Financial Markets

Highlights Monetary Policy: A prominent Fed Governor has acknowledged that inflation expectations have become un-anchored to the downside. This is an important signal and suggests that the Fed will keep policy easy enough for inflation expectations to recover. TIPS: The combination of a Fed that communicates a desire for higher inflation expectations and an end to the current downtrend in realized core inflation will send TIPS breakevens wider. Yield Curve: Higher inflation expectations will cause the yield curve to steepen on a 6-12 month horizon. Although steepener trades no longer appear cheap on our model, we remain overweight the 5-year bullet versus a duration-matched 2/10 barbell. Feature Chart 1Flight To Safety Focused In Real Yields Bond markets digested two important events last week. The first was a politically driven flight to safety. The 10-year yield fell 10 bps (Chart 1) and the average junk spread widened 8 bps as the daily U.S. Policy Uncertainty index1 averaged 121 for the week, its second-highest reading since February. As we have noted in past reports,2 historically the best strategy has been to fade politically driven flights to safety. The second, and more significant, event was a speech3 given by Fed Governor Lael Brainard in which she suggested that inflation expectations have become un-anchored to the downside. As is explained below, this acknowledgement represents an important change in tone from the Fed. One that reinforces our outlook for higher Treasury yields, a steeper yield curve and wider TIPS breakevens on a 6-12 month horizon. You Had One Job The key passage from Governor Brainard's speech is the following: Nonetheless, a variety of measures suggest underlying trend inflation may be lower than it was before the crisis, contributing to the ongoing shortfall of inflation from our objective. To understand the significance of this statement we need some background on how the Fed thinks about inflation. FOMC members tend to apply an expectations-augmented Phillips curve framework to the task of forecasting inflation (Chart 2). Fed Chair Janet Yellen explained this approach in a September 2015 speech.4 In Yellen's words: ...economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from a longer-term trend that is ultimately determined by long-run inflation expectations. [...] An important feature of this model of inflation dynamics is that the overall effect that variations in resource utilization, import prices, and other factors will have on inflation depends crucially on whether these influences also affect long-run inflation expectations. In other words, the Fed's model distinguishes between core inflation's long-run trend and its cyclical fluctuations. Cyclical fluctuations are driven by: Resource utilization (usually measured as the unemployment rate minus its estimated natural rate) Non-oil import prices Idiosyncratic shocks In contrast, core inflation's long-run trend is purely a function of long-term inflation expectations. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, then inflation's long-run trend would be altered and monetary policy would become less effective. In a sense, the worst possible outcome would be if inflation expectations became un-anchored to the downside. Once again, in Janet Yellen's own words: Anchored inflation expectations were not won easily or quickly: Experience suggests that it takes many years of carefully conducted monetary policy to alter what households and firms perceive to be inflation's "normal" behavior, and, furthermore, that a persistent failure to keep inflation under control - by letting it drift either too high or too low for too long - could cause expectations to once again become unmoored. This describes precisely the conventional wisdom as to why the Japanese economy has experienced two decades of deflation despite reasonably high levels of resource utilization. Policymakers did not act quickly or strongly enough following the burst stock market bubble of 1989-91, and this allowed deflationary expectations to become entrenched. In this sense the Japanese experience provides a roadmap for what could happen in the U.S. if the Fed doesn't act quickly to bring inflation expectations back up to target levels. It is true that not all measures of U.S. inflation expectations currently display weakness. For example, the measure we used in our expectations-augmented Phillips curve in Chart 2 - median 10-year PCE expectations from the Survey of Professional Forecasters - appears stable in recent years. However, Governor Brainard pointed to several measures that suggest inflation expectations have already declined (Chart 3). Chart 2The Fed's Inflation Model Chart 3Still Well Anchored? Comparing the three-year period ending in the second quarter of this year with the three-year period ended just before the financial crisis, 10-year-ahead inflation compensation based on TIPS [...] yields is ¾ percentage point lower. Survey-based measures of inflation expectations are also lower. The Michigan survey measure of median household expectations of inflation over the next five to 10 years suggests a ¼ percentage point downward shift over the most recent three-year period compared with the pre-crisis years, similar to the five-year, five-year forward forecast for the consumer price index from the Survey of Professional Forecasters.5 Investment Implications In our view, there are two important facts to keep in mind: In the Fed's model of inflation it is crucial that long-term inflation expectations do not fall. Otherwise, the odds of replicating the Japanese scenario start to increase. A prominent Fed Governor has now suggested that U.S. inflation expectations have become un-anchored to the downside. Chart 4The Market's Rate Hike Expectations Taken together, these two facts have important investment implications. First, the two facts suggest that TIPS breakevens will move wider. While the Japanese experience has taught us that "open mouth operations" become less effective once deflationary expectations are entrenched, they should still have some impact in the States. Notice that the decline in Treasury yields that followed Brainard's comments last week was concentrated in the real component. The 10-year TIPS breakeven inflation rate actually rose 2 bps (Chart 1). The combination of a Fed that communicates a desire for higher inflation expectations and an end to the current downtrend in realized core inflation (see "Economy & Inflation" section below) will be enough to send long-dated TIPS breakevens wider on a 6-12 month horizon. Second, a Fed that is committed to staying accommodative for as long as is necessary to ensure that inflation expectations move higher will cause the yield curve to steepen (see section titled "Inflation Expectations Drive The Curve" below). Third, a Fed that is more committed to fighting deflation should bias Treasury yields lower. However, inflationary pressures in the U.S. economy are strong enough that the Fed will be able to move inflation expectations higher while still delivering more rate hikes than are currently priced into the curve. At present, the overnight index swap curve is discounting that the next 25 basis point rate hike will not occur until November 2018 (Chart 4)! Bottom Line: A prominent Fed Governor has acknowledged that inflation expectations have become un-anchored to the downside. This represents an important signal about the future path of policy and reinforces our view that the Treasury curve will bear-steepen during the next 6-12 months, led by wider TIPS breakevens. Inflation Expectations Drive The Curve Our research6 shows that inflation expectations are the most important driver of changes in the slope of the yield curve. This runs counter to the conventional wisdom which states that the curve flattens when the Fed hikes rates, and steepens when it cuts rates. While the correlation between Fed rate moves and the slope of the curve is undeniable, the relationship results purely from the fact that the Fed responds to changes in inflation. The link between inflation expectations and the yield curve is the dominant relationship. To see this we look at Charts 5 and 6. Both charts show monthly changes in the 5-year, 5-year forward TIPS breakeven inflation rate plotted against monthly changes in the nominal 2/10 slope. Chart 5 shows all available historical data, and we observe a strong positive correlation. In fact, 63% of monthly observations fall into either the top-right or bottom-left quadrants indicating that wider breakevens correlate with a steeper curve and vice-versa. Chart 52/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year / ##br##5-Year Forward (February 1999-Present) Chart 62/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year / 5-Year Forward ##br##During Fed Tightening Cycles (June 1999 To May 2000 & June 2004 To June 2006) The more important question, however, is whether this correlation still holds when the Fed is raising rates. Chart 6 focuses only on prior rate hike cycles and still shows a strong positive correlation. 73% of the monthly observations fall into either the top-right or bottom-left quadrants, although in this case there are more observations in the bottom-left quadrant because typically the Fed lifts rates with the goal of sending inflation and inflation expectations lower. In this respect the current rate hike cycle is unique. The Fed is in the process of lifting rates, but as Brainard's speech shows, it still critically needs inflation expectations to rise. We conclude that the Fed will stay easy enough, long enough, for long-dated TIPS breakevens to return to their pre-crisis trading range between 2.4% and 2.5%. An upward adjustment to this range will occur alongside a steeper 2/10 curve. Unit Labor Costs And The Yield Curve The logic presented above also suggests an inverse relationship between the slope of the curve and wage growth. In a world where inflation expectations are well anchored, stronger wage growth encourages the Fed to tighten policy more quickly, this causes the yield curve to flatten. Conversely, softer wage growth leads to a steeper curve. Our research shows that unit labor costs are the measure of wage growth that correlates most closely with the slope of the curve. The reason is that unit labor costs actually measure both wage growth (compensation per hour) and labor productivity (output per hour). Put differently, the yield curve can flatten because labor compensation is rising and the Fed is tightening policy (bear flattening) or it can flatten because productivity is falling and investors are discounting a slower pace of potential growth and a lower terminal fed funds rate (bull flattening). Unit labor costs capture both of these dynamics. Last week saw second quarter productivity growth revised higher from 0.9% to 1.5% and unit labor cost growth revised down from 0.6% to 0.2% (Chart 7). We expect that productivity will continue to experience a modest late-cycle bounce. Usually, payroll growth starts to moderate late in the business cycle as the labor market tightens. The cost of labor typically rises and encourages firms to substitute capital for workers. This late-cycle boost in capital spending tends to correlate with stronger productivity growth (Chart 8), and this dynamic looks to be in full swing at the moment. Payroll growth has been decelerating since early 2015, and durable goods orders have picked up sharply since the end of last year (Chart 8, bottom panel). Chart 7Weakness In Unit Labor Costs Chart 8Productivity: Look For A Late-Cycle Rebound A modest late-cycle upswing in productivity growth will put downward pressure on unit labor costs and lead to curve steepening. How To Position For Steepening We have been expressing our yield curve view via a long position in the 5-year bullet and a short position in a duration-matched 2/10 barbell since last December.7 So far that trade has returned +28 bps, even though the 2/10 slope has flattened more than 50 bps since its inception. The reason our curve steepener has outperformed even as the curve has flattened is that, when we initiated our trade, the 2/5/10 butterfly spread was discounting an even larger curve flattening. Put differently, the 5-year bullet looked extremely cheap on the curve (Chart 9).8 Chart 92/5/10 Butterfly Spread Fair Value Model This state of affairs has now changed. Our fair value model shows that the 5-year bullet appears slightly expensive compared to the barbell, or alternatively, that the 2/5/10 butterfly spread is priced for a 20 bps steepening of the 2/10 slope during the next six months. According to our model, the 2/10 slope will have to steepen by more than 20 bps during the next six months for our trade to outperform from current levels. Bottom Line: Higher inflation expectations will cause the yield curve to steepen on a 6-12 month horizon. Although steepener trades no longer appear cheap on our model, we remain overweight the 5-year bullet versus a duration-matched 2/10 barbell for now. Economy & Inflation Updates received during the past few weeks indicate that U.S. growth is running solidly above trend, and may even be accelerating. Real second-quarter GDP growth was revised higher from 2.6% to 3%. Second quarter labor productivity growth was also revised higher, as was discussed above. Even following a lackluster August employment report, our back-of-the-envelope tracking estimate for U.S. growth - the sum of year-over-year growth in aggregate hours worked and average quarterly productivity growth since 2012 - is running at 2.7%, well above the Fed's 1.8% estimate of trend (Chart 10). Survey measures also suggest that growth has further upside in the second half of the year, at least according to a simple growth model based on the ISM non-manufacturing survey, our own BCA Beige Book Monitor and a composite of new orders surveys (Chart 11). Chart 10Growth Tracking Above-Trend... Chart 11...And Surveys Suggest Further Upside But bond markets are not getting the message. The 10-year yield is stuck at 2.12%, and the markets seem to be saying that the link between stronger growth and rising inflation has been permanently broken. We disagree and think that investors are simply underestimating the often long and variable lags between economic growth and inflation. Chart 12Inflation Lags Growth Chart 12 shows that real GDP growth has tended to lead core inflation by about 18 months, while changes in year-over-year core CPI (the second derivative of prices) have tended to follow the ISM Manufacturing index with a lag of about 12 months. All signs suggest that the recent downtrend in inflation is nothing more than a reaction to the growth deceleration seen between mid-2015 and mid-2016. Now that growth has re-accelerated, inflation is poised to move higher. Bottom Line: Bond markets are priced as though the link between growth and inflation is broken. We expect they will be proven wrong as inflation regains its uptrend during the next few months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 The daily policy uncertainty index measures the number of news items related to economic uncertainty. For further details please see www.policyuncertainty.com 2 Please see U.S. Bond Strategy Weekly Report, "What We Know About Uncertainty", dated July 12, 2016, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/speech/brainard20170905a.htm 4 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 5 