Financial Markets

Highlights Portfolio Strategy Operating leverage could surprise on the strong side this year, based on the message from our pricing power and wage growth indicators. REITs are experiencing a playable recovery following the Fed-induced sell-off earlier this year, and overweight positions will continue to pay off. Energy services activity is set to steadily accelerate this year, powering an earnings-led share price outperformance phase. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Volatility has climbed to the highest level since the U.S. election, signaling that the broad market is not yet out of the woods. As stocks recalibrate to a cooling in economic growth momentum and an escalation in geopolitical threats, downside risks should be reasonably contained by mounting signs of a healthier corporate sector. Last week we posited that stronger top line revenue growth is necessary to sustain the profit upcycle, and provide justification for historically rich valuations. Chart 1 shows sales and EPS growth over the long-term. Chart 1Joined At The Hip Obviously, the two move closely together, with earnings enjoying more powerful growth phases when revenue accelerates. Since 1960, regression analysis shows that operating leverage for the S&P 500's is 1.4X. In other words, a 5% increase in sales growth typically leads to 7% EPS growth. When sales are initially recovering from a deep slump operating leverage can be even higher, with earnings often rising two to three times as fast as revenue. Clearly, that is not sustainable, but can give the illusion of powerful and sustained growth for brief periods of time. At the current juncture, there are reasons to expect investors to embrace the durability of the profit expansion. Our corporate pricing power proxy has vaulted higher. Importantly, the breadth of this surge has been impressive, which bodes well for its staying power (Chart 2, second panel). On the flip side, rising labor costs look set to take a breather. Compensation growth has crested, and according to our diffusion index, fewer than half of the 18 industries tracked have higher wages than last year. The wage growth diffusion index provides a reliable leading indication for the trend in labor expenses. In other words, pricing power is rising on a broad basis while wage inflation is decelerating on a broad basis. Consequently, there are decent odds that resilient forward operating margin expectations can be matched (Chart 2, bottom panel). Elsewhere, a revival in animal spirits, the potential for easier fiscal policy and prospects for a hiatus in the U.S. dollar bull market bode well for brisk business activity. While the budding recovery in global trade could sputter if protectionism proliferates, our working assumption is that the U.S. Administrations' bark will be worse than its bite. Thus, a self-reinforcing sales and profit upcycle could be materializing. The objective message from our S&P 500 EPS model concurs (Chart 3), underscoring that high single digit/low double digit profit growth could be broadly perceived as attainable this year. Chart 2Profit Margins Can Expand Chart 3Few Sectors Control The Fate Of S&P 500 EPS True, our model has recently shown tentative signs of cresting, but difficult comparisons will only arise later this year. Indeed, Q3 and Q4 2016 were all-time high EPS numbers, implying that 12% estimated growth rates are a tall order (Chart 3, middle panel). Importantly, dissecting the profit growth sectorial contribution is instructive. Calendar 2017 over 2016 S&P 500 earnings growth is concentrated in four sectors: tech, energy, health care and financials comprise over 87% of the incremental profit growth expected (Chart 3, bottom panel). The upshot is that there is a high degree of concentration risk to fulfilling overall profit growth expectations. Energy profits are wholly dependent on the oil price, and financial sector profit optimism appears to have embedded a healthy increase in both interest rates and capital markets activity. In addition, tech sector earnings are heavily influenced by the U.S. dollar. Consequently, it will be critical for monetary conditions to stay loose, otherwise estimates will be at risk of downward revisions. Adding it up, the corporate sector sales pendulum is finally swinging in a positive direction, which should support the cyclical overshoot in stocks for a while longer, notwithstanding our expectation that the current corrective phase has further to run. This week we are updating our high-conviction overweight views on both the lagging energy services index and REIT sector. Revisiting REITs REITs have staged a mini V-shaped rebound after being punished alongside rising bond yields and worries about aggressive Fed rate hikes earlier this year. As outlined in recent Weekly Reports, the reflation theme is likely to lose steam in the second half of the year as economic momentum cools, providing additional impetus for capital inflows into the more stable income profile of REITs. Even if the economy proves more resilient and Treasury yields move higher, there are few barriers to additional outperformance. Our Technical Indicator, a combination of rates of change and moving average divergences, is extremely oversold. Forward intermediate and cyclical relative returns from current readings have been solid, as occurred in 2004, 2008 and 2014 (Chart 4). REIT valuations are more than one standard deviation below normal, according to our gauge. This suggests that poor operating performance and/or higher discount rates are already expected. There may be a limit as to how high bond yields can climb, given that they are already deep in undervalued territory according to the BCA 10-year Treasury Bond Valuation Index (Chart 4). Regardless, history shows that REITs have typically had a more positive than negative correlation with bond yields. The inverse correlation has only been in place since the financial crisis, when zero interest rate policies pushed massive capital flows into all yield generating assets. Chart 5 shows that prior to 2008, REITs outperformed during periods of both rising and falling Treasury yields. Chart 4Unloved And Undervalued Chart 5No Concrete Correlation Pre GFC Similarly, REITs have a solid track record during periods of rising inflation pressures. Since 1975, there have been six periods of rising core PCE inflation: REITs have enjoyed meaningful rallies during five of these phases (Chart 6). Hard assets tend to hold their stock market value well when overall inflation moves higher, with REIT net asset values providing solid support to share price performance. Chart 6Buy REITs In Times Of Inflation Looking ahead, REITs should continue to enjoy success in boosting rental rates. Occupancy rates continue to rise (Chart 7). The unemployment rate is low, consumption is decent and businesses are growing increasingly confident. That is a recipe for higher rental demand. Our Rental Rate Composite has crested on a growth rate basis, but the advance in the CPI for homeowner's equivalent rent, a good proxy for REITs, suggests that the path of least resistance remains higher (Chart 7). REIT supply growth has also leveled off, which provides additional confidence that rental inflation will remain solid. Nevertheless, there are some areas of concern. Banks are tightening lending standards on commercial real estate loans. Some sub-categories are experiencing a mild deterioration in credit quality. For instance, Chart 8 shows that delinquency rates in the retail and office spaces have edged higher. Retail and mall REITs are likely under structural pressure owing to online competition from the likes of Amazon. Chart 7Rental Demand##br## Is Solid Chart 8Watch Delinquencies As ##br##Banks Tighten Credit Standards Overall vacancy rates are still very low (Chart 8), but if credit becomes too tight, then the relentless advance in commercial property prices may cool. For now, our REIT Demand Indicator is not signaling any imminent stress. In fact, the economy is strong enough to expect occupancy rates to keep climbing, to the benefit of underlying property valuations and rental income (Chart 7, bottom panel). In sum, the budding rebound in REIT relative performance should be embraced as the start of a sustained trend. Total return potential is very attractive on a relative basis. Bottom Line: REITs remain a very attractive high-conviction overweight. Energy Servicers Are Cleaning Up Their Act We put the S&P energy services index on our high-conviction overweight list at the start of the year, because three critical factors that typically lead to a playable rally existed, namely; the global rig count had hit an inflection point, oil supplies were easing and global oil production growth had begun to decelerate. While the pullback in oil prices has undermined relative performance for the time being, there is scope for a full recovery, and more. Oil prices have firmed, underpinned by a revival in the geopolitical risk premium following the U.S. bombing campaign in Syria. There is already a wide gap between share prices and oil prices (Chart 9, top panel), and a narrowing is probable, especially as earnings drivers reaccelerate. There are tentative signs that capital spending cuts are finally reversing. The global rig count has rebounded, and is a good leading indicator for investment (Chart 10). This message is corroborated by our Global Capex Indicator, which has recently surged anew (Chart 10). Chart 9Room For ##br##Margin Improvement... Chart 10...As Deflation Eases ##br##And Capex Rebounds The longer that oil prices can stay in their current trading range, or beyond, the more time E&P balance sheets have to heal and the greater the odds that the cost of capital will be reduced. Against this backdrop, there are high odds that previously mothballed exploration projects will be restored. The V-shaped recovery in the global oil rig count, albeit from a very low base, will eventually absorb excess capacity and allow the industry to escape deflation. A major improvement in day rates is unlikely given the scale of the previous capacity boom, but even a modest pricing power improvement should provide a nice boost given high operating leverage. EBITDA margins have considerable room to improve if pricing power grows anew (Chart 9, bottom panel). Importantly, the shifting composition of global production will allow service companies with domestic exposure to shine. Shale oil producers should recapture lost market share, given that the onus to rebalance markets has been taken on by OPEC. OPEC production is contracting, while non-OPEC output is starting to recover (Chart 11, bottom panel), culminating in a widening in the Brent-WTI oil price spread. Production restraint is helping to rebalance physical oil markets. Total OECD inventory growth is reversing, and anecdotal reports are surfacing that floating storage is rapidly being depleted. Oil supply at Cushing is on the cusp of contracting, which is notable given that this has had a high correlation with relative share price performance for the past decade (oil supply shown inverted, Chart 11). On a global basis, global inventory drawdowns have been correlated with a firming industry relative profitability, and vice versa. OECD oil supply growth is rapidly receding, which augurs well for an extension of budding earnings outperformance (Chart 12, middle panel). Chart 11Receding Inventories ##br##Should Boost Performance... Chart 12...EPS And##br## Valuations The rise in clean tanker rates reinforces that oil demand is rising quickly enough to expect additional inventory depletion (Chart 12, bottom panel). Typically, tanker rates and energy service relative valuations are positively correlated. Adding it up, a rising global rig count, decelerating inventories and restrained oil production continue to bode well for a playable rally in the high-beta S&P energy services group. Bottom Line: We reiterate our high-conviction overweight stance in the S&P energy services index. The ticker symbols for the stocks in this index are: BLBG: S5ENRE - SLB, HAL, BHI, NOV, FTI, HP, RIG. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The level of Fed interest rates, in absolute or relative terms, has been a poor determinant of dollar bull markets. A more useful marker has been the relative performance of U.S. assets as well as relative growth rates. The U.S. economy should continue to outperform the rest of the G10 on a cyclical basis, suggesting that the USD could rise further on a 12-18 months basis. April is seasonally the cruelest month for the USD. Once this hurdle is passed, the likelihood grows that the dollar correction will be over. The conditions are slowly falling into place for the SNB to abandon the floor under EUR/CHF. Bank of Canada: Bye-bye easing bias, hello neutrality. Feature One of the great paradox of modern finance is the relationship between the dollar and the Fed. Contrary to a priories, rising U.S. interest rates are not synonymous with a rising dollar (Chart I-1). In fact, since 1975, out of seven protracted Fed tightening campaigns, the greenback fell four times. Obviously, one could argue that domestic interest rates per say are irrelevant, what matters should be the trend of U.S. interest rates relative to the rest of the world. Here again, the evidence is rather inconclusive. As Chart I-2 illustrates, since 1975, out of the eight episodes where U.S. policy rates rose relative to the rest of the advanced economies, the dollar was down or flat five times. Chart I-1The Fed Is Not An All-Weather Friend Chart I-2Rate Differentials Are Also A Fickle Ally This modern Gordian knot is not as intractable as it seems. In fact, we would argue that focusing on the Fed misses some key drivers of flows inside the U.S. economy. What really matters for the U.S. dollar is not just what the Fed does, but in fact, how U.S. assets are performing relative to the rest of the world. It's Not Just The Fed, It's Everything Simple interest rate differentials have a poor long-term track record explaining the U.S. dollar. However, one factor does seem to work better: the relative performance of a portfolio of U.S. stocks, bonds, and money market securities relative to the rest of the world. This does make sense. Investors who want to buy the USD do so because they expect to receive higher returns on their U.S. assets, independently of whether these assets are cash, stocks or bonds. As Chart I-3 shows, the ups and down of the USD have been contemporaneous with the gyrations of a U.S. portfolio invested 40% in stocks, 30% in bonds, and 30% in cash relative to the same portfolio in the euro area (and its predecessor national markets), Japan, the U.K., and Canada. However, there is a problem with this observation. It is expected returns that should drive the inflows into a currency, not the ex-post returns like the one used in the previous chart. But this forgets a key factor influencing asset returns: the momentum effect. As Chart I-4 illustrates, playing momentum continuation strategies has historically been one of the best performing investment philosophies, a fact not lost on investors.1 As such, there is a very rational reason for previously outperforming markets to attract funds by virtue of their previous outperformance. This would also explain why peaks and troughs in the relative U.S. / global portfolios tend to lead the turning points in the dollar itself. Chart I-3It's All About Returns Chart I-4Don't Get Against The Crowd The same dynamics are prevalent when one looks at bilateral pairs. This is particularly true of the EUR/USD, which has a 58% weight in the dollar index vis-à-vis major currencies. As Chart I-5 illustrates, as was the case with the dollar against the majors, EUR/USD dynamics are a function of the relative performance of a European portfolio of various assets against a similar U.S. portfolio. As an aside, it is true that the secular trend in the dollar is not nearly as well explained by the dynamics in the asset markets. On longer time horizons, other factors dominate currency returns. While the most well know long-term exchange rate determinant has been relative inflation rates (the PPP effect), our research has corroborated well-known academic findings that relative productivity differentials and net international investment positions (NIIP) also play important roles.2 While U.S. productivity growth has been equal or superior to that of the other nations comprised in the dollar index against the majors, the other variables have forced the long-term fair value of the dollar downward. Relative to Europe and Japan (the crucial weights in the dollar index), the U.S. NIIP grows each year more deeply into negative territory, and the U.S. has also experienced structurally more elevated inflation than these currency blocs (Chart I-6). Going back to the cyclical moves in the dollar, another factor has had a very strong explanatory power for the USD: Relative trend growth (Chart I-7). The 5-year moving average of real growth rate differentials - when GDP is measured at PPP, thus eliminating some currency effects - has mimicked the moves in the greenback. In the context of portfolio flows, this also makes sense. Ultimately, a faster growing economy should be able to generate higher rates of returns than slower growing ones, and thus attract more funds. Chart I-5EUR/USD And Asset Returns Chart I-6Secular Drags On The USD Chart I-7Growth Is Paramount What do these observations mean for the future path of the dollar? Despite continued noise by President Trump, we think the outlook for the dollar remains bright. First, the dollar is still not nearly as expensive as it has been at the peak of previous cyclical bull markets, which raises the likelihood that the USD has yet to hit the historical pain thresholds of the U.S. economy (Chart I-8). Further reinforcing this probability, U.S. employment in the manufacturing sector represents 10% of the working population today, versus 15% in 2001 and more than 22% in 1985 (Chart I-9). Not only does this mean that the sector of the U.S. economy most exposed to the pain created by a strong dollar is much smaller than at previous dollar peaks - raising the resilience of the U.S. economy to the tightening created by a strong dollar - the share of employment in that sector today remains much lower in the U.S. than it is in Japan and Europe. Chart I-8Valuations Have Yet To Bite Chart I-9The U.S. Is More Resilient To XR Moves Second, on a multi-year basis, the U.S. economic outlook remains more exciting than what the majority of the rest of the G10 has to offer. Most obviously, even if Trump changes immigration laws, the U.S. demographic outlook still outshines that of other nations (Chart I-10). Also, the U.S. benefits from being much more advanced than the rest of the G10 in its deleveraging cycle. As Chart I-11 illustrates, U.S. non-financial private debt to GDP fell from 170% of GDP to a low of 146% of GDP, while outside of the U.S., the same ratio has plateaued at 175%. This means that debt is likely to represents a greater ceiling on growth outside than inside the United States. Chart I-10A Structural Help To The U.S. Chart I-11Lower Deleveraging Pressures In The U.S. Third, U.S. markets can continue to attract funds. For one, most of the net inflows in the U.S. since 2015 has been driven by a surge in U.S. funds repatriation. Foreign investors remain timid buyers of U.S. assets (Chart I-12). This phenomenon is most pronounced in the equity space, where investors have been net sellers of U.S. equities (Chart I-13). Additionally, if the U.S. continues to grow faster than most other large advanced economies, FDIs inflow into the U.S. are likely to improve further, something that could be reinforced by Trump's hard-nosed trade negotiations with the rest of the world (Chart I-14). Chart I-12Foreigners Still Have Room To Buy Chart I-13Big Deficit In U.S. Stock Purchases Chart I-14FDI Inflows In The U.S. Can Grow More Finally, when it comes to money markets, the U.S. continues to hold the advantage. As we have argued, U.S. rates are likely to remain in the top of the G10 distribution. While the level and direction of rate differentials between the U.S. and the rest of the world has been a poor predictor of the USD's trend, how high U.S. rates rank globally has been a better explanatory variable of the greenback (Chart I-15). This means that money markets in the U.S. are likely to remain more attractive to investors needing to park liquidity than money markets outside the U.S. We are currently still positioned negatively on the U.S. dollar against European currencies and the yen on a tactical basis. We expect this phenomenon to be toward its tail end. First, when it comes to seasonality, April is historically the weakest month for the dollar (Chart I-16). Second, Trump's comments on Wednesday regarding the dollar's strength were enough to prompt a vicious sell-off in the dollar. Yet, this seems overdone. Unlike Reagan in 1985, Trump has little levers to force a strong re-evaluation of the euro and the yen. Moreover, his endorsement of Janet Yellen implies that the Fed is less likely to lose its independence in the near future, suggesting that U.S. rates will continue to be tightened if the economy improves. Thus, a plunge in U.S. real rates relative to the rest of the world prompted by a too easy Fed is less of a risk, reducing the probability of the re-emergence of the 1970s.3 Chart I-15Being The Leader Of The Pack Is What Matters Chart I-16April Is The Cruelest Month Bottom Line: On a cyclical basis, more than simple interest rate differentials between the U.S. and the rest of the world, what matters for the dollar's trend is the return on U.S. assets vis-à-vis the rest of the world as well as the growth rate of the U.S. compared to other nations. On this front, relative growth rate differentials continue to be the best factor pointing toward further USD outperformance. Tactically, the USD is in the midst of its seasonally weakest month, suggesting another down leg in DXY is likely in the coming weeks. However, it may soon be time to start buying the USD once again. EUR/CHF: Getting Closer To The End Recent data in Switzerland have shown great improvement. The PMIs are at their highest levels in six years and CPI has moved back into positive territory. This raises the specter of the end of the Swiss National Bank floor under EUR/CHF (Chart I-17). Chart I-17The SNB Floor Lives On While we think this peg might be in its final innings, its end is not imminent. However, we think that if Swiss data continues to improve, late 2017 will be a more supportive environment for the SNB to bury this strategy. What key signals are we looking for? First, inflation may be in positive territory, but it remains very low by recent standards. Most specifically, core CPI stands at a low 0.1%, well below the 0.8% average experienced from 1999 to 2010, an era when the euro already existed, but when the euro area crisis was still outside of investors' lexicons. As well, wage dynamics continue to underwhelm. Swiss wages are growing at a 2.4% rate compared to 3.3% from 1999 to 2010. Growth conditions also remain weak. Swiss real GDP is growing at 1%, half of the average that existed before the euro area crisis. Nominal GDP growth is undershooting the mark by an even greater margin, standing at 0.7% versus an average of 3%. What does this mean for the SNB? We would expect these datasets to move closer to their historical average before the SNB adjusts its policy stance. The main reason for this is 2015. In late 2014, just before the SNB tentatively let the CHF float, nominal and real GDP growth were outperforming current readings, yet the Swiss economy was not strong enough to handle a stronger franc. While Europe and the global economy are in a better place than in these days, risk management and precaution are likely to dictate a more careful approach by the central bank, especially as the ECB has eased monetary policy since that period, potentially causing another slingshot move in the franc if the SNB lets it float once again. In terms of strategy, we would expect the SNB to manage any appreciation in the franc following a lifting of the floor. We expect a move more akin to that of the PBoC in 2005, when the yuan, after an original 2% move, was allowed to increase progressively to minimize disruptions. We think this type of strategy is also currently being employed by the Czech central bank, and that EUR/CZK will continue to depreciate over time. This means that we would use any rebound in EUR/CHF to 1.08 to begin shorting this cross, knowing that the timing of an SNB policy change will be uncertain, but that the conditions are falling into place. Bottom Line: Even if it is still too early to bet on an imminent fall in EUR/CHF, Swiss data is moving in the right direction to expect a lift of the EUR/CHF floor later this year. As such, with the large amount of uncertainty surrounding such a decision, we would use any rebound in EUR/CHF to 1.08 to implement some short positions on the cross to bet on the eventuality of a policy change in Switzerland. Bank Of Canada: Less Dovish But Far From Hawkish The Bank of Canada this week officially removed its dovish bias. Canadian data has been very strong, with recent housing starts coming in at 254 thousand, a 10-year high. Additionally, recent employment data has been strong and so have purchasing managers index and business surveys. As a result, the BoC used this meeting as an opportunity to increase its growth expectation for the year - albeit a move heavily based on a stronger Q1 - and also brought forward in time its expectation of the closing of the output gap to early 2018. Chart I-18Canadian Surprises: More Likely##br## To Roll-Over Than Not Despite this more upbeat picture, the Bank of Canada also highlighted heavy risks to the Canadian economy. Obviously, the risks from the potential for a U.S. border adjustment tax and renegotiations of NAFTA were seen as crucial. The housing market too continues to be a big worry for the Bank of Canada, with affordability being extremely poor. Moreover, the BoC also decreased its estimate of the neutral rate and observed that monetary conditions are not as accommodative as was believed in January. Going forward, we think that the upside for the CAD remains limited. Canadian economic surprises are stretched and are very likely to rollover in the coming months (Chart I-18). This suggests that further upgrades to the Canadian economic outlook may take some time to emerge. As such, we continue to expect rate differentials between the U.S. and Canada to continue to support a higher USD/CAD, especially as Canadian money markets are already pricing in a full rate hike by Q1 2018. Bottom Line: The Bank Of Canada abandoned it dovish bias, but it is still far away from moving toward a hawkish bias. While a rate hike in 2018 is now much more likely, the market already anticipates this. As such, since the Canadian surprise index is very elevated, the likelihood of a move downward in interest rate expectations grows as surprises are likely to roll over. Stay long USD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a discussion on why momentum continuation strategies may have worked, see the April 24, 2015 Global Investment Strategy Special Report titled "Investing In Style" available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled "A Guide To Currency Markets (Part I)", dated April 8, 2016, and the Foreign Exchange Strategy Special Report titled "Assessing Fair Value In FX Markets", dated February 26, 2016, both available at fes.bcaresearch.com 3 For a more detailed discussion of the 1970s stagflation, please see Foreign Exchange Strategy Special Report titled "Trump: No Nixon Redux", dated December 2, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 President Trump, once again, delivered dollar-nuking remarks, after saying it was "getting too strong". The dollar dropped 0.7% on the news, while other currencies appreciated. The dollar has since regained most of its losses, but further upside remains questionable in the coming weeks. The market has already priced-in large amounts of monetary tightening, and recent producer price figures disappointed expectations: PPI increased at a 2.3% annual pace and contracted 0.1% monthly; core PPI increased at a 1.6% annual pace, and did not grow at a monthly pace. Additionally, in the past 5, 10 and 26 years, April has been the weakest month for the dollar. Upside is most likely limited until after the French elections. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent movements in the euro remain largely a function of the dollar. Even after the Trump-induced dollar gyrations, the euro appreciated this week. The ZEW Survey for Economic Sentiment and Current Situation both outperformed expectations, however weak industrial production figures were also evident, which contracted by 0.3% on a monthly basis, and grew at less than expectations at 1.2%. Peripheral economies are also showing strength, with inflation outperforming expectations in Italy and Greece. Nevertheless, the outlook for the euro this month remains decent, as April is notorious for dollar weakness. Moreover, Melanchon's rising popularity is a double-edge sword: while it increases the risk that yet another euro-sceptic becomes the French president, if it grows further it is likely to take away potential voters from Le Pen. In fact, with the chances of Macron winning remaining elevated, this election could ultimately could provide further support to the euro. Report Links: ECB: All About China? - April 7, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 Et Tu, Janet? - March 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 USD/JPY continues to fall rapidly, and now stands at 109. However, we believe the yen could still have more upside. Indeed, EM assets continue to struggle with a technical resistance, and a down leg seems imminent, given the tightening in liquidity conditions that China is currently experiencing. As evidenced by the events of early 2016, such as sell off of EM assets could supercharge yen rallies. On the data side the Japanese economy continues to show mixed signs: Labor cash earning underperformed expectations, growing by a paltry 0.4% from a year ago. However domestic corporate goods prices outperformed expectations, growing by 1.4% year on year. Overall Japanese economic activity continues to be too tepid for the BoJ to have a shift from its ultra-dovish policy. This makes us yen bears on a 12 to 18 month basis. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data from the U.K. has been mixed this week: Industrial production growth underperformed coming in at 2.8% The goods trade balance also underperformed coming in at -12.46 billion pounds. However, average hourly earnings including bonus outperformed coming in at 2.3%, while core inflation come in at 1.8%, below expectations. This last point bodes well for consumption as it would limit the downside to real income caused by the inflationary shock resulting from the depreciation of the pound. Moreover, long term inflation expectations remain relatively stable, which means that British households are looking past the temporary nature of the inflation caused by the pound sell-off. Both of these factors should help the British economy outperform expectations, and ultimately help the GBP rally against the EUR. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The ConqueringDollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 An unfortunate tropical storm, Cyclone Debbie, ravaged through the state of Queensland at the end of March. Queensland is known for its agriculture and mining industries, which suffered heavily during the hurricane. March and April export figures are likely to weaken as output was destroyed and reparations may delay production. Exacerbating this weakness is the risk of faltering import demand from China, which is the most likely the reason behind the current weakness in industrial metal prices. As this trend continues, the AUD is likely to suffer for the remainder of the year. On the bright side, the labor market has regained some vigor as full-time employment outperformed part-time employment in two consecutive months, with full-time job growing at a 30-year-high pace. However, a durable trend needs to be apparent for the labor market to fully strengthen. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 After positive import and export data out of China, the kiwi rallied strongly. The market interpreted this data as evidence that global growth is on a solid footing and that it will continue to surprise to the upside. Although we agree with the first point we disagree with the second one, as outperformance in global growth amid a sharp tightening in Chinese monetary conditions, a slowdown in Chinese shadow banking credit and a deceleration in Chinese house prices, is highly unlikely. Thus, carry currencies like the NZD are likely to underperform against the dollar. Against other commodity currency the picture is more nuanced, as strong PMI numbers of 57.8 as well as solid credit and employment numbers are evidence that the kiwi economy is better equipped to deal with a Chinese shock than Australia. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The BoC left its overnight rate unchanged at 0.5%, citing recent stronger than expected economic activity and a sooner-than-previously-anticipated closure of the output gap. The gains in the energy sector are unlikely to provide as much of a tailwind as earlier this year as the base effects from rising oil prices prove transitory on inflation and exports. The Bank highlighted labor market slack as a key factor which may contribute to the brevity of this growth impulse, as well as the business sector being hampered by low investment aimed at maintenance rather than expansion. Similarly strong data are needed to keep growth rate high enough for the Bank to become hawkish. For the time being, employment data still remains mixed. Although employment increased by 19,400, the unemployment rate ticked up to 6.7%. With only 38% of firms planning to add jobs over the next 12 months, job gains could be modest and slack could remain. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 After a short rally in early March, EUR/CHF cross is once again at 1.066, very close to the SNB's implied floor of 1.065. This sell-off is most likely the result of risk-off flows caused by the French presidential elections. However, we believe these fears are overstated, as Macron seems primed to win the election. Once these political fears dissipate, and economic fundamentals take over, EUR/CHF would likely be at a point where it would become an attractive short, given that there are some early signs that inflation is slowly coming back to the alpine country and that the franc has strong structural forces pushing up its value. While an abandonment of the SNB's floor in unlikely until the end of the year, investors could still begin positioning themselves for this eventuality given that a rally in EUR/CHF beyond the French election should be limited. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The relationship between the NOK and oil prices continues to be a strange one, as the NOK has depreciated this last month even in the face of a strong rally in oil prices. Plummeting inflation and inflation expectations in Norway are probably the main culprit, as it entrenches the Norges Bank dovish bias. All this being said, there are some faint signs that the economy is starting to recover as manufacturing PMI is at 5 year highs while consumer confidence keeps creeping up and is now at its highest point since early 2015. While we are still NOK bears, we will continue to monitor these developments, as the NOK could become an attractive buy against other commodity currencies. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent inflation numbers corroborate downside risk to the krona. Headline inflation dropped by 0.5% to 1.3% on an annual basis; Core inflation dropped by 0.3% to 1%. This is most likely a follow-through of February's producer prices contraction. This may justify the Riksbank's fear over deflationary risks, as inflation remains tamed despite increased economic activity. However, it is likely that this proves to be a temporary phenomenon, as manufacturing new orders expanded at 12% in February, while industrial production expanded at 4.1%. Given that the next monetary policy meeting is in July, it is too early to tell if the Riksbank will further pursue its dovish stance: inflation will need to be consistently underperform further for that to happen, which is still not our base case. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights This week, we provide one of our occasional updates on Commodities as an Asset class (CAAC), examining the strategic case for getting long commodity index exposure. Commodity index exposure is more highly correlated with inflation than equities or bond exposure, indicating commodities - and real assets generally - provide a better hedge against inflation than financial assets. A pure investment case for getting long broad commodity index exposure can be made if backwardation is expected in one or more of the components of a given index. Given our expectation for higher inflation, and our positioning for backwardation in the oil market, we recommend getting long the energy-heavy S&P GSCI index as a strategic portfolio position. Energy: Overweight. Deeper-than-expected production cuts from OPEC were reported by Reuters Tuesday, suggesting Cartel members are at 104% of pledged output reductions.1 Our $50/bbl vs. $55/bbl WTI calls spreads in Jul-Aug-Sep settled at an average of $3.06/bbl, and we are taking profits of 76.9%, per the upside $3.00/bbl stop we established for these positions on March 23/17. We also are taking profits on our Dec/17 vs. Dec/18 WTI backwardation trade basis tonight's close, after registering a gain of more than 700% when we marked to market earlier this week. We are keeping our long Dec/17 vs. short Dec/18 Brent backwardation spread open; it is up 426.3% since we recommended it on March 23/17. We are recommending a strategic long position in the energy-heavy S&P GSCI basis today's close. Given this commodity index's overweight to oil and refined products, we believe price appreciation will offset negative roll returns until crude markets go into backwardation later this year. We expect WTI and Brent to trade on either side of $60/bbl by year end. Base Metals: Neutral. Workers at Southern Copper's Toquepala and Cuajone mines struck Monday seeking higher wages and improved working conditions, according to Metal Report. Front-line copper on the COMEX has been chopping between ~ $2.50/lb and $2.70/lb since the beginning of the year through multiple strike actions. Precious Metals: Neutral. Gold rallied slightly, but our long volatility play still is down 14.7%. Markets do not appear to be overly concerned with Fed actions over the next couple of months. Feature There's a long-standing argument among equities investors as to whether they trade the stock market or a market of stocks. In the case of the former, getting long index exposure makes sense. In the case of the latter, stock pickers sensitive to the idiosyncratic risk of individual equities outperform the broad-exposure devotees. Sometimes, both are right at the same time. Commodities are no different. There are times when broad exposure to commodities is warranted - e.g., in the early stages of a global industrial rebound or when investors expect higher inflation. However, there are periods in which sensitivity to idiosyncratic risk reflecting different fundamental states for each market works best. And, as is the case with equities, there are times when both points of view can co-exist without contradiction. The relative performance of commodities vs. equities post-Global Financial Crisis (GFC) leaves much to be desired (Chart 1A and Chart 1B). The re-balancing of commodities generally, led by crude oil, but apparent in key base metals like copper, suggests the overall commodity down-cycle - with the exception of ags - has leveled out. Fundamentals - supply, demand and inventories - will be far more important for commodities going forward, particularly as the Fed pursues its rates-normalization policy and markets are slowly weaned off the excessive monetary accommodation they've seen in the post-GFC period. Chart 1ACommodities Were Competitive Pre-GFC, ##br##Post-GFC Underperformance Will Reverse Chart 1BCommodities Were Competitive Pre-GFC, ##br##Post-GFC Underperformance Will Reverse There are two global-macro considerations driving our expectation commodities will outperform the other major asset classes going forward, which we consider below. First, consistent with our House view and recent analysis from our Global Fixed Income Strategy (GFIS) service, we expect higher inflation, which already is being reflected in the forward CPI swaps markets. This could be exacerbated if oil supplies tighten on the back of massive capex cuts following the 2015 - 16 oil-price collapse, and if U.S. fiscal stimulus overheats an economy that already is at or near full capacity and full employment. Second, backwardation in crude oil markets will be a positive development for commodity index products generally, and the energy-heavy S&P GSCI in particular. Together, these fundamentals will provide investors portfolio diversification via non-correlated returns vis-à-vis the other asset classes. Higher Inflation Expectations Support Commodity Index Exposure We have been highlighting the inflationary "tail risks" in commodity markets for a number of months. These include the possibility of 1) higher oil prices after 2018, following the more-than-$1 trillion cuts in oil-and-gas capex in the wake of the 2015 - 16 oil price collapse; and 2) a large injection of fiscal stimulus to the U.S. economy from the Republican-controlled U.S. Congress working with President Trump's White House. The fiscal stimulus could become material next year, revving an economy that is at or near full employment and an output gap at or close to being closed.2 Our colleagues on BCA's GFIS desk note, "underlying U.S. inflation pressures remain strong, particularly given the evidence that conditions in the labor market are getting progressively tighter." While inflationary forces are a bit more subdued in Europe and Japan, our colleagues continue to favor being long CPI swaps in both markets (Chart 2).3 BCA's GFIS expects inflation expectations to rise to a level of ~ 2.5% p.a. on 10-year TIPS breakevens, which are priced off the CPI index. If markets do raise the odds of higher inflation over the medium term, it most likely will continue to show up in the 5-year 5-year (5y5y) CPI Swaps in the U.S. and Europe, which we have found to be cointegrated with 3-year forward WTI futures (Chart 3). The oil market will be especially sensitive to the supply-demand balances after 2018, and will move higher if it senses a supply squeeze from too-little investment in production following the massive cuts to supply-side capex. This will feed into the 5y5y CPI swaps markets, which, in turn, will drive TIPS yields higher. Chart 2Early Days Yet, But ##br##U.S. Inflation Pressures Are Building Chart 3Watch 3-Year Forward WTI Futures ##br##For Early Signs Of Higher Inflation Apart from active commodity positioning, commodity index exposure offers better inflation risk coverage than equities or bonds, as can be seen in Table 1.4 Chart 4 shows the out-performance of the commodity indices, the S&P GSCI in particular, in higher-inflation environments. Table 1Correlations Between Real And Financial Assets Our own modeling supports the academic findings. When we estimated the yoy S&P GSCI returns as a function of U.S. CPI yoy changes and the difference between 1st-nearby WTI futures (CL1) and 12th nearby WTI futures (CL12), we found this specification explained just over 84% of the commodity index's annual returns. Our model indicates the S&P GSCI can be expected to increase in value by close to 15bp for every 1% increase in U.S. CPI (Chart 5). This energy-heavy index - crude oil and refined products comprise more than half of the S&P GSCI - performs much better than the more evenly disbursed Bloomberg Commodity Index (BCI) as an inflation hedge. Chart 4Commodities Outperform In##br## Inflationary Markets Chart 5S&P GSCI Index Exposure ##br##Moves With Inflation Profiting From Backwardation Long-only commodity index products generate returns from three sources: Price appreciation; roll yield - the returns generated by selling and replacing futures contracts approaching their terminal trading date (the expiring contract in the index is sold and replaced by a contract with a deferred delivery); and on the collateral posted to carry positions. An investor with a strong view on prices can express it by getting long or short futures. When an investor wants to express a view on the structure of the market - chiefly the shape of the forward curve and whether it will be backwardated (prompt delivery costs more than deferred delivery), or in contango (prompt delivery costs less than deferred delivery) - they can do so either by trading spreads (buying prompt-delivered contracts vs. selling deferred-delivered contracts, and vice versa) or getting long commodity-index exposure such as the S&P GSCI or Bloomberg Commodity Index (BCI). Typically, long-only commodity-index products largest returns are generated via price appreciation and roll yield, which simply are returns generated by "rolling" the underlying futures contracts in the index as these contracts approach the termination of trading to a deferred month. In a backwardated market, prompt-delivered contracts are sold and replaced with lower-cost contracts. In contango markets the opposite occurs. Indexes with heavy concentrations in futures that are likely to be backwardated for a length of time are preferred to indexes with futures that, on a fundamental basis, are more likely to have a flat or contango term structure. We have been positioning for a backwardation in crude oil later this year for some time. We continue to expect backwardation in crude oil markets, and remain long Dec/17 Brent vs. short Dec/18 Brent to express this view. Given the very high concentration of energy exposure in the S&P GSCI index - more than half of the index is crude oil or refined products, according to S&P - this index is best-suited, in our estimation, to benefit from a backwardated oil market.5 Indeed, our modeling, shown in Chart 5, supports our view that backwardation would significantly boost performance in the S&P GSCI index: A 1% increase in the spread between 1st-nearby WTI vs. 12th-nearby WTI contracts likely would translate into gain in the index of slightly more than 1.14%. Bottom Line: We expect higher inflation and backwardation in the oil market later this year. For this reason, we are recommending a long exposure in the energy-heavy S&P GSCI index. Commodities outperform equities and bonds in inflationary markets. In addition, this index's overweight to crude oil and refined products suggests it will outperform when markets backwardate. Given we expect WTI and Brent prices to trade on either side of $60/bbl later this year, we believe price appreciation will offset minor roll-yield losses until markets backwardate. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Exclusive: OPEC futures show oil output cuts exceed pledge in March - sources" published by Reuters.com on April 11, 2017. 2 Please see issue of BCA Research's Commodity & Energy Strategy Weekly Report "Gold's 'Known Unknowns' And Fat Tails," dated February 23, 2017, available at ces.bcaresearch.com. 3 Please see BCA Research's Global Fixed Income Strategy weekly Report "The Song Remains The Same," dated April 11, 2017, available at gfis.bcaresearch.com. 4 Please see Bhardwaj, Geetesh, Gary Gorton and Geert Rouwenhorst (2015), "Facts and Fantasies about Commodity Futures Ten Years Later*" published by Yale University. This article updates earlier research and notes, "In the original study we found that commodities had historically offered a risk premium similar to equities, and at the same time would provide diversification to a traditional portfolio of stocks and bonds. What set commodities apart from these traditional assets was their positive correlation with inflation. (Emphasis added.) Here we provide 10 years of additional data. Although a decade is sometimes too short to draw firm conclusions, our-of-sample period is rich because it includes a global economic expansion led by the industrialization of China, a housing boom and bust in the United States, the largest financial crisis since the Great Depression, followed by a monetary policy stimulus response which has driven interest rates around the world towards zero. ... Many of the basic conclusions of the original study continue to hold." (p. 22) 5 Please see "WTI Crude Oil Remains On Top As S&P Dow Jones Indices Announces 2017 Weights For The S&P GSCI," at http://ca.spindices.com/indices/commodities/sp-gsci, website for the index. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Trades Closed In 2016

Highlights An investment's long-term attractiveness depends on the trade-off between its expected long-term return and its risk of suffering an intermediate loss. On this risk-adjusted basis: Bonds are now less ugly than equities. U.S. T-bonds are more attractive than the average euro area government bond. European equities and U.S. equities are fairly valued against each other... ...but European equities can outperform when euro breakup risk eventually fades. Feature The English poet Samuel Taylor Coleridge coined the term "willing suspension of disbelief" in his Biographia Literaria published in 1817. It describes the sacrifice of reason and logic to believe the unbelievable. Coleridge suggested that if he could instil a "semblance of truth" into a fantastic tale, the reader would suspend judgement about the implausibility of the narrative in order to enjoy it. Today, it feels like financial market prices are relying on the willing suspension of disbelief. At our client meetings, almost everybody disbelieves that current valuations allow developed market equities to generate attractive long-term returns. Yet many investors are willing to suspend this disbelief, at least for the time being. Our own return forecasts justify the disbelief (Chart I-2). In Outlook 2017, Shifting Regimes,1 my colleague and BCA Chief Economist, Martin Barnes, published our long-term nominal return forecasts for the major asset classes. Allowing for market moves since publication, four of those 10-year annualised total returns2 now stand at: Chart I-2Valuation Drives Long-Term Returns European equities3 5.0% U.S. equities4 3.2% U.S. 10-year T-bond 2.3% Euro area 10-year sovereign bond5 1.2% With annual inflation expected at 2%, these numbers imply paltry real returns from mainstream investments over the coming decade. Still, in terms of ranking relative attractiveness, it might appear reasonable to follow the sequence of returns:6 European equities; U.S. equities; the U.S. 10-year T-bond; and then the euro area 10-year sovereign bond. But that sequence would be wrong - at least in the medium term. The key point is that the four investments are not equally risky. For a riskier asset, investors should expect today's price to generate a higher long-term return as compensation for the extra risk of intermediate loss. Put another way, a risky asset must offer a higher long-term return than a less risky asset for an investor to be indifferent between them. If it doesn't, the danger is that the price will adjust (down) at some point until it does. European Equity Valuations Must Allow For Euro Breakup Risk Consider European equities versus U.S. equities. The sovereign bond market is discounting a 5% annual risk of euro break-up (Chart I-3). This shows up as a discount on German bund yields, because in that tail-event a new deutschmark would rise; and a symmetrical premium on Italian BTP yields, because a new lira would fall. But for the aggregate euro area bond, the risk largely cancels out because intra-euro currency redenomination would be zero sum (Chart I-4). Unfortunately, for the aggregate European stock market, the risk does not cancel out. If the euro broke up, European equities would suffer a much greater drawdown than other markets. Recall that at the peak of the euro debt crisis in 2011, the Eurostoxx600 underperformed the S&P500 by 25% in one year (Chart I-5). In an outright break-up, the underperformance would almost certainly be worse, let's conservatively say 30%. So assuming a 5% annual risk, European equities must compensate with a valuation discount which allows a 1.5% excess annual return over U.S. equities. Chart I-3The Bond Market Is Discounting##br## A 5% Risk Of Euro Breakup... Chart I-4...Based On The Sovereign Yield Spread##br## Between Italy And Germany Chart I-5In The Euro Crisis, The Eurostoxx ##br##Underperformed By 25% There is also the issue of the post-2016 bailout rules for European banks. At a stroke, the Bank Recovery and Resolution Directive (BRRD) has made European bank equity investment more risky. In the event of a bank failure, investors must now suffer the first losses - including full wipe-out - before governments can step in. Combining this with the risk of euro breakup, the 1.8% excess annual return that we expect from the Eurostoxx600 versus the S&P500 makes European equity valuations look fair, rather than attractive, on a relative risk-adjusted basis. That said, the good news is that if the risk of euro area breakup gradually fades, it would permit a healthy re-rating of the Eurostoxx600 versus the S&P500. For example, if the annual risk of breakup declined from 5% to 1%, it would equate to a 12% outperformance. But as the greatest political risk to the euro now emanates from Italy - and not the upcoming French Presidential Election - we recommend playing this re-rating opportunity closer to, or after, Italy's next general election.7 Equity Valuations Reliant On "Willing Suspension Of Disbelief" Now consider equities versus bonds. An expected 3.2% annual return from the S&P500 versus a 2.3% 10-year T-bond yield implies an ex-ante 10-year equity risk premium (ERP) of just 0.9% (Chart I-6). This is significantly lower than the 135-year average of 5% and even the post war average of 2.5%8 (Chart of the Week). Chart of the WeekThe Ex-Ante Equity Risk Premium Is Close To Zero Chart I-6In The U.S., The Expected 10-Year Return From Equities And Bonds Is Now Almost The Same What can justify the "willing suspension of disbelief" that permits today's abnormally low ERP? There are three arguments. All have Coleridge's "semblance of truth" but are ultimately flawed. Chart I-7In The 1970s Inflation Scare, Equities##br## Suffered Much More Than Bonds First, it is argued that the ERP should be low because bonds have become more risky. With 10-year bond yields so low, bond prices have limited upside but substantial downside. The problem with this argument is that equities are a much longer duration asset than a 10-year bond, so if inflation did take hold, equities would suffer the much greater drawdown - as they did in the 1970s (Chart I-7). Another counterargument is that bond yields have been this low on previous occasions in the past 135 years, but on those previous occasions the ex-ante ERP was not as depressed as it is today. Second, it is argued that the ERP should be low because central banks now have a tried and tested weapon - QE - which they can pull out at the slightest sign of trouble. Empirically, it might be true that QE did compress the ERP. But theoretically, it shouldn't. Even Ben Bernanke told us at our 2015 New York Conference that QE is nothing more than a signalling mechanism for interest rate policy. So it works by compressing bond yields rather than the ERP. In this sense, justifying a low ERP with QE is a worry rather than a hope. Third, and most recently, it is argued that the surprise arrival of the Trump administration is a game changer for investments - structurally positive for equities, structurally negative for bonds. The jury is out on this. But given the speed of market moves, our sense is that is the hope of fast-moving momentum traders. Slow-moving value investors are still on the side lines, waiting to see what - if anything - will really change. Mr. Market Is Little Short Of Silly In his 1949 seminal work, The Intelligent Investor Benjamin Graham, the grandfather of value investing, introduced us to a whimsical character called Mr. Market. Every day, Mr. Market quotes a price for your investments, at which you can buy or sell. Sometimes, Mr. Market's idea of value seems plausible. At other times: "Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you little short of silly." The point of Graham's allegory is that investors should not cheerlead the market come what may. Mr. Market will not always quote you an attractive price; sometimes he will quote you a very unattractive price (Chart I-8). Chart I-8Mr. Market Will Not Always Quote You An Attractive Price "At which the long-term investor certainly should refrain from buying and probably would be wise to sell." Today, when we see the ugly long-term returns offered by Mr. Market and we risk-adjust for potential drawdowns, we conclude: Bonds are now less ugly than equities. U.S. T-bonds are more attractive than the average euro area government bond. European equities and U.S. equities are fairly valued against each other, but European equities can outperform when euro breakup risk eventually fades. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on December 20, 2016 and available at www.bcaresearch.com 2 Nominal local currency returns including income. 3 Outlook 2017 showed "Other (non-U.S.) developed equities" but this aligns with our forecast for European equities. 4 Since Outlook 2017 was published, equity markets are up around 5%. So 10-year return forecasts have been reduced by around (5/10) = 0.5%. 5 Euro area weighted average 10-year yield weighted by sovereign issue size. 6 This assumes investors can cheaply hedge currency exposure, as is the case now. 7 Please see the Geopolitical Strategy Service Weekly Report titled "Political Risks Are Understated In 2018", dated April 12, 2017 and available at gps.bcaresearch.com 8 In this report we define the ex-ante ERP at any point in time as the Shiller P/E's implied prospective 10-year equity return (see Chart 8) less the 10-year bond yield. Fractal Trading Model* This week's trade is to go long the sugar number 11 futures contract on the NYB-ICE exchange, with a profit target of 7%. Alternatively, a more hedged position is long sugar / short aluminium with a profit target of 10%. 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-9 Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Global political risks are understated in 2018; U.S. policy will favor the USD, as will global macro trends; Trump's trade protectionism will re-emerge; China will slow, and may intensify structural reforms; Italian elections will reignite Euro Area breakup risk. Feature In our last report, we detailed why political risks are overstated in 2017.1 First, markets are underestimating President Trump's political capital when it comes to passing his growth agenda. Second, risks of populist revolt remain overstated in Europe. Third, political risks associated with Brexit probably peaked earlier this year. Next year, however, the geopolitical calendar is beset with potential systemic risks. First, we fear that President Trump will elevate trade to the top of his list of priorities, putting fears of protectionism and trade wars back onto the front burner. In turn, this could precipitate a serious crisis in the U.S.-China relationship and potentially inspire Chinese policymakers to redouble their economic reforms - so as not to "let a good crisis go to waste." That, in turn, would create short-term deflationary effects. Meanwhile, we fear that investors will have been lulled to sleep by the pro-market outcomes in Europe this year. The series of elections that go against populists may number seven by January 2018 (two Spanish elections, the Austrian presidential election, the Dutch general election, the French presidential and legislative elections, and the German general election in September). However, the Italian election looms as a risk in early 2018 and investors should not ignore it. Investors should remain overweight risk assets for the next 12 months. Our conviction level, however, declines in 2018 due to mounting geopolitical risks. Mercantilism Makes A Comeback Fears of a trade war appear distant and alarmist following the conclusion of the Mar-a-Lago summit between U.S. President Donald Trump and his Chinese counterpart Xi Jinping. We do not expect the reset in relations to last beyond this year. Trump has issued a "shot across the bow" and now the two sides are settling down to business - but investors should avoid a false sense of complacency.2 Investors should remember that candidate Trump's rhetoric on China and globalization was why he stood out from the crowd of bland, establishment Republican candidates. Despite the establishment's tenacious support for globalization, Americans no longer believe in the benefits of free trade, at least not as defined by the neoliberal "Washington Consensus" of the past two decades (Chart 1). We take Trump's views on trade seriously. They certainly helped him outperform expectations in the manufacturing-heavy Midwest states of Michigan, Pennsylvania, and Wisconsin (Chart 2). And yet, Trump's combined margin of victory in the three states was just 77,744 votes -- less than 0.5% of the electorate of the three states! That should be enough to keep him focused on fulfilling his campaign promises to Midwest voters, at least if he wants to win in 2020.3 Chart 1America Belongs To The Anti-Globalization Bloc Chart 2Protectionism Boosted Trump In The Rust Belt In 2017, Trump's domestic agenda has taken precedent over international trade. The president is dealing with several key pieces of legislation, including the repeal and replacement of the Affordable Care Act, comprehensive tax reform, the repeal of Obama-era regulations, and infrastructure spending. However, there is considerable evidence that trade will eventually come back up: President Trump's appointments have favored proponents of protectionism (Table 1) whose statements have included some true mercantilist gems (Table 2). Table 1Government Appointments Certifying That Trump Is A Protectionist Table 2Protectionist Statements From The Trump Administration Secretary of Treasury Steven Mnuchin, who is not known as a vociferous proponent of protectionism, prevented the G20 communique from reaffirming a commitment to free trade at the March meeting of finance officials in Baden-Baden, Germany.4 Such statements were staples of the summits over the past decade. The Commerce Department - under notable trade hawk Wilbur Ross - looks to be playing a much more active role in setting the trade agenda under President Trump. Ross has already imposed a penalty on Chinese chemical companies in a toughly worded ruling that declares, "this is not the last that bad actors in global trade will hear from us - the games are over." He is overseeing a three-month review of the causes of U.S. deficits, planning to add "national security" considerations to trade and investment assessments, proposing a new means of collecting duties in disputes, and encouraging U.S. firms to bring cases against unfair competition. Ross is likely to be joined by a tougher U.S. Trade Representative (who has historically been the most important driver of trade policy in the executive branch). In addition, we believe that Trump's success on the domestic policy front, in combination with the global macro environment, will lead to higher risk of protectionism in 2018. There are three overarching reasons: Domestic Policy Is Bullish USD: We do not know what path the White House and Congress will take on tax reform. We think tax reform is on the way, but the path of least resistance may be to leave reform for later and focus entirely on tax cuts in 2017. Whatever the outcome, we are almost certain that it will involve greater budget deficits than the current budget law augurs (Chart 3). Even a modest boost to government spending will motivate the Fed to accelerate its tightening cycle at a time when the output gap is nearly closed and unemployment is plumbing decade lows (Chart 4). This will perpetuate the dollar bull market. Chart 3Come What May, Trump Will Increase The Budget Deficit Chart 4A Fiscal Boost Will Accelerate Inflation Chinese Growth Scare Is Bullish USD: At some point later this year, Chinese data is likely to decelerate and induce a growth scare. Our colleague Yan Wang of BCA's China Investment Strategy believes that the Chinese economy is on much better footing than in early 2016, but that the year-on-year macro indicators will begin to moderate.5 This could rekindle investors' fears of another China-led global slowdown. Meanwhile, Chinese policymakers have gone forward with property market curbs and begun to tighten liquidity marginally on the interbank system. The seven-day repo rate, a key benchmark for Chinese lending terms, has surged to its highest level in two years, according to BCA's Foreign Exchange Strategy. It could surge again, dissuading small and medium-sized banks from bond issuance (Chart 5). Falling commodity demand and fear of another slowdown in China will weigh on EM assets and boost the USD. European Political Risks Are Bullish USD: Finally, any rerun of political risks in Europe in 2018 will force the ECB to be a lot more dovish than the market expects. With Italian elections to be held some time in Q1 or Q2 2018 - more on that risk below - we think the market is getting way ahead of itself with expectations of tighter monetary policy in Europe. The expected number of months till an ECB rate hike has collapsed from nearly 60 months in July 2016 to just 20 months in March, before recovering to 28 months as various ECB policymakers sought to dampen expectations of rate hikes (Chart 6).6 In addition, our colleague Mathieu Savary of BCA's Foreign Exchange Strategy has noted that a relationship exists between EM growth and European monetary policy (Chart 7), which suggests that any Chinese growth scares would similarly be euro-bearish and USD-bullish.7 Chart 5Interbank Volatility Will ##br##Dampen Chinese Credit Growth Chart 6Market Is Way Ahead Of ##br## Itself On ECB Hawkishness Chart 7EM Spreads, ECB Months-To-Hike: ##br##Same Battle The combination of Trump's domestic policy agenda and these global macro-economic factors will drive the dollar up. At some point in 2018, we assume that USD strength will begin to irk Donald Trump and his cabinet, particularly as it prevents them from delivering on their promise of shrinking trade deficits. We suspect that President Trump will eventually reach for the "currency manipulation" playbook of the 1970s-80s. There are two parallels that investors should be aware of: 1971 Smithsonian Agreement - President Richard Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."8 Less understood, but also part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. As president, he staffed his cabinet with trade hawks, including Treasury Secretary John Connally who was in favor of threatening a reduced U.S. military presence in Europe and Japan to force Berlin and Tokyo to the negotiating table.9 Economists in the cabinet opposed the surcharge, fearing retaliation from trade partners, but policymakers favored brinkmanship.10 The eventual surcharge was said to be "temporary," but there was no explicit end date. The U.S. ultimately got other currencies to appreciate, mostly the deutschmark and yen, but not as much as it wanted. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt Trans-Atlantic relations and thus impede Cold War coordination between allies. As such, the U.S. removed the surcharge by December without meeting most of its other objectives, including increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the exchange-rate outcomes of the deal dissipated within two years. 1985 Plaza Accord - The U.S. reached for the mercantilist playbook again in the early 1980s as the USD rallied on the back of Volcker's dramatic interest rate hikes. The subsequent dollar bull market hurt U.S. exports and widened the current account deficit (Chart 8). U.S. negotiators benefited from the 1971 Nixon surcharge because European and Japanese policymakers knew that Americans were serious about tariffs. The result was coordinated currency manipulation to drive down the dollar and self-imposed export limits by Japan, both of which had an almost instantaneous effect on the Japanese share of American imports (Chart 9). Chart 8Dollar Bull Market And ##br## Current Account Balance Chart 9The U.S. Got What It ##br##Wanted From Plaza Accord The Smithsonian and Plaza examples are important for two reasons. First, they show that Trump's mercantilism is neither novel nor somehow "un-American." It especially is not anti-Republican, with both Nixon and Reagan having used overt protectionism as a negotiating tool in recent history. In fact, Trump's Trade Representative, the yet-to-be-confirmed Robert Lighthizer, is a veteran of the latter agreement, having negotiated it for President Ronald Reagan.11 Second, the experience of both negotiations in bringing about a shift in the U.S. trade imbalance will motivate the Trump administration to reach for the same "coordinated currency manipulation" playbook. The problem is that 2018 is neither 1971 nor 1985. The Trump administration will face three constraints to using currency devaluation to reduce the U.S. trade imbalance: Chart 10Globalization Has Reached Its Apex Chart 11Global Protectionism Has Bottomed Economy: Europe and Japan were booming economies in the early 1970s and mid-1980s and had the luxury of appreciating their currencies at the U.S.'s behest. Today, it is difficult to see how either Europe or China can afford significant monetary policy tightening that engineers structural bull markets in the euro and RMB respectively. For Europe, the risk is that peripheral economies may not survive a back-up in yields. For China, monetary policy tightness would imperil the debt-servicing of its enormous corporate debt horde. Apex of Globalization: U.S. policymakers could negotiate the 1971 and 1985 currency agreements in part because the promise of increased trade remained intact. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization. In 2017, however, this promise has been muted. Global trade has peaked as a percent of GDP (Chart 10), average tariffs appear to have bottomed (Chart 11), and the number of preferential trade agreements signed each year has collapsed (Chart 12). Temporary trade barriers have ticked up since 2008 (Chart 13). To be clear, these signs are not necessarily proof that globalization is reversing, but merely that it has reached its apex. Nonetheless, America's trade partners will be far less willing to agree to coordinated currency manipulation in an era where the global trade pie is no longer growing. Geopolitics: During the Cold War, the U.S. had far greater leverage over Europe and Japan than it does today over Europe and China. While the U.S. is still involved in European defense, its geopolitical relationship with China is hostile. What happens when the Smithsonian/Plaza playbook fails? We would expect the Trump administration to switch tactics. Two alternatives come to mind: Protectionism: As the Nixon surcharge demonstrates, the U.S. president has few legal, constitutional constraints to using tariffs against trade partners.12 As the Trump White House grows frustrated in 2018 with the widening trade imbalance, it may reach for the tariff playbook. The risk here is that retaliation from Europe and China would be swift, hurting U.S. exporters in the process. Dovishness: There is a much simpler alternative to a global trade war: inflation. Our theory that the USD will rally amidst domestic fiscal stimulus is predicated on the Fed hiking rates faster as inflation and growth pick up. But what if the Fed decides to respond to higher nominal GDP growth by hiking rates more slowly? This could be the strategy pursued by the next Fed chair, to be in place by February 3, 2018. We do not buy the conventional wisdom that "President Trump will pick hawks because his economic advisors are hawks" for two reasons. First, we do not know that Trump's economic advisors will carry the day. Second, we suspect that President Trump will be far more focused on winning the 2020 election than putting a hawk in charge of the Fed. Chart 12Low-Hanging Fruit Of Globalization Already Picked Chart 13Temporary Trade Barriers Ticking Up Bottom Line: Putting it all together, we expect that U.S. trade imbalances will come to the forefront of the political agenda in 2018. This will especially be the case if the USD continues to rally into next year, contributing to the widening of the trade deficit. We expect any attempt to reenact the Smithsonian/Plaza agreements to flame out quickly. America's trade partners are constrained and unable to appreciate their currencies against the USD. This could rattle the markets in 2018 as investors become aware that Trump's mercantilism is real and that chances of a trade war are high. On the other hand, Trump may take a different tack altogether and instead focus on talking down the USD. This will necessitate a compliant Fed, which will mean higher inflation and a weaker USD. Such a strategy could prolong the reflation trade through 2018 and into 2019, but only if the subsequent bloodbath in the bond market is contained. China Decides To Reform Presidents Trump and Xi launched a new negotiation framework on April 6 that they will personally oversee, as well as a "100 Day Plan" on trade that we expect will result in a flurry of activity over the next three months. One potential outcome of the meeting is a rumored plan for massive Chinese investment into the U.S. that could add a headline 700,000 jobs, complemented with further opening of China's agricultural, automotive, and financial sectors to U.S. investment and exports. Investors may be fêted with more good news, especially with President Trump slated to visit China before long. President Trump, a prominent China-basher, may decide that the deals he brings home from China will be enough to convince the Midwest electorate that he has gotten the U.S. a "better deal" as promised. This would enable him to stabilize China relations in order to focus on other issues, as all presidents since Reagan have done. However, we doubt that the Sino-American relationship can be resolved through short-term trade initiatives alone. There is too much distrust, as we have elucidated before.13 The 100-day plan is a good start but it carries an implicit threat of tariffs from the Trump administration if China fails to follow through; and China is not likely to give Trump everything he wants. Moreover, strategic and security issues are far from settled, despite some positive gestures. As such, we expect both economic and geopolitical tensions to resurface in 2018. Meanwhile Chinese policymakers may decide to use tensions with the U.S. as an opportunity to redouble efforts towards structural reforms at home. Since the Xi Jinping administration pledged sweeping pro-market reforms in 2013, the country has shied away from dealing with its massive corporate debt hoard (Chart 14) and has only trimmed the overcapacity in sectors like steel and coal (Chart 15). It fears incurring short-term pain, albeit for long-term gain. However, if Beijing can blame any reform-induced slowdown on the U.S. and its nationalist administration, it will make it easier to manage the political blowback at home, providing a means of rallying the public around the flag. Chart 14China's Corporate Debt Pile Still A Problem... Chart 15...And So Is Industrial Overcapacity China has, of course, undertaken significant domestic reforms under the current administration. It has re-centralized power in the hands of the Communist Party and made steps to improve quality of life by fighting pollution, expanding health-care access, and loosening the One Child policy. These measures have long-term significance for investors because they imply that the Chinese state is responsive to the secular rise in social unrest over the past decade. The political system is still vulnerable in the event of a major economic crisis, but the party's legitimacy has been reinforced. Nevertheless, what long-term investors fear is China’s simultaneous backsliding on key components of economic liberalization. Since the global financial crisis, the government has adopted a series of laws that impose burdens on firms, especially foreign and private firms, relating to security, intellectual property, technology, legal (and political) compliance, and market access. Moreover, since the market turmoil in 2015-16, the government has moved to micromanage the country’s stock market, capital account, banking and corporate sectors, and Internet and media. The general darkening of the business environment is a major reason why investors have not celebrated notable reform moves like liberalizing deposit interest rates or standardizing the business-service tax. These steps require further reforms to build on them (i.e. to remove lending preferences for SOEs, or to provide local governments with revenues to replace the business tax). But all reforms are now in limbo as the Communist Party approaches its “midterm” party congress this fall. Most importantly for investors, the government has still not shown it can "get off the train" of rapid credit growth that has underpinned China's transition away from foreign demand (Chart 16). The country's relatively robust consumer-oriented and service-sector growth remains to be tested by tighter financial conditions. And the property sector poses an additional, perpetual financial risk, which policymakers have avoided tackling with reforms like the proposed property tax (a key reform item to watch for next year).14 The PBoC's recent tightening efforts come after a period of dramatic liquidity assistance to the banks (Chart 17), and even though interbank rates remain well below their brief double-digit levels during the "Shibor Crisis" in 2013 (see Chart 5 above, page 6), any tightening serves to revive fears that financial instability could re-emerge and translate to the broader economy. Chart 16China's Savings Fueling Debt Buildup Chart 17PBoC Lends A Helping Hand What signposts should investors watch to see whether China re-initiates structural reforms? Already, personnel changes at the finance and commerce ministries, as well as the National Development and Reform Commission and China Banking Regulatory Commission, suggest that the Xi administration may be headed in this direction. Table 3 focuses on the steps that we think would be most important, beginning with the party congress this fall. Given current levels of overcapacity and corporate leverage, we suspect that genuine structural reform will begin with a move toward deleveraging, and involve a mix of bank recapitalization and capacity destruction, as it did in the 1990s and early 2000s. These reforms included the formation of new central financial authorities, like policy banks, regulatory bodies, and asset management companies, to oversee the cleaning up of bank balance sheets and the removal of numerous inefficient players from the financial sector.15 They eventually entailed transfers of funds from the PBoC, from foreign exchange reserves, and from public offerings as major banks were partially privatized. On the corporate side, the reforms witnessed the elimination of a range of SOEs and layoffs numbering around 40% of SOE employees, or 4% of the economically active workforce at the time. Table 3Will China Launch Painful Economic Restructuring Next Year? Chinese President Jiang Zemin launched these reforms after the party congress of 1997, just as his successor, Hu Jintao, attempted to launch similar reforms following the party congress of 2007. The latter got cut short by the Great Recession. The question now for Xi Jinping's administration is whether he will use his own midterm party congress to launch the reforms that he has emphasized: namely, deep overcapacity cuts and financial and property market stabilization through measures to mitigate systemic risks.16 Bottom Line: China may decide to use American antagonism as an "excuse" to launch a serious structural reform push following this fall's National Party Congress. Short-term pain, which is normal under a reform scenario in any country, could then be blamed on an antagonistic U.S. trade and geopolitical policy. While reforms in China are a positive in the long term, we fear that a slowdown in China would export deflation to still fragile EM economies. And given Europe's high-beta economy, it could also be negative for European assets and the euro. Europe's Divine Comedy Investors remain focused on European elections this year. The first round of the French election is just 11 days away and polls are tightening (Chart 18). Although Marine Le Pen is set to lose the second round in a dramatic fashion against the pro-market, centrist Emmanuel Macron (Chart 19), she could be a lot more competitive if either center-right François Fillon or left-wing Jean-Luc Mélenchon squeaks by Macron to get into the second round.17 Chart 18Melenchon's Rise: Comrades Unite! Chart 19Le Pen Cruisin' For A Bruisin' The risk of someone-other-than-Macron getting into the second round is indeed rising. However, Mélenchon's rise thus far appears to be the mirror image of Socialist Party candidate Benoît Hamon's demise. At some point, this move will reach its natural limits: not all Hamon voters are willing to switch to Mélenchon. At that point, the Communist Party-backed Mélenchon will have to start taking voters away from Le Pen. This is definitely possible, but would also create a scenario in which it is Mélenchon, not Le Pen, that faces off against a centrist candidate in the second round. As such, we see Mélenchon's rise primarily as a threat to Le Pen, not Macron.18 While we remain focused on the French election, we think that any market relief from that election - and the subsequent German one - will be temporary. By early next year, investors will have to deal with Italian elections. Unfortunately, there is absolutely no clarity in terms of who will win the Italian election. If elections were held today, the Euroskeptic Five Star Movement (M5S) would gain a narrow victory (Chart 20). However, it is not clear what electoral law will apply in the next election. The current law on the books, which the Democratic Party-led (PD) government is attempting to reform by next February, would give a party reaching 40% of the vote a majority-bonus. As Chart 20 illustrates, however, no party is near that threshold. As such, the next election may produce a hung parliament with no clarity, but with a Euroskeptic plurality. Meanwhile, the ruling center-left Democratic Party is crumbling. Primaries are set for April 30 and will pit former PM Matteo Renzi against left-wing factions that have coalesced into a single alliance called the Progressive and Democratic Movement (DP). For now, DP supports the government of caretaker PM Paolo Gentiloni, but its members have recently embarrassed the government by voting with the opposition in a key April 6 vote in the Senate. If Renzi wins the leadership of the Democratic Party again, DP members could formally split and contest the 2018 election as a separate party. The real problem for investors with Italy is not the next election, whose results are almost certain to be uncertain, but rather the Euroskeptic turn in Italian politics. First, aggregating all Euroskeptic and Europhile parties produces a worrying trend (Chart 21). And we are being generous to the pro-European camp by including the increasingly Euroskeptic Forza Italia of former PM Silvio Berlusconi in its camp. Chart 20Five Star Movement Set For Plurality Win Chart 21Euroskeptics Take The Lead Unlike its Mediterranean peers Spain and Portugal, Italian support for the euro is still plumbing decade lows -- no doubt a reflection of the country's non-existent economic recovery (Chart 22). It is difficult to see how Italians can regain confidence in European integration given that they are unwilling to pursue painful structural reforms. Chart 22Italian Economic Woes Hurt Euro Support The question is not whether Italy will face a Euroskeptic crisis, but rather when. It may avoid one in 2018 as the pro-euro centrists cobble together a weak government or somehow entice the center-right into forming a grand coalition. But even in that rosy scenario, such a government is not going to have a mandate for painful structural reforms that would be required to pull Italy out of its low-growth doldrums. As such, it is unlikely that the next Italian government will last its full five-year term. Bottom Line: Investors should prepare for a re-run of Europe's sovereign debt crisis, with Italy as the main event. We expect this risk to be delayed until after the Italian election in 2018, maybe later. However, it is likely to have global repercussions, given Italy's status as the third-largest sovereign debt market. Will Italy exit the euro? Our view is that Italy needs a crisis in order to stay in the Euro Area, as only the market can bring forward the costs of euro exit for Italian voters by punishing the economy through the bond market. The market, economy, and politics have a dynamic relationship and Italian voters will be able to assess the costs of an exit first hand, as yields approach their highs in 2011 and Italian banks face a potential liquidity crisis. Given that support for the euro remains above 50% today, we would expect that Italians would back off from the abyss after such a shock, but our conviction level is low.19 Housekeeping This week, we are taking profits on our long MXN/RMB trade. We initiated the trade on January 25, 2017 and it has returned 14.2% since then. The trade was a play on our view that Trump's protectionism would hit China harder than Mexico. Given the favorable conclusion to the Mar-a-Lago summit - and the likely easing of risks of a China-U.S. trade war in the near term - it is time to book profits on this trade. We still see short-term upside to MXN and investors may want to pair it by shorting the Turkish lira. We expect more downside to TRY given domestic political instability, which we expect to continue beyond the April 15 constitutional referendum. We see both the yes and no outcomes of the referendum as market negative. In addition, we are closing our short Chinese RMB (via 12-month non-deliverable forwards) trade for a profit of 5.89% and our long USD/SEK trade for a gain of 1.27%. Our short U.K. REITs trade has been stopped out for a loss of 5%. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 For this negotiating sequence, please see BCA Geopolitical Strategy and The Bank Credit Analyst Special Report, "A Q&A On Political Dynamics In Washington," dated November 24, 2016, available at bca.bcaresearch.com, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 3 Trump loves to win. 4 Please see Federal Ministry of Finance, Germany, "Communique - G20 Finance Ministers and Central Bank Governors Meeting," dated March 18, 2017, available at www.bundesfinanzministerium.de. 5 Please see BCA China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead," dated April 6, 2017, available at cis.bcaresearch.com. 6 The head of the Lithuanian central bank, Vitas Vasiliauskas, was quoted by the Wall Street Journal in early April stating that "it is too early to discuss an exit because still we have a lot of significant uncertainties." This was followed by the executive board member Peter Praet dampening expectations of even a reduction in the bank's bond-buying program and President Mario Draghi stating that the current monetary policy stance remained appropriate. 7 Please see BCA Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com. 8 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org, and Barry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936 and 1971," Behl Working Paper Series 11 (2015). 9 Treasury Secretary John Connally was particularly protectionist, with two infamous mercantilist quips to his name: "foreigners are out to screw us, our job is to screw them first," and "the dollar may be our currency, but it is your problem." 10 Paul Volcker, then Undersecretary of the Treasury, provided some color on this divide: "As I remember it, the discussion largely was a matter of the economists against the politicians, and the outcome wasn't really close." 11 We highly recommend that our clients peruse Lighthizer's testimony to the U.S.-China Economic and Security Review Commission. Beginning at p. 29, he recommends three key measures: using the 1971 surcharge as a model (p. 31); going beyond "WTO-consistent" policies (p. 33); and imposing tariffs against China explicitly (p. 35). Please see Robert E. Lighthizer, "Testimony Before the U.S.-China Economic and Security Review Commission: Evaluating China's Role in the World Trade Organization Over the Past Decade," dated June 9, 2010, available at www.uscc.gov. 12 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Reports, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. See also the recent Geopolitical Strategy and Emerging Market Equity Sector Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 14 Please see BCA's Commodity & Energy Strategy Special Report, "Chinese Property Market: A Structural Downtrend Just Started," dated June 4, 2015, available at ces.bcaresearch.com. 15 Please see BCA Geopolitical Strategy, "China: Is Beijing About To Blink?" in Monthly Report, "What Geopolitical Risks Keep Our Clients Awake?" dated March 9, 2016, available at gps.bcaresearch.com. 16 At a meeting of the Central Leading Group on Financial and Economic Affairs, which Xi chairs, the decision was made to make some progress on these structural issues this year, but only within the overriding framework of ensuring "stability." The question is whether Xi will grow bolder in 2018. Please see "Xi stresses stability, progress in China's economic work," Xinhua, February 28, 2017, available at news.xinhuanet.com. 17 That said, the most recent poll - conducted between April 9-10 - shows that Mélenchon may be even more likely to defeat Le Pen than Macron. He had a 61% to 39% lead in the second round versus Le Pen. 18 In the second round, Macron is expected to defeat Mélenchon by 55% to 45%, according to the latest poll, conducted April 9-10. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com.

Highlights Chinese capex and EM domestic demand will falter again in the second half of this year. This is not contingent on a growth slowdown in the advanced economies, but due to a further slowdown in bank lending in EM and lower commodities prices. The direction of EM share prices in absolute terms and relative to the S&P 500 is determined by EPS trajectory, not equity valuations. We expect EM EPS to drop in absolute terms and to underperform U.S. EPS. India's deleveraging cycle is well advanced, especially when compared with other EM economies. Maintain an overweight position in Indian equities within the EM universe. Continue betting on yield curve steepening. Stay long the Czech koruna versus the euro. Feature EM/China growth will relapse in the second half of this year. Share prices, presuming they are forward-looking, will roll over beforehand. Chinese interest rates have risen, which typically heralds a downtrend in the mainland's credit impulse and business cycle (Chart I-1). Chinese interest rates are shown as an annual percentage change, inverted and advanced. This is a typical relationship between interest rates and credit cycles, and there is currently no reason why it will play out any differently in China. Given the mainland has a lingering credit bubble, rising borrowing costs and regulatory tightening of banks and the shadow banking system are guaranteed to lead to a relapse in credit origination, and in turn economic growth. China's yield curve has been flattening in recent months. This often precedes a selloff in both EM share prices and industrial metals (Chart I-2). Chart I-1China: Interest Rates ##br##And Credit/Business Cycles Chart I-2A Flattening Yield Curve In China Is ##br##A Bad Omen For EM And Commodities The Chinese yield curve has been experiencing bear flattening - front-end rates have risen more than long-term rates. Bear flattening in yield curves typically occurs before a major top in growth, when current conditions are still robust but the fixed-income market begins to question growth sustainability going forward. A flattening yield curve is consistent with our assessment: a lack of follow-through from last year's stimulus combined with the recent policy tightening will cause growth to downshift materially very soon. EM narrow (M1) money growth has rolled over decisively, and historically it has been a good leading indicator for EM earnings per share (EPS) (Chart I-3). The former has historically led the latter by about nine months. Chart I-3EM EPS To Roll Over In the Second Half 2017 The same is true in the case of China - the M1 impulse (the second derivative of M1) leads industrial profits by about six months and heralds an imminent reversal (Chart I-4). Chart I-4China's Industrial Profit Growth Recovery Is At A Risk The commodities currency index (an equally weighted average of AUD, NZD and CAD) has relapsed against the greenback. This index points to global growth deceleration in the second half of this year (Chart I-5). Similarly, these commodities currencies also lead commodities prices, and presently signal a top in the commodities complex (Chart I-6). Chart I-5Commodities Currencies Signify Weakness In Global Trade Chart I-6Commodities Currencies Point To Relapse In Commodities Prices In EM ex-China, Korea and Taiwan, bank loan growth has still been decelerating despite the global growth recovery of the past 12 months (Chart I-7, top panel). Besides, retail sales volume growth in EM ex-China, Korea and Taiwan has not ameliorated yet (Chart I-7, bottom panel). All of these economic aggregates are equity market cap-weighted. Similarly, auto sales in EM ex-China, Korea and Taiwan have been stabilizing at very low levels but have not recovered at all (Chart I-8). Hence, we infer that domestic demand in EM ex-China has stabilized, but it has not recovered. For example, manufacturing production in Brazil, Russia, South Africa and Indonesia has been rather subdued (Chart I-9). Chart I-7EM Ex-China, Korea And Taiwan: ##br##Domestic Demand Has Not Recovered Chart I-8EM Ex-China, Korea And Taiwan: ##br##Auto Sales Are Stabilizing At Low levels Chart I-9Synchronized Global Recovery? As EM ex-China credit growth decelerates further due to the lingering credit excesses and poor banking system health, their domestic demand will disappoint. This is a major risk to the EM profit outlook. Bottom Line: Chinese and EM domestic demand and by extension corporate earnings will falter again in the second half of this year. This view is not contingent on a growth slowdown in the advanced economies but will be the outcome of further slowdown in bank lending in EM and lower commodities prices. A reversal in Chinese imports from other EM is the link that explains how a relapse in the mainland's growth in the second half this year will hurt the rest of the world in general, and EM in particular. Profits Hold The Key Chart I-10Profits, Not Valuations, Hold The Key Emerging markets' relative performance versus the S&P 500 has historically been driven by EPS (Chart I-10). In the past 12 months, EM EPS has improved modestly but has not outperformed U.S. EPS in U.S. dollar terms. Consistently, EM stocks have failed to outperform the S&P 500 in common currency terms; they have been flat at low levels in the past 12 months. An important message from this chart is that equity valuations are not critical to EM versus U.S. relative equity performance. It is all about corporate profit cycles. The widely held view within the investment community is that EM stocks are cheaper than those in the U.S., and therefore will outperform based on more attractive valuations. The fact that EM stocks are indeed cheaper versus the S&P 500 only reflects the fact that U.S. equity valuations are expensive and EM equity valuations are neutral in absolute terms. Equity valuations may affect the degree of out- and underperformance, but they do not determine the direction of relative performance as vividly illustrated by Chart I-10. The same can be said about EM stocks' absolute performance. Equity valuations do not determine the direction of share prices; the latter rise when profits expand, and fall when EPS contracts. However, valuations affect the magnitude of the move in equity prices: cheap valuations and growing EPS will produce a larger rally compared to neutral equity valuations and identical growth in EPS. We discussed EM equity valuations at great length in our Weekly Report published two weeks ago.1 In absolute terms, EM equity valuations are presently neutral. Therefore, they have no bearing on the direction of share prices. If EM EPS expands, stocks will continue to rally. If EPS growth stalls or turns negative, EM stocks will stumble. As Charts I-3 and I-4 on page 3 illustrate, EM EPS will soon relapse. In addition, U.S. return on equity (RoE) remains well above EM's RoE (Chart I-11), reflecting better equity capital utilization in the U.S. versus the EM. Looking forward, one variable that has had a reasonably good track record in gauging relative performance of EM versus U.S. share prices is the ratio of industrial metals to U.S. lumber prices (Chart I-12). Industrial metals prices are a proxy for economic growth in China/EM, while U.S. lumber prices are indicative of America's business cycle. Industrial metals prices (the LMEX index) have lately underperformed U.S. lumber prices, pointing to renewed EM underperformance versus the S&P 500. Chart I-11EM RoE Is Below U.S. RoE Chart I-12EM Stocks To Underperform The S&P 500 Our view is that EM EPS growth will contract again within a cyclical investment horizon (over the next 12 months). While not all sectors' earnings are set to shrink, our view is that banks' profits will decline driven by credit growth deceleration and a rise in non-performing loans in a number of countries. Besides, commodities producers' EPS will drop anew if, as we expect, commodities prices head south again. Table I-1 illustrates the weights of each EM equity sector within total EM-listed companies' profits. Financials account for 24%, while energy and materials comprise 7.5% each of the aggregate EM equity market cap, respectively. In aggregate, these sectors make up 50% of EM EPS and 40% of the stock index. Table I-1EM Sectors: Equity Market Caps ##br##And EPS's Share Of Total EPS We remain positive on the technology/internet sector's growth outlook. While this sector's weight in terms of both market cap and EPS is very large, it is not yet sufficient to lift the overall EM equity index if other large sectors falter. In fact, technology/internet stocks have already rallied dramatically and are presently overbought. They will likely correct along with the rest of the universe. Nevertheless, we continue to recommend an overweight stance in technology stocks within the EM benchmark. Bottom Line: The direction of EM share prices in absolute terms and relative to the S&P 500 is determined by EPS trajectory, not equity valuations. We expect EM EPS to drop in absolute terms and to underperform U.S. EPS. Consistently, we maintain our long-standing strategy of being short EM / long the S&P 500. Taking Profits On Short Korean Auto Stocks Initiated on July 3, 2013, this recommendation has generated a 35% gain (Chart I-13, top panel). Notably, Korean auto stocks have failed to rally in the past 12 months. Furthermore, Korean auto stocks have underperformed the overall EM equity index by a whopping 22% since our recommendation (Chart I-13, bottom panel). For dedicated investors, we recommend lifting the allocation to this sector from underweight to neutral. In regard to allocation to the KOSPI overall, we maintain our overweight stance within an EM equity portfolio for now. Geopolitical volatility could create near-term disturbance but the primary trend in Korea's relative performance against the EM benchmark is up (Chart I-14). Within the KOSPI, we continue to overweight technology stocks, companies with exposure to DM growth and domestic industries. Meanwhile, companies with exposure to China's capital spending should be avoided. Chart I-13Take Profits On Short ##br##Korean Stocks Recommendation Chart I-14Korean Equities ##br##Relative To EM Overall Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM Equity Valuations Revisited", dated March 29, 2017, link available on page 21. India: Beyond De-Monetization The growth-dampening effects from India's de-monetization program are beginning to dissipate. Both services and manufacturing PMIs are recovering (Chart II-1). As more cash is injected back into the system, consumer sector growth will improve. Beyond the recovery in consumption, however, capital spending - the key driver of productivity and non-inflationary growth - is still anemic because of structural reasons that began well before de-monetization was announced (Chart II-2). Chart II-1PMIs Are Recovering Chart II-2Capital Spending Is Depressed Public Banks: Is Deleveraging Advanced? The Indian authorities appear serious about restructuring their public banks, and the banking downturn cycle is likely approaching its final stages (Chart II-3). As and when India's public banks find themselves on more solid footing, industrial credit growth will pick up meaningfully and capital expenditures will follow. The previous credit boom that occurred in the infrastructure, mining, and materials sectors left a large number of failed and stalled projects. Chart II-4 shows the number of stalled projects remains stubbornly high and is not yet declining. These mal-investments have ended up as non-performing loans primarily on public banks' balance sheets: Non-performing loans (NPLs) currently amount to 11.8% and distressed assets (DRA) stand at around 4% of total loans on Indian public banks' balance sheets. This has forced public banks to curtail credit growth to the industrial sector (Chart II-5). Chart II-3Bank Credit Growth Is At All Time Low Chart II-4Plenty Of Projects Stalled Chart II-5Bank Credit Growth To Industries Is Contracting Public banks' NPLs and DRAs have spiked because the Reserve Bank of India (RBI) is forcing commercial banks to acknowledge and provision for these bad loans via the central bank's Asset Quality Review (AQR) program. This is eroding public banks' capital and constraining their ability to grow their loan book. However, the program is bullish for India's economy in the long run and stands in stark contrast to other EM countries where authorities are turning a blind eye on banks attempting to window dress their NPLs. India's government and the RBI are currently working with commercial banks and proposing measures to recover loans from defaulters. The government is also injecting capital into public banks. It has announced 100 billion INR in capital injections for this fiscal year and will inject more if needed. It is also forcing banks to raise more capital by ridding their books of non-core businesses. We have performed a scenario analysis on public banks (presented in Table II-1) to gauge their stock valuations. In all scenarios, we assume that DRAs will be constant at 5% of total loans, and also assume a 70% recovery rate on DRAs. We examine various scenarios for NPLs - the latter vary from 12-15% of total loans (the current actual NPL rate is 11.8%). Equity valuations are very sensitive to the recovery rate on NPLs. We stress test for recovery rates of 30%, 40%, 50% and 60%. If one assumes a 12% NPL ratio and a recovery rate of 60%, public bank stocks would be 30% cheap - their adjusted (post provisions, capital impairment, and recapitalization) price-to-book value (PBV) ratio will be 0.7, which is 30% less than its historical mean PBV ratio for public banks of 1.0. By contrast, assuming a 15% NPL ratio and a 30% recovery rate, banks' equity valuations would be 50% expensive - their adjusted (post provisions, capital impairment, and recapitalization) PBV ratio would be 1.5. Table II-1Under/Overvaluation (In %) Of Public Banks Stocks For A Given NPL Ratio And Recovery Ratio* Our bias is to believe that the NPL ratio is somewhere between 14-15% and the recovery rate near 40%. In such a case, public bank stocks would presently be 10-20% expensive. This does not offer a great buying opportunity at current levels, but suggests the downside is probably smaller than in other EM bank stocks. Overall, India is much more advanced in terms of recognizing and provisioning for NPLs as well as re-capitalization of its banking system than many other EM countries. Therefore, we believe India's deleveraging cycle is well advanced, especially when compared with other EM economies. Due to this and the fact that this economy is not exposed to China/commodities prices, we still recommend an overweight position in Indian equities within the EM universe. Inflation And Fixed-Income Strategy While headline inflation is easing due to temporarily lower food prices, core inflation remains sticky. The central government's overall and current expenditures - which often drive inflation - are rising rapidly (Chart II-6). Likewise, state governments' current expenditures are also booming and state development loans - borrowing by state governments - are growing at an extremely fast pace. In addition, in June 2016, the Indian central government announced it will raise salaries, allowances and pensions of government employees by 23%. The central government also raised the minimum wage for non-agriculture laborers by 42% in August 2016, and the Ministry of Labor followed by doubling the minimum wage of agricultural workers in March 2017. All of this will entail accumulating inflationary pressures, even if oil and food prices remain tame. The central bank hiked the reverse repo rate last week to absorb excess liquidity from the banking system. Even though it cited service sector inflation as a concern, we believe it will lag behind accumulating inflationary pressures. This warrants a steeper yield curve. Investors should continue to bet on yield curve steepening by paying 10-year swaps / receiving 1-year swap rates (Chart II-7). Chart II-6Government Expenditures Are Rising Chart II-7Bet On A Yield Curve Steepening Rising inflationary pressures and higher bond yields could weigh on Indian stocks in absolute terms, but will likely not preclude them outperforming the EM equity benchmark. Ayman Kawtharani, Associate Editor aymank@bcaresearch.com Stay Long Czech Koruna Versus Euro On September 28th 2016, we recommended going long CZK / short EUR on the back of expectations that the Czech National Bank (CNB) would abandon its currency peg. Last week, the CNB has floated the koruna. We expect this currency to appreciate versus the euro further and suggest keeping this position. Inflationary pressures in the Czech economy are genuine and heightening. The 1.5% appreciation in the koruna versus the euro since last week will not tighten monetary conditions enough to cap inflation. As such, we expect the CNB to eventually start raising interest rates, leading to further koruna appreciation versus the euro (Chart III-1). The output gap is turning positive, which historically has led to a rise in core inflation (Chart III-2). Chart III-1The Czech Koruna Has More Catch-Up To Do Chart III-2Output Gap And Inflation The labor market is tight - the Czech unemployment rate is the lowest in Europe. Both wages and until labor costs growth are robust and trimmed-mean consumer price inflation is accelerating (Chart III-3). The CNB's foreign exchange reserve accumulation has generated an overflow of liquidity in the Czech financial/banking system (Chart III-4). Chart III-3Inflationary Pressures Are Broad-Based Chart III-4Money And Credit Growth Are Very Strong The rapid expansion of liquidity has led to strong credit growth (Chart III-4, bottom panel), and a rapid appreciation in real estate prices. This warrants higher interest rates to prevent the formation of a bubble. Furthermore, the Czech economy has been benefiting from the recovery in European economic growth in general and manufacturing in particular. Tourist arrivals have also been robust. Notably, the nation's current account surplus stands at 1% of GDP. Chart III-5The Koruna Is Mildly Cheap With regards to currency valuations, the koruna is silently cheap and as such has further room to appreciate (Chart III-5). Either the koruna will gradually appreciate over the next few months, tightening monetary conditions to an extent where the CNB does not need to hike interest rates, or the CNB is eventually forced to hike rates considerably. The latter will push up the value of the Czech currency. We suspect that the CNB is still intervening in the forex market in order to prevent a dramatic appreciation in the koruna. The central bank has stated in its last press conference that it stands ready to intervene to mitigate exchange rate fluctuations if needed. However, in an economy with open capital account, the central bank cannot target the exchange rate and interest rates simultaneously. If the CNB desires to cap inflation, it has to hike interest rates or allow the currency to appreciate considerably. If it chooses the former, the koruna will still rally dramatically. Bottom Line: Stay long the Czech koruna versus the euro. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights High Conviction Views: The global cyclical backdrop remains negative for government bond markets, and the recent declines in yields will not be sustained. We continue to recommend a below-benchmark overall duration stance, favoring U.S. corporate debt with underweight exposures to U.S. Treasuries and Italian government debt, as our highest conviction views. Medium Conviction Views: Staying overweight global inflation protection, French government bonds versus Germany, and Japanese Government Bonds (JGBs) versus the rest of the developed bond markets, while remaining underweight U.S. Mortgage Backed Securities, are recommendations that we hold with a more moderate conviction level. Euro Area Bond Distortions: The ECB's negative interest rate and asset purchase programs have created significant distortions in the German bond yield curve that are not as evident in the Euro Area swap rate curve, especially at shorter maturities. ECB tapering will be the trigger for a reversal of these trends. Feature Chart of the WeekWhy Are Yields Falling? After publishing two Special Reports in the past two weeks, this Weekly Report is our first opportunity to comment on the markets in April. We find it somewhat surprising that government bonds in the developed world have rallied as much as they have since the most recent peak last month, with the benchmark 10-year U.S. Treasury and German Bund seeing yield declines of -29bps and -22bps, respectively. Most of the move in Treasuries has been in the real yield component, while Bunds have seen a more even split between declines in real yields and inflation expectations. This has occurred despite minimal changes in actual growth or inflation pressures in either the U.S. or Europe (Chart of the Week). The price action in the Treasury market after last week's U.S. Payrolls report is a sign that the bond backdrop remains bearish. Yields initially fell all the way to 2.26% after the March increase in jobs fell short of expectations, before subsequently rebounding sharply to end the day at 2.38%. While intraday yield reversals on Payrolls Fridays are as typical as the sun setting in the west, a 12bp swing is one of the larger ones in recent memory (perhaps because investors eventually noticed the weather-related distortions in the data or, more importantly, that the U.S. unemployment rate had fallen to 4.5%). We continue to favor a pro-growth bias for bond investors, staying below-benchmark on overall duration and selectively overweight on corporate credit (favoring the U.S.). Ranking Our Current Market Views, By Conviction We have seen little in the economic data over the past few weeks to change our main strategic market views and portfolio recommendations. We summarize our main opinions below, ranked in order of our conviction level: Highest conviction views: Below-benchmark on overall portfolio duration exposure (for dedicated bond investors). Global bond yields have more room to rise alongside solid economic growth, tightening labor markets, inflation expectations drifting higher and central banks moving to slightly less accommodative monetary policies, on the margin. While the sharp upward momentum in coincident bond indicators like the global ZEW sentiment index has cooled of late, the solid upturn in the BCA Global Leading Economic Indicator continues to point to future upward pressure on real yields (Chart 2). The recent pullback in yields also appears to have run too far versus the trend in global data surprises, which remain elevated (bottom panel). One factor that we see having a potentially huge negative impact on global bond markets is the European Central Bank (ECB) announcing a move to a less accommodative policy stance later this year. A taper of asset purchases starting in 2018 is the more likely outcome than any hike in policy interest rates, which we see as more of a story for 2019. This should help push longer-dated bond yields higher within the Euro Area, and drag up global bond yields more generally. Underweight U.S. Treasuries. We still expect the Fed to deliver at least two more hikes this year, and there is still room for U.S. inflation expectations to rise further and put bear-steepening pressure on the Treasury curve. Our two-factor model for the benchmark 10-year Treasury yield, which uses the global purchasing managers index (PMI) and investor sentiment towards the U.S. dollar as the explanatory variables, indicates that yields are now about 18bps below fair value. From a technical perspective, the Treasury market no longer appears as oversold as it did after the rapid run-up in yields following last November's U.S. elections. The large short positions indicated by the J.P. Morgan duration survey and the Commitment of Traders report for Treasury futures have largely been unwound, while price momentum has flipped into positive territory (Chart 3). This removes one of the largest impediments to a renewed decline in Treasury prices, and we expect that the 10-year yield to rise to the upper end of the recent 2.30%-2.60% trading range in the next couple of months, before eventually breaking out on the way to the 2.80%-3% area by year-end. Chart 2Maintain A Defensive Duration Posture Chart 3Stay Underweight U.S. Treasuries Underweight Italian government bonds, versus both Germany and Spain. Italian government debt continues to suffer from the toxic combination of sluggish growth and weak domestic banks. The OECD leading economic indicator for Italy is declining, in contrast to the stable-to-rising trends in Germany and Spain (Chart 4). Meanwhile, the 5-year credit default swaps (CDS) for the major banks in Italy remain elevated around 400bps, in sharp contrast to the declining CDS in Germany and Spain which are now at 100bps. It is no coincidence that the widening trend in Italy-Germany and Italy-Spain spreads began around the same time last year that Italian bank CDS started to disengage from the rest of Europe (bottom panel). Markets understand that the undercapitalized Italian banking system will need government assistance at some point, which will add to the Italian government's already huge debt/GDP ratio of 133%. Political uncertainty in Italy, with parliamentary elections due by the spring of 2018 and populist parties like the anti-euro Five-Star Alliance holding up well in the polls, will also ensure that the risk premium on Italian bonds stays wide both in absolute terms and relative to other Peripheral European markets. Overweight U.S. corporate bonds, versus both U.S. Treasuries and Euro Area equivalents. The positive case for U.S. corporate debt is built upon two factors - the cyclical decline in default risk and the marginal improvement in balance sheet metrics. The latest estimates from Moody's are calling for a decline in the U.S. speculative grade corporate default rate to 3.1% this year. This leaves our measure of default-adjusted spreads in U.S. high-yield at levels that our colleagues at our sister publication, U.S. Bond Strategy, have shown to have a high probability of delivering positive excess returns over Treasuries in the next 12 months.1 Add to that the recent change in trend of our U.S. Corporate Health Monitor (CHM), which appears largely driven by some more positive numbers coming from lower-rated issuers in the Energy space given the recovery in oil prices, and the optimistic case for U.S. corporate debt is compelling. This is in contrast to our Euro Area CHM, which shows that the improving trend in balance sheet metrics has stalled of late (Chart 5, top panel). Chart 4Stay Underweight Italy Chart 5Stay Overweight U.S. Corporates vs Europe The difference between the U.S. and European CHMs has proven to be a good directional indicator for the relative return performance between the two markets, and is currently pointing to continued outperformance of both U.S. investment grade and high-yield debt versus European equivalents (bottom two panels). The threat of an ECB taper also hangs over the Euro Area investment grade corporate bond market, given the large buying of that debt by the central bank over the past year that has helped dampen both yields and spreads. Chart 6Stay Overweight Inflation Protection Medium-conviction views: Overweight inflation protection (both inflation-linked bonds and CPI swaps) in the U.S., Euro Area and Japan. In the U.S., the breakeven inflation rate on 10-year TIPS looks a bit too wide relative to our shorter-term model based on financial variables. However, underlying U.S. inflation pressures remain strong (Chart 6, top panel), particularly given the evidence that conditions in the labor market are getting progressively tighter. We expect inflation expectations to eventually rise back to levels consistent with the Fed's 2% inflation target on headline PCE inflation (which is around 2.5% on 10-year TIPS breakevens that are priced off the CPI index). The reflation story is somewhat less compelling in Europe and Japan, although CPI swaps are now at levels consistent with the underlying trends in realized inflation in both regions (bottom two panels). We continue to view long positions in CPI swaps in Europe and Japan as having a positive risk/reward skew given the tightening labor market in the former and the yen-negative monetary policies in the latter. Long France government bonds (10yr OATs) versus Germany (10yr Bunds). This is purely a call on the upcoming French election, which our political strategists believe will not end in a victory for the populist Marine Le Pen. While Le Pen has seen a recent bump in support heading into the first round of voting on April 23rd, her strong anti-euro position will eventually prove to be her undoing in the run-off election on May 7th (Chart 7). We first made this recommendation back in early February, and even though France-Germany spreads have been volatile since then as both Le Pen and the far-left candidate Jean-Luc Melenchon have seen a pickup in their poll numbers, the yield differentials are essentially at the same levels.2 We take this as a sign that the market believes current spreads are enough to compensate for the likely probability that either candidate could win the French presidency. Overweight JGBs Vs. the Global Treasury index. The argument here is a simple one - in an environment where there is cyclical upward pressure on global bond yields, favor the lowest-beta bond market (Chart 8). Persistently low inflation will prevent the Bank of Japan (BoJ) from making any changes to its current hyper-accommodative policies this year, especially the 0% cap on the benchmark 10-year JGB yield.3 The lack of yield limits the prospects for JGBs on a total return basis, but relative to other government bond markets, JGBs should outperform over the next 6-12 months as non-Japanese yields rise further. Chart 7Stay Overweight France Vs Germany Chart 8Stay Overweight Low-Beta JGBs Underweight U.S. Agency Mortgage-Backed Securities (MBS). Investors should remain underweight U.S. MBS, as spreads remain tight by historical standards. Our colleagues at U.S. Bond Strategy note that nominal MBS spreads have been flat in recent weeks as the option cost, which is the compensation for expected prepayments, has tightened to offset a widening in the option-adjusted spread (OAS).4 Chart 9Stay Underweight U.S. MBS We tend to think of the OAS as being influenced by trends in net issuance while the option cost is linked to mortgage prepayments (Chart 9). Looking ahead, the supply of MBS should increase further when the Fed starts to shrink its balance sheet later this year (as was mentioned in the minutes of the March FOMC meeting that were released last week), leading to a wider OAS. At the same time, refinancing applications should stay low as Treasury yields and mortgage rates rise. This will keep downward pressure on the option cost component of spreads. But with the option cost already near its historical lows, it is unlikely to completely offset the widening in OAS going forward. We see little value in U.S. MBS at current spread levels. Bottom Line: The global cyclical backdrop remains negative for government bond markets, and the recent declines in yields will not be sustained. We continue to recommend a below-benchmark overall duration stance, favoring U.S. corporate debt with underweight exposures to U.S. Treasuries and Italian government debt, as our highest conviction views. Staying overweight global inflation protection, French government bonds versus Germany, and Japanese Government Bonds (JGBs) versus the rest of the developed bond markets, while remaining underweight U.S. Mortgage Backed Securities, are recommendations that we hold with a more moderate conviction level. How Much Has The ECB Distorted The European Bond Market? Last week, Benoit Coeure of the ECB Executive Board gave a speech entitled "Bond Scarcity and the ECB Asset Purchase Program."5 That title piqued our interest, as that exact topic has come up in several of our conversations with clients this year. In his speech, Coeure discussed how the huge rally at the short-end of the German government bond curve over the past year has been at odds with what has occurred in the Euro swap curve, where interest rates are much higher for shorter-maturity swaps. Typically, German yields and Euro swap rates move in tandem, with the only differences being a function of technical factors like fixed-rate corporate debt issuance or government bond repo rates - and, on occasion, shifts in the perceived health of Euro Area banks that are the counterparties to any interest rate swap. The latter has become much less of an issue in recent years given the regulatory changes to the swap market, where trading has moved to centralized exchanges to reduce counterparty risks. In this environment, the difference between German bond yields and Euro swap rates, a.k.a the swap spread, should be relatively modest. Yet as can be seen in Chart 10, there has been a notable divergence at the shorter-maturity portions of the respective yield curves, where swap rates are rising but bond yields remain subdued. We can also see the divergences in the slopes of the relative yield curves, with the Euro Area swap curve much flatter than the German bond curve, particularly at longer maturities (Chart 11). Chart 10Large Distortions At The Front End Of The German Curve Chart 11Euro Area Swap Curves Are Generally Flatter Coeure argued that part of this distortion can be attributed to ECB asset purchases, especially after the decision taken last December to allow bond buying at yields below the -0.4% ECB deposit rate. This created a more favorable demand/supply balance for German debt, especially given the dearth of short-dated issuance. In addition, Coeure noted that there have been substantial safe-haven flows into shorter-dated German bonds (including treasury bills) by non-Euro Area entities. Some of this demand comes from large institutional investors like sovereign wealth funds and currency reserve managers, who are worried about political risks in France and Italy, and about the general rising trend in global bond yields, and are thus seeking the safety of low duration German debt. But some of the demand for short-dated German paper also comes from non-Euro Area banks, who have excess liquidity that needs to be parked in Euros but do not have access to the ECB deposit facility for the excess reserves of Euro Area banks. We can see this in Chart 12, which shows ECB data for the relative government bond ownership trends for Germany, France and Italy. The data is broken into holdings for bonds with maturities of one year or less (short-term) and bonds with maturities greater than one year (long-term). It is clear that the non-Euro area buyers own a much larger share of short-term German paper, around 90%, than in France and Italy, while Euro Area entities own nearly 80% of long-term bonds in all three countries. Coeure is correct in pointing out that there is an excess demand condition for short-dated core European debt, exacerbated by foreigners who need Euro-denominated safe assets - particularly GERMAN safe assets, if those investors are at all worried about redenomination risks given the rise of anti-euro populist parties in Europe.6 It is clear that the economic messages sent by looking at the German bond and Euro swap curves are very different. The flatter swap curve is more consistent with a steadily growing Euro Area economy where economic slack is being steadily absorbed and inflation pressures are building (albeit slowly). Also, the sovereign spread differentials within Europe do not look as problematic using swaps as the reference rate rather than German bonds. That is the case in France, where spreads versus swaps look in line with the averages of the past few years (Chart 13). This contrasts with the yield differentials versus Germany, which have reportedly gone up as investors have priced in a higher sovereign risk premium before the French presidential election. Chart 12French Bond Valuations Look More Subdued vs Swaps Chart 13French Bond Valuations Look More Subdued vs Swaps The story is a little different for Italy, where bond spreads versus both German bonds and Euro Area swaps have risen for all but the shortest maturities (Chart 14). This could be consistent with an interpretation that Italy's banking sector woes will add to the nation's longer-term fiscal stresses (as discussed earlier in this report), but not in a way that raises immediate default risks (which is why the 2-year Italy vs swap spread is well-behaved). Regardless of the "bias of interpretation", one thing that is clear is that the ECB's extraordinary monetary policies have created distortions in Euro Area bond markets. These may start to unwind, though, if the ECB begins to signal a shift towards a tapering of asset purchases next year, as we expect. The distortions in Euro area government bond yields (and, by association, swap spreads) have occurred alongside both the cuts in ECB policy rates into negative territory and the expansion of its balance sheet to purchase government bonds (Chart 15). As the ECB moves incrementally towards less accommodative monetary policy, we would expect to see front-end Euro swap spreads narrow in absolute terms and relative to longer-tenor spreads, and the German bond curve to flatten toward levels seen in the swap curve. Chart 14Only Short-Dated Italian Bond Valuations Look More Subdued vs Swaps Chart 15ECB Policies Have Caused The Distortions In Euro Swap Spreads Bottom Line: The ECB's negative interest rate and asset purchase programs have created significant distortions in the German bond yield curve that are not as evident in the Euro Area swap rate curve, especially at shorter maturities. ECB tapering will be the trigger for a reversal of these trends. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "Our Views On French Government Bonds", dated February 7, 2017, available at gfis.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Staying Behind The Curve, For Now", dated March 21, 2017, available at gfis.bcaresearch.com 4 Please see BCA U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 5 http://www.ecb.europa.eu/press/key/date/2017/html/sp170403_1.en.html 6 Coeure noted that, at the time that the ECB began its asset purchase program in March 2015, the share of German bonds of less than TWO years maturity held by foreigners was 70%, but that rose to 90% by the 3rd quarter of 2016. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Bond market positioning is no longer at a bearish extreme and the economy is quickly approaching full employment. We expect Treasury yields will soon break through the upside of their post-election trading range. Maintain below-benchmark duration. Fed's Balance Sheet: The unwinding of the Fed's balance sheet is only important for Treasury yields if it impacts the market's rate hike expectations. However, the extra supply of MBS should lead to wider MBS spreads. Credit Cycle: Corporate spreads are in a "payback period" from 2014's energy shock that will allow them to tighten as corporate profits rebound, even though corporate leverage continues to trend higher. The weakening state of corporate balance sheets means spreads are at risk once monetary policy turns less accommodative. Feature The bond bear market has been on pause for the past few months, with Treasury yields confined to a trading range since last November's post-election sell off. While yields have not moved meaningfully higher during this time, firm floors have also formed beneath both the 5-year and 10-year yields (Chart 1). Even after last Friday's disappointing payrolls number, the 10-year did not move below 2.3% and the 5-year did not move below 1.8%. Trading Range About To Break? Our sense is that the current consolidation phase in Treasuries is approaching its end and yields will soon head higher. Global growth indicators have continued to improve during the past few months, and as we noted in last week's report,1 our 2-factor Treasury model, based on Global PMI and U.S. dollar sentiment, pegs fair value for the 10-year yield at 2.54%. We attribute the recent leveling-off in yields to technical shifts in bond positioning and sentiment. Earlier this year, net positions in Treasury futures and asset manager duration allocations were deep in "net short" territory (Chart 2). Extreme short positioning usually leads to a period of bond market strength until short positions are washed out. Now that bond market positioning is closer to neutral, a key impediment to further yield increases has been removed. Chart 1Poised For A Breakout? Chart 2Positioning Has Normalized The elevated level of economic surprises has also been flagged as a potential roadblock to the bond bear market. Extended readings from the economic surprise index tend to mean revert as investor expectations are revised higher in the face of improving data. However, our research suggests that the change in Treasury yields tends to lead the economic surprise index by 1-2 months (Chart 2, bottom panel). Given this relationship, we suspect that the bond market has already discounted a lot of mean reversion in the economic surprise index. Chart 3Approaching Full Employment Finally, last week's employment report should not be taken as a signal that U.S. economic growth is weakening. Bad weather in the northeast played a key role in the low March payrolls number - only 98k jobs added. But more importantly, at this stage of the cycle we should expect payroll growth to slow and wage pressures to increase as we approach full employment. As can be seen in Chart 3, the late cycle trends of slowing payroll growth and rising wages are very much in place. Further, even broad measures of labor market tightness, such as the U6 unemployment rate,2 are quickly approaching levels that suggest the economy is operating at full employment. Increasingly it is measures of labor market utilization, wage growth and inflation that will guide the Fed's decision making, and these measures continue to improve. It was even noted in the minutes from the March FOMC meeting that "tight labor markets [are] increasingly a factor in businesses' planning". The minutes also reported that: Business contacts in many Districts reported difficulty recruiting workers and indicated that they had to either offer higher wages or hire workers with lower qualifications than desired Accordingly, surveys show that households are increasingly describing jobs as "plentiful" (Chart 3, panel 3) and small businesses are indeed ramping up their compensation plans (Chart 3, bottom panel). At this stage of the cycle, continued progress on measures of labor market utilization, wage growth and inflation will be sufficient for the Fed to continue lifting rates, pushing Treasury yields higher. Bottom Line: Bond market positioning is no longer at a bearish extreme and the economy is quickly approaching full employment. We expect Treasury yields will soon break through the upside of their post-election trading range. Maintain below-benchmark duration. The Fed Will Shrink Its Balance Sheet This Year Last week's release of the minutes from the March FOMC meeting also contained some new information about how the Fed plans to deal with its large balance sheet. To summarize, we learned that: The Fed intends to start shrinking its balance sheet later this year (assuming growth maintains its current pace). The Fed will shrink its balance sheet by ceasing the reinvestment of both its MBS and Treasury holdings at the same time. Still no decision has been made about whether reinvestments will stop entirely or whether they will be phased out over time ("tapered"). On February 28, we published a detailed report about the Fed's balance sheet policy.3 In that report we explained why the winding down of the balance sheet will not have much of an impact on Treasury yields, but could lead to a material widening in MBS spreads. The new information received last week does not change either of these conclusions. The minutes did make clear that the Fed favors what Governor Lael Brainard recently called a "subordination strategy" for dealing with its balance sheet.4 [A subordination strategy] would prioritize the federal funds rate as the sole active tool away from the effective lower bound, effectively subordinating the balance sheet. Once federal funds normalization meets the test of being well under way, triggering an end to the current reinvestment policy, the balance sheet would be set on autopilot, shrinking in a gradual, predictable way until a "new normal" has been reached, and then increasing in line with trend increases in the demand for currency thereafter. Under this strategy, the balance sheet might be used as an active tool only if adverse shocks push the economy back to the effective lower bound. Essentially, the Fed is trying to de-emphasize the size of the balance sheet and would rather investors focus on the fed funds rate to assess the stance of monetary policy. For our part, we think it would be unwise to "fight the Fed" on this issue. For Treasury yields, we observe that the real 10-year Treasury yield closely tracks changes in the expected number of rate hikes during the next 12 months, while the inflation component of the 10-year yield tracks changes in realized inflation (Chart 4). These two relationships will continue to determine trends in bond yields going forward, and Fed balance sheet shrinkage is only important if it impacts the expected pace of rate hikes or inflation. The Fed's "subordination strategy" should ensure that the act of winding down the balance sheet does not have much of an impact on the expected pace of rate hikes. Ironically, if Treasury yields were to rise sharply following the announcement of balance sheet runoff, then the ensuing tightening of financial conditions would probably lower the expected pace of rate hikes and bring Treasury yields back down again. The story for MBS is somewhat different. Nominal MBS spreads remain tight by historical standards and closely track implied interest rate volatility (Chart 5). But we can also think of nominal MBS spreads as being split between the option cost, which is the compensation for expected prepayments, and the option-adjusted spread (OAS), which tends to correlate with net supply (Chart 5, panel 2). Chart 4Focus On Rate Expectations Chart 5Stay Underweight MBS In recent weeks, the OAS has widened alongside rising net issuance, but this has been offset by a sharp decline in the option cost. This is generally the pattern we would expect to play out as the Fed lifts rates and removes itself from the MBS market. The increased supply of MBS should lead to wider OAS, but refinancing applications should also stay low as Treasury yields and mortgage rates rise (Chart 5, bottom panel). However, netting it all out, the option cost component of MBS spreads is already near its historical lows and the OAS could move materially wider just to catch up to net issuance. In prior reports,5 we have also made the case that rate volatility should rise as the fed funds rate moves further away from the zero-lower-bound. Investors should stay underweight MBS. Bottom Line: The unwinding of the Fed's balance sheet is only important for Treasury yields if it impacts the market's rate hike expectations. However, the extra supply of MBS should lead to wider MBS spreads. Checking In On The Credit Cycle We continue to recommend overweight allocations to both investment grade and high-yield corporate bonds. This optimistic outlook is predicated on low inflation and a Fed that will support risk assets by remaining sufficiently accommodative until inflationary pressures are more pronounced. We think this "reflationary window" will stay open at least until core PCE inflation is firmly anchored around 2% and long-maturity TIPS breakevens reach the 2.4% to 2.5% range.6 Behind the scenes, however, leverage is building in the nonfinancial corporate sector. In this week's report we take a look at several different indicators of corporate credit quality and conclude that once the support from low inflation and accommodative monetary policy vanishes, it is very likely that corporate defaults will start to increase and corporate spreads will widen. If our anticipated timeline plays out, we will be looking to scale back on credit risk in 2018. Corporate Health Vs. The Yield Curve Our Corporate Health Monitor (CHM, see Appendix for further details) has been signaling deteriorating nonfinancial corporate health since late 2013 (Chart 6), and moved even deeper into 'deteriorating health' territory in Q4 of last year. Chart 6Corporate Health Is Deteriorating, But Monetary Policy Remains Supportive Periods when the CHM is in 'deteriorating health' territory are marked by shaded regions in Chart 6. We see that these regions usually correspond with periods when corporate spreads are widening. Even in the current episode, corporate spreads have yet to regain their mid-2014 tights. However, the bottom panel of Chart 6 shows that periods of deteriorating corporate health and wider corporate spreads are typically preceded by a very flat (often inverted) yield curve. This makes sense because a flat yield curve usually signals that interest rates are high and monetary policy is tight. Tight policy and elevated rates lead to more stringent bank lending standards and increase firms' interest burdens. With the curve still quite steep, we think the risk of sustained spread widening is minimal. However, if the CHM is still above zero when the yield curve is flatter, no support will remain for excess corporate bond returns. Net Leverage & The Payback Period We would further argue that the CHM will almost certainly be in 'deteriorating health' territory once the yield curve is close to flat. In Chart 7 we see that net leverage (defined as: total debt minus cash, as a percent of EBITD) is not only positively correlated with spreads, but also has never reversed its uptrend unless prompted by a recession. In other words, the corporate sector never voluntarily undertakes deleveraging, it only starts to pay down debt when forced by a severe economic contraction. Chart 7The Uptrend In Leverage Will Only Be Broken By Recession Closer inspection of Chart 7 reveals that the period between 1986 and 1989 is the only period when corporate spreads tightened even though leverage remained in an uptrend. In the late 1980s, leverage and corporate spreads both shot higher as a collapse in the energy sector caused overall corporate earnings to contract (Chart 7, bottom panel). But then the energy sector recovered just as quickly, and earnings growth bounced back. This caused spreads to tighten for a couple of years, even though the trend in net leverage only ever managed to flatten-off. Debt growth stayed robust during this time, despite the wild fluctuations in earnings. If any of this sounds familiar, it should. The energy sector collapse of 2014 caused net leverage and spreads to shoot higher, and now spreads have started to tighten again as earnings have rebounded. Notice that just like in the late-1980s, net leverage has not reversed its uptrend. We believe that corporate spreads have entered a "payback period" very similar to the late 1980s. Spreads can tighten as earnings rebound, but because the economy is not in recession, debt growth will remain solid and leverage will continue to trend higher. Once inflationary pressures start to bite and Fed policy becomes less accommodative, the payback period will end and spreads will head wider. Debt Growth Chart 8Bond Issuance Is Back Although we have made the case that the corporate sector does not delever unless prompted by a recession, it is notable that net corporate bond issuance was negative in Q4 of last year and the growth rate in bank lending to the corporate sector has slowed sharply. We do not think this cycle is different, and expect corporate debt growth (both bonds and loans) to rebound in the coming months. We chalk up weak corporate bond issuance in 2016Q4 to uncertainty surrounding the U.S. election. In fact, we see that gross corporate bond issuance has already rebounded strongly in January and February of this year (Chart 8). Turning to bank loans, we observe that the outright level of outstanding bank loans only contracts following a recession, and that the rate of increase follows bank lending standards with a lag (Chart 9). In other words, Commercial & Industrial (C&I) loan growth is still responding to the surge in defaults that resulted from the energy sector's 2014 collapse. Now that defaults have waned, this process will soon be thrown into reverse. In fact, our model of the 6-month rate of change in C&I lending - based on private non-residential fixed investment, small business optimism and corporate defaults - points to an imminent bottoming in C&I loan growth (Chart 10). Chart 9Loan Growth Follows Lending Standards Chart 10BCA C&I Loan Growth Model Bottom Line: Corporate spreads are in a "payback period" from 2014's energy shock that will allow them to tighten as corporate profits rebound, even though corporate leverage continues to trend higher. The weakening state of corporate balance sheets means spreads are at risk once monetary policy turns less accommodative. Ratings Trends & Shareholder Friendly Activities Chart 11Shareholder Friendly Activity Has Ebbed Our assessment of the cyclical back-drop for corporate spreads is primarily based on the combination of balance sheet quality - as determined by our Corporate Health Monitor and its underlying components - and the stance of monetary policy - as determined by the slope of the yield curve and C&I lending standards (among other factors). However, ratings migration and "shareholder friendly" activities have also historically provided advance notice of turns in the credit cycle. Net transfers to shareholders, i.e. payments to shareholders in the form of dividends and buybacks, are a direct transfer of capital from bondholders to equityholders. These transfers tend to rise late in the cycle, just before defaults start to increase and spreads start to widen (Chart 11). Net transfers to shareholders had been moving higher, but have recently rolled over. Similarly, ratings downgrades related to shareholder transfers have also moderated (Chart 11, panel 2). Historically, ratings migration related to "shareholder friendly" activities has been a more reliable indicator of the credit cycle than overall ratings migration. It has tended to move into "net downgrade" territory later in the cycle, closer to the onset of recession (Chart 11, panel 3). Ratings trends and transfers to shareholders are not flagging any imminent risk of spread widening. However, there is the additional risk that downgrades have simply not kept pace with the actual deterioration in credit quality of the nonfinancial corporate sector. Using firm-level data, we calculated the percent of high-yield rated companies with net debt-to-EBITDA ratios above 5. We see that actual ratings migration is too low relative to the number of highly-levered firms (Chart 11, bottom panel). It is possible that ratings agencies have already incorporated the rebound in energy prices and profit growth into their assessments while the actual debt-to-EBITDA data are lagging, but this is still a risk that bears monitoring. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Reflation Window Still Open", dated April 4, 2017, available at usbs.bcaresearch.com 2 The U6 unemployment rate is a broader measure than the headline (U3) unemployment rate. It also includes those "marginally attached" to the labor force and those working part-time for economic reasons. 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 4 https://www.federalreserve.gov/newsevents/speech/brainard20170301a.htm 5 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com Appendix Chart 12Corporate Health Monitor Components Box 1: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole (Chart 12). These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets Fixed Income Sector Performance Recommended Portfolio Specification

Portfolio Strategy Any meaningful weakness in the U.S. dollar could accelerate the budding recovery in corporate revenue growth after a multiyear malaise. Following this year's underperformance, lift the industrials sector to neutral via an upgrade in machinery stocks. The recent jump in auto parts stocks is a selling opportunity. Recent Changes S&P Industrial Machinery - Boost to overweight from underweight. S&P Construction Machinery & Heavy Trucks - Lift to neutral from underweight. S&P Industrials Sector - Remove from high conviction underweight and augment to neutral. Table 1Sector Performance Returns (%) Consolidation remains the dominant tactical market theme. The question is whether momentum behind the cyclical advance will fade at the same time? Our sense is that the overshoot will reassert itself once the corrective phase has run its course. Two weeks ago we updated a number of qualitative factors that suggested that a major market peak had not yet arrived, even though the rally is approaching retirement age and valuations are full. Other variables concur. For instance, while cash holdings are being depleted, they are not yet running on empty, gauging from survey data or depicted as a share of total market capitalization. Surprisingly, there are still a large number of bearish individual investors (Chart 1). Thus, drawing sidelined cash back into stocks at current stretched valuations and with buoyant expectations requires a resumption of top-line growth. Revenue growth has been conspicuously absent throughout the past few years of the bull market. Companies have supported per share profits through cost cutting and aggressive share buybacks, typically funded through debt issuance. Sustaining high valuations without reinvesting for growth is hard enough, but it becomes an even more onerous task without top-line expansion. There is room for cautious optimism. Deflation pressures have abated, and companies are enjoying a modest pricing power revival. As outlined in our regular industry group pricing power updates, the majority of sectors and industries are now able to lift selling prices, and an increasing number are able to keep pace with overall inflation. Our pricing power proxy has moved decisively back into positive territory (Chart 2), following a pattern typically reserved for when the economy exits recession. Even deflation in the chronically challenged retailing sector is ebbing. Chart 1Bears Still Have A Little Cash Chart 2Revenue Revival Importantly, both core inflation and inflation expectations remain well below the zone that would cause the Fed to tighten more aggressively than is currently expected (Chart 3). If financial conditions remain relatively easy, then business activity should stay sufficiently brisk to foster further pricing power improvement, i.e. a return to deflation is unlikely. The readings from both the ISM services and manufacturing sectors, and firming business confidence (Chart 2), indicate brighter revenue opportunities. The pickup in world trade volumes implies that goods and services are flowing more freely than they have for several years, and provided protectionist policies do not gain traction, a rebound in global growth should be supportive of total business sales. We doubt there is a vigorous top-line thrust ahead given that potential GDP growth around the world is limited, but modest growth is probable. If the U.S. dollar were to weaken substantially, especially if it occurred within the context of better economic growth abroad, then revenue upside would increase. Chart 4 shows that S&P 500 sales advanced significantly after the last two major U.S. dollar bull markets peaked. Chart 3The Fed Still Has Latitude Chart 4A Top-Line Boom ##br##Requires Dollar Depreciation In sum, the sales outlook has brightened, which is critical to absorbing the increase in labor costs and cushioning the profit margin squeeze. If investors begin to factor in sales-driven earnings growth, rather than buyback and cost cutting-dependent improvement, then it is plausible that the overshoot in stocks will be extended for a while longer. As outlined in recent weeks, the easing in the U.S. dollar allows for some selective bargain hunting in the lagging deep cyclical sectors, which have underperformed this year. This week we are prospecting in the industrials sector. The Wheels Are Turning: Upgrade Machinery Machinery stocks have been stronger than we anticipated. It is doubtful that an underweight position will pay off even if the broad market stays in a corrective phase. Many of the sales and earnings drags on the broad machinery industry, which comprises both industrial machinery and construction machinery & heavy trucks indexes, are lifting. Our primary concerns had been that the overhang from a lack of resource-related investment and a strong U.S. dollar would undermine sales performance (Chart 5). The former may not change much given poor resource balance sheet health, but the U.S. dollar has stopped appreciating. The currency bull market may have gone on extended hiatus if foreign growth continues to improve and the recent disappointing U.S. labor market report was the beginning of a period of economic cooling, as we expect. Despite the resilience of relative share performance, the machinery group is not overpriced based on a normalized relative forward P/E basis (Chart 5). A move to above average valuations requires an acceleration in relative profits. The objective message from our models has turned upbeat. Our Global Capital Spending Indicator has climbed back into positive territory. That primarily reflects the firming in global purchasing manager's surveys. G3 capital goods order momentum has not yet pushed above zero, but should soon recover based on our model (Chart 6). Chart 5Two Drags, But... Chart 6... Other Engines Are Revving Developing economies may soon participate to a greater degree, if the budding turnaround in long moribund Chinese loan demand gains traction (Chart 6). While China has begun to target a cooler housing market, the improvement in overall credit demand should provide an important offset. Other developing countries are easing policy and trying to spur growth, which should help machinery consumption. When global output growth recovers, machinery demand tends to demonstrate its high beta characteristics. Chart 6 shows that our global, excluding the U.S., machinery new orders proxy has jumped sharply in recent months, consistent with our global machinery exports proxy (Chart 6). While the previously strong U.S. dollar threatened to divert this demand to non-U.S. competitors, the playing field has leveled: U.S. machinery new orders have accelerated. The revival in coal prices is a major plus, given that the coal industry is a key source of domestic machinery demand (Chart 7, second panel). The new order jump, especially compared with inventories, bodes well for additional strength in machinery output (Chart 7, middle panel). Faster production should further propel our productivity proxy, which already suggests analyst earnings upgrades lie ahead (Chart 7). Better machinery sales prospects will add to the productivity gains already evident from cost control and capacity restraint. Chart 8 shows that machinery companies have had a clear focus on profit margin preservation. Headcount continues to contract, while inventories at both the wholesale and manufacturing levels are lean. Chart 7New Order Recovery Chart 8Lean There is corroborating evidence of tight supplies, as machinery selling prices are climbing anew even though factory utilization rates are not far off their lows (Chart 8). If demand strength persists, then additional pricing power upside is probable. All of this argues for making a full shift from underweight to overweight in the S&P industrial machinery group. This full upgrade does not extend to the S&P construction machinery & heavy trucks sub-component. Heavy truck sales are very weak, and the outlook for agriculture and food prices is shaky. Food commodity prices remain depressed (Chart 9), which will limit agricultural spending budgets. There is a high correlation between raw food price inflation and relative forward earnings estimates. Moreover, we remain skeptical that the resource industry is about to embark on a major expansion. Instead, only maintenance capital spending is probable, which is not conducive to driving a meaningful increase in construction machinery demand. It is notable that Caterpillar's machine sales to dealers continue to contract throughout most regions of the world. As such, chronic pricing power pressure will persist, keeping relative forward earnings under wraps (Chart 9). In sum, we are shifting our industrial machinery recommendation from underweight to overweight, to reflect the hiatus in the U.S. dollar bull market and firming in other leading top-line growth indicators. The S&P construction machinery & heavy trucks index only warrants an upgrade to neutral. These allocation changes argue for removing the overall industrials sector from our high-conviction underweight list, protecting the profit that accrued from year-to-date underperformance. From an industrials sector standpoint, it has paid to be skeptical of extrapolating the scale of the surge in leading sentiment indicators, such as capital spending intentions. However, enough evidence has now materialized to expect that the contraction in industrials sector relative forward earnings momentum should soon draw to a close. Core durable goods orders recently returned to growth territory, supporting the budding upturn in our Cyclical Macro Indicator (Chart 10). Both herald profit stabilization. Pricing power has rebounded, although capital goods import prices are still deflating, albeit at a lesser rate. Chart 9A Laggard Chart 10Our Models Have Perked Up Importantly, U.S. export price inflation is no longer lagging the rest of the world, suggesting that the U.S. manufacturers are regaining competitiveness (Chart 10). The upshot is that deflationary pressures are easing. Bottom Line: Lift the S&P industrial machinery index to overweight and the S&P construction machinery & heavy trucks index to neutral. We are also taking the industrials sector off of our high-conviction underweight list and raising allocations to neutral, partially to protect against a continued lateral move in the U.S. dollar. The ticker symbols for the stocks in the S&P construction machinery & heavy truck index are: BLBG: S5CSTF-CAT, PCAR, CMI. The ticker symbols for the stocks in the S&P industrial machinery index are: BLBG: S5INDM-ITW, IR, PH, SWK, FTV, DOV, PNR, SNA, XYL, FLS. Auto Components: Engine Trouble While we are upbeat on the broad consumer discretionary index and recently augmented restaurants to overweight, the niche S&P auto components index remains in the underweight column. Is such bearishness still warranted, especially following recent signs of life in share prices? The short answer is yes. Vehicle sales have plateaued and are unlikely to reaccelerate because pent-up demand has been fully exhausted and auto credit is harder to come by. Banks have started tightening the screws on auto loans. Auto loan delinquency rates are hooking up and charge-off rates have been rising sequentially since Q2/2016 according to the latest FDIC Quarterly Banking Profile. That reflects previous lax lending standards, especially in the sub-prime category. As credit availability dries up, auto loan growth will continue to deteriorate. Chart 11 shows that subprime auto loan originations have an excellent track record in leading light vehicle sales, given that they represent the marginal buyer. Moreover, rising interest rates are also denting affordability (Chart 11, bottom panel). All of this suggests low odds of renewed strength in vehicle demand. The last time vehicle sales flat-lined was in the middle of the last decade, from 2003 to 2007, share prices underperformed reflecting a relative valuation squeeze (Chart 11). Importantly, deflation has taken root in the auto industry and will likely intensify in the coming months. Auto factories are reasonably quiet, in sharp contrast with the recovery in overall industrial production (Chart 12). Chart 11Tighter Auto Loan Standards... Chart 12... Will Sustain Deflationary Forces The auto shipments-to-inventories ratio is probing multi-decade lows and car parts inventories both at the retail and manufacturing levels are beginning to pile up (Chart 13). Without a resurgence in vehicle sales, inventory liquidation pressures will rise, reinforcing the deflationary impulse and warning that industry earnings will likely underwhelm. Moreover, used car prices have nosedived. Used car prices tend to lead new car price inflation (Chart 12). Recent anecdotes of cutthroat competition in dealerships, with massive incentives failing to turn around sales, signal that deflation along the supply chain will likely become entrenched. Finally, international sales are unlikely to fill in the domestic void. Emerging markets (ex-China) automobile sales have been contracting, heralding an underperformance phase for the S&P auto components index (Chart 14, top panel). Chart 13Too Much Supply Chart 14No Global Relief There could be a respite if the U.S. dollar weakens substantially (Chart 14, second panel), but historically high relative valuations warn that optimism has already run ahead of the cloudy earnings outlook (Chart 14, bottom panel). Adding it up, auto demand will remain uninspiring as banks tighten their grip on auto loan lending standards, industry deflation is gaining steam owing to inventory accumulation, and there is no sizeable offset from foreign sales. This is recipe for an underweight position. Bottom Line: We reiterate our underweight stance in the S&P auto components index. The ticker symbols for the stocks in the S&P 1500 auto components index are: DLPH, GT, BWA, GNTX, DAN, DORM, LCII, CTB, CPS, THRM, AXL, FOXF, SMP, MPAA, SUP. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Special Report

Highlights Small caps have not consistently outperformed large caps. However, the cyclical nature of small-cap relative performance may provide tactical timing opportunities. Index methodology plays a very important role in the behavior of small-cap performance. Currently, we recommend being neutral on size in a balanced global equity portfolio because risk/reward between small and large caps is balanced, and because GAA is overweight cyclicals versus defensives, a similar play but with a better risk/reward profile. Feature The Academic Evidence On Size Premium In academic research, the size premium, or the outperformance of small-cap common stocks relative to large-cap common stocks, has been calculated mostly based on the difference between the return of the smallest cap portfolio and that of the largest cap portfolio. Since the first academic paper that "discovered" the "size premium" in 1981, by Rolf Banz of the University of Chicago,1 a great deal of research has been devoted to this subject, both for and against the validity of the size premium.2 Table 1 comes from Asness et al.3 It summarizes the statistics of monthly size premium over time using the two most widely used zero-cost portfolio approaches to capture the returns to size. 1) The "small minus big" (SMB) stock factor return of Fama and French:4 the average return of three small portfolios minus the average return of three large portfolios obtained from Ken French's website;5 and 2) the return spread between size-sorted and market cap-weighted decile portfolios. The universe is all the stocks listed on the NYSE, AMEX and NASDAQ, including delisted securities from the CRSP (Center for Research in Security Prices) database. Table 1Size Premium Over Time* The size premium is statistically significant at the 5% level with a t-stat of 2.27 for SMB and 2.32 for D1-D10 for the full sample period from 19266 to 2012;7 However, most of the size premium comes from January, while in the rest of the year the size return is economically and statistically not different from zero; The size premium was not always positive over time, as evidenced during the period 1980-1999 when small cap suffered a 20-year underperformance right after the size premium was "discovered" in 1981. Compared to SMB, the more extreme approach, Decile 1 minus Decile 10, has produced a larger positive size premium (as well as a larger negative size premium in periods of underperformance), suggesting that micro caps, the most volatile segment of the market, may have a significant impact on the overall size premium. However, for non-quant practitioners, especially asset allocators, the portfolio approaches used in academic research may not be practical. In this report, we will study a series of small cap and large cap benchmark indexes in the U.S. and globally that are commonly used by practitioners to shed some light on the size premium and how it can be harvested, if it indeed exists. Not All Small-Cap Indexes Are Created Equal, Even In The U.S. There is no definitive definition of small cap. The general consensus is that it refers to companies with market value between US$300 and US$2 billion in the U.S., while in other markets this may vary. In the U.S., the first small-cap index, the Russell 2000 (R2K), was created in 1984, after the size premium was discovered in 1981 by Rolf Banz. While Banz was not sure if size per se was responsible for the effect or if size was just a proxy for one or more true unknown factors correlated with size, Fama and French published their ground breaking work in 19926 and 19934 confirming the existence of size and value factors. Then in 1994 the S&P launched its own small-cap index, the S&P 600. Chart 1U.S. Small Cap Performance Divergence Chart 1 shows that the performance of these two indexes has been quite different even though they have been highly correlated. Since December 1994, the S&P 600 has outperformed the R2K by about 50%-about 2% per year on a compound basis. From 1980 to 1994, however, the back-calculated8 S&P 600 significantly underperformed the R2K. So what has contributed to such significant performance difference between these two U.S. small-cap indexes? The answer may lie in the different methodologies used in constructing them. Different Universe And Size Distribution: FTSE Russell9 and S&P Dow Jones10 use different eligibilitFy conditions to define their respective universes for the U.S. equity market. Russell 3000 (R3K) contains the 3000 largest publicly traded companies in the U.S. by market cap. The smallest 2000 names go into the R2K, which currently accounts for about 8% of the R3K by market cap weight.11 The S&P 1500 contains the 1500 largest names, also by market cap, with the S&P 600 being the smallest 600 of these names, which account for less than 3.5% of the S&P 1500. Even though the stated target market-cap range is US$30 million to US$2 billion for the R2K, and US$450 million to US$2.1 billion for the S&P 600, respectively, currently about 50% and 40% of the companies in the R2K and the S&P 600 respectively have a market cap over US$2 billion, as shown in Chart 2. The R2K even has 25% over US$3 billion, about 15% more than the S&P 600. Different Sector Compositions: Both indexes' sector composition has evolved over the years due to changes in the economy and financial markets. Their current sector compositions are shown in Table 2. Most notably, the S&P 600 has higher weights in industrials and consumer discretionary, while R2K has higher weights in technology, financials, real estate and utilities. Chart 2U.S. Small-Cap Index Market Cap Distribution Table 2Canadian Small-Cap Index Sector Composition Global Small Caps Have Not Consistently Outperformed Large Caps MSCI also produces small-cap indexes for each country. According to the MSCI Global Investable Markets Index methodology,12 the size cut-off for each size segment needs to be a balance between the minimum size requirement and the target coverage range, in addition to other requirements such as liquidity and free float. As shown in Table 3, large caps comprise the top 70% of the investable universe, mid caps the next 15%, and small caps a further 14%. As of October 2016, the market-cap range for the DM small-cap index is from US$527 million to US$5 billion, and about half that for the EM small-cap index. Table 3MSCI Size Cut-Offs* MSCI indexes apply the same rules to all markets, which aids the global comparison analysis. Unfortunately, MSCI indexes have very short histories. Chart 3 shows the relative performance of small caps vs. large caps based on the MSCI indexes, and also local exchange indexes (where available). All panels are rebased to 1 as of March 2009 when the S&P 500 reached its low during the most recent financial crisis. The shaded areas are U.S. recession periods as defined by NBER. Several observations from Chart 3: U.S., U.K. and Japan have relatively long histories for the small-cap indexes. Based on the three countries' local indexes, small caps have barely outperformed large caps over the full history available; From the index inceptions until 1999, small-cap indexes broadly underperformed large caps in the U.S., U.K. and Japan, in line with the findings of the academic research shown in Table 1; Since 2000, however, small caps have outperformed large caps in most countries (in line with the academic findings shown in Table 1) with the exception of Canada and Australia, which both have extremely skewed sector composition. As shown in Table 4, a bet on Canadian small caps vs. large caps is essentially a bet on materials, real estate and industrials versus financials and telecoms; In the most recent cycle from March 2009, small-cap outperformance has been most prominent outside the U.S., especially in the U.K. and euro area. This might be due to the fact that the U.S. is the most academically researched market and that most small-cap funds are U.S. oriented. In the U.S., the MSCI and the S&P small-cap indexes have performed better than the Russell indexes, which is likely due to the fact that Russell does not have a midcap segment, with both the R2K and R1K including stocks that would elsewhere be classified as mid caps. Table 4Canadian Small-Cap Index Sector Composition Drivers Of Small/Large Cap Performance Even though small-cap stocks have not consistently outperformed large-cap stocks over the long run, Chart 3 indicates that the relative performance does have cycles, which may provide tactical opportunities for investors. In line with our investment approach across all asset classes, we try to identify the key factors that drive the relative performance of small caps versus large caps based on economic fundamentals, valuation metrics, and technical conditions. Economic Conditions: Compared to large-cap companies, small-cap firms are usually smaller-scale enterprises with a more domestic focus and less tried-and-tested business models. On average, they have less predictable cash flows, lower profit margins and lower credit ratings. As such, their ability to withstand hard times is lower, while their likelihood to prosper in good times is higher. Chart 4 (panel 1) shows that the rate of change in the small/large cap performance ratio has a good correlation with the PMI, indicating that stronger economic growth is indeed better for the more cyclically-oriented small-cap firms. Other factors such as credit spreads and small enterprise confidence also have good correlations with small/large cap performance in the most recent cycle, but historical correlations were much looser (panels 2 and 3). Chart 3Small Vs. Large Cap Performance Chart 4What Drives Size Performance? Valuation Metrics: Asness et al4 labelled 2000-2012 as the "resurrection" period for small-cap outperformance. Chart 4 (panel 4), shows that the first uninterrupted outperformance from 2000 to 2006 started at an extremely cheap valuation in 2000 when small caps were trading at a 36% discount to large caps, two standard deviations below the five-year average discount of 8%. The six-year uninterrupted outperformance was largely driven by relative valuation expansion such that by 2006, when the outperformance peaked, small caps were trading at a 20% premium, two standard deviations above the five-year average, which was a discount of 4%. The unwinding of the excessive valuation over the next two years brought the valuation metrics back to an extremely cheap level again in 2008, which kick-started another strong period of outperformance for small caps. However, since 2012 valuation has failed to expand even though small caps continued to outperform, albeit at a slower pace. This might be due to the fact that, on an absolute basis, small caps have been trading at a premium to large caps, and because valuation expansion became more difficult given how low small-cap profit margins have been (panel 5). Technically, based on our factor studies on momentum, a simple 12-month rate of change has generated positive alpha in a statistically significant way. We use the standardized 12-month rate of change of the relative performance ratio to gauge the relative momentum (panel 6) Portfolio Recommendation: Neutral On Size Over The Next 9-12 Months Chart 5There Is A Better Alternative The top panel of Chart 5 shows that the relative performance of global small caps versus large caps had a close correlation with cyclicals/defensives from 1995 to 2011, but that the two have diverged over the past five years, during which time small caps have outperformed large caps by 7%, but cyclicals have underperformed defensives by 4%, despite a strong reversal in 2016. This divergence could be explained by relative earnings growth, as shown in panel 2: small-cap earnings outpaced large-cap over the past five years, while cyclicals' earnings growth lagged defensives' until 2016 when a reversal occurred. Given our view on global growth and the historical correlation shown in panel 3, it's likely that cyclical earnings growth will further outpace the defensive earnings growth over the next 12 months. GAA's portfolio approach is to take risk where risk is most likely to be rewarded. We already have overweights on equities versus bonds at the asset class level, and on cyclicals versus defensives in our global equity sector positioning, on a 12-month investment horizon. As such, we do not feel comfortable adding a similar, but less rewarding, risk into our recommended global equity portfolio. In addition, current readings on the key performance drivers also support a neutral rating: as shown in Chart 4, both valuation and technical indicators are at the neutral level. The Global PMI is strong, but credit spreads are tight and small enterprise surveys in the U.S. and Japan are already at extremely optimistic levels. Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com 1 Banz, Rolf (1981), "The relationship between Return and Market Value of Common Stocks," Journal of Financial Economics, vol.6, 103-126 2 Van Dijk, Mathijs A, (2011), "Is size dead? A review of the size effect in equity returns," Journal of Banking and Finance, 35, 3263-3274. 3 Asness, Clifford S., Andrea Frazzini, Ronen Israel, Tobias Moskowitz and Lasse H. Pedersen, "Size Matters, If You Control Your Junk", AQR Working Paper, 2015. 4 Fama, Eugene F. and Kenneth R. French (1993), "Common Risk Factors in the Returns to Stocks and Bonds", The Journal of Financial Economics, vol 33, pp.3-56. 5 Kenneth R. French website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/f-f_bench_factor.html 6 Fama, Eugene F. and Kenneth R. French (1992), "The Cross Section of Expected Stock Returns," Journal of Finance 47, 427-465 7 Fama, Eugene F. and Kenneth R. French (1993), "Common Risk Factors in the Returns to Stocks and Bonds," The Journal of Financial Economics, vol 33, pp.3-56. 8 S&P600 history before October 1994 was back calculated by Datastream, Russell 2000 history before 1984 was back calculated by FTSE Russell. 9 Please see "Construction and Methodology : Russell U.S. Equity Indexes, v.2.4," FTSE Russell, March 2017. 10 Please see "S&P U.S. Indices Methodology," S&P Dow Jones, March 2017. 11 https://en.wikipedia.org/wiki/Russell_2000_Index 12 Please see "MSCI Global Investable Market Indexes Methodology," MSCI, Feb 2017.