lags typical of monetary policy, slow the rate of growth in oil demand next year. This will be delivered by tightening monetary policy, led by the U.S. Fed, and a mild recession next year, most likely in 2H19. We expect global demand to grow 1.57mm b/d next year, rising to just under 102mm b/d. EM demand will grow 1.21mm b/d, while DM demand will be up 360k b/d next year. Tightening Balances Will Reverse In 2H18 The yeoman effort put forth by OPEC 2.0 in reducing output and draining commercial inventories globally will reach its apotheosis by the end of 1H18 (Charts 4). Thereafter, as production grows and demand begins to slow, our balances indicate inventories will start to grow again (Chart 5). Chart 4Supply-Demand Balances##BR##No Longer Tightening In 2019 ... Chart 5... Leading To##BR##Inventory Accumulation Markets likely will start focusing on the implications of OPEC 2.0 returning production to the market and the surge in shale in 2H18 and during 2019. Non-forecastable events notwithstanding - e.g., a breakdown in Venezuela's production and exports - markets will be looking to OPEC 2.0 leadership for guidance on how the coalition will manage member-state production from 2H18 forward. If the OPEC 2.0 coalition is allowed to dissolve - something we do not expect - and a production free-for-all resumes similar to that of 2015 - 16, another round of supply destruction, brought about by lower prices, likely will ensue. This would greatly restrict E&P and services companies' access to capital, should it occur, and would, once again, imperil the economies of OPEC 2.0. In addition, because such volatility would discourage investment once again, it would set up a powerful price rally in the early 2020s following the attendant collapse in capex and E&P spending, as occurred in the previous down-cycle. We doubt this is the desired outcome of the OPEC 2.0 leadership, particularly KSA, as the Kingdom will be looking to IPO Saudi Aramco later this year to fund its Vision 2030 diversification efforts. We also doubt this is the desired outcome of Russia, given the economic pain it endured in the 2015 - 16 episode. More Frequent OPEC 2.0 Guidance Expected Given these considerations, we expect KSA and Russia to increase the frequency of forward guidance, directing market participants toward a preferred price band. Right now, this looks like a $50 to $60/bbl range - the 2018 forecast given by Russia's Energy Minister Alexander Novak earlier this week.3 It would be incumbent on OPEC 2.0 leadership to guide markets to expect production and inventory responses consistent with such guidance. We think the combination of OPEC 2.0 production restraint and the powerful synchronized global growth already in place puts Energy Minister Novak's guidance out of range for this year, and we are sticking with our forecasts for Brent and WTI. However, beginning in 2H18, a 2019 Brent forecast in Novak's range appears reasonable, based on the fundamentals discussed above. And, our WTI forecast of $53/bbl also is reasonable, given the average marginal cost of producing in the most prolific fields in the U.S. are at or below $50/bbl, according to the Dallas Fed's periodic Energy Survey.4 We believe the massive drawdown in global oil inventories to be the first step in a longer-term strategy by OPEC 2.0 countries. Lower OECD commercial inventory levels will diminish their shock-absorbing capacity, leading to a higher responsiveness of oil prices to supply-demand shocks. This will allow the coalition to exert greater control over oil prices via rapid, flexible storage adjustments and spare capacity management. Therefore, this year's out-of-range prices will be tolerated by Russia and KSA to achieve their optimal level of global inventories. A $50-to-$60/bbl Brent range for OPEC 2.0 would be consistent with a longer-term strategy to maximize the period of time hydrocarbons are the primary transportation fuel in the world. This is the only way to achieve the development goals set out by leaders of various oil-exporting states seeking to diversify the economic underpinnings of these economies. To do so, they have to keep oil-based transportation competitive for decades. Too much volatility - i.e., frequent excursions between very high and very low prices - will severely limit the access to capital these societies need to pull off this diversification. Managing production in a way that limits this volatility and keeps oil competitive in transport markets therefore is critical. Bottom Line: High prices will cause crude oil production to surge this year and next, particularly in the U.S. shales, and demand growth to slow. We expect Brent prices to average $67/bbl this year and $55/bbl next year. WTI prices will average $63/bbl this year and $53/bbl next year. We expect OPEC 2.0 to increase the frequency of its forward guidance - and to follow through on production and inventory adjustment in a manner that supports a desired price range for Brent prices in 2019 and into the 2020s. Right now, that range looks like $50 to $60/bbl. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 OPEC 2.0 is a name we coined to describe the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was formed at the end of 2016 to rein in out-of-control global oil production by cutting production some 1.4 to 1.5mm b/d last year (vs. a target of 1.8mm b/d). The coalition has been remarkably successful in maintaining production discipline in 2017 and extending their deal to the end of 2018 with an option to review quotas in June. We expect OPEC 2.0 to gradually return production taken off the market over the course of 2H18, which will, by next year, most likely reverse the draws seen in global inventories. 2 KSA's production should lift next year as pipeline repairs at its giant Manifa field are completed. Corrosion problems took some 300k of 900k b/d total production offline. In addition, there is another 500k b/d of capacity offline in the Neutral Zone shared with Kuwait. KSA's capacity likely will remain ~ 11.7mm b/d, versus its historical 12.5mm level, but as Energy Intelligence notes, it will have to balance actual production with spare capacity for the next year or so. Please see "A Headache for Aramco," published July 2017 by Energy Intelligence on its website. 3 Please see "CORRECTED-UPDATE 5-Brent oil falls by $1 but demand underpins near $70/barrel," published by uk.reuters.com on January 16, 2018. 4 In its December 2017 Dallas Fed Energy Survey, the Federal Reserve Bank of Dallas reported the WTI price shale operators needed to profitably drill a new well in Texas and Oklahoma averaged $49/bbl (simple, unweighted survey average). The lowest cost was in the Permian Midland formation ($46/bbl) and the highest costs was in so-called Other U.S. (shale) at $55/bbl. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Special Report

Highlights We are upgrading our allocation to Indian stocks from neutral to overweight within EM equity portfolios. India's public banks are much further along in their necessary adjustment process, and the credit cycle downturn is much more advanced relative to China's. To capitalize on this theme, we recommend going long Indian banks and shorting Chinese bank stocks. India's public bank recapitalization program will allow them to slowly augment credit origination, assisting the economic recovery. Feature Chart I-1Favor Indian Banks Versus Chinese Ones Our report this week highlights the results from stress tests we conducted on Indian and Chinese public banks, and also compares their respective equity valuations. Based on our findings, we are initiating a new relative equity trade: long Indian / short Chinese bank stocks (Chart I-1). The health of the banking system, the credit cycle outlook as well as the performance of bank share prices hold the key to relative performance of any bourse in the EM universe. Provided our positive bias toward Indian banks relative to their EM peers on all the above parameters, we are upgrading our allocation to India from neutral to overweight within EM equity portfolios. Indian Versus Chinese Public Banks From 2003 to 2012, India went through a large credit binge and capital misallocation cycle in its industrial and infrastructure sectors. During this period, banks' loans to companies and bank assets rose from 12% to 23% and 63% to 85% of GDP, respectively (Chart I-2A). By comparison, Chinese (ex-policy) commercial banks' claims on companies and their total assets have surged from 85% to 110% and from under 180% to 230% of GDP, respectively, since 2009 (Chart I-2B). In both countries, the banking sector remains dominated by public banks that hold more than 50% of banking system assets. Chart I-2ACredit Boom In Perspective: India Chart I-2BCredit Boom In Perspective: China Today, Indian public banks - who were the main lenders to industrial companies during the corporate credit binge in the 2003-12 period - have been experiencing mushrooming bad loans. Total public banks' NPLs and distressed asset ratios have reached 13.5% and 2.7% of total loans, respectively (Chart I-3). By contrast, for all Chinese banks, the current NPL ratio is at a mere 1.7%, while the distressed loan ratio stands at only 3.6% of total loans. Chart I-3NPL Ratios In Perspective: India & China Further, under pressure from the central bank, Indian public banks have been raising provisioning levels for bad assets very aggressively. On the flip side, Chinese regulators have been following tolerant policies toward their own commercial banks. As such, the provisions-to-loans ratio at all public banks now stands at 3% in China, compared with 5.6% in India. In addition, Chinese banks have bought a lot of corporate bonds that are not provisioned for at all. Does this higher NPL ratio in India relative to China mean that credit allocation is much worse in India? Not quite. The thesis that Indian public banks are more poorly managed than Chinese public banks is not accurate. These banks are managed by public sector executives who often allocate credit to support government growth policies. This is why it is reasonable to assume that the quality of credit allocation among Chinese and Indian public banks is probably similar. As such, we presume that Chinese banks' current NPL ratio is severely understated, and has the potential to rise to levels currently being reported by Indian public banks. The basis is that the Chinese credit boom has dramatically exceeded that of India (see Chart I-2A and I-2B on page 2). Typically, the resulting NPL ratio is proportional to the magnitude of the preceding credit frenzy. Finally, India's central government announced a major recapitalization plan in October 2017 to assist the country's public banks in cleaning up their balance sheets and to also support them in expanding credit. It is likely, therefore, that these banks are now approaching the final stages of their balance sheet repair and deleveraging process. Bottom Line: India's public banks are much further along in their necessary adjustment, and their credit cycle downturn is also much more advanced relative to Chinese banks. The latter have been postponing the inevitable balance sheet clean-up process. To capitalize on this theme, we recommend going long Indian banks and shorting Chinese bank stocks. Banking Stress Test For India And China We have conducted stress tests for India's top seven and China's top five listed public banks. We used the following assumptions for the three scenarios we considered: Non-performing risk-weighted assets (NPA) ratios to rise to 14% (pessimistic), 12% (baseline) and 10% (optimistic scenario) of risk-weighted assets for both Indian and Chinese public banks. Risk-weighted assets adjust banks' various types of assets based on their degree of riskiness. In that way, the risk-weighted asset values are comparable between the two banking systems. We assume a 30% recovery rate in all three NPA scenarios for both countries. The recovery rate on Chinese banks' NPAs in the 2001-2005 period was 20% amid a booming economy. The assumed recovery rate of 30% is therefore not low. The outcome of the stress tests is as follows: In the baseline scenario of 12% NPA, the losses post recovery and provisions would amount to 1.3 trillion rupees in India (0.9% of GDP) and RMB 3.4 trillion in China (4.2% of GDP). This would translate into a 33% equity impairment for India's seven public banks, and 48% for China's five public banks (Table I-1 and I-2, column 7). Table I-1Stress Test For Top 7 Indian Public Banks Table I-2Stress Test For Top 5 Chinese Public Banks From a valuation standpoint, the post-impairment price-to-book value (PBV) ratio would jump to 1.44 and 1.62 for Indian- and Chinese-listed public banks, respectively. Assuming a fair PBV ratio of 1.3 - which is the average PBV ratio for all EM banks since 2011 - Indian public banks are 11% overvalued and Chinese ones are about 25% overvalued. In other words, if one were to calculate the true PBV ratio of these banks after a comprehensive "clean-up" has been done, then Indian public bank stocks would be cheaper than Chinese ones. It is important to note that the above valuation exercise does not take into consideration banks' future profits. As such, we account for their recurring profits in the following manner: Table I-3 calculates the ratio of NPA losses to banks' recurring net profits before provisioning. Losses are the amount to be written-off post provisioning and recovery. In the baseline scenario of a 12% of NPA, this ratio is 2.5 for India and 3.4 for China. In other words, it will take 2.5 and 3.4 years of net profits before provisions close the "black hole" of NPA losses (post provisions and recovery) in India and China, respectively. Hence, on this measure as well, India's listed public banks appear more appealing than those in China. Table I-3Profit Coverage Of Loan Losses There is a caveat regarding Chinese banks' stress and their post-impairment book value. Our analysis is performed based on risk-weighted assets, and does not include off-balance-sheet assets. Therefore, any losses from off-balance-sheet assets will make losses for Chinese public banks greater than our analysis captures. Further, the Chinese financial authorities are currently tightening regulations, which will likely curtail banks' off-balance-sheet activities and by extension their profitability. These risks are not present in India, where banks have less off-balance-sheet assets. Bottom Line: Public bank stocks are currently overvalued by about 11% and 25% in absolute terms in both India and China, respectively. This favors Indian bank share prices outperforming their Chinese peers. The fact that the "clean-up" has not yet begun in China reinforces this trade. Banks' Recapitalization In India Saddled with NPLs, Indian public banks have not been willing to lend in recent years. Chart I-4 demonstrates that their loan growth has stalled. Credit to large industrial companies has in particular suffered (Chart I-4, bottom panel), as most of this type of credit is typically extended by public banks. Chart I-4India: Public Bank Loan Growth Has Slumped Consequently, India's capital expenditures have languished in recent years, weighing not only on cyclical growth but also depressing long-term productivity and potential growth. In October, the Indian government announced an estimated 2.11 trillion rupees public bank recapitalization program that will be implemented over the next two years. The program is for all public banks, while the above stress test was performed for only the top seven listed public banks. The latter account for around 60% of all public banks' assets, so we assume they will get around 60% of the stated recapitalization amount. The recapitalization program is designed as follows: The central government plans to inject 180 billion rupees of equity capital into all public banks via budgetary allocations. The public banks will in turn raise 580 billion rupees from the market. The remaining 1,350 billion rupees will come from government-issued Bank Recapitalization Bonds. The government will issue bonds to banks and then use the funds to buy more shares from public banks. It is important to note that in the stress test above and for the calculation of post-impairment PBV ratios, we assume the government will not subsidize existing shareholders when it injects money into public banks. This means the government will provide equity capital to public banks at post-impairment equity value - i.e., at a fair market price. It will be difficult for the Indian government to bail out its public banks without making current shareholders bear losses. If the government bails out public banks' private and foreign shareholders, the opposition parties will use the bank recapitalization program against Prime Minister Narendra Modi's government in the general elections scheduled to be held in 2019. Many investors and commentators assume that India's bank recapitalization program is automatically bullish for bank share prices. While it is positive for banks' ability to lend and drive growth in the medium and long term, the program is not necessarily bullish for share prices, particularly at their current high levels. The same is true for potential recapitalization programs in China. Overall, odds are that current shareholders of public banks will likely shoulder meaningful losses in India and possibly in China as well. How well off will capitalized public banks in India be after implementation of the recapitalization program? In the case of the seven Indian public banks we performed the stress test on, Table I-4 estimates that post-impairment and recovery, the total equity capital-to-risk-weighted assets ratio will be 8% in our baseline scenario. This is lower than the regulatory minimum of 9%. Table I-4Capital Ratios For India's Top 7 Public Banks The recapitalization will bring this equity capital adequacy ratio to 11.3%, which exceeds the regulatory minimum of 9%. Hence, after the program is completed, Indian public banks will likely become well capitalized and will be able to resume their lending and expand their assets. This in turn will facilitate the economic recovery. Bottom Line: The Indian government's recapitalization program is sufficient to raise public banks' capital adequacy ratio above the regulatory minimum. This will allow public banks to resume their lending. India's Cyclical Growth Outlook India's cyclical outlook will be one of muted recovery. Yet it is superior to other EMs, where we expect meaningful deceleration due to a potential slowdown in China and a rollover in commodities prices. Public banks' recap program will be slow in India - to be conducted over the next two years - and banks' ability to boost lending will improve only gradually. Meanwhile, private banks have and will probably continue to concentrate their lending efforts on consumers rather than on industrial companies and infrastructure. In the next 12-18 months, a slow improvement in public banks' ability to originate credit will allow only moderate improvement in capital spending growth. The latter is required to resolve bottlenecks and unleash the nation's productivity potential. Several indicators of capital spending are lukewarm (Chart I-5, top panel). However, new capex project announcements and the number of investment proposals have been dropping (Chart I-5, middle panel). Surprisingly, companies' foreign external borrowing is still contracting, despite booming capital inflows into EM (Chart I-5, bottom panel). On the consumer side, the outlook remains bright. Motorcycle sales have recovered sharply and commercial vehicle sales are beginning to pick up (Chart I-6). Chart I-5India's Capital Spending Is Sluggish Chart I-6Indian Consumer Health Is Strong Consumer/personal loans are accelerating from an already strong growth rate, largely thanks to the aggressiveness of private sector banks (Chart I-6, bottom panel). In turn, the employment outlook is finally beginning to show signs of improvement (Chart I-7). The manufacturing PMI has also risen substantially, and is currently in expansion territory (Chart I-8). Likewise, the service sector PMI has bounced above 50. Chart I-7India's Employment Is Turning The Corner Chart I-8India: PMIs Are Positive Finally, India is less exposed to China's growth and a retracement in commodities prices than many other emerging economies. This makes us upbeat on India's cyclical economic dynamics and relative equity and currency performance versus other EMs. Bottom Line: India's cyclical outlook is better than that of many other EMs. Structural Tailwinds And Impediments India holds huge promise for investors as it is a much-underinvested economy, and potential return on capital is considerably higher in those countries than in relatively overinvested ones. In addition, its population and labor force growth are among the highest in mainstream developing countries. On the other hand, for such potential to be realized, the country needs to be able to boost its productivity. On this count, the outlook is less positive. India's share of global goods and services exports has declined substantially since 2011 (Chart I-9). This should not be surprising, given weak investment spending has led to stagnation in trade competitiveness. Chart I-10 reveals that based on the UNCTAD1 dataset, India has been losing market share in both low- and high-skilled labor