Gov Sovereigns/Treasurys

Highlights Chart 1Too Pessimistic On Growth Treasury yields bounced sharply last week and the yield curve steepened. As a result the Bloomberg Barclays Treasury index posted a negative return in June, only the second month of negative Treasury returns so far in 2017. Last week's increase in yields could signal that growth expectations have finally become overly pessimistic. Our U.S. Investment Strategy service has calculated that after the U.S. Economic Surprise Index rises above 40, its average peak to trough decline lasts 90 days. Given that the surprise index peaked above 40 in mid-March, a bottoming-out in the coming weeks would be right on schedule (Chart 1). Net speculative positioning in the futures market has also capitulated, swinging sharply from net short to net long. In recent years, extreme net long positioning has led to higher Treasury yields during the following three months (bottom panel). Our assessment is that U.S. growth will remain above trend for the remainder of the year, and the Treasury curve will continue to bear-steepen as the economic data start to outperform downbeat expectations. Stay at below-benchmark duration, in curve steepeners, overweight spread product versus Treasuries, and overweight TIPS versus nominals. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 50 basis points in June. The index option-adjusted spread tightened 4 bps to end the month at 109 bps. Though below its historical mean, the investment grade spread is actually somewhat elevated compared to the early stages of prior Fed tightening cycles (Chart 2). We calculate that in the early stages of the past two tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 90 bps and traded in a range between 66 bps and 107 bps. While spreads are currently more attractive than is typical for this stage of the cycle, there is good reason for investors to demand some extra risk premium. In a recent report1 we observed that non-financial corporate debt as a percent of GDP is already as high as it was during the past two recessions. Further, the majority of this debt has been issued to finance direct payments to shareholders (dividends & buybacks) as opposed to capital investment. This unfavorable shift in corporate capital structures means that bond investors should demand somewhat greater compensation. All in all, we do not see potential for much spread tightening from current levels. However, a large spread widening would be equally unlikely given the favorable back-drop of steady growth and muted inflation. Small positive excess returns, consistent with carry, remains the most likely scenario. Energy debt underperformed duration-matched Treasuries by 12 bps in June. The sector still looks cheap after adjusting for credit rating and duration (Table 3), and our commodity strategists remain bullish on oil. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 35 basis points in June. The index option-adjusted spread widened 1 bp to end the month at 364 bps, 20 bps above its 2017 low. Energy sector spreads widened sharply in June, alongside falling oil prices, once again de-coupling from the overall index spread (Chart 3). Junk-rated energy credits underperformed the duration-equivalent Treasury index by 190 bps in June, while the High-Yield index excluding energy outperformed by 70 bps. In a report published today,2 our Energy Sector Strategy service takes a detailed look at credit risk among high-yield energy issuers, concluding that while the worst of the energy bankruptcy cycle is behind us, $23 billion of high-yield energy debt remains in distress. 91% of that distressed debt is in the Exploration & Production and Offshore Drilling & Transportation sectors. The continued moderation in energy sector defaults will ensure that the overall speculative grade default rate trends lower for the rest of the year, probably settling below 3% (bottom panel). The decline in defaults means that the current compensation offered by junk spreads in excess of expected default losses stands at 221 bps, right in line with its historical average (panel 3). In last week's report,3 we showed that a default-adjusted spread of 221 bps is consistent with excess returns close to 150 bps during the next 12 months. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 20 basis points in June, dragging year-to-date excess returns down to -20 bps. The conventional 30-year MBS yield rose 11 bps on the month, driven by a 7 bps increase in the rate component and a 6 bps widening of the option-adjusted spread (OAS). This was partially offset by a 2 bps decline in the compensation for prepayment risk (option cost). In last week's report,4 we examined the risk/reward trade-off in different Aaa-rated spread products. We found that despite some recent widening in MBS OAS, you still need to move into 4% coupons or higher to find competitive spreads relative to Aaa-rated corporates, consumer ABS, agency CMBS and non-agency CMBS. Further, MBS OAS are still too tight compared to the trend in net issuance (Chart 4), and even though depressed refi activity will continue to hold down the option cost component of spreads, it is unlikely that a lower option cost will be able to completely offset wider OAS during the next 12 months. The Fed released more details about its balance sheet run-off plan at the June FOMC meeting. We now know that the Fed will start by allowing only $4 billion of MBS per month to run off its balance sheet, but this cap will increase by $4 billion every 3 months until it reaches $20 billion per month. This means that even if the Fed starts to wind down its balance sheet following the September meeting, which is our base case expectation, then it will still be some time before a significant amount of extra supply shifts into the private market. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 21 basis points in June, bringing year-to-date excess returns up to +107 bps. Sovereigns and Local Authorities outperformed the Treasury benchmark by 65 bps and 73 bps, respectively. The low-beta Supranational and Domestic Agency sectors outperformed by 2 bps and 10 bps, respectively. The Foreign Agency sector underperformed duration-matched Treasuries by 4 bps, alongside the dip in oil prices. A weakening U.S. dollar has led to the outperformance of USD-denominated sovereign debt so far this year. Year-to-date, the Sovereign index has outperformed the duration-equivalent Treasury index by 300 bps. This is better than the equivalently-rated Baa U.S. Corporate index, which has outperformed by 195 bps year-to-date. However, there are already signs that the trade-weighted dollar is starting to moderate its downtrend (Chart 5), and we expect the trade-weighted dollar will strengthen as the economic data surprise to the upside in the back half of the year, as discussed on the first page of this report. Granted, the Mexican peso continues to strengthen versus the dollar (panel 3) and this currency pair is particularly important since Mexico is the largest issuer in the Sovereign index. On the heels of its recent outperformance, the Sovereign sector once again looks expensive compared to U.S. corporate sectors, after adjusting for credit rating and duration. Meanwhile, the Local Authority and Foreign Agency sectors continue to look cheap. Supranationals and Domestic Agencies offer very little additional compensation relative to Treasuries, and as we discussed last week,5 there are better options available for investors in need of high-quality spread product. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 18 basis points in June (before adjusting for the tax advantage). Last month we observed that Municipal / Treasury (M/T) yield ratios had become very tight, and we advised reducing municipal bond exposure to underweight. The average M/T yield ratio ticked higher in June, but at 85%, it remains more than one standard deviation below its post-crisis average (Chart 6). There is more compensation available at the long-end of the muni curve than at the short-end (panel 2), and investors should continue to favor long maturities over short maturities on the Aaa Muni curve. The National Association of State Budget Officers recently released its Fiscal Survey of the States and it showed that overall general fund expenditures are expected to increase by only 1% in the 2018 fiscal year, the slowest rate of growth since 2009/10. Meanwhile, 23 states have already enacted mid-year budget cuts in 2017. Budget cutting measures are clearly a response to disappointing tax revenues, which should bounce back somewhat in fiscal year 2018.6 This will help reduce net borrowing, though probably not by enough to justify current municipal bond valuations (panel 3). The state of Illinois avoided a ratings downgrade to junk this week, as the State House of Representatives voted to approve an income tax increase. This measure will keep the rating agencies at bay for now, but a downgrade is still possible in the coming months if the state fails to pass a budget for fiscal year 2018. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened for most of June, before suddenly reversing course and bear-steepening late in the month. The 2/10 slope flattened 15 basis points between the end of May and June 26, and then steepened 15 bps between June 26 and the end of the month. All told, the 2/10 slope was unchanged in June, while the 5/30 slope flattened 17 bps. The abrupt transition from bull-flattening to bear-steepening was prompted by comments from European Central Bank (ECB) President Mario Draghi that suggested a much more hawkish bias from the ECB. Higher rate expectations in the rest of the world should put downward pressure on the U.S. dollar, and historically, bearish sentiment toward the U.S. dollar has led to a steeper U.S. yield curve (Chart 7, bottom panel). This correlation has not held up so far this year, and we suspect this is because a weaker dollar has not translated into higher U.S. inflation and inflation expectations, as it usually does. We have previously made the case that inflation and inflation expectations, and not Fed tightening, are the main determinants of the slope of the yield curve (panel 4).7 As such, we attribute the bulk of this year's curve flattening to disappointing core inflation which has dragged TIPS breakevens lower. This should reverse in the coming months.8 Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 86 basis points in June. The 10-year TIPS breakeven rate fell 8 bps on the month and, at 1.75%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. In a recent report9 we outlined three possible scenarios for Treasury yields between now and the end of the year based on the interaction between incoming inflation data and Fed policy. In our base case scenario inflation will start to rebound in the coming months, heeding the message from our Phillips Curve model (Chart 8), leading to wider TIPS breakevens and keeping the Fed on its current tightening path. Even if realized inflation remains depressed, the next most likely scenario is that the Fed will capitulate later this year and adopt a shallower expected rate hike path. Such a dovish reaction from the Fed would lend support to long-maturity breakeven wideners, even though real yields would decline. The least likely scenario, in our view, is one where realized inflation remains low but the Fed sticks to its hawkish rhetoric. This is also the scenario that would lead to the most downside in the cost of inflation protection. May PCE inflation data were released last Friday, with year-over-year core PCE decelerating from 1.50% to 1.39%, and trimmed mean PCE decelerating from 1.70% to 1.66% (panel 4). One bright spot is that our PCE Diffusion Index swung sharply into positive territory. Historically, this index has a strong track record signaling turning points in core inflation (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in June, bringing year-to-date excess returns up to +54 bps. The index option-adjusted spread for Aaa-rated ABS tightened 2 bps on the month, and remains well below its average pre-crisis level. Despite low spreads relative to history, in a recent report10 we showed that Aaa-rated ABS appear quite attractive compared to other Aaa-rated spread product. Specifically, Aaa consumer ABS offer greater compensation per unit of duration than Agency bonds, agency MBS and Aaa Credit. They offer similar compensation per unit of duration to Agency CMBS, but less than non-Agency Aaa CMBS. Within consumer ABS, auto loan-backed securitizations offer slightly greater compensation than the credit card-backed variety (Chart 9). However, we still prefer credit card ABS over auto loan ABS. While credit card charge-offs remain historically low, auto net loss rates are rising. Auto lending standards also moved deeper into "net tightening" territory in the first quarter, according to the Fed's Senior Loan Officer Survey, while credit card lending standards dipped back into "net easing" territory (bottom panel). We continue to recommend that investors favor Aaa-rated credit cards over Aaa-rated auto loans within an overall overweight allocation to consumer ABS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in June, bringing year-to-date excess returns up to +57 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 1 bp on the month, and remains below its average pre-crisis level (Chart 10). In last week's report,11 we showed that non-agency CMBS offer by far the most compensation per unit of duration of any Aaa-rated spread sector. However, we are concerned that non-agency CMBS spreads will widen on a 6-12 month horizon. Commercial real estate lending standards are tightening and property prices are decelerating. Both of these developments tend to correlate with wider spreads. Despite lower spreads, we are much more comfortable in the Agency CMBS market. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 4 basis points in June, bringing year-to-date excess returns up to +54 bps. Agency CMBS offer somewhat lower spreads than their non-agency counterparts, but this sector should be more insulated from spread widening in the months ahead. Not only do these securities benefit from agency backing, but they also mostly comprise multi-family loans. Multi-family property prices have been stronger than those in the retail and office sectors, and delinquencies have been lower (bottom 2 panels). 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 2.52% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.45%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound. The U.S. PMI has dipped lower in recent months, but remains firmly entrenched above the 50 boom/bust line. Meanwhile, the Eurozone PMI continues to surge ahead. China's PMI sent a worrying signal when it dipped below 50 in May, but it bounced back to 50.4 last month (bottom panel). Overall, the Global PMI came in at 52.6 in June, no change from the prior month. 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 2.35%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 2 Please see Energy Sector Strategy Weekly Report, "HY Debt Update: Offshore Drilling & Transportation Getting Left Behind", dated July 5, 2017, available at nrg.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 For further details please see U.S. Bond Strategy Weekly Report, "Will The Fed Stick To Its Guns?", dated May 16, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Central Banks: The sharp sell-off in global bond markets last week was triggered by more upbeat comments on growth and inflation by several major central bankers, most notably ECB President Mario Draghi. ECB Tapering: Draghi's positive views on the European economy are generally accurate, which puts the ECB on a path to taper its asset purchases next year. Bunds vs. JGBs: Bund yields have more upside in the next 3-6 months as the market reprices a smaller amount of ECB bond buying. Downgrade core European government bonds to underweight (2 out of 5) and upgrade low-beta Japan to maximum overweight (5 out of 5). Feature "The threat of deflation is gone and reflationary forces are at play." - Mario Draghi Chart of the WeekA Co-Ordinated Tightening On The Horizon? Bond market volatility awoke with a vengeance last week, as investors digested a string of hawkish comments from previously dovish central banks. A surprisingly optimistic speech from European Central Bank (ECB) President Mario Draghi set the tone, triggering the biggest single day rise in German bond yields in over two years. This was followed up by comments from Bank of England (BoE) Governor Mark Carney and Bank of Canada Governor Stephen Poloz suggesting that higher rates may be needed soon in the U.K. and Canada, triggering sell-offs in Gilts and Canadian bonds. Even U.S. Treasury yields rose alongside the global move, without any positive U.S. data or more hawkish Fed commentary. This move to a more hawkish tone - or, at least, a less dovish message - is consistent with the current strength of the global economy, as well as the robust performance of risk assets so far in 2017. Policymakers are now being forced to adjust their biases to reflect the more positive backdrop, forcing a repricing of interest rate expectations with most developed economies hovering around full employment (Chart of the Week). A "coordinated" move to tweak policy rates higher suggests bond yields have more room to rise - especially after the decline since March that has driven most government bond yields to expensive levels. The bigger risk for global bonds, however, will come from a likely shift in ECB policy towards a reduction in the size of their current bond purchase program. As we saw last week, even a mere mention of a need to shift to a less accommodative monetary stance was enough to cause Bund yields to nearly double in a matter of days. We have been positioned for a renewed rise in bond yields through our recommended below-benchmark portfolio duration stance. We are also positioned for a bear-steepening of government bond yield curves in our model bond portfolio, as our recommended duration exposures are concentrated in shorter-maturity bonds. With central banks only looking to catch up to the underlying state of the global economy, rather than aiming to more aggressively tighten policy to cool off growth, there is more potential for longer-dated bond yields to rise relative to shorter-maturity debt - especially with market-based inflation expectations now looking too low in most countries. In other words, expect more bear-steepening of global yield curves (ex-Japan) in the next few months. Dissecting Draghi's Speech The jump in global yields last week was broad based, both across countries and when broken down into valuation components. The "high-yielders" among developed markets (U.S., Canada, U.K.), saw modest increases in inflation expectations and term premia, while rate hike expectations jumped sharply in Canada and the U.K. (Chart 2). Among the "low-yielders" (Germany, Japan), the 22bps jump in Bund yields came through higher term premia, with only very modest moves higher in rate hike or inflation expectations (Chart 3). Japanese yields didn't move at all, consistent with the view that the Bank of Japan is the one central bank that does not need to become less accommodative with Japanese core inflation back down to 0%. Chart 2Global Yields Starting To Perk Up A Bit... Chart 3...Led By Europe Mario Draghi's speech, which set off last week's yield spike, was such a shock to markets because of the upbeat description of the underlying strength of the Euro Area economy. It is important to consider where this speech was given - in front of global policymakers at the annual ECB Forum on Central Banking in Portugal (the ECB equivalent to the Fed's annual Jackson Hole conference). The head of the central bank that has been providing the highest degree of monetary stimulus among the major economies over the past couple of years told his global peers that the need for such an extreme accommodative policy stance was now diminished. This is a message shared by the BCA Central Bank Monitors, which are pointing to a need for tighter monetary policy everywhere except Japan (Chart 4). Chart 4Tighter Monetary Policy Is Required Is such a high-conviction view from the ECB justified? Let's do a little "truth check" on some of Draghi's most relevant comments from his speech: "All the signs now point to a strengthening and broadening recovery in the Euro Area." TRUE. Most reliable cyclical indicators - PMIs, consumer confidence, business confidence - are all at, or beyond, pre-2008 crisis levels (Chart 5). The German IFO index hit a record high in June, while data has been strengthening across all the major Euro Area economies (even Italy). "We can be more assured about the return of inflation to our objective than we were a few years ago. [However,] inflation dynamics are not yet durable and self-sustaining. So our monetary policy needs to be persistent." TRUE. The Euro Area unemployment rate at 9.5% now sits within hailing distance of the OECD's estimate of the full employment "NAIRU" rate of 9%. Already, core inflation and wage growth are stabilizing in the Euro Area (Chart 6), suggesting that the estimated full employment rate may be an accurate measure. The ECB is forecasting that the unemployment rate will fall to 8.4% by 2019, which would be below the OECD NAIRU level, and the ECB is now forecasting that Euro Area core inflation will rise to 1.8% within two years. That would likely be close enough to the ECB's official inflation target (headline inflation at or just below 2%) for a potential rate hike by then, but not before. Chart 5European Growth Looks Very Healthy Chart 6Full Employment Is In Sight "The past period of low inflation is [...] on the whole temporary and should not cause inflation to deviate from its trend over the medium term." MOST LIKELY TRUE. The steep fall in European inflation in 2014 triggered deflation fears, and prompted the ECB to finally engage in an asset purchase program just as the Fed was ending its' own "QE". Much of that decline was related to the sharp downturn in global energy prices. Draghi also noted in his speech that, by the ECB's own estimates, around two thirds of the undershoot of Euro Area inflation in 2015/16 came from the impact of lower energy prices. He also mentioned that past fall in oil prices and other "global shocks" are likely to still be restraining core inflation to some degree via pass-through effects in parts of the economy that are more energy-intensive. Draghi did also point out that the current low oil prices are mainly supply driven (a view that BCA's commodity strategists whole-heartedly agree with) and, therefore, can be "looked through" by a central bank. That may be dangerous view to take with wage inflation still subdued in Europe, but it seems clear that core inflation has indeed bottomed out and is in the process of a slow grind higher (Chart 7). This is also helping to stabilize inflation expectations in Europe to some degree, although it is far too early for the ECB to declare victory over "low-flation." "Political winds are becoming tailwinds. There is newfound confidence in the reform process, and newfound support for European cohesion, which could help unleash pent-up demand and investment." TRUE. The 2017 political calendar appeared daunting at the start of the year, with elections scheduled in the Netherlands, France and Germany anti-euro candidates scoring better-than-expected in the polling data. The ECB even cited political uncertainty as one of the reasons for extending its asset purchase program to the end of 2017, in case there was a surprise win by a "Euro-skeptic" party. The electoral losses by Geert Wilders in the Netherlands and Marine Le Pen in France were strong signals that the anti-establishment wave that had washed over the U.K. and U.S. last year would not spill over into Europe. There is a new potential risk in Italy, where fresh parliamentary elections are expected to be called sometime in the first half of 2018. The polling numbers are tight there, with pro- and anti-euro parties showing roughly equal levels of support. Yet with the Italian economy showing some improvement alongside the rest of Europe, and with Italian banks under less immediate pressure after some successful recent rescue packages for struggling lenders (Chart 8), there is less risk of an anti-euro uprising in the polls in Italy next year. Chart 7From Deflation Fears To Reflation Cheers Chart 8Italy Is No Constraint To An ECB Taper At a minimum, the ECB likely would not factor politics into any decision on tapering its asset purchases starting in 2018. Chart 9Taper Tantrum 2.0? "As the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments - not to tighten the policy stance, but to keep it broadly unchanged." TRUE. The Fed was making similar arguments when they moved away from QE bond purchases and, eventually, the timing of the first rate hike. Using words like how the U.S. economy had "healed" from the financial crisis by enough to start removing some policy accommodation. In some respects, the European economy is in much better shape than when the Fed began its own taper in 2014. In Chart 9, we present an idea that we published earlier this year, showing the comparison of Europe now versus the U.S. pre-Fed taper. This is a "cycle-on-cycle" analysis, where the European and U.S. data are lined up to the peak of our months-to-hike indicator, noting the timing of the first rate hike priced into OIS curves after the period of 0% policy rates. The chart shows that the current Euro Area economy is about two percentage points closer to full employment than the U.S. was just before the infamous 2013 Taper Tantrum. The Fed began signaling that major policy shift with core inflation below its 2% target, at similar levels to the current European core inflation rate. A look at the subsequent moves in bond yields and term premia (bottom two panels) suggests that Europe could be on the verge of its own Taper Tantrum in the next few months. Summing it all up, we conclude that the optimism on the European growth and inflation outlook expressed by Draghi is justified. Barring a sudden collapse in the economy or inflation over the summer, the ECB looks to be on course to announce a tapering of its bond purchases, starting in 2018, at the upcoming September policy meeting. Bottom Line: The sharp sell-off in global bond markets last week was triggered by more upbeat comments on growth and inflation by several major central bankers, most notably ECB President Mario Draghi. We see Draghi's positive views on the European economy to be generally accurate, which puts the ECB on a path to taper its asset purchases next year. Downgrade Core European Government Bonds To Underweight Our expectation heading into 2017 was that core European bonds would outperform U.S. Treasuries in the first half of the year as the Fed delivered more rate hikes and the ECB maintained a highly dovish tone at least through the April/May French presidential elections.1 After that, assuming the French election went according to our expectations with a Le Pen loss, the ECB would then turn its attention to potential "taper talk" that would trigger an underperformance of core Europe versus Treasuries. The U.S. Treasury rally since March defied our forecast, even though the Fed did actually hike rates twice! While we still see more Fed tightening and higher U.S. yields as the base case in the latter half of the year, the European story is playing out as we expected. We are sticking to our plan after last week's developments, and we are downgrading core European bonds (Germany, France, Italy) to a recommended underweight ranking (2 out of 5). Importantly, we've likely seen the low in European yields even if there is no tapering in 2018. In Chart 10, we update an analysis we did earlier this year, looking at the projected size of the ECB's monetary base under various asset purchase scenarios for next year: The ECB stops "cold turkey" on December 31 and buys no additional bonds in 2018; The ECB tapers its €60bn/month of bond buying to zero by June 2018; The ECB tapers its €60bn/month of bond buying to zero by December 2018; The ECB announces no taper and keeps on buying at €60bn/month throughout 2018. In the bottom two panels of Chart 10, we show the growth rate of the ECB's monetary base versus the German Bund yield and the term premium. The projections for the growth rates are based off the four scenarios laid out above. In all cases, the growth in the expansion of the ECB monetary base (and its balance sheet) will slow next year - even if there is no tapering. Importantly, the euro is unlikely to spike versus the U.S. dollar in the event of a tapering, as relative money supplies and policy interest rates will remain USD-bullish (Chart 11). Chart 10The ECB Effect On Bunds Will Soon Fade Chart 11A Taper-Fueled Rise In The Euro Has Its Limits This is the dirty little secret about central bank asset purchase programs. They must be delivered in even bigger sizes than before to have the same impact on asset prices and, eventually, economic growth and inflation. Chart 12UST-Bund Spread Looks Too Low We now feel comfortable shifting to a reduced recommended country allocation to core Europe in our model bond portfolio. We have been maintaining a below-benchmark duration stance in core Europe for the past couple of months, by placing less recommended exposure in the longer maturity "buckets" in our portfolio and overweighting the shorter-maturity buckets. Now, we are comfortable cutting the allocation to core Europe across all buckets based on our views on the ECB. What should be upgraded if we are downgrading Europe? As mentioned, we had expected to upgrade U.S. Treasuries at this point in the year, but the disappointing run of U.S. data (especially versus Europe) drove the Treasury-Bund spread sharply lower (Chart 12). Given our view that the U.S. economy and inflation will rebound in the latter half of this year and prompt the Fed to deliver more hikes, we see the Treasury-Bund spread as too low to recommend shifting out of core Europe into the U.S. Instead, we see a better case to upgrade the most defensive country in the developed bond universe - Japan. There is a clear divergence between recent growth and inflation data in the Euro Area versus Japan, most notably with core inflation returning to 0% in Japan (Chart 13). The JGB-Bund spread looks to be at critical support levels that could trigger a quick tightening, especially if there are more upside data surprises in Europe or disappointments in Japan (Chart 14). Chart 13Europe & Japan Are Diverging Chart 14Reduce Core European Exposure In Favor Of JGBs Bottom Line: Bund yields have more upside in the next 3-6 months as the market reprices a smaller amount of ECB bond buying. Downgrade core European government bonds to underweight (2 out of 5) and upgrade low-beta Japan to maximum overweight (5 out of 5). Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "How To Think About Global Bond Investing In 2017", dated December 20 2016, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Recommended Allocation Risk assets have continued to outperform, despite soft inflation data and falling interest rates. Either inflation will pick up again, amid decent growth, and the Fed (and, to a degree, other central banks) will tighten, or the Fed will capitulate and stay on hold. Either scenario should be good for risk assets. No indicator signals a recession on the horizon, and so we continue to expect equities to outperform bonds over the next 12 months. Within equities, we favor DM over EM; we maintain a pro-cyclical sector tilt, but rotate out of Tech into Financials, which are cheaper and should benefit from steeper yield curves. In fixed income, we prefer credit to government bonds, but trim our overweight in investment grade credit as spreads are unlikely to contract further. We are overweight TIPS and Japanese inflation-linked bonds. Feature Overview How To Square Lower Rates And Rising Equities One of the basic principles of BCA's Global Asset Allocation service is that it is highly unusual for equities to underperform bonds for any extended period except in the run-up to, and during, recessions (Chart 1). After the recent decline in long-term interest rates and softness in inflation, we find investors worldwide becoming increasingly nervous about the outlook. We see nothing in the data, however, to indicate a recession in the coming 12 months. Of the three historically most reliable recession indicators - PMIs, credit spreads, and the yield curve (Chart 2) - only the last raises some concerns, but it is still far from inverting, which is the requirement for a recession signal. None of the formal recession models is flashing a warning signal either (Chart 3). Chart 1Stocks Outperform Except Ahead Of Recession Chart 2Usual Recession Signals Still Absent Chart 3Recession Risk Models Not Rising Either Nonetheless, market action in recent months has been unusual. Bond yields have fallen (with the 10-year U.S. Treasury yield slipping to 2.2% from 2.6%), and the dollar has weakened, but risk assets have continued to perform well, with global equities giving a total return of 13% year to date and 4% in Q2. Can this desynchronization continue? We see three possible scenarios:1 Chart 4Market Expects Fed To Be Dovish Reflation returns. The Fed proves to be right that the recent weak inflation data is temporary. Inflation picks up and the Fed raises rates more quickly than the market is currently pricing in (which is only 25 bps over the next 12 months, Chart 4). Initially, the rebound in inflation might be a shock for risk assets but, as long as the Fed is tightening because it is confident about growth and unconcerned about global risk, over 12 months risk assets such as equities should continue to outperform. The Fed capitulates. Inflation fails to rebound and the Fed tightens only in line with what the market is currently pricing in. This could be good for risk assets, as long as the soft inflation is not accompanied by disappointing data on growth. The U.S. dollar would probably weaken further, which should be positive for EM assets and commodities. A policy mistake. The Fed pushes stubbornly ahead with tightening even though inflation fails to rebound. Bond yields fall and the yield curve moves closer to inverting. This would be negative for risk assets, which would start to price in the risk of recession. We think the first scenario is the most likely. Leading indicators of employment suggest the recent sluggish wage growth should prove temporary (Chart 5). The softness in U.S. PCE inflation probably reflects mostly the weak economic growth last year and the recent fall in commodity prices (as well as special factors in telecoms, healthcare and autos). Even if reflation pushes the Fed to tighten more quickly - followed by central banks in the euro area, U.K, and Canada, which have also sounded more hawkish recently - this should not fundamentally undermine the case for risk assets, given how easy monetary policy remains everywhere (Chart 6). It would represent merely a step towards "normalization". Chart 5Sluggish Wage Growth Should Be Temporary Chart 6Real Rates Still Negative Everywhere While scenario (2) would also probably be generally positive for risk assets, the correct portfolio allocation would be different. Under scenario (1) - our central view - the dollar would appreciate, causing commodities and EM assets to underperform, higher beta markets (such as the euro area and Japan) and cyclical sectors would perform the best, and in bond markets investors should be underweight duration and overweight TIPS. Scenario (2) would suggest a less aggressive positioning in equities, with income-generating assets outperforming as bond yields stay low at around current levels. Scenario (3), which we see only as a tail risk, would point to an outright defensive stance. What should investors watch for over the coming months? Besides the trends in inflation and wages discussed above, we would be concerned to see any slippage in global growth expectations, which have so far continued to rise despite the softness in inflation and wages (Chart 7). The most likely cause of this would be a Chinese slowdown, though recent comments by Premier Li Keqiang ("we continue to implement a proactive fiscal policy and prudent monetary policy....[but] will not resort to massive stimulative measures") seem to confirm our view that Chinese growth may slow a little further, but that the authorities will not allow it to collapse ahead of the Party Congress in the fall. As potential upside catalysts for risk assets we see: a rebound in crude oil prices (driven by a drawdown in inventories over coming months as the OPEC production cuts reduce supply, Chart 8), progress on a U.S. tax cut (which BCA's Geopolitical Strategy still expects to come into effect from early 2018), and further surprises in earnings growth (where analysts continue to revise up their forecasts, Chart 9). Chart 7No Signs Of Global Growth Slipping Chart 8Oil Inventories To Draw Down Chart 9Earnings Continue To Be Revised Up Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Why Haven't Inflation And Wages Picked Up? Chart 10Just A Temporary Phenomenon? Eight years into an expansion, U.S. inflation remains stubbornly below 2% on every measure and has even slowed in recent months (Chart 10, panel 1). And, despite headline unemployment of only 4.3% (below the Fed's estimate of 4.6% for the Nairu), wage growth also remains sluggish (panel 3). The Fed's view is that inflation has been pulled down by special factors: weak auto sales, the introduction of unlimited cell phone data packages (which lower hedonically-adjusted prices), and drugs companies which raised prices before last year's U.S. presidential election (panel 2). We agree that these factors are likely to be temporary. But the recent weak wage growth is more puzzling. Wages have trended up since 2012, suggesting that the Phillips Curve is not dead. But the relationship seems to have weakened. With U6 unemployment (which includes marginally attached workers and those working part-time who would like full-time jobs) currently at only 8.4%, one would have expected wage growth to be 1 ppt higher than it is (panel 4). Changes in the structure of the workforce may partly explain this (the growing proportion of low-wage service jobs, the "gig economy"). Last year's weak corporate profits may also be a factor. But, with the labor market clearly very tight, we expect wages - and therefore core inflation - to pick up again over the next 12 months. What To Do When VIX Is So Low? After two brief spikes earlier in the year, VIX has declined to 11.4, closer to the historical low of 9.3 reached in 1993, than the historical average of 19.5. In fact, asset price volatilities have been low across the board in fixed income, currencies and commodities, even though the latter two are not at the same extreme low levels as equities and fixed income (Chart 11). However, the VIX futures curve is still in steep contango, which means that getting the timing wrong would make it very costly to go long the volatility index. In addition, correlation among the index members of the S&P 500 is very low, and so are cross-market equity correlations. We do not forecast a recession until 2019, so a sharp reversal in VIX is unlikely, but brief spikes are possible, implying possible corrections in S&P 500 given the inverse correlation between the two. As such, we recommend four strategies for investors who are concerned that markets are too complacent: Focus on security selection, and rotate into cheaper sectors from expensive ones without altering the pro-cyclical bias. Our preferred way is to buy the much cheaper Financials by selling the more expensive Tech; Allocate a portion of funds to the minimum volatility style as it has been relatively oversold; Raise cash and buy a call spread on the S&P 500; Buy longer-dated VIX futures and sell shorter-dated futures to mitigate the rolling cost. Chart 11Are Investors Too Complacent? Chart 12Overweight To Neutral Have Technology Stock Run Too Far? Technology stocks have outperformed the broad market by 33% since April 2013 and investors are increasingly skeptical about whether the run-up can continue. In this Quarterly, we cut our weighting in the Tech sector from Overweight, but we believe it deserves no lower than a Neutral weighting for the following reasons: Sales & Earnings: New order growth is improving alongside rising consumer spending on technology (Chart 12, panel 2). Sales are growing at 5% YoY and this is likely to continue. Pricing power has also recovered over the past year. These factors should support margins and earnings growth. Valuations: Investors are worried about valuation. However, the recent rally has not led to an expansion of relative forward P/E, which is below the historical average (panel 4). Sector relative performance over the past four years has moved in line with its superior return on equity. Breadth: Improving breadth suggests that relative outperformance should be sustainable. An increasing number of firms are participating in the rally, as seen by the improving advances/declines ratio (panel 3). However, we also have some concerns. For example, a handful of large-cap technology firms have generated the bulk of the stock price performance. However, these firms currently trade at 23x.2 earnings compared to 60x.3 for the top firms at the peak of the TMT bubble in 2000. Additionally, the five largest stocks in the sector comprise only 13% of the index, compared to 16% at the peak of the 2000 bubble. Our recommendation, then, is that investors should hold this sector in line with benchmark. Are Canadian Banks At Risk Due To The Housing Bubble? Chart 13Canadian Housing Puzzle The recent problems at Home Capital Group have drawn investors' attention to the Canadian housing market. Home Capital's shares fell by 70% in April after regulators accused the mortgage lender of being slow to disclose fraud among its brokers. However, the issue is unlikely to have wider consequences: the event took place two years ago and had no impact on the lender's assets. Home Capital lends only to individuals with reliable collateral, and accounts for only 1% of total mortgage loans. We don't see imminent risks to the housing and banking sectors, since the economy is recovering and monetary policy remains loose. Vancouver and Toronto home prices have surged for almost a decade (Chart 13, panel 1). After Vancouver introduced a 15% foreign buyer tax in July 2016, house prices initially pulled back but quickly recovered. A similar tax in Ontario this April is also likely to have limited impact. Cautious macro-prudential rules should ensure banks' health: mortgage insurance is required for down-payments under 20%, and the gross debt service ratio (total housing costs over household income) cannot exceed 32%. However, the rise in house prices has caused household debt to run up (Chart 13, panel 2). Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, hinted in a speech in June that the central bank may soon raise rates. Tighter monetary policy could hurt mortgage borrowers who have enjoyed low interest payments for years (Chart 13, panel 3). Over the longer-term, therefore, we are concerned about the level of household debt, and recommend a cautious stance toward Canadian bank stocks. Global Economy Overview: Goldilocks continues, with global growth prospects still good (PMIs in developed economies generally remain around 55 - see Chart 14 panel 2 and Chart 15 panel 1), but inflation surprising on the downside in recent months. The wild card is China, where growth has slowed since Q1, when GDP reached 6.9%, and it is unclear whether the authorities will ease fiscal and monetary tightening to cushion the slowdown. Chart 14Growth Prospects Generally Remain Good Chart 15But Inflation Expectations Have Fallen U.S.: Growth has been weaker than the over-heated consensus expected, pushing down the Citigroup Economic Surprise Indexes (CESI) sharply (Chart 14, panel 1). However, prospects remain positive for the next 12 months: the Manufacturing ISM is at 54.9, retail sales are growing at 3.8% YoY, and capex has begun to reaccelerate (Chart 14, panel 5). The Fed's Nowcasts point to Q2 GDP growth at 1.9%-2.7% QoQ annualized. With expections now lowered, the CESI is likely to bottom around here. Euro Area: Growth has been stronger than in the U.S, with the PMI continuing to accelerate to 57.3. However, this is largely due to the euro area's strong cyclicality and exposure to global growth. Domestic momentum remains weak in most countries, with region-wide wage growth only 1.4% YoY. European PMIs are likely to roll over in line with the U.S. ISM. But GDP growth for the year is not likely to fall much from the 1.9% achieved in Q1. Japan remains a dual-paced economy, with international sectors doing well (exports rose by 14.9% YoY in May and industrial production by 5.7%) but domestic sectors stagnating, as wage growth remains sluggish (up just 0.5% YoY). Bank of Japan policy will remain ultra-easy, but there is scant sign of fiscal stimulus or structural reform. Emerging Markets: China is showing clear signs of slowdown, with the Caixin Manufacturing PMI falling below 50 (Chart 15, panel 3). The PBoC has tightened monetary policy, causing corporate bond yields to rise by 100 bps since the start of the year and the yield curve to invert. However, with the 19th Communist Party Conference scheduled for the fall, the authorities will prioritize stability: there are signs they are increasing fiscal spending. Elsewhere, many emerging markets are characterized by sluggish growth but falling inflation, which may allow central banks to cut rates. Interest rates: Inflation has softened recently, with U.S. core PCE inflation slowing to 1.4% and euro zone core CPI to 1.1%. We agree with the Fed that the recent weak inflation was caused by temporary factors and, with little slack in the labor market, core PCE will rise to 2% by next year, causing the Fed to hike in line with its dots. In the euro zone, however, the output gap remains around -2% of GDP and countries such as Italy could not bear tightening, so the ECB will taper only gradually next year and not raise rates soon. Chart 16Powered by Earnings and Margin Improvement! Global Equities In Q2 2017 the price gain in global equities was driven entirely by earnings growth, as forward earnings grew by 3.5% while the forward PE multiple barely changed. This is distinctively different from the equity rally in 2016 when multiple expansion dominated earnings growth (Chart 16). The scope of the improvement in earnings so far in 2017 has been wide. Not only are forward earnings being revised up, but 12-month trailing earnings growth has also come in very strong, with 90% of sectors registering positive earnings growth. Margins improved in both DM and EM. Equity valuation is not cheap by historical standards but, as an asset class, equities are still attractively valued compared to bonds given how low global bond yields are. We remain overweight equities versus bonds even though we are a little concerned about the extremely low volatility in all asset classes (see "What Our Clients Are Asking" on page 8). Within equities, we maintain our call to favor DM versus EM despite the 7% EM outperformance year-to-date, which was supported by attractive valuations