BCA Indicators/Model

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 U.S. Treasuries: U.S. Treasury yields are too low relative to the strength of global economic growth and the rising trend in U.S. inflation expectations. Maintain below-benchmark duration exposure in the U.S., stay underweight Treasuries versus global bond benchmarks, and continue to favor TIPS over nominals. Canada: The Canadian economic data is moving from strength to strength, and now price and wage inflation data is moving higher. The Bank of Canada will hike rates next week with additional increases likely in 2018. Remain underweight Canadian government bonds and stay long inflation protection (both through linkers and CPI swaps). 2017 Model Portfolio Performance Wrap-Up: We closed the books on the first full calendar year of our model bond portfolio with a total return of 3.75%. This was a small -13bps of underperformance versus our custom benchmark, coming entirely from underweight positions on longer-dated developed market government bonds that offset the asset allocation gains from overweights to corporate debt. Feature Chart of the WeekGlobal Bond Yields Are Too Low Global Bond Yields Are Too Low Global Bond Yields Are Too Low 2018 has started much as 2017 ended, with growth-sensitive assets rallying alongside robust economic data. Most major global equity markets are already up 2-3% after the first week of the year, with the U.S. NASDAQ, Japanese Nikkei and Italian MIB indices advancing over 4%. Global credit markets are also off to a strong start, with spreads for U.S. High-Yield corporate debt and EM hard currency corporate debt tighter by -17bps and -8bps, respectively. Even commodity markets have joined the party, with the benchmark Brent oil price hitting the highest level in nearly three years. The pro-growth, pro-risk backdrop is keeping upward pressure on global government bond yields. This is occurring primarily through the inflation expectations component of yields, which are rising in all developed economies (even Japan). Real yields, which are not rising despite the strength of the broad-based global growth upturn (Chart of the Week), have been drifting lower, providing some offset to rising inflation expectations. The primary trend for global yields remains upward, however - especially if growth remains solid and inflation expectations continue to push higher, giving central banks like the U.S. Federal Reserve the confidence to continue hiking interest rates. We continue to favor below-benchmark duration exposure, and overweight corporate bond allocations versus government debt, for global fixed income investors over the next 6-9 months. U.S. Treasuries: Still More Reasons To Sell Than Buy U.S. Treasury market participants have a lot to things to be nervous about at the moment. Likely future Fed rate hikes, the weakening U.S. dollar, rising oil prices, ongoing U.S. labor market strength, persistently booming economic growth, the never-ending equity bull market, the potential impact of the Trump fiscal stimulus, the Fed starting its balance sheet runoff - all factors that should force bond investors to expect yields to rise. Yet longer-dated Treasury yields continue to trade too low relative to the bond-bearish fundamentals. The current benchmark 10-year Treasury yield at 2.48% remains well below the fair value from our 2-factor regression model, which is now up to 2.94% (Chart 2). That valuation gap of 46bps is close to the widest levels seen in July 2016 and September 2017, which were both episodes that proved to be excellent entry points for bearish Treasury positions. The two inputs into our Treasury yield model are the global manufacturing PMI and bullish sentiment towards the U.S. dollar (USD). The PMI is included as an indicator of global growth and currently sits at 54.5 - the highest level in nearly seven years - led by strong readings in almost every major economy (Chart 3). This has been the primary driver of the fair value for the 10-year Treasury yield since global growth bottomed out and began to accelerate in mid-2016. Chart 210-Year Treasuries Are##BR##Overvalued On Our Model 10-year Treasuries Are Overvalued On Our Model 10-year Treasuries Are Overvalued On Our Model Chart 3Global Growth##BR##Is Booming Global Growth Is Booming Global Growth Is Booming Sentiment towards the USD is the second input to our Treasury model. It is included as a weakening greenback represents an easing of monetary conditions that could trigger a need for more Fed rate hikes that can push the Treasury curve higher from the short-end (and vice versa for a rallying USD). At the same time, a depreciating USD can drive U.S. inflation higher through higher costs of imported goods & services, which can raise bond yields through higher inflation expectations or greater Fed tightening expectations (again, the opposite holds true for a strengthening USD). Right now, both the strong PMI and weak sentiment towards the dollar are boosting the fair value of the 10-year Treasury yield. The fall in value of the greenback is particularly unusual, as it is flying in the face of widening interest rate differentials between the U.S. and the rest of the world (Chart 4, top panel). This is clearly a function of the fact that global growth is rapidly improving - especially in Europe - but very few central banks have yet to respond to that growth with interest rate hikes that match what the Fed has been delivering. So while actual interest rate differentials remain USD-supportive, expectations of some eventual tighter monetary policy outside the U.S. that could narrow those interest rate gaps are triggering speculative inflows into non-USD currencies. With the trade-weighted USD now 5% below levels of a year ago, this should lead to higher headline inflation in the U.S. in the next few months (middle panel). Combined with the continued strength in global oil prices, that means that the two biggest factors that weighed on realized U.S. inflation- the USD rally and oil price collapse of 2014/15 - are now both acting to boost inflation expectations (bottom panel). Throw in the growing body of evidence that a tight U.S. labor market that is putting gentle upward pressure on wage growth, and U.S. inflation expectations - which still remain 40-50bps below levels consistent with the Fed's inflation target - should continue to move higher in the next six months. Rising longer-term inflation expectations would typically result in bear-steepening pressures on the Treasury yield curve. That is not happening at the moment, however, with the 2-year/10-year Treasury curve still at a relatively flat 53bps at the time this report went to press. The flatness of the Treasury curve has worried investors, and even some Fed officials, given the well-known leading relationship between the yield curve and U.S. economic growth. It is too early to draw any conclusions between the shape of the curve and future U.S. economic growth, however, for several reasons: As mentioned above, inflation expectations are still well below levels consistent with the Fed's 2% inflation target on the PCE deflator (which translates to 2.5% on the CPI index used to price TIPS and CPI swaps). Both the European Central Bank (ECB) and Bank of Japan (BoJ) are still buying bonds through their asset purchase programs, although at a slower pace than previous years. This continues to depress local bond yields in Europe and Japan with spillover effects into the U.S. Treasury market - even as the Fed begins the slow runoff of Treasuries from its massive balance sheet. Data on mutual fund and ETF flows shows that there has been significant and sustained buying of bond funds by U.S. retail investors over the past couple of months. There has also been net selling of equity funds, however, suggesting that U.S. retail investors are rebalancing as the equity markets surge higher. Investor positioning in the U.S. Treasury market is very short at the moment, with the J.P. Morgan survey of "active" bond manager duration exposure at an all-time low and the net positioning on Treasury futures now slightly favoring shorts (Chart 5). It makes little sense to interpret a flattening Treasury curve as a signal that the bond market believes that the Fed was making a policy mistake if professional bond investors were running massive duration underweight positions that would benefit if bond yields rise. Chart 4Upside Pressure On U.S. Inflation##BR##From Oil & The USD Upside Pressure on U.S. Inflation from Oil & The USD Upside Pressure on U.S. Inflation from Oil & The USD Chart 5Big Duration Underweight##BR##Among U.S. Bond Managers Big Duration Underweight Among U.S. Bond Managers Big Duration Underweight Among U.S. Bond Managers All these factors muddy the economic signal provided by the Treasury curve at the moment. Nonetheless, we remain of the view that the Fed would not continue on its rate hiking path without U.S. inflation expectations moving sustainably back to levels consistent with the Fed's inflation target. In other words, the Treasury curve must bearishly steepen first through rising inflation expectations before bearishly flattening later through actual Fed rate hikes. The latter will dampen future U.S. growth expectations and eventually result in a cyclical peak in longer-dated Treasury yields, but from levels closer to 3% on the 10-year after inflation expectations "fully" normalize. Bottom Line: U.S. Treasury yields are too low relative to the strength of global economic growth and the rising trend in inflation expectations. Maintain below-benchmark duration exposure in the U.S., stay underweight Treasuries versus global bond benchmarks, and continue to favor TIPS over nominals. The Bank Of Canada Keeps On Playing Catch-Up The Canadian economic story continues to be the best within the developed world. The year-over-year growth rate for real GDP accelerated to over 3% late last year, primarily on the back of robust consumer spending (Chart 6). Even the lagging parts of the economy, like business investment and government spending, began to perk up last year. The momentum remained powerful at the end of 2017, with the unemployment rate in December hitting a 40-year low. The economic boom forced the Bank of Canada (BoC) to begin lifting interest rates last year, with two 25bp hikes occurring in July and September that unwound the easing from 2015. The rapid pace of growth has absorbed spare capacity much faster than the BoC originally projected. More hikes will be required if the current pace of growth is maintained, particularly with the BoC estimating that the neutral policy rate is around 3% and the current Overnight Rate is only at 1%. The Canadian consumer has been enjoying a powerful shopping spree. Real consumer spending growth is at 4% on a year-over-year basis - the highest level since early 2008 (Chart 7). This is led by a powerful surge in spending on consumer durables, where annual growth has surged to 10% (middle panel). Consumer confidence is booming and Canadian workers are enjoying the fastest pace of income growth since 2014 (bottom panel). Chart 6Robust Canadian Growth,##BR##Led By The Consumer Robust Canadian Growth, Led By The Consumer Robust Canadian Growth, Led By The Consumer Chart 7Canadian Consumers Are##BR##Confidently Spending Canadian Consumers Are Confidently Spending Canadian Consumers Are Confidently Spending Surprisingly, the powerful surge in consumer spending has occurred alongside some cooling of the overheated Canadian housing market. The growth rates of existing home sales and prices have both decelerated massively from the pace of the boom years in 2012-16 (Chart 8). The performance of house prices in the three biggest Canadian cities is now a mixed bag, with Vancouver prices reaccelerating, prices in Toronto decelerating and prices in Montreal growing only modestly (middle panel). Regulatory actions to limit the speculative buying of Canadian real estate by foreigners has helped dampen the surge in house prices in some markets. Although the bigger macro-prudential measures designed to tighten mortgage finance rules and reduce the amount of leverage in Canadian housing transactions has likely had a bigger effect. Canadian banks must now conduct stress tests to check if borrowers are able to pay off their mortgages if Canadian interest rates continue to rise. This represents a reduction in the marginal supply of riskier mortgage lending that will help restrain house price inflation in Canada's major cities. In addition, the supply of Canadian homes is growing with new home-building activity, both for single and multiple units, having picked up and overall residential investment growth now up nearly 5% on a year-over-year basis (bottom panel). With signs that the Canadian housing market has stopped rapidly inflating, the BoC can focus its interest rate policy on domestic growth and inflation considerations without worrying about pricking the housing bubble. On that front, the latest edition of the BoC's Business Outlook Survey, released yesterday, provided plenty of reasons to tighten monetary policy further. The overall survey indicator surged back to the peak seen last summer just before the BoC delivered its first rate hike (Chart 9). Capital spending intentions also rebounded back to the 2017 peaks, which bodes well for future gains in investment spending (second panel). Chart 8Canadian Housing Looking##BR##A Bit Less Frothy Canadian Housing Looking A Bit Less Frothy Canadian Housing Looking A Bit Less Frothy Chart 9BoC Business Outlook Survey Signaling##BR##Tightening Capacity Constraints BoC Business Outlook Survey Signaling Tightening Capacity Constraints BoC Business Outlook Survey Signaling Tightening Capacity Constraints The most interesting parts of the Business Outlook Survey were the capacity utilization measures. A greater share of companies were reporting labor shortages (third panel), with the highest percentage of firms reported difficulties in meeting unexpected increases in demand since 2007 (bottom panel). This suggests that the recent surge in employment, wage growth and price inflation are all sustainable. Headline and core CPI inflation are up to 2.1% and 1.8%, respectively, as of November. This is around the midpoint of the BoC's 1-3% target range (Chart 10). The Bank of Canada forecasts that CPI inflation will continue to rise and remain near 2% target in 2018, but all the risks are to the upside. The unemployment rate is now down to 5.7%, the lowest level since 1976 and well below the OECD's estimate of the NAIRU level at 6.5%. Average hourly earnings growth has surged in response, rising to just under 3% on a year-over-year basis since the trough in early 2017. The Phillips Curve appears to be alive and well in Canada. Canadian interest rate markets have already responded aggressively to the stronger growth and inflation data. Our interest rate discounters now show that the money markets are now expecting 61bps of BoC rate hikes over the next six months and 91bps over the next twelve months (Chart 11). With a 25bp hike at next week's BoC meeting now priced with almost full certainty, the current market pricing suggests at least one more hike will happen by June and nearly three more hikes by year-end. That would be even more hikes than we expect from the Fed in 2018, which is important for the Canadian dollar (CAD). The CAD has appreciated 16% since it bottomed out in early 2016, occurring alongside the rise in global oil prices over the same period (second panel). The price of Canada's Western Select grade of crude oil has lagged the move in other oil benchmarks massively over the past several months, due to a lack of pipeline capacity getting oil out of Alberta that has created a supply glut. This may limit the degree to which additional gains in global energy prices benefit the Canadian dollar from a terms-of-trade perspective. This will not prevent the BoC from delivering additional rate hikes, however - especially if that merely matches the 75bps of Fed rate hikes that the FOMC is projecting, and which we expect, over the rest of the year. In terms of investment strategy, the combination of robust Canadian economic growth and rising inflation pressures leads us to continue recommending an underweight stance on Canadian government bonds, as we have maintained since July 11, 2017. This week, we are introducing two new tactical trades that should benefit as Canadian inflation moves higher and the BoC tightens more aggressively in response (Chart 12): Chart 10The Canadian Phillips Curve Is Not Dead The Canadian Phillips Curve Is Not Dead The Canadian Phillips Curve Is Not Dead Chart 11The Market Now Expects A Lot From The BoC The Market Now Expects A Lot From The BoC The Market Now Expects A Lot From The BoC Chart 12Two New Tactical Trades In Canada Two New Tactical Trades In Canada Two New Tactical Trades In Canada Short the June 2018 Canada Bankers' Acceptance futures contact vs. the December 2018 contract (middle panel). The market is now discounting the likely maximum amount of tightening that the BoC can deliver by year-end, while there are only little more than two hikes priced by June. Assuming that the BoC hikes next week, that means that there is only one more hike expected by June. With three more BoC meetings scheduled between next week and June, that provides plenty of opportunities for hawkish surprises from the BoC before then. In other words, this trade is a way to play for the BoC being forced to front-load more rate hikes into the first half of 2018 versus the latter half. Long 10yr inflation expectations through linkers versus nominal government bonds, or using CPI swaps (bottom panel). Given the pickup in domestic inflation pressures currently underway, plus the rise in global inflation coming from the surge in commodity prices, there is room for Canadian market-based inflation expectations to rise from the current level of 1.7%. Bottom Line: The Canadian economic data is moving from strength to strength, and now price and wage inflation data is moving higher. The Bank of Canada will likely hike rates next week with additional increases likely in 2018. Remain underweight Canadian government bonds. 2017 GFIS Model Bond Portfolio Performance: A Brief Review The turn of the year marked the end of the first full calendar year for the Global Fixed Income Strategy (GFIS) model bond portfolio. This now allows us to report the performance of the portfolio on the same basis as our clients. In the future, we will publish quarterly reviews of the portfolio returns after the end of each quarter in a calendar year (in April, July, October and January). The GFIS model portfolio returned 3.45% in 2017. This underperformed our custom performance benchmark (a blend of the Barclays Global Aggregate Index with global high-yield corporate debt) by -13bps (Chart 13). That underperformance can be entirely attributed to our government bond duration allocations, which lagged the benchmark by -46bps. Our recommended credit positions were a positive contributor, generating 33bps of outperformance primarily through overweights to U.S. Investment Grade and High-Yield corporate bonds. The detailed breakdown of the 2017 returns is presented in Table 1. In terms of the government bond portion of the portfolio, the underperformance can be isolated completely to the longest maturity bucket (10+ years). The combined performance of that bucket for all countries lagged that of the benchmark by -52bps. Given our expectation that global yield curves would bear-steepen in the latter half of 2017, it is no surprise that the bulk of our underperformance came by having too little exposure at the long-end. Also, having too much exposure in Japanese government bonds offering no yield also represented a major drag on the income component of the model portfolio's returns (Chart 14). Chart 13GFIS Model Bond Portfolio##BR##2017 Return Breakdown GFIS Model Bond Portfolio 2017 Return Breakdown GFIS Model Bond Portfolio 2017 Return Breakdown Table 1GFIS Model Bond Portfolio##BR##2017 Return Breakdown Let The Good Times Roll Let The Good Times Roll In terms of our credit allocations, favoring U.S. corporate exposure vs. non-U.S. corporates was the right call, generally speaking (Chart 15). However, we did not have enough portfolio weight in that trade to offset the drag on the overall yield from the Japan government bond overweight. Chart 14GFIS Model Portfolio Government Bond Performance Attribution By Country Let The Good Times Roll Let The Good Times Roll Chart 15GFIS Model Portfolio Spread Product Performance Attribution Let The Good Times Roll Let The Good Times Roll Looking ahead, the new model bond portfolio allocation for 2018 that we discussed in our final report of 2017 should offer a better chance of outperforming the benchmark.1 Specifically, we dialed down the Japan overweight, increased the U.S. Investment Grade corporate bond overweight, and reduced the curve steepening exposure in Euro Area governments. This not only boosted the overall yield of the portfolio, but also moderated the overall portfolio duration underweight. This portfolio will do well in the first half of 2018 if our base case of an inflation-driven rise in global government bond yields, led primarily by the U.S. where corporate debt is also expected to outperform Treasuries, comes to fruition. Bottom Line: We closed the books on the first full calendar year of our model bond portfolio with a total return of 3.75%. This was a small -13bps underperformance of versus our custom benchmark, coming entirely from underweight positions on longer-dated developed market government bonds that offset the asset allocation gains from overweights to corporate debt. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Allocation In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Let The Good Times Roll Let The Good Times Roll Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 31, 2017. The model's allocation to Australia has proven to be quite volatile as evidenced by the large increase to Australia this month to 7% from 1.7% in last month. As a result, the other commodity country, Canada, is now back to underweight from neutral last month. There are no significant large adjustments in other countries, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model underperformed its benchmark by 80 bps in December as the model was underweight the U.K. versus EMU, yet the U.K. was the best performer in the month while EMU underperformed. Since going live in January 2016, the overall model has outperformed the benchmark by 47 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 265 bps. The Level 1 model outperformed the MSCI World benchmark by 19 bps. Table 2Performance (Total Returns In USD) GAA Quant Model Updates GAA Quant Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of January 2, 2018. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Quant Model Updates GAA Quant Model Updates Table 4Performance Since Going Live GAA Quant Model Updates GAA Quant Model Updates The model has turned more bullish on global growth as seen by a 2% increase in aggregate cyclical overweight. However, the model continues to reduce its overweight in the resources-based sectors, and has upgraded financials to overweight on the back of improving momentum. Finally, both utilities and telecom stocks have been moved further into underweight territory. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com.

Highlights The Li Keqiang Index (LKI) is particularly relevant for global investors, who are most concerned with China's investable stock performance and the country's impact on global exports. BCA's view is that the LKI will retrace about 50% of its rise from late-2015 to early-2017. This is consistent with our call that China's economy will experience a benign, controlled deceleration. U.S. financial assets tend to perform better when the LKI is rising, than when it is decelerating. Correlations between China's economy and the S&P 500 have increased in the past few decades. Feature In the past three months, BCA's China Investment Strategy team has significantly heightened its focus on the cyclical condition of China's economy. Our colleagues presented their framework for tracking the end of China's mini-cycle in an October Weekly Report.1 This was followed by a two-part report that examined the key differences between China today and mid-20152 when the economy operated below what investors and market participants considered a stable pace of growth. These articles were anchored by BCA's view that in 2015 China's economy suffered from a double whammy: a weak external demand environment and overly tight monetary conditions. In a Special Report released in late November, BCA's China Investment Strategy took a different approach to gauge the slowdown in China's economy. The strategist tested a wide range of commonly watched macro data series for signs that reliably lead economic activity.3 The study surprisingly showed that measures of money and credit have been the most reliable predictors of China's economy since 2010. A composite leading indicator of these predictors suggests that the country's economy will continue to slow in the coming months. However, the pace and magnitude of the decline are consistent with BCA's view that China will experience a benign, controlled deceleration, and will not repeat its 2015 uncontrolled slowdown. A Brief Methodological Overview We provide a brief overview of our approach and address two questions: what are we trying to predict and what series do we use as predictors,4 to explain the Chinese business cycle? What are we trying to predict? We use the Li Keqiang Index (LKI) as a proxy for China's business cycle for three reasons: Despite the potential to become a consumer-oriented society, the economy remains highly geared to investment (and the industrial sector). Investors are familiar with the LKI since a 2007 U.S. diplomatic cable (leaked in late-2010) quoted Li, then Communist Party Secretary of Liaoning, telling U.S. Ambassador Randt that China's GDP figures were man-made and unreliable. Li's focus on electricity consumption, rail cargo volume and bank loans subsequently became a standard metric for China analysts. Most importantly, we use the LKI as a proxy because it continues to provide key information about China's economy. Chart 1 highlights that LKI leads China's nominal import growth. The index is particularly relevant for global investors who are concerned with China's investable stock performance and the country's impact on global exports. Chart 1The Li Keqiang Index Predicts Chinese Import Growth The Li Keqiang Index Predicts Chinese Import Growth The Li Keqiang Index Predicts Chinese Import Growth What series were used in our approach? To test the predictability of China's business cycle, we compiled a list of 40 highly tracked macroeconomic variables (presented in Appendix Table 1) and grouped them into six categories: Economy-wide measures, such as composite LEIs and models of GDP growth. Measures related to investment and the corporate sector, such as PMIs, fixed-asset investment and industrial production. Variables related to the consumer sector, such as consumer confidence, retail sales and the employment component of official PMIs. Housing indicators, such as house price indexes and residential floor space sold. Government spending. A variety of measures including money, credit and financial conditions. All series, including the LKI, were smoothed with a three-month moving average. The exception was government spending, which was smoothed with a six-month average. Chart 2Measures Of Money & Credit Are ##br## The Best Predictors Of The LKI Measures Of Money & Credit Are The Best Predictors Of The LKI Measures Of Money & Credit Are The Best Predictors Of The LKI Money And Credit: Results From The Data Lab Chart 2 presents the average correlation profiles for the six data categories described above, alongside the ideal profile. The chart allows us to draw several important conclusions: First, it highlights that while economy-wide measures and those related to investment and the corporate sector tended to have a high correlation with the LKI, their correlation profiles lag rather than lead. In other words, the LKI predicts these variables, not vice versa. The Markit/Caixin and NBS manufacturing PMIs are notable exceptions. Furthermore, variables related to both consumer spending and government expenditures appear to have little ability to predict China's business cycle. In the case of government spending, the evidence suggests that the LKI reliably leads expenditures by approximately a year. This implies that fiscal policy in China is responsive and countercyclical (but not leading). Finally, measures of money and credit, and housing to a lesser degree, appear to fulfill our first two criteria to be good leading indicators of the LKI. Both profiles peak in advance of t=0, and at least in the case of money and credit, have a strong relationship (Chart 2). BCA's results show that it is more accurate to state that money supply measures cause the LKI than vice versa, which means that money growth should be closely watched as an economic indicator. Chart 3 presents a composite leading indicator for the LKI based on the six variables presented above. The indicator is advanced by four months and suggests that the LKI will retrace about 50% of its rise from late-2015 to early-2017. This is consistent with our call that China's economy will experience a benign, controlled deceleration. An additional factor that strengthens our conviction is that the weakest components of the indicator on a year-over-year basis, M2 and M3 (as defined by BCA's Emerging Markets Strategy service), have increased more rapidly in the past three months (Chart 4). Chart 3Our Composite LKI Indicator Suggests ##br## A Benign Slowdown In Growth bca.usis_sr_2018_01_02_c3 bca.usis_sr_2018_01_02_c3 Chart 4Money Supply Growth ##br## Has Recently Rebounded Money Supply Growth Has Recently Rebounded Money Supply Growth Has Recently Rebounded BCA's stance is that investors should remain overweight Chinese investable stocks relative to the EM and global benchmarks. However, what does a retracement of the LKI and a slowdown in China's economy mean for U.S. asset classes? Charts 5 and 6 and Tables 1 and 2 show how several key financial markets have performed in periods when the LKI decelerated and accelerated. Chart 5Performance Of U.S. Financial Assets As The LKI Decelerates Performance Of U.S. Financial Assets As The LKI Decelerates Performance Of U.S. Financial Assets As The LKI Decelerates Chart 6Performance Of U.S. Financial Assets As The LKI Accelerates Performance Of U.S. Financial Assets As The LKI Accelerates Performance Of U.S. Financial Assets As The LKI Accelerates Table 1Performance Of U.S. Financial Assets As The LKI Decelerates China: Critical For U.S. Portfolio Allocation? China: Critical For U.S. Portfolio Allocation? Table 2Performance Of U.S. Financial Assets As The LKI Accelerates China: Critical For U.S. Portfolio Allocation? China: Critical For U.S. Portfolio Allocation? The Implications For U.S. Assets U.S. risk assets tend to perform better when the LKI accelerates. BCA has identified seven episodes since 1988 when the LKI slowed (Table 1) and an equal number when the LKI climbed (Table 2). The median returns for the S&P 500, high-yield and investment-grade corporates, small caps, gold, and oil, are all higher when the LKI speeds up. However, the dollar is apt to fall when the LKI accelerates and S&P 500 EPS growth is only one third as fast when the LKI gathers speed versus when the LKI is decelerating. The improved performance of U.S. risk assets when the LKI climbs is noteworthy, given that three U.S. recessions overlap with intervals of escalating LKI, and only one of seven phases of falling LKI intersects with an economic downturn in the U.S. There are pitfalls using LKI data before 2000. The basic structure of China's economy has shifted several times since the late 1980s. This first occurred during the early-to-mid-2000s as China transitioned from its rural roots to a manufacturing and export-led economy. In 2010, Chinese growth slowed as the government guided the economy toward a more consumer-led profile. Nonetheless, even if we exclude the pre-2000 interval, we draw the same conclusions about the performance of U.S. assets as the LKI picks up the pace and slows down. The LKI provided an excellent roadmap for U.S. assets from 2013-2017. The LKI index lost speed as the dollar rose, and oil prices peaked and then rolled over in late 2013 through September 2015. Then it began to reaccelerate in September 2015, five months before oil prices and U.S. equities prices bottomed in early 2016, and moved higher through early 2017. BCA's stock-to-bond ratio, the S&P 500, investment-grade and high-yield bonds, all performed better from September 2015 through early 2017 than in the 2013-2016 episode. As the LKI picked up pace between 2015 and 2017, the performance of small caps, gold, S&P 500 earnings growth and oil were also better than during the 2013-2015 timeframe when the LKI was in a lull. Rising Correlations The S&P 500 has become more sensitive to China's economy over time. Chart 7 presents the relationship between year-over-year shifts in the LKI and annual changes in the S&P 500 in three different eras: Chart 7Correlations Between LKI And S&P 500 Since 2000 China: Critical For U.S. Portfolio Allocation? China: Critical For U.S. Portfolio Allocation? 