Developed Countries

Special Report

Highlights Safe-haven assets do not simply outperform equities on a relative basis during bear markets. In fact, the average return of nine safe-haven assets has been positive in every bear market since 1972. A safe haven should serve two purposes. First, it should have a negative correlation with equities during bear markets, not necessarily in all markets. Second, it should have an insurance-like payoff, surging during systemic crashes. Low intra-correlations between safe-haven assets, and substantial absolute differences between individual returns and the overall group average suggest that selection adds significant alpha. In the next bear market, we recommend positions in CHF over USD and JPY, due to its greater consistency as a safe-haven asset and more attractive valuations. Favor gold over farmland and TIPS, as gold offers a better hedge against political risks while still protecting against rising inflation. Overweight Treasuries relative to Bunds given a more appealing return distribution and high spreads. Feature Feature ChartSafe Haven Performance As the economic expansion approaches its 100th month, far longer than 38.7 month average1 of cycles starting from 1854, concerns continue to mount over the next recession and equity market crash. Memories of over 50% losses in stocks during the subprime crisis are still ingrained in investors' minds and the importance of capital preservation and safe-haven assets cannot be stressed enough. Safe-haven assets do not simply outperform equities on a relative basis during bear markets. In fact, during the subprime crisis, an equal-weighted portfolio of nine safe-haven assets actually increased in absolute value by 12% (Feature Chart)! This has held consistent through every bear market since 1972 and we expect the next crisis to be the same. While we do not expect a bear market in the next 12 months, we do stress the importance of being prepared and tactically flexible given the substantial relative and absolute performance of safe-haven assets. In this Special Report, we analyze behaviors of safe havens during past bear markets in order to recommend tilts to outperform during the next major equity selloff. Historical Perspective For our analysis, we used monthly return data to more accurately compare across asset classes. We used the following nine safe-haven assets: U.S. Dollar - As the world's reserve currency, the U.S. dollar benefits from massive trade volumes. Japanese Yen - Japan is still the world's 3rd largest economy and runs a current account surplus. Investors' perceptions of safety are intact and the currency benefits from unwinding of carry trades during risk-off environments. Swiss Franc - Switzerland has built a reputation for its international banking prowess, political neutrality and economic stability. U.S. Farmland - Farmland differs from the others in that it is a tangible, hard asset. With finite supply and an increasing population leading to higher needs for farming and food, demand will remain robust. U.S. Treasuries - Treasuries have essentially no default risk. Since its formation in 1776, the U.S. has never failed to pay back its debt. German Bunds - Germany benefits from being economically and politically stable. Bunds are extremely liquid and could receive capital inflows in the event of euro area disintegration. Gold - Gold has a longstanding history as a safe-haven asset, protecting against inflation, currency debasement and geopolitical risks. U.S. TIPS - TIPS are the purest inflation hedge; their historical performance has held a very tight correlation with realized changes in consumer prices. Hedge Funds - Hedge funds are attractive given their lack of restrictions and ability to short. We classified an equity bear market as a decline in the S&P 500, from peak to trough, larger than 19%.2 Using this definition, we recorded eight separate instances since 1972 (See Appendix). On average, these episodes lasted about 14 months and equity prices experienced declines of 34%. We examined returns, correlations and recession characteristics in order to draw conclusions about potential future behavior. Key Findings: During bear markets, the value of these nine safe havens increased on average by 9.2% (Table 1). This certainly does not offset the 34% average decline in equities, but it does provide a considerable buffer, particularly if allocators tilt asset class weightings. However, there is concern that safe havens as a whole will not provide as much protection in the next downturn as they have in the past, given weak equity inflows and still-considerable cash on the sidelines (Chart 2). The average absolute spread between the returns of the nine safe havens and their overall average return was 12.3%. While the correlations between financial assets tend to spike upwards during bear markets, they actually remain very low between safe-haven assets. This indicates a significant opportunity for alpha generation during equity downturns. The region from which a crisis stems has little impact on which safe haven outperforms. For example, U.S. Treasuries and the U.S. dollar both increased in value during the past two recessions, despite the tech bubble and subprime crisis originating from the U.S. (Chart 3). Capital inflows into those assets remained robust given their reputation for safety and quality. U.S. Treasuries and the Swiss franc always had positive absolute returns during the eight bear markets, and therefore have always had a negative correlation with equities (Table 2). These two assets have very stable reputations for safety. Nevertheless, other safe havens, such as gold, USD, JPY and Bunds, still maintained negative correlations with equities during most bear markets. U.S. farmland and U.S. TIPS also had positive returns in the three bear markets since their starting dates. Hedge funds, while known to outperform equities during bear markets, did not provide positive absolute returns in any of the four equity downturns since the index began. Table 1Bear Market Performance Chart 2Safe Havens: Less Protection Next Time? Chart 3Location Doesn't Matter Table 2Correlation With Equities Investment Implications Chart 4A Near-term Bear Market Is Unlikely It is crucial to understand the purpose of a safe-haven asset as it pertains to portfolio management. First, a safe-haven asset should have a negative correlation with equities during bear markets, not necessarily in all environments. Secondly, and more importantly, a safe-haven asset should have an insurance-like payoff, surging during systemic crashes. As safe havens naturally receive a smaller allocation in typical portfolios due to their underperformance versus equities in most years, it is imperative that relatively smaller weightings and minor tilts offset large declines in equity prices. It is important, however to note that we view the probability of a bear market as highly unlikely over the next twelve months (Chart 4). First, substantial stock price declines are not very common outside of recessions. As our colleague Martin Barnes points out, the yield curve is not inverted, there are no serious financial imbalances, and the leading economic indicator remains in an uptrend.3 Monetary conditions are still stimulative, and it generally requires Fed tightening to surpass equilibrium before recessions occur. Massive average absolute deviations for each individual safe haven from the overall group average and low intra-correlations suggest that selection adds significant alpha (Chart 5). Unlike most financial assets, intra-correlations between safe havens actually decline during bear markets. In order to best compare and contrast safe havens, we divided the assets into three buckets: currencies, inflation hedges and fixed income. Below, we recommend tilts within these buckets and will revisit these recommendations closer to the next bear market. Chart 5Intra-correlations Remain Low In Bear Markets Currencies: Overweight CHF relative to USD and JPY. As a zero-sum game, currency selection offers a critical avenue for alpha generation. As global growth continues to improve and capital flows to more cyclical currencies, or to the USD where policymakers are tightening, the Swiss franc should become even more attractively valued. The franc's considerable excess kurtosis, indicating higher likelihood of outsized returns, best fits the insurance-like payoff quality (Chart 6). It is the only currency to have outperformed, and therefore held a negative correlation with equities, during each of the eight recessions, indicating high reliability as a safe-haven asset. Going forward, we see no reason for Switzerland's reputation for economic stability or political neutrality to be compromised. The biggest risk to this view would be if the Swiss National Bank were to stick stubbornly to its peg of the CHF to the EUR during the next recession, thereby dampening the franc's risk-off properties. The USD has historically been able to outperform even when the crisis originated in the U.S. Historical bear market performance was greatest, however, following sharp Fed tightening such as the Volker crash, when the Fed increased rates in response to high inflation, or in the subprime crisis, when the Fed increased rates to slow growth (Chart 7). While we expect inflation and growth to grind upward over the cyclical horizon, our base case is not for a surge in consumer prices or for economic growth to expand significantly above trend. Chart 6Return Distributions Chart 7Fed Tightening = USD Outperformance In the next bear market, the JPY will likely benefit from cheap starting valuations as the BoJ is currently aggressively easing, and its current account surplus raises its fair value. Nevertheless, the yen's returns during equity downturns have not always been consistent with its safe haven reputation. Of the three currencies, since 1970, it has had the lowest probability for large returns. Inflation Hedges: Overweight Gold relative to TIPS and Farmland. Over most of the time frames we tested, gold had the highest correlation with both headline and core inflation (Tables 3 & 4). Table 3Correlation With Core Inflation Table 4Correlation With Headline Inflation The main differentiating factor with gold is its ability to hedge against political risk. Our geopolitical strategists found that of all of the safe-haven assets, gold offered the best protection against political shocks4 (Chart 8). As mentioned in one of our recent Special Reports,5 we believe that stagnation in median wages and wealth inequality will continue to fuel the rise in populism and social unrest. Chart 8Gold Is Best At Hedging Political Risk Farmland has historically offered decent inflation protection, but its history is limited, supply is scarce and the massive runup in prices is a cause for concern. While we currently favor TIPS over nominal bonds, their negative skew and excess kurtosis suggest that they are vulnerable to large negative returns, making them a less-than-ideal safe-haven asset. Fixed Income: Overweight Treasuries relative to Bunds. Concerns that, because government yields are starting at very low levels, bonds will not provide safety in the next bear market, are overblown. Recent history proves that yields can reach negative territory, and historical performance for government fixed income has been robust in almost every significant equity decline. Additionally, the end of the 35-year decline in interest rates should not negatively affect the protection capabilities of Treasuries. Yields actually rose leading up to, and during, the 1972 and 1980 bear markets, and Treasuries still provided positive absolute returns (Chart 9). One caveat is that starting yields are much lower today. If yields were to rise during the next recession, they may not achieve positive absolute returns, though government bonds would still certainly outperform equities by a wide margin. Overall, Treasuries have held a more negative correlation with equities during bear markets, spreads over Bunds will likely continue to rise given diverging monetary policy, and they have historically been more prone to outsized positive returns during crisis periods (Chart 10). Bunds are currently benefitting from flight-to-quality flows resulting from political and policy issues originating in the periphery. However, at some point, concerns that the euro crisis will spread to Germany may eliminate this advantage. Chart 9Rising Yields Were Not A Problem Chart 10Relative Treasury Valuations Will Become More Attractive Patrick Trinh, Associate Editor patrick@bcaresearch.com 1 http://www.nber.org/cycles.html. 2 While a 20% decline may be a more widely-used measure for bear markets, there have been three instances of 19% declines since 1972, one of which was a recession. We decided to include these in our analysis to increase the number of observations and improve the reliability of our analysis. 3 Please see The Bank Credit Analyst Special Report, "Beware The 2019 Trump Recession," dated 7 March 2017, available at bca.bcaresearch.com. 4 Please see Geopolitical Strategy Special Report, "Geopolitics and Safe Havens" dated November 11, 2015, available at gps.bcaresearch.com. 5 Please see Global Asset Allocation Special Report, "Refreshing Our Long-Term Themes," dated 5 December 2016, available at gaa.bcaresearch.com.

Highlights The U.S. dollar correction is entering its last innings as investors now only discount marginally more than one rate hike by the Fed over the next 12 months. The last leg of the USD's weakness is likely to be prompted by technical and political factors. Beyond this, the outlook for the U.S. economy remains healthy, yet investors have pared down their expectations, suggesting that positive surprises should emerge. The conciliatory tone of the so-called currency manipulator report suggests that the hopes of a Plaza 2.0 accord should get dashed. EUR/GBP has downside. Feature The dollar continues to decline. Doubts about President Trump's pro-growth agenda and higher borrowing costs are creating worries about future economic growth. Treasury Secretary Mnuchin's admonition that fiscal reform may be delayed only added fuel to the fire. The reality is a bit more nuanced than this. The global economy just experienced one of its most broad-based periods of improvement in decades. Earlier this year, our global economic and financial diffusion index, based on 106 indicators, hit its highest level since 1999 (Chart I-1). This upswing caused global growth expectations to surge, as highlighted by large moves in the global and U.S. stock-to-bond ratios. Chart I-1Broad-Based Economic Upswing Has Lifted Growth Expectations Still, such a pace of improvement is hard to maintain. The handicap is even greater given one of the sharpest increases in global borrowing costs of the past thirty years. Thus, an almost unavoidable growth disappointment is currently underway, as illustrated by the sudden swoon in global economic surprises. As negative surprises accumulate, it is natural for investors to tame their growth expectations, and in the process, to have pulled down their expectations for the level of the Fed funds rate 12 months out (Chart I-2). Unsurprisingly, the dollar has corrected in the process. Going forward, the flattening yield curve and weak inflation expectations could cause market expectations for the Fed Funds rate to fall further (Chart I-3). A downgrade in Fed expectations could push the DXY toward 97 - particularly given that the greenback currently stands at a crucial support (Chart I-4). Chart I-2A Full Rate Hike Has Been ##br##Purged From Expectations Chart I-3The Source Of ##br##The Worry Chart I-4Dollar At ##br##Crucial Spot Moreover, while our dollar capitulation index is already flirting with oversold readings, it can remain in that territory for extended periods of time. In fact, as long as this indicator stays below its 13-week moving average, the dollar tends to remain under downward pressure (Chart I-5). This would suggest that the window of weakness in the dollar has yet to be closed and that a break toward 98-97 in DXY is still very likely. Chart I-5Momentum Still A Headwind For The Dollar Outside of growth considerations, politics could also contribute to a last wave of selling in the dollar against the euro. Macron, the centrist candidate for the French presidency, is currently polling 25% of voting intentions for the first electoral round this weekend, ahead of Marine Le Pen. Yet the press continues to focus on Jean-Luc Mélanchon's surge in the polls, despite the fact that his popularity gains have stalled at 19%. This means that markets may get positively surprised Sunday night when French electoral results come in as the implied probability of a Le Pen / Mélanchon second round has risen. If as is more likely, Macron, not Mélanchon, makes it to the second round, it is important to remember that in head-to-head polls, he currently scores 64% vs 36% for Marine Le Pen (Chart I-6). Beyond these short-term dynamics, the outlook for the dollar continues to look brighter. To begin with, major leading indicators of the U.S. economy still point to a rebound later this year: The ISM manufacturing highlights that the decline in credit growth may be a temporary episode (Chart I-7). Chart I-6Positive Euro Stock This Weekend? Chart I-7U.S. Credit Growth Will Pick Up The U.S. CEO Confidence survey is at a 12 year high, and points toward both stronger capex and GDP growth (Chart I-8). The soft job number in March is likely to have been an aberration, as various indicators suggest that job growth will remain perky (Chart I-9). Moreover, this is happening in an environment where labor market slack is likely to prove limited. Not only is the headline U-3 unemployment rate now in line with NAIRU, but also hidden labor market slack - as approximated by discouraged workers and part-time workers for economic reasons - has greatly normalized (Chart I-10), suggesting that healthy job creation should result in accelerating wage growth this year. The elevated level of consumer confidence along with the healthy state of household finances - debt to disposable income still stands near 15-year lows and debt-service payments are at multi-generational lows - are together pointing toward stronger consumer spending. Chart I-8When CEOs Are Happy, ##br##So Is The Economy Chart I-9Soft March Payrolls: ##br##An Aberration Chart I-10U.S. Labor Market ##br##Slack Is Limited These developments are important as our Composite Capacity Utilization Gauge for the United States has now firmly moved into no-slack territory (Chart I-11). As such, improvements in the U.S. economy later this year will give the Fed plenty of ammunition to increase rates. Thus, we think that markets are ultimately underestimating the FOMC's capacity to lift rates by only anticipating marginally more than one rate hike over the next 12 months. Chart I-11U.S. Capacity Constraints Are Getting Hit As a result, buy any further dips in the dollar. We are already long the USD against commodity currencies, but will use any weakness to close our short USD/JPY trade and begin accumulating the dollar against the euro. In terms of level, we will close our short USD/JPY position at 107 and look to open a short EUR/USD bet at 1.10. Bottom Line: Markets are revising down their expected path for U.S. interest rates, causing a correction in the dollar in the process. After a period of robust and widespread growth improvement, expectations had become lofty and a period of indigestion was all but inevitable. However, forward looking indicators for U.S. growth are still healthy. With U.S. spare capacity becoming increasingly limited, investors are in the process of overdoing their downward adjustment in future U.S. rates. Use any further pull back in the U.S. dollar to buy the greenback. Currency Manipulators On Notice? Not Really This week, the U.S. Treasury published its annual report on Forex policies for the U.S.'s major trading partners, the so-called currency manipulator report. This time around, the report was especially interesting in light of the aggressive campaign rhetoric from President Trump. Chart I-12Conditions For Inflation Are ##br##Emerging In Japan Six countries were highlighted as hitting two of the three criteria necessary to be labeled currency manipulators. These were China, Germany, Japan, South Korea, Switzerland, and Taiwan. Most interesting was the tone of the discussion around China and Japan. Regarding China, the Treasury acknowledged that the PBoC is intervening in the currency market, however not to depress the value of the yuan, but to support it. The discussion was centered on the need for China to ease import restrictions and promote household consumption in order to narrow both the overall current account surplus and the bilateral trade surplus with the United States. These would be steps in the right direction to normalize the Sino-U.S. trade disequilibrium without entering in an all-out trade war. The discussion vis-à-vis Japan was also nuanced. Obviously, Japan's US$69 billion trade surplus with the U.S. was flagged, but the Treasury also acknowledged that the country's 3.7% current account surplus mostly reflected a very large positive income balance. Additionally, the Treasury also recognized that the large surplus was a reflection of Japan's poor domestic demand and that Japan needed to complement its very accommodative monetary policy with further fiscal boost and reforms. We interpreted this comment as a tacit acceptance that Abenomics and the BoJ's policy were squarely domestically focused and that the weak yen was a casualty, not the ultimate end-goal of these policies. With this recognition, it seems unlikely that the calls for a Plaza 2.0 accord would go anywhere. Instead, we expect similar demands to the one exerted on China to take precedence: more opening of the domestic market to imports and more Japanese FDI in the U.S. With this, the U.S. will live with a very dovish BoJ. In this optic, a key development emerged this week in Japan. Two BoJ governors have been replaced by two Abe philosophical allies, Mr. Hitoshi Suzuki and Mr. Goshi Kataoka. Therefore, Japan's monetary policy will remain very accommodative going forward as the near total control of the board by ultra-doves reinforces the institution's commitment to "irresponsible" monetary policy. Most importantly, our Composite Capacity Utilization Gauge for Japan is now in the zone where core inflation should accelerate (Chart I-12). This suggests that inflationary dynamics are likely to emerge after the current wave of global negative economic surprises abates. This should result in exactly what the BoJ wants: lower real rates and higher inflation expectations. This would be poisonous for the yen. Any further yen rally should be used to once again short the JPY. With regards to Germany, the Treasury acknowledged that ECB monetary policy is out of Berlin's control, but it would like to see more efforts to boost domestic demand, and a higher real exchange rate. In other words, at this point the Treasury seems to be hoping for higher German inflation more than for a higher euro. This too is re-assuring considering the initial aggressive stance of the Trump administration toward Germany. Switzerland, Korea, and Taiwan are in slightly more precarious conditions as all have been engaging in open market operations to depress the value of their currencies in recent years. However, with the softened tone exhibited toward China, Japan, and Germany, there is a high chance that the Treasury will find ways to turn a blind eye on these countries going forward. Bottom Line: The current U.S. administration is softening its tough rhetoric on trade and it is coming to grips with the reality that it may not be able to bully its trading partners into appreciating their currencies. Instead, Trump is likely to have to be content with fewer trade barriers to access these nations, and further efforts to stimulate domestic demand, which indirectly may help U.S. exports to these countries. We see these developments as steps in the right direction that should decrease the risks currently hanging over global trade. Politics Abound: What To Do With The Euro And The Pound? This week, Theresa May called for a snap election on June 8. The market perceived this announcement as very positive for the U.K.: it will decrease the risk of a very harsh form of Brexit. A larger Conservative victory, which seems highly likely based on current polls, implies that May will be less reliant on the most extremist Brexiters to govern. As such, the U.K. is perceived to be more likely to concede on some key EU demands such as Brussels's request that London pays the GBP 60 billion it owes to the EU's 2014-2020 budget. If these demands are met by the U.K., it is expected that the EU will be less intransigent when it comes to negotiating transitional agreements. On these dynamics, GBP/USD rallied 2.2% on Tuesday and now stands above its 200-day moving average for the first time since that fateful June 2016 night. EUR/GBP too was hurt by the pound rally, retesting its post referendum lows. What is the outlook for GBP/USD and EUR/GBP? The picture for EUR/GBP is the cleanest. A quick rally next week if Macron clenches a spot in the second round of the French election is very likely, especially as investors might have discounted the positive implications of the election on the pound too quickly. Any such rally should be used to begin building short EUR/GBP positions. EUR/GBP is currently trading 12% above its PPP fair value, but it is also trading at a large premium to real interest rate differentials (Chart I-13, top panel). Moreover, investors are starting to adjust upward the expected path of short rates in the U.K. relative to the euro area. This historically has been associated with a stronger pound (Chart I-13, bottom panel). Additionally, as we have argued, the negative factors affecting the U.K. economy are well known. Yet, the stability of long-term U.K. household inflation expectations suggests that the adjustment in consumption in response to high inflation caused by the lower pound could be limited as households may look through any temporary bump in inflation.1 Finally, positioning and sentiment on EUR/GBP are extremely stretched. Historically, such extended levels of bullishness toward the euro relative to the pound have been followed by sharp sell-offs in EUR/GBP (Chart I-14). Chart I-13Real Rates Points To ##br##EUR/GBP Downside Chart I-14Investors Are Positioned For##br## Further Euro Strength When it comes to the GBP/USD, the pound may continue to rebound in the short term toward 1.35. However, the upside in GBP/USD is likely to be capped if our bullish view on the dollar does pan out. This is why we prefer to express positive views on the pound via a short position in EUR/GBP. Bottom Line: The June 8 U.K. general election is important as it does increase the probability that Theresa May will be able to soften the U.K.'s negotiating stance on key budgetary points regarding Brexit. This means that longer and smoother transitional agreements between the U.K. and the EU are likely to emerge at the end of the Article 50 negotiations. Meanwhile, EUR/GBP is expensive relative to PPP metrics and rate differentials. The risk of a breakdown below 0.83 is growing, especially as investors are not positioned for a rally in the pound against the euro. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the U.K. economy, please refer to the Foreign Exchange Strategy Special Report titled "GBP: Dismal Expectations", dated January 13, 2017 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The greenback's weakness has been a result of declining price and wage pressures this month. A weaker than expected jobless claims and Philadelphia Fed Manufacturing Survey are both indications of the current economic soft patch. However, this is a temporary setback that will do little to alter the Fed's intended hiking cycle. The DXY is currently at a crucial technical level and could face significant pressure from an appreciating euro in the run-up to the French elections. After the outcome of these elections is digested, a return to robust U.S. data will likely propel the greenback upwards as the Fed will keeping lifting rates relative to the rest of the G10. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro strengthens on the back of an optimistic interpretation of Praet's speech in New York. The central banker alluded to diminishing growth risks, but pointed out that short-term risks still remain. It seems that markets have priced in the end of the ECB's easing cycle. Further lifting the euro is expectations that Emmanuel Macron is on his way to the second round of the French election. However, it remains true that peripheral economies are stumbling along with high unemployment and little-to-no wage growth, which points toward widening U.S./European real rate differentials in the longer term. Inflation figures remained unchanged in March both in monthly and annual terms. An annual core inflation figure of 0.7% implies that inflationary pressures remain muted. A bearish outlook on the euro after the French elections is warranted. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 ECB: All About China? - April 7, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 On Tuesday the Japanese parliament nominated Hitoshi Suzuki and Goshi Kataoka to replace two members of the BoJ who had been serial dissenters of Governor Kuroda. This development is important as both of the nominees are known reflationists, which confirms our thesis that the Abe government is committed to support Kuroda's agenda. As the BoJ becomes increasingly dominated by doves, Kuroda will have more leeway in implementing radical reflationary measures, which is bearish for the yen on a cyclical basis. On a tactical basis, we believe the downtrend in USD/JPY might be approaching its last legs, given that we expect the dollar correction to end soon. On the other hand, a risk-off period in the markets seems probable, thus we will stay short NZD/JPY to capture investor's risk aversion. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Cable surged following Theresa May's call of a snap election as the market became less bearish on the U.K. economy given that the election provides an opportunity for the Prime Minister to assert her power over the more radical MPs, and thus set the stage for a softer Brexit. We continue to be relatively optimistic on the pound, particularly against the euro, as we believe that the market is too pessimistic on the U.K. economy. Furthermore, the BoE has shown much less dovish than the ECB as Governor Carney has stated that they will undergo "some modest withdrawal of stimulus" in the next few years, while many members seem to be leaning towards a rate hike. Taking these factors into account, as well as the overly bullish positioning on the euro relative to the pound, we are now confident in shorting EUR/GBP. 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 Chart II-10AUD Technicals 2 The antipodean currency experienced significant downside amidst dovish remarks by the RBA. Highlighted in the minutes were worries associated with the labor market, with members citing higher unemployment and underemployment as contributors to faltering wage growth. As a corollary, the rise in underlying inflation is expected to be "more gradual", with headline inflation expected to reach its 2% target sometime this year. However, members also stressed the role of energy prices, which could complicate the process. An important observation is the adverse impact of Hurricane Debbie on coal production, a major export for Australia. In merrier news, China's economy outperformed expectations, achieving a growth rate of 6.9% in Q1. However, this is a backward looking indicator and likely corroborates the AUD's strength in Q1, while the recent weakness in Chinese capital spending plans and residential property prices are more accurate indicators of future AUD development. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 This week, kiwi headline inflation came at 2.2%, not only surpassing expectations but also reaching the upper half of the 1%-3% target inflation range for the RBNZ. This confirms our suspicion that inflationary pressures in New Zealand are much stronger than what the RBNZ would lead you to believe, and opens the possibility that the RBNZ could abandon its neutral bias for a more hawkish one. This should help the NZD outperform the AUD on a cyclical basis, given that the Australia's domestic inflationary pressures are much weaker. On a tactical basis, we continue to be short the NZD relative to the JPY, given that a China induced risk-off episode will boost safe heavens and hurt carry currencies. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Within the commodity space, CAD should benefit against other commodity currencies. Oil is likely to face relatively consistent global demand vis-a-vis other commodities, such as industrial metals, as it is more insusceptible to the "unwinding of the Trump trade". Moreover, BCA foresees an extension of the OPEC production cuts for the remainder of the year, which will support oil-based currencies. Faltering capital expenditure in China will work against industrial metal demand, further accentuating this development. Limiting the CAD's upside, however, is a stronger USD this year, most probably after April is over. Real rate differentials will evolve in favor of the USD, limiting the upside to commodity prices in general. The result will be an outperformance of CAD relative to AUD and NZD. Finally, the recent non-resident tax implemented by Ontario my cause hick-ups in Canada's largest housing market. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Economic data in Switzerland continues to improve as various measures such as manufacturing PMI, employment PMI and purchase prices have reached 2011 highs. These developments along with rising inflation, will reassure the SNB that the unofficial floor under EUR/CHF has been effective. Nevertheless, we expect the SNB to keep this floor in place until the end of the year, as not only do French elections pose a short term risk, but core inflation and wage growth would have to stay high for a sustainable period of time for the SNB to consider removing accomodation. Moreover, the removal of the floor would likely be gradual, as the SNB has learned from 2015 that a sharp appreciation in the franc could quickly undo any economic progress. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Although USD/NOK has been quite uncorrelated with oil in recent months, EUR/NOK continues to be highly correlated with oil prices. Overall, we expect the NOK to exhibit weakness against the dollar on a cyclical basis given that dollar bull markets tend to weigh on this cross. Moreover, the Norges Bank will continue to have a dovish bias, given that inflation is falling sharply and economic conditions remain weak. However, on a tactical basis, it is possible that the NOK outperforms the AUD, given that base metals are more sensitive to weaknesses in the Chinese economy. Oil, on the other hand, should stay relatively resilient, given that an extension of the OPEC deal until the end of the year seems very likely. 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 Chart II-20SEK Technicals 2 The SEK has largely been trading on the news flow from the U.S. and the euro area following a quiet week in Sweden. Similar to the DXY, USD/SEK is at a crucial technical spot, and EUR/SEK is likely to continue its uptrend in the run-up to the French election. Next week's Riksbank meeting is the last meeting before asset purchases end in June. As inflationary pressures are unlikely to subside substantially, we firmly believe that asset purchases will not be extended further. Nevertheless, while not shifting the policy rate, the Riksbank is likely to reiterate that a future cut is more likely than a future hike, especially as recent inflation figures have disappointed. This is likely to help USD/SEK in the longer run. 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

Bank stocks have been under pressure for the past six weeks, undermined by uninspiring bank earnings, a flattening yield curve and jump in global geopolitical uncertainty. As the Economic Surprise Index mean reverts, commodity prices correct and inflation expectations ease, there could be some additional near-term underperformance risk. Nevertheless, improving value should eventually lead to a buying opportunity. U.S. banks are adequately capitalized owing to the Fed's strict supervision, non-performing loans are at cycle lows and charge-offs remain muted. If the jump in animal spirits begins to lift real economic activity later this year, capital demands could finally break out of their slump and reinvigorate moribund loan demand. We remain underweight, but will look for buying opportunities. The S&P banks index is now on upgrade alert. The ticker symbols for the stocks in the S&P banks index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.

Highlights Treasury yields have slumped since early March, helping to push down the dollar. Slower U.S. growth in the first quarter of the year, weak inflation readings, uncertainty on tax reform, the prospect of a government shutdown, and rising political risks in Europe have all contributed to the Treasury rally. Looking out, U.S. growth should accelerate while growth abroad will stay reasonably firm. The market is pricing in only 34 basis points in rate hikes over the next 12 months. This seems too low to us. Go short the January 2018 fed funds futures contract. Feature What Explains The Treasury Rally? Global bond yields have swooned since early March. The 10-year Treasury yield fell to as low as 2.18% this week, down from a closing high of 2.62% on March 13th. A number of fundamental factors have contributed to the Treasury rally: Recent "hard data" on the U.S. growth picture has been somewhat disappointing. The Atlanta Fed's model suggests that real GDP expanded by only 0.5% in Q1 (Chart 1). So far this month, hard data on payrolls, housing starts, and auto sales have fallen short of consensus expectations. Credit growth has also decelerated sharply (Chart 2). The prospect of tax cuts this year have faded. Treasury Secretary Steven Mnuchin told the Financial Times on Monday that getting a tax bill through Congress by August was "highly aggressive to not realistic at this point."1 Meanwhile, worries about a government shutdown - possibly coming as early as next week - have escalated. Recent inflation readings have been on the soft side. Core CPI dropped by 0.12% month-over-month in March, the first outright decline since 2010. China's growth outlook remains cloudy. Government officials warned this week that recent measures undertaken to cool the housing sector will begin to bite later this month.2 Concerns that the French election will feature a runoff between the "Alt-Right" candidate, Marine Le Pen, and the "Ctrl-Left" candidate, Jean-Luc Mélenchon, have intensified (Chart 3). Euroskeptic parties also continue to make gains in Italy (Chart 4). Chart 1A Disappointing First Quarter Chart 2Credit Growth Slowdown While none of the things listed above can be easily dismissed, the key question for fixed-income investors is whether bond yields are already adequately discounting these risks. Keep in mind that markets are pricing in only 34 basis points in Fed rate hikes over the next 12 months (Chart 5). This is substantially less than the median "dot" in the Summary of Economic Projections, which implies three more hikes between now and next April. Chart 3French Elections: A Many-Way Race? Chart 4Euroskepticism Is On The Rise In Italy Chart 5Markets Are Too Sanguine About The Fed's Rate Hike Intentions U.S. Economy Still In Reasonably Good Shape Our view on rates for the next year is closer to the Fed's than the market's. Yes, the "hard data" on U.S. growth has been lackluster. However, as we discussed last week, the hard data may be biased down by seasonal adjustment problems.3 Moreover, the hard data tend to lag the soft data, and the latter remain reasonably perky. Reflecting the strength of the soft data, our newly-released Beige Book Monitor points to an improving growth picture across the Fed's 12 districts (Chart 6). Worries about plunging credit growth are also overstated. While the increase in interest rates since last year has likely curbed credit demand, some of the recent deceleration in business lending appears to be due to the improving financial health of energy companies. Higher profits have permitted these firms to pay back old bank loans, while also enabling them to finance new capital expenditures using internally-generated funds. In addition, the rising appetite for corporate debt has also allowed more companies to access the bond market. According to Bloomberg, the U.S. leveraged-loan market saw $434 billion in issuance in Q1, the highest level on record (Chart 7). Chart 6Fed Districts See Things Improving Chart 7More And More Leveraged Loans Looking out, business lending should pick up. The Fed's Senior Loan Officer Survey indicates that banks stopped tightening lending standards to businesses in Q1. This should help boost the supply of credit over the coming months (Chart 8). Meanwhile, the recovery in the manufacturing sector will bolster credit demand. Chart 9 shows that an increase in the ISM manufacturing index leads business lending by 6-to-12 months. Chart 8Bank Lending Standards: Stable For Businesses, Tighter For Consumers Chart 9Manufacturing ISM Points To A Pick Up In Business Lending As far as household credit is concerned, higher interest rates and tighter lending standards for consumer loans (especially auto loans) are both headwinds. Nevertheless, overall household leverage has fallen back to 2003 levels and the household debt-service ratio is at multi-decade lows (Chart 10). And while delinquencies have edged higher, they are still well below their historic average (Chart 11). Chart 10Lower Household Leverage Chart 11Despite Slight Uptick, Delinquency Rates Remain Well Contained A reasonably solid growth picture should help lift inflation over the coming months. Chart 12 shows that inflation tends to accelerate once unemployment falls below its full employment level. The U.S. headline unemployment rate currently stands at 4.5%, below the Fed's estimate of NAIRU. Other measures of labor market slack also point to an economy that is quickly running out of surplus labor (Chart 13). As such, it is not surprising that the Atlanta Fed's wage tracker continues to trend higher, as has the NFIB's labor compensation gauge and most other measures of labor compensation (Chart 14). Chart 12The Phillips Curve Appears To Be Non-Linear Chart 13Disappearing Labor Market Slack Chart 14U.S.: Broad Measures Pointing To Rising Wage Pressures Wage Growth Trending Higher U.S. Political Risks Will Diminish... The political risks which have pushed down Treasury yields since early March should also subside over the coming weeks. Concerns that the Trump administration will be unable to pass tax cuts are overblown. Unlike in the case of health care, there is virtual unanimity among Republicans in favor of cutting taxes.4 Congressional hearings on tax reform are scheduled to begin next week. We expect Trump to move quickly to get a deal done. He needs a political victory and this is his best shot. We are also not especially worried about the prospect of a government shutdown. Congress needs to agree on a bill to extend government funding beyond April 28 when congressional appropriations are set to expire. So far, Republican leaders are pursuing a sensible strategy of keeping controversial items - including funding for a border wall and cuts to Obamacare subsidies - out of the bill in the hopes of attracting enough Democrat support to avoid a filibuster in the Senate. Without the inclusion of these contentious measures, it would be politically difficult for the Democrats to take any action that triggers a government shutdown, as they would be blamed for the outcome. ...As Will Risks In Europe... Chart 15The French Are Not Euroskeptic In the U.K., Prime Minister Theresa May's decision to hold a snap election reduces the risk of a "hard Brexit." The current slim 17-seat majority that the Conservatives hold in Parliament has made May highly dependent on a small band of hardline Tories. These uncompromising MPs would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. If the Conservative Party is able to increase its control over Parliament - as current opinion polls suggest is likely - May will have greater flexibility in reaching an agreement with Brussels and will face less of a risk that Parliament shoots down the final deal. Worries about the outcome of French elections should also diminish. Opinion polls continue to signal that Emmanuel Macron will make it to the second round of the presidential contest. If that happens, he would be a shoo-in to win against either Marine Le Pen or the far-left challenger Jean-Luc Mélenchon. Even in the unlikely event that Le Pen or Mélenchon ends up prevailing, their ability to push through their agendas would be severely constrained. Neither candidate is likely to secure a majority in the National Assembly when legislative elections are held in June. French presidents have a lot of leeway over foreign affairs, but need the support of parliament to change taxes, government spending, regulations, or most other aspects of domestic policy.5 Also, keep in mind that France's place in the EU is enshrined in the French constitution. Any modifications to the constitution would require that a referendum be called. Considering that French voters are highly pessimistic of their future outside of the EU, it would require a seismic shift in voter preferences for France to end up following the U.K.'s example (Chart 15). ...And In China Lastly, the risks of a trade war between the U.S. and China have eased following President Trump's summit with President Xi. This should help stem Chinese capital outflows. On the domestic front, the government's efforts to clamp down on property speculation will cool the economy. However, as our China team has pointed out, this may not be such a bad thing, given that recent activity has been strong and parts of the economy are showing signs of overheating. Investment Conclusions Chart 16Bet On The Fed The reflation trade will eventually fizzle out, but our sense is that this will be more of a story for late next year than for 2017. For now, underlying global growth is still strong and the sort of imbalances that usually precipitate recessions are not severe enough. If there is going to be one big surprise in the U.S. fixed-income market this year, it is that the Fed sticks to its guns and keeps raising rates at a pace of roughly once per quarter. With that in mind, we recommend that clients go short the January 2018 fed funds futures contract as a tactical trade (Chart 16). A rebound in U.S. rate expectations will lead to a widening in interest rate differentials between the U.S. and its trading partners. This will produce a stronger dollar. The yen is likely to suffer the most in a rising rate environment, given the Bank of Japan's policy of keeping the 10-year JGB yield pinned close to zero. On the equity side, we continue to recommend a modestly overweight position in global stocks. Investors should favor Japan and the euro area over the U.S. in local-currency terms. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Sam Fleming, Demetri Savastopulo, and Shawn Donnan, "Interview With Steven Mnuchin: Transcript," Financial Times, Monday April 17, 2017. 2 Li Xiang, "Real Estate Investment Likely To Slow Down," Chinadaily.com.cn, April 18, 2017. 3 Please see Global Investment Strategy Weekly Report, "Talk Is Cheap: EUR/USD Is Heading Towards Parity," dated April 14, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 5 Please see Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Utilities stocks are gathering pace relative to the broad market, and there are good odds that the sector will break above key resistance at its 40-week moving average. The Economic Surprise Index is starting to roll over (shown inverted, top panel), which is putting a solid bid under the Treasury market. 10-year yields have additional downside as inflation expectations decelerate, given the valuation starting point. History shows that forward utilities returns are strong when Treasury yields retreat from undervalued levels. Importantly, sector pricing power has surged as a consequence of increased output, an upturn in utilization rates and stronger natural gas prices. We reiterate our recent upgrade to a tactical overweight stance.

Highlights The July 2016 to January 2017 doubling of the global bond yield was possibly the sharpest ever 6-month spike in modern economic history. Its toll is a global growth pause - evidenced by the post February 2017 synchronized retracement of bond yields, commodity prices, steel production, and cyclical equity prices. Until bank credit flows stabilize, stay cyclically overweight bonds - especially T-bonds... ...and stay underweight bank equities, but overweight real estate equities. Fade any knee-jerk move in the CAC40 after the French Presidential Election first round result. Feature Since February, world bond yields have edged down in synchronized fashion; commodity prices - including the global bellwether Dr. Copper - have fallen together (Chart I-2); global steel production has suffered an abrupt reversal; and cyclical sectors in the stock market have rolled over (Chart I-3). Chart of the WeekSharpest Proportionate Change In Bond Yields... Ever? Chart I-2Compelling Evidence Of A Global Growth Pause: ##br##Bond Yields And Commodity Prices Have Rolled Over Chart I-3Steel Production And Cyclical Equity##br## Sectors Have Rolled Over Too For us, the synchronized decline in the four separate indicators - bond yields, commodity prices, steel production, and cyclical equity prices - can mean only one thing: a global growth pause. The Largest Proportionate Increase In Bond Yields Ever... To make sense of what is happening, let's ask a simple but crucial question. If interest rates go up, from say 1% to 2%, is it the absolute increase - of 1% - that matters more for the economy, or is it the proportionate increase - a doubling - that matters more? We ask this simple question because the 0.75% absolute increase in the global government bond yield through July 2016 to January 2017 amounted to one of the sharpest rises in the past decade (Chart I-4). But when it comes to the proportionate increase, the doubling of the global yield in 6 months was the sharpest spike in at least 70 years, and quite possibly the sharpest 6-month spike ever in economic history! (Chart I-5 and Chart of the Week). Chart I-4A Sharp Absolute Spike In ##br##Global Bond Yields... Chart I-5...But An Extremely Sharp ##br##Proportionate Spike Anybody with a mortgage knows that it is not the absolute change in the mortgage rate that matters for your budget; it is the proportionate change that matters. A 1% rise in rates hurts much less when rates start high than when they start low. One way to see this is that to note that a 1% spike in U.K. bond yields over six months was extremely common in the 1970s and 80s - when the level of yields was already high. But outside this era of high nominal numbers, a 1% yield spike over six months is almost unheard of (Chart I-6 and Chart I-7). Chart I-6A 1% Rise In Bond Yields Over Six Months Was Very Common In The 70s And 80s Chart I-7But Today A 1% Rise Equates To An Extreme Proportionate Increase Some people might counter that interest payments are just a transfer from borrowers to savers. For every borrower who complains at a doubling of his interest outlays, there is a mirror-image saver who rejoices at a doubling of his interest income. But understand that higher interest rates do not just redistribute spending power from borrowers to savers. The much more important economic effect almost always comes from the impact on bank lending. Fractional reserve banking allows banks to create money out of thin air. When a bank issues a new loan, the borrower's spending power instantaneously goes up, but there is no equal and opposite saver whose spending power goes down. ...Takes Its Toll On Bank Lending Our thesis is that the change in bank lending depends on the proportionate change in long-term interest rates. If long-term rates rise by, say, 1% then a certain proportion of investment projects will suddenly become unprofitable. Firms (and households) would stop borrowing for such projects, and the drop in borrowing would equal the proportion of projects impacted. It should be clear that the distribution of investment project returns is much wider in an era of high nominal numbers when interest rates are, say, 10% than in an era of low nominal numbers when interest rates are, say, 1%. So the impact on borrowing of a 1% rise in rates is much less when rates are high - as they were in the 1970s and 80s - than when rates are low - as they are today. In other words, the impact depends on the proportionate increase in interest rates. And this explains why a 1% spike in U.K. bond yields over six months was extremely common in the 1970s and 80s, but is almost unheard of now. Some commentators point out that working in the other direction are so-called "animal spirits" - increased optimism about the future and the returns that all investment projects will generate. But as we explained in Credit Slumps While Animal Spirits Soar, Why? 1 the greatest proportionate 6-month increase in global bond yields for at least 70 years has understandably trumped these putative animal spirits. Bank credit flows have slumped. In practice, changes in borrowing can take 3-6 months to impact spending. For this reason, we tend to monitor the change in the credit flow in the last 6 months versus the preceding 6 months. Recently, this global 6-month credit impulse has headed sharply lower (Chart I-8). Chart I-8The Global 6-Month Credit Impulse Has Headed Sharply Lower Putting this all together, the sharpest spike in global bond yields in living memory has taken an understandable toll on bank credit creation and the global 6-month credit impulse. In turn, the slump in the credit impulse is now weighing on the global growth mini-cycle - as signaled by the synchronized retracement in bond yields, commodity prices, steel production and cyclical equity performance. The evidence compellingly suggests that we are two months into a global growth pause. But mini down-cycles tend to last, on average, about six months. So for the time being, and at least until bank credit flows stabilize, own bonds - especially T-bonds - and avoid cyclical equity exposure. Furthermore, as we presciently argued in our February 16 report The Contrarian Case For Bonds, when bond yields decline, bank equities are losers and real estate equities are winners. These arguments still hold. A Brief Comment On Upcoming Elections: France And The U.K. Ahead of the French Presidential Election first round on April 23, we would like to remind readers of two facts. First, the CAC40, like most mainstream European equity indexes, is a collection of large multinational companies. As such, it is not a play on French economics or politics. Indeed, compared to other European indexes, the CAC40 underexposure to banks actually makes it one of the more defensive European equity indexes. Given the loose connection between the index and domestic economics and politics, fade any knee-jerk move that happens after the first round result: sell any relative rally; buy any relative dip. Second, euro area sovereign credit spreads must ultimately relate to the relative competitiveness of their national economies, as this is what would determine the size and direction of redenomination were the euro to break up. In this regard, there is now no difference in competitiveness between France and Spain (Chart I-9), yet Bonos still yield more than OATs. So for long-term investors, it is still right to be long Spanish Bonos versus French OATs. Chart I-9France And Spain Have Converged On Competitiveness We will wait until the more important second round vote on May 7 to present a more detailed assessment of the impact of French politics on the European economic and investment landscape. Lastly, a quick comment on the likely snap U.K. General Election on June 8: the conventional wisdom states that U.K. politics will drive the type of Brexit; and the type of Brexit will drive the long-term destiny of the U.K. economy. But for us, the causality runs the other way round. The U.K. economy will drive the type of Brexit - the weaker the economy gets, the softer that Brexit will get (and vice-versa); and the type of Brexit will drive the long-term destiny of U.K. politics. Therefore, for us, the General Election does not appear to be a game changer - unless it delivers a shock result. I am on holiday right now, so I will cover this topic in more depth on my return next week. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on March 30, 207 and available at eis.bcaresearch.com Fractal Trading Model There are no new trades this week, but all three open positions are now in profit, having produced classic liquidity-triggered trend reversals. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Special Report

Highlights Expanded data availability and increasingly systemized investment processes have powered a surge of interest in factor attribution among academics, quants and ordinary investors. Momentum has long been recognized as a proven factor. Kenneth French's database shows that a zero-net-exposure strategy of shorting the stocks with the weakest momentum to fund the purchase of their strong-momentum counterparts yielded over 10% per year from 1939-1999. Since the crisis, however, momentum has lost its magic touch. As in the 1930s, Fama and French's long/short momentum strategy has stumbled following a crash. The long leg of the strategy's outperformance record remains intact, though, just as it has across the 90 years covered by the Fama-French database. In this Special Report, we examine some hypotheses for why momentum has lost some of its edge and consider the conditions under which it might fully regain it. We then consider the current crop of smart-beta momentum funds based on the features we would like to have in a momentum fund once the factor fully recovers its footing. Feature Regular readers will recognize this installment of our smart-beta ETF series as a departure. Unlike the Value and Dividend Special Reports, this one does not employ the relevant metrics from our Equity Trading Strategy's ("ETS") proprietary multi-factor model to evaluate single-factor ETFs. The momentum factor's post-crisis stumbles may indicate that the classic momentum yardsticks are in need of realignment, and the modest pool of smart-beta momentum ETFs can be winnowed without them. We instead use this Special Report to explore the momentum factor: its empirical history, potential explanations for its long success and current slump, and its interaction with the fed funds rate cycle. We will examine the links between the big picture and factor performance next month, with a particular focus on monetary policy settings. Careful study of the relationship between macro variables and equity factors may shed some light on the most opportune cycle phases for seeking particular factor exposures. It will also illustrate how individual factors could interact within a portfolio to boost risk-adjusted returns. The series' primary goal is still to provide our clients with a solid grounding in the basics of factor investing and the smart-beta process. It is our hope that the addition of macro-level guidance to help recognize the best cyclical backdrops for taking on factor exposures will enhance the micro-level guidance to help choose the optimal ETFs for gaining exposure to a particular factor. The Momentum Paradox Traders are a famously empirical breed with little use for fancy theories. Their common-sense mantras that survive long enough to pass into general use are based on steady observation and hard-won experience. Two of our favorites sum up the duality at the heart of momentum investing: The trend is your friend. Trees don't grow to the sky. Trader intuition is valid: academic research has repeatedly confirmed the existence and persistence of momentum. Alas, it doesn't last forever. The challenge at the heart of developing a working momentum strategy is determining how long the typical trend runs before it reverses. Investors have much longer timeframes than traders, but they would do well to heed traders' warning about overstaying one's welcome when they plot their course: Bulls make money; bears make money; pigs get slaughtered. A History Of Momentum In Five Chapters The Golden Age, 1939-1999 Momentum shot the lights out for 60 years. From late 1939, when it finally threw off the lingering effects of the Great Depression, until the peak of the tech bubble in early 2000, a simple zero-net-exposure strategy developed by Fama and French (please see Box 1 for the parameters of the strategies referenced herein) generated a whopping 10.4% compound annualized return (Chart 1, Phase 3). The strategy's consistency may have been even more remarkable. The 60-year golden age included just one bear event (a peak-to-trough decline of at least 20%),1 and a mild and brief one at that.2 Data from Jegadeesh and Titman, co-authors of the seminal momentum-focused paper,3 corroborate Fama and French's findings. Tracking the results of 32 separate strategies from 1965 to 1989 (Box 1), Jegadeesh and Titman definitively established that the momentum factor generates statistically significant excess returns. The 6-month, 6-month strategy on which they focused (shorting the last six months' biggest laggards to fund the purchase of its biggest outperformers, and holding the portfolio for six months) generated an average compound annual return of 12%.4 The Roaring Twenties, 1927-1932 The Fama-French momentum strategy blasted out of the gate with compound annual returns of 29% through June 1932 (Chart 1, Phase 1). Full year returns were at least 20% every year from 1927 through 1931, as momentum was impervious to the 1929 Crash. This chapter illustrates that stock-price momentum is hardly a new phenomenon, and that momentum strategies, which often zig when the broad market zags, can contribute welcome diversification to a portfolio. The First Failure, 1932-1939 The party came to an abrupt end in July and August 1932, when the strategy lost three-quarters of its value in two months (Chart 1, Phase 2). As the financial crisis would reiterate seven decades later, momentum crashes can be vicious and swift. This one was followed by several years of listless performance, capped by a brutal coda. The aftershocks can be much worse for momentum than the earthquake itself, and it only hit bottom after September 1939's 30% decline. The Wobbly Years, 2000-2008 The end of the tech bubble marked a watershed for momentum. Although the strategy generated hearty positive returns given its zero net exposure (4.7% CAGR from March 2000 through November 2008), its return profile became uncharacteristically volatile (Chart 1, Phase 4). Momentum bear markets became a regular feature, with three separate declines of 23% to 32% occurring between February 2000 and August 2004. Academic research into the momentum factor became a veritable cottage industry after its discovery in the early 1990s, making this the first chapter to unfold against a backdrop of wide investor awareness of its existence. The Crisis and Its Aftermath, 2008-2017... The spring of 2009 witnessed the second great momentum crash, with the strategy losing 58% from its November 2008 peak to its September 2009 trough, sustaining a 49% loss over just the three months of March (-11.5%), April (-34.6%) and May (-12.3%) (Chart 1, Phase 5). The strategy has crept back to post a 3% compound annualized return since the trough, but it has recovered just 18% of its peak-to-trough decline in the ensuing seven-and-a-half years,5 and it just entered a bear market for the first time since the '08-'09 crash. Highlighting its extended slump, the strategy now trades at a level it first reached in December 1999. What Makes Momentum Tick? As with all factors, the jury is out on just what drives momentum's performance. Some researchers have argued for a risk-based explanation, but we do not see momentum as especially risky, relative to other strategies6 (Table 1), and therefore have more sympathy for the behavioral hypotheses advanced by the academic consensus. These hypotheses coalesce around the sense that markets systematically underreact to information, perhaps because of the time required to fully digest it or because the disposition effect lures investors into parting with winning positions too quickly and holding onto losing positions too long. As the built-in lags between portfolio formation and activation described in Box 1 recognize, however, the medium-term underreaction reliably follows an immediate overreaction. Table 1Market-Neutral Momentum Versus The Broad Market BOX 1 Momentum Strategy Parameters We refer to two distinct approaches to building momentum portfolios in this Special Report: Fama and French's single long/short strategy and Jegadeesh and Titman's matrix of sixteen long/short strategies. Both approaches attempt to exploit the observed tendency for outperforming stocks to continue to outperform and underperforming stocks to continue to underperform. Each strategy starts by ordering stocks based on their trailing returns over a stated period (the lookback period) to determine their relative price momentum. Each strategy creates its portfolio after a short lag following the lookback period to evade relative performance's tendency to mean revert over the short term. Each strategy maintains its portfolio for a stated holding period before reshuffling the deck. Fama and French's lookback period is the first eleven months of the preceding twelve-month period, with the twelfth month serving as the lag between portfolio definition and formation. Fama and French form their market-neutral portfolio by buying the top three relative-performance deciles and shorting the bottom three. The portfolio is reconstituted monthly and its sample period extends from 1927 to today. By using four different lookback and holding periods (three, six, nine and twelve months), Jegadeesh and Titman formed sixteen different market-neutral portfolios with a one-week lag. Jegadeesh and Titman's portfolios buy the top, and short the bottom, deciles. They offer a more concentrated take on a long/short momentum strategy than Fama and French's. The near-term overreaction/medium-term underreaction response is additionally complicated by the tendency for relative performance to mean revert over long periods. Trees don't grow to the sky. Over time, investors may unduly extrapolate past surprises into the future, or mean-reversion may impede continued growth surprises via adaptive expectations and/or the law of large numbers. Whatever the cause, our Equity Trading Strategy model navigates the oscillating reaction gauntlet by betting on mean reversion over one- and 36-month timeframes and on momentum over a twelve-month timeframe. Why Isn't Momentum Working Like It Used To? Advances in communications and computing technology may have compressed the timeframes over which the overreaction/underreaction/overreaction pattern unfolds. Information travels faster in a wired world, and enhanced computing power allows it to be digested more rapidly after it's disseminated. Once digested, investors are able to act upon it in milliseconds. Reduced frictions in terms of commission costs and bid-ask spreads (as stocks have gone from being quoted in eighths, to sixteenths to pennies) have made it feasible to capture profits that couldn't be captured before. Specific to the post-crisis landscape, momentum portfolios are particularly susceptible to the whipsawing that can occur in the wake of once-in-a-generation bear markets. Momentum strategies tend to weather the initial storms quite well by steadily migrating to lower-beta stocks and shunning higher-beta ones. Eventually, however, their lopsided beta profiles turn momentum portfolios into sitting ducks for the violent snapback rallies that originate among the most down-and-out stocks. Those rallies inflicted heavy casualties after the Depression, when the bottom three deciles surged by 200% in July and August 1932, versus the top three deciles' 60%, and after the crisis, when the bottom three deciles nearly doubled in March, April and May 2009 while the top three deciles gained just 15%. The gory particulars behind momentum's biggest setbacks illustrate why investors shouldn't write the factor off just yet. Its crashes - and the reason it takes so long to recover from them - are a function of runaway shorts. Table 2 shows the Fama-French momentum portfolio separated into its long (Up Basket) and short (Down Basket) components. As one would expect in a market that's trended steadily higher ever since the Depression, the shorts are volatile and lag both the overall market and the long basket. Jegadeesh and Titman's more concentrated portfolios (confined to stocks in the top and bottom deciles) have struggled mightily in the out-of-sample period, losing money across the board (Chart 2). Table 2Full Speed Ahead For Long-Only Momentum Strategies Chart 2The Last Shall Be First (After A Crash, Anyway) But the real news is in the Up Basket's performance, which has pounded the overall market on both a nominal and a risk-adjusted basis for the entirety of the pre-crisis history and has fought it to a risk-adjusted draw since the crisis (while winning again on a nominal basis). Momentum still works, even now. We like to test factor performance on a market-neutral basis to gauge how well it stratifies a population from top to bottom, but we are sensitive to the fact that the majority of our clients are long-only investors. It is gratifying to see the factor's favored stocks consistently outperforming by a wide margin because it means alpha-generation is available to all investors. The potential excess returns to overweighting the winners and under- or zero-weighting the losers may be limited relative to overweighting the winners and shorting the losers, but they are excess returns nonetheless. We are unwilling to conclude that a factor as persistently robust as momentum is dead. It is simply hibernating, in our view, until the rising tide of extraordinarily accommodative monetary policy stops lifting all boats. ZIRP (and NIRP) have helped enable a bull market that has muffled the distinctions between individual stocks and other risk assets. That's unhelpful for relative value strategies, which feed on wide spreads, but the inflection in Fed policy may soon help mo-mo recover its missing mojo. Momentum And The Fed Funds Rate Cycle We have found that the fed funds rate cycle can provide an excellent guide to broad equity movements. As our U.S. Investment Strategy service has shown, the level of the fed funds rate has exerted a powerful pull on equities, with all of the S&P 500's price returns over 55 years having accumulated in periods when policy settings were accommodative.7 As Table 3 shows, Fama and French's momentum strategy turns that rule on its head, posting its strongest returns during periods when policy settings are restrictive. Table 3Fama French Momentum Portfolio Returns During Rate Cycle Phases From August 1961 The results are not as counterintuitive as they seem when one recalls that they are generated by long/short portfolios. As noted above, accommodative policy could act to narrow the gap between winners and losers. Restrictive policy may have the opposite effect, as reduced liquidity and higher yields make borrowing more fraught and debt service more onerous. It's only when the tide goes out that markets see who was swimming naked. Isolating Fama and French's Up- and Down-Basket returns supports this reading. Average return spreads between the long and short positions widen when policy is restrictive and narrow when it's accommodative (Tables 4A and 4B). Restrictive policy brings internal stresses to the fore, even to the point of inducing recessions (all of the recessions since the inception of our equilibrium fed funds rate model have begun in Phase II or Phase III of the policy cycle). Table 4AFama French Down-Basket Returns During Rate Cycle Phases From August 1961 Table 4BFama French Up-Basket Returns During Rate Cycle Phases From August 1961 The empirical evidence suggesting that restrictive policy settings are more conducive to momentum factor outperformance than accommodative ones carries tactical and strategic implications. The tactical implication suggests there's no rush to assume standalone momentum exposure even though it has distinguished itself over time. The strategic implication suggests that momentum exposure, in conjunction with other factor exposures, could help to reduce portfolio volatility for any given level of expected returns, or increase expected returns for any given level of volatility. The Smart-Beta Momentum Menu The same considerations involved in setting momentum model parameters bear on the choice of smart-beta momentum ETFs (Table 5). What is the optimal lookback period, the optimal rebalancing frequency and portfolio-formation lag? What tweaks might help avoid drawdowns and boost risk-adjusted performance over time? The sponsors of the ETFs tend to keep their lookback-period cards close to the vest, but six- and twelve-month lookback periods seem to be the standard. Lag periods are also treated like competitive secrets, except at the major index providers, where one- and two-month lags are the norm. Table 5The Current Universe Of U.S. Equity-Focused Smart-Beta Momentum ETFs The funds distinguish themselves more clearly in their rebalancing frequencies. Quarterly rebalancings are the standard, but MTUM, ONEO and SPMO, based on benchmarks from established index families, roost at the more patient semi-annual end of the continuum. EEH has the shortest attention span, pursuing its sector rotation strategy with daily rebalancing, and fund-of-funds DWTR rebalances monthly. We note that EEH is an ETN representing an obligation of a Swedish bank and that, all else equal, we prefer ETFs since they carry no credit risk. QMOM recently shifted its registration from Active to Passive, along with three other Alpha Architect funds. Alpha Architect is a quant shop run by a Finance PhD and we have noticed that its funds tend to cluster at the top of our ETS model rankings. It would appear that its portfolio construction models share several factors with the ETS model, and we will be keeping an eye on its funds' performance. Doug Peta, Senior Vice President Global ETF Strategy dougp@bcaresearch.com Philippe Morissette, Associate Vice President Equity Trading Strategy philippem@bcaresearch.com 1 Based on a manual review of the data using month-end closing prices. 2 The strategy lost 20.4% from December 1980 through August 1981 at the beginning of the Volcker bear market. 3 Jegadeesh, Narasimhan and Titman, Sheridan, "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," Journal of Finance, Volume 48, Issue 1 (March 1993), p.70. 4 Ibid, p. 89. 5 Through the end of February. 6 Asness, Clifford S. and Frazzini, Andrea and Israel, Ronen and Moskowitz, Tobias J., "Fact, Fiction and Momentum Investing," Journal of Portfolio Management, Fall 2014 (40th Anniversary Issue); Fama-Miller Working Paper. Asness et al demonstrate that momentum's risk-adjusted returns have outpaced those of more widely celebrated factors and the overall market. 7 Please see U.S. Investment Strategy Special Report, "Stocks And The Fed Funds Rate Cycle," published December 23, 2013, available at usis.bcaresearch.com.

The S&P managed care index is poised to break out to new, sustainable, all-time relative performance highs. The impetus behind upward momentum is fundamentally-driven. United Health raised its full year guidance, a trend that could spread through the industry if our indicators are a good guide. Many companies are exiting unprofitable business lines, most notably health care exchanges, while those remaining are experiencing a meaningful reduction in cost inflation. Indeed, our managed care cost proxy has plunged, reflecting a broad-based easing in both goods and services costs. This indicator suggests that the medical loss ratio will remain low. Importantly, consumers are gradually allocating fewer dollars to health care outlays, which signals that the payers of health care services (such as insurers) are at an earnings advantage compared to the providers of these services (such as hospitals). When relative spending accelerates, managed care lags, and decelerations/contractions tend to coincide with share price strength. Against this backdrop, a profit-led relative performance breakout is in the offing for the S&P managed care index. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC.

Special Report

Highlights The latest saber-rattling signals a turn in U.S. policy; New negotiations, with tighter sanctions, will follow; The Iran playbook can work with North Korea ... ... But failure could mean war down the road. Feature The United States's "Pivot to Asia" was not a passing fancy, as the past two weeks of saber-rattling have shown. Over this period, U.S. President Donald Trump took two largely symbolic actions in Syria and Afghanistan. First he launched 59 Tomahawk cruise missiles at a Syrian air base, then he dropped the world's largest non-nuclear bomb on an underground hub of the Islamic State in Afghanistan. Neither action implied an increase in commitment to the region. Instead, the spotlight shifted to North Korea. Trump's multiple conversations with Chinese President Xi Jinping, his orders to move three aircraft carriers to the peninsula, and his standoff with North Korean leader Kim Jong Un over a failed missile launch, all indicated that one of our major geopolitical themes is alive and well: the rotation of risk from the Middle East to Asia Pacific (Chart 1).1 Chart 1The Pivot To Asia Is Not Done Yet The underlying driver of geopolitical risk on the Korean peninsula is Sino-American rivalry. China is an emerging "great power" that threatens the global dominance of the United States and its alliance system. The immediate consequence is rising friction in China's periphery. That is why Taiwan, the South China Sea, and North Korea are all heating up in various ways.2 However, North Korea's regime is highly unpredictable and potentially able to strike the American homeland in a few years. In that sense it is more significant than the other "proxy battles" between the U.S. and China.3 In essence, North Korea is no longer merely an object of satire. A big new round of negotiations over Korea is about to begin - not unlike the Iranian nuclear negotiations over the past decade. Unless diplomacy succeeds in convincing North Korea to freeze its nuclear and missile progress, the potential for a military conflict is high. What Caused The Latest Spike In Tensions? This past week the new U.S. administration, hitherto untested in foreign affairs, has drawn a stark line on how it intends to manage global security. Both President Barack Obama and Presidential Candidate Trump sowed doubts about America's willingness to remain involved in maintaining global order.4 Obama seemed reluctant to reinforce American "red lines" in Syria, Ukraine, and the South China Sea; Trump threatened outright isolationism, rejecting NATO, and notably suggesting that U.S. allies Japan and South Korea might have to fend for themselves. In office, however, Trump is rapidly "normalizing" and abandoning his isolationist rhetoric. Notably, he is maintaining the Obama administration's "pivot" away from the Middle East and toward Asia Pacific. Though he unilaterally withdrew from the Trans-Pacific Partnership trade agreement, he has emphasized the need to renegotiate America's relationship with China, voiced aggressive support for Taiwan, reinforced U.S. freedom of navigation operations in the South China Sea, and sent Secretary of Defense James Mattis, Secretary of State Rex Tillerson, and Vice President Mike Pence on high-profile regional tours. He may visit China himself in May. The current tense standoff with North Korea - which has seen high-flying rhetoric, the aircraft carrier strike groups diverted to the region, extra military exercises with South Korea and Japan, and no less than three conversations with President Xi of China - should remove any doubt that Asia is high on his foreign-policy list. Another major factor contributing to the current flare-up in Korean tensions is Korean peninsula politics. The past year has seen extraordinary South Korean domestic political turmoil and a sharp increase in the frequency of North Korean nuclear and missile tests (Chart 2). These issues are connected. Robust empirical research shows that North Korean foreign policy from 1960-2011 has been more likely to turn hostile in the context of internal difficulties as well as periods of South Korean power transition (Chart 3).5 The past year's events support that conclusion: Chart 2North Korea Run Amok? Chart 3Bull Market For North Korean Threats South Korean turmoil: South Korea's ruling party, the conservative Saenuri Party - hawkish on North Korea - has collapsed in flames under the Park Geun-hye administration. She has been impeached and removed from office and is now under arrest and investigation. It is a sequence of events without comparison since the turmoil that accompanied the country's transition to democracy in the late 1980s. Essentially, the past ten years of conservative rule in the South appear discredited, even as North Korean dictator Kim Jong Un has consolidated power through purges of enemies and family members at home. If there was ever a time for the North to flex its muscles, the past year has been it. Economic weakness: Kim's muscle-flexing at home and abroad have also coincided with internal economic difficulties. China accounts for about 91% of North Korea's trade ex-South Korea, and the North has suffered from the secular slowdown in Chinese growth. Bilateral trade with China collapsed by 10% since its peak in January 2014 (Chart 4). This slowdown has been particularly pronounced in China's northeast, namely Liaoning province, which is key for North Korea. A composite indicator of Chinese and Russian provinces bordering North Korea suggests that internal demand is still contracting (Chart 5). Moreover, the North is mainly an exporter of commodities, such as coal and iron ore, and did not escape the general commodity bust of 2014-16. The Kim regime, already concerned about the pace of pseudo-liberalization of the economy, is using its military advances to distract its populace. Chart 4China Trade Took A Hit Chart 5Regional Economic Weakness These factors coalesced late last year - as we argued - to create a situation ripe for a new Korean crisis.6 The collapse of South Korea's conservatives meant that left-leaning candidates became the only real contenders in the presidential election, now scheduled on May 9 (Chart 6). All leading candidates are more likely to try diplomacy and economic engagement with North Korea than to maintain the past ten years of conservative efforts to strengthen military deterrence via stronger alliances with the U.S. and Japan.7 As a result, early this year the U.S. and the flailing Park regime rushed ahead with the deployment of the controversial THAAD missile defense system and ratcheted up pressure tactics on the North via high-intensity regular and irregular military exercises.8 The North responded by testing four short-range missiles at once, threatening to attack Japan and American bases with nuclear weapons, launching another unidentified missile in the face of U.S. warnings, and preparing to conduct another nuclear test and an intercontinental ballistic missile test for the first time. Meanwhile, China imposed sanctions on both Koreas - the former for its missile tests and the latter for THAAD, which China resolutely opposes (Chart 7).9 China sees South Korean weakness as an opportunity to increase its sway in the region, but is sanctioning the North as well because it does not want the latter to provide the U.S. with a pretext to intervene on the Korean Peninsula or take anti-China trade measures. Chart 6Leftward Swing In South Korea Chart 7China Imposes Sanctions On Seoul? Bottom Line: The recent spike in Korean tensions (as opposed to some in the past) is driven by real, geopolitical factors - not by media hype alone. The Trump administration is going forward with the "Pivot to Asia" in all but name, and showing a lower threshold than its predecessor for military action globally, while South Korea's power vacuum has emboldened North Korea in its weapons tests and China in its willingness to affect peninsular politics. Is North Korea A Red Herring? Despite the above, this week's spike in Korean tensions failed to generate real panic among global investors, though it did cause a 32% rise in Korean credit-default swaps price and a 2% depreciation of the Korean won from end of March to mid-April (Chart 8). North Korea did not conduct a major provocation on April 15 or thereafter, as it warned it might do.10 The tensions have not fizzled, but seem likely to, once again raising the question of whether North Korea is a red herring for investors. Normally we would say "Yes." Chart 9 explains why. The North has committed a number of acts of aggression over recent decades, killing American as well as South Korean citizens and servicemen. None of these acts has had a pronounced market impact. That is because there is a balance of power on the Korean peninsula and the major players refuse to allow the North to upset that balance through provocations. Chart 8South Korean Risks Rising Chart 9North Korean Provocations Rarely Affect Markets For Long Specifically, the North already has a "nuclear option," and it has nothing to do with an atomic bomb. It is approximately 9,000 units of artillery hidden and deeply ensconced in the hills just 35 miles north of the South Korean capital Seoul. This conventional fighting force is ready to attack on a moment's notice and would take days to defeat even granting the vast superiority of American and South Korean forces. In that time it could cause massive casualties in the metropolitan area. In 1994 - when the U.S. chose diplomacy with North Korea for lack of an acceptable military option - a simulation estimated that 1 million people or 9% of the city's population might die - the equivalent of which would be 2.4 million today.11 A conventional attack on Seoul is North Korea's longstanding and well-known trump card. It has prevented the U.S. or South Korea from trying to "solve" the North Korea problem militarily for decades and it remains an active threat. The question, then, is whether this stalemate is changing in a way that breaks the cycle of transgression-and-containment and poses real risks to regional economies and political stability. The answer is "Yes" again. North Korea is no longer a red herring because its nuclear and missile capabilities are improving and it is becoming a bigger problem in U.S.-China relations. Capabilities First, North Korean capabilities are advancing steadily forward, giving the U.S. a smaller window of opportunity to decide whether it can accept a nuclear-armed North Korea. Previous crises with North Korea occurred after the Soviets fell, after 9/11, and after the Great Recession - they were driven exogenously and the U.S. had the luxury of time and distance. That is gradually proving no longer to be the case. To be clear, North Korea has not proved the ability to launch ICBMs reliably. The farthest it has ever shot a missile is around 1,000km, aside from tests of space launch vehicles, which are comparable but as yet inconclusive. Map 1 demonstrates that its missiles are currently a risk to U.S. military bases and allies in Asia Pacific more so than to the continental U.S. Even hitting Guam may be a stretch at the moment. Effective ICBM capabilities are exceedingly rare, as revealed by the fact that only a handful of countries have achieved them (the U.S., U.K., France, Russia, China, India, and arguably North Korea itself). Map 1North Korea's Proven Missile Reach Nevertheless, a number of prominent U.S. defense and intelligence officials have asserted that the U.S. government must be "prudent" and "assume the worst" - i.e. that the North can attach a nuclear warhead to one of its ICBMs (which may function properly) and fire it at the continental U.S.12 The North has surprised the world several times in recent memory with marked advances on everything from nuclear miniaturization to uranium enrichment to the types of long-range missiles in development. While it has not gained the ability to strike the U.S. reliably and accurately, the U.S. wants to stay ahead of the curve. Moreover, nuclear weapons will give the North a much more influential position on the global stage even assuming that it never intends to push the button. (Pyongyang is unlikely to use nukes because to do so would be regime suicide - the response of the U.S. and its allies would be devastating.) As it gains the ability to strike U.S. bases and neighboring Asian countries, it would be able to blackmail the U.S. and its allies more effectively. One result is that the U.S. and South Korea may start to drift apart. As the North gains the ability to strike the U.S. directly, the U.S. loses the willingness to delay military strikes on account of the people of Seoul. Since South Korea knows this, it has an incentive to engage with North Korea and strike a bilateral deal. This is particularly the perception among Koreans born in the 1970s and 1980s, who are gradually assuming power in the country. Though they still support the U.S., like all Koreans, nevertheless they favor it less than other age groups. They also have the highest sympathy for North Korea and China - especially compared to those born after 1988 (Chart 10 A&B). The latter are too young to take charge of policy while the more conservative elderly cohort has been discredited with the fall of Park, at least until the political pendulum swings back again at some point in the future. This suggests a basis for peace overtures. Chart 10AMiddle-Aged Koreans ##br##Sympathetic With China... Chart 10B... And With ##br##North Korea The May 9 election is likely to point in this direction. An inter-Korean thaw may encourage the North to calm down outwardly, but may also encourage its technological efforts inwardly. This occurred during the "Sunshine Policy" of liberal South Korean governments from 1998-2007. The North will expect to face greater diplomatic leniency and economic assistance. Such a thaw will also raise the potential that the U.S. and Japan eventually grow frustrated with South Korean (and Chinese) inaction over the course of talks, especially if the North breaks faith, as it did in the late 1990s and early 2000s.13 This is why a new round of negotiations is crucial to the probability of war. China The second reason North Korea is no longer a red herring for investors is that the U.S.'s approach to China is shifting - it is threatening to slap China with secondary sanctions, trade tariffs, and other measures. The U.S. is demanding that China enforce sanctions and use its economic leverage to convince the North to freeze its nuclear and missile programs. For the first time ever, the U.S. has sanctioned Chinese companies and individuals for their involvement in the North Korean missile program - this is a trend that will continue to evolve.14 Judging by China's stated willingness to ban some coal imports this year (Chart 11), Beijing knows that the U.S. is getting more serious and needs to be pacified. Chart 11Chinese Yet To Punish Pyongyang But unless "this time is different," China will not impose crippling sanctions on North Korea. The latter is a military and ideological ally, a proxy state that helps keep the U.S. alliance at bay, and a massive liability in the event of collapse (North Korean refugees would flood into northeast China). Investors should remember that the U.S. and China fought a war directly against one another over the Korean peninsula. Time and again, China chooses not to destabilize North Korea, even if that means abetting its nuclear and missile advances.15 In short, North Korea is one more reason - along with trade, China's maritime assertiveness, and Taiwan - that U.S.-China relations will worsen over time, notwithstanding the beginnings of a Trump-Xi détente at Mar-a-Lago in early April. There is some military urgency here as well: Chinese military capabilities are rapidly improving and that further narrows the window for the U.S. to shape the outcome on the peninsula militarily. The longer the U.S. waits, the greater China's ability to deter U.S. action against the North. Hence the U.S.'s simmering conflict with the North could easily feed into a larger U.S.-China confrontation. Moreover, if we are wrong and China imposes crippling sanctions on the North, the investment-relevance of North Korea still goes up. The latter will become unstable in that case, given its vast overreliance on China. Eventually the regime could fragment and impact China's economy and internal stability, or lash out at its other neighbors and instigate tit-for-tat conflicts. Bottom Line - The current saber-rattling is carefully orchestrated. But North Korea can no longer be consigned to the realm of satire. The very fact that the U.S. administration is adopting greater pressure tactics makes this year a heightened risk period. Investors should be especially wary of any missile tests that reveal North Korean long-range capabilities to be substantially better than is known to be the case today. Table 1 provides a checklist for investors to determine if the current tensions get out of hand. Table 1Will The U.S. Attack North Korea? Investors should also be wary of U.S. sanctions on China, or broader U.S.-China tensions, which are structurally driven and have not substantially subsided despite the Trump-Xi talks. In lieu of war, a deterioration in Sino-American relations is the key investment risk from North Korea. What Is The End Game? The U.S. has three paths it can take: Do nothing: The U.S. has allowed murderous tyrants to develop deliverable nuclear weapons before: see Stalin and Mao. It is possible that the U.S. could do the same for North Korea, essentially "setting in stone" the current status quo for lack of willingness to fight a second Korean war. Such an arrangement would put "rational actor theory" to the test - and so far that has been the case, with no second Korean war occurring. Attack, attack, attack! The North holds the South hostage, but Washington might decide someday to "shoot the hostage." For instance, if its own security needs outweigh its loyalty to its ally. Negotiate a solution: China's tentative cooperation on sanctions this year suggests that a major multilateral initiative is getting under way, comparable to the Iranian negotiations that concluded with the nuclear-monitoring and sanctions-lifting deal of 2015. The solution would likely consist of North Korea retaining its nuclear capability but admitting some inspections and refraining from developing long-range missile capabilities. It would seek a peace treaty to replace the 1953 armistice as well as sanctions relief and economic aid. Chart 12The Great East Asian Powder Keg What is wrong with these options? First, the U.S. has not yet accepted the North as a nuclear-armed state. Trump's naval buildup this month was evidence of a policy change designed to increase pressure tactics, with the aim of getting a better (non-nuclear-armed) result. It is still believed that the North will use its nuclear deterrent as a cover to expand its campaign of military intimidation and coercion against sovereign states: it has a record of attacks on civilians, attempted assassinations, and acts of war, including but not limited to the Chonan sinking and Yeonpyeong Island shelling in 2010. As the North gains the ability to strike the U.S., any hostilities will become harder for the U.S. public and defense establishment to ignore. Moreover, doing nothing allows a nuclear-armed Korea to kick off a nuclear arms race in a region that is already developing into a powder keg (Chart 12). More generally, it reduces America's ability to shape outcomes regarding China. A preemptive strike, on the other hand, would devastate Seoul and deliver a shock to the global economy. It would destabilize the peninsula and call all alliances and relationships into question. This option is extremely unlikely unless the U.S. is attacked, believes it is about to be attacked, or sees one of its allies suffer a serious attack. Diplomacy is the only real option. And in fact it is already taking shape. The theatrics of the past few weeks mark the opening gestures. And theatrics are a crucial part of any foreign policy. The international context is looking remarkably similar to the lead-up to the new round of Iranian negotiations in 2012. The United States pounded the war drums and built up the potential for war before coordinating a large, multilateral sanctions-regime and then engaging in talks with real willingness to compromise (Chart 13). Chart 13Tensions Ramp Up As Nuclear Negotiations Begin Today the U.S. is similarly showing off its capabilities and willingness to use force to the North, thus establishing a "credible threat."16 The other actors are playing their parts. China is offering to assist with tougher sanctions than usual; South Korea is heading for a policy shift; Japan is raising alarms and demonstrating its lock-step with the U.S.; Russia is calling for calm and a return to talks. However, over time, diplomacy could be unsatisfactory if it merely approximates the first option of "doing nothing." This is likely North Korea's last chance to prove that it can be pragmatic. Bottom Line: Therefore we are at the critical phase - within say one-to-four years - in which the U.S. must decide whether to attack. Given the current heightened tensions, the danger zone consists of (1) the near-term, in which the U.S. is applying more pressure, tensions are spiking, and talks have not yet taken shape (2) the long term, when talks could fail. Conclusion The Korean peninsula is the site of a proxy battle between China and the U.S. However, China sees the dangers of a nuclear-armed North Korea and recognizes that its patronage has a strategic downside by provoking U.S. military intervention. Like Russia in the Iranian negotiations, it can be brought to the table if the U.S. is convincing in warning that it may take matters into its own hands. China's apparent decision to enforce sanctions on coal imports, combined with the U.S. aversion to preemptive strikes and South Korean political leftward tilt, make this new round of talks especially likely to occur. Japan also prefers North Korea to be a threat, but a contained threat, as it looks to normalize its defense posture yet avoid an economic destabilization. The threat in North Korea will be a convenient excuse for Prime Minister Abe to pursue his re-militarization agenda. Thus, over the next four years, the North might be persuaded to freeze its programs to create an uneasy modus vivendi, as with Iran. This would require a non-aggression nod from the U.S. and a lifting of sanctions. It could also bring economic engagement with all parties into focus, even though North Korea does not have as much economic resources to offer as Iran. It is looking to trade national security for national security. All of this has a limit, however. China will not cripple the North Korean economy or force out the regime. Remember that in the case of Iran it was only willing to go so far, and received a waiver for the Iranian oil sanctions - yet North Korea is even closer to its immediate security. Therefore the North's willingness to change its behavior - to demonstrate that it is a rational player if brought in from the cold - is critical to the effectiveness of negotiations. Trump's reelection prospects may also be critical. A lame duck Trump in 2020, in the face of another failed North Korea policy, could attempt a decisive action, especially if the North is belligerent. By contrast, there is very little risk that Japan will "go rogue" and attack North Korea - even less so than there was with Israel in the Iran talks. It is Trump who is playing the role of the unpredictable negotiator who might "go it alone." The U.S. will continue to make the military option credible in spite of Seoul's vulnerability to retaliation. Therefore any failure of negotiations will induce a real crisis in which the U.S. contemplates unilateral action. The final question of whether the U.S. will attack may hinge on the fact that the U.S. has a potent form of nationalism in the country that could be directed against North Korea under certain circumstances, as has happened against other regimes like Vietnam and Iraq. A North Korean act of war, or even a suspected imminent act of war in certain scenarios, could prompt a wave of reaction. Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com Oleg Babanov, Editor/Strategist EM Equity Sector Strategy obabanov@bcaresearch.co.uk 1 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, and Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and EM Equity Sector Strategy Joint Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was," dated March 8, 2017, Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, and "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 5 Please see Robert Daniel Wallace, "The Determinants Of Conflict: North Korea's Foreign Policy Choices, 1960-2011," doctoral dissertation, Kansas State University (2014), available at krex.k-state.edu. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Joint Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 7 Most notably, the South Korean foreign policy shift will likely put an end to the unified U.S.-Japan-Korea stonewalling of North Korea that has prevailed since 2008. If Moon Jae-In wins, in particular, it will call the U.S. THAAD missile system emplacement into question. It will also call into question the progress in Korea-Japan relations, which includes a Japanese attempt to settle the "comfort women" controversy and a notable military-cooperation and intelligence-sharing agreement. 8 Including letting it be known that they would simulate special-forces operations to strike at the leadership in Pyongyang and decapitate the regime. 9 China opposes THAAD because its radar will be able to penetrate deep into China's territory. More broadly, it opposes U.S. efforts to upgrade its military capabilities in the region or otherwise shift the regional balance of power. 10 Kim Il Sung Day, or the "Day of the Sun," is, like several regime holidays, a possible occasion for missile tests or other provocative actions or revelations. However, Pyongyang is rarely predictable. Faced with a notable display of force by the U.S., the North conducted a small missile test, which failed. Notably, it steered clear of testing another nuclear device, as predicted. More may be to come. 11 Please see W. J. Hennigan and Barbara Demick, "Trump administration faces few good military options in North Korea," April 14, 2017, available at www.latimes.com. 12 Please see Admiral Bill Gortney's comments: "Our assessment is that they have the ability to put a nuclear weapon on a KN-08 [ICBM] and shoot it at the homeland ... That is the way we think, and that's our assessment of the process," in Aaron Mehta, "US: N. Korean Nuclear ICBM Achievable," April 8, 2015, available at www.defensenews.com. In 2013, Chairman of the Joint Chiefs of Staff General Martin Dempsey said that "in the absence of concrete evidence to the contrary, we have to assume the worst case, and that's ... why we're postured as we are today," quoted in "Hagel: North Korea Near 'Red Line,'" UPI, April 10, 2013, available at www.upi.com. See also Mark Landler, "North Korea Nuclear Threat Cited by James Clapper, Intelligence Chief," New York Times, February 9, 2016; Siegfried S. Hecker, "The U.S. Must Talk To North Korea," New York Times, January 12, 2017, available at www.nytimes.com; Jeff Seldin, "N. Korea Capable of Nuclear Strike at US, Military Leader Says," Voice of America, April 7, 2015, available at www.voanews.com. 13 Japan is especially likely to diverge from South Korea as a left-leaning government in Seoul will likely see relations decline far faster with Japan than with the U.S. Increasingly, Japan is concerned about North Korea's risk and is boosting its Self-Defense Forces and attempting to win popular support for controversial constitutional revisions that would ultimately have a bearing on national security posture. North Korea is both a real and a convenient threat at this time. 14 Please see "US sanctions Chinese company for alleged support of North Korea," The Guardian, September 26, 2016, available at www.theguardian.com; see also the Department of Commerce, "Secretary of Commerce Wilbur L. Ross, Jr. Announces $1.19 Billion Penalty For Chinese Company's Export Violations To Iran And North Korea," dated March 7, 2017, available at www.commerce.gov. 15 And Chinese state-owned companies are implicated in significant and recent military advances, such as the provision of Transporter-Erector-Launchers (TELs) for North Korea's mobile-launched ICBM prototypes. Please see Melissa Hanham, "North Korea's Procurement Network Strikes Again: Examining How Chinese Missile Hardware Ended Up In Pyongyang," Nuclear Threat Initiative, July 31, 2012, available at www.nti.org. 16 Please see BCA Geopolitical Strategy Special Report, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, available at gps.bcaresearch.com.

Highlights Duration: The recent strength in bond markets appears to be a flight to quality driven by heightened political uncertainty. Underlying economic growth remains solid, and investors should fade the recent moves by adding to duration underweights. Quality Spreads: It might be wise to take advantage of current tight quality spreads to hedge the risk of the corporate interest expense tax deduction being repealed. Credit Curve: There is a substantial spread advantage to extending maturity within an allocation to investment grade corporate bonds. Further, this spread advantage should dissipate as Treasury yields move higher. Feature Political risks dominated the headlines last week, sparking what looks like a textbook flight-to-quality in financial markets. The 10-year Treasury yield broke below its long-standing 2.3% floor to end the week at 2.24%, and the S&P 500 declined by just over 1%. Another telltale sign of a flight-to-quality is that the term structure of implied equity volatility inverted (Chart 1). That is, implied volatility on 1-month S&P 500 index options rose above 3-month implied vol. We know the playbook here. Politically driven risk-off episodes that are unlikely to materially impact economic growth should be faded. This means staying at below-benchmark duration and overweight spread product, while favoring curve steepeners and TIPS breakeven wideners. We don't have to look that far back to identify another politically driven risk off episode. The Brexit vote from early last summer also caused the equity volatility term structure to invert, and drove the 10-year Treasury yield down to 1.37%, well below the fair value dictated by global economic fundamentals. Following the Brexit vote the 10-year Treasury yield was 58 bps expensive according to our 2-factor Treasury model.1 Presently, the 10-year yield appears 30 bps expensive (Chart 2), and much like in the aftermath of the Brexit vote, the deviation from fair value looks to be driven by spiking political uncertainty. Chart 1Inverted Vol Term Structure Chart 210-Year Treasury Yield Fair Value Now, the Global Economic Policy Uncertainty Index has been above normal levels since Donald Trump's election last November (Chart 2, bottom panel), and as long as the reading from that index is elevated the risk of another flight-to-quality episode in financial markets will remain high. However, spikes in policy uncertainty that do not coincide with economic deterioration have historically tended to mean-revert in relatively short order. We anticipate that Treasury yields will rise as policy uncertainty eases in the months ahead. Chart 3The Fed Is Being Priced Out Coincident with the drop in long-dated Treasury yields, the overnight index swap curve is now priced for only 39 bps of rate hikes between now and the end of the year (Chart 3). That's barely more than one 25 basis point hike! We previously recommended shorting January 2018 Fed Funds Futures on March 21,2 and would advise investors who have not yet entered this trade to do so now from even more attractive levels. We calculate that a short January 2018 Fed Funds Futures trade will return 20 bps (from current levels) in the event that the Fed hikes twice more this year, and 45 bps in the event of three more hikes. In our view, growth will be strong enough to support at least two more rate hikes this year. Bottom Line: The recent strength in bond markets appears to be a flight to quality driven by heightened political uncertainty. Underlying economic growth remains solid, and investors should fade the recent moves by adding to duration underweights. Are Markets Sniffing Out A Slowdown? Of course, bond markets could just be rallying in response to slowing U.S. economic growth. After all, the Atlanta Fed's GDPNow forecast is calling for a measly 0.5% annualized GDP growth in Q1. In stark contrast, the New York Fed's GDP Nowcast is calling for robust growth of 2.6% in Q1 and 2.1% in Q2 (Chart 4). How do we square the two? The answer relates to the ongoing debate between so-called "soft" and "hard" data. The New York Fed model incorporates a great deal more "soft data" than the Atlanta Fed model. In other words, it incorporates a wider swathe of survey data than the Atlanta Fed model, which relies more heavily on actual production and spending statistics. We think it would be unwise to dismiss the more positive economic message being sent by survey data. First, surveys tend to lead actual spending so we should expect some divergence whenever the economy reaches a turning point. Second, "hard data" are often revised after the fact and there are question marks about whether residual seasonality has biased Q1 growth lower during the past few years. The minutes from the March FOMC meeting showed that participants "noted that residual seasonality might have exaggerated the increase" in the PCE price deflator in January and February. The corollary of an unduly strong PCE price deflator is unusually weak real consumer spending. Real consumer spending was indeed weak in January and February, as was the headline retail sales figure for March. However, the weakness in March retail sales was concentrated in gasoline stations and auto sales. The more stable retail sales control group - a measure that excludes autos, gas stations and building materials - ticked higher in March (Chart 5). While the recent decline in auto sales should not be dismissed, it is too soon to call for a broad slowdown in consumer spending. Finally, as was recently noted by our colleagues at BCA's Global Investment Strategy service,3 even with bad weather having been a large drag on employment growth in March, aggregate hours worked still grew 1.5% in Q1 (Chart 6). This means that productivity growth would need to be negative in order to achieve the Atlanta Fed's 0.5% forecast. Given that aggregate hours worked were biased lower due to weather in the first quarter, and that quarterly productivity growth has averaged approximately +0.7% (annualized) since 2010, overall GDP growth forecasts closer to 2% seem more reasonable going forward. Chart 4Soft Data Versus Hard Data Chart 5Weak Auto Sales Are A Concern Chart 6Aggregate Hours Still Robust No Deflation Here GDP growth in the neighborhood of 2% is sufficient to keep measures of core inflation gradually trending higher. Higher inflation, in turn, will eventually translate into increased inflation expectations and higher long-dated Treasury yields. While last week's release showed that core CPI actually contracted in March, we note that this followed two months of extremely strong inflation (Chart 7). Taking a step back, it still appears as though measures of core inflation put in a cyclical bottom in early 2015 (Chart 8). While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Chart 7March CPI Is An Anomaly Chart 8Inflation Still Trending Higher One final point relevant to the inflation outlook is that last week President Trump refused to rule out re-appointing Janet Yellen as Fed Chair when her current term expires early next year. If we can take the President at his word, then this potentially removes what was an important tail risk for the inflation outlook and the reflation trade more generally. If Trump were to appoint a staunch hawk as Fed Chair, then a much tighter Fed policy would likely halt the uptrend in core inflation. This would also cause the Treasury curve to bear-flatten and risk assets to sell off. However, an FOMC hewing closer to the status quo would allow inflation to trend higher, prolonging the reflation trade. Bottom Line: We don't see enough evidence to call for a slowdown in economic growth or inflation. Growth in the neighborhood of 2% going forward will be sufficient to send inflation expectations and long-dated nominal yields higher. Corporate Bond Positioning: Credit Rating & Maturity In last week's report we performed an assessment of the corporate credit cycle and concluded that corporate bonds should perform well relative to Treasuries this year, but are at risk next year once inflationary pressures start to bite and the Fed speeds up the pace of tightening.4 This week, we consider the implications of this outlook for positioning across the corporate bond quality and maturity spectrums. Quality Spreads Chart 9Quality Spreads Are Tight Obviously, lower rated corporate bonds offer a spread advantage relative to more highly rated bonds. This spread advantage is usually worth chasing unless the default outlook is worsening and overall corporate spreads are widening. At the moment, the option-adjusted spread (OAS) advantage in the Barclays High-Yield index relative to the Investment Grade index is 274 bps, about 100 bps below its long-run average. Further, Baa-rated investment grade corporate bonds currently offer a spread advantage of 77 bps over Aa-rated bonds, about 20 bps below the long-run average. Even though these quality spreads are somewhat tight by historical standards, the mere fact that the quality spread is positive means there is an advantage to moving down the quality spectrum as long as default risk is benign. For this reason, it is more relevant to consider the additional compensation for moving down in quality relative to our expectations for default losses during the next 12 months.5 In Chart 9 we see that quality spreads are in fact tighter than average, even after adjusting for default loss expectations, although there have also been extended periods when they were even tighter than current levels. Although the risk/reward trade-off for moving down in quality is not all that attractive by historical standards, given our view that corporate spreads will be well behaved this year, we are fairly agnostic about moving down in quality on a 6-12 month investment horizon. There is, however, one additional factor to consider with regards to positioning across the credit quality spectrum. Corporate tax reform, some form of which our Geopolitical strategists still see as having a high probability of being passed before the end of this year,6 will involve some combination of lower tax rates and the repeal of some deductions. One deduction that is very much at risk is that of corporate interest expense. If implemented, it seems likely that corporate interest deductibility would be phased out over time. That is, the interest on outstanding corporate bonds would remain tax deductible, and only the interest on newly issued debt would be excluded from the deduction. While the gradual phase-out would prevent a wave of defaults related to a sudden surge in tax expense, the provision very clearly favors large highly-rated firms relative to small lower-rated firms, whose interest expense makes up a larger proportion of total expenses. Investors with longer time horizons might be wise to take advantage of current tight quality spreads (i.e. move up in quality) to hedge the risk of the corporate interest expense tax deduction being repealed. Credit Curve Considerations Turning to the corporate bond term structure, we see that the OAS advantage in long-maturity investment grade corporate bonds is extremely high relative to history (Chart 10). As we discussed in a 2013 report,7 the two main drivers of the credit OAS curve are differences in duration and expected default losses. A greater difference in duration between the long-maturity and intermediate-maturity investment grade corporate bond indexes leads to a greater OAS advantage in the long-maturity index. Conversely, an increase in perceived default risk causes the OAS curve to flatten, as short-maturity credits are perceived to be at greater risk of default. We find that the majority of the spread advantage in long-dated corporate bonds represents compensation for duration risk. If we look at OAS per unit of duration rather than outright OAS, the credit curve no longer appears steep (Chart 10, panel 2). Digging a little deeper, we see that the difference in duration between the long-maturity and intermediate-maturity indexes has been steadily increasing since 1990. In the early 1990s the increase was at least partially attributable to actual changes in the maturity structure of the indexes themselves (Chart 10, panel 3). However, in recent years the increased duration spread is entirely the result of lower Treasury yields (Chart 10, bottom panel). It follows that if Treasury yields continue to trend lower, then the corporate OAS curve will remain very steep. Higher Treasury yields would reduce the difference in duration between the intermediate and long maturity indexes, causing the OAS curve to flatten. After adjusting for differences in duration, we also need to consider the default outlook. By performing a regression of the difference in OAS per unit of duration between the long-maturity and intermediate-maturity indexes on our measure of expected default losses, we find that the amount of spread per unit of duration at the long-end of the curve looks somewhat attractive given our outlook for default losses (Chart 11). Chart 10OAS Term Structure Is Steep Chart 11Higher Defaults = Flatter OAS Curve Adding it all up, there is a compelling case to be made for favoring long-maturity investment grade corporate bonds relative to short maturities. Not only is the spread advantage substantial on its face, but the OAS curve should flatten if Treasury yields move higher - as we expect they will. The OAS curve also appears too steep relative to our assessment of default risk. Bottom Line: There is a substantial spread advantage to extending maturity within an allocation to investment grade corporate bonds. Further, this spread advantage should dissipate as Treasury yields move higher. Investors should favor long-maturity issues over short-maturity issues within an overweight allocation to investment grade corporate bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our 2-factor Treasury model is based on Global Manufacturing PMI and bullish sentiment toward the U.S. dollar. For further details please see U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 3 Please see Global Investment Strategy Weekly Report, "Talk Is Cheap: EUR/USD Is Heading Toward Parity", dated April 14, 2017, available at gis.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 5 We calculate expected default losses using the Moody's baseline forecast for the default rate and our own forecast of the recovery rate. 6 Please see Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017", dated April 5, 2017, available at gps.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "On The Term Structure Of Credit Spreads", dated July 10, 2013, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification