Policy

Highlights U.S. Treasuries: The surprisingly positive response from financial markets to last week's Fed rate hike should force the Fed to quickly shift back to a hawkish bias. Maintain an underweight exposure to U.S. Treasuries, and an overall below-benchmark portfolio duration stance. Bearish Fed Trade: As a new tactical trade, go short the January 2018 fed funds futures contract to benefit from the Fed ramping up the hawkish language again. Japan: Japanese inflation remains too low for the Bank of Japan to move away from its 0% target on JGB yields anytime soon, even with signs of better Japanese growth and rising pressure on global bond yields. Upgrade low-beta Japan to above-benchmark in global hedged bond portfolios, while downgrading core Europe (Germany, France, the Netherlands) to neutral. Feature Chart of the WeekAre Central Banks OK With This? The major central banks all had a chance to send a more hawkish message to the markets in the past couple of weeks, and every one took a pass. Even the Fed, who actually hiked rates, signaled that U.S. monetary policy would not be tightened more aggressively than previously planned, which financial markets took very bullishly. With the global economy finally enjoying a synchronized upturn after several years of sluggishness, policymakers are showing no interest in hitting the brakes too hard, too soon and risking a sudden downturn in growth The current backdrop of improving economic momentum, with central banks remaining accommodative, is sustaining the strong performance of growth-sensitive assets like equities and corporate debt over government bonds. This should continue over the next 6-12 months. Inflation rates, both realized and expected, continue to rise across the developed economies alongside faster economic growth, putting upward pressure on government bond yields (Chart of the Week). Central bank dovishness is looking increasingly non-credible as long as this dynamic persists, but policymakers will likely be slow to respond without a more rapid rise in inflation. Bond yields will continue to climb higher against this backdrop, first from continued increases in inflation expectations and, later, from a shift to less restrictive monetary settings. We continue to recommend a below-benchmark duration stance, while underweighting government bonds versus corporate debt, particularly in the U.S. This week, we are making a significant portfolio shift to get even more defensive within our government bond allocation, upgrading low-beta Japan to above-benchmark while downgrading core Europe (Germany, France & the Netherlands) to neutral. The Fed Declares Victory Over "Low-flation" The market response to last week's Fed tightening was consistent with the idea of a "dovish hike", with U.S. equity and bond markets rallying while the U.S. dollar sold off and overall U.S. financial conditions actually easing. There was heightened nervousness heading into the meeting that the Fed could signal a faster or steeper trajectory for interest rates. That turned out to be a false alarm, as not much was changed from the Fed's prior guidance to markets. The range for the funds rate was raised to 0.75-1.00%, as expected, but there was virtually no change to any of the median FOMC member projections for GDP growth, inflation or interest rates out to 2019. Another 50bps of increases are expected this year, with 75bps in both 2018 and 2019 (Chart 2). This would bring the funds rate to 3% in 2019, which is the median FOMC member's assessment of where the terminal rate lies. The pricing from the U.S. Overnight Index Swap (OIS) curve shows that market expectations for the funds rate are in line with the Fed's projections for this year, but lower for the next two years. Our proxy measure for the market's assessment of the terminal rate - the 5-year OIS rate, 5-years forward - sits at 2.25%, 75bps below the Fed's number. Our bias is closer to the market on this point, as we do not see a need for the funds rate, in real terms, to end this tightening cycle much above 0% against a backdrop of still very high U.S. debt levels and low U.S. productivity growth. A 0% real funds rate would be the result of the Fed successfully getting U.S. inflation expectations back to its 2% target level, with a nominal funds rate of 2%. That inflation goal has not yet been reached, however, as inflation expectations are still below levels consistent with the Fed's inflation target (Chart 3, bottom panel). Chart 2FOMC & Market Disagree Beyond This Year Chart 3Few Signs Of An Overheating U.S. Economy The FOMC has made it clear that they believe the U.S. economy is running very close to full employment. Yet the recent modest deceleration in the various measures of wage inflation (middle panel) suggests that there could still be some excess slack in the U.S. labor market - even with the recent Payrolls reports showing job growth of over 200k per month. If that pace is sustained for several months, however, the unemployment rate will likely fall further and wage pressures will intensify. In the near-term, the Fed will continue to focus on financial markets to get a sense of whether current policy settings are too restrictive or too accommodative. One recent development on this front is that the correlation between the U.S. dollar (USD) and risk assets has flipped, with a stronger USD now positively correlated to global equities and credit (Chart 4). This shift was already starting to happen before the election of Donald Trump and his pro-growth agenda last November, likely because the global economy was improving as evidenced by the accelerating trend in our global purchasing managers' index (PMI, bottom panel). We have written extensively about the Fed being stuck in a "policy loop" in the past couple of years, where a shift to a more hawkish bias would sharply drive up the USD and cause a risk-off move in global financial markets. This unwanted tightening of financial conditions would cause the Fed to back off from its hawkishness, causing the USD to soften and markets to rally. We have argued that the way to break out of this loop would likely be a rise in non-U.S. economic growth that would allow the Fed to continue slowly normalizing U.S. monetary policy without disrupting global markets. We seem to be in that period now. One implication of this is that the longer risk assets can withstand rising U.S. interest rates and a stronger USD, the more the fed funds rate and U.S. Treasury yields must rise in response to U.S. economic strength. For this reason, we continue to recommend a below-benchmark duration stance on U.S. Treasuries on a 6-12 month horizon. We also maintain our bias towards a bear-steepening of the Treasury curve through our butterfly trade, long the 5-year bullet versus a duration-matched 2-year/10-year barbell. The curve will remain positively correlated to inflation expectations until those reach the Fed's target level, after which any additional Fed rate hikes will likely flatten the yield curve in a more typical pattern during the latter stages of a tightening cycle. It is possible, though, that because markets shrugged off the latest rate increase, the Fed could return to sending hawkish signals in the near term. To play for this possibility, our colleagues at BCA U.S. Bond Strategy recommend that investors add a tactical trade: going short the January 2018 fed funds futures contract (Chart 5). We are today adding this trade to our list of Tactical Overlay Trades (see page 12). Chart 4The Strong USD Is Not A Problem Chart 5Go Short January 2018 Fed Funds Futures We calculate that this trade will return 11bps in a scenario where the Fed lifts rates twice more before the end of the year and 37bps in a scenario where the funds rate is raised a more aggressive-than-expected three times. However, we do not expect to hold this trade until the end of the year. Rather, we expect the Fed will nudge rate expectations higher in the next month or two in response to the latest easing of financial conditions, and that these gains will be realized over a much shorter horizon. We also add a caveat that, in the present environment, it is safer to implement any "hawkish Fed trades" in either fed funds futures or the OIS market. The Eurodollar market does not provide the same potential for gains because the LIBOR / OIS spread is currently elevated and could tighten to offset the profits from rising rate expectations. Bottom Line: The surprisingly positive response from financial markets to last week's Fed rate hike could force the Fed to quickly shift back to a hawkish bias. Maintain below-benchmark exposure to U.S. Treasuries. As a new tactical trade, go short the January 2018 fed funds futures contract to benefit from the Fed ramping up the hawkish language again. Japan: A Weaker Yen Is Still The Only Way Out The Bank of Japan (BoJ) stayed on hold last week, as expected. There had been some increased speculation of late that the BoJ could start to signal a potential increase in its 0% target for the 10-year Japanese Government Bond (JGB) yield, given the rising trend in global yields and signs of better growth in Japan. At the press conference following the BoJ meeting, however, Governor Kuroda shot down that notion, saying that the current accommodative policy stance must be maintained given how far Japanese inflation is below the central bank's 2% target. It remains far too soon for the central bank to signal any shift to a less accommodative stance, as both the pace of economic growth and inflation are not only modest but lagging the current global upturn. In Chart 6, we show some Japanese growth variables relative to an aggregate of the same data for the major developed economies.1 What is clear from the chart is that Japan is benefitting from faster global growth on the industrial side, with the manufacturing PMI above 50. However, the domestic demand story is not as positive, with consumer confidence and real retail sales growth languishing. The lack of real income growth remains the biggest drag on Japanese consumers, as we show in another set of international comparisons in Chart 7. Japan's unemployment rate, currently at 3%, is below the OECD's estimate of the full employment level (consistent with stable domestic inflation pressures). This is in contrast to the other major economies, which are either at, or close to, full employment. Yet Japanese wages continue to struggle, both in nominal terms (a year-over-over growth rate of 1%) and real terms (a year-over-year growth rate of 0.4%). The current annual spring round of Japanese wage negotiations is showing that downward pressure remains powerful, with many manufacturing companies offering pay raises only half as large as those of last year.2 Chart 6Japan Is Lagging The Global Upturn Chart 7Still No Wage Growth In Japan Japan is still struggling to generate positive rates of inflation, even as price growth is accelerating in the other major economies (Chart 8). This is keeping Japanese inflation expectations, which the BoJ believes are mostly a function of the recent performance of actual inflation, subdued. As always, the only reliable source of Japanese inflation seems to be yen weakness. We continue to see this as the only way out of the low-inflation trap for Japan - keeping Japanese interest rates depressed versus the rest of the world, thus weakening the yen through increasingly unattractive interest rate differentials. The BoJ's 0% yield curve targeting framework has been successful in keeping rate differentials wide enough to soften up the yen, especially against the USD (Chart 9). Given our expectations of additional Fed rate hikes, and higher U.S. Treasury yields, over the rest of the year, the yen will likely depreciate further as long as the BoJ sticks with its current interest rate targets. A similar argument holds for the yen versus the Euro, given the increasing likelihood that the European Central Bank (ECB) will be forced to signal a less accommodative monetary policy stance later this year. Against this backdrop, JGBs are likely to outperform the major global government bond markets over the rest of 2017. We upgraded our recommended stance on JGBs from underweight to neutral last October after the BoJ introduced its yield curve targeting framework. In Chart 10, we show the relative performance of JGBs versus some other bond benchmarks, on a duration-matched and common-currency (hedged into USD) basis. We broke up the returns into two periods, from our October 11, 2016 Japan upgrade to January 31 of this year when we upgraded our U.S. corporate bond exposure and cut our overall portfolio duration stance to below-benchmark. The chart shows that JGBs were a good defensive hedge during the latter part of 2016 when global yields were rising, led by U.S. Treasuries. The more recent period, however, shows a much more negligible relative performance, both against other government bonds and corporate debt, during a period where global bond yields have generally traded sideways. Chart 8Japan Inflation Still A No-Show Chart 9A Weaker Yen Is Still Necessary Chart 10Relative Performance Of JGBs Given our views that U.S. Treasury yields will continue to move higher in the next 6-9 months, and that the performance of core European government bonds will suffer over the same period as the ECB signals a slower pace of asset purchases for next year, a return to the late 2016 relative performance of JGBs is very likely. Thus, we are upgrading Japan to an above-benchmark stance in our model portfolio this week, while downgrading core Europe (Germany, France, the Netherlands) to neutral. This is purely a move to get even more defensive in our overall country exposures, by allocating into JGBs which are low-beta to both U.S. Treasuries (where we are already below-benchmark) and core European government debt. Bottom Line: Japanese inflation remains too low for the Bank of Japan to move away from its 0% target on JGB yields anytime soon, even with signs of better Japanese growth and rising pressure on global bond yields. Upgrade Japan to above-benchmark in global hedged bond portfolios, while downgrading core Europe (Germany, France, the Netherlands) to neutral. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The U.S., Euro Area, U.K., Canada & Australia 2 https://www.ft.com/content/0895c4ee-eb3b-11e5-888e-2eadd5fbc4a4 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 Duration & Fed Policy: The longer risk assets can withstand rising rates, the higher will be the ultimate resting place for Treasury yields. Maintain below-benchmark duration on a 6-12 month horizon and add a short fed funds futures trade to profit from increased Fed hawkishness in the near-term. Yield Curve: While the long-run trend will be for the yield curve to flatten as the Fed hiking cycle progresses, rising inflation expectations will cause the curve to steepen between now and the end of the year. Maintain a position long the 5-year bullet, short a duration-matched 2/10 barbell to profit from a steeper curve on a 6-9 month horizon. Feature Say Uncle Chart 1More Tightening To Come The Fed lifted rates last week but kept its median projected path for future rate hikes unchanged. Judging from the market's reaction, this was a more dovish outcome than was anticipated. Since last Wednesday's meeting the dollar is down 0.5%, junk spreads have tightened 10 basis points and the 2/10 yield curve has steepened 1 bp. In other words, financial conditions have continued to ease even as the Fed took another step toward more restrictive policy. All in all, money markets are now discounting only a slightly slower pace of rate hikes than the Fed's median forecast (Chart 1) and financial conditions suggest that further incremental tightening is in store. The financial conditions component of our Fed Monitor1 is above zero, meaning that financial conditions are more accommodative than the long-run average, and the Chicago Fed's Adjusted Financial Conditions Index also shows that conditions are easy relative to the strength of the economy (Chart 1, bottom panel). New York Fed President William Dudley has previously described how the Fed incorporates financial conditions into its decision making:2 Chart 2The Fed Policy Loop All else equal, if financial conditions tighten sharply, then we are likely to proceed more slowly. In contrast, if financial conditions were not to tighten at all or only very little, then - assuming the economic outlook hadn't changed significantly - we would likely have to move more quickly. In the end, we will adjust the policy stance to support financial market conditions that we deem are most consistent with our employment and inflation objectives. We have also described this process in the context of our Fed Policy Loop3 (Chart 2). In essence, the Fed will continue to nudge rate hike expectations higher until financial conditions tighten excessively. At that point - because with inflation below target the Fed still has an interest in supporting the recovery - it will quickly shift to a more dovish stance. Chart 3Short Jan 2018 Fed Funds Futures One implication of the Fed Policy Loop is that the longer risk assets can withstand rising rates, the higher will be the ultimate resting place for the fed funds rate and Treasury yields. As such, we continue to recommend a below-benchmark duration allocation on a 6-12 month horizon. Another implication is that because markets shrugged off the latest rate increase, Fed policy is likely to turn more hawkish in the very near term. We therefore recommend investors add a tactical trade: short the January 2018 fed funds futures contract (Chart 3). We calculate that this trade will return 11 bps in a scenario where the Fed lifts rates twice more before the end of the year and 37 bps in a scenario where the funds rate is raised three times. However, we do not expect to hold this trade until the end of the year. Rather, we expect the Fed will nudge rate expectations higher in the next month or two and that these gains will be realized over a much shorter horizon. We also add a caveat that, in the present environment, it is safer to implement any "hawkish Fed trades" in either fed funds futures or the overnight index swap market. The Eurodollar market does not provide the same potential for gains because the LIBOR / OIS spread is currently elevated and could tighten to offset the profits from rising fed funds rate expectations (Chart 3, bottom panel). Fed hawkishness also argues for a flatter yield curve in the very near term. While this could materialize, we continue to hold our position in the 5-year bullet over a duration-matched 2/10 barbell - a trade designed to profit from a steeper 2/10 slope. For reasons described in the next section we believe the yield curve will steepen between now and the end of the year, although the risks are tilted toward flattening in the very near term and in 2018 and beyond. What Drives The Yield Curve? In this week's report we present an overview of the main drivers of the slope of the Treasury yield curve. Specifically, we identify (i) the fed funds rate, (ii) inflation expectations, (iii) implied volatility and (iv) unit labor costs as factors that correlate strongly with the slope of the yield curve on a cyclical horizon. We review the outlook for each of these factors and conclude that the Treasury yield curve has room to steepen between now and the end of the year. Beyond that, the curve will likely resume flattening as inflationary pressures start to bite and the Fed's rate hike cycle picks up steam. Chart 4Fed Rate Hikes Flatten The Curve 1. The Fed Funds Rate Not surprisingly, the slope of the Treasury curve correlates very strongly with the level of short rates (Chart 4). Typically, short-maturity yields are much more influenced by the expected path of Fed rate hikes than long-maturity yields. As such, when the Fed is lifting rates the yield curve tends to bear-flatten - both the 2-year and 10-year Treasury yields rise, but the 2-year rises more quickly. In contrast, when the Fed is cutting rates the yield curve tends to bull-steepen - both the 2-year and 10-year Treasury yields fall, but the 2-year falls more quickly. In a typical cycle the yield curve will start to flatten as the Fed lifts rates and will eventually become completely flat when the end of the rate hike cycle is reached and the fed funds rate is at its "equilibrium" or "terminal" level. Usually, at that point in the cycle, the Fed will keep policy too tight in an effort to rein in inflation. This causes the economy to slow and the yield curve to invert, signaling the start of the next recession. A recent BCA Special Report4 speculates that if the federal government succeeds in delivering sizeable fiscal stimulus, inflationary pressures could start to build next year, leading to a more rapid pace of Fed rate hikes and a flat or inverted yield curve by the end of 2018. This would be consistent with a recession in 2019. In terms of the behavior of the yield curve, this is not far off from the Fed's own projections. At present, the median FOMC projection calls for the fed funds rate to reach its equilibrium level of 3% by the end of 2019. If this forecast plays out, it means that the 2/10 Treasury slope must flatten by roughly 117 bps between now and then. Turning back to Chart 4, we see that the Treasury curve has already flattened considerably even though the Fed has only raised rates three times. This means that either the equilibrium fed funds rate is much lower than the Fed's 3% projection and the 2/10 slope will reach zero with a much lower fed funds rate, or that the curve flattening is overdone and the curve has room to steepen before it resumes its cyclical flattening trend. As is explained below, we favor the latter interpretation. 2. Inflation Expectations The 5-year/5-year forward TIPS breakeven inflation rate is also highly correlated with the slope of the yield curve (Chart 5). As long-dated inflation expectations increase the yield curve tends to steepen, and vice-versa. Interestingly, the positive correlation between long-dated inflation expectations and the slope of the Treasury curve persists even when the Fed is hiking rates. Notice that in the 1999 rate hike cycle, the yield curve did not start to flatten until the 5-year/5-year breakeven fell. Also, in the 2004-06 hike cycle, curve flattening ebbed just as the breakeven started to widen. Chart 5Rising TIPS Breakevens Steepen The Curve Charts 6 and 7 show the relationship between the 2/10 Treasury slope and the 5-year/5-year breakeven in more detail. Chart 6 shows the correlation between monthly changes in the 2/10 Treasury slope and the 5-year/5-year breakeven using all available data back to January 1999. We see that a positive correlation between the slope and the breakeven prevailed in 64% of monthly observations, while only 36% of months displayed a negative correlation. Chart 62/10 Nominal Treasury Slope Vs. TIPS Breakeven ##br##Inflation Rate 5-Year/5-Year Forward (February 1999 - Present) Chart 72/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year/5-Year ##br##Forward During Fed Tightening Cycles (June 1999 To May 2000 & June 2004 To June 2006) In Chart 7, we focus exclusively on the past two Fed tightening cycles (1999-2000 & 2004-2006). Not only does a linear regression show an even stronger correlation than was achieved with the full sample, but we also see that a positive correlation between the slope and the breakeven existed in 73% of monthly observations, while only 27% of months displayed a negative correlation. At present, core PCE inflation is still below the Fed's 2% target and different measures of inflation expectations are all well below levels that prevailed during prior rate hike cycles (Chart 8). In other words, the Fed must proceed slowly enough with rate hikes to ensure that long-dated inflation expectations continue to trend higher, which argues for a steeper yield curve until inflation and inflation expectations are more firmly anchored around the Fed's target. For the 5-year/5-year forward TIPS breakeven inflation rate we think a range of 2.4% to 2.5% would signal that inflation expectations are well anchored around the Fed's target. 3. Volatility Implied interest rate volatility - as measured by the MOVE volatility index - is another factor that correlates with the yield curve on a cyclical horizon (Chart 9). In theory, higher rate volatility should coincide with a steeper yield curve, all else equal, and this is exactly the correlation we observe. Chart 8Fed Wants Inflation Expectations To Rise Chart 9Higher Vol Steepens The Curve Let's consider that there is a risk premium applied to taking a unit of duration risk (usually called the term premium) and that said risk premium is larger for longer-maturity bonds that carry more duration risk. All else equal, the risk premium applied to one unit of duration risk should be larger when rate volatility is higher. This should also coincide with a steeper yield curve, since there is more duration risk at the long-end of the curve. In a recent report,5 we concluded that the level of disagreement among forecasters about future GDP growth and T-bill rates were the two most important drivers of cyclical swings in implied rate volatility, the Global Economic Policy Uncertainty Index has at times also played a role (Chart 9, bottom 3 panels). Chart 10Higher Unit Labor Costs Flatten The Curve At the moment, the amount of forecaster disagreement about future GDP growth is near its lows since 1990 and T-bill forecast disagreement has, until recently, been suppressed by the zero lower bound on interest rates. All this implies that the balance of risks favors higher implied interest rate volatility in the months ahead, which will apply steepening pressure to the yield curve. 4. Unit Labor Costs Unit labor costs are the final yield curve indicator we discuss in this report. Since faster wage growth tends to coincide with Fed tightening and slowing wage growth tends to correlate with Fed easing, it makes sense for wage indicators to be inversely correlated with the slope of the yield curve. While it is broadly true that all wage indicators show a reasonable inverse correlation with the slope of the curve, unit labor costs are the best. The reason is that unit labor costs (compensation per unit produced) actually measure both wage growth (compensation per hour) and labor productivity (output per hour) (Chart 10). It turns out that the yield curve can flatten in the traditional way - a bear-flattening driven by rising wages and Fed tightening - but occasionally it can also bull-flatten if the market starts to discount a lower equilibrium (or terminal) fed funds rate. We might expect this sort of curve behavior in an environment of extremely low productivity growth, and this is exactly what has occurred during the past few years. Notice in Chart 10 that compensation per hour does not explain the curve flattening that started in 2014, but unit labor costs do because they also factor in incredibly low productivity growth. In the longer-run, we would strongly expect unit labor costs to remain in an uptrend. Wage growth is accelerating and there are structural headwinds that will prevent productivity growth from returning to the levels seen at the height of the IT revolution in the late 1990s and early 2000s. As was discussed last year in a Special Report from our Global Investment Strategy service,6 the rate of human capital accumulation is in a secular downtrend as is the share of workers in their 40s - the age cohort when people are most productive. However, there has also been a cyclical component to the productivity slowdown and it is possible that productivity growth could accelerate somewhat in the near-term as the cycle matures. The capital stock per worker correlates strongly with productivity growth (Chart 11), and while capital investment has been depressed for most of the recovery there are finally some signs that it may return (Chart 12). Chart 11Productivity Held Back By Lack Of Investment Chart 12Getting Optimistic About Capex In fact, it is even conceivable that more rapid wage growth itself might encourage firms to replace labor with capital, causing traditional measures of wage growth to accelerate relative to unit labor costs. Also, the prospect of tax reform and regulatory relief could give capital spending a boost - it has already led to a jump higher in small business optimism (Chart 12, bottom panel). Unit labor costs will likely continue to accelerate on a cyclical investment horizon, applying flattening pressure to the yield curve. But this flattening pressure would be mitigated to the extent that there is any cyclical rebound in productivity growth. Yield Curve Strategy Upon consideration of the four factors described above, we conclude that while the slope of the yield curve will likely be close to zero sometime in late 2018, curve flattening won't start in earnest until late this year or early next year when inflation expectations are higher (2.4% to 2.5% on long-dated TIPS breakevens) and core PCE inflation is firmly anchored around the Fed's 2% target. This conclusion is based on our observations that: TIPS breakevens and the slope of the curve tend to be positively correlated, even during rate hike cycles. Interest rate volatility is more likely to rise than fall. Unit labor costs are likely to remain in an uptrend on a cyclical horizon, but there is scope for them to level-off if we see a modest late-cycle rebound in productivity growth. To position for a steeper yield curve between now and the end of this year we continue to recommend that investors favor the 5-year Treasury note relative to a duration-matched position in a 2-year/10-year barbell. Long bullet/short barbell trades tend to outperform when the yield curve steepens, and our model suggests that the 5-year yield is currently very cheap relative to the 2/10 slope (Chart 13). We have been recommending this trade since December 20, 2016 and it has so far returned +2 bps even though the 2/10 slope has flattened 13 bps during that time. The strong positive carry means that not much curve steepening is required for the trade to realize strong positive gains. Chart 13The 5-Year Bullet Is Cheap On The Curve Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 For further details on our Fed Monitor please see U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com 2 https://www.newyorkfed.org/newsevents/speeches/2015/dud150605 3 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 4 Please see BCA Special Report, "Beware The 2019 Trump Recession", dated March 7, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 6 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians", dated March 25, 2016, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Dear Client, In addition to an abridged Weekly Report, we are also including a Special Report written by our Global ETF Strategy team. BCA's Global ETF Strategy, launched in September joins comprehensive ETF analysis with BCA's global macroeconomic thematic research: its aim is to help clients connect the dots from BCA themes to individual ETF ticker symbols with real-time market expressions of our views. The team is currently producing a series of reports on smart-beta ETF selection, whereby they examine the key factors recognized by academia and investment practitioners as persistent drivers of market performance. In this second installment, the team focuses on dividend-focused funds. Although the team finds that dividends do not qualify as a true standalone factor consistently explaining equity returns, dividend policy can add to multi-factor models' explanatory power at the margin. Given the popularity of dividend investing, we think dividend policy could be a fruitful subject for further research. Best regards, Lenka Martinek Feature U.S. financial markets breathed a collective sigh of relief last week when the FOMC followed through on a fully discounted 25 bps rate hike, but did not increase the number of expected rate hikes for the year. In other words, the Fed successfully delivered a "dovish hike", thus reassuring investors that the policy sweet spot - the period when interest rates are rising but have not become restrictive - will last a while longer (Chart 1). Chart 1A "Dovish Hike" Chart 2Low Structural Unemployment Rate The Fed's assessment of the economy is not very different from our own, though there were a few details in the economic projections worth highlighting. First, the estimate for the structural rate of unemployment was scaled down further by a tenth of a percentage point to 4.7%. This may seem minor, but it suggests that policymakers believe the labor market has more running room before wage inflation moves higher. Granted, any forecast for structural unemployment should be taken with a dose of salt, but our bias throughout this cycle - and as outlined in our November Special Report - has been to expect wage inflation to lag relative to past cycles due to structural factors (Chart 2). And as can be seen in Chart 3, Japan provides a roadmap: in that country, demographic factors helped push the unemployment rate to below 3% without creating inflationary pressures. Of course, the U.S. economy is very different from Japan and we do not expect unemployment to drop as low. However, as occurred in Japan, we would not be surprised to see the FOMC trim its forecast for the structural unemployment rate further in the coming quarters. A related point is that the Fed also adjusted the wording of the FOMC statement regarding its inflation targets. The statement said that the Fed was looking for a "sustained" return to 2% inflation, while also referring to its inflation target as a "symmetric" one. Our interpretation is that the Fed is trying to clarify that it will not react too aggressively if core inflation were to drift somewhat above 2%. Clearly, the Fed is beginning to see the balance of risks toward higher inflation. That makes sense, given that the economy is operating close to full employment. However, we maintain that a sustained rise in inflation above the Fed's 2% core PCE target is not imminent. Indeed, the message from last week' CPI report reinforces our view that with the exception of a few components, inflation is very well contained (Chart 4). Our diffusion index of the major inflation components is in negative territory. Importantly, price surveys continue to show that businesses are not able to easily raise prices. For example, despite the continued optimism in the headline components of the NFIB small businesses survey, small businesses have not been able to - and do not yet anticipate being able to - raise prices. This reinforces our long-held view that after a long period of disinflation - and outright deflation in the retail sector - inflation expectations are extremely well-anchored and savvy consumers know how to extract a better deal. Core PCE inflation may converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot should not be a major driver of investment decision-making over the next 6-12 months. Chart 3Japan: A Low Unemployment Rate ##br##And Little Wage Inflation Chart 4Inflation ##br##Still Low In the end, it is Fed Chair Yellen's least sophisticated remarks that provide the best summation. During the FOMC press conference, she stated that "the simple message is the economy is doing well". Indeed, the moderate pace of growth that has prevailed since the beginning of the recovery means that the typical imbalances and pressure points that accumulate in the advanced stages of a business cycle are so far still absent. The backdrop overwhelmingly favors stocks relative to government bonds on a cyclical horizon. To be sure, equities are expensive, but as we wrote last week, relative to competing assets, valuations are not extreme. The greater near-term risk continues to be a phase of economic and earnings disappointments that could develop later this year, since there remains a tremendous amount of optimism in the business community regarding regime change in Washington. Note that the policy uncertainty index remains very elevated (Chart 5) and Trump's "skinny budget", which aims to slash spending across all discretionary items save military and veterans affairs, will be contested. Our geopolitical team notes that Democrats could threaten a government shutdown later this year to try to force Republicans' hand at removing the most controversial elements of the budget. Democrats can filibuster parts of the appropriations process which makes the concrete budget allocations. Chart 5Political Uncertainty Still Elevated On this basis, we remain skeptical that fiscal policy will be clean fuel for the equity bull market. However, we adhere to Yellen's "simple message" that the economy is on a stable footing. That implies that Washington disappointments will most likely lead to equity setbacks rather than a painful breakdown. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommendation weightings for the major asset classes are unchanged: neutral equity exposure at 60% (benchmark 60%), neutral Treasury allocation at 30% (benchmark 30%) and cash at 10% (benchmark 10%). The diffusion index of the three components for The Equity Model remained neutral. The technical component "buy" signal strengthened, with sturdy advances for both the breadth & trend and momentum indicators. The monetary component, which measures overall liquidity conditions within the financial and economic system and designed to lead equity prices, is slightly more bullish and still favorable for equities. The earnings-driven component continues to give a cautious signal. Real operating earnings remain at a significant distance from positive economic expectations which have moved higher yet again. Moreover, earnings momentum is still sluggish, based on our earnings diffusion index, which compares nominal earnings growth relative to four key macro proxies for business costs. The model's recommendation for bonds remains at benchmark which still fits with our neutral qualitative stance for Treasuries in balanced portfolios since November 7, 2016. Although the cyclical component of the bond model is more constructive than the valuation component, the further deterioration in the technical component maintains the "sell" signal for Treasuries firmly in place. Chart 6Portfolio Total Returns Chart 7Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009. Highlights Factor attribution began a half-century ago with the Capital Asset Pricing Model ("CAPM"). Although the CAPM itself has been superseded, selected factors have exerted a consistent influence on equity performance. The empirical evidence does not support including dividends among the proven factors, yet dividend-focused funds are the most numerous in the smart-beta universe. The ambiguity surrounding dividends' effect on equity performance leaves plenty of room for smart-beta purveyors to build a better mousetrap, but our own research suggests that they will have to do so with something other than purely dividend-related metrics. Reflecting the fact that many of the dividend funds already incorporate multi-factor inputs, we evaluate them based on their exposure to all of the metrics within our Equity Trading Strategy service's multi-factor model. Feature Welcome to the second installment of our series on smart-beta ETF selection. Over the course of the series, we intend to examine the factors widely recognized by academia and investment practitioners as persistent drivers of equity performance. Each Special Report will weigh the evidence for the factor's efficacy, consider the metrics that best reveal its presence and compare our ideal metrics with the metrics utilized by our proprietary Equity Trading Strategy ("ETS") multi-factor model. It will then evaluate the menu of smart-beta ETFs using either our ETS model's metrics or an augmented version of them. The series began last month with a review of the Value factor, enshrined by Fama and French's research, and the current subset of Value smart-beta ETFs.1 This month we examine Dividend smart-beta ETFs. Subsequent installments will examine Quality, Momentum and Volatility,2 and we will likely wrap up the series with a review of Multi-Factor smart-beta ETFs. This installment provides some background on factor investing and the smart-beta process before subjecting Yield (Dividends) to scrutiny to determine whether or not it really constitutes a standalone equity factor. Back To The Beginning The ubiquity of beta in discussions of investing performance originates from the Capital Asset Pricing Model ("CAPM"), as advanced by William Sharpe and other researchers in the early 1960's. The CAPM posits that the expected return of stock XYZ is solely a function of XYZ's riskiness relative to the overall equity market. XYZ's riskiness is a function of its covariance with the market, and is represented in the CAPM's simple linear model as the coefficient "beta.3" The elegantly simple CAPM holds that any stock's expected return (E(rs)) is the sum of the risk-free rate (rf) and the product of its beta (ßs) and the difference between the expected market return (E(rm)) and the risk-free rate (rf): E(rs) = rf + ßs x (E(rm) - rf) As noted by several researchers, including Eugene Fama and Kenneth French,4 CAPM's return predictions are woefully errant when applied to stocks. As Chart 1 indicates, the returns projected by the CAPM bear little relationship to empirical results. It turns out that low-beta stocks have systematically outperformed high-beta stocks on a risk-adjusted basis (Chart 2), just as low-book-multiple stocks have crushed high-book-multiple stocks without regard for beta (Chart 3). This is powerful evidence for value, and for the low-volatility factor that we will examine in a subsequent report, but it is damning for the simple application of the CAPM to stocks. Chart 1CAPM Sounded Great In Theory ... Chart 2... But It Flopped In Practice Chart 3Low-Book-Multiple Stocks Systematically ##br##Flout CAPM Predictions A New Vocabulary Despite its empirical shortcomings, the CAPM provides an intuitive way of conceptualizing the risk-return tradeoff, and it paved the way for the asset-pricing research that followed it. The notion that individual securities' risks come in two flavors, market and idiosyncratic, is a critical element of portfolio theory and its thou-shalt-diversify commandment. It is also the basis, as we shall see, for beta, alpha and the factor-investing approach enabled by smart-beta ETFs. For that application, let us add an alpha term to the CAPM to account for the component of realized returns that cannot be explained by market exposures: rs = rf + ßs x (E(rm) - rf) + a Rearranging terms to solve for alpha shows it to be the difference between the realized return and the return expected by CAPM: a = rs - (rf + ßs x (E(rm) - rf)) From CAPM To Factors To Smart Beta In today's accepted usage, alpha is the ex-post difference between portfolio and benchmark return, adjusted for risk. It is the component of return attributed to portfolio manager skill, whereas beta is the return accruing to simple market exposure. As return-attribution research has uncovered the systematic factors underpinning performance, beta has claimed an increasing share of the pie from alpha. The salubrious effect for investors, especially those who employ third-party managers, has been to demystify the sources of portfolio returns. Beta's expanding share has also opened the door to a middle course between purely active and purely passive portfolio management strategies. Factor research has made it possible to join the main advantages of passive strategies - transparency, predictability and low cost - with active strategies' aim of delivering a risk-adjusted return profile distinct from those offered by cap-weighted benchmarks. Investors have embraced the factor approach and traditional asset managers have obliged them with a torrent of smart-beta ETF choices. Both should put investors on alert: according to the late Barton Biggs, there is no investment idea so good that it can't be destroyed by too much money, and fund company enthusiasm may correlate more closely with its own profits than its clients'. Biggs' admonition is always on our mind, but we don't think the established factors are in imminent danger of losing their zest. Factor excess returns are not new news. 25 years after Fama and French's paper, low-book-multiple stocks continue to outperform high-book-multiple stocks and smaller stocks continue to outperform larger stocks. We do not see the comparatively modest aggregate smart-beta ETF AUM as a catalyst for bidding away the returns that have durably accrued to factors. Are Dividends Really An Equity Factor? For the purposes of this report, our first objective is to determine whether or not Dividends can properly be considered a factor alongside the big five (Value, Quality, Momentum, Volatility and Size). Unable to find compelling evidence for their inclusion, we do not think they should. Yield may be a promising factor in fixed income, but extending the concept to equities is problematic. Across all capitalization buckets for the last 20 years, it cannot even be said that dividend payers outperform non-dividend payers (Chart 4). The empirical record for more sophisticated slicing and dicing is mixed, depending on the level of granularity. Breaking the universe of U.S. equities into non-dividend payers and dividend payers, and then segmenting the latter by yield into the lowest three deciles, the median four deciles and the highest three deciles, Fama and French's 90-year dataset supports the idea that higher-yielding stocks generate higher total returns (Chart 5). The breakout is neatly consistent, with dividend payers outperforming non-dividend payers, and each yield cohort of the dividend payers outperforming the lower-yielding cohorts beneath it (Chart 6, top panel). Zoom into the dividend payers at the quintile and decile levels, however, and the consistency disappears as the tidy staircase pattern begins instead to resemble a jagged picket fence (Chart 6, lower panels). Chart 4Dividends Have Been Hazardous To Investors' ##br##Wealth Over The Last 20 Years ... Chart 5... Though They've Rewarded Investors ##br##Over Nine Decades Chart 6Not Ready For A Close-Up Adjusting for risk makes the picture even murkier. While the non-payers and the lowest-yielding cohorts always post the smallest risk-adjusted returns, they are the only cohorts the highest-yielders manage to beat. The median 40 is the winner among our 30-40-30 cohorts, while the fourth and the second quintiles bracketing the median 40 easily outpace the top quintile, and the eighth, fourth and seventh deciles break away from the rest of the decile pack (Chart 7). It should come as no surprise that our long top 30%/short bottom 30% litmus test failed to reveal any viable excess return strategies based on dividend yields. Our attempts to develop simple portfolio construction rules based on markers of dividend quality and sustainability failed to conclusively advance the dividend cause. Long/short strategies founded on dividend growth added no value to a simple portfolio built from dividend yield and change in share count (Chart 8). Payout ratio metrics, which might shed some light on both quality and sustainability, provided pretty solid results, but they weren't enormous winners (Chart 9). Our analysis left us unable to conclude that Yield merits inclusion among the established equity factors. Chart 7No Theme To Risk-Adjusted Return Profiles Chart 8No Viable Long/Short Dividend-Growth Strategy ... Chart 9... But Payout Ratios Work Pretty Well An Ideal Dividend Index The fact that the way forward for dividend strategies is not obvious is good news for smart-beta sponsors. The ambiguity leaves plenty of room for developing better index-construction methods. Some sources of improvement might include: A means of identifying and sidestepping "yield traps," high and/or growing yields that are actually a distress signal. A way to review historical metrics to gain a sense of ongoing dividend growth. An evaluation of a dividend's source, valuing dividends supported by operating cash flows more highly than those supported by financing activities or asset dispositions. A process for limiting sector exposures, and an awareness of the most auspicious backdrops for taking on exposure to specialized yield plays like mortgage REITs, MLPs and BDCs. Ticking off every item on this wish list, however, would necessarily involve infringing on other factors' turf. Quality, Value, Size and Volatility could all spill into the process of assessing dividend quality and sustainability. Given that our attempts at creating our own tests to measure up to the wish list came up empty, it seems that a cross-disciplinary approach might be the only option. Even if the indexes are not based completely on dividend-derived metrics, it may be possible for a few dividend accents to add some incremental value to the overall stew. Smart-Beta Fund Evaluation These issues were on our mind when we set out to define the metrics that we would use to evaluate the indexes created by our Dividend smart-beta ETF subset. The two payout metrics in the ETS model, dividend yield and change in shares outstanding, are pretty thin gruel for evaluating the dividend ETFs. The ETS payout metrics were selected based on their interaction with the Value, Safety, Quality, Momentum and Sentiment metrics, 23 in all, that comprise the rest of the stock-level inputs into our model. They were not intended to be stand-alone measures. Many of the ETFs in our subset explicitly screen for Quality, Value and/or Low Volatility. They could just as accurately be described as multi-factor funds in a dividend-first wrapper, and we have therefore deployed the entire ETS model to evaluate them. To assess whether or not their constituent selection process consistently improves upon a simple dividend strategy, we compare their ETS scores to those of VIG, the Vanguard Dividend Appreciation ETF, which tracks the NASDAQ US Dividend Achievers Select Index of stocks (ex-REITs and LPs) with at least 10 consecutive years of dividend increases. First Trust Rising Dividend Achievers ETF (RDVY) RDVY's ETS scores have stood out from its smart-beta peers' since the fund's inception at the beginning of 2014. Its concentrated 50-stock portfolio allows it to focus on exposure to its preferred growth and sustainability metrics. Only stocks that have grown their dividends over 3- and 5-year periods, and their non-zero earnings per share over a 3-year period, make it through the growth filters. The sustainability filters admit only stocks with cash-to-debt ratios of at least 50% and dividend payout ratios of 65% or less. Chart 10Good Things Come To Those Who Wait Although the fund has outperformed VIG since inception, its relative performance has not been nearly as consistent as its relative ETS scores (Chart 10). It has taken a 40% surge over the 12 months ended February 28th to put RDVY over the top. We recognize that performance can be capricious, however, and place more weight on RDVY's consistently stellar relative ETS scores, which are 20% more, on average, than its smart-beta peers'.5 RDVY's 50-basis-point ("bps") expense ratio exceeds the 36-bps group average, but we think its screens and concentration are worth the incremental 14 bps. The fund is on the smaller side with $127 million of AUM, and daily turnover of just over $2 million, but larger investors can make use of the creation/redemption unit process to transact in larger volumes without concern. We recommend RDVY for investors seeking large- and mid-cap dividend exposure. FlexShares Quality Dividend Index Fund (QDF) QDF stands second to RDVY on an ETS score basis. Its relative scores have been remarkably stable, rarely falling below 110% en route to averaging 113% of the aggregate Dividend smart-beta score. QDF's selection process is proprietary, and it incorporates measures of cash flow, profitability, and management's skill at deploying capital and financing its activities. The mix has enabled QDF to outperform VIG from the get-go, and steadily pad its lead ever since (Chart 11). Its 37-bps expense ratio is right in line with the group's and its $1.7 billion AUM and $5 million average daily turnover provide a nice sense of ballast. We recommend QDF, along with RDVY, as the best Dividend smart-beta options. Chart 11Wire-To-Wire Outperformance WisdomTree MidCap Dividend Fund (DON) O'Shares FTSE US Quality Dividend ETF (OUSA) WisdomTree has been a pioneer in creating dividend-weighted indexes, but the formula it's applied to selecting constituents for DON, its mid-cap dividend ETF, has not found favor with the ETS model. The fund's constituents have repeatedly earned an aggregate ETS score below 40, holding its relative score below 80% for extended periods. OUSA is a newer fund, with less than a year of history, but its ETS scores have been noticeably weak. We would avoid OUSA until it compiles enough of a track record to permit more conclusions about its process and we would advise investors seeking targeted mid-cap exposure to gain it via funds other than DON. Dividends' Curious Attraction Our work in researching this Special Report has brought dividends' many contradictions to light. In countries like the U.S., where ordinary income is taxed at a higher rate than capital gains, dividends represent an especially tax-inefficient way of redeeming a portion of one's investment. Either share buybacks or sales to third parties would yield more after-tax cash. Humans feel a strong pull to book gains, and steadily redeeming portions of a successful investment has an intuitive emotional appeal: "Let's quit while we're ahead, let's go while the getting is good." It's exactly the wrong thing to do with investments, however. If the quarterly dividend flow assuages the remorse over a mistaken investment, encouraging an investor to stick with a losing position, it's even worse. It is possible that dividends, even though they're small, help reinforce our innate resistance to selling losers and letting winners run. From management's perspective, legacy dividend payments can act as handcuffs. Fearful of issuing a signal that is sure to be interpreted negatively by the market, firms take pains to refrain from cutting dividends. Dividend declarations, then, are a part of the capital budgeting process that is not rooted in economics. A rigorously utility-maximizing visitor from outer space may have found the oil majors' borrowing to fund their dividends in the midst of the severe downturn in crude prices to be very odd indeed. All of these shortcomings may help explain why we were unable to find clear evidence that dividends exert a clear and consistent influence on stock prices. And yet, dividends are enormously popular, with dividend funds by far outnumbering every other flavor of smart-beta ETF. We, too, like to think of positions in balanced portfolios on a total-return basis, as does our U.S. Investment Strategy service, which has successfully recommended the Dividend Aristocrats much longer than we have. Total return is important, but we are increasingly leaning toward the view that specialty dividend plays, purchased at the right point of the cycle, are the best way for an investor to capture income from equity holdings. Such an all-or-nothing approach may well be superior to the one-foot-in, one-foot-out stance that is embodied by the average 2% large-cap dividend yield. Our U.S. Investment Strategy service has successfully surfed the cyclical wave in mortgage REITs, and we are attempting to do so now with the inclusion of BIZD, the business development company ETF, in our U.S. portfolios. Adding cycle analysis would make our smart-beta studies too long, but we are conducting research into the interaction between factor performance and cycle phases, and we will share our findings with our clients in standalone Special Reports if they are insightful enough to merit their attention. Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com Jennifer Lacombe, Research Analyst Global ETF Strategy Jenniferl@bcaresearch.com Philippe Morissette, Associate Vice President Equity Trading Strategy philippem@bcaresearch.com 1 Please see Global ETF Strategy/Equity Trading Strategy Special Report, "Smart-Beta ETF Selection, Part I - Value Funds," published February 15, 2017, at etf.bcaresearch.com. 2 Size may be too straightforward to allow for an index-construction edge. 3 Stock XYZ's beta is equal to the covariance of its returns with the market's returns, divided by the variance of the market's returns, where its covariance with the market equals its returns' correlation with the market's times the product of XYZ's volatility and the market's volatility. 4 Fama, Eugene F. and French, Kenneth R., "The Capital Asset Pricing Model: Theory and Evidence," Journal of Economic Perspectives, Volume 18, Number 3 (Summer 2004), pp. 25-46. 5Befitting its benchmark status, VIG’s ETS scores have averaged 99.8% of the entire subset’s since inception.

Highlights ­­The U.S. Treasury is unlikely to label China as a currency manipulator in the upcoming semi-annual assessment in April. A bigger threat is the possibility that President Trump unilaterally imposes punitive tariffs or import quotas on Chinese goods through administrative powers. The risk of that at the moment is low. The current episode of Chinese capital outflow can be largely viewed as the unwinding of the RMB "carry trade". The PBoC's official reserves have functioned as a reservoir to buffer volatile cross-border capital flows driven by short-term speculative incentives. Beyond the near term, the Chinese authorities will likely continue to encourage domestic entities to directly acquire foreign assets to improve the returns of the country's overall international investment positions. The grand trend of increasing Chinese overseas investment by the private sector will resume once the downward pressure on the RMB dissipates. Feature As we go to press this week, the Federal Reserve has just released its interest rate decision. The 25-basis-point rate hike was well anticipated, and the markets should be assuaged by the fact that the Fed does not anticipate a more rapid pace of rate hikes than it did in December. As far as China is concerned, the RMB, which has been put on the backburner by global investors in recent months, is once again back in the spotlight, as its descent against the dollar has resumed after a relatively calm period. Both Chinese interest rates and the USD/CNY have been pushed higher by the latest moves in U.S. Treasury prices and the broad dollar trend (Chart 1). Chart 1The U.S. Connection Beyond The Currency Manipulator U.S. Treasury Secretary Steven Mnuchin signaled late last month that he wants to use a regular review process of foreign-exchange markets to identify currency manipulators, which means the U.S. administration intends to follow normal legal procedure to decide if China is manipulating its currency. This is a significant departure from President Donald Trump's repeated campaign trail promises, and has reduced the odds of an immediate clash between the U.S. and China on the RMB. If the Treasury follows the formal process laid out in statutory law, it is unlikely to label China as a currency manipulator in the upcoming semi-annual assessment to be published in April, simply because the country does not meet all the conditions required for being charged with currency manipulation, as discussed in detail in our previous report.1 Even if China was indeed labeled a currency manipulator in the April assessment, the existing procedure does not authorize the administration to immediately impose punitive measures. Instead, the law requires the Treasury to negotiate with the allegedly "guilty" party to correct the currency manipulation and remove unfair trade practices. Even if negotiations fail, the punitive measures that the Treasury must follow under the existing legal framework are largely symbolic for a country like China. The recommended remedial measures such as prohibiting federal procurement from offending countries and seeking additional surveillance through the International Monetary Fund are hardly biting for China. In short, a "currency manipulation" charge, even if it were imposed, would mostly be a symbolic move, and the real economic consequences would be limited. A bigger threat is the possibility that President Trump unilaterally imposes punitive tariffs or import quotas on Chinese goods through administrative powers, which would be far more unpredictable and would inevitably lead to harsh retaliation from the Chinese side. The risk of that at the moment is low. President Trump appears to be occupied with domestic issues and has notably toned down his anti-China rhetoric. Meanwhile, President Xi is reportedly scheduled to visit the U.S. next month, at which time he will likely seek to improve bilateral ties. We expect both sides will try to set up a new high-level mechanism for effective communication and negotiations over key policy issues to replace the annual U.S.-China Strategic and Economic Dialog (S&ED) under the Obama administration. Given the numerous "China hawks" in President Trump's inner circle, trade frictions between the two countries will likely increase, but the risks appear to be pushed out to at least next year. Where Did The Money Go? China's official foreign reserves have stabilized at around US$3 trillion in recent months, compared with a peak of over US$4 trillion in the second quarter of 2014. The common perception is that the People's Bank of China (PBoC) has been fighting a constant bleed of domestic capital, and the rapid decline in its foreign reserves means an ever-smaller war chest, which will eventually force the PBoC to surrender. There has been open debate within China's policy-making circles and prominent think-tanks on whether the PBoC should protect the RMB exchange rate or preserve its official reserves. While the decimal changes in China's official reserves have been grabbing headlines among the financial media of late, much less known is China's total international investment positions. In fact, China having a hefty current account surplus means the country's domestic savings exceed its domestic investment, and subsequently the excess savings become holdings of foreign assets - the PBoC's official reserves are just a part of the country's growing total foreign claims. Therefore, it is important to have a closer look at China's total foreign investment positions to understand cross-border capital flows. On the asset side, since the second quarter of 2014 when official reserves peaked out, China's total foreign assets have continued to grow, albeit at a slower pace (Chart 2). The decline in official reserves has been more than offset by increases in other forms of investments. Specifically, direct overseas investments, foreign loans and holdings for foreign securities increased by US$503 billion, US$170 billion and US$79 billion, respectively, between Q2 2014 and Q3 2016, the latest available data points, compared with a US$792 billion decline in official reserves during the same period. In other words, the country as a whole has continued to accumulate foreign assets, but the corporate sector and households have been increasing their holdings at the same time that the public sector has been trimming positions. On the liability side, the Chinese corporate sector has been paying back foreign debt aggressively since Q2 2014, which also increased demand for foreign currencies and contributed to the decline in the PBoC's official reserves. Loans and trade credit taken by Chinese firms dropped by US$423 billion between Q2 2014 and Q3 2016. The outstanding balance of total foreign loans and trade credit at the end of Q3 2016 stood at US$583 billion, almost half the US$1 trillion peak in Q2 2014 (Chart 2, bottom panel). Regarding foreigners' claims in China, the RMB fluctuation has had no meaningful impact on both foreign direct investments (FDIs) and foreigners' investments in Chinese domestically listed securities such as stocks and bonds. In fact, both FDIs and foreign investments in Chinese securities have continued to rise despite heightened anxieties on the RMB (Chart 3). However, foreigners' liquid holdings of Chinese financial assets, cash and savings deposits have dropped by US$100 billion from a peak of US$441 billion in Q2 2014 to US$340 billion at the end of Q3 2016. This could well be the withdrawal of foreign "hot money" that flew into China in previous years. Chart 2Where Did The Money Go? Chart 3Foreign Investment In China: The Ins And Outs Taken together, the decline in China's official reserves appears less disconcerting. Chinese companies' debt repayments and foreign "hot money" repatriation accounted for the lion's share of the decline in Chinese foreign reserves since 2014. Therefore, the current episode can be largely viewed as the unwinding of the RMB "carry trade": In previous years, when the RMB was appreciating against the dollar, Chinese firms undertook loans in dollars and foreign 'hot money" also rushed into China - the tide has been reversing as the USD/CNY trend has shifted. The PBoC's official reserves have functioned as a reservoir to buffer volatile cross-border capital flows driven by short-term speculative incentives. Chinese Foreign Reserves: The Big Picture While the dominant concern at the moment is that Chinese official reserves, still by far the largest in the world, are not enough to maintain exchange rate stability, easily forgotten is that the consensus was the opposite a mere three years ago (Chart 4). Back then the prevailing view was that the country had too much foreign reserves, which was both a waste of resources and an economic burden. While popular perceptions in the marketplace always swing dramatically, it is important to keep the big picture in mind. At the onset, official reserves currently account for 50% of China's total international investment positions. This is a notable decline from a peak of 71% in 2009, but still far higher than any other major economy (Chart 5). For example, Japanese official reserves account for 16% of total international claims, 26% for Taiwan, and a mere 2% for the U.S. Chart 4Chinese Official Reserves Are ##br##Still By Far The Largest Chart 5Chinese International Assets Are ##br##Primarily Official Reserves As China's foreign assets are primarily represented in official reserves, the return of China's foreign claims is extremely low, as official reserves are mainly invested in risk-free highly liquid assets, with achieving higher returns always having been of secondary consideration. The average return of Chinese foreign assets has been hovering around 3%, not much higher than U.S. Treasury yields (Chart 6). By contrast, foreign investments in China are primarily engaged in the real economy and are able to garner much higher yields. This mismatch, ironically, has led to a net loss in China's international investment position. In other words, even though China is a massive net creditor to the rest of the world, the country's net investment income has in fact been negative, as the country pays a lot more to foreign investors than it gets from its own overseas investments. Chart 6China Gets Less Than It Pays This mismatch has been one of the key reasons why the PBoC in previous years tried to encourage domestic entities to hold foreign assets directly rather than through official channels in the form of foreign reserves. The more recent rapid increase in capital outflows from the Chinese corporate sector and households has challenged the PBoC's near-term priority to maintain exchange rate stability, prompting the authorities to tighten capital account controls to support the RMB. From a big-picture point of view, however, the Chinese authorities will likely continue to encourage domestic entities to directly acquire foreign assets to improve the returns of the country's overall international investment positions. All in all, the near term CNY/USD cross rate will remain largely determined by the Fed action and the broad trend of the dollar, but the PBoC will continue to intervene to prevent major currency depreciation. The RMB is unlikely to depreciate against the greenback more than other major currencies in a period of dollar strength. The grand trend of increasing Chinese overseas investment by the private sector will resume once the downward pressure on the RMB dissipates. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China As A Currency Manipulator?," dated November 24, 2016, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Dear Client, In addition to this brief note concerning Wednesday's FOMC meeting, we will be sending you a Special Report written by my colleague Brian Piccioni, head of BCA's Technology Strategy service. Brian discusses the investment implications of what could be one of the most profound technological developments of the 21st century: CRISPR, a radical new technique for genetic engineering. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy The dollar and U.S. Treasury yields fell sharply in the aftermath of Wednesday's FOMC meeting, while equities rallied. Indeed, so pronounced was the asset market reaction that financial conditions eased markedly for the day, making the Fed's actions an "unhike" of sorts. The FOMC meeting produced several dovish surprises. First, the number of participants who expected four rate hikes or more did not increase, as some observers had anticipated. Second, the estimate for the structural rate of unemployment was scaled down further by a tenth of a percentage point to 4.7%. Third, the FOMC statement said that the Fed was looking for a "sustained" return to 2% inflation, while also referring to its inflation target as a "symmetric" one. Fourth, Minneapolis Fed President Kashkari dissented in favor of keeping rates unchanged, which few people had expected. Having said all this, the market's reaction still seems rather excessive. The key message from the March meeting was that the Fed now sees inflation as having finally reached its 2% target. This was reflected in the decision to strip the reference to the "current shortfall of inflation" from the statement. Consistent with this, the FOMC raised its growth forecast for 2018 from 2.0% to 2.1%. In addition, it lifted its inflation forecast for this year from 1.8% to 1.9%. The median projection for the funds rate also edged up from 2.9% to 3% for 2019. The mean dot rose 9 bps in both 2018 and 2019, while the modal dot increased by 25 bps in both years. None of this is particularly dovish. As far as the reference to the Fed's "symmetric" target is concerned, this is something that Chair Yellen and other FOMC officials have stressed many times before. All it means is that the Fed will not react too aggressively if core inflation were to drift somewhat above 2%. It does not mean that the Fed will purposely try to engineer an inflation overshoot. If the Fed had wanted to do that, it would have lifted its 2019 inflation forecast. It didn't do that and the inflation forecast remains stuck at 2.0%. Why, then, did the FOMC bother massaging the language? The answer is that the Fed simply wanted to reassure the public and the investment community that it would maintain its "go slow" approach to raising rates. After all, investors were pricing in only a small probability of a March hike just a few weeks ago. A "hawkish hike" could have led to an excessive tightening in financial conditions, similar to what happened during the taper tantrum. However, given that financial conditions actually eased significantly in response to the FOMC's decision, it is likely that Fed speeches will lean in a less dovish direction over the coming weeks. The implication for investors is that the dollar is likely to rebound. Indeed, the longer-term risk to the dollar is not that the Fed turns out be too dovish, but that it turns out to be too hawkish - that it raises rates so much that the economy begins to roll over. However, with interest rates still low in absolute terms, this is more of a risk for late 2018 or 2019 than it is for the next 12 months. As such, investors should continue to cyclically overweight global equities, favouring stock markets such as those in Europe and Japan that have a "higher beta" to global growth than the U.S. A modest bearish tilt towards long-term government bonds is also warranted. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com

Highlights Geopolitics will not spoil the stock rally yet; European election risks remain overstated; In China, look beyond the National Party Congress; China's reforms could re-launch in 2018 ... ... But India's reforms are gaining momentum now. Feature The global economy continues to surprise to the upside, with the latest round of global purchasing managers' indices (PMIs) confirming that the business cycle continues to accelerate (Chart 1). In the context of firming global growth, the Fed's decision to hike rates may not produce as violent of a reaction from the dollar as last year, giving way to further upside in stocks. And while investors continue to fret about valuations, U.S. stocks are expensive only relative to history, not relative to competing assets, as our colleague Lenka Martinek of the U.S. Investment Strategy service points out (Chart 2).1 Chart 1Because I'm Happy Chart 2U.S. Stocks Pricey By History, Not Peers What geopolitical news could break up the party over the next six months? Europe: As we argued three weeks ago, the European electoral calendar is unusually busy (Table 1).2 However, we have also posited in our 2017 Strategic Outlook that Europe will be a red herring this year, allowing risk assets to "climb the wall of worry."3 The first test of this thesis comes today, with the Dutch general elections taking place. The polls suggest that the Dutch electorate is not following the populist trend of the Brexit referendum and U.S. election (Chart 3), but rather in the footsteps of the little noticed Austrian presidential election in December, which saw the populist presidential candidate defeated. Dutch Euroskeptics, who have led the polling throughout the last twelve months, are bleeding support as election day approaches. Meanwhile, in France, Marine Le Pen is struggling to keep momentum going with only a month and a half to the first round. Thus far, our thesis on Europe is holding. Table 1Busy Calendar For Europe This Year Chart 3Dutch Euroskeptics Are An Overstated Threat The U.S.: Investors will finally get to put numbers to President Trump's rhetoric when the White House announces its budget on March 16. As we argued last week, President Trump is who we thought he was: an economic populist looking to shake up America's status quo. That suggests he will err on the side of greater deficits and large middle-class tax cuts. We do not think Congress will bar his way, as it has rarely restrained a Republican president from profligacy (Chart 4). We could be wrong, but it is unclear if a more fiscally responsible budget would be negative for the markets. On one hand, it may disappoint optimistic growth projections, but on the other, it would mean that the Fed would have no reason to err on the side of more rate hikes in 2017. Meanwhile, while we continue to fear protectionism's impact on the market, it is unlikely that the Trump White House will focus on trade when so many domestic priorities are looming this summer. Russia: As we argued in a Special Report with the Emerging Markets Strategy group last week, Russia may be entering a low-beta paradigm - escaping from its close embrace with oil prices - due to the combination of orthodox monetary policy, modest structural reforms, and growing confidence in its geopolitical predicament.4 This is not the time for President Putin to rattle nerves in the West. He does not want to give Europe and the U.S. a reason to cooperate. We therefore expect Russia's geopolitical risk premium to continue to decline, a boon for European risk assets (Chart 5). Chart 4Budgets: Republican Presidents##br## Get What They Want Chart 5Russia's Calm##br## Is Europe's Profit From a tactical perspective, we believe that the confluence of geopolitical forces supports our continued overweight of developed-market equities versus those of emerging markets. Within developed markets, the BCA House View is to prefer euro-area equities due to overstated geopolitical risks and favorable valuations relative to the U.S. equity market. BCA's Global Investment Strategy has pointed out that euro-area equities are one standard deviation undervalued relative to the U.S., when one applies U.S. sector weights to them (Chart 6). In addition, BCA's U.S. Bond Strategy service believes that Treasury yields have more room to rise, with growth putting upward pressure on inflation and the Fed in a rate-hike cycle. This makes sense to us given that no major geopolitical risk is materializing and considerable upside risk exists in U.S. growth due to Trump's populist policies. Chart 6European Stocks Still A Buy Relative To U.S. In what follows, we take a break from poring over geopolitical risks in Europe and the U.S. and focus on emerging markets. Since January, very few investors have asked us about EM politics, save for the occasional question about Brazil. However, the two Asian giants - China and India - are both a source of risk: the first a downside, left-tail risk and the second an upside, right-tail risk. China: What Comes After The Party Congress This Fall? Since 2013, we have been outspoken in our low expectations for China's structural reforms.5 This view was confirmed with a series of stimulus efforts that displaced reforms, including the local government debt swap program in 2014 and extensive fiscal and monetary easing in 2015 and especially 2016.6 The upside of weak reforms was better-than-expected growth in the short run, as stimulus took effect. Indeed, China has pulled off a remarkable economic turnaround since early last year: infrastructure and housing investment have increased, the weaker yuan has boosted exports, and the global recovery in commodity prices has helped producer prices to recover, easing deflationary pressures (Chart 7). Chart 7Deflationary Pressures Easing Chart 8Stimulus Dropped Off Accordingly, Chinese policymakers, who are attempting to strike a balance between stimulus and restructuring, have begun leaning against the economy's gathering momentum. Government spending has collapsed now that a 6.5% GDP growth "floor" has been established (Chart 8). A new round of property market regulatory tightening began last fall, though it has had little impact so far. Also, the People's Bank of China has begun draining some liquidity (Chart 9). Signals coming out of the "Two Sessions" over the past two weeks, namely the National People's Congress, suggest that the Chinese leadership is content with the current state of affairs. Policymakers set their growth targets for 2017 a little lower than last year's targets and a little higher than last year's actual performance (Table 2).7 It is a line so thin that it is almost imperceptible. They do not want significant change. Chart 9PBoC Draining Liquidity Table 2China's Economic Targets For 2017 This stance fits with a deeper desire to keep the economy on an even keel during a pivotal year for Chinese politics. The legislative session took place under the shadow of the Communist Party's impending 19th National Party Congress - the "midterm" meeting of the party that happens every five years and features extensive promotions, rotations, and retirements for the party leadership. This year's congress promises to be especially influential because of Xi Jinping's ascendancy and the fact that around 70% of the upper tier of leaders will be replaced. Chart 10, which we have been showing clients over the past year to dampen expectations of stimulus, reveals that the party congress is not normally an excuse to throw open the floodgates of credit and government spending. Rather, it is a reason to avoid anything that might rock the boat, whether stimulus or reform. Chart 10Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Thus while government spending has declined, it should be expected to rise again if growth slows down too much for too long. There may be a period of slowdown and market jitters before the leaders reach for the fiscal lever again, but the "Socialist Put" remains in place. Meanwhile, we are not surprised that structural reforms continue to suffer. It is not that China has eschewed all reforms but rather that its reforms have focused on centralizing power for the ruling party and alleviating some outstanding social grievances. These are positive in themselves but they do not address the key concerns of foreign investors relating to economic openness, financial stability, and the role of the state. The recent imposition of capital controls and a host of non-tariff barriers in the name of "state security" exemplify a negative trend. The delayed rollout of the property tax is also a sign of Beijing's proclivity to delay policies that may be financially risky.8 And Beijing has only tentatively attempted to cut back state-owned enterprises. Simply put, a push to overhaul any significant sector or sub-sector does not fit Beijing's priorities at the moment. However, if growth, debt, or asset prices should climb too rapidly, then we expect countermeasures to tamp them down. Even on the geopolitical front - where we have a high conviction view that tail risks to financial markets are higher than the market perceives them to be, both in China and the broader Asia Pacific - there have been some signs of the U.S. and China playing ball on a shared desire for "stability," at least for the moment.9 While we expect a negative geopolitical shock, the market will only believe it when it sees it. All of the above suggest that China will focus on "maintaining stability" this year even more than usual due to the party congress. This is clearly bullish, especially given improving U.S. and global growth. However, the mantra of "stability" and "party congress" should not prevent investors from looking beyond October or November of this year. Chart 11China Needs More##br## Credit For Same Growth Chart 12China Gets Old ##br##Before It Gets Rich Even assuming that China experiences no significant internal or external economic shocks from now until this fall, it is important to remember that China's growth potential is still slowing for structural reasons. Productivity is collapsing and credit dependency is rising (Chart 11). The slowdown stems from deep shifts such as the end of the debt supercycle in the U.S. (weak external demand), the tipping point in Chinese demographics (higher dependency ratio) (Chart 12), and the extremely rapid build-up in corporate debt (Chart 13). Chart 13Corporate Debt Skyrockets Chart 14As Good As It Gets This is what leads our colleague Mathieu Savary, of BCA's Foreign Exchange Strategy, to surmise that China is at the peak of its current economic mini-cycle. This is "as good as it gets," as he shows in Chart 14. Barring a situation in which Xi somehow fails to consolidate power at the party congress, the market impact will depend on which of two scenarios follows: First scenario: Xi achieves a dominant position in all party and state organs, yet 2018 sees a continuation of the current pattern of mini-cycles of stimulus, lackluster reform, and foreign policy aggressiveness. Xi implicitly deems the strategic cost of reform too great, as we argued he would do over the past four years, and dedicates his stint in office to the accumulation of power. Perhaps a successor will be able to use these powers to enact painful reforms in the mid-2020s; that is not Xi's immediate concern. This is short-term bullish for global and Chinese growth, long-term bearish for Chinese assets. Second scenario: Xi achieves a dominant position and uses his power to reinvigorate the country's stalled reforms. Hints of big measures emerge in the wake of the party congress in November or December, and January 2018 begins with a bang. This would necessarily mean that Xi accepts slower growth, or even that he imposes it through tighter fiscal policy, real credit control, SOE failures, and aggressive overcapacity cuts. However, Chinese productivity would begin to recover. This is short-term bearish for Chinese and global growth. However, it is the most bullish outcome for the long-term performance of Chinese assets. In China's current state - with capital controls newly reinstituted (Chart 15), Xi lauding the "central role" of SOEs in development, and Xi's administration still focused on purging the party and controlling the media - the second scenario admittedly seems far-fetched. Chart 15Are Capital Controls Working? Moreover, Xi seems averse to risky experiments at home that could weaken the country in the face of unprecedented strategic threats from the United States and Japan. Nevertheless, a 2018 reform push should not be dismissed out of hand. Why? Because an overbearing state, credit excesses, and weak productivity really do threaten the sustainability of the Chinese economy and hence the Communist Party's grip on power. Xi must keep them in check, as the current gestures toward tighter policy indicate. The government has overseen a massive monetary and credit expansion to protect the country from faltering external demand since 2008. As the current account surplus has declined, the country's massive savings have built up at home in the form of debt (Chart 16).10 Yet the investment avenues are restricted by the role of the state. As a result, the inefficient state-supported sector is getting propped up while the shadow financial sector grows wildly and creates murky systemic risks that are difficult to monitor and control. The PBoC has undertaken further extraordinary actions to keep financial conditions loose (Chart 17). Chart 16Savings Invested At Home Chart 17PBoC Lends A Helping Hand What signposts should investors watch for to see which path Xi will take after the party congress? Jockeying ahead of the party congress: The latest NPC session saw some political maneuvering. Several sixth generation leaders made appearances and spoke to media.11 Xi's supposed favorite, Chen Min'er, Party Secretary of Guizhou, distinguished himself by cutting reporters short at a press conference. Meanwhile former President Hu Jintao appeared publicly alongside his apprentice, Hu Chunhua, Party Secretary of Guangdong. Elite party gatherings in the summer, especially any retreat at Beidaihe, should be watched closely for any clues of who may be up and who down, and what general policy trajectory may be forthcoming. Xi's future: First, will Xi Jinping and Li Keqiang establish clear successors for their top two positions in 2022?12 A failure to do so will suggest that Xi intends to stay in power beyond his de facto term limit of 2022. This would mean that Xi will prioritize his own future over painful structural reforms. On the other hand, a clear commitment to a leadership transition in five years may re-focus the Xi-Li administration towards their initial commitment to economic restructuring. National Financial Work Conference: This conference is held every five years, usually connected with a major new financial reform or regulatory push, and due sometime in 2017. The government is looking into serious changes to financial regulation - including the creation of a super-ministry to house the various regulatory agencies. This, or the broader attempt to ensure adequate capitalization of banks, could be behind the delay. New central banker: Central bank governor Zhou Xiaochuan, in office since 2002, may step down this fall. He could be replaced with another technocrat to little fanfare, but his exit introduces the opportunity for shaking up the PBoC regime as a whole. Other new officials: A slew of other appointments and reshuffles will take place this year as a generation of leaders born before the Revolution retires. A new director of the state economic planner, the National Development and Reform Commission, was just named, while late last year a new finance minister took his post. These officials have yet to make their mark. Their statements should be watched closely for any shifts in economic policy emphasis. Time frames for reforms: The market is still waiting for concrete proposals and time frames for major reform initiatives, particularly opening up to foreign competition and restructuring state-owned enterprises. Overcapacity cuts have also had mixed results. We do not expect major advances on big structural reforms this year due to the party congress, but details that can be gleaned about the process and timetables could be important. Bottom Line: Watch for signs of a renewed reform drive after the nineteenth National Party Congress. Xi is not going to reverse what he has done so far. And China is not going to become a market economy on the ideal western model. But a pivot point could be in the cards next year for China to pursue some pro-efficiency reforms that it has already set out for itself in a more resolute way. Xi's decision to stay in power beyond 2022 would be bearish for reforms as it would incentivize the current "Socialist Put" model of policymaking over a genuine paradigm shift. India: What Comes After Modi's Big Win? Prime Minister Narendra Modi has won a crushing victory in India's most populous state, Uttar Pradesh, positioning himself, his Bharatiya Janata Party (BJP), and National Democratic Alliance (NDA) coalition very well for the 2019 general elections. Policymaking is going to become easier for the ruling party - though there are still serious political and economic constraints. We have been long Indian equities relative to EM equities since the "Modi wave" began with Modi's victory in the Lok Sabha or lower house in 2014.13 The end of the commodity bull market signaled an opportunity for India, which imports about a third of its energy. The decline of global trade also heralded the outperformance of domestic demand-driven economies like India. Further, Modi's sweeping victory held out the promise for a reform agenda of tighter monetary and fiscal policy that would reduce inflation and make room for private investment to grow. This would make Indian risk assets attractive, especially relative to other EMs, which were at that time either lagging at reforms or failing to undertake them entirely. Since then we have seen Modi rack up a key legislative victory - the passage of the Goods and Services Tax, in the process of implementation - and engineer a surprise "demonetization" effort late last year to increase bank deposits, bring the country's gray markets into the open, and flush out crime and corruption.14 The ruling coalition's gains in Uttar Pradesh and a few other state elections this year are a striking vindication of popular support after this highly unconventional and controversial maneuver.15 Uttar Pradesh is the most important of these elections. It was slated to be a grand testing ground for Modi well before demonetization. It is the most populous Indian state, with about 200 million people, and the third largest state economy (producing about 10% of GDP). It is the second-poorest state, with a GDP per capita of about $730, it has the highest proportion of "scheduled castes" (untouchables), and ranks around the middle of states in terms of the Hindu share of population - all challenges for the landed, pro-business, Hindu nationalist BJP (Map 1). Politically, aside from its inherent heft in population and centrality, Uttar Pradesh sends the most representatives of any state to India's upper house (31 seats), the Rajya Sabha, where Modi lacks a majority. It is thus a key source of federal power and an important state ally. Map 1Modi's Saffron Wave Takes The Indian Core Given the above, it is hugely bullish that Modi's BJP romped to a historic victory in the state election, winning 312 out of 403 seats (about 39.7% of the vote), up from 47 seats previously. His coalition rose to 324 seats total (Chart 18). The BJP now has the largest majority of any party in the state since 1980. These results were not anticipated. A close election was predicted and opinion polls had BJP winning 157 seats, short of the 202 needed for a majority. This was only slightly ahead of its closest rival, an alliance made up of the local Samajwadi Party and its national partner, the left-leaning Indian National Congress (INC). Exit polls even suggested that the Samajwadi-INC coalition had edged ahead of the BJP. The immediate takeaway is that Modi will have better luck governing Uttar Pradesh itself now that the state government is on his side. Individual states hold the key to reform in India because of the country's size and socio-economic disparities. The state will now be expected to implement Modi's policies faithfully and push approved policies forward on its own. The second takeaway is that while Uttar Pradesh will not give Modi control of India's upper house of parliament, the Rajya Sabha, it will give him a better position there. The BJP has 56 seats in the upper house (fewer than the INC's 59), and the ruling coalition has 74, out of a total of 250. The coalition needs 52 seats for a simple majority. Uttar Pradesh will deliver 10 seats at most by the 2019 general election. Modi would have to win almost every seat of the 56 non-allied seats coming open between now and 2019 in order to win the upper house by that time (Chart 19). That is unlikely, but Modi is moving in the right direction and an upper-house majority cannot be ruled out in the long run. Chart 18Modi's Big Win In Uttar Pradesh Chart 19Modi's National Position Improves Of course, Modi has already shown with the Goods and Services Tax that he can pass very difficult legislation through the upper house without controlling a majority there. This achievement last year was perhaps an even greater surprise than the victory in Uttar Pradesh, which reinforces it. Modi also has a secret weapon: in case of a national emergency, however defined, he can call a joint session of parliament, where his coalition would carry the day. This is now more likely because it is the Indian president who is responsible for calling a joint session, and Modi is now more likely to get his candidate into that position due to the win in Uttar Pradesh. President Pranab Mukherjee, who is affiliated with the INC, will step down on July 25. Though Modi does not have all the votes in the electoral college to choose the president outright, smaller parties may fall in line now that the BJP has so much national momentum.16 Controlling the presidency will also give Modi greater influence over constitutional obstacles and gradually over the legal system. Separately, in August, Modi's alliance will be able to choose the vice president as well. More broadly, the Uttar Pradesh election marks a victory for Modi's style of appealing to voter demand for greater economic development as a general priority over longstanding religious and caste grievances that frequently determine electoral outcomes in state elections. This is a hugely significant indication for India's economic structural reform and nation building. Bottom Line: Modi's victory in Uttar Pradesh is proof that for all of India's sprawling inefficiencies, its political system is capable of responding to the large public demand for economic development. Do not underestimate reform momentum now. Modi's political capital remains high. Investment Conclusions The conventional wisdom has for decades been that China is better at reforming its economy because of its authoritarian regime, whereas India democratized too early and has thus lagged at reforms. We have never agreed with this simplistic view of economic reforms. Structural reforms are always and everywhere painful. As such, they require political capital. As our "J-Curve of Structural Reforms" posits, reforms deplete political capital as the pain spreads through the economy and opposition mounts among both the elite and the common man (Chart 20). Eventually, the government is faced with a "danger zone" in which the pain of reforms lingers, the benefits remain beyond the horizon, and all political capital is exhausted. Many leaders chose to water down the reforms, or back off from them altogether, at this point. Chart 20The J-Curve Of Structural Reform On the surface, authoritarian regimes have massive political capital with which to burst through the danger zone of reform. But this assumption is not entirely correct. In China's case, the political capital for reform came after disastrous performances by the "conservative" political forces. Reformers in China were buoyed by the failures of the "Cultural Revolution" (which ended in 1976) and the 1989 Tiananmen Square protests. Each political and social crisis gave the reformers an opening - following a consolidation period - to pursue controversial economic reforms at the expense of "conservative" forces. The fruit of these reform efforts has been the growth of China's middle class. And while this middle class expects reforms in the delivery and quality of public services, it is not interested in seeing a slowdown in economic growth, no matter how temporary or healthy it may be. As such, Chinese leaders are faced with a significant hurdle to their reform preference: how to convince the public that a slowdown is needed in order to restructure the economy. We are unsure whether the upcoming party congress will make a difference. However, we can see a scenario where President Xi decides to pursue market-friendly reforms because he sees an increase in his political capital. In particular, he may feel that he has cemented his personal dominance over his intra-party rivals and that the aggressive foreign and trade policy emanating from the Trump White House gives him a foil to blame for any downturn in growth. Reform would also be a return to Xi's original agenda, and would conform to the playbook of former president Jiang Zemin, whose precedents Xi has followed in some other areas. Given Xi's modus operandi, a post-consolidation reform drive would be executed relatively effectively and would therefore present short-term risks to Chinese and hence global growth, despite the long-term improvement. Markets are definitely not expecting such a policy pivot at the moment. China bulls are content with the current reforms, while China bears see no chance of the Xi administration changing tack. While we are just beginning to see the potential for a turn in Chinese policymaking towards reforms, India is a much clearer example of a reformist administration. Modi will feel empowered by the Uttar Pradesh election, a political recapitalization of sorts. Foreign investment will likely continue cheering Modi's ongoing revolution (Chart 21). The question now is whether Modi intends to use the infusion of political capital for genuine reforms. After all, the economy is not looking up (Chart 22). Chart 21Foreign Investors Cheer On Modi Chart 22Indian Economy Still Weak The evidence is mixed. First, Modi has not maintained strictness on fiscal spending and the budget deficit is creeping back to where it was when he took over the reins (Chart 23). Rising government spending along with higher commodity prices suggest that inflation will continue making a comeback (Chart 24). Poor food production is also driving up inflation. And higher spending and inflation pose a key threat to the sustainability of the reform agenda, since rising government bond yields will crowd out private investment. Chart 23Losing Budgetary Discipline? Chart 24Inflation Makes A Comeback Second, the RBI will be less likely to pursue a tighter monetary policy with both political influence and weak growth pressing on it. Moreover, Indian stocks are not all that cheap. In 2014, valuations were favorable and the backdrop included cheap commodities, fiscal prudence, and Modi's electoral success. Today, India is trading at its historical mean relative to EM (Chart 25), but using the equal sector weighted P/E ratio, by which India was very cheap back in 2014, India is at a 52% premium now (Chart 26). Chart 25Indian Stocks Trading##br## At Mean Against EM Chart 26Indian Stocks Pricey##br## Versus EM Sector-Weighted We are therefore taking this opportunity to close our long India / short EM trade for a 28% gain (since May 2014). We will reassess Modi's structural reform priorities in future research and gauge whether a new entry point is warranted. We remain optimistic on India in the long run as Modi certainly has the political capital for reforms. The question is whether he plans to use it. Meanwhile, we remain skeptical about China's long-term trajectory. To become fully optimistic about Chinese risk assets in absolute terms, we need to see the Xi administration chose short-term pain for long-term gain. For the time being, China continues to repress its structural problems rather than deal with them head on, relying on minimal openness, high and rising leverage, and state-owned banks and companies. India may be lagging in its reform effort, but it has at least established market reforms as a priority. And the Modi administration has built political capital through the slow and painful democratic process. Over the long term, India's approach is more sustainable. If President Xi wastes the opportunity afforded to him by the upcoming party congress, we suspect that China will face a much higher probability of left-tail economic risks than India over the long term. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "How Expensive Are U.S. Stocks?," dated March 13, 2017, available at usis.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Reflections On China's Reforms," dated December 11, 2013, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com, and "China: The Socialist Put And Rising Government Leverage" in Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA China Investment Strategy, "Messages From The People's Congress," dated March 9, 2017, available at cis.bcaresearch.com. 8 Please see Chong Koh Ping, "No plans for NPC to discuss property tax," Straits Times, March 5, 2017, available at www.straitstimes.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. 11 China's leadership is typically referred to in terms of "generations," with Mao Zedong and his peers the first generation, Deng Xiaoping and his cohort the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth. The fifth generation was born in the early 1950s, the sixth generation was born in the early 1960s. 12 Xi may tweak retirement norms to let close allies, like Wang Qishan, the anti-graft attack dog, stay on the Politburo Standing Committee. This might also suggest that Xi himself intends to overstay his age limit in 2022. 13 Please see Geopolitical Strategy Special Report, "Long Modi, Short Jokowi," dated August 28, 2014, available at gps.bcaresearch.com, and Emerging Markets Strategy Special Report, "Long Indian / Short Indonesian Stocks," dated July 30, 2014, available at ems.bcaresearch.com. 14 Please see "India: Demonetization And Opportunities In Equities," in Emerging Markets Strategy Weekly Report, "EM: Untenable Divergences," dated December 21, 2016, available at ems.bcaresearch.com. 15 Though the mixed results also indicate persistent regional differences. Modi's coalition won seats in Uttarakhand and Manipur but lost them in Goa and Punjab. Gujarat, Modi's home state, will hold elections later this year. Himachal Pradesh will also vote this year and will be a subsequent testing ground. 16 Please see Gaurav Vivek Bhatnagar, "BJP Sweep in UP Will Impact Decision on President, Rajya Sabha Numbers," The Wire, March 12, 2017, available at https://thewire.in/116044/bjp-sweep-will-impact-decision-president/

Highlights Fed: The Fed will deliver another rate hike tomorrow, but we do not expect a signal that a higher trajectory for the funds rate is necessary. The Fed wants to see higher inflation expectations and will remain as accommodative as possible until that happens. Maintain a below-benchmark allocation to U.S. Treasuries within global fixed income portfolios. ECB: The ECB opened the door slightly to a less-accommodative policy stance last week, although the talk of a rate hike is premature. A 2018 taper is the more probable scenario, likely to be introduced at the September 2017 policy meeting. This will raise longer-dated European bond yields and widen spreads for both Peripheral European government debt and Euro Area corporate bonds. Reduce Euro Area IG to below-benchmark. U.S. High-Yield: U.S. junk bond spreads have widened even though default rate indicators continue to show improvement. With valuations now looking more attractive, we upgrade U.S. High-Yield from neutral to overweight. Feature Chart of the WeekStill A Positive Backdrop ##br##For U.S. Corporates After a run of smooth sailing for the markets so far in 2017, investors will have a lot of event risk to chew over this week. A slew of central bank meetings - the Fed on Wednesday followed by the Bank of England, Bank of Japan and Swiss National Bank all on Thursday - provide opportunities for policymakers to respond to the rising trends in global growth and inflation. Only the Fed is expected to make a change, though, delivering a now fully priced rate hike. Throw in the Dutch elections on Wednesday and the G20 finance ministers meeting in Germany at the end of the week and there are plenty of potentially market-moving headlines that can hit the tape. While there has been selling pressure on all global bonds during the bear phase since last July, U.S. Treasuries still remain most exposed to additional losses in the near term given the combination of improving growth, booming asset markets, a whiff of Trumpian "animal spirits" and a Fed that still appears to be playing catch-up to the overall positive U.S. macro backdrop. A bigger potential move in yields could occur if and when the European Central Bank (ECB) shifts to a less accommodative monetary stance - a taper of asset purchases first, not a rate hike, in our view - although that will likely require more evidence that medium-term Euro Area inflation expectations are sustainably moving back to the ECB's 2% target (Chart of the Week). For now, we continue to see a more negative near-term environment for U.S. Treasuries over core European debt, and a more positive environment for U.S. corporate bonds than European equivalents. As we have discussed in recent Weekly Reports, the time is coming for a shift out of core European government debt into U.S. Treasuries, although we prefer to wait for that switch until after the French elections. After the recent back-up in U.S. High-Yield spreads that has restored some value to junk bonds, however, we are upgrading our allocation to U.S. High-Yield this week to above-benchmark, while downgrading Euro Area Investment Grade corporate bonds to neutral from above-benchmark. Simply put, we prefer to take our growth-sensitive spread risk in U.S. corporates over European equivalents. Fed Vs. ECB: Dawn Of Hawkish? Some investors and financial media pundits have been asking if the Fed has fallen "behind the curve" with regards to U.S. monetary policy, especially after another solid Payrolls report and with U.S. inflation expectations holding firm despite a pullback in oil prices. In our view, being a little bit behind the curve is exactly where the Fed wants to be, allowing the economic upturn to blossom and inflation expectations to continue drifting towards the Fed's 2% target. We do not anticipate that the Fed will shift to a more aggressively hawkish stance this week, with no signal that rates will rise in 2017 more than is currently projected (three times by year-end). However, we do expect some acknowledgement of the positive macro backdrop both in the U.S. and abroad, justifying the need to move sooner by hiking now. This is especially true with the U.S. dollar still well off the 2017 peak and not providing much of a tightening in monetary conditions that could postpone a Fed rate hike. Any surprise shift higher in the Fed's interest rate projections (the "dots") would not be taken well by the Treasury market, particularly after last week's European Central Bank (ECB) meeting where a message that was merely less dovish than expected sent European bond yields sharply higher. A more hawkish shift by either central bank would be premature right now, as bond markets are not yet signaling that significantly higher real interest rates are necessary. It is important to note that most of the rise in Treasury yields since last July, and virtually all of the rise in German Bund yields, has come from rising inflation expectations rather than higher real yields (Chart 2 & Chart 3). Also, the market expectation for the real terminal policy rate - where interest rates should end up at the end of the tightening cycle - remains around 0% in the U.S. and -1% in Europe, using our proxy measure of the 5-year Overnight Index Swap (OIS) rate, 5-years forward minus the equivalent forward inflation rate from the TIPS and CPI swap markets (bottom panel of both charts). In other words, markets are only expecting a cyclical rise in interest rates in response to faster inflation, not a structural rise in interest rates because of faster potential economic growth. Chart 2Rising Inflation Explains ##br##Most Of The Rise In U.S. Yields... Chart 3...And All Of The Rise##br## In European Yields On that front, the winds are shifting in a fashion that is more bearish for Treasuries, at least in the near term. In Chart 4, we show the relationship between inflation expectations and oil prices for the U.S. and Euro Area. As can be seen in the bottom panel, the correlation between oil and expectations remains high in the Euro Area, but has fallen to zero in the U.S., where inflation expectations are increasingly influenced by domestic price pressures (i.e. rising wage growth and faster core inflation). Chart 4U.S. Inflation Now Not Just About Oil, ##br##Unlike Europe This remains a key element underpinning of our current below-benchmark call on U.S. Treasuries, particularly versus core European bonds. U.S. yields are likely to have more upside from higher inflation expectations with the Fed likely to stay as accommodative as possible by hiking rates at a slower pace than inflation is rising. At some point, monetary policy will become restrictive, particularly if the U.S. dollar bull market resumes with gusto as the Fed is delivering additional rate hikes and expectations for U.S. growth and inflation moderate, capping the current cyclical rise in Treasury yields. We are still some time away from that point, however. Bottom Line: The Fed will deliver another rate hike tomorrow, but we do not expect a signal that a higher trajectory for the funds rate is necessary. The Fed wants to see higher inflation expectations, and will remain as accommodative as possible until that happens. Maintain a below-benchmark allocation to U.S. Treasuries within global fixed income portfolios. ECB Begins The Path To Tapering The ECB last week put a relatively positive spin on the Euro Area economy, while declaring that the worst of the deflationary pressures have passed. President Draghi sounded less downbeat on the Euro Area economy than he has for some time, citing the broadening Euro Area economic upturn that was pushing down unemployment and absorbing economic slack. The ECB only slightly raised its growth forecast for 2017 and 2018, though, raising both figures by 0.1 percentage points to 1.8% and 1.7%, respectively. This would still be sufficient to remove additional slack from the economy, with the ECB currently estimating trend growth of around 1% in the Euro Area. A look at the details of those projections showed that real consumer spending is only expected to grow by 1.4% this year and next, even as the Euro Area unemployment rate is projected to fall below 9% in 2018 on the back of steady job gains. Capital spending is also expected to pick up in the next couple of years, but the projections were downgraded slightly from previous forecasts. These numbers seem a bit too cautious compared to the recent improvements seen in consumer and business confidence in the Euro Area (Chart 5), and to the more positive tone on the economy expressed in the ECB policy statement and in Draghi's press conference following the meeting. Perhaps this is simply central bank prudence at work, particularly in an environment where there is still considerable uncertainty about politics within the Euro Area and global trade in the Trumpian era. Whatever the reason, it now seems likely that growth will at least match, if not exceed, the relatively low bar set by the ECB. This is important, as the central bank is already projecting that the Euro Area will reach full employment by 2019, when the unemployment rate is projected to fall to 8.4%. The ECB expects wage pressures to rise as a result, helping boost core inflation up to 1.8% within two years (Chart 6). This would be consistent with the rising path of interest rates currently discounted in the Euro Overnight Index Swap (OIS) curve where rates are now expected to start going up in the middle of next year, with the negative rate era ending in 2019 (bottom panel). Chart 5ECB Too Pessimistic On ##br##Euro Area Growth? Chart 6ECB Will Not Hike Rates Before ##br##Full Employment Is Reached The ECB knows that interest rates will have to rise if its core inflation forecast pans out, as this would almost certainly mean that headline inflation and inflation expectations would be at the ECB target of "at or just below" 2%. Yet it is still too soon to discuss that scenario, with core inflation struggling to surpass 1% and the 5-year CPI swap rate, 5-years forward at similar levels. The ECB did slightly alter its forward guidance in its policy statement to suggest that it was now much less likely that additional monetary easing would be needed to boost growth, and that it would no longer be necessary to use "all instruments" to fight deflation in Europe. This was taken as a hawkish surprise by the markets, particularly after media reports indicated that some members of the ECB discussed raising interest rates before the tapering of the ECB's asset purchases. As we discussed in our previous Weekly Report, the current backdrop in Europe looks similar in many respects to the U.S. prior to the "Taper Tantrum" episode in 2013.1 We see the ECB following a similar path to what the Fed did during the Tantrum, by signaling a tapering of asset purchases several months in advance, then raising interest rates after the taper is complete. Many clients have asked us if it is possible for the ECB to raise short-term interest rates before starting a tapering of asset purchases. This question also came up at last week's ECB meeting, and President Draghi reiterated the view that rates would be expected to "remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases." This fits with the ECB's unemployment and inflation scenarios, which do not project a return to full employment - which would justify a rate hike - until 2019. A rate hike too soon would result in an unwanted tightening in financial conditions in Europe that could threaten the current economic upturn. We do not believe that investors could neatly separate the impact of a rate hike from that of a taper. A tightening is a tightening, as can be seen in the strong correlation of our Euro Area months-to-hike measure and the term premium on 10yr German Bund yields in recent years (Chart 7).2 If the ECB were to deliver a rate hike, even a modest one of less than the typical 25bp increment, while maintaining the current pace of bond buying, it would send a contradictory message given the ECB's benign inflation outlook for the next couple of years. Clearly, the market is already a bit confused, as the months-to-hike has been rapidly declining, even as shorter-dated bond yields in core Europe stay low and the term premium on longer-dated government debt has stopped rising. We still see a taper next year as a more likely scenario, to be announced at the September 2017 ECB meeting, with a rate hike to occur within 6-12 months of the completion of the taper. This would allow the ECB to reduce the pace of monetary expansion in line with a less deflationary backdrop in Europe, while leaving the rate hike for a more traditional move when full employment is reached in 2019. In Chart 8, we present some potential tapering scenarios and what it would mean for the growth rate of the ECB's monetary base. We show the base case for this year of €60bn/month in asset purchases that ends in December (a "full-stop" with no tapering), along with alternative scenarios of a pace of tapering that reduces the bond buying to zero within six months (i.e. a €10bn/month reduction until June 2018) and with a full taper over 12 months (i.e. a €5bn/month reduction until December 2018). We also show an additional scenario where the ECB decides to extend the asset purchases into 2018 at the same current pace of €60bn/month. Chart 7A Rate Hike Before Tapering ##br##Is A Confusing Message Chart 8Taper Or Not, ECB Effect ##br##On Bund Yields Fading... The bottom panels of Chart 8 show the annual growth rate of the monetary base under the different scenarios, and how that maps into longer-term German bond yields through a widening term premium. Importantly, the growth rate of the ECB's monetary base would decelerate even if there was no taper next year, which would put upward pressure on European bond yields. Unless the ECB is willing to raise the pace of bond buying next year, which would only occur if there was an unexpected downturn in the Euro Area economy before full employment is reached, then the writing is on the wall for Euro Area government bond yields. They are moving higher. The same goes for Peripheral European debt and even Euro Area Investment Grade corporate debt, which the ECB has also been buying. A slowing pace of ECB buying will put upward pressure on both yields and spreads next year (Chart 9), although a better Euro Area economy that improves corporate profits and tax revenues will help mitigate the rise in yields. It is possible that the ECB could alter the composition of its purchases while tapering, choosing to continue to buy more shorter-dated bonds to limit the potential of an unwanted rise in the Euro. As can be seen in Chart 10, the typical indicators that correlate to the EUR/USD currency pair - the relative balance sheets of the Fed and ECB, and the 2-year interest rate differential between European and U.S. interest rates - are still pointing to an extended period of Euro weakness. It would take a combination of rate hikes in Europe and rate cuts in the U.S. to turn EUR/USD around on a sustainable basis. While the tapering announcement will likely push the Euro immediately higher, such a move will not last without a more fundamental change in relative interest rates. Chart 9...And For European ##br##Spread Product, Too Chart 10Tapering Will Not Sustainably ##br##Boost The Euro Bottom Line: The ECB opened to door slightly to a less-accommodative policy stance last week, although the talk of a rate hike is premature. A 2018 taper is the more probable scenario, likely to be introduced at the September 2017 policy meeting. This will raise longer-dated European bond yields and widen spreads for both Peripheral European government debt and Euro Area corporate bonds. Reduce Euro Area Investment Grade to below-benchmark. The Value Is Back In U.S. High-Yield One of our key themes for 2017 is that the uptrend in the U.S. High-Yield default rate is due for a pause.3 With the first quarter of the year nearly complete, all the indicators that make up our U.S. Default Rate Model are showing noticeable improvement (Chart 11). Interest coverage remains elevated A strong U.S. Manufacturing PMI points to a rebound in after-tax cash flow Lending standards have rolled over and are now just barely in "net tightening" territory An improving sales/inventory ratio portends a return to positive industrial production growth Job cut announcements have fallen back to 2011 levels on a trailing 12-month basis Chart 11Default Rate Indicators Are Showing Improvement Meantime, even though the default outlook continues to improve, junk spreads have actually widened during the past couple of weeks. The average option-adjusted spread on the Bloomberg Barclays U.S. High-Yield index has widened from a low of 344bps up to 378bps (Chart 12). Some of that spread increase is likely attributable to declining oil prices, as energy sector credits have indeed underperformed the overall index. However, the underperformance of the energy sector did start before the sharp drop in oil prices (Chart 12, bottom panel). In any event, our commodity strategists are not expecting the current decline in oil prices to persist and their estimates show that the oil market has recently shifted from an environment of excess supply to one of excess demand. U.S. crude oil inventories are poised to decline later this month and the OPEC / non-OPEC production deal negotiated by the Kingdom of Saudi Arabia and Russia at the end of last year should be met with high compliance.4 If this view is correct, then the energy sector will not drag overall junk spreads wider in the months ahead. The combination of wider junk spreads and an improving default outlook has led to an increase in our preferred gauge of value for high-yield bonds - the default-adjusted spread (Chart 13). The default-adjusted spread is calculated by subtracting an ex-ante estimate of default losses from the average spread on the Bloomberg Barclays U.S. High-Yield index. Chart 12Energy Contributed To Junk Sell-Off Chart 13Some Value Returns To High-Yield To arrive at an estimate of default losses we use the Moody's baseline forecast for the default rate and our own forecast for the recovery rate based on the historical relationship between recoveries and defaults. With the release of February's default report, the Moody's baseline default rate forecast fell to 3.14% for the next 12 months. Based on this forecast, we estimate that the recovery rate will be 44%. Combining the default and recovery rate forecasts gives an estimate for default losses of 3.14% x (1- 0.44) = 176bps for the next 12 months. Since the average option-adjusted spread of the Bloomberg Barclays U.S. High-Yield index is currently 378bps, we calculate the default-adjusted spread to be: 378 bps - 176bps = 202bps. A default-adjusted spread of 202bps is 60bps higher than the reading of 142bps that prevailed just last week. This 60bps spread advantage makes a considerable difference in terms of projected excess returns. Chart 14 shows the relationship between 12-month excess returns and the starting default-adjusted spread. We observe a reasonably strong correlation and note that, using a linear regression, an extra 60bps of spread translates to an extra +251bps of excess return on average over a 12-month period. Chart 1412-Month Excess High-Yield Returns Vs. Ex-Ante Default-Adjusted Spread (2002 - Present) Table 1 provides more detail in terms of what excess returns have historically been associated with different levels of the default-adjusted spread. We see that when the default-adjusted is between 100 bps and 150bps, high-yield bonds earn positive excess returns 64% of the time over the following 12 months. When the default-adjusted spread is between 200bps and 250bps, high-yield earns a positive 12-month excess return 71% of the time. Table 112-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Given our upbeat assessment of the trend in defaults and a wider junk spread than we have seen in a while, we think it is a good time to upgrade high-yield from neutral to overweight. The key near-term risk to this view is that the Fed will be more hawkish than we anticipate at this week's meeting. If the Fed's median forecast is revised up to four hikes in 2017, then it is possible that the recent bout of junk spread widening will have a bit further to run. However, given still-low inflation readings, the Fed would eventually be forced to back away from its hawkish rhetoric and support renewed spread tightening. In our view, the main risk to upgrading junk this week is that we are a bit too early. Bottom Line: U.S. junk bond spreads have widened even though default rate indicators continue to show improvement. With valuations now looking more attractive, we upgrade U.S. High-Yield from neutral to overweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Will The Hawks Walk The Talk?", dated March 7, 2017, available at gfis.bcaresearch.com 2 Last week, we presented the Euro Area months-to-hike measure. We discovered that our measure was not calibrated for the current era of negative interest rates in Europe, and the months-to-hike indicated was actually signaling the "months until interest rates turned positive." We have since corrected our methodology to show the months until one full 25bp rate hike was priced in from the current negative levels, which is what is shown in Chart 7 of this report. This does not change the direction of the months-to-hike indicator, but it does bring forward to date of the first rate hike versus what was presented last week. 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, "Fed's Pre-Emptive Hike Will Hit Gold, Not Oil", dated March 9, 2017, available at ces.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 Monetary Policy: The Fed will lift rates this week, but will likely leave its median forecast for three hikes this year unchanged. With inflation still below target the Fed has an incentive to take it easy. Curve steepeners, TIPS breakeven wideners and overweight spread product positions will benefit. Duration: The growth outlook is improving and the 10-year Treasury yield could soon move higher, breaking out of its recent trading range. An already elevated economic surprise index should not be a deterrent. High-Yield: Junk spreads have widened even though default rate indicators continue to show improvement. With valuations now looking more attractive, we upgrade high-yield from neutral to overweight. Feature Chart 1How Much Hawkishness ##br##Can Markets Take? In early November, just prior to the U.S. election, money markets were still only discounting one rate hike before the end of 2017. The Fed has already raised rates once since then and the market is now almost priced for another three hikes before year-end (Chart 1). Encouragingly, financial markets digested the shift up to two 2017 rate hikes without much of a hiccup - the yield curve steepened, TIPS breakevens widened and junk spreads tightened - but the journey from two to three hikes has not gone down quite as easily (Chart 1, bottom panel). The yield curve has now started to flatten, breakevens have leveled off and junk spreads have edged wider. The worry is that a further shift in expectations - from three to four hikes in 2017 - might cause markets to choke. Fed Will Take It Slow Markets are already priced for a rate hike at this week's FOMC meeting along with no change to the Fed's median forecast for three hikes in 2017. As such, we would not expect much of a market reaction if that outcome is delivered. If the Fed were to increase its median forecast from three to four hikes in 2017, then we would anticipate at least some tightening of financial conditions. In other words, we would expect the yield curve to flatten, TIPS breakevens to narrow, the dollar to strengthen and credit spreads to widen. As we have written several times,1 with core inflation and TIPS breakevens still below target, the Fed must ensure that the economic recovery continues. It will therefore be quick to back away from any nascent hawkishness if financial conditions start to tighten. With markets already showing some signs of stress, we expect the Fed to err on the side of caution this week. This means the Fed will lift rates, but also leave the median forecast of three 2017 rate hikes unchanged. This notion that the Fed should be lifting rates, but only very slowly, is confirmed by our Fed Monitor (Chart 2). The Fed Monitor is a composite of 32 indicators that track the evolution of U.S. economic growth, inflation pressures and financial market conditions. Historically, a positive reading from the monitor has coincided with rate hikes, and vice versa. Chart 2BCA Fed Monitor Suggests A Slow Pace Of Rate Hikes The Fed Monitor just recently moved above zero, suggesting that only modestly tighter monetary policy is required. As an aside, we view the strongly positive readings from the Fed Monitor in 2011 and 2012 as anomalous and an artifact of the zero-lower-bound on interest rates. Since interest rates could not be lowered as much as would have been necessary (according to the Fed Monitor) in 2009, they also could not be raised as quickly as the monitor suggested in 2011. With the base effects from the financial crisis now out of the data, the Fed Monitor should go back to providing a useful signal about the future course of monetary policy. Chart 3BCA Fed Monitor Components We gain further insight from splitting the Fed Monitor into its three key components: growth, inflation and financial conditions (Chart 3). The growth component has accelerated strongly into positive territory but the inflation component still suggests that an easy policy stance is required. Financial conditions are also consistent with modest Fed tightening but have ticked down in recent weeks as the market has discounted a more rapid pace of hikes. Judging from the prior two cycles, an acceleration of the inflation component will be necessary for the Fed to deliver on its current expected path of rate hikes. While the Fed has sometimes started to lift rates with the inflation component below zero, that component has always surged into positive territory soon after hikes began (Chart 3, panel 2). While economic growth is accelerating, below-target inflation means that the Fed must continue to nurture the economic recovery. Investors should position for a steeper curve, wider TIPS breakevens and tighter credit spreads until inflationary pressures are more pronounced. This means at least until long-maturity TIPS breakevens reach the 2.4% to 2.5% range and core PCE inflation is firmly anchored around 2%. Bottom Line: The Fed will lift rates this week, but will likely leave its median forecast for three hikes this year unchanged. With inflation still below target the Fed has an incentive to take it easy. Curve steepeners, TIPS breakeven wideners and overweight spread product positions will benefit. Consolidation Complete? The 10-year Treasury yield has been stuck in a tight range below 2.6% since mid-December (Chart 4), but recent trends in the economic data suggest that it could be on the verge of breaking through this key resistance level. Economic surprises are positively correlated with changes in the 10-year Treasury yield and currently appear extended (Chart 4, bottom panel). While not a mean-reverting series by construction, economic surprises tend to follow a mean reverting pattern because investors revise their expectations higher as the economic data outperform. Eventually, expectations are bound to become excessive and the series will mean revert. However, we have found that economic surprises are usually first reflected in Treasury yields. In fact, changes in the 10-year Treasury yield tend to lead the economic surprise index by several weeks. This means that stagnant yields during the past few months have already foreshadowed a reversal in the surprise index. In other words, some mean reversion in economic surprises is already in the price and should not prevent yields from rising in the coming weeks. More important is that economic growth should be sustainably above trend on a 6-12 month horizon. This will continue to put upward pressure on inflation and ensure that the Fed remains in a rate hike cycle. Judging from recent data, not only is growth sustainably above trend, but it is probably even accelerating. Last week's February employment report showed that nonfarm payrolls rose by 235k, the second consecutive month of gains above 200k. The rate of change of employment growth is now threatening to reverse the downtrend that started in early 2015, and aggregate hours worked have accelerated suggesting that GDP growth will be strong in Q1 (Chart 5). Chart 410-Year Yield Facing Resistance Chart 5Labor Market Points To Stronger Growth... Financial conditions are also supportive of a further acceleration in growth. We found that the financial conditions component of our Fed Monitor provides a strong indication of near-term trends in GDP growth (Chart 6). This highlights that growth should be strong during the next few months but also that the Fed must respond to any tightening in financial conditions if it wants growth to remain robust. Chart 6...So Do Financial Conditions Bottom Line: The growth outlook is improving and the 10-year Treasury yield could soon move higher, breaking out of its recent trading range. An already elevated economic surprise index should not be a deterrent. The Value Is Back In High-Yield One of our key themes for 2017 is that the uptrend in the high-yield default rate is due for a pause.2 With the first quarter of the year nearly complete, all the indicators that make up our Default Rate Model are showing noticeable improvement (Chart 7). Chart 7Default Rate Indicators Are Showing Improvement Interest coverage remains elevated A strong Manufacturing PMI points to a rebound in after-tax cash flow Lending standards have rolled over and are now just barely in "net tightening" territory An improving sales/inventory ratio portends a return to positive industrial production growth Job cut announcements have fallen back to 2011 levels on a trailing 12-month basis Meantime, even though the default outlook continues to improve, junk spreads have actually widened during the past couple of weeks. The average option-adjusted spread on the Bloomberg Barclays High-Yield index has widened from a low of 344 basis points up to 378 bps (Chart 8). Some of that spread increase is likely attributable to declining oil prices, as energy sector credits have indeed underperformed the overall index. However, the underperformance of the energy sector also started before the sharp drop in oil prices (Chart 8, bottom panel). In any event, our commodity strategists are not expecting the current decline in oil prices to persist and their estimates show that the oil market has recently shifted from an environment of excess supply to one of excess demand. U.S. crude oil inventories are poised to decline later this month and the OPEC / non-OPEC production deal negotiated by the Kingdom of Saudi Arabia and Russia at the end of last year should be met with high compliance.3 If this view is correct, then the energy sector will not drag overall junk spreads wider in the months ahead. The combination of wider junk spreads and an improving default outlook has led to an increase in our preferred gauge of value for high-yield bonds - the default-adjusted spread (Chart 9). The default-adjusted spread is calculated by subtracting an ex-ante estimate of default losses from the average spread on the Bloomberg Barclays High-Yield index. Chart 8Energy Contributed To Junk Sell-Off Chart 9Some Value Returns To High-Yield To arrive at an estimate of default losses we use the Moody's baseline forecast for the default rate and our own forecast for the recovery rate based on the historical relationship between recoveries and defaults. With the release of February's default report, the Moody's baseline default rate forecast fell to 3.14% for the next 12 months. Based on this forecast we estimate that the recovery rate will be 44%. Combining the default and recovery rate forecasts gives an estimate for default losses of 3.14% x (1- 0.44) = 176 bps for the next 12 months. Since the average option-adjusted spread of the Bloomberg Barclays High-Yield index is currently 378 bps, we calculate the default-adjusted spread to be: 378 bps - 176 bps = 202 bps. A default-adjusted spread of 202 bps is 60 bps higher than the reading of 142 bps that prevailed just last week. This 60 bps spread advantage makes a considerable difference in terms of projected excess returns. Chart 10 shows the relationship between 12-month excess returns and the starting default-adjusted spread. We observe a reasonably strong correlation and note that, using a linear regression, an extra 60 bps of spread translates to an extra +251 bps of excess return on average over a 12-month period. Chart 1012-Month Excess High-Yield Returns Vs. ##br##Ex-Ante Default-Adjusted Spread (2002 - Present) Table 1 provides more detail in terms of what excess returns have historically been associated with different levels of the default-adjusted spread. We see that when the default-adjusted is between 100 bps and 150 bps, high-yield bonds earn positive excess returns 64% of the time over the following 12 months. When the default-adjusted spread is between 200 bps and 250 bps, high-yield earns a positive 12-month excess return 71% of the time. Table 112-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Given our upbeat assessment of the trend in defaults and a wider junk spread than we have seen in a while, we think it is a good time to upgrade high-yield from neutral to overweight. The key near-term risk to this view is that the Fed will be more hawkish than we anticipate at this week's meeting. If the Fed's median forecast is revised up to four hikes in 2017, then it is possible that the recent bout of junk spread widening will have a bit further to run. However, given still-low inflation readings, the Fed would eventually be forced to back away from its hawkish rhetoric and support renewed spread tightening. In our view, the main risk to upgrading junk this week is that we are a bit too early. Bottom Line: Junk spreads have widened even though default rate indicators continue to show improvement. With valuations now looking more attractive, we upgrade high-yield from neutral to overweight. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see Commodity & Energy Strategy Weekly Report, "Fed's Pre-Emptive Hike Will Hit Gold, Not Oil", dated March 9, 2017, available at ces.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Feature Dear Client, Instead of our usual weekly report, we are sending you a report written by my colleague Matt Gertken, Associate Editor of BCA's Geopolitical Strategy service. In this piece, Matt argues that there is more than a 50% chance that the Border Adjustment Tax (BAT) will pass and Donald Trump's support will be the decisive factor. There are also high chances that trade retaliation would unfold likely detracting from the trade benefits of the proposed tax. In addition, given the likelihood of the BAT implementation, we are highlighting U.S. equity sector investment implications and ranking industries on three variables: taxes, margins and foreign sales exposure. We trust that you will find this Special Report useful and insightful. Best Regards, Anastasios Avgeriou There are good chances that the border adjustment tax (BAT) will pass as the House GOP has a governing trifecta. Trump has not yet endorsed the BAT, which will be critical, and carve-outs will likely be made to reduce the impact on low- and middle-income households. Still, we can draw some sectoral implications from the known GOP proposal. While a lot of ink has been spilled on potential direct winners and losers from the BAT and what is priced in by the markets, we focus our sector analysis on the sweet spot of tax rates, profit margins and international sales exposure. Chart 1 shows a Venn diagram of these three factors, with the overlap representing the optimally positioned sector. We deem that industries with a combination of high tax rates, high profit margins and low or no foreign sales exposure will be prime beneficiaries of the BAT. Chart 1Sweet Spot At first glance this backdrop may appear counterintuitive, especially the international revenue exposure angle, given the preferential treatment that exporters would receive with the BAT implementation. Almost immediately upon Trump's election and news of BAT the market bought companies/industries with negative net import share and discarded sectors with high net import content (Chart 2A & Chart 2B). Chart 2AInvestors Have Been... Chart 2B... Preferring Exporters To Importers Watch The U.S. Dollar And Emerging Markets Nevertheless, what is worrisome is the market's neglect of a U.S. dollar knee jerk appreciation as our sister Global Investment Strategy service outlined in the January 20th Special Report titled: "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017." Chart 3U.S. Dollar And EM Risks It is difficult to fathom why a greenback surge will not be disruptive especially for the emerging markets (EM) and U.S. cyclical sector proxies trading in tandem with EM. According to the Bank for International Settlements, U.S. "Dollar credit to non-banks outside the United States reached $9.8 trillion at end-Q2 2015. Borrowers resident in EM accounted for $3.3 trillion of this amount, or over a third."1 The EM still have a large stock of U.S. dollar denominated debt to service, both interest payment and principal repayments/refinancing (Chart 3). While the FX straight jacket is not in place as in the 1990s, at least a mini EM crisis seems inevitable if the trade-weighted U.S. dollar moved up 10% from current levels as is likely owing to a BAT. Keep in mind that recent U.S. dollar moves of a similar magnitude (as in 2015), (Chart 3) have been rather unsettling, causing tremors in the EM that reverberated across the globe. Tack on uncertainty surrounding the Chinese renminbi that would only aggravate the U.S. dollar's rise and factors are falling into place for another troublesome EM episode. As a result, global final demand may come under pressure and U.S. exporters may initially suffer more than they benefit from the export subsidy they would enjoy. Another U.S. dollar induced global manufacturing recession would bode ill for U.S. cyclicals exposed to the EM. A Few Words On Manufacturing While the intent of bringing back manufacturing jobs to U.S. shores is appealing, practically it will prove very difficult. Developed economies are services oriented economies with manufacturing dwindling toward 10-15% of GDP (Chart 4). Moreover, the U.S. is a closed economy dominated by PCE comprising 70% of the overall economy. Thus, shifting the U.S. more toward a net export driven economy is also likely to prove challenging. Chart 4Tough To Shift The U.S. Economy's Profile Chart 5Will Capex Revive? Finally, manufacturing is tightly linked to capital expenditures and a recent post by the Atlanta Fed2 tried to shed some light as to why investment in the U.S. has lagged especially versus previous recoveries when the economy was near full employment (Chart 5 & Table 1). Interestingly, the biggest hindrance against boosting capex has been lack of skilled labor, and not the lack of financing or poor sales outlook or low return on investment for example. In fact the larger the firm (in terms of sales) the more pronounced the inaccessibility to qualified staff as a factor constraining investment. While tax reform aims to boost capex by accelerated depreciation schedule in the first year, it does not address the small business complaint of inability to find skilled labor. Table 1Impact Of "High Pressure" Labor Conditions On Capital Spending BAT Winners Therefore, we would want to bulletproof the portfolio by identifying industries that would do well owing to the BAT and resulting U.S. dollar appreciation. U.S. domestic services oriented firms fit the bill, and there is room for sizable outperformance if our thesis proves accurate. Chart 6 highlights 47 sub-industries from 9 GICS1 sectors (energy & materials are excluded) that we singled out that satisfy the domestic and services oriented prerequisite (See Appendix on page 8 for more details). U.S. manufacturers with little or no foreign sales exposure would also stand to get an earnings boost, especially relative to the broad market and to their internationally geared peers. Homebuilders, select construction materials and building products companies would be included in this category. Energy is a special case (please refer to Box 1 on page 6). Meanwhile, high profit margin businesses with sticky pricing power and high effective tax rates also come out on top of our analysis as these outfits would benefit more from overall tax reform. Table 2 shows the top 11 sectors in the S&P 500 on the three metrics. Chart 6Buy Domestic Services Table 2 Health care, utilities, and telecom services score well on all three counts. Real estate and financials also get high marks. In contrast, technology, materials, energy and industrials get poor grades on most of our metrics, with the balance of sectors falling somewhere in between. Box 1 Energy Is A Special Case Chart 7U.S. Remains A Net Importer Of Oil The energy sector is a special case. The U.S. still imports north of 7 MMb/d of oil and represents about 10% of the trade deficit (Chart 7). Were energy to be included in the BAT legislation, WTI crude oil prices would likely shoot higher by ~$10/b as U.S. oil consumers (refiners) would seek to avoid the $10+ BAT on imported light sweet crude by buying domestic oil, and U.S. oil producers would try to benefit from the export subsidy. U.S. exploration & production companies and energy servicers would be clear winners, while refiners would be losers. Nevertheless, the dollar jump would be an offsetting factor. Given the outsized impact on the consumer (gasoline price inflation sapping discretionary spending power) and the close political and energy-security relationship with Canada (60% of net U.S. petroleum imports), there is a high likelihood that energy would be exempt from the BAT. In fact, small and medium businesses (SME) would disproportionately benefit from lower corporate taxes especially compared with S&P 500 constituents that are privileged with a lower effective tax rate. Large capitalization multinationals with sizable foreign sourced sales/profits already use the "double Irish" or "Dutch sandwich" to bring down their tax bills. Keep in mind that SMEs also tend to have low or no foreign sales exposure insulating them from the looming U.S. dollar appreciation. Thus, small caps have a considerable advantage versus their large cap brethren upon implementation of the BAT and general tax reform, and we continue to recommend a small cap tilt in our size bias. For reference purposes Table 3 highlights small cap GICS1 sectors on an operating profit margin and effective tax rate basis. What follows in the appendix is a list of sub-industries per GICS1 sector we have identified that would likely stand to benefit from the BAT implementation assuming a U.S. dollar appreciation. Table 3 Bottom Line: We are comfortable maintaining a defensive versus cyclically exposed portfolio, that would shield us from the BAT implementation, especially if a greenback induced correction materialized in the coming months. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com 1 "Dollar credit to emerging market economies" by Robert Neil McCauley, Patrick McGuire and Vladyslav Sushko, 6 December 2015, Bank for International Settlements, Quarterly Review, December 2015, available at: http://www.bis.org/publ/qtrpdf/r_qt1512e.htm 2 http://macroblog.typepad.com/macroblog/2017/02/can-tight-labor-markets-inhibit-investment-growth.html Appendix Consumer Discretionary Advertising Broadcasting Cable & Satellite Casinos & Gaming Movies & Entertainment Publishing & Printing Restaurants Specialized Consumer Services Consumer Staples Food Distributors Financials Asset Management & Custody Banks Consumer Finance Diversified Banks Insurance Brokers Investment Banking & Brokerage Life & Health Insurance Multi-line Insurance Multi-Sector Holdings Property & Casualty Insurance Regional Banks Health Care Health Care Distributors & Services Health Care Facilities Life Sciences Tools & Services Managed Health Care Industrials Diversified Support Services Environmental & Facilities Services Human Resource & Employment Services Railroads Research & Consulting Services Trading Companies & Distributors Trucking Information Technology Data Processing & Outsourced Services Electronic Manufacturing Services Internet Software & Services IT Consulting & Other Services Real Estate Health Care REITs Hotel & Resort REITs Industrial REITs Office REITs Real Estate Services Residential REITs Retail REITs Specialized REITs Telecommunication Services Alternative Carriers Integrated Telecommunication Services Utilities Electric Utilities Independent Power Producers & Energy Traders Multi-Utilities Highlights The U.S. Border Adjustment Tax is likely to pass; Yet the political pieces are not in place; Trump himself will be the decisive factor; Trade retaliation would detract from trade benefits of the tax; Stay long volatility; small caps versus large caps; and long USD versus EM currencies. Remain short China-exposed S&P 500 stocks, and German exporters versus consumer services. Feature Donald Trump is a trend-setter. After winning the U.S. election on a protectionist platform that played well to voters in the Midwest, Trump has established an anti-globalization brand of politics. His success has revealed the preferences of the American "median voter."3 Other U.S. politicians are taking notice. The "Border Adjustment Tax" (BAT) is part of this new political trend, though it did not originate with Trump. The House GOP leadership has presented it as a response to economic dislocation in the American heartland, which propelled Trump to the White House. Is it protectionism? Yes, and in this analysis we explain why. The rest of the world is highly unlikely to treat the BAT as a standard Value Added Tax (VAT). It will therefore spark trade retaliation unless Congress addresses outstanding issues. So far President Trump is on the fence, and his support is necessary for passage. We think he will ultimately go with the proposal. The prospect of turning the tables on the U.S.'s trade partners, while spurring domestic investment and capital spending, speaks to his core promises to his voters. Trump's support for the plan should be read as a headwind for markets in the short term due to the uncertainties of implementation and trade disputes. If he should oppose the plan, it would be bullish for U.S. stocks in the short term, since it would mean cutting the corporate tax without radically altering the global status quo. It would signal that he is more interested in economic growth and corporate profits than changing the world or balancing the U.S. budget. Why Reform The Corporate Tax System? American policymakers have long struggled with the country's corporate income tax system. Leaving aside party politics, there are three main complaints:4 Corporate tax revenues are weak: Revenues have disappointed as companies have shifted profits to tax havens and used deductions and loopholes to avoid paying the 35% statutory rate. This erosion of the tax base has contributed to budget deficits as well as public dissatisfaction with governing institutions (Chart 1). U.S. companies have lost competitiveness: American businesses are overtaxed relative to their developed-market peers, taking a toll on competitiveness both at home and abroad (Chart 2). The middle class is losing out: U.S. workers are not as well compensated as their developed-market peers and have lost their share of American wealth in recent decades (Chart 3). The corporate tax contributes to this because companies foist the tax onto workers. The Republican Party examined fundamental tax reform in 2005 but could not make progress on it - instead it settled for the Bush tax cuts, which focused primarily on cutting household tax rates.5 Now that the Republicans have control of all three branches of government again, its leaders are attempting broad tax reform anew. The GOP is primarily concerned with corporate competitiveness, but they also need to appease the middle class - the source of the populist angst that supported both Obama and Trump (the former being the Republicans' arch-nemesis, the latter a strange bedfellow). The GOP also wants to raise some revenue to make their desired tax rate cuts "revenue neutral," i.e. somewhat fiscally defensible, at least enough to pass the bill. Enter Paul Ryan, Speaker of the House, and Kevin Brady, Chairman of the Ways and Means Committee, and their "Better Way" tax plan, which proposes a sweeping overhaul of the U.S. tax system.6 The core idea is to pay for tax cuts by transforming the current corporate income tax system into a "destination-based cash-flow tax" (DBCFT) with border adjustability ("border adjustment tax" or BAT for short).7 We will get to the definition of that, but first, what is the ultimate point? The plan would purportedly drive corporate investment and economic growth by allowing companies to write off the expense of new investments immediately, the first year, rather than gradually through depreciation. (Depreciation schedules often mean that the tax write-off barely covers the cost of investment, thereby causing companies to err on the side of risk-aversion.) The plan would also remove the preferential treatment of corporate debt over equity, which is built into the current tax code through the deduction of interest - this change would discourage corporate indebtedness and encourage equity financing. Finally the plan would not allow U.S. companies to write off the expense of imported goods, as currently, and as such is essentially a tax on the U.S. trade deficit. Roughly, it could yield about $108 billion in revenue (assuming a 20% rate on the $538 billion deficit). The BAT is the chief tax uncertainty today for investors. That is because there are few constraints on the GOP passing some kind of corporate tax cut this year. Presidents Reagan, Clinton, and Bush all managed to pass major tax legislation in their first years, and Trump has stronger majorities than Bush did (Table 1). The GOP has been planning tax reform throughout the Obama administration, staffers and think tanks have "off the shelf" plans, and lawmakers know that time is short. There is every reason to think it will happen fast. In recent decades, the average length of time from the introduction of a major tax reform to the president's signature has been five months. Table 1Major Tax Legislation And The Congressional Balance Of Power In other words, Trump and his party would need to have a train wreck to fail to pass something this year. That is not beyond belief! But the overriding question is whether the tax reform will be focused on cutting rates, or transforming the system. Currently, the market seems to think the BAT will go through. A basket of stocks based on potential winners and losers suggests that investors believe it will pass (Chart 4). Meanwhile, however, the share prices of high-tax companies (who should benefit the most if taxes are cut) have fallen back from the pop after Trump's election. This could signal the opposite expectation, or that that investors recognize that many high-tax sectors stand to lose from a tax on imports (Chart 5). There is considerable uncertainty in this measure. We think the Trump administration will ultimately accept the House GOP's BAT proposal. But the road between here and there will be tortuous, as past attempts at tax reform show. We expect dollar volatility, which is relatively restrained at present, to rise as the BAT debate intensifies, given that the proposal is bullish for the greenback (Chart 6). Bottom Line: The Trump administration and GOP would have to be unusually incompetent to fail to achieve tax reform this year. The question is whether it will be mere rate cuts or a radical reform to the tax system as a whole. This is critical to the U.S. and global economy - especially given that the passage of a BAT will intensify trade disputes with the U.S. Why Is A Border Adjustment Tax "Protectionist"? Diagram 1 provides a simple illustration of how the current U.S. corporate tax works compared to the proposed BAT. The current system is a "worldwide" corporate income tax. The U.S. government taxes American companies based on their global profits (global revenues minus global costs). No matter where they incur costs, they can write them off, and no matter where they make profits, they must pay tax on them, at least in principle. Diagram 1Explaining The Border-Adjusted Destination-Based Cash-Flow Tax The new system, by contrast, would be a "destination-based" tax in which the government taxes companies only on domestic profits (domestic revenues minus domestic costs). This means that revenues earned abroad from exports or sales in foreign jurisdictions would be free from tax. However - and here is the tricky part - it also means that costs incurred abroad, imports or purchases in foreign jurisdictions, would be ignored by the tax authority, i.e. they could not be written off like domestic costs. As the "rebate" in the Diagram shows, the BAT is effectively a tax on imports and subsidy to exports. This is not as egregiously protectionist as it sounds at first, because it is very similar to a Value-Added Tax (VAT), which is the dominant tax system across the world. The U.S. is a massive outlier for not having a VAT. But notice that the amount of the rebate to the exporting company in the diagram is higher (at $40) than the amount of tax that would be due if it paid a tax on its foreign profits, since ($200 - $100) x 20% = $20. The WTO may rule against the law if it believes major U.S. exporters will pay net negative taxes as a result of the rebate. Moreover, the BAT has certain differences from a VAT that ensure that the world will see it as a protectionist affront. The BAT is a combination of a VAT, which is a tax on consumption, and an income tax, which is the current system. However, the BAT would allow companies to write off wages and salaries as costs, just like under the current system. Under VAT systems, this is not possible because wages are not consumption and therefore not deductible.8 If the GOP proposal becomes law without addressing this difference - that is, without denying corporates the wage deduction, or taxing them in some other way to compensate - it will likely prompt global trade retaliation. While the World Trade Organization may deem the BAT legal by interpreting it as a VAT, it will not do so if U.S. companies cannot show that they are not getting a leg up on their international rivals by retaining the wage deduction from the former corporate income tax code. Wages are obviously a very large part of a company's expenses. They make up about 68-72% of U.S. companies' costs (Chart 7), and have grown at about 2-4% each year for the export-oriented sector (Chart 8). If U.S. companies can write off the wage expense in their exported goods, then foreign countries will have to adjust, possibly by imposing duties to counteract the share of taxes avoided by that write-off. Bottom Line: The BAT is a hybrid of tax systems. It is likely that the WTO and U.S. trading partners will object to it as an import tax and export subsidy, particularly because of the wage deduction. The House GOP could adjust the proposal ahead of time or afterwards to avoid this conflict, but that has not happened yet. In addition, corporate lobbying against removing wage deductions would be severe. Will A BAT Get Passed Into Law? Currently, the House GOP leaders face a rising wave of criticism about the BAT proposal and have begun to signal greater flexibility in drafting the law so as to win over various stakeholders. A salient point to remember about U.S. tax legislation is that it is very rare in recent decades for a ruling party to bungle it. Only eight pieces of tax legislation have been vetoed by presidents since 1975, only two of which were serious bills, and in both cases the president vetoed the legislation pushed by an opposition-controlled Congress (Table 2). By the time a serious tax bill makes it to the president's desk, a veto is unlikely, especially if the president and Congress belong to the same party. Table 2Major Tax Legislation Is Set Up For Success Even more salient, only 23 pieces of tax legislation since 1975 have been struck down in either of the two houses. Of these, seven were attempts to amend the constitution (not likely to pass), nine were attempts to amend the internal revenue code for highly specific things (spirits, cigars, the holding of conventions on cruise ships). Only seven were major bills, and in only one of these cases did the Senate strike down the bill, which was a case of a Republican Senate defending a Republican president from an opposition Congress. In only one case did the ruling party in the House kill a serious tax bill proposed by one of its own members, but it is not comparable to the tax reform in question today.9 What this means is that the BAT is highly likely to be passed into law if the House remains loyal to its leader Paul Ryan, and to the Ways and Means Committee chair Kevin Brady, the two authors of the BAT proposal. However, Trump could derail Ryan's best laid plans. Trump seemed to throw a wrench in the gears when he cast doubt on border adjustment tax, saying that it was too complicated. However, the Trump administration has recently made comments favorable to the BAT. Peter Navarro, chief of the new National Trade Council, highlighted it as a way to bring manufacturing supply chains back into the U.S. (note the protectionist angle of the comment). Meanwhile Sean Spicer, Trump's spokesman, said it would be a good way to make Mexico pay for the infamous wall to be constructed on the border (again, note that the angle is protectionist and populist, not about balancing the budget).10 In each case, the Trump team has gone to pains to emphasize that the BAT is only one option among many. Yet the fact that they have repeatedly brought it up as a solution to their own populist promises is suggestive. We think Trump will ultimately hew to the Republican Party leadership on tax reform.11 Why? Time's a'wastin': Party control of all three branches is a fleeting boon and 2018 mid-term campaigning would make the BAT harder to pass because it could hike the prices of consumer goods. Republicans have a plan ready to go, the House ultimately controls the purse, and Trump wants to move fast on tax cuts and boosting the economy. Furthermore, Republicans remember how short-lived the Democrats' control of Congress was after 2008. Trump wants to be transformative, not merely transactional:12 Trump was elected in a populist revolution and has vowed to improve American manufacturing and trade. His protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT: remove the "tax" on corporate investment to improve U.S. capital stock and productivity, and remove incentives to locate, operate, and stash profits offshore. There is at least some positive correlation between higher VAT rates and positive trade balances, and the law is simultaneously supposed to boost productivity (Charts 9 and 10). Trump needs domestic and international "legitimacy": His protectionist platform will stand on firmer ground if he adopts policy that is at least debatable at the WTO, as opposed to imposing tariffs willy-nilly through bare executive power, which is eventually vulnerable to congressional and judicial oversight. Domestic courts have already shown an inclination to halt Trump's controversial executive orders.13 By contrast, they would almost certainly defer to Congress even on the most radical tax reforms. Trump needs a tradeoff for infrastructure spending: Unpopular presidents cannot set the legislative agenda.14 But Trump may be able to trade GOP-style corporate tax reform - which offsets tax cuts with new revenue provisions, such as the BAT - in return for infrastructure spending, which the GOP is reluctant to embrace. Trump is willing to lead a crusade against the WTO: This may be a necessary prerequisite for the passage of this bill, and Trump is heaven-sent to play the role. He would be to the WTO what George W. Bush was to the United Nations. It would be disastrous for the U.S.-built international liberal order, but it would give Trump the ability to pursue protectionism while rallying the public around the flag against America's "globalist" enemies. (Sovereignty over taxation is a cause that is hard to beat in the U.S.)15 BAT allows Trump to save face on the "Wall" with Mexico: As the White House spokesman hinted, Trump may use creative accounting to satisfy his promise that Mexico would pay for the wall. Moreover, if Trump comes out in support of the BAT, it will likely get passed: Precedent: President John F. Kennedy's and Jimmy Carter's efforts at tax reform failed because Congress was not supportive, which is not a problem today; whereas Ronald Reagan's personal support for the 1986 tax reform - despite his reservations about the attempt to transform the system and broaden the base - proved critical in helping the bill move through Congress.16 Political science: The political context is a better determinant of presidential success than individual talents, and rising political polarization in the U.S. has created an environment in which "majority presidents," those whose party has a majority in Congress, are even more likely to be successful, while "minority presidents" are more likely to fail on key initiatives. The relevant factors of political context are the party's grip on Congress, the extent of polarization, and, somewhat less significantly, whether the president is in his "honeymoon period" and enjoys public support.17 Of these factors, Trump is only weak on public support, though not among conservatives (Chart 11), who could vote their representatives out of office if they defy Trump on tax reform. The Senate could still cause a serious hang-up. But if Trump and the House GOP stand behind the legislation then Senate Republicans would have to be suicidal to oppose it.18 What about the corporate lobbies that oppose the BAT? Certainly it is highly controversial at home. The tax could hurt import-heavy U.S. businesses and punish citizens with a high propensity to consume - i.e. the poor and elderly, both constituents that make up an important part of Trump's base. But that suggests that there will be carve-outs or phased implementation for key imports like food, fuel, and clothing. Such compromises will be messy, and will mitigate any dollar appreciation and reduce the tax revenues to be gained, but would probably enable the bill to get passed. The opposition of retailers like Wal-Mart and Target is overrated in terms of their power as a lobby. Importers form a slightly larger lobby than exporters, which makes sense given that the U.S. is a net importing economy, but neither of them comprises a large share of total lobbying (Chart 12). The sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart 13). The opposition of the Koch brothers is also overrated, given their unhelpful attitude toward Trump's candidacy for president! Bottom Line: The BAT is a radical plan to spur corporate investment and production in the United States, and that goal matches Trump's vision. Trump will be hard pressed to find a more effective, structural way of achieving his goals. And the two-year window with assured GOP control of government will close faster than one might think. Risks To The View A major risk to the BAT is that Trump will fear the repercussions on his political base of higher consumer prices, as hinted above. Consumer pain is a necessary consequence of his mercantilist vision of rebalancing the U.S. from consumption to investment and bringing down the U.S. trade deficit, so Trump will have to decide whether he means what he says. Moreover, if the dollar rises sharply as a result of the BAT, as expected, it would cause pain for the economy and S&P 500 companies, which source 44% of earnings outside the U.S. According to BCA's Global Investment Strategy, the impact of a much stronger dollar on U.S. assets denominated in foreign currencies could amount to a loss worth of 13% of U.S. GDP! (Not to mention Trump's personal wealth from overseas.) Given the huge uncertainties of a totally new tax system, and potential disruption to the economy, it would be perfectly understandable if Trump refused to hitch his fate as president to this wonkish grand experiment. Further, it is not as if there is no alternative to the BAT. Since Republicans will be humiliated if they fail to deliver on tax cuts, Trump's opposition to the BAT would force the House GOP to go back to good ol' fashioned tax cuts without significant revenue raising measures, and specific add-ons to deal with concerns like corporate inversions. Trump would still likely get the repatriation of overseas earnings, a political win, and the economy would experience an increase in investment from tax rate cuts without the uncertain consequences of deeper change. Ronald Reagan's administration offers a precedent for this sequencing, since he began his term with simple tax cuts in 1981 and only later attempted the dramatic tax overhaul of 1986. There is also a risk that the business lobby against the BAT proves stronger than expected and gains traction in the media and popular opinion as a result of the feared consequences on consumer prices. Tax reform is never going to be easy and will always hang in a precarious balance. These are serious risks, but we think Trump and the GOP will move now rather than make any assumptions about their ability to win subsequent elections and enact massive tax reform. The fact that the GOP controls all three branches of government, the BAT plan is well in the making, and Trump is looking to reshape the American economy in ways that align with the BAT, make the odds of passage higher than 50%. Unfortunately, this also means the world should brace for a sharp spike in trade disputes. Bottom Line: There are plenty of reasons to think the BAT plan could collapse of its own weight. The path of least resistance is certainly not the BAT. But we think the preponderance of power in GOP hands in Washington favors radical change, even if it ends up being a policy mistake. Investment Implications: Trade War The WTO is supposed to presume innocence with a country's laws, and it might also approve the BAT on the basis that proponents argue: the U.S. imposing the BAT is not much different from a VAT country increasing its VAT rate while simultaneously slashing the payroll tax (as France has done under President Hollande's administration). This view is misguided. The WTO will rule on the statute and international trade treaties, not the special pleading of the advocates. It may or may not accept that the BAT is equivalent to a VAT; it may or may not object to the wage deduction as a holdover from the "direct" tax on income. The GOP has not yet introduced a draft law, but given the express intention - in the Ryan plan, not even to mention Trump - to put "America first" with a "pro-America approach for global competitiveness," it seems likely that a clash of interests is in the making. In other words, American proponents of the tax are not even hiding its overt protectionist intentions. The WTO will probably discover a subsidy for U.S. exporters and a violation of the principle of trade neutrality with respect to imports. WTO litigation will take years. When the European Union sued the U.S. over its use of Foreign Sales Corporations, a comparable dispute, the proceedings began in 1999 and the WTO ruled against the U.S. in 2002. Ultimately, the U.S. Congress amended the law to avoid retaliation in 2004.19 Trump and the GOP would be less likely to amend their pet project in the current environment, especially if the litigant is the EU at the WTO! Trump, as mentioned, would be inclined to take the fight to the WTO - he has even threatened to withdraw the United States from it. His support group feeds on conflict with supra-national bodies and he may see foreign retaliation as a convenient reason to impose tariffs of his own. The trade environment would deteriorate in the meantime. In 2002, it was assumed that the U.S. and EU could work out an agreement without punitive measures, but that assumption does not hold today. And it would not only be the EU leveling complaints. In short, the U.S. would face foreign retaliation, during the proceedings and likely as a consequence of the WTO ruling. The Trump administration would attempt to mitigate the blowback through a series of bilateral deals, and perhaps the U.S. law would ultimately be modified, but the entire saga would have a negative impact on global trade. Financial markets had many factors to contend with during this period (like the dot-com bubble), and they will similarly respond to large currents in the coming years aside from any BAT. Nevertheless, the tax would reinforce our themes of global multipolarity, mercantilism, and protectionism - and thus reinforce several of our existing trades: We continue to favor small caps over large caps. Small caps are insulated from global trade, will benefit most from the cut in tax rates, and will suffer least from any appreciation of the dollar. Long volatility - Long VIX 20-25 call spread for expiration in March; Long USD versus short EM currencies; Short China-exposed S&P stocks; Short German exporters versus long consumer services. If Trump comes out in opposition to the BAT, he would send a bullish signal for markets in the short term. It would mean, first, that the U.S. will have corporate tax cuts without the broader uncertainties of the BAT; and second, that Trump is actually a pragmatist who eschews radical change if he thinks it will cause too much trouble for U.S. consumers or economic growth. However, it would not necessarily mean that the U.S. would avoid a trade conflict, given Trump's executive powers.20 Of course, the BAT's failure - which is not our baseline - would also be worse for the deficit and debt, as the GOP tax cuts would have no offsetting revenue increases but would rely purely on creative accounting, "dynamic scoring," to appear fiscally acceptable. This legislation would also likely fail to simplify the tax code as much as the BAT would. Matt Gertken, Associate Editor mattg@bcaresearch.com 3 Please see BCA Geopolitical Strategy, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 4 Please see Alan J. Auerbach, "A Modern Corporate Tax," Center for American Progress, dated December 2010, available at www.americanprogress.org. 5 Please see President's Advisory Panel on Federal Tax Reform, "Final Report," dated November 1, 2005, available at govinfo.library.unt.edu. 6 Please see "A Better Way: Our Vision For A Confident America: Tax," dated June 24, 2016, available at abetterway.speaker.gov. 7 Our colleagues at BCA's Global Investment Strategy have recently provided a very helpful Q&A on the border adjustment tax (BAT), and we would refer readers to that report for a detailed discussion. Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 8 Please see Reuven S. Avi-Yonah, "Back To 1913?: The Ryan Blueprint And Its Problems," Tax Notes 153: 11 (2016), 1367-47, reprinted by University of Michigan, available at www.repository.law.umich.edu. 9 Amo Houghton, a liberal-leaning Republican from New York, proposed the Taxpayer Protection and IRS Accountability Act of 2002, a bill to streamline IRS administration. It failed in the Republican Congress under President Bush. 10 Please see Shawn Donnan, "Trump's top trade adviser accuses Germany of currency exploitation," Financial Times, January 31, 2017, available at www.ft.com, and Bob Bryan, "Trump press secretary says the administration is considering a 20% border tax on Mexican imports to help pay for the wall," Business Insider, January 26, 2017, available at www.businessinsider.com. National Economic Council Director Gary Cohn has also indicated that the BAT is an option but not yet decided upon, see CNBC, "Squawk on the Street," February 3, 2017, available at www.cnbc.com. 11 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 13 The U.S. Ninth Circuit Court of Appeals has already issued a temporary injunction against President Trump's executive orders on immigration. Please see "State of Washington & State of Minnesota v. Trump," available at www.ca9.uscourts.gov. 14 Please see John Lovett, Shaun Bevan, and Frank R. Baumgartner, "Popular Presidents Can Affect Congressional Attention, For A Little While," Policy Studies Journal 43: 1 (2015), 22-44, available at www.unc.edu. 15 Please see BCA Geopolitical Strategy Weekly Reports, "The Trump Doctrine," dated February 1, 2017, and "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 16 Joseph A. Pechman, "Tax Reform: Theory and Practice," The Journal of Economic Perspectives 1:1 (1987), pp. 11-28 (15). 17 Jeffrey E. Cohen, Jon R. Bond, and Richard Fleisher, "Placing Presidential-Congressional Relations In Context: A Comparison Of Barack Obama And His Predecessors," Polity 45:1 (2013), 105-126. 18 The Senate Financial Services Committee's support will be critical. Chairman Orrin Hatch has criticized but not yet declared against the BAT. Even if he does, it would not necessarily kill the deal. One of his predecessors, Senator Bob Packwood, initially opposed the Tax Reform Act in 1986 but was ultimately persuaded to support it. If Hatch and the Finance Committee support the initiative, it will pass the Senate. First, the tax overhaul can be accomplished by "reconciliation," a congressional trick that will enable the GOP to avoid a Senate filibuster and pass the tax reform with a simple majority. Second, the Republicans today have almost exactly the proportion of seats in the Senate as the average in previous examples of successful tax reform (see Table 1). So there would have to be a higher share of Republican defectors than in the past to overturn the bill. This is possible but unlikely if Trump and the House GOP are behind the bill. 19 Please see Congressional Research Service, "A History of the Extraterritorial Income (ETI) and Foreign Sales Corporation (FSC) Export Tax-Benefit Controversy," dated September 22, 2006, available at digital.library.unt.edu. 20 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com.

Highlights U.S. equity valuations are historically high, based on a variety of metrics. However, relative to competing assets and global equity peers, U.S. stock valuations are not an extreme. For U.S.-based investors, our upbeat view on the U.S. dollar implies that efforts to diversify globally may come up short. The Fed will allow its Agency bond and MBS portfolios to run off starting in 2018, but it is much more uncertain whether it will ever cease the reinvestment of its Treasury holdings. Feature The S&P 500 remains near record highs, despite a modest setback last week. And the only period when stocks were more expensive was during the halcyon days of the dot-com bubble. Have stock prices outpaced fundamentals, and if so, how much of a risk does this present over the cyclical horizon? And should U.S. investors look further afield than domestic markets for a relative deal? On a historical basis, it is hard to argue that U.S. equities are anything other than expensive. A preferred valuation metric is the cyclically adjusted P/E ratio (CAPE), see Chart 1. Based on this metric, stocks are expensive, trading at their highest valuation outside of the dot-com bubble. However, valuing equities is a complicated issue, and the CAPE is not without its weaknesses. Examining a broad array of valuation indicators provides a slightly different message; U.S. stocks are expensive in absolute terms based on historic relationships, but are less stretched relative to both other asset classes and other equity indexes. Expensive, But... Our BCA valuation index captures the message from a broad range of metrics in one gauge (Chart 2). The valuation index was constructed using 11 different measures in an attempt to approach valuation from multiple angles. Decomposing the index into its three major components - earnings, balance sheet metrics and yield - show that stocks prices are well into expensive territory in absolute terms based on traditional fundamentals: Chart 1(Part I) U.S. Stocks Are Expensive ##br##Relative To History Chart 2(Part II) U.S. Stocks Are Expensive Relative ##br##To History Earnings Group: There are five inputs to the earnings component of our valuation indicator, including trailing price/earnings ratio, price/sales, market cap as a share of GDP. The second panel of Chart 2 shows that the aggregate of the Earnings Group indicators sits at historical highs, excluding the tech bubble. Balance Sheet Metrics: This component includes measure of the market value of equities relative to corporate net worth, both using market value (replacement cost) and historical cost. This measure of valuation has the same profile as the Earnings Group. Yield Group: The yield group compares the price of stocks to interest rates, nominal and real, government and corporate. Of the three groups, it is this Yield Group that gives a less expensive reading on equities (bottom panel of Chart 2). Overall, the Valuation Indicator is already well into "overvalued territory". There is only one episode since 1970 when the indicator has reached a significantly more extreme reading (the dot-com bubble). ...Not So On A Relative Basis Stocks are expensive on an absolute basis, but are far more appealing in relative terms. The current earnings yield on stocks is well above the real corporate bond yield and corporate bond spreads are historically very tight, despite the erosion in balance sheet health (our corporate health monitor has been deteriorating for several months). And compared to housing returns, stocks look downright cheap (Chart 3). Within the U.S., we expect stocks to be the biggest beneficiary of investment flows in the next year or two, in part because equity market value is the most appealing. Meanwhile, relative to global peers, U.S. equities valuations have been climbing since 2009 (Charts 4 and Chart 5). This eight-year rise in valuations now leaves U.S. P/Es at the higher end of the historical range relative to G10 ex-U.S. equities. U.S. stocks are especially expensive relative to Japanese equities. In any case, standard valuation measures have always been lower in Japan, with the exception of price-forward earnings. As our Bank Credit Analyst monthly publication points out, Japanese companies generally have a much higher interest coverage ratio compared to Corporate America. Nonetheless, they tend to come up short in terms of profitability. Operating margins in the U.S. have typically been double that of Japan. Japan's return-on-equity (RoE) has been dismal because of low levels of corporate leverage and loads of low-yielding cash sitting on balance sheets. Nonetheless, the valuation gap is at an extreme, with Japanese equities appearing to be a screaming value relative to U.S. stocks. Chart 3Stocks Look Less Expensive Relative To Competing Assets Chart 4(Part I) U.S. Outperformance Phase Can Continue Chart 5(Part II) U.S. Outperformance Phase Can Continue A similar, albeit less extreme, valuation case can be made for European stocks relative to the U.S. Eurozone stocks have also almost always traded at a discount to U.S. equities and this continues to be the case. Stocks have gotten even more expensive, more quickly, in the U.S. over the past year. But relative valuations are not near historic extremes. Tack on the fact that BCA's view is that the dollar will continue to appreciate over the next six-twelve months. For U.S.-based investors, the coming rise in the domestic currency implies that efforts to diversify globally may come up short, despite better value in major foreign markets. It is important to note that BCA does not view valuation measures as market timing tools. They are only useful at extremes. The bottom line is that U.S. equities are certainly far from cheap, but are not so expensive in relative terms to warrant an allocation change on this basis. We believe that equity returns should outperform Treasuries, cash and high-quality corporate bonds over the next 1-2 years as the bond bear market plays out. The Fed's Balance Sheet: What's Next? Recently we have received a number of client questions about the Fed's balance sheet and how it will evolve during the next few years. In response, we reprint below work from our U.S. Bond Strategy team, who recently addressed the topic in detail. The Fed's Stated Plan The most up-to-date guidance we have received about the Fed's balance sheet plans comes from Janet Yellen's recent Congressional testimony: "The FOMC has annunciated that its longer run goal is to shrink our balance sheet to levels consistent with the efficient and effective implementation of monetary policy. And while our system evolves and I can't put a number on that, I would anticipate a balance sheet that's substantially smaller than at the current time. In addition, we would like our balance sheet to again be primarily Treasury securities, whereas as you pointed out, we have substantial holdings of mortgage-backed securities." From this, and similar statements from other Fed officials, we conclude that the Fed will allow its balance sheet to shrink once the fed funds rate is somewhere in the range of 1% to 1.5%. Surveys also show that the median primary dealer expects the Fed will change its balance sheet policy when the target fed funds rate is 1.38%. As such, and under reasonable assumptions for the pace of rate hikes, we think it is very likely that the Fed will start to let its balance sheet shrink sometime in 2018. MBS First, Treasuries Maybe Later Yellen's statement to Congress also makes clear that the Fed would be more comfortable with a balance sheet that consists entirely of Treasury securities. For this reason, the central bank will start by simply ceasing the reinvestment of its Agency bond and MBS portfolios. At least initially, the Fed will continue to reinvest the proceeds from its maturing Treasury portfolio. Yellen also left open the possibility that reinvestment could be "tapered" rather than just halted altogether. While this is possible, and in fact 70% of primary dealers think that reinvestments will be phased out over time while only 14% think they will be ceased all at once, it seems to us like a needless complication. We expect that reinvestments of Agency bonds and MBS will end all at once sometime in 2018. As for the Fed's holdings of Treasury securities, it is much less clear whether the Fed will allow these balances to run down. In a Report in 2014,1 we describe in detail the differences between the Fed's pre-crisis mode of operation, when bank reserves were scarce, and the Fed's current mode of operation with large bank reserve balances. As of now, the Fed has stated that it intends to eventually drain bank reserves from the system and return to its pre-crisis mode of operation, but there are several possible advantages to running a system with an outsized Fed balance sheet and large bank reserve balances. None other than Ben Bernanke pointed out a few of those reasons in a blog post last fall.2 In our view, the most compelling is that regulatory changes have increased private sector demand for safe, short-maturity, liquid assets in recent years. If the Treasury department is unwilling to supply T-bills in sufficient numbers, then the Fed can supply safe, short-maturity, liquid assets to the market by purchasing long-maturity Treasury securities and replacing them with bank reserves. Chart 6Reserves Can Be Drained Fairly Quickly Of course, we take the Fed at its word when it says that it would like to eventually drain excess bank reserves from the system. But even in that case, the steady growth of currency in circulation means that bank reserves will decline over time even if the Fed keeps the asset side of its balance sheet flat. For example, Chart 6 shows what would happen to bank reserves if the amount of currency in circulation grows at a conservative 5% per year pace, and if the Fed decides to allow its Agency bond and MBS portfolios to run off at the beginning of next year while keeping its Treasury portfolio flat. We assume that MBS runs off the Fed's balance sheet at a pace of $15 billion per month, slightly below the recent pace of MBS reinvestment. During the past three years, the Fed has reinvested between $20bn and $40bn MBS each month with an average monthly reinvestment of $32bn. In this scenario, outstanding bank reserves would decline to zero by the end of 2025. At that point the Fed would have to start adding to its Treasury holdings just to keep pace with the amount of currency in circulation. Bottom Line: While it is very likely that the Fed will allow its Agency bond and MBS portfolios to run off starting in 2018, it is much more uncertain whether it will ever cease the reinvestment of its Treasury holdings. If the Fed does allow its Treasury holdings to run down as well, it will have to start buying Treasuries again before 2025. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report "Cleaning Up After The 100-Year Flood", dated June 10, 2014, available at usbs.bcaresearch.com. 2 https://www.brookings.edu/blog/ben-bernanke/2016/09/02/should-the-fed-keep-its-balance-sheet-large/