Policy

Highlights Increased regulatory scrutiny on the domestic financial sector may continue to create some headline risks and financial volatility, but the real economic impact should be marginal. The recent regulatory crackdown has mainly caused liquidity issues in the domestic market rather than any sort of real growth issue. Chinese shares listed overseas will continue to grind higher. Domestic A shares will remain largely trendless. Domestic corporate bonds are starting to look attractive after the most recent panic selloff. Feature Chinese domestic stocks and bonds have taken a beating of late as the authorities ramped up scrutiny to rein in excesses in the country's financial sector. While it is warranted to control accumulated financial risk - especially associated with shadow banking activity - the "campaign" style administrative crackdown has caused widespread confusion and mini-panics among domestic investors. The actions and corresponding reactions illustrate the authorities' primitive control tools, which are increasingly at odds with the rapidly developing financial sector, and how blanket actions can spur undue financial volatility and provoke unintended consequences. For now, we expect the economic fallout to be limited, unless the financial crackdown causes further spikes in interest rates and a sudden halt in credit flows. Chinese shares listed overseas will continue to grind higher in the absence of a major policy mishap that short-circuits the broad growth improvement and the profit cycle upturn. Domestic A shares will remain largely trendless, while the more richly valued bubbly segments of the market will continue to deflate. Domestic corporate bonds are starting to look attractive after the most recent panic selloff. What Do They Want To Achieve? Policymakers' primary focus has been on cracking down on excessive speculation in financial markets and restricting lending activities that are not in compliance with legal and regulatory requirements. Financial sector deregulation in recent years has increasingly blurred the lines between banks, insurance companies, brokers and trust companies, and regulators are constantly challenged to monitor all the increasingly sophisticated moving parts. From the banking sector's point of view, regulators are concerned that lenders have been aggressively boosting their exposure to other banks and non-bank financial institutions instead of providing credit to the "real economy." Overall commercial banks' claims on other banks and non-bank financial institutions have increased from 12% of their total assets in 2006 to over 25% as of January 2017, while their liabilities to other banks and non-bank financial firms have increased from 7% to 12% (Chart 1). Smaller banks are even more dependent on interbank financing for loanable funds. Interbank transactions and repo activities account for about 14% of smaller lenders' total source of funding, compared with 2% for large banks (Chart 2). Some small banks regularly borrow at lower costs through the interbank market or use negotiable certificate of deposits to purchase "wealth management products" offering higher returns issued by other banks or financial institutions. The duration mismatch leads to constant pressure to roll over these short-term financial instruments. The increasing interdependence among the country's financial institutions also creates the risk of a chain reaction in the financial system should some type of credit event erupt. Chart 1Increasing Interdependence Among Financial Institutions The Chinese authorities have long regarded preventing systemic financial risk as a top priority, and the recent growth improvement has provided a window of opportunity for some housecleaning without a major adverse impact on the economy. Therefore, it is unlikely that regulators will back off from tightening regulatory supervision going forward. Overall, the authorities will continue to discourage overtrading within the financial system, and enforce full disclosure of off-balance-sheet items and shadow lending activities. The saving grace is that tightened macro prudential measures have already begun to curtail banks' aggressive expansion to non-bank financial institutions. Commercial banks' claims to these firms have slowed sharply since last year's peak (Chart 3). Meanwhile, the recent rise in interbank rates should also further discourage the perceived "risk-free" funding arbitrage to play the interest rate gap between long- and short-dated financial assets. All of this reduces the pressure of an escalation in the regulatory crackdown. Chart 2Smaller Banks Depend More On##br## Wholesale Funding Chart 3Banks' Exposure To Non-Bank Financial Firms ##br##Has Been Scaled Back Should Investors Be Concerned? In essence, banks' rising claims to other financial institutions means a lengthening of the credit intermediation channel, in which financing goes from credit providers through multiple layers of intermediaries to reach final borrowers in the real economy. In other words, banks, instead of lending directly to borrowers, channel loans to trust companies or securities brokers, who in turn transfer the funds to the real economy through "shadow banking" activities such as trust loans or various forms of "wealth management products", typically at higher rates. From this perspective, cracking down on lending excesses within the financial system in of itself should not have a material impact on credit flows to final corporate borrowers. In fact, streamlining the financial intermediation channel holds the promise of increasing accessibility to bank credit for the corporate sector and reducing its funding cost, which should benefit the overall economy in the long run. In the near term, liquidity tightening and the regulatory crackdown could push up interest rates and disrupt credit flows, which should be closely monitored to assess near-term negative impact on the economy. So far, the impact does not appear material. Chart 4Regulatory Crackdown ##br## Has Not Interrupted Credit Flows Interbank rates have increased by about 100 basis points across the board since the beginning of this year, and 10-year government bond yields have risen by 50 basis points - both of which pale in comparison to the significant improvement in overall business activity. Nominal GDP growth expanded by 11.8% in the first quarter, compared with 9.6% in Q4, 2016. Furthermore, the central bank early this week re-started its medium-term lending facility (MLF), which was designed to avoid liquidity overkill in the domestic financial sector. Overall, the risk of overtightening of liquidity is not high. The regulatory crackdown since early this year has not had a meaningful impact on credit expansion. Banks' claims to other financial institutions have slowed sharply, but overall loan growth has been rather stable. Importantly, medium- and long-term loans to the corporate sector, pivotal for overall capital spending, have in fact accelerated (Chart 4). In short, increased regulatory scrutiny on the domestic financial sector may continue to create some headline risks and financial volatility, but the real economic impact should be marginal. We expect the authorities to remain highly vigilant and avoid policy overkill. Reading Market Tea Leaves There have been some notable divergences among different classes of Chinese stocks (Chart 5). Chinext, the domestic small-cap venture board, has suffered heavy losses of late, while large-cap A shares have been much more resilient. Meanwhile, offshore Chinese shares have barely felt any pressure at all. H shares have moved higher of late, while Chinese firms listed in the U.S. have decisively broken out. The divergence between onshore and offshore Chinese stocks' performance confirms the recent regulatory crackdown has mainly caused liquidity issues in the domestic market rather than any sort of real growth issue. Barring major policy mistakes, we expect the Chinese economy to stay buoyant, as discussed in detail in our recent report.1 As such, a few investment conclusions can be drawn. Tighter liquidity will likely continue to place downward pressure on domestic stock prices, but the downside is limited by overall buoyant activity and improving profits. We expect the broad-A share market will remain narrowly range-bound. Overseas-listed Chinese shares are not subject to domestic liquidity constraints, and will likely continue to grind higher supported by growth improvement, profit recovery and low valuation multiples. The small-cap Chinext market has long been viewed as the more speculative segment of the domestic financial market, with higher multiples and greater volatility than large-cap A shares. As such, this market will remain vulnerable to domestic liquidity tightening. Even after the most recent selloff, the bourse's trailing price-to-earnings ratio and price-to-book ratio are still at 38.4 and 4.6, respectively, much higher than for broader onshore and offshore Chinese stocks. The recent selloff in the onshore corporate bond market has also been driven by liquidity pressure, which in our view is overdone. While it's true that economic acceleration justifies higher yields, corporate spreads have also widened sharply, which is at odds with the broad growth acceleration and profit recovery. In addition, after the most recent selloff, Chinese corporate spreads are significantly higher than in most other major markets (Chart 6). In the near term, tighter liquidity may continue to induce more selling pressure in the domestic bond market. Cyclically we expect Chinese corporate bond spreads to narrow. Chart 5Diverging Market Trends Chart 6The Sharp Spike In Chinese Corporate ##br##Spreads Is Overdone Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Has China's Cyclical Recovery Peaked?" dated May 5, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Fed: The Fed is likely to lift rates in June, which could roil markets if economic data do not improve between now and then. Municipal Bonds: Weak state & local government revenue growth reflects the fall-out from the mid-2014 commodity price collapse. Now that energy sector capex has recovered, state & local government revenues will soon follow. Economy & Inflation: Consumer confidence remains elevated, and this should lead to a snapback in consumer spending in the second quarter. Stronger growth and a tight labor market should also cause core inflation to soon resume its uptrend, driven by accelerating wage growth. Feature How stubborn are Fed policymakers? This is an important question for markets at the moment. The Fed has clearly articulated that its base case economic outlook will result in two more rate hikes before the end of 2017, and even traditionally dovish Chicago Fed President Charles Evans said he "could be fine with two more rate hikes this year."1 Meanwhile, broad indexes of financial conditions suggest that markets can absorb another rate increase (Chart 1). Everything appears to be set up for the FOMC to lift rates by another 25 basis points when it meets next month, and this remains our expectation. The only problem is that the flow of economic data has turned decisively negative (Chart 2). Most recently, core CPI disappointed expectations by increasing only 0.1% in April, causing the year-over-year growth rate to fall to 1.9%. It was only three months ago that core CPI was growing 2.3% year-over-year. True to form, President Evans also noted last week that "downside risks [to inflation] still predominate". Chart 1Green Light From Financial Conditions Chart 2Red Light From Data Surprises The risk from a market point of view is that the Fed holds true to its promise and lifts rates in June, despite the fact that recent data have disappointed and inflation remains well below target. In that scenario, it is possible that markets come to the conclusion that the Fed is running an overly tight policy, resulting in a bear-flattening of the yield curve and a near-term sell-off in spread product. Chart 3Stay Positioned For Higher Yields As we have highlighted numerous times in the context of our Fed Policy Loop,2 with inflation below target, the Fed will be quick to adopt a more dovish stance when faced with a sharp tightening of financial conditions. This will put a floor under risk assets. Further, as was discussed in last week's report,3 negative data surprises are not likely to persist for much longer. But until that turnaround occurs, there is a heightened risk of a near-term widening in credit spreads if the Fed sticks to its guns. Ultimately, the Fed will continue to support credit spreads, and we remain overweight spread product on a 6-12 month investment horizon. Our 6-12 month outlook for Treasury yields is also unchanged, even though recent yield movements reflect the "hawkish Fed" scenario described above. The nominal 10-year yield has risen in recent weeks, driven entirely by real yields that have moved higher alongside increasingly hawkish rate hike expectations (Chart 3). The compensation for inflation protection has actually declined, in reaction to disappointing inflation data and perceptions of a more hawkish Fed. Even in the event that financial conditions tighten and the Fed is forced to adopt a more dovish policy