https://www.federalreserve.gov/newsevents/speech/brainard20170905a.htm 6 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 8 For further details on how butterfly trades respond to changes in the yield curve, and on how we use our fair value yield curve models please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Beige Book highlights disconnect between inflation words and inflation data. Peak in auto sales is not a harbinger of recession. Capital spending still trending higher. Inflation and inflation surprise will need to move higher before Fed hikes again. Big disconnect between 10-year yield and our fair value model. Feature Disconnect On Inflation Chart 1Beige Book Monitors Support##BR##Fed's Outlook On Economy And Inflation The Beige Book released on September 6 supports the Fed's base case outlook for the economy and inflation. It also keeps the Fed on track to begin trimming its balance sheet in September and boost rates by another 25 basis points in December if the CPI and PCE inflation readings turn higher. Our quantitative approach to the qualitative data in the Beige Book points to an acceleration in GDP and inflation, less business unease from a rising U.S. dollar, and ongoing improvement in real estate, both commercial and residential (Chart 1). At 64%, the BCA Beige Book Monitor was still near its cycle highs in September, providing further confirmation that economic growth was sturdy in the first two months of Q3. The Fed noted that "the information included in the report was primarily collected before Hurricane Harvey made landfall on the Gulf Coast." However, there was a mention of the storm's clout based on preliminary assessments of business and banking contacts across several districts. The U.S. dollar should not be much of an issue in the Q3 earnings season, according to the Beige Book. The greenback seems to have faded as a concern for small businesses and bankers, in sharp contrast with 2015 and early 2016 when Beige Book references to a strong dollar surged. The Q3 earnings reporting season will provide corporate managements with another forum to discuss the currency's impact on their operations. The 2% decline in the dollar over the past 12 months suggests that the dollar may even provide a small lift to Q3 results (Chart 1, panel 4). Remarkably, business uncertainty over government policy (fiscal, regulatory and health) has moved lower in 2017. The implication is that the business community is largely ignoring the lack of progress by Washington policymakers on Trump's agenda (Chart 1, panel 5). Echoing the market's disagreement with the Fed on inflation, the big disconnect in the Beige Book showed up in the number of inflation words (Chart 1, panel 3). Expressions of inflation dipped between the July and September reports. That said, a wide disconnect remains between the elevated inflation mentions 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 Beige Book backs the Fed's assertion that the economy will expand around 2% this year and inflation will mount in the coming months, supporting a gradual removal of policy accommodation. Policy uncertainty in Washington and worries over the dollar seem to be fading. The divide between the quantity of inflation words in the Beige Book and measured inflation remains unresolved. Neither the soft data in the Beige Book nor the hard data on the economy suggest that an economic downturn is nigh. Recession Not Imminent Some investors have concluded that the peak in auto sales, a key component of consumer spending on durable goods, suggests that a recession is imminent (Chart 2). We take a different view. Zeniths in consumer durable goods, followed closely by consumer services, were primary harbingers of economic downturns in the post-WWII period. However, expenditures on autos, light trucks and other durables tend to peak seven quarters before the onset of recession. Consumer spending on nondurable goods and services provide less of a warning, topping out just five and four quarters out, respectively. The implication for investors is that the peak in auto sales suggests that a recession is still several years away (Chart 3, panels 1-4). Chart 2Vehicle Sales May##BR##Have Peaked Chart 3Consumer Spending And##BR##Housing Prior To Recessions Housing investment provides an even earlier indication that a recession is on the horizon (Chart 3, panel-panel 5). Housing peaked 17 quarters before the start of the 2007 recession and 20 quarters, on average, before the onset of the 2001 and 1991 recession. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced. While housing's contribution to overall economic growth plunged in Q2, we expect housing to provide fuel for the next few years as pent up demand from the depressed household formation rate since the GFC is worked off. The implication from our upbeat view on housing is that the next recession is still several years away. Bottom Line: We expect the next recession to be triggered by an over aggressive Fed, not by imbalances in one of more segments of the economy. It is premature to say that the economy is headed into recession based on a peak in auto sales. Stay long stocks versus bonds, but we recommend that clients be prudent, paring back any overweight positions and holding some safe-haven assets within diversified portfolios. Business Capital Spending Still Up Elevated readings on capex in the first half of the year should persist into the second half. Corporate managements may be postponing investment decisions until they have more clarity on federal tax policy and the Trump administration's plans for infrastructure investment. In short, corporations continue to struggle with how much and when to spend, rather than whether to invest at all. The key supports for sustained corporate spending stayed in place despite the soft July factory orders report and lackluster C&I loan growth. BCA's model for capex (based on non-residential fixed investment, small business optimism and the speculative-grade default rate) suggests lending is poised to climb on a 12-month basis (Chart 4) despite the softening of C&I loan growth since November 2016. Moreover, the 3.3% month-over-month (m/m) drop in factory orders in July masked an upward revision to orders in June and a substantial 1.0% m/m gain in core orders. Core shipments, which feed directly into GDP, rose 1.2% m/m in July. Almost all of the weakness in orders and shipments in July was linked to a 71% plunge in the volatile aircraft orders segment. BCA's research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. Consumer expenditures averaged an above-trend 2.7% in 1H. We anticipate that household spending will continue to improve in the second half of 2017.1 Moreover, recent readings on core durable goods orders and shipments show that the uptrend that began in mid-2016 persists, despite recent monthly wiggles in the data (Chart 5). Chart 4BCA Capex Model Points##BR##To Further Improvement Chart 5Capital Spending##BR##Remains In An Uptrend CEO confidence, still a primary support for capex, recently soared to a 13-year high in Q1, but retreated modestly in Q2. The last reading on this survey was in mid-July, and the dip in sentiment reflects the lack of legislative progress in Washington (Chart 5, top panel). The next CEO survey is set for mid-October. The dip in CEO sentiment in Q2 stands in sharp contrast with the easing of concerns around policy in the Beige Book. Chart 6Surprising Drop In Policy##BR##Uncertainty This Year Surprisingly, the chaos in Washington during the first eight months of the Trump administration has not led to an increase in economic policy uncertainty (Chart 6). Instead, after rising sharply in the wake of the Brexit vote in mid-2016 and the U.S. presidential election in November, policy uncertainty has ebbed. While uncertainty over economic policy remains elevated relative to the past few years, the concern under Trump is surprisingly subdued. This metric is in line with the Beige Book's assessment of Trump's impact on sentiment. A series of business-friendly legislative wins for the GOP and President Trump would further reduce any qualms. Even so, a failure by Congress to boost the debt ceiling and fund the U.S. government later this month would increase business worries/fears. Late last week, Trump cut a deal with Congressional Democrats to extend the debt ceiling for three months and is in talks to do away with it altogether. Bottom Line: The fundamentals still support solid business spending. However, BCA's positive capex outlook in the U.S. could be blemished if the Republicans fail to deliver on their promises to cut taxes and boost infrastructure spending in the next several months. Inflation Surprise And The Fed Chart 7The Fed Cycle And Inflation Surprise We expect inflation surprise to move higher, which could spur the Fed to resume its rate hike campaign. A disconnect has opened between economic surprise and inflation surprise.2 In the past 13 years, there have been 15 periods when economic surprise has climbed after a trough. The inflation surprise index temporarily increased in 13 of those episodes. For example, in the aftermath of the oil price peak in the U.S. in mid-2014, both economic surprise and inflation surprise diminished through early 2015 and then began climbing. However, today's inflation surprise index has rolled over while economic surprise has gained. The inflation surprise index escalated during previous tightening regimes when the economy was at full employment and the Fed funds rate was in accommodative territory (Chart 7). The last time those conditions were in place, which was in 2005, the Fed was wrapping up a rate increase campaign that began in mid-2004. Mounting inflation surprise also accompanied most of the Fed's rate increases from mid-1999 through mid-2000 under similar conditions. In late 2015, as the current set of rate hikes commenced, the inflation surprise index was on the upswing, the economy was close to full employment and the Fed funds rate was accommodative. What Does This Mean For The Fed? The above analysis underscores that economic growth is in good shape and it is likely to remain so for the next year at a minimum, barring any nasty shocks. Normally, the positive U.S. (and global) growth backdrop would place upward pressure on bond yields. It has not been the case this time. Investors appear skeptical of the ability of strong economic growth to generate higher inflation. The attitude seems to be "we will believe it when we see it". Some on the FOMC are taking a similar attitude. Lael Brainard, a FOMC governor, presented an interesting speech last week that makes this point. She speculated that inflation has been lower post-Lehman for structural reasons related partly to a drop in long-term inflation expectations. The Fed has been reluctant in the past to even hint that inflation expectations have become unmoored, because that could reinforce the trend, thus making it harder for the Fed to move inflation up to target. Brainard, a voting member of the committee with a dovish bias, argued that unemployment may have to undershoot the full employment level for longer than normal because low inflation expectations will be a persistent headwind. She also implied that the central bank should allow inflation to temporarily overshoot the 2% target. At a minimum, she wants to see evidence of rising inflation and inflation expectations before the Fed delivers the next rate hike. In the past, Brainard's speeches have sometimes heralded shifts in the FOMC's consensus. An example is her December 1, 2015 speech at Stanford.3 It is not clear if this is the case this time, but it does reinforce the view that a strong economy and a falling unemployment rate is not enough to justify another rate hike this year according to the consensus on the FOMC. Bottom Line: Our inflation indicators are pointing mildly up. Nonetheless, timing the upturn in inflation is difficult and the Fed will not hike in December without at least a modest rise in inflation (together with higher inflation expectations). We are short duration because Treasuries are overvalued and market expectations for Fed rate hikes over the next year are overly complacent (see next section). Nonetheless, a rise in yields may not be imminent. Disconnect On Duration The Global Manufacturing PMI reached a more than 6-year high in August, climbing from 52.7 in July to 53.1 last month (Chart 8, panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (Chart 8, bottom panel). Together, these two factors suggest that global growth is accelerating and becoming broader based. BCA's U.S. Bond Strategy service4 views the improving global economic backdrop as an extremely bond-bearish development. A wide global recovery means that when U.S. data turns surprisingly positive, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand and surge in the dollar. Our Treasury model (based on Global PMI and dollar sentiment) currently places fair value for the 10-year Treasury yield at 2.67% (Chart 8, top panel). Moreover, our 3-factor version of the model (which includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.68% (not shown). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. After adjusting for changes in credit rating and duration over time, the average spread offered by the Bloomberg Barclays corporate bond index is fairly valued relative to similar stages of past business cycles. However, the Aaa-rated portion of the market looks expensive. Further, strong Q2 profit growth likely foreshadows a decline in net leverage. This lengthens the window for corporate bond outperformance. We recommend an overweight in the high-yield market. In the early stages of the previous two Fed tightening cycles (February 1994 to July 1994 and June 2004 to December 2005), the index option-adjusted spread averaged 342 bps and traded in a range between 259 bps and 394 bps. This puts the current junk spread (378 bps) almost in line with the average achieved during other similar monetary conditions (Chart 9). We continue to favor a "buy on the dips"5 approach in the high-yield market. Chart 8Treasury Fair Value Models Chart 9High-Yield Market Overview Regarding high-yield valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6% and recovery rate of 49% (Chart 9, bottom panel). We remain underweight MBSs; While MBS are starting to look more attractive, especially relative to Aaa credit, we think it is still too soon to buy. The Fed will announce the run-off of its balance sheet when it meets later this month. The market has been pricing in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments. Bottom Line: Rates have tested their post-election lows, but BCA's fair value model suggests a bounce higher, which supports our stocks-over-bonds stance. In terms of U.S. bonds, we favor short duration over long and credit over high quality. MBSs will be hurt more than Treasuries as the Fed begins to shrink its balance sheet. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy ryans@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", July 24, 2017. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Surprise, Surprise", August 28, 2017. Available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/newsevents/speech/brainard20151201a.htm 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "The Cyclical Sweet Spot Rolls On," September 5, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA's U.S. Bond Strategy Weekly Report, "Keep Buying Dips," March 28, 2017. Available at usbs.bcaresearch.com.

Highlights Portfolio Strategy A supply/demand imbalance has created a playable opportunity in the niche refining energy sub-index. Increase exposure to overweight. Safe haven demand is supporting gold mining equities, but shifting macro forces suggest that it will soon be time to move to the sidelines. Global gold miners are now on downgrade alert. Recent Changes Lift the S&P oil & gas refining & marketing index to overweight today. Put the global gold mining equity index (ticker GDX:US) on downgrade alert. Table 1 Feature The S&P 500 moved laterally last week as sustained geopolitical uncertainty offset encouraging economic data. Synchronized global growth coupled with the related global liquidity-to-growth transition remain the dominant macro themes. Dovish Fed speeches triggered a recalibration of market rate hike expectations and a lower 10-year Treasury yield. As long as lower bond yields reflect a less hawkish Fed rather than a deflationary relapse, they should underpin stock prices. Encouragingly, the latest ISM manufacturing survey catapulted higher to a level last seen in early 2011, diverging steeply from the bond market, as manufacturing optimism reigns supreme (Chart 1). The labor market confirmed this data. The most cyclical parts of the U.S. economy are firing on all cylinders, with manufacturing and construction job creation comprising 1/3 of nonfarm payroll growth last month (Chart 2). This is the highest reading since July 2011. Chart 1Unsustainable Divergence Chart 2Manufacturing Flexing Its Muscle Meanwhile, despite the Trump administration's shortcomings, America's CEOs are going against the grain. Capex is up smartly for the second consecutive quarter adding to real GDP growth and our capital spending model remains upbeat heralding additional outlays for the remaining two quarters of the year (Chart 3). Similarly, regional Fed surveys of capex intentions point to a sustainable pickup in capital spending in the coming months (Chart 3). Still generationally low interest rates, a less hawkish sounding Fed, coupled with a tamed greenback (Chart 4) and synchronized global growth have combined to revive animal spirits. The implication is that profit growth rests on solid foundations, a message corroborated by our S&P 500 EPS growth model (Chart 5). Chart 3CapEx To The Rescue Chart 4Dollar... Chart 5...And EPS Model Waving Green Flag Adding it up, the macro backdrop remains favorable for stocks. In fact, it represents a goldilocks equity scenario. This week we continue to add some cyclicality to our portfolio by further boosting a niche energy play. We also update our view on a portfolio hedge. Buy Refiners For A Trade In early July, we lifted refiners to neutral and locked in impressive gains for our portfolio, but three reasons kept us at bay and prevented us from turning outright bullish on this niche energy sub-sector.1 Namely, all-time high refining production, high refined product stocks and breakneck pace refinery runs were offsetting the nascent recovery in gasoline consumption, rising crack spreads and a mini V-shaped recovery in industry shipments. Net, we posited that a balanced EPS outlook would prevail in coming quarters. Hurricane Harvey has significantly changed this calculus and now clearly refiners are in a sweet earnings spot for at least the remainder of the year, compelling us to lift exposure to overweight. Severe refinery shutdowns are likely to return industry production levels to what prevailed early in the decade, representing a major, albeit temporary, setback (Chart 6). This production curtailment will result in sizable petroleum products inventory drawdowns and a likely halt (if not reversal) in refined product net exports in order to satisfy domestic demand. The longer it takes for refinery production to return to normalcy, the greater the inventory whittling down. Historically, relative share price momentum has been inversely correlated with inventory growth and the Harvey-related inventory clear-out is heralding additional relative performance gains (bottom panel, Chart 7). It is notable that both industry net exports and inventories had already been receding since the beginning of 2017, suggesting that hurricane Harvey will only accelerate a downtrend that was already in place. Chart 6Hurricane Related Blues... Chart 7... Are A Boon For Crack Spreads Taken together, this represents an ultra-bullish pricing power backdrop for the U.S. refining industry, at a time when capacity additions are also likely to, at least, pause for breath (bottom panel, Chart 6). Chart 8Brisk Demand Indeed, refining margins have jumped recently and will likely remain elevated as the Brent/WTI spread is widening anew (middle panel, Chart 7). Surging crack spreads are synonymous with higher earnings for this extremely capital-intensive and high operating leverage industry. Nevertheless, the refining supply disruptions only tell half the story. Refined product demand is exploding higher, pushing all-time highs and signaling that a substantial supply/demand imbalance is in the works (top panel, Chart 8). Typically this gets resolved via higher gasoline prices, further boosting industry EPS prospects (third panel, Chart 8). As a result, we expect a re-rating phase in relative valuations in the coming months, reversing the year-to-date deflation in the relative price-to-sales ratio. The second panel of Chart 8 shows that relative valuations and refined product consumption move in lockstep, and the current message is to expect a catch up phase in the former. In sum, a playable rally in refiners is in the offing on the back of a budding profit recovery that has yet to filter through analysts' EPS estimates (bottom panel, Chart 8). The longer-than-usual hurricane Harvey-related refining production disruptions, along with the spike in refined product demand, have created an exploitable opportunity. Bottom Line: Boost the S&P oil & gas refining & marketing index (PSX, VLO, MPC, ANDV) to overweight. What To Do With Gold Mining Equities? Gold and gold mining equities serve as great portfolio hedges especially in times of duress. Recent geopolitical jitters surrounding North Korea along with inaction in Washington and the substantial year-to-date selloff in the U.S. dollar have served as catalysts for gold to shine anew, hitting one-year highs. So is it time to trim exposure to shiny metal equities? The short answer is not yet. Real yields are sinking courtesy of a moderately less hawkish Fed (top panel, Chart 9). The probability of a December Fed hike has now collapsed to 30%, and the 5th hike this cycle is only priced in for next June. This is keeping a bid under gold and gold miners, as zero yielding bullion and near-zero yielding gold mining equities appear at the margin relatively more appealing. The equity risk premium has also stopped falling owing largely to the lower 10-year Treasury yield (bottom panel, Chart 9), representing another source of support for global gold miners. Meanwhile, policy uncertainty in the U.S. and around the globe is hooking up especially given North Korea's unpredictability, Washington's polarization, the upcoming German elections and, most importantly, the looming Chinese Congress. Historically, the policy uncertainty index and relative performance have been joined at the hip and the current message is positive for bullion related stocks (middle panel, Chart 9). Similarly, the Philly Fed's Partisan Conflict Index2 ("The Partisan Conflict Index tracks the degree of political disagreement among U.S. politicians at the federal level by measuring the frequency of newspaper articles reporting disagreement in a given month. Higher index values indicate greater conflict among political parties, Congress, and the President.") and bullion enjoy a tight positive correlation since the early 1980s (Chart 10), likely warning that the precious metal's run has more upside in the short term. Chart 9Shining Chart 10Increase In Partisanship Is Bullish Gold Moreover, demand for safe haven assets remains upbeat as evidenced by recent flows into gold-related ETFs. Positioning in the commodity pits are also signaling that more gains are in store for gold and the relative share price ratio (Chart 11). Nevertheless, there are some pockets of weakness that are pointing to a more cautious stance toward this portfolio hedge. The improving U.S. economic backdrop is weighing on gold mining equities (ISM manufacturing shown inverted, middle panel, Chart 12). Not only U.S. growth, but also synchronized global growth suggests that eventually demand for bullion will subside. In fact, global growth expectations continue to perk up (GDP expectations shown inverted, Chart 12), and G10 economic surprises are also shooting higher, anchoring gold and gold related equities (economic surprise index shown inverted, top panel, Chart 12). Chart 11Safe Haven Demand Comeback Chart 12Not All The Glitters Is Gold Tack on the inevitable liquidity withdrawal once the Fed starts to wind down its balance sheet later this month, and the handoff from liquidity-to-growth represents a bearish backdrop for gold and gold mining equities. Chart 13 shows that the Fed's balance sheet is positively correlated with bullion's relative performance versus the broad commodity complex, warning that the recent push toward multi-decade highs in relative performance are on borrowed time. Finally, our relative EPS model for the global gold mining index encapsulates most of these macro forces and suggests that relative profit growth will gravitate lower in the coming months (Chart 14). Chart 13Watch The Fed's Balance Sheet Chart 14EPS Model Is Outright Bearish Bottom Line: While our confidence in maintaining the gold-related equity portfolio hedge has fallen a notch, we are staying patient before moving to the sidelines. Put the global gold mining index (ticker GDX:US) on downgrade alert. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the July 10, 2017 U.S. Equity Strategy Report titled "SPX 3,000?", available at uses.bcaresearch.com 2 https://www.philadelphiafed.org/research-and-data/real-time-center/partisan-conflict-index Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Based on long-term moving averages and the advance/decline line, the dollar selloff is still only a severe correction. These factors need to be monitored closely as they stand on the edge. To rebound, the dollar will need U.S. inflation to pick up, which will lift the U.S. OIS curve. Signs are accumulating that U.S. inflation will trough toward the end of 2017. Buying the dollar versus the yen is a much safer bet than shorting the euro. The CAD has more upside, especially on its crosses. Feature The U.S. dollar continues to be tested by investors. As paradoxical as it may sound, it is still too early to sound the death knell for the dollar bull market. However, it is not time either to aggressively bet on a rebound. For that to happen, U.S. inflation must regain its footing in a more convincing fashion. Why Isn't The Bull Market Dead? There are many facets to this question, but let's begin with technical considerations. First, the dollar's advance / decline line has not broken down (Chart I-1). A breakdown in this measure would be one of the key technical signals that the dollar has begun a new cyclical downtrend. In the mid-1990s, the dollar did experience a period of correction. During that time frame, the A/D line was also unable to break down, later highlighting that what was initially perceived as the beginning a new bear market was ultimately a prolonged period of consolidation. Chart I-1Still Not A Cyclical Bear Market Second, the dollar's trend has been best approximated by the four-year moving average of monthly prices. Since the Smithsonian Agreement of 1971, during bear markets, the dollar tends to find its ceiling around this indicator, and during bull markets, it tends to put a floor around this moving average (Chart I-2). Today, the dollar has yet to end a month below this measure. Third, positioning in the dollar is now depressed, as investors have purged their stale USD longs (Chart I-3). When one looks at net long speculative positions in EUR/USD - the most convenient and liquid instrument to bet on the dollar - investors are clearly enamored with the euro, which by definition illustrates their dislike of the greenback. Chart I-2No Trend Break For Now Chart I-3Dollar Downside Is Limited Technical indicators argue that we have experienced a painful correction in the USD, but valuation considerations suggest it will be difficult for these technical indicators to deteriorate enough to begin flagging a cyclical bear market. Our long-term fair value model, which incorporates productivity differentials, highlights that the dollar never hit the nosebleed levels associated with bull market tops in 1985 or in 2001 (Chart I-4). The stability in the trade balance and the current account - both have been stable at around 3% of GDP and 2.5% of GDP, respectively - are at odds with the sharp deterioration in the balance of payments that has occurred when the dollar has been genuinely expensive. Our intermediate-term valuation models point to an even more unequivocal conclusion. Based on this metric, the DXY is at its cheapest level since 2009, a discount that historically has been associated with dollar bottoms, at least temporary ones (Chart I-5). This gives us comfort that the A/D line is unlikely to break down for now, or that the dollar will end September significantly below its crucial four-year moving average. However, if these things happen, the dollar could experience significant downside. Chart I-4The Dollar Never Reached Nosebleed Valuations Chart I-5Big Discount To IRP Economic forces too do not point to a sharp move in the DXY below 91 - one that could drive the dollar down into the low 80s. After a period of deep underperformance, the U.S.'s economic surprises relative to the G10 have begun to stabilize, as have inflation surprises. More saliently, the incredible strength in the U.S. ISM manufacturing index, especially when compared to other PMIs around the world, points to a rebound in the USD, or at the very least, stabilization (Chart I-6). Finally, the market has now all but priced out additional hikes from the U.S. interest rate curve. There are only 30 basis points of hikes priced in over the next 24 months. Moreover, the probability of the fed funds rate remaining between 1% and 1.25% only falls below 50% in September 2018 (Table I-1). This seems to be a sanguine scenario. Chart I-6Cyclical Support ##br## For USD Table I-1Investors See U.S. Rates At Current ##br##Levels Until Late 2018 Bottom Line: The dollar's technicals are not yet indicative of the end of the cyclical bull market. However, they do need to be monitored closely. Additionally, the dollar is trading at a large discount to interest rate parity relationships, and the Federal Reserve is not expected to execute its next hike until late 2018. While these factors may not point to an imminent rebound in the USD, they do suggest that the down-wave in the dollar is very long in the tooth. Chasing the dollar lower is dangerous. Too Early To Bet The House On A Renewed Upleg Chart I-7The Global Deflation Anchor This observation on the probability of a Fed move brings us to the vital question of what could lift the U.S. interest rate curve higher, and thus the dollar. This would be the outlook for inflation. As Fed Governor Lael Brainard clearly argued this week, the Fed is not meeting its inflation mandate, warranting a slower pace of rate increases as global deflationary forces remain very potent. The dovish path implied by interest rate markets shows that investors already agree with this assessment. There is no denying that inflation has been globally and structurally pulled down by various forces. While the "Amazon effect" has grabbed headlines, Mark McClellan argues in The Bank Credit Analyst this month that the effect of e-commerce on inflation is no greater than that of Walmart in the 1990s - and probably amounts to a meagre 0.1-0.2% depressive impact on inflation.1 Instead, we peg the capacity buildup in EM and China - which has lifted the global capital stock massively since the turn of the millennia - as the main source of global deflation (Chart I-7). Now that global credit growth is lower than it was before 2008, it has become clearer that the global supply side of the economy has expanded faster than underlying demand, resulting in downward pressure on prices. Nonetheless, while