Financial Markets

Highlights Chart 1Keep A Close Eye On Financial Conditions The market's rate hike expectations moved sharply higher during the past two weeks as a string of Fed speeches, including one by Chair Yellen, all but confirmed a March rate hike. The market is now priced for 75 basis points of hikes during the next 12 months, compared to 50 bps at the end of January. At least so far, broad indicators of financial conditions have not tightened in response to this re-rating of the Fed (Chart 1). However, there are some preliminary indications that the reflation trade is fraying at the edges. The trade-weighted dollar has appreciated +0.2% since the end of January, the 2/10 Treasury slope has flattened 9 bps and the 10-year TIPS breakeven inflation rate has declined 1 bp. The Fed is currently testing the markets with hawkish rhetoric but, with inflation and TIPS breakevens still below target, will ultimately support the reflation trade if it comes under threat. In this environment investors with 6-12 month investment horizons should maintain below-benchmark duration, remain overweight spread product and continue to position for a steeper curve and wider TIPS breakevens. Feature Chart 2Investment Grade Market Overview Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 48 basis points in February. The index option-adjusted spread tightened 6 bps on the month and, at 112 bps, it remains well below its historical average (134 bps). Our research1 shows that when core PCE inflation is between 1.5% and 2%2 investment grade corporate bonds produce an average monthly excess return of close to zero. A 90% confidence interval places monthly excess returns between -19 bps and +17 bps with inflation in this range and excess returns do not turn decisively negative until core PCE is above 2%. Given the Fed's desire to nurture a continued recovery in inflation, we are not worried about significant spread widening until inflation is sustainably above 2%. In the meantime we expect corporate bond excess returns to be low, but positive. While supportive monetary policy should ensure excess returns consistent with carry, investors should not bank on further spread compression as corporate spreads have already discounted a substantial improvement in leverage (Chart 2). Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3), and our commodity strategists expect oil prices to remain firm even in the face of a stronger U.S. dollar. This week we upgrade the Wireless and Packaging sectors from underweight to neutral and downgrade the Consumer Cyclical Services sector from neutral to underweight. The former two sectors now appear cheap on our model, while the latter has become expensive. Table 3ACorporate Sector Relative Valuation And Recommended Allocation*Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 112 basis points in February. The index option-adjusted spread tightened 25 bps on the month and, at 349 bps, it is currently 170 bps below its historical average. One of our key investment themes3 for this year is that the uptrend in defaults is likely to reverse (Chart 3), mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Despite the positive outlook for defaults, we retain only a neutral allocation to High-Yield because of very tight valuations. The index option-adjusted spread is now within a hair of the average level of 340 bps that prevailed during the 2004 - 2006 Fed tightening cycle, when indicators of corporate balance sheet health were in much better shape. In fact, the index spread is now only 116 bps wider than its all-time low of 233 bps, reached in 2007. Our preferred measure of High-Yield valuation is the default-adjusted spread - the average spread of the junk index less our forecast of 12-month default losses. At present, the default-adjusted spread is 142 bps. Historically, a default-adjusted spread between 100 bps and 150 bps is consistent with positive excess returns during the subsequent 12 months 64% of the time. It is only when the default-adjusted spread falls below 100 bps that positive excess returns become unlikely. Junk has provided positive excess returns over a 12-month horizon only 13% of the time when the starting default-adjusted spread is between 50 bps and 100 bps. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in February. The conventional 30-year MBS yield fell 5 bps on the month, driven by a 7 bps decline in the rate component. The compensation for prepayment risk (option cost) increased by 1 bp, as did the option-adjusted spread. MBS spreads remain extremely tight relative both to history and Aaa-rated credit, although they have begun to widen somewhat relative to credit in recent weeks (Chart 4). More distressing is that the nominal MBS spread appears too tight relative to interest rate volatility (bottom panel). As we noted in a recent report,4 the long-run trend in interest rate volatility tends to be driven by uncertainty about the macroeconomic and political environment. In fact, rate volatility can be modeled using forecaster disagreement about GDP growth and T-bill rates. While the Fed's policy of forward guidance and a fed funds rate pinned at zero limited the amount of forecaster disagreement in recent years, this disagreement will re-emerge the further the fed funds rate moves off its lower bound. Another medium-term risk for MBS comes from the Fed ending the reinvestment of its MBS portfolio. As we described in a recent Special Report,5 the Fed is likely to allow its MBS portfolio to shrink at some point in 2018, putting further upward pressure on MBS spreads. Government Related: Underweight Chart 5Government-Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 30 basis points in February, bringing year-to-date excess returns up to +51 bps. The high-beta Sovereign and Foreign Agency sectors outperformed the Treasury benchmark by 90 bps and 59 bps, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors each outperformed by 4 bps. Local Authorities returned 24 bps in excess of duration-matched Treasuries. Sovereigns have outperformed Baa-rated corporate bonds year-to-date, a trend consistent with the rise in commodity prices and a trade-weighted dollar that has weakened by 1.5% (Chart 5). However, the dollar has started to appreciate in recent weeks and probably has further upside in the medium-term, especially if the Fed maintains its hawkish posture. Historically, it has been very rare for Sovereigns to outperform U.S. corporate bonds when the dollar is appreciating. After adjusting for credit rating and duration, the Foreign Agency and Local Authority sectors continue to appear cheap relative to U.S. corporate credit. In contrast, Sovereigns, Supranationals and Domestic Agencies all appear expensive. We continue to recommend overweight allocations to Foreign Agencies and Local Authorities, alongside underweight allocations to the rest of the government-related index. In a television interview last month Treasury Secretary Steven Mnuchin confirmed that GSE reform is still a priority for the new administration but that tax reform is much higher on the agenda. This means that agency spreads will likely remain insulated from any "reform risk" until next year at the earliest. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 13 basis points in February (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio has fallen 4% since the end of January and remains firmly anchored below its post-crisis average. The decline in the average M/T yield ratio was concentrated in short maturities, while ratios at the long-end of the curve actually rose (Chart 6). Accelerating fund flows and falling issuance will continue to support yield ratios in the near term. In fact, our tactical yield ratio model - based on issuance, fund flows and ratings migration - shows that yield ratios are presently very close to fair value. Although the average M/T yield ratio still appears expensive if we include the global economic policy uncertainty index as an additional explanatory variable.6 One risk to Munis is that yield ratios have already discounted a substantial reduction in state and local government net borrowing in Q1 (panel 3). While we expect this improvement will materialize in the next few quarters, net borrowing is biased upward beyond this year based on the lagged relationship between corporate sector and state and local government health.7 Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve has bear-flattened since the end of January as the market revised its Fed rate hike expectations sharply higher. Both the 2/10 and 5/30 Treasury slopes have flattened by 9 basis points since January 31. As such, our recommended position long the 5-year bullet and short the 2/10 barbell - designed to profit from a steeper yield curve - has returned -26 bps since the end of January, although it has returned close to 0 bps since it was initiated on December 20.8 As was stated on the front page of this report, the Fed's increasingly hawkish rhetoric has already caused the uptrend in TIPS breakevens to pause and the nominal Treasury slope to flatten (Chart 7). With inflation still below target these trends are not sustainable from the point of view of Fed policymakers. If the trend of decreasing TIPS breakevens and a flattening curve persists, we would expect the Fed to back away from its hawkish rhetoric. This dynamic will support a steeper yield curve at least until core PCE inflation is back to the Fed's 2% target and long-dated TIPS breakevens are anchored in a range between 2.4% and 2.5% (a range that is typically consistent with core PCE inflation at 2%). The persistent attractiveness of the 5-year bullet relative to the rest of the curve makes a position long the 5-year bullet and short a duration-matched 2/10 barbell the most attractive way to position for a steeper yield curve (panel 3). The carry buffer in the 5-year helps mitigate some of the risk of curve flattening. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent Treasury index by 18 basis points in February. The 10-year TIPS breakeven rate declined 3 bps on the month and, at 2.04%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. While the catalyst for the recent softening in TIPS outperformance seems to be the hawkish re-rating of Fed rate hike expectations, the uptrend in TIPS breakevens was probably due for a pause in any case. Breakevens had become stretched relative to our TIPS Financial Model - based on the dollar, oil prices and the stock-to-bond total return ratio (Chart 8). Diffusion indexes for both PCE and CPI inflation have also shifted into negative territory, suggesting that realized inflation readings will soften during the next couple of months. On a cyclical horizon, however, the Fed will be keen to allow breakevens to rise toward levels more consistent with its inflation target and will quickly adopt a more dovish stance if breakevens fall significantly. This "Fed put" should remain in place at least until core PCE inflation is firmly anchored around 2% and long-dated TIPS breakevens return to a range between 2.4% and 2.5%. As we detailed in a recent report,9 while accelerating wage growth will ensure that inflation remains in a long-run uptrend, the impact from wages will be mitigated by deflating import prices meaning that the uptrend will be slow. We continue to expect that year-over-year core PCE inflation will not attain the Fed's 2% target until the end of this year. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities performed in-line with the duration-equivalent Treasury index in February. Aaa-rated issues underperformed the Treasury benchmark by 2 basis points, while non-Aaa issues outperformed by 12 bps. The index option-adjusted spread for Aaa-rated ABS widened 3 bps on the month. At 50 bps, the spread remains well below its average pre-crisis level. Banks are now tightening lending standards on both auto loans and credit cards (Chart 9). While we do not think this will have much of an impact on consumer spending,10 it is usually an indication that there is growing concern about ABS collateral credit quality. While credit card charge-offs remain well below their pre-crisis levels, net losses on auto loans have in fact started to trend higher (bottom panel). We continue to recommend Aaa-rated credit cards over Aaa-rated auto loans, despite the spread advantage in autos. We will closely monitor the evolving credit quality situation, but for now continue to view consumer ABS as a very attractive alternative to other short-duration Aaa-rated spread product such as MBS and Agency bonds. The main reason being the sizeable spread advantage that has persisted in ABS for some time. At present, Aaa-rated consumer ABS offer an option-adjusted spread of 50 bps, compared to 31 bps for 30-year conventional Agency MBS and 18 bps for Agency bonds. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 34 basis points in February. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 7 bps on the month, but remains below its average pre-crisis level (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are firmly entrenched below their pre-crisis average. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 20 basis points in February. The index option-adjusted spread for Agency CMBS widened 5 bps on the month, and currently sits at 53 bps. The spread offered on Agency CMBS is similar to what is offered by Aaa-rated consumer ABS (50 bps) and greater than what is offered by conventional 30-year MBS (31 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.42% (Chart 11). Our 3-factor version of the model, which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.21%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.49%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2016, available at usbs.bcaresearch.com 2 Year-over-year core PCE inflation is currently 1.74%. 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 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 5 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 6 For further details on the model please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 For further details on the linkage between corporate sector health and state & local government health please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon) Current Recommendation

Highlights Assessing Our Tilts: Our decision to upgrade corporate spread product versus government debt in the U.S., and to reduce overall recommended duration exposure, at the end of January has been performing well. Maintain these tilts, with both soft and hard economic data pointing to a broadening global economic upturn and the Fed prepared to hike rates next week. Fed Vs ECB: Cyclical comparisons of the Euro Area today to the U.S. in the months prior to the Fed's 2013 "Taper Tantrum" show that the Euro Area is closer to full employment, with headline inflation at target, compared to the U.S. four years ago. The ECB may be facing its own tantrum pressures later in 2017. U.K.: Gilts have already priced in a significantly weaker U.K. economic outlook, especially with regards to consumer spending, yet inflation expectations are only now starting to peak. Raise U.K. bond exposure to neutral, from underweight. More clarity on the Brexit negotiations status is necessary to develop a firmer conviction on Gilts with yields already at rich levels. Feature Chart of the WeekAre Central Banks Getting ##br##Behind The Curve? A whiff of central bank hawkishness has quickly swept over the major bond markets. In the U.S., a series of Fed speeches, coming after a string of improving economic data amid booming asset markets, has turned a March Fed rate hike from a long-shot to a virtual certainty in little more than a week. In Europe, another round of stronger inflation data is emboldening some of the hawks at the European Central Bank (ECB) to more openly question if some tapering of the central bank's asset purchases will be necessary next year. Even in the U.K., the Bank of England (BoE) is letting its latest round of Gilt quantitative easing (QE) expire, although the BoE is not close to considering a rate hike, as we discuss later in this Weekly Report. Chart 2A Supportive Backdrop ##br##For Taking Credit Risk A move by the Fed next week now seems like a done deal, and the new question for investors is: how many more times the Fed will lift rates in 2017? The market is now pricing in "only" 75bps of hikes over the next year, even as the S&P 500 sits close to its all-time high and U.S. jobless claims hit a 43-year low last week (Chart 1). We still see three hikes - the Fed's current projection - to be the most that the Fed will deliver in 2017. Yet the fact that equity & credit markets have taken the rising odds of a March rate increase in stride might nudge the Fed towards even more hikes this year than currently forecast. Bond markets around the world will likely not take a shift higher in the Fed "dots" very well, although in the U.S. the immediate upside for yields remains tempered by the persistent short positioning in the U.S. Treasury market. We still expect Treasury yields to rise over the next 6-9 months, though, driven by additional increases in inflation expectations rather than a sharp repricing of the expected path of the funds rate. The biggest risk looming for global bonds, however, would come from any signal by the ECB that a taper is in the cards next year. That would likely result in wider term premiums and bear-steepening of yield curves in the major developed government bond markets. It would be a surprise if the ECB started preparing the markets for a less accommodative policy stance at this week's meeting, although questions about a taper will certainly be posed to ECB President Draghi by reporters after the meeting. Evaluating Our Recommendations As Global Growth Improves Back on January 31st, we shifted to a more pro-growth stance in our fixed income portfolio recommendations, moving our duration tilt back to below-benchmark, while downgrading government debt and upgrading corporate bond exposure.1 The key to that shift was a growing body of evidence pointing to a broadening global economic upturn. The latest round of global purchasing managers' indices (PMIs) released last week confirmed that the business cycle dynamics continue to accelerate to the upside (Chart 2). This will maintain upward pressure on bond yields and downward pressure on credit spreads. Our portfolio recommendations have generally done well since we made our shift. In Chart 3, we show the excess returns (on a currency-hedged basis) for the individual government debt markets versus the overall Barclays Global Treasury Index since the end of January. Our underweight positions in the U.S., Spain and Australia (up to February 21st, when we upgraded Aussie debt to neutral) performed well, as did our overweights in core Europe (Germany & France). Our worst performing tilts were our below-benchmark stances on Italy, which benefitted greatly from some diminished pressures on French government debt last week, and U.K. Gilts, which we discuss later in this report. In Chart 4, we show the excess returns (on a currency-hedged basis) for the major spread product markets, since January 31. Our decisions to upgrade U.S. investment grade (IG) to above-benchmark, and U.S. high-yield (HY) to neutral, have done well as U.S. corporate spreads continue to tighten in response to improving U.S. economic growth. Our relative exposures between the U.S. and Euro Area remain our biggest tilts between countries. Specifically, we remain overweight core Euro Area government debt versus U.S. Treasuries, while we are neutral U.S. HY and underweight Euro Area equivalents. On IG corporate debt, we are above-benchmark on both sides of the Atlantic. Our marginal preference, however, is for U.S. IG given the shifting changes in relative balance sheet health in the U.S. (improving, but from relatively poor levels) versus Europe (stable, but at relatively strong levels) suggested by our Corporate Health Monitors. On a currency-hedged and duration-matched basis, our relative U.S. vs Euro Area tilts have done well since our major allocation shift on January 31 (Chart 5), with Treasuries underperforming, U.S. HY outperforming and both U.S. and European IG performing similarly. Chart 3Our Recent Country Allocation Performance Chart 4Our Recent Spread Product Allocation Performance Chart 5Our Europe Vs U.S. Tilts Have Done Well Of Late Bottom Line: Our decision to upgrade corporate spread product risk versus government debt in the U.S., and to reduce overall recommended duration exposure, at the end of January has been performing well. Maintain these tilts, with both soft and hard economic data pointing to a broadening global economic upturn and the Fed prepared to hike rates next week. The Timing Of A Potential "Bund Tantrum" Looking ahead, timing a potential turn in our U.S. versus Europe tilts will likely remain the biggest call we make this year. With the Fed now set to raise rates again next week, and the ECB likely to deflect any talk of a taper to after the upcoming French elections (at the earliest), the bias will remain toward Treasury market underperformance in the near term. Yet the marginal pressures on inflation in both the U.S. and Euro Area suggest that a turning point in U.S./Core Europe bond spreads could arrive sooner than many expect. While realized inflation rates are moving higher in both regions, the underlying price pressures have a different look. In the U.S., headline inflation (using the Fed's preferred measure, the change in the personal consumption expenditure, or PCE, deflator) has risen to 1.89%, a mere 15bps above core PCE inflation with both measures now sitting just below the Fed's 2% target. Yet the breadth of the rise in core inflation has rolled over, according to our diffusion index (Chart 6). This suggests that the recent acceleration in core inflation, which we believe the Fed is most focused on, may take a pause in the next few months. The opposite is true in the Euro Area, where headline HICP inflation (the ECB's target measure) has soared to 1.9%, right at the ECB target of "at or just below" 2%. The gap between headline and core HICP inflation has been widening, though, as there has been very little follow through from the acceleration in headline inflation, largely driven by base effects related to previous rises in energy prices and declines in the euro, into core prices. Our Euro Area headline inflation diffusion index is moving higher, highlighting that the increase in headline HICP inflation is becoming more broadly based (Chart 7). Chart 6A Narrowing Increase In U.S. Inflation Chart 7A Broadening Increase In Euro Area Inflation The cyclical uptrend in Euro Area growth and inflation is also fairly broad-based at the country level, with the individual country PMIs and headline HICP inflation rates all in solid uptrends for the major countries in the region (Chart 8). At the same time, core inflation rates remain well contained. Various ECB members have pointed to the benign core inflation readings as a reason to stay the course on extraordinarily accommodative monetary policy settings. Yet with unemployment rapidly falling in many parts of the Euro Area, it is becoming increasingly difficult to get a consensus view on maintaining the status quo on ECB policy. Already, the German Bundesbank has been quite vocal in questioning the need for the ECB to maintain the current pace of its asset purchase program, and that pressure will only grow with German inflation now above 2%. So how close is the ECB to a potential asset purchase taper? Some clues emerge when comparing Europe now to the U.S. around the time of the Fed's 2013 "Taper Tantrum." In Chart 9, we show "cycle-on-cycle" comparisons for both the Euro Area and U.S. All series in the chart are lined up to the peak in our Months-To-Hike indicator, which measures the number of months to the first rate hike of the next interest rate cycle, as discounted in the Overnight Index Swap (OIS) curve. That indicator peaked in the U.S. in late 2012, several months before Ben Bernanke's infamous speech in May 2013 that signaled the Fed's QE appetite was beginning to wane. Chart 8A Consistent Upturn##br## In Europe Chart 9Less Spare Capacity In Europe Now Vs ##br##Pre-Taper Tantrum U.S. In the Euro Area, the Months-To-Hike indicator peaked in July of last year right around the time of the U.K. Brexit vote. Interestingly, the indicator remains much higher than it ever was in the U.S. during the QE era, indicating how the market believes that the ECB will have to maintain zero (or lower) interest rates for longer. Yet, by some measures, the ECB is closer to reaching its policy goals then the Fed was in 2012/13. In the 2nd panel of Chart 9, we show the "unemployment gap" - the difference between the unemployment rate and the rate consistent with inflation stability - for the U.S. and Euro Area. Note that there is far less spare capacity in labor markets today in Europe than there was in the U.S. when the Fed raised the topic of a QE taper to the markets. The U.S. unemployment rate was a full three percentage points above the full employment level in 2012, while Euro Area unemployment is now only one percentage point above full employment. In the bottom two panels of Chart 9, we show the gap between headline and core inflation in both the U.S. and Euro Area, relative to the 2% inflation targets that both the Fed and ECB aim to hit. U.S. inflation was in the vicinity of the Fed's target around the time of the Taper Tantrum. While Euro Area headline inflation is similarly close to the ECB's 2% target today, core inflation is much further away from 2% than U.S. core inflation was four years ago. If the ECB focuses on headline rather than core inflation, then Europe could be getting close to its own Taper Tantrum. Yet the relatively calmer readings on Euro Area core inflation suggest that the ECB does not have to make a rush to judgement on its asset purchase program, especially given the uncertainties presented by the upcoming French elections in April & May. We are still maintaining our overweight stance on core European government debt versus U.S. Treasuries, but we are growing increasingly worried that a turning point may be on the horizon. As can be seen in the additional cycle-on-cycle comparisons in Chart 10, the benchmark 10-year German Bund is tracing out a similar path to that of the 10-year U.S. Treasury around the time of the Fed Taper Tantrum. If the ECB focuses on the tightening labor market and accelerating pace of headline inflation in the Euro Area, a "Bund Tantrum" could become the big story for global bond markets later this year. Bottom Line: Cyclical comparisons of the Euro Area today to the U.S. in the months prior to the Fed's 2013 "Taper Tantrum" show that the Euro Area is closer to full employment, with headline inflation at target, compared to the U.S. four years ago. The ECB may be facing its own tantrum pressures later in 2017. Gilt(y) Optimism? The British economy has surprised to the upside in the last few months. Policy uncertainty has collapsed, while inflation expectations have marched higher and business optimism has stabilized. Most surprising against this backdrop, Gilt returns, on a currency hedged basis, have beaten most of their developed market fixed income peers (Chart 11). Chart 10A Bund Taper On The Horizon? Chart 11Gilts Should Have Underperformed This outperformance cannot be linked to factors such as the usual safe-haven status of Gilts, with no signs of major financial stresses in the Euro Area that would cause money to flow into Gilts (Chart 12). Indeed, the opposite has been happening as foreigners have been net sellers of Gilts in recent months. A better explanation might come from what has become a bond-bullish linkage between the British currency, inflation, real wages and consumption. In all likelihood, investors have already incorporated most of the impact of a weak Pound on U.K. inflation expectations and Gilt yields. Yet higher expected prices continue to erode household purchasing power, leading to weaker consumer spending (Chart 13). This dynamic is bullish for bonds. Chart 12Can't Blame The Safe Haven Status This Time Chart 13Consumers Will Feel The Pinch Already, this backdrop has become widely accepted. The Bloomberg survey of economists' forecasts is calling for U.K. consumer spending growth to decelerate to 1.6% on a year-over-year basis in 2017, down from 2.8% in 2016. The BoE adopted a more dovish stance at last month's Monetary Policy Committee (MPC) meeting, citing the downside risks to consumption from high currency-driven inflation at a time of persistent spare capacity in labor markets and modest wage increases.2 This threat to U.K. growth from a more sluggish consumer should continue, at least in the short term. BCA's U.K. real average weekly earnings model is clearly pointing towards additional declines in inflation-adjusted wages (Chart 14). This should restrain consumption growth, especially as other factors boosting spending are likely to fade. For example, the gains to disposable income growth from falling interest rates are likely done for this cycle, with mortgage rates having little room to decline further from the current 2.5% level (Chart 15). Also, consumer credit is now expanding 10% year-over-year - a pace that is most likely unsustainable with household debt still at high levels relative to income and the savings rate having fallen close to pre-recession levels (Chart 16). As a result, U.K. consumers are unlikely to continue stretching their financial situation to support spending. Chart 14Real Wages Will Constrain Consumption Chart 15Little Room For Lower Mortgage Rates Chart 16Structural Limits On Consumer Credit Growth Additionally, the housing market could dent consumer confidence in the near term. Since the beginning of 2014, all measures of house price inflation have rolled over, while mortgage approvals have moved sideways (Chart 17). Signs of increased weakness are appearing and could force households to revise their spending habits downward. There are also potential risks coming from the business side, despite some more positive data of late. BCA's U.K. capex indicator, composed of several survey measures, points to a cyclical improvement in capital spending in the next few quarters. At the same time, net lending to non-financial institutions is growing at a robust rate (Chart 18), suggesting that credit availability is not an impairment for U.K. businesses. Chart 17Housing: From Tailwind To Headwind? Chart 18Some Optimism Is Warranted... However, the situation remains very fragile. The upcoming Brexit negotiations will keep animal spirits well contained. Firms have become more risk averse and less willing to take balance sheet risks according to the Deloitte CFO survey (Chart 19). Until the details on the U.K.'s future economic links to Europe are resolved, corporate decision-makers will be dissuaded from making long-term investments in productivity-enhancing capital such as plant and machinery. In turn, the continued lack of productivity gains will further depress U.K. corporate profitability (Chart 19, bottom panels). This uncertain environment will mean suppressed hiring intentions, greater slack in the economy and decreasing inflationary pressure. Consequently, the BoE should remain patient. The accommodative policy measures introduced last August after the Brexit vote have been working so far. Rock bottom real yields and highly expansionary money supply growth have spurred domestically generated inflation. While the BoE's latest Gilt QE program is expiring, there is no rush to hike rates until core inflation has reached the 2% threshold or until headline inflation tops out at 2.7% in Q1 2018, as the BoE predicts.3 As such, the probability of a rate hike this year, which has collapsed from 55% to 17% since January, will fall even further, to the benefit of Gilts (Chart 20). Chart 19...But The Brexit-Induced Stalemate ##br##Effects Still Prevail Chart 20More Time Needed ##br##For The BoE This week, we are upgrading our recommended stance on Gilts from below-benchmark to neutral. We have maintained an underweight posture since October 18th of last year, primarily driven by our expectation that rising U.K. inflation would put upward pressure on Gilt yields. Now that the main force driving inflation higher - the exchange rate - is bottoming out and possibly set to reverse, we have to change tack. On that note, our colleagues at BCA Geopolitical Strategy have recently laid out a very compelling bullish case for the Pound.4 They disagree with the assessment that further volatility in the currency is warranted because of the Brexit process. They oppose the market narrative that: Europeans will seek to punish the U.K. severely for Brexit, to set an example to their own Euroskeptics; Exiting the common market is negative for the country's economy in the short-term; Remaining legal uncertainties about Brexit could derail the process. In their view, two events that occurred in January - the U.K. Supreme Court decision that the U.K. parliament must have a say in triggering Article 50 and Prime Minister May's "Brexit means exit" speech - have reduced political uncertainty regarding Brexit. The first because parliament would ultimately be bound by the popular referendum. The second because the main cause of European consternation - the U.K. asking for special treatment with respect to the common market - was taken off the table. Thus, going forward, Europe will exact a price, but it will not be severe. And the negative economic repercussions of leaving will only be fully registered in the coming years. If our colleagues are right, an overweight position in Gilts could be tempting, as a stronger Pound would decrease inflation expectations, pushing nominal yields lower. This case is even stronger given the economic uncertainties we've laid out above. Despite their convincing arguments, we prefer to take a cautious approach, while waiting to see on what ground the Brexit negotiations will start. Moreover, Gilt valuations now seem rich, with spreads versus U.S. Treasuries at historic lows. Thus, we are only upgrading to a neutral allocation to Gilts for now. In our model portfolio (shown on Page 16), we are funding the increased Gilt allocations by equally reducing the U.S. and German exposure, given the upward pressure on yields in those markets described earlier in this Weekly Report. Bottom Line: The U.K. economy has surprised to the upside and inflation expectations have reacted in line with the domestic currency weakness. There is now a greater chance that both of those trends will reverse, to the benefit of Gilts. Raise U.K. bond exposure to neutral, from underweight. More clarity on the Brexit negotiations status is necessary to develop a firmer conviction on Gilts, especially with yield already at rich levels. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Growth Upturn Has Legs: Reduce Duration, Upgrade Credit Exposure", dated January 31, 2017, available at gfis.bcaresearch.com 2 The BoE lowered its estimate of the full-employment level of the U.K. unemployment rate, consistent with accelerating wage growth, from 5% to 4.5% at the February MPC meeting. 3 Please see "Inflation Report", February 2017, Bank Of England, available at http://www.bankofengland.co.uk/publications/Pages/inflationreport/2017/feb.aspx 4 Please see BCA Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?", dated January 25, 2017, available at gps.bcaresearch.com 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 Portfolio Strategy A relapse in the global financials sector threatens to spill into U.S. financials as credit growth sinks. Bank equities are the most vulnerable to such a phase, given their reliance on rising interest rate expectations rather than increased lending. Take profits in the S&P health care facilities index and downgrade to neutral. Recent Changes S&P Health Care Facilities - Take profits of 12% and downgrade to neutral. Table 1Sector Performance Returns (%) Feature Momentum continues to trump all else, with the equity market surging to new all-time highs last week. However, in the background, the Fed is becoming steadily more hawkish, and the odds of a March rate hike have risen substantially. This should be cause for some trepidation. Chart 1Multiples Are Headed##br## Lower As The Fed Hikes The market advance since November has been supported primarily by valuation expansion, along with some improvement in corporate profits. The forward P/E has climbed to 18, its highest level in well over a decade. The scope for further expansion is limited. Importantly, if a transition to an earnings-led rally is in the offing, Fed funds expectations likely need to be ratcheted higher. Chart 1 shows that valuation multiples contract during Fed tightening cycles, using cycle-on-cycle analysis. Thus, the valuation expansion is inconsistent with a significant upgrade in the economic and profit outlook, particularly with return on equity so weak (Chart 1). In other words, the economy has good momentum, but that is not translating one for one to the corporate sector. Keep in mind that even a small two P/E multiple point decline requires 11% earnings growth for the market just to hold its ground. That is a tall order given the squeeze on profit margins from labor cost inflation and a strong U.S. dollar. Ironically, high multiples would be more durable if economic data softened enough for the Fed to hold its fire. Against this background, it is not surprising that a stealthy flight to safety has developed, although it is not uniform across asset classes. For instance, gold has outperformed most major currencies (note we recently upgraded the gold shares group as a portfolio hedge); global government yields have eased back while sovereign bond spreads have widened (Chart 2). In the U.S., the economically-sensitive transport group has rolled over in line with the yield curve narrowing (Chart 2), the equity SKEW index remains historically elevated, and a defensive vs. cyclical portfolio bias has outperformed handily since early December (Chart 2, bottom panel), on broad-based non-cyclical sector participation. These shifts, on the margin, signal that some investors are bracing for a bout of volatility. On the flipside, U.S. junk bond spreads have narrowed back to 2014 lows, and emerging market corporate bond spreads are testing similarly tight levels. The global purchasing manager survey recorded yet another monthly gain (Chart 3). Chart 2Contrarian##br##Alert... Chart 3... Defensives Can Outperform##br## When Growth Is Good Ergo, a systemic economic threat is not the main obstacle to further asset price appreciation. Rather, it is that expectations in some assets and sectors have become divorced from reality. Indeed, we have noted for the last two months the disturbing downtrend in bank credit growth and the unprecedented gap between strong 'soft' and pedestrian 'hard' economic data. Mixed economic and financial market messages suggest that any equity turbulence may be marked by a mostly rotational correction rather than a savage drawdown in the broad averages. Still, the latter cannot be ruled out given the high degree of complacency and buoyant profit and economic expectations. It is notable that defensive equities embarked on a massive outperformance phase when both U.S. and EM bond spreads were just as low as they are currently, i.e. they hit 'as good as it gets' levels (Chart 3). Any widening in corporate bond spreads would tighten financial conditions, spurring a slowdown in growth down the road. In sum, the odds of an equity market sweet spot extension beyond the very near run have diminished as a consequence of ongoing strong economic data, which reflects the easing in financial conditions a year ago. In terms of positioning portfolios, there is still a mismatch between developed and developing markets, as measured by the relative ISM indexes (Chart 3, fourth panel). The upshot is that defensives will continue to generate much more cash than their cyclical counterparts (Chart 3, bottom panel), supporting the nascent relative share price recovery. The financial sector could also be due for a correction. Financials And Banks: Where To Next? The global financials sector has cheered the firming in leading economic indicators and back up in bond yields since last autumn, but that celebration is likely drawing to a close. Euro area financials have rolled over, in line with renewed weakness in German government bond yields (Chart 4). Continued slippage in global yields could cap U.S. yields, thereby flattening the yield curve (Chart 5). U.S. financials are much more expensive than their euro area counterparts (Chart 5, bottom panel), suggesting heightened vulnerability. Chart 4Are EMU Financials ##br##Sending A Warning Signal? Chart 5Watch The##br## Yield Curve In our view, the S&P bank index contains the most downside vulnerability, in relative performance terms, of all the financial sector sub-components, especially if regulatory reform disappoints and/or is slow to evolve. True, as outlined in a Special Report published on October 3, 2016, interest rate expectations have a checkered history of predicting bank stock relative performance. When they do drive bank stocks, it is typically because most other profit drivers are lacking, as is currently the case (Chart 5, top panel). This cycle, interest rate spreads have been unduly suppressed by the zero lower bound. Under normal circumstances, when short-term interest rates are well above zero lower bound, banks can target a spread between rates on assets and liabilities. But when the fed funds rate is at zero, the spread is compressed, because banks generally cannot charge customers a penalty implied by negative interest rates on deposits (at least in the U.S.). As the Fed pushes interest rates back upward, banks may be able to return their spreads to their target levels, by raising deposit rates more slowly than loan rates. However, this dynamic has been fully priced in over the last few months and the risk is that higher net interest margins will not offset the lack of credit creation and/or that Fed funds rate expectations will level off if economic data start to disappoint. After all, Chart 6 shows that net interest margins can both widen and narrow when the Fed is hiking interest rates. Moreover, the yield curve is narrowing, after peaking two months ago. If rising fed interest rate expectations are the primary factor driving bank stock performance, then it follows that market expectations must continue to price in a much more hawkish rate environment in order to extend any rally in bank share prices. However, the global credit impulse is still negative, albeit less so, reflecting capital constraints and deleveraging. The Bank of International Settlements global credit impulse indicator has been an excellent leading indicator of relative bank profitability, and it is premature to expect earnings outperformance (Chart 7). U.S. credit data are also inconsistent with a major upshift in Fed funds interest rate expectations. Total loan growth is contracting, led by commercial & industrial loans (Chart 8). Commercial real estate loan growth has also turned lower. Chart 6Net Interest Margins And The Fed Chart 7Don't Chase Without Profit Support Chart 8Shrinking Balance Sheets The most recent Fed Senior Loan Officer Survey showed that banks are tightening lending standards in most categories, with the exception of mortgages (Chart 9). The number of banks reporting increased loan demand has also softened. Since the credit crisis, banks have shifted their balance sheet exposure toward businesses and away from consumers and residential mortgages, underscoring that a decent housing market is unlikely to provide an offset to lackluster corporate credit demand. Only mortgages have experienced an uptick in loan demand and availability of funds (Chart 9). This credit backdrop is not conducive to a much more aggressive Fed, reinforcing that it would be dangerous to discount a sustained and meaningful uptrend in net interest margins. To further confound the bank stock reward/risk profile, bank employment continues to rise steadily (Chart 10), even though balance sheet expansion is no longer a sure thing. We have shown in past Reports that bank stocks have almost always underperformed when bank employment is rising. Chart 9Credit Standars Are Tightening Chart 10Sagging Productivity The current combination of fading credit creation and rising employment has done a number on our bank productivity proxy. The latter is now contracting on a rate of change basis, warning that the expansion in bank stock valuations is due for a squeeze (Chart 10). Bottom Line: The run in bank stocks over the past few months is on the cusp of a reversal, based on the leading message from the euro area, sinking productivity and punk credit demand. Our financial sector preference remains skewed toward areas not dependent on credit creation, such as asset managers. Book Profits In Health Care Facilities We bought the S&P health care facilities index last December after a steep post-election sell-off created a valuation and technical undershoot relative to the fundamental outlook. The doomsday concern was that President Trump would tear up the Affordable Care Act (ACA), potentially leaving millions without insurance: treating the uninsured is the bane of any hospital's existence. At the time of purchase, the 52-week rate of change was diverging positively from the share price ratio after hitting deeply oversold levels, often a harbinger of a playable rally (Chart 11). That was particularly true given an historically high short position. The index has outperformed by 12% since then, encouraged by a jump in analyst net profit revisions following upbeat profit results and guidance from industry heavyweights such as HCA Holdings (Chart 11), and a realization that any ACA action is likely to be more of a rework than a total rebuild. Valuations remain appealing, but a technical breakout above key resistance levels requires increased confidence in the durability of profit outperformance. Is such a phase forthcoming? Our conviction level has decreased a notch. Our concern is primarily revenue based, rather than fear that provisions for doubtful accounts will suddenly deteriorate as a consequence of treating uninsured patients. Instead, the main push from the surge in the insured population and increase in procedures on the back of rising consumer confidence/job security is likely to peter out. Consumer spending on hospitals has already rolled over decisively on a growth rate basis (Chart 12, third panel), and is contracting compared with total consumer spending. The same is true of spending on physician visits. Fewer doctor visits mean a reduction in procedures performed at hospitals. Chart 11Hitting Resistance Chart 12Top-Line Trouble Ahead? Health care is a labor-intensive industry. Health care facilities staff up when they get busy and prune when capacity utilization slips. As such, slowing growth in hospital employment reinforces that patient volume growth is likely to ebb (Chart 12). In fact, the contraction in hospital hours worked signals the same ahead for hospital sales (Chart 12, bottom panel). The good news is that labor costs remain in check, as measured by the employment cost index for hospitals (Chart 13). Other input costs, such as the cost of medical equipment and supplies, have perked up (Chart 13), which may require increased pricing power in order to sustain profit margins. However, the revenue trends noted above suggest that hospitals may not experience a sufficient rise in patient volumes to the extent that restores pricing power to a more solid footing. Chart 14 shows that the consumer price index for hospitals is losing momentum relative to overall inflation. Durable outperformance phases require accelerating relative pricing power, in addition to a cooling in overall economic growth, as proxied by the ISM manufacturing index (see shading, Chart 14). Those conditions provide a durable competitive profit advantage. Chart 13A Mixed Picture For Costs Chart 14Shaky Long-Term Support Chart 15Macro Headwinds In addition, the ideal macro conditions for hospital stocks exist when consumer spending on overall health care services is accelerating relative to total spending. That implies that the providers of health care services have an advantage over those that pay for them, such as insurers. Total medical care spending is steadily decelerating (Chart 15), underscoring that investors are better off targeting investments in other parts of the sector. In sum, the forces required to sustain the oversold rally in the S&P 1500 health care facilities index are losing clout, so we recommend booking profits. Bottom Line: Downgrade the S&P 1500 health care facilities index to neutral, locking in a 12% profit since inception in December 2016. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Risk assets have rallied smartly, yet key indicators like the relative performance of Swedish stocks or the price of kiwi equities are not corroborating these moves. With the Fed now very likely to increase rates in March, the broad-trade-weighted dollar could be about to resume its rally. This would prompt a correction in metals, and EM as well as commodity currencies. We think the tactical correction in the broad-trade-weighted dollar is over, and the cyclical dollar rally can resume. EUR and JPY will not suffer as much as the commodity currencies, go long EUR/AUD, short NZD/JPY. Feature In the Roman calendar, the Ides of March corresponds to the 15th of that month. Consigning that date to posterity in the year 44 BCE, Julius Caesar was assassinated on the floor of the senate in Rome, with his adoptive son Brutus, being among the conspirators. This event prompted yet another round of civil war in the republic, and ultimately a regime shift: the end of the Roman Republic and the Beginning of Imperial Rome under Augustus in 27 BCE. Fast forward 2061 years to the present. March 15th will be the day when the FOMC meeting ends. Will the period around the Ides of March represent a regime shift once again - albeit on a much different scale - where risk assets finally correct? Can the dollar resume its ascent? We believe the answer to both questions is yes. Unusual Market Moves Strange market dynamics have piqued our interest. In recent weeks, DM stock prices, and bond yields have been moving up (Chart I-1). This is consistent with investors pricing in an improving growth outlook and a Fed moving toward a tighter policy. On the other hand, EM stocks, metals, and gold in particular have also been moving up (Chart I-2). This move is more disturbing as it tends to imply an easing in monetary conditions, especially the strength in gold, even if it may have ended yesterday. This strange performance could be explained if the dollar was weakening or inflation expectations were moving up. However, the dollar has been strengthening in recent days and inflation expectations have been flat. Additionally, the U.S. yield curve has flattened, suggesting that the adjustment in the Fed's expected rate path is beginning to have marginally negative implications for future growth (Chart I-3). Chart I-1More Growth, More Hikes Chart I-2More Reflation As Well Chart I-3No Sign Of A Fed Behind The Curve So based on current information, how are these market moves likely to resolve themselves? Let's look at indicators. In the past, we have followed the common-currency performance of Swedish relative to U.S. equities as a gauge for the global growth outlook, and particularly non-U.S. growth relative to U.S. growth. This reflects the fact that U.S. stocks tend to be defensive, while Swedish stocks are very pro-cyclical. This dynamic is accentuated by the nature of the Swedish economy. Sweden is a small open nation that trades heavily with EM. While its biggest trading partner is the euro area, where it tends to export many intermediate goods and machinery, which are then re-exported as finished products to the EM space. Currently, Swedish equities continue to underperform U.S. ones. What is most striking is that this underperformance has happened despite a strong performance in EM stocks and metals, a very rare divergence (Chart I-4). Another worrying signal comes from New Zealand stocks in USD terms. New Zealand is another small open economy with deep trade links to the EM space. It is therefore very sensitive to global growth dynamics. While Kiwi equities did flag the rebound in EM growth and global manufacturing activity that happened in 2016, since late January, they have stopped participating in the rally in global risk assets despite a booming New Zealand economy. They have even begun swooning in recent weeks (Chart I-5). Chart I-4A Strange Divergence Chart I-5Are Kiwi Stocks Telling Us Something? Finally, two other reliable indicators of global growth are also not corroborating any further improvement in global growth from here: Small caps are underperforming large caps and oil is underperforming gold (Chart I-6). Obviously the next question becomes: are all these indicators likely to converge back toward EM equities, the AUD and the BRLs of the world or are the risk assets mentioned above likely to be the ones experiencing a downward adjustment? Here economics should give us a clue. For one, the 2016 rally in EM and risk assets can be explained by the large improvement in economic conditions. G10 and EM surprise indexes have moved up vertically in recent months (Chart I-7). However, this move might reflect the past not the future. Chart I-6Some Growth Indicators Are##br## Not Doing Well Anymore Chart I-7Too Much Of##br## A Good Thing? China has been a key reason explaining why EM assets and economic activity have been so positive. However, the large dose of fiscal stimulus that has supported that economy has dissipated (Chart I-8). Based on the IMF's October Fiscal Monitor, the fiscal thrust in China was 1.7% of potential GDP in 2015 (heavily loaded to the second half of that year), and 0.3% in 2016. It is moving to 0% in 2017. This means that as the lagged effects of the late 2015 fiscal surge dissipate, a key reflationary wind behind the global economy will disappear. The Keqiang index is mirroring these dynamics. After flirting with cyclical highs, and therefore highlighting a sharp improvement in the Chinese industrial sector, it has begun to roll over (Chart I-9). More weakness is likely in the cards. Fiscal dynamics have followed a similar pattern on a global level. The overall EM fiscal thrust was at its strongest in 2015, at 0.6% of EM potential GDP, fell to 0.1% in 2016, and is expected to hit -0.2% in 2017. In the DM, the pattern is slightly different. The high point of fiscal stimulus was 2016, when the fiscal impulse hit 0.4% of potential GDP. However, this measure is moving back to -0.1% in 2017. Chart I-8Losing A Source ##br##Of Reflation Chart I-9Chinese Industrial Activity ##br##May Be Rolling Over Additionally, the monetary environment is not as stimulative as it once was. Bond yields have risen in the whole DM space, with Treasury yields now more than 110bps higher than in July, Bund yields having moved from -0.18% to 0.31%, and JGB yields having adjusted 37bp higher to 0.07%. High-frequency loan data out of the U.S. already shows some strains caused by this rise in borrowing costs (Chart I-10). This combination points toward a deceleration in the growth impulse, especially in the goods sector. As such, we do expect the EM and G10 surprise indexes to roll over in coming weeks. Even if this phenomenon may prove temporary, the market is not priced for this event. Highlighting this vulnerability is the high level of complacency we have already flagged last week, which suggests that global investors are positioned for a continuation of the improvement in the growth outlook (Chart I-11). So high seems the conviction that growth will continue to accelerate that it is outweighing the move toward a tighter Fed going forward. Finally, the implied correlation in the S&P 500 has fallen to post 2010-lows. This could incentivize investors to take on more leveraged bets on portfolios of stocks. A low correlation results into higher diversification benefits and therefore, a lower portfolio volatility (Chart I-12). A rise in correlation would cause volatility to rise and thus a mini-deleveraging and de-risking cycle to take hold amongst investors. Chart I-10Response To Higher Yields Chart I-11Lots Of Complacency Globally Chart I-12Correlation-Induced Derisking On Its Way? Bottom Line: DM stocks are up, yields are up, the dollar is firming, yet EM equities, metals and gold especially have risen as well, and the U.S. yield curve is flattening while inflation expectations have recently been stable. We expect risk assets to end up buckling. Some reliable indicators of the trend in risk assets are pointing south, global investors are expecting further growth improvement in the coming months while global growth may in fact temporarily decelerate, and finally, if the low level of implied correlation in stocks normalizes, a correction may be catalyzed. What About The Fed Because Lael Brainard has been such a reliable dove on the FOMC, when she says that a hike is coming soon, we must listen. The fact that the market has come to price in an 83% probability of a Fed hike in March will only give the FOMC more comfort in increasing interest rate when it meets in two weeks (Chart I-13). While we have been expecting the Fed to move in line with its Summary of Economic Projection's interest rate forecast, and thus increase three times this year, we are surprised by the fast change of tune in recent days. Nonetheless, we are acknowledging this reality. Is this publication moving toward expecting four rate hikes in 2017? Not yet. We want to see how the market handles the coming hike going forward. A correction in risk assets, commodities, and EM is likely to force the Fed to pause again before resuming its hiking path. We are clearly expecting such a development. The broad dollar is likely to be caught in a bullish cross current. However, differentiation between the minors vis-à-vis the EUR and JPY might be essential for investors. Chart I-14 shows that recently, the broad-trade-weighted dollar has not kept pace with the increase in interest rate expectations for the U.S. With our capitulation index for this measure of the dollar moving closer to "oversold" territory, the weeks leading up to the Fed meeting could witness a stronger broad trade-weighted dollar. We are therefore removing our tactical short bias and moving in line with our cyclical bullish dollar stance. Chart I-13The Fed Tends To Telegraph ##br##Its Intention To Hike Chart I-14The Dollar Should ##br##Catch Up We believe that in this process, the dollar will be strongest against EM and commodity currencies. To begin with, the USD is trading near 19, 18, and 17 months lows against the BRL, ZAR, and RUB respectively. As recently as Wednesday, the AUD was also trading near the top of its distribution of the past two years (Chart I-15). Moreover, EM and commodity currencies are heavily geared to global growth. As such, the combination of a tightening Fed, rising bond yields, and a potential roll-over in global economic surprises may weigh especially heavily on them. On the other hand, in 2015 and 2016, the dollar has tended to be softer against the EUR and the JPY in periods of market turbulence. Thus, the call on EM and commodity currencies seems much cleaner than on these two currencies. In this regard, two crosses have caught our eye. One is EUR/AUD. Not only is it at the bottom end of a trading range established since June 2013, it has only traded lower at the apex of the euro area crisis between 2011 and the first half of 2013 (Chart I-16). The recent rollover in French / German bund spreads is potentially a good signal to buy this cross. The picture for JPY is now muddied. While higher interest rates should hurt the JPY, a period of risk-asset selloff should support the JPY. To play the cross-current described above, we are opening a short NZD/JPY position, a cross historically levered to rising volatility (Chart I-17). Chart I-15AUD Is Elevated Chart I-16To Fall From Here, EUR/AUD Needs A Euro Crisis Chart I-17Short NZD/JPY: A Risk-Off Play Bottom Line: The Fed moving forward its planned rate hike to March could be the ultimate catalyst to prompt a correction in risk assets, especially the segment of the market most levered to EM and growth conditions: EM and commodity currencies. We are removing our tactical USD stance and we are moving in line with our bullish cyclical stance. We are also buying EUR/AUD and shorting NZD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar USD Technicals 1 USD Technicals 2 Recent data paints a healthy picture for the U.S. economy: Fourth quarter annualized GDP came in unchanged from the previous quarter at 1.9%; PCE Price Index increased at a 1.9% annual pace, near the Fed's target; Core PCE remained steady at 1.7% annually and increased to 0.3% monthly, indicative of a robust economy; ISM Manufacturing PMI went up to 57.7. The market is now pricing in an 83% probability of a rate hike. Further enhancing growth prospects were Trump's remarks at his Joint Address to Congress, where he stated that there will be a "big, big cut" in corporate tax, and that he will seek to gain approval for a $1 trillion infrastructure plan. Hawkish comments from the previous FOMC meeting strengthened the dollar in February; Trump's comments may be an additional tailwind to the dollar's upside this month. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 The Euro EUR Technicals 1 EUR Technicals 2 Fundamentally, the euro area economy remains resilient: Services sentiment, business climate, and industrial confidence all picked up in February, outperforming expectations; Germany recorded a decrease in unemployed persons of 14,000; German CPI picked up to a 2.2% annual pace, also beating expectations Nevertheless, EUR/USD is unlikely to see any substantive upside in the coming months. With the Dutch elections in around 2 weeks, considerable volatility could rise up, something which has not been priced in. The Euro Stoxx 50 Volatility Index is showing a low reading of 16.55, just above the all-time low of 12. The ECB will meet next week and is likely to display a dovish bias due to potential political turmoil. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 The Yen JPY Technicals 1 JPY Technicals 2 On a cyclical basis we are still bearish on the yen, as the BoJ will continue to pursue radical measures to pull Japan out of its liquidity trap. Recent data seems to indicate that these measures have been somewhat successful: Retail trade YoY growth outperformed expectations coming in at 1%. Housing starts YoY growth also outperformed, coming in at 12.8%. On a tactical basis the picture is more nuanced. While it is very possible that the coming rate hike could lift rate expectations in the U.S., lifting USD/JPY, there is a risks that the hike might trigger a sell-off in risks assets, which could be very positive for the yen. For this reason we are shorting NZD/JPY, as this cross is very vulnerable to an increase in volatility. Report Links: JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 British Pound GBP Technicals 1 GBP Technicals 2 The past week has not been kind to the pound, with GBP depreciating by about 2% against both the Euro and the U.S. Dollar. This was in part due to the prospect of a Scottish Independence referendum. On the economic side, data for the U.K. continue to be mixed: House prices annual growth outperformed expectations coming in at 4.5% M4 broad money annual growth continues to climb higher and it is now at 7%. On the other hand manufacturing PMI, although still high, underperformed expectations, coming in at 54.6. Although the cyclical dollar bull market should continue to weigh on cable, we are more bullish on the pound, particularly against the euro, as expectations for the U.K. economy continue to be too pessimistic, while the dark cloud of this year's election cycle looms on the euro. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar AUD Technicals 1 AUD Technicals 2 AUD lost 1.3% of its value Thursday morning amid disappointing trade data. It seems that the market largely ignored stronger data this week: GDP grew at a 2.4% annual rate Q42016 and both NBS and Ciaxin Chinese Manufacturing PMI beat expectations. Exports, however, contracted at a 3% pace and the surplus missed expectations by 66%, most likely due to the AUD's strength this year, even alongside higher commodity prices. This is also particularly worrying seeing that exports failed to pick up despite a previously strong Chinese PMI reading. Now, alongside a Keqiang Index that is topping out, the future for Australian exports could be limited. Additionally, this outlook is further supported by investment diverting to the non-resource sector. It is difficult to see whether the RBA will respond to this export slump, as the contractionary Q32016 GDP data was largely overlooked and dismissed. Nevertheless, we stand by our bearish outlook on AUD. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 New Zealand Dollar NZD Technicals 1 NZD Technicals 2 The RBNZ continues to assert its neutral bias. On Wednesday, RBNZ Governor Graeme Wheeler stated that "there is an equal probability that the next OCR adjustment could be up or down". This caused the kiwi to come close to reaching 0.71, its lowest point since mid-January. We continue to believe that the RBNZ stance is not hawkish enough, as powerful inflationary forces continue to brew in New Zealand. That being said, it is very likely that the RBNZ will continue with its neutral tone up until the middle of the year, when we start to have a clearer picture about the outcome in European elections. Therefore, given that the Fed is likely to hike in March, diverging monetary policies should continue to weigh on NZD/USD until then. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Canadian Dollar CAD Technicals 1 CAD Technicals 2 The BoC left their overnight rate target unchanged at 0.5% despite a high CPI reading of 2.1% in January. A further surprise was a particularly dovish tone, highlighting that higher energy prices will have a temporary effect on inflation, and indicating "material excess capacity in the economy". Additional weaknesses were highlighted with regards to competitiveness challenges for the export sector and subdued wage growth accompanied by contracting hours worked. Trade developments are an additional headwind for the Canadian economy that the bank is monitoring and will continue to do so until the outlook clarifies. CAD has lost more than 2% of its value against the USD in 3 days due also to a stronger dollar based on Fed rate hike expectations and Trump's potential infrastructure spending and tax cuts. It is unlikely that CAD will see any strength in the near future as the Bank has set forth a rather cautious tone. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc CHF Technicals 1 CHF Technicals 2 Recent data has been mixed, which indicates that although economic activity in Switzerland is improving, it still is very tepid: The KOF leading indicator outperform expectations coming in at 107.2 Retail sales outperformed expectations. However they are still contracting by 1.4% GDP annual growth was 0.6%, falling significantly from last quarter reading of 1.4% The SNB is currently in a tight spot, as improvements are very marginal and it is evident that the economy is still plagued by strong deflationary forces. Meanwhile EUR/CHF is under 1.065 and has been unable to climb above this level this month, as the SNB continues to fight risk off flows coming into the franc due to the risks of the European election cycle. As these risks increase, the floor in this cross will continue to get tested. 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 NOK Technicals 1 NOK Technicals 2 Risks continue to point for further upside in USD/NOK. Oil is unlikely to rally much further from current levels, even if the OPEC agreement continues. Thus the movements in USD/NOK should be dominated by monetary divergences between the United States and Norway. These are likely to continue to favor the dollar, as the Fed should continue its hawkish tone. Meanwhile the Norges Bank is likely to stay dovish, as their economy has been to be very weak. GDP growth is negative, the output gap is over -2% of GDP and employment and real wages continue to contract. Meanwhile, the high inflation that Norway experiences last year is likely to continue its slowdown, as the effects of the currency depreciation should start to dissipate. 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 SEK Technicals 1 SEK Technicals 2 In past reports, we have argued that the Swedish economy is robust and inflation is picking up. This has been corroborated by strong consumer and business confidence, and high resource utilization and inflation expectations. Recent data has supported this view: Retail sales picked up 2.2% annually; Producer price index was up 8.2% from last year in January; Annual GDP growth came in at 2.3% at the end of last year. Growth and inflation have been supported by expansionary monetary policy. With the Riksbank stating that "there is still a greater possibility that the rate will be cut than... raised in the near future", these conditions are unlikely to falter. Nevertheless, it is important to note that it is this cautionary stance by the Bank that is the reason for the SEK's recent weakness, not fundamentals. It is now the probable case that any upside in the SEK will be noted and limited by the Riksbank, capping the upside on the krona. 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 In this week's report, we update the "Three Controversial Calls"1 we made at BCA's New York Investment Conference held on September 26-27th, 2016. Call #1: "Trump Wins, And The Dollar Rallies." We still see 5% more upside for the greenback. Call #2: "Japan Overcomes Deflation." Inflation expectations have moved higher over the past five months, while the yen has weakened. This trend will persist. Call #3: "Global Banks Finally Outperform." Bank shares have beaten their global benchmark by 14% since we made this prediction. European financials have finally turned the corner. Feature Call #1: "Trump Wins, And The Dollar Rallies" Chart 1From Unrealistic To Even More Unrealistic We never bought into the notion that a Trump victory would cause investors to flee the dollar. On the contrary, we argued that most of Trump's policies were bond bearish/dollar bullish. In particular, we reasoned that Trump's attempts to browbeat companies into moving production back home would help reduce the U.S. trade deficit, boosting aggregate demand in the process. Efforts to curb illegal immigration would also push up the wages of low-skilled workers. Meanwhile, fiscal stimulus would fire up the labor market at a time when it was already approaching full employment. Fiscal Deficit On Upward Path With nearly four months having passed since the election, what have we learned? First, and foremost, a big increase in the budget deficit still looks likely. As Trump's address to the joint session of Congress on Tuesday night underscored, the president has plenty of specific areas in mind where he would like to increase spending (more money for defense, infrastructure, etc.) and a long list of taxes he would like to cut (corporate and personal income taxes, estate taxes, a new childcare tax credit,2 etc.). We do not take seriously Trump's pledge to pay for increased military spending by cutting annual nondefense discretionary spending by $54 billion relative to the existing CBO baseline. Chart 1 shows that under current budgetary rules, nondefense discretionary spending is set to decline from 3.3% of GDP in 2016 - already close to a historic low - to only 2.7% of GDP in 2026. Cutting that portion of the budget above and beyond what has already been legislated is unrealistic. There simply aren't enough programs like the National Endowment for the Arts that Republicans can take to the woodshed without facing a severe political backlash (Chart 2). As long as big ticket entitlement programs such as Social Security and Medicare remain unscathed - which Treasury Secretary Steven Mnuchin confirmed would be the case earlier this week - overall government spending will rise, not fall. Chart 2Nondefense Discretionary Spending: Where The Money Goes Trump And Trade The one category where Trump would be more than happy to see taxes go up is on imports. The constraint here is political. A unilateral move to legislate large-scale import duties would be in gross violation of WTO rules and could spark a global trade war. Many of Trump's Republican colleagues, as well as a fair number of Democrats, also favor free trade and would resist such an effort. One solution that Trump vaguely alluded to in his speech is to raise duties on imports within the context of a broader tax reform bill. A border adjustment tax, for example, would bring in $1.2 trillion in revenues over ten years.3 As we argued in a Special Report earlier this year, the introduction of a BAT would be highly dollar bullish.4 Pulling Back The Welcome Mat? On immigration, Trump has sent mixed messages. On the one hand, he continues to insist that he will build "the wall" and has maintained his hardline stance on refugee policy. On the other hand, he has backed off his campaign promise to reverse Obama's executive order protecting the so-called "dreamers." This order allows immigrants who came to the U.S. illegally as children to remain in the country indefinitely, provided they do not commit a serious criminal offence. During his speech, Trump signaled a willingness to shift the U.S. immigration system towards one based on merit, similar to what countries such as Canada and Australia already have. This is an excellent idea, but it raises the question of what will happen to the 11 million illegal aliens currently residing in the country, the vast majority of whom are poorly educated. It is important to remember that U.S. immigration laws are already very strict. Trump has given the U.S. Immigration and Customs Enforcement agency (ICE) greater leeway in enforcing these laws, while also pledging to hire 5,000 more border agents and 10,000 additional ICE officers. As such, a "status quo immigration policy" under Trump could prove to be much more restrictive than the one under Obama even if no new legislation is passed. A key implication is that labor shortages in areas such as construction and hospitality services may intensify. Solid U.S. Growth Outlook Favors A Stronger Dollar Meanwhile, the U.S. growth picture remains reasonably bright (Chart 3). This may not be obvious from current Q1 tracking estimates, which are pointing to real GDP growth of below 2%. However, the weak Q1 numbers are mainly due to an unexpectedly large jump in imports and a sharp decline in inventory accumulation. According to the Atlanta Fed's model, taken together these two factors have shaved a full percentage point off growth. Real private final demand is still rising at nearly 3% (Chart 4). If U.S. growth stays solid as we expect, the Fed will raise rates three or four times this year, starting in March. This is slightly more than the market is currently pricing in, which should be enough to ensure that the trade-weighted dollar strengthens by another 5% or so over the remainder of the year (Chart 5). We see the greatest upside for the dollar versus EM currencies, and as we discuss next, against the yen. Chart 3U.S. Economic Data Are Upbeat Chart 4Trade And Inventories Detract From ##br##A Bright Q1 Growth Picture Chart 5Real Rate Differentials Are ##br##Driving UpThe Dollar Call #2: "Japan Overcomes Deflation" Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 6). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. For most of the past 25 years, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 7). Chart 6Japan: Easing Deflationary Forces Chart 7Japan: Low Household Saving Rate ##br##And A Tightening Labor Market Chart 8Investors Still Not Entirely ##br##Convinced Japan Is Eradicating Deflation Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seem to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous circle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Stay Short The Yen Consistent with this narrative, market-based inflation expectations have risen over the past five months. But with inflation swaps still pricing in inflation of only 0.6% over the next 20 years, there is plenty of scope for real rates to fall further (Chart 8). This implies that investors should maintain a structurally short position in the yen. A weaker yen will help boost Japanese stocks, at least in local-currency terms. As a relative play, investors should consider overweighting Japanese exporters versus domestically-exposed sectors. Multinational manufacturers stand to gain the most, as they will benefit from increased overseas sales, while the highly automated, capital-intensive nature of their operations will limit the burden of rising real wages. Call #3: "Global Banks Finally Outperform" Global bank shares have risen by 25% since we made this call, outperforming the MSCI All Country World Index by 14% (Chart 9). The thesis that we outlined five months ago still remains intact (Charts 10 and 11): Chart 9Global Bank Shares Have Bounced Chart 10Factors Supporting Bank Stocks Chart 11Global Banks Are Still Fairly Cheap Improving business and consumer confidence should continue to support credit demand. Stronger economic growth will reduce nonperforming loans. Capital ratios have improved significantly, reducing the risk of further equity dilution. Yield curves have steepened since last summer, which should flatter net interest margins. Despite the run-up in share prices over the past five months, valuations remain attractive. Looking across regions, European banks stand out as being particularly attractive over a cyclical horizon of about 12 months. BCA's European Corporate Health Monitor continues to improve, foreshadowing further progress in mending loan books (Chart 12). The ECB's lending survey indicates that a majority of banks are seeing stronger loan demand (Chart 13). This suggests that credit growth is not about to stall anytime soon. Meanwhile, euro area banks are trading at a miserly 0.8-times book value, which gives valuations plenty of upside. Chart 12Euro Area: Improving Corporate Health Chart 13Euro Area: Banks See Rising Loan Demand Political Risks Chart 14This Will Not Get Le Pen Into The Elysee Palace The risk is that European political developments sabotage this thesis. Our view here is "near-term sanguine, long-term cautious." We continue to think that populism is in a long-term secular bull market. However, unlike in the case of Brexit or Trump, populist leaders in continental Europe will have to wait until the next economic downturn (probably in two or three years) before they seize power. To that extent, the prevailing - though admittedly rather myopic - consensus view is correct: Marine Le Pen will not become president this year. Keep in mind that the National Front underperformed during regional elections in December 2015, just weeks after the terrorist attacks in Paris. Despite a recent uptick in the polls, support for Le Pen is actually lower now than it was back then (Chart 14). As long as the French economy continues to show signs of tentative improvement, the establishment parties will succeed in keeping Le Pen out of power. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 2 Despite the populist sounding nature of this proposal, the Tax Policy Center estimates that 70% of the childcare credits will go to households earning $100,000 and up. See Lily L. Batchelder, Elaine Maag, Chye-Ching Huang, and Emily Horton, "Who Benefits from President Trump's Child Care Proposals?" Tax Policy Center (February 27, 2017) for details. 3 James R. Nunns, Leonard E. Burman, Jeffrey Rohaly, Joseph Rosenberg, and Benjamin R. Page, "An Analysis of the House GOP Tax Plan," Tax Policy Center (September 16, 2016). 4 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature Dear Client, I am travelling this week so this report is a little different. It is the full transcript and slides of a client presentation I recently gave. The presentation summarises several years of in-house work on applying the Fractal Market Hypothesis to real-life investing. Dhaval Joshi The Efficient Market Hypothesis Is Wrong Good morning In the next 30 minutes or so I want to challenge the way you think about financial markets. You see, at school we are taught the mainstream models of financial markets: Modern Portfolio Theory, the Capital Asset Pricing Model and the Efficient Market Hypothesis. And we are led to believe that these models describe the real world. But I'm sad to say that these mainstream models are deeply flawed. They simply don't describe financial markets as they behave in the real world. And in your heart of hearts, you know it. Take the supposed bedrock of financial market theory, the Efficient Market Hypothesis, and look at the assumptions it makes about markets (Slide 2). Slide 2 One. That economic and market returns follow a Normal - which is to say a standard bell-curve - distribution. Really? Everybody knows that returns exhibit 'fat-tails' in which extreme events happen much more frequently than the bell-curve would suggest. By the way, this also means that a statement such as "the financial crisis was a five standard deviation - five-sigma - event with odds of 3 million to 1" is also complete nonsense. Accounting for the true fat-tails, the likelihood of extreme events is much higher than the flawed bell-curve models would suggest, as we should all now be painfully aware! Two. That the distribution is stationary - its mean doesn't change through time. Again, wrong. We know that economies and markets can and do experience regular regime-shifts or phase-shifts. Three. That markets have no memory - they exhibit no trends. Now this is getting silly! We all know that markets exhibit very strong trends. Four. That markets do not produce repeating patterns at any scale. Untrue. And five. That markets are continuously stable at all scales. Wrong again. I'm sure you'll all agree that none of these assumptions that underlie the Efficient Market Hypothesis describe the markets that we all know and work with. The good news is that there is a model that does describe the financial markets as they behave in the real world (Slide 3). It correctly assumes the return distribution is non-Normal, the mean can change over time, markets can trend, produce repeating patterns, and can generate instabilities at any scale. Slide 3 The model is called the Fractal Market Hypothesis, first proposed by Edgar Peters in 1991. Now I can see some looks of fear at the mention of this intimidating word 'fractal'. But hang in there, there really is nothing to fear. A fractal is just a pattern that repeats over and over at different scales. You come across fractals all the time, perhaps without realizing it. A cloud is a fractal - because a small part of a cloud is just a scaled-down version of the whole cloud. And for those of you who enjoy your vegetables, you will notice that cauliflowers and broccoli are fractals because the florets are just miniature versions of the whole vegetable. But perhaps the most familiar example is a tree (Slide 4). You can clearly see that a tree is just a simple pattern repeating over and over at different scales. Indeed, on this next slide (Slide 5), you see images of the twigs, branches, and trunk structure - and you could not tell them apart. Except that the twigs are on a scale of millimeters, the branches are on a scale of centimeters, and the trunk is on a scale of meters. Slide 4 Slide 5 Let's switch back to financial markets. On this next slide (Slide 6), you see three images of ten successive points on the S&P500. Again, the three images look very similar. In fact, they're very different. The first is on a scale of weeks, the second on a scale of months, and the third on a scale of years. But just like the twigs, branches and trunk, you could not tell them apart without seeing the scale. In other words, financial markets are scale-invariant. They are fractals. Slide 6 But why? And so what? To answer these questions we must now introduce the four basic assumptions of the Fractal Market Hypothesis. One. Investors are not homogeneous. The market is composed of many participants with a large number of different time horizons (Slide 7) - ranging from the milliseconds or seconds for a high frequency trader, through the days or weeks for a hedge fund to the years or decades for a pension fund. Two. These different time horizons interpret the same fundamental information differently (Slide 8). For example, a short-term technical trader interprets a rising price as a buy signal. Whereas a long-term fundamental value investor interprets the same information as a sell signal. Slide 7 Slide 8 Three. The market price reflects the combination of the short-term technical trader's interpretation of the information and the long-term value investor's interpretation of the same information (Slide 9). Crucially, this means the market is not efficient unless all time horizons are active in setting the price. Four. The stability of the market at a given price depends on plentiful liquidity - an adequate balancing of supply and demand at that price (Slide 10). When many different time horizons are active, the market is efficient and liquidity is plentiful. This is because different investors will disagree on the interpretation of the same information, and will trade with each other in volume without moving the price. Slide 9 Slide 10 However, if one time horizon becomes dominant, the market becomes inefficient and liquidity will evaporate. As investors become a 'groupthink herd', the healthy disagreement that is needed to create liquidity disappears. And the market loses its stability. So to answer the question 'why' markets are fractals, it is clear that the short-term investors generate the short-term patterns while long-term investors generate the long-term patterns. And to answer the question 'so what', it is clear that if the fractal structure breaks down, it is a warning sign that liquidity is evaporating and the market is losing its stability. Next we must discuss how we can measure the market's fractal structure, and for this I'm going to digress a little and ask you a famous question. How long is Britain's coastline? This is the question that the grandfather of fractals, Benoit Mandelbrot, first asked in 1967. Actually, it's a trick question. The answer is that there is no answer! You see a coastline is also a fractal. And the more detail you capture and measure, the longer it becomes (Slide 11). The point is that with a fractal structure you cannot measure its length or size. But the good news is that you can measure its extent of 'fractal-ness' using something called a fractal dimension. In fact the next slide (Slide 12) shows how Mandelbrot first defined the fractal dimension of Britain's coastline. Slide 11 Slide 12 Then a couple of years ago we thought why don't we extend this concept to a financial market? After all, a price chart is similar to a coastline, except that distance is replaced with time. In fact, the maths is a little more complicated, but this is how we ended up defining the fractal dimension of a financial market (Slide 13). Bear in mind that you won't find this or any of the following analysis in any textbook because it is our own unique work. Rest assured, you don't need the maths to understand the concept intuitively. Think of it like this (Slide 14). A market that is not trending tends to sweep out 2-dimensional space. So its fractal dimension might be close to 2. But a market that is trending gets less and less fractal and closer and closer to a perfect 1-dimensional line. So its fractal dimension drops close to 1. Slide 13 Slide 14 And now we get to our findings, which are both remarkable and uplifting. When we applied our unique definition of fractal dimension to different financial markets in different historical timeframes, we discovered that the tipping point of instability turned out to be exactly the same across different historical eras, geographies and asset classes. We had come across a universal property of financial markets, irrespective of generation, culture or investment. Financial markets tended to reverse their near-term trend when the fractal structure between the 65-day investment horizon and the 1-day investment horizon disappeared. Specifically, when the 65-day fractal dimension dropped to 1.25. So we called this the "Universal Constant Of Finance". You can see that this universal constant applied to the top and initial bottom of the market during the 1929 Wall Street Crash (Slide 15), and to the top and bottom of the 1987 Crash (Slide 16). It also perfectly picked the tops and bottoms of the 1990 Nikkei Crash (Slide 17), and the 1993 Bond Market Crash (Slide 18). Slide 15 Slide 16 Slide 17 Slide 18 Some financial markets also tended to reverse long-term trends when the fractal structure between the 60-month investment horizon and the 1-month investment horizon disappeared. Specifically, when the 60-month fractal dimension dropped to 1.25. You can see here (Slide 19) how this has perfectly picked many of the structural turning points in the dollar. And when we see the rare star-alignment of a long-term signal coinciding with a near-term signal, it can predict a very strong reversal in a short space of time. This is precisely what we saw ahead of crude oil's sharp bounce in early 2016 (Slide 20 and Slide 21). So to conclude (Slide 22): Slide 19 Slide 20 Slide 21 Slide 22 Financial markets are efficient only when all investment horizons are present and active in setting the price. In other words, when the market has a rich fractal structure. When investment horizons converge to a groupthink herd, the fractal structure breaks down, and the fractal dimension nears its lower bound. This is a warning sign of an impending liquidity-triggered trend reversal, either short-term or long-term. I am now happy to take any questions. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com

Special Report

Feature Debt and leverage sit at the core of global investors' concerns over China's macro situation. Our recent conversations with clients confirm that fears of an "imminent" Chinese crash have abated, but investors remain fundamentally uncomfortable with China's seemingly ever-rising debt levels, and are concerned that a proverbial day of reckoning will eventually come, dragging the world into severe recession. Amid these deeply rooted woes, some investors have failed to detect China's cyclical improvement since early last year, and have been caught off guard by the powerful risk-on rally in some asset classes, such as commodities and emerging markets. We have addressed China's debt issue extensively in various reports of late. This week, we add to views articulated in a report penned by my colleague Peter Berezin, chief strategist of our Global Investment Strategy team, titled, "Does China Have A Debt Problem Or A Savings Problem?" Taken together, we intend to shed light on this complicated issue and dispute some commonly held misperceptions. In a nutshell: China's massive buildup of debt is rooted in the country's vast domestic savings and a financial intermediation system that relies heavily on the banking sector. It is wrong to discuss the debt problem without understanding China's basic macro features. (See also China Investment Strategy special report, "Chinese Deleveraging? What Deleveraging!" dated June 15th 2016).1 Therefore, China's rising debt is the mirror image of the accumulation of savings through investment. In this vein, assessing the debt situation essentially boils down to assessing the viability of China's capital spending. In our China Investment Strategy special reports, "How Much Does China Overinvest," dated May 4th 2016, and "The Myth Of Chinese Overcapacity," dated October 6th 2016,2 we found no systemic evidence of massive misallocation of capital, as claimed by many. In fact, the "efficiency" of Chinese capital spending is either comparable or superior to global norms, according to our calculations. While investors and analysts fixated on China's "debt bubble" focus almost entirely on the country's rising debt-to-GDP ratio, we have looked beyond this widely scrutinized conventional indicator by checking corporate financial statements for the true leverage situation at the micro level. In China Investment Strategy special reports, "Rethinking Chinese Leverage," dated October 27th, 2016, and "Rethinking Chinese Leverage, Part II,"3 dated January 5th 2017, we concluded that China's corporate debt situation in terms of both leverage ratios and debt sustainability is far from as precarious as widely perceived. It goes without saying that we are not completely sanguine about the increase in Chinese corporate debt, and we fully appreciate the risk that banks' asset quality would inevitably suffer in an economic downturn. We differ, however, on whether the expected increase in non-performing assets held by banks would degenerate into a financial crisis with chaotic consequences. In our China Investment Strategy special report, "Stress-Testing Chinese Banks," dated July 27th 2016,4 we made the case that Chinese banks would be able to withstand a dramatic increase in non-performing loans without suffering systemic stress, and that the market had priced in a rather extreme situation that in our view was unjustified. Finally, mounting concerns on China's macro debt situation among investors have broad-brushed virtually all Chinese stocks. Almost all Chinese sectors have been trading at steep discounts to their global counterparts, despite comparable leverage and profitability conditions at the micro level. This, in our view, represents market mispricing, and the large valuation gap will eventually be arbitraged away. This is the fundamental reason for our strategically positive assessment on Chinese stocks, especially H shares. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, “Chinese Deleveraging? What Deleveraging!,” dated June 15, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, “The Myth Of Chinese Overcapacity,” dated October 6, 2016, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, “Rethinking Chinese Leverage, Part II,” dated January 5, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report, “Stress-Testing Chinese Banks,” dated July 27, 2016, available at cis.bcaresearch.com. Does China Have A Debt Problem Or A Savings Problem? There is little evidence of a major "credit bubble" in China. Rising debt is largely the consequence of the country's high saving rate. This has mixed implications for global bonds: On the one hand, an exaggerated fear of a hard landing in China has kept global bond yields below where they would otherwise be; on the other hand, high levels of Chinese savings will continue to weigh on real long-term yields. The real trade-weighted RMB will depreciate by a further 3%-to-5% over the next 12 months, with the bulk of the decline coming against the U.S. dollar. Chinese shares are still attractive at current valuation levels. Go long the H-share market versus the MSCI EM index. The China Question Recent Chinese economic data have been fairly solid and our China analysts expect that growth momentum will be sustained over the coming months.5 Nevertheless, there are plenty of clouds on the horizon. Direct fiscal spending has slowed sharply over the past 12 months. In addition, a crackdown on property speculation last year has led to a deceleration in home price inflation, which could adversely affect household spending and construction later this year. Then, of course, there is all that debt. There is no shortage of commentators who argue that China is experiencing a full-blown credit bubble. Others contend that rising debt in China is largely a manifestation of a chronic excess of domestic savings. Knowing which side is correct is critical for investors. If China is in the midst of a massive credit bubble, then it is natural to fear that this bubble will burst fairly soon. This could prove to be devastating to global financial markets. In contrast, if rising debt in China mainly reflects an overabundance of savings, then it is possible that debt will continue rising until those savings dissipate - something that may not happen for many years. We won't beat around the bush. Our view is that rising debt in China has largely been the result of excess savings. This implies that a financial crisis in China is unlikely anytime soon. That does not mean that China will cease being a source of occasional investor angst. But if another major global recession is coming, it will not be because of China. The Debt-Savings Tango Endless ink has been spilled on the question of whether savings create bank credit or bank credit creates savings. In reality, the answer is "both": Just like income can create spending and spending can create income, savings can create debt and vice versa. If an economy is operating at less than full employment, the decision by banks to extend new credit is likely to boost aggregate demand, leading to more hiring. This will raise household disposable income and potentially lift aggregate savings.6 On the flipside, if households decide to save a bit more, this will push down real interest rates. That, in turn, could entice firms to increase how much they borrow and invest. Debt creates savings, and savings create debt; it's a two-way street. Admittedly, thinking through the specific forces underlying the relationship between debt and savings is one of those things that can make your head spin. Thus, it is worthwhile to go through a few simple examples in order to elucidate the principles at work. With this knowledge in hand, we will be able to debunk many of the fallacies that investors routinely succumb to. Cuckoo For Coconuts: How To Think About Debt And Savings Imagine a small island economy consisting of 100 people, each of whom toils away producing 100 coconuts every year, resulting in annual GDP of 10,000 coconuts. Consider the following five examples, summarized in Table 1: Table 1Cuckoo For Coconuts:##br## Debt Creates Savings, Savings Create Debt Example #1: Each person consumes 100 coconuts. As a result, a total of 10,000 coconuts are consumed. Total savings is zero, as is total investment. No debt is created. Example #2: Each person consumes only 75 coconuts, selling the other 25 coconuts to a nearby plantation. The plantation buys these coconuts with the help of a bank loan and plants them, resulting in 2,500 new coconut trees. Total consumption falls to 7,500. Savings and investment equals 2,500 coconuts. 2,500 coconuts worth of bank loans are created. Notice that higher savings have led to more debt. Example #3: Same as Example 2, but now instead of selling the excess coconuts to a nearby plantation, they are exported abroad. Savings equal 2,500 coconuts, investment is zero, and the current account surplus is 2,500. The island accumulates 2,500 coconuts worth of foreign assets. The lesson here is that if a country can export some of its excess savings abroad, debt may not need to rise by as much as if the savings had to be intermediated by the domestic financial system. Note also that this example reveals the famous economic identity: S-I=CA. Example #4: Each person consumes 125 coconuts, made possible by importing 25 coconuts per person. Consumption now equals 12,500 coconuts. Savings equal -2,500 coconuts, investment is zero, and the current account deficit is 2,500. The island takes on 2,500 coconuts worth of external debt. Example #5: Half the island's residents consume 75 coconuts each, while the other half consumes 125 coconuts each. Those who consume 75 coconuts sell their surplus nuts on the open market, placing the proceeds in a bank. The bank lends out these savings to the other half of the population. Net savings and investment is zero. However, 1,250 coconuts worth of new bank loans are created. Debt Puzzles The key idea stemming from these examples is that debt is often formed when there is a persistent divergence between spending and income.7 This is true for the economy as a whole, as well as for its individual constituents (households, firms, and the government). Understanding this point helps resolve a number of seeming puzzles. For instance, it is sometimes alleged that China's debt buildup cannot be the result of the country's high saving rate because U.S. debt also rose rapidly in the years leading up to the financial crisis, an era during which the U.S. national saving rate was very low. Our simple examples demonstrate why this is a misleading argument. Examples 2, 4, and 5 show that debt levels will rise regardless of whether income exceeds spending or spending exceeds income. It is the absolute difference between the two that matters, not whether the residual is positive or negative. In Example 2, which is applicable to China today, households spend less than they earn. The resulting savings are intermediated by the financial system and transformed into investment, creating new debt along the way. In Example 4, which is applicable to the U.S. before the financial crisis, households spend more than they earn, leading them to take on new debt in order to finance imports. The increase in debt may get amplified, as in Example 5, if some households save while others dissave. As discussed in Box 1, Example 5 also helps explain why inequality and debt levels tend to rise and fall together over time. The Future Of Chinese Household Savings Chinese household savings now stand at nearly 40% of disposable income, notably higher than in other major developed and emerging economies. The increase in China's household savings, along with a widening gap between rich and poor, have been important drivers of faster debt growth (Chart 1). As time goes by, China's household saving rate will begin to decline due to the aging of its population, the expansion of household credit, and the emergence of a stronger "consumer culture." Yet, that shift is likely to be a gradual one. Progress in building out a social safety net has been painfully slow. This has forced households to maintain high levels of precautionary savings. The share of China's population in its 'prime savings years' (between the ages of 30-and-59) will also continue to increase over the next 15 years, which should support an elevated saving rate (Chart 2). Chart 1China: Higher Saving Rate And ##br##Inequality Went Hand In Hand With Debt Growth Chart 2China: Share Of Population In Its High Saving Years ##br##Has Not Yet Peaked In addition, sky-high property prices have forced young people to save a large fraction of their incomes in order to have any hope of owning a home. This is particularly true for men. Brides are in short supply in China. The saving rate among single-child households with one son is about four percentage points higher in rural areas and two percentage points higher in urban areas, compared to single-child households with one daughter. One academic study concluded that about half of the increase in China's household saving rate since the late-1970s could be attributed to this factor.8 Unfortunately, this problem is not going to go away anytime soon. The ratio of men between the ages of 25-and-39 and women between the ages of 20-and-34 - a proxy for gender imbalances in the marriage market - will surge from 1.06 at present to 1.35 by the middle of the next decade (Chart 3). What do countries with surplus savings and surplus men tend to do? Historically, the answer is that they have sent them off to fight. China's military spending has grown by leaps and bounds over the past decade (Chart 4). This trend is bound to continue, making East Asia an increasingly likely setting for future military conflicts.9 Chart 3A Shortage Of Chinese Brides Chart 4China: A Lot Of Dry Powder Understanding Chinese Corporate Debt Dynamics Many companies around the world rely heavily on retained earnings and equity sales to finance new investment projects. When this happens, investment can take place without the need for the creation of new debt. China has its fair share of consistently profitable companies that fund capital expenditures using internally generated funds, while tapping the equity markets as necessary to finance larger projects. However, the country is also awash with companies that are in constant need of debt financing. Perhaps not surprisingly, the former tend to be private firms while the latter are often state-owned enterprises (SOEs). Chart 5China: State-Owned Companies Are Not The Only Ones ##br##With Access To Cheap Financing Pundits like to assert that the secret to boosting growth in China is to wean these money-losing public companies off cheap credit, forcing them to cut back on production and capital spending. This will allow scarce economic resources to migrate to better-managed firms that will use them more wisely. But is this really a sensible assumption? What exactly is the evidence that China's well-run private companies have been starved of credit because most of it is flowing to money-losing companies? The data does not fit this "crowding out" story at all (Chart 5). The Japan Analogy A more sensible narrative is that the Chinese government has been prodding state-owned banks into lending money to state-owned companies and local governments in order to support aggregate demand and keep unemployment from rising. The experience of Japan is instructive here. Starting in the early 1990s, Japan entered an extended era where the private sector was trying to spend less than it earned (Chart 6). In order to keep unemployment from rising, the Japanese government was forced to try to export these excess savings abroad via a current account surplus or, failing that, absorb them with dissavings from the public sector. While Japan was able to lift its current account surplus from 1.4% of GDP in 1990 to 3% of GDP in 1998, this was not enough to fully offset the surge in desired private-sector savings. This necessitated the government to run large budget deficits. The same sort of fiscal trap now stalks China. Up until the Great Recession, China was able to export much of its excess savings. The current account surplus hit a record high of nearly 10% of GDP in 2007. In effect, China was doing what the islanders in Example 3 were able to do. The subsequent appreciation of the RMB undermined this strategy, forcing the government to take steps to boost domestic demand. It is no surprise that China's debt stock began to grow rapidly just as its current account surplus started to dwindle (Chart 7). Chart 6Japan Relied On Fiscal Largess And ##br##Current Account Surpluses To Offset The Rise In ##br##Private-Sector Savings Chart 7China: Debt Increased##br## When Current Account Surplus ##br##Began Its Descent Keep in mind that fiscal policy in China entails much more than adjustments to government spending and taxes. Central government spending accounts for a fairly small share of GDP. The vast majority of fiscal stimulus is done via the banking system. This makes Chinese fiscal policy nearly indistinguishable from credit policy. From this perspective, China's so-called "debt mountain" is not much different from Japan's debt mountain once we acknowledge that the bulk of China's corporate debt in China is, in fact, quasi-fiscal debt. As evidence, note that in sharp contrast to the SOE sector, the ratio of liabilities-to-assets among private Chinese companies has actually been trending lower over the past decade (Chart 8). Yes, many of the investment projects undertaken by SOEs and local governments are of questionable economic merit. But that's beside the point. China's money-losing SOEs are the equivalent of Japan's fabled "bridges to nowhere." From the Chinese government's point of view, an SOE that is producing something is still preferable to one that is producing nothing. The ever-rising debt burden that these state-owned firms must carry to cover operating losses and finance new investment is just the price the government must pay to keep the economy afloat. Little Evidence Of A Genuine Credit Bubble Genuine credit bubbles tend to happen during periods of euphoria. U.S., Spanish, and Irish banks all traded at lofty multiples to book value on the eve of the financial crisis, having massively outperformed their respective indices in the preceding years. That's obviously not the case for Chinese banks today, which remain one of the most loathed sectors of the global equity market (Chart 9). Chart 8Chinese Private Firms: Liabilities-To-Assets##br## Trending Lower For A Decade Chart 9Chinese Banks: Unloved And Unwanted The U.S., Spanish, and Irish housing booms also occurred alongside ballooning current account deficits, something that doesn't apply to China (Chart 10). One can debate whether China is in the midst of a property bubble, but even if it is, it looks a lot more like the one Hong Kong experienced in the late 1990s. When that bubble burst, property prices plummeted by 70%. Yet, Hong Kong banks were barely affected (Chart 11). Chart 10Recent Credit Bubbles##br## Developed Amid Widening Current Account Deficits Chart 11Hong Kong##br## Is The Correct Analogy Chart 12Chinese Debt: Not Predominately Tied ##br##To The Property Market There is a lot of debt in China. However, most of it has not been centered on the property market (Chart 12). Rather, just as in Japan, debt has served a fiscal purpose - it has been used to absorb the excess savings of the private sector, so as to keep unemployment from rising. Chart 13 shows that national saving rates and debt-to-GDP ratios are positively correlated across emerging economies. China sits close to the trend line, suggesting that its debt stock is roughly what you would expect it to be. Chart 13Positive Correlation Between National Savings And Indebtedness Investment Conclusions Where does this leave investors? For global bonds, the implications of our analysis are somewhat mixed. On the one hand, the high probability that the Chinese government can maintain the status quo of continued credit expansion for the foreseeable future means that a hard landing for the economy - and the associated drop in safe-haven developed economy government bond yields that this would trigger - is unlikely to occur. On the other hand, high levels of Chinese savings will continue to fuel the global savings glut, keeping real long-term bond yields lower than they would otherwise be. On balance, investors should maintain a modest underweight allocation toward global bonds. Our analysis does not warrant either a very bearish or very bullish stance towards the RMB. Granted, a banking crisis could prompt Chinese savers to look for ways to move more of their money overseas, leading to further capital flight and a tumbling currency. As noted, however, such an outcome is not in the cards. On the flipside, a chronic shortfall of domestic demand will keep the pressure on the government to try to export excess production abroad by running a larger current account surplus. As we foretold in our March 2015 report "A Weaker RMB Ahead," this will push the authorities to weaken the currency.10 We expect the real trade-weighted RMB to depreciate by a further 3%-to-5% over the next 12 months, with the bulk of the decline coming against the U.S. dollar. If China averts a debt crisis, that's good news for global equities. In the developed market universe, Europe and Japan stand to benefit the most, given the cyclical bent of their stock markets. We are overweight both regions (currency hedged). Despite a weak start to the year, both markets have outperformed the U.S. in local-currency terms since bottoming last summer, a trend we expect will resume over the coming months (Chart 14). What about Chinese shares specifically? Clearly, there are many risks facing the Chinese economy that transcend debt worries, a possible trade war with the U.S. being the prominent example. Yet, considering that Chinese stocks trade at fairly cheap valuation levels, our sense is that these risks have been more than fully priced in by investors. With this in mind, we are going long Chinese H-shares relative to the overall EM basket.11 Chart 15 shows that H-shares now trade at a substantial discount to the EM index. Chart 14Euro Area And Japan: Rebound Will Continue Chart 15Chinese Investable Stocks Are Cheap Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com Box 1 Debt And Inequality Chart 16U.S.: Positive Correlation Between ##br##Income Inequality And Debt-To-GDP Income inequality and the ratio of private debt-to-GDP have been positively correlated in the U.S. over the past century (Chart 16). The existence of this relationship is not merely due to a third factor: economic growth. Growth was strong in the 1920 and 1980s/90s - two periods of rapidly increasingly inequality - but it was also strong during the 1960s, a decade when inequality was falling. Our analysis helps shed light on this relationship. Return to Example 5, but this time assume that each resident consumes 100 coconuts, with half the population producing 75 coconuts and the other half producing 125 coconuts. 10,000 coconuts are still produced and consumed in aggregate, resulting in no net savings. But because half the population is borrowing money to acquire coconuts from the other half, debt levels still rise. Higher inequality leads to more debt. To be sure, the correlation between inequality and debt runs in both directions. Rising debt has historically led to an expansion of the financial sector. This has helped enrich Wall Street elites. In this way, rising debt can exacerbate inequality. On the flipside, rising income inequality entails a shift of income from poorer households - with high marginal propensities to consume - to richer ones - who generally save a large fraction of their income. This tends to reduce aggregate demand. Lower aggregate demand, in turn, leads to lower real rates, making it easier for poorer households to load up on debt and live beyond their means. 5 Please see China Investment Strategy, "Be Aware Of China's Fiscal Tightening," dated February 16, 2017, available at cis.bcaresearch.com. 6 A few technical caveats are in order. Think of a simple closed-economy "Keynesian" model where aggregate demand determines income and where savings (S), by definition, are equal to investment (I). In this model, investment is usually treated as exogenous. Thus, if increased bank credit is used to finance new investment projects, this will also translate into higher savings (i.e., if "I" goes up, "S" must also rise). In contrast, if the credit ends up flowing into consumption, savings will remain unchanged. More plausibly, one can imagine that investment is subject to an "accelerator effect," so that increased aggregate demand prompts firms to increase capital spending. In that case, even if the credit flows into consumption, investment will still rise - and since savings is equal to investment, this means that savings will also go up. Intuitively, this happens because the increase in income derived from higher employment more than offsets the increase in consumption. This leads to higher aggregate savings. 7 The word "persistent" is important here. To see why, suppose that in Example 5, the people who consumed 125 coconuts each had previously been thrifty, which had allowed them to build up large bank deposits. Then they could finance their additional spending by running down their accumulated savings, rather than taking on new debt. Likewise, if those who consumed 75 coconuts had previously lived beyond their means, then instead of adding to their deposits, they would be paying back existing debt. The net result would be less debt, not more. 8 Shang-Jin Wei and Xiao Zhang, "The Competitive Saving Motive: Evidence From Rising Sex Ratios And Savings Rates In China," Journal of Political Economy, Vol. 119, No. 3, 2011. 9 Please see Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 10 Please see Global Investment Strategy Weekly Report, "A Weaker RMB Ahead," dated March 6, 2015, available at gis.bcaresearch.com. 11 The exact trade is to be long China H-Shares versus the MSCI Emerging Market index, currency unhedged. The corresponding ETFs for this trade are the Hang Seng Investment Index Funds Series: H-Share Index ETF (2828 HK), and the iShares MSCI Emerging Markets ETF (EEM US). The Hang Seng China Enterprise index comprises of China H-Shares (Chinese stocks available to international investors) currently trading on the Hong Kong Stock Exchange. Cyclical Investment Stance Equity Sector Recommendations

Highlights Crude-oil fundamentals stand out among commodities because of the active efforts by critical producers to rein in supply since the end of last year. This can be seen in even-higher compliance with the production accord - a supply shock in many ways - negotiated by the Kingdom of Saudi Arabia (KSA) and Russia: Last month, Reuters estimated 94% compliance on the 1.2mm b/d in cuts pledged by OPEC states. We expect compliance to remain high, which will strengthen the divergence between oil prices and the USD, as markets look toward the upcoming summer driving season in the Northern Hemisphere. Active supply management and robust demand growth wrought by lower prices could continue to overwhelm a strong USD's influence on oil prices, if this Agreement becomes a durable modus operandi for KSA and Russia going forward. We give a high probability to this outcome, even as the Fed leans into its interest-rate normalization. Energy: Overweight. This past Thursday, we closed our long WTI Dec/17 vs. short Dec/18 backwardation spread at +$0.96/bbl (Dec/17 over); it was initiated February 9 at -$0.11/bbl (Dec/17 under), resulting in a 972.7% gain. We also closed our Dec/19 short WTI vs. long Brent spread, elected February 6 at +$0.07/bbl (WTI over) at -$1.17/bbl (WTI under), for a gain of 1,771.4%. Base Metals: Neutral. Any demand uptick for base metals' coming from U.S. fiscal stimulus will not hit markets until 2H18 at the earliest. We remain neutral. Precious Metals: Neutral. Based on last week's analysis, we are tactically long a Jun/17 gold put spread (long the $1200/oz put vs. short the $1150/oz puts) and call spread (long the $1275/oz call vs. short the $1325/oz calls) at a net debit of $21/oz. Ags/Softs: Underweight. The USDA expects continued demand from China to keep soybeans relatively well bid versus corn and wheat in the 2017/18 crop year. Total planted area for these crops is expected to be the lowest since 2011, keeping ending stocks flat to lower. Feature Prior to the end of the 1990s, crude-oil prices were, to use one of the most popular catch-phrases in finance, mean-reverting: The price of crude oil imported to the U.S. averaged just over $19/bbl from Mar/83, when WTI futures began trading, to 1999 (Chart of the Week). This meant WTI traded at ~ $20/bbl on average over that period. Prices were volatile, but pretty much returned to $20ish/bbl, which allowed traders to take a view on how soon prices would revert to their mean. Whenever prices were too far removed from that level, markets expected producers - OPEC mostly - to adjust output to meet current and expected demand conditions. Since roughly 2000 - maybe a little earlier - oil prices have followed a random walk.1 During this time, oil prices have been negatively correlated with the broad trade-weighted index (TWI) for the USD. One striking characteristic of oil prices and the USD TWI during this time is both followed random walks, which "like the walk of a drunken sailor, wanders indefinitely far, listing with the wind," to borrow Paul Samuelson's well-turned metaphor (Chart 2).2 Chart of the WeekOil's Past As Prelude: ##br##A Return To Mean Reversion? Chart 2Oil Prices And The USD Followed ##br##A Common Long-term Trend Until 1Q16 We believe this was caused by OPEC's decision to become a price-taker at the end of the 1990s - shortly after Dec/98 or thereabouts - after years of unsuccessfully trying to manage oil prices via production adjustments. After the price of oil imports in the U.S. dropped below $10/bbl (nominal), it appears the Cartel took the decision to respond to prices set by market forces (supply, demand, inventories and exchange rates), and to abandon its price-management efforts. The long-term correlation between oil and the USD was due to the fact that while oil prices and the USD followed random walks, they followed a common long-term trend as they wandered indefinitely about. This held up to the end of 1Q16, when a massive sell-off in risky-asset markets globally took oil prices below $30/bbl (Chart 3).3 This came on the heels of a price collapse brought about by OPEC's Nov/14 decision to launch a market-share war. By no means did this high correlation mean oil and the USD were always moving in lock step. The collapse in oil prices at the end of the last century led to a production-cutting agreement among OPEC states, Norway and Mexico, which lifted U.S. import prices from less than $10/bbl at the end of 1998 to $30/bbl by Nov/00. Likewise, export disruptions in Venezuela in 2002 - 2003 and, to a lesser extent, hurricane losses in the U.S. Gulf in 2005 sharply curtailed supply and lifted oil prices above what could have been expected given the USD's level at the time, as the Chart of the Week shows.4 End Of Oil's Random Walk? The price collapse of 1Q16 marked the bottom of the price move begun a few months prior to the Nov/14 market-share war declaration. The subsequent divergence between oil prices and the USD since then has been remarkable (Chart 4). The market-share strategy, which essentially allowed Cartel members to produce full-out and grab as much market share as possible, was engineered by KSA, and, we believe, initially was directed at undermining Iran's efforts to restore oil production lost to nuclear-related sanctions. From time to time, it also appeared OPEC was trying to retard the continued growth of shale-oil production in the U.S., which, by 2014, was increasing at an annual rate of more than 1mm b/d, enough to replace the entire output of Libya. Chart 3Close-up Of USD vs. ##br##Brent Divergence Chart 4The Divergence Between ##br##Oil Prices And The USD Is Remarkable This strategy was a complete failure. The price collapse that ensued brought KSA and Russia - both highly dependent on oil revenues - to the brink of financial ruin, compelling them to find a way to work together.5 After several false starts in 2016, they succeeded late in the year with a negotiated production cut. OPEC pledged to reduce output by as much as 1.2mm b/d, and non-OPEC producers agreed to cut output by close to 600k b/d, half of which is expected to come from Russia. Recent tallies by Reuters indicate 94% of the cuts from OPEC states that signed on to the deal have actually been realized.6 Should KSA and Russia find a way to coordinate their and their allies' production in a way that maintains the backwardation we expect later this year - the result of production cuts (Chart 5), and robust demand growth (Chart 6) - we could see oil prices become mean-reverting once again. Chart 5If KSA And Russia Can ##br##Coordinate Production ... Chart 6... And Demand Continues To Grow, ##br##The Oil-Price Backwardation Could Persist This likely requires the forward curves for WTI and Brent to remain backwardated, so as to moderate the growth in shale production, and for prices to remain between $55/bbl and $65/bbl, so as not to set off another shale boom. Gulf sources have indicated KSA prefers prices this year of ~ $60/bbl, which, we believe would allow it to keep some control over the rate at which shale production revives.7 Chart 7Supply Destruction And Robust Growth ##br##Rallied Oil Despite A Strong USD Investment Implications We are not calling for a return to mean-reversion in oil prices just yet. We are, however, highlighting the possibility for such a sea-change in the market if all the supply-side pieces fall into place - i.e., KSA, Russia and their respective allies find a way to work together to moderate U.S. shale-oil production. That said, we will be watching closely to see whether the KSA - Russia Agreement becomes a durable modus operandi in the oil market, particularly as regards the management of inventories and production in the market generally. If these states are able to keep prices ~ $60/bbl, and gain some control over the forward curve's slope - i.e., literally manage their production for backwardation - then there is a chance oil prices could once again become mean-reverting. In a mean-reverting world with backwardated oil prices, commodity-index exposure is favored, since investors would, once again, earn positive roll yields as the indices are rebalanced monthly in the underlying futures markets. Bottom Line: The persistent negative correlation between oil prices and the USD broke down following the global asset sell-off in 1Q16. Since then, the combination of supply destruction and robust demand growth has allowed oil prices to rally despite a strong USD (Chart 7). If KSA and Russia can continue to cooperate in their production-management deal - i.e., find a way to manage production so that prices remain closer to $60/bbl than not - and Brent and WTI forward curves backwardate, markets could once again become mean-reverting. In such a world, commodity-index exposures are favored - particularly those heavy on crude-oil and refined-products price exposure - for their positive roll yield. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Technically, oil prices have been I(1) variables (integrated of order 1) since about 2000, meaning they are mean-reverting in first differences (e.g., today's price minus yesterday's price). Please see Geman, Helyette (2007), "Mean Reversion Versus Random Walk in Oil and Natural Gas Prices," pp. 219 - 228, in Advances in Mathematical Finance. Haidar, Imad and Rodney C. Wolff (2011) obtained similar results, reporting crude prices were mean-reverting from Jan/86 - Jan/98, then random-walking since then; please see pp. 3 - 4 of "Forecasting Crude Oil Price (revisited)," presented at the 30th USAEE/IAEE North American Conference in Washington, D.C., during October 2011. Our own research corroborates these results - we find WTI and Brent were mean-reverting from Mar/83, when WTI futures started trading, to Mar/98; and were random-walking I(1) variables after that. 2 Please see Samuelson, Paul A. (1965), "Proof That Properly Anticipated Prices Fluctuate Randomly," in Industrial Management Review, 6:2. 3 This is to say, these variables were cointegrated, and could be expressed in a linear combination using an error-correction model. 4 Our colleague, Mathieu Savary, who runs BCA Research's Foreign Exchange Strategy, addressed these oil-USD divergences in "Party Like It's 1999," published November 25, 2016. It is available at fes.bcareseach.com. 5 We discuss this at length in the feature article of Commodity & Energy Strategy published September 8, 2016, entitled "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash." Both states were burning through cash reserves, and were trying tap foreign markets for additional funds by selling interests in their most valuable holdings - via the IPO of, and via the sale of just under 20% of Rosneft held by the Russian government. Russia placed its Rosneft shares late last year with Glencore and Qatar's sovereign wealth fund, while KSA is expected to IPO Aramco in late 2018. 6 Please see "OPEC compliance with oil curbs rises to 94 percent in February: Reuters survey," published by the news service online February 28, 2017. 7 Please see "Exclusive: Saudi Arabia wants oil prices to rise to around $60 in 2017 - sources," published by Reuters online February 28, 2016. Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of February 28, 2017. The model has maintained its large overweight in the U.S. Within the non-U.S. level 2 model, Spain and Italy weights have been increased at the expense of Japan and Switzerland. Japan and U.K. remain the two largest underweight countries. (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, both the level 1 and level 2 models outperformed their respective benchmarks in February, resulting in a 39 bps outperformance of the aggregate model vs. the MSCI World. Since inception, the GAA model has outperformed its benchmark by 30 bps. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of February 28, 2017. The momentum component has shifted Consumer Discretionary from overweight to underweight. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Associate Editor patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

How Long Is The Sweet Spot? Table 1Recommended Allocation The sweet spot on a baseball bat, scientists find,1 is the small area about two inches (5 cm) long, some six inches from the tip. The sweet spot for global risk assets may not be much bigger. The 22% rise in global equities since February last year has been driven by a "goldilocks" combination of recovering economic activity, quiescent inflation, and still-accommodative monetary policy. But, after such a strong rally, markets must walk a fine line - no slowdown in growth and no surprising tightening of monetary conditions - for prices to rise further. Our analysis suggests that they can, but the risk of a correction is rising. A lot of the better news of the past year has already been priced in. The price-to-sales ratio for U.S. stocks is close to an all-time high, and even the plain-vanilla 12-month forward PE ratio has reached 17.5x, the highest since 2002 (Chart 1). Volatility has fallen to a low level, with the VIX not rising above 12 over the past month, and the S&P500 index going 98 days without a one-day decline of 1% or more, the longest such period since 1995 (Chart 2). To a degree, this is justified by the recent strong pick-up in global growth. Sentiment indicators have accelerated since the election of President Trump, and even hard data is now showing the first signs of recovery (Chart 3) with, for example, U.S. retail sales rising 5.6% year-on-year in January, and core durable goods orders starting to follow the rise in companies' capex intentions (Chart 4). Similar positive economic surprises are visible in Europe, Japan, China and elsewhere. The problem is that further upside surprises are likely to be limited. Regional Fed NowCast surveys for Q1 real GDP growth are already at 2.5-3.1%. Consensus forecasts for S&P500 earnings growth in 2017 look about right at 10.5% but, with a stronger dollar and rising wages, are unlikely to be beaten. Chart 1Historically High Valuations Chart 2Time For A Pull-Back? Chart 3Hard Data Starting To Recover Too Chart 4Orders To Follow Capex Intentions Headline inflation has picked up (to 2.5% in the U.S. and 1.9% in the Eurozone), mainly because of higher oil prices, but core inflation remains sufficiently under control that central banks don't need to slam on the brakes. The rise in unit labor costs in the U.S. suggests that core PCE inflation will gradually move up to 2% during the year (Chart 5). The latest FOMC minutes revealed that members want a further rate hike "fairly soon", and BCA expects the Fed to raise three times this year (to which the futures market ascribes only a 36% probability). But Fed policy remains very accommodative (Chart 6), the European Central Bank is unlikely to end its asset purchases soon on account of political and banking system concerns, and the Bank of Japan remains committed to its 0% yield target for 10-year government bonds until inflation is well above 2%. Absent a powerful fiscal stimulus in the U.S. or a move by the "hard money" advocates in the Trump administration to change the Fed's modus operandi, we think its unlikely that a tightening of monetary policy will drag down asset prices. Chart 5Labor Costs Putting Pressure On Prices Chart 6Fed Policy Still Accomodative Risks certainly abound. The Trump administration could start a trade war with China. Its proposals for corporate and personal tax cuts could disappoint both in terms of their details and the timing of Congress's passing them. European politics remain a concern, with the probability of Marine Le Pen becoming French President increasing recently (though it remains small). But risk markets tend to rise on a wall of worry. Investor sentiment is not particularly bullish at the moment, with the bull/bear ratio among individual investors barely above 1 (Chart 7) and flows into equity funds in recent months not reversing the outflows of last year (Chart 8). Chart 7Retail Investors Not So Bullish Chart 8Equity Flows Are Still Tepid After a year of a strong cyclical risk-on rally, progress from now on will get tougher. A short-term change of direction is quite possible (and has already happened in some assets, with the yen moving back to 112 and the 10-year Treasury yield to 2.3%). But we expect economic growth to remain robust this year - with U.S. real GDP growth likely to come in close to 3% on the back of surprises in capex - which will push the 10-year Treasury yield above 3% by year-end. In this environment, we continue to favor equities over bonds, and maintain our pro-risk tilt in equity sectors, credit and alternative assets. Equities: U.S. equities have outperformed Eurozone ones by 5% year-to-date, mainly because of worries about Europe's political risk and the fragility of its banking sector. Though we think the political risks are overstated (except perhaps in Italy), we continue to prefer the U.S. in common currency terms because of our expectations of further dollar appreciation and because the lower volatility of the U.S. helps reduce the beta of our recommended portfolio. Emerging markets have outperformed global equities by 3% YTD, mainly on the back of stronger commodities prices. But we remain underweight EM because of the risks from a stronger dollar and rising global rates, concerns about protectionism and debt refinancing, and because of the likelihood that China's rebound will run out of steam over the next 12 months (Chart 9). Fixed Income: Rates have pulled back recently: long-term institutional investors have begun to find attraction in the long end of the U.S. Treasury yield curve at 2-3%, though speculative investors remain short (Chart 10). With the Fed likely to raise rates three times this year, inflation expectations to pick up further, and nominal GDP growth in the U.S. to reach 4.5-5%, we expect the U.S. 10-year yield to rise above 3%. We therefore remain underweight duration and prefer inflation-linked over nominal bonds. In the improving economic environment, we continue to like credit, but find valuations more attractive for investment-grade bonds than for high-yield. Currencies: Dollar appreciation has been on hold since January but we think the long-term trend remains in place because of the probable direction of relative interest rates. Neither Japan nor the Eurozone is likely to move towards monetary tightening over the next 12 months. Even if the Trump administration were to want a weaker dollar, a few tweets would not be enough to offset monetary fundamentals. And, while it is true that sentiment towards the dollar is already bullish, this has historically not precluded further appreciation, for example in the late 1990s (Chart 11). Chart 9EM Equities Correlated With China PMIs Chart 10Divergent Views On U.S. Bonds Chart 11Optimism Need Not Stop USD's Rise Commodities: The oil price remains close to its equilibrium level at around $55 a barrel, with the OPEC agreement largely holding but being offset by a production increase from the U.S. shale drillers, whose rig count has doubled since last May. We are neutral on industrial commodities: Chinese demand resulting from last year's reflationary policy is likely to be offset by the stronger dollar. Gold remains a useful portfolio hedge in a world of elevated geopolitical worries and inflation tail-risk, but is also negatively correlated with the U.S. dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see, for example, "The Sweetspot of a Hollow Baseball or Softball Bat", by Daniel A. Russell, Pennsylvania State University, available at www.acs.psu.edu/drussell/bats/sweetspot.html Recommended Asset Allocation Model Portfolio (USD Terms)