2000-2005, as China entered the world stage as an economic power after joining the WTO in the early 2000s; 2005 through 2007, after China revalued the yuan, but before the onset of the Great Recession; and 2007-2009, during and immediately following the Great Recession. It is difficult to find any positive correlation between the LKI and the S&P 500 in the early 2000s. However, a relationship began unfolding between 2005 and 2007, and from 2007 to 2009, the positive connection became even more defined. Many asset classes were highly correlated during and just after 2009, but the jump in the correlation between 2005-2007 and 2007-2009 is unmistakable. More recently (2009-present) the link weakened slightly, but it remains stronger than in the 2000-2007 period (not shown). The rise in foreign earnings as a share of total S&P 500 profits in recent years helps to explain the stronger link between China and U.S. equities. China has become a key driver of globally-sourced earnings as China share of global GDP has risen in the past two decades. Bottom Line: China's economy and financial markets play a much more critical role in the performance of U.S. financial assets than in the recent past. History suggests that U.S. assets perform better when the LKI picks up speed. However, BCA's stance is that the LKI is poised to decelerate modestly. This is consistent with our view that China's economy will experience a benign, controlled slowdown and not a sudden downturn, such as in late 2015 and early 2016. History suggests that U.S. assets perform better when the LKI is accelerating, not decelerating. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Appendix Appendix Table 1List Of Macroeconomic Data Series Included In Our Study China: Critical For U.S. Portfolio Allocation? China: Critical For U.S. Portfolio Allocation? 1 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle," published October 12, 2017. Available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part II): Monetary Policy", published November 9, 2017. Available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing the Predictability Of China's Business Cycle," published November 30, 2017. Available at cis.bcaresearch.com. 4 The original China Investment Strategy Special Report also explains how we judge which series are "useful" in explaining the Chinese business cycle.

Highlights 2018 Model Bond Portfolio Positioning: Translating our 2018 key global fixed income views into recommended positioning within our model bond portfolio comes up with the following: target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. Country Allocations: Divergences in likely central bank policy moves in 2018 will lead to more cross-country bond market investment opportunities. In our model portfolio, we are maintaining underweight positions in the U.S., Canada and the Euro Area, keeping a moderate overweight in low-beta Japan, and adding small overweights in the U.K. and Australia (where rate hikes are unlikely). Spread Product: Slower bond buying by central banks will result in a more volatile bond backdrop later in 2018, which will impact credit spreads. Stay overweight in the first half of the year, however, until higher inflation forces the hand of central banks. Feature Two weeks ago, we published our "Key Views" report, outlining the main fixed income investment implications deriving from the 2018 BCA Outlook.1 In this, our final report of 2017, we translate those Key Views into direct allocations in the Global Fixed Income Strategy (GFIS) model bond portfolio. As we always remind our clients, our model portfolio is intended as a vehicle to communicate our opinions on the relative attractiveness and trade-offs between fixed income countries and sectors. That is to say, the portfolio not only includes our traditional individual country and sector recommendations, but attaches actual weightings to those views within a fully invested hypothetical bond portfolio. The main takeaway from our Key Views is that bond market performance, and ideal asset allocation, is likely to look very different as the year progresses (Table 1). The first half of the year will see continued strong global growth and slowly rising inflation, but with central banks only slowing shifting to a less accommodative policy stance. This will create an environment where global bond yields will rise but with credit markets outperforming government bonds. The story will play out differently in the latter half, however, as worries over global growth expectations for 2018 will create more market volatility - albeit with lower cross-asset correlations as central banks act in a less-coordinated fashion than in recent years. Table 1A Pro-Risk Recommended Portfolio In H1/2018, Looking To Get Defensive Later In The Year Our Model Bond Portfolio Allocation In 2018: A Tale Of Two Halves Our Model Bond Portfolio Allocation In 2018: A Tale Of Two Halves Top-Down Bond Portfolio Implications Of Our Key Views The main predictions for 2018 in our Key Views report from December 5th were the following: A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. The most dovish central banks will be forced to turn less dovish: The ECB and BoJ will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. The first step in translating these themes into allocations into our model bond portfolio is to determining the ideal top-down asset allocation parameters for the start of the 2018: Maintain a moderate overall level of portfolio risk. Both bond yields (Chart 1) and credit spreads (Chart 2) are at the low end of their historical ranges since 2000. This suggests that bond market returns will be much lower than in recent years, simply because initial valuations are not cheap. Coming at a time when bond volatility is also at historically depressed levels, and with central banks starting to slowly take away the monetary punch bowl, keeping overall portfolio risk at modest levels is prudent. Within the GFIS model bond portfolio, that means keeping our tracking error versus our custom benchmark performance index well below our maximum target level of 100bps (Chart 3). Chart 1Historical Range Of Bond Yields For Various Fixed Income Markets, 2000-2017 Our Model Bond Portfolio Allocation In 2018: A Tale Of Two Halves Our Model Bond Portfolio Allocation In 2018: A Tale Of Two Halves Chart 2Historical Range Of Global Credit Spreads, 2000-2017 Our Model Bond Portfolio Allocation In 2018: A Tale Of Two Halves Our Model Bond Portfolio Allocation In 2018: A Tale Of Two Halves Maintain a below-benchmark overall portfolio duration. The combination of solid global growth, rising inflation and a slower pace of bond buying by the major central banks all suggest that bond yields will move higher in 2018. We will continue to target a recommended portfolio duration that is one year short versus our benchmark index (Chart 4). Chart 3Maintain Moderate Overall Portfolio Risk Maintain Moderate Overall Portfolio Risk Maintain Moderate Overall Portfolio Risk Chart 4Stay Cautious On Duration Risk Stay Cautious On Duration Risk Stay Cautious On Duration Risk Maintain an overweight stance on corporate credit over government bonds, focusing on the U.S. Although spreads are tight in so many asset classes, the global growth and monetary backdrop remains supportive for the outperformance of credit over government bonds. We recommended focusing on U.S. corporate credit, both Investment Grade (IG) and High-Yield (HY), where growth momentum remains solid and Fed policy is not yet restrictive. After setting those broad portfolio parameters, our recommendations get more interesting in terms of country allocations. Bond yields within the developed markets have become highly correlated to inflation expectations in the past few years (Chart 5). This is no surprise given how strongly central banks have tied their monetary policy decisions to their own inflation forecasts, and to market-based and survey-based inflation expectations. Inflation is likely to move higher next year alongside tight global labor markets and higher oil prices. If the bullish views on oil from BCA's commodity strategists comes to fruition, this implies that both market-based inflation expectations can rise and yield curves can bear-steepen. The key to the latter will be how fast central banks respond to faster rates of inflation. Yield curve steepness remains highly correlated to the level of REAL interest rates. Curves steepen when real interest rates decline and vice versa. Lower real rates can happen in two ways - bullishly, if central banks cut policy rates faster than inflation is falling; or bearishly, if central banks do not hike rates as fast as inflation is rising. We see the latter as being the likely story in 2018, which will lead to steeper government bond yield curves but through higher yields and rising inflation expectations. In Chart 6, where we plot the level of real central bank policy rates (deflated by 10-year CPI swaps as a measure of inflation expectations) vs. the 2-year/10-year bond yield curves. If global inflation expectations merely follow the path implied by our bullish oil forecast (Brent crude average $65/bbl in 2018), and central banks did not respond with rate hikes, then this would generate lower real interest rates (the "x" in each panel of the chart) and steepening pressure on yield curves. Chart 5Bond Yields In 2018 Will Be Driven More##BR##By Inflation Expectations Bond Yields In 2018 Will Be Driven More By Inflation Expectations Bond Yields In 2018 Will Be Driven More By Inflation Expectations Chart 6Steepening Pressure On Yield Curves##BR##From Inflation In 2018 Steepening Pressure On Yield Curves From Inflation In 2018 Steepening Pressure On Yield Curves From Inflation In 2018 We don't see all central banks responding the same way to an oil-driven move higher in inflation. Lower unemployment rates, and other measures of diminished economic slack, will be needed to give policymakers confidence that their economies can tolerate higher interest rates. Judging central banks along these lines will create more interesting country bond allocation decisions in 2018 (Chart 7). Specifically, we see a greater likelihood that the Fed and Bank of Canada (BoC) can actually raise interest rates next year. It will be much harder for the Bank of England (BoE) to raise rates given sluggish domestic economic growth, lingering Brexit uncertainty and the fact that market-based inflation expectations have already peaked. The Reserve Bank of Australia (RBA) will also be unable to hike rates next year given the lack of core inflation pressures and with an unemployment rate that is still much higher than previous cyclical troughs. This leads us to add moderate portfolio overweights in the U.K. and Australia to the government bond portion of our model bond portfolio, while maintaining our current underweight stances for the U.S. and Canada (Chart 8). The ECB and Bank of Japan (BoJ) will be nowhere near a point where interest rate hikes would be considered, although the decisions those banks make with their asset purchase programs will be a bigger issue for their bond markets in 2018. Chart 7Tight Labor Markets Will##BR##Influence Bond Returns Tight Labor Markets Will Influence Bond Returns Tight Labor Markets Will Influence Bond Returns Chart 8Monetary Policy Divergences##BR##Will Drive Country Allocation Monetary Policy Divergences Will Drive Country Allocation Monetary Policy Divergences Will Drive Country Allocation Bottom Line: Translating our 2018 key global fixed income views into recommended positioning within our model bond portfolio comes up with the following: target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. The Asset Allocation Implications Of Slower Central Bank Asset Purchases The big risk factor for global bonds in 2018 will be how markets respond to less buying from the Fed, ECB and BoJ. As the growth rate of the expansion of the major balance sheets slows, bond yields have the potential to rise through two channels: higher term premia on longer maturity bonds and the market pulling forward the expected future path of interest rates. This will become a major issue for Euro Area bond markets in the 2nd half of 2018, as the ECB will be forced by strong domestic growth and rising inflation pressures to announce a full taper of its asset purchase program by the end of 2018. This will come on top of a slower pace of buying by the BoJ (who is now targeting a price target on bond yields rather than a quantity target), and the Fed allowing some run off of its massive balance sheet. The result is that the growth rate of the major developed market central bank balance sheets is likely to slow to a low single-digit pace in 2018 (Chart 9), creating upside potential for global yields. The case for significant underweights in Euro Area fixed income will be much stronger later next year when the ECB will be forced to prepare the market for a taper. But in the first half of 2018, the impact of the ECB's purchases will continue to dampen Euro Area bond yields. At the same time, Japanese yields will remain pegged near 0% by BoJ buying. In terms of our model bond portfolio, we are maintaining an overweight stance on low-beta Japan given our views on rising global bond yields, while keeping aggregate Euro Area bond weightings close to neutral (and looking to go more aggressively underweight later in the year as the ECB taper talk ramps up). Bond markets that are less propped up by ultra-accommodative central banks will create a more volatile market backdrop for global fixed income as the year progresses. That is hardly a provocative