there is a lid on inflation, this does not imply that cyclical determinants of inflation have been fully neutered. They simply have become weaker. Inflation can still ebb and flow in response to the business cycle, but the upside is not as strong as it once was. This limits how high nominal interest rate can go, which is why it is hard to envision a terminal rate much above 3% - a very low reading by post-war standards. Here, we continue to see a turning point coming later this year for inflation, one that would pull core PCE closer to the 2% mark wanted by the Fed in 2018. In the background, our composite capacity utilization indicator is now firmly in "no slack" territory, an environment in which inflation tends to perk up and where interest rate exhibit upside (Chart I-8). This is not enough to warrant fears of inflation, but healthy growth in this context should be a red flag for deflationists. This is exactly the set of circumstances we envision for the next 12 months, even if hurricane Harvey and its potential successors create noise in upcoming data. The U.S. economy has benefited from a strong easing in financial conditions since February 2016. The recent fall in real rates, which has been the key driver of the 60 basis-points fall in Treasury yields since December 2016, is now demonstrably reflationary. Lumber prices are once again at the top of their trading range since 2013, and gold prices have regained vigor. In this optic, the ratio of metal to bond prices - adjusted for their very different volatilities - has been a reliable leading indicator of U.S. growth (Chart I-9). Today, it is pointing to an acceleration of GDP growth relative to potential, the very definition of declining slack. Chart I-8Tight U.S. Capacity Is Inflationary Chart I-9Relfation Will Boost U.S. Growth Above Trend The labor market continues to display signs of resilience as well. True, the last employment report was paltry, but August has been marked by seasonal weaknesses for the past seven years. Moreover, August weaknesses have tended to be minimized in the wake of the notorious revisions typical of the U.S. Department of Labor. However, the strength in the labor market components of the NFIB small businesses survey highlights the potential for more job gains going forward. Where this indicator really shines though, is in its capacity to forecast household total wages and salaries (Chart I-10). Today, this gauge highlights that the income of middle class households will accelerate over the next six months. This matters because if the middle class - a category of U.S. households that gather the vast majority of their income from wages - experiences strong income growth, this will create robust support for consumption. With consumption accounting for 70% of U.S. GDP, a boost to this component would go a long way in lifting aggregate growth. Stronger growth in a tight economy is inflationary, and monetary dynamics confirm this risk. The U.S. velocity of money has picked up meaningfully, and now suggests that inflation will gather steam later this year (Chart I-11). Chart I-10The Labor Market Is Still Strong Chart I-11Monetary Dynamics Point To More Inflation We therefore expect that when this turnaround in inflation emerges, investors will re-assess their expectations for the path of U.S. monetary policy, and the dollar will finally be able to resume its upward trek toward new highs. But until inflation turns the corner, the dollar will continue to struggle to rally durably. Bottom Line: The U.S. economy is still on a firming path. With the amount of slack in the economy vanishing and with the velocity of money accelerating, this will lead to a pick-up in inflation late this year. The end of Q4 is likely to prove the moment when the dollar will finally be able to begin firming up. Investment Implications Shorting the Yen Is Still The Safest Bet Shorting the yen remains the best way to play a dollar rebound for now. The yen has not benefited much from the recent bout of risk aversion prompted by the renewed flare-up of in tensions in the Korean peninsula. It remains weak on its crosses like EUR/JPY, CAD/JPY or even AUD/JPY. USD/JPY seems incapable of staying below 108.5, and may even be forming a consolidation pattern reminiscent of the one experienced in 2013 (Chart I-12). In late 2013, this pattern was resolved by U.S. bond yields moving higher. This time is likely to be similar. The recent weakness in Japanese wages remains a key hurdle that the Bank of Japan does not seem able to shake off. Wage growth hit it slowest pace since 2015 and real wages are worryingly weak (Chart I-13). This is not the picture of an economy with any hint of inflation, even if the labor market is tight. Illustrating this point, contrarily to the euro area, Japanese inflation expectations have not kept pace with the U.S. in recent months (Chart I-14). This argues that the BoJ faces the greatest burden of any central bank. With the BoJ now packed with doves, we expect that interest rates and bond yields in Japan will remain capped for the foreseeable future. As a result, if U.S. bond yields can rise in the face of a strong U.S. economy, JGB yields will not follow higher. This will flatter USD/JPY. Chart I-12Consolidation Pattern In USD/JPY Chart I-13Falling Labor Income In Japan Chart I-14Japanese CPI Swaps Are Outliers A More Complex Picture For The Euro As investors have become more comfortable with the economic and political prospects of the euro area, the euro has become increasingly over-owned, but most importantly, has completely deviated from interest rate parity relationship (Chart I-15). At first glance, this would indicate the euro is greatly vulnerable. This reality, along with very long positioning of speculators in EUR/USD, highlights that it will be difficult for the euro to stay above 1.20 in the coming months. However, for the euro to move below 1.15, U.S. inflation has to pick up. Thus, for the remainder of the year, the EUR/USD is likely to remain range bound between these two numbers. Two factors make the picture less clear for EUR/USD than for USD/JPY. First, the European Central Bank is intent on beginning to taper its asset purchases this year, a move that will be announced in October. At yesterday's press conference, ECB President Mario Draghi was unequivocal about this, despite the slight curtailments to the central bank's inflation forecasts. Moreover, the seeming lack of concern vis-à-vis this year's 6% increase in the trade-weighted euro was perceived by investors as a green light to keep betting on a stronger EUR/USD. Second, as we argued five months ago, exchange rate dynamics are more a function of assets' expected returns than just interest rate differentials.2 As Chart I-16 illustrates, when a portfolio of eurozone stocks, bonds and cash outperforms a similar U.S. one, this leads to a durable rally in EUR/USD. Today, the relative performance of this European portfolio is toward the bottom of its historical distribution, and may even be already turning the corner. If this move has durability, inflows into the euro area could push EUR/USD back into the 1.3 to 1.4 range. Chart I-15Euro Is Expensive ##br##To IRP Chart I-16Outperforming Euro Area Assets##br### Could Support EUR/USD The Loonie Will Keep Flying The Bank of Canada delivered another rate hike this week. The BoC continues to focus on closing the Canadian output gap and the strong economy, ignoring weak wages and inflation. The BoC was rather sanguine regarding the slowdown in real estate activity in Toronto, Canada's largest city, and seemed comfortable with the CAD's recent strength, arguing it was a reflection of Canada's strength and not yet an impediment to it. The CAD interpreted this announcement bullishly. We agree. In a Special Report written last July, we argued that the BoC was among the best-placed central banks to tighten policy among the G10.3 Additionally, the CAD is cheap, trading at a 7% discount to PPP. It is also still below its fair value, implied by interest rate differentials. As such, we continue to overweight the Canadian dollar, being long the loonie against the euro and the Aussie. It also has upside against the USD, but could prove vulnerable to a pick-up in U.S. inflation. Thus, we remain committed to buying the CAD on its crosses. Bottom Line: The euro may be expensive relative to interest rate differentials, but the anticipation around the ECB's tapering continues to represent a support under EUR/USD. As a result, this pair is likely to remain range-bound, roughly between 1.2 and 1.15. USD/JPY has more upside as Japanese inflation expectations and wages are sagging, suggesting the BoJ is nowhere near the ECB in terms of moving away from an ultra-accommodative stance. The CAD will continue to experience upside for the remainder of the year; stay long the loonie on its crosses. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see The Bank Credit Analyst Monthly Report, "Did Amazon Kill The Phillips Curve?" dated August 3, 2017, available at bca.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "The Fed And The Dollar: A Gordian Knot", dated April 14, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy And Global Alpha Sector Strategy Special Report, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The dollar had a particularly eventful week. With Fed officials Brainard and Kashkari unleashing their dovish remarks, the greenback suffered as investors pushed down 10-year yields. While Brainard highlighted her concern over the "recent low readings of inflation", Kashkari took it further and said that the hikes may be "doing real harm" to the economy. Adding to the Fed's concerns, Stanley Fischer, a long-serving Fed official and an ardent supporter of policy normalization, announced his resignation on Wednesday. Mario Draghi's hawkish press conference added further downward pressure on the dollar, with the DXY making a new low of 91.41. It is unlikely that the dollar will be able to meaningfully rally until inflation re-emerges, a year-end event. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro reacted very positively to the ECB monetary policy speech. Draghi highlighted the uncertainty associated with the strong currency, but noted that the ECB doesn't expect it to have a large impact on inflation, which helped the euro hit a high of EUR/USD 1.2018. He nonetheless highlighted that achieving the ECB's price mandate will require "patience" and "persistence" and he expects inflation to hit its target by 2020. Additionally, the ECB lowered its inflation forecasts, while increasing its 2017 growth forecasts. In terms of QE, Draghi clarified that details will be revealed in the next meeting held on October 26, but that interest rates will remain accommodative for an extended period of time. Although President Draghi laid out some concerns about the strong euro, it seems momentum is unlikely to falter unless markets become more positive on the dollar or the pound. We expect this to occur by the end of this year, when inflation picks up again in the U.S. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: Industrial production yearly growth declines substantially from June's 5.5% number, coming in at 4.7%. This data point also underperformed expectations. Housing starts contracted by 2.3% on a YoY basis, also underperforming expectations. Meanwhile, labor cash earnings also contracted by 0.3% on a yearly basis, underperforming expectations. As we highlighted a few weeks ago, multiple indicators are signaling a slowdown in the Japanese economy. The recent batch of negative data seems to confirm this view, which means that the dovish bias of the BoJ will only be further reinforced. Consequently the yen will be the mirror image of U.S. bonds. Given that rate expectations have collapsed to the point that the market is only anticipating 30 basis points in hikes in the U.S. over the next 2 years, risks point upwards for USD/JPY. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in U.K. has been mixed: Markit manufacturing PMI increased from August to July, coming in at 56.9. This data point also outperformed expectations. Meanwhile, both construction and Markit services PMI underperformed expectations coming in at 51.2 and 53.2, respectively. Finally, nationwide house price year-on-year growth also underperformed expectations, coming in at 2.1%. At the beginning of August, we warned of a repricing of rate expectations in the U.K. given that the pass through from the currency was set to dissipate, while the housing market and real disposable income were undergoing a major slowdown. So far, this view has proven correct, with the pound falling against the dollar and the euro. We expect that GBP/USD has further downside on a 12 month basis, as rate expectations in the U.S. have likely found a bottom. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Data out of Australia was not particularly strong: TD Securities Inflation dropped on an annual basis to 2.6% from 2.7%; Gross operating profits contracted at a 4.5% rate, below the expected 4% contraction; Current account balance came in at AUD -9.862 bn, below expectations, following a 59% decrease in the trade balance from the last quarter, and a 4% decrease in the net primary income; Most notably, GDP grew at the expected 1.8% annual rate, albeit faster than the previous growth rate of 1.7%. The RBA decided to leave rates unchanged, but with a slightly hawkish tone. While growth is generally in line with the Bank's forecasts, it was also highlighted that the appreciating exchange rate and low wages remain headwinds for inflation. A brighter housing market was noted as house price increases are slowing down, owing to macroprudential measures. While the Bank sees an improving labor market, we remain skeptical as the underemployment rate has not improved, which is limiting wage growth. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Surprisingly, in spite of the weakness of the U.S. dollar, the kiwi has been falling for the past month. This has been in part due to some weak data coming out of New Zealand: Building permits continued their decline, with a Month-on-Month decline in July of 0.7%. Both the ANZ Activity Outlook and the Business Confidence indicators declines in August relative to July. The New Zealand terms of trade Index underperformed expectations, coming in at 1.5%. Additionally July's number was revised down from 5.1% to 3.9%. The recent weakness in the NZD might be indicative of some weakness permeating from EM, given that the New Zealand economy is highly sensitive to the global economy. If an EM selloff materializes we expect significant downside for the NZD particularly against the yen. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data has been quite strong out of the Canadian economy recently: The current account deficit was better than expected at CAD -16.32 bn, with the merchandise trade balance also improving; Manufacturing PMI came in at 51.7, beating the expected 51.3; GDP growth came in at an astonishing 4.5% annualized rate; Accordingly, the BoC raised the overnight rate to 1%. Markets were expecting hawkish remarks, but not a hike. The CAD rallied more than 1% against USD on the news, and outperformed all other G10 currencies. Current expectations for a December hike are at 68%, and we agree. The CAD will see further strength against all G10 currencies except USD by the end of the year. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Gross Domestic Product yearly growth came in at 0.3%, underperforming expectations and deaccelerating from a month ago. Headline inflation came in line with expectations at 0.5%, it also increase from the previous month reading of 0.3%. Real retails sales underperformed expectations, contracting by 0.7% on a YoY basis. However the SVME PMI outperformed and increased from the July reading, coming in at 61.2. After reaching 1.15 in early August, EUR/CHF has stabilized around to 1.135. Overall the Swiss economy is still too weak for the SNB to change their stance on currency intervention. Core Inflation will have to pick up to at least 1% for the SNB to consider a change in stance and let go of the implied floor in EUR/CHF. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retails sales monthly growth came in at 0.4%, recovering from last month negative reading ad outperforming expectations. Manufacturing output growth also outperformed expectations, coming in at 1.5%. Finally registered unemployment came in at 2.7%, declining from last month reading and coming in line with expectations. USD/NOK has continued to go down as rate expectations for the U.S. have decreased and oil prices have increased thanks to the refining shut-downs in Texas due to hurricane Harvey. We expect this trend to reverse once rate expectations in the U.S. start to go up. However, we do expect more downside in EUR/NOK as this cross is much more sensitive to oil prices. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data was largely downbeat: Retail sales are growing at a 3.7% annual rate, in line with expectations; The Swedish trade balance went into a deficit in July of SEK -0.5 bn from a SEK 5.4 bn surplus in June; Consumer confidence decreased to 100.3 from 102.2 and below the expected 103; Manufacturing PMI also disappointed at 54.7, below the expected 60; Swedish IP is growing at a still high 5.3% annual pace, but less than the previous 8.9% rate; While this data was somewhat weak, Swedish inflation is at or above its target across all measures. The Riksbank left its repo rate unchanged at -0.5%. In its press release, the Bank highlighted high growth and inflation but stated that the rate will not be increased until the middle of 2018. It also increased inflation forecasts, with CPI and CPIF predicted at 2.9% and 2.1% by 2019. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights The ECB can talk down the euro, but not by much. The central bank has previously expressed comfort with EUR/USD at 1.15. The cyclical and structural direction of EUR/USD is higher... ...because the euro area versus U.S. long bond yield spread should ultimately compress to -40 bps from today's -130 bps. Remain neutral in Germany's DAX and underweight Sweden's OMX. Equity markets with a strong base currency and a large exposure to exporters will come under pressure. Overweight German consumer services equities versus German exporters and the DAX. Underweight U.K. consumer services equities versus the FTSE100. Feature When mariners know that a sea-change is coming, their concern is not whether it comes today, tomorrow or the day after tomorrow. The big issue is the sea-change itself - because it brings major implications for navigating the seas. In the same way, when currency markets know that a sea-change in monetary policy is coming, their concern is not whether the policy announcement comes on September 7, October 26 or December 141 - or indeed whether the sea-change will happen suddenly or gradually. At a sea-change, currency markets look much further ahead. Just as for mariners, the big issue is the sea-change itself. EUR/USD is now moving in lockstep with the expected differential between euro area and U.S. policy interest rates not next year, nor the year after next, but rather the differential five years out (Chart I-2). Chart I-1AA Strong Euro Is Good For ##br##German Consumer Services... Chart I-1B...A Weak Pound Is Bad For##br## U.K. Consumer Services Chart I-2EUR/USD Is Moving In Line With The Interest ##br##Rate Differential Expected In 2022 The ECB Can Talk Down The Euro, But Not By Much Chart I-3EUR/USD Might Find Support At 1.15 Therefore, if the ECB really wants to unwind the euro's sharp appreciation this year, the central bank must tell the market that the expectation for a sea-change is completely wrong. In other words, the ECB must indicate that it has no intention to dial back its emergency monetary accommodation. Such a volte-face is unlikely, for two reasons. First, the ECB likes to adjust market expectations incrementally rather than violently. The last policy meeting made the case "for proceeding gradually and prudently when approaching adjustments in the monetary policy stance and communication." Second, not to dial-back its emergency monetary accommodation flies in the face of a euro area economic expansion that is solid, broad, and among the strongest and best-established among major developed economies. "Postponing an adjustment for too long could give rise to a misalignment between the Governing Council's communication and its assessment of the state of the economy, which could (eventually) trigger more pronounced volatility in financial markets." Nevertheless, at the margin, dovish words from Draghi could pare back the euro. How much? Consider that at the last policy meeting EUR/USD stood at 1.15 and the ECB justified this level on the basis of the improved "relative fundamentals in the euro area vis-à-vis the rest of the world." (Chart I-3) Given that these relative fundamentals are still intact, 1.15 might provide a level of support in a technical retracement. Of course, EUR/USD also depends on the Federal Reserve and expectations for its policy rate five years out. EUR/USD would sink if the market became much more hawkish about where it sees the U.S. 'terminal' interest rate. However, for the terminal rate expectation to rise suddenly and sharply in the U.S. relative to the euro area would also fly in the face of the economic data on both sides of the Atlantic. Recently, there has been little difference in either economic growth or inflation rates. The 'Neutral' Real Interest Rates In The Euro Area And U.S. Are The Same More fundamentally, there is little difference in the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. Through the 19 years of the euro's life, the euro area versus U.S. long bond yield spread has averaged -40 bps2 (Chart I-4). Over this same period, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-5). Ergo, the real interest rate differential has averaged zero. Meaning, the neutral real interest rates in the euro area and the U.S. have been exactly the same. Chart I-4Euro-U.S.: Average Interest ##br##Differential = -40bps Chart I-5Euro Area-U.S.: ##br##Inflation Differential = -40bps Bear in mind that the 19 year life of the euro captures multiple manias and crises, some centred in Europe, some in the U.S. Hence, 1999-2017 is a good representation of what the future holds, at least in relative terms if not in absolute terms. With little difference in the neutral real rates over the past two decades, is there any reason to expect a big difference in the future? Our starting assumption has to be no. Chart I-6If Composition Differences Were Removed, ##br##Euro Area And U.S. Inflation Would Be Near-Identical In fact, even the -40 bps annual inflation shortfall in the euro area is due to a compositional difference in the consumer price baskets. The euro area does not include owner occupied housing costs, whereas the U.S. does at a hefty weighting.3 If this compositional difference were removed, inflation would also be near-identical (Chart I-6). Still, each central bank must target inflation as it is defined in its respective jurisdiction, so let's assume the annual inflation differential continues to average -40 bps. In this case, the long bond yield spread should also ultimately compress to -40 bps from today's -130 bps. The biggest risk to this view is if the existential threat to the euro resurfaced. Looking at the political calendar, the German Federal Election on September 24 poses no such threat. Meanwhile, ahead of the Italian general election to be held no later than May 20 2018, even the non-establishment Five Star Movement and Northern League are toning down their anti-euro rhetoric. As my colleague Marko Papic, our Chief Geopolitical Strategist, puts it: "euro area politics are a red herring." On this basis, our central expectation is that the euro area versus U.S. yield spread has the scope to compress much further from its current -130 bps. This means that after a possible near-term retracement, we expect the cyclical and the structural rally in the euro to resume. German Consumers Are Winners, U.K. Consumers Are Losers When European currencies strengthen, the big winners are European consumers because they become richer in terms of the goods and services they can buy in international markets. This is significant because Europe imports its food and energy in large (and inelastic) volumes. Hence, their price decline in local currency terms significantly boosts the real spending power of consumers. And vice-versa (Chart I-7). As if to prove the point, German consumer services equities have rallied strongly this year (Chart I-8). And their outperformance has closely tracked euro strength (Chart of the Week, left panel). Across the English Channel, it is the mirror-image story. The pound has slumped. And the big losers are U.K. consumers, whose real spending power is evaporating as food and energy prices - in pound terms - rise. Again, to prove the point, U.K. consumer services equities have struggled to make any headway this year (Chart I-9). And their underperformance has closely tracked the trade-weighted pound's weakness (Chart of the Week, right panel). Chart I-7German Consumption Accelerating,##br## U.K. Consumption Decelerating Chart I-8German Consumer Services ##br##Have Rallied Chart I-9U.K. Consumer Services ##br##Have Struggled If the euro has more cyclical and structural upside - as we anticipate - then these equity performance trends have further to run. Chart I-10The Exporter Heavy DAX And##br## OMX Have Struggled Remain overweight German consumer services equities versus German exporters and the DAX. And remain underweight U.K. consumer services equities versus the FTSE100. At the same time, equity markets with a strong base currency and a large exposure to exporters will come under pressure. Mostly, this is because the translation of multi-currency international earnings into a strengthening base currency hurts index profits. For the time being, this influences our allocation to Germany's DAX - in which we have been neutral relative to the Eurostoxx600 - and Sweden's OMX - in which we have been underweight (Chart I-10). Next week, we will update our overall European country allocation. Given the large sector skews in European equity indexes, this country allocation is heavily dependent on the stance towards Healthcare and Banks. Hence, we await any incremental communication from the ECB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 These are the dates of the ECB's three remaining monetary policy meetings in 2017. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 The imputed cost of owner occupied housing (owners' equivalent rent of residences) comprises 25% of the U.S. consumer price basket but 0% of the euro area consumer price basket. Fractal Trading Model Basic materials equities are technically overbought. Initiate a short position relative to the broad market with a profit target / stop loss at 2.5%. In other trades, long Mediaset Espana / short IBEX35 hit its stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 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 Chart 1"Trump Trade" Progress Report One of our seven investment themes for 2017, published in a Special Report last December, is that the combination of strong U.S. growth and accommodative Fed policy creates a cyclical sweet spot in which risk assets will outperform. After last week's GDP revisions we now know that real growth averaged 2.1% in the first half of the year, solidly above the Fed's 1.8% estimate of trend. Meanwhile, weak inflation has caused markets to discount an exceptionally shallow path for Fed rate hikes - only 19 bps of rate hikes are priced for the next 12 months. This divergence between growth and inflation is reflected in Treasury yields. The real 10-year yield is 24 bps above its pre-election level, while the compensation for inflation protection is only 5 bps higher (Chart 1). Not surprisingly, the cyclical sweet spot has led corporate bonds to outperform duration-matched Treasuries by 296 bps since the election. The persistence of the cyclical sweet spot leads us to believe that last month's politically-driven spread widening should be seen as an opportunity to increase exposure to corporate bonds. Remain at below-benchmark duration and overweight spread product in U.S. fixed income portfolios. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 62 basis points in August, dragging year-to-date excess returns down to 146 bps. The average index option-adjusted spread widened 8 bps on the month to reach 110 bps. In last week's report,1 we demonstrated that to properly assess corporate bond valuations it is not sufficient to simply look at the average index spread. We need to adjust for the fact that both the average credit rating and duration of the index change over time. We also need to consider corporate spreads relative to other similar stages of the economic cycle, not relative to long-run averages. In this respect, considering the breakeven spread2 for each credit tier relative to where it traded in the early stages of prior Fed tightening cycles gives us the best sense of the value proposition in corporate bonds. At present, this analysis shows that while Aaa corporate spreads are expensive, the other investment grade credit tiers all appear fairly valued (Chart 2). Corporate profit data for the second quarter was released last week and showed a big jump in our measure of EBITD (panel 4). This makes it extremely likely that net corporate leverage declined in Q2. All else equal, this lengthens the window for corporate bond outperformance Table 3.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 67 basis points in August, dragging year-to-date excess returns down to 378 bps. The index option adjusted spread widened 26 bps to end the month at 378 bps, 55 bps above the mid-2014 cycle low. Back in March4 we tested a strategy of buying the High-Yield index relative to Treasuries whenever spreads widened by more than 20 bps in a single month, and then holding the trade for a period of one, two or three months. We found that this "buy the dips" strategy works very well when inflationary pressures are low, but performs poorly when inflation is high and rising. When inflation is low the Fed needs to support the recovery by adopting a more dovish posture whenever financial conditions tighten. With the St. Louis Fed Price Pressures Measure5 at only 6% (Chart 3), we expect a "buy the dips" strategy will continue to work for some time. In terms of valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6%, and an expected recovery rate of 49%. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to -9 bps. The conventional 30-year MBS yield fell 13 bps in August, driven by an 18 bps decline in the rate component. This was partially offset by a 4 bps increase in the compensation for prepayment risk (option cost) and a 1 bp widening of the option-adjusted spread (OAS). The Fed is likely to announce the run-off of its balance sheet when it meets later this month. For its part, the market has been pricing-in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments (Chart 4). In this sense, the Fed's commitment to proceed with balance sheet normalization no matter the outlook for the future pace of rate hikes is doubly negative for MBS spreads. OAS are biased wider as Fed buying exits the market, while low rates encourage faster prepayments and a higher option cost component of spreads. Going forward, the option cost component of spreads will decline as mortgage rates cease their downtrend, but OAS still appear too tight relative to trends in net issuance. Despite robust issuance so far this year and the Fed backing away as a buyer, the conventional 30-year MBS OAS remains well below its pre-crisis mean (panel 2). While MBS are starting to look more attractive, especially relative to Aaa credit (panel 3), we think it is still too soon to buy. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 5 basis points in August, bringing year-to-date excess returns up to 154 bps. The Foreign Agency and Local Authority sectors drove the index outperformance in August. Both beat the duration-matched Treasury benchmark by 12 bps. Sovereigns outperformed the benchmark by 3 bps, Supranationals outperformed by 1 bp, and Domestic Agency bonds underperformed by 2 bps. We took a detailed look at the Sovereign index in a recent report,6 both at the aggregate and individual country levels. At the aggregate level, the two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the U.S. dollar (Chart 5). At present, relative valuation is skewed heavily in favor of domestic U.S. credit (panel 2). Added to that, given downbeat Fed rate hike expectations, we view further dollar weakness as unlikely on a 6-12 month horizon. Taken together, we continue to favor U.S. credit over USD-denominated Sovereign debt. At the country level, we identified several countries where USD-backed debt appears attractive. We found that Finland, Mexico and Colombia all offer attractive spreads. However, the spread pick-up available in Mexican and Colombian debt is compensation for heightened exchange rate volatility. Finnish debt appears the most attractive on a risk/reward basis. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 40 basis points in August (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 144 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio held flat in August, and it remains extremely tight relative to its post-crisis trading range (Chart 6). The M/T yield ratio remains very low despite the fact that state & local government net borrowing continues to rise. Net borrowing increased to $209 billion in Q2, the highest level since the second quarter of last year. Further, the Trump administration appears to be finally tackling the issue of tax reform. While comprehensive tax reform is probably too ambitious, some form of corporate and personal tax cuts seems likely, probably in the first half of next year. Lower tax rates are obviously a negative for municipal bonds, but some of the negative impact could be offset if current tax deductions (such as the deduction of state & local income tax) are removed. All else equal, fewer available tax deductions elsewhere makes the tax exemption of municipal bonds look more attractive. Of course, the municipal bond tax exemption itself could also be threatened, but at least so far this appears less likely. The bottom line is that current M/T yield ratios are far too low given the looming risks of rising state & local government borrowing and looming federal tax cuts. Remain underweight. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull flattened in August. The 2/10 slope flattened 17 bps and the 5/30 slope flattened 2 bps. The market moved to discount an even shallower path for Fed rate hikes in August. At the end of July the market had expected 27 bps of rate hikes during the next 12 months, and that number has now fallen to 19 bps (Chart 7). Consequently, our recommendation to short the July 2018 fed funds futures contract has suffered. The position is now 17 bps in the red, but we continue to believe that the market's expected rate hike path is too benign. From current levels, a position short the July 2018 fed funds futures contract will return 35 bps if there are two hikes between now and next July and 61 bps if there are 3 hikes. We also continue to recommend a position long the 5-year bullet versus a duration-matched 2/10 barbell on the view that the Treasury curve will steepen as inflation and TIPS breakevens move higher. This position has earned 28 bps since initiation last December, but valuation is starting to look less attractive. Our butterfly spread model7 suggests that the 5-year bullet is now slightly expensive compared to the 2/10 barbell (panel 3). Or put differently, that the 2/10 Treasury slope will have to steepen by more than 20 bps during the next 6 months for our trade to earn a positive return. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 36 basis points in August, dragging year-to-date excess returns down to -169 bps. The 10-year TIPS breakeven inflation rate fell 6 bps on the month and, at 1.76%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Despite robust growth, extremely weak realized inflation has caused breakevens to tighten this year. Last week's July PCE release was yet another disappointment. The year-over-year core inflation rate fell from 1.51% to 1.41% and the year-over-year trimmed mean rate fell from 1.68% to 1.64% (Chart 8). However, measures of pipeline inflation pressure such as the supplier deliveries and prices paid components of the ISM Manufacturing survey point towards higher inflation. The supplier deliveries component increased from 55.4 to 57.1 in August (panel 4) while the prices paid component held firm at an elevated 62 (panel 3). Adding it all up, and incorporating the fact that employment growth should stay strong enough to maintain downward pressure on the unemployment rate, we think it is very likely that core inflation will soon reverse course and resume the steady uptrend that began in early 2015. TIPS breakevens will widen alongside. At present, our TIPS Financial model suggests that breakevens are trading in line with other financial market instruments (panel 2). In other words, there is no apparent mis-valuation in breakevens relative to other financial markets, and higher realized inflation is likely required before breakevens move sustainably wider. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in August, bringing year-to-date excess returns up to 71 bps. Aaa-rated ABS outperformed the benchmark by 10 bps in August, bringing year-to-date excess returns up to 63 bps. Meanwhile, non-Aaa ABS outperformed by 26 bps in August, bringing year-to-date excess returns up to 147 bps. Credit card ABS outperformed the Treasury benchmark by 10 bps in August, bringing year-to-date excess returns up to 69 bps. Auto loan ABS outperformed by 12 bps, bringing year-to-date excess returns up to 71 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps on the month, and remains well below its average pre-crisis level (Chart 9). At 36 bps, the option-adjusted spread for Aaa-rated ABS is now the same as the option-adjusted spread for conventional 30-year Agency MBS. Meanwhile, lending standards are now tightening for both auto loans and credit cards. Further, the New York Fed's Household Debt and Credit Report for the second quarter revealed that "flows of credit card balances into both early and serious delinquencies climbed for the third straight quarter - a trend not seen since 2009."8 While overall credit card charge-offs in ABS collateral pools remain low (panel 4), it is clear that the cyclical winds are shifting against consumer ABS. If the trends of tightening lending standards and rising delinquencies continue, then it will soon be time to reduce consumer ABS exposure, possibly shifting into Agency MBS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in August, bringing year-to-date excess returns up to 116 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month, and is approaching one standard deviation below its average pre-crisis level (Chart 10). The combination of tightening lending standards and weaker demand for commercial real estate (CRE) loans (as evidenced by the Fed's Senior Loan Officer Survey) suggests that credit concerns are starting to mount in the CRE space. Meanwhile, CMBS delinquency rates have leveled-off during the past few months and remain much lower in the multi-family space (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in August, bringing year-to-date excess returns up to 79 bps. The average index option-adjusted spread for the Agency CMBS index held flat at 48 bps on the month. This compares favorably to the 36 bps offered by both Aaa-rated consumer ABS and conventional 30-year Agency MBS. Not only does the Agency CMBS sector continue to offer an attractive spread relative to both consumer ABS and Agency MBS, but its agency guarantee and concentration in the multi-family space (where delinquencies are still low) makes it look particularly attractive. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.67% (Chart 11). Our 3-factor version of the model (not shown), which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.68%. The Global Manufacturing PMI rose to 53.1 in August, from 52.7 in July, reaching a 75-month high (panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (bottom panel). Taken together, these two factors suggest that not only is global growth accelerating but that the global economic recovery is increasingly broad based. This is an extremely bond-bearish development. A broad based global recovery means that when U.S. data finally start surprising positively, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.16%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Policy Reflections", dated August 29, 2017, available at usbs.bcaresearch.com 2 The 12-month breakeven spread is the basis point widening required over a 12-month period before a corporate bond delivers losses relative to a duration-matched Treasury security. We assume no impact from convexity and calculate the breakeven spread as OAS divided by duration. 3 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 5 The Price Pressures Measure is a composite indicator which shows the percent chance that PCE inflation will exceed 2.5% during the next 12 months. 6 Please see U.S. Bond Strategy Weekly Report, "The Upside Of A Weaker Dollar", dated August 15, 2017, available at usbs.bcaresearch.com 7 For further details on our models please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 8 https://www.newyorkfed.org/microeconomics/hhdc Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Special Report

Feature Healthy consumer spending driving a booming sales environment, along with the operating leverage that high revenue growth produces, have been the key underpinnings of the nascent revival in the S&P 500 margin expansion. This has occurred against the backdrop of muted wage growth in most sectors which has amplified margin expansion. We recently showed that S&P 500 operating leverage has historically added $1.4 of earnings for every $1 of incremental revenues (please see our Weekly Report of April 17, 2017 for more details). On a trailing 12-month basis, the S&P 500 has added more than $3 of earnings for every $1 of incremental revenues, more than double the historical average operating leverage. Clearly this pace of margin expansion is unsustainable, particularly since the tight labor market seems likely to force a reacceleration in wage growth. A common narrative among investors has been that late-cycle dynamics will soon force a mean reversion in S&P 500 operating margins. However, and while every economic cycle is different, true mean reversion only happens in recessions (Chart 1). Chart 1Margins Can Expand From Here Further, the absolute margin level of the S&P 500 is far from being without precedent. Since the 1970's, margins have typically peaked for the cycle only after approaching one standard deviation above the trend and the current S&P500 margin is just past halfway there. It is also worth noting that margins can stay extended for a considerable time; margins have surpassed one standard deviation above trend twice this decade without a material retrenchment. Chart 2 shows the high, low and current trailing operating margins of the S&P 500 and the eleven GICS1 sectors. At first glance, it appears that margins are particularly high in the heavyweight financials and IT sectors. Some context is required; both sectors experienced bubbles in the last two decades that saw operating profits plumb extreme lows in the subsequent busts, making their profit ranges appear unusually broad. Chart 3 corrects to exclude two-standard deviation events for all sectors. The message is clear: margins still have significant room to run. Chart 2High, Low And Current Trailing S&P 500 Operating Margins Chart 3High, Low And Current Trailing S&P 500 Operating Margins, Normalized Operating margins in isolation only tell part of the story. In Chart 4, we compare profitability to the capital deployed in pursuit of said profits. Capital deployed and its earned return should theoretically plot on a linear function; plotting above the fitted regression line implies insufficient returns, while plotting below the line indicates excess returns. In our analysis, most sectors plot relatively closely to the market line with a few notable outliers. Financials are likely earning significant excess returns on capital, while utilities are waving a warning flag. We reiterate our overweight and underweight ratings on these two sectors, respectively (Chart 4). Chart 4Capital Intensity Of Profits The upshot of high margins and low capital requirements is above-average return on capital. Consequently, rising valuation multiples move in tandem with ROIC and vice-versa. Our analysis bears that out; financials are relatively far along the continuum along which most of the S&P 500 sectors plot, though still modestly below the fitted regression line indicating fair value. Conversely, real estate, while attractive from a return on capital perspective, is highly overvalued (Chart 5). Chart 5Margin Efficiency And Valuation This Special Report takes a sector-by-sector view on the margin outlook that supports our thesis of ongoing margin gains delivering an earnings-driven stock market rally. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com Chart 6Oil Stocks Look Set To Decline Chart 7Capital Formation Should Take Off Chart 8Consumers Have Opened Their Wallets Chart 9Surging Global Manufacturing Chart 10Real Estate Rents Look##br## Set To Decline Chart 11The Right Conditions For Industrial##br## Margin Expansion Chart 12Dark Clouds On The Horizon ##br##For Health Care Margins Chart 13Utilities Margins Are##br## Likely To Contract S&P Energy (Overweight) Chart 14S&P Energy Energy operating profit margins have been on a wild ride, collapsing with the underlying commodity and then partially recovering as the industry rationalized. Analysts are forecasting more of the same, with the industry forecast to generate profits for the first time in more than two years. Pricing power has spiked higher, though from an extremely low base, as the aforementioned industry rationalization has taken hold. Wage growth looks fairly tepid and the net margin impact supports the forecast view of margin expansion. Rampant cost inflation appears to be a thing of the past. Accordingly, the essential component for margin recovery will be top line growth. The key factors in a top-line growth scenario for the energy sector will be a demand-driven recovery in crude oil prices, supported by continued supply-side discipline. The current global economic revival and pause in the U.S. dollar bull market are catalysts for the former while OPEC 2.0 supply cuts (with effective compliance) and lower crude supply are catalysts for the latter. Encouragingly, the rig count remains well below peak levels, Cushing crude oil inventories are contracting on a year-over-year basis and OECD oil stocks appear poised to contract in late autumn/early winter (Chart 6). Net, we are constructive on energy sector margins (Chart 14). S&P Financials (Overweight) Chart 15S&P Financials Margins, though below historic peak levels, have improved dramatically. The stock market has not rewarded the sector for the solid performance, making financials a standout sector where earnings have led prices higher, rather than multiple expansion. A healthy consumer, housing market and corporate sector should lead to strong capital formation which, in turn, implies improving revenue growth for financials. This is captured by our loans & leases model which points to the largest upswing in credit growth of the past 30 years (Chart 7) Banks in particular benefit from a healthy economy as very low unemployment should be accompanied by solid loan quality which makes the industry's margin gains more durable (Chart 7). We expect banks, as the largest segment of the financials sector, to lead the index higher. Pricing power and wage growth have recently been diverging with the former moving steeply positive and the latter falling to the slowest growth of the past 5 years. These moves bode well for future margin expansion; analysts agree, with forecasts pointing to margins approaching twenty-year highs (Chart 15). S&P Consumer Discretionary (Overweight) Chart 16S&P Consumer Discretionary Consumer discretionary margins have inflated dramatically and, despite a moderation in actual and forecast profitability, they remain more than one standard deviation above normal. Wage growth is declining from fairly eye-watering levels but still remains faster than the muted sector pricing power. The net of these points is falling margins, in line with analyst forecasts. Spending has recently poked higher as a much improved household balance sheet and wage growth have made the consumer feel flush enough to start spending some of their accumulated savings of the past few years (Chart 8). This resurgence in demand should mean, barring any external shock, that pricing power will recover, though a tight labor market could present a considerable offset via above-normal wage growth. Within the index, margin strength is particularly notable in Home