sectors export markets worldwide. Chart I-9India's Share In Global Trade Chart I-10India Has Been Losing Export Market Share While certain reforms such as the introduction of a sales tax will have a positive impact on the economy, other much-needed changes, such as land and labor market reforms, have so far remained unattainable. Moreover, the agriculture sector still faces material challenges. Without these vital reforms, it will be difficult to boost efficiency and productivity and build global competitiveness. Finally, in terms of education enrollment, India lags other EMs, especially China, in tertiary education (Chart I-11). This makes it even more difficult to boost productivity and growth potential. Bottom Line: India has great secular potential, but the structural advance has stalled since 2011. The jury is still out on whether it can implement additional reforms to realize this potential. Investment Conclusions India's banking sector outlook is brighter, and the deleveraging cycle is much more advanced, compared with many other EMs in general and China in particular. Therefore, we recommend a new relative equity trade: long Indian banks / short Chinese banks. Investors could buy Indian public banks or all banks with the understanding that private banks are typically in better shape than their state-owned peers, but are also much more expensive. We will be tracking this trade's performance using the Bankex index for India and the MSCI bank index for China. The Bankex index has a larger share of market cap of public banks than the MSCI India bank index. Within China, we are maintaining our short small and medium / long large banks position initiated on October 26th 2016. We are also recommending EM equity investors upgrade the Indian bourse from neutral to overweight. We shifted Indian stocks from overweight to neutral on August 23rd 2017, but the risk-reward has improved since then (Chart I-12). Chart I-11India's Education Improvement Is Lagging Chart I-12Upgrade Indian Bourse Within EM Universe Our primary concerns with EM stocks are a China slowdown, a rollover in commodities prices and a rebound in the U.S. dollar. Associated strains in countries with large foreign debt levels or wide current account deficits as well as lack of credit deleveraging and bank recapitalization will define EM financial markets' performance in the next 12-18 months. On all of these counts, India scores better than many EMs, justifying this equity upgrade. The absolute outlook for Indian stocks, however, is not inspiring. This equity market is rather expensive and overbought in absolute terms. If EM risk assets experience a setback in 2018, as we expect, Indian equities will also relapse in absolute terms. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com   1 United Nations Conference on Trade and Development.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Equities have melted up in recent weeks, celebrating the tax bill passage, synchronized upswing in global economic data, still quiescent inflation and near vanishing tail risk. On July 10th when we penned the "SPX 3,000?" report, the S&P 500 was close to 2400.1 Over the past six months stocks have been in an uninterrupted upleg, moving to within 10% of our SPX 3,000 target. Table 1 Stocks have run "too far too fast" for our liking and there are increasing odds of a healthy pullback, especially now that no pundits are talking of a correction. In addition, were the selloff in the bond markets to accelerate in a short time frame, at some point it will cause equity market consternation. But, bonds still remain extremely overvalued versus stocks (Chart 1). Late last year, we began to modestly de-risk the portfolio via booking impressive gains in tactical market-neutral trades, as our upbeat cyclical view remains intact.2 Our cyclical strategy is to "buy the dip", as we do not foresee a recession in the coming 9-12 months. Importantly, profits will dictate the S&P 500's direction and the cyclical path of least resistance is higher still. Our SPX profit model continues to forecast healthy EPS growth in 2018 (Chart 2) and as we posited in the last report of 2017, earnings will do the heavy lifting at the current juncture with the forward P/E multiple likely moving laterally (Chart 3). Chart 1Simple Bond Valuation Metric Says:##br## Bonds Are Overvalued Vs. Stocks Chart 2All ##br##Clear Chart 3EPS Will Do The##br## Heavy Lifting In 2018 A simple decomposition shows that equity returns could reasonably reach a low-to-mid double digit level this year. Our assumptions are the following: nominal GDP can grow near 5% (3% real plus 2% inflation) and thus we estimate organic EPS growth that typically mimics GDP at this stage of the cycle of ~5%, ~2% dividend yield, ~2% buyback yield, ~5% tax related boost to EPS and no multiple expansion. The above assumptions are based on four key drivers: energy and financials will command a larger slice of the earnings pie,3 synchronized global capex upcycle will boost EPS,4 delayed positive translation effects from the U.S. dollar will lift profits5 and easy fiscal policy will also act as a tonic to EPS.6 On this note, this White Paper officially introduces the U.S. Equity Strategy earnings models for the eleven GICS1 equity sectors. We have identified key macro earnings drivers for each sector and incorporated them into individual sector models. The objective is to forecast the direction of earnings growth. Beyond introducing our EPS models, the purpose of this White Paper is to also compare and contrast the cyclical readings of our equity sector models with sell-side analysts' profit growth (Charts 4 & 5) and margin expectations and help clients position portfolios for the rest of 2018. The earnings models carry the most weight in determining our sector positioning, with our macro overlay and our valuation and technical indicators rounding out our methodology. Currently, our earnings models are consistent with maintaining a mostly cyclically biased portfolio structure (top panel, Chart 6), and thus participating in the broad market's overshoot. Chart 4What EPS Are Priced In... Chart 5...Per Sector For 2018 Chart 6Continue To Prefer Cyclicals Over Defensives Encouragingly, an equal weight of the 10 GICS1 sector model outputs (we are excluding real estate due to lack of history), accurately forecasts the S&P 500's profit growth (bottom panel, Chart 6), and currently also confirms the broad market's upbeat four factor macro EPS model (Chart 2). Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Financials (Overweight) Our financials earnings growth model comprises bank credit growth, the U.S. dollar index and net earnings revisions. The U.S. credit impulse is gaining traction, indicating that the market has digested the almost doubling in long-term rates over the past 18 months. Bankers are willing extenders of C&I credit and, with the economy humming north of 3% in real GDP terms, the outlook for loan growth is excellent. Loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities are all welcome news for financials profitability. Tack on BCA's higher interest rate view in 2018 and net interest margins will also get a bump, further adding to the sector's EPS euphoria. Credit quality is the third key profit driver for bank profitability and pristine credit quality is a harbinger of increased profits. The unemployment rate is plumbing generational lows and suggests that non-performing loans as a percentage of total loans will remain on a downward trajectory. Our profit model is expanding at twice the current profit growth rate (second panel, Chart 7) and 10 percentage points above the Street's 12-month forward estimates (top panel, Chart 5). In fact, the latter have gone vertical of late playing catch up to our model's estimates. The S&P financials sector remains a core portfolio overweight and we reiterate our high-conviction overweight status in the heavyweight S&P banks index. Chart 7Financials (Overweight) Energy (Overweight) The three drivers behind the S&P energy sector EPS growth model are oil-related currencies, the U.S. oil & gas rig count and WTI crude oil prices. A depreciating greenback, whittling down OECD oil stocks and rising global oil demand are all boosting energy profitability. OPEC 2.0 cutbacks have not only helped stabilize oil markets, but also paved the way for a breakout in oil prices above the $62.50/bbl stiff resistance level. Sustained OPEC output restraint will counterbalance U.S. shale oil production increases and coupled with rising global demand likely continue to underpin oil prices. Our synchronized global capex upcycle theme included the basic resources following a multi-year drubbing in outlays. Energy capex cannot contract at double digit rates indefinitely. Already a V-shaped capex momentum recovery is in store, as 2018 capital spending budgets are on track to at least match 2017. Our EPS growth model (second panel, Chart 8) matches sell-side analyst optimism (third panel, Chart 5). Keep in mind that only recently did the energy space become profit positive, making a solid recovery from an extremely low base. Margins are only now renormalizing above the zero line and breakneck pace EPS growth should continue in 2018. Following a negative 2017 return, the S&P energy sector is the best performing sector year-to-date, and we reiterate the high-conviction overweight stance. Chart 8Energy (Overweight) Industrials (Overweight) Our S&P industrials EPS model comprises the ISM manufacturing survey, raw industrials commodity prices and interest rates. It has an excellent track record in forecasting industrials EPS momentum, and sports one of the highest explanatory powers amongst all sector EPS models. While industrials EPS growth has been bouncing off the zero line for the better part of the past five years, our profit model has spoken: forecast EPS are in a V-shaped recovery since the end of the recent manufacturing recession (second panel, Chart 9). Commodity prices are recovering and increasing final demand, coupled with a soft U.S. dollar suggest that more gains are in store. Tack on the global virtuous capex upcycle, and the stars are aligned for this deep cyclical sector to break out of its multi-year trading range funk on the back of a surge in profits. China is a wild card, but signs of stability are enough to sustain the upward trajectory in the commodity-levered complex, including industrials stocks. Our industrials sector EPS model suggests that industrials profits will easily surpass the low (and below the overall market) analysts' EPS growth hurdle (third panel, Chart 4). The late-cyclical S&P industrials sector remains an overweight. Chart 9Industrials (Overweight) Consumer Staples (Overweight) The S&P consumer staples EPS growth model key drivers are: food exports, non-discretionary retail sales and analysts' net earnings revision ratio. Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (middle panel, Chart 10). Our model is expanding at a near double digit rate, and is in line with 12-month forward EPS growth estimates (second panel, Chart 4). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put out positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. This small hedge will serve our portfolio well if we do indeed get a healthy Q1/2018 pullback, as we expect. Chart 10Consumer Staples (Overweight) Consumer Discretionary (Neutral - Downgrade Alert) Measures of consumer confidence, consumer discretionary exports and the net earnings revisions ratio comprise BCA's global consumer discretionary EPS growth model, which has an excellent track record in forecasting the path of consumer discretionary profits. Consumer confidence is rolling over, albeit from a nose-bleed level, signaling that, at the margin, discretionary consumer outlays will remain tame. Worrisomely, rising interest rates coupled with a breakout in crude oil prices are net negatives for consumer spending. Our consumer drag indicator captures these consumer headwinds and warns that the sector is not out of the woods yet (bottom panel, Chart 11). The Fed is on track to raise rate three more times in 2018 and continue to mop up liquidity via renormalizing its balance sheet. This dual tightening backdrop bodes ill for early cyclical discretionary stocks as we highlighted in the September 25th Weekly Report. Our consumer discretionary EPS growth model is making an effort to bounce, signaling that contracting earnings will likely reverse course and come out of their recent funk (second panel). But, analysts are overly optimistic penciling in a near double-digit profit growth backdrop for the consumer discretionary sector (fourth panel, Chart 5). Netting it all out, the anemic message from our profit model along with the ongoing Fed tightening cycle and spiking energy prices warrant a downgrade alert. Stay tuned. Chart 11Consumer Discretionary (Neutral-Downgrade Alert) Telecom Services (Neutral) Telecom pricing power and capital expenditures expectations comprise our S&P telecom services EPS growth model. Telecom capital expenditures have bounced off the zero line and are growing at 4% per annum while sector sales growth has been nil. This capital-intensive industry must continually invest to stay relevant. A push by telecom carriers into TV offerings as part of a quad-play (internet, wireline, wireless and TV) has rekindled an M&A boom, and capex is slated to increase. However, margins will suffer if increased investment fails to translate into new sales (bottom panel, Chart 12). Steeply contracting pricing power is a bad omen both for top and bottom line growth prospects (fourth panel). Hopefully, industry consolidation will lead to a better pricing backdrop, but the jury is still out. Our EPS model has sunk into the contraction zone (second panel). Analysts are a little bit more sanguine, penciling in low single-digit profit growth (bottom panel, Chart 4). Industry deflation is not alone as a headwind as the bond market selloff is weighing on the high dividend yielding telecom services stocks. Despite all the bearish news, near all-time lows in relative valuation and washed out technicals are keeping us on the sidelines. Chart 12Telecom Services (Neutral) Materials (Neutral) Materials EPS growth is a far cry from the near 100% year-over-year mark hit during the commodity super-cycle the mid-2000s and the reflex rebound following the Great Recession (second panel, Chart 13). Our S&P materials EPS model inputs include the U.S. currency, metals commodity prices and a measure of borrowing costs. The model has been steadily decelerating recently, and moving in the opposite direction compared with sell-side analysts' optimistic estimates (bottom panel, Chart 5). Consequently, there is scope for downward revisions. Materials stocks are reflationary beneficiaries and also high fixed cost high operating leverage deep cyclicals that benefit most during the later stages of the business cycle when a virtuous capex/EPS upcycle takes root. A number of both developed and developing central banks have recently embarked on tightening monetary policy following in the Fed's footsteps. Global liquidity is on the verge of getting mopped up as even the ECB and the BoJ have started to hint that they would remove some of their ultra-accommodative and unconventional policy measures. These opposing forces keep us at bay and we continue to recommend a benchmark allocation in the S&P materials index. Chart 13Materials (Neutral) Real Estate (Neutral) Commercial real estate loan demand, a labor market measure and the EUR/USD comprise our S&P real estate profit growth model (second panel, Chart 14). The 10-year Treasury yield and real estate relative performance have been nearly perfectly inversely correlated since the GFC as REITs sport a hefty dividend yield and thus are considered a fixed income proxy. BCA's higher interest rate 2018 theme suggests that more downside looms for this rate-sensitive sector. Similarly, a firming EUR/USD reflecting the nearly 100% domestic exposure of the sector weighs on real estate relative performance. Our EPS model has recently sunk into the contraction zone and is in sync with sell-side analysts' negative profit growth figures for calendar 2018 (second panel, Chart 5). While all this signals that an underweight stance is appropriate, we would rather stay on the sidelines for three reasons: First, sector pricing power (mostly rents) has not eroded yet, despite the surge in multi-family housing construction. Second, most of the bad news is likely already discounted in sinking valuations and extremely oversold technicals. Finally, we would rather concentrate our interest rate related underweight in the pure play fixed income proxy, the utilities sector (please see page 15). Stick with a benchmark allocation in the S&P real estate index. Chart 14Real Estate (Neutral) Health Care (Underweight) Our S&P health care EPS growth model consists of health care pricing power, labor costs and a measure of health care outlays. Health care demand is fairly inelastic, signaling that health care spending prospects remain upbeat, especially given the aging population. However, the industry's up-to-recently structurally robust pricing power backdrop is under intense scrutiny. Medical commodity cost inflation is melting and drug pricing power has nearly halved since early 2016. Democrats and Republicans alike, despise the pharmaceutical/biotech industry's pricing tactics and drug price containment is on nearly every legislator's agenda. Add on the generic drug inroads, and Big Pharma/biotech resilient profits appear vulnerable, weighing heavily on the sector's relative performance. From a secular perspective, there is scope for health care sector profit gains. Developing countries are only just starting to institute social "safety nets" that the developed world already has in place. Our profit model is decelerating (second panel, Chart 15) and forecasting single digit EPS growth, in line with the Street's 12-month forward profit estimates (fourth panel, Chart 4). The S&P health care sector is a core underweight portfolio holding and we reiterate the high-conviction underweight status in the heavy weight S&P pharma sub index. Chart 15Health Care (Underweight) Utilities (Underweight) Utilities pricing power, the yield curve and analysts' net earnings revisions are the key inputs in our S&P utilities EPS growth model (second panel, Chart 16). While natgas prices, the industry's marginal price setter, have been stuck in a trading range between $2.6 and $3.4/mmbtu over the past 18 months, they are currently contracting and weighing heavily on industry pricing power. The U.S. economy is firing on all cylinders (bottom panel, Chart 16) and a selloff in the 10-year Treasury market near 3% is BCA's base-case scenario for 2018. Under such a backdrop, fixed income proxied defensive equities lose their luster, and thus utilities stocks will likely remain under intense downward pressure, Our S&P utilities EPS growth model is expanding at a mid-single digit growth rate, broadly in line with sell-side analysts' forecasts (fifth panel, Chart 4) and roughly 700bps below the broad market. The S&P utilities sector is a high-conviction underweight. Chart 16Utilities (Underweight) Technology (Underweight - Upgrade Alert) Our three-factor global technology EPS growth model includes capex intentions, the trade-weighted U.S. dollar and sell-side analysts' net earnings revision ratio. While the tech sector is still largely considered a deep cyclical, we view it as more defensive. The majority of large capitalization tech companies are mature, cash rich, cash flow generating, dividend paying and high margin. Tech firms thrive in a deflationary backdrop as business models have been built to withstand the inherently disinflationary "creative destruction" process. BCA's interest rate view calls for an inflationary driven sell off in bonds for 2018, suggesting that investors avoid high-flying tech stocks. Weakness in basic resources explains most of the delta in cyclical capital outlays. Encouragingly, technology's share of the U.S. capex pie is making inroads rising to roughly 10% (bottom panel, Chart 17). Tech investment has been so abysmal for so long that it is hard to get any worse. In fact, it has started to improve both on an absolute and relative basis, as pent-up tech demand is being unleashed. Our synchronized global capex upcycle theme is gaining traction and the tech sector will continue to make gains at the expense of resource-related spending. Our global tech EPS model is forecasting modest double-digit growth in the coming quarters (second panel, Chart 17), largely aligned with sell-side analysts' profit growth expectations (fifth panel, Chart 5). On balance, we are putting the S&P tech sector on upgrade alert reflecting the capex tailwind offsetting the rising interest rate backdrop, and reiterate our capex-related high-conviction overweight in the S&P software sub-index. Chart 17Technology (Underweight-Upgrade Alert) 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And "Nothing Else Matters"," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Dissecting Profit Composition," dated July 24, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Dollar The Great Reflator," dated September 18, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?," dated October 9, 2017, available at uses.bcaresearch.com.