and the weak U.S. dollar. BCA's house view is that the USD will strengthen versus EM currencies over the coming 12 months. Within EM, we have been more positive on China and remain so on a 6-9 month horizon, in spite of China's 6.7% outperformance versus EM. Our upgrade of euro area equities to overweight at the expense of the U.S. in our last Quarterly Portfolio Outlook proved to be timely as the euro area outperformed the U.S. by 641 bps in Q2. We continue to like Japan on a currency hedged basis (see next page). Sector-wise, we maintain a pro-cyclical tilt. However, we are taking profit on our overweight in Technology (downgrade to neutral) and upgrading Financials to overweight from neutral. Japanese Equities: Maintain Overweight, With Yen Hedge We upgraded Japanese equities to overweight in June 2016 (please see our Quarterly Report, dated June 30, 2016 and our Special Report, dated June 8, 2016) on a currency hedged basis. These positions have worked very well as the yen is down by 10% and MSCI Japan has gained 32% in yen term, outperforming the global benchmark by 12% in local currency terms, but in line with benchmark in USD (Chart 17). Going forward, we recommend clients continue to overweight Japanese equities in a global portfolio and hedge the JPY exposure. Reasons: First, since December 2012 when Abenomics started, MSCI Japanese equities have gained 82% in yen terms, but earnings have risen by much more, with a 180% increase. Valuation multiples have contracted, in stark contrast to other major equity markets where multiple expansion has led to stretched valuations. Second, divergent monetary policy between the BOJ and the Fed will put more downside pressure on the JPY. More importantly, weak fundamentals, as evidenced by falling inflation and a slowing in GDP growth, are likely to push the BOJ to resort to more extraordinary policy measures, such as debt monetization, which would further weaken the JPY, boosting exports and therefore the export sector dominated Japanese equity market. Note that our quant model is still underweight Japan, but has become slightly less so compared to six months ago. We have overridden the model because 1) the model is unhedged in USD terms and, more importantly, 2) the model cannot capture potential policy action such as debt monetization. Chart 17Japanese Equities: Remain Overweight Chart 18Financials Vs Tech: Trading Places Sector Allocation: Upgrade Financials to Overweight by Downgrading Tech to Neutral. We have been overweight Technology since July 2016 (please see our Monthly Update, July 29, 2016) and the sector has outperformed the global benchmark by 11.8%, of which 9% came this year. In line with our general concern on asset valuations, we are taking profit on the Tech overweight and use the proceeds to fund an overweight in the much cheaper Financials sector. As shown in Chart 18, the relative total return performance of Financials vs. Technology is back to extreme levels (panel 1), while the relative valuation of Financials measured by price to book has reached an extremely cheap level (panel 2). Also, Financial shares offer a good yield pick-up over Tech even though this advantage is in line with the historical average (panel 3). BCA's house view calls for higher interest rates and steeper yield curves over the next 9-12 months. Financial earnings benefit from a steepening yield curve. If history is any guide, we should see more aggressive analysts' earnings revisions going forward in favor of Financials (panel 4). Overall, our sector positioning retains its tilt towards cyclicals vs. defensives. (Please see Recommended Allocation table on page 1), in line with the tilt from our quant model. Within the cyclical sectors, however, we have overridden the model on Financials and Tech since the momentum factor is a major driver in the model and we judge that momentum has probably run too far. Chart 19MSCI ACW: Factor Relative Performance Smart Beta Update: In Q2, an equal-weighted multi-factor portfolio outperformed the global benchmark (Chart 19, top panel). Among the five most enduring factors - size, value, quality, minimum volatility, and momentum - quality and momentum factors continued the Q1 trend of outperformance, while value continued to underperform. It's worth noting that the underperformance of minimum volatility stabilized in the last two months of the quarter, indicating that the extremely low market vol has caught investor attention and some investors have started to seek protection by moving into the low vol space, albeit gradually. Value has continued to underperform growth, and small caps to underperform large caps. We maintain our neutral view on styles and prefer to use sector positioning to implement the underlying themes given the historically close correlation between styles and cyclicals versus defensives (bottom two panels). As show in Table 1, however, even though value has underperformed growth across the globe, small caps in Japan and the euro area have consistently outperformed large caps year-to-date, the opposite to that in the U.S., in line with the higher beta nature of these two markets. Table 1Divergence In Style Government Bonds Maintain Slight Underweight Duration. U.S. bond yields declined significantly in Q2 to below fair value levels in response to weaker "hard data" (Chart 20, top panel). But weakness in Q1 U.S. GDP was concentrated in consumer spending and inventories, both of which are likely to strengthen in the months ahead. In addition, after the June rate hike, we expect the Fed to deliver another rate hike by year end, while the market is pricing in only 14 bps of rate rise. Maintain overweight TIPS vs. Treasuries. As the nominal 10-year yield fell, so did 10-year TIPS breakeven inflation. In terms of relative valuation, now TIPS is fairly valued vs. the nominal bonds (panel 2). However, our U.S. Bond Strategy's core PCE model, which closely tracks the 10-year TIPS breakeven rate (panel 3), is sending the message that inflationary pressures are building in the economy and that core PCE should reach the Fed's 2% target later this year. This suggests that the bond markets are not providing adequate compensation for the inflationary economic backdrop. Overweight Inflation-linked JGBs (JGBi) vs. Nominal JGBs. Inflation in Japan has been falling despite strong GDP growth. However, the labor market has not been this tight since the mid-1990s, with the unemployment rate at 3.1% and jobs-to-applicants ratio at 1.49, both post-1995 extremes (Chart 21, panel 2). BCA Foreign Exchange Strategy service believes that wage pressures, in addition to the inflationary effect of a weakening yen, could lead inflation higher. Accordingly, inflation-linked JGBs offer good value relative to nominal JGBs (Chart 21, panel 1). Chart 20Inflationary Pressures Are Building Chart 21Overweight JGBi Vs JGB Corporate Bonds Given our expectations that global growth will remain robust over the coming 12 months, pushing the U.S. 10-year Treasury yield above 3%, we continue to favor credit over government bonds. However, U.S. corporate health has deteriorated further in the past two quarters (Chart 22) and so, when the next recession comes, returns from corporate credit may be particularly bad. We cut our double overweight in investment grade debt to single overweight. The spread over Treasuries of U.S. IG credit has fallen to around 100 bps. Given high U.S. corporate leverage currently, it is unlikely that the spread will tighten any further to reach previous lows (Chart 23), so investors will benefit only from the carry. Moreover, the ECB is likely to reduce its bond buying from January 2018 and, though it is unclear whether it will taper corporate as well as sovereign purchases, this represents a potential headwind for European credit. Remain overweight high yield debt. U.S. junk bonds have been remarkably resilient in the face of falling oil prices and the subsequent blowout in energy bond spreads. The default-adjusted spread is just over 200 bps (Chart 24), based on Moody's default assumption of 2.7% over the next 12 months and a recovery rate of 47%. Historically, a spread of this size has produced an excess return over the following year 74% of the time, for an average of 84 bps. Chart 22U.S. Corporate Health Deteriorating Chart 23IG Spreads Unlikely To Tighten Further Chart 24Junk Spreads Give Sufficient Reward Commodities Chart 25Mixed Feelings Towards Commodities Secular Perspective: Bearish: We continue to hold a negative secular outlook for commodities (Chart 25). A gradual shift towards a service-led economy in China, combined with sluggish global growth, will prevent demand from rising further. This lack of demand, together with record high inventory levels for major commodities, keep us from turning bullish. Cyclical Perspective: Neutral We are positive on oil because we believe that inventories will continue to draw. We are negative on base metals due to weak demand and excess supply. We are somewhat bullish on precious metals based on the political uncertainties ahead. Energy: Bullish OPECextended its production cuts for another nine months, carrying the cuts through to Q1, when the oil price is typically seasonally weak. We expect demand growth will increasingly outpace production growth in 2017, producing inventory drawdowns. The current weakness in the crude price is largely due to investors' concerns over shale production. However, the OPEC cut of 1.2 MMb/d, supplemented by an additional 200,000 - 300,000 b/d of voluntary restrictions on non-OPEC oil, are enough to offset any spurt in shale production. Base metals: Bearish China is slowly tightening monetary policy and, following the 19th Communist Party Congress later this year, reflationary stimulus will probably continue to wind down. We have seen a cooling in the Chinese property market along with a slowdown in the manufacturing sector. The Caixin manufacturing PMI, a key indicator for metals demand, fell below 50 in May for the first time in 11 months. At the same time, inventories for copper and iron ore have risen. Precious metals: Long-term Bullish Inflation has not picked up as we expected, which may prevent the gold price from rising further in 2017. However, we expect inflation to move higher going into 2018. As a safe haven, gold is also a good hedge against geopolitical risks. We believe that the political risks in 2018 are underestimated, especially the Italian general election (probably in March or April). Currencies Chart 26Fed Will Support The Dollar In 2017, the U.S. dollar (Chart 26) has weakened by 5% on a trade-weighted basis. However, we believe that the soft patch in inflation and wage data that caused this weakness is temporary and that underlying economic momentum remains strong. Following its rate hike in June, the Fed kept its forecast for core PCE in 2018 and 2019 at 2%. As inflation and wage pressures return, market expectations will converge with the Fed's forecast. The subsequent improvement in relative interest rates will support the dollar. Euro: The euro is up by 8% versus the dollar so far this year. The ECB is likely to continue to set policy for the weakest members of the euro zone, in the absence of a major pickup in inflation. While economic activity has improved, inflation has recently fallen back again, along with the oil price. The ECB is particularly sensitive to political uncertainty surrounding the upcoming Italian elections and the fragility of the Italian banking system. This suggests that the ECB will only gradually taper its asset purchases starting early next year, but will not move to raise rates until at least mid-2019. This is likely to cause the euro to weaken over the coming months. Yen: The yen has strengthened by 4% versus the dollar year to date. With core core inflation in Japan struggling to stay above 0%, we think it highly likely that the BOJ will continue its yield curve control policy. If, as we expect, U.S. long-term interest rate trend up in the coming months, relative rates will put downward pressure on the yen. Our FX strategists expect the USD/JPY at 125 within 12 months. EM Currencies: With Chinese growth likely to remain questionable over the coming months, emerging market currencies will lack their biggest tailwind. Terms of trade will continue to turn negative as commodity prices weaken. EM monetary authorities will mostly be easing policy in order to support growth. With rates kept low, relative monetary policy is likely to will force EM currencies, especially those for commodity exporters, to depreciate from current levels. Alternatives Chart 27Attractive Risk-Return Profile Return Enhancers: Favor private equity vs. hedge funds In 2016, private equity returned 9%, whereas hedge funds managed only a 3% return (Chart 27). Strong performance led to private equity funds raising $378 bn last year, the highest level of capital secured since the Global Financial Crisis. By contrast, hedge funds have underperformed global equities and private equity since the financial crisis of 2008-09. However, investors have become increasingly concerned with valuation levels in private markets. Our recommendation is that investors should continue to overweight private equity vs hedge funds, since we do not see a recession as likely over the next 12 months. Within the hedge fund space, we would recommend overweighting event-driven funds over the cycle, and macro funds heading into a recession (please see our Special Report, dated June 16, 2017). Inflation Hedges: Favor direct real estate vs. commodity futures In 2016, direct real estate returned 9%, whereas commodity futures achieved 12%. Given the structural nature of this recommendation, investors need to look past recent short-term moves in commodity prices. Low interest rates will keep borrowing cheap, making the spread between real estate and fixed income yields continue to be attractive. Moreover, with 48% of institutional investors currently below their target allocation for real estate, there is a lot of potential for further capital allocations to the asset class. With regards to the commodity complex, the long-term transition of China to a services-based economy will lead to a structural decline in commodity demand. Investors should continue to overweight direct real estate vs commodity futures on a 3-5 year target horizon. Volatility Dampeners: Favor farmland & timberland vs. structured products In 2016, farmland and timberland returned 9% and 3% respectively, whereas structured products returned 2%. Farmland and timberland will continue to benefit from favorable global demographic trends, as a growing population and improving prosperity in the developing world increase food consumption. However, increased volatility in lumber and agriculture prices have made investors concerned about cash flows. With regards to structured products, increasing rates and deteriorating credit quality in the auto loan market will slow credit origination. Given that the Fed will start unwinding its balance sheet this year, increased supply will put upward pressure on spreads. Investors can reduce the volatility of a multi-asset portfolio with the inclusion of farmland and timberland. Risks To Our View We explained the two alternative scenarios to our main view in the Overview section of this Quarterly. There are three other specific areas where our views differ notably from the consensus: Strong dollar. Our view is predicated on the Fed tightening policy more than the market currently expects, and the ECB less. Interest rate differentials (Chart 28) certainly point to a stronger USD, and speculative positions have reversed from being very dollar-long at the start of the year. But the euro momentum could continue for a while, especially given mixed messages from Mario Draghi, for example when he said in late June that "the threat of deflation is gone and reflationary forces are at play." Crude oil back at $55. Our Energy strategists believe that the oil price is currently being driven by supply, not demand. They argue that OPEC production cuts will hold and cause inventories to draw down rapidly over the coming six months. However, speculative positioning in oil has shifted from very long to significantly short since the start of the year. The risk is that U.S. oil production continues to accelerate (Chart 29), as fracking technology improves and availability of capital for oil producers remains easy. Negative on EM. Our 12-month EM view is predicated on a stronger dollar, higher U.S. interest rates, slowing Chinese growth, and falling commodity prices. We could be wrong about these drivers. Falling inflation in emerging markets such as Brazil (Chart 30) could allow central banks to cut rates aggressively, which might temporarily boost growth. Chart 28Rate Differentials Suggest Strong Dollar Chart 29Oil Bears Point To U.S. Output Chart 30Sharp Fall In Brazilian Inflation 1 Our U.S. Bond Strategists explain the detailed thinking behind these three scenarios in their Weekly Report "Three Scenarios for Treasury Yields In 2017," dated June 20, 2017, available at usbs.bcaresearch.com 2 Market-cap weighted average of Apple, Alphabet, Microsoft, Amazon and Facebook. 3 Market-cap weighted average of Microsoft, Cisco Systems, Intel, Oracle and Lucent. Recommended Asset Allocation

Highlights Economic Outlook: Global growth will remain strong over the next 12 months, but will start to slow in the second half of 2018, potentially setting the stage for a recession in 2019. Overall Strategy: Investors should overweight equities and spread product for now. However, be prepared to pare back exposure next summer. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S. Treasurys, stay neutral Europe, and overweight Japan. Equities: Remain overweight developed market equities relative to their EM peers. Within the DM sphere, favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares have significant upside. Currencies: The selloff in the dollar is overdone. The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar, as does the euro. Commodities: Oil will rally over the coming months as global inventories decline. Gold will continue to struggle, before exploding higher towards the end of this decade. Feature I. Global Macro Outlook End Of The Global Manufacturing Recession Global growth estimates have been trending higher over the past 12 months, having bottomed last summer. Ironically, the collapse in oil prices in late 2014 was both the main reason for the deterioration in global growth as well as its subsequent rebound. Plunging oil prices led to a massive decline in capital spending in the energy sector and associated industries. In the U.S., energy capex dropped by 70% between Q2 of 2014 and Q3 of 2016. The economic fallout was even more severe in many other economies, especially emerging markets such as Russia and Brazil. The result was a global manufacturing recession and a pronounced slump in international trade (Chart 1). When thinking about oil and the economy, the distinction between levels and rates of change is important: While rapidly falling oil prices tend to be bad for global growth, lower oil prices are good for it. By the middle of 2016, the damage from the oil crash had largely run its course. What was left was a massive windfall for households, especially poorer ones who spend a disproportionate share of their paychecks at the pump. Industries that use oil as an input also benefited. Simply put, the oil crash went from being a bane to a boon for the global economy. A Solid 12-Month Outlook We expect global growth to remain firm over the next 12 months. Financial conditions in most countries have eased substantially since the start of the year thanks to rising equity prices, lower bond yields, and narrower credit spreads (Chart 2). Our empirical analysis suggests that easier financial conditions tend to lift growth with a lag of 6-to-9 months (Chart 3). This bodes well for activity in the remainder of this year. Chart 1The Manufacturing Recession Has Ended Chart 2Financial Conditions Have Eased Globally A number of "virtuous cycles" should amplify the effects of easier financial conditions. In the U.S., a tight labor market will lead to faster wage growth, helping to spur consumption. Rising household spending, in turn, will lead to lower unemployment and even faster wage growth. Strong consumption growth will also motivate firms to expand capacity, translating into more investment spending. Chart 4 shows that the share of U.S. firms planning to increase capital expenditures has risen to a post-recession high. Chart 3Easier Financial Conditions Will Support Growth Chart 4U.S. Firms Plan To Boost Capex The euro area economy continues to chug along. The purchasing manager indices (PMIs) dipped a bit in June, but remain at levels consistent with above-trend growth. The German Ifo business confidence index hit a record high this week. Corporate balance sheets in the euro area are improving and credit growth is accelerating. This is helping to fuel a rebound in business investment (Chart 5). The fact that the ECB has no intention of raising rates anytime soon will only help matters. As inflation expectations begin to recover, short-term real rates will fall. This will lead to a virtuous circle of stronger growth, and even higher inflation expectations. The Japanese economy managed to grow by an annualized 1% in the first quarter. This marked the fifth consecutive quarter of positive sequential growth, the longest streak in 11 years. Exports are recovering and both the manufacturing and non-manufacturing PMIs stand near record-high levels (Chart 6). Chart 5Euro Area Data Remain Upbeat Chart 6Japanese Economy Is Rebounding Chart 7China: Slight Slowdown, But No Need To Worry The Chinese economy has slowed a notch since the start of the year, but remains robust (Chart 7). Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production are rising at a healthy clip. Exports are accelerating thanks to a weaker currency and stronger global growth. Retail sales continue to expand, while the percentage of households that intend to buy a new home has surged to record-high levels. The rebound in Chinese exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 8). A better profit picture should support business capital spending in the coming months. Meanwhile, the Chinese government's "regulatory windstorm" - as the local press has called it - has largely bypassed the real economy. In fact, medium and long-term lending to nonfinancial corporations, a key driver of private-sector capital spending and physical commodity demand, has actually accelerated over the past eight months (Chart 9). Chart 8China: Higher Selling Prices Fueling A Rebound In Profits Chart 9China: Credit To The Real Economy Is Accelerating All Good Things Must Come To An End We remain optimistic about global growth over the next 12 months. Unfortunately, things are likely to sour in the second half of 2018, possibly setting the stage for a recession in the U.S. and several other countries in 2019. The odds of a recession rise when economies approach full employment (Chart 10). The U.S. unemployment rate now stands at 4.3% and is on track to break below its 2000 low of 3.8% next summer. A cursory look at the data suggests that the unemployment rate is usually either rising or falling (Chart 11). And once it starts rising, it keeps rising. In fact, there has never been a case in the postwar era where the three-month average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing. Chart 10Recessions Become More Likely When The Labor Market Begins To Overheat Chart 11Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Modern economies contain numerous feedback loops. When unemployment starts increasing, this fuels a vicious cycle where rising joblessness saps confidence and incomes, leading to less spending and even higher unemployment. History suggests that it is almost impossible to break this cycle once it starts. The Fed is well aware of the risks of letting the unemployment rate fall to a level where it has nowhere to go but up. Unfortunately, calibrating monetary policy in a way that achieves a soft landing is easier said than done. Changes in monetary conditions affect the economy with a lag of about 12-to-18 months. Once it has become obvious that a central bank has either loosened or tightened monetary policy too much, it is often too late to right the ship. The risks of a policy error are particularly high in today's environment where there is significant uncertainty about the level of the long-term neutral rate. Question marks about the future stance of fiscal policy will also complicate the Fed's job. We expect the Trump administration to succeed in passing legislation that cuts both personal and corporate income taxes later this year or in early 2018. The bill will be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This will generate a modest amount of fiscal stimulus over the next few years. That being said, the proposed changes to health care legislation could more than neutralize the effects of lower tax rates. The Senate bill, as currently worded, would lead to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Our base case is that Republicans in Congress fail to pass a new health care bill, thus leaving the Affordable Care Act largely unscathed. However, if they succeed, the overall stance of federal fiscal policy would likely shift from being somewhat accommodative, on net, to somewhat restrictive. This would expedite the timing of the recession. How Deep A Recession? If the U.S. does succumb to a recession in 2019, how bad will it be? Here, there is both good news and bad news. The good news is that financial and economic imbalances are not as severe today as those that existed in the lead-up to the past few recessions. The Great Recession was preceded by a massive housing bubble, associated with overbuilding and a sharp deterioration in mortgage lending standards (Chart 12). Today, residential investment stands at 3.9% of GDP, compared to a peak of 6.6% of GDP Q1 of 2006. Lending standards, at least judging by FICO scores, have remained fairly high over the course of the recovery. In relation to income and rents, home prices are also much lower today than they were a decade ago. Likewise, the massive capex overhang that preceded the 2001 recession is largely absent at present. Chart 12No New Bubble In The U.S. Housing Sector Chart 13Consumer Credit: Making A Comeback... The bad news is that cracks in the economy are starting to form. In contrast to mortgage debt, student debt has gone through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 13). Not surprisingly, this is starting to translate into higher default rates (Chart 14). The fact that this is happening when the unemployment rate is at the lowest level in 16 years is a cause for concern. Meanwhile, the ratio of corporate debt-to-GDP has risen above 2000 levels and is closing in on its 2007 peak (Chart 15). Chart 14...With Defaults Starting To Rise In Some Categories Chart 15U.S. Corporate Sector Has Been Feasting On Credit We are particularly worried about the health of the commercial real estate (CRE) market. CRE prices currently stand 7% above pre-recession levels in real terms, having risen by a staggering 82% since the start of 2010 (Chart 16). U.S. financial institutions hold $3.8 trillion in CRE loans, $2 trillion of which are held by banks. As a share of GDP, the outstanding stock of CRE bank loans in most categories is near pre-recession levels (Chart 17). Chart 16Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 17CRE Debt Is Rising The retail sector is already under intense pressure due to the shift in buying habits towards E-commerce. Vacancy rates in the apartment sector have started to tick higher and rent growth has slowed (Chart 18 and Chart 19). The number of apartment units under construction stands at a four-decade high, despite a structurally subdued pace of household formation (Chart 20). Most of these units are likely to hit the market in 2018, which will result in a further increase in vacancy rates. Vacancies in the office sector are also likely to rise, given the recent increase in the number of new projects in the pipeline. On the flipside, demand growth for new office space is set to weaken, as a tighter labor market leads to slower payroll gains. Chart 18Vacancy Rates Are Bottoming Outside The Industrial Sector... Chart 19...While Rent Growth Is Losing Steam If vacancy rates across the CRE sector start rising in earnest, real estate prices will fall, leading to a decline in the value of the collateral backing CRE loans. This could prompt lenders to pull back credit, causing prices to fall further. Seasoned real estate investors are no strangers to such vicious cycles, and if the next one begins late next year when growth is slowing because the economy is running out of spare capacity and financial conditions are tightening, it would further add to the risks of a recession. Chart 20Apartment Supply Is Surging, But Will There Be Enough Demand? Gauging The Global Spillover Effects What repercussions would a U.S. recession have for the rest of the world? Simply based on trade flows, the answer is "not much." U.S. imports account for less than 5% of global ex-U.S. GDP. Thus, even a significant decline in U.S. spending abroad would not make much of a dent in overseas growth. More worrisome are potential financial spillovers. As the IMF has documented, these have been the dominant drivers of the global business cycle in the modern era.1 Chart 21Global Debt Levels Are Still High Correlations across global markets tend to increase when risk sentiment deteriorates. Thus, if U.S. stocks buckle in the face of rising recessionary risks, risk assets in other economies are sure to suffer. The fact that valuations are stretched across so many markets only makes the problem worse. A flight towards safety could trigger a pronounced decline in global equity prices, wider credit spreads, and lower property prices. This, in turn, could lead to a sharp decline in household and corporate net worth, resulting in tighter financial conditions and more stringent lending standards. Elevated debt levels represent another major source of vulnerability. Total debt as a share of GDP is greater now than it was before the Great Recession in both advanced and emerging markets (Chart 21). High debt burdens will prevent governments from loosening fiscal policy in countries that are unable to issue their own currencies. The monetary transmission mechanism also tends to be less effective in the presence of high debt. This is especially the case in today's environment where the zero lower-bound on nominal interest rates remains a formidable challenge. The presence of these fiscal and monetary constraints implies that the severity of the next recession could be somewhat greater than one might expect based solely on the underlying causes of the downturn. II. Financial Markets Overall Strategy The discussion above implies that the investment outlook over the next few years is likely to be of the "one step forward, two steps back" variety. The global economy is entering a blow-off stage where growth will get better before it gets worse. We are bullish on global equities and spread product over the next 12 months, but expect to turn bearish on risk assets next summer. Until then, investors should position for a stronger dollar and higher bond yields. We recommend a slight overweight allocation to developed market equities over their EM peers. Within the DM sphere, we favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares stand out as offering an attractive risk-reward profile. Comparing government bonds, we are underweight U.S. Treasurys, neutral on European bonds, and overweight Japan. These recommendations are broadly in line with the output of our in-house quantitative models (Table 1 and Chart 22). Table 1BCA's Tactical Global Asset Allocation Recommendations* Chart 22Message From Our U.S. Stock Market ##br##Timing Model Equities Earnings Are Key Earnings have been the main driver of the global equity bull market. In fact, the global forward P/E ratio has actually declined slightly since February, despite a 3.9% gain in equity prices (Chart 23). Strong global growth should continue to boost corporate earnings over the next 12 months. Consensus bottom-up estimates call for global EPS to expand by 14% in 2017 and a further 11% in 2018. The global earnings revision ratio moved into positive territory earlier this year for the first time in six years (Chart 24). Chart 23Earnings Have Been The Main Driver ##br##Of The Global Equity Bull Market Chart 24Global Earnings Picture ##br##Looks Solid Global monetary conditions generally remain favorable. Our U.S. Financial Conditions Index has loosened significantly. Historically, this has been a bullish signal for stocks.2 Excess liquidity, which we define as M2 growth less nominal GDP growth, is also still well above the zero line, a threshold that has warned of a downturn in stock prices in the past. Chart 25Individual Investors Are Not Overly Bullish On U.S. Equities But... Sentiment is stretched, but not excessively so. The share of bullish respondents in the AAII's weekly poll of individual investors stood at 29.7% this week (Chart 25). This marked the 18th consecutive week that optimism has been below its long-term average. Market Vane's survey of traders and Yale's Investor Confidence index paint a more complacent picture, as do other measures such as the VIX and margin debt (Chart 26). Nevertheless, as long as earnings continue to grow and monetary policy remains in expansionary territory, sentiment can remain elevated without being a significant threat to stocks. Overweight The Euro Area And Japan Over The U.S. Regionally, earnings revisions have been more positive in Europe and Japan than in the U.S. so far this year. Net profit margins are also lower in Europe and Japan, which gives these two regions more room for catch-up. Moreover, unlike the Fed, neither the ECB nor the BoJ are likely to raise rates anytime soon. As we discuss in greater detail in the currency section of this report, this should lead to a weaker euro and yen, giving European and Japanese exporters a further leg up in competitiveness. Lastly, valuations are more favorable in the euro area and Japan than in the U.S., even if one adjusts for differing sector weights across the three regions (Chart 27). Chart 26...There Are Signs Of Complacency Chart 27U.S. Valuations Seem Stretched Relative ##br##To Other Bourses Mixed Outlook For EM Earnings growth in emerging markets has accelerated sharply. Bottom-up estimates imply EPS growth of 20% in 2017 and 11% in 2018 for the EM MSCI index. Our EM strategists believe this is too optimistic, given the prospect of a stronger dollar, high debt levels across the EM space, poor corporate governance, and the lack of productivity-enhancing structural reforms. These problems warrant a slight underweight to emerging markets in global equity portfolios. Nevertheless, considering the solid backdrop for global growth, EM stocks should still be able to deliver positive real total returns over the next 12 months. Within the EM space, we favor Russia, central Europe, Korea, Taiwan, India, Thailand, and China. Chinese H-shares, in particular, remain quite attractive, trading at only 7.1-times forward earnings and 1.0-times book value. Favor Cyclicals Over Defensives ... For Now Looking at global equity sectors, upward revisions have been largest for industrials, materials, financials, and real estate. Revisions for energy, health care, and telecom have been negative. We expect cyclical stocks to outperform defensives over the next 12 months. Energy stocks will move from being laggards to leaders, as oil prices rebound. Financials should also do well, as steeper yield curves, increased M&A activity, and falling nonperforming loans bolster profits. Equity Bear Market Will Begin Late Next Year As growth begins to falter in the second half of 2018, stocks will swoon. U.S. equities are likely to fall 20% to 30% peak to trough, marking the first sustained bear market since 2008. Other stock markets will experience similar declines. Global equities will eventually recoup most of their losses at the start of the 2020s, but the recovery will be a lackluster one. As we have argued extensively in the past, global productivity growth is likely to remain weak.3 Population aging will deplete savings, leading to higher real interest rates. The next recession could also propel more populist leaders into power. None of these things would be good for stocks. Against today's backdrop of lofty valuations, global stocks will deliver a total real return in the low single-digit range over the next decade. Fixed Income Bonds Have Overreacted To The Inflation Dip We turned structurally bearish on government bonds on July 5th, 2016. As fate would have it, this was the very same day that the U.S. 10-year Treasury yield dropped to a record closing low of 1.37%. The dramatic bond selloff that followed was too much, too fast. We warned at the start of this year that bond yields were likely to climb down from their highs. At this point, however, the pendulum has swung too far in the direction of lower yields. Chart 28 shows that almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained resilient, suggesting that investors' views of global growth have not changed much. This helps explain why stocks have been able to rally to new highs. The fall in inflation expectations has been largely driven by the decline in commodity prices. Short-term swings in oil prices should not affect long-term inflation expectations, but in practice they do (Chart 29). If oil prices recover in the second half of this year, as we expect, inflation expectations should shift higher as well. This will translate into higher bond yields. Chart 28Inflation Expectations Declined This Year, ##br##But Real Yields Remained Resilient Chart 29Low Oil Prices Drag Down##br## Inflation Expectations U.S. Treasurys Are Most Vulnerable Tightening labor markets should also boost inflation expectations. This is particularly the case in the U.S., where the economy is quickly running out of surplus labor. Some commentators have argued that the headline unemployment rate understates the true amount of economic slack. We are skeptical that this is the case. Table 2 compares a wide variety of measures of labor market slack with where they stood at the height of the business cycle in 2000 and 2007. The main message from the table is that the unemployment rate today is broadly where one would expect it to be based on these collaborating indicators. Table 2Comparing Current Labor Market Slack With Past Cycles 12-MONTH If the U.S. has reached full employment, does the absence of wage pressures signal that the Phillips curve is dead? We don't think so. For one thing, wage growth is not that weak. Our wage growth tracker has risen from a low of 1.2% in 2010 to 2.4% at present (Chart 30). In fact, real wages have been rising more quickly than productivity for the past three years (Chart 31). Unit labor cost growth is now just shy of where it was at the peaks of the last two business cycles (Chart 32). Chart 30Stronger Labor Market ##br##Is Leading To Faster Wage Growth Chart 31Real Wages Now Increasing Faster##br## Than Productivity Chart 32Unit Labor Cost Growth Close ##br##To Previous Two Peaks The evidence generally suggests that the Phillips curve becomes "kinked" when the unemployment rate falls towards 4%. In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 4.5% to 3.5% does. The experience of the 1960s is illustrative in that regard. Chart 33 shows that much like today, inflation in the first half of that decade was well anchored at just below 2%. However, once the unemployment rate fell below 4%, inflation took off. Core inflation rose from 1.5% in early 1966 to nearly 4% in early 1967, ultimately making its way to 6% by 1970. The Fed is keen to avoid a repeat of that episode. In a recent speech, New York Fed President and FOMC vice chairman Bill Dudley warned that "If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation ... Then the risk would be that we would have to slam on the brakes and the next stop would be a recession." If U.S. growth remains firm and inflation rebounds in the second half of this year, as we expect, the Fed will get the green light to keep raising rates in line with the "dots." The market is not prepared for that, as evidenced by the fact that it is pricing in only 27 basis points in rate hikes over the next 12 months. We are positioned for higher rate expectations by being short the January 2018 fed funds contract. The ECB And The BoJ Will Not Follow The Fed's Lead Could better growth prospects cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl? We doubt it. Investors are reading too much into Mario Draghi's allegedly more "hawkish" tone. There is a huge difference between removing emergency measures and beginning a full-fledged tightening cycle. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 34). Chart 33Inflation In The 1960s Took Off ##br##Once The Unemployment Rate Fell Below 4% Chart 34Euro Area: Labor Market Slack##br## Is Still High Outside Of Germany At this point, the market is pricing in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 25 months at present (Chart 35). Investors now expect real yields in the U.S. to be only 16 basis points higher than in the euro area in five years' time.4 This is below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 36). Chart 35ECB: Markets Are Pricing In Too Much Tighteninh Chart 36The Neutral Rate Is Lowest In The Euro Area As for Japan, while the unemployment rate has fallen to a 22-year low of 2.8%, this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Bank Of England's Dilemma Gilts are a tougher call. The equilibrium rate is higher in the U.K. than in most other developed economies. Inflation has risen, although that has largely been a function of a weaker currency. Fiscal policy is turning more accommodative, which, all things equal, would warrant a more bearish view on gilts. The big wildcard is Brexit. Chart 37 shows that the U.K. is the only major country where growth has faltered this year. Worries over Britain's future relationship with the EU have likely contributed to the slowdown. Ongoing Brexit angst will keep the Bank of England on hold, justifying a neutral weighting on gilts. Stay Short Duration ... For Now In summary, investors should keep global duration risk below benchmark levels over the next 12 months. Regionally, we recommend underweighting U.S. Treasurys, overweighting Japan, and maintaining a neutral position towards euro area and U.K. government bonds. Reflecting these recommendations, we are closing our short Japanese, German and Swiss 10-year bond trade for a gain of 5.3% and replacing it with a short 30-year U.S. Treasury bond position. As global growth begins to slow in the second half of next year, global bonds will rally. However, as we discussed at length in our Q2 Strategy Outlook, the rally will simply represent a countertrend move in what will turn out to be a structural bear market.5 The 2020s, in short, could end up looking a lot like the 1970s. Spread Product: Still A Bit Of Juice Left While we prefer equities to high-yield credit on a risk-adjusted basis over the coming months, we would still overweight spread product within a global asset allocation framework. The option-adjusted spread of the U.S. high-yield index offers 200 basis points above the Treasury curve after adjusting for expected defaults, roughly in line with the mid-point of the historical data (Chart 38). Corporate defaults are likely to trend lower over the next 12 months, spurred by stronger growth and a rebound in oil prices. Chart 37U.K. Is Lagging Its Peers Chart 38Default-Adjusted Junk Spreads Are At Historical Average As with all our other views, the picture is likely to change sharply in the second half of next year. At that point, corporate spreads will widen, warranting a much more defensive stance. Currencies And Commodities The Dollar Bull: Down But Not Out Our long-standing dollar bullish view has come under fire over the past few months. The Fed's broad trade-weighted dollar index has fallen 4.6% since December. Momentum in currency markets can be a powerful force, and so we would not be surprised if the dollar remains under pressure over the coming weeks. However, over a 12-month horizon, the greenback will strengthen, as the Fed raises rates more quickly than expected while most other central banks stand pat. When all is said and done, the broad-trade weighted dollar is likely to peak next summer at a level roughly 10% higher than where it is today. That would still leave it substantially below prior peaks in 1985 and 2000 (Chart 39). The U.S. trade deficit has fallen from a peak of nearly 6% of GDP in 2005 to 3% of GDP at present (Chart 40). Rising shale production has reduced the demand for oil imports. A smaller trade deficit diminishes the need to attract foreign capital with a cheaper currency. Chart 39The Dollar Is Below Past Peaks Chart 40The U.S. Trade Deficit Has Halved Since 2005 Sentiment and speculative positioning towards the dollar have swung from extremely bullish at the start of the year to being more neutral today (Chart 41). In contrast, long euro speculative positions and bullish sentiment have reached the highest levels in three years. Our tactical short euro/long dollar trade was stopped out this week for a loss of 1.6%. However, we continue to expect EUR/USD to fall back towards parity by the end of the year. We also expect the pound to weaken against the dollar, but appreciate slightly against the euro. Now that the Bank of Japan is keeping the 10-year JGB yield pinned to zero, the outlook for the yen will be largely determined by what happens to yields abroad. If we are correct that Treasury yields - and to a lesser extent yields in Europe - rise, the yen will suffer. Commodity Currencies Should Fare Well Higher commodity prices should benefit currencies such as the Canadian and Aussie dollars and the Norwegian krone. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. While shale output continues to rise, this is largely being offset by falling production from conventional oil fields. Consequently, oil inventories should fall in the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 42). Chart 41USD: Sentiment And Positioning ##br##Are Not Lopsided Anymore Chart 42Falling Oil Inventories Should Lead ##br##To Higher Crude Prices The outlook for industrial metals is not as upbeat as for oil, but metal prices should nevertheless rebound over the coming months. We suspect that much of the recent weakness in metal prices can be attributed to the regulatory crackdown on shadow banking activity in China. Many Chinese traders had used commodities as collateral for loans. As their loans were called in, they had no choice but to liquidate their positions. Today, speculative positioning in the commodity pits has returned to more normal levels (Chart 43). This reduces the risk of a further downdraft in commodity prices. BCA's China strategists expect the Chinese authorities to relax some of their tightening measures. This is already being seen in a decline in interbank lending rates and corporate bond yields (Chart 44). Chart 43Commodities: Long Speculative Positions Returning ##br##To More Normal Levels Chart 44China: Some Relief##br## After Recent Tightening Action? One key reason why the authorities have been able to let interest rates come down is because capital outflows have abated. Compared to late 2015, economic growth is stronger and deflationary pressures have receded. The trade-weighted RMB has also fallen by 7.5% since then, giving the economy a competitive boost. As such, the seeming can't-lose bet on further yuan weakness has disappeared. We still expect the RMB to depreciate against the dollar over the next 12 months, but to strengthen against most other currencies, including the euro and the yen. If the yuan remains resilient, this will limit the downside risk for other EM currencies. Nevertheless, at this point, much of the good news benefiting EM currencies has been priced in. Across the EM universe, in addition to the Chinese yuan, we like the Mexican peso, Taiwan dollar, Indian rupee, Russian ruble, Polish zloty, and Czech koruna. Lastly, a few words on the most timeless of all currencies: gold. We expect bullion to struggle over the next 12 months on the back of a stronger dollar and rising bond yields. However, once the Fed starts cutting rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For example, please see Box 4.1: Financial Linkages and Spillovers in "Spillovers and Cycles in the Global Economy," IMF World Economic Outlook, (April 2007). 2 Please see Global Investment Strategy Weekly Report, "The Message From Our Stock Market Timing Model," dated May 5, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; Global Investment Strategy - Strategy Outlook, "First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters), First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters)," dated January 6, 2017; and Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 U.S. minus euro area 5-year/5-year forward real bond yields. Real bonds yields are calculated as a difference between nominal yields and the CPI swap rate. Euro area yields refer to a GDP-weighted average of Germany, France, the Netherlands, Belgium, Austria, Italy, and Spain. 5 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Trade 1: An unwinding of the Trump reflation trade... has worked exactly as expected. Take profits and switch into Trade 5. Trade 2: Short pound/euro at €1.18 and simultaneously buy call options at €1.30... is up 4%. Take profits and add to long euro/dollar. Trade 3: Underweight French OATS... has worked well both in a European bond portfolio and in a global bond portfolio. Stick with this trade. Trade 4: Long euro/yuan... is up 6%. Stick with this trade. Trade 5 (New): Underweight emerging market equities. European equity investors should underweight Poland. Feature At the mid-point of the year, we are devoting this report to appraise our top investment ideas for 2017 - as recommended in our December 22 report Five Pressing Questions (And Four Trades) For 2017. Half-time is a good moment to review the thoughts we had at the start of 2017, establish how the ideas have performed in the first half, and assess whether to stick with them or make some changes in the second half. Chart of the WeekFor EM Equities, Excessive Groupthink Is Hitting Its Natural Limit Trade 1: An Unwinding Of The Trump Reflation Trade Chart I-2The Trump Reflation Trade Has Unwound Our thoughts at the start of 2017: "Can a modern day King Canute1 single-handedly turn the tide of global deflation - the combined structural forces of over-indebtedness, demographics, technology, and globalization? This publication believes that the tide has not turned... Rationality and analysis will conclude that Trumponomics is not the structural game changer that the market seems to believe right now." How has the trade performed in the first half? Exactly as scripted, the Trump reflation trade - in its various guises - has unwound. Since our original report, the trade-weighted dollar is down 5%; the global bond yield is down 15bps (the 10-year T-bond yield is down 40bps); and banks have underperformed the market by 5% (Chart I-2). Our thoughts for the second half of 2017: Never forget that the financial markets are a complex ecosystem in which long-term investors jostle with short-term traders. The equilibrium of this ecosystem relies on rationality and analysis ultimately checking emotion and impulse. In February, our prescient warning in The Contrarian Case For Bonds was that as emotional and impulsive short-term traders had been left unchecked to drive markets, excessive groupthink was hitting its natural technical limit. The 6-month sell-off in bonds had reached a point of instability. And sure enough, the trend broke (Chart I-3). Chart I-3For Bonds, Excessive Groupthink Hit Its Natural Limit In February At such tipping points of excessive groupthink, a good benchmark is that the preceding trend will reverse by one third. On this basis, a large part of the gains in the Trump trade unwind have now been made. Take profits and switch into new trade 5. Trade 2: Short Pound/Euro At €1.18 And Simultaneously Buy Call Options At €1.30 Our thoughts at the start of 2017: "2017 will be an especially unpredictable year for U.K. politics and economics because Brexit creates a larger number of moving parts, complex interactions and feedback loops, both negative and positive... The pound is unlikely to stay near today's €1.18. Expect a sharp move one way or the other." How has the trade performed in the first half? For U.K. politics, "especially unpredictable" could be the understatement of the year! An unpredicted general election generated an even more unpredicted result. With pound/euro now below €1.13, the directional position is up 5% in gross terms, and up around 4% in net terms allowing for the cost of the call options (Chart I-4). Chart I-4Pound / Euro Has Underperformed In 2017 Our thoughts for the second half of 2017: In a hung parliament, the minority Conservative government does not have the parliamentary maths to legislate for a hard Brexit in either the House of Commons or the House of Lords. Significantly, the so-called 'Salisbury Convention' - in which the House of Lords does not oppose the second or third reading of any government legislation promised in its election manifesto - does not necessarily apply in a hung parliament. This is because, by definition, the minority Conservative government's manifesto did not secure a majority in the House of Commons. With the hard Brexit tail-risk diminished, our current preference for currencies is euro first, pound second, dollar third, based on the evolution of interest rate expectations explained below. Hence, take profits in short pound/euro and add to long euro/dollar. Trade 3: Underweight French OATS Our thoughts at the start of 2017: "2016 was the year when QE peaked... The credibility of the ECB to suppress long-term bond yields would then be severely damaged. And the greatest danger would be to those euro area bond yields closest to zero." How has the trade performed in the first half? French OATS have substantially underperformed both U.K. gilts (Chart I-5) and U.S. T-bonds (Chart I-6). So it has been correct to underweight French government bonds both in a European bond portfolio and in a global bond portfolio. Chart I-5French OATs Have Underperformed In##br## A European Bond Portfolio... Chart I-6...And A Global ##br##Bond Portfolio Our thoughts for the second half of 2017: Central banks' professed commitment to data-dependency means that their words - and ultimately actions - must acknowledge the hard data. No ifs, buts or maybes. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses, which lead activity, euro area hard data will continue to be among the best among the major economies. Combined with the supply shortages the ECB is now facing in buying German bunds, expect the ECB's words to continue becoming more hawkish. The recent relatively smooth winding down of three failing banks - Spain's Banco Popolare and Italy's Banca Popolare di Vicenza and Veneto Banca - will also hearten the ECB that the strategy for resolving its undercapitalised banks does not pose a systemic risk to the economy or markets. Hence, expect euro area interest rate expectations to continue converging with other developed economies. And stick with the underweight French OATS (or German Bunds) trade, especially in a global bond portfolio. Chart I-7Euro / Yuan Is Up 6% Trade 4: Long Euro/Yuan Our thoughts at the start of 2017: "The debt super cycle is over when the cost of malinvestment and misallocation of capital outweighs the benefit of good credit creation... China appears to be approaching this point. One manifestation would be continued weakness in its currency against the major developed market crosses." How has the trade performed in the first half? Euro/yuan is up 6% (Chart I-7). Our thoughts for the second half of 2017: The thoughts we expressed at the start of 2017 are still entirely valid and supported by the argument for trade 5 below. Stick with long euro/yuan. Trade 5 (New): Underweight Emerging Market Equities Just as we presciently warned of excessive negative groupthink towards bonds in February, we are now seeing similarly excessive positive groupthink towards EM equities hitting its natural technical limit. This is a strong warning that the first half 15% rally risks reversing, or fizzling, in the second half (Chart of the Week). Chart I-8If EM Underperforms DM, Poland ##br##Underperforms Europe For the detailed fundamental analysis, I refer you to the latest reports penned by my colleague, BCA's Chief Emerging Markets Strategist, Arthur Budaghyan. But in summary, Arthur says: "China's liquidity conditions have tightened, warranting a meaningful slowdown in money/credit and economic growth... the outlook for EM risk assets is extremely poor... and we continue to recommend an underweight allocation towards EM within global portfolios across stocks, credit and currencies."2 For European equity investors, this means underweighting Poland, whose relative performance tracks EM versus DM equities (Chart I-8). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In fact, the story of King Canute has been misinterpreted. Rather than show that he could turn the tide, he wanted to show the opposite: that he was powerless against the tide. 2 Please see the Emerging Markets Strategy Weekly Report "EM: Contradictions And A Resolution" published on June 14, 2017 and available at ems.bcaresearch.com Fractal Trading Model* As shown on page 1, this week's trade is to go short emerging markets with a corresponding long in developed markets. In this case, the trade duration is up to 6 months with a profit target and stop-loss of 3%. Amongst our other open trades, long FTSE100 / short IBEX35 is approaching its 4% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Special Report

Highlights The EM carry trade - supported by a commodity price rally, falling bond yields, and a weak USD - have propped up South African assets; Investors have largely ignored politics and focused on personalities instead of political fundamentals; South Africa's socio-economic factors - governance, middle class wellbeing, productivity, and unemployment - have all regressed; The "median voter" has therefore turned more radical and left-wing; Stay short ZAR versus USD and MXN, stay underweight stocks, sovereign credit, and domestic bonds, and bet on yield-curve steepening. Feature Why do investors in Europe and the U.S. continue to invest in South Africa? - Every client in South Africa Our recent week-long trip to South Africa was revealing for two reasons. First, it reminded us of the promise and opportunity of this amazing country and its people. Second, it impressed upon us the deep pessimism of its entire financial community. As the quote at the top of this report suggests, every client we met over seven days was deeply puzzled by continued resilience of foreign inflows. Clients were surprised that foreign investors continued to find value in South Africa's fixed income and currency markets amidst a continued growth downtrend, soft commodity prices, and the ongoing political imbroglio (Chart I-1). The answer to the puzzle is simple: the main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart I-2). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart I-1ZAR Rally Amidst Economic##br## And Commodity Downturn Chart I-2EM Carry Trade Is ##br##Alive And Well How likely is it that the carry trade can continue? BCA's Global Investment Strategy and Emerging Markets Strategy both argue that U.S. growth will soon accelerate.1 The U.S. financial conditions have eased thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart I-3). Historically, an easing in financial conditions has foreshadowed faster growth (Chart I-4). Meanwhile, the relative U.S. growth underperformance versus DM is late and will turn around very soon (Chart I-5). As U.S. economic growth surprises pick up, investors will bid up the 10-year Treasury yield and the greenback, ushering in the end of the carry trade. Chart I-3U.S. Financial Conditions Have Eased... Chart I-4...U.S. Growth Should Therefore Sharply Rebound Chart I-5U.S. Underperformance Is Long-In-The-Tooth How resilient are South Africa's economic fundamentals and politics? In this report, we argue that they are not resilient at all. The country is facing considerable structural problems on both economic and political fronts. Even its sole silver lining - that it retains cyclical maneuvering room, i.e., it can adopt fiscal stimulus - will only encourage its leaders to double-down on a populist growth model that has already run out of steam. Cyclical Outlook: A Dark Cloud With A Silver Lining The cyclical outlook for South Africa has darkened as of late. All the drivers that pushed the rand to appreciate over the last 12 months are now showing signs of a reversal: The rand's rally in the past six months or so - a period when it decoupled from commodities prices - is often attributed to its higher interest rates. However, Chart I-6 demonstrates that higher local interest rates historically did not prevent the rand's selloff when metal prices fell. In short, we believe the last six months is an aberration rather than a new norm. Remarkably, hedged yields in South Africa are no longer attractive within the EM space. South Africa already offers the worst hedged returns, after Turkey and China, for the U.S. dollar and euro-based investors (Chart I-7 and Chart I-8).2 The situation will only get worse as the U.S. dollar appreciates and Treasury yields rise. Chart I-6High Local Interest Rates ##br##Are No Panacea For ZAR The drop in precious metal prices will force the rand to selloff (Chart I-9). The unprecedented resilience in the rand was supported by increasing financial flows. Now that these are decreasing, the historic correlation with precious metals should reemerge. The decoupling between the ZAR and AUD since early this year is unprecedented (Chart I-10). Both economies are leveraged to industrial and precious metals as well as coal prices, making both exchange rates correlated. Needless to say, Australia commands much better governance and politics than South Africa. In fact, higher interest rates in South Africa have never precluded the rand's depreciation when the AUD dropped. Chart I-9Is The Divergence With Precious Metals... Chart I-10...And AUD Sustainable? Therefore, we conclude that the rand's strength has not been warranted by any of its historic drivers. It has been due to nothing else than the blind search for yield. Over the medium and long run, the outlook for the rand remains bleak. The ongoing dynamic of high wage growth and negative productivity growth will assure a lingering stagflationary environment (Chart I-11). This is bearish for the rand. Surprisingly, despite a rising currency and falling bond yields over the last 12 months, the South African economy is still showing signs of weakness. The household sector, which represents 61% of the economy, is not showing signs of a recovery yet. Credit growth to households is still falling and private consumption is abysmal. (Chart I-12). On the corporate side, the situation is not reassuring either. Firms are not investing and business confidence has not shown any signs of a significant recovery (Chart I-13). Chart I-11Productivity Is Weak But Wages Are Strong Chart I-12Household Consumption Is Declining Chart I-13No Confidence, No Investment The one positive is that the government has fiscal room to maneuver. South African gross government debt is at a comfortable 51% of GDP. However, we suspect that the nature of fiscal spending will likely result in transfers to appease the population - especially ahead of key elections in late 2017 and 2018 - rather than investments that can genuinely improve productivity. In fact, fiscal spending in the form of transfers could very well entice consumers to import more and consequently widen the current account deficit, putting more downward pressure on the rand. Bottom Line: The commodity price rally in 2016 and falling bond yields failed to buoy the economy. While policymakers do retain fiscal room to stimulate, the problem is that such efforts will likely merely rekindle populist policies that have failed South Africa thus far. Structural Outlook: Late Innings Of The Crisis Of Expectations South Africa is not alone in the EM universe in having failed to improve governance over the past decade. Most EM economies have squandered the commodity bull market and Chinese industrialization, allowing their governance to stagnate or even worsen during the good times (Chart I-14).3 However, South Africa does stand alone when it comes to a tepid rise in middle class, as percent of total population (Chart I-15), and continued high income inequality (Chart I-16). Chart I-14Quality Of EM Governance Declined##br## Amidst The Good Times Chart I-15Middle Class Has ##br##Barely Budged... The data is clear: South Africa is as unequal overall, and its middle class unchanged relative to overall population, as it was at the end of apartheid in the early 1990s. Governance in the country has continued to deteriorate, and while it remains higher than in Sub-Saharan Africa, the gap has astonishingly begun to narrow from both ends (Chart I-17). Chart I-17Governance Gap With Sub-Saharan ##br##Africa Is Closing! A major reason for the deterioration in governance is the "state capture" thesis that has become a popular one in characterizing President Jacob Zuma's rule.4 This process began early, as the country shifted its developmental program in 1996 away from a top-down, state-led, developmental model to one that encouraged a free-market economy balanced with welfare spending. This was a natural result of the global rise of laissez-faire capitalism, the Washington Consensus, and "Third Way" politics of left-leaning parties. A commitment to laissez-faire capitalism and free markets, combined with a strong welfare state, were seen as hallmarks of a successful economy. The problem with this approach is that it confused the symptoms of developed economies with their catalysts. South Africa needed a much more state-led approach to development, one that would have harnessed the resources of the state for productivity-enhancing investments. As such, the laissez-faire approach unsurprisingly failed to address the inequalities of the apartheid system and the country saw a decline in the middle class as percent of total population under both Presidents Nelson Mandela and Thabo Mbeki. This pivot towards free-market capitalism ended with the 2007 "Polokwane moment," which saw President Mbeki's free-market, reactive, attempt to address inequality between the white and black populations replaced with the proactive policy of Jacob Zuma. Zuma's more radical approach was to complement welfare transfers and high wage growth with an activist use of state owned enterprises (SOEs) as a vehicle for redistribution. This proactive policy meant using the government's tender system to doll out lucrative contracts to well-connected insiders, under the auspices of helping enfranchise black entrepreneurs and businesses. While the media has focused on the role that the Indian-born Gupta family has played in this process, it is highly unlikely that they are the only beneficiaries. Zuma's administration has, in the name of black enfranchisement and the fight against inequality, essentially rigged the entire government tender system for the sake of its own political preservation. The results of this process are unsurprising. First, government wages have outpaced those in both manufacturing and mining sectors (Chart I-18). Meanwhile, productivity has declined precipitously since 2007 and has been negative since 2012. South Africa has a lower productivity rate than both Latin American EM economies and its neighbors in sub-Saharan Africa (Chart I-19). Chart I-18Government Wages Have Outpaced All Others Chart I-19South African Productivity Has No Peer Financial media and investment research have continued to focus on the intricacies of the ruling African National Congress (ANC) politics. And we do so as well below. However, investors have to understand that South Africa's ills will not be fixed by the appointment of a pro-market finance minister or even the removal of Jacob Zuma from rule. South Africa has failed to develop inclusive economic institutions that engender creative destruction, which is at the heart of all successful development stories.5 South Africa ranked 74th in the World Bank's annual Doing Business report in 2017, an astonishing fall from grace over the past decade (Chart I-20). Compared to regional averages, South Africa barely beats the Sub-Saharan "distance to frontier" scores in several World Bank categories (Chart I-21). This is not due to the gross failure of the Zuma administration to do the "right thing." Rather, it exhibits a structural failing of South African political institutions. This development path is not unique to South Africa. Most sub-Saharan African states experienced a similar regression within 10-20 years of decolonization. Political scientist Robert Bates famously documented how African leaders co-opted colonial-era extractive economic institutions - such as the state marketing boards that purchased all cash crops and exported them on the global market - in order to generate enough revenue to industrialize their economies.6 While their intentions may have originally been noble, if misplaced, they quickly began to use control over marketing boards for political purposes. The rent generated from marketing boards became an immense source of political power for African leaders and they held on to it to the detriment of the economic development of their state. South Africa is far more developed than its sub-Saharan peers were in the 1970s. Nevertheless, its leaders are exhibiting similar rent-seeking behavior, albeit at a much higher level of development. It is also entering a dangerous period in its post-apartheid history: it has now been twenty years since South Africa's effective decolonization and it is facing its first serious economic downturn. Bottom Line: We doubt that anyone in the current leadership elite will be able to fully abandon the rent-seeking behavior of the Zuma administration and improve South Africa's economic institutions. The crisis of expectations among the country's voters is palpable and demands for greater redistribution are rising. This is not a context for pro-market reforms that will encourage creative destruction. Instead, we would expect a doubling-down of populism and greater emphasis on proactive redistribution, which will, at the same time, encourage greater out-migration of talent out of the country and rent seeking behavior from political elites. Can Any One Man Or Woman Fix South Africa? The African National Congress (ANC) will meet in December 2017 to decide the party candidate that will contest the 2019 general election (Diagram I-1). Given the ANC's stranglehold on the country's politics, it is likely that whoever emerges at the upcoming ANC Congress will be the next president of South Africa. BCA's Geopolitical Strategy subscribes to the idea that policymakers are price takers in the political marketplace, not price makers. This is particularly the case in democracies, but it is also the case in some authoritarian regimes where public opinion is relevant. As such, the puzzle investors have to resolve is not what policymakers stand for, but rather what the median voter wants. In South Africa, the median voter lives in a rural area, works in the agriculture or service industry, and is a black citizen. The polls indicate that the main concerns of the median voter are a high structural unemployment rate (Chart I-22), endemic corruption (Chart I-23), poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. Chart I-22Crisis Of Expectations Is this the profile of a median voter about to elect a pro-market reformer willing to pursue painful structural reforms? We do not think so. The two candidates vying for the ANC presidency are the ex-wife of Jacob Zuma and former Chair of the African Union, Nkosazana Dlamini-Zuma, and former Deputy President, Cyril Ramaphosa. Ramaphosa is the darling of the international investment community. This is because he has abandoned his previous union credentials - he founded the country's largest trade union, the National Union of Mineworkers in addition to founding the Congress of South African Trade Unions (COSATU) - and turned into a successful businessman. As such, the narrative among South Africa bulls (who are exclusively found in Europe and the U.S.) is that he would be able to bridge the divide between the demands for redistribution and pro-market reforms. To the median voter, however, Ramaphosa is alleged to be involved in the Marikana Massacre. Acting as the Deputy President, he ordered increased police presence at the mines and called for the use of force, which resulted in 47 deaths in August-September 2012. Dlamini-Zuma, on the other hand, speaks the language of the median voter while also not being seen as part of Zuma's corrupt entourage. Her credentials are bolstered by a successful tenure as Chair of the African Union and as a woman independent and strong enough to divorce President Zuma. She has not amassed personal wealth and does not hold strong loyalties to a particular faction within the ANC. However, she has begun to parrot Zuma's line that the country requires "radical economic transformation," which is a signal to left-leaning members of the ANC that she will continue much of economic policies begun under Zuma. Both the ANC Youth and Women's Leagues, which are left leaning, support her. The problem that investors face in South Africa is that there is no clear demand for pro-market reforms. Investors cheered the results of the August 2016 municipal election, for example, because the ANC lost in several key cities and saw its total vote share fall by 8%. However, few in the media or investment research community raised the obvious point that the centrist Democratic Alliance only saw its vote total rise by 3% compared to the 2011 election. It was the radically left-wing Economic Freedom Fighters, led by ex-Youth League leader Julius Malema, which saw the largest increase in vote share, by over 8%. In other words, ANC voters that did abandon Zuma most likely fell behind Malema, who is far more redistributionist. As such, we stick to our long-held view that Zuma and the ANC leadership are unlikely to do what investors want them to do given that the South African median voter is swinging further to the left. There is no demand for pro-market reforms and thus policymakers are more likely to double-down on populism. Bottom Line: Dlamini-Zuma is the likely winner of the upcoming ANC Congress, which will effectively decide the next president of South Africa. She has the sufficient left-leaning economic credentials to satisfy the demands for redistribution of the median voter. There is also a chance that she will attempt to clean up the corruption that has become endemic under Zuma, which would undoubtedly be a good thing for the country. However, it is unlikely that the macroeconomic context she will face will be positive, or that she will have the mandate to balance redistributive policies with painful pro-market reforms that would rebuild institutions required for creative destruction. Investment Implications South African assets are ultimately at the mercy of foreign inflows. When the dollar is weakening, U.S. bond yields falling, and Chinese growth stable, even the election of Julius Malema to the presidency would not dent foreign enthusiasm for yield in South African assets. Given the expected improvement in U.S. growth and the transitory nature of the drop in the U.S. inflation rate, we expect the global macro backdrop to worsen substantially for carry trades in general, and for South Africa in particular. China remains the wild card in our analysis, but its credit and fiscal impulse has rolled over, suggesting slower import growth over the next six months (Chart I-24). Even if Chinese policymakers react by re-stimulating the economy, the effects will only be felt in early 2018 given lead times. When the global carry trade reverses, it will not matter who is in charge of South Africa. Investors will realize that the country has failed to address serious socio-economic ills that have plagued South Africa since the end of apartheid. BCA's Emerging Markets Strategy continues to recommend the following investment positions: Chart I-24China Slowdown Is A Risk To EM Chart I-25Yield Curve Will Steepen Continue shorting ZAR versus USD and MXN. Underweight South African stocks, sovereign credit and domestic bonds relative to their respective EM benchmarks. A new trade: bet on yield-curve steepening (Chart I-25). The short end of the curve will be steady but populist politics, larger fiscal deficits/higher public debt, and an inflationary backdrop will push up long-end yields. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Beement Alemayehu, Research Assistant beementa@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "Stocks Are From Mars, Bonds Are From Venus?" dated June 23, 2017, available at gis.bcaresearch.com, and BCA Emerging Market Strategy Weekly Report, "EM: Contradictions And A Resolution," dated June 14, 2017, available at ems.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Local Bonds: Looking At Hedged Yields," dated May 10, 2017, available at ems.bcaresearch.com. 3 'Governance' is a catchall term that attempts to capture the quality of public service delivery, broadly defined. In essence, investors can consider governance as a factor that underpins the quality of political institutions. We rely on the World Bank's Development Indicators because the World Bank aggregates the work of several credible surveys on governance. These indicators are also useful because the World Bank standardizes the results in a way that allows cross-country/region comparisons. We then aggregate the scores across five different variables and look for trends and changes over time. 4 Please see State Capacity Research Project, "Betrayal Of The Promise: How South Africa Is Being Stolen," dated May 2017, available at pari.org.za. 5 Please see Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 6 Please see Robert H. Bates, Markets and States in Tropical Africa: The Political Basis of Agricultural Policies (Berkeley, University of California Press, 2014 edition). Geopolitical Calendar

Special Report

Highlights The EM carry trade - supported by a commodity price rally, falling bond yields, and a weak USD - have propped up South African assets; Investors have largely ignored politics and focused on personalities instead of political fundamentals; South Africa's socio-economic factors - governance, middle class wellbeing, productivity, and unemployment - have all regressed; The "median voter" has therefore turned more radical and left-wing; Stay short ZAR versus USD and MXN, stay underweight stocks, sovereign credit, and domestic bonds, and bet on yield-curve steepening. Feature Why do investors in Europe and the U.S. continue to invest in South Africa? - Every client in South Africa Our recent week-long trip to South Africa was revealing for two reasons. First, it reminded us of the promise and opportunity of this amazing country and its people. Second, it impressed upon us the deep pessimism of its entire financial community. As the quote at the top of this report suggests, every client we met over seven days was deeply puzzled by continued resilience of foreign inflows. Clients were surprised that foreign investors continued to find value in South Africa's fixed income and currency markets amidst a continued growth downtrend, soft commodity prices, and the ongoing political imbroglio (Chart I-1). The answer to the puzzle is simple: the main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart I-2). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart I-1ZAR Rally Amidst Economic##br## And Commodity Downturn Chart I-2EM Carry Trade Is ##br##Alive And Well How likely is it that the carry trade can continue? BCA's Global Investment Strategy and Emerging Markets Strategy both argue that U.S. growth will soon accelerate.1 The U.S. financial conditions have eased thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart I-3). Historically, an easing in financial conditions has foreshadowed faster growth (Chart I-4). Meanwhile, the relative U.S. growth underperformance versus DM is late and will turn around very soon (Chart I-5). As U.S. economic growth surprises pick up, investors will bid up the 10-year Treasury yield and the greenback, ushering in the end of the carry trade. Chart I-3U.S. Financial Conditions Have Eased... Chart I-4...U.S. Growth Should Therefore Sharply Rebound Chart I-5U.S. Underperformance Is Long-In-The-Tooth How resilient are South Africa's economic fundamentals and politics? In this report, we argue that they are not resilient at all. The country is facing considerable structural problems on both economic and political fronts. Even its sole silver lining - that it retains cyclical maneuvering room, i.e., it can adopt fiscal stimulus - will only encourage its leaders to double-down on a populist growth model that has already run out of steam. Cyclical Outlook: A Dark Cloud With A Silver Lining The cyclical outlook for South Africa has darkened as of late. All the drivers that pushed the rand to appreciate over the last 12 months are now showing signs of a reversal: The rand's rally in the past six months or so - a period when it decoupled from commodities prices - is often attributed to its higher interest rates. However, Chart I-6 demonstrates that higher local interest rates historically did not prevent the rand's selloff when metal prices fell. In short, we believe the last six months is an aberration rather than a new norm. Remarkably, hedged yields in South Africa are no longer attractive within the EM space. South Africa already offers the worst hedged returns, after Turkey and China, for the U.S. dollar and euro-based investors (Chart I-7 and Chart I-8).2 The situation will only get worse as the U.S. dollar appreciates and Treasury yields rise. Chart I-6High Local Interest Rates ##br##Are No Panacea For ZAR The drop in precious metal prices will force the rand to selloff (Chart I-9). The unprecedented resilience in the rand was supported by increasing financial flows. Now that these are decreasing, the historic correlation with precious metals should reemerge. The decoupling between the ZAR and AUD since early this year is unprecedented (Chart I-10). Both economies are leveraged to industrial and precious metals as well as coal prices, making both exchange rates correlated. Needless to say, Australia commands much better governance and politics than South Africa. In fact, higher interest rates in South Africa have never precluded the rand's depreciation when the AUD dropped. Chart I-9Is The Divergence With Precious Metals... Chart I-10...And AUD Sustainable? Therefore, we conclude that the rand's strength has not been warranted by any of its historic drivers. It has been due to nothing else than the blind search for yield. Over the medium and long run, the outlook for the rand remains bleak. The ongoing dynamic of high wage growth and negative productivity growth will assure a lingering stagflationary environment (Chart I-11). This is bearish for the rand. Surprisingly, despite a rising currency and falling bond yields over the last 12 months, the South African economy is still showing signs of weakness. The household sector, which represents 61% of the economy, is not showing signs of a recovery yet. Credit growth to households is still falling and private consumption is abysmal. (Chart I-12). On the corporate side, the situation is not reassuring either. Firms are not investing and business confidence has not shown any signs of a significant recovery (Chart I-13). Chart I-11Productivity Is Weak But Wages Are Strong Chart I-12Household Consumption Is Declining Chart I-13No Confidence, No Investment The one positive is that the government has fiscal room to maneuver. South African gross government debt is at a comfortable 51% of GDP. However, we suspect that the nature of fiscal spending will likely result in transfers to appease the population - especially ahead of key elections in late 2017 and 2018 - rather than investments that can genuinely improve productivity. In fact, fiscal spending in the form of transfers could very well entice consumers to import more and consequently widen the current account deficit, putting more downward pressure on the rand. Bottom Line: The commodity price rally in 2016 and falling bond yields failed to buoy the economy. While policymakers do retain fiscal room to stimulate, the problem is that such efforts will likely merely rekindle populist policies that have failed South Africa thus far. Structural Outlook: Late Innings Of The Crisis Of Expectations South Africa is not alone in the EM universe in having failed to improve governance over the past decade. Most EM economies have squandered the commodity bull market and Chinese industrialization, allowing their governance to stagnate or even worsen during the good times (Chart I-14).3 However, South Africa does stand alone when it comes to a tepid rise in middle class, as percent of total population (Chart I-15), and continued high income inequality (Chart I-16). Chart I-14Quality Of EM Governance Declined##br## Amidst The Good Times Chart I-15Middle Class Has ##br##Barely Budged... The data is clear: South Africa is as unequal overall, and its middle class unchanged relative to overall population, as it was at the end of apartheid in the early 1990s. Governance in the country has continued to deteriorate, and while it remains higher than in Sub-Saharan Africa, the gap has astonishingly begun to narrow from both ends (Chart I-17). Chart I-17Governance Gap With Sub-Saharan ##br##Africa Is Closing! A major reason for the deterioration in governance is the "state capture" thesis that has become a popular one in characterizing President Jacob Zuma's rule.4 This process began early, as the country shifted its developmental program in 1996 away from a top-down, state-led, developmental model to one that encouraged a free-market economy balanced with welfare spending. This was a natural result of the global rise of laissez-faire capitalism, the Washington Consensus, and "Third Way" politics of left-leaning parties. A commitment to laissez-faire capitalism and free markets, combined with a strong welfare state, were seen as hallmarks of a successful economy. The problem with this approach is that it confused the symptoms of developed economies with their catalysts. South Africa needed a much more state-led approach to development, one that would have harnessed the resources of the state for productivity-enhancing investments. As such, the laissez-faire approach unsurprisingly failed to address the inequalities of the apartheid system and the country saw a decline in the middle class as percent of total population under both Presidents Nelson Mandela and Thabo Mbeki. This pivot towards free-market capitalism ended with the 2007 "Polokwane moment," which saw President Mbeki's free-market, reactive, attempt to address inequality between the white and black populations replaced with the proactive policy of Jacob Zuma. Zuma's more radical approach was to complement welfare transfers and high wage growth with an activist use of state owned enterprises (SOEs) as a vehicle for redistribution. This proactive policy meant using the government's tender system to doll out lucrative contracts to well-connected insiders, under the auspices of helping enfranchise black entrepreneurs and businesses. While the media has focused on the role that the Indian-born Gupta family has played in this process, it is highly unlikely that they are the only beneficiaries. Zuma's administration has, in the name of black enfranchisement and the fight against inequality, essentially rigged the entire government tender system for the sake of its own political preservation. The results of this process are unsurprising. First, government wages have outpaced those in both manufacturing and mining sectors (Chart I-18). Meanwhile, productivity has declined precipitously since 2007 and has been negative since 2012. South Africa has a lower productivity rate than both Latin American EM economies and its neighbors in sub-Saharan Africa (Chart I-19). Chart I-18Government Wages Have Outpaced All Others Chart I-19South African Productivity Has No Peer Financial media and investment research have continued to focus on the intricacies of the ruling African National Congress (ANC) politics. And we do so as well below. However, investors have to understand that South Africa's ills will not be fixed by the appointment of a pro-market finance minister or even the removal of Jacob Zuma from rule. South Africa has failed to develop inclusive economic institutions that engender creative destruction, which is at the heart of all successful development stories.5 South Africa ranked 74th in the World Bank's annual Doing Business report in 2017, an astonishing fall from grace over the past decade (Chart I-20). Compared to regional averages, South Africa barely beats the Sub-Saharan "distance to frontier" scores in several World Bank categories (Chart I-21). This is not due to the gross failure of the Zuma administration to do the "right thing." Rather, it exhibits a structural failing of South African political institutions. This development path is not unique to South Africa. Most sub-Saharan African states experienced a similar regression within 10-20 years of decolonization. Political scientist Robert Bates famously documented how African leaders co-opted colonial-era extractive economic institutions - such as the state marketing boards that purchased all cash crops and exported them on the global market - in order to generate enough revenue to industrialize their economies.6 While their intentions may have originally been noble, if misplaced, they quickly began to use control over marketing boards for political purposes. The rent generated from marketing boards became an immense source of political power for African leaders and they held on to it to the detriment of the economic development of their state. South Africa is far more developed than its sub-Saharan peers were in the 1970s. Nevertheless, its leaders are exhibiting similar rent-seeking behavior, albeit at a much higher level of development. It is also entering a dangerous period in its post-apartheid history: it has now been twenty years since South Africa's effective decolonization and it is facing its first serious economic downturn. Bottom Line: We doubt that anyone in the current leadership elite will be able to fully abandon the rent-seeking behavior of the Zuma administration and improve South Africa's economic institutions. The crisis of expectations among the country's voters is palpable and demands for greater redistribution are rising. This is not a context for pro-market reforms that will encourage creative destruction. Instead, we would expect a doubling-down of populism and greater emphasis on proactive redistribution, which will, at the same time, encourage greater out-migration of talent out of the country and rent seeking behavior from political elites. Can Any One Man Or Woman Fix South Africa? The African National Congress (ANC) will meet in December 2017 to decide the party candidate that will contest the 2019 general election (Diagram I-1). Given the ANC's stranglehold on the country's politics, it is likely that whoever emerges at the upcoming ANC Congress will be the next president of South Africa. BCA's Geopolitical Strategy subscribes to the idea that policymakers are price takers in the political marketplace, not price makers. This is particularly the case in democracies, but it is also the case in some authoritarian regimes where public opinion is relevant. As such, the puzzle investors have to resolve is not what policymakers stand for, but rather what the median voter wants. In South Africa, the median voter lives in a rural area, works in the agriculture or service industry, and is a black citizen. The polls indicate that the main concerns of the median voter are a high structural unemployment rate (Chart I-22), endemic corruption (Chart I-23), poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. Chart I-22Crisis Of Expectations Is this the profile of a median voter about to elect a pro-market reformer willing to pursue painful structural reforms? We do not think so. The two candidates vying for the ANC presidency are the ex-wife of Jacob Zuma and former Chair of the African Union, Nkosazana Dlamini-Zuma, and former Deputy President, Cyril Ramaphosa. Ramaphosa is the darling of the international investment community. This is because he has abandoned his previous union credentials - he founded the country's largest trade union, the National Union of Mineworkers in addition to founding the Congress of South African Trade Unions (COSATU) - and turned into a successful businessman. As such, the narrative among South Africa bulls (who are exclusively found in Europe and the U.S.) is that he would be able to bridge the divide between the demands for redistribution and pro-market reforms. To the median voter, however, Ramaphosa is alleged to be involved in the Marikana Massacre. Acting as the Deputy President, he ordered increased police presence at the mines and called for the use of force, which resulted in 47 deaths in August-September 2012. Dlamini-Zuma, on the other hand, speaks the language of the median voter while also not being seen as part of Zuma's corrupt entourage. Her credentials are bolstered by a successful tenure as Chair of the African Union and as a woman independent and strong enough to divorce President Zuma. She has not amassed personal wealth and does not hold strong loyalties to a particular faction within the ANC. However, she has begun to parrot Zuma's line that the country requires "radical economic transformation," which is a signal to left-leaning members of the ANC that she will continue much of economic policies begun under Zuma. Both the ANC Youth and Women's Leagues, which are left leaning, support her. The problem that investors face in South Africa is that there is no clear demand for pro-market reforms. Investors cheered the results of the August 2016 municipal election, for example, because the ANC lost in several key cities and saw its total vote share fall by 8%. However, few in the media or investment research community raised the obvious point that the centrist Democratic Alliance only saw its vote total rise by 3% compared to the 2011 election. It was the radically left-wing Economic Freedom Fighters, led by ex-Youth League leader Julius Malema, which saw the largest increase in vote share, by over 8%. In other words, ANC voters that did abandon Zuma most likely fell behind Malema, who is far more redistributionist. As such, we stick to our long-held view that Zuma and the ANC leadership are unlikely to do what investors want them to do given that the South African median voter is swinging further to the left. There is no demand for pro-market reforms and thus policymakers are more likely to double-down on populism. Bottom Line: Dlamini-Zuma is the likely winner of the upcoming ANC Congress, which will effectively decide the next president of South Africa. She has the sufficient left-leaning economic credentials to satisfy the demands for redistribution of the median voter. There is also a chance that she will attempt to clean up the corruption that has become endemic under Zuma, which would undoubtedly be a good thing for the country. However, it is unlikely that the macroeconomic context she will face will be positive, or that she will have the mandate to balance redistributive policies with painful pro-market reforms that would rebuild institutions required for creative destruction. Investment Implications South African assets are ultimately at the mercy of foreign inflows. When the dollar is weakening, U.S. bond yields falling, and Chinese growth stable, even the election of Julius Malema to the presidency would not dent foreign enthusiasm for yield in South African assets. Given the expected improvement in U.S. growth and the transitory nature of the drop in the U.S. inflation rate, we expect the global macro backdrop to worsen substantially for carry trades in general, and for South Africa in particular. China remains the wild card in our analysis, but its credit and fiscal impulse has rolled over, suggesting slower import growth over the next six months (Chart I-24). Even if Chinese policymakers react by re-stimulating the economy, the effects will only be felt in early 2018 given lead times. When the global carry trade reverses, it will not matter who is in charge of South Africa. Investors will realize that the country has failed to address serious socio-economic ills that have plagued South Africa since the end of apartheid. BCA's Emerging Markets Strategy continues to recommend the following investment positions: Chart I-24China Slowdown Is A Risk To EM Chart I-25Yield Curve Will Steepen Continue shorting ZAR versus USD and MXN. Underweight South African stocks, sovereign credit and domestic bonds relative to their respective EM benchmarks. A new trade: bet on yield-curve steepening (Chart I-25). The short end of the curve will be steady but populist politics, larger fiscal deficits/higher public debt, and an inflationary backdrop will push up long-end yields. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Beement Alemayehu, Research Assistant beementa@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "Stocks Are From Mars, Bonds Are From Venus?" dated June 23, 2017, available at gis.bcaresearch.com, and BCA Emerging Market Strategy Weekly Report, "EM: Contradictions And A Resolution," dated June 14, 2017, available at ems.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Local Bonds: Looking At Hedged Yields," dated May 10, 2017, available at ems.bcaresearch.com. 3 'Governance' is a catchall term that attempts to capture the quality of public service delivery, broadly defined. In essence, investors can consider governance as a factor that underpins the quality of political institutions. We rely on the World Bank's Development Indicators because the World Bank aggregates the work of several credible surveys on governance. These indicators are also useful because the World Bank standardizes the results in a way that allows cross-country/region comparisons. We then aggregate the scores across five different variables and look for trends and changes over time. 4 Please see State Capacity Research Project, "Betrayal Of The Promise: How South Africa Is Being Stolen," dated May 2017, available at pari.org.za. 5 Please see Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 6 Please see Robert H. Bates, Markets and States in Tropical Africa: The Political Basis of Agricultural Policies (Berkeley, University of California Press, 2014 edition). Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The divergence between global bond yields and equity prices is not as puzzling as it may first appear. Thus far, lower inflation has dampened the need for central banks to tighten monetary policy. This has caused bond yields to fall, lifting stocks in the process. Looking out, the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment. The "blow-off" phase for the U.S. economy is likely to last until mid-2018. The dollar and Treasury yields will move higher over this period. The euro and the yen will suffer the most against a resurgent greenback, the pound less so. China's economy will remain resilient, helping to boost commodity prices. This will support the Canadian and Aussie dollars. Stronger global growth will provide a tailwind to emerging markets. However, at this point, most of the good news is already reflected in EM asset valuations. Feature Stocks And Bonds: A Curious Divergence Chart 1Global Growth: Increasing Optimism One could be forgiven for thinking that equity and bond investors are living on different planets. Global bond yields have been trending lower thus far this year, while stocks have been setting new highs. Are bonds signaling an imminent slowdown which equity investors are willfully ignoring? Not necessarily. Almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained reasonably steady, suggesting that growth worries are not foremost on investors' minds. The fact that consensus global growth estimates for 2017 and 2018 have continued to grind higher is consistent with this observation (Chart 1). A quiescent inflation picture has given investors more confidence that the Fed will not need to raise rates aggressively. This has pushed down bond yields, weakened the dollar, and fueled the rally in stock prices. The decline in headline inflation, in turn, has been largely driven by lower commodity prices. In the U.S., several one-off factors - including Verizon's decision to move to unlimited data plans, a temporary lull in health care inflation, and a drop in airline fares - have helped keep core inflation in check. The U.S. Economy: It Gets Better Before It Gets Worse Looking out, global growth is likely to remain firm. This should ultimately translate into higher inflation, particularly in the U.S., where the economy has already achieved full employment. Granted, as we discussed last week,1 the U.S. business cycle expansion is getting long in the tooth. However, history suggests that the transition between boom and bust is often accompanied by a revelry of sorts where things get better before they get worse. Call it a "blow-off" phase for the business cycle. The example of the late 1990s - the last time the U.S. unemployment rate fell below NAIRU for an extended period of time - comes to mind. Chart 2 shows that final domestic demand accelerated to 8.3% in nominal terms in Q1 of 2000. Personal consumption growth surged, reaching 8.4% in nominal terms and 5.7% in real terms. Obviously, there are many differences between now and then. However, there is at least one critical similarity: The unemployment rate stood at 4.3% in January 1999. This is exactly where it stands today. And if it keeps falling at its current pace, the unemployment rate will dip below its 2000 low of 3.8% by next summer. As was the case in the past, an overheated labor market will lead to faster wage growth. In the U.S., underlying wage growth has accelerated from 1.2% in 2010 to 2.4% at present (Chart 3). Chart 2The Late 1990s: An End-Of-Cycle Blow-Off Chart 3Stronger Labor Market Is Leading To Faster Wage Growth Granted, this is still well below the levels seen in 2000 and 2007. However, productivity growth has crumbled over the past decade while long-term inflation expectations have dipped. Real unit labor costs - a measure of compensation which adjusts for shifts in productivity growth and inflation - are rising at a faster rate than in 2007 and close to the pace recorded in 2000 (Chart 4). In fact, real wage growth in the U.S. has eclipsed business productivity growth for three straight years (Chart 5). As a result, labor's share of national income is now increasing. Chart 4Real Unit Labor Cost Growth: Back To Its 2000 Peak Chart 5Real Wages Now Increasing Faster Than Productivity What happens to aggregate demand when the share of income going to workers rises? The answer is that at least initially, demand goes up. Companies typically spend less of every marginal dollar of income than workers. This is especially the case in today's environment where the distribution of corporate profits has become increasingly tilted towards a few winner-take-all firms which, for the most part, are already flush with cash (Chart 6). Thus, a shift of income towards workers tends to boost overall spending. In addition, an overheated labor market typically generates the biggest gains for workers at the bottom of the income distribution. Wages for U.S. workers without a college degree have been rising more quickly than those with a university education for the past few years (Chart 7). Such workers often live paycheck-to-paycheck and, hence, have a high marginal propensity to consume. Chart 6A Winner-Take-All Economy Chart 7Tighter Labor Market Boosting Wages Of Less Educated Workers Let's Get This Party Started The discussion above suggests that U.S. aggregate demand could accelerate over the next few quarters. There is some evidence that this is already happening (Chart 8). Despite a moderation in auto purchases, real PCE growth is still tracking at 3.2% in the second quarter according to the Atlanta Fed's GDPNow model. And with the personal saving rate still stuck at an elevated 5.3%, there is scope for consumer spending to grow at a faster rate than disposable income. Chart 9 shows that the current saving rate is well above the level one would expect based on the ratio of household net worth-to-disposable income. Chart 8Solid Near-Term Outlook For U.S. Consumers Financial conditions have eased over the past six months thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart 10). Historically, an easing in financial conditions has foreshadowed faster growth (Chart 11). This could make the coming blow-off phase even more explosive than in past business cycles. Some commentators have noted that while financial conditions have eased, bank lending has slowed significantly. If true, this would imply that easier financial conditions are not boosting credit growth in the way one might expect. The problem with this argument is that it takes a far too limited view of the U.S. financial system. Although bank lending to companies has indeed slowed, bond issuance has soared. In fact, total nonfinancial corporate debt rose by $212 billion in the first quarter according to the Fed's Financial Accounts database, the largest increase in history (Chart 12). Chart 10Financial Conditions Have Been Easing... Chart 11...Which Will Support Growth Chart 12Nonfinancial Corporate Debt Surged In Q1 All Good Things Must Come To An End Unfortunately, the burst of demand that often occurs in the late stages of business cycle expansions contains the seeds of its own demise. Initially, when consumer spending accelerates, firms tend to react by expanding capacity. This translates into higher investment spending. However, as labor's share of income keeps rising, an increasing number of firms start incurring outright losses. This causes them to dismiss workers and cut back on investment spending. Such a souring in corporate animal spirits is not an immediate risk for the U.S. economy. Hiring intentions remain solid and businesses are still signaling that they expect to increase capital spending over the coming months (Chart 13). Profit margins are also quite high by historic standards, which gives firms greater room for maneuver. This will change over time, however. Margins are already falling in the national accounts data (Chart 14). History suggests that S&P 500 margins will follow suit. This raises the risk that capex and hiring will start to slow late next year, potentially sowing the seeds for a recession in 2019. We remain overweight global equities on a cyclical 12-month horizon, but will be looking to significantly pare back exposure next summer. Chart 13Corporate America Feeling Great Again Chart 14Economy-Wide Margins Have Slipped The Dollar Bull Market Is Not Over Yet Chart 15Historically, A Rising Labor Share Has Pushed Up The Dollar Until U.S. growth does decelerate, the path of least resistance for bond yields and the dollar will be to the upside. Chart 15 shows the strikingly close correlation between labor's share of income and the value of the trade-weighted dollar. As noted above, the initial effect of accelerating wage growth is to put more money into workers' pockets. This results in higher aggregate demand and, against a backdrop of low spare capacity, rising inflation. Historically, such an outcome has prompted the Fed to expedite the pace of rate hikes, leading to a stronger dollar. This time is unlikely to be any different. The market is currently pricing in only 21 basis points in Fed rate hikes over the next 12 months. This seems far too low to us. Other things equal, a stronger dollar implies a weaker euro and yen. Improved export competitiveness will lead to better growth prospects and higher inflation expectations in the euro area and Japan. Unless the ECB and the BoJ respond by tightening monetary policy, short-term real rates will fall. This, in turn, could put further downward pressure on the euro and the yen. The ECB And The BoJ Will Not Follow The Fed's Lead Many commentators have argued that better growth prospects will cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl. We doubt it. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 16). If anything, the market has priced in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 28 months at present (Chart 17). Investors now expect real rates in the U.S. to be only 23 basis points higher than in the euro area in five years' time. This is well below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 18). Chart 16Euro Area: Labor Market Slack Is Still High Outside Of Germany Chart 17ECB: Markets Are Pricing In Too Much Tightening Chart 18The Neutral Rate Is Lowest In The Euro Area As for Japan, while it is true that the unemployment rate has fallen to 2.8% - a 22-year low - this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Pound Will Rebound Against The Euro, But Weaken Further Against The Dollar Chart 19Pound: Unloved And Underappreciated While we continue to maintain a strong conviction view that the euro and yen will weaken against the dollar, we are more circumspect about other currencies. Bank of England Governor Mark Carney played down speculation this week that the BoE would raise rates later this year, noting in his annual speech at London's Mansion House that "now is not yet the time to begin that adjustment." U.K. growth has been the weakest in the G7 so far in 2017, partly because of growing angst over the forthcoming Brexit negotiations. Nevertheless, U.K. inflation remains elevated and fiscal policy is likely to be eased in the November budget, as Chancellor Hammond confirmed in a BBC interview on Sunday. Sterling is already quite cheap based on our metrics (Chart 19). Our best bet is that the pound will weaken against the dollar over the next 12 months but strengthen against the euro and the yen. We are currently long GBP/JPY. The trade has gained 7.2% since we initiated it in August 2016. CAD Has Upside We went long CAD/EUR in May. Despite the downdraft in oil prices, the trade has managed to gain 2.6% thus far. We are optimistic on the Canadian dollar over the coming months. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 20). The Bank of Canada has also turned more hawkish. Senior Deputy Governor Carolyn Wilkins suggested last week that interest rates are likely to rise later this year. The market is now pricing in a 84% chance of a rate hike in 2017, up from only 18% earlier this month. The Canadian economy continues to perform well (Chart 21). Retail sales are growing briskly, the unemployment rate is close to its lowest level in 40 years, and goods exports are recovering thanks to a weak loonie and stronger growth south of the border. While the bubbly housing market remains a source of concern, this is as much a reason to raise interest rates - to prevent further overheating - as to cut them. Chart 20Falling Oil Inventories Should Lead To Higher Crude Prices Chart 21Canadian Economy: Chugging Along China Will Drive The Aussie Dollar And EM Assets After a very strong start to the year, Chinese growth has slipped a notch. Housing starts slowed in May, as did gains in property prices. M2 growth decelerated to 9.6% from a year earlier, the first time broad money growth has fallen into the single-digit range since the government began publishing such statistics in 1986. Still, the economy is far from falling off a cliff, as evidenced by the fact that the IMF upgraded its full-year 2017 GDP growth forecast from 6.6% to 6.7% last week. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Export growth is accelerating thanks to a weaker currency and stronger global growth. The PBoC's trade-weighted RMB basket has fallen by over 8% since it was introduced in December 2015. Retail sales continue to expand at a healthy clip. The percentage of households that intend to buy a new home has also surged to record-high levels. This should limit the fallout from the government's efforts to cool the housing market. The rebound in exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 22). A better profit picture should support business capital spending in the coming months. The government also remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system last Friday. This was the single biggest one-day intervention since January, when demand for cash was running high in the lead up to the Chinese New Year celebrations. Fiscal policy has also been eased (Chart 23). So far, the "regulatory windstorm" of measures designed to clamp down on financial speculation has largely bypassed the real economy. Medium and long-term lending to nonfinancial corporations - a key driver of private-sector capital spending - has actually accelerated over the past eight months (Chart 24). Chart 22China: Higher Selling Prices Fuelling A Rebound In Profits Chart 23Fiscal Spending Is On The Mend Chart 24China: Credit To The Real Economy Is Accelerating The key takeaway for investors is that Chinese growth is likely to slow over the next few quarters, but not by much. Considering that fund managers surveyed by BofA Merrill Lynch in June cited fears of a hard landing in China as the biggest tail risk facing financial markets for the second month in a row, the bar for positive surprises out of China is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the Aussie dollar and other commodity plays. Strong Chinese growth should provide a tailwind for EM assets. However, EM stocks and currencies have already had a major run, which limits further upside. The fact that serial-defaulter Argentina could issue a 100-year bond this week in an offering that was three times oversubscribed is a testament to that. The fundamental problems plaguing many emerging markets - high debt levels, poor governance, and lackluster productivity growth - remain largely unaddressed. Until they are, the long-term outlook for EM assets will continue to be challenging. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The Fed Is Right: Wage growth and inflation increase as growth rebounds in the second half of the year. Treasury yields move higher, the yield curve steepens and TIPS breakevens widen. This is the most likely scenario. The Fed Capitulates: Inflation fails to rebound but the Fed responds by signaling a shallower rate hike path. Increased inflation compensation offsets lower real yields, leaving long-maturity nominal yields unchanged. Meanwhile, wider TIPS breakevens cause the yield curve to steepen. This is the second most likely scenario. Policy Mistake: Inflation fails to rebound and the Fed continues to tighten. Nominal yields move lower and tighter TIPS breakevens cause the yield curve to flatten. This is the least likely scenario. Feature Chart 1Pricing A Policy Mistake Rather than go out of her way to assure markets that the Fed will respond to recent weakness in core inflation, Janet Yellen insisted at last week's post-FOMC press conference that low inflation will prove transitory. The Fed decided to plough ahead with its second rate hike of 2017, while maintaining its median projection for one more before the year is out. The Treasury market remains skeptical. Long-maturity nominal yields continued to decline following the FOMC meeting while short-maturity yields increased (Chart 1). The resultant curve flattening - the 2/10 Treasury slope is back down to 84 basis points - signals that the market is pricing-in an overly aggressive pace of Fed tightening. Consistent with this message, the drop in long-dated yields continues to be concentrated in the inflation component while real yields - which are linked to the expected pace of Fed rate hikes - remain firm (Chart 1, bottom panel). We were surprised by Yellen's reluctance to throw the market a bone, but we actually agree with her assessment of the fundamentals underpinning inflation. Our base case scenario is that inflation will soon resume its gradual uptrend, causing the Treasury curve to bear-steepen and TIPS breakevens to widen. Whether or not this base case scenario plays out, it is clear that the next few inflation prints and how the Fed responds to them will dictate the path for Treasury yields between now and the end of the year. We see three possible scenarios, and this week we examine each in turn, in order of most likely to least likely. Specifically, we would characterize Scenario 1 as our base case scenario, Scenario 2 as unlikely and Scenario 3 as a remote tail risk. Scenario 1: The Fed is Right The Fed is taking a gamble betting against the markets, but as we have argued in the past several reports,1 we think this gamble will soon pay off. In fact, it is quite likely that weak core inflation during the past three months is nothing more than a lagged response to last year's deceleration in economic growth. A deceleration that has already reversed. The year-over-year change in core CPI tends to lag year-over-year GDP growth by about 18 months. Meanwhile, GDP growth has already rebounded and leading indicators such as financial conditions, the BCA Beige Book Monitor and the BCA Composite New Orders Indicator, all point to a further acceleration (Chart 2). More importantly, it would be very unusual for core inflation to trend lower while the unemployment rate is falling and wage growth is increasing (Chart 3). This Phillips Curve relationship between the labor market and prices is the basis for the Fed's belief that inflation will resume its uptrend, and it has worked quite well since 1995.2 Chart 2Inflation Set To Rebound Chart 3Fundamentals Suggest Inflation Will Rise Further, our U.S. Investment Strategy3 service has calculated that it does not take much growth for the unemployment rate to continue its descent (Chart 4). Even a monthly increase of 130k in nonfarm payrolls is sufficient to bring the unemployment rate down, assuming the labor force participation rate stays flat. Monthly payroll gains are already averaging 162k so far this year, and our model suggests that number is poised to accelerate (Chart 5). Chart 4The Unemployment Rate Under Various Monthly Job Count Scenarios ##br##The Unemployment Rate Will Keep Falling Chart 5BCA Employment##br## Model What Could Cause Inflation To Fall? A Rising Participation Rate. While labor market fundamentals support gradually rising inflation, it follows that inflation would likely fall if the unemployment rate were to increase. This is not a likely scenario, but it could occur if there is either a severe slowdown in payroll growth, or a surge of re-entrants into the labor market, leading to an increase in the labor force participation rate. The labor force participation rate fell from 65.9% at the end of 2007 to 62.8% in June 2014. As of today it stands at 62.7%, not far off its mid-2014 level (Chart 6). A paper published by the White House's Council of Economic Advisors (CEA) in July 20144 attributed 1.6% of the decline since 2007 to the ageing of the population, another 0.5% of the decline to normal cyclical factors and left the remaining 1% of the drop unexplained. The demographic effect is not about to reverse. Also, normal cyclical variation in the participation rate is linked to changes in the unemployment rate itself (Chart 6, panel 2). With the unemployment rate already low, it is likely that any normal cyclical decline in the participation rate has already been unwound. It is the remaining 1% residual decline in the participation rate that is tougher to pin down. The CEA offers two possible explanations for that residual 1% drop. The first is that it is the result of the downtrend in the prime age (25-54) participation rate that pre-dated the Great Recession (Chart 7). Prior to the recession, this downtrend had been partially offset by increasing participation among those aged 55+, but that latter trend has leveled off since 2010. If the 1% residual is the result of this longer-run trend in prime age participation, a trend possibly driven by technological advancement and the outsourcing of jobs overseas, then it is unlikely to reverse. Chart 6Can The Part Rate ##br##Bounce Back? Chart 7Secular Downtrend In Prime-Age ##br##Participation The second possible explanation is that the extra 1% is accounted for by the large increase in long-term unemployment that followed the Great Recession (Chart 6, bottom 2 panels). There is an observable correlation between the participation rate and the average duration of unemployment. If this correlation holds, and the duration of unemployment falls back to pre-crisis levels, then the participation rate could increase in the near term. However, there is also a school of thought that says the longer a person is out of the labor force the less likely it is they will ever return.5 If this turns out to be an accurate description of the dynamic between long-term unemployment and the participation rate, then it suggests that the permanent damage from the Great Recession has already been done. Even if the average duration of unemployment falls from current levels, its correlation with the participation rate would likely break down. If we assume that the participation rate rises 0.5% during the next year, then it would take payroll gains of more than 200k per month to keep the unemployment rate flat. That is too high a hurdle. While a much higher participation rate is not our base case, mathematically it is possible to envision a scenario where increasing participation causes the unemployment rate to rise, keeping a lid on wage growth and inflation in the process. Bottom Line: Overall, we agree with the Fed that wage growth and inflation will increase as growth rebounds in the second half of the year. This will very likely cause Treasury yields to move higher, the yield curve to steepen and TIPS breakevens to widen. Indications that the average duration of unemployment is rapidly falling and/or that the labor force participation rate is rising could lead us to change our view. Scenario 2: The Fed Capitulates Chart 8A Dovish Fed Can Boost Breakevens Now let's imagine that U.S. growth remains steady, the labor market continues to tighten, yet core PCE inflation is still close to 1.5% by the time the Fed meets in September. In this scenario we would expect the Fed to send a much more dovish message to markets than it did last week. Specifically, we would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. What sort of impact would this have on the yield curve? Long-maturity real yields, which are highly correlated with rate hike expectations, would almost certainly fall. However, if the Fed sends a sufficiently aggressive signal that it is willing to take action to support inflation, then it is conceivable that the long-maturity compensation for inflation protection could rise, offsetting some of the decline in real yields. In last week's report we noted how this exact scenario played out in 2011/12.6 Regression analysis shows that the 10-year real yield has historically moved about half as much as our 24-month Fed Funds Discounter (Chart 8), with the exception of the period surrounding the 2013 taper tantrum. If we assume the historical beta of 0.5 holds, then even if the market starts to discount no Fed rate hikes during the next two years and our discounter falls from its current level of 42 bps to zero, the 10-year real yield would have only 21 bps of downside. The current 10-year TIPS breakeven inflation rate is 1.67%, and would only need to return to 1.88% to completely offset the decline in real yields from the Fed being completely priced out. This does not seem like a high bar (Chart 8, top panel). Bottom Line: If core PCE inflation remains close to 1.5% by the time the Fed meets in September, then we would expect the Fed to respond more aggressively by signaling a shallower path of rate hikes. In this scenario it is likely that wider TIPS breakevens would offset the impact from lower real yields, leaving nominal Treasury yields close to unchanged. Scenario 3: A Policy Mistake A monetary policy mistake in its strongest form would be tightening so aggressively that the slope of the yield curve flattens all the way to zero before inflation has reached the Fed's target. In prior cycles we are used to seeing much higher inflation when the slope of the 2/10 curve is as flat as it is today (Chart 9), which suggests that the market is already starting to discount a premature Fed tightening. If core inflation remains low between now and the September FOMC meeting, and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would go further to price-in a policy mistake scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. We still view this as the least likely scenario. The Fed should be concerned about inflation expectations becoming un-anchored to the downside. As we showed in last week's report,7 it is well documented that when inflation expectations become unmoored, the relationship between prices and the labor market is significantly weakened. Further, the longer that actual inflation deviates from target the more likely it becomes that inflation expectations will become un-anchored to the downside. In last week's press conference Janet Yellen said: It is true that some household surveys of inflation expectations have moved down, but overall I wouldn't say that we've seen a broad undermining of inflation expectations.8 That claim is undoubtedly open for interpretation (Chart 10), but the important point is that the longer inflation stays below target, the more likely a "broad undermining of inflation expectations" becomes. We expect the Fed will heed this message from the markets, but after last week's meeting we cannot completely rule out a policy mistake. Chart 9Curve Is Too Flat Versus Inflation Chart 10Still Well Anchored? Bottom Line: If inflation stays low between now and September, but the Fed sticks to its current forward rate guidance, then the market will price-in more of a policy mistake scenario. Nominal yields will fall, led by tighter TIPS breakevens, and the yield curve will flatten. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Reports, "Two Challenges For U.S. Policymakers", dated May 23, 207, "The Fed Doctrine", dated May 30, 2017 and "Low Inflation And Rising Debt", dated June 13, 2017, all available at usbs.bcaresearch.com 2 The post-1995 environment has been characterized by stable inflation expectations. It is well documented that the relationship between labor markets and inflation is much weaker when inflation expectations become un-anchored. We discuss this risk in Scenario #3. 3 Please see U.S. Investment Strategy Weekly Report, "Balancing Act", dated June 12, 2017, available at usis.bcaresearch.com 4 https://scholar.harvard.edu/files/stock/files/labor_force_participation.pdf 5 http://www.nber.org/reporter/2015number3/2015number3.pdf 6 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 8 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20170614.pdf Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights Risk Budgeting: We are introducing a more formal risk measurement element to our model global bond portfolio. This is to identify if our individual views are potentially creating too much volatility, in aggregate, but also as a way to express the conviction of our individual recommendations through allocation of a "risk budget". Tracking Error Of Our Portfolio: We are setting our maximum allowable tracking error, or excess volatility of our portfolio versus our benchmark index, at 100 basis points. Our current tracking error is just under ½ of that limit. We estimate that our highest conviction views at the moment - staying below-benchmark on duration risk, overweighting U.S. corporates, underweighting both U.S. Treasuries and Italian government debt - contribute nearly 4/5ths of our overall portfolio tracking error. Feature Last September, we introduced a model portfolio framework to Global Fixed Income Strategy.1 This was done to better communicate our investment research into actionable ideas more in line with the day-to-day decisions and trade-offs made by professional bond managers. We followed that up with the addition of performance measurement tools to more accurately track the returns of our model bond portfolio versus a stated benchmark.2 We are now initiating the final piece of our model bond portfolio framework in this Special Report - introducing a risk management component to identify cumulative exposures and guide the relative sizes of our suggested tilts. Our goal is to translate our individual investment recommendations into the language of a "risk budget", i.e. how much of the desired volatility of the portfolio would we suggest placing into any single trade idea. This will allow our readers to apply our proposed tilts - based on how much conviction (i.e. "risk") we allocate to each position - to their own portfolios which may have different risk limits and return expectations. For example, our current recommendation to overweight U.S. corporate debt, both Investment Grade (IG) and High-Yield (HY) represents nearly 1/3 of our estimated total portfolio risk, by far our largest source of potential volatility both in absolute terms and versus our benchmark index (Table 1). Overweighting U.S. corporates, both versus U.S. Treasuries and Euro Area equivalents, is one of our highest conviction trades at the moment. A client who may choose to run a lower risk portfolio can still follow our recommendation by placing enough into U.S. corporates so that 33% of the desired portfolio volatility will come from those positions. Table 1Risk Allocation In Our Model Bond Portfolio In the rest of this Special Report, we will discuss some of the various ways to measure fixed income portfolio risk, apply them to our model portfolio, and introduce some measures to monitor our aggregate portfolio volatility. Going forward, we will closely watch our established metrics and position sizes to ensure that the combination of our individual investment recommendations that we discuss on a week-to-week basis does not create a portfolio that is potentially more volatile than desired. Risk Measurement In Fixed Income Portfolios While investors are typically focused on meeting return targets for their portfolios, the other side of the equation - managing portfolio volatility - is often less stressed. This is especially true during bull markets for any asset class. Investors may become complacent if returns meet or exceed their targets when, in fact, excess returns may have actually been earned through overly risky positions that could have easily not worked in the investors' favor. In the current macro environment, where many financial asset prices are at new highs with stretched valuations and with most of the major global central banks incrementally moving towards less accommodative monetary policy stances, risk management should be even more important for investors. Overly concentrated positioning could now lead to considerable portfolio losses, especially if measuring risk with a metric that is flawed or incomplete, which can lead to a false sense of security. With that in mind, we consider some typical risk measurement metrics used by fixed income investors: Duration: Duration is usually the most popular risk metric for fixed income portfolios as it measures interest rate sensitivity. Duration is defined as the percentage change in a portfolio or asset resulting from a one percentage point change in interest rates. While it provides a solid base understanding of interest rate risk, it does make a simplifying assumption that there is a linear relationship between interest rates and bond prices. Value-At-Risk: Value-At-Risk (VaR) is a statistical technique that measures the loss of an investment, or of an entire portfolio, over a certain period with a given level of confidence. However, there are two considerable flaws with this approach. First, the VaR output suggests a portfolio can lose at least X%, it does not actually indicate how big the potential loss could be. Instead, using a measure such as Historical VaR, if a portfolio has a long enough track record, can better quantify potential losses. Second, VaR is highly susceptible to estimation errors. Certain assumptions on correlations and the normality of return distributions can have a substantial impact on VaR readings. Table 2Value At Risk Of Our Benchmark In Table 2, we show the Historical VaR (HVAR) of our benchmark index, calculating the potential monthly loss using data going back to 2005. On that basis, the worst expected monthly loss for our benchmark is -1.6% (using a 95% confidence interval) and -2.1% (using a 99% confidence interval). Tracking Error: Tracking error measures the volatility of excess returns relative to a certain benchmark. It is a standard risk measure used by a typical "real money" bond manager with a benchmark performance index, like a mutual fund. Tracking error does not offer information on alpha generation (i.e. how much you can expect to beat your benchmark based on your current investments), it simply indicates how much more volatile a portfolio is expected to be versus its benchmark. As our model portfolio returns are measured on a relative basis to our stated bond benchmark index, tracking error is quite appropriate as our main risk metric. A Historical Examination Of Our Portfolio When we first created our model portfolio, we also introduced a benchmark index against which we could measure our performance. Our customized benchmark differs from typical multi-sector measures like the Barclays Global Aggregate Index in that it has a broader scope, including sectors that can have credit ratings below investment grade such as High Yield corporates. The benchmark does, however, exclude smaller regions that we only occasionally discuss such as Sweden, Portugal, Norway and New Zealand. These smaller markets offer comparatively poor liquidity and we want our benchmark to be as investible as possible. Nevertheless, our customized benchmark has been highly correlated to the Barclays Global Aggregate Index over the past decade. As our portfolio has not had a full year of return data, its history is quite limited. Still, in our first performance review conducted two months ago, we indicated that our portfolio had been very closely tracking our customized benchmark. We have since increased our positions in our highest conviction views and our tracking error has risen noticeably and now sits at just over 40bps (Chart 1). Within our model portfolio, we are setting an expected excess return target of 100bps per year. That means that we are setting a goal of beating our benchmark index returns by one full percentage point per year. Given that we are measuring our performance versus currency-hedged benchmarks that are primarily rated investment grade or better, 100bps of annual excess return is a reasonable target. We are also setting a limit where the excess return/tracking error ratio should aim to be equal to 1 each year. This is under the simple assumption that we want an equal amount of return over our benchmark for our expected excess volatility versus our benchmark. On that basis, we are setting our tracking error "limit" at 100bps per year. That suggests that our current tracking error is relatively low. However, correlations between the individual components of our benchmark index have been rising over the past couple of years (Chart 2). Therefore, running a relatively low overall level of risk at a time where diversification among the positions within our portfolio is now harder to achieve, and when the valuations on most government bond and credit markets look rich, is prudent. Chart 1Higher Tracking Error, But Still Well Below Our Target Chart 2Correlations Across Fixed Income Sectors Have Been Rising This is another way that we can control the overall riskiness of our model portfolio. Not only by how much of our risk budget (tracking error) that we want to allocate to each of our recommended positions, but also how big of a risk budget do we want to run at any given point in time. If we see more assets trading at cheap valuations, then we could choose to run a higher tracking error than when most assets look expensive. Bottom Line: We are introducing a more formal risk measurement element to our model global bond portfolio. This is to identify if our individual views are potentially creating too much volatility, in aggregate, but also as a way to express the conviction of our individual recommendations through allocation of a "risk budget". We are setting our maximum allowable tracking error, or excess volatility of our portfolio versus our benchmark index, at 100 basis points. Measuring The Contribution To Risk From Our Market Tilts In our model portfolio, we include a wide range of geographies and sectors from the global fixed income universe. Understanding the risk contribution of each position to the overall portfolio provides a clearer picture as to where our potential risks lie, and by how much. To measure the risk contribution of each of our individual recommendations to our overall portfolio volatility, we used the following formula: wA * E CovAB * wB Where W = the weight of any single asset in our portfolio and COV is the covariance between the asset and other assets in the portfolio. As such, an asset's contribution to risk is a function of its weight in the portfolio and its covariance with the other assets. Importantly, since we are measuring our model portfolio performance in terms of excess returns, we examined each position's contribution to risk relative to the benchmark. All calculations begin in late 2005, when return data is available for all of the assets in our portfolio. The results are summarized in Table 1 on Page 1. Our portfolio tilts are based off of our four highest conviction themes. They include: Stronger global growth led by the U.S. The U.S. economy should expand at a faster pace in the latter half of the year on the back of a rebound in consumption and strong capital spending, all supported by solid income growth and easy financial conditions. We have expressed this theme through our overweight allocation to U.S. corporate debt. While our U.S. Corporate Health Monitor is flashing that balance sheets are becoming increasingly strained, easy monetary conditions and an expansionary economic backdrop should continue to support excess returns for U.S. corporates. More Fed rate hikes than expected. We expect U.S. economic and corporate profit growth to remain robust due to accommodative monetary conditions, diminishing slack and resilient consumption. As such, the Fed will continue tightening policy by more than what markets are currently pricing in. This theme is expressed through an underweight position in U.S. Treasuries, which accounts for 17% of our volatility versus 24% for that of the benchmark. This wide spread relative to the benchmark is a substantial source of our tracking error, but one that we are comfortable running given our view that U.S. Treasury yields are too low. Chart 3Realized Bond Volatility Has Been Declining Rising tapering risks in Europe. Our expectation is that the European Central Bank (ECB) will be forced to announce a slower pace (tapering) of bond buying starting next year, given the current robust economic expansion in Europe that is rapidly absorbing spare capacity. An ECB taper announcement is expected to lead to rising longer-term global bond yields, mostly via rising term premia. We are expressing that view in our portfolio through our overall underweight interest rate duration stance. Our current portfolio duration is 5.6 years versus our benchmark duration of 7.0 years. That is a large tilt that represents a significant portion of our tracking error, but given our view that U.S. Treasuries also look overvalued, running a large overall duration underweight does correlate to our conviction level. Rising geopolitical risks and banking sector issues in Italy. Geopolitical risks remain elevated leading up to parliamentary elections in 2018, and Italian banks remain undercapitalized with non-performing loans still in an uptrend. Therefore, we are underweight Italian debt, though this is a smaller deviation of portfolio risk versus our benchmark (around 2%), given the smaller size of Italy in our benchmark. Purely looking at geography and sector selection, our four highest conviction views make up almost 80% of the active portfolio risk that we are "running" in our model portfolio. That number may seem high but, as described earlier, our realized portfolio volatility has been quite low (Chart 3). That suggests that there could be some degree of underlying diversification within our recommended portfolio given lower correlations of certain assets to the rest of the portfolio. This is a topic that we will investigate more deeply in future Weekly Reports. Bottom Line: We estimate that our highest conviction views at the moment - staying below-benchmark on duration risk, overweighting U.S. corporates, underweighting both U.S. Treasuries and Italian government debt - contribute nearly 4/5ths of our overall portfolio tracking error. Patrick Trinh, Associate Editor Patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Introducing Our Recommended Global Fixed Income Portfolio", dated September 20 2016, available at gfis.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "An Initial Look At The Performance Of Our Model Bond Portfolio", dated April 18 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Table 4