Improvement Retail and Cable & Satellite; both are benefitting from the themes noted above and have seen revenue growth driving wider margins. The Auto Components index is a rare underperformer with margins shrinking as the companies adjust to slowing North American light vehicle production. Net, we remain positive on consumer discretionary profit growth (Chart 16). S&P Consumer Staples (Overweight) Chart 17S&P Consumer Staples Consumer staples margins have seen a general upward trajectory over the past three years, though have recently rolled over. The key culprits have been food & drug deflation with retail struggling to maintain profits. Forecasts are pointing to a resumption of the upward margin trend, in line with our improving proxy measure (Chart 17, bottom panel). Eventually staples will regain some share of the consumer's wallet. The wage bill is moving in the right direction and even a modest uptick in sector pricing power could trigger margin expansion. It is worth noting that consumer staples is our only remaining overweight defensive index as we have drifted toward cyclical sectors with our increasingly bullish stance over the course of the year. Still, we remain confident of a modest sector margin recovery, though expect consumer discretionary to have a better profit growth profile. S&P Telecommunication Services (Neutral) Chart 18S&P Telecom Services S&P telecom services is at the very bottom of the GICS1 sector EPS growth table this year despite easy comparable quarters in 2016; this is reflected in the index's steady downward drift (Chart 18, top panel). Still, margins have started staging a recovery and the sell-side appears reasonably optimistic. The issue is pricing, the weakness of which is taking profits down regardless of margin resilience. Encouragingly, selling prices cannot contract at 10% per annum indefinitely and recent anecdotal evidence from earnings calls suggests that the peak deflationary impulse is likely behind the industry. Impressive labor cost discipline along with even a modest pricing power rebound signal that a grinding higher margin backdrop is likely in the coming months, though our margin proxy is weighed down by still-falling pricing power (Chart 18, bottom panel). S&P Materials (Neutral) Chart 19S&P Materials Margins in the S&P materials index have recovered sharply from their recent lows, with analysts forecasting continued margin expansion. Said margin expansion will be dependent on the industry holding on to the pricing power gains it has made over the past year; we think odds are good this can happen. A global manufacturing rebound appears to be underway; the global manufacturing PMI has recently reaccelerated and jumped to a six year high (Chart 9). Further, it looks likely that a coordinated central bank tightening cycle has begun which should make U.S. exports relatively more attractive, even if the greenback moves laterally from current levels. With respect to chemicals, the dominant materials component industry, a wave of global mergers (Chart 9) should limit price competition while also stripping out some overcapacity which has been a perennial margin overhang. As well, domestic operating conditions have taken a turn for the better as U.S. chemical production has troughed and utilization rates have improved (Chart 9). Still, inventories have surged in advance of the manufacturing recovery (not shown) and any demand misstep could have serious margin implications. Our materials margin proxy points to modest margin gains (Chart 19). S&P Real Estate (Neutral) Chart 20S&P Real Estate The S&P Real Estate index comprises mostly REITs and does not compare well to the other sectors on an operating margin basis, owing to the vastly different business model. Still, a discussion of drivers of both revenues and costs is worthwhile. Real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still (Chart 10). The implication is that rental inflation will remain under intense downward pressure, as has been the case since the beginning of 2016. Worrisomely, credit quality in select commercial real estate (CRE) segments is deteriorating at the margin (Chart 10). Should the trend worsen, REIT margins will deteriorate. According to a recent Fed Senior Loan Officer Survey, bankers are less willing to extend CRE credit. In fact, if one excludes the GFC spike, the tightening in CRE lending standards is near the two previous recessionary highs (Chart 10 on page 8). If banks continue to close the credit taps, CRE prices will suffer a setback. Nevertheless, the tight labor market and accelerating industrial production should keep the appetite for CRE upbeat and prices may have a bit more room to run before reaching a cyclical peak (Chart 20). S&P Industrials (Neutral) Chart 21S&P Industrials A demand revival, both domestic and globally, has helped drive a recovery of S&P industrials margins from the mini manufacturing recession of 2015/early-2016. The U.S. dollar bull market has paused (Chart 11), global demand and credit growth has recovered (Chart 11) and domestic optimism abounds (Chart 11); all the conditions look supportive of the consistent margin profile forecast by the sell-side. However, the margin expansion thesis is not without risk; pricing power gains appear to have rolled over while the wage bill, the weakness of which was a significant margin driver, has spiked. The result is that our industrials margin proxy has eased, though we discount the measure as it has not correlated well with observed margins. Still, if demand continues to remain upbeat, the operating leverage impact on the relatively high fixed cost sector should offset labor cost spikes. Net, we expect margins to drift mostly sideways (Chart 21). S&P Health Care (Underweight) Chart 22S&P Health Care S&P health care margins are showing warning signs of a potential retreat. Pricing power has worsened significantly since recent highs in 2016 which could warn of a top line contraction, particularly in the context of drug price inflation. Chart 12 shows that since 2005 drug prices have nearly doubled and the slope has actually steepened since 2011. Health care spending in the U.S. comprises over 17% of GDP, the highest in the world, but it has likely plateaued. Real health care spending is decelerating in absolute terms, and had been contracting compared with overall PCE earlier this year (Chart 12). This suggests that selling price blues are demand driven and will likely continue to weigh on health care profits. Not only are selling prices softening, but also the health care sector wage bill is on fire, pushing multi-year highs. Taken together, operating margins will continue to compress, sustaining the recent down drift. Should margins worsen as we expect, the recent updraft in the index price should follow earnings downward (Chart 22). S&P Utilities (Underweight) Chart 23S&P Utilities In earlier sections of this report, we have discussed the beneficiaries of growing ebullience in global economic expectations; utilities are at the opposite end of the spectrum. Now that the Fed is ready to start unwinding its balance sheet, the ECB is preparing the waters for QE tapering and a slew of CBs are on the cusp of a new tightening interest rate cycle, there are high odds that fixed income proxies, utilities among them, will continue to suffer. From a profit perspective, our margin proxy is pointing to a pricing driven recovery. However, contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty (Chart 13). Tack on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place (Chart 13). Importantly, industry utilization rates are probing multi-decade lows and overcapacity is negative for pricing power. Chart 13 confirms that utilities construction is relentless at a time when turbine and generator inventories have been hitting all-time highs. This is a deflationary backdrop, and suggests that sell-side analyst optimism is wrong footed. Net, we think margin weakness should persist (Chart 23). S&P Information Technology (Underweight) Chart 24S&P Information Technology Margins in the S&P information technology index are pushing their 20-year highs. However, the sector is a story of leaders and laggards. The technology hardware, storage & peripherals sub-index (almost entirely AAPL), for example, has seen their operating margin roughly double in the past ten years. Conversely, communications equipment is in the midst of a collapse in pricing power as intense competition has engulfed telcos (their principal customer group) and the uncertainty in the federal government has held back outlays. Our margin proxy is pointing to a modest margin contraction, a result of slipping sector pricing power partially offset by a flat to slightly negative sector wage bill. This stands in contrast to sell-side forecasts who expect margins to hit record levels in the next year. We view the sell-side as overly sanguine with respect to margins and expect pricing power to weigh in coming months (Chart 24).

Highlights Some caution warranted here. Hurricane Harvey's impact on the economy and markets. Tensions in North Korea will linger. NIPA and S&P now telling same story on profits, margins. Is the August employment report enough for the Fed? Feature The impact of Hurricane Harvey will ripple through the economic data in the coming months, but will not impact the overall trajectory of the economy or the Fed. However, elevated equity valuations, escalating tensions in North Korea, a widening disconnect between the bond market and the Fed and profit growth that is poised to peak in the second half of the year warrants careful attention from investors. Nonetheless, we remain slightly overweight stocks and favor stocks over bonds. Caution On Risk Assets We recommend that clients be prudent, paring back any overweight positions and holding some safe-haven assets within diversified portfolios. BCA research has demonstrated that U.S. Treasuries, Swiss bonds and JGBs were the best performers during a crisis (Chart 1). The same is true for the Swiss franc and the Japanese yen, such that the currency exposure should not be hedged in these cases. The dollar is more nuanced. It tends to perform well during financial crises, but not in geopolitical crises or recessions. Chart 1Gold Loves Geopolitical Crises Gold tends to perform well in geopolitical events, although not in recessions or financial crunches. Our base case projects stocks outperforming cash and bonds over the next 6-12 months. BCA's dollar and duration positions have disappointed so far this year. Much hinges on U.S. inflation. Investors appear to have adopted the stance that structural headwinds to inflation will forever dominate the cyclical pressures. Therefore, the bond market is totally unprepared for any upside shocks on the inflation landscape. Admittedly, a rise in bond yields may not be imminent, but the risks appear to be predominantly to the upside. Harvey's Lingering Aftermath History shows that natural disasters such as Hurricane Harvey have a temporary effect on the U.S. economy, the financial markets and the Fed. Ultimately, the macro environment in place before the storm will reassert itself. Nonetheless, it may be a few months before investors determine the long-term impact of the record rainfall and flooding in Houston. Chart 2 shows the ranking of Harvey's preliminary damage estimate of $30B versus other storms of similar magnitude. We are still several weeks away from the peak of the Atlantic hurricane season (mid-September) and two of the most destructive storms in the past 25 years made landfall in mid-to-late October (Wilma and Sandy). Chart 2Economic Impact From Major Hurricanes Chart 3 shows the performance of key economic, inflation and financial market indicators in the past two years and also around five major hurricanes since 1992. Most of the activity-related economic statistics are volatile in the aftermath of the storms and then they recover. The Citi economic surprise index initially moves higher after a storm, and then fades (Chart 3A). There are big swings in housing starts and industrial production and employment growth slows. Inflation tends to climb post-landfall (Chart 3B). In prior episodes, core PCE and core CPI have accelerated along with gasoline prices. Consumer confidence dips initially, but then recovers. Wages are volatile, but tend to accelerate after several months. Chart 3C shows that stocks drift lower for several months following hurricanes and subsequently recoup the losses. The stock-to-bond ratio also moved lower, but regains its pre-storm heights about two months later. Treasury yields fall after storms, but we note that yields have been in a secular decline for 25 years. Chart 3AMajor Hurricane Impact##BR##On Activity Data Chart 3BMajor Hurricane Impact On##BR##Sentiment And Inflation Data Chart 3CMajor Hurricane Impact On##BR##Financial Markets & The Fed Hurricane Harvey will not shake the Fed. Nonetheless, the central bank will acknowledge the disaster in the FOMC statement, the FOMC minutes, and/or in Fed Chair Janet Yellen's news conference. We are unchanged in our view that policymakers will begin to pare its balance sheet later this month and bump up rates again in December, assuming that core inflation shows some signs of strength between now and then. History shows (Chart 3C) that, on average, the Fed funds rate tends to move higher in the months after storms hit, but the primary message is that the Fed just continues to do whatever it was doing before the storm. The Fed cut rates in the aftermath of Hurricane Andrew in 1992 in what turned out to be the final rate reduction of the cycle that began in 1989. Ivan hit in September 2004, but the monetary authority raised rates in the final three FOMC meetings of 2004, including at the meeting only a week after the hurricane made landfall. Similarly, the Fed clung to its rate hike regime after Wilma in October 2005. In 2008, Ike arrived in Texas two days before Lehman Brothers collapsed in mid-September. The Fed, which had been cutting rates since September 2007, lowered rates in the final months of 2008. The Fed announced QE3 in late summer 2012 and continued with the program after Sandy came ashore at the end of October 2012. Harvey will be a game changer in some respects: the devastation reduces the odds of a government shutdown or of failing to increase the debt ceiling. We have maintained that there were extremely low odds that the debt ceiling would not be raised. We stated that there was a 25% chance of a government shutdown between October 1, when the current funding expires, and sometime in mid-October when the debt ceiling will hit according to the Congressional Budget Office. However, it would be unfathomable to shut down the government and force the Federal Emergency Management Agency (FEMA) to cease operations. The resulting outrage would damage the Republicans, especially in Texas. Bottom Line: Harvey may have a near-term impact on the economy, but the Fed will stick to its plan. The catastrophe makes it increasingly likely that the debt ceiling will be raised and a resolution will be passed to keep the government operating into the new fiscal year. Thus, equity investors can safely ignore these two risks, and focus on the key risk in the outlook: North Korea. North Korea Could Linger Over Markets BCA believes that the probability of a war on the Korean Peninsula is very low,1 but it may take a while before the uncertainty in Northeast Asia is resolved. Between now (escalating tensions) and then (a negotiated settlement), there will be more provocations and market volatility. There are long-standing constraints to war. The first is a potentially high death toll: Pyongyang can inflict massive civilian casualties in Seoul with a conventional artillery barrage. Furthermore, U.S. troops, and Japanese forces and civilians, would also suffer. Secondly, China is unlikely to remain neutral. Strategically, China will not tolerate a U.S. presence on its border with North Korea. Nevertheless, Washington must establish a credible threat of military action if it is to convince Pyongyang that negotiations offer a superior outcome. It is unclear how long it will take Trump to convince North Korea that the threat of a U.S. preemptive strike is credible. Chart 4 shows the arc of diplomacy2 that the U.S. took with Iran between 2010 and 2014. From an investor perspective, it will be difficult to gauge whether the brinkmanship and military posturing are part of this territorial threat display or evidence of real preparations for an actual attack. More market volatility may occur, but for the time being, we do not think that the tensions in the Korean peninsula will end the bull market in global equities. Positions in traditional safe-haven assets, such as gold, U.S. Treasuries, Swiss francs and (perhaps) Japanese yen, should be considered as hedges against increased market swings. Chart 4Arc Of Diplomacy: Tensions Ramp Up As Nuclear Negotiations Begin Update: Equity Valuations, Sentiment And Technicals U.S. equity valuations are stretched, but elevated valuations alone are not enough to prompt a sell-off in stocks. The BCA valuation indicator is in overvalued territory, where it has been since late 2013. History shows3 that stocks can stay overvalued for extended periods, even when the Fed is raising rates, but policy is still accommodative as it is today. BCA's composite valuation indicator is still shy of the +1 standard deviation level that defines extremely over-valued (Chart 5). However, this is due to the components that compare equity prices with bond yields. The other three elements of the equity indicator, which are unrelated to bond yields, suggest that stock valuation is stretched (Chart 5 panels 2, 3 and 4). That said, equities are attractively priced relative to competing assets, such as corporate bonds and Treasuries (Chart 6). Chart 5U.S. Equities##BR##Are Overvalued... Chart 6...But Look Less Expensive##BR##Relative To Competing Assets Valuation is not a reliable tool to time market turning points and, absent a significant deterioration in the economic, profit and margin environment, we do not forecast a sustained pullback in stocks. Looking beyond BCA's tactical 6-12 month window, above-average market multiples alone imply below-average returns for stocks across a strategic time horizon. Chart 7No Strong Signal From##BR##Sentiment Or Technicals BCA's technical and sentiment indicators are not at extremes (Chart 7). The BCA technical indicator, while above zero, is not at a level that in the past has triggered a stock pullback. Similarly, the BCA investor sentiment composite index, while at the top end of its bull market range, is not at an extreme. Moreover, only 50% of the stocks in the NYSE composite are above their 10-week moving average, a level which has not been previously associated with major equity sell-offs. Bottom Line: The solid earnings backdrop remains in place for U.S. stocks as measured by either the S&P or the national accounts. We anticipate that profit growth has peaked according to S&P 500 data on a 4-quarter moving total basis due to tough comparisons although it will slip only modestly in the second half of the year. Next year will see EPS growth drop back into the mid-single digit range. The consensus estimate for 2018 EPS growth is 11%. While valuations are elevated, neither sentiment nor technical indicators are flashing red. We recommend stocks over bonds in the next 6-12 months, but acknowledge that risks to BCA's stance are climbing. A Reconnection In Q2 The Q2 data show that the NIPA and S&P earnings measures have reconnected. In our July 3, 2017 Weekly Report "Summer Stress Out"4 we highlighted the apparent disconnect between the S&P and NIPA, sales earnings and margin data through Q1 2017. The release of the Q2 corporate profits data in the national accounts and the end the Q2 S&P 500 reporting season allow us to provide an update. The year-over-year reading on the NIPA earnings measure ticked up in Q2 while the S&P-based metric ticked down. That said, while there are marked differences in annual growth rates between the two measures, the levels were close to the same point in the second quarter of 2017 (Chart 8, bottom panel). Chart 9 shows that a wide difference persists between corporate sales measured by S&P and the national accounts. Margins calculated on the S&P basis climbed in Q2 while NIPA margins held steady. Even so, a modest gap still remains between NIPA margins at 15.2% and S&P margins at 13.2%. Most of the divergence is related to the denominator of the calculation. The NIPA denominator is corporate sector Gross Domestic Product (GDP). This is a value-added concept that is different from sales. It is not clear why, but GDP has grown much faster than sales since the end of 2014. Chart 8S&P And NIPA##BR##Profit Comparison Chart 9Denominator Explains##BR##S&P/NIPA Margin Divergence We believe that the S&P statistics are painting a more accurate picture because sales are easier to measure while value-added is more complicated. The slow growth of sales is not a bullish point for stocks. Nonetheless, it does not appear that financial engineering has distorted bottom-up company data to such an extent that the S&P readings are falsely signaling strong profit growth. We expect the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the profit backdrop is positive for stocks for now. Is The August Jobs Report Enough For The Fed? Chart 10Labor Market Conditions##BR##Favor Risk Assets U.S. payrolls expanded by 156,000 in August. Relative to the underlying growth rate in the labor force, this is still a healthy pace of jobs growth. Nevertheless, it fell short of expectations for a 180,000 increase and the prior two months saw a cumulative downward revision of 41,000. The August data were not impacted by Hurricane Harvey. Aggregate hours worked, a measure of total labor inputs based on changes in employment and the workweek, fell by 0.2% m/m. That said, aggregate hours worked are up 1.3% at a quarterly annualized rate thus far in Q3. This is consistent with GDP growth of a bit over 2%, which has been the trend in the current economic expansion. Meanwhile, wage gains remain muted. Average hourly earnings rose just 0.1% m/m. Annual wage inflation has been steady at 2.5% for several months now (Chart 10, bottom panel). If productivity is expanding modestly around 1%, the current pace of wage gains would suggest that unit labor costs are growing around 1.5%. This will make it difficult for general price inflation to accelerate to the Fed 2% target. Nonetheless, the reacceleration in the 3-month change in average hourly earnings from 1.9% in January 2017 to 2.6% in August supports the Fed's view on inflation. Finally, the unemployment rate ticked up to 4.4% from 4.3%. This was because the separate household survey showed a 74,000 drop in employment. The participation rate held steady at 62.9% in August. Bottom Line: While falling short of expectations in August, U.S. employment growth remains solid and job gains are continuing at a pace consistent with the 2% GDP growth rate of recent years. However, muted wage gains mean that progress to the Fed's 2% inflation target is looking suspect. We anticipate that the Fed will announce the process of running down its balance sheet at the September FOMC meeting. Rate hikes are on hold at least until the December FOMC meeting, and even then only if core inflation shows some signs of strength in the next few months. U.S. risk assets should continue to benefit from moderate growth, low inflation and a "go slow" approach by the Fed. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?", August 16, 2017. It is available at gps.bcaresearch.com. 2 Please see BCA's Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets? ,"May 24, 2017, available at gps.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Sizing Up The Second Half", July 10, 2017, available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Summer Stress Out", July 3, 2017, available at usis.bcaresearch.com.

Feature Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report written by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst. Mark makes a compelling case that the deflationary effects of the "Amazon economy" are overstated. I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Chart 1September Is Generally ##br##Not A Good Time Of Year For Stocks My colleagues and I convened a meeting earlier this week to discuss whether to abandon our long-standing cyclically bullish view towards risk assets. Several of them felt it was time to turn more cautious. I am sympathetic to their concerns: Valuations are stretched, volatility is low, and geopolitical risks (most notably North Korea) are on the rise. Profit growth is likely to decelerate later this year, as the easy comps stemming from the depressed level of earnings in the first half of 2016 vanish. Meanwhile, stocks are entering the volatile early autumn months, a period which has historically seen poor returns (Chart 1). Nevertheless, at times like these, it is useful to fall back on our time-tested indicators. Bear markets have almost always coincided with economic recessions, with the latter usually causing the former (Chart 2). None of our recession-timing signals are flashing red: To cite just a few examples, ISM manufacturing new orders are strong, initial unemployment claims are low, core capital goods orders are accelerating, and the yield curve is not in any immediate risk of inverting (Chart 3). Chart 2Recessions And Bear Markets Usually Overlap Chart 3No Warnings Of Recession Here U.S. financial conditions have eased sharply this year, which should support growth over the next few quarters (Chart 4). A recent IMF report highlighted that easier U.S. financial conditions tend to generate positive spillovers onto other countries.1 The fact that all 45 countries monitored by the OECD are on track to grow this year - the first time this has happened since 2007 - is a testament to the strong fundamentals underpinning the global economy. Chart 4Easing Financial Conditions Bode Well For Growth The Fed's Dot Problem In this light, the Fed's projection that the unemployment rate will end this year at 4.3% and only fall to 4.2% by end-2018 no longer looks credible. If U.S. GDP growth remains above trend, as we expect, the unemployment rate could fall below its 2000 low of 3.8% by next summer. That will be enough to prompt investors to price in a few more rate hikes. Considering that the market expects just 22 basis points in hikes through to end-2018, this is not a high bar to clear. A bit more fiscal stimulus would add to the pressure to tighten monetary policy. While any meaningful progress on tax reform will be difficult to achieve, the odds are good that Congress will agree to cut statutory corporate and personal tax rates, with the latter focusing mainly on middle-income earners. Failure to raise the debt ceiling or extend federal spending authority beyond the current budget window could scuttle the benefits from lower tax rates. Fortunately, the risks of such an outcome have receded. If there is a silver lining from Hurricane Harvey, it is that the disaster could at least temporarily overcome the political impasse in Washington. Congress will need to appropriate additional disaster relief funds over the coming weeks. Politicians who are seen as creating roadblocks to such funding will face the electorate's wrath. The odds of an infrastructure bill passing through Congress have also risen. All recoveries eventually run out of steam, but this one can last at least until the second half of 2019, which will make it the longest U.S. expansion on record. As we discussed several weeks ago, the next recession is likely to be triggered by the Fed scrambling to hike rates in response to rising inflation.2 This is not an immediate concern, given that it usually takes a while for an overheated economy to generate inflation - especially since the U.S. currently can satisfy rising domestic demand with higher imports. However, the risks of overheating will increase as unemployment falls further and excess capacity elsewhere in the world is absorbed. Draghi After Jackson Hole Chart 5A Stronger Euro Is Deflationary Textbook economic theory states that a shift in consumption towards imported goods requires a real appreciation of the currency. The dollar, of course, has done exactly the opposite of that, depreciating by 6.6% in trade-weighted terms since the start of the year. The euro, in particular, has gained significant ground against the greenback, rising above $1.20 at one point this week. Mario Draghi's failure to express concerns about the resurgent euro during his Jackson Hole address was construed by many market participants as a green light for further currency strength. We are skeptical of this "saying nothing means you are saying something" interpretation. Draghi wanted to acknowledge (and partly take credit for) the recovery across the euro area, but he is cognizant of the problems posed by a stronger euro. The ECB's June forecast showed inflation rising to only 1.6% in 2019. In the period since those forecasts were compiled, the trade-weighted euro has appreciated by 3.9%, bringing the year-to-date gain to 6.2% (Chart 5). ECB staff calculations, which Draghi has approvingly quoted, show that a 10% appreciation in the euro would reduce inflation by 0.2 percentage points in the first year and 0.6-to-0.8 points in the subsequent two years.3 Better-than-expected growth since the June forecasts will offset some of the deflationary impact from the stronger euro, but probably not by much, given that the Phillips curve is quite flat at high-to-moderate levels of spare capacity. With labor market slack across the euro area still 3.2 percentage points higher today than in 2008 (and 6.7 points higher outside of Germany), it will be a while before stronger growth generates markedly higher inflation. We expect the ECB to reduce its 2018/2019 inflation forecast by 0.1-to-0.2 percentage points next week. It would be awkward for the central bank to play up the prospect of monetary policy normalization while it is simultaneously trimming its inflation projections. This suggests that the ECB's communications could turn more dovish, thereby limiting further upside for the euro. EUR/USD is currently trading near the top of the $1.10-to-$1.20 range that we foresee lasting for the next 10 months. Thus, our expectation is that the euro will weaken over the next few months, ending the year near $1.15, and potentially moving back towards its 2017 lows in the second half of next year, as an overheated U.S. economy forces the Fed to pick up the pace of rate hikes. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, (Chapter 3), (April 2017). 2 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery to Retro-Recession?" dated August 18, 2017. 3 Please see European Central Bank, "March 2017 ECB Staff Macroeconomic Projections For The Euro Area." APPENDIX 1 Tactical Global Asset Allocation Monthly Update To complement our analysis, we use a variety of time-tested models to assess the global investment outlook. At present, these models favor global equities over bonds over a three-month horizon (Appendix Table 1). Appendix Table 1BCA's Tactical Global Asset Allocation Recommendations* Our business cycle equity indicators remain in bullish territory, as reflected in strong global growth and rising corporate earnings. Our monetary and financial indicators are also generally supportive. In contrast, our sentiment readings are sending mixed signals. On the one hand, implied equity volatility remains low and institutional exposure to stocks is quite high. On the other hand, surveys of retail investors show a healthy skepticism towards the bull market, which is a positive contrarian indicator. As has been the case for some time, our valuation measures are signaling that stocks are expensive, but these are typically useful only over horizons beyond one or two years. As we flagged last month, stocks tend to do poorly in August and September, which may hurt returns over the next few weeks. The stronger euro will negatively impact earnings in the euro area. This has caused our models to suggest a slight downgrade to European equities. However, we are inclined to fade this signal, given our expectation that the euro will give up some of its recent gains. Japanese stocks continue to score well on our metrics, buoyed by strengthening corporate profits and attractive valuations. Emerging market equities are fairly valued, although China still appears cheap. The rally in U.S. Treasurys has caused the gap between the 10-year yield and our model's fair value estimate to widen to around 50 basis points, the highest since last September. European and Japanese bonds also look somewhat overvalued, although the latter will continue to receive support from the BoJ's yield curve targeting operations. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades