Consumer

Highlights The locomotive of the U.S. economy, the consumer, remains supported by powerful tailwinds. The Fed will be able to tighten monetary policy relative to other central banks by a higher degree than the market appreciates. The dollar will rise further. Use this dip to buy more dollars. Being tactically long the yen is a hedge against growth disappointments. Set a stop-sell for AUD/NZD. Feature In June of last year, we wrote a piece titled "What Could Go Right?" arguing key changes in the global economy may have justified a more pro-risk stance for investors.1 The core of the argument was that markets were pricing in a lot of negatives, as the annual return of the global stock-to-bond ratio was deeply negative and could only fall further if a recession were to emerge. Moreover, as commodity prices were improving, we foresaw a waning of deflationary forces that had engulfed the world. This easing deflation would cause real rates to fall and economic activity in EM to rebound. Chart I-1Global Asset Prices: From Gloom To Glee Global Asset Prices: From Gloom To Glee Global Asset Prices: From Gloom To Glee Over the subsequent nine months, this scenario moved from the world of theories to being the reality for the global economy. Today, the annual return of the global stock-to-bond ratio is now the mirror image of last June (Chart I-1). Thus, for the stock-to-bond ratio to move higher, we need to explore where growth may come from. Moreover, we need to consider whether this growth is likely to help the dollar or help other currencies. The U.S. Is In Charge The U.S. economy continues to show the most promise. It is true that some signs do point to a weak Q1. Much noise has been made about the decline in commercial and industrial loans. We are more sanguine. To begin with, the Conference Board includes C&I loans in its list of lagging indicators, not leading ones. Additionally, C&I loans lag banks' lending standards, and, in fact, the weakness in this subsection of credit aggregates is the natural consequence of the 2015-2016 tightening in lending standards. Their recent easing points toward a rebound in C&I loans, as do core durable goods new orders (Chart I-2). What is more concerning is the slowdown in credit to households (Chart I-3). The U.S. economy is driven by household dynamics and the Conference Board does include consumer credit in its list of leading indicators. Moreover, the amount of MBS and ABS on primary dealers' balance sheets remains in a downtrend. This is worrisome because it suggests that the slowing accumulation of consumer debt on banks' balance sheet is genuine, and not a reflection of securitization (Chart I-4). Chart I-2C&I Loans##br## Will Pick Up C&I Loans Will Pick Up C&I Loans Will Pick Up Chart I-3However, Household Credit ##br##Dynamics Are A Worry However, Household Credit Dynamics Are A Worry However, Household Credit Dynamics Are A Worry Chart I-4Securitization Unlikely ##br##To Be The Culprit Securitization Unlikely To Be The Culprit Securitization Unlikely To Be The Culprit However, there are causes to minimize these concerns. Mainly, the drivers of household income and spending are still healthy. First, U.S. financial conditions remain easy, a phenomenon that tends to boost GDP growth in the following quarters, suggesting that national income will remain strong. Second, the outlook for employment in the U.S. remains robust. As Chart I-5 illustrates, the employment components of the ISM and the Philly Fed surveys both point to a pick-up in job creation. This further supports the notion that nominal household income will strengthen Third, our real disposable income indicator, based on various components of the NFIB survey, is showing that households should enjoy strong income growth in the coming months (Chart I-6). Moreover, despite the failure of the AHCA, Marko Papic, the head of BCA's Geopolitical Strategy service argues that it will be much easier for the GOP to implement tax cuts, especially geared toward the middle class, than it was to repudiate the much-maligned Obamacare.2 This could further help household disposable income. Chart I-5Job Growth Will Rebound Job Growth Will Rebound Job Growth Will Rebound Chart I-6Household Income: Highway Star Household Income: Highway Star Household Income: Highway Star Fourth, household liquid assets represent 270% of disposable income, the highest level in decades. Moreover, household debt-servicing costs are still near multi-generational lows, suggesting that households are in the best financial shape they have been in decades. And fifth, household confidence has surged to its highest levels since 2000, reflecting both the large increase in net worth created by surging asset values as well as the very low level of unemployment in the U.S. (Chart I-7). Thus, the decline in the savings rate from 6.2% in 2015 to 5.5% at present could deepen further, adding more impetus to transform income gains into consumption gains. At the worst, this development suggests that the household savings rate will not rise much. These factors all imply that household consumption will remain robust and may in fact accelerate in the coming quarters. Consequently, that capex too has upside. We have highlighted how capex intentions have risen substantially, and this has historically been a powerful leading indicator of capex itself.3 However, the financial press is replete with commentators reminding us that the positive global economic surprises have mostly been a reflection of "soft data" and that "hard data" has not followed through. Not only do we philosophically disagree with this statement - historically soft data does indeed lead hard data - but as Chart I-8 illustrates, core capital goods orders have risen quite sharply, mimicking the developments in retail sales. A combination of strong retail sales and strong orders tend to portend to a rise in capex. Chart I-7Happy Shiny People Happy Shiny People Happy Shiny People Chart I-8Capex Will Rebound Capex Will Rebound Capex Will Rebound These developments raise the likelihood that U.S. growth will power the global economy and that the Fed will be in a good position to make good on its intent to increase interest rates two more times this year. In fact, there is even a growing probability that the Fed will add another tool to its tightening arsenal: letting MBS run off, resulting in a contraction of its balance sheet. The combined tightening of two more hikes and a shrinking balance sheet will be much greater than any tightening emanating from an ECB taper. As we argued last week: Europe's inflation and wage backdrop remains icy cold, limiting how far the ECB can tighten monetary policy.4 While an environment of globally rising rates is normally negative for the yen, with the BoJ displaying and even easier bias than in the past, any increase in rates in the U.S. is likely to supercharge weaknesses in the yen, as the BoJ will put a lead on JGB yields and force them to remain subdued.5 As a result of these views, we remain very committed dollar bulls on a 12-18 months basis and recommend using the current dip in the dollar as a buying opportunity, especially on a trade-weighted basis. Bottom Line: While consumer loan growth has slowed - which could result in a poor Q1 U.S. growth number - the outlook for U.S. household income and consumption remains promising. This will also feed through to higher investment growth, clearing the Fed's path toward higher rates. This dip in the dollar should be used as an occasion to buy the greenback. But Why Still Long The Yen Tactically? This position has two purposes. First, we have been worried about dynamics in China that could cause a correction in EM markets.6 More recently, the decline in Chinese house-price appreciation has deepened, representing an ominous sign for the iron ore market (Chart I-9). Poor metal prices tend to represent a negative terms of trade shock and therefore an economic handicap for many large EM nations. Moreover, back in June, the improvement in Taiwanese IP was one of the factors that prompted us to highlight a potential improvement in the global economy. So was the uptrend in our boom/bust indicator. Today, not only is the boom/bust indicator losing steam, but Taiwanese IP has sharply rolled over (Chart I-10). While this is not a reason to worry about our bullish view on the U.S. economy, this could suggest that the global manufacturing upswing has seen its heyday, a development that is likely to weigh more heavily on EM economies than on the U.S. Any EM stress is likely to boost the yen's appeal, temporarily countering the BoJ's aggressive stance. Chart I-9Problems For Iron Ore Problems For Iron Ore Problems For Iron Ore Chart I-10Two Clouds For Global Growth Two Clouds For Global Growth Two Clouds For Global Growth Second, we do not want to be dogmatic on our U.S. growth view. As the top panel of Chart I-11 illustrates, increases in 2-year Treasury yields have tended to lead to decreases in U.S. inflation expectations. While we would argue that the U.S. economy is on a stronger footing to withstand higher rates than at any point since 2010, a policy mistake is not out of the scope of probabilities. If rising rates is indeed a policy mistake, a large risk-off event would be a very likely outcome, one that boosts the yen. Finally, as the middle and bottom panels of Chart I-11 shows, a fall in U.S. inflation expectations would also extract its toll on EM and cyclical plays, further reinforcing any disappointment out of China, and further adding shine to the yen. Our original target on USD/JPY was 110, we are moving it to 108. At this point, we will become sellers of the yen, unless we see signs that the global economy is entering a more dangerous path than originally anticipated. Additionally, investors looking to express a bearish view on EM may want to go short MXN/JPY (Chart I-12). The peso has massively rallied and is now at a crucial technical spot against the JPY. Moreover, while being short USD/JPY may be a dangerous move - after all, we are playing what amounts in our view to a countertrend bounce in the yen - if EM are at risk, these risks could be exacerbated by the tightening in financial conditions created by a higher dollar. Mexico, with its high external debt, representing nearly 70% of GDP, is particularly exposed to this problem. Also, MXN, with its high liquidity for an EM currency, is often a vehicle for investors to play EM weaknesses. Thus, shorting MXN/JPY could be a great hedge for investors with long EM exposures. Chart I-11Are We Out Of The Woods Yet? Are We Out Of The Woods Yet? Are We Out Of The Woods Yet? Chart I-12A Gauge And A Play A Gauge And A Play A Gauge And A Play Bottom Line: Being tactically long the yen in a portfolio offers two advantages. First, it is a direct play on any disappointment of investors in the EM space, and, second, it is also a hedge against the risks to our strong U.S. growth view. AUD/NZD: Not A Bargain It is often argued that AUD/NZD is a bargain as it trade 6% below its purchasing power parity rate. This may be a valid reason to buy this cross, but only for investors with extremely long investment horizons, as PPP deviations can take seven years to correct. In fact, following the recent rebound in AUD/NZD, we would be inclined to short this pair once again. On the international front, AUD/USD seems to be driven by the dynamic in Chinese nominal GDP growth. We doubt Chinese nominal GDP growth will accelerate much beyond Q1. As Chart I-13 illustrates, AUD/USD seems to have moved ahead of Chinese GDP, putting this currency at risk. We also can also interpret AUD/NZD as a vehicle to play the growth rebalancing in China. The AUD (iron ore, other metals, and coal) is a bet on industrial and investment growth while the NZD (dairy, meat, and wool) is a wager on the Chinese households. As China moves away from an investment-led growth model toward a more consumption-led growth model, AUD/NZD should underperform. A simple fair value model for this cross designed to capture these dynamics as well as the USD dynamics indicates that AUD/NZD is 8% overvalued (Chart I-14). Chart I-13AUD Prices In Chinese Optimism AUD Prices In Chinese Optimism AUD Prices In Chinese Optimism Chart I-14AUD/NZD Is Expensive AUD/NZD Is Expensive AUD/NZD Is Expensive Moreover, still with an eye firmly planted on China, AUD/NZD has tended to perform poorly when Chinese monetary conditions tighten. The recent upward move in the Chinese 7-day repo rate could be a harbinger of bad things to come for this cross. Relative domestic factors also temper any bullishness on AUD/NZD. Kiwi house prices are outperforming Aussie prices and New Zealand inflation is catching up to that of Australia's. Moreover, the RBA has been paying more attention to the poor state of the Australian labor market, while that of New Zealand remains very strong. These dynamics suggest that kiwi rates could rise relative to that of Australia (Chart I-15). More technically, investors are massively long the AUD relative to the NZD (Chart I-16). This usually is a good signal to bet against this pair. Chart I-15Domestic Conditions Favor##br## Higher NZ Rates Vs. Australia Domestic Conditions Favor Higher NZ Rates Vs. Australia Domestic Conditions Favor Higher NZ Rates Vs. Australia Chart I-16Speculators ##br##Are Bullish Speculators Are Bullish Speculators Are Bullish Bottom Line: Shorting AUD/NZD at current levels makes sense. Not only is it a way to take advantage of the desire by Chinese authorities to rebalance growth away from the Chinese industrial sector, the Kiwi economy is outperforming that of Australia, and too much negativity has been priced in for the RBNZ relative to the RBA. Finally investors are overly long the AUD relative to the NZD. Set up a stop-sell of AUD/NZD at 1.1100, with a target of 1.000 and a stop at 1.1330. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "What Could Go Right?", dated June 24, 2016 available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Five Questions On Europe", dated March 22, 2017 available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Outlook: 2017's Greatest Hits", dated December 16, 2016 available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "JPY: Climbing To The Springboard Before The Dive", dated February 24, 2017 available at fes.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The DXY displayed resilience this week: the third estimate for U.S. GDP in 2016Q4 outperformed expectations at 2.1%, after being revised up from 1.9%; consumer confidence increased to 125.6, the highest level since 2000; yet Initial jobless claims ticked in at 258,000, underperforming expectations of 248,000 but beating previous figures of 261,000. Another factor lifting the dollar were recent comments by Secretary of Transportation, Elaine Chao, who stated that Trump's $1 trillion infrastructure plan will be unveiled later this year. This could be considerably positive for U.S. economic growth as it will cover a large part of the economy: "transportation infrastructure, energy, water and potentially broadband and veterans hospitals as well." Although specifics were not disclosed, such stimulus in the face of tightening labor market could fan inflation. Under the assumption of a proactive Fed, this could translate into a strong dollar. Report Links: USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Last week's hawkish comments by ECB board member Ewald Nowotny drove the euro higher, while recent comments by Peter Praet confirmed that "a very substantial degree of monetary accommodation is still needed", which pushed the euro down. Promoting the euro's downside were Italian industrial sales and orders, which contracted at a monthly pace of 3.5% and 2.9% respectively, although annual rates remain positive. Article 50's invocation was another factor which contributed to volatility. How Brexit negotiations evolve will dictate movements in EUR/GBP for the foreseeable future. President Tusk's demeanor was also quite negative in his speech, focusing on minimizing "the costs for EU citizens, businesses and Member States". In other news, Portugal's Finance Minister Mario Centeno hinted at a possible upgrade to the growth forecast to around 2% from 1.5% as exports grew by 19% in January. As exports continue to be a key driver of growth for this country, this suggests a weaker euro is still needed to support growth in the periphery. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data has been mixed for Japan: Corporate services prices rose by 0.8% year-over-year, outperforming expectations. However, retail trade yearly growth deteriorated to 0.1% from 1% the previous month, underperforming expectations. Furthermore, manufacturing PMI fell to 52.6 from 53.3 the previous month. We are changing our tactical target for USD/JPY from 110 to 108. The decline in Chinese property prices as well as slowing inflation expectations in the U.S. might create a risk off environment that will affect carry currencies and will benefit the safe havens like the yen. On a cyclical basis, we remain yen bears, as recent sluggishness will only embolden BoJ policy makers to maintain their radical monetary stance. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 It's official: Theresa May has triggered Article 50. The pound reacted relatively positive to the event as both parties in the negotiations chose to start with the carrot rather than the stick: In her letter to the EU Theresa May stated that she hoped to enjoy a "deep and special" relationship with the European Union once Brexit is finalized. On the other side of the channel, Donald Tusk also pledged to work "closely" with their counterparts in London, and that he hoped that the U.K. will stay a close partner after Brexit. These developments are encouraging, as it shows that cooler heads might prevail at the end of the day. This rosier outlook in an environment where expectations for the Britain are still too pessimistic makes the pound a very attractive buy, particularly against the euro, despite the potential for short-term volatility as the stick will ineluctably come out. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 In an attempt to curb housing market euphoria, all four major banks - ANZ, CBA, NAB and Westpac - increased lending rates on investor and interest-only mortgages this month. Fitch Ratings reports that the tightening was done "ahead of probable regulatory tightening", as hinted frequently by the RBA. Rising wholesale funding costs due to tighter U.S. policy is also a motivating factor behind this. For the time being, the housing market risk will continue to be restricted through macroprudential policies rather than actual tightening by the central bank. Eventually risks related to record-high household debt will limit the capacity of the RBA to increase rates. On the brighter side, banks are well positioned with strong capital buffers and pre-impairment to profitability, with Fitch rating them 'Stable'. This means that risks may not lie with the banking sector, but that the consumer sector will be the key drag on growth. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 In the current environment, although we like to continue to be short the NZD against the yen, we are also shorting AUD/NZD once again. Beyond its uncorrelated nature, there are many reasons why this is an attractive cross to short: AUD/NZD tends to perform poorly when Chinese monetary conditions tighten. Therefore, the spike in Chinese repo rates could weigh on this cross. Furthermore, investors are very long the AUD relative to the NZD. This gives us confidence that this cross might be in overbought territory and that the 5.5% rally in AUD/NZD over the last 2 months may be exhausting itself. Finally, as we have mentioned before, domestic factors still favor the NZD, as kiwi house prices are rising at a faster pace than Aussie ones, which should put pressure on rate differentials. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD is displaying some strength on the back of stronger oil prices, outweighing the pressure from a stronger USD. As mentioned last week, the trend for USD/CAD is still negative in the short term, as corroborated by a negative MACD trend. The greenback's seasonal behavior is also generally negative in April, which could buoy the CAD in the next month. Nevertheless, at the Bank of Canada's meeting in two weeks, Poloz is likely to continue displaying a dovish rhetoric, limiting the CAD's resilience. Similar to Australia, risks lie with the consumer sector, which is burdened by a huge debt load. This gives another reason for Poloz to stay off hikes for the time being and concentrate instead on promoting the implementation of macroprudential policies to regulate lending standards and mitigate housing market risks. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF now hovers around 1.07, clearing the implied floor by the Swiss National Bank. Recent data have been positive: The Zew survey for economic expectations reached 29.6, up from 19.4 in February. It is now at the highest level in 3 years. The KOF leading indicator came at 107.6, above expectations. Although it does seem that the Swiss economy is still improving, the SNB will stay resolute in its intervention for the time being. Indeed, this was the message of SNB Governing Board Member Andrea Maechler, who asserted that there was no limit on their expansion of FX reserves, and that the Swiss franc was "strongly overvalued". We will continue to observe how the Swiss economy develops. However, for the time being the SNB is likely to keep its floor in place. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has been relatively flat this week, even in the face of a rally in oil prices. This has been in part due to a phenomenon that should continue in the next months: an appreciation of the U.S. dollar against EM and commodity currencies. Furthermore, domestic factors should continue to weigh on the krone, as employment continues to contract and inflation is receding due to the stabilization of the krone. Indeed, Governor Olsen signaled that the Norges bank will likely leave rates unchanged for "a good while" due to these developments. Furthermore, oil could be at risk as well, as the market is starting to doubt the Russian commitment to its deal with OPEC. This, coupled with a slowdown in EM, could prompt a down leg in oil, hurting the NOK in the process. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data came out strong: Retail sales annual growth remains unchanged at 2.7%; The producer price index grew at 7.5%; Consumer confidence for March was at 102.6, down from the previous 104.3. Interesting technical developments for the krona are pointing to further weakness. USD/SEK has rebounded from oversold levels and the MACD line is beginning to overtake the signal line. More importantly, the Coppock curve is rebounding, signifying a bullish trend. EUR/SEK is showing similar signs with the MACD pointing up and the Coppock curve rebounding. Interestingly, Swedish inflation expectations have substantially decreased this week which might give the Riksbank cover to remain dovish. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights A gradual rise in interest rates will not be problematic for the housing market. Throughout the cycle, it has been potential homebuyers' lack of savings, and tougher lending standards, that has held back the housing expansion. A steady improvement in household balance sheets is now allowing more households to qualify for loans. We assign low odds that housing policy reform will have a direct impact on the market over the next year; macroeconomic forces will be the primary driver for residential real estate activity and prices. Feature Since 2013, the U.S. housing market has enjoyed a relative period of calm after the bubble (2004-2007), bust (2008-2011) and prolonged clean-up period (2011-2014). Indeed, since 2013, the residential real estate market has made steady gains both in terms of construction and price returns. Rock-bottom interest rates, an improving labor market, and tight supply have provided good conditions for the housing market to expand. But these conditions are changing. Both residential investment and home prices are procyclical and highly sensitive to interest rates. With the Fed now beginning to deliberate its fourth rate hike of the cycle, investors should wonder whether this poses a risk to housing. Meanwhile, there is much talk about tax reform from Washington. This Special Report focuses on the top questions relating to the U.S. housing market. Question #1: Won't rising mortgage rates kill the nascent recovery in mortgage activity? Throughout this expansion, the level of interest rates has not been the major hurdle to the housing recovery; it was a lack of savings and tighter credit conditions that kept potential homebuyers out of the market. Table 1 is a breakdown of the National Association of Realtors' Affordability of First-time Homebuyers. The median price of a starter home is currently $199,800 and the qualifying income on such a home (assuming 10% down payment) is $42,000. Since the median family income is currently $46,040, this implies that at today's interest rates, potential first-time homebuyers do have the required income to enter the housing market. Earlier in the recovery, the problem had been the 10% down payment. According to the Federal Reserve's triennial survey of Consumer finances in 2014, median net worth for non-homeowners (i.e. renters) was $5,400, i.e. far short of the down payment required. A meaningful rise in the homeownership rate was always going to be difficult to pull off until consumers built sufficient savings for a down payment and/or mortgage lending standards loosened significantly. Table 1Potential Homebuyers: Savings A Bigger Hurdle Than Rates U.S. Housing: What Comes Next? U.S. Housing: What Comes Next? We do not have up-to-date median renter savings data (the next Federal Reserve survey of consumer finances will only be published in September), but the savings rate has risen over the past several years. It is likely that an improvement in renter finances is alleviating the major hurdle that exists for potential home buyers. Outside of the down payment issue, housing affordability is very good even under an aggressive interest rate scenario. In Chart 1, we stress-test housing affordability under different rate scenarios. Even if mortgage rates rise by 200bps, mortgage payments relative to income will remain well below their long-term average. The bottom line is that we do not see a rise in interest rates as overly problematic for the housing market. Throughout the cycle, it has been potential homebuyers' lack of savings, and tougher lending standards that have held back the expansion. A steady improvement in household balance sheets is now allowing more households to qualify for loans. Question #2: And how are lending standards today? Historically, lending standards always swung between very tight at the beginning of an economic cycle and very loose at the height of the expansion. This time, it appears that banks have kept a more cautious attitude toward consumers relative to past cycles (Chart 2). This shouldn't be a surprise, given that this was the area of greatest excesses during the past business cycle. Chart 1Higher Rates Won't Kill ##br##The Housing Recovery Higher Rates Won’t Kill The Housing Recovery Higher Rates Won’t Kill The Housing Recovery Chart 2Improved Household Balance Sheets Mean ##br##More Qualifying Borrowers Improved Household Balance Sheets Mean More Qualifying Borrowers Improved Household Balance Sheets Mean More Qualifying Borrowers As mentioned above, consumers' balance sheets have largely been mended over the course of this cycle. In fact, the average U.S. FICO score is now at an all-time high. This is great news, although still perhaps not great enough for banks. According to Deutsche Bank, the average credit score required is 750, and this number has not changed much since 2007. The average FICO score for the total U.S. population is still considerably below this. However, as scores improve, over time more and more people are qualifying. Overall, while it appears that banks have not drastically changed lending standards, more prospective buyers are meeting the criteria. Question #3: Is there still a supply glut? No- as Chart 3 shows, on a national basis, traditional measures of housing inventory for sale are near-record lows. Of course, geography is very important for real estate and some markets are tighter than others, but aggregate data does not show any meaningful imbalances. If anything, a catch-up building phase may be required in some areas. Question #4: How will Trump affect the housing market? We do not anticipate that any direct policy measures will impact the housing market in 2017. If interest rates rise over the next year because the Fed believes that monetary policy needs to tighten in the face of expansive fiscal policy, then this will surely provide a mild brake on lending activity. We address the impact of higher rates in Question #1. As for direct policy measures, perhaps the most impactful one would be a change to the mortgage interest deduction. Recall that U.S. taxpayers currently can deduct the interest expense on their mortgage to reduce their taxable income. Trump had previously floated the idea to adjust the cap on the amount of eligible debt (currently at $1 million for married couple jointly filing taxes). But earlier this month, Treasury Secretary Mnuchin dismissed this idea. Tax cuts or broader tax reform are unlikely to pass until the second half of the year at earliest. Until the legislation is written it is impossible to know what aspects of the Trump or House GOP proposals will be included. Similarly, Mnuchin has voiced that he is keen to privatize the GSEs. But that is unlikely to occur this year and the implications of such a development are unclear. The bottom line is that we assign low odds that housing policy reform will have a direct impact on the market over the next year; macroeconomic forces will be the primary driver for residential real estate activity and prices. Question #5: How much will residential real estate contribute to GDP? Residential investment currently stands at 4% of GDP (Chart 4). This is way above the low reached in 2009, but is still short of the pre-recession high of 6% of GDP and is still significantly shy of the thirty year average of 5%. Based on the still low level of inventories, and the potential for household formation to rise, a reasonable expectation is that construction climbs back to 5% of GDP over the next several years. If that occurs, then the contribution to GDP growth from construction should rise toward 0.8% this year and stay at a high level. Chart 3Inventory Is Tight Inventory Is Tight Inventory Is Tight Chart 4Construction Will Be A More Significant GDP Contributor Construction Will Be A More Significant GDP Contributor Construction Will Be A More Significant GDP Contributor Question #6: 4% of GDP is pretty small. How else does the housing market contribute to growth? The housing market affects the economy through multiple channels; even a casual observer of the 2008/09 meltdown can attest to that! Besides the banking system, it is especially homeownership that affects consumer spending patterns. First, the overall wealth effect - the change in spending that accompanies a change in perceived wealth - is driven primarily by the change in the value of housing assets, rather than financial assets (Chart 5). On average, a one-dollar decline in housing wealth tends to reduce consumption by 12 cents. This is two-to-four times as large as the impact on consumption from a one-dollar increase in housing wealth, and much larger than the impact from a one-dollar decline in stock market wealth.1 Second, homeownership impacts spending decisions through the collateral effect. Real consumption and real debt growth have been strongly correlated since 1960. As the top panel of Chart 5 shows, greater credit availability for households has been associated with lower saving rates -and thus higher consumption (this process went into reverse during the GFC).2 Since homeownership is the most significant means for households in the U.S. to access credit (over 80% of household debt is held as mortgage debt), it is really the trend in homeownership and its accompanying mortgage debt that drives the changes in household debt positions, and therefore their ability to boost spending above incomes. Now that there are reasons for the homeownership rate to rise, this wealth effect could play a larger role than during the past few years. Question #7: And how much will prices rise? The U.S. housing recovery has closely followed the classic cycle - our stylized roadmap based on the experience of countries that previously recovered from a housing/financial crisis (Chart 6). If the path of home prices continues to follow this roadmap, then real home price appreciation will be around 4% in 2017 (6% in nominal terms). Chart 5Homeownership = Leverage Homeownership = Leverage Homeownership = Leverage Chart 6More Price Gains Ahead More Price Gains Ahead More Price Gains Ahead Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Case, Quigley and Shiller. "Wealth Effects Revisited". February, 2011. 2 The Fed has done extensive work on this topic. A comprehensive background piece is available here: http://www.kansascityfed.org/publicat/sympos/2007/PDF/Muellbauer_0415.pdf

Highlights Monetary Policy: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Economy: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. High-Yield: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Feature Chat 1A Hawkish Market Reaction A Hawkish Market Reaction A Hawkish Market Reaction After having been relatively subdued in the two months since the Fed's last rate increase, rate hike expectations priced into money market curves awakened last week following Janet Yellen's semi-annual Congressional testimony. Expectations priced into the overnight index swap curve have returned close to levels last seen on the day of the December 2016 FOMC meeting (Chart 1). As of last Friday's close, the market was priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. The implied probability of a March hike peaked at 34% last Wednesday.1 In this week's report we discuss why a March rate hike is unlikely. We also consider the outlook for U.S. economic growth in 2017, which we expect will remain decidedly above trend. Above-trend growth will allow the gradual increase in core inflation to persist, reaching the Fed's target by the end of the year. As a result, the Treasury curve will bear-steepen during this timeframe. To position for this outcome, investors should maintain below-benchmark duration and favor the belly (5-year bullet) of the curve relative to the wings (2/10 barbell) in duration-matched terms.2 Yellen's Hawkish Turn? Most news reports of Janet Yellen's testimony last week perceived a hawkish tone in her remarks and focused specifically on the following sentence: As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.3 However, more important than the above boilerplate is the simple fact that inflation remains below target and the Fed has an incentive to tread cautiously to support its eventual recovery. There is no pressing need to move quickly on rate hikes and we expect that the next rate increase will not occur until June. One reason is that, in the current cycle, the Fed has not lifted rates without having first guided market expectations in the months leading up to the hike. As can be seen in Chart 2, rate hike probabilities implied by fed funds futures were already well above 50% one month prior to each of the last two rate hikes. If there was a strong desire to lift rates in March, Yellen would have likely sent a more powerfully hawkish signal in her testimony last week. Instead, Yellen chose not to mention the March meeting specifically and said only that the Fed would continue to evaluate the case for further rate hikes at its upcoming "meetings". Chart 2Market-Implied Rate Hike Probabilities: March Looks Too High Market-Implied Rate Hike Probabilities: March Looks Too High Market-Implied Rate Hike Probabilities: March Looks Too High Second, as was alluded to above, core PCE inflation is running at 1.7% year-over-year, still below the Fed's 2% target. What's more, long-dated TIPS breakeven inflation rates are also below levels that are consistent with inflation being anchored near the Fed's target (Chart 3). At present, the 5-year/5-year forward TIPS breakeven rate is 2.17%. Historically, a range of 2.4% to 2.5% is consistent with inflation at the Fed's target. Further, even though a strong January core CPI print, released last week, seemed to strengthen the case for a March hike, the details of the report show that only a few components (new cars +0.9% m/m, apparel +1.4% m/m, and airline fares +2.0% m/m) accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in contractionary territory (Chart 4), it is very likely that inflation will soften in the coming months. Chart 3Inflation Still Too Low Inflation Still Too Low Inflation Still Too Low Chart 4Inflation Recovery Not Broad Based Inflation Recovery Not Broad Based Inflation Recovery Not Broad Based Both our own and the Fed's forecasts for continued inflation increases are contingent on the view that tight labor markets are causing wage pressures to mount, and certainly wages have accelerated during the past few years. However, wage growth in both real and nominal terms is still below where the Fed would like it to be, and there has been scant evidence of wage acceleration during the past few months. While the Atlanta Fed's Wage Growth Tracker remains strong in nominal terms, it has leveled off in real terms, and both the Employment Cost Index and Average Hourly Earnings have recently been flat (Chart 5). A final factor that will prevent the Fed from lifting rates in March is the extremely high degree of policy uncertainty. As shown in Chart 6, economic policy uncertainty traditionally correlates with financial conditions. With financial markets having already discounted a very positive fiscal policy outcome, there is a heightened risk that some disappointing news on the fiscal front will lead to a sharp tightening of financial conditions in the near term. Such an event would definitely put the Fed on hold until financial markets recovered. Chart 5Fed Needs Wage Growth To Pick Up Fed Needs Wage Growth To Pick Up Fed Needs Wage Growth To Pick Up Chart 6Policy Uncertainty Remains Elevated Policy Uncertainty Remains Elevated Policy Uncertainty Remains Elevated Bottom Line: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Policy Aside, U.S. Growth Is Heating Up Chart 7ISM Surveys Point To Strong Growth ISM Surveys Point To Strong Growth ISM Surveys Point To Strong Growth Most recent economic discussion has focused on when President Trump will get around to enacting some of the more stimulative parts of his policy agenda, and whether or not the impact of these policies (tax cuts, infrastructure spending) will ultimately be offset by other spending cuts. But in the meantime, leading indicators of GDP growth have been picking up steam. Both the manufacturing and non-manufacturing ISM surveys point to an increase in GDP growth in the first quarter (Chart 7), and consistently, the New York Fed's tracking model suggests Q1 GDP will grow by 3.1%. The Atlanta Fed's GDP tracking model pegs Q1 growth slightly lower at 2.4%. Our own sense is that GDP growth will remain solidly above trend this year, in the range of 2.5% to 3%, even in the absence of major fiscal stimulus. This forecast hinges on the view that both residential and non-residential investment will rebound from the depressed levels seen last year and that consumer spending will remain strong. Residential Investment Chart 8Residential & Non-Residential Investment Residential & Non-Residential Investment Residential & Non-Residential Investment Residential investment was actually a drag on GDP growth for two quarters in 2016, even though leading indicators such as the months supply of new homes and homebuilder confidence remained supportive (Chart 8, panels 1 & 2). The progress made on foreclosures since the financial crisis has driven housing inventory to its lowest level since the mid-1990s,4 meaning that housing supply no longer poses a headwind to construction. Further, demographics should also help boost the housing market during the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the Millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.5 While rising mortgage rates will be a drag on housing at the margin, they will not pose a significant headwind to residential investment in 2017. At least so far, mortgage purchase applications have been resilient in the face of rising rates (Chart 8, panel 3). Non-Residential Investment Non-residential investment was a small drag on growth in 2016, but this was largely related to depressed investment in the energy sector (Chart 8, panel 4). Now that the oil price has recovered, non-residential investment should return to being a small positive contributor to growth. Our composite indicator of New Orders surveys also suggests that non-residential investment will trend higher this year (Chart 8, bottom panel). While there is some concern that the optimism displayed in these survey measures may not filter through to the "hard" economic data, a Special Report from our Bank Credit Analyst publication that will be published on Thursday concludes that a tangible growth acceleration is indeed underway throughout the G7. Consumer Spending As always, the consumer is the main driver of U.S. growth and we expect consumer spending will remain firm in 2017. Our U.S. Investment Strategy service recently undertook a detailed analysis of consumer spending,6 focusing on its two main drivers - income growth and the savings rate (Chart 9). A look at past cycles suggests that income growth can remain strong even after the economy reaches full employment as rising wages compensate for decelerating payroll growth (Chart 10). The recent spike in consumer income expectations suggests that the impact from rising wages might be particularly important in the current cycle (Chart 10, panel 1). Chart 9Consumer Spending Is Driven By Income Growth And The Savings Rate Consumer Spending Is Driven By Income Growth And The Savings Rate Consumer Spending Is Driven By Income Growth And The Savings Rate Chart 10Wages Can Drive Income Growth Wages Can Drive Income Growth Wages Can Drive Income Growth Another benefit of the economy reaching full employment is that increased job security can translate into greater consumer confidence and a lower savings rate (Chart 9, bottom panel). Confidence trends suggest that the savings rate has scope to decline during the next few months. One possible headwind to consumer spending is the recent tightening of consumer lending standards. The Fed's Senior Loan Officer Survey for the fourth quarter of 2016 shows that lending standards on auto loans have tightened for three consecutive quarters and that credit card lending standards also recently spiked into "net tightening" territory. In other words, more banks are now tightening lending standards on consumer loans than easing them. Prior to the financial crisis, consumer lending standards were strongly correlated with the savings rate (Chart 11). More stringent lending standards slowed the pace of consumer credit growth and led to reduced consumer spending. But this relationship broke down following the financial crisis. After the housing bust, households were no longer eager to supplement their consumption with as much credit as possible. Their chief concern became repairing their own balance sheets. As such, the supply of credit is no longer the most important driver of the savings rate. In the data, we observe that the savings rate did not fall by as much as would have been predicted by easing lending standards in the early years of the recovery. As a result, we do not think that modestly tighter lending standards will have much of an impact either. The Fed's latest Senior Loan Officer Survey also showed that demand for consumer credit declined sharply in 2016 Q4. This is potentially more worrisome for the savings rate since lower credit demand may still suggest a reduced appetite for spending, even in the wake of the Great Recession. However, a look back at prior cycles shows that loan demand from the Senior Loan Officer Survey tends to decline several years prior to the next recession, but the savings rate has tended to stay low until the next recession actually hits (Chart 11, bottom panel). We would not be surprised to see the same dynamic play out again. Bottom Line: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. Chart 11Lending Standards Less Of A Risk Lending Standards Less Of A Risk Lending Standards Less Of A Risk Chart 12Default-Adjusted Spread Default-Adjusted Spread Default-Adjusted Spread A High-Yield Valuation Update With the release of the Moody's default report for January we are able to update our forecast for High-Yield default losses during the next 12 months, and also our High-Yield default-adjusted spread. The default-adjusted spread is our preferred valuation indicator for both High-Yield and Investment Grade corporate bonds. It is calculated by taking the option-adjusted spread from the Bloomberg Barclays High-Yield index and subtracting an estimate of expected default losses during the next twelve months (Chart 12). Default loss expectations are calculated using the Moody's baseline forecast for the 12-month High-Yield default rate and our own forecast of the recovery rate based on its historical relationship with the default rate (Chart 12, bottom two panels). The current reading from our default-adjusted spread is 152 basis points. Most of the time, a reading of 152 bps on the default-adjusted spread is consistent with small positive excess returns for both High-Yield and Investment Grade corporate bonds (Chart 13 & Chart 14). This is also consistent with the excess returns we expect from corporate credit this year. Chart 1312-Month Excess High-Yield Returns Vs. Ex-Ante ##br##Default-Adjusted Spread (2002 - Present) The Odds Of March The Odds Of March Chart 1412-Month Excess Investment Grade Returns Vs. Ex-Ante High-Yield##br## Default-Adjusted Spread (2002 - Present) The Odds Of March The Odds Of March In fact, when the default-adjusted spread is between 150 bps and 200 bps, 12-month excess returns to High-Yield have been positive in 65% of cases, with a 90% confidence interval placing 12-month excess returns in a range between -5.0% and +1.7%. Given the favorable economic back-drop of strong economic growth and accommodative Fed policy, we would expect High-Yield excess returns to be positive during the next 12 months. But given the tight starting valuation, probably not above +1.7%. Bottom Line: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculations of rate hike probabilities implied by fed funds futures are lower than those shown on Bloomberg terminals. Our measure differs because we use the actual data for the effective fed funds rate and also adjust for the well-known fact that the effective fed funds rate tends to fall by approximately 10 basis points on the last day of the month. 2 For further details on our recommended yield curve trade please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/testimony/yellen20170214a.htm 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see "The State Of The Nation's Housing 2016", Joint Center for Housing Studies of Harvard University. 6 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Feature The FX Market has a strange way of proving everyone wrong. Currently, we are finding ourselves uncomfortable with our cyclically bullish stance on the dollar as it has become a consensus view. A review of the rationale and risks to our view is in order. To begin with, let's review valuations. The dollar is overvalued by 8% at the current juncture. However, this overvaluation is still much more limited than the overvaluation of 22% registered in 1985 and of 17.7% recorded in 2002 (Chart I-1). Chart I-1Dollar Is Not Cheap, Yet It Can Get More Expensive Dollar Is Not Cheap, Yet It Can Get More Expensive Dollar Is Not Cheap, Yet It Can Get More Expensive This has two implications. First, we have always considered valuations as the ultimate measure of sentiment. After all, it is a reflection of how much people are willing to pay for an asset or currency, and therefore, how optimistically they view the prospects for that asset/currency. The USD's overvaluation being limited compared to previous instances suggests that investors' love affair with the greenback has yet to reach the exuberant heights reached in 1985 and 2002. In fact, at this point in time, the U.S. basic balance has improved considerably, especially vis-à-vis the euro area (Chart I-2). This suggests that investors are finding more attractive investments in the U.S. than in the euro area, and that so far, the strong dollar has not had a deleterious enough effect to hurt the perceived long-term earning power of the U.S. This can continue to weigh on EUR/USD, lifting DXY in the process. Second, the dollar has yet to represent the same drag on the U.S. economy that it did at its previous peaks. It is true that U.S. potential GDP growth is now lower than previously, dragged down by both lower labor force growth and lower trend productivity growth. However, manufacturing represents a much smaller share of employment than in these two instances, suggesting that the labor market should prove more robust in the face of the strong USD (Chart I-3). Chart I-2Basic Balance Dynamics Have ##br##Favored The USD Until Now Basic Balance Dynamics Have Favored The USD Until Now Basic Balance Dynamics Have Favored The USD Until Now Chart I-3The U.S. Dwindling ##br##Manufacturing Employment The U.S. Dwindling Manufacturing Employment The U.S. Dwindling Manufacturing Employment Thus, we continue to expect that the ongoing labor market tightening can run further. With the amount of slack in that market having now vanished, we are disposed to expect a quickening in wage growth in the coming quarters (Chart I-4). Additionally, we expect the U.S. labor market to promote a virtuous circle for the economy. As the job market tightens, wages and salary as a share of the economy rise. This skews the income distribution away from the top 1% of households - families who derive more than 50% of their incomes from profits, rents, and proprietors' incomes - toward the middle class. This redistribution effect should support consumption: middle class and poor households have marginal propensities to spend ranging between 90% and 100% while rich families have a marginal propensity to spend of around 60% Not only does household consumption represent nearly 70% of the U.S. economy, but also 70% of this consumption goes toward services. Services are principally domestically sourced and are a sector of the economy where productivity is hard to come by. As a result, we expect the boost in household consumption to be a key mechanism that will support employment and wage growth. Additionally, the strength of wages and salaries as a share of gross national income, coupled with the high degree of consumer confidence, could be a harbinger of a revival in capex. Historically, when these two measures of household health are behaving as they currently do, investment in the economy increases (Chart I-5). A few factors can explain this relationship: First, this strength in households boosts residential investment; Second, it also gives confidence to the business sector that final domestic demand is durable, a key factor boosting domestic producers willingness to invest; Third, the boost to residential investment lifts investment in the sectors of the economy linked to consumer durable goods. Moreover, the stabilization of U.S. profits, along with the narrowing of U.S. corporate spreads have boosted the capex intentions of businesses, a move that began even before Trump won the election. This has historically been a reliable leading indicator of both capex and the overall business cycle (Chart I-5). Chart I-4A Tight Labor Market ##br##Will Support Households... The Labor Market Is Tight A Tight Labor Market Will Support Households... The Labor Market Is Tight A Tight Labor Market Will Support Households... Chart I-5...And Households Support ##br##Domestic Businesses ...And Households Support Domestic Businesses ...And Households Support Domestic Businesses With U.S. trend GDP growth having fallen, lower growth is needed than in prior cycles to absorb the slack in the economy. In fact, our composite capacity utilization gauge currently shows an absence of slack (Chart I-6). Any further acceleration of growth would move the economy into "no slack" territory, an environment that has historically coincided with protracted Fed tightening campaigns. Chart I-6If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken However, if the Fed does let capacity move much above its constraint and does not react as much as it ought to, the inflationary outcome created by such a move would be devastating for the dollar: Rapidly rising U.S. price levels would hamper the USD's long-term PPP fair value; The process would also result in falling U.S. real yields, especially vis-à-vis nations with more signs of excess capacity, like the euro area, pushing down the greenback from a real interest-rate parity perspective; The easy Fed policy would ease global liquidity conditions, creating a shot in the arm for the global economy and EM in particular. Historically, an accelerating global economy hurts the dollar. We remain with the view that the Fed is unlikely to let such an outcome materialize. Yellen has gone out of her way to highlight that generating a "high-pressure" economy in the U.S. was a dangerous outcome that the FOMC wanted to avoid. In fact, the potential for Trump's fiscal stimulus, whenever it may be enacted, only raises the likelihood that the Fed leans against the inflationary under-current created by dissipating economic slack. The second risk to the dollar is the growing talk of a new Plaza Accord in the U.S. At this point, with Trump attacking China, the EU, and in fact, most trading partners, we think that the likelihood of moral suasion achieving its goal is low. However, we want to study this topic in more detail before coming to definitive conclusion. So where does this leave us with regard to our original discomfort with standing in the middle of the crowd? We continue to expect the dollar cycle to expand. However, we expect that the correction that begun after the December Fed meeting could run further before exhausting itself. This would be the key mechanism through which the stale longs that are accumulating will get shaken off. In fact, the current push-back against Trump by the political establishment, from both the republicans and the bureaucratic apparatus could raise doubts on Trump's ultimate capacity to achieve his fiscal policy goals. While we expect that these doubts will stay just that, doubts, and that Trump will ultimately make stimulus into law, this period of questioning could be enough to hurt a dollar still too loved by investors. Bottom Line: We are finding ourselves in the middle of the consensus with our cyclical dollar-bullish stance. However, U.S. economic fundamentals are still firmly bullish for the dollar and valuations are not yet potent enough to prompt the end of the dollar bull market. Short AUD/NZD After a long hiatus, inflation is making a comeback in New Zealand. Last week, inflation numbers for Q4 came in at 1.3%, marking the first time since 2014 that it exceeded 1%. This has significant implications for the RBNZ, given that persistently low inflation was the shackle that kept its dovish bias in place. As inflation starts to creep up, this should put upward pressure in rates and lift the NZD. Chart I-7Domestic Factor Points Will Help ##br##The Kiwi Outperform The Aussie Domestic Factor Points Will Help The Kiwi Outperform The Aussie Domestic Factor Points Will Help The Kiwi Outperform The Aussie Nevertheless, we are reticent to buy NZD/USD outright, as the dollar bull market should continue to weigh on the kiwi as well as on other commodity currencies. Instead we are expressing our view by shorting AUD/NZD. The outlook for these Oceanian countries could not be more different. New Zealand has been the best performing economy in the G10 with real GDP rising by 3.5% and employment growing at a staggering 6% pace, the highest level of the last 23 years. Meanwhile, Australia's real GDP growth has slowed down to 1.7% while employment growth is currently in negative territory. This contrast in economic performance is likely to dramatically increase inflationary pressures in New Zealand relatively to Australia, particularly if one considers that New Zealand's economy is growing at 2% above potential GDP while Australia's output gap is far from closed. Furthermore, growing divergences in housing and stock prices are also pointing to a widening in rate differentials (Chart I-7). These factors along with inflation should push kiwi rates up vis-à-vis Australian rates, and consequently weigh on AUD/NZD. The outlook for New Zealand's and Australia's main commodities (dairy products and iron ore respectively) also points to further downside in this cross. As previously highlighted, a weakening Chinese industrial sector and a tightening of global dollar liquidity should translate to an underperformance of base metals in the commodity space, given that China consumes roughly half of the world's industrial metals and that these commodities are highly sensitive to EM liquidity conditions. Meanwhile, although China is also the main consumer of dairy products, prices should hold up thanks to the recent loosening in the "One child" policy, which should increase demand for baby formula.1 This view is not without risks. The all-time low for AUD/NZD of 1.02 is not that far away, and could likely provide significant support to this cross. Indeed, one could argue that much of the widening in rate differentials is probably already priced in the cross. However, the difference in overnight rates between the central banks of these countries is a measly 25 basis points (with roughly another 25 basis points priced by the market until the end of 2017). Given the stark difference between the outlooks for these two economies we believe further widening could be warranted. Moreover, while it is true that the recent disappointment in kiwi unemployment numbers might provide fuel for the doves in the RBNZ for a bit longer, the markets have already reacted accordingly, with AUD/NZD rallying sharply since. Thus, we think that this recent rally provides a good entry point to short this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "The OPEC Debate", dated November 24, 2016, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The FOMC held the federal funds rate at 0.75%, as expected. The Committee highlighted that the economy is growing "at a moderate pace", also as expected. The labor market, consumer and business sentiment, and household spending all are improving. It is also expected that this trend continues and eventually leads to their 2% inflation target. Unlike the other G10 central banks, the FOMC sees near-term risks to the economic outlook as "roughly balanced", which may warrant a greenlight for their planned hikes. ISM Prices Paid, Manufacturing PMI, and the change in employment all beat expectations, confirming the economy's healthy path. The dollar will likely display limited movements, according to both seasonality and the economy developing as expected, and will likely remain relatively weak, in wait of fiscal policy information. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Economic activity within the common market this week was mixed, however the overall euro area is accelerating: Confidence indicators (consumer, services, overall economic, and industrial) beat expectations across the board; Annual GDP growth outperformed at 1.8%; Unemployment came at better than expected at 9.6%; Most importantly, inflation was recorded at 1.8% - more or less in line with the ECB target. Nevertheless, core inflation remains at 0.9%, which is corroborated by the mixed performance of the major euro states - Germany, in particular, performed relatively poorly. The European Commission upgraded their forecasts for GDP, unemployment and inflation, however, highlighted that risks can emanate from emerging markets and the U.S, affecting financial markets and global trade. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data continues to show indications of a recovery in the Japanese economy: The jobs/applicants ratio beat expectations, and now stands at 1.43 The contraction in spending seems to be receding, with overall household spending falling by 0.3% vs a 1.5% contraction in November. December industrial production also outperformed expectations, growing by 0.5%. In their latest monetary policy report the BoJ took into account the good economic data that we have been highlighting as they have raised their forecast in GDP growth going forward. This should not be taken as a sign that the BoJ is starting to back off from its radical policies, as they project that inflation will reach 2% in 2018 (the target, as we have mentioned before lies above this level). Thus, the cyclical outlook for the yen remains bearish. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 In their monetary policy meeting yesterday, the BoE decided to keep their policy rate unchanged. While it is true that they raised their inflation forecast for the short term, they also decreased their forecast for inflation for the long term compared to their last meeting. More importantly they adjusted their equilibrium unemployment rate to 4.5% from 5%, a development which makes the BoE more dovish than otherwise. Markets have taken notice of this, as the pound has depreciated against all major currencies. Despite this development we continue to have a bullish bias towards the pound, as we still believe that both the BoE and the market are overestimating the negative effects that Brexit can have on the British economy. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Just as the dollar began to correct, AUD displayed an upbeat performance, appreciating 6.75% since then. The weak dollar has helped commodity prices rally, iron and copper prices have appreciated in anticipation of U.S. infrastructure spending, Chinese Manufacturing PMI beat expectations, and the trade balance also outperformed expectations. While it is possible that a weak dollar can help alleviate much of the pressure off AUD, we remain obstinate on the fundamental weakness of the AUD. The Australian economy is still haunted by the mining industry slump, with the labor market feeling much of the pain. As mentioned before, a longer-term bull market in the dollar, and Trump's expected policies, can have very adverse effects on EM, global growth, global trade, and thus commodity currencies. AUD is also approaching overbought RSI-levels, as well as an important resistance level, and is likely to see some downside soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 On Tuesday unemployment came in at 5.2%, significantly above the market expectation of 4.8%. This caused the NZD to fall off, particularly against its crosses. However we believe that the bullish story for the NZD is still intact. Immigration continues to increase, with visitor arrivals increasing by 11% YoY. This should continue to add fuel to the stellar kiwi economy. On the commodity side, in spite of a slowdown, dairy prices continue to grow at an astonishing 47% YoY pace. Moreover the relative robustness of dairy prices to EM liquidity conditions should help the NZD outperform the AUD, as base metals are more likely to bear the brunt of a shortage in EM liquidity triggered by a rising dollar. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 On Tuesday, USD/CAD fell below 1.30 for the first time since September, breaking through an important trend line, displaying newfound strength on the back of a weak greenback. As the USD continues its corrective phase, the strong CAD could hurt Canadian exports in the near future. Canada's exports represent 25% of its GDP, and 77% of its exports are to the U.S. An implementation of the Border-Adjustment Tax could have adverse consequences for this export-oriented economy. Although this tax will likely be bullish for the greenback, Trump has emphasized his view on the excessively strong dollar. The recent GDP monthly figure of 0.4% beat consensus due to the improving domestic economy. However, the aforementioned points can be a very real threat to this improvement, and should be monitored closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 After falling to an 18-month low, below 1.065, EUR/CHF has once again rallied and is now close to reaching 1.07. This is the third time that our recommendation of buying this cross whenever it falls below the crucial 1.07 level proves successful. We continue to reiterate that whenever EUR/CHF approaches this level, the SBN will not be shy to intervene, as a strong franc would accentuate the deflationary pressures that plague the Swiss economy. Recent data has been disappointing, and one should expect that the SNB will be more overzealous in its management of the franc: The KOF leading indicator stood at 101.7, falling from the previous month and underperforming expectations. SVME Manufacturing PMI also fell short of expectations and fell relative to November. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 This week, the Norwegian Krone built on its stellar 2017 rally. Indeed, USD/NOK has fallen by almost 5% since the start of the year. This rally in the krone has been particularly surprising, as it has happened in an environment where oil prices have stayed relatively flat. Thus, If OPEC cuts start to cause significant inventory drawdowns, the NOK could rally much further. Additionally it is worth reminding that Norwegian inflation is a unique case in the G10, as it is the only country which has an inflation level above their central bank target. A breaking point will eventually come, where the Norges Bank will have to choose between backing off their dovish bias and letting inflation run amok. Thus, we will continue to monitor inflation in Norway closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Sweden's economy continues to show strength. Producer prices increased at a 6.5% yearly pace, and a 2.1% monthly pace; Consumer confidence increased to 104.6 from last month's 103.2; Manufacturing PMI increased to 62; The monthly trade balance is positive for the first time since August. The data paints a positive picture of the economy: improving inflation, high consumer confidence, and a healthy industrial and export sector. Sweden's future for its exports seems hopeful on the back of an increasing manufacturing PMI and the lagged effects of a weak SEK. Additionally, Sweden is unlikely to be majorly affected by U.S. protectionism. Exports to the U.S. only account for 2% of GDP, and 7.7% of overall exports, whereas exports to the euro area account for 11% of GDP and 40.6% of exports. The risk of a strong SEK will be limited as the Riksbank monitors its pace of strength, and the USD will eventually resume its appreciation. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Duration: Treasuries are now slightly expensive relative to global growth indicators, and the global economic recovery appears sustainable. Despite lingering concerns about policy uncertainty and bearish bond positioning, we recommend shifting back to a below-benchmark duration stance. Spread Product: The combination of an improving global growth back-drop and still-accommodative Fed policy will be positive for spread product. As such, we increase our allocation to investment grade corporate bonds - and spread product more generally - from neutral (3 out of 5) to overweight (4 out of 5). We also upgrade high-yield bonds from underweight (2 out of 5) to neutral (3 out of 5). Economy: U.S. GDP growth will be solidly above trend in 2017, driven in large part by accelerating consumer spending. Feature The divergence in economic growth between the U.S. and the rest of the world has been one of our key investment themes for much of the past two years. All else equal, the greater the divergence in growth between the U.S. and the rest of the world, the more the U.S. dollar comes under upward pressure. A strengthening dollar limits how far the Fed can lift rates and caps the upside in long-dated yields. In fact, in a report published last October titled "Dollar Watching: An Update"1 we wrote: Our continued expectation that the Fed will lift rates in December leads us to maintain below-benchmark portfolio duration and a neutral allocation to spread product until a December rate hike has been fully discounted by the market. Beyond December, our investment strategy will depend largely on how the dollar responds to an upward re-rating of rate expectations. Strong dollar appreciation would likely cause us to reverse our below-benchmark duration stance and become even more cautious on spread product. Conversely, a tame dollar could mean that the sell-off in bonds and rally in spreads have further to run. With the December rate hike now in the rearview mirror, global growth divergences do not appear to be a strong headwind for bond yields. In fact, the trade-weighted dollar has flattened off since the Fed lifted rates and bullish sentiment toward the dollar has plunged even though rate hike expectations remain elevated (Chart 1). This suggests that the dollar is so far not having much of an impact on the U.S. growth outlook or the expected path of monetary policy. Digging a little deeper, it appears we are witnessing a synchronized upturn in global growth led by the manufacturing sector (Chart 2). The Global Manufacturing PMI is in a clear uptrend, while the diffusion index suggests the improvement is broad based. Similarly, our Global Leading Economic Indicator is once again expanding, while its diffusion index is holding steady above the 50% line. Chart 1Dollar Sentiment: A Key Indicator Dollar Sentiment: A Key Indicator Dollar Sentiment: A Key Indicator Chart 2Synchronized Global Recovery Synchronized Global Recovery Synchronized Global Recovery Although the extremely high level of economic policy uncertainty increases the odds of a near-term selloff in risk assets and related flight-to-quality into Treasury securities, the strength of the global growth impulse and sustainability of the U.S. economic recovery (see section titled "U.S. Economy: A Healthy Consumer Leads The Way" below) means we would view any risk-off episode as an opportunity to reduce portfolio duration and increase exposure to spread product. As such, given our 6-12 month investment horizon and the inherent difficulty in forecasting near-term market riot points, this week we begin the process of shifting our portfolio in this direction. Specifically, we move from an "At Benchmark" back to a "Below Benchmark" duration stance and we also upgrade spread product from neutral (3 out of 5) to overweight (4 out of 5), while downgrading Treasuries from neutral (3 out of 5) to underweight (2 out of 5). Within spread product we upgrade investment grade corporates from neutral (3 out of 5) to overweight (4 out of 5) and upgrade high-yield from underweight (2 out of 5) to neutral (3 out of 5). We expand on the rationale for each move below. Portfolio Duration Chart 3Treasuries Now Expensive Treasuries Now Expensive Treasuries Now Expensive Two weeks ago,2 we detailed our bearish 6-12 month outlook for U.S. bonds, while also pointing to three factors that had so far prevented us from adopting a below-benchmark duration stance. The three factors were: (i) valuation, (ii) economic policy uncertainty and (iii) sentiment & positioning. Factor 1: Valuation Two weeks ago the 10-year Treasury yield was trading 9 basis points cheap on our 2-factor model based on Global PMI and bullish dollar sentiment. Since then, bullish sentiment has declined and Flash3 PMI readings from the U.S., Eurozone and Japan were all strong. If we assume that final PMIs from these regions are in line with the Flash numbers and that the PMIs from all other countries remain flat, then we calculate that the 10-year Treasury yield is actually 4 basis points expensive relative to fair value (Chart 3). In short, valuation argues even more in favor of reducing portfolio duration than it did two weeks ago. Factor 2: Uncertainty Economic policy uncertainty remains elevated and, unusually, has de-coupled from surveys of consumer and business confidence (Chart 4). Certainly, there is a risk that confidence measures relapse in the near-term if it appears as though some of the new President's promises related to tax cuts and deregulation will not be delivered. However, this risk needs to be weighed against the bond-bearish combination of protectionism and fiscal stimulus favored by the new administration, especially at a time when the economy is close to full employment. Factor 3: Sentiment & Positioning Bond sentiment and positioning remain decidedly bearish according to our Bond Sentiment Indicator and net speculative positioning in Treasury futures, although the J.P. Morgan client survey shows that clients' duration positioning is close to neutral (Chart 5). It is likely that some further capitulation of short positions is necessary before Treasury yields can move decisively higher. However, these shifts in positioning can occur very quickly and given the reading from our valuation model we feel that now is the appropriate time to reduce duration exposure. Chart 4Elevated Uncertainty Remains A Near-Term Risk... Elevated Uncertainty Remains A Near-Term Risk... Elevated Uncertainty Remains A Near-Term Risk... Chart 5...As Does Bearish Positioning ...As Does Bearish Positioning ...As Does Bearish Positioning Bottom Line: Treasuries are now slightly expensive relative to global growth indicators, and the global economic recovery appears sustainable. Despite lingering concerns about policy uncertainty and bearish bond positioning, we recommend shifting back to a below-benchmark duration stance. Spread Product In last week's report,4 we explored the performance of spread product throughout the four phases of the Fed cycle (Chart 6), which are defined as follows: Chart 6Stylized Fed Cycle Dollar Watching: Another Update Dollar Watching: Another Update Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. Based on the fact that core PCE inflation remains below the Fed's target and the view that its uptrend will proceed only gradually, we concluded that we are presently in Phase I of the Fed cycle and would probably remain there for the balance of the year. Historically, spread product has performed well in Phase I of the Fed cycle, with only Phase IV producing higher average monthly excess returns. However, the Fed cycle is only part of the story. Our Corporate Health Monitor (CHM) - a composite measure of balance sheet health for the nonfinancial corporate sector - has been in "deteriorating health" territory since late 2013. Historically, this measure has an excellent track record of flagging periods of spread widening (Chart 7). Chart 7The Corporate Health Monitor And Credit Spreads The Corporate Health Monitor And Credit Spreads The Corporate Health Monitor And Credit Spreads To augment our analysis, this week we re-examine average monthly excess returns for investment grade corporate bonds in the four phases of the Fed cycle but this time we also split each phase into periods of improving and deteriorating corporate health (Table 1). Table 1Investment Grade Corporate Bond Excess Returns* Given Reading From ##br##BCA Corporate Health Monitor And The Phase Of The Fed Cycle (July 1989 To Present) Dollar Watching: Another Update Dollar Watching: Another Update Table 1 shows there have been 14 months since 1989 when Phase I of the Fed cycle coincided with deteriorating corporate health, according to the CHM. Conversely, Phase I of the Fed cycle coincided with improving corporate health in 25 months. However, 13 of the 14 months when Phase I of the Fed cycle coincided with deteriorating corporate health are the most recent 13 months. In other words, the current combination of tightening (but still-supportive) monetary policy and weak corporate balance sheets is unprecedented. The other factor we have not yet considered is valuation, as measured by the starting level of corporate spreads. In Table 2 we present average monthly excess returns for investment grade corporate bonds split by both the phase of the Fed cycle and the investment grade corporate option-adjusted spread. At present, the average option-adjusted spread for the Bloomberg Barclays investment grade corporate index is 120 bps. Table 2Investment Grade Corporate Bond Excess Returns* Given Previous Month Option-Adjusted Spread** ##br##And The Phase Of The Fed Cycle (July 1989 To Present) Dollar Watching: Another Update Dollar Watching: Another Update In Table 2 we observe that usually spreads are much lower in Phase I of the Fed cycle, typically between 50 bps and 100 bps, and that periods when spreads are above 100 bps generally coincide with higher excess returns. However, we must also recall that corporate health is typically still improving in Phase I of the Fed cycle, so today's higher spread levels might be justified by worse credit quality. Chart 8Value Is Stretched In Junk Value Is Stretched In Junk Value Is Stretched In Junk It goes without saying that the unusual combination of deteriorating corporate health and still-supportive Fed policy is a complicated environment for credit investors to navigate. Our view is that accommodative Fed policy will prevent material spread widening, at least until inflation breaks above the Fed's target and we shift into Phase II of the Fed cycle, but it is also probably not reasonable to expect spreads to tighten much further from current levels. We are looking for low, but positive, excess returns from spread product, consistent with the available carry. Bottom Line: The combination of an improving global growth back-drop and still-accommodative Fed policy will be positive for spread product. As such, we increase our allocation to investment grade corporate bonds - and spread product more generally - from neutral (3 out of 5) to overweight (4 out of 5). We also upgrade our allocation to high-yield bonds from underweight (2 out of 5) to neutral (3 out of 5). We retain only a neutral allocation to high-yield due to the longer-run risks posed by poor corporate health, and tight valuations for high-yield bonds (Chart 8). U.S. Economy: A Healthy Consumer Leads The Way U.S. GDP growth decelerated to 1.9% in Q4 from 3.5% in Q3. Growth in consumer spending slowed to 2.5% from 3.0%, while fixed investment spending picked up to 4.2% from 0.1%. The headline 1.9% GDP print also includes a -1.7% contribution from net exports and +1.0% contribution from inventories. Taking a step back from the quarterly data, we see that the growth in real final sales to domestic purchasers - a measure of growth that strips out the volatile trade and inventory components - has clearly shifted into a higher range during the past couple of years (Chart 9). Further, leading indicators for each individual component of growth all suggest that further acceleration is in store (Chart 10). Chart 9Growth Finds A Higher Gear Growth Finds A Higher Gear Growth Finds A Higher Gear Chart 10Contributions To GDP Growth Contributions To GDP Growth Contributions To GDP Growth But crucially, it is the fundamental drivers underpinning the outlook for consumer spending that lead us to believe that U.S. economic growth will maintain an above-trend pace throughout 2017. As was observed by our U.S. Investment Strategy service in a recent report,5 income growth - the main driver of consumption trends - appears poised to accelerate, driven by accelerating wage growth that is starting to kick in now that the economy has finally reached full employment (Chart 11). The boost in consumer confidence could also lead to a lower savings rate, further increasing the impact on spending (Chart 11, bottom panel). Chart 11Consumer Spending = Income + Confidence Consumer Spending = Income + Confidence Consumer Spending = Income + Confidence Bottom Line: A healthy consumer is the back bone of the U.S. economy, and elevated consumer demand will also lend support to corporate fixed investment and the housing market. We expect that U.S. growth will be solidly above trend in 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, titled "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 3 The flash estimate is typically based on approximately 85%-90% of total PMI survey responses each month and is designed to provide an accurate advance indication of the final PMI data. 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Feature For the first time since the beginning of the recovery in 2009, the U.S. economy has the potential - and is showing signs - of entering a self-reinforcing phase. After years of expecting that the next recession is just around the corner, economic agents are now optimistic about the strength and longevity of the business cycle. The likelihood of a period of above-trend growth would be a bullish development for risk assets (Chart 1). Our view is that the surge in business confidence is exaggerated due to federal politics, and Trump's election "honeymoon" effect will partially unwind at some point. However, the U.S. consumer is finally well-placed to shake some of the long-term angst that has been in a fixture for almost a decade. This chart-driven Special Report looks at the U.S. economy from several angles and highlights key themes (Chart 2): Chart 1Self-Reinforcing Recovery Finally At Work Self-Reinforcing Recovery Finally At Work Self-Reinforcing Recovery Finally At Work Chart 2U.S. Consumer Is The Bright Light U.S. Consumer Is The Bright Light U.S. Consumer Is The Bright Light Consumption will be the brightest spot in the recovery: The uptrend in consumer confidence has the potential to be lasting, and therefore lead to an acceleration in real consumption over the next several quarters. Most important is that the main driver of consumption trends, income, is on track to accelerate. Despite a moderation in payroll growth, overall income growth is likely to stay perky, now that the labor market has reached full employment and wages are rising. Residential real estate will be resilient despite the threat of higher rates: Residential construction will continue to make a positive contribution to growth, given that the supply of homes is low, especially relative to our expectations for a pick-up in demand. Capex will continue to lag: Non-residential business investment is likely to remain a sore spot for the economy for some time. Capex spending historically follows consumption with a lag; businesses first wait to see a pick-up in demand for their products and services before undertaking capital expansion. Various measures of capital utilization also suggest that there is still ample capacity, especially in the manufacturing sector, although capital spending growth has historically been driven by the direction of capacity utilization, not its level. Fiscal thrust could be positive but only late in the year: Federal, state and local government spending were only a very modest positive contribution to growth in 2016 and that is likely to be the case at least for the first half of 2017. Thereafter, federal spending may have a much larger impact, although there remain many unknowns. Thus, the coming cyclical improvement in growth will be mainly driven by the consumer sector, at least at first. Although our global leading economic indicators are heading higher, we are wary to extrapolate an overly positive view. There are a number of unresolved headwinds in China, Trump's anti-trade rhetoric is a risk, as is U.S. dollar strength for U.S. exporters. Meanwhile, financial markets are in the midst of a "euphoria rally," based on the expectation that a new U.S. federal government will unleash a powerful combination of pro-business reforms and fiscal ease. Thus, although the U.S. economic recovery rests on improving fundamentals, the stretched level of optimism suggests that investors should be prepared for a reality check. Consumer Spending Rising expectations for real household income growth over the next one to two years and improving job security are a result of a tightening labor market. Since income trends are the main driver of consumption growth, an improved labor market should help boost consumer spending growth to over 3% in 2017 (Chart 3). The cost of essential items as a share of income has declined throughout the recovery. In particular, food and energy costs as a share of income are very low and it is only the seemingly incessant climb in medical payments that keeps overall spending on essential items above 40% of disposable income. Still, at 41% of total disposable income, spending on essential items is far from burdensome relative to historical norms. This leaves plenty of room for spending on discretionary items. The combined wealth effect from real estate and financial markets has been positive for some time. Thus, it is not a new driver of consumer spending, but is nonetheless positive that wealth positions continue to improve. If our forecasts for financial markets and house prices pan out - i.e. that the bull market in stocks continues over time, that bonds experience only a mild bear market and that house price appreciation remains in the mid-single digits - then a positive wealth effect will continue to support consumption in 2017. Wages And The Labor Market U.S. wage growth is in a sustainable uptrend now that the bulk of our indicators suggest that the labor market is at full employment (Chart 4). According to the Atlanta Fed's wage tracker, overall median wages are growing at their fastest pace since the 2008. The gains are broad-based: wage gains have occurred for both "job switchers" and "job stayers." Other measures of wage inflation are also turning higher. The Employment Cost Index (ECI) is the most decisive measure for tracking broad developments for employee wages and benefits among geographic divisions, sectors (services vs goods-producing) and industries. The gains in this index are not as robust, but are nonetheless still rising and, according to business surveys, labor compensation is likely to continue to rise. The Fed views wage growth in the range of 3-4% per year as an important signal that consumer price inflation is moving toward the Fed's 2% target. Although the ECI is still below this range, if the current trend pace continues, 3% inflation in the wages and salaries component is reachable later this year. Chart 3Tailwinds For Robust Consumer ##br##Spending Are Firmly In Place Tailwinds For Robust Consumer Spending Are Firmly In Place Tailwinds For Robust Consumer Spending Are Firmly In Place Chart 4Tight Labor Market Will Boost ##br##Further Wage Growth Tight Labor Market Will Boost Further Wage Growth Tight Labor Market Will Boost Further Wage Growth Residential Investment Residential investment as a percent of GDP normally averages about 5% of GDP; it currently stands at 3.7%. However, it should continue to recover, making a significant positive contribution to GDP growth through 2017. Robust long-term fundamentals suggest that residential construction should continue to follow the recovery path experienced by other developed countries when boom/bust cycles occurred (Chart 5). Household formation is a critical measure of new housing demand over the long-term. The number of households formed continues to build towards pre-recession rates. Demographics may help the housing market over the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the Millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.1 Finally, housing supply is no longer a headwind. This suggests that if final demand continues to improve, the lack of inventory overhang implies that the incentive for builders to take on new projects is high. Non-Residential Investment The corporate sector has been loath to undertake capital investment throughout the recovery. Despite rock-bottom interest rates, the lack of confidence in the outlook for final demand has kept businesses from investing (Chart 6). Business confidence has surged in recent months, although the sustainability of this trend is questionable. Survey respondents' optimism has been buoyed by great expectations about pro-business reform in Washington. This excessive optimism is vulnerable to pullbacks should Trump's leadership and policies disappoint. Only once businesses see a clear upswing in demand for their products and services will a new capex cycle emerge. The BCA Model for business investment tracks broad capex swings and has been trending down for several months now and remaining in contractionary territory. Investment in equipment, the largest portion of business investment, has been falling sharply for the past year. Much of the weakness is concentrated in the energy sector following the collapse in oil prices in late-2014. The U.S. dollar has also been a headwind for the manufacturing sector. Chart 5Housing Market Is ##br##Recovering Gradually Housing Market Is Recovering Gradually Housing Market Is Recovering Gradually Chart 6Corporate Sector Has Yet ##br##To Unleash Capex Spending Corporate Sector Has Yet To Unleash Capex Spending Corporate Sector Has Yet To Unleash Capex Spending Exports Net exports were a slight positive to GDP growth at the end of 2016, after being a drag for the past three years. However, the Q3 2016 improvement is due chiefly to one sector - a surge in soybean exports (Chart 7). Indeed, exports to all regions except Asia remain weak. Exports to the rest of North America, Europe, and Central & South America all peaked in 2014. As mentioned above, the exception to this trend is Asia, which now accounts for about 28% of total U.S. exports. Surging soybean exports to China were the major driver of the Q4 trend change. Government Federal spending was a drag on GDP growth from 2011 to 2015. In 2016, federal spending was a modest positive. Looking ahead, hopes are high that a new government in Washington will significantly boost fiscal spending. Our base case is that the Federal fiscal thrust will rise by about 0.5% of GDP, although the timing is uncertain and may not boost GDP growth until 2018 (Chart 8). Tax cuts could provide an earlier lift, but it would show up as increased consumer and capital spending. State and local spending lost momentum in 2016 after finally recovering the previous year. The 2016 decline in state tax revenues was not confined to oil-producing states. A recent report by the Rockefeller Institute compiled state tax revenue forecasts for 2017 and concludes that the decline in tax revenues from all sources (sales, income and corporate) will be slow to recover next year. Chart 7Nominal Exports Led Mainly By Asia Nominal Exports Led Mainly By Asia Nominal Exports Led Mainly By Asia Chart 8Government Spending Will Expand Modestly Government Spending Will Expand Modestly Government Spending Will Expand Modestly Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see "The State Of The Nation's Housing 2016," Joint Center for Housing Studies of Harvard University.

Highlights U.S. policy uncertainty has increased again early in the New Year. President Trump's inaugural speech highlighted that he has not tempered his "America First" policy prescription. The Trump/GOP agenda is still a moving target, but three key risks have emerged for financial markets. A border tax could see a 10% rise in the U.S. dollar. It would also be bearish for global bonds and EM stocks. Position accordingly. Second, President Trump has his sights on China. U.S. presidents face few constraints on the trade and foreign policy side. Investors seem to be under-appreciating the risk of a trade war. Third, the plan to slash Federal government spending could completely offset the fiscal stimulus stemming from the proposed tax cuts and infrastructure spending. The good news is that the major countries, including China, appear to have entered a synchronized growth acceleration. There is more to the equity market rally than a "sugar high". The global profit recession is over and the rebound has been even more impressive than we predicted. As long as any U.S. protectionist policies do not derail the growth acceleration, corporate EPS in the major countries should rival (traditionally overly-optimistic) bottom-up expectations in 2017. The Fed will hike three times this year, one more than is discounted. The Bank of Japan will continue to target a 10-year JGB yield of 0%, but the ECB will begin hinting at another taper in the fall. Our bond team tactically took profits on a short-duration position, but expect to move back to below-benchmark duration before long. The U.S. policy backdrop is very fluid but, for now, the new Administration has boosted confidence and thereby reinforced a global cyclical upswing. As long as protectionist policies implemented this year do not unduly undermine U.S. growth (our base case), then stocks will beat bonds by a wide margin. Investors should consider long VIX positions, but add to equity exposure on dips. Feature It has become a cliché to describe the economic and financial market outlook as "unusually uncertain". Since 2007, investors have had to deal with rolling financial crises, deleveraging, recession, deflation pressures, quantitative easing, negative interest rates, re-regulation, a collapse in oil prices and Brexit. Chart I-1Stocks Decouple From Policy Uncertainty Stocks Decouple From Policy Uncertainty Stocks Decouple From Policy Uncertainty Now, there is Donald Trump. The new President's inaugural speech highlighted that he has not tempered his "America First" policy prescription. Protectionism, de-regulation and tax reform are high on the agenda but details are scant, leaving investors with very little visibility. There are many policy proposals floating around that have conflicting potential effects on financial markets. Which ones will actually be pursued and how will they be prioritized? Is the U.S. prepared to fight a trade war? Is a border tax likely? Will President Trump push for a "Plaza Accord" deal with China? Even the prospect for fiscal stimulus is a moving target because the Trump Administration is reportedly considering a plan to slash Federal spending by $10 trillion over the next decade! Some have described the global equity rally as just a "sugar high" that will soon fade. No doubt, some of the potentially growth-enhancing parts of the Trump agenda have been discounted in risk assets. Given the highly uncertain policy backdrop, it would be easy to recommend that investors err on the side of caution if the U.S. and global economies were still stuck in the mud. The level of the S&P 500 appears elevated based on its relationship with the policy uncertainty index (shown inverted in Chart I-1). Nonetheless, what complicates matters is that there is more to the equity rally than simply hope. Both growth and profits are surprising to the upside in what appears to be a synchronized global upturn. If one could take U.S. policy uncertainty out of the equation, risk assets are in an economic sweet spot where the deflation threat is waning, but inflation is not enough of a threat to warrant removing the monetary punchbowl. Indeed, the Fed will proceed cautiously and official bond purchases will continue through the year in Japan and the Eurozone. We begin this month's Overview with two key protectionist policies being considered that could have important market implications. We then turn to the good news on the economic and earnings front. The conclusion is that we remain positive on risk assets and bearish bonds on a 6-12 month investment horizon. It will likely be a rough ride, but investors should use equity pullbacks to add exposure. Protectionism Risk #1 A U.S. border tax has suddenly emerged on the U.S. policy program. More formally, it is called a destination-based cash flow tax. Under current U.S. law, corporate income taxes are assessed on worldwide profits, which are the difference the between worldwide revenues and worldwide costs. The introduction of a border tax adjustment would change the tax system to one where taxes are assessed only on the difference between domestic revenues and domestic costs (i.e., revenues derived in the U.S. minus costs incurred the U.S.). The mechanics are fairly complicated and we encourage interested clients to read a Special Report on the topic from BCA's Global Investment Strategy service.1 The result would be a significant increase in taxes on imported goods and a reduction in taxes paid by exporters. One benefit is that the border tax would generate a large amount of revenue for the Treasury, which could be used to offset the cost of corporate tax cuts. Another benefit is that the tax change would eliminate the use of international "transfer pricing" strategies that allow American companies to avoid paying tax. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field! In reality, there are reasons to believe that the dollar's adjustment would not be fully offsetting. First, much depends on how the Fed responds. Second, some central banks would take steps to limit the dollar's ascent. To the extent that the dollar did not rise by the full amount (25% in our example), then the border tax would boost exports and curtail imports. The resulting tailwind for U.S. growth would eventually be reflected in higher inflation to the extent that the economy is already near full employment. The result is that a border tax would be bullish the dollar and bearish for bonds. Our base case is that a 20% border tax would lift the dollar by about 10% over a 12-month period, above and beyond our current forecast of a 5% gain. The 10-year Treasury yield could reach 3% in this scenario. Subjectively, we assign a 50% probability to a border tax being introduced in some form or another, although our sense is that it will be somewhat watered down so as not to generate major dislocations for the economy. It appears that investors are underestimating the likelihood that the U.S. proceeds with this new tax, suggesting that the risks to the dollar and bond yields are to the upside. This is another reason to underweight U.S. bonds relative to Bunds on a currency-hedged basis. For stocks, any growth boost from the border tax would benefit corporate profits, at least until the Fed responded with a faster pace of rate hikes. It is another story for EM equities as a shrinking U.S. trade deficit implies less demand for EM products and shrinking international dollar liquidity. A border tax could be seen as the first volley in a global trade war, souring investor sentiment towards EM stocks. Another major upleg in the U.S. dollar could also spark a financial crisis in some EM countries with current account deficits and substantial dollar-denominated debt. Protectionism Risk #2 Chart I-2Trade War Risk Is Elevated Trade War Risk Is Elevated Trade War Risk Is Elevated While President Trump wants a smaller trade deficit generally, he has his sights on China because of the elevated U.S. bilateral trade deficit (Chart I-2). His choices for Commerce Secretary, National Trade Council and U.S. Trade Representative are all China critics. U.S. presidents face few constraints on the trade and foreign policy side. He can order tariffs on specific goods, or even impose a surcharge on all dutiable goods, as Nixon did in 1971. Congress is unlikely to be a stumbling block. Trump's election was a signal that the U.S. populace wants protectionist policies. His electoral strategy succeeded in great part because of voter demand for protectionism in key Midwestern states. We expect the Trump Administration to give a largely symbolic "shot across China's bow" in the first 100 days, setting the stage for formal trade negotiations in the subsequent months. The initial shot will likely rattle markets. A calming period will follow, but this will only give a false sense of security. The U.S. is in a relatively good negotiating position because China's exports to the U.S. are much larger than U.S. exports to China. However, tensions over the "One China" policy and international access to the South China Sea will greatly complicate the trade negotiations. The bottom line is that there is little hope that U.S./China relations will proceed smoothly.2 A long position in the VIX is prudent given that the market does not appear to be adequately discounting the possibility of a trade war. Synchronized Global Growth Upturn While the U.S. policy backdrop has become more problematic for investors, the global economic and profit picture has brightened considerably. We were predicting a pickup in global growth before last November's election based on our leading indicators and the ebbing of some headwinds that had weighed on economic activity early in 2016. As expected, the manufacturing sector is bouncing back after a protracted inventory destocking phase. The stabilization in commodity prices has given some relief to emerging market manufacturers. The drag on global growth from capex cuts in the energy patch is moderating even though the level of capital spending will contract again in 2017. Moreover, the aggregate fiscal thrust for the advanced economies turned positive in 2016 for the first time in six years. The major countries, including China, appear to have entered a synchronized growth acceleration. The pick-up is confirmed by recent data on industrial production, purchasing managers' surveys and the ZEW survey (Chart I-3). The global ZEW composite has been a good indicator for world earnings revisions and the global stock-to-bond return ratio. The synchronized uptick in global coincident and leading economic data, including business and consumer confidence, suggests that there is more going on than a simple post-election euphoria. Euro Area sentiment measures hooked up at the end of 2016 and the acceleration in growth appears to be broadly based (Chart I-4). A simple model based on the PMI suggests that Eurozone growth could be as much as 2% this year, which is well above trend. Chart I-3Positive Global Indicators bca.bca_mp_2017_02_01_s1_c3 bca.bca_mp_2017_02_01_s1_c3 Chart I-4Euro Area To Beat Growth Estimates Euro Area To Beat Growth Estimates Euro Area To Beat Growth Estimates While Japan will not be a major contributor to overall global growth given its well-known structural economic impediments, the most recent data reveal a slight uptick in consumer confidence, business confidence and the leading economic indicator (Chart I-5). We have noted the impressive rebound in China's leading and coincident growth indicators for some time. Some indicators are consistent with real GDP growth well in excess of the 6.7% official growth figure for 2016 Q4. Both the OECD leading indicator and our proprietary GDP growth model are calling for faster growth in 2017 (Chart I-6). A potential increase in trade or even military tensions between China and the U.S. is a potential risk to this sunny picture. Nonetheless, given what we know about the underlying economy at the moment, China looks poised to deliver another year of solid growth. Chart I-5Even Japanese Sentiment Is Turning Up Even Japanese Sentiment Is Turning Up Even Japanese Sentiment Is Turning Up Chart I-6Upside Risk To China's Growth Upside Risk To China's Growth Upside Risk To China's Growth In the U.S., President Trump appears to be stirring long-dormant animal spirits. CEOs are much more upbeat and several regional Fed surveys indicate a surge in investment intentions (Chart I-7). Spending on capital goods has the potential to soar given the historical relationship with the survey data shown in Chart I-8 (the caveat being that Congress will need to deliver). Even the long depressed small business sector is suddenly more optimistic. The December reading of the NFIB survey showed a spike in confidence, with capital expenditures, hiring plans and overall optimism returning to levels not seen in this expansion. Chart I-7Animal Spirits Reviving In The U.S.... Animal Spirits Reviving In The U.S.... Animal Spirits Reviving In The U.S.... Chart I-8...Which Will Spark Capital Spending ...Which Will Spark Capital Spending ...Which Will Spark Capital Spending There is a good chance that a deal between the White House and Congress on tax reform will occur in the first half of 2017, including a major tax windfall for the business sector that would boost the after-tax rate of return on equity. Nonetheless, past research shows that sustainable capital spending cycles only get underway once businesses see clear evidence that consumer demand is on the upswing. In other words, consumers need to move first. On that score, a number of cyclical tailwinds have aligned for household spending. Credit scores have largely been repaired since the recession and income growth is on track to accelerate (Chart I-9). Despite a moderation in monthly payrolls, overall income growth is likely to stay perky, now that wage gains are on an upward path. And, importantly, various surveys highlight an improvement over the past year in consumer confidence about long-term job prospects. The propensity to spend rather than save is higher when households feel secure in their jobs. Chart I-10 highlights that the saving rate tends to decline when confidence is elevated. The wealth effect from previous equity and housing price gains has been a tailwind for some time but, until now, consumers have held back because it seemed to many that the recession had never ended. Chart I-9Share Of Home Mortgage Borrowers ##br##Who Recovered Pre-Delinquency Credit Score After Foreclosure February 2017 February 2017 Chart I-10Room For U.S. Consumer To Spend Room For U.S. Consumer To Spend Room For U.S. Consumer To Spend In other words, there are increasing signs that the scar tissue from the Great Recession is finally fading, at a time when tax cuts are on the way. We expect that U.S. real GDP growth will be in the 2½-3% range this year with risks to the upside, as long as the Trump Administration does not start a trade war that undermines confidence. Corporate Earnings Liftoff Chart I-11Profits Are Bouncing Back Profits Are Bouncing Back Profits Are Bouncing Back The good news on the economy carries over to corporate earnings. The profit recession is over and the rebound has been even more impressive than we predicted (Chart I-11). Eurozone EPS "went vertical" near the end of 2016. Blended S&P 500 Q4 bottom-up estimates reveal a huge increase in EPS last year to $109 (4-quarter trailing), providing an 8.5% growth rate for 2016 as a whole. The 4-quarter trailing growth figure will likely surge again to 16% in 2017 Q1, even if the sequential EPS figure is flat. Some of the growth acceleration is technical, reflecting a particularly sharp drop in profits at the end of 2015 (which will eventually fall out of the annual growth calculation). Of course, a spike in energy earnings on the back of higher oil prices made a major contribution to the overall growth rate, but there is more to it than that. Consumer Discretionary, Financials and Health Care all posted solid earnings figures last year. Earnings momentum has also picked up in Materials, Real Estate and Utilities, although profit growth in these sectors is benefiting from favorable comparisons. Dollar strength has pushed the U.S. earnings revisions ratio slightly into negative territory, while revisions have surged into positive terrain in the other major markets (Chart I-12). The sharp upturn in our short-term EPS indicators corroborates the more upbeat earnings outlook for at least the next few months (Chart I-13). Chart I-12Earnings Revisions Earnings Revisions Earnings Revisions Chart I-13Short-Term EPS Indicators Are Bullish Short-Term EPS Indicators Are Bullish Short-Term EPS Indicators Are Bullish Our medium-term profit models also paint a constructive picture for equities. These are top-down macro models that include oil prices, exchange rates, industrial production (to capture top-line dynamics), and the difference between nominal GDP and labor compensation (to capture margin effects). Given our more optimistic economic view, the model forecasts for 2017 EPS growth have been revised higher for the global aggregate and each of the major developed markets (Chart I-14). The U.S. is tricky because of the impact of comparison effects that will add volatility to the quarterly growth profile as we move through the year. We are now calling for a 10% gain for 2017 as a whole, which is just shy of the roughly 12% increase expected by bottom-up analysts. This is impressive because actual market expectations are typically well below the perennially-optimistic bottom-up estimates. A 10% EPS growth figure might seem overly optimistic in light of the dollar appreciation that has occurred since last November. Some CEOs will no doubt guide down 2017 estimates during the current earning season. However, in terms of EPS growth, the annual change in the dollar matters more than its level. Chart I-15 shows that the year-over-year rate of change in the dollar is moderating despite the recent rise in the level. This is reflected in a diminishing dollar drag on EPS growth as estimated by our model (bottom panel in Chart I-15). We highlighted in the December 2016 monthly report that it does not require a major growth acceleration to overwhelm the negative impact of a rising dollar on earnings. Chart I-14Medium-Term Profit Models Are Also Bullish Medium-Term Profit Models Are Also Bullish Medium-Term Profit Models Are Also Bullish Chart I-15Dollar Effect On U.S. EPS Dollar Effect On U.S. EPS Dollar Effect On U.S. EPS The models for Japan and the Eurozone point to 2017 EPS growth in the mid-teens. Both are roughly in line with bottom-up estimates which, if confirmed this year, would be quite bullish for stock indexes. Keep in mind that these projections do not include our base case forecast that the U.S. dollar will appreciate by another 5% this year (more if a border tax is enacted). Incorporating a 5% dollar appreciation would trim U.S. EPS growth by 1 percentage point and add the same amount to profit growth in Japan and the Eurozone. The bottom line is that we expect corporate profits to be constructive for global bourses this year. Within an overweight allocation to equities in the advanced economies, we continue to favor the European and Japanese markets versus the U.S. As we discussed in the 2017 Outlook, political risks in the Eurozone are overblown. Currency movements and relative monetary policies will work against U.S. stocks on a relative (currency hedged) basis. FOMC: Hawks Gradually Winning The Debate Fed officials are in a state of quandary over how the policies of the incoming Administration will affect the growth and inflation outlook. Nevertheless, the last FOMC Minutes confirmed that the consensus on the Committee is still shifting in a less dovish/more hawkish direction. The tone of the discussion was decidedly upbeat, especially on the manufacturing and capital spending outlook. "Most" of the meeting participants felt that the U.S. economy has reached full employment, although there is still an ongoing debate on the benefits and costs of allowing the unemployment rate to temporarily move below estimates of full employment. Running the economy "hot" for a while might draw more discouraged workers back into the workforce and thereby expand the supply side of the economy. Other members, however, highlight that past attempts by the Fed to fine tune the economy in this way have always ended in recession. Our view is that the FOMC will not follow the Bank of Japan's example and explicitly target a temporary inflation overshoot. Conversely, the Fed will not attempt to pre-emptively offset any forthcoming fiscal stimulus either (if indeed there is any net fiscal stimulus). Policymakers will watch the labor market and, especially, wage and price inflation to guide them on the appropriate pace of rate hikes. Core PCE inflation is roughly 30 basis points below target and has only edged erratically higher over the past year. The pickup in shelter inflation has been largely offset by falling core goods prices, reflecting previous dollar strength. We expect shelter inflation to soon flatten off, but goods prices will continue to contract if the dollar rises by another 5% this year. Year-ago comparison effects will also depress the annual rate of change over the next couple of months. However, the key to the underlying inflation trend will be wage pressures, which are most highly correlated with the non-shelter part of the service component. Up until recently, the structural and cyclical forces acting on wage gains were pulling in the same downward direction. Structural factors include automation and population aging; as high-paid older workers leave the workforce, the vast majority of new entrants to full-time employment do so at below-median wages, putting downward pressure on median earnings growth.3 These structural factors will not disappear anytime soon, but the cyclical forces have clearly shifted. The main measures of U.S. wage growth are all trending higher. Excess labor market slack appears to have been largely absorbed. Only the number of people working part time for economic reasons suggests that there is some residual slack remaining. To what extent will cyclical wage pressures exert upward pressure on inflation? That will depend on the ability of companies to raise prices in order to protect profit margins. Wage inflation trends do not lead, and sometimes diverge from, inflation in goods and services. Theory suggests that there is a two-way relationship between wages and prices. Sometimes inflation starts in the labor market and spills over into consumer prices (cost-push inflation), and sometimes it is the other way around (demand-pull inflation). At the moment, the corporate sector appears to have limited ability to pass on rising wage costs. Balancing off the opposing factors, we believe that core PCE inflation will grind higher and should be near the 2% target by year end. This would end the Fed's debate over whether to run the economy hot, helping to keep upward pressure on Treasury yields. Bond Bear To Return Chart I-16Watch Bond Technicals To Short Again Watch Bond Technicals To Short Again Watch Bond Technicals To Short Again Global yields troughed a full four months before the U.S. election. As discussed above, the U.S. and global economies were showing signs of increased vigor even before Trump won the Presidency. The new President's policies reinforce the bond-bearish backdrop, especially protectionism and fiscal stimulus, at a time when the economy is already near full employment. Long-term inflation expectations imbedded in bond yields have shifted up in recent months across the major markets. Real yields have been volatile, but generally have not changed much from late last year. We remain modest bond bears over a 6-12 month horizon. Inflation and inflation expectations will continue to grind higher in the major markets and we expect the FOMC to deliver three rate hikes in 2017, one more than is discounted in the Treasury market. A rise in 10-year TIPS breakevens into a range that is consistent with the Fed's 2% inflation target (2.4%-2.5% based on history) would be a strong signal that the Fed will soon lift the 'dot plot.' ECB bond purchases will limit the increases in the real component of core European yields, but any additional weakness in the euro would result in a rise in European inflation. The ECB was able to announce a tapering of monthly purchases last year while avoiding a bond rout by extending the QE program to the end of 2017, but this will be more difficult to pull off again if inflation is on the rise and growth remains above-trend this year. We expect the ECB to provide hints in September that it will further taper its QE program early in 2018. Thus, the Eurozone bond market could take over from U.S. Treasurys as the main driver of the global bond bear market late in 2017. The Japanese economy is also performing impressively well, reducing the probability of a "helicopter drop" policy. The dollar's surge has depressed the yen and lifted inflation expectations, relieving some pressure on PM Abe to ramp up fiscal spending beyond what is already included in the supplementary budgets. In any event, the BoJ will keep the 10-year yield pinned near to zero, limiting the upside for bond yields to some extent in the other major bond markets. That said, we are neutral on JGBs, not overweight, because most of the yield curve is in negative territory. We remain overweight Bunds versus both Treasurys and JGBs on a currency-hedged basis. In terms of the duration call, our bond strategists felt in early December that the global bond selloff had progressed too far, too fast (Chart I-16). They recommended temporarily taking profits on short-duration positons and shifting to benchmark, which turned out to be excellent timing. Yields have drifted lower since then and the technicals have improved enough to warrant shifting back to below-benchmark duration. Investment Conclusions Chart I-17A Better Growth ##br##Backdrop For USD Strength A Better Growth Backdrop For USD Strength A Better Growth Backdrop For USD Strength Equity markets have gone into a holding pattern as investors weigh heightened U.S. policy risk against the improving profit and global macro backdrop. The latter appears to have broken the Fed policy loop that had been in place for some time. Expectations for a less dovish Fed helped to drive the dollar and Treasury yields higher late in 2016. But, rather than sparking a correction in risk assets as has been the case in recent years, stock indexes surged to new highs (Chart I-17). The difference this time is that there has been a meaningful improvement in the growth and profit outlook that has overwhelmed the negative impact of a stronger dollar and higher borrowing rates. The protectionist policies currently being considered are clearly dollar bullish, and bearish for global bonds and EM stocks. Investors should be positioned accordingly. It is more complicated for stocks. The passing of a major tax reform package would no doubt buttress the budding revival in private sector animal spirits, but a nasty trade war has the potential to do the opposite. The multitude of policy proposals floating around greatly complicate asset allocation. It is a very fluid situation but, for now, the new Administration has boosted confidence and thereby reinforced a global cyclical upswing. As long as protectionist policies implemented this year do not unduly undermine global growth (our base case), then corporate earnings growth will be solid in 2017 and stocks will beat bonds by a wide margin. We wish to be clear, though, that equities are on the expensive side in most of the main markets. This means that overweighting equities and underweighting cash and bonds in a balanced global portfolio is essentially playing an equity overshoot. It may end badly, but the overshoot is likely to persist for as long as the economic and profit upswing persists. Investors should consider long VIX positions, but add to equity exposure on dips. Our view on corporate bonds is unchanged this month. Poor value and deteriorating corporate balance sheet health make it difficult to recommend anything more than a benchmark position in the U.S. relative to Treasurys. However, investors can pick up a little spread in the Eurozone corporate bond market, where balance sheet health is better and the ECB is soaking up supply. Mark McClellan Senior Vice President The Bank Credit Analyst January 26, 2017 Next Report: February 23, 2017 1 U.S. Border Adjustment Tax: A Potential Monster Issue for 2017. BCA Global Investment Strategy service, January 20, 2017. 2 For more information, please see: Trump, Day one: Let the Trade War Begin. BCA Geopolitical Strategy Weekly Report, January 18, 2017. 3 For more information in the structural and cyclical wage pressures, please see: U.S. Wage Growth: Paid in Full? U.S. Investment Strategy Service, November 28, 2016. II. Global Debt Titanic Collides With Fed Iceberg? The spike in bond yields since the U.S. election has focussed investor attention on the economic implications of higher borrowing costs. In this world of nose-bleed debt levels, it seems self-evident that certain parts of the global economy will be ultra-sensitive to rising rates. The "cash flow" effect on debt service is a headwind for growth as rising interest payments trim the cash available to spend on goods and services. Some market commentators believe that the Fed will not be able to raise interest rates much because the cash-flow effect will be so severe this time that it will quickly derail the economic expansion. However, a number of factors make projecting interest payments complicated, such that back-of-the-envelope estimates are quite misleading. In order to provide a sense of the size of the cash-flow effect, in this Special Report we estimate the sensitivity of interest payments to changes in borrowing rates in the corporate, household and government sectors for four of the major economies. The key finding is that interest burdens will rise only modestly, and from a low level, over the next couple of years even if borrowing rates increase immediately by 100 basis points from today's levels. It would require a 300 basis point jump to really "move the dial". Interest rate shocks are more dramatic for the Japanese government interest burden due to the size of the JGB debt mountain, but much of the interest payments would simply make the round trip to the Bank of Japan and back again. We are not downplaying the risks posed by the rapid accumulation of debt since the Great Recession. Rather, our aim is to provide investors with a sense of the debt-service implications of a further rise in borrowing rates. Our main point is that the cash-flow effect of higher interest rates should not be included in the list of reasons for believing that Fed officials will be quickly thwarted if they proceed with their rate hike plan over the next couple of years. Investors are justifiably worried that the bond selloff will get ahead of itself, spark an economic setback and a corresponding flight out of risk assets. After all, there have been several head fakes during this recovery during which rising bond yields on the back of improving data and optimism were followed by an economic soft patch and a risk-off phase in financial markets. In this world of nose-bleed debt levels, it seems self-evident that certain parts of the global economy will be ultra-sensitive to rising rates. Indeed, global debt has swollen by 41½ percentage points of GDP since 2007 (Chart II-1). Households, corporations and governments tried to deleverage simultaneously to varying degrees in the major countries since the Great Recession and Financial Crisis, but few have been successful. Households in the U.S., U.K., Spain and Ireland have managed to reduce the level of debt relative to income. U.K. and Japanese corporations are also less geared today relative to 2007. Outside of these areas, leverage has generally increased in the private and public sectors (see Chart II-2 and the Appendix Charts beginning on page 37). The astonishing pile-up of debt in China has been particularly alarming for the investment community (Chart II-3). Chart II-1Leverage Has Increased Since 2007 Leverage Has Increased Since 2007 Leverage Has Increased Since 2007 Chart II-2Leverage In Advanced Economies Leverage In Advanced Economies Leverage In Advanced Economies Chart II-3China's Alarming Debt Pile-Up China's Alarming Debt Pile-Up China's Alarming Debt Pile-Up Governments can be excused to some extent for continuing to run fiscal deficits because automatic stabilizers require extra spending on social programs when unemployment is high. Fiscal policy was forced to at least partially offset the drain on aggregate demand from private sector deleveraging, or risk a replay of the Great Depression. More generally, history shows that it is extremely difficult for any one sector or country to deleverage when other sectors and countries are doing the same. The slow rate of nominal income growth makes the job that much harder. Borrowing Rates And The Economy There are several ways in which higher borrowing rates can affect the economy. Households will be incentivized to save rather than spend at the margin. Borrowing costs surpass hurdle rates for new investment projects, causing the business sector to trim capital spending. Uncertainty associated with rising rates might also undermine confidence for both households and firms, reinforcing the negative impact on demand. Banks, fearing a growth slowdown ahead and rising delinquencies, may tighten lending standards and thereby limit credit availability. These negative forces are normally a headwind for growth, but not something that outweighs the positive Keynesian dynamics of rising wages, profits and employment until real borrowing rates reach high levels. However, if the neutral or "equilibrium" level of interest rate is still extremely low today, then it may not require much of a rise in market rates to tip the economy over. A lot depends on confidence, which has been quite fragile in the post-Lehman world. The "cash flow" effect on debt service is another headwind for growth as rising interest payments trim the cash available to spend on goods and services. For the government sector, a swelling interest burden will add to the budget deficit and may place pressure on the fiscal authorities to cut back on spending in other areas. Some market commentators believe that the Fed will not be able to raise interest rates much because the cash-flow effect will quickly derail the expansion in the U.S. and potentially in other countries as the Treasury market selloff drags up yields across the global bond market. This is an argument that has circulated at the beginning of every Fed tightening cycle as far back as we can remember. Some even predict that central banks will be forced to use financial repression for an extended period to prevent the interest burden from skyrocketing and thereby short-circuiting the economic expansion. Back-of-the-envelope estimates that simply apply a 100 or 200 basis point increase in borrowing rates to the level of outstanding debt, for example, imply a shocking rise in the debt service burdens. Fed rate hikes could be analogous to the iceberg that took down the Titanic in 1912. Key Drivers Of Interest Sensitivity However, back-of-the-envelope calculations like the one described above paint an overly pessimistic picture for three reasons. First, the starting point for debt service burdens in the corporate, household and government sectors is low (Chart II-4). These burdens have generally trended down since 2007 because falling interest rates have more than offset debt accumulation, with the major exception of China.1 Second, the maturity distribution of debt means that it takes time for interest rate shifts to filter into debt servicing costs. For example, the average maturity of corporate investment-grade bond indexes in the major economies is between 3 and 12 years (Chart II-5). The average maturity of government indexes range from 7½ to 16 years. Moreover, the majority of household debt is related to fixed-rate mortgages. Even a significant portion of consumer debt is fixed for 5-years and more in some countries. Households have been extending the maturity structure of their debt in recent decades (Chart II-5, bottom panel). Chart II-4Debt Service Has Generally Declined Debt Service Has Generally Declined Debt Service Has Generally Declined Chart II-5Average Maturity Of Debt Is Long Average Maturity Of Debt Is Long Average Maturity Of Debt Is Long Third, even following the backup in yield curves since the U.S. election, current interest rates on new loans are still significantly below average rates on outstanding household loans, corporate debt and government debt. The implication is that most older loans and bonds coming due over the next few years will be rolled over at a lower rate compared to the loans and bonds being replaced. This will even be true if current yield curves shift up by 100 basis points in many cases (except for the U.S. where current yields are closer to average coupon and loan rates). In this Special Report, we estimate the sensitivity of interest payments to changes in borrowing rates in the corporate, household and government sectors for four of the major economies. We could not include China in this month's analysis because data limitations precluded any degree of accuracy, but the sheer size of China's debt mountain justifies continued research in this area. The key finding is that interest burdens will rise only modestly, and from a low level, over the next couple of years even if borrowing rates rise immediately by 100 basis points from today's levels. It would require a 300 basis point rise in yield curves to really "move the dial" in terms of the cash-flow impact on spending. An interest rate shock of that size would be particularly dramatic for the Japanese government interest burden given the size of its debt mountain, but much of the interest payments would simply make the round trip to the Bank of Japan and back again. Consumer Sector U.S. households have worked hard at deleveraging since their net worth was devastated by the housing bust. Still, the overall debt-to-income level is elevated by historical standards. U.S. household leverage has generally trended higher since the Second World War and has been a source of angst for investors as far back as the late 1950s. Yet, we find no evidence that U.S. consumers have become more sensitive to changes in borrowing rates over the decades.2 This counter-intuitive result partially reflects the fact that consumers have partially insulated themselves from rising interest rates by adopting a greater proportion of fixed-rate debt. The bottom panel of Chart II-6 presents the two-year change in debt service payments expressed as a percent of income (i.e. the swing or the "cash flow" effect). The fact that these swings have not grown over time suggest that the cash-flow effect of changes in interest rates on debt service has not increased.3 Chart II-6U.S. Consumers Have Not Become More Sensitive To Interest Rates U.S. Consumers Have Not Become More Sensitive To Interest Rates U.S. Consumers Have Not Become More Sensitive To Interest Rates Another way to demonstrate this point is to compare disposable income growth with a measure of "discretionary" disposable income that subtracts debt service payments (Chart II-6, top panel). This is the amount of money left over after debt servicing to purchase goods and services. The annual rate of growth in disposable income and discretionary income are nearly identical. In other words, growth in spending power is determined almost exclusively by changes in the components of income (wages, hours and employment). Moreover, the fact that some households are net receivers of interest income provides some offset to rising interest payments for other households when rates go up. This conclusion applies to households in the other major countries as well. Charts II-7 to II-10 present projections for household interest payments as a percent of GDP under three scenarios: no change in yield curves, an immediate 100 basis point parallel shift up in the yield curve and a 300 basis point shift. Assuming an immediate increase in yields across the curve is overly blunt, but the scenarios are only meant to provide a sense of how much interest payments could rise on a medium-term horizon (say, one to five years). The exact timing is less important. Chart II-7U.S. Household Sector Interest Payment Projection U.S. Household Sector Interest Payment Projection U.S. Household Sector Interest Payment Projection Chart II-8U.K. Household Sector Interest Payment Projection U.K. Household Sector Interest Payment Projection U.K. Household Sector Interest Payment Projection Chart II-9Japan Household Sector Interest Payment Projection Japan Household Sector Interest Payment Projection Japan Household Sector Interest Payment Projection Chart II-10Eurozone Household Sector Interest Payment Projection Eurozone Household Sector Interest Payment Projection Eurozone Household Sector Interest Payment Projection Unsurprisingly, household interest payments as a fraction of GDP are flat-to-slightly lower in "no change" interest rate scenario for the major countries. The interest burden increases by roughly 1 percentage point in the 100 basis point shock, although the level remains well below the pre-Lehman peak in the U.S., U.K. and Eurozone. In Japan, the interest payments ratio returns to levels last seen in the late 1990s, although this is not particularly onerous. A 300 basis point shock would see interest burdens ramp up to near, or above, the pre-Lehman peak in all economies except in the U.K. For the latter, borrowing rates would still be below the 2007 peak even if they rise by 300 basis points from current levels. This scenario would see the household interest burden surge well above 3% of GDP in Japan, a level that exceeds the entire history of the Japanese series back to the early 1990s. Also shown in the bottom panel of Chart II-7, Chart II-8, Chart II-9, Chart II-10 is the associated 2-year swing in interest expense as a percent of GDP under the three scenarios. The 2-year swing moves into positive (i.e. restrictive) territory for all economies under the 100 basis point shock, although they remain in line with previous monetary tightening cycles. It is only for the 300 basis point scenario that the cash-flow effect appears threatening in terms of consumer spending power over the next two years. Corporate Sector The starting point for interest payments and overall debt-service in the corporate sector is also quite low by historical standards, although less so in the U.S. Falling interest rates have been partially offset by the rapid accumulation of American company debt in recent years. We modeled national accounts data for non-financial corporate interest paid using the stock of corporate bonds, loans and (where relevant) commercial paper, together with the associated interest or coupon rates. The model simply sums interest payments across these types of debt to generate a grand total, after accounting for the maturity structure of the loans and debt. Chart II-11, Chart II-12, Chart II-13 and Chart II-14 present the three yield curve scenarios for corporate interest payments. The interest burden is flat-to-somewhat lower if yield curves are unchanged, as old loans and bonds continue to roll over at today's depressed levels. Even if market yields jump by 100 basis points tomorrow, the resulting interest burdens would rise roughly back to 2012-2014 levels in the U.S., Eurozone and the U.K., which would still be quite low by historical standards. The resulting two-year cash-flow effect is modest overall. The rate increase feeds into corporate interest payments somewhat more quickly in the Eurozone and Japan because of the relatively shorter average maturity of the corporate debt market, but a shock of this size does not appear threatening to either economy. Chart II-11U.S. Corporate Sector Interest Payment Projection U.S. Corporate Sector Interest Payment Projection U.S. Corporate Sector Interest Payment Projection Chart II-12U.K. Corporate Sector Interest Payment Projection U.K. Corporate Sector Interest Payment Projection U.K. Corporate Sector Interest Payment Projection Chart II-13Eurozone Corporate Sector Interest Payment Projection Eurozone Corporate Sector Interest Payment Projection Eurozone Corporate Sector Interest Payment Projection Chart II-14Japan Corporate Sector Interest Payment Projection Japan Corporate Sector Interest Payment Projection Japan Corporate Sector Interest Payment Projection It is a different story if yields rise by 300 basis points. The interest ratio approaches previous peaks set in the 2000s in the U.S. and Eurozone. The interest ratio rises sharply for the U.K. corporate sector as well, although it stays below the 2000 peak because interest rates were even higher 17 years ago. Japanese companies would also feel significant pain as the interest ratio rises back to where it was in the late 1990s. Government Sector Government finances are not at much risk from a modest increase in bond yields either (Chart II-15). We focus on the level of the interest burden rather than the cash-flow effect for the government sector since changes in interest payments probably have less impact on governments' near-term spending plans than is the case for the private sector. Chart II-15Government Sector Interest Payment Projection Government Sector Interest Payment Projection Government Sector Interest Payment Projection As discussed above, Treasury departments in the U.K., Eurozone and Japan have taken advantage of ultra-low borrowing rates by extending the average maturity of public debt. The average maturity of the Barclays U.K. government bond index has extended to 16 years, while it is close to 10 years in Japan and the Eurozone (Chart II-5). The U.S. Treasury has not followed suit; the Barclays U.S. index is about 7½ years in maturity. The lengthy average maturity means that index coupon rates will continue to fall for years to come if rates are unchanged in the U.K., Japan and the Eurozone, resulting in a declining interest burden. Even if rates rise by another 100 basis points, the interest burden is roughly flat as a percent of GDP for the U.K. and Eurozone, and rises only modestly in Japan. The limited impact reflects the fact that the starting point for current yields is well below the average coupon on the stock of government debt. In contrast, the U.S. interest burden is roughly flat in the "no change" scenario, and rises by a half percentage point by 2025 in the 100 basis point shock scenario. Keep in mind that we took the neutral assumption that the stock of government debt grows at the same pace as nominal GDP growth. This assumes that governments deal effectively with the impact of aging populations on entitlement programs in the coming years. As many studies have shown, debt levels will balloon if entitlements are not adjusted and/or taxes are not raised to cover rising health care and pension costs. We do not wish to downplay this long-term risk, but we are focused on the impact of higher interest rates on interest expense over the next five years for the purposes of this Special Report. As with the household and corporate sectors, the pain becomes much more serious in the event of a 300 basis point rise in interest rates. Interest payments rise by about 1 percentage point of GDP in the U.S. and U.K. to high levels by historically standards. It takes a decade for the full effect to unfold, although the ratios rise quickly in the early years as the short-term debt adjusts rapidly to the higher rate environment. For the Eurozone, the roughly 100 basis points rise takes the level of the interest burden back to about 2003 levels (i.e. it does not exceed the previous peak). Given Japan's extremely high government debt-to-GDP ratio, it is not surprising that a 300 basis point rise in interest rates would generate a whopping surge in the interest burden from near zero to almost 5% of GDP by the middle of the next decade. Nonetheless, this paints an overly pessimistic picture for two reasons. First, the Bank of Japan is likely to hold short-term rates close to zero for years as the authorities struggle to reach the 2% inflation target. This means that only long-term JGB yields have room to move higher in the event of a continued global bond selloff. Second, 40% of the JGB market is held by the central bank and this proportion will continue to rise until the Bank of Japan's QE program ends. Interest paid to the BoJ simply flows back to the Ministry of Finance. The net interest payments data used in our analysis are provided by the OECD. These data net out interest payments made between all arms of the government except for the central bank. The implication is that rising global bond yields in the coming years will not place the Japanese government under any fiscal strain. The same is true in the U.S., U.K. and Eurozone, where the respective central banks also hold a large portion of the stock of government debt (although this conclusion does not necessarily apply to the peripheral European governments). Conclusion The spike in bond yields since the U.S. election has focussed investor attention on the economic implications of higher borrowing costs given the sea of debt that has accumulated. As discussed in our 2017 BCA Outlook, we believe that the secular bond bull market is over but foresee only a gradual uptrend in yields in the coming years. Inflation is likely to remain subdued in the major countries and bond supply will continue to be absorbed by the ECB and Bank of Japan. The stock of government bonds available to the private sector will drop by $750 billion in 2017 for the U.S., Eurozone, Japan and the U.K. as a group. This follows a contraction of $546 billion in 2016. Forward guidance from the BoJ and ECB will also help to cap the upside for global bond yields. Still, we believe that the combination of gradually rising U.S. inflation, Fed rate hikes and the Trump fiscal stimulus plan will push Treasury yields above current forward rates in 2017. Other bond markets will outperform in local currency terms, but will suffer losses via contagion from the U.S. Despite the dizzying amount of debt accumulated since the Great Recession, it does not appear that debt service will sink the economies of the advanced economies as the Fed continues to normalize U.S. monetary policy. Debt service will rise from a low starting point and the swing in interest payments as a percent of GDP is unlikely to exceed previous cycles on a 2-year horizon for a 100 basis point rise in yields. The level of the interest payments/GDP ratio should not exceed previous peaks in most cases. The picture is much more threatening if yields were to surge by 300 basis points over the next couple of years, although this scenario would require an unexpected acceleration of inflation in the U.S. and/or the other advanced economies. We are not making the case that the buildup of debt is benign. Academic research has linked excessive leverage with slower trend economic growth and a higher risk of financial crisis. For governments, elevated debt can result in a rising risk premium that will crowd out spending in important areas, such as health and pensions, in the long run. For consumers and the corporate sector, excessive leverage could result in financial distress and a spike in defaults in the next downturn, reinforcing the contraction in output. The Bank for International Settlements agrees: "Increased household indebtedness, in and of itself, is not likely to be the source of a negative shock to the economy. Rather the primary macroeconomic implication of higher debt levels will be to amplify shocks to the economy coming from other sources, particularly those that affect household incomes, most notably rises in unemployment." 4 Debt lies at the heart of BCA's longstanding Debt Supercycle thesis. For several decades, the willingness of both lenders and borrowers to embrace credit was a lubricant for economic growth and rising asset prices and, importantly, underpinned the effectiveness for monetary policy. During times of economic and/or financial stress, it was relatively easy for the Fed and other central banks to improve the situation by engineering a new credit upcycle. That all ended with the 2007-09 meltdown. Since then, even zero policy rates have been unable to trigger a strong revival in private credit growth in the major developed countries because the starting point for leverage is already elevated. Growth headwinds finally appear to be ebbing, at least in the U.S., prompting the FOMC to begin the process of "normalizing" short-term interest rates. The U.S. economy could suffer another setback in 2017 for a number of reasons. Nonetheless, the key point of this report is that the cash-flow effect of rising interest rates should not be included in the list of reasons for believing that Fed officials will be quickly thwarted if they proceed with their rate hike plan over the next couple of years. Mark McClellan Senior Vice President The Bank Credit Analyst 1 For China, the BIS only provides an estimate of the debt service ratio for the household and non-financial corporate sectors combined. 2 See: U.S. Consumer Titanic Meets the Fed Iceberg? The BCA U.S. Fixed Income Analyst, July 2004. 3 The absence of a rise in volatility of the cash flow effect is partly due to the decline in, and the volatility of, interest rates after the 1980s. 4 Guy Debelle, "Household Debt and the Macroeconomy," BIS Quarterly Review, March 2004. Appendix Charts Chart II-16, Chart II-17, Chart II-18, Chart II-19 Chart II-16U.S. Debt By Sector U.S. Debt By Sector U.S. Debt By Sector Chart II-17U.K. Debt By Sector U.K. Debt By Sector U.K. Debt By Sector Chart II-18Japan Debt By Sector Japan Debt By Sector Japan Debt By Sector Chart II-19Euro Area Debt By Sector Euro Area Debt By Sector Euro Area Debt By Sector III. Indicators And Reference Charts Global equities have been in a holding pattern so far in 2017, consolidating the gains made at the end of last year. Our key equity indicators are mixed at the moment. The Valuation indicator continues to hover at about a half standard deviation on the expensive side. The effect of the rise in global equity indexes late last year on valuation was offset by a surge in profits. Stocks are not cheap but, at this level, valuation not a roadblock to further price gains. Our Monetary indicator deteriorated further over the past couple of months, driven by a stronger dollar and higher bond yields. A shift in this indicator below the zero line would be negative for stock markets. Sentiment is also frothy, which is bearish from a contrary perspective, although our Technical indicator is positive. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The WTP indicators have all turned higher from a low level for the Japanese, the European and the U.S. markets. This suggests that investors, after loading up on bonds last year, have "dry powder" available to buy stocks as risk tolerance improves. The U.S. WTP has risen the fastest and is closing in on the 0.95 level. Our tests show that, historically, investors would have reaped impressive gains if they had over-weighted stocks versus bonds when the WTP was rising and reached 0.95. The WTPs suggest that the U.S. market should outperform the Eurozone and Japanese markets in the near term, although for macro reasons we still believe the U.S. will lag the other two. We expect the global stock-to-bond total return ratio to rise through this year. The latest selloff has pushed U.S. Treasurys slightly into "inexpensive" territory based on our Valuation model. Bonds are still technically oversold and sentiment remains bullish, suggesting that the consolidation phase may last a little longer. Nonetheless, we expect to recommend short-duration positions again once the overbought conditions unwind. The U.S. dollar is near previous secular peaks according to our valuation measure. Nonetheless, policy divergences are likely to drive the U.S. dollar to new valuation highs before the bull market is over. Technically overbought conditions have almost unwound, clearing the way for the next leg of the dollar bull run. Commodities have been on a tear on the back of improving and synchronized growth across the major countries (and some dollar weakness very recently). The commodity price outlook is clouded by the prospect of a border tax, which could send the U.S. dollar soaring. The broad commodity market is also approaching overbought levels. The cyclical growth outlook is positive for commodity demand, although supply factors favor oil to base metals. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights The uptrend in consumer confidence has the potential to be lasting, and therefore lead to an acceleration in real consumption over the next several quarters. In contrast, the rise in business optimism is thus far built on shakier fundamentals, and therefore vulnerable to disappointment - at least until corporate executives see signs of a pickup in consumer demand. Some of the cyclical tailwinds that have aligned for consumers are: very low essential spending burdens, rising incomes, a positive wealth effect, and improved credit scores. Several areas of the U.S. equity market are set to outperform on the back of this improved consumer profile. Feature Financial markets continue to be optimistic about a more fertile business backdrop under a Trump presidency. At current valuations, equities are likely to undergo a testing phase. Indeed, the equity market's reaction to President-elect's press conference last week - the first in months - may be an omen of what is in store should Trump disappoint relative to what appears like very high expectations for the early days of his Presidency. At first blush, it appears that the surge in sentiment among a broad range of economic agents was precipitated by just one factor: Donald Trump's victory in the presidential election. Measures of both business and consumer confidence all rose sharply after November 8th (Chart 1). An important question is how sustainable and how far-reaching is this new-found optimism? After all, a major missing ingredient in the recovery to date has been faith that the economic future would get better. Last year, over half of respondents to a Nielsen global confidence survey still believed the world was in recession. Our take is that the uptrend in consumer confidence has the potential to be lasting, and therefore lead to an acceleration in real consumption over the next several quarters. In contrast, the rise in business optimism is thus far built on shakier fundamentals, and therefore vulnerable to disappointment - at least until corporate executives see signs of a pickup in consumer demand. This view runs counter to the current popular narrative, where businesses - and therefore their stock prices - perform better once a new era of pro-business policies are ushered in. We have noted in past weekly reports that we believe the equity market has overshot and that policy is likely to under-deliver; it is a high bar to assume that the new American government will succeed in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending and a lighter regulatory burden, while simultaneously avoiding any negative shocks from trade reform and foreign policy blunders.1 Thus, we interpret the surge in business confidence, as reported in various surveys, to be exaggerated and prone to a pullback. On the flipside, a number of cyclical tailwinds have aligned for consumers. Although consumer sentiment surveys also spiked higher since November, this merely extends an already rising trend. Below, we outline the fundamental factors that support stronger consumption growth in the coming quarters. Cost Of Essentials Is Ultra-Low First, the cost of many essential items have declined throughout the recovery, particularly energy prices (Chart 2). The decline in energy prices since 2014 means that spending on energy as a percent of disposable income is near thirty year lows. Likewise, spending on food and interest payments as a share of income is also as low as it has been in thirty years. It is only the seemingly incessant climb in medical payments that keeps overall spending on essential items above 40% of disposable income. Still, at 41% of total disposable income, spending on essential items is far from burdensome relative to historical norms. Chart 1Confidence Surge: Some Trump, ##br##Some Fundamentals Confidence Surge: Some Trump, Some Fundamentals Confidence Surge: Some Trump, Some Fundamentals Chart 2Essential Spending Burden##br## Is Very Low Essential Spending Burden Is Very Low Essential Spending Burden Is Very Low Incomes Are Rising And Jobs Are Secure Much more importantly, the main driver of consumption trends, income, is on track to accelerate (Chart 3). Despite a moderation in payroll growth, overall income growth is likely to stay perky, now that wage growth is rising. Indeed, as we highlighted in a Special Report in November, the labor market has reached full employment, which is the necessary threshold for a broad-based acceleration in wages (Chart 4). Although there are structural factors that will mitigate rapid wage hikes, it is likely that mild upward pressure on wages will continue throughout 2017 (Chart 5). This is obviously good news because higher wages means that consumers will have the wherewithal to spend more. In addition to this, a tighter job market has boosted job security. Various measures of consumer confidence highlight that over the past year, consumers now have much greater confidence in long-term job prospects. This is important because when job security is high, the propensity to spend instead of save is much higher (Chart 3, bottom panel). Chart 3Income Properties Drives Spending##br## More Than Any Other Factor Income Properties Drives Spending More Than Any Other Factor Income Properties Drives Spending More Than Any Other Factor Chart 4(Part I) Full Employment Calls##br## For Gradually Higher Wages (Part I) Full Employment Calls For Gradually Higher Wages (Part I) Full Employment Calls For Gradually Higher Wages Chart 5Part (II) Full Employment Calls##br## For Gradually Higher Wages Part (II) Full Employment Calls For Gradually Higher Wages Part (II) Full Employment Calls For Gradually Higher Wages Although income is the primary driver of consumption, the trend can be enhanced by several factors, including consumer wealth, the ability of consumer to finance purchases and fiscal handouts. The Wealth Effect Will Remain A Tailwind The wealth effect is the change in spending that accompanies a change, or perceived change, in wealth. The combined wealth effect from real estate and financial markets has been positive for some time (Chart 6). Thus, it is not a new driver of consumer spending, but is nonetheless positive that wealth positions continue to improve. If our forecasts for financial markets and house prices pan out, i.e. that the bull market in stocks continues over time, that bonds experience only a mild bear market and that house price appreciation remains in the mid-single digits, then a positive wealth effect will continue to support consumption in 2017. Debt/Deleveraging Cycle Is Advanced One of the major headwinds to consumer spending since 2008 has been the long, dark shadow of deleveraging. But that process is now well-advanced for the consumer sector. Consumer debt levels as a percent of disposable income peaked in 2008 at over 120%, but are now back under 100%, i.e. at the level that existed prior to the housing bubble and bust. Indeed, the financial obligation ratio for households (both renters and homeowners) is lower today than at any time in the past thirty-five years (Chart 7). Of course, part of this is due to very low interest rates, but our Bank Credit Analyst will show in their February publication that even a 100 basis point rise in borrowing rates from current levels would not lift the interest payment burden to elevated levels by historical standards. Chart 6Wealth Effect Will Remain Positive Wealth Effect Will Remain Positive Wealth Effect Will Remain Positive Chart 7Credit Conditions Are Not Problematic Credit Conditions Are Not Problematic Credit Conditions Are Not Problematic Finally, access to credit remains favorable. In late 2016, lending standards for consumer loans tightened slightly in late 2016, but access to credit generally is not a constraint on spending. A second important point is the ability of those scarred from the housing bust to re-enter the credit market. By law, information about any credit payment delinquencies, including mortgage payment delinquencies, must be removed from an individual's credit record after seven years. Therefore, if no other delinquencies occurred, individuals who experienced a foreclosure see their credit scores recover in seven years and can once again become candidates for mortgage purchases and therefore homeownership. According to research by the Chicago Federal Reserve, since the peak of foreclosures occurred prior to 2011, the bulk of borrowers that foreclosed during the housing bubble and bust are now seeing their credit scores improve. By 2016, both prime and sub-prime borrowers who entered foreclosure between six and nine years earlier (in 2007-10) appear to have recovery rates that are converging with the historical rates of recovery among their predecessor cohorts: nearly 100% of sub-prime borrowers from 2007-2010 who foreclosed have re-attained their previous credit scores, while over 60% of prime borrowers from 2007-2010 re-attained theirs (Chart 8). This means that in large part, the massive drag on housing demand due to poor credit scores from the previous housing bust have been alleviated. Chart 8Share Of Home Mortgage Borrowers Who Recovered ##br##Pre-Delinquency Credit Score After Foreclosure U.S. Consumer: The Comeback Kid U.S. Consumer: The Comeback Kid Fiscal Help? President-elect Donald Trump has promised fiscal stimulus in the form of infrastructure spending, corporate tax cuts and personal income tax cuts. The latter could have a positive impact on consumption, although it would likely be small. According to the Tax Policy Centre, if enacted, the highest income taxpayers (0.1 percent of the population, or those with incomes over $3.7 million in 2016 dollars) would experience an average tax cut of nearly $1.1 million, over 14 percent of after tax income. Households in the middle fifth of the income distribution would receive an average tax cut of $ 1,010, or 1.8 percent of after -tax income, while the poorest fifth of households would see their taxes go down an average of $110 or 0.8 percent of their after-tax income.2 The bottom line is that fiscal policy, if Trump's plan is enacted, could be a small positive tailwind for consumption in 2017. Overall, there are increasing signs that the scar tissue from the Great Recession is finally fading and that the improvement in consumer confidence is sustainable. This, combined with better income prospects will give households the wherewithal to spend more freely and will push real GDP growth up to 2.5% or perhaps slightly stronger. Our past research shows that sustainable capital spending cycles only get underway once businesses see clear evidence that consumer final demand is on the upswing. Thus, perhaps a healthier capex cycle will get underway, and businesses will have a fundamental reason to be more upbeat about their prospects. But for now, it seems more likely that businesses are at risk of being disappointed with the speed and efficacy of federal policy changes. On this basis, favoring equity sectors geared to the consumer rather than capex still makes sense. Favor Consumer-Geared Equity Sectors An acceleration in consumer spending will benefit consumer-sensitive equity sectors and would also support our domestic-over-global equity tilt. In our December 5th report, we outlined the bullish prospects and compelling value on offer in the consumer discretionary sector. In addition, our sister publication, U.S. Equity Strategy service just published their annual high conviction equity list. Home improvement retail, and consumer finance stocks were top of the list of high conviction overweights: Home Improvement Retail (Chart 9): Enticing long-term housing prospects argue for looking through the recent rise in mortgage rates. And as highlighted above, consumers have only recently started re-levering, with banks more than willing to facilitate renewed appetite for mortgage debt. In addition, remodeling activity is booming and anecdotes of house flipping activity picking up steam are corroborating that the housing market is vibrant. Now that house prices have recently overtaken the 2006 all-time highs, the incentive to upgrade and remodel should accelerate. While the recent backup in bond yields has been a setback for housing affordability, the U.S. consumer is not priced out of the housing market. Yields are rising in tandem with job security and wages. Mortgage payments remain below the long-term average as a share of income and effective mortgage rates remain near generationally low levels. Consumer Finance (Chart 10): This group offers early-cyclical exposure and is levered to the rising interest rate environment and debt-financed consumer spending. Chart 9Home Improvement Retail Stocks Home Improvement Retail Stocks Home Improvement Retail Stocks Chart 10Consumer Finance Stocks Consumer Finance Stocks Consumer Finance Stocks Importantly, higher interest rates have boosted credit card interest rate spreads (the industry's equivalent net interest margin metric), underscoring that the next leg up in relative share prices will be earnings led. This group is well-placed to take advantage of the improving consumer trends discussed above. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Q&A: The Top Ten", dated November 21, 2016, available at usis.bcaresearch.com 2 http://www.taxpolicycenter.org/publications/analysis-donald-trumps-revised-tax-plan/full Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommended weightings for the major asset classes are unchanged: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The diffusion index of the three components for The Equity Model remained neutral. The technical component retained its "buy" signal, with slightly more advancement in the breadth & trend indicators relative to the momentum indicator. The monetary component, which measures overall liquidity conditions, is still favorable for equities, albeit is moving into less bullish territory. However, on the cyclical front, the earnings-driven component still warrants caution. Even as real operating earnings have marginally improved, they remain at a significant distance from positive economic expectations. Earnings momentum is also sluggish, based on our earnings diffusion index. Our qualitative stance for the allocation of Treasuries in balanced portfolios is neutral (since November 7, 2016) in contrast to the slightly overweight recommendation from our quantitative model, unchanged from last month. Although the valuation and technical components of the bond model are still constructive, the cyclical component is significantly less bullish this month. Chart 11Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Chart 12Current Model Recommendations Current Model Recommendations Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009.

Highlights The economy is near full employment, but betting on significant inflation is premature. Market-based inflation expectations have risen substantially in recent weeks but these moves are not corroborated by survey measures of inflation expectations. Consumer inflation expectations are very well anchored due to ongoing deflation in many frequently purchased goods and services. We are on high alert for a near-term equity pullback, with Chinese liquidity tightening as a potential catalyst. Feature Chart 1Market-Based Inflation ##br##Expectations Breaking Out Market-Based Inflation Expectations Breaking Out Market-Based Inflation Expectations Breaking Out After years of focusing on deflation, the possibility of inflation has made a comeback on investors' radars. The shift makes sense, given that the labor market is now operating near full employment. The December payroll report showed that payrolls increased by 156,000, slightly lower than the 3-month average of 165,000. But, average hourly earnings increased by 0.4%, suggesting that slightly weaker employment growth is not due to sluggish demand, and reflects a smaller available pool of workers. However, as we explain below, the potential for a major inflation surge is low in 2017 and is premature as an investment theme. We are on high alert for a near-term pullback to the equity bull market, given that valuation and sentiment are stretched. But as we outline, the threat to the equity market is less likely to be domestic inflation than an external event, such as the fallout from tightening liquidity in China (similar to what occurred in mid-2015 and early 2016). In the past few weeks, one-year inflation expectations have moved to their highest level since mid-2014, when oil prices were above $110/bbl. Long-run inflation expectations have also spiked since the U.S. election (Chart 1). The extent to which this trend is judged sustainable, and provides an accurate forecast for general inflation, has important investment implications. Our view is that, although TIPS could move a bit higher, the market move should not be interpreted as a harbinger for a broad-based inflation acceleration. Policymakers consider a range of inflation expectations measures, but in recent years, market-based measures have garnered a lot of attention. The 5-year/5-year forward TIPS breakeven rate in particular is often viewed as the market's assessment of whether the Fed can successfully achieve its inflation target. According to the Minutes of the December FOMC meeting, the recent rise in market-based inflation expectations was discussed at length. On this basis, the rise in TIPS is important as it could have a significant role in setting monetary policy. Beyond that, we have argued for some time that a major challenge for firms this cycle will be to raise selling prices, i.e. a lack of pricing power will restrain profit margins and, ultimately, earnings growth. If the recent pick-up in market-based inflation expectations heralds a more robust rise in actual inflation, then profits could positively surprise this year. The Rise In TIPS Is Partially Energy-Driven... Since 2010, there has been a strong correlation between oil prices and TIPS (Chart 2). The correlation has somewhat confounded policymakers.1 In theory, any oil price shock, even if it is considered to be permanent, should not exert any lasting impact on long-dated forward measures of inflation expectations. The reason is that as long as the Fed is committed to its 2% inflation target, then the market should expect that monetary policy will prevent a one-time shock to oil prices from having any permanent effect on the overall inflation rate. This is why, in theory, the 5-year/5-year forward TIPS breakeven rate is a good indicator for policymakers. Chart 2Oil Prices And Breakevens Oil Prices And Breakevens Oil Prices And Breakevens As our fixed income team explained in a report last year,2 the main reason for the tight correlation between TIPS and oil prices stems from the market perception that monetary policy has been constrained. Prior to the financial crisis, oil prices rose from below $40 in 2003 to $140 in 2008. During that time, long-dated breakevens remained stable. One possible explanation for this lack of correlation is that the Fed tightened policy during this period, offsetting the inflationary impact from higher oil prices. But in 2015-2016, when oil prices fell from above $100 to below $40, breakevens plunged alongside. If the market perceives monetary policy to be constrained by the zero lower bound, then it could be the case that the cost of inflation compensation is highly sensitive to falling oil prices because the market perceives that the Fed has no ability to offset the deflationary shock. In other words, the 5-year/5-year TIPS breakeven rate has fallen because the zero lower bound is challenging the credibility of the Fed's inflation target. Our U.S. fixed income team forecasted that breakevens will head higher once oil prices move up and that the correlation between oil prices and breakevens will eventually weaken as the fed funds rate moves further away from the zero lower bound. The bottom line is that TIPS are most likely being unduly affected by energy price movements. ..And Only Thinly Corroborated By Alternative Inflation Indicators Despite our bias that the recent moves in market-based inflation expectations are exaggerated, TIPS are not the only gauge sending a more inflationary signal. This week's ISM manufacturing and non-manufacturing surveys both reported an uptick in prices paid (Chart 3). According to the manufacturing survey, 18 out of 21 recorded inputs were up in price over the past month. However, the bulk of these are commodities that have gone up in price alongside other financial market prices, and it is not clear the extent that the price rise is physical demand-driven, or financial demand-driven. In the non-manufacturing survey, the price rise was not quite as broad-based, but is nonetheless suggestive of upward price pressure. The NFIB small business survey also hinted at higher prices, although much more modestly than the ISM surveys (Chart 3). The Atlanta Fed's Business Inflation Expectations Survey has not broken out of the range that has held since 2011. There was no change in inflation expectations from the most recent survey of professional forecasters. Meanwhile, as we noted last week, consumers are not at all worried about inflation. In fact, according to the Conference Board survey, consumer inflation expectations are at a new cyclical low! At least part of the reason that consumers do not expect more inflation is likely due to their experience with frequently-purchased items. Table 1 shows inflation rates for selected high-frequency spending items, which account for about 30% of the total CPI basket. The table makes it easy to understand why perceptions about inflation are low: almost half of the items in the table are in deflation and only two are above the Fed's target of 2%. It may not matter that a good or service accounts for a small share of spending: if its price is going up/down at a steady pace, then there will be an impact on perceptions about inflation. Currently, very low or negative rates of inflation among frequently purchased items are likely pulling down consumers' perceptions of broad-based inflation. In this sense, one could argue that inflation expectations are very well-anchored. Chart 3Survey-Based Inflation ##br##Expectations More Mixed Survery-Based Inflation Expectations More Mixed Survery-Based Inflation Expectations More Mixed Table 1Inflation Rates For Selected ##br## High-Frequency Spending Items Inflation In 2017: An Idle Threat Inflation In 2017: An Idle Threat Actual Inflation Will Stay Subdued In 2017... Chart 4Only Mild Uptrend Likely In 2017 Only Mild Uptrend Likely In 2017 Only Mild Uptrend Likely In 2017 For many years, we have deconstructed core CPI and core PCE into their three major components to better understand and forecast the trend in consumer price inflation (Chart 4). Performing this exercise today continues to give a fairly benign forecast for inflation. Shelter, the largest component of core CPI, is mostly determined by rental vacancies which appear to be stabilizing just as market rents are rolling over. Our model suggests that shelter will not drive inflation higher in 2017. Core goods inflation (25% of core CPI) will also remain very low and possibly stay in deflationary territory. This component of inflation is most tightly correlated with the trade-weighted dollar (Chart 4, panel 3), and so will stay depressed as long as the bull market in the dollar remains intact. Wage growth is most tightly correlated with service sector inflation excluding shelter and medical care (Chart 4, bottom panel). This component, which accounts for 25% of core CPI, is the most likely source of inflation pressure now that wages are beginning to rise. But as we wrote in a Special Report on November 28, 2016, any wage inflation and pass-through is likely to be very gradual based on several structural headwinds at play this cycle. All in all, core PCE may converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot should not be a major driver of investment decision-making over the next six - twelve months. ...And Don't Blame Government Spending For Higher Inflation When It Does Come One missing ingredient from the above analysis is the likelihood that the political environment will become inflationary. This subject has been thoroughly covered by the financial press. Our own view has been that upcoming policies may not turn out to be particularly inflationary, at least not this year. For example, Trump's fiscal package may not boost aggregate demand by as much as the more optimistic estimates suggest. There simply are not enough marquee "shovel-ready" projects around that can make use of the public-private partnership structure that Trump's plan envisions in 2017. As for proposed personal tax cuts, the impact is likely to be modest, given that the benefits are tilted towards higher income groups that tend to save much of their earnings. Likewise, corporate tax cuts will have only an incremental effect on business capex, given that many companies are already flush with cash and effective tax rates are well below statutory levels. Our benign view about the impact of government spending on inflation is shared by researchers at the St Louis Federal Reserve. In a recent paper,3 researchers looked at periods when the central bank was not working to offset the potentially inflationary effects of fiscal policy, e.g. between 1959 and 1979, when the Fed followed a policy in which it accommodated increases in inflation. They found almost no effect of government spending on inflation. For example, a 10 percent increase in government spending during that period led to an 8 basis point decline in inflation. Note that this period covers years of when the economy was operating at full employment and below. As the researchers point out, this does not imply that countercyclical government spending is ineffective at boosting output, but it simply demonstrates that empirical evidence of inflation related to government spending is thin. The bottom line is that we view the likelihood of significant inflation pressure as low in 2017. The implication is that under this scenario, the Fed can afford to adjust their "dots" gradually, diminishing the risk for stocks and bonds of an aggressive adjustment to the policy backdrop. Equity Correction: Will China Be A Contributing Factor? Chart 5Is China Liquidity Tightening##br## A Repeat Threat To U.S. Equities? Is China Liquidity Tightening A Repeat Threat To U.S. Equities? Is China Liquidity Tightening A Repeat Threat To U.S. Equities? Over the past few weeks, we have argued that the odds of a meaningful equity correction are running high, given the aggressive rise in bond yields and exaggerated move in sentiment relative to only minor upside surprises in economic and earnings growth. We are still on high alert for this outcome and believe that one possible trigger is tighter liquidity conditions in China, which are aimed at supporting the renminbi. Indeed, just like the start of 2016, the Chinese renminbi is kicking off 2017 on a weak note. Chinese policymakers are again tightening rules to limit capital outflows: earlier this week, they adjusted the FX basket used to set the CNY's official daily fix. The new FX basket will include 24 currencies (up from 13). Consequently, the weight of the U.S. dollar drops from 26.4% to 22.4%. This will make it easier for the authorities to target a relatively stable renminbi versus the basket even as USD/CNY pushes higher. These attempts to support the renminbi is leading to tighter liquidity conditions and higher interbank interest rates. In Hong Kong, 3-month CNH Hibor has spiked to 10%. In the past, a combination of a weaker renminbi and rising interbank rates has spelled trouble for U.S. and global equities (Chart 5). There is no guarantee that history will repeat itself and one big difference with the sharp market sell-offs in mid-2015 and early 2016 is that the Chinese economy is not as weak as it was then. The PMIs released this week were generally firm. Overall, we are positive on equities and negative on bonds on a 12-month horizon but still see the risk of a correction to the Trump trade as elevated. Thus, investors should continue to stick close to benchmark tactically, looking to implement positions after a pullback in stock prices. Like in 2015 and early 2016, China could provide the trigger to that pullback if the authorities give up on capital controls and allow a sharp depreciation of the RMB. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.stlouisfed.org/~/media/Files/PDFs/Bullard/remarks/Bullard-N… 2 Please see U.S. Bond Strategy Weekly Report "A Tale Of Two Rallies", dated March 29, 2016, available at usbs.bcaresearch.com 3 https://www.stlouisfed.org/on-the-economy/2016/may/how-does-government-…

Highlights After steep climbs in November and early December both bond yields and stock prices were overdue for a pause or correction. Although the domestic economy is on reasonably sound footing, stock prices have now discounted way too much good news. Evidence of an exuberant overshoot is apparent at the sector level. For example, the abrupt jump in the cyclical vs. defensive share price ratio has not been tracked by EM share performance. Despite the spike in small cap performance and the rising likelihood of a near-term correction, a strong U.S. dollar and likelihood of renewed emerging market financial strains argue for riding out any volatility and maintaining a core overweight in this asset class. Feature Investors who failed to check their screens since December 23rd are coming to back to the office to see the broad equity indices in the same spot as when they left. After steep climbs in November and early December both bond yields and stock prices were overdue for a pause or correction: financial market prices have become ever more divorced from economic reality (Chart 1). Although the domestic economy is on reasonably sound footing, stock prices have now discounted way too much good news. This is reflected in our sentiment indices, which have moved firmly into overbought territory (Chart 2). Chart 1Equities Are Moving Ahead Of Economic Reality Equities Are Moving Ahead Of Economic Reality Equities Are Moving Ahead Of Economic Reality Chart 2Sentiment Is Extended Sentiment Is Extended Sentiment Is Extended Consumers have also become extremely hopeful. The Conference Board's consumer confidence survey surged in December (Chart 3). All of the rise is due to better expectations about the future. In fact, sentiment about current conditions declined. According to the survey, consumers are expecting a goldilocks scenario of more income and lower prices. Income expectations are rising, but consumer price expectations hit a new cyclical low. It is unclear whether this new optimism will translate into much better consumer spending. Confidence and consumption growth broadly track over the course of the business cycle, but spikes such as the current one often give false signals. Preliminary reports about holiday spending do not show much improvement over last year and official data (last reported month is November) from the PCE report show that real consumer spending rose only 0.1% m/m. In fact, personal consumption growth looks to have slowed to around 2% in Q4, down from a pace of 3% in Q3, which will lead to downward revisions to Q4 GDP forecasts. Still, we are upbeat that at least some of consumers' optimism will trigger a more robust spending wave. After all, the labor market is robust and job security has improved considerably in recent months. Evidence of an exuberant overshoot is apparent at the sector level. For example, the abrupt jump in the cyclical vs. defensive share price ratio has not been tracked by EM share performance. Typically, emerging market (EM) equities and the cyclical vs. defensive share price ratio have tended to move hand-in-hand (Chart 4). The former are pro-cyclical and outperform when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the U.S. cyclical vs. defensive share price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debt liabilities, and the lack of EM equity participation reinforces that the recent rise in industrials is not a one way bet. Chart 3Newfound Optimism Newfound Optimism Newfound Optimism Chart 4Unsustainable Divergence? Unsustainable Divergence? Unsustainable Divergence? In addition to the overshoot in cyclicals relative to defensives, small cap performance relative to large caps has also spiked higher. We have been favoring small caps over larger S&P 500 companies based on several appealing fundamentals. Most importantly, small caps are appealing when the domestic growth outlook is rosier than the global backdrop, as is the case today. Despite the spike in small cap performance and the rising likelihood of a near-term correction, a strong U.S. dollar and likelihood of renewed emerging market financial strains argue for riding out any volatility and maintaining a core overweight in this asset class. We will recommend profit taking if evidence of a reversal in the small vs. large cap profit outlook materializes. The NIFB small business survey is already showing that labor compensation plans are rising faster than reported price changes. On this basis, headwinds to profit margins appear stiffer for the small business sector than for large companies. Granted, the big swing factor for large multinationals is the strong dollar and smaller domestic focused companies are relatively shielded from this risk. A pause or reversal in the dollar rally -if sustained even for a few months - would lessen the appeal to small caps. That is not our base case, and for now, we are comfortable sticking with a small cap bias. However, the small/large share price ratio is trading well above one standard deviation from its mean. Such a stretched technical level warns against getting too comfortable. The bottom line is that a consolidation phase in financial markets is overdue. Investors have pulled forward profit growth expectations due to anticipated fiscal stimulus at a time when domestic monetary conditions are tightening. Still, we remain constructive on risk asset prices on a cyclical basis. We expect earnings growth to be modest, but the likelihood of overshoots in equity prices in 2017 is high because the economic recovery is finally moving toward a more virtuous, self-reinforcing phase. That does not mean that the quiet ending to 2016 will be sustained throughout 2017. In BCA's annual outlook (published on December 20th), we outlined several regime shifts that we expect to occur in 2017. In the Appendix below, we provide a brief summary of these expected changes and the implications for financial markets. We will expand upon these themes in future reports. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com Appendix: Summary Bullets Of The BCA Annual Outlook: Shifting Regimes A number of important regime shifts will impact the economic and investment outlook over the next few years. These include the end of the era of falling inflation and interest rates, a move away from fiscal conservatism, a policy pushback against globalization, and a rise in the labor share of income at the expense of profit margins. Together with an earlier regime shift when the Debt Supercycle ended, these trends are consistent with very modest returns from financial assets over the next decade. The failure of low interest rates to trigger a vigorous rebound in private credit growth is consistent with our end-of-Debt Supercycle thesis. The end-point for dealing with high debt levels may ultimately be sharply higher inflation, but only after the next downturn triggers a new deflationary scare. The potential for trade restrictions by the incoming U.S. administration poses a threat to the outlook, but the odds of a global trade war are low. Time-lags in implementing policy mean that the fiscal plans of president-elect Trump will boost U.S. growth in 2018 more than 2017. This raises the risk of an overheated economy in 2018 leading to a monetary squeeze and recession in 2019. They key issue will be whether the supply side of the economy expands alongside increased demand and it will be critical to monitor business capital spending. Lingering structural problems will prevent any growth acceleration outside the U.S. The euro area and emerging economies are still in the midst of a deleveraging cycle and demographics remain a headwind for Japan. Not many countries will follow the U.S. example of fiscal stimulus. Nevertheless, for the first time since the recovery began, global growth forecasts are likely to avoid a downgrade over the next couple of years. China remains an unbalanced and fragile economy but the authorities have enough policy flexibility to avoid a hard landing, at least over the year or two. The longer-run outlook is more bearish unless the government moves away from its stop-go policy approach and pursues more supply-side reforms. Inflation has bottomed in the U.S., but the upturn will be gradual in 2017 and it will stay subdued in the euro area and Japan. Divergences in monetary policy between the U.S. and other developed economies will continue to build in 2017 as the Fed tightens and other central banks stay on hold. Unlike a year ago, the Fed's rate expectations look reasonable. Bond yields in the U.S. may fall in the near run after their recent sharp rise, but the cyclical trend is up against a backdrop of monetary tightening, fiscal stimulus and rising inflation. Yields in the euro area will be held down by ongoing QE, while the 10-year yield will stay capped at zero in Japan. The secular bull market in bonds is over although yields could retest their recent lows in the next downturn. The search for yield will remain an important investment theme, but rich valuations dictate only a neutral weighting in investment-grade corporate bonds and a modest underweight in high-yielders. The U.S. equity market is modestly overvalued, but the conditions are ripe for an overshoot in 2017 given optimism about a boost to profits from the new administration's policies. Earnings expectations are far too high and ignore the likelihood that rising labor costs will squeeze margins. Nevertheless, that need not preclude equity prices moving higher. There is a good chance of a sell-off in early 2017 and that would be a buying opportunity. Valuations are better in Japan and several European markets than in the U.S. and relative monetary conditions also favor these markets. We expect the U.S. to underperform in 2017. We expect emerging markets to underperform developed markets. The oil price should average around $55 a barrel over the next one or two years, with some risk to the upside. Although shale production should increase, the cutbacks in oil industry capital spending and planned production cuts by OPEC and some other producers will ensure that inventories will have to be drawn down in the second half of 2017. Non-oil commodity prices will stay in a trading range after healthy gains in 2016, but the long-run outlook is still bearish. The dollar bull market should stay intact over the coming year with the trade-weighted index rising by around 5%. Relative policy stances and economic trends should all stay supportive of the dollar. The outlook for the yen is especially gloomy. A stabilization in resource prices will keep commodity prices in a range. We remain bearish on EM currencies. The biggest geopolitical risks relate to U.S.-China relations, especially given president-elect Trump's inclination to engage in China-bashing. Meanwhile, the defeat of ISIS could create a power vacuum in the Middle East that could draw Turkey into a disastrous conflict with the Kurds and Iran/Russia. The coming year is important for elections in Europe but we do not expect any serious threat to the EU or single currency to emerge.