statement, of course, given the starting point of utterly low realized bond market volatility (Chart 10). As discussed earlier, our views for 2018 lead us to recommend a more moderate portfolio risk level in 2018. The potential for higher central-bank driven market volatility fits with that expectation. Chart 9Global Yields Will Rise As##BR##Central Banks Buy Fewer Bonds Global Yields Will Rise As Central Banks Buy Fewer Bonds Global Yields Will Rise As Central Banks Buy Fewer Bonds Chart 10The Low Bond Vol Regime##BR##Looks Stretched The Low Bond Vol Regime Looks Stretched The Low Bond Vol Regime Looks Stretched A slower pace of central bank bond buying also has another implication for portfolio construction. With the wave of central bank liquidity becoming a less dominant factor, cross-asset correlations should diminish. We can see that by looking at the average correlation between sectors within our model bond portfolio benchmark index (Chart 11). We have found that the correlation is itself highly correlated to the breadth of global economic growth, as measured by our leading economic indicator diffusion index (top panel). But the average correlation is also linked to the growth rate of central bank balance sheets (bottom panel), which is a by-product of massive asset purchases reducing global macroeconomic risks and forcing investors to plow into similar asset classes to chase acceptable returns. Slightly less coordinated global growth, and less active central banks, should result in lower market correlations in 2018. At the same time, as central banks shift to a less accommodative stance - especially in the U.S. - the uncertainty about future growth has the potential to increase interest rate volatility that can also push corporate credit spreads wider (Chart 12). This will likely lead us to cut our recommended overweight allocations to U.S. IG and HY corporate debt in our model portfolio later in 2018. To begin the year, however, we are keeping an overweight stance until the Fed is forced to signal a shift to a more hawkish stance because of rising U.S. inflation. Chart 11Expect Lower Global Bond##BR##Correlations In 2018 Expect Lower Global Bond Correlations In 2018 Expect Lower Global Bond Correlations In 2018 Chart 12The Link Between U.S. Growth,##BR##Bond Vol & Credit Spreads The Link Between U.S. Growth, Bond Vol & Credit Spreads The Link Between U.S. Growth, Bond Vol & Credit Spreads Bottom Line: Slower bond buying by central banks will result in a more volatile bond backdrop later in 2018, which will impact credit spreads. Stay overweight in the first half of the year, however, until higher inflation forces the hand of central banks. Summing It All Up Chart 13Aiming For Moderate Carry##BR##In Our Model Portfolio Aiming For Moderate Carry In Our Model Portfolio Aiming For Moderate Carry In Our Model Portfolio On Page 12, we show our model bond portfolio allocations after making some changes to reflect our key views for 2018. We are doing some tweaks to our existing recommendations: modestly increasing our overweight U.S. IG corporates allocation at the expense of U.S. Treasuries; reducing our underweight in the Euro Area by reducing the large Italy underweight; adding exposure to the U.K. and Australia; while cutting our large overweight in Japan. The latter was there as a desire to get more defensive on the portfolio's duration stance, but having such a large allocation has left our portfolio with no yield advantage versus the custom benchmark index (Chart 13). With the changes we are making this week, the model bond portfolio will have a yield that is 12bps over that of our custom index. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Our Model Bond Portfolio Allocation In 2018: A Tale Of Two Halves Our Model Bond Portfolio Allocation In 2018: A Tale Of Two Halves Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The November jobs report keeps the Fed on track. Despite rising government debt levels, crowding out is not a significant threat. Capex as a share of GDP rises the year before a tax cut and falls in the year after. Holiday spending on track, boosted by tax bill. Feature Last week, investors assessed the ramifications of the OPEC meeting and the Senate's passage of the tax plan. The dollar was noticeably higher, and oil moved lower during the week, but other financial markets ended little changed. Chart 1 shows that the Trump trades are making a comeback, providing ample opportunity for investors who may have missed the trade the first time around. In this week's report, we examine the impact of the tax bill on the debt, deficit, and capital spending and more importantly on corporate balance sheets and financial markets. BCA's view is that the risk that rising government debt levels will crowd out private borrowing is low and that the tax cut will provide a tiny boost to an already robust capital spending environment. We also examine what signal the equity markets are sending about household spending in the holiday season. Chart 1Markets Responding To GOP Tax Plan Markets Responding To GOP Tax Plan Markets Responding To GOP Tax Plan Living In Paradise The November employment report, released last Friday, paints a Goldilocks-type macro environment for U.S. assets. Strong economic growth, muted inflation, and a go-slow Fed should prolong the bull market in U.S. equities. The economy added 228K in net new jobs, and the unemployment rate held steady at 4.1% in November. With the average work week rising by 0.1 hours, aggregate hours worked rose by a solid 0.5% m/m. Even if hours worked hold flat in December, the average for Q4 will be up 2.6% at an annualized rate from Q3. The November payroll data are easily consistent with about 3.5% GDP growth in Q4. BCA expects above-potential real GDP growth to persist well into 2018. Despite the strong growth and tight labor market, wage pressures remain contained. Average hourly earnings rose just 0.2% m/m in November, which followed a downwardly revised 0.1% m/m decline last month. Annual wage inflation is running at 2.5% (Chart 2). Last week's report will not dissuade the Fed from raising rates again next week. As long as GDP growth remains above trend and the labor market is tightening, the Fed will remain somewhat confident that wages will accelerate and inflation will gradually return to the target level. However, there is no reason yet for the Fed to turn more aggressive for fear of falling behind the curve. Chart 2November Jobs Report Keeps Fed On Track November Jobs Report Keeps Fed On Track November Jobs Report Keeps Fed On Track It's Getting Mighty Crowded The recently passed U.S. Senate tax reform bill has to be reconciled with the House bill, but it appears that the Republicans may meet their Christmas deadline after all. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018 at the latest.1 Although some technical differences between the two versions remain, the two bills are close enough that compromise should not be difficult. The Republicans are under pressure to deliver a "win" ahead of the 2018 mid-term elections. Most of the tax adjustments will occur early next year, except for a reduction in the corporate tax rate that may be delayed until 2019. The Senate version, if passed, would decrease individual taxes by about $680 billion over 10 years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of all the tax cuts will probably boost real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability of the tax changes and immediate capital expensing to lift animal spirits in the business sector and bring forward investment spending. The total impact - at this stage - is difficult to estimate. According to the Joint Committee on Taxation (JCT), by the end of 2027 the legislation will add $1 trillion to the debt, including the effects of dynamic scoring. Without the boost from faster economic activity due to the tax changes, the deficit is expected to be $1.4 trillion higher than the CBO's baseline projection for 2027. While nominal economic growth would increase under the plan, the debt-to-GDP ratio would climb to 95% of GDP by 2027, up from 91% under current law (Chart 3). Chart 3Federal Debt As A Share Of GDP Set To Rise Sharply In Coming Decades Federal Debt As A Share Of GDP Set To Rise Sharply In Coming Decades Federal Debt As A Share Of GDP Set To Rise Sharply In Coming Decades So far, the Treasury market has shown little reaction to the passage of the Senate bill. Fixed-income investors do not appear to be overly concerned about the implications of the size of the public debt and do not believe that the tax changes alter the Fed's calculations. BCA is also not concerned about the size of public debt in the near term but thinks the tax changes will alter the Fed's forecasts. Nonetheless, more government red ink is likely to raise equilibrium bond yields in the long term. The Fed estimates that the equilibrium 10-year bond yield would rise on a structural basis by 3-4 basis points for each percentage point increase in the Federal government's debt-to-GDP ratio, and by 25 basis points for every percentage point increase in the deficit-to-GDP ratio.2 The implication is that if the GOP plan becomes law, then the 10-year yield will be 12-16 bps higher than under current legislation. Nonetheless, there is only a modest risk that mounting U.S. government debt will crowd out private borrowing and choke off investment on a 12-month horizon. Crowding out occurs when soaring government debt sparks competition between the public and private sectors for available savings. Increased demand for private credit, a narrowing output gap, and elevated interest payments as a percentage of GDP, are all preconditions for crowding out. While the output gap has closed, demand for private credit is mixed, at best, and federal interest payments will remain in check. Private credit demand has rebounded from the recession, but it is still tepid. At 2% of corporate sales, nonfinancial corporate borrowing is at the lower end of its post-crisis range and has downshifted since 2015 (Chart 4). Before the 2007-2009 financial crisis, there was a tight relationship between corporate demand for funds and Treasury yields. Since 2009, the link has weakened; credit demand snapped back, but Treasury yields stayed low. Soft C&I loan demand also indicates less of a risk for crowding out (panel 3). Interest payments on the Federal debt are expected to climb, but remain well below all-time highs set in the early 1990s (Chart 5). The CBO's baseline projects that interest payments on the debt as a share of nominal GDP will more than double from 1.4% in 2017 to 2.9% in 2027. These payments will triple in absolute terms from $300 billion in 2017 to more than $800 billion in 2027. The GOP tax plan will boost the 2027 projection, but the CBO has not yet released a new estimate. In a study prepared prior to the passage of the tax bill, the OECD forecast that the federal government's interest payments would climb to 2.9% by 2019. Chart 4Private Credit Demand Has Rebounded,##BR##But Remains Tepid Private Credit Demand Has Rebounded, But Remains Tepid Private Credit Demand Has Rebounded, But Remains Tepid Chart 5Gradual Rise in Net Interest Payments##BR##Not A Crowding Out Threat Gradual Rise in Net Interest Payments Not A Crowding Out Threat Gradual Rise in Net Interest Payments Not A Crowding Out Threat Moreover, the Tax Policy Center, a center-left think tank, also concluded that interest costs will move up under the new tax law.3 On balance, interest payments on federal debt obligations as a share of the economy are expected to escalate in the next 10 years to 2.5-3%. This reading is in line with the average in the past 20 years, but is still below the 4-4.5% average reached in the late 1980s and early 1990s, and the 3.5-4% range observed from 1970-2000. If nothing else changes, higher federal interest payments would absorb funds that could instead be used for areas that add to the productive capacity of the economy, such as education, training and technical innovation. That said, the impact on long-term growth from "crowding out" may only represent a partial offset to the supply-side benefits of the fiscal package to the extent that the business sector lifts capex spending as a result of a lower corporate tax rate and immediate expensing (see below). Bottom Line: Tax cuts are bond bearish but support our overweight stance on equities on the surface. The effective corporate tax rate could decline by about two percentage points, which would boost after-tax cash flows by roughly 2½%. While this is not trivial, much of the good news already appears to be discounted in the S&P 500. Moreover, to the extent that faster growth in 2018 may bring forward hikes in the Fed funds rate, the equity market will have to contend with rising bond yields next year. Investors are also wondering about the tax plan's potential impact on capital spending and corporate balance sheets. Tiny Steps As discussed above, the fiscal package has the potential to generate significant supply side benefits, to the extent that the business sector turns on the capex taps. The JCT estimates that the tax bill will boost U.S. capital stock by 1.1% in 2027, an increase of about 0.1% a year. However, it is uncertain if corporations will permanently boost capex due to increased allowances for capital spending or if the tax shift will merely bring forward future spending. BCA's view is closer to the latter. We expect higher budget and trade deficits in the coming decade as a result of the Senate plan. These deficits will limit the ability of domestic saving to fund needed capital spending projects. Foreign saving will fill the gap. U.S. domestic saving is below the low end its 1960-2008 range (Chart 6). Chart 7 shows that since 1960, there have been four distinct periods of expanding net saving by foreigners. Nominal 10-year Treasury yields rose in three of the four intervals. However, real yields declined in the 1960s, rose in the mid-1970s and early 1980s as foreign saving increased, and then fell in the 1990s and 2000s. Moreover, a rise in the share of foreign saving led to higher capex in the mid-1960s and 1980s, but lower business expenditures in the 1990s (Chart 8). Chart 6Foreigners Will Finance Capex As##BR##Domestic Saving Declines Foreigners Will Finance Capex As Domestic Saving Declines Foreigners Will Finance Capex As Domestic Saving Declines Chart 7Interest Rates As##BR##Foreign Saving Rises Interest Rates As Foreign Saving Rises Interest Rates As Foreign Saving Rises Setting aside who will finance the spending, history suggests that business capital spending tends to climb faster in the 12 months prior to a period of rising fiscal thrust than it does in the 12 months following (Chart 9 and Tables 1 and 2). Note that our analysis shows that recessions occurred in five of the seven episodes of pro-cyclical fiscal policy. Chart 8Capex And Rising Foreign Saving Capex And Rising Foreign Saving Capex And Rising Foreign Saving Chart 9Capex During Periods Of Fiscal Stimulus Capex During Periods Of Fiscal Stimulus Capex During Periods Of Fiscal Stimulus In addition, as fiscal thrust escalates, stocks in the industrial and technology sectors underperform the broad market. Small caps generally beat large caps. Since 2000, the fed funds rate fell during periods of fiscal stimulus. Prior to that, the Fed both eased and tightened policy during these episodes (not shown). Table 1Business Spending 12 Months Before Pro-Cyclical Fiscal Policy Opportunity Opportunity Table 2Capex In The Year After Stimulative Fiscal Policy Is Enacted Opportunity Opportunity BCA's Corporate Health Monitor (CHM) has a tendency to improve during phases of increased fiscal thrust; Chart 10 shows that the CHM improved in five of the seven periods. Free cash flow and return on capital are the best performers during these intervals. In contrast, corporate leverage is apt to shoot up as fiscal policy takes hold. Chart 10Stimulative Fiscal Policy And The Corporate Health Monitor Stimulative Fiscal Policy And The Corporate Health Monitor Stimulative Fiscal Policy And The Corporate Health Monitor Our fiscal thrust measure includes both personal and corporate tax cuts, and along with increases in government spending. We use fiscal thrust as a proxy because there are a very limited number (just 3 since 1970) of corporate tax cuts to analyze. The paragraphs below covers the impact of corporate tax cuts on capital spending, capital spending-related financial metrics and corporate balance sheets. Capital spending is inclined to rise faster in the 12 months before a corporate tax cut than in the year afterward. The caveat is that there have been only 3 corporate tax cuts in the past 50 years. Charts 11 and 12 and Tables 3 and 4 examine the impact of previous corporate tax reductions on nonresidential fixed investment (and its components) as a share of GDP and on several capex-related metrics in the financial market. Chart 11Corporate Tax Cuts And Capital Spending Corporate Tax Cuts And Capital Spending Corporate Tax Cuts And Capital Spending Chart 12Corporate Tax Cuts And Financial Markets Corporate Tax Cuts And Financial Markets Corporate Tax Cuts And Financial Markets Moreover, industrial stocks underperform the broad market after a tax cut, while tech stocks outperform (Chart 12 again). Small-cap performance is mixed. Both the Fed funds rate and the 10-year Treasury yield rise after corporate tax decreases take effect. Table 3Capex The Year Before A Corporate Tax Cut Opportunity Opportunity Table 4Capex In The Year After A Corporate Tax Cut Opportunity Opportunity Corporate health weakens in the year before a business tax cut is enacted, but then it improves modestly in the ensuing year. Chart 13 and Tables 5 and 6 examine the significance of previous corporate tax cuts on BCA's Corporate Health Monitor (CHM) and several of its components. The interest coverage ratio deteriorates, on average, both before and after a corporate tax reduction, but leverage increases substantially in the 12 months following a corporate tax cut. Free cash flow deteriorates in the year prior to a drop in the business tax rate, but is little changed in the subsequent year. Chart 12Corporate Tax Cuts And Financial Markets Corporate Tax Cuts And Financial Markets Corporate Tax Cuts And Financial Markets Chart 13Corporate Tax Cuts And The Corporate Health Monitor Corporate Tax Cuts And The Corporate Health Monitor Corporate Tax Cuts And The Corporate Health Monitor Bottom Line: Business capital spending was already on the upswing and the output gap was already closed before the tax cut was passed. Accelerated depreciation allowance may pull capex ahead, but not materially change its trajectory over the long term. Corporate tax cuts and fiscal stimulus, in general, boost capex and corporate health, and support BCA's view that credit will outperform Treasuries in 2018. Table 5BCA's Corporate Health Monitor A Year Before A Corporate Tax Cut... Opportunity Opportunity Table 6...And In The 12 Months After Opportunity Opportunity Boxing Day The critical holiday spending season is in full bloom. Holiday retail sales make up the bulk of total consumer spending, representing about 20% to 30% of total annual retail sales (and about 40% of total personal consumption expenditures). Moreover, according to the National Retail Federation (NRF), although 54% of consumers surveyed expect to spend the same amount in this year's holiday season as in 2016, 24% are prepared to spend more. The NRF forecasts that holiday sales will increase between 3.6% and 4.0%, exceeding last year's 3.6% rate and the 5-year average forecast of 3.5%. Holiday retail sales have faded in nominal and real terms from an average of 4.9% in the 1993-1999 period to 3.7% pre-2008 (2000-2007) and to an average of 3.3% post-2008 GFC (2009-2016). However, the baseline trend, based on average annual growth rates, remains stable at 3%, with upside potential of as much as 6% during robust economic growth phases(mid 2000s) and downside risk to as low as -4% in recessions (2008) (Chart 14). Chart 14Holiday Sales: Strong Tailwinds Intact Opportunity Opportunity Holiday sales this season may just get an unexpected boost from stout consumer finances. The implication is that U.S. economic growth should remain above potential well into 2018. Solid consumer balance sheets remain a tailwind even at this late stage of the business cycle. Household balance sheets have been repaired in an optimal way and household net worth continues to soar to new highs. The implication is that households are much less likely to forego holiday spending this season than in periods where household net worth is under downward pressure. Furthermore, stock market returns for the U.S. consumer discretionary sector, measured between the mid-September to mid-December period, are well correlated with holiday spending trends (Chart 15). The 8.6% rise in the consumer discretionary sector since mid-September heralds another healthy holiday spending season. However, global consumer discretionary retailers are a better predictor of holiday sales than domestic consumer discretionary retailers. Prices here are up 6.6% since mid-September. Chart 15Trends Of Holiday Sales And Equity Returns Opportunity Opportunity Furthermore, expectations of tax reform legislation becoming law by the end of the year will incentivize low income households to spend more this holiday season. This cohort is apt to pay for holiday purchases with cash. The NRF has likened the benefit of the tax plan to a "free Christmas".4 The NRF suggests that the cumulative savings from the tax package for an average household will offset the $967.13 projected to be spent this year by the average household in the holiday season. Moreover, a 2016 Fed study finds that the financing for holiday spending varies by income. Low income households have a tendency to source holiday spending from savings/income rather than borrowing, and if access to credit is not readily available, they simply will not spend on holiday shopping.5 To ensure that a majority of U.S. households contribute towards a robust holiday spending season, strong employment growth alongside stable wage growth (and higher real income expectations) and sturdy consumer confidence is required. With an already tight labor market and the underemployment rate (U-6) close to pre-recession lows, solid consumer fundamentals remain intact. Bottom Line: A robust holiday shopping season is likely in 2017, supported by stout consumer balance sheets, the new tax bill, and rising wages and incomes. The 8.6% run up in consumer discretionary stocks also suggests that a happy holiday for retailers is in prospect. BCA's U.S. Equity Strategy service has a neutral rating on the Consumer Discretionary sector, but recommends an overweight the advertising, home improvement retail and leisure products industry groups. Additionally, BCA maintains an overweight to the holiday-sensitive Air Freight and logistics industry within the Industrial sector.6 Strong personal spending will support above potential GDP growth in Q4 and into 2018, eliminate the output gap, push the unemployment rate further below NAIRU and push up inflation and ultimately bond yields. Stay short duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 2 "New Evidence on the Interest Rate Effects of Budget Deficits and Debt", Thomas Laubach, Board of Governors of the Federal Reserve System, May 2003. https://www.federalreserve.gov/pubs/feds/2003/200312/200312pap.pdf 3 http://www.taxpolicycenter.org/sites/default/files/publication/148841/2001606-macroeconomic-analysis-of-the-tax-cuts-and-jobs-act-as-passed-by-the-house-of-representatives_1.pdf 4 https://nrf.com/media/press-releases/retailers-say-senate-passage-of-tax-reform-could-give-shoppers-free-christmas 5 https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/holiday-spending-and-financing-decisions-in-2015-survey-of-household-economics-and-decisionmaking-20161201.html 6 https://uses.bcaresearch.com/trades/recommendations

GAA DM Equity Country Allocation Model Update One thing worth noting is that the model now is neutral on Canada, after a long-standing underweight. Canada's valuation ranking had been improving, but the signal was only confirmed this month by the technical ranking. There are no significant changes among other countries, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 68 bps in November as the model was underweight both the U.S. and Japan, which were the only two countries to outperform the MSCI World benchmark in November! The underweight in the U.K. and Australia worked well, but not enough to offset the loss from the overweight of the euro area. Since going live in January 2016, the overall model has outperformed the benchmark by 157 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 489 bps. Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates Table 2Performance (Total Returns In USD) GAA Quant Model Updates GAA Quant Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of November 30, 2017. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Quant Model Updates GAA Quant Model Updates Table 4Performance Since Going Live GAA Quant Model Updates GAA Quant Model Updates The model has turned more bullish on global growth and consequently increased the aggregate cyclical overweight. However, within the cyclical basket there has be re-shuffle from resources-based sectors to consumer discretionary and technology stocks. This was driven by improving momentum in these two sectors. Finally, utilities stocks have been downgraded to underweight on the back of the bullish growth outlook. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights In this report we use a statistical approach to test the ability of a broad array of macro data series to reliably predict the Chinese business cycle. Out of 40 series that we examined, only 6 passed our test criteria. All 6 of these series are measures of money & credit, supporting the view that money growth deserves to be closely watched as an indicator for the Chinese economy. A composite leading indicator of the 6 "passing" series suggests that the Chinese economy will continue to slow over the coming months, but in a benign, controlled fashion. Investors should stay overweight investable Chinese stocks in US$ terms, versus both the EM and global equity benchmark. Feature Over the past two months we have significantly heightened our focus on the cyclical condition of China's economy. We presented our framework for tracking the end of China's mini-cycle in our October 12 Weekly Report,1 and recently followed up with a two-part report that examined the key differences facing China today from what prevailed in mid-2015, when the economy operated below what investors and market participants considered to be a "stable" pace of growth.2 All of these reports have been anchored by our view that China's economy suffered from a "double whammy" in 2015; a weak external demand environment and overly tight monetary conditions. In this report, we take a different approach to gauging the slowdown in China's economy by testing a wide range of commonly-watched macro data series for signs that they reliably lead economic activity. While our criteria for testing these series in our "data lab" are statistical in nature, they are not overly difficult for investors to grasp, and they help provide an empirical basis for understanding what data are relevant in predicting the direction and magnitude of China's economic growth trend. The conclusions of our study are revealing, in that they strongly point to measures of money & credit as the most reliable predictors of the Chinese economy since 2010. While a composite leading indicator of these predictors suggests that the Chinese economy will continue to slow over the coming months, the pace and magnitude of the decline are both consistent with our view that China will experience a benign, controlled deceleration. A Brief Methodological Overview Below we provide a brief overview of our approach, by addressing three key questions: what are we trying to predict, what series do we use as predictors, and how do we judge what series are "useful" in explaining the Chinese business cycle? What are we trying to predict? We use the Li Keqiang Index (LKI) as a proxy for the Chinese business cycle in this report, for three reasons (described below): Despite the potential to eventually become a consumer-oriented society, the Chinese economy remains highly geared to investment (and the industrial sector more generally). Investors are very familiar with the LKI, ever since a 2007 U.S. diplomatic cable (leaked in late-2010) quoted Li, then Communist Party Secretary of Liaoning, as saying to U.S. Ambassador Randt that China's GDP figures are "man-made" and unreliable. Li's focus on electricity consumption, rail cargo volume, and bank loans have since become a standard metric for China analysts to track. More importantly, however, we use the LKI as a proxy because it continues to provide important information about the Chinese economy: Chart 1 shows that it correlates well with the growth in earnings for the MSCI China index ex technology, and Chart 2 highlights that it also leads China's nominal import growth. As such, the index is particularly relevant for global investors, who are most concerned with China's investible stock performance and the country's impact on global exports. What series were used in our approach? Chart 1The Li Keqiang Index Predicts Investable EPS... The Li Keqiang Index Predicts Investable EPS... The Li Keqiang Index Predicts Investable EPS... Chart 2...And Nominal Import Growth ...And Nominal Import Growth ...And Nominal Import Growth In order to test the predictability of China's business cycle, we compiled a list of 40 highly-tracked macroeconomic variables (presented in Table 1) and grouped them into six distinct categories: Economy-wide measures, such as composite LEIs and models of GDP growth Measures related to investment and the corporate sector, such as PMIs, fixed-asset investment, and industrial production Variables related to the consumer sector, such consumer confidence, retail sales, and the employment component of the official PMIs Housing indicators, such as house price indexes and residential floor space sold Government spending, and A variety of money, credit, and financial conditions measures Table 1List Of Macroeconomic Data Series Included In Our Study The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle As part of this analysis, all series, including the LKI, were smoothed with a 3-month moving average. Government spending was the exception, which was smoothed with a 6-month average. How do we judge which series help predict the business cycle? Using a sample of January 2010 to September 2017, we test whether any of these measures can reliably predict the LKI using two statistical concepts: a lead/lag correlation profile, and the Granger causality test. A summary of these concepts is presented below: Lead/Lag Correlation Profile: While most investors are quite familiar with the Pearson correlation coefficient, in this report we present it in a unique way. For each variable, we calculate the correlation between the Li Keqiang index and leading and lagged values of the variable, to create a series of correlations which we present as a function of time. Variables that reliably lead the LKI should have a higher correlation with future values of the LKI, and vice versa. Chart 3 presents the ideal correlation profile for a predictor of the LKI (which we will use as a reference point), given that it illustrates the correlation profile of the LKI with itself in six-months. Granger Causality Test: While somewhat technical, the concept of Granger causality is fairly simple and is similar to the correlation profile presented above. The logic of the test is that if one variable predicts another, lagged values of the predictor should help explain the dependent variable in a regression model. Granger causality simply takes the extra step of controlling for the possibility that the dependent variable predicts itself, by including lagged values of itself in the regression. Our criteria for a good leading indicator for the LKI is thus: A correlation profile that leads rather than lags (i.e., a profile that peaks in advance of t=0, like that shown in Chart 3) A relatively strong correlation profile, defined as a peak correlation coefficient that exceeds 0.5 A causality test result that suggests the indicator "Granger-causes" the LKI. Chart 3The Best Profile Will Look Like The Correlation Of The LKI With Future Values Of Itself The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle The Importance Of Money & Credit: Results From The "Data Lab" Chart 4 presents the average correlation profiles for the six data categories described above, alongside the "ideal" profile. Individual correlation profiles for all 40 of the underlying macro series used in this report are available in Appendix I. Chart 4Measures Of Money & Credit Are ##br##The Best Predictors Of The LKI The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle The chart presents several important conclusions: First, it highlights that while economy-wide measures and those related to investment and the corporate sector have tended to have a high correlation with the LKI, their correlation profiles lag rather than lead. In other words, the LKI tends to predict these variables, not the other way around. The Markit/Caixin and NBS manufacturing PMIs stand out as notable exceptions to this conclusion. Second, variables related to both consumer spending and government expenditure appear to have little ability to predict the Chinese business cycle as defined in this report. In fact, in the case of government spending, the evidence points to the fact that the LKI reliably leads expenditure by approximately a year, which suggests that fiscal policy in China is responsive and countercyclical (but not leading). Third, measures of money and credit, and housing indicators to a lesser degree, appear to fulfill the first two of our criteria for a good leading indicator of the LKI. Both profiles peak in advance of t=0, and at least in the case of money & credit, have a decently strong relationship. To test the third criterion listed above, we selected all of the individual macro series that passed the correlation profile test and subjected them to a Granger causality test. Table 2 presents the variables that were selected as well as the results of the test, expressed as a probability that the variable in question "Granger-causes" the LKI, and vice versa. Of the 12 variables that were selected, Table 2 highlights that only 6 passed, all of which belong to the money & credit category. This is noteworthy, especially given the focus of many investors on the private and official manufacturing PMIs. Among these 6 remaining variables, the relative strength of the probabilities shown in columns 3 and 4 suggest that monetary conditions and the Bloomberg China Credit Impulse Index (the flow of adjusted total social financing expressed as a percent of GDP) appear to be the most reliable, with money measures being the least. Table 2Granger Causality Test Results For Select Macro Series The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Still, our results show that it is more accurate to state that money supply measures "cause" the LKI than vice versa, supporting the view that money growth deserves to be closely watched as an indicator for the Chinese economy. Investment Implications Chart 5 presents a composite leading indicator for the Li Keqiang index based on the six variables presented above. The indicator is advanced by 4 months, and currently suggests that the LKI will end up retracing about 50% of its late-2015 to early-2017 rise. For now, this is consistent with our view that the Chinese economy will experience a benign, controlled deceleration. An additional factor that strengthens our conviction in this view is the fact that the weakest components of the indicator on a YoY basis, M2 and M3 (as defined by our Emerging Markets Strategy service), have been growing more rapidly over the past three months (Chart 6). Chart 5Our Composite LKI Indicator Suggests ##br##A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Chart 6Money Supply Growth ##br##Has Recently Rebounded Money Supply Growth Has Recently Rebounded Money Supply Growth Has Recently Rebounded Given this economic outlook, our view is that investors should remain overweight Chinese investible stocks relative to the EM and global benchmarks. The first factor in favor of an allocation towards China is its tech sector weight; 42% of the index is made up of technology stocks, versus 29% and 19% in the EM and global benchmarks. While China's tech sector has already massively outperformed this year, Chart 7 highlights that it is a clear domestic/consumer play and thus unlikely to underperform significantly over the coming year. Chart 7Chinese Tech Companies ##br##Are A Domestic Play Chinese Tech Companies Are A Domestic Play Chinese Tech Companies Are A Domestic Play Excluding technology, we noted in our November 9 Weekly Report3 that while a deceleration in the LKI would weigh on the earnings growth of ex-tech investable stocks, we also expect earnings growth to moderate in the developed world. However, this ambiguous ex-tech relative earnings outlook is buttressed by the fact that Chinese ex-tech stocks are extremely undervalued compared to their global peers, a valuation gap that we believe will lessen if the end of China's recent mini-cycle is truly benign. Bottom Line: A broad test of China's macro data suggests that several money & credit measures have been the best predictors of the Chinese business cycle since early-2010. While these measures suggest that Chinese economic activity is set to decelerate even further, a return to 2015-like conditions does not appear to be likely. Investors should stay overweight Chinese investable stocks in US$ terms, versus both the EM and global equity benchmark. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports, "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, and "China's Economy - 2015 Vs Today (Part II): Monetary Policy", dated November 9, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part II): Monetary Policy", dated November 9, 2017, available at cis.bcaresearch.com. Appendix I Li Keqiang Lead/Lag Correlation Profile For All Variables In Our Study Chart A1 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A2 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A3 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A4 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A5 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A6 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A7 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A8 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Cyclical Investment Stance Equity Sector Recommendations

Highlights The centrist consensus is breaking down across the developed world; In its place is rising political plurality, with non-centrist and anti-establishment parties gathering support; This trend is not to be feared by the markets; Political systems that encourage political plurality - such as those of continental Europe - are more stable in the long run than those promoting political duopoly; Establishment parties in Europe can neuter single-issue parties by selectively adopting their agenda; Emergence of a third party in the U.S. would be positive for both the markets and the economy in the long run. Feature Chart 1European Border Enforcement Is Effective European Border Enforcement Is Effective European Border Enforcement Is Effective Germany's Social Democratic Party (SPD) signaled on November 23 a willingness to entertain another Grand Coalition with its rival the Christian Democratic Union (CDU). If coalition talks reproduce the centrist coalition that has ruled Germany since 2013, the risk of a new election will be averted. While European markets breathe a sigh of relief, there is much to be concerned about. First, the left-leaning, liberal Socialists will likely force Chancellor Angela Merkel to accept that family reunification for asylum claimants will remain an eligible migration route into the country. This means that the 1.3 million asylum seekers that have entered Germany since 2015 will be able to apply for family members to join them, swelling the numbers of migrants from Africa and the Middle East. This could raise tensions inside Germany and increase support for anti-establishment parties. This risk is overstated, as asylum seekers to Germany have collapsed since the EU stepped up enforcement of its borders after the 2015 crisis (Chart 1). Nonetheless, the perception that Merkel is soft on migrants will hound her for the remainder of what we believe will be her last term in power. Second, the SPD performed terribly in the September election, garnering only 20.5% of the popular vote, its worst performance since March 1933 (Chart 2).1 If the German Socialists enter another Grand Coalition, it will leave the anti-establishment, anti-immigrant, and anti-EU Alternative für Deutschland (AfD) in the ceremonial role of the leader of the opposition.2 Chart 2The Center-Left Has Collapsed In Germany Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? This brings up the larger concern for investors: collapse of the centrist monopoly on political power in the West writ large. Germany is hardly the only country that is facing centrifugal forces that are eroding the hold on power by the center-left and center-right establishment parties. Across a number of critical economies, the center-left and center-right political behemoths are giving way to new entrants into the political system. This political plurality means that post-World War Two era centrist duopolies are breaking down as new parties, many of them anti-establishment and populist, enter the scene. Should investors fear this development? The consensus says yes. We disagree. Even in the United States, we doubt that a "third party" would be a negative development. Introducing The Political Concentration Index Chart 3 shows the developed economy measure of our BCA Political Concentration Index (PCI), which we constructed using the Herfindahl-Hirschman index normally used to measure the level of monopoly in a particular industry.3 Our modified index measures political - rather than economic - monopoly. We replace "firms" with "parties" and "industry" with "political system" (i.e., country). A country with a single ruling party would register a 1 on the index, while a country with 10, equal-sized parties in its parliament would register a 0.1. Chart 3Political Plurality Is On The Rise In The Developed World Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? As Chart 3 illustrates, the developed economy concentration of political power has declined considerably. Power is concentrated in the hands of more and more political parties. Chart 4 shows the PCI of ten major western economies, illustrating that the culprits for the overall collapse of political monopoly are Australia, Canada, Germany, Spain, Sweden, and the Netherlands. Our indicator would illustrate an even greater decline of political concentration if we excluded the U.S. and the U.K. Somewhat surprisingly, Italy is actually holding up well, with current levels of political concentration in line with the post-World War Two era and higher than the free-wheeling 1990s. Chart 4Political Concentration Is On The Decline Across The Developed World Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? France also surprisingly illustrates rising political concentration, at least relative to the 1980-1990s. However, this result also reveals the weakness of our index. Our measure is ignorant of the rise and fall of major parties. As such, it has failed to take into account the massive political earthquake that has occurred in France, where President Emmanuel Macron's La République En Marche! (REM) has completely replaced the Socialist Party as the main center-left French party. This shift is not picked up by the index as the degree of concentration of political power in the French National Assembly remains unaltered. Overall, the data confirm the suspicions of many of our clients that the political consensus is breaking down across the western world. There are likely three culprits: The economic dimension is eroding in relevance: The post-World War Two organization of western political parties across the left-right economic spectrum echoed the late-nineteenth and early-twentieth century cleavages between the conservative bourgeoisie and revolutionary proletariat. The Industrial Revolution created immense wealth across Europe and North America, but also immense inequalities. As the urban proletariat grew in size, it demanded political and economic rights. For example, the German SPD remained committed to a radical proletariat revolution almost right up until the First World War. While the question of economic redistribution remains relevant today, the left-right economic axis is not as cogent in a world where living standards have risen massively since the turn of the last century. Culture wars: With the vast majority of western voters no longer responding to basic, Malthusian needs, identity issues are rising in prominence and drawing votes away from the centrist parties arrayed along the left-right economic spectrum. Several single-issue parties have found a permanent foothold in the political system, from the German Greens (since 1980) to the U.K. Independence Party (since 1993). A number of young and old parties have found particular success focusing on immigration, most prominently the Dutch Party for Freedom (founded in 2006), the Swedish Democrats (founded in 1988), the AfD (founded in 2013), and the New Zealand First party (founded in 1993). Generational cleavages: Voters born after the Cold War are particularly drawn to new and anti-establishment parties. Spain's Podemos and Italy's Five Star Movement (M5S) have had particular success appealing to young voters. Similarly, parties with a strong anti-immigration and anti-globalization focus have found success recruiting older voters. There is no single unifying theory that explains the erosion of the left-right economic spectrum as the defining political cleavage in the West. For example, France's Front National - anti-establishment, Euroskeptic, and anti-immigration - is particularly successful in recruiting young French voters, whereas its populist peers generally have not. Each country has its own set of idiosyncratic variables that explain how the political system is evolving. These range from endogenous factors (political system, demographics, ethnic makeup) to exogenous factors (economic crisis, membership in the EU, geopolitical risk, etc.). Even in the case of the U.S. - which shows no decline in political concentration (Chart 4), as Republicans and Democrats so far maintain a grip on their duopoly - numerous cleavages are evolving. Primary elections, particularly in the Republican Party, are pitting anti-establishment candidates - often ideologically aligned with the small government "Tea Party" - against establishment centrists. While these anti-establishment policymakers are officially aligned with the GOP, they often operate as an independent bloc in the House of Representatives. Bottom Line: For a number of reasons, different in each political system, the left-right economic spectrum is no longer driving voter preferences. Hence it should no longer serve as a starting point of analysis. Politicians who realize this - such as President Donald Trump or President Emmanuel Macron, both of whom challenged left-right orthodoxies on economic policy - are rewarded with surprising upsets. Our Political Concentration Index suggests that a trend is underway. Should investors fear the trend? The short answer is no. Political Plurality Is Stabilizing Political plurality should not be feared. True, in the short term, political plurality will produce political volatility. Aside from the ongoing German coalition talks, investors may remember the recent Spanish and Greek elections. Both countries had to hold two elections before producing a relatively stable political equilibrium due to the breakdown in what were traditionally two-party systems.4 Our PCI obviously suggests that similar outcomes are likely and to be expected. Germany could still become a case in point and Italy looms ominously in Q1 2018. However, there are three reasons why risks of more political plurality are overstated. The first is obvious. Chart 5 is the same as our Chart 3, but we have grafted onto it average GDP growth and unemployment rates. There is no clear difference in economic performance between periods of rising and falling political concentration. Chart 5The Economy Does Not Drive Political Concentration Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? The second is also obvious from Chart 5. There appears to be a pattern in the rise and fall of political concentration. In other words, investors should not necessarily extrapolate today's low concentration into the future. We suspect that the reason for the natural oscillation in our index is also the third reason that more political plurality is not a risk to the markets and the economy. A field of multiple parties allows establishment, centrist politicians to steal certain popular aspects of the electoral platform of the anti-establishment parties. Over time - what appears to be a roughly 7-year interval, or two electoral cycles on our chart - the establishment simply swallows the most competitive portions of the anti-establishment platform, repackages it in a way that is palatable for the median voter, and rebrands it as an establishment policy. The recent Austrian election is a perfect case study. Austria held a general election this year in October and the anti-establishment Freedom Party (FPÖ) came in third with 26% of the vote, a 5.5% increase from its 2013 outcome. It was not, however, the best performance for the FPÖ, as it had several strong performances in the late 1990s (Chart 6). Furthermore, investors often make the mistake of only comparing the performance of a party to the last election. In case of Austria, that means that analysts are ignoring four years' worth of polling data. In the particular case of the FPÖ, that means ignoring that the party's 26% performance was an absolute crushing collapse. As Chart 7 shows, the FPÖ went from leading in the polls for much of 2016, at one point reaching 35% support, to coming in third. Why? Chart 6Austrian Populists Have Been Here Before Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? Chart 7The Establishment Stole FPO's Thunder Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? As we illustrate in Chart 7, the Austrian establishment was not stupid. The center-right People’s Party (ÖVP) appointed 31-year-old Sebastian Kurz as its leader in May 2017. Kurz promptly shifted the ÖVP towards the FPÖ’s policy on immigration while retaining centrist views on literally everything else. From that point until the election, the centrist ÖVP crushed the FPÖ in the polls (the ultimate vote swing was nearly 15%). What the Austrian example shows is that a plural political system allows establishment, centrist parties to co-opt portions of the anti-establishment agenda without bringing them on board. In the long term, single-issue parties that focus on anti-globalization, immigration, the environment, or low-income families could see their support erode as the establishment parties adopt portions of their electoral manifesto, without setting-off major political earthquakes. Our forecast is that anti-immigration, populist parties in Europe have likely seen their peak in 2017. Other center-right parties will observe Kurz's success.5 There is simply no reason for them to stand in favor of open borders for asylum seekers in Europe going forward, particularly since newly arrived immigrants cannot vote. As such, it is far more likely that Kurz becomes a model for conservatives rather than, say, Angela Merkel. We concede that Merkel may be the last conservative holdover on immigration. She appears to be stuck defending her decision made in 2015 and is unable to pivot away from that episode. Our strong conviction view is that her successor as head of the CDU will have no such qualms and that the next conservative Chancellor of Germany will close all non-European immigration avenues to the country. Bottom Line: BCA's Political Concentration Index illustrates that political pluralism abates every seven years, or two electoral cycles. This is because single-issue and anti-establishment parties introduce new ideas and policies into the political marketplace, allowing the establishment players to co-opt some of those ideas and win elections without causing a dramatic - and market shattering - break with the past. Beware Of Political Duopolies Is there nothing that investors should fear in our data? No, they should fear persistent political monopolies and duopolies. Take the U.S. and the U.K. It is interesting that the two countries that have experienced the most populist political outcomes in the past two years - Brexit, Trump - are also consistently rated as having the highest political concentration (see Chart 4 on page 4). Why? We suspect that it is because the establishment parties in both political systems try to be catch-all, "big tent" conglomerates that capture a wide array of ideological views on several issues.6 By trying to capture diverse positions, including some fringe ones, they are in danger of becoming entrapped by them. One of the reasons for the "big tent" nature of Anglo-Saxon parties is the "first-past-the-post" electoral system of individual electoral districts. Unlike proportional representation systems favored on the European continent, first-past-the-post electoral systems radically reduce the incentives for small parties to launch independent campaigns.7 For example, UKIP captured 12.7% of the vote in the 2015 election, but it was awarded only one seat in the House of Commons. Such a record of failure is difficult to maintain for any political entity over a long period of time. Eventually, small parties are swallowed whole by their big tent counterparts. The problem with swallowing the whole party, instead of merely biting off an anti-establishment issue here and there, is that the big tent parties often swallow more than they can chew. In the case of the U.K.'s Conservative Party (which has almost wholly swallowed the anti-establishment UKIP), it has been forced to push forward with Brexit, which is dragging on the economy and making it difficult to govern. In the case of the Republican Party in the U.S., the Republicans absorbed the anti-establishment Tea Party, but the two wings of the party are at risk of descending into open warfare. The particular danger for U.S. parties is that their primary elections are normally poorly attended, particularly in midterm election years that lack the star-power of presidential candidates. This means that a candidate representing the far-left or far-right fringe can often win a candidacy with merely 4%-7% of the electorate in each district (the average turnout for primary elections in a midterm year).8 They then can easily proceed to be elected to the House of Representatives due to the fact that so few American electoral districts are truly competitive (Chart 8). As these anti-establishment voices gather force in Congress - 41 members of the GOP belong to the Tea Party-aligned Freedom Caucus for example - they can heighten already considerable polarization by preventing compromise (Chart 9). Chart 8No Competitive Districts Left In The U.S. No Competitive Districts Left In The U.S. No Competitive Districts Left In The U.S. Chart 9Polarization In The U.S. Is Historically High Polarization In The U.S. Is Historically High Polarization In The U.S. Is Historically High A heightened state of political polarization, which persists throughout the term in office, is far more market-relevant than heightened volatility around an election produced by more political plurality. For the most part, Europe's political systems have weathered a severe double-dip recession (triple-dip in Italy's case!), a massive loss of political confidence in European institutions, and a Biblical migration crisis with relatively few early elections (Table 1). In this turbulent period, many European governments have pushed through draconian austerity measures, far-reaching economic structural reforms, and agreed to fund or receive costly bailout programs. When anti-establishment parties came to power - as they legitimately did in Greece - they quickly migrated to the middle in order to govern, needing the votes of other parties. Table 1Europe: Less Volatile Relative To Context Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? Empirically speaking, there is no evidence that low political concentration is therefore inferior to the perceived stability of high political concentration exhibited in the U.S. and the U.K. The American and British economies both have seen generally better economic performances since 2008, yet they are struggling with dramatic bouts of populism in 2016.9 In the U.K.'s case, Brexit will reduce potential GDP. In the U.S.'s case, Trump's tax cuts will be inflationary, could hasten the next recession, and will likely exacerbate income inequality. We do not have a view on whether a third party will emerge in the U.S. Political polarization is a powerful trend at present, and since by definition it promotes the existence of two opposing ideological camps, it reinforces the two-party system. Republicans want to maintain control of the conservative base and hence cannot afford to let the Tea Party split off, while Democrats want to control the liberal base and cannot afford to let the progressive wing split off. If either party fractures, the other benefits. Nevertheless, there is nothing unique about the U.S. electoral system that would prevent a breakdown of the American political duopoly: other first-past-the-post systems exhibit political plurality, most notably in Canada. If a third party does emerge, we would wager that it would increase, not decrease, political stability; and reduce, not increase, political polarization. For example, if Tea Party policymakers were to run as independent candidates, it would free up both Tea Partiers and centrist Republicans to pursue their preferred policies in Congress. Centrist Republicans could vote with the Tea Party on matters of common concern and vote with the Democrats on issues where the Tea Party is deemed to be on the fringe. The basic ability to pass a budget would not be hindered by the Tea Party's single-mindedness on government spending, yet voters demanding tighter budgets would not be denied representation. Alternatively, if a new single-issue party emerged, say one favoring tighter immigration policy, Republicans would be free to co-opt aspects of its view on immigration and neutralize the threat of losing votes. They would not be forced to absorb the entire party and pursue hardline policies that would cause gridlock with Democrats. Bottom Line: Empirical evidence since the 2008 Great Financial Crisis does not support the conventional wisdom that low political concentration (i.e., political plurality) is less favorable for investors than high political concentration. Both the U.S. and the U.K., which score the highest on our PCI, have produced highly volatile political outcomes. Investment Implications Investors should not worry about the emergence of new parties in Europe. Particularly harmless are single-issue parties, specifically those focusing on tighter immigration controls. Conservative parties across Europe have already adopted more stringent immigration policies while still sounding sane, a potent electoral mix relative to some of the populist anti-immigrant parties currently vying for the votes of concerned citizens on the continent. Meanwhile, we do not fear the emergence of a third, or fourth, party in the U.S. In fact, such a development could play a role in reducing historically high political polarization in the country. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Yes. That 1933 election. 2 There is no official "leader of the opposition" in Germany and as such the AfD leadership is merely ceremonial. The left-wing Die Linke was in the same position from 2013-2017 with little effect. In fact, Die Linke saw only an incremental increase in its support (0.6%) between the two elections. 3 Regular readers of Geopolitical Strategy will know that we are big fans of the Herfindahl-Hirschman index. We have applied it before to measure geopolitical hegemony. Originally, the index was designed to assist in competition law and antitrust cases as it is an indicator of the amount of competition between firms in a particular sector. The formula for the index is shown below, where si is the market share of firm i in the market, and the N is the number of firms; Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? 4 Spain held an election in December 2015 and another in June 2016. The latter produced a minority government led by the center-right People's Party that is essentially supported by the Spanish Socialists Workers' Party (PSOE). Greece similarly held two elections, one in January 2015 and another in September of that year. 5 The German, establishment, Free Democratic Party (FDP) did so in the most recent election, copying ÖVP's focus on tight immigration policy. It has seen its support rise to 10.7%, a substantive increase from 2013. 6 We admit that the case for the U.K. as a political duopoly is harder to make given that there are third (and fourth) parties; although both the Labour Party and the Conservative Party have cleavages on the economy, globalization, and European integration that few European peers have. This is largely due to both parties' attempt to capture a diverse coalition of views. 7 First-past-the-post refers to an electoral system where the country is divided into electoral districts. In each electoral district, the party that wins the most votes generally sends its candidate to the legislature. While there are some variations on this model, and some mixed systems, this electoral system tends to favor political duopolies. In political science, this tendency has often been referred to as Duverger's law (named after the French sociologist Maurice Duverger who first observed this phenomenon). 8 Please see Elaine C. Kamarck, "Increasing Turnout In Congressional Primaries," Center for Effective Public Management at Brookings, dated July 2014, available at brookings.edu. 9 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com.

Highlights Risk assets continue to rise despite a flattening yield curve. Individual investors are more sanguine than institutional investors as stocks make new highs. The S&P 500 is testing the top of a key channel. Will it break out or break down? Bond market sentiment, positioning and technicals today vs. 1994. Feature Risk-on returned to financial markets last week as the S&P 500 hit a new all-time high and oil prices reached a 2-year high. Credit spreads narrowed as well. This occurred despite growing investor angst regarding the flattening yield curve. At 58 basis points, the 2/10 yield curve is still in positive territory, but the recent flattening could be interpreted as heralding a Fed policy mistake. We, too, are concerned. The flattening curve is being driven by the Fed's determination to continue lifting short-term rates even in the face of subdued inflation readings. Our base case outlook sees inflation grinding higher in the coming months, leading to a temporarily steeper curve. Nonetheless, we will re-evaluate our asset allocation if the curve continues to flatten and core inflation remains stuck in a range. BCA expects U.S. stocks to outperform Treasuries in 2018. S&P 500 EPS growth and margins will hold up through mid-year, supported by an above-trend domestic economic expansion in 1H 2018, a dose of fiscal stimulus and accelerating economic activity outside the U.S. Still, many investors are concerned that sentiment and valuations are signaling that a pullback is nigh. Sanguine Sentiment Our technical and sentiment indicators are not flashing red as in previous bear markets, but neither are they giving an all-clear for U.S. equity investors. Sentiment levels are a bigger concern than technical indicators and investors should monitor both for signs of an equity sell-off. BCA's U.S. equity sentiment indicator is elevated, although not at an extreme (Chart 1). Remarkably, in contrast to previous market troughs, individual Investors (panel 2) are more sanguine than either financial advisors (panel 3) or traders (panel 4). Bullishness among traders is at a 10-year high. Typically, after a long bull run, institutions are more cautious about equities than the oft-maligned individual investor. Several other sentiment surveys illustrate the divergence in sentiment between institutions and individuals. As per the American Institute of Individual Investors, the percentage of small investors who are bearish (Chart 2, 35%, panel 2) is in the middle of a 30-year range while the percentage of bulls (29%, panel 3) is at the low end. Moreover, Chart 3 shows the gap in the expectation between households and professionals on future stock market returns (as tallied by the Yale School of Management's International Center for Finance) and on buying the dips (panel 4). That said, individuals and institutions are more aligned on the likelihood of a stock market crash in the next six months. None of the three sentiment indicators from the Yale survey are at an extreme. Chart 1Overall Sentiment Levels Elevated##BR##But Not At Extremes Overall Sentiment Levels Elevated But Not At Extremes Overall Sentiment Levels Elevated But Not At Extremes Chart 2Individuals Are Not##BR##Overly Bullish Individuals Are Not Overly Bullish Individuals Are Not Overly Bullish Active managers have reduced equity risk since the beginning of Q4 (Chart 4). At 61%, the average equity exposure of institutional investors surveyed by the NAAIM1 is at the lowest level since May 2016 and is nearly half the 102% exposure at the start of 2017. The March 2017 reading was the highest since 2007, just before the S&P 500 peak in October 2007. Chart 3Gap Between Individual##BR##And Institutional Investors Gap Between Individual And Institutional Investors Gap Between Individual And Institutional Investors Chart 4Active Managers Still##BR##Overweight Equities... Active Managers Still Overweight Equities... Active Managers Still Overweight Equities... Similarly to previous bear markets, BCA's equity speculation index moved into "high speculation" territory in early 2017 and remains so as the year ends and range bound on average at somewhat lower levels. Net speculative positions of S&P 500 stocks are in balance, however, and do not signal that market risk-taking is rampant (Chart 5). Moreover, the dispersion of equity volatility of new high and lows of the S&P500 is quite wide, ranging from over 20% to below 5%, over previous historical periods since 1994. Although volatility is not a leading indicator of future equity market returns, good or bad, the current low level of volatility, especially over the short-term, 6 months to 1-year, may be longer-lasting, having peaked from over 15% only since early 2016 and now closer to 5%. Longer-term volatility, for example, based on 2-, 3- and 4-years, still remains above 10%. It is not unusual for both short-term and long-term volatility to eventually converge, as seen in post-bear market phases, especially in the mid-2000s (Chart 6). Chart 5Speculation High, But Not At Extremes Speculation High, But Not At Extremes Speculation High, But Not At Extremes Chart 6Equity Vol Remains Low Equity Vol Remains Low Equity Vol Remains Low Warning Signs From Technicals? On balance, the technical indicators we monitor do not suggest that the market is stretched. Chart 7 shows that the S&P 500 is testing the top end of the 2009-2017 recovery trend channel. A failure to break out of the channel may result in some near-term consolidation for U.S. equities. However, a definitive break above 2616 would imply another upleg for stocks. The escalating advance/decline line is also in a bullish trend (Chart 7). The other technical indicators we monitor fall into two categories. Some are elevated, but not at extremes. Others are still in the middle of the range and are not a concern. The S&P 500 is 6% above its 200-day moving average, in the upper end of its post-2000 range, which is well below the recent highs set in 2009, 2011 and 2013. The S&P's distance from its 50-day MA is in a similar position (Chart 8, panels 1 and 2). BCA's composite technical measure is in the middle of the 2007-2017 range, and is not a concern (Chart 9, panel 5). Moreover, the percent of NYSE stocks above their 10- and 30-week highs are midway in their recent range. Furthermore, new highs minus new lows is at neutral lows (Chart 6, panel 2). Chart 7Breakout...Or Breakdown##BR##At Top Of Channel? Breakout...Or Breakdown At Top Of Channel? Breakout...Or Breakdown At Top Of Channel? Chart 8S&P Not Elevated Vs.##BR##Moving Averages S&P Not Elevated Vs. Moving Averages S&P Not Elevated Vs. Moving Averages Chart 9U.S. Stocks Not##BR##Overextended U.S. Stocks Not Overextended U.S. Stocks Not Overextended Bottom Line: Neither sentiment nor technical indicators are flashing red, although the fact that institutional managers are heavily overweight stocks is worrying. We continue to recommend stocks over bonds in the next 12 months, but acknowledge that risks to BCA's stance are climbing. Investors should be prudent with risk assets, paring back any maximum overweight positions and holding some safe-haven assets within diversified portfolios. BCA's U.S. Equity Strategy service maintains a positive technical stance on the energy sector2 and notes that technicals in the consumer discretionary sector look washed out.3 BCA downgraded consumer discretionary from overweight to neutral on September 25, 2017 despite the attractive technical backdrop of the sector. Is It 1994 - Again? BCA's U.S. Bond Strategy service puts fair value on the U.S. 10-year Treasury at 2.69%,4 and rates may climb as high as 3.0% in 2018 if inflation returns to the Fed's 2.0% target. Fundamentals (elevated inflation, above-trend U.S. growth, a more aggressive Fed) support our bond view. However, what does the technical picture in the bond market tell investors? Charts 10 and 11 show the sentiment and technical indicators for the bond market in 2017 and 1994. The duration positioning of portfolio managers in late 2017 matches the situation in 1994. At 100%, portfolio duration is the highest since March 21, 2017. This positioning implies that the market is vulnerable to a spike in rates, as it was in 1994 when the Fed's 75-basis point rate hike in February caught the market off guard. In October 1994, portfolio duration was 103%. While BCA views a Fed policy mistake as a risk to our bullish equity call in 2018, a 1994-style surprise from the Fed is unlikely. In 1994, the Fed's policy intentions were opaque, at best. Since then, the Fed has become increasingly transparent and frequently seeks a "buy-in" from the market before boosting rates. Chart 10Bond Market Positioning,##BR##Sentiment And Technicals In 1994.... Bond Market Positioning, Sentiment And Technicals In 1994.... Bond Market Positioning, Sentiment And Technicals In 1994.... Chart 11...And In##BR##2017 ...And In 2017 ...And In 2017 The 10-year Treasury yield is currently in an uptrend as it was in early 1994. Today, yields have climbed 80 bps off their post-Brexit lows in mid-2016. The 10-year yield troughed in October 1993 at 5.19%, and rose 60 bps before the Fed's shock rate hike in early 1994. However, in 1994 yields were only beginning to enter the second decade of what would become a 35-year fall in bond yields. BCA's view is that the 1.57% yield in June 2016 marked the end of that multi-year decline. The bond market in late 2017 is as oversold as the bond market was in early 1994, although it took different paths to get to the same juncture. According to BCA's Composite Bond Indicator, the bond market in late 1993 and early 1994 was working off a deeply overbought position. However, by early 1994, bonds were modestly oversold. BCA's bond measure was deeply oversold in late 2016 and early 2017, but shifted into overbought territory in the summer. Today, bonds are modestly oversold. Panel 4 of Charts 10 and 11 show that Fed rate hikes were not priced in at the end of 1993 and in early 1994; today, a few increases are priced in. Investors were net purchasers of bond funds in 1993 and 1994, which is the same as the current situation. In 1993, however, investors were shedding bond funds while individuals are now adding to their bond positions. Bottom Line: Several sentiment and technical indicators in the bond market echo the scenario in 1994. Nonetheless, 25 years of increased Fed transparency means it would be unlikely that the market will be surprised by the Fed's next rate increase. Still, with a new Fed Chair, a record number of vacancies on the Fed's Board and an unprecedented unwinding of its balance sheet, a policy misstep by the Fed would threaten BCA's position on the economy, equities and bonds in 2018. A bigger risk may be that the bond market is still priced for the low inflation environment to persist. Accordingly, if there is an upside surprise on inflation, bonds could be hit hard on a re-assessment of the Fed's rate path. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 National Association of Active Investment Managers. 2 Please see BCA Research's U.S. Equity Strategy Weekly Report "Invincible", published November 6, 2017. Available at uses.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Weekly Report "Resilient", published September 25, 2017. Available at uses.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "Into The Fire", published November 7, 2017. Available at usbs.bcaresearch.com.