Asset Allocation

Highlights A thorough audit of our trade book highlights that our country and sector allocation recommendations have been quite profitable for investors. Of the 12 active trades in our book, 11 have generated a positive return, including one with a 32% annualized rate of return. A review of the original basis and subsequent performance of our trades suggests that investors should close 6 out of 12 of our active positions, predominantly related to resource & construction and domestic stock market themes. We will be looking for opportunities to add new trades to our book over the coming weeks and months that have broad, "big-picture" relevance. Watch this space. Feature In this week's report we conduct a thorough audit of our trade book, by revisiting the original basis and subsequent performance of all 12 of our active trades. While these trades have been initiated at different points over the past five years, they can be broadly grouped into five different themes: Core Equity Allocation & General Pro-Risk Trades (4 Trades) Reform-Oriented Trades (2 Trades) Resource & Construction Plays (2 Trades) Domestic Stock Market Trades (2 Trades) Trades Linked To Hong Kong (2 Trades) Overall, our trade book performance has been excellent. Of the 12 active trades in our book, 11 have generated a positive return, including one with a 32% annualized rate of return (since December 2015). As a result of our trade book review, we recommend that investors close six trades and maintain six over the coming 6-12 months. The closed trades predominantly fall into the resource & construction and domestic stock market categories, although we also recommend closing our long China H-share / short industrial commodity trade as well as our long Hong Kong REITs / short Hong Kong broad market trade. We present our rationale for retaining or closing each trade below. Over the coming weeks and months we will be looking for opportunities to add new trades to our book. Stay tuned. Core Equity Allocation & General Pro-Risk Trades We have four open core equity allocation and pro-risk trades: Overweight MSCI China Investable stocks versus the emerging markets benchmark, initiated on May 2, 2012 Long China H-shares / short industrial commodities, initiated on March 16, 2016 Short MSCI Taiwan / Long MSCI China Investable, initiated on February 2, 2017 and Long China onshore corporate bonds, initiated on June 22, 2017 We recommend that investors stick with three of these trades, but close the long China H-shares / short industrial commodities position for the following reasons: Chart 1Be Overweight China Vs EM In This Environment Be Overweight China Vs EM In This Environment Be Overweight China Vs EM In This Environment Overweight MSCI China Investable Stocks Versus The EM Benchmark (Maintain) This trade represents one of the most important equity allocation calls for Chinese stocks, and is one of the ways that BCA expresses a view on the Chinese economy in our House View Matrix.1 While it hasn't always been the case, we noted in a recent Special Report that Chinese stocks have become a high-beta equity market versus both the global aggregate and the emerging market benchmark, even when excluding the technology sector.2 China's high-beta nature, the fact that EM equities remain in an uptrend (Chart 1), and our view that China's ongoing slowdown is likely to be benign and controlled all suggest that investors should continue to overweight Chinese stocks vs their emerging market peers. Long China H-Shares / Short Industrial Commodities (Close) We initiated this trade in March 2016, one month after Chinese stock prices bottomed following the significant economic slowdown in 2015. At that time it was not clear to global investors that a mini-cycle upswing in the Chinese economy had begun, and this pair trade was a way of taking a limited pro-risk bet. Given our view of a benign, controlled economic slowdown in China, this hedged trade is no longer needed, especially given the uncertain impact of ongoing supply side constraints in China on global commodity prices. As such, we recommend that investors close the trade, locking in an annualized return of 15.7%. Short MSCI Taiwan / Long MSCI China Investable (Maintain) Chart 2If The TWD Declines Materially, ##br##Upgrade Taiwan (From Short) If The TWD Declines Materially, Upgrade Taiwan (From Short) If The TWD Declines Materially, Upgrade Taiwan (From Short) We initiated our short MSCI Taiwan / long MSCI China investable trade last February, when the risk of protectionist action from the Trump administration loomed large. While there have been no negative trade actions levied against Taiwan this year, macro factors, particularly the strength of the currency, continue to argue for an underweight stance within the greater China bourses (China, Hong Kong, and Taiwan). We reviewed the basis of this trade in a report last month,3 and recommended that investors stick with the call despite significantly oversold conditions (Chart 2). A material easing in pressure on Taiwan's trade-weighted exchange rate appears to be the most likely catalyst to close the trade and to upgrade Taiwan within a portfolio of greater China equities. Long China Onshore Corporate Bonds (Maintain) Chinese corporate bond yields have risen materially since late-2016, largely in response to expectations of tighter monetary policy. These expectations have been validated, with 3-month interbank rates having risen over 200bps since late-2016. We argued last summer that the phase of maximum liquidity tightening was likely over, and that quality spreads and government bond yields would probably drop over the coming three to six months. While this clearly did not occur (yields and spreads rose), the total return from this trade has remained in the black owing to the significant yield advantage of these bonds versus similarly-rated bonds in the developed world. Chart 3 highlights that Chinese 5-year corporate bond spreads are also considerably less correlated with equity prices than their investment-grade peers in the U.S. This underscores that the rise in yields and spreads over the past year has reflected expectations of tighter monetary policy, not rising default risk. Our sense is that barring a significant improvement in China's growth momentum, significant further monetary policy tightening is improbable, meaning that corporate bond yields are not likely to rise much further. As a final point, as of today's report we are changing the benchmark for this trade from a BCA calculation based on a basket of 5-year AAA and AA-rated corporate bonds to the ChinaBond Corporate Credit Bond Total Return Index. Chart 3Chinese Corporate Spreads Aren't A Risk ##br##Barometer Like In The U.S. Chinese Corporate Spreads Aren't A Risk Barometer Like In The U.S. Chinese Corporate Spreads Aren't A Risk Barometer Like In The U.S. Reform-Oriented Trades We have two open trades related to China's rebooted reform initiative, both of which were initiated on November 16, 2017: Long China investable consumer staples / short consumer discretionary stocks and Long China investable environmental and social governance (ESG) leaders / short investable broad market These trades were recently opened, and we continue to recommend that investors maintain both positions: Long China Investable Consumer Staples / Short Consumer Discretionary Stocks (Maintain) The basis for the first trade stems from the current limitations of China's investable consumer discretionary index as a clear-cut play on retail-oriented consumer spending. We argued in our November 16 Weekly Report that Chinese investable consumer staples would be a better play on Chinese consumer spending owing to the material weight of the automobiles & components industry group in the discretionary sector, which may fare poorly over the coming year due to the environmental mandate of President Xi's proposed reforms. We argued in the report that this trade would likely be driven by alpha rather than beta, and indeed Chart 4 illustrates that staples continue to rise relative to discretionary against a backdrop of a rising broad market. Long China Investable ESG leaders / Short Investable Broad Market (Maintain) In the same report we recommended that investors overweight the China investable ESG leaders index, based on the goal of favoring firms that are best positioned to deliver "sustainable" growth in an era of heightened environmental reforms. The index overweights firms with the highest MSCI ESG ratings in each sector (using a proprietary MSCI ranking scheme), and maintains similar sector weights as the investable benchmark, which limits the beta risk of the trade. Chart 5 highlights that the trade is progressing in line with our expectations, suggesting that investors stick with the position over the coming 6-12 months. Chart 4Staples Vs Discretionary Isn't A Low Beta Trade Staples Vs Discretionary Isn't A Low Beta Trade Staples Vs Discretionary Isn't A Low Beta Trade Chart 5Likely To Continue To Outperform Likely To Continue To Outperform Likely To Continue To Outperform Resource & Construction Plays We have two open trades related to the resource sector: Long China investable oil & gas stocks / short global oil & gas stocks, initiated on April 26, 2014 and Long China investable construction materials sector / short investable broad market, initiated on December 9, 2015 We recommend that investors close both of these positions, based on the following rationale: Chart 6Similar Earnings Profile, ##br##But Weaker Dividend Payouts Similar Earnings Profile, But Weaker Dividend Payouts Similar Earnings Profile, But Weaker Dividend Payouts Long China Investable Oil & Gas Stocks / Short Global Oil & Gas Stocks (Close) This trade was initiated based on the view that the valuation gap between Chinese and global oil & gas companies is unjustifiable given that the earnings off both sectors are globally driven. Indeed, Chart 6 shows that the trailing EPS profiles of both sectors in US$ terms have been broadly similar over the past few years, and yet China's oil & gas sector trades at a 40% price-to-book discount relative to its global peers. However, panel 2 of Chart 6 highlights that this discount may represent investor concerns about earnings quality and/or state-owned corporate governance. The chart shows that while the earnings ROE for Chinese oil & gas companies is higher than that of the global average, the dividend ROE (dividends per share as a percent of shareholders equity) is considerably lower. While China's oil & gas dividend ROE has recently been rising, the gap remains wide relative to global oil & gas companies, suggesting that there is no significant re-rating catalyst that is likely to emerge over the coming 6-12 months. Close for an annualized return of 1.4%. Long China Investable Construction Material Stocks / Short China Investable Broad Market (Close) The relative performance of Chinese investable construction material stocks has been positive over the past two years, with the trade having generated an 8.1% annualized return since initiation. There are two factors contributing to our view that it is time for investors to book profits on this trade. The first is that China's investable construction materials are dominated by cement companies, which may suffer in relative terms from China's rebooted reform initiative this year.4 The second is that the relative performance of construction materials stocks is closely correlated with, and led by, the growth in total real estate investment (Chart 7). Residential investment makes up a significant component of total real estate investment, and Chart 8 highlights that a significant gap between floor space sold and completed has narrowed the inventory to sales ratio over the past three years. But the ratio remains somewhat elevated relative to its history which, when coupled with the ongoing growth slowdown in China and the deceleration in total real estate investment growth, implies a poor risk/reward ratio over the coming 6-12 months. Chart 7Cement Producers Trade Off Of Real Estate Investment Cement Producers Trade Off Of Real Estate Investment Cement Producers Trade Off Of Real Estate Investment Chart 8No Clear Construction Boom Is Imminent No Clear Construction Boom Is Imminent No Clear Construction Boom Is Imminent Domestic Stock Market Trades We have two open trades related to China's domestic stock market: Long China domestic utility sector / short domestic broad market, initiated on January 22, 2014 and Long China domestic food & beverage sector / short domestic broad market, initiated on December 9, 2015 Similar to our resource & construction plays, we recommend that investors close both of our recommended domestic stock market trades: Long China Domestic Utility Sector / Short Domestic Broad Market (Close) We initiated this trade in early-2014, following a comprehensive reform plan released in late-2013 by the Chinese government. The plan called for allowing market forces to play a decisive role in allocating resources, which we argued would grant utilities more pricing power, reduce their earnings volatility associated with policy risks, and lead to a structural positive re-rating. Chart 9 illustrates that this trade gained significant ground in 2014 and early-2015, even prior to the significant melt-up in domestic stock prices that began in Q2 2015. However, the trade has underperformed significantly since the middle of last year, which has been driven by a sharp deterioration in ROE. This decline in ROE appears to have been cost-driven, as coal is an important feedstock for Chinese utility companies and has risen substantially in price over the past two years. While domestic utilities are now significantly oversold in relative terms, we recommend that investors close this trade because the original reform-oriented basis has shifted significantly. The priorities that emanated from October's Party Congress were decidedly environmental in nature, meaning that coal prices may very well remain elevated over the coming 6-12 months (due to restricted supply). This means that a recovery in ROE would rest on the need to raise utility prices, which is a low-visibility event that will be difficult to predict. Close for an annualized return of 3%. Long China Domestic Food & Beverage Sector / Short Domestic Broad Market (Close) We initiated this trade in December 2015, based on this sector's superior corporate fundamentals and undemanding valuation levels. We argued that the anti-corruption campaign since late-2012 was likely the cause of prior underperformance, given that the group is dominated by a few high-end alcohol producers. The market overacted to the high-profile crackdown, and ultimately the fundamentals of the sector did not deteriorate materially. Our view has panned out spectacularly, with the trade having earned a 32% annualized return since inception5 (Chart 10 panel 1). While the group's ROE remains significantly above that of the domestic benchmark, valuation measures suggest that investors have more than priced this in (Chart 10 panel 2). The trade has mostly played out and we would not like to overstay our welcome. In addition, panel 3 illustrates that technical conditions are extremely overbought, suggesting that investors are being presented with an excellent opportunity to exit the position. Chart 9Sidelined By A Major Hit To ROE Sidelined By A Major Hit To ROE Sidelined By A Major Hit To ROE Chart 10Time To Book Profits Time To Book Profits Time To Book Profits Trades Linked To Hong Kong We have two open trades related to Hong Kong: Long U.S. / short Hong Kong 10-Year government bonds, initiated on January 15, 2014 and Short Hong Kong property investors / long Hong Kong broad market, initiated on January 21, 2015 We recommend that investors stick with the first and close the second, based on the following perspectives: Long U.S. / Short Hong Kong 10-Year Government Bonds (Maintain) Hong Kong has an open capital account and an exchange rate pegged to the U.S. dollar, meaning that its monetary policy is directly tied to that of the U.S. Yet, Hong Kong's 10-year government bond yield is non-trivially below that of the U.S., which argues for a short stance versus similar maturity U.S. Treasurys. While it is true that the Hong Kong - U.S. 10-year yield spread does vary and can widen over a 6-12 month horizon, Chart 11 highlights that the relative total return profile of the trade (in unhedged terms) trends higher over time due to the carry advantage. Short Hong Kong REITs / Long Hong Kong Broad Market (Close) There are cross-currents facing the outlook for Hong Kong REITs vs the broad market, arguing for a neutral rather than an underweight stance. Close this trade for an annualized return of 3.6%. While the relative performance of global REITs is typically negatively correlated with bond yields, Chart 12 shows that the relationship with Hong Kong property yields has been positive and lagging (i.e. falling yields lead declining relative performance, and vice versa). Under this regime, a rise in U.S. government bond yields, as we expect, would suggest an improvement in the relative performance of Hong Kong REITs. Chart 11A Straightforward Carry Pick Up Trade A Straightforward Carry Pick Up Trade A Straightforward Carry Pick Up Trade Chart 12Rising Bond Yields Implies ##br##Positive HK REIT Performance Rising Bond Yields Implies Positive HK REIT Performance Rising Bond Yields Implies Positive HK REIT Performance Chart 13 highlights that periods of positive yield / REIT performance correlation have tended to occur when Hong Kong property prices are rising significantly relative to income, as they have been for the past several years. One interpretation of this dynamic is that when house prices are overvalued and potentially vulnerable, REIT investors react positively to an improvement in economic fundamentals (which tends to push yields up due to higher interest rate expectations). The risk of an eventual collapse of Hong Kong property prices is clear, but we cannot identify an obvious catalyst for this to occur over the coming 6-12 months. Importantly, the fact that property prices have continued to rise during a period of tighter mainland capital controls suggests that only a significant economic shock will be enough to derail the uptrend in prices, circumstances that we do not expect over the coming year. Finally, Chart 14 highlights that Hong Kong REITs are deeply discounted relative to book value when compared against the broad market. This suggests that at least some of the risks associated with the property market have already been priced in by investors. Chart 13Yields & REITs Positively Correlated ##br##When House Prices Are Overvalued Yields & REITs Positively Correlated When House Prices Are Overvalued Yields & REITs Positively Correlated When House Prices Are Overvalued Chart 14Hong Kong REITs Are Cheap Hong Kong REITs Are Cheap Hong Kong REITs Are Cheap Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 https://www.bcaresearch.com/trades 2 Please see China Investment Strategy Weekly Report, "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report "Taiwan: Awaiting A Re-Rating Catalyst", dated December 14, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress", dated November 16, 2017, available at cis.bcaresearch.com. 5 Please note that the total return from this trade had been erroneously reported for some time due a data processing error on BCA's part. The return since inception now properly sources the China CSI SWS Food & Beverage index from CHOICE. We sincerely regret the error and any confusion it may have caused. Cyclical Investment Stance Equity Sector Recommendations

Highlights One of the biggest mistakes in finance is to equate risk with volatility. The correct measure of risk is the negative skew in payoff distributions. If 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. This would be the point at which to scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Feature It is the crucial question that all investors should ask at all times. What is the relative risk of the two major asset classes - bonds and equities - and are their relative return prospects commensurate with the relative risk? Chart of the WeekBelow A 2% Yield, 10-Year Bonds Are Riskier Than Equities Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? But first, there is an even more fundamental question: what do we mean by risk? Conventional wisdom says that the risk of an investment is captured by its volatility. Indeed, through instruments such as the VIX futures and currency volatility options, volatility has become a multi-trillion dollar asset-class in its own right. Therefore, volatility must measure the risk of an investment, right? Wrong. The Biggest Mistake In Finance As a measure of risk, volatility is clearly wrong. Volatility regards price gains in exactly the same way as it regards price losses. But investors don't mind gains, they only mind losses! Consider an investment whose price moves alternately sideways and sharply higher. The maths would say that the returns have high volatility, implying that the investment is very risky. In truth though, the investment is highly desirable and 'risk-free' - because its price never declines. At our recent New York conference, Nobel Laureate Daniel Kahneman warned that one of the biggest mistakes in finance is to equate risk with volatility. After decades of empirical and theoretical studies - which culminated in the 2002 Nobel Prize for Economics - Kahneman proved that investors are not concerned about the symmetrical fluctuations in investment returns. Instead, they are concerned about the asymmetry - or skew - in payoff distributions. Kahneman explained the underlying psychology. "People are limited in their ability to comprehend and evaluate extreme probabilities, so highly unlikely events are overweighted." If the payoff distribution is symmetric, the overweighting of unlikely events in the loss tail and the gain tail exactly cancels out. But if the distribution is asymmetric, the longer tail determines the perceived attractiveness of the payoff. Where the longer tail is on the gain side, the distribution is said to have positive skew (Figure I-1). The classic example is a lottery. When people play the lottery, their loss is limited to the ticket price, but their gain could be tens of millions. People perceive the positive skew as attractive because they overweight the minuscule probability of becoming a millionaire. As a result, they overpay for the lottery ticket versus its expected value. Where the longer tail is on the loss side, the distribution is said to have negative skew (Figure I-2). This is like a lottery in reverse. The gain size is relatively limited, but the loss could be very large. People perceive the negative skew as unattractive because they overweight the probability of a large loss. As a result, they demand overpayment to take it on. Figure I-1People Like Positive Skew Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? Figure I-2People Dislike Negative Skew Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? For investments with negative skew, this overpayment takes the form of an excess return demanded from the market - a 'risk premium' - versus investments with less negative skew. Are Bonds A Greater Risk Than Equities? We are now in a position to tackle the question in the title. To determine whether bonds are riskier than equities or vice-versa, we must compare the skews of their return profiles.1 The important point is that for a bond, the skew of its return profile changes with its yield. At yields above 2.5%, 10-year bond returns show no skew. Worst losses broadly equal best gains. However, when yields drop below 2%, returns start to exhibit negative skew (Chart I-2). And at yields below 1%, the negative skew becomes extreme. Chart I-2Bond Risk Increases At ##br##Low Bond Yields Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? Chart I-3Equity Risk Does Not Increase At##br## Low Bond Yields Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? The reason is obvious. Central banks accept that there is a 'lower bound' for policy interest rates - perhaps slightly negative - below which there would be an exodus of bank deposits. The limit also marks the lower bound for bond yields. Close to this lower bound for yields, bond mathematics necessarily creates a negatively skewed return profile. Simply put, prices have little upside, but they have a lot of downside! Chart I-4A 40Bps Rise In Yields Would Make Global ##br##Bonds Riskier Than Equities A 40Bps Rise In Yields Would Make Global Bonds Riskier Than Equities A 40Bps Rise In Yields Would Make Global Bonds Riskier Than Equities Turning to equities, the empirical evidence shows that equity returns always exhibit negative skew. Worst losses are typically around 1.5 times the size of best gains (Chart I-3). But the negative skew of equity returns is largely independent of the bond yield. The upshot is that there is a crossover bond yield below which the negative skew on 10-year bonds exceeds that on equities. This crossover bond yield is around 2%. In negative skew terms, we can say that at a 10-year bond yield below 2%, 10-year bonds are riskier than equities. And at a yield above 2%, equities are riskier than 10-year bonds (Chart of the Week). So in negative skew terms, 10-year bonds are riskier investments than equities in Europe and in Japan. But equities are riskier investments than 10-year bonds in the United States. Still, given that developed financial markets tend to move en masse, the relationship that is most significant is the aggregate one. At a global level, 10-year bond yields are 40bps below the crossover yield at which equities become riskier than bonds (Chart I-4). QE Distorted The Relative Valuation Of Equities Versus Bonds Which segues us neatly to today's ECB monetary policy meeting. Many people, worried about the end of QE, point out that the $10 trillion of bonds that the 'big four'2 central banks have bought is not far short of the size of the euro area economy. However, in the context of a global fixed income market of $220 trillion,3 $10 trillion of buying is small change. For the $220 trillion global bond and bank loan complex, the much more significant driver of yields has been the expected path of policy interest rates. As ECB Chief Economist Peter Praet put it, serial QE has been nothing more than "a signalling channel which reinforces the credibility of forward guidance on (ultra-low) policy rates." Chart I-5A Promise To Keep The Policy Rate Ultra-Low ##br##Pulls Down Bond Yields A Promise To Keep The Policy Rate Ultra-Low Pulls Down Bond Yields A Promise To Keep The Policy Rate Ultra-Low Pulls Down Bond Yields Central bankers know that QE depressed bond yields by signalling an extended period of ultra-low interest rates (Chart I-5). They also know that if the prospective return on bonds drops, so must the prospective return on competing investments such as equities. Thereby, the absolute valuations of bonds and equities both rise. However, one largely overlooked impact of QE - even by central bankers - has been the effect on the relative valuation of equities versus bonds. To repeat, when 10-year bond yields drop below 2%, their return distribution becomes more negatively skewed than that for equities. But if bonds become riskier investments, the 'risk premium' (excess return) on equities must disappear. Meaning equity valuations and prices get a second boost, compressing the prospective 10-year equity return to become 'bond-like'. Is this the case? Unlike for 10-year bonds, we do not know the 10-year prospective return from equities with certainty. However, we can get a good estimate from today's starting valuation. But which valuation metric to use? We are cautious of using profit based metrics as these will be flattered by the advanced position in the business cycle as well as the structural uptrend in profit margins. Instead, at an aggregate level, world equity market capitalisation to world GDP has been an excellent predictor of the prospective 10-year return on world equities. Today, this valuation metric is at the same level as in 2000 and 2007, and implies a prospective return of less than 2% a year (Chart I-6). Chart I-6World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return Nevertheless, while the global 10-year bond yield stays below 2%, this is a sustainable valuation for equities. Effectively, equities and bonds are offering broadly similar negative skews, and therefore should offer broadly similar prospective returns. However, if 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. Though not there yet, this would be the point when we would scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 One simple way to quantify this skew is to find an extended period of time in which the price ended where it started, and then to calculate the period's worst 3-month loss as a multiple of the best 3-month gain. We define skew = -ln(worst 3-month loss / best 3-month gain) using log returns for 3-month loss and 3-month gain. 2 The Federal Reserve, ECB, Bank of Japan and Bank of England. 3 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017. Fractal Trading Model* This week's trade is to position for an underperformance of the Japanese energy sector (led by JXTG Holdings And Inpex) versus the overall Japanese market. This is a longer trade than normal with a maximum duration of 26 weeks. Set a profit-target at 8% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-7 Short Japan Oil & Gas Short Japan Oil & Gas The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

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

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

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

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

Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined Bitcoin: Most Of It Has Been Mined Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut Governments Will Want Their Cut Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Where Low Rates Have Fueled House Prices Where Low Rates Have Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Rent Growth Is Cooling Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Low Volatility Is In High Demand Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Erosion Of Supply In The Stock Market Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Will Bitcoin Be DeFANGed? Will Bitcoin Be DeFANGed? Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 China's Holdings Of Treasurys: Largely Flat Since 2011 China's Holdings Of Treasurys: Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases BoJ Has Been Reducing Its Bond Purchases BoJ Has Been Reducing Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Yen Is Already Cheap... Yen Is Already Cheap... Chart 15...And Unloved ...And Unloved ...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Euro Area Economic Surprises Edging Lower Euro Area Economic Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Negative Credit Impulse In The Euro Area Will Weigh On Growth Negative Credit Impulse In The Euro Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials The Euro Has Strengthened More Than Justified By Interest Rate Differentials The Euro Has Strengthened More Than Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Euro Positioning: From Deeply Short To Record Long Euro Positioning: From Deeply Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The beta of Chinese stocks has been steadily increasing over the past few years, versus both emerging markets and global stocks. Rising relative currency volatility has likely durably increased the cyclicality of Chinese stock prices. The high-beta nature of Chinese investable stocks suggests that they should be favored when the EM and global stock benchmarks are rising. This supports our current overweight stance. A portfolio strategy that favors equity sectors with high alpha significance has outperformed the broad investable market by a non-trivial amount over time, without adding to portfolio risk. Barring a few exceptions, the model's current allocation is generally consistent with our theme of a benign slowdown in Chinese economic growth. Feature Chart 1Beta Matters, But So Does Alpha Beta Matters, But So Does Alpha Beta Matters, But So Does Alpha While concepts such as alpha, beta, and correlation are frequently applied by investment managers at the security or sector level, they are less commonly employed from a top-down regional equity perspective and are rarely examined as a time series. In addition, the concept of alpha persistence (i.e. alpha that is persistently positive or negative) is also frequently ignored by investors, despite it having significant implications for portfolio returns. This is vividly illustrated by the relative performance of developed commodity markets during the last economic expansion: these countries resoundingly outperformed a rising global benchmark from 2000 to 2007, despite having a market beta that averaged one over the period (Chart 1). This seeming inconsistency is explained by persistent volatility-adjusted outperformance throughout the period (panel 3), underscoring the importance of tracking this measure from a top-down perspective. In this report we examine the recent evolution of MSCI China's alpha and beta versus both the emerging market (EM) and global benchmarks. We conclude that China is no longer a low-beta market (supporting an overweight stance), and also present a simple alpha-based sector model for Chinese investable stocks that has generated impressive outperformance over time without adding to portfolio risk. The Evolution Of China's Alpha & Beta Chart 2 presents the evolution of alpha and beta for Chinese investable stocks since 2010, versus the emerging market and global index. Given the significant outperformance of the technology sector over the past year, we also present this analysis in ex-tech terms. The values shown in Chart 2 are calculated using a standard single-factor model approach to estimating alpha and beta, namely a regression of weekly stock price returns in US$ terms in excess of the return from U.S. short-term Treasury bills on excess returns of the benchmark index.1 The chart yields the following observations: The beta of Chinese stocks has been steadily increasing over the past few years, versus both emerging markets and global stocks, regardless of whether the tech sector is removed from the picture. Chinese stocks had a beta of 1.4 versus their global peers in 2017, placing it in the 80th percentile of all country equity market betas for the year. Chinese stocks earned a modestly negative alpha vs global stocks in 2016, which was even larger when compared to the EM benchmark. This likely occurred because of lower exposure to resource-oriented sectors, given the significant rebound in commodity prices in 2016. Chinese stocks experienced a surge in alpha in 2017, even excluding technology stocks. In 2017, in all cases (vs EM and global, including or excluding tech) Chinese equities moved into the top right alpha/beta quadrant, which is the quadrant that offers the highest return to investors when the benchmark is rising. This is a remarkable development given that there were indications of a peak in Chinese economic momentum in the first half of the year, and suggests that investors do not view the ongoing slowdown as being problematic for investable equity performance. Chart 2 raises the obvious question of why China has become a higher beta market. We have two theories, but only the second one appears to fit the data. The first theory is that the establishment of the stock connect in late-2014 caused a volatility spillover from China's domestic stock market into the investable market. But while it is true that A-shares were considerably riskier than investable stocks in late-2015 / early-2016, Chart 3 makes it clear that A-shares have not historically been much more volatile than investable stocks. In addition, Chart 2 underscores that the rise in China's market beta since 2014 has been persistent, whereas A-shares in 2017 recorded their lowest share price volatility in over 15 years. So to us, this does not appear to be the most probable explanation. Chart 2China Has Become A High-Beta Market China: No Longer A Low-Beta Market China: No Longer A Low-Beta Market The second theory, which seems much more likely, is that the rising currency volatility has increased the cyclicality of Chinese stock prices. China's decision to devalue the RMB in August 2015 clearly led to a period of significantly increased capital controls, but Chart 4 highlights that the CNY/USD exchange rate has steadily become more volatile. This is especially true when compared with a basket of emerging market currencies, with CNY/USD actually being more volatile than the basket over the past year. Chart 3The Stock Connect Does Not Explain##br## The Rise In China's Beta The Stock Connect Does Not Explain The Rise In China's Beta The Stock Connect Does Not Explain The Rise In China's Beta Chart 4Rising Relative Currency Volatility ##br##= Higher Beta Rising Relative Currency Volatility = Higher Beta Rising Relative Currency Volatility = Higher Beta While it is certainly true that Chinese policymakers have stepped up their management of the currency by tightening capital controls over the past year, the PBOC's decision to pursue its "partial" version of the impossible trinity still implies, in our view, that RMB volatility will now be structurally higher than what prevailed on average prior to August 2015.2 This suggests that China's equity market beta will be durably higher than before, absent a presently negative correlation between CNY/USD and EM or global stock prices. Bottom Line: The beta of Chinese stocks has been steadily increasing over the past few years, versus both emerging markets and global stocks. Rising relative currency volatility has likely durably increased the cyclicality of Chinese stock prices. Investment Implications Of China's Recent Relative Performance There are two clear investment strategy implications from Chinese equities becoming a high-beta asset. The first is that Chinese investable stocks are now a pro-risk asset to be favored when the EM and global stock benchmarks are rising. Chart 5 shows that both are currently well above their 200-day moving averages, which supports our overweight stance towards China. The second is that when comparing the performance of China's overall investable index versus that excluding technology, it is clear that a non-trivial amount of the alpha earned by China's overall index in 2017 came from the tech sector. This suggests that a reversal of the high-flying performance of Chinese technology stocks is a material risk to our overweight stance towards Chinese equities. For now, this high-alpha outperformance appears to be fundamentally-based: Chart 6 highlights that forward earnings for Chinese tech shares have risen enormously relative to the investable benchmark over the past three years, a trend that we have noted appears to be driven by Chinese consumer demand (and thus unlikely to decline over the coming year).3 In addition, the relatively modest but positive alpha earned by Chinese ex-tech stocks in 2017 was likely driven by extremely cheap valuation, and these multiples remain quite low relative to other countries. We highlighted in our December 7 Weekly Report that the relative re-rating of Chinese investable ex-tech stocks was a key theme for 2018,4 suggesting that there is room for further re-rating/alpha if China's economic slowdown remains benign (as we expect). Chart 5Investors Should Overweight ##br##Chinese Stocks In This Environment Investors Should Overweight Chinese Stocks In This Environment Investors Should Overweight Chinese Stocks In This Environment Chart 6Tech's Recent Alpha Appears ##br##Fundamentally-Based Tech's Recent Alpha Appears Fundamentally-Based Tech's Recent Alpha Appears Fundamentally-Based Bottom Line: The now high-beta nature of Chinese investable stocks suggests that they are a pro-risk asset to be favored when the EM and global stock benchmarks are rising. This supports our current overweight stance. Alpha, Applied: A Simple Sector Model For Chinese Investable Stocks We noted earlier that the concept of alpha has had significant implications for regional equity portfolio returns in the past. In order to test the predictive power of alpha within the context of a Chinese equity portfolio, we evaluate the returns of an investment strategy that allocates to China's investable equity sectors based on the significance of alpha. Table 1 presents statistics summarizing the performance of this sector alpha portfolio relative to the overall investable market, Table 2 shows the portfolio's current sector allocation, and Chart 7 illustrates the cyclical behavior of the portfolio's relative performance trend since 2004. Several important conclusions emerge: Table 1An Alpha-Based Sector Model Has Historically Outperformed ##br##China's Investable Stock Market China: No Longer A Low-Beta Market China: No Longer A Low-Beta Market Table 2Sector Alpha Portfolio Weights Are Generally Consistent With ##br##A Benign Growth Slowdown China: No Longer A Low-Beta Market China: No Longer A Low-Beta Market The model has outperformed the broad investable market by an impressive 235 bps per year without appearing to take on any additional risk. Measured either as volatility or drawdown, the riskiness of the portfolio appears to be the same as that of the overall investable market. The outperformance of the model occurs in spurts, but sustained periods of underperformance are not common. The 2007-2009 period served as an exception to this rule, but even in this case the cumulative underperformance of the model vs the investable index was not large (roughly 6%). Chart 7Impressive Outperformance Over Time Impressive Outperformance Over Time Impressive Outperformance Over Time The model is currently underweight financials (significantly), energy, industrials, telecoms, and utilities. Overweights are concentrated in the tech sector, real estate, health care, and consumer stocks. For now, these weights are generally consistent with our benign slowdown scenario, although there are some potential exceptions to monitor (such as the overweight stance towards real estate and materials). Bottom Line: A portfolio strategy that favors equity sectors with high alpha significance has outperformed the broad investable market by a non-trivial amount over time, without adding to portfolio risk. Barring a few exceptions, the model's current allocation is generally consistent with our theme of a benign slowdown in Chinese economic growth. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 China: No Longer A Low-Beta Market China: No Longer A Low-Beta Market 2 Please see China Investment Strategy Weekly Report, "How Will China Manage The Impossible Trinity", dated December 8, 2016, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart 1Bond Bear On Pause? Bond Bear On Pause? Bond Bear On Pause? The start of a new year often brings optimism and nowhere is this more evident than in economic projections. In three of the past four years (2017 being the exception) Bloomberg consensus GDP growth expectations ended the year lower than where they began. A related pattern played itself out in the Treasury market. At the turn of each of the past four years the average yield on the Bloomberg Barclays Treasury Index increased in December only to fall back in January. In two of those instances the January decline exceeded the December increase. Should we expect a similar January bond rally this year? Our favorite short-term indicators are not sending a strong signal (Chart 1). Net speculative futures positions weakly suggest that the 10-year yield will be lower in three months, but our auto regressive model suggests the Economic Surprise Index will still be in positive territory at the end of the month. In a recent report we showed that yields tend to rise in months where the Surprise Index is above zero.1 Perhaps most importantly, our 2-factor Treasury model shows that yields are significantly lower than is suggested by global economic fundamentals. Maintain below-benchmark duration. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 49 basis points in December and by 335 bps in 2017. At 94 bps, the average index spread is 28 bps tighter than at the beginning of 2017 and investment grade corporate spreads are extremely expensive compared to history (Chart 2). After adjusting for changes in the average duration of the index over time, we calculate that A-rated corporate spreads have only been tighter 5% of the time since 1989 (panel 2), and Baa-rated spreads have only been tighter 7% of the time (panel 3). Essentially, at this stage of the credit cycle we should expect excess returns no greater than carry. As for the credit cycle itself, we noted in our last report that with corporate balance sheets deteriorating, low inflation and still-accommodative monetary policy are the sole supports for corporate spreads.2 We expect spreads will start to widen later this year once inflation rises and policy becomes more restrictive. With excess returns likely to be lower in 2018 than in 2017, we should also expect a lower marginal return from increasing the riskiness within credit portfolios.3 For investors looking to scale back on credit risk, our model shows that Financials and Technology are the most attractive low-risk sectors. Energy, Basic Industry and Communications are all attractive high-risk sectors (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* January Effect January Effect Table 3BCorporate Sector Risk Vs. Reward* January Effect January Effect High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 23 basis points in December and by 602 bps in 2017. The average index option-adjusted spread tightened 1 bp on the month and 66 bps in 2017. Though spreads appear somewhat more attractive than for investment grade corporates, there is still not much room for spread compression in high-yield. In fact, we calculate that if the high-yield index spread tightens another 117 bps, junk bonds will be the most expensive they have been since 1995. In an optimistic scenario where the index spread tightens 100 bps, bringing it close to all-time expensive levels, then we would expect junk excess returns to be in the range of 600 bps (annualized). Given trends in corporate leverage, another 100 bps of spread tightening should be viewed as unlikely. More realistically, we expect excess returns in the range of 200 bps to 500 bps (annualized) between now and the end of the credit cycle (Chart 3). Given our forecast for default losses, flat spreads translate to a 12-month excess return of 213 bps. An additional warning sign for junk spreads is that the slope of the 2/10 Treasury curve is hovering around 50 bps. We showed in a recent report that when the 2/10 slope is between 0 bps and 50 bps, junk bonds underperform Treasuries in 48% of months, and average monthly excess returns (though still positive) are much lower than when the curve is steeper.4 MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 16 basis points in December and by 51 bps in 2017. The conventional 30-year zero-volatility MBS spread narrowed 2 bps in December, the combination of a flat option-adjusted spread (OAS) and a 2 bps decline in the compensation for prepayment risk (option cost). The Z-spread widened 2 bps in 2017, as an 8 bps OAS widening was offset by a decline of 6 bps in the compensation for prepayment risk. The substantial OAS widening in early 2017 was almost certainly caused by investors pricing-in the eventual run-off of the securities on the Fed's balance sheet. Now that run-off has begun we see no obvious catalyst for further OAS widening in the months ahead. Turning to the compensation for prepayment risk, with Treasury yields biased higher as the Fed continues to lift rates, we see little risk of a material increase in refinancing activity. This will ensure that overall MBS spreads stay capped near historically low levels (Chart 4). All in all, with MBS OAS looking more attractive relative to Aaa-rated credit than at any time since 2015 (panel 3), we think this is an opportune time for investors looking to de-risk their portfolios to shift some of their spread product allocation away from corporate bonds and into MBS. We already upgraded our recommended allocation to MBS from underweight to neutral in October, and will likely further increase exposure as we advance toward the end of the credit cycle. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 5 basis points in December, but outperformed by 216 bps in 2017. Sovereign bonds underperformed the Treasury benchmark by 36 bps in December, Foreign Agencies and Domestic Agencies underperformed by 8 bps and 1 bp, respectively. Local Authorities outperformed the benchmark by 17 bps, and Supranationals underperformed by 1 bp. Sovereign bonds were the best performers within the Government-Related index in 2017, delivering excess returns of 538 bps relative to duration-matched U.S. Treasuries. This outperformance was concentrated early in the year and was driven by the sharp depreciation of the U.S. dollar (Chart 5). With the market still priced for a relatively modest 63 bps of Fed rate hikes during the next 12 months, further sharp dollar depreciation appears unlikely. We recommend an underweight allocation to Sovereign debt. We remain overweight Local Authority and Foreign Agency bonds, sectors that delivered excess returns of 420 bps and 248 bps, respectively in 2017. Despite the outperformance, both of these sectors still offer attractive spreads after adjusting for credit rating and duration. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 15 bps and 17 bps of option-adjusted spread, respectively. We much prefer Agency-backed MBS and CMBS which are also relatively low risk and offer option-adjusted spreads of 28 bps and 42 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 99 bps in December and by 332 bps in 2017 (before adjusting for the tax advantage). The average Aaa Municipal / Treasury (M/T) yield ratio fell 5% in December, and is 12% below where it began 2017 (Chart 6). The recent decline follows a sharp increase that was driven by fluctuating supply trends related to the passage of U.S. tax legislation. The final tax bill ends the practice of advance refunding municipal bonds. As a result, December set a new high of $55.6 billion for municipal issuance as issuers rushed to get their advance refunding deals to market before the bill was passed (panel 3). Now that the bill has passed, visible supply has evaporated and the average M/T yield ratio has fallen back to one standard deviation below its post-crisis mean. The absence of advance refunding will bias municipal bond issuance lower in 2018, thus removing one potential risk for yield ratios. The M/T yield ratio for short maturity debt has risen considerably relative to the yield ratio for long maturity debt in recent months (panel 2), and the risk/reward trade-off now appears more balanced. We close our recommendation to favor long maturities versus short maturities on the Aaa Muni curve. The third quarter update of our Muni Health Monitor showed a slight improvement (panel 5), but still no clear reversal of trend. Although health remains supportive for now - and consistent with municipal upgrades outpacing downgrades - with yield ratios close to their lows we maintain an underweight allocation to Municipal bonds.  Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in December. The 2/10 Treasury slope flattened 13 bps on the month, and the 5/30 Treasury slope flattened 15 bps. The evolution of the Treasury curve in 2018 will come down to a trade-off between how quickly inflation rises versus how quickly the Fed lifts rates. For example, in a recent report we showed that the 10-year Treasury yield will likely settle into a range between 2.80% and 3.25% by the time that core PCE inflation reaches the Fed's 2% target.5 That same report shows that if that adjustment occurs relatively quickly, and the Fed has only lifted rates once or twice between now and then, then the 2/10 Treasury slope is much more likely to steepen than to flatten. Conversely, if the Fed lifts rates three or four more times between now and the time that inflation returns to target, then the curve is more likely to flatten. For our part, we think it is wise to maintain a position long the 5-year bullet and short a duration-neutral 2/10 barbell. Such a position profits from a steeper curve, and our model shows that the butterfly spread is currently priced for significant curve flattening (Chart 7). According to our model, the 2/5/10 butterfly spread is discounting 27 bps of 2/10 flattening during the next six months.6 In other words, if the 2/10 slope steepens or flattens by less than 27 bps, then our recommended position will profit. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 41 basis points in December, but underperformed by 43 bps in 2017. The 10-year TIPS breakeven inflation rate went on a wild ride last year. It started 2017 at 1.95% and, driven by strong inflation prints and continued post-election euphoria, reached as high as 2.09% in January. The breakeven dropped to a low of 1.66% in June, as inflation started to disappoint in the second quarter, but has rebounded during the past couple of months and just recently broke back above 2%. The 10-year TIPS breakeven rate is currently 2.02%, above where it began 2017. According to our TIPS Financial Model, the recent widening in breakevens is in line with the message from other related financial market instruments (Chart 8). Specifically, oil prices, the trade-weighted dollar and the stock-to-bond total return ratio. Further, measures of pipeline inflation pressure continue to signal an increase in inflationary pressures (panels 3 and 4), and the trimmed mean PCE shows that the realized inflation data are forming a tentative bottom (bottom panel). The annualized 6-month rate of change in the trimmed mean PCE ticked up to 1.68% in November, higher than the 12-month rate of change (1.67%). The 1-month rate of change is higher still at 2.19%, annualized. We continue to see signs that inflation will start to rebound in the coming months, and this will cause long-maturity TIPS breakeven inflation rates to reach a range between 2.4% and 2.5% by the time that inflation returns to the Fed's target. Remain overweight TIPS versus nominal Treasury securities. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities performed in line with the duration-equivalent Treasury index in December and outperformed by 92 basis points in 2017. In 2017, Aaa-rated ABS outperformed the Treasury benchmark by 79 bps and non-Aaa ABS outperformed by 217 bps. The index option-adjusted spread for Aaa-rated ABS widened 1 bp in December, but tightened 21 bps in 2017. It now sits at 31 bps, only 4 bps above its all-time low (Chart 9). At 31 bps, Aaa-rated ABS now offer only a 3 bps spread advantage over Agency-backed MBS, and offer 11 bps less spread than Agency-backed CMBS. With consumer lending standards tightening and delinquency rates rising, we view no more than a neutral allocation to ABS as appropriate. On lending standards, the Fed's October Senior Loan Officer's Survey showed a continued tightening in lending standards on both credit cards and auto loans (panel 4), and also that demand for credit card and auto loans was essentially unchanged from the prior quarter. It also included a set of special questions regarding the reasons for changes in the supply and demand for consumer credit. Banks cited a less favorable or more uncertain economic outlook, a deterioration in existing loan quality and a general reduced risk tolerance as reasons for tightening the supply of credit. The hard data confirm that banks are seeing a deterioration in the quality of their consumer loan books (bottom panel). Although delinquencies remain depressed compared to history, with ABS spreads near all-time tights, rising delinquencies and tightening lending standards make for a poor risk/reward trade-off in the sector. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in December and by 201 bps in 2017. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps in December and 13 bps in 2017. At its current level of 64 bps, the index spread is about one standard deviation below its pre-crisis mean, and only 13 bps above its all-time low reached in 2004 (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we continue to view the risk/reward trade-off in non-Agency CMBS as unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 21 basis points in December and by 133 bps in 2017. The index option-adjusted spread for Agency CMBS tightened 3 bps in December and 13 bps in 2017. At its current level of 42 bps, the sector offers greater option-adjusted compensation than a position in Agency-backed MBS (28 bps) and Aaa-rated consumer ABS (31 bps). Such an attractive spread pick-up in a sector that benefits from Agency backing is surely worth grabbing.   Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.94% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.92%. PMIs across the world continue to surge. December PMI data show increases in the four largest economic blocs (U.S., Eurozone, China, Japan), and more broadly show that 86% of the 36 countries with available data currently have PMIs above the 50 boom/bust line. Meanwhile, bullish sentiment toward the U.S. dollar continues to trend lower in response to strong growth in the rest of the world (bottom panel). This is also a bearish development for U.S. bonds. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.48%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com 6 For further details on the model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Upbeat economic reports for December set the stage for a solid 2018. The FOMC minutes acknowledged the flatter curve and only a minority of members discounted the signal from the curve. A majority thought that a tighter labor market would lead to higher inflation. The Citi Economic Surprise Index is peaking, but risk assets should hold up as the Index rolls over. Feature The first week of 2018 brought more good news for risk assets. U.S. stocks beat bonds, oil prices rose, and credit spreads narrowed amid a solid set of economic data. Several high-profile U.S. companies announced share buybacks, and/or one-time bonuses or wage increases linked to the tax cut plan passed by Congress at the end of 2017. Moreover, there were hints of further economic stimulus as lawmakers from both sides of the aisle discussed relaxing the sequester rules that would lift federal spending this year. Markets shrugged off a fresh round of saber rattling between the U.S. and North Korea. Gold prices nudged higher and the U.S. dollar fell despite the upbeat economic news. December's reports on manufacturing and service sector ISM, vehicle sales and the labor market, along with November's numbers on construction spending, trade and factory orders, all lifted estimates for Q4 GDP and boosted the prospects for corporate earnings in Q4 2017 and beyond. Chart 1 shows that the elevated ISM figures provide a favorable backdrop for earnings and sales in 2018. Moreover, Chart 2 indicates that IP, a proxy for S&P 500 sales, is poised to advance in 2018 and provide a lift to corporate profits. We will preview the S&P 500's Q4 2017 earnings reports in next week's U.S. Investment Strategy. Chart 1Favorable Macro Backdrop For Earnings And Sales Favorable Macro Backdrop For Earnings And Sales Favorable Macro Backdrop For Earnings And Sales Chart 2ISM Components Suggest IP Poised To Accelerate ISM Components Suggest IP Poised To Accelerate ISM Components Suggest IP Poised To Accelerate The Atlanta Fed GDP Now estimate stood at 2.7% on January 5, while the New York Fed's Nowcast for Q4 GDP was a healthy 4% (Chart 3). Both soundings are well above the FOMC's assessment of the economy's long-term potential growth rate (1.8%) and puts GDP growth in 2017 above the Fed's forecast. The implication is that the output gap pushed deeper into positive territory as 2017 ended, setting the stage for higher inflation in 2018. The December 2017 jobs report, released last Friday, January 5, does not change BCA's outlook for the U.S. economy or the Fed. The U.S. economy added a lower than expected 148,000 new jobs in December, which left the unemployment rate unchanged at 4.1%. Despite the softer than anticipated data, the 3-month average of payrolls growth is still a very healthy 204,000. The monthly increase in wages quickened to 0.3% m/m in December, up from 0.1% m/m last month. However, annual wage inflation remains modest at just 2.5% (Chart 4). Chart 3U.S. Economic Growth Well##BR##Ahead Of Potential In Q4 U.S. Economic Growth Well Ahead Of Potential In Q4 U.S. Economic Growth Well Ahead Of Potential In Q4 Chart 4Labor Market Still Tightening Despite##BR##Soft December Report Labor Market Still Tightening Despite Soft December Report Labor Market Still Tightening Despite Soft December Report The indications for Q4 GDP growth are solid. Aggregate hours worked rose 2.5% at an annualized rate in Q4 2017. Assuming modest growth in productivity, the payrolls data are consistent with over 3% GDP growth in Q4. There is nothing in the December payroll data to suggest that the underlying trajectory in the U.S. economy has changed. The economy continues to grow above trend. Wage gains are modest at the moment, but should accelerate as the labor market keeps tightening with above-trend GDP growth. This upbeat economic outlook is also supported the December 2017 non-manufacturing ISM survey, also released last Friday. While the overall index fell from 57.4 to 55.9, it is still consistent with solid GDP growth. Moreover, the employment index rose from 55.3 to 56.3, which signals firm job gains, and the prices paid index held steady at a fairly elevated level of 60.8. Bottom Line: It's been solid start to 2018 and it's steady as she goes for the U.S. economy and the Fed. FOMC Minutes: A Rubric BCA's U.S. Bond Strategy service expects that the 2/10 yield curve will languish between 0 and 50 bps in 2018. The curve will steepen from 51 bps at the end of 2017 through mid-year 2018, and then flatten into year-end (Chart 5). Which asset classes would benefit if our curve call is accurate? BCA's "The Bucket List"1 explains our view of the curve in 2018 and details the past performance of various U.S. assets in differing yield curve environments. Chart 5A Flat Yield Curve Is OK For Most Risk Assets A Flat Yield Curve Is OK For Most Risk Assets A Flat Yield Curve Is OK For Most Risk Assets BCA expects that the yield curve will first steepen in 2018, then become flatter, ultimately spending most of the year between 0 and 50 bps. A flat curve is the ideal environment for the S&P 500 and the stock-to-bond ratio. However, small cap stocks struggle when the curve is flat; BCA's view is that small caps will outperform large caps in 2018. A flat yield curve raises the risk of a sell-off in high yield, but provides a favorable grounding for oil, which is in line with BCA's fundamental view. BCA expects EPS growth will be positive this year; earnings growth is higher 75% of the time when the curve is flat. The yield curve's slope was a focus of debate at the FOMC's December 12-13, 2017 meeting. Participants cited several reasons for the flat curve2: recent increases in the target range for the federal funds rate; reductions in investors' estimates of the longer-run, neutral real interest rate; lower longer-term inflation expectations; lower term premiums Fed economists recently updated their quantitative assessments of the FOMC's minutes. The note provides a guide (Table 1 in the Fed paper3 and Tables 1 and 2 below) to the number of quantitative descriptors in the minutes (one, a couple, a few, etc.). We use this rubric to assess the committee's latest views on the yield curve and inflation. Table 1FOMC Assessment Of The Yield Curve Solid Start Solid Start Table 2FOMC Assessment Of Inflation Solid Start Solid Start In short, the FOMC acknowledged the flatter curve and only a minority of members discounted the signal from the curve. Moreover, a majority thought that a tighter labor market would lead to higher inflation. Only one participant held the view that secular trends were muting inflation. Bottom Line: BCA expects the Fed to deliver 3 to 4 rate hikes in 2018, which is still not fully priced in by the market. Investors should maintain below-benchmark duration in fixed income portfolios. Asset allocators should remain overweight stocks versus bonds. Growth is strong and the yield curve is not inverted yet. Therefore, it is still early to de-risk portfolios. Is Economic Surprise Peaking? The Citigroup (Citi) Economic Surprise Index is elevated relative to its recent history, but it may have further to run. Economic prospects were cheery following the 2016 presidential election and the economic data exceeded those lofty projections, aided by a warmer than usual winter. However, the temperate conditions borrowed activity from the spring, which was cooler and wetter than normal, and the combination of lofty expectations and seasonal distortions sent the Citi Economic Surprise Index spiraling lower through mid-year 2017. Since its bottom in June 2017 at -78.6%, the index climbed for 135 days before its peak in late December 2017 (Chart 6, panel 1). On average since 2010, the Citi Index moved from trough-to-peak in 96 days, which means the recent run-up was much longer than usual. However, that phenomenon may have been due to the raised economic expectations and variable weather patterns at the start of 2017. Chart 6Economic Surprise Index Has Surged, But Expectations Remain Muted Economic Surprise Index Has Surged, But Expectations Remain Muted Economic Surprise Index Has Surged, But Expectations Remain Muted At 80.7%, the Index has been above zero for 68 days (Chart 6, panel 1). It typically takes 46 days for it to climb from zero to its zenith. Table 3 shows the performance of financial markets and other assets after the Index moves from zero to the peak. The most recent episode (October through December 2017) matched historical averages across most asset classes, although the underperformance of small caps versus large ran counter to the past as the Surprise Index climbed from zero. Table 3Risk Assets Perform Well As Surprise Index Climbs Solid Start Solid Start Since 2010, the Index has stayed above 40 for an average of 51 days (Chart 6, panel 1). The Index has been over 40 since November 16, 2017, or 35 days. This suggests that it can remain elevated for another month or so before it again moves lower. However, the Index is mean reverting and investors wonder what will happen to risk assets after economic surprise rolls over. Table 4 and Chart 7 shows the performance of key financial markets and commodities when the Citi Index returned to zero from 40-plus. There have been six such intervals since 2010. On average, gold and oil perform well as the surprise index dips to zero. Stocks and credit outperform Treasuries during these episodes, and small caps beat large caps. Rising economic surprise (Table 3) is a more favorable environment for stocks, credit and oil than when the surprise index is rolling over. However, the performance of gold and small caps is better after the Citi Surprise Index peaks (Table 4). Table 4Risk Assets Hold Up When Citi Surprise Index Rolls Over Solid Start Solid Start Chart 7U.S. Assets As Economic Surprise Rolls Over U.S. Assets As Economic Surprise Rolls Over U.S. Assets As Economic Surprise Rolls Over Nonetheless, muted economic expectations will limit the downside in the Index in the coming months. Panel 3 of Chart 6 shows that the outlook for both hard and soft economic data remained muted through the end of November 2017, especially when compared with the significant improvement in economic prospects in late 2016 and early 2017. Bottom Line: Risk assets outperformed as the Citi Economic Surprise Index climbed in the second half of 2017. The Index can stay near recent peaks for several more months thanks to subdued economic forecasts, but it will roll over eventually. However, the elevated level of the Index suggests that there are near-term risks for equities and credit because a lot of good economic news is already priced in. Still, we recommend that investors ride out the volatility given our view that stocks will outperform bonds in the next 6-12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "The Bucket List", published December 18, 2017. Available at usis.bcaresearch.com. 2 https://www.federalreserve.gov/monetarypolicy/fomcminutes20171213.htm 3 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm