Consumer

Highlights An extended period of synchronized global growth suggests above-potential U.S. growth will persist into 2018. BCA expects inflation to move back to the Fed's 2% target in 2018, allowing the Fed to raise rates four times. However, a new study by the SF Fed suggests that inflation could be stuck in low gear for a while longer. The U.S. consumer is poised to have a good year in 2018, aided by rising incomes, solid balance sheets and elevated confidence about future increases in employment and incomes. BCA expects a rebound in residential investment in 2018 despite higher mortgage rates. Feature BCA's Outlook for 2018 was published just recently.1 The report laid out the macroeconomic and policy themes that will impact financial markets during the next year. In this week's report we expand on those themes and discuss what they mean for the U.S. economy and financial markets specifically. A period of synchronized global growth will persist into 2018 and allow the U.S. economy to grow well above its long-term potential for a time. Overseas demand will lift U.S. profit growth in 2018, although both earnings and profit growth will peak next year. Widespread global growth and a positive output gap in the U.S. will lead to accelerating wages, higher inflation, a more aggressive Fed and higher bond yields. U.S. stocks will outperform bonds in 2018. Despite higher mortgage rates, the U.S. housing market will provide a lift to the U.S. economy in 2018 as residential investment rebounds after a challenging 2017. A peak in residential investment provides an early indication that a recession is on the horizon. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced. In the long duration economic expansions in the 1980s and 1990s, residential construction provided an even earlier signal. The U.S. consumer will also add to growth in 2018, aided by solid balance sheets, near record confidence and elevated confidence about future increases in employment and incomes. Risks remain, however, and the biggest threat to our view of the U.S. economy and financial markets in 2018 is that inflation overshoots the Fed's 2.0% target. BCA's view is that inflation will return to 2% gradually. A faster pace of inflation may prompt a more aggressive Fed and catch markets off guard. If inflation fails to move back to 2%, the Fed may slow the pace of hikes, clearing the way for the current goldilocks scenario to persist even longer. Synchronized Global Growth For the first time in more than a decade, global economic activity is widespread. Led by a surge in capital spending, the economy is experiencing its strongest growth since the mid-2000s. The solid international expansion will bump U.S. industrial production and capital spending orders even higher and also support U.S. exports (Chart 1). The ebullient global backdrop may persist for a while. The OECD's global leading economic indicator is in a clear uptrend and suggests above-trend growth will persist through the end of 2018 (Chart 2). Global PMIs are also climbing (panel 2). The robust global growth has added to mounting inflationary pressures. In the U.S., the unemployment rate is below NAIRU; other OECD countries have followed suit. In all, almost 75% of member countries in the OECD are running at full employment (Chart 3). Chart 1Animal Spirits Are Stirring Animal Spirits Are Stirring Animal Spirits Are Stirring Chart 2Upbeat Global Growth Prospects bca.usis_wr_2017_12_04_c2 bca.usis_wr_2017_12_04_c2 Chart 3NAIRU Is A Global Phenomenon NAIRU Is A Global Phenomenon NAIRU Is A Global Phenomenon U.S. corporate profits will benefit from vigorous global economic activity. On average, 43% of S&P 500 sales are derived from overseas. Several sectors (Energy, Information Technology and Industrials) rely on international business for more than 50% of their sales and earnings. BCA's view that the U.S. dollar will move only modestly higher in 2018 implies that the currency will not have a major impact on EPS. When more than 90% of nations have positive GDP growth, stocks beat bonds, and the output gap narrows and closes, which leads to a lower unemployment rate and a more active Fed (Charts 4 and 5). The dollar's performance is mixed during intervals of strong global growth. The dollar climbed in the late 1990s, but sagged in the early- to mid-2000s. When global growth is strong, U.S. industrial production is generally higher. However, IP dipped in 2015 as oil prices fell at the start of the recent period of synchronized growth. Chart 4Widespread##BR##Global Growth ... Widespread Global Growth... Widespread Global Growth... Chart 5... Supports Risk Assets, Trade And##BR##A Narrower Output Gap ... Supports Risk Assets, Trade And A Narrower Output Gap ... Supports Risk Assets, Trade And A Narrower Output Gap Global growth could be derailed by any one of several threats. The risk of a prolonged flare-up in geopolitical risk in northeast Asia could curtail global trade. Furthermore, BCA's Geopolitical Strategy team expects that relations between the U.S. and North Korea will follow the example of U.S. negotiations with Iran in the mid-2000s; periodic conflicts accompanied by back channel negotiations over several years.2 A policy mistake by the Fed or China may also disrupt the global bonhomie and, in turn, slow growth. Most measures of China's credit impulse are decelerating and the Chinese government's reforms may impact growth more than we expect. Moreover, weak poll numbers may lead President Trump to trigger trade disputes with important trading partners such as China, Mexico and Canada. Bottom Line: Synchronized global growth supports BCA's view that U.S. EPS growth will top out in 2018, but will remain positive. Margins should also top out in 2018. The positive backdrop will allow stocks to beat bonds next year, and credit to outperform Treasuries, even as the Fed raises rates. The environment for risk assets will stay supportive even if inflation does not accelerate. However, our forecast could be derailed by a sudden surge in inflation in 2018. Inflation At An Inflection Point? The Fed can rest a little easier following last week's rise in their preferred gauge of inflation, the core personal consumption expenditures (PCE) price index, as the monthly rise was somewhat strong at 0.2% and the annual growth rate inched higher to 1.4% (year-over-year) in October, up from the previous month at 1.3% (year-over-year). In contrast, a diffusion index which includes the components of the PCE index, unlike the CPI, has moved back below zero, implying that inflation pressures are not yet widespread (Chart 6). Regardless of current sluggish inflation dynamics, BCA's view is that inflation will rise by enough to convince the Fed that continuing to boost rates next month is the right direction for monetary policy. However, patience will be required as it is too early to say if inflation has reached an inflection point as it is still below the Fed's 2 percent inflation target and remains persistently at a low level. Outgoing Chair Yellen's voiced this concern by saying at the September 19-20 FOMC meeting that the shortfall of inflation from 2 percent is a "mystery", which echoed Fed Chair nominee Powell's sentiment at Jackson Hole (August 2017). Furthermore, prior to the PCE release last week and in her last testimony, Yellen reiterated that "Even with a step-up in growth of economic activity and a stronger labor market, inflation has continued to run below the 2 percent rate. The recent lower readings on inflation likely reflect transitory factors. As these transitory factors fade, I anticipate that inflation will stabilize around 2 percent over the medium term. However, it is also possible that this year's low inflation could reflect something more persistent. Indeed, inflation has been below the Committee's 2 percent objective for most of the past five years." As we have discussed previously,3 though the Fed is unified on its gradual path for monetary policy, Chair Yellen's current dismay about the uncertainty for the path of inflation is not a widely held view among the members of the committee. The internal debate at the Fed about this "mystery" continues, and may heat up as four new board members join the FOMC. BCA's view is that inflation will move higher over the next year. However, a recent study4 by the FRB of San Francisco takes a different view. Economists at the San Francisco Fed concluded that the path for inflation (based on core PCE) has more downside. Their work suggests that health-care services inflation will remain a drag to core PCE due to recent changes in health care legislation. Health-care services represent about 35% of the PCE spending category identified as non-cyclical (58% of core PCE is non-cyclical or "acyclical" while 42% of core PCE is "procyclical"). Authors of the study estimated that health care services have subtracted about 0.3% from core PCE compared to the last recovery period in 2002-2007 (Chart 7). Accordingly, the unrelenting decline in health-care services inflation has prevented core PCE inflation from returning to its pre-recession average above 2 percent. Moreover, overall non-cyclical inflation is subtracting about 0.6% from core PCE inflation compared with the mid-2000s. Chart 6CPI And PCE Diffusion##BR##Indices Signals Diverge CPI And PCE Diffusion Indices Signals Diverge CPI And PCE Diffusion Indices Signals Diverge Chart 7Noncyclical Sources##BR##Driving Inflation Lower Noncyclical Sources Driving Inflation Lower Noncyclical Sources Driving Inflation Lower The Fed's rationale for higher rates of the previous 2004-2006 tightening cycle was quite different than today's. Just prior to the initial rate hike, the economy was "expanding at a rapid pace" and members of the FOMC had a high level of conviction that "robust growth would be sustained." More importantly, policymakers viewed the household sector as a "key driver in the expansion" as consumer spending was expected to continue to grow at a strong pace.5 Though inflation pressures were building, "most members saw low inflation (core PCE) as the most likely outcome" amid strong productivity growth. Even so, inflation persisted in an uptrend near the 2% threshold (and eventually crossed over in the following months) even as "considerable" labor market slack remained and wage growth moderated (though within the 3-4% range). That said, the bond market today is concerned about a policy mistake by the Fed. The 2/10 Treasury yield curve moved from 86 in October to 58 last week, reflecting the risk that the downward pressures on inflation remain elevated. If the i.e. transitory factors do not dissipate core inflation may get entrenched into a lower channel. The Fed may have to pause or cut short its tightening cycle if lower inflation persists and is accompanied by a decline in market-based measures of long-term inflation expectations. Bottom Line: BCA expects inflation to move back to the Fed's 2% target in 2018, allowing the Fed to raise rates four times. The market is only expecting one or two hikes next year. Our view is that the curve will steepen in 2018, as the market acknowledges the return of inflation. BCA's U.S. Bond Strategy service expects the 10-year Treasury yield to move above 2.8% next year, and may move as high as 3%. Stay overweight stocks versus bonds and underweight duration. U.S. Consumer Outlook Thanks to the consumer, the U.S. economy is operating very close to its long-term potential. Household balance sheets are in better shape than in the corporate sector. For example, total household liabilities are 11.3% below their long-term trend (since 1950) and have moved sharply lower since the early 1980s (17.2% in 1983Q1). Household net worth in 2017Q2 was at a record high, the result of stable house prices and frothy equity markets, according to the latest Flow of Funds data for 2017Q2 (Chart 8). House prices, based on the Case-Shiller National index, have increased steadily and have experienced their fastest yearly growth rate since June 2014 (6.15% year-over-year). Nationwide, housing prices are 46% above their 2012 trough and 6% above the pre-recession peak (July 2006). Moreover, given the equity market's recent new highs, households' financial position should continue to record further gains for at least the next two quarters (2017Q3 Flow of Funds data is due on December 7). Consumer confidence - although mostly a coincident indicator for consumer spending - continued to climb in November to a 17-year high. The increase was the result of elevated expectations for future gains in employment and income, though the latter decreased very slightly. These inflated readings may further support steady consumer expenditures at this late stage of the business cycle, especially heading into the holiday shopping season. Next week, we will examine previous spending cycles to better understand the implications for the 2017 holiday retail season. Consumers remain very optimistic about future labor market advances, making it easier ("jobs plentiful") rather than difficult to find a job ("jobs hard to get"). Furthermore, 46% of consumers expect stock market returns to strengthen in the next year in contrast to only 19% expecting stock prices to decrease over the same period. Nevertheless, there are risks that may dampen the pace of consumer spending. BCA expects employment growth to slow because the labor market cannot get much tighter. Plus, there is a shortage of skilled employees, according to the National Federation of Independent Business (NFIB) and the Fed's Beige Book. Moreover, the personal savings rate cannot sustainably remain at its recovery low of 3.2%. However, small businesses' upbeat plans for labor compensation still bode well for rising wages and salaries as they are at their highest level since March 2000. For consumer spending to flourish, overall labor income will need to improve. At 2.6%, annual wage compensation growth remains sluggish and far from the 3-4% per year that the Fed has stated would be consistent with an economy closer to a 2% inflation rate (Chart 9). Chart 8"Teflon" Household Balance Sheets "Teflon" Household Balance Sheets "Teflon" Household Balance Sheets Chart 9Consumer Spending Tailwinds Consumer Spending Tailwinds Consumer Spending Tailwinds Moreover, households are unlikely to binge on more debt to smooth out their expenditures as they did in the mid-2000s. A further acceleration in consumer spending would occur alongside steady improvement in the labor market and improving household confidence on future employment and income gains. As such, last week's income and spending report showed that while the consumer held back on real spending in October (+0.1% month-over-month), real personal income rose by 0.3% month-over-month. Real income growth troughed in December 2016 but has climbed by almost 2% in the past three months. Fed policymakers can take comfort that over the medium-term, consumer spending remains quite stable at around 2.5-3.0%. BCA still expects consumer spending to continue to grow by at least 2% pace in 2018 which should keep the expansion humming along. Bottom Line: The outlook for the U.S. consumer remains bright due to solid fundamental tailwinds such as strong employment growth, stable disposable incomes, frothy household net worth and buoyant confidence. This should continue to support the domestic economy and global growth, especially ahead of the holiday shopping season. Consumer headwinds to monitor are households' incentive to start saving more as wages remain stagnant and employment growth slows. However, as the fundamental tailwinds outweigh the headwinds for household spending, BCA still expects the U.S. consumer sector to remain steady over the near term. Residential Investment: More Than Just A Q4 Snapback Housing will boost GDP growth in 2018. BCA's view is that housing did not peak in early 2016 (Chart 10, panel 4). Investment in residential construction in Q2 was held down by higher rates and a mild 2016-17 winter that pulled construction ahead into Q1. Hurricanes Harvey and Irma made a major dent in Q3. A bounce in activity is underway in Q4, but we expect more than just a single quarter snapback. Instead, conditions are in place for an extended period of growth in residential investment. Low inventories, a rising homeownership rate, and a 12-year high in homebuilder sentiment, all support our bullish view (Chart 10). Inventories of unsold new and existing homes are near record lows (panel 2), and in many areas of the country, low inventories are limiting sales activity and pushing up prices. Homeownership rates are escalating again (panel 3), led by solid momentum in real disposable income, which in turn, and is a product of the booming labor market and rising wage inflation. Moreover, housing affordability will remain above average even if our forecast for a 2.8% 10-year Treasury yield is met (Chart 11). A 200 bps rise would push affordability below its long-term average for the first time in nine years. A more plausible path for rates would be a 100 bps increase in mortgage rates. Under this scenario, the affordability index would deteriorate, but remain a tailwind for the housing market. Chart 10Solid Housing##BR##Fundamentals In Place Solid Housing Fundamentals In Place Solid Housing Fundamentals In Place Chart 11Housing Affordability Under##BR##Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing investment is not only an important gauge of economic growth, but it also is the best leading indicator among all sectors. Construction of new homes and apartments, along with additions and alterations to existing stock, peaks as a share of GDP, on average seven quarters before the end of an expansion. Consumer spending on durable, nondurable and services reach a high five quarters before GDP hits a zenith, while business capital spending tops out six quarters ahead of the economy. There are risks for housing despite the upbeat fundamentals. Banks have been tightening their lending standards in recent quarters and an overtightening may impede the real estate market. A major change in the treatment of state and local real estate taxes and mortgage interest in the GOP tax plan may also negatively affect housing demand, particularly at the high end of the market. Additionally, rising foreign demand in certain U.S. markets may lead to mini-bubbles in coastal areas. The latest reading on the Case Shiller home price index showed housing prices up at the fastest rate in three years. A prolonged period of home price increases above income gains would challenge our sanguine view of housing affordability. However, the Fed and the banking system that it regulates are hyper-vigilant about excesses in the housing market, and it is unlikely that another housing bubble will be tolerated.6 Bottom Line: Housing is a reliable leading indicator of economic activity. Spending on new construction will add to growth in the coming year, allowing the economy to expand at a pace well above its long-term potential. Faster GDP growth will be accompanied by higher inflation and a more active Fed, especially relative to current market expectations. Moreover, a healthy housing market will continue to support solid consumer spending, the economy's largest and most important sector. 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 Outlook 2018, "Policy And The Markets: On A Collision Course", November 20, 2017. Available at bca.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?", August 16, 2017. Available at gps.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Managing The Risks", published October 2, 2017. Available at usis.bcaresearch.com. 4 Mahedy, Tim and Shapiro, Adam, "What's Down With Inflation?", Federal Reserve Bank of San Francisco, November 27, 2017. http://www.frbsf.org/economic-research/publications/economic-letter/2017/november/contribution-to-low-pce-inflation-from-healthcare/ 5 Minutes of The Federal Open Market Committee, May 4, 2004: https://www.federalreserve.gov/fomc/minutes/20040504.htm 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com.

Highlights Powell's nomination will not change the Fed's gradual rate hike path, but open Board seats are a worry. Household debt growth is slower than usual, but auto debt levels are a concern. Stocks will beat bonds and oil will rise after EPS growth peaks next year. Funding liquidity should remain adequate as the Fed unwinds its balance sheet. Feature Last week was an extraordinarily busy week for U.S. financial markets, but BCA's view on the economy, the Fed and asset class returns remains the same. President Trump named Jerome Powell to replace Janet Yellen as Fed Chair and the GOP released additional details of their tax plan. The October readings on employment, manufacturing, and wage growth fell short of expectations. However, data on consumer confidence, non-manufacturing ISM and vehicle sales for October exceeded expectations. The Q3 Employment Cost Index will give Fed policymakers confidence that the Phillips curve is not dead, but the persistent weakness in unit labor costs (the Q3 data was released last week) will concern the FOMC. The Fed remains on track to raise rates by 0.25% in December and three more times in 2018, matching their dot plot. While average hourly earnings disappointed in October, the impacts of Hurricanes Harvey and Irma make the data difficult to interpret. Nonetheless, the year-over-year growth in the 3-month moving average of average hourly earnings was 2.6% in October, up from 2.5% in July, before Harvey made landfall in Texas. Moreover, real GDP is growing faster than the economy's long term potential (1.8% per the Fed), and at 4.1%, the unemployment rate is well below the Fed's measure of full employment (4.6%) (Chart 1). Jerome Powell will continue to pursue the gradual rate hikes preferred by his predecessor. However, Powell is the first Fed Chair since G. William Miller (1978-79) to not have a PhD in economics. He is not known as a policy hawk or a dove, and this lack of conviction in his own policy suggests that he will rely on more on his Board colleagues for direction than recent chairs. The potential power shift from the chair to the committee may make FOMC communications more difficult to interpret. After Yellen departs the Fed early next year, the seven-member board will be down to just four, providing Trump the opportunity to further shape monetary policy. Table 1 provides Powell's comments on key aspects of the economy, monetary and regulatory policy. Chart 1Labor Market Conditions Tightening##BR##And Support More Rate Hikes Labor Market Conditions Tightening And Support More Rate Hikes Labor Market Conditions Tightening And Support More Rate Hikes Table 1Powell On Monetary Policy, The Economy And Regulation Powell's In Power Powell's In Power BCA expects that Powell, a Republican, will be confirmed by the Senate and preside over the FOMC meeting in March 2018. Powell already sits on the Fed Board. In 2012 President Obama appointed Powell to the Fed to fill an unexpired term. The Senate voted 74-21 to confirm. Two years later, Powell was confirmed 67-21 for a full term (14 years) as a governor. Fifty-one votes are required for confirmation. BCA's Chief Economist, Martin Barnes, wrote about the potential for change at Federal Reserve Board earlier this year.1 The bottom line is that looming changes in the composition of the Fed's Board of Governors are important, but we doubt that the overall integrity of the Fed will be seriously compromised by bad appointments. However, at this stage, it is futile to guess who the Administration will choose. Regardless of who controls the Fed, there always will be the potential for errors because their economic models (along with everybody else's) are imprecise, data can be unreliable, and the policy tools are crude. Some uptick in inflation is likely and would even be desirable, but it will not be allowed to get out of control. The bigger uncertainty is what will happen after the next economic downturn because even the most hawkish policymakers may be forced to embrace inflationary policies that will make the past cycle's actions pale by comparison. Subprime Auto Sector Signals Household deleveraging has ended, but consumers are reticent to take on new debt despite an improving labor market and record household net worth. Household debt is growing at under 2% a year, less than half the pre-crisis pace. Moreover, household debt relative to disposable income remains well below a decade ago, but the household indebtedness profile is not uniform. While the debt-to-disposable income ratio of mortgage and revolving consumer credit has moved lower, the ratio of non-revolving credit (which includes both auto and student loan debt) has moved up since 2010 and surpassed the 15.8% pre-crisis peak in 2012 (Chart 2). Chart 2Household Debt By Sector Household Debt By Sector Household Debt By Sector In 2016, 34% of U.S. families had vehicle loans, up from a low of 30% in 2010. In 2004-2007, more than one-third of U.S. families carried auto debt (Chart 3). The median value of households' auto loans is $13,000 (in 2016 dollars), up from $11,000 in 2010, but still below the 2004-2007 peak of $14,000 (Chart 4). However, delinquency rates are on the rise in those areas where consumers have been adding debt (credit cards, auto loans and student loans) (Chart 5). Chart 3Rise In % Of Families With Auto Loan Debt... Rise In % Of Families With Auto Loan Debt... Rise In % Of Families With Auto Loan Debt... Chart 4...But Auto Debt Levels Are Manageable ...But Auto Debt Levels Are Manageable ...But Auto Debt Levels Are Manageable In particular, default rates in auto and student loans are above their mid-2000s readings, but are below their 2010-2012 zenith. Lending standards for vehicle loans were easy at the start of the decade, became less so recently and then turned restrictive in mid-2016. In the mid-2000s, borrowing guidelines for student loans and credit cards (data on bank lending standards for auto loans began in 2011) were easy in 2004-2007. Banks are taking a cautious approach to consumer lending in this cycle. The gradual tightening of lending criteria between 2010 and 2016 led to a drop in the average FICO score for new auto loans. However, as standards tightened in 2016 and into the first quarter of 2017, the average FICO escalated. FICO scores for new vehicle loans moved sharply lower in Q2; it may be a new trend or perhaps a blip in the data. Even with the latest dip, the FICO for new auto loans (698) is well above the 675-685 range that prevailed in 2004-2006 (Chart 6, bottom panel). Chart 5Consumer Loan Metrics Consumer Loan Metrics Consumer Loan Metrics Chart 6ABS Market Overview ABS Market Overview ABS Market Overview Subprime auto loans as a percentage of all auto loans remain well below pre-crisis levels and should limit a wave of subprime auto defaults in the years ahead. Only 22% of the $148 billion in new vehicle loans recorded in Q2 2017 were issued to borrowers with FICO scores below 620. The latest reading is in the middle of the range that has been in effect since 2010 (18-25%). Between 2004 and 2007, the share of auto loans issued to subprime borrowers was as high as 32% in 2006 and averaged 28%. The FOMC has elevated financial stability in its recent deliberations2 and is watching for imbalances. The September 20-21 FOMC meeting minutes noted that "Subprime auto loan balances have declined so far this year, partly reflecting the tighter lending standards, and the average credit score of all borrowers who obtained an auto loan in the second quarter remained near the upper end of its range of the past few years." We expect the Fed to remain vigilant on this issue. Bottom Line: Household debt ratios are well below the pre-2007 peak, but consumers are piling on more auto debt. While delinquency rates for auto debt are rising, banks are tightening lending requirements and have not extended auto credit to subprime borrowers outside of historical norms. If household incomes, the stock market and housing prices rise, and banks and regulators remain vigilant, then the subprime auto sector would not pose a systemic risk to the U.S. economy or financial system.3 BCA's U.S. Bond Strategy service prefers Aaa-rated credit card ABS over Aaa-rated auto loan ABS (Chart 6). Investment Direction After EPS Peak Chart 7Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon The BCA earnings model shows that S&P 500 EPS growth is peaking and should slow through 2018 toward a level commensurate with 3½-4% nominal GDP growth (Chart 7). Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller force. This forecast excludes any positive effects on growth from tax cuts that would encourage EPS and the S&P 500 index in the short term, although this would also bring forward Fed rate hikes. We will provide an update on the Q3 earnings reporting season in next week's report. Investors are questioning what will happen to risk assets after earnings growth peaks, but before it slips below zero (Table 2). BCA has identified seven episodes between 1973 and 2015 when S&P 500 EPS growth reached a top and subsequently dipped below zero. Four of the seven periods (1973-75, 1976-80, 1988-1991, and 1993-2001) partially overlapped with recessions. The U.S. economy was in recession during the entire 1973-75 period but the recession occurred at or near the end in the other three occurrences. U.S. stocks, Treasuries and oil behave consistently during these periods. The performance of gold, the dollar, small caps (relative to large) and high yield (relative to Treasuries) is not consistent, and investment-grade corporate debt underperformed Treasuries in six of the seven intervals. On average, stocks beat bonds by 3,000 bps after earnings decelerate, but before they turn negative. Oil (+8,310 basis points) and gold (+6,950 bps) are the standouts; both commodities beat stocks) as earnings growth fades. Small caps barely outperform large, and the dollar, on average, is flat across all seven periods. Investment-grade corporate debt underperforms Treasuries by an average of 50 bps during these episodes. Table 2U.S. Asset Class Performance As EPS Growth Slows Powell's In Power Powell's In Power The three occasions when EPS growth crested and then slowed to zero, but the economy avoided a recession, were in the mid-1980s, the mid-2000s and the early part of the current decade. These mid-cycle slowdowns were triggered by Fed rate hikes in the mid-1990s and mid-2000s; in the early 2010s, there were similar fears of a rate increase, coupled with a stronger dollar and a collapse in oil prices. The performance of risk assets during these mid-cycle earnings corrections was similar to the entire sample, although the magnitude of the asset class performances shifted. Oil (+12,560 bps) and gold (+8,400 bps) were standouts; equity and Treasury prices both rose, but equities beat Treasuries by nearly 10,000 bps, easily surpassing the 3,000 bps outperformance in all periods. Small caps underperformed large caps and the dollar climbed (Chart 8). Chart 8U.S. Asset Class Performance As EPS Growth Slows U.S. Asset Class Performance As EPS Growth Slows U.S. Asset Class Performance As EPS Growth Slows Bottom Line: S&P 500 earnings growth will peak in 2018. Stocks will outperform bonds as profit growth slows, which matches BCA's stance for the next 12 months. Gold and oil have both outpaced equities as earnings abate; this supports BCA's bullish position and above-consensus view of oil for 2018. BCA's modestly bullish stance on the dollar in the next 12-18 months aligns with the historical achievements of the dollar as earnings moderate, but BCA's bullish view on small caps runs counter to history after EPS growth crests. The Great Balance Sheet Unwind Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart 9 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. In an October 2017 Special Report,4 the Bank Credit Analyst outlines how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. Chart 10 presents our forecast for how quickly the Fed's balance sheet will contract. Following the September 19-20 FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasuries and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasuries and $20 billion per month for MBS. Chart 9G4 Central Bank Balance Sheets G4 Central Bank Balance Sheets G4 Central Bank Balance Sheets Chart 10Fed Balance Sheet Fed Balance Sheet Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.5 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario, the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. The bond market's reaction will be far more important than balance sheet shrinkage. Empirical estimates suggest that the Fed's shedding of Treasuries could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio; As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. However, it will be a whole different story if inflation lurches higher. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "Should You Fear Looming Changes At The Federal Reserve?", September 21, 2017. Available at bca.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Bond Strategy Portfolio Allocation Summary, "Return Of The Trump Trade," October 3, 2017. Available at usbs.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "Liquidity And The Great Balance Sheet Unwind," In the October Monthly Report. Available at bca.bcaresearch.com. 5 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017).

Highlights London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago. Stay underweight U.K. real estate and consumer services versus German real estate and consumer services. The global bond yield mini-cycle is driving asset allocation, sector allocation, value/growth allocation and country allocation. We are more than half way through the current mini-upswing in global bond yields. Look for opportunities to cut back overall portfolio cyclicality towards the end of the year. Feature London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago (Chart of the Week). The average London home is now worth £584,000,1 down from £628,000. Moreover, our leading indicator for London house prices which compares the number of new viewings (demand) with the number of new listings (supply) suggests no imminent end to the sharpest price decline since the 2008 financial crisis (Chart I-2). Chart I-1Brexit Begins To Bite In London Brexit Begins To Bite In London Brexit Begins To Bite In London Chart I-2The Sharpest Decline In London House Prices Since 2008... The Sharpest Decline In London House Prices Since 2008... The Sharpest Decline In London House Prices Since 2008... Unsurprisingly, the many uncertainties surrounding the unfolding Brexit process are having a much greater impact on the London housing market than on the U.K. housing market as a whole. Outside London, the housing market is broadly flat-lining (Chart I-3). The average U.K. home outside London is now worth £256,500, modestly down from £260,000. Chart I-3 ...But Outside London, Prices Are Flat-Lining ...But Outside London, Prices Are Flat-Lining ...But Outside London, Prices Are Flat-Lining U.K. Households Squeezed We are writing ahead of the Bank of England monetary policy meeting, at which the BoE may deliver its first interest rate hike since July 2007. But hike or no hike, we can confidently say one thing: U.K. households will be squeezed. If the BoE does hike the base rate in an attempt to counter overshooting inflation, it could tip the precariously flat-lining housing market outside London into a downturn - as this market is much more exposed to mortgage affordability than it is to Brexit uncertainties. Alternatively, if the BoE does not hike the base rate, the boost to sterling from recent hawkish rhetoric will be priced out, and the pound will come under renewed downward pressure. This would keep U.K. inflation elevated, and further choke U.K. households' real incomes. Absent the post Brexit vote slump in the pound, U.K. inflation would be substantially lower than it is (Chart I-4 and Chart I-5). So the pound's weakness explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. And as we explained in Why Robots Will Kill Middle Incomes,2 nor is it likely to in the near future. Chart I-4The Weaker Pound Lifted U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... Chart I-5...And U.K. Core Inflation ...And U.K. Core Inflation ...And U.K. Core Inflation But doesn't textbook economic theory say that the pound's weakness should make U.K. exports more competitive - thereby boosting the net export contribution to economic growth? Yes, the theory does say that a currency devaluation should allow firms to trade in markets that were previously unprofitable to them. However, to trade in these newly profitable markets, firms first need to invest - for example, in marketing and distribution. The trouble is that, post-Brexit, many of the newly profitable markets may be unavailable, or come with heavy tariffs. So firms will hold off making the necessary investments, unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. In summary, U.K. consumer spending faces a continued squeeze. If the BoE delivers a rate hike, household borrowing is likely to fade as a driver of spending. But if the BoE does not deliver the rate hike, the pound will once again weaken, keeping inflation elevated and weighing on real incomes. Stay underweight U.K. consumer services versus German consumer services (Chart I-6). And stay underweight U.K. real estate versus German real estate - expressed either through direct real estate exposure or through real estate equities (Chart I-7). Chart I-6U.K. Consumer Services Equities Are Underperforming U.K. Consumer Services Equities Are Underperforming U.K. Consumer Services Equities Are Underperforming Chart I-7U.K. Real Estate Equities Are Underperforming U.K. Real Estate Equities Are Underperforming U.K. Real Estate Equities Are Underperforming Investment Reductionism Illustrated Turning to markets more generally, it is crucial to understand that most of the moves in most financial markets reduce to a very small number of over-arching macro drivers. We call this very important principle Investment Reductionism. Investment Reductionism emerges from two guiding philosophies: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle (the 80:20 rule) - which says that a small minority of causes usually explain a large majority of effects. The upshot of Investment Reductionism is that the seeming complexity of asset allocation, sector selection, the choice between value or growth, and country allocation usually reduces to something much simpler. Let's illustrate this. The global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset allocation (Chart I-8). The direction of the global bond yield drives sector selection: for example Banks versus Healthcare. This is because higher bond yields imply higher net interest margins for banks as well as an improving growth outlook, favouring cyclicals over defensives. And vice-versa (Chart I-9). Chart I-8Investment Reductionism Step 1: ##br##The Global Credit Impulse Leads The Bond Yield Cycle Investment Reductionism Step 1: The Global Credit Impulse Leads The Bond Yield Cycle Investment Reductionism Step 1: The Global Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield Drives ##br##Sector Performance Step 2: The Bond Yield Drives Sector Performance Step 2: The Bond Yield Drives Sector Performance Banks versus Healthcare determines the European Value versus Growth decision. This is because in Europe, Banks and Healthcare are the dominant value sector and growth sector respectively (Chart I-10). Banks versus Healthcare also determines the country allocation between, say, Italy's MIB - which is bank heavy - and Denmark's OMX - which is healthcare heavy (Chart I-11). Chart I-10Step 3: Sector Performance Drives Value ##br##Vs. Growth Step 3: Sector Performance Drives Value Vs. Growth Step 3: Sector Performance Drives Value Vs. Growth Chart I-11Step 4: Sector Performance Drives ##br##Country Performance Step 4: Sector Performance Drives Country Performance Step 4: Sector Performance Drives Country Performance Therefore, the important lesson from Investment Reductionism is to ignore the hundreds of things that matter little, and to focus on the very small number of things that matter a lot. And one of the things that matters a lot is the global bond yield mini-cycle. Where Are We In The Bond Yield Mini-Cycle? Empirically, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months (Chart I-12). The global bond yield shows a similarly regular wave like pattern with each half-cycle also averaging about 8 months (Chart I-13). Chart I-12The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Chart I-13The Global Bond Yield Has Shown A Regular Wave Like Pattern The Global Bond Yield Has Shown A Regular Wave Like Pattern The Global Bond Yield Has Shown A Regular Wave Like Pattern It is not a coincidence that the bank credit impulse and bond yield exhibit near identical half-cycle lengths. The global credit impulse and global bond yield are inextricably embraced in a perpetual mini-cycle. A stronger credit impulse boosts economic growth. In response to the stronger economic data, the bond yield rises, which slows credit growth. A weaker credit impulse weighs down economic growth. In response to the weaker economic data, the bond yield declines, which re-accelerates credit growth. Go back to step 1 and repeat ad perpetuam. At this moment, from an investment perspective, there are three points worth making: first, bond yield mini-upswings tend to occur mostly within the credit impulse upswing; second, credit impulse mini-upswings have a consistent duration lasting about 8 months; and third, the current mini-upswing started in May. What does this mean for investment strategy? It means that we are more than half-way through the current mini-upswing which we would expect to end around January/February. And at some point early next year we are likely to enter a mini-downswing. So it is slightly premature to cut back cyclical exposure right now. But we would certainly consider opportunities as we move to the end of the year - especially if our now tried and tested fractal timing indicators signal that the price action in specific investments has reached a technical tipping point. Stay tuned. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Source: LSL Acadata 2 Please see the European Investment Strategy Special Report "Why Robots Will Kill Middle Incomes", dated August 10 2017 available at eis.bcaresearch.com. Fractal Trading Model* This week, our model suggests that the New Zealand dollar is oversold and ripe for a technical rebound. The recommended trade is long NZD/USD with a profit target/stop loss set at 3%. In other trades, long Canada 10-year bond/short German 10-year bund achieved its profit target while short Norway/long Switzerland hit its stop loss. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-14 Long NZD/USD Long NZD/USD * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Storms set a low bar for Q3 EPS. BCA's Beige Book Monitor near cycle highs despite storms. Investors should fade the Q3 housing weakness. Latest Survey Of Consumer Finances highlights student loan debt issue. Feature Chart 1Q3 GDP Growth Has Held Up##BR##Remarkably Well Despite Hurricane Impact Q3 GDP Growth Has Held Up Remarkably Well Despite Hurricane Impact Q3 GDP Growth Has Held Up Remarkably Well Despite Hurricane Impact U.S. equities hit fresh all-time highs again last week, undeterred by the downward adjustment in Q3 earnings estimates in part due to Hurricanes Harvey and Irma. Investors appear to be looking through any near-term hit to economic growth and profits. Trump's tax plan cleared a key hurdle in Congress and tax cuts would surely give the market a boost if they are eventually passed. Bond yields and the dollar edged higher on speculation that President Trump will choose John Taylor as the next Fed Chair, who many believe will be a hawk. While we agree that investors should look through the hurricane effects, we worry that equity markets appear increasingly frothy. While the storms will cast a shadow over the Q3 earnings reports, the economic data has held up remarkably well. At 2.7% and 1.5%, the Atlanta Fed GDP Now and New York Fed's Nowcast for Q3 have recouped nearly all the ground they lost in the immediate aftermath of the storms (Chart 1). The Fed's Beige Book revealed a stout underlying economy despite the most weather related disruptions since superstorm Sandy in 2012. The Beige Book and most of the other economic data released in the past few weeks, aside from the inflation data, support a December rate hike. Markets are pricing in a near 100% chance of a 25bps hike at the December 12-13 FOMC meeting. The impact of Harvey and Irma have also lowered expectations for housing and residential investment in Q3, but housing is poised to rebound in the coming quarters even if the Fed raises rates once this year and three more times as we expect next year. The Fed's latest Survey of Consumer Finances will raise more concern over student loan debt, but also show that households' low cash balances and elevated allocation to equities match consumers' elevated confidence readings. Q3 Earnings Outlook Clouded By Storms Hurricanes Harvey and Irma may temporarily undermine corporate profits in a few industries in the third quarter. The annual growth rate of the 4-quarter moving total was poised to peak anyway, given more demanding year-ago comparisons (Chart 2). Still, EPS growth is peaking at a high level and should decelerate only slowly through 2018 toward a level more commensurate with 3.5-4% nominal GDP growth. We thus expect the earnings backdrop to remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any positive impact on growth from tax cuts. The announcement of tax cuts would be positive for EPS and the S&P 500 price index in the short term, although this would also bring forward Fed rate hikes. Rising oil prices are turbocharging earnings in the energy patch and we expect this to continue. Indeed, BCA's Commodity & Energy Strategy service raised its 2018 target price for both Brent and WTI last week to $65.15/bbl and $62.95/bbl, respectively. These estimates are up by $5.51 and $5.98/bbl from our forecast last month.1 The soft industrial production readings in September would be a concern for BCA's profit forecast, absent the storms' impact (industrial production is included in our top-down EPS model). However, the Fed noted that "the continued effects of Hurricane Harvey and, to a lesser degree, the effects of Hurricane Irma combined to hold down the growth in total production in September by 1/4 percentage point. For the third quarter as a whole, industrial production fell 1.5 percent at an annual rate; excluding the effects of the hurricanes, the index would have risen at least 1/2 percent." Moreover, strong readings in September and October on both the New York and Philadelphia Fed's manufacturing indices imply that the aftermath of the storms did not extend beyond Texas and Florida, and suggest a rebound in IP in Q4. The elevated readings on the Cass Freight index in recent months support that view (Chart 3). Chart 2Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon Chart 3Storms Impacted IP In Q3 Storms Impacted IP In Q3 Storms Impacted IP In Q3 Bottom Line: The earnings season is underway and forecasts have collapsed to a mere 4.2% year-over-year growth rate for Q3. They were as high as 5.5% at the start of Q3. Financials are heavily weighing on the outlook and the sector's profits are expected to contract by 9%. While the insurance sub-sector may be behind the bulk of the negative EPS revisions owing to the hurricanes, such extreme pessimism is unwarranted and the bar is set extremely low for both financials and the overall market. Based on the September and October Beige Books, corporate managements will not be too concerned with the dollar during this earnings reporting season. The Beige Book: Beyond The Storms The Beige Book released on October 18 supports the Fed's stance that the hurricanes will not alter the U.S. economy's medium-term trajectory and will keep the Fed on track to boost rates by another 25 basis points in December. BCA's quantitative approach2 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market, but there is still a disconnect between the Beige Book's view of inflation and the market's stance. Moreover, the stronger dollar has disappeared from the Beige Book and despite the lack of progress in Washington on Trump's pro-business agenda, business uncertainty is down. In addition, the prospects for commercial and residential real estate remain bright. Chart 4Beige Book Monitors Support Fed's Outlook##BR##On Economy And Inflation Beige Book Monitors Support Fed's Outlook On Economy And Inflation Beige Book Monitors Support Fed's Outlook On Economy And Inflation At 63%, BCA's Beige Book Monitor stayed near its cycle highs in October, providing more confirmation that the underlying economy remained upbeat in Q3 despite Hurricanes Harvey and Irma (Chart 4). The latest Beige Book covered the period from mid-September to October 6. Hurricane Harvey hit Texas and Louisiana in late August while Irma made landfall in Florida in early September and moved on to neighboring southeastern states through mid-month. While there were only four mentions of "weather", "hurricane" was used 58 times and "storm" nine times. The total 71 puts the weather impact on the Beige Book at its highest since superstorm Sandy struck the northeastern U.S. in Q4 2012 (Chart 4, panel 2). Based on the Beige Book, the dollar should not be an issue in the Q3 or Q4 earnings seasons. The greenback is no longer a concern for small businesses and bankers, which is in sharp contrast to 2015 and early 2016 when there was a surge in Beige Book mentions of a strong dollar (Chart 4, panel 4). In October, there were no remarks at all. The past three Beige Books (July, September and October) have seen only a single reference to a stronger dollar. The last time that three consecutive Beige Books had so few mentions was in late 2014. Remarkably, business uncertainty over government policy (fiscal, regulatory and health) has moved lower in 2017. The implication is that the business community is ignoring the lack of progress by Washington policymakers on Trump's agenda (Chart 4, panel 5). Echoing the market's disagreement with the Fed on inflation, a significant discrepancy in the Beige Book was evident in the number of inflation words (Chart 4, panel 3). Expressions of inflation dipped to a 7-month low in October. However, a disconnect persists between the still-elevated mentions of inflation and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The recent Beige Book backs BCA's view that the hurricanes will not derail the economy. Indeed, the September reading on our Beige Book monitor in early October suggests that the economy rebounded smartly as the effects of the storms waned in late Q3 and early Q4. However, the Beige Book has done little to resolve the debate around why an economy growing above potential and a tightening labor market have not boosted inflation. Moreover, the October Beige Book all but warned investors to fade the Q3 weakness in the housing data. Housing Woes Continue In Q3 The weakness in residential investment in Q3 is temporary and housing has not peaked for the cycle. The monthly data on housing in August and September were affected by Hurricanes Harvey and Irma. Housing starts for September were weaker than anticipated and below August's readings. Specifically, the 9% m/m drop in September's starts in the South followed the 5% drop in August. Existing home sales posted a modest month-over-month gain in September after a three month decline. Nonetheless, October's 68 reading on homebuilder sentiment was four points above September's reading and the highest since May (Chart 5). Rising rates are not a threat to housing affordability, even if the Fed is able to lift rates in line with its dot plot. Chart 6 shows the influence of higher rates on housing affordability and effective mortgage rates under two scenarios. A 200-basis point increase in mortgage rates (Chart 6, panel 1) would push the housing affordability index below its long-term average for the first time in nine years. BCA assigns a low probability to a rate jump given the Fed's commitment to gradually increase rates. A more plausible path for mortgage rates in the next year is a 100bps rise (Chart 6, panel 3). Under this scenario, the affordability index would deteriorate, but remain a tailwind for housing. Chart 5Solid Housing##BR##Fundamentals In Place Solid Housing Fundamentals In Place Solid Housing Fundamentals In Place Chart 6Housing Affordability Under##BR##Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing Affordability Under Various Rate Assumptions The historically low reading on Bloomberg's Housing and Real Estate Surprise Index also suggests that housing is poised to rebound in the coming quarters (Chart 7). The last time that the index was as low as the -1.2 reading in mid-October was in late 2013 amid the taper tantrum, and prior to that in late 2008/early 2009. Moreover, the gap between Bloomberg's overall Economic Surprise Index and the Housing Surprise index has never been wider. Therefore, the weakness in the housing data is a weather-related anomaly. Chart 7Big Disconnect Between Housing Surprise And Economic Surprise Big Disconnect Between Housing Surprise And Economic Surprise Big Disconnect Between Housing Surprise And Economic Surprise It is important to assess whether residential investment has peaked for the cycle. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced.3 While housing's contribution to overall economic growth plunged in Q2 and Q3, we expect housing to provide fuel for the next few years as pent up demand is worked off from the depressed household formation rate since the 2008 financial crisis. Moreover, BCA does not anticipate that rising rates will be a serious threat to housing in the next 12 months. The implication from our upbeat view on housing is that the next recession is still several years away. Reliable leading indicators of a recession such as the LEI, the yield curve and the 26-week change in claims, are not signaling a downturn (Chart 8). BCA's recession model puts the probability in the next 12 months at a meager 2%. Only one of the eight components signal a downturn. Furthermore, neither the St. Louis Fed's nor the Atlanta Fed's recession indicators is in the danger zone. BCA does not expect a buildup in the types of imbalances that previously led to economic declines. Instead, a recession may be triggered by a Fed policy mistake,4 a terrorist attack that disrupts economic activity over a large area for an extended time, or a widespread natural disaster. Chart 8Odds Of A Recession In Next Year Remain Low Odds Of A Recession In Next Year Remain Low Odds Of A Recession In Next Year Remain Low Bottom Line: In the next 12 months, investors should remain positioned for stocks to outperform bonds and rising rates. While markets have entered a more dangerous late-cycle "blow off" phase,5 housing's contribution to GDP has not peaked for the cycle, which means that recession is still more than a year away. Housing will rebound in Q4 after an appalling performance in Q2 and Q3. A healthy housing market will continue to support the consumer. Surveying The Consumer Table 1Household Balance Sheets Prior##BR##To Recessions And Today Lowered Expectations Lowered Expectations The Fed's latest triennial Survey of Consumer Finances (SCF) shows that the consumer is less sensitive to housing, holds less cash and more equities than in the past. However, the report also shows that households that own interests in small businesses may disproportionately benefit from the GOP's corporate tax cut proposal. The SCF data supply a detailed examination of consumer health, not provided by the macro data. Nonetheless, key household- and consumer-related spending, which are saving- and balance sheet-related concepts in the SCF, closely track similar statistics in the macro datasets such as the Flow of Funds and the NIPA accounts.6 Table 1 shows household balance sheets in 1989, 1998, 2007, a year or two before the recessions and bear markets of 1990, 2001 and 2008-2009. The latest (2016) is also shown. Households are more sensitive to business conditions than ever before. Households in 2016 hold less cash (as a percentage of financial assets) than in any other pre-recession year, while consumers' equity holdings are the highest on record. Consumers' mix of nonfinancial assets showed that while housing was still the largest single asset (42.4% in 2016), the share of household assets devoted to primary residences was the lowest on record. Vehicles were only 4.8% of a household's nonfinancial assets in 2016, a new low. In contrast, individuals' equity in business (34%) was the highest ever. The implication is that a plunge in housing prices would be as detrimental to consumers today as it was in the mid-2000s. Hence, households' higher exposure to business ventures suggests that a tax cut that favors small businesses over individuals may shore up household finances. Despite improvement in many areas of consumer finances, the household exposure to student loans in 2016 was alarmingly high (Table 2). On the surface, the SCF data do little to ease fears that student loans will compromise household balance sheets and lead to the next recession. The mean student loan debt per household in 2016 was $34,200, 37% higher than in 2007, and more than triple the 1989 level. While 22% of families had student debt in 2016, a slight improvement from 2013, only 9% of families had student debt in 1989. Moreover, educational debt accounts for 8% of household debt. While that figure is dwarfed by the 67% of family debt in housing, a scant 4% of family debt was related to student loans prior to the last recession in 2007.7 Furthermore, 42.6% of families with education debt report that they have student loan debt of more than $25,000, a sharp upsurge from 2007 and more than double the percentage reporting $25,000 or more in 1989.8 Table 2Nearly Half Of All Families With Education Debt Have Student Loan Debt Of At Least $25,000 Lowered Expectations Lowered Expectations That said, BCA's view remains that student debt is a modest drag on economic growth, and is not a threat to U.S. government finances nor does it represent the next subprime crisis.9 John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten," October 19, 2017. Available at ces.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report "The Great Debate Continues", dated April 17, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Disconnected," September 11, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks and the Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 6 https://www.federalreserve.gov/econresdata/feds/2015/files/2015086pap.pdf 7 Sourced from 1989-2016 Survey of Consumer Finances Database at https://www.federalreserve.gov/econres/scfindex.htm. Historic Tables - Table 16 - Amount of debt of all families, distributed by purpose of debt. 8 Jeffrey P. Thompson and Jesse Bricker, "Does Education Loan Debt Influence Household Financial Distress? An Assessment Using The 2007-09 SCF Panel," October 16, 2014, Federal Reserve. 9 Please see The Bank Credit Analyst Special Report, "Student Loan Blues: Can't Replay What I Borrowed," November 2016. Available at bca.bcaresearch.com.

Highlights U.S. credit growth is set to improve as capex has more upside and households benefits from a positive backdrop. The U.S. has substantially more room to increase leverage than the rest of the G10, pointing toward further monetary divergences. The euro is not very cheap and is trading at a significant premium to forward rate differentials. It is thus at risk if U.S. rates can rise vis-à-vis Europe. Chinese underlying inflation is becoming elevated, which could prompt additional tightening by the PBoC. Moreover, Xi Jinping's speech this week suggests a move away from the debt-fueled, investment-led growth model. The AUD is at risk. Feature A general lack of credit growth has been one of the key factors hampering both broader growth and inflation in the U.S. Not only has this muted activity and weak pricing pressure kept the Federal Reserve on the easier side of policy, the absence of lending growth has further depressed real rates as demand for loanable funds remains low. Can credit pick up from here, and what are the implications for the USD? Room For Optimism There are good reasons to lean a bit more on the positive side regarding the U.S. credit growth outlook. As Chart I-1 illustrates, U.S. commercial and industrial loan growth seems to be rebounding. Confirming that this impulse could gain momentum, it follows an easing in lending standards and a pick-up in durable goods orders - two leading indicators of business borrowings. Household debt is also showing some signs of revival. While the annual growth rate of household borrowings from banks has yet to trough, the annualized quarterly growth rate has picked up significantly - a development that tends to precede accelerations in the yearly measure. Moreover, this improvement is broad based among all the key components of household borrowings (Chart I-2). Chart I-1Upside For U.S. C&I Loans... Upside For U.S. C&I Loans… Upside For U.S. C&I Loans… Chart I-2... And For Household Debt As Well ... And For Household Debt As Well ... And For Household Debt As Well This has positive implications for U.S. nonfinancial private credit, which has been in the process of forming a shallow bottom relative to GDP. Moreover, based on the low level of debt servicing costs for both households and businesses, this trend has room to develop (Chart I-3). However, most of the increase in the debt-to-GDP since 1994 has been caused by financial engineering, with firms swapping equity for debt in their capital structure, and has therefore not lifted domestic demand nor created inflationary pressures. However, we posit that this phenomenon is toward its tail end, and that additional debt accretion could have a meaningful impact on growth. Why? On the business front, capex - an essential but volatile component of aggregate demand - is set to accelerate further. Business investment is led by firms' capex intentions, a series that has surged since the summer of 2016 (Chart I-4, top panel). Confirming the message from this indicator, profits from U.S.-listed businesses have also sharply rebounded, a signal that leads capex by a year, as highlighted last Monday by Anastasios Avgeriou, who heads BCA's U.S. Equity Sector Strategy service (Chart I-4, bottom panel).1 Chart I-3The U.S. Has Room To Relever The U.S. Has Room To Relever The U.S. Has Room To Relever Chart I-4Capex Outlook Looks Good Capex Outlook Looks Good Capex Outlook Looks Good On the household front, three factors support our assessment: First, household nominal and real wages and salaries should enjoy further upside as the labor market remains very healthy. This means more consumption and more capacity to accumulate debt, especially as household financial obligations remain near multi-generational lows (Chart I-5). In fact, U.S. real median household income already hit an all-time high in 2016. Chart I-5Supports To Household Consumption Supports To Household Consumption Supports To Household Consumption Second, household confidence is still near record-high levels, a factor which tends to lead credit growth and consumption. Optimistic households are more likely to spend their income gains and buy durable goods like houses or apartments, especially as the household formation rate has regained vigor. Third, U.S. net wealth has hit 430% of disposable income, a record, which will keep supporting consumption. As households see their net worth increase, they can boost consumption and debt as their leverage ratios improve, especially when financial obligation ratios are as low as they are today. These factors point toward a continued increase in the indebtedness of the U.S. private sector, one which this time we anticipate will add to demand through investments, real estate purchases and general consumption. This also means that real rates are likely to experience upside. More debt-fueled aggregate demand implies more demand for loanable funds, and thus higher real rates. In an economy operating near full capacity, it can also lift inflation. Tax cuts and fiscal stimulus would only be a bonus in this environment. This should give the Fed room to increase interest rates in line with its dot plot, or more than the two-and-a-half hikes priced into the OIS curve over the next two years. However, as 2017 has vividly demonstrated, movements in U.S. rates alone are not enough to make a call on the U.S. dollar. One needs to have a sense of how U.S. rates could evolve vis-à-vis the rest of the world. In the context of debt accumulation, we are optimistic that the U.S. could experience a re-leveraging relative to the rest of the G10, putting upward pressures on U.S. real rates relative to the rest of the world. To begin with, U.S. non-financial private credit stands at 150% of GDP, a drop of 20% of GDP since its peak in 2009. The rest of the G10 has not experienced the same extent of post-financial crisis deleveraging, and nonfinancial private credit there still hovers around 175% of GDP (Chart I-6). Today, the indebtedness of the U.S. relative to other advanced economies is near its lowest levels of the past 50 years. Debt levels are obviously not the only consideration; the ability to service that debt also must enter the equation to judge the capacity of an economy to accumulate debt relative to the rest of the world. Currently, according to the BIS, the debt-service ratios of the U.S. nonfinancial private sector still stand well below the GDP-weighted average of the rest of the G10 (Chart I-7). This also highlights that the U.S. has plenty of room to have both higher debt accumulation and higher real rates than the rest of the G10. Chart I-6U.S. Vs. G10: Debt Upside U.S. vs. G10: Debt Upside U.S. vs. G10: Debt Upside Chart I-7Lower Private Sector Debt-Servicing Costs In The U.S. Lower Private Sector Debt-Servicing Costs In The U.S. Lower Private Sector Debt-Servicing Costs In The U.S. This should support the dollar in 2018. As Chart I-8 shows, 10-year bond yield differentials between the U.S. and other large advanced economies lead tops in the dollar by one year. To highlight this relationship, this chart de-trends the DXY by plotting it as a deviation from its 10-year moving average. Not only does the current trend in real rate differentials already point to a higher dollar, but room for more debt accumulation in the U.S. relative to the rest of the G10 supports the notion that the elevated level of spreads could even expand, implying the era of monetary divergence has yet to end. As we highlighted last week, the dollar may not be as expensive as seems at first glance. We have expanded on our 'modelization' exercise this week, using methods employed by the Swiss National Bank to incorporate the Balassa -Samuelsson effect.2, 3 This metric, which incorporates the relative price of manufactured goods in each economy, further confirm our assessment from last week that the dollar is not expensive enough to warrant a sell-signal (Chart I-9). Thus, with competitiveness a non-issue for the dollar for now, the USD is likely to be able to take advantage of potentially supportive real interest rate spreads. Chart I-8Real Rates Point To A Higher Peak For The USD Real Rates Point To A Higher Peak For The USD Real Rates Point To A Higher Peak For The USD Chart I-9U.S. Only Sightly Expensive U.S. Only Sightly Expensive U.S. Only Sightly Expensive On the technical side, our U.S. Dollar Capitulation Index hit very depressed levels earlier this year, but is now rebounding. Crucially, it has moved meaningfully back above its 13-week moving average, an event which normally characterizes uptrends in the dollar (Chart I-10). Chart I-10Dollar: From Bearish To Bullish Mood Dollar: From Bearish To Bullish Mood Dollar: From Bearish To Bullish Mood Bottom Line: The U.S. economy looks set to enjoy an episode of rising debt supporting increasing economic activity and higher rates as capex should grow further and a supportive backdrop continues to emerge for households - whether or not tax cuts happen. Because the U.S. private sector has comparatively healthy balance sheets relative to the rest of the G10, this means that U.S. re-leveraging should outpace the rest of the world. Even if this U.S. re-leveraging is only a cyclical phenomenon and not a resumption of the debt super-cycle, it would imply that monetary policy divergences have yet to reach their apex, and thus the dollar could experience additional upside. Even Against The Euro? We tend to view the euro as the anti-dollar. It is the main vehicle to play both uptrends and downtrends in the dollar and it is also the most liquid instrument, backed with an economy similarly sized as the U.S. Thus, the views expressed above would imply a negative slant on EUR/USD. Such a framework can give an impetus to a EUR/USD view, but is also not enough. Indeed, factors more specific to this pair argue that EUR/USD does have downside. When it comes to valuations, using the SNB's methodology, the EUR/USD is more or less the mirror image of the DXY. This pair is slightly cheap, essentially within the statistical definition of fairly valued (Chart I-11). Thus, valuations alone are fully neutral for the euro. This means EUR/USD remains prisoner to relative interest rate dynamics. On this front, a key driver of this pair paints a risky picture for euro bulls. The 1-year/1-year forward risk-free rate spread between the euro area and the U.S. has been a reliable guide of the EUR/USD's trend for the past 12 years. Yet, the euro's rally has not been matched by a similar move in this spread. As a result, the gap between the currency pair and its rates-implied fair value is at its highest since the summer of 2014 (Chart I-12). Chart I-11Euro: Not That Cheap Euro: Not That Cheap Euro: Not That Cheap Chart I-12Forward Interest Rates Point To Euro Risk Forward Interest Rates Point To Euro Risk Forward Interest Rates Point To Euro Risk But then again, the differential between the European and U.S. 1-year/1-year forward risk-free rate is at its lowest ever over the time frame of this chart. However, it was even lower than current levels in 1999 and 1997. This suggests that if the U.S. can re-leverage relative to the rest of the G10, the spread could grow as negative as it was in these two previous instances. Supporting this assessment, we anticipate U.S. inflation to outperform euro area measures going forward. Last week, we explored the reasons why we see an upcoming uptick in U.S. inflation next year: U.S. financial conditions have eased, American velocity of money has increased, pipeline inflationary pressures are growing and underlying wage growth seems to be improving.4 Meanwhile, European financial conditions have tightened, especially against the U.S., which historically leads to an underperformance of European inflation measures. Very importantly, the euro area core CPI diffusion index has rolled over and is now below 50%, suggesting that euro area core CPI has limited upside (Chart I-13). This means potential downside vis-à-vis the U.S. and room for upside in U.S. rates relative to the euro area, especially as the European Central Bank is likely to craft its message carefully next week when it announces the tapering of its asset purchases, to prevent quick upward movement in interest rate expectations. Additionally, the dollar is still quite under-owned by speculators relative to the euro. Our favorite positioning measure, which sums long bets in the euro with short bets on the DXY - two equivalent wagers - continues to hover near record-high levels, suggesting potential downside in EUR/USD (Chart I-14). This continues to highlight the risks to the euro created by a repricing of the Fed. Chart I-13Euro Area CPI Peaking? Euro Area CPI Peaking? Euro Area CPI Peaking? Chart I-14Excess Bullishness In Euro Intact Excess Bullishness In Euro Intact Excess Bullishness In Euro Intact Bottom Line: The euro is obviously at risk if the dollar gets lifted by rising economic activity and indebtedness in the U.S., even if this cyclical upswing in debt does not represent a resumption of the debt super-cycle. Moreover, 1-year/1-year forward rates differentials point to heightened EUR/USD vulnerability, especially if U.S. inflation bottoms relative to the euro area. Moreover, long euro bets have yet to be washed out, deepening the EUR/USD's vulnerability. A Few Words On China Chart I-15China: Good Reasons For Policy Tightening China: Good Reasons For Policy Tightening China: Good Reasons For Policy Tightening Despite a marginal slowdown in Chinese real GDP growth and slightly disappointing industrial production and fixed asset investment numbers for the third quarter, some key Chinese economic activity metrics have been very robust. Imports are growing at a 19% annual pace, credit growth continues to outperform expectations and electricity production and excavator sales remain robust. Should this make investors bullish on China plays? In our view, two key risks lurk on the horizon. The first is monetary tightening. Pricing pressures in China are growing and are looking increasingly genuine. As Chart I-15 shows, core CPI is clocking in at 2.3%, the highest level since 2010-2011, a level which in the past prompted monetary tightening by the Chinese authorities. Additionally, services inflation - a purely domestic sector and thus one reflective of domestic inflationary pressures - is now above 3% and accelerating. Also, PPI has re-accelerated to 6.9%, pointing to a paucity of deflationary forces in the Chinese economy that could potentially give the People's Bank of China the green light to tighten further. We would expect the rise in the Shibor 7-day rate to continue and monetary conditions, which have been tightening since the end of 2016, to become an even bigger handicap in the future. The second risk lies around the Communist Party Congress underway in Beijing. Xi Jinping's marathon speech highlighted his vision for Chinese socialism in a new era. Xi is very clearly dedicated to the primacy of the Chinese communist party. He did highlight, however, that the new principal problem for the Chinese population is the need for a better life, with less imbalances, less inequalities. This fits with his previously revealed policy preferences. As Matt Gertken, who heads the Asian efforts on our Geopolitical Strategy team, has shown, Xi's administration has massively increased spending to protect the environment and increased financial regulation (Table 1).5 These preferences fit in the optic of addressing China's new principal problems: too much pollution and too much debt. Table 1Fiscal Priorities Of Recent Chinese Presidents All About Credit All About Credit Moreover, the continued fight against corruption also fits into that mold. It is a key tool to maintain the legitimacy of the Communist party, and a popular way to address some of the inequalities and imbalances plaguing China today. What does this mean? China has continued to accumulate debt over the past 10 years, with debt to GDP increasing by nearly 120% between 2008 and 2017 (Chart I-16). If a window is opening to tighten monetary policy because inflationary pressures are growing while there is political will to combat inflation and imbalances, it is likely that investment - which pollutes heavily - and debt - a byproduct of large capex programs - could be curtailed. Moreover, the Chinese government still has the wherewithal to support aggregate economic activity through fiscal stimulus. In addition, in the context of the above, much fiscal stimulus could be deployed to fight pollution and decrease inequalities by supporting households. This means that while Chinese GDP growth is unlikely to weaken substantially, the capex intensity of the economy could decrease. So would imports of raw materials and capital goods. As a result, this could be a very negative environment for metals. Metals prices have rebounded sharply since 2016 as Chinese investment has increased. But now that policy could be tightened further and that Xi's new administration has more freedom to move away from an investment-heavy, deeply polluting growth model, the rally in metals could be at risk. Copper, a bellwether for the metals complex, has surged nearly 70% since 2016, and bullish sentiment on the red metal is now at levels historically associated with imminent corrections (Chart I-17). Chart I-16Is This What Deleveraging Looks Like? All About Credit All About Credit Chart I-17Tighter Policy And A Reform Push Put Metal At Risk Tighter Policy And A Reform Push Put Metal At Risk Tighter Policy And A Reform Push Put Metal At Risk This means that currencies for which metals prices are a key driver of terms of trade are at great risk, specifically the BRL, the CLP and the AUD. Moreover, the latter is expensive, having recently been buoyed by some positive economic numbers, and is now widely owned by very bullish investors. We have a short sell AUD/USD at 0.79 and our short AUD/NZD trade at 1.11 was triggered following the Labor/NZ First/Green coalition announced Thursday in New Zealand. Bottom Line: Chinese authorities are set to tighten monetary conditions further as domestic inflationary pressures are growing. Moreover, while short on details, this week's speech by Xi Jinping at the opening of the 19th Communist Party Congress in Beijing seemed to confirm that addressing imbalances, inequalities, and environmental problems will be a key objective of this administration. This points toward a less debt-/investment-driven economic model - at least until deflationary problems re-emerge. While overall GDP growth could be supported by targeted fiscal support, investment plays linked to Chinese capex and real estate could suffer. The AUD is at risk, and we are entering our proposed short AUD/NZD trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Strategy Special Report, titled “Top 5 Reasons To Favor Cyclicals Over Defensives” dated October 16, 2017, available at uses.bcaresearch.com 2 The Balassa Samuelson effect is an empirical observation that countries with higher productivity tend to experience an appreciating trend in there real exchange rate. Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 3 Samuel Reynard, “What Drives the Swiss Franc?” Swiss National Bank Working Papers (2008 – 14). 4 Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 5 Please see Geopolitical Strategy Weekly Report, titled “How To Read Xi Jinping’s Party Congress Speech”, dated October 18, 2017, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1 USD Technicals 1 USD Technicals 1 Chart II-2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: Last week's CPI releases showed that inflation disappointed in September, with headline CPI increasing by only 2.2%, below the expected 2.3%; and Core CPI coming in at 1.7%, in line with expectations; However, long-term TIC data showed a large inflow of funds of USD 67.2 bn, much larger than the expected USD 14.3 bn. The labor market continues to tighten with initial jobless claims and continuing claims dropping to 222,000 and 1.888 million respectively. The DXY has rebounded this week on this news, and also helped by a somewhat disappointing ZEW survey from the euro area, but pared its gains on Wednesday. Regardless, positive developments in the U.S. fiscal space and disappearing slack will provide a tailwind for the greenback. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 2017 The Euro Chart II-3 EUR Technicals 1 EUR Technicals 1 Chart II-4 EUR Technicals 2 EUR Technicals 2 Data from the euro area has been mixed: Industrial production grew at an annual rate of 3.8% in August; The trade balance contracted to EUR 16.1 bn from EUR 23.2 bn on a non-seasonally-adjusted basis, but improved on a seasonally-adjusted basis. The final estimate for core CPI hit 1.1%, in line with expectations; The ZEW Survey dropped and underperformed expectations; Despite largely weak data, the euro has pared all of last week's losses. Markets may be pricing in Catalan developments as a bullish case. The Spanish government has threatened to enact Article 155 of the constitution if Catalonia does not comply, which will give Spain the authority to take measures to ensure compliance by the rogue region. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5 JPY Technicals 1 JPY Technicals 1 Chart II-6 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Bank lending outperformed expectations, growing at a 3% year-on-year pace. Machinery orders yearly growth also outperformed to the upside, coming in at 4.4% However, the annual growth of both imports and exports underperformed expectations and declined significantly from last month, coming in at 12% and 14.1% respectively. The yen has remained relatively flat these past two weeks. Overall, we expect USD/JPY to have additional upside, given that the U.S. OIS curve is not pricing in enough rate hike over the next 2-years. Ultimately, the driver of USD/JPY will simply be U.S. rates as Japanese 10-year rates are capped near 0%. This situation is not likely to change any time soon, as the Japanese economy is still hampered by very low inflation. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 2017 British Pound Chart II-7 GBP Technicals 1 GBP Technicals 1 Chart II-8 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Average hourly earnings outperformed expectations, growing at a 2.2% pace from a year ago. Both headline and core inflation came in line with expectations at 3% and 2.7% respectively. However, both retail sales and retail sales ex-fuel growth underperformed expectations, coming in at 1.2% and 1.6% respectively. Overall, we do not expect much more upside for the pound relative to the U.S. dollar, given that there is already a hike priced for November. At this point, the economic situation does not warrant any more hikes beyond just removing the emergency measures implemented after the Brexit fallout. Furthermore inflation has stopped climbing, and could start to come down in the coming months as the effects of the currency dissipate. Finally, Brexit negotiations have hit a bit of a temporary impass. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9 AUD Technicals 1 AUD Technicals 1 Chart II-10 AUD Technicals 2 AUD Technicals 2 The AUD has not seen much action this week. The RBA minutes highlighted that "slow growth in real wages and high levels of household debt were likely to be constraining influences". This is largely in line with our argument that spare capacity is limiting wage growth and inflation in the economy. Going forward, China remains a risk to our view, with the most recent import figures having provided a welcomed fillip to the AUD. Nevertheless, remarks by RBA Governors will limit the upside in the AUD. Expectations of a rate hike by the RBA depend upon growth numbers, which are unlikely to be achieved given the current trajectory of wages and consumer spending. Furthermore, high underemployment in the economy also remains a drag on spending, dampening the positive effect of a strong job report. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11 NZD Technicals 1 NZD Technicals 1 Chart II-12 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: Electronic card retail sales year-on-year growth declined form 4.4$ to 2.9%. Business NZ PMI softened from 57.9 to 57.5. However, headline inflation came in at 1.9%, rising from the previous month reading of 1.7% and outperforming expectations. The kiwi sold off by almost 2% yesterday, as Jacinda Ardern was elected as the new prime minister of New Zealand. The market is now pricing the risk that the Labor party, which Ardern leads, could change the mandate of the central bank from just targeting inflation to also seeking full employment. Moreover, Labor and its coalition partner, NZ First, want to curtail immigration, one of the tailwind to New Zealand growth. These development would structurally limit the upside for kiwi rates, acting as a headwinds to the New Zealand dollar. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13 CAD Technicals 1 CAD Technicals 1 Chart II-14 CAD Technicals 2 CAD Technicals 2 The CAD has been somewhat strong recently due to developments in the oil market. KSA-Russia support for an extension of supply cuts to OPEC 2.0, as well as developments in Iraq, have pointed to an increase in prices. While the path for Canadian interest rates seem fairly priced, oil prices could buoy the CAD. Risks surrounding NAFTA remain, as President Trump stays inflexible with regards to tariffs, although this is likely to have a greater effect on Mexico than on Canada. Furthermore, albeit still in its infancy Morneau's tax plan, which is anticipated to mostly affect the richest of small business, could have an effect on investment intentions. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15 CHF Technicals 1 CHF Technicals 1 Chart II-16 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has surprised to the upside: The unemployment rate decreased from 3.2% and 3.1%, outperforming expectations. Producer and import prices yearly growth came in at 0.8%, also surprising to the upside. Finally, the trade balance also outperformed, coming in at 2.918 billion dollars for September. It seems that the fall in the franc has been very positive to the Swiss economy. Overall, it would be difficult to see much more upside in EUR/CHF, as the euro already reflects euro area positives. That being said, we are reticent to be outright bearish on this cross as the economic data is still too weak for the SNB to change its monetary policy stance. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17 NOK Technicals 1 NOK Technicals 1 Chart II-18 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been negative: Manufacturing yearly output growth underperformed expectations, contracting at 5.7%. Both core and headline inflation also surprised to the downside, coming in at 1% and 1.6% against expectations of 1.2% and 1.7% respectively. Finally, the Norwegian trade balance declined from 12.4 billion dollars to 9.2 billion dollars USD/NOK has risen 3% since September, even as oil prices have continued their path upward. This was first and foremost reflective of the higher probability of rate hikes in the U.S. in December. Additionally, the recent Norwegian inflation and trade balance numbers are showing that the krone rebounds has tightened monetary conditions in this Scandinavian economy. Overall, we remain bullish on USD/NOK and bearish on EUR/NOK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19 SEK Technicals 1 SEK Technicals 1 Chart II-20 SEK Technicals 2 SEK Technicals 2 The most recent inflation data was slightly weak, with CPI increasing by 0.1% monthly, and 2.1% yearly. Unemployment worsened as the rate rose to 6.2% from 6%. The krona depreciated against the euro on the news, but was flat against the dollar. Despite this temporary setback, PMIs are still perky across the board, and credit is hooking up. China and Europe's recent performance has likely provided a tailwind for growth, which should translate into higher inflation as capacity utilization is extremely tight. Furthermore, the depreciation of the SEK since the beginning of September has eased monetary conditions, making way for the central bank to begin a tightening process in the wake of the ECB's tapering program. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights It's ok to ignore the September jobs report. Is the small cap comeback sustainable? Assessing the threat to the consumer from higher rates and oil prices. The ISM is over 60, now what? Feature Risk assets outperformed again last week, as the S&P 500, the dollar, and the 10 year- Treasury yield all moved higher. Oil was an exception, as WTI dipped back below $50 per barrel, but BCA's Commodity & Energy Strategy service expects WTI to end the year over $55/bbl. Small-cap stocks outperformed as well and conditions are in place for the rise in small caps to continue. The rise in risk assets in recent weeks occurred alongside a marked improvement in the Citi Economic Surprise Index (Chart 1), which moved into positive territory last week for the first time since April, despite the impacts of Hurricanes Harvey and Irma. Chart 1S&P And 10 Year Treasury Yield Tracks Economic Surprise S&P And 10 Year Treasury Yield Tracks Economic Surprise S&P And 10 Year Treasury Yield Tracks Economic Surprise The lack of impact from the hurricanes on the economic data is surprising. Before Hurricane Harvey made landfall, the Atlanta Fed GDP Now reading for Q3 was 3.4%, but moved as low as 2.1% in late September as the August economic data was reported. The most recent Atlanta Fed forecast pegged Q3 GDP at 2.5%. The 60+ readings on September's manufacturing ISM composite and 70+ reading on prices were notably strong, as was the 18.6 million reading on September vehicle sales, the strongest in 12 years. That said, the impact of the storms was evident in the employment data released last week (See below). U.S. Jobs Report: All Noise, No Signal U.S. nonfarm payrolls fell 33,000 in September, which was entirely due to the hurricanes. According to the BLS, 1.47 million workers could not show up for their jobs due to the weather. Because this data series is not seasonally adjusted, one cannot simply add it back to the headline payrolls number. Unfortunately, the separate household survey does not help to shed any better light on the state of the labor market. The household survey is known to be much more volatile than the establishment survey. This was quite apparent with the 906,000 surge in jobs, which followed a 74,000 decline in the previous month. The outsized and unbelievable surge in household employment was the main reason for the decline in the jobless rate to 4.2% from 4.4%. The labor force actually grew by a hefty 575,000 and the participation rate rose to 63.1%, the highest since March 2014 (Chart 2). The 0.5% m/m gain in average hourly earnings needs to be discounted as well. Employment in the low-paying leisure and hospitality sector fell by 111,000 in September, helping to boost the aggregate average hourly wage. As these workers return to their jobs, average hourly wages will correct lower. Bottom Line: Investors should ignore the September jobs report. The 3-month average of payrolls growth from June to August was 172K. This is probably the best gauge of underlying jobs growth and this pace is above the trend growth in the labor force. To the extent that the Fed believes the tightening labor market will push inflation to its 2% target, the calculus for the December FOMC should not change after today's report. Small Caps Make A Comeback Rising prospects for tax cuts have lifted the Trump trades, including small-cap equities. We first initiated an overweight to small caps on November 14, 20161 (Chart 3). Since then, small caps have underperformed large by 162 bps, but not uniformly. The trade was successful from the start through to late January, but faded by late summer along with the prospects for Trump's tax cuts. Starting in mid-August, small cap made a comeback as odds of the tax cut troughed. Chart 2The September Jobs Report Is More Noise Than Signal The September Jobs Report Is More Noise Than Signal The September Jobs Report Is More Noise Than Signal Chart 3The Trump Trades Are Back On The Trump Trades Are Back On The Trump Trades Are Back On Several factors support our overweight view. According to BCA's U.S. Equity Strategy service S&P 600 valuation indicator, small caps are even more undervalued today than when we last discussed them in June2 (Chart 4). Moreover, the Cyclical Capitalization Indicator (CCI) moved sharply into positive territory following the U.S. election despite a modest dip in subsequent months (Chart 5). In addition, small cap stocks have been a reliably high-beta segment of U.S. capital markets since the middle of the last economic cycle (Chart 5, panel 2). That characteristic of small caps argues for a bullish stance given our upbeat view on growth and our overweight positions in U.S. equities versus bonds. BCA's outlook for regulation, inflation, the dollar, the Fed and the consumer also favor small over large caps. Trump has already made significant progress in slowing the pace of new regulations,3 which has long been a concern for small businesses. We expect inflation to move back to 2% in the coming quarters and then begin to climb higher in 2018. Chart 6 shows that small caps often thrive when inflation accelerates. BCA's outlook is that the dollar will see modest appreciation over the next 12 months. Small-cap stocks are less sensitive to dollar movements than large caps. Gradually rising rates will not impede small caps and credit conditions remain favorable. Finally, small caps are more closely linked to the consumer than the S&P 500, and BCA's view on household spending remains upbeat. Chart 4Small Caps Are Cheap, But Not Historically Cheap Small Caps Are Cheap, But Not Historically Cheap Small Caps Are Cheap, But Not Historically Cheap Chart 5Our CCI Supports Small Caps Our CCI Supports Small Caps Our CCI Supports Small Caps Chart 6Accelerating Inflation Usually Supports Small Caps Accelerating Inflation Usually Supports Small Caps Accelerating Inflation Usually Supports Small Caps Despite the upbeat prospects for small caps, some risks linger. Tighter credit conditions for consumers and businesses, an abrupt pullback in housing that would trigger a consumer retrenchment, persistent weakness in the dollar, and a "risk off" environment would see small caps underperform large caps. Bottom Line: It is too early to abandon our bullish bias toward small caps. Conditions remain in place for small caps to outpace large caps. Favorable valuation and encouraging prospects for Trump's pro-small business platform are key to BCA's view, as our favorable outlook for the U.S. consumer. Will Higher Rates And Oil Prices Crush The Consumer? Supports remain in place for continued strength in U.S. consumer spending despite rising interest rates and oil prices. That support was confirmed by September's reports on employment and vehicle sales, and August's personal income and spending data, all released in the past two weeks. However, investors should be aware of hurricane-related distortions in the August and September figures.4 Moreover, BCA's position is reinforced by elevated readings on consumer confidence and booming household net worth statistics, and record high FICO scores (Chart 7). The conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 8 shows that at 41%, household purchases of essentials as a percentage of disposable income are near an all-time low and have dropped by 1.3 percentage points since 2012. In contrast, spending on necessities rose by a record 3.5% in the five years ending in 2008, matching the bruising impact of higher rates, surging inflation and soaring oil prices seen by the end of 1980. Wrenching consumer-driven economic downturns ensued after both episodes. We see gradual increases ahead for both oil prices and interest rates, but nothing that would trigger the collapse of the consumer.5 Furthermore, BCA forecasts only a modest rise in inflation and an acceleration in wage growth; both will provide a boost to disposable income. Personal tax cuts as part of the plan Trump proposed last month would also enhance incomes. Chart 7Plenty Of Support For The Consumer Plenty Of Support For The Consumer Plenty Of Support For The Consumer Chart 8Consumer In Good Shape Despite Rise In Oil, Rates Consumer In Good Shape Despite Rise In Oil, Rates Consumer In Good Shape Despite Rise In Oil, Rates BCA's research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. The latest reading on the manufacturing ISM composite and the 60+ readings on the new orders component of ISM since February suggest that managements are starting to note the robust pace of consumer spending. Signals From Elevated ISM Readings September's numbers on the ISM manufacturing index support BCA's case for accelerating corporate profits in the coming quarters. The ISM is a good proxy for industrial production, which in turn tracks S&P 500 sales. The recent strong data on ISM suggests that IP should pick up in the next six months (Chart 9). A rollover in the 12-month change in IP would challenge our constructive stance on earnings. While a decline is possible given that the index is already lofty, the leading components of the ISM, including the new orders index and the new orders-to-inventory ratio, indicate that the ISM will remain above 50 in the months ahead (Chart 10). Chart 9Favorable Macro Backdrop For Earnings And Sales Favorable Macro Backdrop For Earnings And Sales Favorable Macro Backdrop For Earnings And Sales Chart 10ISM Components Suggest IP Poised To Accelerate ISM Components Suggest IP Poised To Accelerate ISM Components Suggest IP Poised To Accelerate Some investors question how long the composite and new orders indices will remain beyond 60 and what that will mean for risk assets. Additionally, the second 70+ reading on the ISM Prices index this year challenges the notion that inflation is dormant. Other investors are concerned about what will happen after these ISM components are so elevated. Others may fear that the index will soon fall below 50. We analyze the historical periods when the ISM and its sub-indexes were above the 60 threshold, and then what happens to the returns of risk assets 12 months after they fall below the 60 threshold (Chart 11A, Chart 11B and Chart 11C). Chart 11AComposite ISM And Risk Assets Composite ISM And Risk Assets Composite ISM And Risk Assets Chart 11BISM New Orders And Risk Assets ISM New Orders And Risk Assets ISM New Orders And Risk Assets Chart 11CISM Prices And Risk Assets ISM Prices And Risk Assets ISM Prices And Risk Assets Historically, the relative performance of large cap equities to Treasuries is typically poor when the ISM Manufacturing Composite Index is over 60, but investment-grade credit outperforms and both gold and oil usually gain. The performance of these assets is similar even excluding the period around the 1973 OPEC oil embargo and the 1987 stock market crash (Chart 11A and Appendix Table 1). The ISM Manufacturing Composite Index ticked up to 60.8 in September, the first 60+ reading since 2004. The indicator also reached 60 three times in the 1970s and twice in the 1980s, and it stayed above 60 on average for 8 months. The last time it breached 60, it remained at that level for 6 months (December 2003 through June 2004). That interval, along with most of the others, was accompanied by tightening monetary policy and accelerating inflation late in the latter half of economic cycles. Gold and oil perform strongly in the 12 months after ISM Composite Index goes below 60, large-cap equities barely do better than Treasuries, while investment-grade credit underperforms. Surprisingly, high-yield bonds and small-cap stocks outperform 12 months after the ISM falls back below 60, although the sample size is limited. In 1974-1975, the economy was in recession. In all but one other instance (the mid- 1980s), the economy was in a late stage of the cycle, nearing full employment and inflation was on the rise. Risk assets also are strong performers when the New Orders component of the ISM exceeds the 60 threshold (Chart 11B and Appendix Table 2). Moreover, the episodes are more numerous (14 since 1971 versus only 6 for the composite) but, on average, they persist as long as the signal from the ISM Composite. New Orders have been above 60 since February 2017 (7 months), just shy of the 46-year average (8 months). Large cap equities and credit (both investment-grade and high-yield) have outperformed Treasuries, and gold has climbed since February. This performance matches the historical pattern when the New Orders index exceeds 60. In the past 8 months, the underperformance of small caps and the drop in oil prices in that span runs counter to history. The performance of risk assets in the year after the new orders index moves below 60 is mixed, at best. In these periods, while the S&P 500 outperforms Treasuries on average, and small caps outperform large caps, credit underperforms. The big winners when the New Orders index is falling from over 60 are gold (average 14% gain) and oil (22%). Chart 11C and Appendix Table 3 shows the performance of risk assets when the ISM Prices index is greater than 70 and then 12 months after the index crosses below 70. Gold and oil are standouts in the first case, and small cap tends to outperform large. Note that 3 of these 11 episodes coincided with recessions (early 1970s, 1980 and 2008) and 1 occurred during the 1987 stock market crash. Small-cap equities continue to outperform as the Prices index fades, and returns on gold and oil are muted. High-yield bonds underperform Treasuries when the ISM Prices index dips back below 70, and the total return on investment-grade corporate struggles, but it beats Treasuries. Moreover, 3 of these 11 occurred during recessions (early 1980s, 2001, 2008-2009). Separately, there has been a tight relationship between the 12-month change in the 10-year Treasury yield and both the overall ISM, the New Orders and Prices component of the ISM in the past 25 years (Chart 12). Nonetheless, the relationship between the ISM Prices component and the 10-year Treasury has broken down since oil prices peaked in 2014. The 12-month jump in ISM Prices surge in 2016 was met with a decline in Treasury yields. Prior to that, a rise in Prices index was almost always accompanied by a move higher in bond yields. BCA's view is that the ISM manufacturing Composite will remain elevated (although not necessarily more than 60 in the months ahead), supporting our bullish stance on corporate sales and earnings. However, if we are wrong and the ISM dips below 60 and then down to 50, would that signal a downturn and concomitant selloff in risk assets? The ISM has a mixed track record as a leading indicator of recessions (Chart 13). Since 1948, the ISM has provided 9 false signals, using 3 consecutive months below 50 as the indication of an economic decline. Furthermore, 5 of the 9 examples occurred since 1985, as the U.S. economy became less reliant on manufacturing. In the 6 instances that the ISM warned of contractions, the average lead time was 4 months. In the 4 other economic slumps, the ISM moved and stayed below 50 for 3 consecutive months only after the start of recession. The lag averaged 4 months. This was the case in the 2007-2009 episode when the ISM did not send a recession signal until May 2008, 5 months after the official start of the downturn. Chart 1210 Year Treasury Vs. ISM 10 Year Treasury Vs. ISM 10 Year Treasury Vs. ISM Chart 13The Rocky Relationship Between ISM And Recessions The Rocky Relationship Between ISM And Recessions The Rocky Relationship Between ISM And Recessions Bottom Line: Elevated readings on ISM support BCA's view that profit growth will accelerate for a few more quarters while the recent rise in the ISM Prices index confirms the move higher in Treasury yields. Stay overweight stocks versus bonds and underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "Easier Fiscal, Tighter Money?," November 14, 2016. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Waiting For The Turn," June 26, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Still Waiting for Inflation, "August 14, 2017. Available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From the Storm," September 5, 2017. Available at usis.bcaresearch.com. 5 Please see The Bank Credit Analyst Monthly Report, "Global Debt Titanic Collides With Fed Iceberg?," February 2017. Available at bca.bcaresearch.com. Appendix: Table 1 Small Cap Surge Small Cap Surge Table 2 Small Cap Surge Small Cap Surge Table 3 Small Cap Surge Small Cap Surge

Highlights Duration: As long as inflation shows signs of stabilizing during the next couple of months the Fed will lift rates again in December. Stay at below-benchmark duration and remain overweight TIPS versus nominal Treasuries. Credit Cycle: The process of corporate sector re-leveraging is well underway, but the corporate bond trade still has further to run. In fact, the second quarter decline in net leverage likely prolongs the length of time that overweight corporate bond positions will be profitable. Economy & Inflation: While households are no longer paying down debt, the pace of re-leveraging has so far been slow. With delinquency rates already starting to rise for certain classes of consumer credit, we see household debt growth as remaining tepid at best. Feature Janet Yellen struck a somewhat hawkish tone in her press conference following last week's FOMC meeting, as did the post-meeting statement and Summary of Economic Projections (SEP). Predictably, the bond market sold off and is now priced for 39 bps of rate hikes between now and the end of 2018 (Chart 1). While this is still well below the 100 bps predicted in the SEP, it proved sufficient to send the 2-year Treasury yield to a new cycle high (Chart 1, bottom panel). The Fed also announced the unwind of its balance sheet, as had been widely anticipated, and Yellen took great pains to stress that the pace of balance sheet reduction will not be altered unless the economy encounters a shock severe enough to send the fed funds rate back to zero. As was discussed in last week's report,1 this is a calculated move by the Fed meant to sever the link between the balance sheet and expectations about the future path of rate hikes. The SEP showed that most FOMC participants still expect to lift rates once more this year, and that only four out of 16 believe the Fed should stand pat, the same number as in June. However, expectations for one more hike this year are most likely contingent on inflation showing some further signs of strength. To see this, we note that the real fed funds rate is very close to at least one popular estimate of its equilibrium level (Chart 2). With inflation still below the Fed's target it is imperative that an accommodative monetary policy stance is maintained. Practically, this means keeping the real fed funds rate below equilibrium so that economic slack can be absorbed and inflation can rise. If inflation stays flat and the Fed hikes in December, then the real fed funds rate will move above the Laubach-Williams estimate of equilibrium. Chart 1Fed Pushes Yields Higher Fed Pushes Yields Higher Fed Pushes Yields Higher Chart 2Funds Rate Must Stay Below Neutral Funds Rate Must Stay Below Neutral Funds Rate Must Stay Below Neutral We calculate that if the Fed delivers a 25 basis point hike in December, then year-over-year core PCE inflation must rise from its current 1.41% to 1.63% for the real fed funds rate to stay below its neutral level (Chart 2, bottom panel). This squares with the Fed's central tendency forecast that calls for core PCE inflation between 1.5% and 1.6% by the end of the year. In our view, as long as inflation shows further signs of stabilizing and moves toward the Fed's central tendency range during the next couple of months, then the Fed will likely lift rates again in December. However, if inflation resumes its recent downtrend, then the Fed will take a pass. Inflation Expectations: Yellen vs. Brainard Perhaps the most interesting detail to emerge from last week's FOMC meeting is that the committee is so far rejecting Governor Lael Brainard's claim that inflation expectations have become unanchored to the downside. As we discussed in a recent report,2 inflation expectations are critical to the Fed's way of thinking about inflation. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, it would suggest that inflation's long run trend had been altered. This would make monetary policy much less effective, and a timely return of inflation to target much less likely. Governor Brainard views the recent weakness in inflation as suggesting that inflation expectations have in fact become unmoored. As evidence she points to the low levels of: TIPS breakeven inflation rates (Chart 3, top panel) Chart 3Inflation Expectations Inflation Expectations Inflation Expectations Household inflation expectations from the University of Michigan survey (Chart 3, panel 2) 5-year, 5-year forward CPI forecasts derived from the Survey of Professional Forecasters (SPF) (Chart 3, panel 3) In contrast, at her post-meeting press conference Chair Yellen pointed to median 10-year forecasts from the SPF as evidence that inflation expectations remain well-anchored (Chart 3, bottom panel). Although, she also admitted that she is unable to explain why inflation has fallen this year: I can't say I can easily point to a sufficient set of factors that explain this year why inflation has been this low. I've mentioned a few idiosyncratic things, but frankly, the low inflation is more broad-based than just idiosyncratic things. What matters for bond investors is that TIPS breakeven inflation rates, a measure of the compensation for inflation protection embedded in nominal bond yields, are well below levels that are usually seen when core inflation is well anchored around the Fed's target. At present, the 10-year TIPS breakeven inflation rate is 1.84%. We expect it will return to a range between 2.4% and 2.5% by the time that year-over-year core PCE inflation reaches 2%. In Yellen's view, inflationary pressures are strong enough for this process to play out with the Fed still being able to gradually lift rates, once more this year and then three more times in 2018. But the longer that inflation fails to rebound as Yellen expects, the more likely it becomes that the committee will come around to Brainard's view and scale back the pace of hikes. A slower expected pace of rate hikes will lend support to inflation and TIPS breakevens, and in either scenario we would expect TIPS breakevens to reach the 2.4% to 2.5% range by the end of the cycle. The uncertainty surrounds what level of real rates will be required to achieve that outcome. In that regard we are more inclined toward Yellen's view. Inflation will soon follow growth indicators higher,3 and the Fed will be able to deliver a pace of rate hikes similar to what it currently projects. But with so few rate hikes priced into the curve, we think the investment implications are the same in either scenario. Investors should stay at below-benchmark duration and remain overweight TIPS versus nominal Treasuries. Bonds In The Long-Run? The Fed's median projection for the level of longer-run interest rates also declined last week, from 3% to 2.75%. It is now only 8 bps above the 5-year, 5-year forward Treasury yield (Chart 4). Chart 4Fed Slowly Embracing A Low Neutral Rate Fed Slowly Embracing A Low Neutral Rate Fed Slowly Embracing A Low Neutral Rate In general, we think the 5-year, 5-year Treasury yield should be equal to the nominal interest rate expected to prevail in the longer-run plus a small risk premium. In that respect, the yield still looks a tad low compared to the Fed's forecast, although the gap has narrowed considerably. While we would not want to hinge our investment strategy on the accuracy of the Fed's longer-run interest rate forecast, it is notable that the Fed continues to price-in a future where the equilibrium interest rate remains depressed. Please see the Economy & Inflation section (below) for a discussion of the longer-run outlook for the fed funds rate. Corporate Credit Cycle Prolonged Second quarter Financial Accounts (formerly Flow of Funds) data were released last week, allowing us to update some of our credit cycle indicators. Chart 5 shows that, historically, three conditions must be met before the credit cycle turns and we experience a period of sustained corporate bond underperformance. Our Corporate Health Monitor (CHM) must be in "deteriorating health" territory, signaling that the corporate sector is aggressively taking on debt (Chart 5, panel 2). Monetary policy must be restrictive. This can be signaled by the real federal funds rate crossing above its equilibrium level (Chart 5, panel 3), or an inversion of the yield curve (Chart 5, panel 4). Banks must be tightening standards on commercial & industrial loans (Chart 5, bottom panel). So far this cycle only the first criterion has been met and while the CHM remains firmly in "deteriorating health" territory, it actually took a sizeable turn toward zero in Q2. The marginal improvement in corporate health was broad based across all six of our monitor's components (Chart 6). Even return on capital, which had been in free fall, managed to move higher (Chart 6, panel 3). Chart 5Credit Cycle Indicators Credit Cycle Indicators Credit Cycle Indicators Chart 6Corporate Health Monitor Components Corporate Health Monitor Components Corporate Health Monitor Components Box 1Corporate Health Monitor Components Won't Back Down Won't Back Down The slower pace of deterioration in corporate health can mostly be chalked up to surging profit growth. EBITD4 growth outpaced debt growth in Q2, sending our measure of net leverage lower (Chart 7). Year-over-year EBITD growth is now within striking distance of corporate debt growth for the first time since 2015 (Chart 7, bottom panel). Chart 7Can Leverage Reverse Its Uptrend? Can Leverage Reverse Its Uptrend? Can Leverage Reverse Its Uptrend? It is rare for corporate spreads to tighten while leverage is rising. So in that regard the tick lower in leverage probably extends the period of time we can remain overweight corporate bonds in a U.S. fixed income portfolio. Chart 8Profit Outlook Still Positive Profit Outlook Still Positive Profit Outlook Still Positive Since 1973, we calculate that investment grade corporate bonds have outperformed duration-equivalent Treasuries in 62% of six month periods, for an average annualized excess return of 45 bps. In prior research5 we showed that, during the same timeframe, when leverage rose for two consecutive quarters corporate bonds outperformed in only 45% of the following six month periods, for an average annualized excess return of -190 bps. This quarter's decline in leverage breaks a streak of two consecutive increases. But what about going forward? Further declines in leverage will depend on whether profit growth can sustain its recent strength. While some moderation is likely, our leading profit indicators suggest that growth will remain firm for the remainder of the year (Chart 8). Total business sales less inventories have hooked a tad lower, but are still consistent with solid profit growth (Chart 8, panel 1). Industrial production growth also rolled over last month, but that reflects temporary weakness related to Hurricane Harvey. Continued elevated readings from the ISM manufacturing index suggest that underlying demand is strong (Chart 8, panel 2). Meanwhile, dollar weakness continues to provide a tailwind for profit growth (Chart 8, panel 3), and our profit margin proxy has also ticked higher (Chart 8, bottom panel). Our profit margin proxy has risen due to weakness in unit labor costs. While tightening labor markets should cause the corporate wage bill to increase, a late-cycle rebound in productivity growth will ensure that unit labor cost growth stays muted compared to other wage growth measures. We made the case for a late-cycle rebound in productivity growth driven by stronger non-residential investment in a recent report.6 That being said, mounting wage pressures will likely cause margins to narrow next year, although a sharp margin-driven hit to profit growth is not likely in the next few quarters. Bottom Line: The process of corporate sector re-leveraging is well underway, but the corporate bond trade still has further to run. In fact, the second quarter decline in net leverage likely prolongs the length of time that overweight corporate bond positions will be profitable. Economy & Inflation: Household Re-leveraging Still A Slog As was noted above, both model-driven estimates and FOMC forecasts posit that the real equilibrium fed funds rate is very low by historical standards. One school of thought, secular stagnation, views the low equilibrium rate as a permanent state of affairs. While another, the "headwinds" thesis, claims that the fall-out from the financial crisis is keeping the equilibrium rate low for now, but that it will rise as the vestiges of the crisis start to fade. In this second theory, the major headwind keeping the equilibrium rate temporarily low would be the slow pace of household re-leveraging. Chart 9 shows the correlation between the Laubach-Williams estimate of the real equilibrium fed funds rate and growth in household debt. Household debt has only recently started to increase, and even today it is growing at a historically slow pace. So far this has not translated into strong enough growth to push the equilibrium interest rate higher, perhaps because the modest debt growth is occurring off quite a low base. Overall household debt is no longer falling relative to disposable income, but it has also not yet started to rise (Chart 9, panel 2). Whether you fall into the secular stagnation or headwinds camp, we would argue that the pace of household re-leveraging will remain tepid, keeping a lid on the equilibrium interest rate for quite some time. Household debt is dominated by housing, where still-tight lending standards and a lack of savings on the part of potential first-time homebuyers remain semi-permanent features of the economic landscape that will take a long time to disappear. Outside of housing, consumers have been adding debt fairly aggressively, especially in the non-revolving (auto loan and student loan) spaces (Chart 9, bottom panel). The problem is that in those areas where consumers have been adding debt (credit cards, auto loans and student loans), we are also seeing delinquency rates start to rise (Chart 10). Chart 9Household Debt & The Neutral Rate Household Debt & The Neutral Rate Household Debt & The Neutral Rate Chart 10Consumer Credit Delinquency Rates Consumer Credit Delinquency Rates Consumer Credit Delinquency Rates Delinquency rates are elevated compared to pre-crisis levels for both auto loans and student loans. For credit cards, where the re-leveraging is not as far advanced, delinquency rates remain low but have started to increase. It is only in the mortgage market, where re-leveraging has not occurred, that delinquencies remain low. The fact that delinquency rates have already started to increase for auto loans, student loans and credit cards suggests that there is limited scope to add further debt in those areas. Bottom Line: While households are no longer paying down debt, the pace of re-leveraging has so far been slow. With delinquency rates already starting to rise for certain classes of consumer credit, we see household debt growth as remaining tepid at best. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com 4 Earnings before interest, taxes and depreciation. 5 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The Fed will shrink its balance and is determined to raise rates. Implications of synchronized global growth and global NAIRU. Consumers are upbeat and ready to spend. What's the signal from record high consumer expectations for equities? Feature Risk assets and Treasury yields rose up to and after last week's Fed meeting, but late-week saber-rattling by North Korea left most asset classes little changed on the week. The U.S. economic data released last week continued to be impacted by Hurricanes Harvey and Irma, but the Fed notes that the storms are "unlikely to materially alter the course of the national economy beyond the next few months". The backdrop has turned more bearish for bonds even before the Fed's recommitment last week to raising rates gradually and shrinking its balance sheet. The Fed's hawkish stance short term and dovish stance long term will allow risk assets to outperform Treasury bonds and cash, but a sudden move higher in inflation would challenge that view. FOMC: Short Term Hawkish... The Fed sent a hawkish short-term signal on the outlook for monetary policy at its meeting last week. The vast majority of FOMC members, 12 out of 16, expect to raise rates again by December (Chart 1). A 0.2% downward revision to the Fed's 2017 core PCE inflation forecast was offset by an equal 0.2% upward revision to its GDP growth forecast. Moreover, Fed Chair Janet Yellen downplayed this year's soft inflation figures and stressed that inflation expectations remain "reasonably well anchored". Although the relationship may have weakened somewhat recently, the Fed is loath to throw the Phillips curve model into the dust bin just yet. The unemployment rate forecasts were lowered from 4.2% to 4.1% for 2018 and 2019, while the Fed kept its NAIRU estimate at 4.6%. The tightening labor market is expected to place upward pressure on wage inflation and push PCE inflation to the 2% target by 2019. Chart 1Market Expects A Hike In December Market Expects A Hike In December Market Expects A Hike In December Incoming data on actual inflation and inflation expectations will determine whether the Fed will be able to pull the trigger in December. Further softness in the core PCE inflation and CPI will raise doubts as to whether the inflation undershoot is indeed transitory. And especially worrisome will be a decline in inflation expectations. It is noteworthy that 10-year inflation breakevens fell nearly 4bps immediately following yesterday's FOMC announcement. At 1.85%, 10-year breakevens are already running below the 2.4-2.5% range that is consistent with the Fed's 2% target for PCE inflation. Any further decline in breakevens will call into question the Fed's view that inflation expectations remain well anchored. Further, with the decline in inflation expectations, the 2/10-year yield curve flattened following the Fed's announcement. This is could be considered a sign of a slight lowering in growth expectations. Finally, there was little surprise on the Fed's balance sheet announcement. For now, the Fed is committed to slowly unwinding its bond holdings. Janet Yellen said that the Fed will only resume full reinvestment of maturing bonds after it had cut the policy rate back to the zero bound. In other words, the Fed funds rate is now the primary tool to set monetary policy. The odds of another Fed rate hike by year-end have certainly increased (Chart 1). This need not upset risk assets if the incoming data justify higher rates. Only a policy error, where the Fed hikes rates even as inflation expectations decline and the yield curve flattens, will trigger a sizeable pullback in risk assets. This is not our baseline scenario. Softness in inflation and inflation expectations will force the Fed to back down. ...But Long Term Dovish Although the Fed signaled a greater probability of an interest rate hike in the near-term, it lowered the long-run outlook for policy rates. First, the median FOMC member now expects only two rate increases in 2019, down from three in the June forecast (not shown). Second, the estimate for the terminal rate was lowered to 2.75% from 3.0% (Chart 2, panel 4). With the long-run inflation target being 2% (Chart 2, panel 3), this means that the FOMC collectively believes the long-term neutral real Fed funds rate to be just 0.75%. Currently, the Laubach-Williams estimate of the neutral real Fed funds rate is near zero (Chart 3). Therefore, the FOMC sees it rising only modestly from current levels over the coming years. Chart 2The FOMC's "Long Run" Forecasts Since 2012 The FOMC's "Long Run" Forecasts Since 2012 The FOMC's "Long Run" Forecasts Since 2012 Chart 3Neutral Real Rate Near Zero Neutral Real Rate Near Zero Neutral Real Rate Near Zero For any given term premium, a lower short-term interest rate path will mean a lower 10-year yield. If estimates for the terminal policy rate outside the U.S. remain unchanged, the Fed's lower projection will mean narrower interest rate differentials, reducing the relative attractiveness of the dollar. As for equities, a lower estimate for the long-run policy rate would be a wash if it also reflected a lower estimate for long-term GDP growth. However, the Fed kept its longer run real GDP growth estimate unchanged at 1.8% (Chart 2, panel 1). If that proves accurate, lower interest rates and a weaker dollar will be more supportive for U.S. equities over the long-term. Notably, the Fed did not adjust its view of NAIRU, keeping it at 4.6%, where it has been since April (Chart 2, panel 2). Bottom Line: In terms of investment implications, the lower estimate of the long-run neutral rate is supportive for 10-year Treasuries, negative for the dollar and positive for equities. Stay overweight stocks versus bonds and short duration. Don't Downplay NAIRU Synchronous global growth remains in place in 2017 and will persist into 2018, but this growth alone may not be enough to push up inflation. BCA's OECD Real GDP Diffusion Index is at 100% after it dipped to 14% during the financial crisis. The index was also above 90% from 1994 through 1998, and then again from 2001 through 2007. Moreover, the OECD expects that GDP growth will climb above zero in all the member countries in BCA's diffusion index again in 2018. The broad-based global GDP growth has historically been associated with a rising stock-to-bond ratio, rising global trade flows, a narrowing output gap and accelerating industrial production (Chart 4). However, there is no consistent pattern on the dollar, the unemployment rate, or core inflation. Chart 5 shows that during prior periods of robust global growth, equities beat bonds, the U.S. output gap tightened and industrial production increased. U.S. exports tend to contribute more to GDP growth during these phases, but not in a uniform way. Meantime, the Fed has both raised and lowered rates during these periods. Chart 4Widespread##BR##Global Growth... Widespread Global Growth... Widespread Global Growth... Chart 5... Supports Risk Assets,##BR##Trade And A Narrower Output Gap ... Supports Risk Assets, Trade And A Narrower Output Gap ... Supports Risk Assets, Trade And A Narrower Output Gap Nonetheless, while the dollar jumped in the 1990s when BCA's OECD growth index was above 90%, it fell from 2001 to 2007, and it's performance since 2015 has been mixed. The unemployment rate declined in the mid-to-late 1990s, but initially rose in the 2001-2007 period and has dropped since 2010. The Fed both raised and lowered rates during the previous episodes, but has only boosted rates in the current phase. Core inflation slowed in the 1990s when 90% of countries saw positive GDP growth, but accelerated in the early 2000s. Since 2015, core inflation has both climbed and decelerated. What will trigger higher inflation if more than 90% of the globe is experiencing positive economic growth? BCA's Global Fixed Income Strategy service notes that1 67% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", a level not seen since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 6). However, the link between inflation and NAIRU waned during and just after the 2007-2009 recession and only reconnected lately. The implication for investors is that there is a global NAIRU level (or global output gap), which is more important in determining worldwide inflation rates than individual country NAIRU measures. Chart 6The NAIRU Concept Is Not Dead Yet The NAIRU Concept Is Not Dead Yet The NAIRU Concept Is Not Dead Yet Bottom Line: Surging global growth is a precondition for higher inflation, but sustained improvement in the labor market is needed to drive up inflation and prompt more action from the Fed. Investors may be downplaying the NAIRU concept at a time when it is finally set to bite. If that is the case, inflation expectations around the world are too low, although it will take some evidence of faster realized inflation (especially in the U.S. and Europe) before the markets begin to discount that view in bond yields. Stay underweight duration. Flow Of Funds Update On Consumer And Corporate Health The latest readings on the health of household and corporate balance sheets from the Fed's flow of funds accounts reinforce BCA's stance that consumer spending will provide strong support for the U.S. economy through 2017 and 2018. Household net worth continues to rise and is well above average at this point in a long expansion (Chart 7). The total wealth effect for consumer spending is still lagging prior cycles, but remains supportive. Debt-to-income ratios are at multi-decade lows. The ongoing repair of consumer balance sheets has led to an all-time high in FICO scores (Chart 7, panel 4). Last week's U.S. flow of funds report also allows us to update BCA's Corporate Health Monitor (CHM) (Chart 8). The level of the CHM improved slightly between Q1 and Q2, but the overall level still suggests corporate balance sheets are deteriorating. The progress in Q2 was broadbased, as all the components improved, notably the net leverage component. Profit growth surged while debt moved up modestly in Q2, modestly reducing leverage. The Monitor has been a reliable indicator of the trend in corporate bond spreads. The upswing in the CHM in Q2 - and particularly the dip in leverage - supports our corporate bond overweight. On the consumer front, while the recent weakness in vehicle sales and overall retail sales are noteworthy, they do not signal the end of the business cycle. We found2 that a peak in vehicle sales leads the end of the economic cycle by two years. Moreover, Hurricane Harvey weighed on August's retail sales report and Irma will have the same impact on September's sales.3 Instead, the backdrop for consumer spending remains strong. For example, the most recent Fed Senior Loan Officer's Survey suggests that the banking sector is willing to lend to households and that consumers are open to borrowing, although household demand for loans has weakened in recent quarters (Chart 9). Chart 7Support For The Consumer##BR##Remains In Place Support For The Consumer Remains In Lace Support For The Consumer Remains In Lace Chart 8Improved A Bit In Q2##BR##But Still Deteriorating Improved A Bit In Q2 But Still Deteriorating Improved A Bit In Q2 But Still Deteriorating Chart 9Senior Loan Officers##BR##Survey Still Supportive Senior Loan Officers Survey Still Supportive Senior Loan Officers Survey Still Supportive In addition, consumer spending intentions remain in an uptrend and the decade-high readings on "plans to buy" a house and a car are telling (Chart 10, panels 1 and 2). Overall measures of consumer confidence remain at 16-year peaks (Chart 10, panel 3). Furthermore, the sturdy labor market, modest wage growth and low inflation are all factors that support a solid pace of real income growth, which reinforces the spending backdrop (Chart 10, panel 4). Student loan debt increased again in Q2 and investors are concerned by the risks posed by the upswing. The Bank Credit Analyst covered the topic in a comprehensive report in November 2016.4 The key message was that student debt is a modest drag on economic growth, but is not a threat to U.S. government finances and does not represent the next subprime crisis. Nearly a year later, BCA's conclusions remain unchanged. A recent report5 by the Federal Reserve Bank of New York provides data on student loans through Q2 2017. The report noted that while student debt levels were little changed between Q1 and Q2 2017, they are up $85B from a year ago and at record highs (Chart 11). Although student loan delinquencies ticked higher in Q2, and remain elevated by historical standards, they have moved sideways in recent years. We will continue to monitor all types of consumer indebtedness as we assess hazards in the U.S. economy. Student loans are only a mild economic headwind and do not represent a source of systemic financial risk. Chart 10Consumers Upbeat And Ready To Spend Consumers Upbeat And Ready To Spend Consumers Upbeat And Ready To Spend Chart 11Student Loan Debt Is Elevated Student Loan Debt Is Elevated Student Loan Debt Is Elevated Bottom Line: The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. This climate will allow the Fed to boost rates one more time this year and begin paring its balance sheet starting next month. The solid underpinnings for the consumer will sustain corporate earnings growth and, ultimately, higher stock prices. However, favorable consumer attitudes toward U.S. equity prices are a mild concern. Signals From Stock Sentiment Surveys Record U.S. consumer optimism - as measured by the University of Michigan (UM) - on forward stock returns does not necessarily signal a market top. On the other hand, it supports BCA's view that investors be prudent with risk allocations. Respondents to the UM Survey of Consumers assign a 65% probability that the U.S. stock market will move higher in the next 12 months, surpassing the previous zenith in mid-2004. Interestingly, before the 2014 high (60%), the top reading was in mid-2007 (62%), only three months prior to the October 2007 equity market peak. A cursory look at Chart 12, panel 1 shows that peaks on this metric line up with those in equities. We view it another way. Investors should not assume that stocks are peaking based on the UM data. The bottom panel of Chart 12 shows that at just 5.6%, the annual change in the percentage of respondents who expect stocks to move higher in the next 12 months is not at an extreme. The 12-month change was as high as 18% in early 2004 and again in March 2010. Stock returns in the 12 months after these peaks in sentiment were lower than in the 12 months prior. However, we are not yet in the danger zone based on this indicator. Furthermore, BCA's Investor Sentiment Composite Index (not shown) is not at an extreme, although it is at the top end of its bull market range. We expect the stock-to-bond ratio to move higher in the next 6-to-12 months, despite the elevated readings on households' expected return on stocks. Our position is driven more by our bearish stance on Treasury bond prices than on an overly bullish call on equity returns. Chart 13 illustrates this point across three time horizons given our view of fair value on the 10-year Treasury yield (2.67%).6 Our analysis assumes a 2% annualized dividend yield on the S&P 500. Panel 1 shows the ratio between now and year end will remain positive if U.S. equities dip by 5%. Looking ahead 6 and 12 months (Panels 2 and 3), the S&P 500 will have to drop by between 5% and 10% to signal a localized peak in the stock-to-bond ratio. Chart 12Consumers' Expectations For Equity Returns Are Elevated Consumers' Expectations For Equity Returns Are Elevated Consumers' Expectations For Equity Returns Are Elevated Chart 13Scenarios For Stock-To-Bond Ratio Scenarios For Stock-To-Bond Ratio Scenarios For Stock-To-Bond Ratio Bottom Line: Despite heightened consumer sentiment toward equities, we expect the stock-to-bond ratio to move higher in the next 6 to 12 months. Nonetheless, investors should be prudent with risk assets, paring back any maximum overweight positions and holding some safe-haven assets within diversified portfolios. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No.", September 12, 2017. Available at gfis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Disconnected," September 11, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From The Storm, "September 5, 2017. Available at usis.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "Student Loan Blues: Can't Replay What I Borrowed", November 2016. Available at bca.bcaresearch.com. 5 https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2017Q2.pdf 6 Please see BCA's U.S. Bond Strategy Portfolio Allocation Summary, "The Cyclical Sweet Spot Rolls On," September 5, 2017. Available at usbs.bcaresearch.com.

Highlights The ECB can talk down the euro, but not by much. The central bank has previously expressed comfort with EUR/USD at 1.15. The cyclical and structural direction of EUR/USD is higher... ...because the euro area versus U.S. long bond yield spread should ultimately compress to -40 bps from today's -130 bps. Remain neutral in Germany's DAX and underweight Sweden's OMX. Equity markets with a strong base currency and a large exposure to exporters will come under pressure. Overweight German consumer services equities versus German exporters and the DAX. Underweight U.K. consumer services equities versus the FTSE100. Feature When mariners know that a sea-change is coming, their concern is not whether it comes today, tomorrow or the day after tomorrow. The big issue is the sea-change itself - because it brings major implications for navigating the seas. In the same way, when currency markets know that a sea-change in monetary policy is coming, their concern is not whether the policy announcement comes on September 7, October 26 or December 141 - or indeed whether the sea-change will happen suddenly or gradually. At a sea-change, currency markets look much further ahead. Just as for mariners, the big issue is the sea-change itself. EUR/USD is now moving in lockstep with the expected differential between euro area and U.S. policy interest rates not next year, nor the year after next, but rather the differential five years out (Chart I-2). Chart I-1AA Strong Euro Is Good For ##br##German Consumer Services... A Strong Euro Is Good For German Consumer Services... A Strong Euro Is Good For German Consumer Services... Chart I-1B...A Weak Pound Is Bad For##br## U.K. Consumer Services ...A Weak Pound Is Bad For U.K. Consumer Services ...A Weak Pound Is Bad For U.K. Consumer Services Chart I-2EUR/USD Is Moving In Line With The Interest ##br##Rate Differential Expected In 2022 EUR/USD Is Moving In Line With The Interest Rate Differential Expected In 2022 EUR/USD Is Moving In Line With The Interest Rate Differential Expected In 2022 The ECB Can Talk Down The Euro, But Not By Much Chart I-3EUR/USD Might Find Support At 1.15 EUR/USD Might Find Support At 1.15 EUR/USD Might Find Support At 1.15 Therefore, if the ECB really wants to unwind the euro's sharp appreciation this year, the central bank must tell the market that the expectation for a sea-change is completely wrong. In other words, the ECB must indicate that it has no intention to dial back its emergency monetary accommodation. Such a volte-face is unlikely, for two reasons. First, the ECB likes to adjust market expectations incrementally rather than violently. The last policy meeting made the case "for proceeding gradually and prudently when approaching adjustments in the monetary policy stance and communication." Second, not to dial-back its emergency monetary accommodation flies in the face of a euro area economic expansion that is solid, broad, and among the strongest and best-established among major developed economies. "Postponing an adjustment for too long could give rise to a misalignment between the Governing Council's communication and its assessment of the state of the economy, which could (eventually) trigger more pronounced volatility in financial markets." Nevertheless, at the margin, dovish words from Draghi could pare back the euro. How much? Consider that at the last policy meeting EUR/USD stood at 1.15 and the ECB justified this level on the basis of the improved "relative fundamentals in the euro area vis-à-vis the rest of the world." (Chart I-3) Given that these relative fundamentals are still intact, 1.15 might provide a level of support in a technical retracement. Of course, EUR/USD also depends on the Federal Reserve and expectations for its policy rate five years out. EUR/USD would sink if the market became much more hawkish about where it sees the U.S. 'terminal' interest rate. However, for the terminal rate expectation to rise suddenly and sharply in the U.S. relative to the euro area would also fly in the face of the economic data on both sides of the Atlantic. Recently, there has been little difference in either economic growth or inflation rates. The 'Neutral' Real Interest Rates In The Euro Area And U.S. Are The Same More fundamentally, there is little difference in the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. Through the 19 years of the euro's life, the euro area versus U.S. long bond yield spread has averaged -40 bps2 (Chart I-4). Over this same period, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-5). Ergo, the real interest rate differential has averaged zero. Meaning, the neutral real interest rates in the euro area and the U.S. have been exactly the same. Chart I-4Euro-U.S.: Average Interest ##br##Differential = -40bps Euro-U.S.: Average Interest Differential = -40bps Euro-U.S.: Average Interest Differential = -40bps Chart I-5Euro Area-U.S.: ##br##Inflation Differential = -40bps Euro Area-U.S.: Inflation Differential = -40bps Euro Area-U.S.: Inflation Differential = -40bps Bear in mind that the 19 year life of the euro captures multiple manias and crises, some centred in Europe, some in the U.S. Hence, 1999-2017 is a good representation of what the future holds, at least in relative terms if not in absolute terms. With little difference in the neutral real rates over the past two decades, is there any reason to expect a big difference in the future? Our starting assumption has to be no. Chart I-6If Composition Differences Were Removed, ##br##Euro Area And U.S. Inflation Would Be Near-Identical If Composition Differences Were Removed, Euro Area And U.S. Inflation Would Be Near-Identical If Composition Differences Were Removed, Euro Area And U.S. Inflation Would Be Near-Identical In fact, even the -40 bps annual inflation shortfall in the euro area is due to a compositional difference in the consumer price baskets. The euro area does not include owner occupied housing costs, whereas the U.S. does at a hefty weighting.3 If this compositional difference were removed, inflation would also be near-identical (Chart I-6). Still, each central bank must target inflation as it is defined in its respective jurisdiction, so let's assume the annual inflation differential continues to average -40 bps. In this case, the long bond yield spread should also ultimately compress to -40 bps from today's -130 bps. The biggest risk to this view is if the existential threat to the euro resurfaced. Looking at the political calendar, the German Federal Election on September 24 poses no such threat. Meanwhile, ahead of the Italian general election to be held no later than May 20 2018, even the non-establishment Five Star Movement and Northern League are toning down their anti-euro rhetoric. As my colleague Marko Papic, our Chief Geopolitical Strategist, puts it: "euro area politics are a red herring." On this basis, our central expectation is that the euro area versus U.S. yield spread has the scope to compress much further from its current -130 bps. This means that after a possible near-term retracement, we expect the cyclical and the structural rally in the euro to resume. German Consumers Are Winners, U.K. Consumers Are Losers When European currencies strengthen, the big winners are European consumers because they become richer in terms of the goods and services they can buy in international markets. This is significant because Europe imports its food and energy in large (and inelastic) volumes. Hence, their price decline in local currency terms significantly boosts the real spending power of consumers. And vice-versa (Chart I-7). As if to prove the point, German consumer services equities have rallied strongly this year (Chart I-8). And their outperformance has closely tracked euro strength (Chart of the Week, left panel). Across the English Channel, it is the mirror-image story. The pound has slumped. And the big losers are U.K. consumers, whose real spending power is evaporating as food and energy prices - in pound terms - rise. Again, to prove the point, U.K. consumer services equities have struggled to make any headway this year (Chart I-9). And their underperformance has closely tracked the trade-weighted pound's weakness (Chart of the Week, right panel). Chart I-7German Consumption Accelerating,##br## U.K. Consumption Decelerating German Consumption Accelerating, U.K. Consumption Decelerating German Consumption Accelerating, U.K. Consumption Decelerating Chart I-8German Consumer Services ##br##Have Rallied German Consumer Services Have Rallied German Consumer Services Have Rallied Chart I-9U.K. Consumer Services ##br##Have Struggled U.K. Consumer Services Have Struggled U.K. Consumer Services Have Struggled If the euro has more cyclical and structural upside - as we anticipate - then these equity performance trends have further to run. Chart I-10The Exporter Heavy DAX And##br## OMX Have Struggled The Exporter Heavy DAX and OMX Have Struggled The Exporter Heavy DAX and OMX Have Struggled Remain overweight German consumer services equities versus German exporters and the DAX. And remain underweight U.K. consumer services equities versus the FTSE100. At the same time, equity markets with a strong base currency and a large exposure to exporters will come under pressure. Mostly, this is because the translation of multi-currency international earnings into a strengthening base currency hurts index profits. For the time being, this influences our allocation to Germany's DAX - in which we have been neutral relative to the Eurostoxx600 - and Sweden's OMX - in which we have been underweight (Chart I-10). Next week, we will update our overall European country allocation. Given the large sector skews in European equity indexes, this country allocation is heavily dependent on the stance towards Healthcare and Banks. Hence, we await any incremental communication from the ECB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 These are the dates of the ECB's three remaining monetary policy meetings in 2017. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 The imputed cost of owner occupied housing (owners' equivalent rent of residences) comprises 25% of the U.S. consumer price basket but 0% of the euro area consumer price basket. Fractal Trading Model Basic materials equities are technically overbought. Initiate a short position relative to the broad market with a profit target / stop loss at 2.5%. In other trades, long Mediaset Espana / short IBEX35 hit its stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Short Basic Materials Vs. Market Short Basic Materials Vs. Market The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations