Economy

Highlights Monetary Policy: A prominent Fed Governor has acknowledged that inflation expectations have become un-anchored to the downside. This is an important signal and suggests that the Fed will keep policy easy enough for inflation expectations to recover. TIPS: The combination of a Fed that communicates a desire for higher inflation expectations and an end to the current downtrend in realized core inflation will send TIPS breakevens wider. Yield Curve: Higher inflation expectations will cause the yield curve to steepen on a 6-12 month horizon. Although steepener trades no longer appear cheap on our model, we remain overweight the 5-year bullet versus a duration-matched 2/10 barbell. Feature Chart 1Flight To Safety Focused In Real Yields Bond markets digested two important events last week. The first was a politically driven flight to safety. The 10-year yield fell 10 bps (Chart 1) and the average junk spread widened 8 bps as the daily U.S. Policy Uncertainty index1 averaged 121 for the week, its second-highest reading since February. As we have noted in past reports,2 historically the best strategy has been to fade politically driven flights to safety. The second, and more significant, event was a speech3 given by Fed Governor Lael Brainard in which she suggested that inflation expectations have become un-anchored to the downside. As is explained below, this acknowledgement represents an important change in tone from the Fed. One that reinforces our outlook for higher Treasury yields, a steeper yield curve and wider TIPS breakevens on a 6-12 month horizon. You Had One Job The key passage from Governor Brainard's speech is the following: Nonetheless, a variety of measures suggest underlying trend inflation may be lower than it was before the crisis, contributing to the ongoing shortfall of inflation from our objective. To understand the significance of this statement we need some background on how the Fed thinks about inflation. FOMC members tend to apply an expectations-augmented Phillips curve framework to the task of forecasting inflation (Chart 2). Fed Chair Janet Yellen explained this approach in a September 2015 speech.4 In Yellen's words: ...economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from a longer-term trend that is ultimately determined by long-run inflation expectations. [...] An important feature of this model of inflation dynamics is that the overall effect that variations in resource utilization, import prices, and other factors will have on inflation depends crucially on whether these influences also affect long-run inflation expectations. In other words, the Fed's model distinguishes between core inflation's long-run trend and its cyclical fluctuations. Cyclical fluctuations are driven by: Resource utilization (usually measured as the unemployment rate minus its estimated natural rate) Non-oil import prices Idiosyncratic shocks In contrast, core inflation's long-run trend is purely a function of long-term inflation expectations. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, then inflation's long-run trend would be altered and monetary policy would become less effective. In a sense, the worst possible outcome would be if inflation expectations became un-anchored to the downside. Once again, in Janet Yellen's own words: Anchored inflation expectations were not won easily or quickly: Experience suggests that it takes many years of carefully conducted monetary policy to alter what households and firms perceive to be inflation's "normal" behavior, and, furthermore, that a persistent failure to keep inflation under control - by letting it drift either too high or too low for too long - could cause expectations to once again become unmoored. This describes precisely the conventional wisdom as to why the Japanese economy has experienced two decades of deflation despite reasonably high levels of resource utilization. Policymakers did not act quickly or strongly enough following the burst stock market bubble of 1989-91, and this allowed deflationary expectations to become entrenched. In this sense the Japanese experience provides a roadmap for what could happen in the U.S. if the Fed doesn't act quickly to bring inflation expectations back up to target levels. It is true that not all measures of U.S. inflation expectations currently display weakness. For example, the measure we used in our expectations-augmented Phillips curve in Chart 2 - median 10-year PCE expectations from the Survey of Professional Forecasters - appears stable in recent years. However, Governor Brainard pointed to several measures that suggest inflation expectations have already declined (Chart 3). Chart 2The Fed's Inflation Model Chart 3Still Well Anchored? Comparing the three-year period ending in the second quarter of this year with the three-year period ended just before the financial crisis, 10-year-ahead inflation compensation based on TIPS [...] yields is ¾ percentage point lower. Survey-based measures of inflation expectations are also lower. The Michigan survey measure of median household expectations of inflation over the next five to 10 years suggests a ¼ percentage point downward shift over the most recent three-year period compared with the pre-crisis years, similar to the five-year, five-year forward forecast for the consumer price index from the Survey of Professional Forecasters.5 Investment Implications In our view, there are two important facts to keep in mind: In the Fed's model of inflation it is crucial that long-term inflation expectations do not fall. Otherwise, the odds of replicating the Japanese scenario start to increase. A prominent Fed Governor has now suggested that U.S. inflation expectations have become un-anchored to the downside. Chart 4The Market's Rate Hike Expectations Taken together, these two facts have important investment implications. First, the two facts suggest that TIPS breakevens will move wider. While the Japanese experience has taught us that "open mouth operations" become less effective once deflationary expectations are entrenched, they should still have some impact in the States. Notice that the decline in Treasury yields that followed Brainard's comments last week was concentrated in the real component. The 10-year TIPS breakeven inflation rate actually rose 2 bps (Chart 1). The combination of a Fed that communicates a desire for higher inflation expectations and an end to the current downtrend in realized core inflation (see "Economy & Inflation" section below) will be enough to send long-dated TIPS breakevens wider on a 6-12 month horizon. Second, a Fed that is committed to staying accommodative for as long as is necessary to ensure that inflation expectations move higher will cause the yield curve to steepen (see section titled "Inflation Expectations Drive The Curve" below). Third, a Fed that is more committed to fighting deflation should bias Treasury yields lower. However, inflationary pressures in the U.S. economy are strong enough that the Fed will be able to move inflation expectations higher while still delivering more rate hikes than are currently priced into the curve. At present, the overnight index swap curve is discounting that the next 25 basis point rate hike will not occur until November 2018 (Chart 4)! Bottom Line: A prominent Fed Governor has acknowledged that inflation expectations have become un-anchored to the downside. This represents an important signal about the future path of policy and reinforces our view that the Treasury curve will bear-steepen during the next 6-12 months, led by wider TIPS breakevens. Inflation Expectations Drive The Curve Our research6 shows that inflation expectations are the most important driver of changes in the slope of the yield curve. This runs counter to the conventional wisdom which states that the curve flattens when the Fed hikes rates, and steepens when it cuts rates. While the correlation between Fed rate moves and the slope of the curve is undeniable, the relationship results purely from the fact that the Fed responds to changes in inflation. The link between inflation expectations and the yield curve is the dominant relationship. To see this we look at Charts 5 and 6. Both charts show monthly changes in the 5-year, 5-year forward TIPS breakeven inflation rate plotted against monthly changes in the nominal 2/10 slope. Chart 5 shows all available historical data, and we observe a strong positive correlation. In fact, 63% of monthly observations fall into either the top-right or bottom-left quadrants indicating that wider breakevens correlate with a steeper curve and vice-versa. Chart 52/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year / ##br##5-Year Forward (February 1999-Present) Chart 62/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year / 5-Year Forward ##br##During Fed Tightening Cycles (June 1999 To May 2000 & June 2004 To June 2006) The more important question, however, is whether this correlation still holds when the Fed is raising rates. Chart 6 focuses only on prior rate hike cycles and still shows a strong positive correlation. 73% of the monthly observations fall into either the top-right or bottom-left quadrants, although in this case there are more observations in the bottom-left quadrant because typically the Fed lifts rates with the goal of sending inflation and inflation expectations lower. In this respect the current rate hike cycle is unique. The Fed is in the process of lifting rates, but as Brainard's speech shows, it still critically needs inflation expectations to rise. We conclude that the Fed will stay easy enough, long enough, for long-dated TIPS breakevens to return to their pre-crisis trading range between 2.4% and 2.5%. An upward adjustment to this range will occur alongside a steeper 2/10 curve. Unit Labor Costs And The Yield Curve The logic presented above also suggests an inverse relationship between the slope of the curve and wage growth. In a world where inflation expectations are well anchored, stronger wage growth encourages the Fed to tighten policy more quickly, this causes the yield curve to flatten. Conversely, softer wage growth leads to a steeper curve. Our research shows that unit labor costs are the measure of wage growth that correlates most closely with the slope of the curve. The reason is that unit labor costs actually measure both wage growth (compensation per hour) and labor productivity (output per hour). Put differently, the yield curve can flatten because labor compensation is rising and the Fed is tightening policy (bear flattening) or it can flatten because productivity is falling and investors are discounting a slower pace of potential growth and a lower terminal fed funds rate (bull flattening). Unit labor costs capture both of these dynamics. Last week saw second quarter productivity growth revised higher from 0.9% to 1.5% and unit labor cost growth revised down from 0.6% to 0.2% (Chart 7). We expect that productivity will continue to experience a modest late-cycle bounce. Usually, payroll growth starts to moderate late in the business cycle as the labor market tightens. The cost of labor typically rises and encourages firms to substitute capital for workers. This late-cycle boost in capital spending tends to correlate with stronger productivity growth (Chart 8), and this dynamic looks to be in full swing at the moment. Payroll growth has been decelerating since early 2015, and durable goods orders have picked up sharply since the end of last year (Chart 8, bottom panel). Chart 7Weakness In Unit Labor Costs Chart 8Productivity: Look For A Late-Cycle Rebound A modest late-cycle upswing in productivity growth will put downward pressure on unit labor costs and lead to curve steepening. How To Position For Steepening We have been expressing our yield curve view via a long position in the 5-year bullet and a short position in a duration-matched 2/10 barbell since last December.7 So far that trade has returned +28 bps, even though the 2/10 slope has flattened more than 50 bps since its inception. The reason our curve steepener has outperformed even as the curve has flattened is that, when we initiated our trade, the 2/5/10 butterfly spread was discounting an even larger curve flattening. Put differently, the 5-year bullet looked extremely cheap on the curve (Chart 9).8 Chart 92/5/10 Butterfly Spread Fair Value Model This state of affairs has now changed. Our fair value model shows that the 5-year bullet appears slightly expensive compared to the barbell, or alternatively, that the 2/5/10 butterfly spread is priced for a 20 bps steepening of the 2/10 slope during the next six months. According to our model, the 2/10 slope will have to steepen by more than 20 bps during the next six months for our trade to outperform from current levels. Bottom Line: Higher inflation expectations will cause the yield curve to steepen on a 6-12 month horizon. Although steepener trades no longer appear cheap on our model, we remain overweight the 5-year bullet versus a duration-matched 2/10 barbell for now. Economy & Inflation Updates received during the past few weeks indicate that U.S. growth is running solidly above trend, and may even be accelerating. Real second-quarter GDP growth was revised higher from 2.6% to 3%. Second quarter labor productivity growth was also revised higher, as was discussed above. Even following a lackluster August employment report, our back-of-the-envelope tracking estimate for U.S. growth - the sum of year-over-year growth in aggregate hours worked and average quarterly productivity growth since 2012 - is running at 2.7%, well above the Fed's 1.8% estimate of trend (Chart 10). Survey measures also suggest that growth has further upside in the second half of the year, at least according to a simple growth model based on the ISM non-manufacturing survey, our own BCA Beige Book Monitor and a composite of new orders surveys (Chart 11). Chart 10Growth Tracking Above-Trend... Chart 11...And Surveys Suggest Further Upside But bond markets are not getting the message. The 10-year yield is stuck at 2.12%, and the markets seem to be saying that the link between stronger growth and rising inflation has been permanently broken. We disagree and think that investors are simply underestimating the often long and variable lags between economic growth and inflation. Chart 12Inflation Lags Growth Chart 12 shows that real GDP growth has tended to lead core inflation by about 18 months, while changes in year-over-year core CPI (the second derivative of prices) have tended to follow the ISM Manufacturing index with a lag of about 12 months. All signs suggest that the recent downtrend in inflation is nothing more than a reaction to the growth deceleration seen between mid-2015 and mid-2016. Now that growth has re-accelerated, inflation is poised to move higher. Bottom Line: Bond markets are priced as though the link between growth and inflation is broken. We expect they will be proven wrong as inflation regains its uptrend during the next few months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 The daily policy uncertainty index measures the number of news items related to economic uncertainty. For further details please see www.policyuncertainty.com 2 Please see U.S. Bond Strategy Weekly Report, "What We Know About Uncertainty", dated July 12, 2016, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/speech/brainard20170905a.htm 4 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 5 https://www.federalreserve.gov/newsevents/speech/brainard20170905a.htm 6 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 8 For further details on how butterfly trades respond to changes in the yield curve, and on how we use our fair value yield curve models please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Beige Book highlights disconnect between inflation words and inflation data. Peak in auto sales is not a harbinger of recession. Capital spending still trending higher. Inflation and inflation surprise will need to move higher before Fed hikes again. Big disconnect between 10-year yield and our fair value model. Feature Disconnect On Inflation Chart 1Beige Book Monitors Support##BR##Fed's Outlook On Economy And Inflation The Beige Book released on September 6 supports the Fed's base case outlook for the economy and inflation. It also keeps the Fed on track to begin trimming its balance sheet in September and boost rates by another 25 basis points in December if the CPI and PCE inflation readings turn higher. Our quantitative approach to the qualitative data in the Beige Book points to an acceleration in GDP and inflation, less business unease from a rising U.S. dollar, and ongoing improvement in real estate, both commercial and residential (Chart 1). At 64%, the BCA Beige Book Monitor was still near its cycle highs in September, providing further confirmation that economic growth was sturdy in the first two months of Q3. The Fed noted that "the information included in the report was primarily collected before Hurricane Harvey made landfall on the Gulf Coast." However, there was a mention of the storm's clout based on preliminary assessments of business and banking contacts across several districts. The U.S. dollar should not be much of an issue in the Q3 earnings season, according to the Beige Book. The greenback seems to have faded as a concern for small businesses and bankers, in sharp contrast with 2015 and early 2016 when Beige Book references to a strong dollar surged. The Q3 earnings reporting season will provide corporate managements with another forum to discuss the currency's impact on their operations. The 2% decline in the dollar over the past 12 months suggests that the dollar may even provide a small lift to Q3 results (Chart 1, panel 4). Remarkably, business uncertainty over government policy (fiscal, regulatory and health) has moved lower in 2017. The implication is that the business community is largely ignoring the lack of progress by Washington policymakers on Trump's agenda (Chart 1, panel 5). Echoing the market's disagreement with the Fed on inflation, the big disconnect in the Beige Book showed up in the number of inflation words (Chart 1, panel 3). Expressions of inflation dipped between the July and September reports. That said, a wide disconnect remains between the elevated inflation mentions and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The Beige Book backs the Fed's assertion that the economy will expand around 2% this year and inflation will mount in the coming months, supporting a gradual removal of policy accommodation. Policy uncertainty in Washington and worries over the dollar seem to be fading. The divide between the quantity of inflation words in the Beige Book and measured inflation remains unresolved. Neither the soft data in the Beige Book nor the hard data on the economy suggest that an economic downturn is nigh. Recession Not Imminent Some investors have concluded that the peak in auto sales, a key component of consumer spending on durable goods, suggests that a recession is imminent (Chart 2). We take a different view. Zeniths in consumer durable goods, followed closely by consumer services, were primary harbingers of economic downturns in the post-WWII period. However, expenditures on autos, light trucks and other durables tend to peak seven quarters before the onset of recession. Consumer spending on nondurable goods and services provide less of a warning, topping out just five and four quarters out, respectively. The implication for investors is that the peak in auto sales suggests that a recession is still several years away (Chart 3, panels 1-4). Chart 2Vehicle Sales May##BR##Have Peaked Chart 3Consumer Spending And##BR##Housing Prior To Recessions Housing investment provides an even earlier indication that a recession is on the horizon (Chart 3, panel-panel 5). Housing peaked 17 quarters before the start of the 2007 recession and 20 quarters, on average, before the onset of the 2001 and 1991 recession. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced. While housing's contribution to overall economic growth plunged in Q2, we expect housing to provide fuel for the next few years as pent up demand from the depressed household formation rate since the GFC is worked off. The implication from our upbeat view on housing is that the next recession is still several years away. Bottom Line: We expect the next recession to be triggered by an over aggressive Fed, not by imbalances in one of more segments of the economy. It is premature to say that the economy is headed into recession based on a peak in auto sales. Stay long stocks versus bonds, but we recommend that clients be prudent, paring back any overweight positions and holding some safe-haven assets within diversified portfolios. Business Capital Spending Still Up Elevated readings on capex in the first half of the year should persist into the second half. Corporate managements may be postponing investment decisions until they have more clarity on federal tax policy and the Trump administration's plans for infrastructure investment. In short, corporations continue to struggle with how much and when to spend, rather than whether to invest at all. The key supports for sustained corporate spending stayed in place despite the soft July factory orders report and lackluster C&I loan growth. BCA's model for capex (based on non-residential fixed investment, small business optimism and the speculative-grade default rate) suggests lending is poised to climb on a 12-month basis (Chart 4) despite the softening of C&I loan growth since November 2016. Moreover, the 3.3% month-over-month (m/m) drop in factory orders in July masked an upward revision to orders in June and a substantial 1.0% m/m gain in core orders. Core shipments, which feed directly into GDP, rose 1.2% m/m in July. Almost all of the weakness in orders and shipments in July was linked to a 71% plunge in the volatile aircraft orders segment. BCA's research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. Consumer expenditures averaged an above-trend 2.7% in 1H. We anticipate that household spending will continue to improve in the second half of 2017.1 Moreover, recent readings on core durable goods orders and shipments show that the uptrend that began in mid-2016 persists, despite recent monthly wiggles in the data (Chart 5). Chart 4BCA Capex Model Points##BR##To Further Improvement Chart 5Capital Spending##BR##Remains In An Uptrend CEO confidence, still a primary support for capex, recently soared to a 13-year high in Q1, but retreated modestly in Q2. The last reading on this survey was in mid-July, and the dip in sentiment reflects the lack of legislative progress in Washington (Chart 5, top panel). The next CEO survey is set for mid-October. The dip in CEO sentiment in Q2 stands in sharp contrast with the easing of concerns around policy in the Beige Book. Chart 6Surprising Drop In Policy##BR##Uncertainty This Year Surprisingly, the chaos in Washington during the first eight months of the Trump administration has not led to an increase in economic policy uncertainty (Chart 6). Instead, after rising sharply in the wake of the Brexit vote in mid-2016 and the U.S. presidential election in November, policy uncertainty has ebbed. While uncertainty over economic policy remains elevated relative to the past few years, the concern under Trump is surprisingly subdued. This metric is in line with the Beige Book's assessment of Trump's impact on sentiment. A series of business-friendly legislative wins for the GOP and President Trump would further reduce any qualms. Even so, a failure by Congress to boost the debt ceiling and fund the U.S. government later this month would increase business worries/fears. Late last week, Trump cut a deal with Congressional Democrats to extend the debt ceiling for three months and is in talks to do away with it altogether. Bottom Line: The fundamentals still support solid business spending. However, BCA's positive capex outlook in the U.S. could be blemished if the Republicans fail to deliver on their promises to cut taxes and boost infrastructure spending in the next several months. Inflation Surprise And The Fed Chart 7The Fed Cycle And Inflation Surprise We expect inflation surprise to move higher, which could spur the Fed to resume its rate hike campaign. A disconnect has opened between economic surprise and inflation surprise.2 In the past 13 years, there have been 15 periods when economic surprise has climbed after a trough. The inflation surprise index temporarily increased in 13 of those episodes. For example, in the aftermath of the oil price peak in the U.S. in mid-2014, both economic surprise and inflation surprise diminished through early 2015 and then began climbing. However, today's inflation surprise index has rolled over while economic surprise has gained. The inflation surprise index escalated during previous tightening regimes when the economy was at full employment and the Fed funds rate was in accommodative territory (Chart 7). The last time those conditions were in place, which was in 2005, the Fed was wrapping up a rate increase campaign that began in mid-2004. Mounting inflation surprise also accompanied most of the Fed's rate increases from mid-1999 through mid-2000 under similar conditions. In late 2015, as the current set of rate hikes commenced, the inflation surprise index was on the upswing, the economy was close to full employment and the Fed funds rate was accommodative. What Does This Mean For The Fed? The above analysis underscores that economic growth is in good shape and it is likely to remain so for the next year at a minimum, barring any nasty shocks. Normally, the positive U.S. (and global) growth backdrop would place upward pressure on bond yields. It has not been the case this time. Investors appear skeptical of the ability of strong economic growth to generate higher inflation. The attitude seems to be "we will believe it when we see it". Some on the FOMC are taking a similar attitude. Lael Brainard, a FOMC governor, presented an interesting speech last week that makes this point. She speculated that inflation has been lower post-Lehman for structural reasons related partly to a drop in long-term inflation expectations. The Fed has been reluctant in the past to even hint that inflation expectations have become unmoored, because that could reinforce the trend, thus making it harder for the Fed to move inflation up to target. Brainard, a voting member of the committee with a dovish bias, argued that unemployment may have to undershoot the full employment level for longer than normal because low inflation expectations will be a persistent headwind. She also implied that the central bank should allow inflation to temporarily overshoot the 2% target. At a minimum, she wants to see evidence of rising inflation and inflation expectations before the Fed delivers the next rate hike. In the past, Brainard's speeches have sometimes heralded shifts in the FOMC's consensus. An example is her December 1, 2015 speech at Stanford.3 It is not clear if this is the case this time, but it does reinforce the view that a strong economy and a falling unemployment rate is not enough to justify another rate hike this year according to the consensus on the FOMC. Bottom Line: Our inflation indicators are pointing mildly up. Nonetheless, timing the upturn in inflation is difficult and the Fed will not hike in December without at least a modest rise in inflation (together with higher inflation expectations). We are short duration because Treasuries are overvalued and market expectations for Fed rate hikes over the next year are overly complacent (see next section). Nonetheless, a rise in yields may not be imminent. Disconnect On Duration The Global Manufacturing PMI reached a more than 6-year high in August, climbing from 52.7 in July to 53.1 last month (Chart 8, panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (Chart 8, bottom panel). Together, these two factors suggest that global growth is accelerating and becoming broader based. BCA's U.S. Bond Strategy service4 views the improving global economic backdrop as an extremely bond-bearish development. A wide global recovery means that when U.S. data turns surprisingly positive, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand and surge in the dollar. Our Treasury model (based on Global PMI and dollar sentiment) currently places fair value for the 10-year Treasury yield at 2.67% (Chart 8, top panel). Moreover, our 3-factor version of the model (which includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.68% (not shown). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. After adjusting for changes in credit rating and duration over time, the average spread offered by the Bloomberg Barclays corporate bond index is fairly valued relative to similar stages of past business cycles. However, the Aaa-rated portion of the market looks expensive. Further, strong Q2 profit growth likely foreshadows a decline in net leverage. This lengthens the window for corporate bond outperformance. We recommend an overweight in the high-yield market. In the early stages of the previous two Fed tightening cycles (February 1994 to July 1994 and June 2004 to December 2005), the index option-adjusted spread averaged 342 bps and traded in a range between 259 bps and 394 bps. This puts the current junk spread (378 bps) almost in line with the average achieved during other similar monetary conditions (Chart 9). We continue to favor a "buy on the dips"5 approach in the high-yield market. Chart 8Treasury Fair Value Models Chart 9High-Yield Market Overview Regarding high-yield valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6% and recovery rate of 49% (Chart 9, bottom panel). We remain underweight MBSs; While MBS are starting to look more attractive, especially relative to Aaa credit, we think it is still too soon to buy. The Fed will announce the run-off of its balance sheet when it meets later this month. The market has been pricing in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments. Bottom Line: Rates have tested their post-election lows, but BCA's fair value model suggests a bounce higher, which supports our stocks-over-bonds stance. In terms of U.S. bonds, we favor short duration over long and credit over high quality. MBSs will be hurt more than Treasuries as the Fed begins to shrink its balance sheet. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy ryans@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", July 24, 2017. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Surprise, Surprise", August 28, 2017. Available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/newsevents/speech/brainard20151201a.htm 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "The Cyclical Sweet Spot Rolls On," September 5, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA's U.S. Bond Strategy Weekly Report, "Keep Buying Dips," March 28, 2017. Available at usbs.bcaresearch.com.

Highlights Portfolio Strategy A supply/demand imbalance has created a playable opportunity in the niche refining energy sub-index. Increase exposure to overweight. Safe haven demand is supporting gold mining equities, but shifting macro forces suggest that it will soon be time to move to the sidelines. Global gold miners are now on downgrade alert. Recent Changes Lift the S&P oil & gas refining & marketing index to overweight today. Put the global gold mining equity index (ticker GDX:US) on downgrade alert. Table 1 Feature The S&P 500 moved laterally last week as sustained geopolitical uncertainty offset encouraging economic data. Synchronized global growth coupled with the related global liquidity-to-growth transition remain the dominant macro themes. Dovish Fed speeches triggered a recalibration of market rate hike expectations and a lower 10-year Treasury yield. As long as lower bond yields reflect a less hawkish Fed rather than a deflationary relapse, they should underpin stock prices. Encouragingly, the latest ISM manufacturing survey catapulted higher to a level last seen in early 2011, diverging steeply from the bond market, as manufacturing optimism reigns supreme (Chart 1). The labor market confirmed this data. The most cyclical parts of the U.S. economy are firing on all cylinders, with manufacturing and construction job creation comprising 1/3 of nonfarm payroll growth last month (Chart 2). This is the highest reading since July 2011. Chart 1Unsustainable Divergence Chart 2Manufacturing Flexing Its Muscle Meanwhile, despite the Trump administration's shortcomings, America's CEOs are going against the grain. Capex is up smartly for the second consecutive quarter adding to real GDP growth and our capital spending model remains upbeat heralding additional outlays for the remaining two quarters of the year (Chart 3). Similarly, regional Fed surveys of capex intentions point to a sustainable pickup in capital spending in the coming months (Chart 3). Still generationally low interest rates, a less hawkish sounding Fed, coupled with a tamed greenback (Chart 4) and synchronized global growth have combined to revive animal spirits. The implication is that profit growth rests on solid foundations, a message corroborated by our S&P 500 EPS growth model (Chart 5). Chart 3CapEx To The Rescue Chart 4Dollar... Chart 5...And EPS Model Waving Green Flag Adding it up, the macro backdrop remains favorable for stocks. In fact, it represents a goldilocks equity scenario. This week we continue to add some cyclicality to our portfolio by further boosting a niche energy play. We also update our view on a portfolio hedge. Buy Refiners For A Trade In early July, we lifted refiners to neutral and locked in impressive gains for our portfolio, but three reasons kept us at bay and prevented us from turning outright bullish on this niche energy sub-sector.1 Namely, all-time high refining production, high refined product stocks and breakneck pace refinery runs were offsetting the nascent recovery in gasoline consumption, rising crack spreads and a mini V-shaped recovery in industry shipments. Net, we posited that a balanced EPS outlook would prevail in coming quarters. Hurricane Harvey has significantly changed this calculus and now clearly refiners are in a sweet earnings spot for at least the remainder of the year, compelling us to lift exposure to overweight. Severe refinery shutdowns are likely to return industry production levels to what prevailed early in the decade, representing a major, albeit temporary, setback (Chart 6). This production curtailment will result in sizable petroleum products inventory drawdowns and a likely halt (if not reversal) in refined product net exports in order to satisfy domestic demand. The longer it takes for refinery production to return to normalcy, the greater the inventory whittling down. Historically, relative share price momentum has been inversely correlated with inventory growth and the Harvey-related inventory clear-out is heralding additional relative performance gains (bottom panel, Chart 7). It is notable that both industry net exports and inventories had already been receding since the beginning of 2017, suggesting that hurricane Harvey will only accelerate a downtrend that was already in place. Chart 6Hurricane Related Blues... Chart 7... Are A Boon For Crack Spreads Taken together, this represents an ultra-bullish pricing power backdrop for the U.S. refining industry, at a time when capacity additions are also likely to, at least, pause for breath (bottom panel, Chart 6). Chart 8Brisk Demand Indeed, refining margins have jumped recently and will likely remain elevated as the Brent/WTI spread is widening anew (middle panel, Chart 7). Surging crack spreads are synonymous with higher earnings for this extremely capital-intensive and high operating leverage industry. Nevertheless, the refining supply disruptions only tell half the story. Refined product demand is exploding higher, pushing all-time highs and signaling that a substantial supply/demand imbalance is in the works (top panel, Chart 8). Typically this gets resolved via higher gasoline prices, further boosting industry EPS prospects (third panel, Chart 8). As a result, we expect a re-rating phase in relative valuations in the coming months, reversing the year-to-date deflation in the relative price-to-sales ratio. The second panel of Chart 8 shows that relative valuations and refined product consumption move in lockstep, and the current message is to expect a catch up phase in the former. In sum, a playable rally in refiners is in the offing on the back of a budding profit recovery that has yet to filter through analysts' EPS estimates (bottom panel, Chart 8). The longer-than-usual hurricane Harvey-related refining production disruptions, along with the spike in refined product demand, have created an exploitable opportunity. Bottom Line: Boost the S&P oil & gas refining & marketing index (PSX, VLO, MPC, ANDV) to overweight. What To Do With Gold Mining Equities? Gold and gold mining equities serve as great portfolio hedges especially in times of duress. Recent geopolitical jitters surrounding North Korea along with inaction in Washington and the substantial year-to-date selloff in the U.S. dollar have served as catalysts for gold to shine anew, hitting one-year highs. So is it time to trim exposure to shiny metal equities? The short answer is not yet. Real yields are sinking courtesy of a moderately less hawkish Fed (top panel, Chart 9). The probability of a December Fed hike has now collapsed to 30%, and the 5th hike this cycle is only priced in for next June. This is keeping a bid under gold and gold miners, as zero yielding bullion and near-zero yielding gold mining equities appear at the margin relatively more appealing. The equity risk premium has also stopped falling owing largely to the lower 10-year Treasury yield (bottom panel, Chart 9), representing another source of support for global gold miners. Meanwhile, policy uncertainty in the U.S. and around the globe is hooking up especially given North Korea's unpredictability, Washington's polarization, the upcoming German elections and, most importantly, the looming Chinese Congress. Historically, the policy uncertainty index and relative performance have been joined at the hip and the current message is positive for bullion related stocks (middle panel, Chart 9). Similarly, the Philly Fed's Partisan Conflict Index2 ("The Partisan Conflict Index tracks the degree of political disagreement among U.S. politicians at the federal level by measuring the frequency of newspaper articles reporting disagreement in a given month. Higher index values indicate greater conflict among political parties, Congress, and the President.") and bullion enjoy a tight positive correlation since the early 1980s (Chart 10), likely warning that the precious metal's run has more upside in the short term. Chart 9Shining Chart 10Increase In Partisanship Is Bullish Gold Moreover, demand for safe haven assets remains upbeat as evidenced by recent flows into gold-related ETFs. Positioning in the commodity pits are also signaling that more gains are in store for gold and the relative share price ratio (Chart 11). Nevertheless, there are some pockets of weakness that are pointing to a more cautious stance toward this portfolio hedge. The improving U.S. economic backdrop is weighing on gold mining equities (ISM manufacturing shown inverted, middle panel, Chart 12). Not only U.S. growth, but also synchronized global growth suggests that eventually demand for bullion will subside. In fact, global growth expectations continue to perk up (GDP expectations shown inverted, Chart 12), and G10 economic surprises are also shooting higher, anchoring gold and gold related equities (economic surprise index shown inverted, top panel, Chart 12). Chart 11Safe Haven Demand Comeback Chart 12Not All The Glitters Is Gold Tack on the inevitable liquidity withdrawal once the Fed starts to wind down its balance sheet later this month, and the handoff from liquidity-to-growth represents a bearish backdrop for gold and gold mining equities. Chart 13 shows that the Fed's balance sheet is positively correlated with bullion's relative performance versus the broad commodity complex, warning that the recent push toward multi-decade highs in relative performance are on borrowed time. Finally, our relative EPS model for the global gold mining index encapsulates most of these macro forces and suggests that relative profit growth will gravitate lower in the coming months (Chart 14). Chart 13Watch The Fed's Balance Sheet Chart 14EPS Model Is Outright Bearish Bottom Line: While our confidence in maintaining the gold-related equity portfolio hedge has fallen a notch, we are staying patient before moving to the sidelines. Put the global gold mining index (ticker GDX:US) on downgrade alert. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the July 10, 2017 U.S. Equity Strategy Report titled "SPX 3,000?", available at uses.bcaresearch.com 2 https://www.philadelphiafed.org/research-and-data/real-time-center/partisan-conflict-index Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Dear Client, I have been visiting clients in Europe this week, so today's report is somewhat shorter than usual. We will be back next week with an exciting Special Report on the macro effects of bitcoin and other virtual currencies. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Global growth remains strong and broad-based. U.S. GDP growth will accelerate over the next few quarters thanks to the easing in financial conditions so far this year. The market is pricing in only 20 basis points in cumulative rate hikes between now and the end of next year. This is far too low. Go short the Dec-2018 fed funds futures contract. The euro has strengthened more this year than one would have expected based solely on the change in interest rate differentials. Positioning shifts are the likely culprit. In real terms, the terminal rate in the U.S. based on 5-year, 5-year forward OIS rates is currently only 13 bps higher than in the euro area. We will automatically open a tactical short EUR/USD position if the euro moves above $1.22 any time over the next three weeks. Feature Global Economy Firing On All Cylinders The global economy continues to chug along. All 46 countries monitored by the OECD are on track to grow this year, the first time this has happened since 2007. Usually, economists are too optimistic about growth prospects. This has not been the case over the past 12 months. Consensus global growth estimates for 2017 and 2018 have marched higher during this time, led by the euro area, Japan, and a number of emerging economies (Chart 1). U.S. growth projections have been broadly stable, but these too are likely to be revised higher. Both the manufacturing and non-manufacturing ISM indices improved in August. The same goes for core capital goods orders, consumer confidence, retail sales, and homebuilder sentiment. The employment report was on the weak side, but it was probably distorted by seasonal factors - August payrolls have now fallen short of expectations for seven years in a row, a suspiciously long streak. Hiring intention surveys and perceptions of job availability both remain strong. The net share of households who see jobs as "plentiful" as opposed to "hard to get" rose further in August. It is now well above its pre-recession peak (Chart 2). Chart 1Higher And Higher Chart 2A Healthy U.S. Labor Market Fed Rate Expectations Are Too Dovish The Treasury market remains oblivious to these developments, focusing only on the failure of inflation to rise. This could prove to be a fatal mistake. Inflation is a highly lagging indicator. It typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 3). Trying to infer the true level of economic slack from today's inflation rate is like trying to read the speedometer of an automobile when there is a 30-second delay between what the dial says and when you step on the accelerator. Many market participants and a number of Fed officials have argued that interest rates are already close to neutral, implying little need for further rate hikes. We agree that the neutral rate is lower than in the past, but their argument misses a crucial point. Even if the Fed knew what the level of the neutral rate is - which, of course, it doesn't - it would still need to get the timing right. If the Fed waits too long to bring rates up to neutral, the unemployment rate will end up falling below NAIRU. This could force the Fed to raise rates more aggressively than it (or the markets) would like. Such an outcome now looks increasingly likely. The easing in U.S. financial conditions since the start of the year should boost real GDP growth over the next few quarters (Chart 4). This could cause the unemployment rate to fall to 3.5% by next summer, leaving it below its 2000 lows and more than a full point below most estimates of NAIRU. If this were to happen, it would prompt the Fed to turn up the hawkish rhetoric. Chart 3Inflation Is A Lagging Indicator Chart 4Easing Financial Conditions In The U.S. Bode Well For Growth The market is not giving enough weight to such an outcome. The December-2018 fed funds futures contract is pricing in only 20 basis points in cumulative rate hikes between now and the end of next year. That is much too low. We recommend that clients short this contract and are initiating a new tactical trade to this effect. ECB Will Take It Easy In contrast to the U.S., euro area financial conditions have tightened this year. During his press conference, Mario Draghi expressed confidence in the growth outlook, but acknowledged the risks to the region from a stronger currency. He noted that "the recent volatility in the exchange rate represents a source of uncertainty which requires monitoring with regard to its possible implications for the medium-term outlook for price stability." As we predicted last week, the ECB trimmed its 2018 inflation forecast from 1.3% to 1.2%, and its 2019 forecast from 1.6% to 1.5%. Chart 5 shows the market's estimate of the gap in terminal interest rates between the U.S. and the euro area using 5-year, 5-year forward OIS rates. The gap has narrowed by around 50 bps since the start of the year. However, EUR/USD has strengthened more than one would have expected based solely on the movement in interest rate differentials. Specifically, the market now expects U.S. five-year yields to be 78 basis points higher in 2022 than in the euro area. This is precisely the same gap that prevailed last October. Yet, EUR/USD was $1.10 back then. Today, it is $1.20. Shifts in positioning help explain why the euro has strengthened so much. Traders were heavily short the euro at the start of this year. Today, they are heavily long (Chart 6). Looking out, with few euro shorts left, EUR/USD is likely to trade off the interest rate gap between the two regions. Chart 5U.S. Vs. Euro Area: Interest Rate Gap Has Narrowed Chart 6Euro Positioning: From Deeply Short To Long Chart 7Fiscal Policy Is More Stimulative In The U.S. In real terms, the terminal rate in the U.S. is currently only 13 bps higher than in the euro area. That seems rather low to us. Trend growth is faster in the U.S., the banking system is in better shape, and fiscal policy is more stimulative (Chart 7). All this suggests that the real neutral rate is substantially higher in the U.S. As such, we will automatically open a tactical short EUR/USD position if the euro moves above $1.22 at any time over the next three weeks, with a stop of $1.24 and a year-end target of $1.15. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Based on long-term moving averages and the advance/decline line, the dollar selloff is still only a severe correction. These factors need to be monitored closely as they stand on the edge. To rebound, the dollar will need U.S. inflation to pick up, which will lift the U.S. OIS curve. Signs are accumulating that U.S. inflation will trough toward the end of 2017. Buying the dollar versus the yen is a much safer bet than shorting the euro. The CAD has more upside, especially on its crosses. Feature The U.S. dollar continues to be tested by investors. As paradoxical as it may sound, it is still too early to sound the death knell for the dollar bull market. However, it is not time either to aggressively bet on a rebound. For that to happen, U.S. inflation must regain its footing in a more convincing fashion. Why Isn't The Bull Market Dead? There are many facets to this question, but let's begin with technical considerations. First, the dollar's advance / decline line has not broken down (Chart I-1). A breakdown in this measure would be one of the key technical signals that the dollar has begun a new cyclical downtrend. In the mid-1990s, the dollar did experience a period of correction. During that time frame, the A/D line was also unable to break down, later highlighting that what was initially perceived as the beginning a new bear market was ultimately a prolonged period of consolidation. Chart I-1Still Not A Cyclical Bear Market Second, the dollar's trend has been best approximated by the four-year moving average of monthly prices. Since the Smithsonian Agreement of 1971, during bear markets, the dollar tends to find its ceiling around this indicator, and during bull markets, it tends to put a floor around this moving average (Chart I-2). Today, the dollar has yet to end a month below this measure. Third, positioning in the dollar is now depressed, as investors have purged their stale USD longs (Chart I-3). When one looks at net long speculative positions in EUR/USD - the most convenient and liquid instrument to bet on the dollar - investors are clearly enamored with the euro, which by definition illustrates their dislike of the greenback. Chart I-2No Trend Break For Now Chart I-3Dollar Downside Is Limited Technical indicators argue that we have experienced a painful correction in the USD, but valuation considerations suggest it will be difficult for these technical indicators to deteriorate enough to begin flagging a cyclical bear market. Our long-term fair value model, which incorporates productivity differentials, highlights that the dollar never hit the nosebleed levels associated with bull market tops in 1985 or in 2001 (Chart I-4). The stability in the trade balance and the current account - both have been stable at around 3% of GDP and 2.5% of GDP, respectively - are at odds with the sharp deterioration in the balance of payments that has occurred when the dollar has been genuinely expensive. Our intermediate-term valuation models point to an even more unequivocal conclusion. Based on this metric, the DXY is at its cheapest level since 2009, a discount that historically has been associated with dollar bottoms, at least temporary ones (Chart I-5). This gives us comfort that the A/D line is unlikely to break down for now, or that the dollar will end September significantly below its crucial four-year moving average. However, if these things happen, the dollar could experience significant downside. Chart I-4The Dollar Never Reached Nosebleed Valuations Chart I-5Big Discount To IRP Economic forces too do not point to a sharp move in the DXY below 91 - one that could drive the dollar down into the low 80s. After a period of deep underperformance, the U.S.'s economic surprises relative to the G10 have begun to stabilize, as have inflation surprises. More saliently, the incredible strength in the U.S. ISM manufacturing index, especially when compared to other PMIs around the world, points to a rebound in the USD, or at the very least, stabilization (Chart I-6). Finally, the market has now all but priced out additional hikes from the U.S. interest rate curve. There are only 30 basis points of hikes priced in over the next 24 months. Moreover, the probability of the fed funds rate remaining between 1% and 1.25% only falls below 50% in September 2018 (Table I-1). This seems to be a sanguine scenario. Chart I-6Cyclical Support ##br## For USD Table I-1Investors See U.S. Rates At Current ##br##Levels Until Late 2018 Bottom Line: The dollar's technicals are not yet indicative of the end of the cyclical bull market. However, they do need to be monitored closely. Additionally, the dollar is trading at a large discount to interest rate parity relationships, and the Federal Reserve is not expected to execute its next hike until late 2018. While these factors may not point to an imminent rebound in the USD, they do suggest that the down-wave in the dollar is very long in the tooth. Chasing the dollar lower is dangerous. Too Early To Bet The House On A Renewed Upleg Chart I-7The Global Deflation Anchor This observation on the probability of a Fed move brings us to the vital question of what could lift the U.S. interest rate curve higher, and thus the dollar. This would be the outlook for inflation. As Fed Governor Lael Brainard clearly argued this week, the Fed is not meeting its inflation mandate, warranting a slower pace of rate increases as global deflationary forces remain very potent. The dovish path implied by interest rate markets shows that investors already agree with this assessment. There is no denying that inflation has been globally and structurally pulled down by various forces. While the "Amazon effect" has grabbed headlines, Mark McClellan argues in The Bank Credit Analyst this month that the effect of e-commerce on inflation is no greater than that of Walmart in the 1990s - and probably amounts to a meagre 0.1-0.2% depressive impact on inflation.1 Instead, we peg the capacity buildup in EM and China - which has lifted the global capital stock massively since the turn of the millennia - as the main source of global deflation (Chart I-7). Now that global credit growth is lower than it was before 2008, it has become clearer that the global supply side of the economy has expanded faster than underlying demand, resulting in downward pressure on prices. Nonetheless, while there is a lid on inflation, this does not imply that cyclical determinants of inflation have been fully neutered. They simply have become weaker. Inflation can still ebb and flow in response to the business cycle, but the upside is not as strong as it once was. This limits how high nominal interest rate can go, which is why it is hard to envision a terminal rate much above 3% - a very low reading by post-war standards. Here, we continue to see a turning point coming later this year for inflation, one that would pull core PCE closer to the 2% mark wanted by the Fed in 2018. In the background, our composite capacity utilization indicator is now firmly in "no slack" territory, an environment in which inflation tends to perk up and where interest rate exhibit upside (Chart I-8). This is not enough to warrant fears of inflation, but healthy growth in this context should be a red flag for deflationists. This is exactly the set of circumstances we envision for the next 12 months, even if hurricane Harvey and its potential successors create noise in upcoming data. The U.S. economy has benefited from a strong easing in financial conditions since February 2016. The recent fall in real rates, which has been the key driver of the 60 basis-points fall in Treasury yields since December 2016, is now demonstrably reflationary. Lumber prices are once again at the top of their trading range since 2013, and gold prices have regained vigor. In this optic, the ratio of metal to bond prices - adjusted for their very different volatilities - has been a reliable leading indicator of U.S. growth (Chart I-9). Today, it is pointing to an acceleration of GDP growth relative to potential, the very definition of declining slack. Chart I-8Tight U.S. Capacity Is Inflationary Chart I-9Relfation Will Boost U.S. Growth Above Trend The labor market continues to display signs of resilience as well. True, the last employment report was paltry, but August has been marked by seasonal weaknesses for the past seven years. Moreover, August weaknesses have tended to be minimized in the wake of the notorious revisions typical of the U.S. Department of Labor. However, the strength in the labor market components of the NFIB small businesses survey highlights the potential for more job gains going forward. Where this indicator really shines though, is in its capacity to forecast household total wages and salaries (Chart I-10). Today, this gauge highlights that the income of middle class households will accelerate over the next six months. This matters because if the middle class - a category of U.S. households that gather the vast majority of their income from wages - experiences strong income growth, this will create robust support for consumption. With consumption accounting for 70% of U.S. GDP, a boost to this component would go a long way in lifting aggregate growth. Stronger growth in a tight economy is inflationary, and monetary dynamics confirm this risk. The U.S. velocity of money has picked up meaningfully, and now suggests that inflation will gather steam later this year (Chart I-11). Chart I-10The Labor Market Is Still Strong Chart I-11Monetary Dynamics Point To More Inflation We therefore expect that when this turnaround in inflation emerges, investors will re-assess their expectations for the path of U.S. monetary policy, and the dollar will finally be able to resume its upward trek toward new highs. But until inflation turns the corner, the dollar will continue to struggle to rally durably. Bottom Line: The U.S. economy is still on a firming path. With the amount of slack in the economy vanishing and with the velocity of money accelerating, this will lead to a pick-up in inflation late this year. The end of Q4 is likely to prove the moment when the dollar will finally be able to begin firming up. Investment Implications Shorting the Yen Is Still The Safest Bet Shorting the yen remains the best way to play a dollar rebound for now. The yen has not benefited much from the recent bout of risk aversion prompted by the renewed flare-up of in tensions in the Korean peninsula. It remains weak on its crosses like EUR/JPY, CAD/JPY or even AUD/JPY. USD/JPY seems incapable of staying below 108.5, and may even be forming a consolidation pattern reminiscent of the one experienced in 2013 (Chart I-12). In late 2013, this pattern was resolved by U.S. bond yields moving higher. This time is likely to be similar. The recent weakness in Japanese wages remains a key hurdle that the Bank of Japan does not seem able to shake off. Wage growth hit it slowest pace since 2015 and real wages are worryingly weak (Chart I-13). This is not the picture of an economy with any hint of inflation, even if the labor market is tight. Illustrating this point, contrarily to the euro area, Japanese inflation expectations have not kept pace with the U.S. in recent months (Chart I-14). This argues that the BoJ faces the greatest burden of any central bank. With the BoJ now packed with doves, we expect that interest rates and bond yields in Japan will remain capped for the foreseeable future. As a result, if U.S. bond yields can rise in the face of a strong U.S. economy, JGB yields will not follow higher. This will flatter USD/JPY. Chart I-12Consolidation Pattern In USD/JPY Chart I-13Falling Labor Income In Japan Chart I-14Japanese CPI Swaps Are Outliers A More Complex Picture For The Euro As investors have become more comfortable with the economic and political prospects of the euro area, the euro has become increasingly over-owned, but most importantly, has completely deviated from interest rate parity relationship (Chart I-15). At first glance, this would indicate the euro is greatly vulnerable. This reality, along with very long positioning of speculators in EUR/USD, highlights that it will be difficult for the euro to stay above 1.20 in the coming months. However, for the euro to move below 1.15, U.S. inflation has to pick up. Thus, for the remainder of the year, the EUR/USD is likely to remain range bound between these two numbers. Two factors make the picture less clear for EUR/USD than for USD/JPY. First, the European Central Bank is intent on beginning to taper its asset purchases this year, a move that will be announced in October. At yesterday's press conference, ECB President Mario Draghi was unequivocal about this, despite the slight curtailments to the central bank's inflation forecasts. Moreover, the seeming lack of concern vis-à-vis this year's 6% increase in the trade-weighted euro was perceived by investors as a green light to keep betting on a stronger EUR/USD. Second, as we argued five months ago, exchange rate dynamics are more a function of assets' expected returns than just interest rate differentials.2 As Chart I-16 illustrates, when a portfolio of eurozone stocks, bonds and cash outperforms a similar U.S. one, this leads to a durable rally in EUR/USD. Today, the relative performance of this European portfolio is toward the bottom of its historical distribution, and may even be already turning the corner. If this move has durability, inflows into the euro area could push EUR/USD back into the 1.3 to 1.4 range. Chart I-15Euro Is Expensive ##br##To IRP Chart I-16Outperforming Euro Area Assets##br### Could Support EUR/USD The Loonie Will Keep Flying The Bank of Canada delivered another rate hike this week. The BoC continues to focus on closing the Canadian output gap and the strong economy, ignoring weak wages and inflation. The BoC was rather sanguine regarding the slowdown in real estate activity in Toronto, Canada's largest city, and seemed comfortable with the CAD's recent strength, arguing it was a reflection of Canada's strength and not yet an impediment to it. The CAD interpreted this announcement bullishly. We agree. In a Special Report written last July, we argued that the BoC was among the best-placed central banks to tighten policy among the G10.3 Additionally, the CAD is cheap, trading at a 7% discount to PPP. It is also still below its fair value, implied by interest rate differentials. As such, we continue to overweight the Canadian dollar, being long the loonie against the euro and the Aussie. It also has upside against the USD, but could prove vulnerable to a pick-up in U.S. inflation. Thus, we remain committed to buying the CAD on its crosses. Bottom Line: The euro may be expensive relative to interest rate differentials, but the anticipation around the ECB's tapering continues to represent a support under EUR/USD. As a result, this pair is likely to remain range-bound, roughly between 1.2 and 1.15. USD/JPY has more upside as Japanese inflation expectations and wages are sagging, suggesting the BoJ is nowhere near the ECB in terms of moving away from an ultra-accommodative stance. The CAD will continue to experience upside for the remainder of the year; stay long the loonie on its crosses. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see The Bank Credit Analyst Monthly Report, "Did Amazon Kill The Phillips Curve?" dated August 3, 2017, available at bca.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "The Fed And The Dollar: A Gordian Knot", dated April 14, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy And Global Alpha Sector Strategy Special Report, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The dollar had a particularly eventful week. With Fed officials Brainard and Kashkari unleashing their dovish remarks, the greenback suffered as investors pushed down 10-year yields. While Brainard highlighted her concern over the "recent low readings of inflation", Kashkari took it further and said that the hikes may be "doing real harm" to the economy. Adding to the Fed's concerns, Stanley Fischer, a long-serving Fed official and an ardent supporter of policy normalization, announced his resignation on Wednesday. Mario Draghi's hawkish press conference added further downward pressure on the dollar, with the DXY making a new low of 91.41. It is unlikely that the dollar will be able to meaningfully rally until inflation re-emerges, a year-end event. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro reacted very positively to the ECB monetary policy speech. Draghi highlighted the uncertainty associated with the strong currency, but noted that the ECB doesn't expect it to have a large impact on inflation, which helped the euro hit a high of EUR/USD 1.2018. He nonetheless highlighted that achieving the ECB's price mandate will require "patience" and "persistence" and he expects inflation to hit its target by 2020. Additionally, the ECB lowered its inflation forecasts, while increasing its 2017 growth forecasts. In terms of QE, Draghi clarified that details will be revealed in the next meeting held on October 26, but that interest rates will remain accommodative for an extended period of time. Although President Draghi laid out some concerns about the strong euro, it seems momentum is unlikely to falter unless markets become more positive on the dollar or the pound. We expect this to occur by the end of this year, when inflation picks up again in the U.S. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: Industrial production yearly growth declines substantially from June's 5.5% number, coming in at 4.7%. This data point also underperformed expectations. Housing starts contracted by 2.3% on a YoY basis, also underperforming expectations. Meanwhile, labor cash earnings also contracted by 0.3% on a yearly basis, underperforming expectations. As we highlighted a few weeks ago, multiple indicators are signaling a slowdown in the Japanese economy. The recent batch of negative data seems to confirm this view, which means that the dovish bias of the BoJ will only be further reinforced. Consequently the yen will be the mirror image of U.S. bonds. Given that rate expectations have collapsed to the point that the market is only anticipating 30 basis points in hikes in the U.S. over the next 2 years, risks point upwards for USD/JPY. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in U.K. has been mixed: Markit manufacturing PMI increased from August to July, coming in at 56.9. This data point also outperformed expectations. Meanwhile, both construction and Markit services PMI underperformed expectations coming in at 51.2 and 53.2, respectively. Finally, nationwide house price year-on-year growth also underperformed expectations, coming in at 2.1%. At the beginning of August, we warned of a repricing of rate expectations in the U.K. given that the pass through from the currency was set to dissipate, while the housing market and real disposable income were undergoing a major slowdown. So far, this view has proven correct, with the pound falling against the dollar and the euro. We expect that GBP/USD has further downside on a 12 month basis, as rate expectations in the U.S. have likely found a bottom. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Data out of Australia was not particularly strong: TD Securities Inflation dropped on an annual basis to 2.6% from 2.7%; Gross operating profits contracted at a 4.5% rate, below the expected 4% contraction; Current account balance came in at AUD -9.862 bn, below expectations, following a 59% decrease in the trade balance from the last quarter, and a 4% decrease in the net primary income; Most notably, GDP grew at the expected 1.8% annual rate, albeit faster than the previous growth rate of 1.7%. The RBA decided to leave rates unchanged, but with a slightly hawkish tone. While growth is generally in line with the Bank's forecasts, it was also highlighted that the appreciating exchange rate and low wages remain headwinds for inflation. A brighter housing market was noted as house price increases are slowing down, owing to macroprudential measures. While the Bank sees an improving labor market, we remain skeptical as the underemployment rate has not improved, which is limiting wage growth. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Surprisingly, in spite of the weakness of the U.S. dollar, the kiwi has been falling for the past month. This has been in part due to some weak data coming out of New Zealand: Building permits continued their decline, with a Month-on-Month decline in July of 0.7%. Both the ANZ Activity Outlook and the Business Confidence indicators declines in August relative to July. The New Zealand terms of trade Index underperformed expectations, coming in at 1.5%. Additionally July's number was revised down from 5.1% to 3.9%. The recent weakness in the NZD might be indicative of some weakness permeating from EM, given that the New Zealand economy is highly sensitive to the global economy. If an EM selloff materializes we expect significant downside for the NZD particularly against the yen. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data has been quite strong out of the Canadian economy recently: The current account deficit was better than expected at CAD -16.32 bn, with the merchandise trade balance also improving; Manufacturing PMI came in at 51.7, beating the expected 51.3; GDP growth came in at an astonishing 4.5% annualized rate; Accordingly, the BoC raised the overnight rate to 1%. Markets were expecting hawkish remarks, but not a hike. The CAD rallied more than 1% against USD on the news, and outperformed all other G10 currencies. Current expectations for a December hike are at 68%, and we agree. The CAD will see further strength against all G10 currencies except USD by the end of the year. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Gross Domestic Product yearly growth came in at 0.3%, underperforming expectations and deaccelerating from a month ago. Headline inflation came in line with expectations at 0.5%, it also increase from the previous month reading of 0.3%. Real retails sales underperformed expectations, contracting by 0.7% on a YoY basis. However the SVME PMI outperformed and increased from the July reading, coming in at 61.2. After reaching 1.15 in early August, EUR/CHF has stabilized around to 1.135. Overall the Swiss economy is still too weak for the SNB to change their stance on currency intervention. Core Inflation will have to pick up to at least 1% for the SNB to consider a change in stance and let go of the implied floor in EUR/CHF. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retails sales monthly growth came in at 0.4%, recovering from last month negative reading ad outperforming expectations. Manufacturing output growth also outperformed expectations, coming in at 1.5%. Finally registered unemployment came in at 2.7%, declining from last month reading and coming in line with expectations. USD/NOK has continued to go down as rate expectations for the U.S. have decreased and oil prices have increased thanks to the refining shut-downs in Texas due to hurricane Harvey. We expect this trend to reverse once rate expectations in the U.S. start to go up. However, we do expect more downside in EUR/NOK as this cross is much more sensitive to oil prices. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data was largely downbeat: Retail sales are growing at a 3.7% annual rate, in line with expectations; The Swedish trade balance went into a deficit in July of SEK -0.5 bn from a SEK 5.4 bn surplus in June; Consumer confidence decreased to 100.3 from 102.2 and below the expected 103; Manufacturing PMI also disappointed at 54.7, below the expected 60; Swedish IP is growing at a still high 5.3% annual pace, but less than the previous 8.9% rate; While this data was somewhat weak, Swedish inflation is at or above its target across all measures. The Riksbank left its repo rate unchanged at -0.5%. In its press release, the Bank highlighted high growth and inflation but stated that the rate will not be increased until the middle of 2018. It also increased inflation forecasts, with CPI and CPIF predicted at 2.9% and 2.1% by 2019. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights Chinese monetary conditions have tightened on the margin, but have remained fairly stimulative compared with previous years, likely the key reason why overall growth has remained reasonably robust. Listed Chinese firms reported strong and broad based H1 earnings growth. The profit recovery is of fundamental importance to the Chinese economy, and the positive feedback between profits and business activity has further to run. Collectively the markets are likely flashing further upside in China’s growth cycle. At a minimum, there is no sign of an imminent downturn. The macro backdrop of economic and market fundamentals are conducive for higher equity prices in general, and Chinese equities in particular. Feature Recent manufacturing PMIs from a number of major countries confirm that the global economy is on a synchronized upturn. As an increasingly important driving force of the world economy, how China's growth outlook pans out matters materially. On this front, the most recent news has been encouraging. Chinese manufacturing PMIs, both official and private, accelerated in August and remained above the expansion/contraction threshold. Meanwhile, earnings of Chinese-listed companies in the first half of the year increased strongly from a year earlier across all major sectors, with both stronger sales and higher margins, confirming that the Chinese profit cycle upturn is firmly in place. This should further support business activity, especially among private enterprises. In addition, some market signals from global assets that are traditionally sensitive to Chinese growth trends have been fairly strong of late, likely signaling further upside in the Chinese business cycle. All of this is conducive for higher prices for Chinese equities, and paints a bullish backdrop for global risk assets. A Closer Look At The PMI The stronger-than-expected August Chinese PMI numbers set a firmer tone for the economic data to be released in the coming weeks. They also herald that economic growth in the third quarter will likely remain comfortably above the government's target, setting an ideal political environment for the country's top leadership going into the 19th Communist Party Congress in October. The policy setting will likely be maintained at status quo, and downside risks remain low. It is important to note that the recent rise in PMI has occurred in tandem with a continued decline in Chinese broad money growth, suggesting the improvement in Chinese industrial activity has little to do with money and credit stimuli (Chart 1). Some analysts have been preoccupied with inventing some obscure measures of "credit impulse" to guestimate China's near-term growth outlook, which in our view is misguided.1 Instead, China's growth improvement since last year has to a larger extent been due to marked easing in monetary conditions - a combination of lower real rates and a cheaper trade-weighted RMB. In this vein, Chinese monetary conditions have begun to tighten on margin, but have remained fairly stimulative compared with previous years. This is likely the key reason why overall growth has remained reasonably robust, despite falling monetary aggregates. It is particularly noteworthy that the trends of new orders and finished products inventory have diverged of late. New orders have stayed at close to multi-year highs, while inventory PMI has remained well below 50 since 2012, and has relapsed anew in recent months, leading to a significant rise in the new orders-to-inventory ratio (Chart 2). In other words, manufacturers remain decisively in a destocking mood, despite the improvement in new orders. Looking forward, this should supercharge production should new orders remain strong, and create a buffer for manufacturing activity should orders roll over. Chart 1Chinese PMI: Monetary Conditions ##br##Matter More Than Money Supply Chart 2Manufacturers Remain Decisively ##br##In Destocking Mood Another important development is that there appears to be some regained pricing power among service providers, which historically has been a leading indicator for manufacturers' producer prices (PPI), as shown in Chart 3. It appears that PPI may continue to downshift toward year end and regain some strength early next year. PPI has been a key signpost for China's reflation trend, and matters materially for manufacturers' profit margins and the real cost of funding. Any sign of PPI improvement will likely be viewed as a positive development from a market perspective. The market relevance of the PMI survey is that it often leads net earnings revisions of listed Chinese companies by bottom-up analysts (Chart 4). If history is any guide, net earnings revisions will likely improve further, notwithstanding earnings of listed companies have already recovered strongly in the first half of the year. Chart 3Early Signs Of PPI Bottoming? Chart 4PMI Leads Net Earnings Revisions Earnings Reality Check Chart 5A Sharp Profit Upturn By now, all listed firms in Chinese domestic stock exchanges have released financial statements for the first half of the year. Our calculations show that total earnings increased by 18% year-over-year for all listed firms, or 36% if banks and petroleum firms are excluded - both sharply higher compared with a year earlier. This is largely in line with the profit upturn reported by the national statistics agency2 (Chart 5, top panel). A few observations can be made: First, the sharp increase in earnings is due to a combination of rising sales and improving margins, underscoring a marked ease in deflationary pressures and a significant pickup in business activity in nominal terms. (Chart 5, bottom two panels). It is noteworthy that revenue growth stagnated for several consecutive years before the strong recovery since mid-last year. Similarly, profit margins dropped to close to record low levels between 2012 and mid-2016, and have since largely recovered. Profit margins, however, do not yet look overly excessive from a historical perspective. Second, the improvement in earnings is broad-based, as shown in Table 1. Materials producers and energy concerns have experienced a massive profit boom, particularly steelmakers. With the only notable exception being utilities, largely thermal power plants, whose profit margins have been squeezed by rising coal costs, most other sectors have also booked healthy profit gains. This means the profit upturn has been driven by improvement in the broader economy rather than specific government policies that benefit select industries. Finally, the banking sector has also experienced a pickup in earnings growth, especially among large state-controlled banks. More importantly, asset quality of bank loans has also improved, albeit marginally. Our calculation shows that non-performing loans (NPL) and "special-mention-loans," which banks place closer scrutiny on as borrowers face higher risks of default, have both begun to decline (Chart 6). This should not be surprising, given the corporate sector's rising profits. Leaders in the current profit recovery are mining companies, materials producers and some industrial firms, all of which have been regarded as major trouble spots in banks' loan books.3 It may be premature to declare the peak of China's NPL problem, but the profit improvement has certainly helped banks mend their balance sheets. Table 1Earnings Scorecard Chart 6Marginal Improvement##br## In Banks' Asset Quality In short, we maintain the view that profit recovery is of fundamental importance to the Chinese economy, a key pillar in our positive stance on China's cyclical outlook.4 Rising profits restore entrepreneurial confidence, boost private-sector capital spending, ease balance sheet stress of asset-heavy enterprises and de-escalate banking sector risk. It is certainly unrealistic to expect profit growth to perpetually accelerate, but there are no signs of a sudden contraction in profits anytime soon. We expect the positive feedback loop between profits and business activity has further to run. Reading Market Tea Leaves Stronger Chinese growth is also reflected in asset prices well beyond its borders. Some asset classes that are traditionally highly sensitive to Chinese growth cycles have been showing remarkable strength of late. Metals prices have been firm across the board. The London Metal Exchange Index has historically been a reliable leading indicator of China's business cycle (Chart 7). Stock prices of metals producers in major producing countries have significantly outperformed their respective benchmarks, likely pointing to an imminent upturn in China's leading economic indicator (Chart 8) The Baltic Dry Index, the benchmark for bulk shipping rates that is largely driven by Chinese materials demand, has stayed elevated, probably a sign that China's bulk commodities intake has remained fairly robust (Chart 9) Turning to the Chinese equity market, real estate developers have been among the star performers in the Chinese equity universe so far this year - historically, the relative performance of Chinese developers has been an excellent leading indicator for home sales, which in turn drives real estate investment (Chart 10). Chart 7Metals Point To Further Upside##br## In Chinese Business Cycle... Chart 8...So Do Metal Producers Chart 9Baltic And Chinese Commodity Imports Chart 10Developers' Relative Performance ##br##Leads Home Sales Collectively the markets are likely flashing further upside in China's growth cycle. At a minimum, there is no sign of an imminent downturn. Currently, global equity markets, including those in the Greater China region, are clouded by the escalating geopolitical risk over the Korean Peninsula, where the near term outlook remains volatile and unpredictable.5 Barring an extreme scenario, the macro backdrop of economic and market fundamentals are conducive for higher equity prices in general, and Chinese equities in particular. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report "A Chinese Slowdown: How Much Downside?" dated June 8, 2017, and Special Report, "Focusing On Chinese Money Supply", dated July 27, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations", dated August 31, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "Stress-Testing Chinese Banks", dated July 27, 2016, available at cis.bcaresearch.com. 4 Please see China Investment Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard", dated January 12, 2017, and "China Outlook: A Mid-Year Revisit", dated July 13, 2017, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Weekly Report, "China's Geopolitical Pressure Points: Knowns, Unknowns And A Hedge", dated August 17, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Beijing's continued focus on reducing excess industrial capacity in the lead-up to the 19th National Congress of the Communist Party will keep iron ore and steel markets buoyant for the balance of the year. The trajectory of prices further out the curve will, however, depend greatly on how quickly China's reflationary policies wane next year. Energy: Overweight. U.S. gasoline inventories could fall by 7-10mm barrels in the first week following the storm (data to be reported today by the EIA), and another 5-10mm barrels (or more) over the next month, depending on how long it takes to restart all of the refineries knocked offline by Hurricane Harvey, according to estimates in BCA Research's Energy Sector Strategy. Current gasoline inventories sit about 20 million barrels above the 2011-2015 average, which, based on our calculations, could be completely evaporated within a month, materially changing the U.S. gasoline market and related crack spreads.1 Base Metals: Neutral. Following our analysis last month, we are recommending a tactical short Dec/17 COMEX copper position at tonight's close, expecting the market to correct in line with the fundamentals we highlighted.2 Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge. The metal will be supported by low real interest rates and safe-haven demand. The position was recommended May 4, 2017, and is up 8.7%. Ags/Softs: Underweight. Another bumper crop is being priced into corn this year. Expectations for higher corn yields this year - ranging from 166.9 bushels/acre (bpa) to 169.2 bpa vs. 169.5 bpa expected by the USDA - will keep prices under pressure. We remain bearish.3 Feature In reaction to Chinese economic and environmental policies, iron ore and steel each rallied by ~78% in 2016. While steel continued its ascent in 2017 - gaining a further ~20% in the year-to-date (ytd), iron ore broke away from this trend and plummeted by more than 40% between mid-February and mid-June (Chart of the Week). Chart of the WeekSteel And Iron Ore Diverged Earlier This Year Although iron ore has since reversed its path and regained most of the loss, the divergence between steel and the ore from which it is produced comes down to a difference in fundamentals. Increased supplies of iron ore at a time of healthy inventories were bearish in H1. On the other hand, closures of both steel capacity as well as coal capacity kept the steel market tight. While China's supply-side policies have been the force behind the strength in both to date, Chinese demand - which accounts for ~50% of global iron ore and steel consumption, and steel production - will take center stage next year. The speed at which China's reflationary policies wane will determine the long-term trajectory of steel and iron ore markets. Granted while there are some early signs of a potential slowdown in China's economy, we do not expect this to hit metals generally in the near term. As Beijing continues its focus on reducing excess capacity in the steel sector, and as policymakers prepare for the 19th National Congress later this year, we expect steel and iron ore to remain buoyant in H2. China's Steel Production Paradox Eliminating Excess Steel Capacity At The Forefront Of Reform Agenda... The National Development and Reform Commission (NDRC) - China's top economic planning authority - has made clear that reducing overcapacity is at the forefront of its reform priorities. More concretely, Beijing aims to cut steel capacity by up to 100-150mm MT over the five-year period between 2016 and 2020. It has already made progress towards that end - shuttering a reported 65mm MT last year - and is on track to meet its targeted 50mm MT of steel capacity cuts by the end of 2017. Additionally, in January the central government announced its intention to eliminate all steel capacity from intermediate frequency furnaces (IFF) by the end of June 2017. So it is no surprise that steel has been performing so well. However, this narrative is inconsistent with Chinese data. ...Yet Chinese Production Is At All-Time Highs Steel production from China this year has been soaring, growing by more than 5% year-on-year (yoy) in the first seven months of 2017. In fact, latest production data from July came in at 74mm MT, marking a more than 10% yoy increase, and an all-time record high for monthly production (Chart 2). And since ~50% of global steel is produced in China, this has translated into strong global steel production figures in 2017. Production grew by 4.75% yoy in the first seven months of 2017, the most since 2011 and almost five times as much as the five-year average yoy increase for that period. In fact, the China Iron and Steel Association recently announced that the strength in steel prices does not reflect underlying fundamentals and is instead due to speculation and a misunderstanding of the market impact of China's policies. In an effort to deter speculation, China's commodity exchanges implemented several restrictions in August, including increasing margins on futures contracts and limiting positions (Chart 3).4 Chart 2Record Steel Production##BR##Amid Chinese Capacity Cuts Chart 3Pure Speculation Or Not?##BR##Beijing Cracking Down On Market Speculation It Comes Down To The Nature Of IFFs This paradox of record high production at a time of capacity closures comes down to the nature of IFF capacity that was shutdown. While for the most part, old, outdated and unproductive facilities were targeted for closure last year, the shift in focus towards IFFs had a different effect on the market in 2017. IFFs use scrap steel, rather than iron ore, as a raw material, which is melted through an induction furnace to produce low-quality steel. Because this steel fails to meet government specifications for high-quality steel, it is considered "illegal" and, although it is used to satisfy steel demand, it is not included in official production data. Thus, efforts to shut-down these producers are not evident in China's production figures. However, IFF steelmaking capacity is estimated to be 80-120mm MT a year, and accounts for ~10% of steel production capacity in China. In terms of output, this substandard steel accounts for almost 4% of Chinese production. Thus, traditional steelmaking facilities have been required to fill the supply void caused by IFF closures, raising the official production figures. Steel Exports Take A U-Turn As "Illegal" Capacity Is Shuttered Moreover, Chinese exports have reversed their trend and are on the decline. Steel exports registered a ~30% yoy fall in the first seven months of this year (Chart 4). This is further evidence that the capacity closures have had a real impact on actual steel production, and that domestic consumers have turned to steel that is typically exported, in order to fulfill their demand for the metal. Furthermore, as authorities crack down on IFFs, demand for scrap steel - the main raw material in IFFs - has declined. Amid waning demand, scrap steel prices fell by 9% in H1 before regaining almost 6% in July. This follows a ~70% rally last year (Chart 5). Chart 4Exports Are Down As##BR##Capacity Is Shutdown Chart 5Scrap Steel Rally Takes A Break##BR##As Demand From IFFs Eliminated Coking Coal Cost Push As part of its environmental protection plans, China's policymakers announced plans to replace 800mm MT of outdated coal mining capacity with 500mm MT of "advanced" capacity by 2020. Last year, coal-mining capacity closures exceeded the 250mm MT target, reversing the slump in coal prices and leading an almost 225% rally in coke futures. Coking coal, or metallurgical coal, is a key ingredient in the steelmaking process. Although coke dipped since its December high, it has rallied by 34% in the past two months. Thus, Chinese steel mills are now producing in an environment of higher input costs, which will translate to higher prices for the finished good. China's Capacity Closures Likely Peaked Given that China has set June 30, 2017 as the target for eliminating induction furnace-based steelmaking, we do not expect IFF shutdowns to continue impacting the steel market. Additionally, while excess steel capacity is conventionally estimated to be 325-350mm MT in China, the Peterson Institute for International Economics (PIIE) argues that this estimate does not account for the need for a certain amount of excess capacity. Instead, they cite 130mm MT as a more reasonable figure of Chinese excess steel capacity. According to PIIE estimates, this means that by the end of the year, China will have eliminated almost all of its excess capacity, and will be very close to the quantity of capacity closures it aims to achieve by 2020. Consequently, we do not expect shutdowns to continue driving up steel prices. However, plans to halve blast-furnace production at Northern China mills to reduce pollution during the winter will weigh on near term Chinese production and the steel market. Bottom Line: Chinese authorities are closing in on their targeted capacity shutdowns. We do not expect this reduction in capacity to continue impacting steel markets in the long term. Near-term supply dynamics will be driven by efforts to reduce winter pollution. IFF Closures Spur Demand For Iron Ore Chart 6Mid-Year China Inventories At Record High With the elimination of IFFs, which take in scrap steel as the main input, we expect greater demand for iron ore from traditional steel mills as they work toward filling the supply gap left by the loss of the so-called illegal steel. While steel prices have been on a consistent uptrend since 2016, iron ore - which usually moves in tandem with steel - diverged from its main demand market earlier this year, before resuming its rally in Q2. The deviation earlier this year was due to increased supplies from Australia and Brazil amid record levels of Chinese inventories (Chart 6). This has reversed, and iron ore has resumed its climb. Stronger demand for iron ore is consistent with import data, which shows that China has been hungry for Australian and Brazilian iron ore. However, since the average iron ore production cost in China - estimated at more than 60 USD/MT, or roughly three (3) times the cost of iron-ore production in Brazil and Australia - is greater than in other regions, many Chinese mines go offline during periods of low prices. By the same token, elevated prices tempt high-cost Chinese producers back online, increasing global supply. Bottom Line: Since the closure of induction furnaces has shored up demand for iron ore, pulling prices up with it, we do not anticipate further drops in prices. However, if prices remain elevated, increased production from China amid well stocked global markets will keep a tight lid on iron ore prices. Chinese Appetite Will Determine Long-Run Market Performance While steel and iron ore are currently well supported, their near term strength is in large part due to China's reflation policies which have revived demand. Given that it is a sensitive political year, we do not foresee downturns in the Chinese economy this year. Authorities will want to go into the 19th National Congress of the Communist Party in mid-October with solid economic data as a backdrop. However, waning Chinese growth would be a long-run negative for the markets (Chart 7). Specifically, official government data indicate: 1. There are early warning signs that the property market in China may be losing momentum. New floor space started, and new floor space completed contracted in July, while growth in floor space under construction and floor space sold have been easing. Furthermore, while total real estate investment has been growing at an average monthly rate of almost 9% yoy since the beginning of the year, July figures show a marked slowdown, at less than 5% yoy growth. We would not be surprised to see the property market winding down as China begins to tighten its real estate policies. 2. Chinese automobile production has slowed significantly from all-time highs recorded at the end of last year. The monthly average 4% yoy growth in the five months to July is a significant deceleration from the 10% yoy average witnessed during the same period last year. 3. However, infrastructure investment has been strong, recording its all-time high in June, and a 20% yoy increase in July. With the National Congress scheduled in October, we do not expect a slowdown in infrastructure spending this year. In addition, August manufacturing PMI data in China came in above expectations, and registered a slight increase from the previous month (Chart 8). The index has remained relatively stable since the beginning of the year, after gaining strength last year. Chart 7Despite Signs Of Fizzling,##BR##Slowdown Not Expected In 2017 Chart 8Accomodative Policies Will##BR##Keep Near Term Demand Solid Bottom Line: Although we expect China's appetite for steel will begin to wane as the economy unravels from its reflationary policies, steel demand will remain strong in 2017. Chinese authorities will want to ensure solid growth in the run-up to the National Congress scheduled for mid-October. Thus, the near-term focus will remain on supply, and the impact of its reforms on ferrous metals. Post-Harvey Rebuilding Will Spur Steel Demand Hurricane Harvey is expected to impact steel markets in three main ways: 30-35% of all U.S. steel imports come through Port Houston. However, the port resumed operations as of September 1 and there is no longer a threat posed on steel imports. The disruption in freight service resulting from Harvey is expected to temporarily push up trucking rates in the next few weeks. This will give U.S. steel firms, which have long been suffering from cheaper Chinese imports, an advantage and opportunity to fill the demand void which will be bullish for U.S. steel. Harvey will have a longer-run positive impact on steel markets through the demand that will be generated from the infrastructure rebuilding process. Still, increased demand for steel will be partially mitigated by a rise in scrap steel supply, in the aftermath of destruction. While it is still too early to measure the extent of damage and the impact of the rebuilding process on steel markets, estimates from the storm's damage run as high as USD 120 billion. Texas's governor estimated the damage to be much greater - between USD 150-180 billion. This compares to USD 110 billion from Hurricane Katrina, the most devastating storm to hit the U.S. prior to Harvey. Bottom Line: While it is still too early to determine the full extent of destruction, the infrastructure rebuilding phase will spur demand for steel. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's Energy Sector Strategy Weekly Report "Upgrading Refining Sector As Harvey Clears Out Inventories," published September 6, 2017 It is available at nrg.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," published August 24, 2017. It is available at ces.bcaresearch.com. 3 Please see "GRAINS - Corn lower as U.S. yield forecasts rise; soy, wheat climb," published by reuters.com on September 1, 2017. 4 Please see "Shanghai exchange urges steel investors to act rationally, hikes fees" published by reuters.com on August 11, 2017. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

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

Highlights Industrial metals prices are signaling that China's business conditions are presently robust, but they lag the credit and money measures. The most reliable leading (forward looking) indicators of Chinese business cycle have been money and credit. Presently, all money and credit indicators forecast an imminent slowdown in the industrial sectors and a relapse in base metals prices. A new trade: short copper / long Chilean peso. Inflation in Hungary will surge. Continue betting on yield curve steepening in Hungary and stay short HUF versus PLN. Feature Copper and industrial metals prices continue to signal strong growth in China, while the majority of the country's money and credit measures forecast an imminent growth slump. Which one is correct, and which one should investors heed to when formulating their investment strategy? Chart I-1 demonstrates that our broad money measure (M3) and private and public credit impulses for China both lead copper and industrial metals prices by about nine months. Based on the historical track record, odds are that investors will be better off following these money and credit indicators rather than heeding the bullish message from copper and other industrial commodities. While copper prices are coincident with the business cycle, money and credit impulses lead not only the real economy but also industrial metals prices. Copper Copper prices have surged of late (Chart I-2), seriously challenging our negative view on Chinese capital spending, commodities and EM. In fact, the rally in industrial metals has not been confined to copper but has been broad-based, and is, at first blush, suggestive of continued strength in global and Chinese industrial cycle. Chart I-1China's Money/Credit Leads Industrial Metals Prices Chart I-2Traders Are Very Bullish On Copper: A Contrarian Signal? Consistently, China's manufacturing PMI has picked up over the past three months, as has the overall EM PMI ex-China (Chart I-3). China's aggregate imports of copper products, unwrought copper, copper ore and concentrate as well as copper scrap have been contracting since May, and interestingly, they have historically often been negatively correlated with copper prices (Chart I-4). Hence, little insight can be drawn from Chinese imports of copper, as these purchases do not correlate with the mainland's business cycle. Chart I-3China/EM PMIs Have Risen Chart I-4Chinese Copper Imports And ##br##Copper Prices: Negative Correlation? On the contrary, Chinese imports of copper typically rise when copper prices fall and its industrial sector is decelerating. The reason: Chinese importers time their commodities purchases when prices slump, and do not chase prices higher. In short, when attempting to predict the sustainability of Chinese economic activity, there is little to be gained in examining Chinese copper imports. Bottom Line: Industrial metals prices are signaling that China's business conditions are presently robust, but they lag the credit and money measures discussed below. Leading Indicators: Money And Credit In our experience, the best leading indicators of the Chinese business cycle have been money and credit growth, more specifically, their impulses. The latter is the change in money/credit growth, or the second derivative of outstanding money/credit. In fact, money/credit impulses lead both the leading economic indicator and the well-known Li Keqiang index (Chart I-5). The latter two are often used by analysts and investors to gauge the direction of the Chinese economy. In recent months, we have done extensive work to properly measure money and credit. This has led us to the realization that China's official M2 and total social financing have not reflected the true dynamics in money creation and leverage formation over the past two years. In particular, M2 has over the years become a less all-encompassing money measure, as the size of commercial banks' liabilities that are not counted as part of M2 has exploded in recent years. So, the gap between M2 and other measures of money and credit has in the recent years widened as depicted on the top panel of Chart I-6. Chart I-5China: Money/Credit Leads ##br##Leading Economic Indicators Chart I-6China: Money/Credit Growth Have Fallen To New Lows The bottom panel of Chart I-6 demonstrates official M2, our version of broad money M3 (calculated using commercial banks' liabilities), credit-money (computed based on banks' balance sheet assets) and aggregate of private and public credit. All these measures have slowed to new lows. The most reasonable and all-inclusive measures from the four, in our view, is our measure of broad money M3 and private and public credit. As such, this is what we use to gauge the Chinese business cycle outlook. Chart I-7A and Chart I-7B demonstrate that the impulses of both M3 and private and public credit lead various business cycle and financial variables such as nominal GDP, manufacturing PMI, total imports, imports of capital goods, the freight index and producer prices as well as industrial profits. Chart I-7AChina: Money And Credit Impulses ##br##Entail Business Cycle Slowdown (II) Chart I-7BChina: Money And Credit Impulses ##br##Entail Business Cycle Slowdown (I) Regardless of which money and credit measure we use, and regardless of their past track record, all of them currently suggest that China's business cycle is about to experience a considerable slump. Besides, money and credit impulses typically lead copper and industrial metals prices by about nine months, as shown in Chart I-1. These are the primary fundamental reasons why we are reluctant to alter our negative view on China's industrial cycle. Bottom Line: The most reliable leading indicators of the mainland business cycle have been money and credit. All money and credit indicators presently forecast an imminent slowdown in the industrial sectors. Financial markets are typically forward looking, and they change their direction before business cycles actually turn. Hence, from an investment strategy perspective, it makes sense to heed messages from leading indicators. Other Big Picture Considerations We have for several years argued that the rampant build-up in China's debt and credit excesses is unsustainable, and when credit growth normalizes/slows the economy will undergo a marked deceleration. Chart I-8Rising Interest Rates Herald A Further ##br##Slowdown In Money/Credit Growth Have these excesses been partially unwound, and has credit growth normalized? Not at all - the credit excesses have gotten larger. In fact, corporate and household debt and shadow banking credit have expanded enormously in the past two years. Even after the recent deceleration, broad money and credit continue growing at around 10% from a year ago (Chart I-6, bottom panel on page 5). Importantly, borrowing costs in China have recently resumed their upward move (Chart I-8, top panel) and rising interest rates will further dampen already slowed money and credit growth (Chart I-8, bottom panel) and thereby economic activity. In brief, from a big-picture standpoint, China's leverage situation has worsened, and interest rates are rising. While growth momentum is currently strong, financial markets leveraged to China's growth have already rallied a lot, and investor sentiment is quite bullish, as illustrated in Chart I-2 on page 2 in the case of copper. This makes the investment risk-reward profile of EM risk assets and commodities poor. Finally, some readers might wonder why we have been spending so much time focusing on China versus other developing economies. The basis is that China is now a major pillar of the global economy, and its cyclical economic trend materially influences those of many EM and DM countries. In short, every other developing country is too small to affect EM financial markets. But China does affect financial market dynamics in many other parts of the EM world. So, to gauge overall trends in EM financial markets, China and other global variables matter, yet individual developing countries do not. For the majority of emerging economies in Asia, Latin America and Africa, China is the dominant external force, similar to how the U.S. is for many of its trading partners. Similarly, Chinese interest rates are as important as borrowing costs in the U.S. Therefore, developments in Chinese interest rates, money/credit and economic activity are of paramount significance to many emerging markets. In particular, China's money as well as private and public credit impulses lead both EM and DM export shipments to China by about nine months (Chart I-9A and Chart I-9B). These developing nations' exports to China make up a meaningful part of their respective economies. In addition, industrial metals prices are by and large driven by China's capital spending, and hence affect commodities-producing countries. Chart I-9AExports To China Correlate ##br##With China's Money/Credit Chart I-9BExports To China Correlate ##br##With China's Money/Credit Bottom Line: In 2015 and 2016, China resorted to its standard playbook: money and credit origination, boosting capital spending and overall growth. In particular, China's broad money M3 and private and public credit both have surged by RMB 46 trillion in the past two years alone. Consequently, the excesses have become larger. That said, President Xi Jinping's ongoing campaign to control financial risks - and consequential tightening of monetary/liquidity conditions - entails considerable growth deceleration ahead. Risks Of Relying On Money And Credit There are a number of risks involved in relying on measures of money and credit. We discussed the velocity of money, the money multiplier and productivity in our last report1, and will only touch on these briefly this week: An economy can accelerate with sluggish or slowing money growth if the velocity of money rises materially. However, there is no basis to expect the velocity of money to rise in China now, given it has been declining for the past 10 years. Money and credit growth can recover quickly, despite rising interest rates, if the money multiplier spikes. However, the money multiplier is already extremely elevated in China, and the odds are low that it will surge further. This is especially true amid rising interest rates and the ongoing regulatory crackdown on off-balance sheet assets of banks and shadow banking. Real economic output can improve if productivity growth notably accelerates. Money growth and velocity of money will define nominal output, yet productivity will boost real output. However, it is unrealistic to expect productivity to improve meaningfully in China when structural reforms have not been widely implemented. Chart I-10China's Exports To The U.S. And EU Are ##br##Small Compared With Credit Origination Finally, some argue that robust exports to the U.S. and Europe can boost mainland growth, even if domestic demand slips. We disagree. China's combined annual exports to the U.S. and EU currently make up only US$ 0.77 trillion (6.6% of GDP). On the other hand, the amount of new private and public debt origination has amounted to US$ 3 trillion (25% of GDP) in the past 12 months (Chart I-10). Bottom Line: Given money and credit growth have already slumped, our negative outlook for China's capital spending and imports will be wrong if the 1) velocity of money rises considerably, 2) the money multiplier shoots up, or 3) productivity growth accelerates materially. If any one of these were to occur, relying on money growth to forecast economic growth will prove futile. That said, assumptions about a substantial increase in either the velocity of money, the money multiplier or productivity from current levels would be highly conjectural, speculative and unreasonable. Some Market Observations: The U.S. Dollar And Oil The Greenback Chart 11 demonstrates that the U.S. dollar sits on its three-year moving average. A three-year moving average sometimes marks the borderline between structural bull and bear markets, as demonstrated in the case of the S&P 500 in the bottom panel of Chart I-11. Hence, the U.S. dollar is flirting with a structural bear market. Indeed, if the greenback slides further, it would signify a breakdown into a structural bear market. That said, if the broad trade-weighted U.S. dollar finds a bottom here, a meaningful rebound will ensue. Interestingly, the U.S. dollar has plunged even though U.S. real rates have not declined much (Chart I-12). The overwhelming portion of the drop in U.S. bond yields since early this year has been due to inflation expectations. Chart I-11Will The Greenback Find ##br##Support At Current Levels? Chart I-12U.S. TIPS Yields Have Not Dropped A Lot Typically, stable real rates amid falling inflation expectations are neutral-to-positive for an exchange rate. This has not been the case with the dollar this year. Pessimism within the fixed income and currency markets on U.S. growth is overdone. U.S. domestic demand is strong, the labor market is tight and global disinflationary forces that have suppressed U.S. inflation are alive and rampant in other parts of the world as well. Hence, there is no basis why the U.S. dollar should be punished more than other currencies because of secular global disinflation. Odds are that the euro has seen its lows in this cycle, and any selloff will not take it anywhere close its 2015-16 lows. Nevertheless, the outlook for EM currencies is meaningfully negative. The basis is that we believe EM business cycle amelioration is not sustainable - a growth slump in China, as discussed above, lower commodities prices and the hangover from the preceding credit booms in a number of countries will cap EM growth and weigh on their currency values. Bottom Line: Our take is that the dollar has been hammered too fast too far. Unless the U.S. dollar is in a structural bear market, odds are it will likely find floor here. Oil The current bear market in oil prices is tracking the 1980s bear market in crude reasonably well (Chart I-13). Based on this profile, oil prices will relapse further. We are reiterating our trade recommendation from March 8, 2017: short the spot oil price / long the Russian ruble. While both are correlated, the ruble offers 7.8% carry and will have less downside than crude. Hence, by being long the ruble, traders are being paid to short oil (Chart I-14). Stay with this position. Chart I-13Oil Is Tracking Its 1980s Bear Market Chart I-14Maintain Short Oil / Long Ruble Position A New Trade: Short Copper / Long CLP This week we recommend replicating the above oil trading strategy in the copper market. We believe shorting copper and going long a copper-related currency such as the Chilean peso offers an attractive risk-reward profile. The rationale to short copper is the potential relapse in China's growth (Chart I-1 on page 1) and elevated bullish sentiment on copper as shown in Chart I-2 on page 2. To hedge the timing risk and earn some carry, it makes sense to complement the short copper position with a long leg in a currency exposed to industrial metals/copper prices that is not vulnerable due to domestic reasons, i.e., beside copper price effect. Such a currency is the Chilean peso, in our view. The country's macro fundamentals are fine: domestic demand seems to be bottoming out and inflation is under control (Chart I-15). The primary risk to this exchange rate is copper prices. Chart I-16 depicts the total return of the combined return of a short copper and long CLP position accounting for the carry. The CLP has lagged the recent surge in copper prices and this trade offers a good entry point. Chart I-15Signs Of Bottom In The Chilean Economy Chart I-16A New Trade: Long Chilean Peso / Short Copper Bottom Line: Short copper and go long the Chilean peso. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Hungary: Inflation Is Set To Surge The dovish tone following the National Bank of Hungary's (NBH) most recent monetary policy meeting has reinforced the notion that more unconventional policy tools are likely to be forthcoming. In our view, the NBH is displeased about the recent currency strength and is presently laying the groundwork for pegging/depreciating the currency. This reinforces our view that inflation is set to surge. We have been recommending a short HUF / long PLN trade since September 28, 2016 on the basis that the NBH will remain dovish far longer than the National Bank of Poland (NBP) in the face of rising genuine inflationary pressures in both economies2 (Chart II-1). Also, the NBH has much less appetite for tolerating currency appreciation than the NBP. In turn, the NBP will hike interest rates and allow the zloty to appreciate. The latest rhetoric from the NBH reinforces our conviction, and today we are reiterating our short HUF / long PLN trade. Furthermore, relative to the forint, the zloty is still cheap based on relative real effective exchange rates, calculated using unit labor costs (Chart II-2). Chart II-1Relative Swap Rates Justify Higher PLN/HUF Chart II-2Zloty Is Cheap Versus Forint When a central bank favors extremely low interest rates and a cheap currency amid an economy that is operating above full employment and a labor market that is extremely tight, inflation is set to surge. This is exactly what is happening in Hungary. The NBH has been downplaying the tight labor market, noting that so far there has been little impact on inflation. We see a major problem with this argument. Inflation is a lagging indicator; to gauge where inflation will be headed in the coming six to 12 months, one has to monitor forward-looking indicators such as labor market dynamics and money/credit conditions. Presently, the majority of these indicators point toward much higher inflation in the coming months: The labor market is definitely tight - labor shortages are widespread, the unemployment rate is making historical lows and the participation rate is high (Chart II-3). Both wages and unit labor cost growth are surging (Chart II-4). Chart II-3Labor Market Is Super Tight In Hungary Chart II-4Hungary: Labor Costs Are Surging While private credit growth is meager, money supply is booming at a double-digit rate (Chart II-5). Such a gap between money and credit is probably due to loan write-offs. In brief, new loan origination is much stronger than implied by private credit growth, which is being affected by loan write-offs. Besides, government spending growth is currently above 20%, and banks have been funding the government by increasing their holdings of government bonds. This has also boosted money supply and is ultimately inflationary. All in all, odds are that the NBH will allow inflation to run away. As a result, long-dated local bond yields will spike, while short-term yields will be anchored by the NBH's dovish policy. We have been recommending betting on the yield curve steepening in Hungary: receive 1-year / pay 10-year swap rates. This trade remains intact (Chart II-6). Chart II-5Money Growth Is Booming Chart II-6The Yield Curve Will Steepen Further Bottom Line: Stay short the HUF versus the PLN. Maintain a bet on yield curve steepening in Hungary: receive 1-year / pay 10-year swap rates. For other fixed-income and currency as well as equity positions in central Europe and elsewhere in the EM universe, please refer to pages 19-20. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Making Sense Of The EM Business Cycle", dated August 30, 2017, link available on page 21. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Central European Strategy: Two Currency Trades," dated September 28, 2016 and Emerging Markets Strategy Special Report, titled "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, links available on page 21. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Chart 1"Trump Trade" Progress Report One of our seven investment themes for 2017, published in a Special Report last December, is that the combination of strong U.S. growth and accommodative Fed policy creates a cyclical sweet spot in which risk assets will outperform. After last week's GDP revisions we now know that real growth averaged 2.1% in the first half of the year, solidly above the Fed's 1.8% estimate of trend. Meanwhile, weak inflation has caused markets to discount an exceptionally shallow path for Fed rate hikes - only 19 bps of rate hikes are priced for the next 12 months. This divergence between growth and inflation is reflected in Treasury yields. The real 10-year yield is 24 bps above its pre-election level, while the compensation for inflation protection is only 5 bps higher (Chart 1). Not surprisingly, the cyclical sweet spot has led corporate bonds to outperform duration-matched Treasuries by 296 bps since the election. The persistence of the cyclical sweet spot leads us to believe that last month's politically-driven spread widening should be seen as an opportunity to increase exposure to corporate bonds. Remain at below-benchmark duration and overweight spread product in U.S. fixed income portfolios. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 62 basis points in August, dragging year-to-date excess returns down to 146 bps. The average index option-adjusted spread widened 8 bps on the month to reach 110 bps. In last week's report,1 we demonstrated that to properly assess corporate bond valuations it is not sufficient to simply look at the average index spread. We need to adjust for the fact that both the average credit rating and duration of the index change over time. We also need to consider corporate spreads relative to other similar stages of the economic cycle, not relative to long-run averages. In this respect, considering the breakeven spread2 for each credit tier relative to where it traded in the early stages of prior Fed tightening cycles gives us the best sense of the value proposition in corporate bonds. At present, this analysis shows that while Aaa corporate spreads are expensive, the other investment grade credit tiers all appear fairly valued (Chart 2). Corporate profit data for the second quarter was released last week and showed a big jump in our measure of EBITD (panel 4). This makes it extremely likely that net corporate leverage declined in Q2. All else equal, this lengthens the window for corporate bond outperformance Table 3.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 67 basis points in August, dragging year-to-date excess returns down to 378 bps. The index option adjusted spread widened 26 bps to end the month at 378 bps, 55 bps above the mid-2014 cycle low. Back in March4 we tested a strategy of buying the High-Yield index relative to Treasuries whenever spreads widened by more than 20 bps in a single month, and then holding the trade for a period of one, two or three months. We found that this "buy the dips" strategy works very well when inflationary pressures are low, but performs poorly when inflation is high and rising. When inflation is low the Fed needs to support the recovery by adopting a more dovish posture whenever financial conditions tighten. With the St. Louis Fed Price Pressures Measure5 at only 6% (Chart 3), we expect a "buy the dips" strategy will continue to work for some time. In terms of valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6%, and an expected recovery rate of 49%. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to -9 bps. The conventional 30-year MBS yield fell 13 bps in August, driven by an 18 bps decline in the rate component. This was partially offset by a 4 bps increase in the compensation for prepayment risk (option cost) and a 1 bp widening of the option-adjusted spread (OAS). The Fed is likely to announce the run-off of its balance sheet when it meets later this month. For its part, the market has been pricing-in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments (Chart 4). In this sense, the Fed's commitment to proceed with balance sheet normalization no matter the outlook for the future pace of rate hikes is doubly negative for MBS spreads. OAS are biased wider as Fed buying exits the market, while low rates encourage faster prepayments and a higher option cost component of spreads. Going forward, the option cost component of spreads will decline as mortgage rates cease their downtrend, but OAS still appear too tight relative to trends in net issuance. Despite robust issuance so far this year and the Fed backing away as a buyer, the conventional 30-year MBS OAS remains well below its pre-crisis mean (panel 2). While MBS are starting to look more attractive, especially relative to Aaa credit (panel 3), we think it is still too soon to buy. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 5 basis points in August, bringing year-to-date excess returns up to 154 bps. The Foreign Agency and Local Authority sectors drove the index outperformance in August. Both beat the duration-matched Treasury benchmark by 12 bps. Sovereigns outperformed the benchmark by 3 bps, Supranationals outperformed by 1 bp, and Domestic Agency bonds underperformed by 2 bps. We took a detailed look at the Sovereign index in a recent report,6 both at the aggregate and individual country levels. At the aggregate level, the two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the U.S. dollar (Chart 5). At present, relative valuation is skewed heavily in favor of domestic U.S. credit (panel 2). Added to that, given downbeat Fed rate hike expectations, we view further dollar weakness as unlikely on a 6-12 month horizon. Taken together, we continue to favor U.S. credit over USD-denominated Sovereign debt. At the country level, we identified several countries where USD-backed debt appears attractive. We found that Finland, Mexico and Colombia all offer attractive spreads. However, the spread pick-up available in Mexican and Colombian debt is compensation for heightened exchange rate volatility. Finnish debt appears the most attractive on a risk/reward basis. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 40 basis points in August (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 144 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio held flat in August, and it remains extremely tight relative to its post-crisis trading range (Chart 6). The M/T yield ratio remains very low despite the fact that state & local government net borrowing continues to rise. Net borrowing increased to $209 billion in Q2, the highest level since the second quarter of last year. Further, the Trump administration appears to be finally tackling the issue of tax reform. While comprehensive tax reform is probably too ambitious, some form of corporate and personal tax cuts seems likely, probably in the first half of next year. Lower tax rates are obviously a negative for municipal bonds, but some of the negative impact could be offset if current tax deductions (such as the deduction of state & local income tax) are removed. All else equal, fewer available tax deductions elsewhere makes the tax exemption of municipal bonds look more attractive. Of course, the municipal bond tax exemption itself could also be threatened, but at least so far this appears less likely. The bottom line is that current M/T yield ratios are far too low given the looming risks of rising state & local government borrowing and looming federal tax cuts. Remain underweight. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull flattened in August. The 2/10 slope flattened 17 bps and the 5/30 slope flattened 2 bps. The market moved to discount an even shallower path for Fed rate hikes in August. At the end of July the market had expected 27 bps of rate hikes during the next 12 months, and that number has now fallen to 19 bps (Chart 7). Consequently, our recommendation to short the July 2018 fed funds futures contract has suffered. The position is now 17 bps in the red, but we continue to believe that the market's expected rate hike path is too benign. From current levels, a position short the July 2018 fed funds futures contract will return 35 bps if there are two hikes between now and next July and 61 bps if there are 3 hikes. We also continue to recommend a position long the 5-year bullet versus a duration-matched 2/10 barbell on the view that the Treasury curve will steepen as inflation and TIPS breakevens move higher. This position has earned 28 bps since initiation last December, but valuation is starting to look less attractive. Our butterfly spread model7 suggests that the 5-year bullet is now slightly expensive compared to the 2/10 barbell (panel 3). Or put differently, that the 2/10 Treasury slope will have to steepen by more than 20 bps during the next 6 months for our trade to earn a positive return. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 36 basis points in August, dragging year-to-date excess returns down to -169 bps. The 10-year TIPS breakeven inflation rate fell 6 bps on the month and, at 1.76%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Despite robust growth, extremely weak realized inflation has caused breakevens to tighten this year. Last week's July PCE release was yet another disappointment. The year-over-year core inflation rate fell from 1.51% to 1.41% and the year-over-year trimmed mean rate fell from 1.68% to 1.64% (Chart 8). However, measures of pipeline inflation pressure such as the supplier deliveries and prices paid components of the ISM Manufacturing survey point towards higher inflation. The supplier deliveries component increased from 55.4 to 57.1 in August (panel 4) while the prices paid component held firm at an elevated 62 (panel 3). Adding it all up, and incorporating the fact that employment growth should stay strong enough to maintain downward pressure on the unemployment rate, we think it is very likely that core inflation will soon reverse course and resume the steady uptrend that began in early 2015. TIPS breakevens will widen alongside. At present, our TIPS Financial model suggests that breakevens are trading in line with other financial market instruments (panel 2). In other words, there is no apparent mis-valuation in breakevens relative to other financial markets, and higher realized inflation is likely required before breakevens move sustainably wider. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in August, bringing year-to-date excess returns up to 71 bps. Aaa-rated ABS outperformed the benchmark by 10 bps in August, bringing year-to-date excess returns up to 63 bps. Meanwhile, non-Aaa ABS outperformed by 26 bps in August, bringing year-to-date excess returns up to 147 bps. Credit card ABS outperformed the Treasury benchmark by 10 bps in August, bringing year-to-date excess returns up to 69 bps. Auto loan ABS outperformed by 12 bps, bringing year-to-date excess returns up to 71 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps on the month, and remains well below its average pre-crisis level (Chart 9). At 36 bps, the option-adjusted spread for Aaa-rated ABS is now the same as the option-adjusted spread for conventional 30-year Agency MBS. Meanwhile, lending standards are now tightening for both auto loans and credit cards. Further, the New York Fed's Household Debt and Credit Report for the second quarter revealed that "flows of credit card balances into both early and serious delinquencies climbed for the third straight quarter - a trend not seen since 2009."8 While overall credit card charge-offs in ABS collateral pools remain low (panel 4), it is clear that the cyclical winds are shifting against consumer ABS. If the trends of tightening lending standards and rising delinquencies continue, then it will soon be time to reduce consumer ABS exposure, possibly shifting into Agency MBS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in August, bringing year-to-date excess returns up to 116 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month, and is approaching one standard deviation below its average pre-crisis level (Chart 10). The combination of tightening lending standards and weaker demand for commercial real estate (CRE) loans (as evidenced by the Fed's Senior Loan Officer Survey) suggests that credit concerns are starting to mount in the CRE space. Meanwhile, CMBS delinquency rates have leveled-off during the past few months and remain much lower in the multi-family space (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in August, bringing year-to-date excess returns up to 79 bps. The average index option-adjusted spread for the Agency CMBS index held flat at 48 bps on the month. This compares favorably to the 36 bps offered by both Aaa-rated consumer ABS and conventional 30-year Agency MBS. Not only does the Agency CMBS sector continue to offer an attractive spread relative to both consumer ABS and Agency MBS, but its agency guarantee and concentration in the multi-family space (where delinquencies are still low) makes it look particularly attractive. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.67% (Chart 11). Our 3-factor version of the model (not shown), which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.68%. The Global Manufacturing PMI rose to 53.1 in August, from 52.7 in July, reaching a 75-month high (panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (bottom panel). Taken together, these two factors suggest that not only is global growth accelerating but that the global economic recovery is increasingly broad based. This is an extremely bond-bearish development. A broad based global recovery means that when U.S. data finally start surprising positively, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.16%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Policy Reflections", dated August 29, 2017, available at usbs.bcaresearch.com 2 The 12-month breakeven spread is the basis point widening required over a 12-month period before a corporate bond delivers losses relative to a duration-matched Treasury security. We assume no impact from convexity and calculate the breakeven spread as OAS divided by duration. 3 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 5 The Price Pressures Measure is a composite indicator which shows the percent chance that PCE inflation will exceed 2.5% during the next 12 months. 6 Please see U.S. Bond Strategy Weekly Report, "The Upside Of A Weaker Dollar", dated August 15, 2017, available at usbs.bcaresearch.com 7 For further details on our models please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 8 https://www.newyorkfed.org/microeconomics/hhdc Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)