stance, we would expect the decline in real yields to be offset by an increase in the cost of inflation compensation, which still has considerable upside (see section titled "The Consumer Is Strong, But Where's The Inflation?" below). We therefore continue to recommend a below-benchmark duration stance. Finally, futures market positioning is now solidly net long, suggesting that yields are biased higher during the next three months (Chart 3, bottom panel). Bottom Line: Risk assets could sell off in the near-term if economic data do not turn around and the Fed proceeds with a June hike. However, Fed policy will ultimately encourage tighter credit spreads and a higher cost of inflation compensation on a 6-12 month horizon. Remain at below-benchmark duration and overweight spread product. Municipal Bonds: Not Just About Taxes The uncertain outlook for fiscal policy is the immediate concern in municipal bond markets. While we expect some sort of tax bill will make its way through Congress before the end of the year, as of now, we don't have much clarity on what that bill will include. Lower corporate and individual tax rates seem likely, and the administration has also expressed a desire to curb deductions. Unfortunately, for now that's about all we can say for certain. Lower tax rates would be negative from the perspective of municipal bond investors, but fewer deductions would increase demand for munis, assuming the municipal bond tax exemption is not scrapped altogether. We haven't even mentioned the potential replacement of Obamacare and a possible federal infrastructure bill! For now, the muni market seems content to shrug off this uncertainty. Muni / Treasury (M/T) yield ratios are approaching their post-crisis lows across the entire curve (Chart 4), though longer maturity yield ratios remain elevated compared to pre-crisis levels (Chart 5). We recently recommended that investors favor long over short maturities on the Aaa muni curve.4 Chart 4Yield Ratios At Post-Crisis Lows Chart 5More Value In Long Maturities As for tax reform, although nothing is known for certain, we do expect that the administration's desire for increased infrastructure investment will keep the muni tax exemption in place. We also anticipate lower corporate and individual tax rates. How much of an impact will lower tax rates have on M/T yield ratios? Even that is hard to pin down, although we note that historically there has only been a loose relationship between yield ratios and the top marginal income tax rate (Chart 6). Chart 6The Municipal Treasury Yield Ratio & Tax Rates Further, elevated yield ratios since the financial crisis are much more driven by concerns about credit quality than changes in tax policy. With the potential for municipal bankruptcy more present than ever in investors' minds, as long as the muni tax exemption is not repealed, we think that trends in state & local government balance sheet health will continue to drive yield ratios. On that latter point, there is growing reason for optimism. Revenue Growth Ready To Rebound Periods of rising state & local government net savings have historically coincided with tightening M/T yield ratios, and vice-versa. Net savings increases when revenue growth exceeds expenditure growth. However, expenditure growth has been outpacing revenue growth since early 2015 and net savings have declined as a result (Chart 7). Unsurprisingly, state & local governments have reduced their pace of hiring in an effort to protect budgets (Chart 7, panel 3). Ratings downgrades have also spiked, but the message from our Municipal Health Monitor is that they will soon subside (Chart 7, bottom panel).5 We concur, and in fact believe that state & local government revenue growth has reached an inflection point and is poised to head higher. Breaking out the different sources of state & local government revenue we see that the recent deceleration has been concentrated in income tax and sales tax revenues (Chart 8). Property tax growth has been steady, if unspectacular. Transfers from the federal government have also decelerated since early 2015, but have been flat recently. Transfer revenue is at risk of falling if the federal government is able to pass a healthcare bill that includes the block-granting of Medicaid payments. But there is still a long road ahead before any proposed healthcare bill becomes law, and a lot can change in the interim. Chart 7A Setback In State & Local Savings Chart 8State & Local Revenue By Source What seems clear at the moment is that personal income growth is heading higher and consumer spending is firm (please see the following section of this report, titled "The Consumer Is Strong, But Where's The Inflation?", for a discussion of the outlook for income and consumer spending growth). Both suggest that income and sales tax revenue growth have bottomed for the time being. Chart 9State & Local Revenue By State Using data from the Rockefeller Institute, we can also examine state & local government revenue by state. Then, if we split out the nine states that are most heavily dependent on the energy and mining sectors,6 we observe that commodity-dependent states have dragged overall state & local government revenue growth lower since commodity prices collapsed in mid-2014 (Chart 9). Further, we see that revenue growth in commodity-dependent states is heavily influenced by nonresidential investment in the energy and mining sectors (Chart 9, bottom panel). Now that commodity prices have recovered from the 2014 bust and energy sector investment is coming back on line, we would expect state & local revenue growth to follow with a lag. Investment Implications Although we expect state & local government revenue growth to accelerate from here, yield ratios already reflect quite a lot of good news. Also, heightened policy uncertainty means there is an increased risk that yield ratios will widen sharply in the coming months. For now, we recommend only a neutral allocation to Municipal bonds within U.S. fixed income portfolios. However, an interesting opportunity could lie in focusing municipal bond exposure on those aforementioned commodity-dependent states, where revenues are likely to grow more quickly as energy capex rebounds, and whose bonds might still trade at a discount because of lower current revenues. Looking at Charts 10 & 11, we notice that the General Obligation (GO) bonds of energy-dependent Texas offer a yield advantage of 15 bps versus the overall Aaa muni curve at the 10-year maturity point. This is close to the same yield advantage offered by Massachusetts GO bonds, even though Massachusetts is rated Aa1 and Texas carries a Aaa rating. Other Aaa-rated states (Virginia, Georgia, Maryland, North Carolina, South Carolina and Tennessee) trade at much lower yields. Not only that, but Texas has also seen the strongest population growth during the past 12 months of all the states in our sample (Chart 11), and employment growth in Texas should continue to rebound alongside rising oil prices (Chart 12). Our Commodity & Energy Strategy service maintains a $60/bbl year-end oil price target.7 Chart 10Grab The Premium In Texas GOs Part I Chart 11Grab The Premium In Texas GOs Part II Chart 12Texas Bouncing Back Bottom Line: Weak state & local government revenue growth reflects the fall-out from the mid-2014 commodity price collapse. Now that energy sector capex has recovered, state & local government revenues will soon follow. Commodity-dependent states should benefit disproportionately. Texas GOs in particular look attractive on a risk/reward basis. The Consumer Is Strong, But Where's The Inflation? Consumer Spending Chart 13Consumer Spending Looks Solid The post-election surge in consumer confidence does not look as though it's about to reverse. At least not according to the University of Michigan Consumer Sentiment Survey, which was released last week. The expectations component of that survey, which closely tracks real consumer spending (Chart 13), rose from 87 in April to 88.1 in May, suggesting that weak first quarter consumer spending will prove to be nothing more than a blip. We like to think about consumer spending as a combination of income growth and the savings rate. On income growth, survey measures are also pointing to an imminent acceleration (Chart 13, panel 2). Meanwhile, the savings rate will likely remain elevated compared to pre-crisis levels, but is unlikely to move meaningfully higher from here. In our February 21 report,8 we noted that while tightening bank lending standards correlated with a higher savings rate prior to the financial crisis, that relationship has since completely broken down (Chart 13, panel 3). Since the housing bust, the supply of credit is no longer the chief constraint on consumer borrowing. Households are now much more concerned with maintaining the health of their own balance sheets. For this reason, we do not view the recent tightening of consumer lending standards as a meaningful impediment to consumer spending. Similarly, we do not think the recent decline in demand for consumer credit (according to the Fed's Senior Loan Officer Survey) will soon translate into much weaker consumer spending. In prior cycles, we see that loan demand tended to fall several years prior to the next recession, while the savings rate did not spike until the recession actually hit (Chart 13, bottom panel). Inflation & TIPS As was mentioned above, the Consumer Price Index for April was also released last week. Not only was the core CPI print disappointing, but the decline was broad based across the four major components of core CPI: shelter, core goods, core services excluding shelter, and medical care (Chart 14). The tick lower in shelter inflation is not surprising, and in fact should continue now that rental vacancies have put in a bottom. We would also expect core goods inflation to stay low, given that the U.S. dollar remains in a bull market. More worrisome is the large drop in core services inflation excluding shelter (Chart 14, panel 3). This component of core inflation correlates most closely with wage growth, and we would expect this component to drive core inflation higher as the labor market tightens and wage growth accelerates. It is worth noting that while wage growth has also weakened during the past few months, leading wage growth indicators are still trending up (Chart 15). Pipeline measures of inflationary pressures, such as the core Producer Price Index and the Supplier Deliveries and Prices Paid components of the ISM Manufacturing index, are the other bright spots in the inflation outlook (Chart 16). While the 10-year TIPS breakeven rate has fallen all the way to 1.85% from its post-election high of 2.08%, these pipeline measures suggest the decline will prove fleeting. Chart 14Core CPI By Major Component Chart 15Wage Growth Will Recover Chart 16Pipeline Measures Still Positive We continue to expect that the 10-year TIPS breakeven inflation rate will reach 2.4% to 2.5% by the time that core PCE inflation returns to the Fed's 2% target, sometime near the end of this year. Bottom Line: Consumer confidence remains elevated, and this should lead to a snapback in consumer spending in the second quarter. Stronger growth and a tight labor market should also cause core inflation to soon resume its uptrend, driven by accelerating wage growth. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.bloomberg.com/news/articles/2017-05-12/evans-says-risks-to-fed-inflation-outlook-still-on-the-downside 2 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "Past Peak Pessimism", dated May 9, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Reflation Window Still Open", dated April 4, 2017, available at usbs.bcaresearch.com 5 For further details on our Municipal Health Monitor, please see: U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 6 These states are: Alaska, Louisiana, Montana, New Mexico, North Dakota, Oklahoma, Texas, West Virginia and Wyoming. 7 Please see Commodity & Energy Strategy Weekly Report, "Oil: Be Long, Or Be Wrong", dated May 11, 2017, available at ces.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

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

Highlights The Economic Surprise Index has declined and may continue to roll over until expectations wash out. But that shouldn't derail risk assets or the Fed. The GDP data is a mix of art and science. For investors focused on what the quarterly GDP release reveals about the state of the economy, it is important to remember that the advance release involves more of the former. The FOMC called the weakness in Q1 "transitory". The U.S. economy can grow fast enough over the final three quarters of the year to meet the Fed's 2.0% growth target. The recent readings on inflation and the labor market remain consistent with 2 more rate hikes this year, starting in June. We expect the stock-to-bond ratio to hit new highs by the end of the year even without a big move in equity prices. Feature U.S. equities have now returned to their early March highs despite the ongoing weakness in economic surprises. The latest high profile negative surprises were in the Q1 GDP report, and the March reading on core PCE inflation. Have equity prices disconnected from the underlying economic fundamentals or is something else at play? More importantly, how does the Fed view the recent weakness in economic data? The outlook for inflation, the Fed, and growth supports the relative performance of stocks vs bonds, even assuming modest returns to the former. What To Expect After A Weak Q1 The Q1 GDP report was weak. It was the latest in a string of U.S. economic reports stretching back to mid-March that have disappointed relative to (raised) expectations. In February,1 we highlighted the risk that the "current period of economic surprise could last for another month or two..." before inevitably giving way to elevated expectations and finally disappointment. On average since 2010, elevated levels of economic surprise have lasted roughly two months, with the latest period lasted about 11 weeks (Chart 1). So now what? Chart 1Economic Surprise Index Has Rolled Over Since Early to Mid March Each day that passes, economic expectations move lower, adjusting the bar down for the next batch of economic reports. The starting point was set relatively high just after last fall's election and early this year, as investors anticipated quick action from the Trump Administration and Congress on tax cuts, tax reform and infrastructure. More recently however, some of the key data have not only failed to match raised expectations, but have begun to roll over. Since 2010, periods of disappointing economic reports have persisted, on average, for 4 months (Chart 1). We are nearly 2 months in, implying that expectations will be washed out soon. With a solid backdrop for corporate earnings, and ebbing geopolitical risk, any equity pullback based on near-term weakness in the economic data should be short-lived. Q1 real GDP growth came in at just 0.7%, well below expectations of a 1.1% increase. At the start of 2017, consensus estimates were in the 2 to 2.5% range, but we were not surprised by the weak report and markets should not have been either. In our two most recent reports,2 we highlighted the well-known seasonality issues with Q1 GDP. Markets seemed to have - correctly in our view - taken the Q1 GDP report in stride and are looking ahead to Q2 and beyond. We expect a snapback in growth in Q2 and over the rest of 2017. The Atlanta Fed's Q2 estimate (+4.2%) supports our view but the NY Fed's latest nowcast for Q2 (+1.8) suggests a more modest rebound. In addition to the potential for higher growth later in the year, there is also the chance that Q1 growth was misstated. Investors can track revisions to Q1 GDP via the Atlanta and NY Fed's Nowcasts, and should bear in mind that the GDP data is a mix of art and science. For investors focused on what the quarterly GDP release reveals about the state of the economy, it is important to remember that the advance release involves more of the former. The Bureau of Economic Analysis' (BEA) GDP data are subject to near constant revision. For example, the Q1 2007 GDP data (released in April 2007) has already been revised 10 times (Table 1). Availability to the BEA of input data that is both timely and comprehensive is at the root of this constant revision. Investors need to take this into account as they try to assess the health of the U.S. economy in "real time". In the past 8 years, Q1 GDP has been revised lower half the time between the advance estimate (1/3 of the hard data) and the second estimate (50% of the data). But as currently reported, Q1 GDP in 5 of the last 8 years is now higher than it was when first reported and in some cases these revisions have been significant in magnitude (Table 1). Which reading should investors trust? A look at the composition of those estimates may help. Table 1GDP Is A Mix Of Art And Science When the BEA released Q1 GDP in late April it had collected just over a third of the "hard" data that feeds into GDP (Chart 2). The rest of the data used to calculate Q1 GDP was filled in by the BEA using assumptions, or "judgmental trend," or by using data from a similar data series. By the time the second estimate is released in late May, the BEA will have just 50% of the "hard" data. Thus, a healthy dose of skepticism is warranted when evaluating the U.S. economy on the initial reports of GDP. Chart 2Advance Estimate Of GDP##br## Is More Art Than Science For now, U.S. equities have not been affected by the weak Q1 GDP data or the recent collapse in positive economic surprises. Our work shows that the disappointing economic data may persist for another few months. Stocks are within a few points of their all-time high set in March; which suggests that markets are less focused on the noise in the economic data, but remain intently focused on the Trump Administration passing some profit friendly legislation at some point this year. If economic disappointments persist for longer than a few more months and Congress doesn't follow through, we can't rule out a meaningful correction in U.S. equities. Nonetheless, the lack of excesses in the economy, general agreement between the Fed and the market on the path of rates for this year and rising, but still modest, inflation are likely to make any pullback in U.S. stocks a buying opportunity for investors. Bottom Line: Investors should fade the recent disappearance in positive economic surprises by staying overweight stocks vs bonds over the coming 6-12 months. FOMC: Growth Weakness Is Transitory Chart 3GDP, Inflation And Labor Market All Tracking##br## To Fed's Forecast = Gradual Rate Hikes The pace of economic growth, and more importantly how that growth impacts the labor market and inflation, remain a crucial factor in how investors assess the number of additional Fed rate hikes that can be expected this year. We continue to expect two more 25 basis point hikes in 2017, whereas the market, as of May 4, was pricing in just 38 bps. At the start of the weakness in the economic data in early March, the market had penciled in 68 bps (almost 3 rate hikes). The soft performance of the economy in Q1 was certainly a focus at last week's FOMC meeting. The FOMC's assessment was that the slowdown in growth in the economy in Q1 was "transitory." The FOMC made no material changes to its assessment of inflation or the labor market in the statement. The minutes of last week's meeting due on May 24 will provide more color. While not officially part of the Fed's dual mandate (of inflation and unemployment), economic growth obviously matters to the Fed. Growth that runs above the Fed's view of potential GDP will push the unemployment rate lower and push inflation higher. Top panel of Chart 3 shows that real GDP growth rose 1.9% from a year ago in Q1, just a tenth of a percent below the Fed's central tendency range for 2017 of 2.0 to 2.2% (Chart 3, panel 2). Despite the poor start to 2017, real GDP growth would have to average only a modest 2.5% per quarter over the rest of the year to hit the Fed's 2.0% target. Is 2.5% growth over the final three quarters achievable absent positive revisions to Q1? We think it is. Since 2010, GDP growth in the final 3 quarters of the year has averaged 2.5%. The headwinds facing the economy today are weaker than they were in the early years of the recovery. The April readings on manufacturing (54.8) and non-manufacturing (57.5) ISM imply GDP growth in the 3 to 3.5% range in Q2. The FOMC is correct to look through the temporary weakness in Q1 and continue on its gradual path of rate hikes this year to match the "modest" pace of economic growth. Investors got a few other key inputs to the FOMC's decision making process last week: The March reading on PCE inflation and the April employment report. Both readings keep the Fed on track for gradual hikes in 2017. A soft reading on core PCE inflation - the Fed's preferred measure - was also a contributor to the weakness in the economic surprise index. For now, we see few signs that suggest core inflation is headed sustainably lower. Chart 4 shows that, since 2000, core PCE inflation has closely correlated with a one year lag of real consumer spending. Even with the recent deceleration in spending, the chart suggests that the recent decline in inflation is temporary. In addition, our sense is that the Fed is more likely to tolerate a rate of inflation that is modestly below its estimate as long as growth remains strong and there is evidence that the weakness in inflation is transitory. Chart 4Core PCE Inflation Likely To Move Higher To Meet Spending The April labor market data was released last week as well and confirmed the FOMC's assessment of a solid labor market, but it also had a one negative surprise for markets. The 211,000 increase in jobs in April exceeded expectations (+185,000) and accelerated from the 79,000 gain in March. Over the past three months, the average monthly gain in payrolls was 174,000,well above the 100,000 to 125,000 per month pace the Fed says is needed to tighten the labor market. The drop in the unemployment rate in April to 4.4% puts the unemployment rate at pre-recession lows and more importantly, below the lower end of the Fed's 4.5% to 4.6% central tendency for this year. (Chart 3, panel 3). The negative surprise in the April jobs report came from wages. Average hourly earnings decelerated to 2.5% year-over-year in April from +2.6% in March. The consensus was looking for a 2.7% increase. Despite the lack of traction on wages, the April jobs supports the view that the economy is growing fast enough to tighten the labor market, push up wages and ultimately inflation. June remains a close call for the next Fed rate hike, but an analysis of the economy and the Fed's reaction function suggests that two rate hikes remain the most likely event this year. Our view is that the market will adjust up expectations toward the Fed's view for 2018. Bottom Line: The recent disappointment in the data is not enough to knock the Fed off course. Investors should continue to expect two additional rate hikes in 2017, with the next move coming at the June meeting. A Pro-Cyclical Asset Stance: It's Not Just About Stocks Chart 5Investors' Preference For Bonds##br## Is Understandable... One of the most basic ways that BCA evaluates the trend in financial markets is to look at what we call the "stock-to-bond ratio". In this publication the ratio is shown as the S&P 500 total return index divided by that of U.S. 10-year government bond. Chart 5 shows the amazing evolution of the stock-to-bond ratio over the past decade, rebased to 100 at the end of 2007 (the official beginning of the 2008-2009 recession). Panel 2 of the chart shows the component total return indexes, also rebased to 100 at the end of 2007. The chart illustrates two incredible points. First, while it is true that stocks have massively outpaced bonds since the low in March 2009, it took equity investors who bought and held at the onset of recession until late-2013 to outpace bond investors who did the same. Second, until the U.S. election in November, the stock-to-bond ratio was only 10% higher than it was in December 2007, which is a powerful testament to the ability of bonds to preserve capital over the long haul. Given these observations and the still-fresh memory of the global financial crisis, it is easy to see how some investors continue to prefer the relative safety of bonds, especially since equity multiples have risen significantly over the past year. However, Chart 6 highlights how our long stock-to-bond call is motivated by an expectation of higher stock prices and negative returns from bonds. The chart shows the likely trajectory of the 10-year Treasury yield over the coming year, under the base case scenario envisioned by our U.S. Bond Strategy service: core PCE inflation rises to 2%, and the spread between the 10-year breakeven inflation rate and core rises to 50 bps. Chart 7 illustrates the implications of this forecast for bond total returns, alongside the resulting stock-to-bond ratio. For stocks, we assume a very conservative 3% annualized nominal total return, which is the sum of a 2% dividend yield and a 1% assumed nominal price return. Chart 6...But The Bond Bull Market Is Over Chart 7A New High By Year-End The key point from Chart 7 is that the stock-to-bond ratio is likely to rise to a new high by the end of the year, even without aggressive assumptions for equity returns. We agree that bond yields will fall in the event of another risk-off event, and that 10-year Treasurys remain an important component of a diversified portfolio. But it is also important for investors to recognize that, absent these types of events, the relative performance of stocks vs. bonds is set to move higher in part because 10-year Treasurys are likely to generate a negative absolute return over the coming 6-12 months. Bottom Line: Investors should retain a pro-cyclical asset allocation stance. The outlook for the inflation, the Fed, and growth supports the relative performance of stocks vs bonds, even assuming modest returns to the former. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see U.S. Investment Strategy Special Report "Goldilocks: For How Long?," dated February 20, 2017, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Special Reports "Spring Snapback" dated April 24, 2017 and "The Good And The Bad". May 1, 2017, available at usis.bcaresearch.com.

Highlights China's recent growth moderation is due to marginally tighter monetary conditions. There is no case for severe policy tightening that could lead to a material growth relapse. There are plenty of signs the economy could continue to run hotter on almost all fronts. The downside risk in the economy remains fairly low, even if annual growth rates of various macro variables do not continue to accelerate. Feature Chart 1Tighter Monetary Conditions ##br##Led To Growth Moderation Our team was in China over the past two weeks, talking to investors and exchanging views with our local contacts for some on-the-ground reconnaissance. Investors appeared more upbeat on China's cyclical outlook than during our recent past trips, but generally speaking conviction remained low, and concern on some structural issues - particularly credit and the housing market - remained deeply rooted. Investors' more upbeat sentiment on growth reflected China's cyclical recovery since early last year, but the rapidly-emerging consensus appeared to be that the growth acceleration peaked in the first quarter, and the economy is facing growing downward pressure, even though few investors seem worried about a chaotic "hard landing" at the moment. Collectively, investors appeared largely preoccupied with downside risks and mindful of negative surprises, while the upside risks were not really discussed. China's latest PMI numbers released this week seemed to validate the consensus view of an imminent growth top. Most major components of the PMI surveys in both the manufacturing and service sectors had setbacks, which were also reflected in softer commodities prices (Chart 1).1 A key reason for the growth moderation is likely the performance of the RMB. We have long argued that the RMB's depreciation has been a key reflationary force for China, which boosted producer prices, enhanced profit margins and reduced the real cost of funding.2 By the same token, the pace of RMB depreciation has moderated in recent months, removing some reflationary impulses within the economy. However, it is important to note that China's worsening growth deterioration in previous years was in part attributable to sharp RMB appreciation, a replay of which is highly unlikely going forward (Chart 2). The RMB appreciated by almost 30% between 2012 and 2015, a massive deflationary shock to the economy. Currently, the trade-weighted RMB is still depreciating, albeit at a slower pace, and real interest rates deflated by PPI are still negative. In other words, although tighter on the margin, monetary conditions are still fairly stimulative, which should continue to help the economy improve. On the fiscal front, the government significantly reduced fiscal stimulus toward the end of last year, but quickly reversed course (Chart 3).3 Both direct fiscal spending and infrastructure investment have picked up notably, and its impact will continue to ripple through the broader economy. Moreover, China's fiscal spending tends to be pro-cyclical: growth recovery typically boosts fiscal revenues, which gives the government more financial resources for fiscal expenditures, and vice versa. Unless the government steps on the brakes, there is no case for a sudden retrenchment in fiscal stimulus soon. Chart 2China: But Monetary Conditions ##br##Remain Fairly Stimulative Chart 3... Meets Waning Fiscal Stimulus China: ##br##Fiscal Retrenchment Has Been Reversed In short, China's policy setting remains expansionary, a major departure from previous years when the Chinese economy was under the heavy weight of policy tightening while external demand also weakened. Looking forward, there is little chance that the Chinese authorities will commit similar policy mistakes that could lead to a major growth downturn. Chart 4China: More Upside In Exports? Barring a major policy mistake of aggressive tightening, Chinese growth should remain buoyant. In fact, there are plenty of signs the economy could continue to run hotter on almost all fronts: Exports are likely to continue to accelerate, according to our model, barring disruptions from major external shocks such as election surprises in Europe and /or broad protectionist measures from the Trump administration (Chart 4). America's latest anti-dumping measures on some Chinese steel products are irrelevant from a big picture point of view, as U.S. steel imports from China only account for a mere 1% of Chinese steel output.4 The upturn in the profit cycle will likely boost investment, particularly among private industrial enterprises (Chart 5). Rising profits and higher output prices indicate tighter capacity utilization, which would in turn encourage capital spending. The prolonged downturn in China's capital spending cycle has likely come to an end. Domestic consumption may further benefit from improvement in the labor market, which is lifting both income and confidence. This is particularly important for large-ticket consumer durable goods such as automobiles and household appliances. Housing construction will likely continue to improve, driven by strong demand. The most recent central bank survey showed that households' home-buying intentions jumped to an all-time high in the last quarter, underscoring a massive increase in pent-up demand (Chart 6). Developers are also warming to increasing supply - and land purchases have resumed positive growth in recent months after a prolonged slump. Tighter housing policies in major cities will prevent a massive boom, but will not short-circuit the recovery. Chart 5China: Private Capex Should Have Bottomed Chart 6China: A Sharp Recovery In Housing Demand All in all, we reiterate our view that the downside risk in the Chinese economy is low from a cyclical perspective, even if annual growth rates of various macro variables do not continue to accelerate. Growth figures to be released in the coming weeks will become noisy, but we lean against being overly bearish. Overall, business activity will remain fairly robust, and a major relapse in growth is unlikely. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead" dated April 6, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "2016: A Choppy Bottoming" dated January 6, 2016, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening" dated February 16, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Reflecting On The Trump-Xi Summit" dated April 13, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

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

Highlights Ongoing monetary tightening in China poses a substantial threat to EM risk assets. Yet financial markets remain highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Business conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The pillars of the EM business cycle are China, commodities, and their own domestic credit cycle, rather than the U.S. and Europe. Continue shorting/underweighting the Malaysian currency, stocks and sovereign credit. Feature Chart I-1China: Ongoing Liquidity Tightening There is one major underappreciated risk in global financial markets: China's gradual yet unrelenting monetary tightening. Though slow and measured, this policy tightening constitutes a significant risk, particularly for emerging markets. The basis is that it could trigger a disproportionally large negative effect on Chinese growth because it is taking place amid a lingering credit bubble in China.1 Mainland interbank rates and onshore corporate bond yields have risen as the People's Bank of China (PBoC) has reduced its net liquidity injections via open market operations (Chart I-1, top panel). The PBoC's monetary tightening is bound to reduce money/credit growth in China. The bottom panel of Chart I-1 demonstrates that changes in the central bank's claims on commercial banks lead by 3 months asset growth at commercial banks. Diminished liquidity injections by the PBoC will soon push commercial banks to reduce the pace of their balance sheet expansion. Asset growth/loan origination among policy banks2 has already slowed (Chart I-2). On top of this, China's regulatory tightening aimed at curbing speculative (high-risk) financial activity will also curtail commercial banks' loan origination. For example, bank regulators are forcing banks to bring off-balance-sheet assets onto their balance sheets. As a result, money/credit growth is set to decelerate meaningfully. This, in turn, will cause another slump in this credit-addicted economy. It is very probable that the mini-business cycle in China has already reached its peak - our credit and fiscal impulse heralds further drop in the manufacturing PMI (Chart I-3). Chart I-2Commercial Banks And Policy ##br##Banks' Loan Growth To Slow Further Chart I-3China's Growth Has Rolled Over While China's monetary tightening is not a direct risk to domestic demand in the U.S. or Europe, it poses an imminent risk to commodities prices and EM risk assets. Consistent with slowing Chinese manufacturing output growth, commodities prices trading in mainland China have lately tanked. Bottom Line: BCA's Emerging Markets Strategy team maintains that ongoing monetary tightening in China poses substantial risks to EM risk assets and commodities. Yet financial markets remain complacent. Perplexing Complacency It is very perplexing that EM risk assets have so far ignored the risks stemming from China's tightening and renewed relapse in commodities prices. It seems portfolio allocation into risk assets, including those in the EM universe, is pushing prices higher irrespective of a major relapse in forward-looking indicators for both China and EM growth. EM stocks, currencies and credit spreads have decoupled from a number of indicators with which they historically had a high correlation: In recent weeks, we have brought to investors' attention that an unsustainable gap has been opening between the commodities currencies index - an equal-weighted average of AUD, NZD and CAD - and both EM exchange rates and EM share prices in local currency terms (Chart I-4A & Chart I-4B). Chart I-4AHeed The Message From Commodities Currencies Chart I-4BHeed The Message From ##br##Commodities Currencies Not only have commodities currencies decisively rolled over, but also commodities prices have begun sliding. Historically, EM risk assets in general and the sovereign credit market in particular have always sold off when commodities prices have drifted lower (Chart I-5). EM equity volatility is back to its lows (Chart I-6). This corroborates reigning complacency in the marketplace. Chart I-5Commodities Prices And ##br##EM Sovereign Spreads Chart I-6A Sign Of Complacency EM sovereign and corporate spreads have also fallen to their narrowest levels in recent years (Chart I-7). Notably, our valuation model for EM corporate bonds - which is constructed based on our EM Corporate Financial Health Index - posits that EM corporate credit is very expensive (Chart I-8). Chart I-7EM Sovereign And Corporate Spreads Chart I-8EM Corporate Credit Is Expensive Finally, EM local currency bond yield spreads over U.S. Treasurys have also dropped a lot, signifying complacency on the part of EM investors (Chart I-9). Chart I-9EM Local Bond Yield Spreads ##br##Over U.S. Treasurys Are Low Bottom Line: EM financial markets are not cheap, and investors are highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Can EM Decouple From China? An oft-asked and relevant question is whether EM ex-China can decouple from China itself. Not for the time being, in our view. On the contrary, as we argued in last week's report titled Toward A Desynchronized World,3 China's slowdown will weigh on the majority of the EM investable equity, currency and credit markets. As a result, growth conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The three pillars of EM ex-China growth are commodities, China and their domestic credit cycles. The primary link is via commodities. As China's growth decelerates and its imports relapse, commodities prices will plunge (Chart I-10). Latin America, Africa, the Middle East, Russia, Malaysia and Indonesia are set to experience negative terms-of-trade shocks as commodities prices deflate. As a result, their currencies will depreciate and growth will suffer. Although Mexico is leveraged to the U.S., oil prices still matter for it. This leaves non-commodities producing economies in Asia and central Europe. The latter is too small to matter for EM benchmarks. Central Europe correlates with Europe's business cycle rather than EM. In emerging Asia, Korea and Taiwan - the largest equity market cap weights after China in the MSCI EM index - sell much more to China than to the U.S. and Europe combined. Korea's shipments to China account for 25% of total exports while those to the U.S. and Europe combined make up 22%. For Taiwan the numbers are 27% and 20%, respectively. Thailand sells to China as much as it does to the U.S. This by and large leaves only three mainstream EM economies that are not substantially exposed to China: India, the Philippines and Turkey (Table I-1). Indian and Philippine stocks are expensive, and these nations confront their own unique problems. Turkey in turn is facing major political, economic and financial predicaments. Chart I-10Industrial Metals Prices To head Lower Table I-1Export To China And U.S. In short, among mainstream EM countries, there are very few plays not exposed to China or commodities and offer a reasonable risk/return profile. Investors also often ask if commodities importing economies in Asia can rally in absolute terms when and as commodities prices drop. Chart I-11 illustrates the Korean and Taiwanese equity indexes have historically (in the past 20 years) been strongly correlated with oil and industrial metals prices. The reason is that commodity price swings partially reflect global growth conditions. Being heavily dependent on exports, Korea and Taiwan are highly sensitive to fluctuations in global growth. We expect global trade to slow down anew, driven by weakness in China/EM imports, even if U.S. and European demand remains resilient. We elaborated on this theme in last week's report.4 Therefore, Korean and Taiwanese export shipments are set to slow as well. We are not bearish on Korean and Taiwanese domestic demand - we are in fact overweight these bourses within the EM equity universe, with a focus on technology and domestic sectors. That said, consumer and business spending in these economies is relatively small in a global context to make a difference for other EM markets. In addition, given these economies' mature phase of development, the pace of their income and domestic demand growth will be moderate. Many EM countries have experienced excessive credit growth in the past 15 years, but their banking systems have not restructured - i.e. banks have not sufficiently provisioned for non-performing loans. Until they do so, domestic loan growth remains at risk of weakening. There has been modest deleveraging in Brazil, Russia and India (Chart I-12). However, there is no evidence that these economies have embarked on a new credit cycle. Chart I-11Korean And Taiwanese Stocks ##br##Correlate With Commodities Chart I-12Some Moderate Deleveraging ##br##In Brazil, Russia And India Case in point are Indian state-owned banks: their experience shows that deleveraging can be more protracted and painful than one might initially expect. The reason is that it takes time for banks to acknowledge non-performing loans, be recapitalized and get ready to boost loan growth again. In addition, Brazil and Russia are still commodities plays at the mercy of commodities price dynamics. Besides, Brazil needs to undergo painful fiscal adjustment/reforms. In other developing countries, bank loan growth remains elevated and bank loan-to-GDP ratios continue to rise (Chart I-13). In these economies, credit retrenchment and even a mild deleveraging has not yet occurred. Prominently, as EM currencies come under downward pressure, interest rates in many economies running current account deficits will be pressured higher. This will lead to a slowdown in bank credit growth and will depress demand. Finally, if it were not for the pick-up in Chinese imports, the EM ex-China business cycle and commodities prices would not have ameliorated in the past 12 months. Notably, excluding China, Korea and Taiwan, developing nations' retail sales volumes and new vehicle sales remain dormant (Chart I-14). Similarly, there has not been much recovery in capital spending and, consistently, imports of capital goods in EM ex-China, Korea and Taiwan (Chart I-15). Chart I-13No Deleveraging In Many EMs Chart I-14EM Ex-China, Korea And Taiwan: ##br##Stabilization But No Revival Chart I-15EM Ex-China, Korea And Taiwan: ##br##Not Much Of Recovery As credit growth slows or fails to pick up in these economies, domestic demand recovery will be tepid, and will certainly disappoint market expectations. Bottom Line: Given budding divergence between U.S./Europe and Chinese growth, EM ex-China growth will fail to recover and will surprise to the downside. The basis is that the pillars of the EM's business cycle are China, commodities and their own domestic credit cycle, rather than the U.S. and Europe. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November, 23 2016, and January 18, 2017, the links are available on page 16. 2 Policy banks are China Development Bank, Agricultural Development Bank and Export-Import Bank of China. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. 4 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. Malaysia: Not Out Of The Woods Arenewed relapse in Chinese growth later this year coupled with lower commodities prices will once again expose Malaysia's vulnerabilities. Notably, 26% of Malaysia's exports are related to commodities - mainly crude oil, natural gas, petroleum products and palm oil. Another downleg in the ringgit's value along with lower commodities prices will cause domestic interest rates to rise. However, Malaysia is in no position to tolerate higher interest rates. Leverage has risen considerably in the past ten years in Malaysia, and is very high (Chart II-1A). Indeed, the country has one of the highest debt-servicing costs in the EM universe, according to BIS data (Chart II-1B). Chart II-1A...And Debt Servicing Costs Chart II-1BHigh Leverage... If the Malaysian central bank attempts to cap interest rates by injecting local currency liquidity into the system, the ringgit will plunge even further. Chart II-2 shows that in recent years local interbank rates have tended to rise when the central bank curtailed its net liquidity injection. If on the other hand the Bank Negara of Malaysia (BNM) does not inject liquidity into the banking/financial system, interest rates will rise as the currency depreciates. Interestingly, despite strong inflows into EM generally, the BNM has continued to inject local liquidity into the economy - albeit at a slower pace than in recent years - to keep local rates tame (Chart II-2). Additionally, despite the significant growth slowdown that has occurred in the past two years in Malaysia, banks' NPLs have not risen much (Chart II-3). As banks start acknowledging loan losses and setting provisions for them, their profitability will decline, capital will be eroded, and loan origination will fall. Chart II-2BNM Has Been Injecting Liquidity ##br##To Control Interest Rates Chart II-3Malaysian Banks Haven't ##br##Acknowledged Enough Losses Yet Meanwhile, even though global trade and commodities prices have picked in the past 15 months, Malaysia's economy has failed to recover. This reflects the country's underlying economic vulnerability as the borrowing/credit spree of the past decade has come to a halt: Commercial and passenger vehicle sales are shrinking. Retail trade and employment are also still anemic. Property sales volumes and housing construction approvals are collapsing (Chart II-4). Capital expenditures are depressed (Chart II-4, bottom panel). On the external side, the semiconductor/electronics sector has boomed in Asia since early 2016, but Malaysia has failed to benefit much. Indeed, the recovery in Malaysia's electronics sector has been weak compared to other technology hubs such as Taiwan and Korea. This confirms why Malaysia has been losing market share in electronics products to Korea, Taiwan and the Philippines (Chart II-5). Chart II-4Cyclical Growth Remains Anemic Chart II-5Malaysia Is Losing Tech Market ##br##Share To Its Asian Competitors Bottom Line: Continue shorting MYR versus the U.S. dollar and the Russian ruble. Equity investors should continue to underweight Malaysian stocks within an EM equity portfolio. Relative value traders should maintain our long Russian / short Malaysia equity trade. Buy/hold Malaysian CDS or underweight this sovereign credit market within an EM credit portfolio. Ayman Kawtharani, Associate Editor aymank@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights ECB: The ECB is still on track to move to a less accommodative policy stance over the next year. Hints of this will be given at the June policy meeting, while a 2018 asset purchase taper announcement will be made at the September meeting. Rate hikes will follow the taper, unless core inflation surges faster than expected. Position for steeper core Euro Area government curves now, and a narrowing of the U.S. Treasury-German Bund spread in the second half of this year. France-Germany Spreads: France-Germany bond spreads are now too narrow relative to the probability-weighted outcomes of this Sunday's final round of the French presidential election. Even with a Macron victory highly likely, we do not recommend long positions in French OATs versus German Bunds. Feature Investors have navigated a minefield of political headline risks over the past few weeks. From French politics to North Korean missile launches, from Donald Trump's tax cuts to Theresa May's snap U.K election, uncertainty abounds. Yet risk assets remain unscathed. That can be mostly be chalked up to the strength of the global cyclical economic upturn, which has boosted corporate profits in the developed world and lifted equity and credit market valuations. The continued accommodative monetary stance of the major central banks is also helping investors see through the political noise, although the winds there are shifting (Chart of the Week). Chart of the WeekCyclical Upturn Remains Intact In the U.S., financial conditions have eased since the Fed's "dovish hike" in March, and too few rate increases are now discounted with leading indicators pointing to a reacceleration of growth after the soft Q1 print. Across the Atlantic, the European Central Bank (ECB) is having an increasingly open debate about the ongoing need for an exceptionally dovish policy stance given the robust (by European standards) economic expansion. A lack of inflation will keep the Bank of Japan in hyper-easy mode for longer, but the data is presenting a more mixed message for other developed economy central banks like the Bank of Canada and the Bank of England. We continue to see the current level of global bond yields as priced too low given the ongoing cyclical growth and inflation pressures. A pro-growth fixed income investment stance, with below-benchmark portfolio duration and overweight allocations to corporate credit versus sovereign debt (favoring the U.S.), is still appropriate. ECB Outlook: Language Change Coming In June, Policy Change Coming In September Last week's ECB meeting offered few surprises, on the surface. The official statement sounded a cautious note, discussing downside risks to the Euro Area economy from global factors (i.e. trade policy vis-à-vis the U.S. and U.K., geopolitical uncertainty), and that there is still not enough evidence suggesting that inflation was sustainably on course to return to the ECB's 2% target. In the post-meeting press conference, however, the questions aimed at ECB President Mario Draghi turned into an almost farcical dissection of every word in the official statement. Like this exchange, taken directly from the press conference transcript:1 Question: If I got it right, there's one sentence missing in the statement, and this is the sentence, "There are no signs yet of a convincing upward trend in underlying inflation." What is the reason? No? Have I got it wrong? Draghi: No, you're right in a sense that there is one sentence less, but this one is there. On page 2 you have: "Moreover, the ongoing volatility in headline inflation underlines the need..." Constâncio: "...yet to show a convincing upward trend." Draghi: "...convincing upward trend." If you read the end of page 1, beginning of page 2... Question: So there is no change in your assessment of the underlying inflation trend? That was finally the question. Draghi: That is there. No, the one that is not equal exactly like in the last statement is the balance of risks sentence, which repeated twice that the risks remained tilted on the downside in the last statement, and you can find it only once on the second page. That's the difference. Chart 2ECB Policies Are Working... It is clear that the ECB Governing Council is now stuck in a very difficult position. The domestic Euro Area economic data continues to show a very solid pace of expansion that is soaking up spare capacity, supported by the highly accommodative ECB monetary policies of large-scale asset purchases and rock-bottom interest rates (Chart 2). Yet both wage growth and core inflation remain subdued, suggesting that there is no rush to send any signal that a shift in monetary policy settings is on the horizon - even though the market is aware that the current ECB asset purchase program is set to expire at year-end. The political calendar is playing a role here, as the ECB has not wanted to create additional market volatility by discussing any potential tapering of asset purchases or interest rate hikes during the French election campaign. But with the pro-euro candidate now well-placed to win the French Presidency this Sunday, the market's focus will shift away from ''President Le Pen" disaster scenarios towards timing the ECB's next policy move. The latest round of Euro Area inflation data, released last Friday, showed that the sharp drop in inflation in March was a statistical aberration. Headline HICP inflation (on a year-over-year basis) rose to 1.9% in April from 1.5%, while core inflation jumped to 1.2% from 0.7% - the highest level in almost four years. An acceleration in core inflation now would be consistent with the evidence seen in the Euro Area jobs data, with the unemployment rate steadily falling towards the "full employment" level of 8% (Chart 3). This also fits with the ECB's latest projections that show core inflation returning to just under 2% by 2019. Already, markets are starting to get more jittery about a potential change in the ECB's policy stance in the coming months. Realized bond volatility at the front-end of the German yield curve has risen to the highest level since 2013, although our "months-to-hike" measure is still at 25 months, suggesting that the next ECB rate hike will not occur until 2019 (Chart 4). That pricing makes sense, in our view, as the ECB is likely to taper its asset purchases before considering any interest rate increase. Chart 3...Perhaps Now Too Well? Chart 4Tightening Pressures Building Draghi and other senior members of the ECB (like Chief Economist Peter Praet) have reiterated that exact forward guidance of sequencing - tapering before rate hikes - in recent weeks, citing a desire to not cause an unwanted tightening of financial conditions too soon. That sounds to us like code language for "we do not want to hike rates and cause the euro to appreciate sharply", which is more likely to happen, with greater magnitude, after an increase in policy rates than a taper of bond purchases. We continue to expect that the ECB will move toward a less accommodative monetary stance over the next year, starting with a tapering of asset purchases followed by rate hikes. The initial signal for that will come at the June meeting where a new set of ECB staff economic projections will be prepared, followed by an announcement in September that tapering will begin in early 2018. Rate hikes will not begin until after the tapering ends, likely not until late 2018 or early 2019. This sequencing could change, however, if core inflation was to rise more rapidly than the ECB currently projects, with a rate hike happening sooner in that case. In terms of bond strategy, we recommend curve steepeners in core European government bond markets as an initial way to position for a less accommodative ECB. We anticipate moving to an underweight allocation stance to core Europe (both Germany and France) at some point before the June ECB meeting. We would like to see higher U.S. Treasury yields before making that change, as we expect Treasury-Bund spreads to narrow as the ECB tapers. With the market not pricing in enough rate hikes into the U.S. curve, in our view, we see the Treasury-Bund spread moving wider first as Treasuries reprice, before narrowing after the ECB taper is announced. Bottom Line: The ECB is still on track to move to a less accommodative policy stance over the next year. Hints of this will be given at the June policy meeting, while a 2018 asset purchase taper announcement will be made at the September meeting. Rate hikes will follow the taper, unless core inflation surges faster than expected. Position for steeper core Euro Area government curves now, and a narrowing of the U.S. Treasury-German Bund spread in the second half of this year. OAT-Bund Spreads Are Now Fairly Valued Last week, we closed our recommended long 10-year French OAT vs. 10-year German Bund Tactical Overlay trade following the first round of the French presidential election, at a profit of 1.3%.2 While we view the chances of Marine Le Pen winning this Sunday's run-off vote versus Emmanuel Macron as remote, betting on additional spread tightening from the current level of 53bps does not offer an attractive risk/reward opportunity. To judge this, we performed a scenario analysis to determine a probability-adjusted level of the OAT-Bund spread under the two tail events of a Macron or Le Pen victory. In the first scenario, we assigned a 15% probability to Le Pen winning the election, as currently indicated by online betting markets (Chart 5). In the second, we increased the probability to a more pessimistic 40%, which is Le Pen's current level of support in head-to-head opinion polls. We then came up with OAT-Bund spread projections for a victory by either candidate. If Le Pen were to pull off the upset and win the presidency, this would re-ignite fears of a potential Eurozone breakup given her anti-euro stance. Fears of a "Frexit" would likely push the OAT-Bund spread up to at least the same level (around 190bps) reached during the peak of the Euro debt crisis in late 2011 when euro breakup risk was at extreme levels. Even that spread level, however, may not adequately compensate for France's worsening fiscal backdrop, with France's debt/GDP ratio now 40% larger, relative to Germany's, than during the Euro debt crisis (Chart 6). Chart 5Macron Is The Favorite To Win Chart 6No Value In Staying Long France Vs Germany As a simple way to account for this, we increased the spread target for a Le Pen victory scenario by 1.4 times to account for the increased stock of French sovereign debt, which is all denominated in euros, that would be at risk of default if France was to pull out of the euro. This gives an upside spread target for a Le Pen victory of 266bps. In the event that the poll numbers prove correct, as they did in the first round of the election, and Macron wins as expected, this market-friendly result would prompt the OAT-Bund spread to decline further. Our estimate for a downside spread target after a Macron win is 36bps, which is the average level during 2015-2016 before the rise in uncertainty surrounding the elections. Again, this is adjusted upward in order to reflect changes in the relative debt-to-GDP ratios for France and Germany, with the former nearly 10% higher versus the latter over the past two years. Table 1Probability-Weighted OAT-Bund ##br## Spread Scenarios Using these spread targets and our base case election odds (85% chance of a Macron victory), we come up with a probability-adjusted spread of 71bps (Table 1). Using the head-to-head probabilities from the polling data (60% chance of a Macron win), the expected spread is 128bps. With the current OAT-Bund spread at 53bps, well below either projection, we conclude that the potential reward of holding onto a long OAT/short Bund position for a Macron victory does not adequately compensate for the non-zero probability that Le Pen pulls out the win this Sunday. Bottom Line: France-Germany bond spreads are now too narrow relative to the probability-weighted outcomes of this Sunday's final round of the French presidential election. Even with a Macron victory highly likely, we do not recommend long positions in French OATs versus German Bunds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Global Fixed Income Strategy patrick@bcaresearch.com 1 https://www.ecb.europa.eu/press/pressconf/2017/html/ecb.is170427.en.html 2 Please see BCA Global Fixed Income Strategy Weekly Report "Global Bond Yields On The Move, Higher", dated April 25, 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Geopolitical tensions eased last week, but there are still a few near term hurdles to clear. Domestic policy uncertainty remains. Investors still can't seem to reconcile the disconnect between weak "hard" data and solid "soft" data. A gradual Fed may be the right response to the recent run of mixed economic data. Housing and housing-related investments led the global economy into the last recession. Housing is still on the mend. The housing sector will contribute about 0.2 percentage points and 0.5 percentage points to real GDP growth in 2017 and 2018, respectively. Investors should look to housing-related assets as a source of potential outperformance over the coming 6-12 months. Feature U.S. equity prices neared record highs and Treasury yields bounced off of their late-March low last week as near term international and domestic political risk melted away in the minds of investors. We continue to expect U.S. equities to beat bonds this year. Oil prices continue to trade near $50/bbl, and the dollar held steady amid all the news-good and bad. Both have upside over the remainder of 2017. In today's report, we examine the following key issues for investors: Since the end of the Great Recession, geopolitical risks have ebbed and flowed, and 2017 has proven to be no different. Are political risks over, or just over for now? How does the recent run of mixed U.S. data influence the Fed, and what does this mean for risky asset prices? Housing and housing-related investments led the global economy into the last recession. Where do we stand now? Are Geopolitical Concerns Over? North Korea failed to test another nuke after a nerve rattling Easter Weekend. The leadup to the presidential election in South Korea on May 9 may have motivated a part (or most) of the uptick in belligerence that we are seeing from North Korea. All leading candidates are more likely to try diplomacy and economic engagement with North Korea than to maintain the past ten years of conservative efforts to strengthen military deterrence via stronger alliances with the U.S. and Japan. In the euro area, the good news is that the polls in the first round of the French election (April 23) were correct. The bad news is that there is still another election. Macron and Le Pen face off on this Sunday (May 7), and markets are betting that the polls will be correct again given Macron's 20 point lead over Le Pen. The June parliamentary elections in France should be a non-event for U.S. financial markets; we still see Italy - where most voters favor Eurosceptic parties - as the biggest risk on the geopolitical scene in the next year or so. In the U.K., the ruling Tories look to add to their majority in June's parliamentary election, which will provide British Prime Minister Theresa May with a stronger hand to negotiate with Europe and increases the odds of a less extreme Brexit outcome (Chart 1). Chart ICGeopolitical Risk Is Ebbing...For Now Chart 1BGeopolitical Risk Is Ebbing...For Now Chart 1AGeopolitical Risk Is Ebbing...For Now There was good news and bad news on the domestic policy front last week as well. The release of the long awaited Trump tax plan and the passage of a spending bill by Congress to avert a government shutdown (at least until later this week) helped to remove some domestic political uncertainty. The bad news is that the plan was more tax cut than tax reform. The one page plan lacked detail and still has to pass muster with the House GOP. The Trump Administration may have started a trade war with Canada (over lumber) and sent trial balloons about pulling out of NAFTA (despite walking back from this position soon after). Is this "negotiator" Trump or something worse? The bad news is that tax reform, trade wars, dynamic scoring, and yes, even Obamacare will be with us until late Summer/early Fall. The good news is that the border adjustment tax may not be. The takeaway for investors is that while geopolitical concerns have not disappeared, they have ebbed, and this will support the relative performance of U.S. equities over 10-year government bonds over the coming year. Italy (not North Korea, France, or Germany) remains the biggest geopolitical risk on the horizon, but the next election there isn't until early-2018. Domestically, Trump's pro-growth agenda is advancing at a pace that is slower than many investors would prefer, but it is advancing, which we believe will continue to support a pro-cyclical asset allocation stance. Bottom Line: Geopolitical concerns have not disappeared, but they have ebbed materially to the benefit of risky asset prices. Investors should stay overweight U.S. stocks vs 10-year government bonds within a multi-asset portfolio. Mixed Data Warrants A Gradual Fed Investors still can't seem to reconcile the disconnect between weak "hard" data and solid "soft" data. The recent uptick in initial claims and the soft Q1 GDP data are the most recent examples. Investors should recall that claims are inherently noisy; a rise in claims of more than 75,000 over a 6-month period is typically needed to signal a recession. Chart 2 makes it clear that the latest wiggles on claims are not sending a recessionary signal. Chart 2Claims Are Not Even Close To Sending A Recession Signal Friday's GDP report highlighted that growth in Q1 was soft again. As we noted in last week's report, GDP growth in Q1 averaged -0.1% over the last 10 years. Q2 growth has averaged more than 2%. Q1 growth has been below Q2 in 8 of the last 10 years. 2017 is shaping up to be a repeat performance. Defense spending - identified by the Cleveland Fed as a key culprit in the unwanted seasonal weakness in Q1 GDP - fell 4% in Q1, subtracting 0.2% from growth. Inventories were also singled out by the Cleveland Fed, and they shaved 0.9% off of GDP in Q1. We expect to see a snapback in all three components of growth (GDP, defense spending and inventories) in Q2. Business capital spending, and housing were bright spots in Q1 (Chart 3). Corporate earnings are the ultimate piece of hard data. Equity prices track earnings growth over the long term. With 288 members of the S&P 500 reporting, 77% have beaten expectations on the bottom line. Healthcare, financials and technology lead the way. Weakness was evident in defensives. More impressive is the 7.1% gain in revenues in Q1 so far (Table 1). But overall, corporations appear to have pricing power. The ECI accelerated in Q1 to +2.4% year-over-year from +2.2%, but remain relatively subdued. This implies that margins will hold up, which will continue to support our view that stocks will beat bonds this year. With no Fed Chair Yellen press conference, a new set of dot plots or a new economic forecast, markets will have to be content with just the FOMC statement this week. A speech by Fed Vice Chair Fischer will be closely watched for signals about the June FOMC meeting. The market has been too quick to price out rate hikes in 2017. Expectations for rate hikes in 2018 have all but disappeared (Chart 4). We expect this gap will close - in favor of the Fed for both 2017 and 2018. We expect Treasury yields and inflation to head higher this year, despite recent soft readings on March CPI. The March PCE deflator - also due this week-is key. Chart 3Markets Shouldn't Be Surprised By Weak##br## Q1 GDP, Or What Caused It Table 1S&P 500: ##br##Q1 2017 Results* Chart 4Still Plenty Of Disagreement Between Fed ##br##And Market; Both Expect Gradual Hikes Though Bottom Line: We continue to expect the hard data to catch up to the soft data in the coming months. Financial markets have overreacted to the weak data and have been too quick to price out Fed rate hikes this year and next. The Fed is taking a gradual approach to rate hikes for a reason; the data-hard or soft-doesn't warrant an aggressive Fed. But a gradual Fed and solid profit growth strongly favor an allocation towards stocks over bonds this year. Housing: Set To Keep A "Slow-Burn" Expansion Burning Housing is one sector of the economy that stands to look relatively good over the coming few years, with some important implications for housing-related asset performance. The monthly Bank Credit Analyst recently published some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment in the labor market, similar to what has occurred since the Great Recession. Chart 5 compares the current cycle (dotted lines) with the average of the 1980s and 1990s long expansions (solid lines). The cycles are all lined up with the beginning of the expansion, indicated by the first vertical line. These long "slow burn" recoveries also extended well beyond the point at which the economy first reached full employment (called late-cycle phases, shaded in Chart 5). Inflation pressures were slower to emerge in these types of recoveries, allowing the Fed to proceed cautiously when normalizing interest rates. Interestingly, earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. We are not making the case that returns will be anywhere near this level in the coming years. The starting point for valuation, for example, is much more extended than it was in previous long cycles. There are also plenty of possible sources of shocks that could end the expansion abruptly. Nonetheless, it is not going to die simply of old age. In the absence of any major shocks, this expansion may continue for a while yet. One reason is that there are no major areas of overspending that would make the economy highly vulnerable. This includes the housing sector, where investment has lagged previous slow-burn recoveries by a wide margin. A lagging housing market is not surprising given the bloated inventory of vacant homes that had to be absorbed in this cycle. The good news is that overhang appears to now be gone. The stock of unsold new and existing homes has returned to low levels by historical standards (inventories of new homes are in fact now rising, after plunging between 2006 and 2012; Chart 6). Chart 5The Current Cycle Is ##br##A "Slow Burn" Expansion Chart 6The Overhang From Housing##br## Inventories Is Gone Other positive factors include the following: Lending standards haven't eased much, but FICO scores have increased sharply, meaning that more renters now qualify for loans and thus might move from rental unit to a single family home (which generates more GDP per unit). This factor was highlighted in a recent Special Report on housing.1 Affordability is favorable, and the cost of owning is cheap relative to the cost of renting. The home-ownership rate has returned to its long-term average (Chart 6, bottom panel). If the pre-Lehman bubble in the homeownership rate has been unwound, it removes a headwind for construction activity because renting favors multi-family construction that produces less GDP per unit than single family homes. The supply of foreclosed homes onto the market has withered along with the foreclosure rate. This might not affect construction activity because it represents families simply swapping homes for other ones, but it supports home prices. Importantly, household formation is still recovering from a period in which young adults stayed with their parents for longer than normal for economic reasons. The tightening in the labor market and cyclical rebound in real disposable income growth is allowing millennials to finally move out, boosting the demand for new housing stock (Chart 7). Chart 8 presents a simple way of estimating the remaining pent-up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the remaining gap implies an extra 540,000 housing units. Chart 7Income Growth Is Helping Young Americans To Leave The Nest Chart 8A Catch-Up Housing Construction Will Occur If This Gap Closes The equilibrium number of housing starts that cover underlying population growth plus the units lost to scrappage is estimated to be about 1.4 million annually. If the household formation 'catch up' occurs over the next two years, adding another 250,000 units per year, total demand could be 1.6 to 1.7 million in each of the next two years. This compares to the just-released March housing starts level of 1.2 million. If starts rise smoothly from today's level to 1.7 million at the end of 2018, then the housing sector will contribute about 0.2 percentage points and 0.5 percentage point to real GDP growth in 2017 and 2018, respectively (Chart 9). Chart 9A Housing Catch-Up Will Boost GDP Growth For the economy, the implication is that this already-aged expansion phase could persist for a couple of more years as long as it is not hit by a negative shock and inflationary pressures remain quiescent, allowing the Fed to proceed slowly. Bottom Line: Housing starts remain well below the equilibrium level implied by underlying household formation, and a "catch up" phase could help keep the current "slow burn" expansion burning over the coming years. Favor Housing-Related Assets The above analysis also has some favorable implications for housing-related financial assets. We originally examined the implications of a rebound in home construction in 2012, during the early phase of the recovery in housing starts.2 Our approach was to test the historical excess return performance of several financial assets as a function of key housing market variables, and concluded that housing-related financial assets were set to outperform their respective benchmarks in a bullish housing scenario over the following year (and beyond). We have updated our original analysis in this report, with a few modifications. First, we examine the relationship between key housing market variables and excess returns of housing-related assets since the onset of the U.S. economic expansion in June 2009, given the structural change in the housing market that occurred following the Great Recession. Second, our analysis is based on a more focused set of housing market indicators, given the relatively poor predictive power of new home sales and the months' supply of homes following the crisis period on housing-related asset returns. Table 2 presents the list of housing-related assets that we examined,3 along with the key housing market variables used to forecast excess returns (and whether they were significant predictors in the post-crisis era). The table highlights that most of the variables do contain useful information, with the exception of the two noted above. The rightmost column presents the share of excess returns explained by a composite model of the factors noted as significant for each asset, which varies from a low of 13% to a high of 20%. Table 2Important Predictors Of Housing-Related Asset Excess Returns* (June 2009-December 2016) Charts 10 and 11 present a set of relatively conservative assumptions for the key housing market variables shown in Table 2, based on a rise in housing starts modestly above the scrappage rate that we noted in the previous section. We assume that house price appreciation and housing affordability moderate due to further rate hikes from the Fed, that the already-elevated homebuilders' confidence index stays flat, that refi applications remain low due to the uptrend in mortgage rates, and that purchase applications rise in lockstep with housing starts. Chart 10A Set Of Conservative Assumptions... Chart 11...For Key Housing Market Variables Finally, Table 3 illustrates the predicted excess returns over the coming 12-months of the housing-related assets that we examined, along with the annualized excess returns in 2016 and over the entire sample period for the purposes of comparison. It is important to note that excess returns of corporate bonds are presented relative to duration-matched government bonds, not a speculative- or investment-grade corporate bond aggregate. Table 3Excess Returns Of Housing-Related Assets* (%) The analysis presented above highlights several important conclusions for investors: The predictive power of key housing market variables has been smaller over the course of this economic expansion than in the past economic cycle (including the recession of 2008-2009), suggesting that housing market developments were more important during the downturn than they have been during the recovery. Still, housing market data is an important driver of excess returns for housing-related assets. All of the housing-related assets that we examined are expected to outperform their respective benchmarks over the coming year, even given the relatively conservative assumptions that we have made about the pace of gains in the housing market. For the three corporate bond assets shown in Tables 2 and 3, our model predicts outperformance even relative to their respective corporate bond benchmarks, albeit only marginally in the case of investment-grade banks. With the exception of S&P 500 homebuilders and banks, the model's predicted excess returns are lower over the coming year than they have been on an annualized basis since the onset of the recovery, highlighting that housing-related assets have front-run at least some of the expected normalization in the housing market over the coming few years. However, a full rise to our equilibrium estimate of 1.7 million starts over the coming two years could potentially lead to even larger outperformance than the model would predict. Charts 12 and 13 do not suggest that valuation will be an impediment to the outperformance of housing-related assets. Chart 12Valuation Won't Be An Impediment... Chart 13...For Housing Related Assets Bottom Line: Investors should look to housing-related assets as a source of potential outperformance over the coming 6-12 months. The historical relationship between key housing market variables and the excess returns of these assets implies the latter is set to outperform even given conservative assumptions about the former. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge Vice President, Special Reports jonathanl@bcaresearch.com 1 Please see U.S. Investment Strategy Special Report "U.S. Housing: What Comes Next?", dated March 27, 2017, available at usis.bcaresearch.com 2 Please see U.S. Investment Strategy Weekly Report U-3 Or U-6?", dated February 13, 2012, available at usis.bcaresearch.com 3 Note that we have excluded fixed and floating rate home equity loan ABS from our list of housing-related assets owing to a lack of data, as well as investment-grade REITs because of a very low degree of return predictability from key indicators of the housing market

Highlights Lean against depressed and euphoric interest rate expectations. The ECB will remove or fade the negative deposit rate, with an outside chance that it happens this year. The U.K. economy will determine the nature of Brexit - not the other way round. The snap General Election doesn't change anything. Expect an ongoing narrowing in the U.S. T-bond/German bund yield spread and U.S. T-bond/U.K. gilt yield spread. Expect the following order of currency performance: euro first, pound second, dollar third. Expect the FTSE100 to outperform the Eurostoxx50. Feature The interplay between interest rate expectations - in the U.K., U.S. and euro area - is one of the most important factors in explaining what has happened, what is happening, and what will happen, to financial markets. Chart of the WeekBrexit Depression Has Unwound; ##br##Trump Euphoria Hasn't... Yet Interest rate expectations convincingly explain the movements in the U.S. T-bond/German bund yield spread, the U.S. T-bond/U.K. gilt yield spread, euro/dollar, and pound/dollar. Thereby, they also explain FTSE100/Eurostoxx50 relative performance which is just an (inverse) currency play. Chart I-2, Chart I-3, Chart I-4, Chart I-5 and Chart I-6 should leave readers in absolutely no doubt. Chart I-2Interest Rate Expectations Explain The ##br##T-Bond/German Bund Yield Spread Chart I-3Interest Rate Expectations Explain The##br## T-Bond/U.K. Gilt Yield Spread Chart I-4Interest Rate Expectations ##br##Explain Euro/Dollar Chart I-5Interest Rate Expectations##br## Explain Pound/Dollar Chart I-6Pound/Euro (Inversely) Explains ##br##FTSE100/Eurostoxx50 Lean Against Depressed And Euphoric Interest Rate Expectations Last year's shock victories for Brexit and Trump dramatically swung the market mood towards the U.K. and U.S. economies. After Brexit, the knee-jerk response was depression; after Trump, the knee-jerk response was euphoria. But extreme mood swings to depression and euphoria are rarely justified, and ultimately tend to unwind. Responding to last year's dramatic mood swings, U.K. and U.S. interest rate policy - both actual and expected - moved very sharply in opposite directions. Following the Brexit vote, the BoE cut the base rate by a quarter percent, and the rate expected two years out plunged by three quarters of a percent. In contrast, following the Trump victory, the Federal Reserve twice hiked the Fed funds rate by a quarter percent, and the rate expected two years out surged by more than a percent. Meanwhile, throughout all this activity, the ECB repo rate and deposit rate were anchored at zero and -0.4% respectively, and the interest rate expected two years out remained in negative territory. Fast forward to today, and the U.K. interest rate expected two years out has fully unwound the Brexit vote depression - the expected BoE policy rate two years out stands exactly where it stood before the EU Referendum. In contrast, the expected Fed policy rate two years out retains its Trump euphoria (Chart of the Week). Meanwhile, the expected ECB policy rate two years out remains anchored close to the realistic limit of negativity. To reiterate, the extreme market moods of depression and euphoria are rarely justified, and tend to unwind. On this basis, we can say that policy rate expectations in relative terms now have the scope to: Get less depressed in the euro area. Remain broadly unchanged in the U.K. Get less euphoric in the U.S.1 Hence, on a 12-month horizon, expect a continued narrowing in the U.S. T-bond/German bund yield spread and U.S. T-bond/U.K. gilt yield spread. For currencies, expect the following order of performance: euro first, pound second, dollar third. And therefore, expect the FTSE100 to outperform the Eurostoxx50. Brexit: A Reductionist View Many millions of words have been written about Brexit, and we suspect that many millions more will be written. But true to our reductionist philosophy, we can reduce those millions of words to a single sentence. Brexit was, is, and always will be, about the trade-off between national sovereignty and access to the European single market. Irrespective of the vote to leave the EU and the start of the divorce proceedings, the full spectrum of possibilities in this trade-off is still open to the U.K. At one extreme the U.K. could get a full divorce, and thereby regain absolute national sovereignty in all areas including law and immigration. But in this full divorce, the EU27 would regard the U.K. as a complete outsider whose status is little different to say, Russia. At the other extreme, the U.K. could near enough replicate its current economic and political relationship with the EU27 in a 'pseudo-marriage'. Technically, the U.K. would be divorced, but practically, there would be only minor differences to being married. Although the U.K. would lose its official place at the EU top table, in all likelihood the EU27 would still listen to the British voice given the U.K.'s size and global standing. But in this pseudo-marriage the EU27 would exact a cost: the U.K. could not regain any national sovereignty. All points on the spectrum between a full divorce and a pseudo-marriage are now available to the U.K. The relationship that the U.K. ends up with depends on the trade-off that the British public - and therefore its political representatives in the government and parliament - will accept. In turn, this will depend on the evolution of the economy and standards of living. A strong economy will embolden the British public to want something close to a full divorce. Conversely, a weakening economy might be blamed, rightly or wrongly, on Brexit. In which case, public opinion would shift towards something closer to a pseudo-marriage. Therefore, the causality runs from the economy to Brexit, not from Brexit to the economy. The U.K. economy will determine where the U.K. ends up on the Brexit spectrum - at least, in terms of the initial deal. The snap General Election doesn't change anything. Nor is the General Election a game changer for the pound. The preceding section demonstrated that relative interest rate expectations - rather than Brexit per se - are driving the pound. We expect the BoE to remain relatively inactive because empirically, U.K. real consumption is hyper-sensitive (inversely) to inflation. When inflation is too high, real consumption growth is undermined, making it difficult to hike rates; and when inflation is too low, real consumption tends to grow strongly, making it difficult to cut rates (Chart I-7). This ties the hands of the BoE, and explains why the post EU Referendum emergency rate cut has been the BoE's only interest rate change since early 2009! Chart I-7Why The Bank Of England's Hands Are Tied While rate expectations can get less depressed in the euro area, and less euphoric in the U.S., they are likely to change least in the U.K. Hence, we like the pound less than the euro; but we like the pound more than the dollar. Role Playing On The ECB Governing Council We are writing ahead of the ECB policy meeting, but we do not anticipate any substantive announcements - given that we are only half way through the French Presidential Election. In the absence of major developments, the euro's strong recent advance might take a tactical breather. But what then? Some people argue that ECB policy should be based not on the aggregate euro area economy, but instead on the weaker links in the euro area economy. These arguments have some merit, as the ECB - unlike other central banks - has to contend with a permanent existential threat. On this basis, let's finish this week with a role playing exercise. Imagine you're on the ECB Governing Council, and the weak link that worries you is euro area bank fragility, particularly in some of the southern member states. Your own (ECB) analysis, illustrated in Chart I-8, shows that extreme accommodative monetary policy has had a negligible net impact on bank profitability. The QE component has probably been a mild net positive - admittedly, a flatter yield has dragged down banks' net interest margins; but it has also generated profits in banks' bond portfolios; and in so far as QE has boosted economic growth, it has reduced bank charge-offs. Chart I-8What Is The Point Of The ECB's Negative Deposit Rate? But the negative deposit rate - charging banks for excess liquidity - has been a clear drag on bank profitability. And there is little evidence that it has encouraged lending. What would you do? Even if the ECB is setting policy for the euro area weak links, the central bank's own analysis suggests that it should remove, or at least fade, the negative deposit rate. Our central expectation is for this to happen early next year, with an outside chance that it is even sooner. With expectations for ECB policy rates still anchored close to the realistic limit of negativity, the euro exchange rate has cyclical upside. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Assuming that the U.S. government does not approve inappropriate fiscal stimulus. Fractal Trading Model* This week's trade is to go long the FTSE100 versus the IBEX35 with a profit target and stop loss of 4%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations