Financial Markets

Highlights Global manufacturing inventories are low but this does not guarantee higher share prices for global cyclical stocks. If an increase in inventories is accompanied by strengthening final demand, it will be very bullish for the global business cycle. If final demand growth falters, global cyclical plays will relapse amid rising inventories. China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out raising the odds of a reversal in EM/China plays sooner than later. The risk/reward of EM/China plays remains unattractive. Feature Global Manufacturing Inventories Global manufacturing inventories have been depleted over the past 12 months, and inventory levels are generally low (Chart I-1 and Chart I-2). Chart I-1Global Manufacturing Inventories Are Low Chart I-2Global Manufacturing Inventories Are Low Could inventory re-stocking extend the current manufacturing cycle recovery worldwide? Will low inventories and re-stocking in China lengthen the nation's business cycle upswing? Chart I-3 demonstrates inventory cycles and manufacturing production within manufacturing-intensive economies. The correlation is not stable. Currently, this entails that low manufacturing inventories and a potential rise in inventories over the course of this year do not guarantee acceleration in industrial output growth. Having reviewed manufacturing inventory cycles and their correlation with share prices, we conclude that the key to share prices is final demand - not inventory swings. Manufacturing inventories have dropped in the past 12 months because final demand has been robust (Chart I-4). Historically, periods of re-stocking have often coincided with poor equity market performance. Indeed, Taiwanese, Korean, Japanese and German non-financial share prices have no stable correlation with their respective manufacturing inventory cycles (Chart I-5). In short, manufacturing inventories could rise in the months ahead, but this does not guarantee higher share prices in cyclical industries. Chart I-3Inventories And Production ##br##Are Not Always Correlated Chart I-4Robust Demand Has Led ##br##To Inventory Depletion Chart I-5Non-Financial Share Prices And##br## Inventories: Little Correlation By and large, the outlook for corporate profits is contingent on final demand rather than re-stocking. All of the above confirms that inventories are a residual of demand and supply. Stronger-than-expected demand is bullish for share prices, though it also often coincides with declining inventories. By contrast, rising inventories typically reflect demand falling behind output growth (one can define it as involuntary re-stocking) and these periods are not favorable for share price gains in cyclical industries. One caveat is that there could be a re-stocking cycle amid strengthening demand or, in other words, voluntary re-stocking. If this transpires in the coming months, it will be extremely bullish for share prices as it will supercharge output growth. While the latter scenario - inventory re-stocking amid strengthening final demand - could very well occur within the advanced economies this year, odds of such positive dynamics are low in EM/China. Bottom Line: Share prices in global cyclical sectors are driven by swings in final demand - not in inventories. Going forward, global manufacturing inventories will rise. If this rise is accompanied by strengthening demand, it will be very bullish for the global business cycle. Otherwise, global cyclical plays will relapse as inventories rise. What Drives China's Inventory Cycles Chart I-6 shows that China's manufacturing inventories typically deplete when the credit and fiscal impulse is rising, and vice versa. China's manufacturing inventories have been exhausted because demand has been strong in the past 12 months. In turn, demand strength has originated from the country's massive fiscal and credit stimulus push from the first half of 2016. Chart I-6China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction That said, China's aggregate fiscal and credit impulse seems to have recently rolled over, pointing to a top in its manufacturing mini-cycle and commodities prices (Chart I-7). This signals a potential deceleration in final demand. On the whole, the ongoing modest tightening by the People's Bank of China and by the bank regulator (the China Banking Regulatory Commission) amid a lingering credit bubble is raising the odds of a moderate credit slowdown in the months ahead. Even modest credit growth deceleration will result in a negative credit impulse (Chart I-8, top panel). Meanwhile, the mainland's fiscal impulse has already dropped (Chart I-8, bottom panel). Chart I-7China: Aggregate Credit And Fiscal##br## Stimulus Has Topped Out Chart I-8China: A Breakdown Of Credit ##br##And Fiscal Impulses On the whole, these developments are leading us to maintain our negative bias toward EM risk assets and China plays. What has gone wrong in our view/analysis on China in the past 12 months is that the nation's credit growth has stayed much stronger than we expected. In our April 13, 2016 report,1 we did a scenario analysis and argued that China's large fiscal stimulus push would be offset by a negative credit impulse if credit growth slowed from 11.5% to below 10%. In reality, credit growth has been between 11.5-12.5%, producing a positive credit impulse. Barring tightening by the central bank or bank regulators, mainland banks can continue originating loans/money at a double-digit pace, as they have been doing for many years (Chart I-9). In general, commercial banks do not need savings to create money/loans and there are few limits on Chinese banks originating loans "out of thin air," as we argued in our Trilogy of Special Reports on money/loan creation, savings and investment.2 Chart I-9China's Credit/Money Growth##br## Remains Rampant Therefore, if credit growth does not slow, our negative view on China's growth will be off-the-mark again. The pressure point in such a case will be the exchange rate. Unlimited money creation/oversupply of local currency is bearish for the value of the RMB. The RMB will continue depreciating, but it is not certain if it will hurt EM risk assets. It is a major consensus view nowadays that the Chinese authorities will not allow growth to suffer ahead of the Party Congress in autumn of this year. Yet, the PBoC and bank regulators are modestly tightening to "normalize" credit growth. Some clients may wonder why we are placing so much emphasis on the rollover of credit and fiscal impulses now, while placing little emphasis on these same indicators in 2016 when they were recovering. The rationale is as follows: when there is a credit bubble - as there is in China now - we tend to downplay the importance of policy easing and put more significance on policy tightening. The opposite also holds true: when the credit/banking system is healthy, we tend to downplay the impact of moderate policy tightening and put greater emphasis on policy easing. In a credit bubble, it does not take much tightening to trigger a downtrend that unwinds excesses. Similarly, moderate tightening in a healthy credit system should not be feared. From a big picture perspective, we turned bearish on China's growth several years ago due to the formation of a credit bubble. The bubble has only gotten larger and an adjustment has not yet even started. This does not justify altering our fundamental assessment of China's growth outlook. It would have been ideal to turn positive tactically on EM/China plays a year ago. Unfortunately, we did not do that. Presently, chasing the market higher might not be the best investment idea. Based on all this and given: the sharp rally in EM/China plays and widespread investor complacency and consensus that "everything" will be fine before the end of this year; modest tightening in Chinese monetary policy amid lingering credit and asset (property and the corporate bond market) bubbles; our outlook for higher U.S. bond yields and a stronger U.S. dollar; the fact that financial markets are forward looking, and timing is impossible; We believe the risk/reward of EM/China plays remains unattractive. In regard to EM ex-China, as we documented in last week's report, domestic demand in the developing economies has not recovered at all, or is mixed at best. DM final demand strength and global manufacturing inventory rebuilding will certainly help Korea and Taiwan, but not other emerging economies. The most important variables for other EM economies including China are domestic demand and/or commodities prices. If commodities prices relapse along with China's credit and fiscal impulse (Chart I-7, bottom panel), EM financial markets will suffer regardless of the growth trends within advanced economies. In fact, strong U.S. growth could lead to higher U.S. interest rate expectations and prop up the U.S. dollar. This will also be a bad omen for EM and commodities. Bottom Line: China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out, raising the odds of a reversal in EM/China plays sooner than later. Industrial Metals Inventories And Prices There is no good data reflecting industrial metals inventories globally. London Metal Exchange and Shanghai Futures Exchange data are likely not indicative of global metals stockpiles. China accounts for close to 50% of global demand for industrial metals, and its demand is critical to prices. Given that the large spike in metals prices in the past several months has coincided with improving Chinese economic data, one would expect the mainland to be the driving force behind the rally. However, Chart I-10 demonstrates that China's imports of industrial metals actually contracted in 2016. This is puzzling, but we have to take it at face value. The top panel of Chart I-11 depicts that traders' net long positions in copper are at a six-year high. This might partially explain the rally in copper in the recent months. Chart I-10China's Import Of Base Metals##br## And Base Metals Prices Chart I-11Traders Are Long ##br##Copper And Oil Clearly, China has been depleting its stock of industrial metals, and is likely primed to increase its imports. Nevertheless, periods of metals re-stocking by the mainland have historically not entailed higher industrial metals prices (Chart I-10). On the contrary, rising Chinese imports of metals have actually coincided with falling prices. One can interpret this relationship as China buying industrial metals when prices are falling. This is consistent with China attempting to buy commodities on dips. As to metals inventories in China, the picture is as follows: Steel inventories have plummeted and are low (Chart I-12). One can safely argue that there will be an inventory re-stocking cycle in China. Nevertheless, it is highly uncertain if this will be bullish for steel prices and steel stocks. In fact, there has been a mild negative correlation between steel prices and inventories; historically, when inventories have risen, prices declined (Chart I-12, top panel). This confirms that inventory levels are a residual of demand and supply, and prices are often driven by final demand - not inventories. This is also corroborated by the bottom panel of Chart I-12, which illustrates that share prices of global steel companies are sometimes negatively correlated with China's steel inventories. Stock prices occasionally sell off when inventories rise, and rally when inventories are shrinking. In contrast to steel and steel products, iron ore inventories have risen, and it seems the re-stocking cycle is well advanced (Chart I-13). Chart I-12China: Steel Inventories And Prices Chart I-13China: Iron Ore Inventories And Prices Yet, again there is no strong correlation between inventories and prices of iron ore (Chart I-13). In our discussions with clients, investors often attribute the rally in industrial metals in general and steel prices in particular over the past 12 months to supply cutbacks in China. While supply reductions have helped in the case of certain metals, it is also evident that the rally in industrial commodities has been driven by rising demand globally and in China. First, China's aggregate credit and fiscal impulse was positive until very recently, implying strengthening demand and thereby higher metals prices. Second, if there were only production cutbacks in steel and other commodities and not demand recovery, the mainland's manufacturing PMI would not have risen (Chart I-14). Finally, steel production has risen both in China and the rest of the world (Chart I-15). Hence, world steel supplies have expanded in the past 12 months. Given this has coincided with rising steel prices, it confirms there has been notable improvement in demand for steel. Chart I-14China: Steel Prices Are Up ##br##Because Of Strong Demand Chart I-15Chinese And Global ##br##Steel Production We are not experts in the ebbs and flows of commodities supplies, but it seems the Chinese government's mandated steel capacity cutbacks have not prevented rising steel output in China. In the meantime, rising prices amid rising production and falling inventories are indicative of robust final demand for many metals. Bottom Line: Industrial metals prices have risen because demand in the real economy and among financial investors has been strong. That said, a rollover in China's fiscal and credit impulse and a strong U.S. dollar will likely create headwinds for industrial metals prices over the course of this year. A Word About Oil Inventories OECD oil product inventories have continued to rise, despite supply cuts (Chart I-16, top panel). At the same time, our proxy for change in China's oil inventories has been very elevated for a while, depicting strategic and/or commercial inventory building on the mainland (Chart I-16, bottom panel). It is true that supply curtailments have been instrumental to the rally in oil prices, but the continued inventory buildup also indicates that supply is still outpacing demand. Besides, traders' net long positions in crude have spiked close to their 2014 highs (Chart I-11, bottom panel). This corroborates that demand for crude, like for copper, has partially been financial rather than from final consumers. Finally, U.S. rig counts have recovered somewhat, which may be indicative of a continued rise in America's oil output (Chart I-17). Chart I-16Oil Inventories Keep On Rising Chart I-17U.S. Rig Counts And Oil Production Bottom Line: While we do not have expertise to follow or forecast oil supply dynamics, we are biased in believing that the risk-reward for oil prices is unattractive because of a strong U.S. dollar and potentially weak EM/China asset prices, which could trigger a reduction in net long positions in crude. Investment Conclusions Complacency reigns in the global financial markets. EM equity volatility has fallen close to its cycle lows, the U.S. VIX is depressed, U.S. equity investor sentiment is very elevated and EM corporate credit spreads have plummeted to a ten-year low (Chart I-18). While the timing of a reversal is impossible, the risk-reward profile of EM financial markets is greatly unattractive. The U.S. trade-weighted dollar has consolidated recently, and might be primed for another upleg. As the U.S. dollar resumes its uptrend, EM risk assets will likely sell off. Finally, EM share prices have failed to outperform the developed bourses much, despite the rally in commodities and amelioration in Chinese growth (Chart I-19). Chart I-18Complacency Reigns Chart I-19EM Equities Have Not Yet Outperformed Remarkably, analysts' net earnings revisions for EM stocks have so far failed to turn positive (Chart I-20). Either analysts' EPS expectations were originally still too high, or companies are failing to deliver profits. Whatever the reason, the implication is that the consensus is more bullish on EM than is suggested by the underlying fundamentals. Within an EM equity portfolio, our overweights remain Taiwan, Korea, India, China, Thailand, Russia and central Europe. Our underweights are Malaysia, Indonesia, Turkey, Brazil and Peru. We are neutral on other bourses. Finally, the EM equity benchmark is at a critical technical resistance level (Chart I-21) but odds do not favor a sustainable breakout. Chart I-20EM EPS Net Revisions Are Still Negative Chart I-21EM Stocks: A Breakout Attempt Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Revisiting China's Fiscal And Credit Impulses", dated April 13, 2016, available at ems.bcaresearch.com 2 Trilogy of Special Reports on money/loan creation, savings and investment, titled, "Misconceptions About China's Credit Excesses" dated October 26, 2016, "China's Money Creation Redux And The RMB", dated November 23, 2016 and "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Fed & Yields: Positive U.S. growth and inflation momentum is maintaining the credibility of the Fed's 2017 rate hike plans. U.S. bond yields, in particular, and global yields, in general, will remain under upward pressure in this environment, despite the aggressive short positioning in the U.S. Treasury market. Maintain a below-benchmark portfolio duration stance. "Soft" vs. "Hard" Data: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The cyclical outlook Down Under has become murkier of late, even with the RBA starting to shift in a more hawkish direction. We are taking profits on our recommended pro-growth tilts in Australia. Feature The positive momentum on global growth continues to put upward pressure on bond yields, despite the large short positioning already in place in the government bond markets. The benchmark 10-year U.S. Treasury yield returned to 2.5% at one point last week, led by a rash of better-than-expected data on U.S. retail sales and inflation, combined with hawkish comments from numerous Fed officials (Chart of the Week). Markets started to more seriously consider a March Fed rate hike, although we still see June as the more likely date for the Fed's next tightening move. As we have discussed in several recent reports, it is a surge in global economic survey data that suggests that a broad-based upturn currently underway. While this is all good news for risk assets, there is some concern among investors that a pick-up in growth has been slow to appear clearly in the "hard" economic data related to final demand. Without a boost in actual economic activity, and not just "feel good" surveys, the pro-growth momentum currently embedded in equity and bond markets may melt away as rapidly as it was built up. Mark McClellan, the Chief Strategist at BCA's flagship publication, The Bank Credit Analyst, is releasing a report this week that digs into the differences between "soft data" (i.e. surveys) and "hard data" (i.e. employment and production).1 We present some excerpts from that report in the following section. Global Growth Pickup: Fact Or Fiction? Investors have taken some comfort from the fact that leading indicators are trending up across most of the developed and emerging economies. BCA's Global Leading Economic Indicator is moving higher and will climb further in the coming months given that its diffusion index is well above 50 (Chart 2). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook. Chart of the WeekNo Bond-Bearish Data In The U.S. Chart 2A Consistent, Positive Message On Growth Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart 3). Importantly, the improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Indices (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. The good news is that there is more to the cyclical upturn than hope. The improved tone in the forward-looking data is now clearly showing up in some measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, we start with some bad news. There has been a worrying loss of momentum in job creation in recent months (Chart 4). While employment gains have accelerated in Japan, Canada and Australia, the payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart 3Surging Confidence, Production Following Suit Chart 4Global Employment Growth Cooling Off Also on the positive side, households are opening their wallets a little wider according to the retail sales data (Chart 5), where growth has accelerated sharply in all the major economies except U.K. and Australia (NOTE: we discuss the Australian bond outlook later in this Global Fixed Income Strategy report). Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart 6). The acceleration of imported capital goods for our 20-country global aggregate corroborates the stronger new orders reports (bottom panel). Chart 5On Your Mark, Get Set, Shop!! Chart 6Global Capex Cycle Turning Positive Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across all of the major advanced economies (Chart 7). Production growth has been particularly robust in the Eurozone, U.K. and Japan. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart 8). Chart 7A Global Manufacturing Upturn Chart 8A Broad-Based Acceleration At the moment, the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. The Soft Data Chart 9Global GDP Growth Is Accelerating Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that President Trump's election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey are all measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. To test the reliability of the growth message from the "soft data", we employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart 9). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter of 2017. We expect growth of close to 3% in the U.S. and a little over 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 2% in the first quarter based on these indicators. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Stronger Chinese capital spending in 2017 will boost imports and thereby support activity in China's trading partners, particularly in Asia. Conclusions We have little doubt that a meaningful global growth acceleration is underway. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. American CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts or trade wars. This economic backdrop is positive for risk assets and bearish for government bonds. Bottom Line: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The Equation Gets More Complicated Two weeks ago, the Reserve Bank of Australia (RBA) unsurprisingly left its cash rate unchanged at 1.5%. The post-meeting statement by RBA Governor Philip Lowe was considered hawkish by economic analysts. Nonetheless, the market reaction has been relatively muted, with the Australian government bond yield curve steepening by only 5 bps, and the Aussie dollar remaining stable, since the meeting. Pricing in the OIS curve suggests that the RBA will probably remain on hold throughout 2017, but the implied odds of a rate hike are rising, standing now at 20%. The RBA's assessment of the current global economic backdrop was relatively constructive, pointing to above-trend growth expectations in a number of advanced economies. Domestically, the RBA foresees a boost to Australian export growth from the resource sector, an end to the decline in mining investment and a pick-up in non-mining capital spending.3 With such a tone, the central bank might have set up the market for some disappointments. The new forecast of economic growth around 3% for the next couple of years seems overly optimistic. This is higher than the median expectation of economists surveyed by Bloomberg, who foresee 2.5% and 2.8% growth for 2017 and 2018, respectively. The IMF does not expect growth to reach 3% until 2019. Granted, several parts of the economy have shown very robust performances of late. The service sector PMI has surged to pre-crisis levels. The NAB survey of business conditions also shot higher last week. Goods exports have exploded at a 40% annual growth rate, causing the December trade balance to jump to $3.5bn, nearly double the consensus $2.0bn estimate (Chart 10). Those jumps in activity are hard to ignore. From a big picture perspective, however, Australian economic data has not been surprising to the upside, unlike the trend in in the rest of the world over the past few months (Chart 11). This is intriguing, since an easy monetary policy, loose bank credit conditions, improving profit expectations and a reflationary impulse coming from China were all tailwinds that should have supported Australian growth; this was our view last year.4 Now, those favorable factors have started to reverse, raising the chances of a cyclical economic downturn. Chart 10Surging Numbers Chart 11Surprisingly Unsurprising Foremost, overall labor market conditions are uninspiring (Chart 12): Although the monthly employment change for January did positively surprise, at 13.3k versus an expected 10k, the pace of job creation remains under 1% year-over-year, which is low by historical standards. The diverging trend between plunging full-time and steady part-time job growth indicates a sub-optimal labor market. The labor force participation rate declined from 65.2 to 64.6 in 2016, suggesting an increasing amount of discouraged workers. Underemployment has not budged in the last two years and is stuck at historically high levels. As result, a rise in labor market slack poses a risk for the Australian consumer; wage growth has already been in a downtrend since 2011 (Chart 12, bottom panel). The construction sector further confirms our apprehensions on the true strength of the economy. Households believe that it is not a good time to buy a home, while building approvals for new dwelling units fell from bubbly levels at the end of last year. At the same time, speculative money, which was supposed to have been curbed by macroprudential policy measures, has returned to the housing market (Chart 13). Lower supply and increased speculation could push residential prices even higher, inflating debt burdens, and leaving households with fewer dollars to consume. Chart 12Consumption: Set To Deteriorate Chart 13The Foundations Are Shaking Externally, the Chinese reflationary mini-boom - which boosted the prices of iron ore and other commodities exported by Australia last year - will probably retreat to some extent in 2017. Although China's overall cyclical momentum remains solid, according to our GFIS China Checklist,5 government spending growth has severely relapsed, potentially signaling an end to last year's largesse (Chart 14). With that in mind, it has become difficult to envision a continuation of the positive effects from the terms of trade shock experienced by Australia in 2016. In a similar vein, but domestically-driven, Australia's credit growth has become a headwind. Between 2013 and 2015, business credit growth was expanding, creating a positive impulse for the economy. Unfortunately, this trend changed tack in 2016, with slowing credit growth now representing a negative economic force (Chart 15). With Australian banks having suffered declining profits and rising bad debt charges in the last few quarters, credit conditions could tighten going forward. This is especially worrisome since personal credit was already contracting in 2016. Chart 14China Mini-Boom Could Be Over Chart 15Negative Credit Impulse top of all this, the IMF is projecting that Australia's fiscal thrust - the change in the primary government budget balance - will be negative in each of the next five years (Chart 16). As such, this economy could run out of supporting impulses in the short to medium term. Summing it all up, we agree with the current market pricing of interest rates, given the economic uncertainties. The RBA will most likely remain on hold for the foreseeable future. The story remains the same; the central bank wants to depreciate the overvalued Aussie dollar, but excesses in the housing market prevent them from weakening the currency through interest rate cuts (Chart 17). Now, the declining cyclical outlook will only complicate the equation. Chart 16Negative Fiscal Impulse Chart 17The RBA Has Little Room To Maneuver Investment Implications Our updated and more balanced economic view of Australia leads us to neutralize our recommended pro-growth Australia bond tilts: Asset allocation. As discussed above, the previously favorable factors supporting the Australian economy are progressively reversing. This is not the case in most of the other bond markets where additional cyclical upward pressure on global yields is anticipated. To reflect this view, today we are upgrading our recommended Australian bond exposure to neutral, from below-benchmark, within global hedged bond portfolios. This underweight position produced +188bps of excess return versus the global benchmark since inception in June 2016. Duration. The 10-year Australian government bond yield, 1-year forward, is 3.04%, 25bps above the current yield of 2.79%. There is a good chance that yields will rise at a faster pace than implied by the forwards at times over the course of the year, given the improving global growth and inflation backdrop. However, these instances will be opportunities to extend duration within dedicated Australian fixed income portfolios. Current Australian government bond valuation has become very cheap and is now at a level that has been associated with the beginning of positive absolute performance in the past. Moreover, the 10-year inflation breakeven is already pricing in a fair amount of inflation increases; those expectations will be hard to surpass, especially considering the low starting point (Chart 18). Curve. In May 2016, we initiated an Australian butterfly curve trade, going long the 2-year/6-year barbell versus the 4-year bullet. At the time, the 2/4/6 part of the government bond yield curve was kinked, with the 4-year sector trading very expensive versus the 2-year and 6-year maturities, reflecting the perception of a dovish stance by the RBA. then, the market has priced out these rate cut expectations, as we expected, and this part of the curve has bear steepened (Chart 19). Today, we close this trade at a +36bps profit. The RBA's future potential actions - or, more likely, inaction - are now properly discounted in the curve and reflect our neutral stance on the RBA. Chart 18Time To Buy Australian Bonds Chart 19Taking Profits On Our 2/4/6 Butterfly Trade Credit trades. Developing economic uncertainties warrant more cautiousness towards Australian credit. In March 2016, we recommended going long Australian semi government debt versus federal government bonds as an initial way to play what was, at the time, a relatively constructive view on the Australian economy.6 Now, given the increased economic risks, we are closing this relative value trade with a +133bps profit. Mark McClellan, Senior Vice President markm@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President rrobis@bcaresearch.com 1 Please see The Bank Credit Analyst, Section II, "Global Growth Pickup: Fact Or Fiction?," dated March 2017, available at bca.bcaresearch.com 2 Machinery orders used for Japan 3 http://www.rba.gov.au/media-releases/2017/mr-17-02.html 4 For details, please see BCA Global Fixed Income Strategy Weekly Report, "Last Minute Recommendations Before The Brexit Vote," dated June 21, 2016, available at gfis.bcaresearch.com 5 For details concerning this indicator, please see BCA Global Fixed Income Strategy Weekly Report, "How To Assess The "China Factor" For Global Bonds," dated November 11, 2016, available at gfis.bcaresearch.com 6 Please see BCA Global Fixed Income Strategy Special Report, "Australian Credit: Time To Test The Waters," dated March 29, 2016, available at gfis.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 Monetary Policy: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Economy: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. High-Yield: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Feature Chat 1A Hawkish Market Reaction After having been relatively subdued in the two months since the Fed's last rate increase, rate hike expectations priced into money market curves awakened last week following Janet Yellen's semi-annual Congressional testimony. Expectations priced into the overnight index swap curve have returned close to levels last seen on the day of the December 2016 FOMC meeting (Chart 1). As of last Friday's close, the market was priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. The implied probability of a March hike peaked at 34% last Wednesday.1 In this week's report we discuss why a March rate hike is unlikely. We also consider the outlook for U.S. economic growth in 2017, which we expect will remain decidedly above trend. Above-trend growth will allow the gradual increase in core inflation to persist, reaching the Fed's target by the end of the year. As a result, the Treasury curve will bear-steepen during this timeframe. To position for this outcome, investors should maintain below-benchmark duration and favor the belly (5-year bullet) of the curve relative to the wings (2/10 barbell) in duration-matched terms.2 Yellen's Hawkish Turn? Most news reports of Janet Yellen's testimony last week perceived a hawkish tone in her remarks and focused specifically on the following sentence: As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.3 However, more important than the above boilerplate is the simple fact that inflation remains below target and the Fed has an incentive to tread cautiously to support its eventual recovery. There is no pressing need to move quickly on rate hikes and we expect that the next rate increase will not occur until June. One reason is that, in the current cycle, the Fed has not lifted rates without having first guided market expectations in the months leading up to the hike. As can be seen in Chart 2, rate hike probabilities implied by fed funds futures were already well above 50% one month prior to each of the last two rate hikes. If there was a strong desire to lift rates in March, Yellen would have likely sent a more powerfully hawkish signal in her testimony last week. Instead, Yellen chose not to mention the March meeting specifically and said only that the Fed would continue to evaluate the case for further rate hikes at its upcoming "meetings". Chart 2Market-Implied Rate Hike Probabilities: March Looks Too High Second, as was alluded to above, core PCE inflation is running at 1.7% year-over-year, still below the Fed's 2% target. What's more, long-dated TIPS breakeven inflation rates are also below levels that are consistent with inflation being anchored near the Fed's target (Chart 3). At present, the 5-year/5-year forward TIPS breakeven rate is 2.17%. Historically, a range of 2.4% to 2.5% is consistent with inflation at the Fed's target. Further, even though a strong January core CPI print, released last week, seemed to strengthen the case for a March hike, the details of the report show that only a few components (new cars +0.9% m/m, apparel +1.4% m/m, and airline fares +2.0% m/m) accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in contractionary territory (Chart 4), it is very likely that inflation will soften in the coming months. Chart 3Inflation Still Too Low Chart 4Inflation Recovery Not Broad Based Both our own and the Fed's forecasts for continued inflation increases are contingent on the view that tight labor markets are causing wage pressures to mount, and certainly wages have accelerated during the past few years. However, wage growth in both real and nominal terms is still below where the Fed would like it to be, and there has been scant evidence of wage acceleration during the past few months. While the Atlanta Fed's Wage Growth Tracker remains strong in nominal terms, it has leveled off in real terms, and both the Employment Cost Index and Average Hourly Earnings have recently been flat (Chart 5). A final factor that will prevent the Fed from lifting rates in March is the extremely high degree of policy uncertainty. As shown in Chart 6, economic policy uncertainty traditionally correlates with financial conditions. With financial markets having already discounted a very positive fiscal policy outcome, there is a heightened risk that some disappointing news on the fiscal front will lead to a sharp tightening of financial conditions in the near term. Such an event would definitely put the Fed on hold until financial markets recovered. Chart 5Fed Needs Wage Growth To Pick Up Chart 6Policy Uncertainty Remains Elevated Bottom Line: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Policy Aside, U.S. Growth Is Heating Up Chart 7ISM Surveys Point To Strong Growth Most recent economic discussion has focused on when President Trump will get around to enacting some of the more stimulative parts of his policy agenda, and whether or not the impact of these policies (tax cuts, infrastructure spending) will ultimately be offset by other spending cuts. But in the meantime, leading indicators of GDP growth have been picking up steam. Both the manufacturing and non-manufacturing ISM surveys point to an increase in GDP growth in the first quarter (Chart 7), and consistently, the New York Fed's tracking model suggests Q1 GDP will grow by 3.1%. The Atlanta Fed's GDP tracking model pegs Q1 growth slightly lower at 2.4%. Our own sense is that GDP growth will remain solidly above trend this year, in the range of 2.5% to 3%, even in the absence of major fiscal stimulus. This forecast hinges on the view that both residential and non-residential investment will rebound from the depressed levels seen last year and that consumer spending will remain strong. Residential Investment Chart 8Residential & Non-Residential Investment Residential investment was actually a drag on GDP growth for two quarters in 2016, even though leading indicators such as the months supply of new homes and homebuilder confidence remained supportive (Chart 8, panels 1 & 2). The progress made on foreclosures since the financial crisis has driven housing inventory to its lowest level since the mid-1990s,4 meaning that housing supply no longer poses a headwind to construction. Further, demographics should also help boost the housing market during the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the Millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.5 While rising mortgage rates will be a drag on housing at the margin, they will not pose a significant headwind to residential investment in 2017. At least so far, mortgage purchase applications have been resilient in the face of rising rates (Chart 8, panel 3). Non-Residential Investment Non-residential investment was a small drag on growth in 2016, but this was largely related to depressed investment in the energy sector (Chart 8, panel 4). Now that the oil price has recovered, non-residential investment should return to being a small positive contributor to growth. Our composite indicator of New Orders surveys also suggests that non-residential investment will trend higher this year (Chart 8, bottom panel). While there is some concern that the optimism displayed in these survey measures may not filter through to the "hard" economic data, a Special Report from our Bank Credit Analyst publication that will be published on Thursday concludes that a tangible growth acceleration is indeed underway throughout the G7. Consumer Spending As always, the consumer is the main driver of U.S. growth and we expect consumer spending will remain firm in 2017. Our U.S. Investment Strategy service recently undertook a detailed analysis of consumer spending,6 focusing on its two main drivers - income growth and the savings rate (Chart 9). A look at past cycles suggests that income growth can remain strong even after the economy reaches full employment as rising wages compensate for decelerating payroll growth (Chart 10). The recent spike in consumer income expectations suggests that the impact from rising wages might be particularly important in the current cycle (Chart 10, panel 1). Chart 9Consumer Spending Is Driven By Income Growth And The Savings Rate Chart 10Wages Can Drive Income Growth Another benefit of the economy reaching full employment is that increased job security can translate into greater consumer confidence and a lower savings rate (Chart 9, bottom panel). Confidence trends suggest that the savings rate has scope to decline during the next few months. One possible headwind to consumer spending is the recent tightening of consumer lending standards. The Fed's Senior Loan Officer Survey for the fourth quarter of 2016 shows that lending standards on auto loans have tightened for three consecutive quarters and that credit card lending standards also recently spiked into "net tightening" territory. In other words, more banks are now tightening lending standards on consumer loans than easing them. Prior to the financial crisis, consumer lending standards were strongly correlated with the savings rate (Chart 11). More stringent lending standards slowed the pace of consumer credit growth and led to reduced consumer spending. But this relationship broke down following the financial crisis. After the housing bust, households were no longer eager to supplement their consumption with as much credit as possible. Their chief concern became repairing their own balance sheets. As such, the supply of credit is no longer the most important driver of the savings rate. In the data, we observe that the savings rate did not fall by as much as would have been predicted by easing lending standards in the early years of the recovery. As a result, we do not think that modestly tighter lending standards will have much of an impact either. The Fed's latest Senior Loan Officer Survey also showed that demand for consumer credit declined sharply in 2016 Q4. This is potentially more worrisome for the savings rate since lower credit demand may still suggest a reduced appetite for spending, even in the wake of the Great Recession. However, a look back at prior cycles shows that loan demand from the Senior Loan Officer Survey tends to decline several years prior to the next recession, but the savings rate has tended to stay low until the next recession actually hits (Chart 11, bottom panel). We would not be surprised to see the same dynamic play out again. Bottom Line: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. Chart 11Lending Standards Less Of A Risk Chart 12Default-Adjusted Spread A High-Yield Valuation Update With the release of the Moody's default report for January we are able to update our forecast for High-Yield default losses during the next 12 months, and also our High-Yield default-adjusted spread. The default-adjusted spread is our preferred valuation indicator for both High-Yield and Investment Grade corporate bonds. It is calculated by taking the option-adjusted spread from the Bloomberg Barclays High-Yield index and subtracting an estimate of expected default losses during the next twelve months (Chart 12). Default loss expectations are calculated using the Moody's baseline forecast for the 12-month High-Yield default rate and our own forecast of the recovery rate based on its historical relationship with the default rate (Chart 12, bottom two panels). The current reading from our default-adjusted spread is 152 basis points. Most of the time, a reading of 152 bps on the default-adjusted spread is consistent with small positive excess returns for both High-Yield and Investment Grade corporate bonds (Chart 13 & Chart 14). This is also consistent with the excess returns we expect from corporate credit this year. Chart 1312-Month Excess High-Yield Returns Vs. Ex-Ante ##br##Default-Adjusted Spread (2002 - Present) Chart 1412-Month Excess Investment Grade Returns Vs. Ex-Ante High-Yield##br## Default-Adjusted Spread (2002 - Present) In fact, when the default-adjusted spread is between 150 bps and 200 bps, 12-month excess returns to High-Yield have been positive in 65% of cases, with a 90% confidence interval placing 12-month excess returns in a range between -5.0% and +1.7%. Given the favorable economic back-drop of strong economic growth and accommodative Fed policy, we would expect High-Yield excess returns to be positive during the next 12 months. But given the tight starting valuation, probably not above +1.7%. Bottom Line: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculations of rate hike probabilities implied by fed funds futures are lower than those shown on Bloomberg terminals. Our measure differs because we use the actual data for the effective fed funds rate and also adjust for the well-known fact that the effective fed funds rate tends to fall by approximately 10 basis points on the last day of the month. 2 For further details on our recommended yield curve trade please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/testimony/yellen20170214a.htm 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see "The State Of The Nation's Housing 2016", Joint Center for Housing Studies of Harvard University. 6 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Add the S&P asset manager & custody banks index to the high-conviction overweight list. Prospects for higher interest rates bode well for a catch up phase with the rest of the financials sector. Initiate a long S&P consumer staples/short S&P technology pair trade, a truly out of consensus call. Housing-related equities are likely to gain ground as housing activity should stay resilient amidst rising borrowing costs. Recent Changes S&P Asset Managers & Custody Banks - Added to our high-conviction overweight list on February 16th. Long S&P Consumer Staples/Short S&P Technology - Initiate this pair trade today. Table 1Sector Performance Returns (%) Feature Momentum continues to drive the broad market trend. The drag from a reduction in global liquidity courtesy of depleting foreign exchange reserves continues to be overwhelmed by economic optimism. The latter is fueling a major rotation from bonds to stocks, which is the dominant market force. Valuations have taken a backseat, emblematic of blow-off phases. Two weeks ago we introduced our Complacency-Anxiety Indicator, which hit a new high. Another way to measure greed overwhelming fear is the relentless rise of the forward P/E over the VIX. The spread between these two measures can also gauge complacency. This Indicator has also soared to an all-time high (Chart 1). Chart 2 applies this methodology for the broad S&P sectors, using forward P/E and implied equity volatility, and then standardizes the result to remove biases from perennially low and high P/E sectors. A low reading suggests lower risk, and vice versa. Chart 1Buy At Your Own Risk Chart 2Sector Vulnerabilities And Opportunities At the moment, financials, telecom, utilities, REITs and health care have the lowest implicit vulnerability, while cyclical sectors carry the most risk. How long can this overshoot phase last? There are obviously no easy answers. However, from a purely technical perspective and in the absence of any major monetary, economic and/or geopolitical shocks, an examination of our Composite Technical Indicator (CTI) suggests some running room remains. Our CTI is driven primarily by momentum components. Overbought conditions are signaled once it hits one standard deviation above the mean. Currently, the TI remains slightly below this threshold (Chart 3). Even then, it can cross decisively into the danger zone before the S&P 500 eventually sells off in a meaningful fashion. Chart 3Overbought Conditions Can Persist Importantly, when the CTI swings quickly from deeply oversold to overbought levels, there can be a multi month lead before the broad market crests or suffers a sustained setback (Chart 3), and the bulk of those moves are associated with economic recessions and/or growth disappointments. The implication is that even though extended broad market valuations virtually guarantee paltry long-term returns and economic expectations are now sky-high, technical conditions suggest that momentum may continue to carry the day for a while longer. That does not mean investors should abandon a largely defensive portfolio structure, given that this is where the reward/risk tradeoff is most attractive and timing corrections is inherently difficult. Two weeks ago we recommended buying both gold and packaging stocks. As part of our ongoing rebalancing, this week we are further tweaking our portfolio. We recommend a pair trade to position for the inevitable sub-surface mean reversion heralded by our Indicators in the coming 3-6 months. Asset Managers: Shifting To High-Conviction Status The interest rate and market-sensitive S&P asset managers & custody banks index (AMCB) has lagged most other financials sub-indexes at a time when macro forces are lining up bullishly, particularly in view of the sector's attractive ranking on a forward P/E to volatility basis. While the capital markets and banks groups are seen as having higher torque to these positive forces, these three groups tend to move together. Lately, a divergence has opened, but a number of factors point to an imminent AMCB catch up phase (Chart 4), especially given that AMCB is not levered to overall credit growth, which has dried up. Fed Chair Yellen's testimony last week was interpreted to be slightly more on the hawkish side. That, coupled with the recent upside surprise in core inflation, raises the possibility of more 2017 tightening than currently discounted. That would provide further relief for custody banks, as ultra-low interest rates have been an anchor on this group's profitability as fees earned on funds held in trust have been minimal. The increase in short-term Treasury yields heralds a share price rally (Chart 5, top panel). Chart 4Catch Up Ahead Chart 5Time To Rally Moreover, the boost in economic expectations signals scope for an increase in fee generating activity, such as M&A, stock issuance and even stock lending. BCA's Global Economic Sentiment Index also indicates that the share price ratio has undershot (Chart 5). Most importantly, the asset preference shift from bonds to stocks reverses another major drag on profitability (Chart 5, third panel). Fixed income products carry lower margins than equity products, so as equity assets under management grow, profit margins should expand. If so, then we would anticipate a relative valuation re-rating, especially if the pace and scale of financial sector deregulation disappoints. The latter has been a key factor propelling capital markets and banks, and any disappointment could cause a capital rotation into the lagging AMCB index. Bottom Line: We are already overweight the S&P asset management & custody banks index, and added it to our high-conviction list in a daily Sector Insight on February 16th. New Pair Trade This week we are recommending what can be considered a highly contrarian pair trade: long the S&P consumer staples sector and short the S&P technology sector. It may be difficult to swallow executing such a non-consensus position while the broad market is going gangbusters. However, the objective message from our Indicators and increasing odds of a vicious, un-telegraphed correction, argue that the reward/risk trade-off is too attractive to ignore. As outlined in last week's Cyclical Indicator Update, the technology sector's relative earnings profile has deteriorated, because the corporate sector is not spending much yet and tech companies have suffered a serious loss of pricing power. Conversely, the consumer staples sector has a better chance of earnings outperformance, according to our model (Chart 6). Both sectors appear to have discounted the opposite outcome. Moreover, from a technical perspective, tech stocks are overbought and consumer staples are extremely oversold (Chart 6). Even a simple technical/momentum renormalization would imply a sharp jump in the share price ratio. Both sectors lose competitiveness when the U.S. dollar rise, but given that the technology sector's share of foreign sales (58%) is much higher than that of consumer staples (28%), the pain is disproportional. Importantly, consumer staples exports are accelerating, whereas tech exports are shrinking (Chart 7). Chart 6Contrasting Profiles Chart 7The Strong Dollar Is Worse For Tech Non-durable consumer goods are less sensitive to emerging market prospects, and thus when their currencies weaken, momentum in the consumer staples/tech share price ratio tends to accelerate (EM currencies shown inverted and advanced, bottom panel, Chart 7). Moreover, a strong U.S. dollar tends to reduce input costs for many consumer staples vendors, both through lower commodity prices and a reduced cost of imported goods sold. We have shown that tech stocks fare poorly toward the latter stages of a U.S. dollar bull market, when consumer staples start to shine. This dynamic reflects the economic fallout abroad from a strong U.S. dollar, particularly on developing economies, as well as the drag on U.S. corporate profits, and by extension, capital spending. While the U.S. dollar and stocks have risen in tandem in recent months, that cannot continue indefinitely, and when the correlation breaks down, the defensive consumer staples sector should outperform. In terms of economic dynamics, this share price ratio tends to accelerate when consumer spending outperforms capital spending. Consumer confidence is outpacing business confidence (Chart 8, top panel), signaling such an environment ahead. That sentiment mismatch has already translated into faster consumption than business investment on tech goods (Chart 8, second panel). Unless the gap between the return on and cost of capital reverses course and widens anew, then this trend is likely to persist. As a result, the surge in consumer staples vs. technology pricing power will continue, ultimately flattering the share price ratio through relative profit performance (Chart 8, bottom panel). The message is that consumer staples profits can have the upper hand over tech even when overall GDP growth is positive, provided the underlying driver is consumption rather than capital spending. From an external standpoint, it is notable that consumer staples have a better track record than tech stocks during inflationary periods. Chart 9 shows that the uptrend in long-term inflation expectations and increase in actual inflation both forecast a revival in this pair trade. Chart 8Unsustainable Divergences Chart 9Inflation Pressures? Buy This Ratio Rising inflation ultimately heralds tighter monetary policy, which is a precursor to elevated broad market volatility and a rise in the discount rate, to the detriment of long duration sectors. History shows that the high priced tech sector is more vulnerable than the safe haven staples sector in such an environment. In sum, the time is ripe for a contrary pair trade favoring consumer staples vs. technology. Notable risks to this trade are that the U.S. dollar weakens meaningfully and/or global capital spending re-accelerates decisively, relative to consumer spending. Bottom Line: We recommend a market neutral long consumer staples/short technology pair trade. The time horizon for this trade is 3-6 months. Will Housing Stocks Go Through The Roof? Housing-related stocks have delivered positive earnings surprises, but anxiety about rising mortgage rates challenges the outlook. While the latter is a risk, cheap valuations and consumers' underappreciated ability to absorb rising borrowing costs offset these concerns. Sensitivity analysis shows that even a 200 basis point (bps) spike in interest rates from current levels would fail to push housing affordability back to the long-term average (Chart 10). Moreover, mortgage payments as a percentage of incomes and effective borrowing costs would also remain below their respective historic means even with such a spike. Importantly, housing market fundamentals are improving. Lumber prices are on fire. Lumber has been the best performing commodity year-to-date. This is a real time indicator of housing demand (Chart 11). Similarly, railroad carloads of lumber are also firming, signaling that the price rise is demand-driven rather than a speculative bet in the trading pits. Sustained house price inflation, solid housing turnover and the acceleration in building permits reinforce that housing activity remains robust (Chart 11). Chart 10Higher Rates Are Not A Show Stopper Chart 11Lumber Strength Is Housing Bullish The credit tap to sustain strong activity is still open. According to the latest Fed Senior Bank Loan Officer Survey, banks are willing and able to extend residential mortgage credit (bottom panel, Chart 11). This contrasts with many other credit categories, where banks are tightening the screws and credit demand is faltering: C&I loans have shrunk over the past three months, as has total bank credit. First time home buyers are also reappearing and anecdotes of increased house flipping activity signal a vibrant market with unobstructed access to credit. All of this should continue to support earnings-led outperformance from both homebuilders and home improvement retailers (HIR). The bullish outlook for the S&P homebuilding index rests on four pillars. The latest National Association of Home Builders (NAHB) survey revealed that sales expectations remain over 20 points above the boom/bust line and just shy of recent cyclical highs (Chart 12). Homebuilders are clearly still seeing strong traffic. New home prices are still expanding at a healthy clip (Chart 12). Sales growth and new home price inflation are tightly linked. The mortgage application purchase index has picked up steam despite the mortgage rate increase, confirming that first time homebuyers are entering the market after a long hiatus as the financial motivation to buy vs. rent has improved. This optimism is causing an aggressive re-rating in earnings estimates from chronically bearish levels (Chart 12), a harbinger of further gains in relative share prices. The S&P HIR index also has a concrete foundation. Higher lumber prices flow straight to the bottom line, because HIR companies typically earn a set margin on lumber-related sales. Moreover, higher housing turnover is a boon for industry sales volumes (Chart 13). Historically, home sales momentum has been an excellent leading indicator of renovation activity. Chart 12Buy Homebuilders... Chart 13... And Building Supply Retailers Encouragingly, the NAHB remodeling survey is still in expansion territory, and tends to follow the trend in home sales, underscoring that home renovation activity is set to improve (Chart 13). Our HIR model encapsulates many of these key drivers, and has climbed anew (Chart 13). The message is that profits, and share prices, are on track to outperform. Adding it all up, the housing backdrop remains attractive, and even a steady increase in borrowing costs should not disrupt momentum. The time to become concerned will be if inflation becomes a serious risk, causing the Fed to get 'tight' and credit availability to dry up. The next few interest rate hikes won't move the monetary settings to that phase yet. Until then, we recommend erring on the bullish side. Bottom Line: We reiterate our high-conviction overweight in the S&P home improvement retail index (HD, LOW) and continue to recommend an above benchmark allocation in the S&P homebuilding index (PHM, DHI, LEN). Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Recent economic and inflation data can be characterized as Goldilocks: strong enough to keep recession fears at bay, yet not hot enough to warrant Fed tightening. Historical precedent suggests that the current period of positive economic surprises could persist for at least another month or two, fueling ever-more lopsided positioning into equities. Despite a lot of good news already discounted, we retain a cyclical bias toward small caps. Currently, the main driver of style performance is sector weightings. Value stocks are likely to perform slightly better than Growth by virtue of a smaller weighting in technology and larger weighting to financials. Higher conviction in Value stocks outperformance awaits better credit growth trends. Feature The term Goldilocks is used to describe an economy that is growing, but is not quite hot enough to create serious inflation risks, and not so cold that it fosters recession fears. Last week's major data reports fit this view of the world and helped U.S. equity prices soar to a new all-time high (Chart 1): NFIB Small Business Survey: Since small businesses have long been considered the job engine of the U.S. economy, monitoring the sentiment of small businesses owners, their likelihood to undertake expansion plans, and raise/cut prices, can often give a good glimpse into the likelihood of financial market trends to be sustained on a cyclical basis. In January, the NFIB small business sentiment indexes surged and to our surprise, the positive sentiment did not correct in February (Chart 2). The expectations component actually rose even further! Chart 1Rotation Into Stocks Chart 2Will Hopes Be Dashed? We continue to believe the survey reflects a lot of hope and is likely to reverse substantially. According to the survey, business conditions are the best in thirty years, save for a brief period in the early 2000s. Even the most ardent of Trump supporters will find it difficult to explain how a handful of executive orders and memoranda have so significantly altered the business landscape in such a short space of time! This radical shift in sentiment makes risk asset prices vulnerable: the pace of economic expansion has only gradually improved, but investors and other economic agents have drastically revised upward their expectations. Retail Sales: A number of cyclical tailwinds are beginning to finally align for consumers, as discussed in January 16 Weekly Report, and consumers appear to be in slightly better shopping moods in 2017. January retail sales beat expectations and prior months were revised higher. Spending improved across categories and these broad-based gains reinforce our view that the consumer can lead a gradual, self-reinforcing economic recovery (Chart 3). Inflation: We do not worry that cyclical inflation trends will be strong enough to force the Fed to raise rates faster than the FOMC's current expectations (three rate hikes by end-2017). True, both headline and core CPI were stronger than consensus expectations in January, and producer prices are in a noticeable uptrend. But this should not be viewed as the beginning of a new, more dangerous inflation problem. As Chart 4 shows, producer prices - at all stages of production - have been rising for the past few months. But only a fraction of any price rise at the producer level is likely to be passed on to consumers. Chart 5 shows that core goods prices have decoupled with finished goods producer prices (i.e. the last stage of production) since 2000. This speaks to the massive deflationary impulse at the end of the supply chain: a combination of deflation via imported goods, major technological advances in supply chain management and logistics, and changing consumer behavior in an e-commerce age means that consumers are not price takers. These factors imply that any budding inflation pressures will stay "trapped" at the earlier stages of the supply chain and it should not be a foregone conclusion that PPI can drive CPI prices higher. Chart 3Consumer Supports Are In Place Chart 4Producer Prices Turning Higher... Chart 5...But PPI Barely Leaks Into CPI Similarly, the rise in the headline inflation rate - for the first time since 2013 above core CPI - should not be viewed as an omen for what lies ahead for broader inflation trends. As Chart 6 shows, the relationship between energy prices and core CPI broke down during the early 1980s: a rise in energy prices does not correlate with non-energy consumer prices. Chart 6Energy Prices Uncorrelated With Core CPI Since The 1980s Finally, we note that despite general optimism about business conditions in the NFIB survey, the pricing backdrop remains a glaring exception. In the most recent survey, the number of businesses expecting to raise prices actually fell. With respect to last week's core CPI print, the monthly increase of 0.3% is unlikely to be sustained. A few components were behind the upside surprise. For example, new car prices increased 0.9% m/m, apparel prices rose 1.4% m/m and airline fares spiked 2.0% m/m. The usual suspects behind outsized price gains were actually quite tame in January. Homeowners' equivalent rents increased by 0.2% m/m versus several months of 0.3% gains. Similarly, medical care was up 0.2% m/m. Our CPI diffusion index fell further below the zero line, confirming that inflation pressures are not broad based. Perhaps the only negative development last week was that positive data surprises, combined with a slightly hawkish interpretation of Janet Yellen's testimony, have pushed forward the bond market's expectations of the next Fed interest rate hike. We expect the most likely outcome will be that the next rate hike will be in June. If that forecast proves correct, then any upward pressure on bond yields should be modest in the next few months. We do not expect a resumption of the cyclical bond bear market to be a headwind for stocks until later this year at the earliest. How long can the Goldilocks backdrop persist? As Chart 7 shows, positive economic surprises have been propping up financial markets alongside optimism about a Trump-led Republican government. Importantly, for the first time since 2011, positive economic surprises are occurring in the first quarter of the calendar year. During past episodes, this level (i.e. above 40) in the Economic Surprise Index has persisted for upwards of three months. The implication is that economic surprises may continue to help fuel the momentum in equity prices for another month or even longer. Chart 7Economic Surprises Could Persist A While Longer This corroborates our review two weeks ago of technical indicators, which showed that apart from extreme sentiment and despite the persistent run-up in equity prices, most short-term indicators are not yet flashing warning signs. In sum, recent data prints show that the U.S. economy is on sturdier footings. The absence of a meaningful inflation threat implies that a prolonged economic cycle can feed positive gains in the stock/bond ratio over a cyclical horizon. But these positive underpinnings cannot explain the speed and magnitude of the recent financial market adjustments. Although the bulk of our indicators suggest that positioning may become more lopsided in the short term, the current phase of the rally is high-risk. Size And Style Guide Several clients have asked about size and style investing in recent weeks. We remain overweight small caps relative to large, and are only slightly more optimistic about Value versus Growth. In the case of Value versus Growth, we echo the advice of our Global ETF strategy:1 the Value/Growth decision has become, more than ever, a matter of sector preference. As Table 1 shows, there are three sectors with vastly differing weights between S&P Growth and Value Indexes. The Value index is dominated by Financials (27% of the index, versus a 4% weight in the Growth index and 15% in the S&P 500) and Energy (12% in the Value Index versus 3% and 7% in the Growth and S&P 500 Indexes, respectively). Meanwhile, technology stocks make up a whopping 34% of the Growth Index. It is no wonder then that Value stocks shot higher on the back of a post-election financial sector outperformance streak (Chart 8). Financials (as well as the energy sector) received a big boost due to the promise of drastic de-regulation of the industry under a majority-Republican government. TABLE 1Sector Composition Our U.S. Equity Strategy service is underweight the technology sector, but only neutral on financials and energy stocks. On this basis, only a slight Value bias would make sense. At present, relative sector weightings appear to be the highest conviction argument in favor of a particular style, since many indicators that have reliably gauged style performance are not convincingly tilting in one direction or another. For example, growth stocks tend to need rising long-term earnings expectations to help them outperform. But this cycle, Growth stocks outperformed long before long-term earnings expectations started to move higher. Now that EPS have adjusted upward, it is hard to see - absent a repeat of the tech bubble in the late 1990s - long-term earnings growth rising enough to drag relative share performance higher. Conversely, the conditions for a plunge in long-term earnings expectations do not exist (Chart 8). Similarly, Value stocks tend to require improving global growth conditions in order to sustain relative outperformance over Growth stocks (Chart 8, bottom panel). That condition is in place, though the strength of the trend is unclear. In an upcoming publication by our Bank Credit Analyst, BCA editors uncover that although it is clear that an upswing in global growth is occurring in both the "soft" and "hard" data, there is little concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles so far in this lackluster expansion. The bottom line is that the outperformance in Value stocks relative to Growth may endure, by virtue of Value stocks having a comparably small allocation to technology stocks and a relatively larger allocation to financials (and energy). A more compelling case for Value stocks requires a higher conviction view in a prolonged financial sector outperformance phase. The latter awaits a move from promises to watch action on financial deregulation and more importantly, a more positive outlook on credit creation. As for small caps relative to large, we expect that the cyclical outperformance trend in small caps is sustainable (Chart 9). True, in the near term, there is room for overbought conditions to be further unwound. The consensus opinion that corporate tax reform and Trump trade policy will disproportionately benefit small companies is likely already fully discounted, making small cap share prices vulnerable to political disappointment. Chart 8Growth Will Struggle ##br##To Keep Up With Value Chart 9Small Cap Outperformance##br## Is Not Constrained By Valuation Meanwhile, if the dip in the U.S. dollar becomes a more sustainable trend, then small caps will be at further risk. However, that is not our base case: we expect broad dollar strength to be supportive of small cap stocks over the next six to twelve months. The U.S. economy is on sounder footing than its global counterparts and the Fed is far out in front; both of these conditions are supportive of a stronger dollar. Fortunately, small caps earnings are far more insulated from dollar strength, by virtue of the fact that small caps revenues are much more domestically oriented than large caps. The one area that small caps earnings may come under more pressure than large caps is margins. As noted above, small businesses are not yet particularly optimistic about their ability to raise prices in order to match wage hikes. Nonetheless, we expect better domestic (and thus small-cap positive) top-line growth to outweigh a margin squeeze felt more heavily for small caps versus large. Finally, small caps are often viewed as a higher beta play on growth (although this has not always been the case). Since relative valuations are not yet problematic, then if our base case of a prolonged, albeit not necessarily overly robust, non-inflationary economic expansion pans out, then the small cap outperformance phase could also endure for a prolonged period. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Global ETF Strategy/ETS Equity Trading Strategy Special Report “Smart-Beta ETF Selection, Part I - Value Funds,” dated February 15, 2017, available at bcaresearch.com.

Special Report

Feature Valuations, whether for currencies, equities, or bonds, are always at the top of the list of the determinants of any asset's long-term performance. In this optic, we regularly update the set of long-term valuation models for currencies we introduced in a February 16 Special Report titled "Assessing Fair Value In FX Markets." Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials, and proxies for global risk aversion.1 These models cover 23 currencies, incorporating both G10 and EM FX markets. Twice a year, we provide clients with a comprehensive update of all these long-term models in one stop. This time around, a few fair value estimates have changed. This reflects the revisions to the productivity estimates we source from the Conference Board. These models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning, or middle of a long-term currency cycle. Second, by providing strong directional signals, these models help us judge whether any given move is more likely be a countertrend development or not, offering insight on its potential longevity. Third, they help us and our clients to cut through the fog, and understand the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1Upward Revisions To Productivity Have Lifted The USD's Fair Value Based on its key long-term drivers - real yield differentials and the relative productivity trend between the U.S. and its trading partners - the U.S. dollar is trading around 5% above its upward-pointing fair value. Moreover, the equilibrium exchange rate for the USD has risen from previous estimations as the U.S. productivity series computed by the Conference Board have been revised upward. This comforts us in our bullish stance on the U.S. dollar. For one, the valuation premium has fallen relative to its previous estimate. Second, the dollar remains substantially below previous overvaluation peaks, where it traded at a more than 20% premium to fair value (Chart 1). Additionally, with the U.S. slack being much smaller than in most other major economies, the Fed is in a much firmer position to increase rates than most of its counterparts. This suggests that U.S. rates will continue to boost the dollar higher, justifying a growing premium to its long-term equilibrium. Finally, the dollar's recent valuation picture on a broad basis reflects the fact that many EM currencies and commodity producers are still pricey. As such, this also comforts us in our stance to underweight commodity currencies versus European ones and the yen. The Euro Chart 2The Euro Can Cheapen Further On a multi-year time horizon, the euro is driven by the relative productivity trend of the euro area with its trading partners, its net international investment position, terms-of-trade shocks, and rates differentials. The euro continues to trade at a 6% discount to its fair value (Chart 2). However, the euro was in fact 15% below equilibrium in both 1984 and 2002, respectively, suggesting that the valuation advantage of the euro is not yet large enough to justify aggressively bidding up the common currency. Additionally, monetary divergences with the U.S. will continue to weigh on the EUR. On a structural basis the euro area continues to exhibit signs of slack. The employment-to-population ratio for prime age workers is at 2008 levels and domestic inflationary pressures remain muted, especially when one considers how cheap the euro is. The ECB policy is therefore likely to remain very easy for the foreseeable future. Additionally, the ECB might leave policy even easier than the broad euro area economic averages would suggest as it focuses its efforts on the weakest members of the union. While in the early 2000s it was Germany, today it is the European periphery that is in need of easy money to create fiscal room and ease latent deleveraging pressures. The Yen Chart 3The Yen Will Stay Cheap The yen's long-term equilibrium is a function of Japan's net international investment position, global risk aversion, and commodity prices. The large Japanese current account surplus continues to lift the yen's fair value, albeit at a slower pace than last year. While the yen may have strengthened substantially in recent months against the dollar, on a broader basis the yen is still very cheap (albeit not as cheap as a year ago) (Chart 3). This simply reflects the fact that many Asian currencies and the euro - key competitors of Japan - and the CNY - the currency of the most crucial export market for the Japanese - have also fallen substantially versus the dollar. The current outsized efforts by the Bank of Japan to lift domestic inflation expectations at any costs suggest that Japanese policy will maintain a dovish bias for an extended period of time, even if realized inflation perks up. As such, like the euro, the yen is likely to remain a prey to global monetary policy divergences, especially against the USD. Nonetheless, the yen's attractive valuation - comparable to that which prevailed around the time of the Plaza Accord - implies that USD/JPY could stay as the preferred cross by which to play any dollar correction that should emerge along the upward trajectory of the greenback. The British Pound Chart 4GBP: The Economy Matters More Than Valuations The fair value of the pound has fallen over the past year and is projected to continue doing so in 2017. This development is explained by the U.K.'s poor trend productivity growth, falling real yields, and slowing house price appreciation. Despite this change in the fair value, following the drubbing received by the pound in the Brexit vote aftermath, GBP is cheap on a long-term basis (Chart 4). However, the decline in investment that may materialize following the fall in British FDI inflows mean that the U.K.'s productivity may deteriorate even faster than is currently projected. This would further depress the pound's fair value, implying that the GBP may not be as cheap as the model currently highlights. Even if this prospect were to materialize, the pound could still be an attractive play on a cyclical horizon. For one, British real rates are likely to pick up as the economy continues to surprise to the upside, mitigating some of the negative implications of falling productivity on the GBP's fair value. Additionally, the last legal hurdles to the invocation of the Article 50 of the Lisbon Treaty are being cleared, suggesting that the Brexit negotiations will begin in earnest in March. While this could create some episodes of currency volatility as the British and EU negotiators establish their stances, the end of the anticipation of this fearful moment may let investors focus on the U.K.'s economic robustness. The Canadian Dollar Chart 5CAD At Fair Value: The Future Depends On Oil The Loonie's fair value is driven by commodity prices, relative productivity trends, and the Canadian net international position. While the Canadian current account deficit and the nation's poor productivity growth would argue for a lower fair-value, these have been compensated by a rebound in commodity prices, creating stability for the CAD's equilibrium exchange rate. The sharp rebound in the Canadian dollar over the past 12 months means that the exceptional undervaluation in February last year has been fully eradicated (Chart 5). However, the CAD is not experiencing the same level of overvaluation as many of the other commodity currencies, like the AUD, the NZD, the BRL, or the RUB. This could reflect the NAFTA discount now created by Trump's demanding a renegotiation of the trade deal, which puts Canadian exports at marginal risk. Ultimately, with the CAD troughs and peak very much a direct negative function of the USD, our bullish stance on the greenback suggests that the CAD could once again experience a discount in the coming 12 to 18 months, especially as the U.S. dollar carries such a heavy weight in the trade-weighted CAD. In fact, we expect the Canadian economy to underperform that of the U.S. as the Canadian consumer remains hampered by higher debt loads and as Canadian capex remains hurt by excess capacity. This will only accentuate the monetary divergence between the CAD and the USD. The Australian Dollar Chart 6The AUD Has Overshot Fundamentals: Use Further Rallies To Sell The fair value of the Aussie, driven by Australia's net international position and commodity prices, has stabilized. However, it may begin to deteriorate anew if commodity prices lose some of their luster, a growing probability event in the face of a strong USD. Moreover, the AUD's rally has only caused this currency to become ever more expensive and it now offers one of the poorest risk-reward profiles in the G10. Historically, current levels of overvaluation have proved a reliable sell-signal for the Aussie and warrant shorting this currency right now (Chart 6). Our portfolio has a negative AUD bias. The AUD's poor valuations suggest that it is discounting an extremely positive growth outcome in the Chinese economy. We think China is likely to surprise to the downside, especially against such lofty expectations. Raising the AUD's risk profile even further, China has not only exhausted its latest fiscal stimulus and clamped down on the real estate market, but also cracked down on excess steel production. This means that the demand for iron ore and coking coal - of which China has accumulated large inventory piles - could weaken even more than a Chinese economic deceleration would imply. Australian terms-of-trades could suffer a nasty shock. The New Zealand Dollar Chart 7NZD Is Expensive, But Not As Much As The AUD Natural resources prices, real rate differentials, and the VIX are the key determinants of the Kiwi's fair value, highlighting the NZD's nature as both a commodity currency and a carry currency. Both the fall in the VIX and the rebound in commodities are currently causing the gradual appreciation in the New Zealand's dollar equilibrium exchange rate. Thus, this trend could easily reverse if the global reflation trade begins to wane. Currently, the NZD is expensive (Chart 7), albeit not as exceptionally so as the AUD, the BRL, or the RUB. This partly explains why we like the Kiwi more than these currencies. In fact, while we worry about the outlook for the NZD versus the USD, the attractive domestic situation in New Zealand, where growth is the highest in the G10 and employment is growing at an eye-popping 6% annual rate, suggests that the RBNZ could abandon its new-found neutral bias in favor of a hawkish one later this year. Hence, we like the Kiwi against the AUD, the BRL, or the RUB. The Swiss Franc Chart 8The Swiss Net International Investment Position Makes The SNB's Life Difficult Switzerland's enormous and growing net international investment position continues to be the most important factor lifting the fair value of the Swiss franc. Yet, in the short-term, this is irrelevant. The SNB has demonstrated its capacity and credibility when it comes to keeping a floor under EUR/CHF. Thus, the Swiss franc will continue to trade in line with the euro, even if the current French political risks would have normally caused an appreciation in the Swiss Franc versus the euro. This means that the real trade-weighted CHF should not deviate much from its long-term fair value estimate (Chart 8). Nonetheless, this peg contains the seeds of its own demise. The cheaper the CHF gets, the larger the economic distortions in the Swiss economy become. Already, Switzerland sports the most negative interest rates in the world. This directly reflects the large injections of liquidity required from the SNB to stem any CHF appreciation. A consequence of these low real rates has been the appreciation in the already-expensive Swiss real estate. Ultimately, we expect the SNB to be forced to capitulate to all the inflows and abandon its floor. While this will not happen tomorrow, it will likely result in a comparable move to the one that followed the tentative unpegging of January 2015. Back then, the CHF was not particularly cheap. While it is too early to make this bet, we suspect that a pick-up in actual inflation will constitute the key signal for investors to begin betting against the SNB's current policy. The Swedish Krona Chart 9The Riksbank Has Achieved One Of Its Goal: SEK Is Cheap The Swedish krona continues to trade cheaply, even if its long-term fair value remains on a secular downward trajectory (Chart 9). Yet, the undemanding valuations of the SEK hides a complex picture. It is approximately fairly valued against the GBP and expensive against the NOK, two of its largest trading partners. However, the SEK is cheap against the USD and the euro. Amongst the latter two, we prefer buying the Swedish krona against the EUR rather than against the USD. The SEK has historically been very sensitive to the USD; therefore, USD/SEK is very exposed to the dollar's cyclical bull market. However, the current widening of European government spreads echoes the 2010-2012 period, when EUR/SEK softened considerably as the survival of the euro was up in the air in investors' minds. Dutch, French, and potential Italian elections this year could prove similarly unnerving for investors, creating a source of downside risk in EUR/SEK. Moreover, Swedish domestic fundamentals remain much stronger than those of the euro area, further strengthening the case of for shorting EUR/SEK. The Norwegian Krone Chart 10NOK, Still Undervalued Despite The Rally A year ago, when global markets were in full panic mode, the Norwegian krona became the most attractive currency in the world on a valuation basis. After a blistering rally, this is not the case anymore (Chart 10). Nonetheless, it continues to trade on the cheap side, and remains the cheapest commodity currency in the world along with the Colombian peso. We therefore maintain a positive bias toward the NOK against the rest of the commodity complex, especially the very expensive and equally oil-exposed RUB. While USD/NOK, like USD/SEK, is very exposed to general dollar strength, we remain short EUR/NOK on a 12-month basis. The NOK's main long-term favorable factor still is its enormous net international investment position of 194% of GDP, which creates a structural upward bias on the country's current account surplus. Today, while the euro area runs a record high current account surplus of 3% of GDP, its net international investment position remains negative at 8% of GDP. Additionally, in an almost perfect mirror image to the euro area, Norway shows little signs of having entered a liquidity trap post-2008. The money multiplier remains high, loan growth has stayed strong, and inflation has remained perky. This means that the Norges Bank is in a better position to cyclically increase rates than the ECB. Chinese Yuan Chart 11Can The Yuan Weaken More? As commodity prices strengthened and Chinese productivity growth slowed, the strong upward bias to the yuan's long-term fair value paused in 2016 and may even fall a bit in 2017. Nonetheless, the CNY continuous fall has cheapened this currency considerably since 2015 (Chart 11). Does this mean that the CNY is a buy at this juncture? No. First, on a trade-weighted basis, the experience of the past 20 years has been that it bottoms at greater discounts to fair value. Moreover, while testing the current model, we also tried various productivity series for China. Depending on the one used, the yuan's discount to fair value would considerably shrink, implying a high degree of uncertainty around the actual cheapness of the RMB. Second, China continues to suffer from capital outflows, suggesting that domestic expected returns have yet to be equilibrated with those available in the rest of the world. A lower RMB would help generate this adjustment. Third, China is still an economy with too much capacity and too much debt that also intends to liberalize its internal markets and external accounts, even if slowly. Historically, this set of circumstances has most often come along with a weak currency, a key tool to alleviate the deflationary tendencies created by these forces. Fourth, and more specific to the dollar, the PBoC now targets a basket of currencies which means that when the DXY strengthens, USD/CNY also rallies. The dollar bull market will therefore continue to hurt the RMB versus the USD. Finally, Trump's protectionist rhetoric represents a big risk for China as exports to the U.S. represent 4% of China's GDP. A simple way to regain some of the competitiveness that would be lost to tariffs would be for the PBoC to let the CNY drift lower against the USD, though this would also aggravate the trade tensions. The Brazilian Real Chart 12Trouble In Rio Hampered by poor productivity trends, which weigh on the Brazilian current account balance, the fair value of the real remains quite depressed, even as commodity prices have sharply rebounded over the course of the past 12 months. In fact, the violent rally in the BRL over the same timeframe has made it one of the most expensive currencies tracked by our models (Chart 12). At current levels of overvaluation, the next 6 months return on the BRL has always been negative. The potential downside for BRL over the next 12-18 months is large. The rally reflected a general easing in EM financial conditions, fiscal stimulus in China, and the ejection of Dilma Rousseff, replaced by Michel Temer. While the change of government has depressed the geopolitical risk premium, any real improvement rests on the Temer administration's stated goal of slashing the size of the public sector. In the Mundell-Fleming model, the resulting destruction in domestic demand cuts local real rates, and therefore, the BRL's appeal to international investors. This a severe headwind to overcome, especially when coupled with as clear of a message as the one currently sent by valuations. Finally, the recent strength in the dollar along with the rise in DM global rates is creating a tightening of global and EM liquidity conditions, exactly as the Chinese fiscal stimulus wanes. This is a very poor risk profile for the BRL. The Mexican Peso Chart 13MXN Is Not Cheap Enough Yet Interestingly, despite the surge in USD/MXN in the wake of Trump's electoral victory, the MXN is not very cheap on a real trade-weighted basis (Chart 13). The peso's equilibrium rate has been pulled lower by the nation's persistent current account deficit which has continuously hurt its net international investment position. Conceptually, this is akin to a relative oversupply of Mexican assets to the rest of the world, depressing the peso's fair-value. The large stock of Mexican USD-denominated debt is a testament to this phenomenon. At this juncture, while PPP valuations suggest that the peso is attractive relative to the USD, Mexico's negative net international investment position and its large stock of U.S.-dollar debt warrant cautiousness. The Mexican economy is very exposed to a tightening in global liquidity conditions and the borrowing-costs squeeze represented by a higher dollar and higher U.S. rates. Hence, USD/MXN could have more upside from here on a 12-to-18 month basis. Compared to other EM currencies like the BRL, the RUB, or the CLP, however, the Mexican peso seems very attractively priced as all these currencies currently trade at large premia to their fair value. Additionally, a "Trump-protectionism" risk premium is already embedded in the Mexican peso, but the above currencies do not seem to suffer from the same handicap. While not as directly exposed to this risk as Mexico, these countries would nonetheless be affected by a trade war between the U.S. and Asia, and particularly between the U.S. and China. The Chilean Peso Chart 14The CLP Has Overshot The Chilean peso real effective exchange rate is driven by the country's productivity trend relative to its trading partners and the real price of copper - which proxies the Chilean terms-of-trade. As a result of the rally since the winter of 2015, the real CLP is at a 4-year high and is now in expensive territory (Chart 14). Global risks point to downside for the CLP, as copper is likely to underperform against other commodities. EM liquidity conditions should dry up due to the rising dollar, compounding potential problems created by China's efforts to crack down on real estate activity, the biggest source of copper consumption by a wide margin. The recent meteoric surge in copper prices will leave the red metal vulnerable to such dynamics. Domestic factors also don't bode well for the peso. The Chilean housing market is currently going through its biggest downturn since 2008 while economic activity remains anemic. Furthermore, the worker's strike in "La Escondida", the world's biggest copper mine, should cause strains on Chilean exports. All of these factors will be too great for the CLP to overcome. Thus, we remain short the peso. The Colombian Peso Chart 15COP Is A Cheap Oil Play The real COP is driven by Colombia's relative productivity trends and the price of oil, the country's main export. With oil prices having rebounded, the fair value has returned to 2014 levels. Nevertheless, the COP still undershoots its fundamentals (Chart 15). This reflects the premium demanded by investors to compensate for Colombia's large current account deficit equal to 6.3% of GDP. The outlook for the COP has brightened, especially against other commodity currencies. The OPEC deal to cut oil production seems to be on track so far, with 90% compliance amongst OPEC members. Furthermore, the potential for a strong economic performance in DM economies suggests that oil demand should remain firm. This should help the COP outperform currencies that have a higher sensitivity to metals like the BRL and the ZAR. Domestic factors also paint a positive picture for the peso. The Colombian economic situation is more robust than in other EM economies. During the commodity boom years, Colombian banks were much more orthodox in their lending than their EM counterparts. Thus, this Andean country does not suffer from unsustainable debt dynamics, and therefore, if EM suffers a liquidity-induced slowdown, Colombia should withstand this shock better. The South African Rand Chart 16ZAR Has Outshined Gold, Higher Rates Will Be A Problem South Africa's dismal productivity trends continue to force a downtrend upon the rand's long-term fair value. The rally in commodity prices has nonetheless lifted the current fair value of the ZAR for early 2017 compared to estimates run last year. Despite this improvement, the rand's 6% rally in real terms has still overshot any justifiable fundamentals, leaving this currency overvalued (Chart 16). Furthermore, if commodity prices were to correct, not only would the fair value of the rand fall, but the current overshoot would also correct. This implies substantial downside risk to the ZAR. The ZAR may remain stable in the short term as the dollar's correction continues and gold prices enjoy a healthy bounce. However, the rand's copious handicaps will come back to haunt investors once the previous dollar strength is fully digested and the USD resumes its cyclical bull market. Moreover, such a move is likely to come hand-in-hand with rising U.S. rates, embracing both gold and the rand in an inescapable kiss of death. The Russian Ruble Chart 17RUB Has Fully Priced Any Russia-American Rapprochement Buoyed by both the perceived benefits to the Russian economy of OPEC oil production cuts and the fall in the geopolitical risk premium coming from the expected Trump/Putin rapprochement, the Ruble is now very expensive (Chart 17). While RUB was more expensive in the years prior to the 1998 Russian default, it still manages currently to trade at its highest premium in more than 18 years. Trump and Putin really need to get along famously well - and it is not clear that they will at the moment. As the RUB is massively expensive, we would not chase it higher from here. Not only is the upside to oil prices limited, since at current oil prices, shape of the oil curve, and financing costs, shale producers are once again investing in their oil fields, pointing to higher U.S. production in the coming quarters. Also, the civility between Trump and Putin is likely to prove ephemeral: Russia's commercial links are with Europe and China, not the U.S. If anything, the U.S.'s growing exports of energy products mean that both nations will soon compete in that market. We know how much Trump loves foreign competition. Thus, we prefer other petro currencies to the RUB. At the current juncture, buying CAD/RUB and NOK/RUB makes sense. Especially as the valuation disadvantage is clear enough to point to a large ruble-bearish move in both crosses. The Korean Won Chart 18No Big Discount In The KRW The fair value of the won is positively correlated with the nation's net international investment position, but shows a strong negative relationship with oil prices. This reflects the status of the nation as an oil importer, and thus lower oil prices constitute a positive terms-of-trade shock for Korea. Also, the real trade-weighted won is inversely correlated with EM spreads. This makes sense as the won is a very pro-cyclical currency reflecting the tech and manufacturing bias of the Korean economy. At the current juncture, the won is moderately cheap (Chart 18). The Korean won may be trading on the cheap side, but we worry that this good value may prove somewhat illusory. A strong U.S. dollar and rising DM real rates are likely to result in stresses for many EM borrowers, whether they borrow in USD, produce commodities, or even worse, do both. Such an event would put pressure on EM spreads and push down the fair value of the KRW. An additional problem for the won is Donald Trump. Korea has been one of the greatest beneficiaries of the expansion of globalization from 1980 to 2008, as its export growth was some of the strongest in the world. Today, if Trump's protectionist tendencies gather momentum, Korea is likely to end up on his line of sight. The passage of import-punishing tax reform, cancellation of the KORUS free trade agreement, or imposition of tariffs on that country would have two potential effects on the won. They could cause the country's current account to deteriorate, hurting the prospective path of Korea's net international position and dragging the KRW fair value lower. This would be a slower drag on the won. Or, the other path, which we judge more likely, market participants (probably helped by Korean monetary authorities) could embed a discount into the KRW's fair value equivalent to the expected impact of the tariffs. This discount would alleviate the pain of the tariff, and would materialize in swift fashion. The Indian Rupee Chart 19SGD Has Downside The fair value of the real trade-weighted INR is driven by India's productivity performance relative to its trading partners - the key factor behind the gentle upward slope in the equilibrium value for the rupee, its net international investment position, and Indian real interest rate differentials. However, the elevated level of inflation by global standards in India means that despite its long-term nominal downtrend, the INR is not cheap (Chart 19). Yet, while it will be difficult for this currency to rally against the USD if the dollar is in a broad-based uptrend, things are looking up for the INR relative to other EM currencies. The swift implementation of the currency reform last year was a bit of a debacle, but results are beginning to show through: deposit growth is improving. Thus, the constant shortage of loanable savings that has structurally hurt Indian capex and fomented elevated inflation in that country might begin to decrease. This means that over the long term, India's relative productivity performance might improve further and the country's stubborn inflation might decrease. This would lift the INR's fair value over time. The key to this positive outlook will be the RBI. With the personnel and political-administrative changes at its helm, it is hard to judge whether the Indian central bank will lift rates enough as capex perks up. That would limit future inflation and protect the value of the fiat currency and hence the long-term attractiveness of keeping money in Indian banks. We are optimistic, but await clearer proofs. The Philippine Peso Chart 20The Duterte Discount President Rodrigo Duterte's politics have been a source of fear for investors. As a result, PHP has depreciated against the USD and is now trading at a 10% discount (Chart 20). The fair value of the peso, driven by the cumulative current account and commodity prices, is on an uptrend. This will likely continue as a strong USD should depress commodity prices, improving the Philippines' trade balance and terms of trade. Additionally, improving DM economies will likely generate higher remittances to the Philippines, boosting the current account balance, domestic consumption, and the PHP's long-term value. These dynamics underpin our bullish long-term view on the PHP. However, potential political risks still loom large for the economy. So far Duterte has allowed technocrats to run economic policy, but if he takes a greater personal interest in this area it is likely to be unfriendly to foreign investors, potentially endangering broader FDI inflows. This could erode the PHP long-term equilibrium value over time. Relations with the Trump administration do not have any clarity yet but potentially offer substantial downside risks. Tempering our fear for now, Duterte is taking a reasonable approach to economic management and opening the way for new investment from China, suggesting political risks to foreign investment remain contained. The Singapore Dollar Chart 21INR Real Equilibrium Keeps Rising, But Inflation Still Clouds The Outlook Our model points to a relatively stable long-term valuation of the Singaporean Dollar. The currency displays little statistical significance with economic factors, with its relationship with commodities being one of indirect statistical coincidence. This is because the Monetary Authority of Singapore (MAS) utilizes the currency as its main monetary policy tool, underpinning the SGD's cyclical nature. As inflation has only just stepped back into positive territory in December 2016, and retail prices remain weak, MAS is unlikely to deviate from its current policy stance and will remain accommodative. Therefore, SGD is likely to depreciate from its current 3.6% overvaluation (Chart 21). This strong mean-reverting characteristic warrants a short position on the SGD. Last September, we suggested selling SGD against USD over JPY, a recommendation we stick to, since a dollar bull market will add additional pressure onto the SGD. The Hong Kong Dollar Chart 22HKD Is Expensive But The Peg Will Survive While USD/HKD is pegged, the real trade-weighted Hong-Kong dollar can still experience wild swings. Since 2011, its real appreciation has been driven by a wave of EM currency weakness and higher inflation in HK than the U.S. Also, the strength in USD/CNY since January 2014 has added to the HKD's surge. Thanks to this combination, the Hong Kong dollar remains more expensive than it was in 1997, on the eve of the Asian Crisis (Chart 22). This does not mean that HKD is about to depreciate. In fact, we expect the Hong Kong Monetary Authority to keep the peg alive as it has been a pillar of stability since its introduction in 1983. With reserves of 114% of GDP, not only does the HKMA have the financial fire-power to support the HKD, but also Hong Kong continues to sport a current account surplus of 4%. While it is possible that USD/HKD will appreciate toward 7.85, the upper range of the target zone, any depreciation in the real HKD will be a consequence of deepening deflation. This suggests that HK real estate prices will suffer more, especially as they remain significantly overvalued. The Saudi Riyal Chart 23Saudi Needs Higher Oil Prices Or An Internal Devaluation Will Rage For Years To Come The Saudi Riyal shares two attributes with the HKD: It is a pegged currency and a prohibitively expensive one (Chart 23). Moreover, the very poor productivity performance of the Saudi economy necessitates a perpetually falling real effective exchange rate. Like the HKMA, SAMA will continue to defend its exchange rate for now, as it holds reserves of US$538 billion to protect its currency. Also, Saudi budget deficits can be curtailed further and the Saudi government can continue to borrow in the debt market. Finally, the production-cut agreements between OPEC and Russia have put a floor under oil prices for the time being, exactly as the market was already moving into deficit. They give SAMA even more time. However, one cannot forget that following the 1986 oil collapse, USD/SAR rose by 11%. Therefore, if oil prices relapse as U.S. shale production picks up anew or as the broad USD rallies further, the probability of a SAR surprise devaluation grows. Moreover, selling SAR could also act as insurance against further trouble in the Middle East, especially if Trump follows through on his demand that America's allies pay more for their own defense. At the current juncture, a small long USD/SAR position within a portfolio is equivalent to owning an instrument with a deep out-of-the-money option-like payoff: It costs little, has a small probability of being exercised, but if it does, it will pay great rewards. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets," dated February 26, 2016, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, In addition to our regular Weekly Report, we sent you a Special Report on Wednesday prepared by my colleague Marko Papic, BCA's chief geopolitical strategist, assessing the election landscape in Europe this year. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights Global growth has accelerated, corporate earnings are rebounding, and leading indicators suggest that these positive trends will persist over the remainder of the year. This supports our cyclically bullish view on global equities. Looking further out, the impulse to growth from the easing in financial conditions that began in early 2016 will fade, setting the stage for a slowdown in 2018. If growth does falter next year, easier fiscal policy could provide an offsetting tailwind. However, there continues to be a large gap between what politicians are promising and what they can realistically deliver. What is different this time is that spare capacity is much lower than it was during previous mid-cycle slowdowns. Thus, while global bond yields could eventually dip, they remain in a secular uptrend. Feature The Elusive Correction We have been arguing since last fall that stronger global growth will help fuel a variety of reflationary trades.1 This part of our view has panned out nicely. What has surprised us is just how relentlessly the market has traded that view. With the exception of a few small wobbles, the S&P 500 has basically marched higher since the morning following the U.S. presidential election. Reflecting this development, the VIX fell to near record low levels earlier this week (Chart 1). The market's failure to take a breather has sabotaged our efforts to have our cake and eat it too - to maintain an overweight stance on global equities, while also profiting from the occasional correction. In contrast to our last three tactical hedges - which generated a cumulative return of 42% - our latest hedge is now down 9%. That's a lot of red ink. Out of pure risk management considerations, we will close this trade if the loss breaches 10%. Nevertheless, most indicators continue to warn of a looming correction. In particular, our U.S. equity strategists' new "Complacency-Anxiety" index is at an all-time high, suggesting that stocks have entered a technical overshoot phase (Chart 2).2 Chart 1VIX Is Near Record Lows Chart 2Complacency Reigns Cyclical Picture Still Solid In contrast to the short-term outlook, the 12-month cyclical picture for risk assets still looks reasonably good. Measures of current activity are rebounding as animal spirits begin to kick in (Chart 3). Falling unemployment and stronger wage growth are causing households to open their wallets. Against the backdrop of decreasing spare capacity, firms are reacting to this by increasing investment spending. Capital goods orders in the G3 economies have jumped higher in recent months, and capex intention surveys are pointing to further upside (Chart 4). Chart 3Current Activity Indicators Are Rebounding Chart 4An Upswing In Capex Corporate earnings have also accelerated on the back of faster economic growth. Consensus estimates call for global EPS to expand by 12% in local-currency terms this year, with the S&P 500 registering 10.4% growth, the STOXX Europe 600 gaining 14.3%, Japan's TOPIX adding 12.5%, and MSCI EM leading the pack at 16%. Outside the U.S., year-to-date earnings revisions have generally been positive, particularly in Japan and EM (in the U.S., 2017 EPS estimates have ticked down a modest 0.8%). BCA's in-house earnings models are consistent with this optimistic profit picture (Chart 5). What accounts for this fortuitous turn of events? A number of reasons help explain why growth accelerated in the second half of 2016: The drag on global growth from the plunge in commodity sector investment ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7 percent off the level of U.S. GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 6). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus, helping to reflate the economy. Global growth benefited with a lag from the easing in financial conditions that began in earnest in early 2016. Government bond yields fell to record low levels in July. In addition, junk bond spreads collapsed, dropping from a peak of 7.9% in February to 4.3% by year-end (Chart 7). Higher equity prices, particularly in a number of beaten down emerging markets, also helped. Chart 5Broad-Based Acceleration In Corporate Earnings Chart 6Inventory Destocking Was A Drag On Growth Chart 7Corporate Borrowing Costs Have Fallen How Much Longer? Chart 8Improvement In Global ##br##Leading Economic Indicators The key question for investors is how long the good times will last. Right now, most leading indicators that we follow are signaling that the expansion will endure for the remainder of this year (Chart 8). As we look towards 2018, however, things get murkier. Conceptually, it is the change in financial conditions that matters for growth. While the ongoing rally in global equities and continued narrowing in credit spreads has contributed to some easing in financial conditions since the U.S. presidential election, this has been partly offset by higher government bond yields. A stronger dollar has also led to an incremental tightening in the U.S., as well as in some emerging markets with high levels of U.S. dollar-denominated debt. As such, it is likely that the positive "impulse" to economic growth from the easing in financial conditions that took place last year will begin to dissipate towards the end of this year. Fiscal Policy To The Rescue? If growth does slow next year, easier fiscal policy could provide an offsetting tailwind. The fiscal thrust for developed economies turned positive in 2016, the first year this happened since 2010 (Chart 9). However, it remains to be seen whether this trend will continue. There is little support among Republicans in Congress for a big infrastructure program. It once seemed possible that Chuck Schumer and his fellow Democrats could find common ground with President Trump on this issue, but that is looking less likely with each passing day, given the level of vitriol in Washington. Broad-based tax cuts are a certainty, but the risk is that they will be coupled with cuts to government spending. Empirically, the latter have a larger "multiplier effect" on GDP than the former. To complicate matters, the introduction of a border adjustment tax - something to which we assign 50% odds - could generate significant near-term dislocations for the global economy.3 Meanwhile, much of Trump's regulatory agenda is in limbo. A repeal of Dodd-Frank is off the table. Senate Republicans do not have the 60 votes needed to scrap it. The Volcker rule is here to stay. On the other side of the Atlantic, the European Commission has recommended a further loosening in fiscal policy this year, but member states themselves are actually targeting somewhat smaller fiscal deficits (Chart 10). As is often the case, budgetary overruns are likely, but with the Greek bailout program now back on the ropes, Germany and a number of other countries may begin to dial up the austerity rhetoric. Chart 9Will Fiscal Policy Continue To Ease? Chart 10European Commission Recommending Greater Fiscal Expansion Uncertainty over the slew of European elections slated for this year could also weigh on business sentiment. Marine Le Pen is likely to place first in the initial round of the French presidential election, but faces an uphill battle in the subsequent runoff. Nevertheless, betting markets are assigning a one-in-three chance of Le Pen becoming president - similar to the odds they were assigning to a Brexit "yes vote" and a Trump victory (Chart 11). Italy also remains a risk, as my colleague Marko Papic, BCA's chief geopolitical strategist, discussed in this week's Special Report.4 Anti-euro sentiment is now stronger there than in any other major European economy (Chart 12). Chinese fiscal policy has already tightened significantly, with the year-over-year rate of change in government spending falling from a high of 25% in November 2015 to zero at present (Chart 13). So far the Chinese economy has held up well, but there is a risk that this may change. Despite Trump's backpedaling on the "One China" question, we expect the Trump administration to declare China a currency manipulator later this year. This will pave the way for higher tariffs on a variety of Chinese goods, which could lead to retaliatory measures by China. Chart 11Brexit, Then Trump... Is Le Pen Next? Chart 12Italy: Anti-Euro Sentiment Is A Risk Chart 13China: Fiscal Stimulus Is Fading Investment Conclusions Chart 14Diminished Slack In The Global Economy Global growth continues to be strong, and is likely to stay that way for the remainder of this year. However, there is a heightened risk that the global economy will falter in 2018. We remain cyclically overweight global equities and underweight government bonds, but are not dogmatic about this view. As the discussion above suggests, plenty of things could derail the reflation trade. If evidence begins to mount that a slowdown is coming earlier than we think, we will turn more bearish on stocks. Given that equities are technically overbought at present, we would not fault anyone for taking some money off the table. If growth does slow in 2018, does this mean that bond yields will fall back towards last year's lows? We don't think so. For one thing, a major deflationary commodity bust of the sort we endured in 2014-15 is not in the cards. In addition, there is less slack in the global economy now than there was last year, or for that matter, anytime since early 2008 (Chart 14). As we discussed in our Q1 Strategy Outlook, potential GDP growth is likely to remain structurally depressed across much of the world, owing to slower productivity and labor force growth.5 Lower potential growth means that excess capacity could continue to be absorbed even if growth slows somewhat from its current well-above trend pace. In the U.S., this absorption of excess capacity is nearly complete, with most labor market indicators suggesting that the economy is approaching full employment (Chart 15). In this vein, we would heavily discount the decline in average hourly earnings in January's employment report. Chart 16 shows that this was mainly driven by an anomalous drop in compensation in the financial sector. Broader measures continue to point to brewing wage pressures (Chart 17). We expect the Fed to raise rates three times this year, one more hike than the market is now pricing in. If this happens, the dollar is likely to strengthen modestly over the remainder of the year. Chart 15U.S. Economy Approaching ##br##Full Employment Chart 16Financial Sector Dragging ##br##Down Hourly Earnings In The U.S. Chart 17U.S.: Broad Measures Pointing ##br##To Rising Wage Pressures Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. 2 Please see U.S. Equity Strategy Weekly Report, "Bridging The Gap," dated February 6, 2017, available at uses.bcaresearch.com. 3 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. 4 Please see Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 5 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights We expect the high level of compliance with the OPEC - non-OPEC production agreement engineered by the Kingdom of Saudi Arabia (KSA) and Russia will endure, leading to significant reductions in global oil inventories this year and next. All else equal, this should backwardate WTI and Brent forward curves later this year. However, recent developments in the North American pipeline market - i.e., U.S. President Donald Trump's orders to revive development of the Keystone XL (KXL) and completion of the Dakota Access (DAPL) pipelines - could send as much as 1mm barrels/day (bbl/d) of crude south from Canada and the Bakken, which would boost inventories at Cushing and other Midwest storage facilities later in this decade. Depending on when these pipelines are completed - likely by 2020 in the case of KXL - the WTI forward curve could return to a sustained contango.1 The expanded flows of heavy crude via KXL, and light-tight oil south via the DAPL could undo a subtle benefit arising from the backwardation induced by the KSA - Russia production pact, which we uncovered in our modeling. Energy: Overweight. At Tuesday's close, our short Dec/19 WTI vs. long Dec/19 Brent spread elected last week at $.07/bbl (WTI over) was up 700%. Our long Dec/17 WTI vs. short Dec/18 WTI front-to-back spread, entered into at -$0.11/bbl on Feb 9/17, was up 263%. Base Metals: Neutral. BHP declared force majeure at its Escondida mine, which accounts for ~ 5% of global supply, after workers voted to strike. Union leaders agreed to another round of government-mediated talks with BHP management. Precious Metals: Neutral. Fed Chair Yellen's Senate Banking Committee testimony was more hawkish than expected, which rallied the USD and muted gold's overnight strength. We continue to look to get long gold at $1,180/oz. Ags/Softs: Underweight. The USDA revised grain and soybean supply/demand estimates last week, showing markets tightening slightly, with ending stocks for the 2016/17 crop year expected to be a touch lower. We remain bearish. Feature Chart of the WeekStorage Drawdowns Should Accelerate ##br##As U.S. Oil Imports Slow Regular readers of BCA's Commodity & Energy Strategy service will not be surprised by the very high compliance levels seen in the wake of the OPEC - non-OPEC production Agreement engineered by KSA and Russia late last year.2 Because the stakes are so high for KSA and Russia - and their respective oil-producing allies - we expect compliance to remain high into June, resulting in a drawdown of global oil storage, the stated goal of the deal. We believe the pact will result in both WTI and Brent forward curves returning to backwardation, as global storage levels fall some 300mm bbl (Chart of the Week). We are positioned for this outcome by being long Dec/17 WTI vs. short Dec/18 WTI. We are expecting to see the last of the Persian Gulf export surge to the U.S. this month, as the 45- to 50-day sailing time from the Gulf to the U.S. implies the last of these vessels will be arriving this week or next. This backwardation will, in all likelihood, restrain the rate at which U.S. shale-oil producers return rigs to the market next year. Chart 2Curve Shape Can Affect Rig Counts WTI Term Structure And Rig Counts: It's Complicated Recent modeling we've completed suggests curve shape can affect rig counts in the U.S. light-tight oil fields. When we regress U.S. rig count on the WTI forward curve, we find rig counts can be expected to increase when the forwards are in contango, and to decline when the market is backwardated. A flat forward curve can be expected to keep rig counts fairly constant (Chart 2).3 Obviously, the starting point for these outcomes is critical. We simulated rig counts by assuming Monday's closing prices for March through June WTI futures, then assumed different levels for July WTI futures as a starting point for estimating rig counts to end-2018. We used $50, $55 and $60/bbl in July as our starting point. All else equal, with the July/17 WTI at ~ $55/bbl and the forward curve backwardated by 10% 18 months out, we would expect to see average rig counts fall by 4.38 rigs/month in 2018, given the three-to-four month lag between rigs actually being deployed and the price signal being sent by the futures market. A contango term structure produces the opposite result. With the July/17 WTI at ~ $55/bbl and the forward curve in a contango of 10% 18 months out, we would expect to see rig counts increase by 4.57 rigs/month in 2018. There obviously is a price threshold from which the forward curve originates in this analysis, which we believe to be between $50 and $55/bbl. Below this level, we would expect shale producers to retreat back to their core production areas, and await a price signal to increase their rig counts. Above $60/bbl, backwardation and contango matters for rig counts over the next 2 to 2.5 years. A backwardated forward curve will, all else equal, incentivize a slightly lower level of rigs being deployed than a contango. For example, a 10% contango with a $60/bbl starting point results in 5.24 rigs/month being deployed, while 10% backwardation would lead us to expect 5.02 rigs/month being deployed. Sustaining Backwardation Will Be Difficult A sustained backwardation will be threatened later in this decade by the expansion of the North American pipeline grid, following U.S. President Trump's orders to revive the Keystone XL (KXL) pipeline's development and the completion the Dakota Access Pipeline (DAPL). The KXL and DAPL buildouts, if approved, will expand U.S. midcontinent crude deliveries by 1mm bbl/d, according to Genscape's tally.4 The KXL volumes would add close to 600k bbl/d to Canadian exports, and would flow directly into Cushing, OK. Another 400k bbl/d of light-tight oil from the Bakken LTO fields will flow to the midcontinent refining market via the DAPL. "Increased flows into Cushing due to the addition of Keystone XL could lead to a bottleneck of inventories at the hub, which would put downward pressure on crude prices," Genscape notes. Work on the KXL could start this year, and be completed before 2020. The DAPL is ~ 95% complete, and should be done in 6 months or less. Genscape believes the DAPL could be built and line fill could be in place in less than three months. Indeed, "drilling under Lake Oahe in southern North Dakota for Energy Transfer Partner's Bakken-to-Patoka, IL, Dakota Access (DAPL) crude pipeline began immediately upon receiving an easement from the U.S. Army Corps of Engineers on February 8, according to a company spokesman. It is expected to take 83 days for construction and linefill... ." We will monitor these pipeline buildouts closely, given the profound implications they have for U.S. midcontinent and Gulf Coast refiners, who could once again find themselves benefiting from a widening of the Brent vs. WTI differential, and Canadian E&Ps, who can be expected to increase production into this KXL buildout. The key market to watch as these pipelines are under construction will be the WCS vs. WTI spreads (Chart 3). As pipeline capacity opens up, exports of heavy crude from Canada will increase and the WCS - WTI differential will narrow, which will benefit Canadian E&Ps (Chart 4). A return of contango following the opening of these pipelines would benefit U.S. refiners, who can be expected to increase exports. Chart 3Expanding the N. American Pipeline Network##br## Will Widen WTI Differentials Chart 4Crude Differentials Will##br## Adjust To Pipeline Buildouts Bottom Line: The backwardation of the WTI and Brent forwards should accelerate as the last of the surge in exports from the Persian Gulf arrives in the U.S. President Trump's decision to expedite KXL and the completion of the DAPL in 6 months or less will have a profound impact on crude movements and storage levels in the U.S. later in the decade. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 President Trump's decision to revive KXL was endorsed by House and Senate leaders in the U.S. last month, which greatly raises the odds it will go ahead. In addition, the DAPL received an easement from the U.S. Army Corps of Engineers to complete construction. 2 Please see issue of BCA Research's Commodity & Energy Strategy Weekly Report "Raising The Odds Of A KSA-Russia Oil-Production Cut," dated November 3, 2016, available at ces.bcaresearch.com. 3 Our previous modeling indicates Granger causality goes from WTI prices to rig counts - i.e., E&P companies drilling decisions are driven by price levels and curve shape. We believe this relationship arises from the hedging behavior of shale-oil producers, many of whom hedge their forward revenues in the futures markets over a two-year interval. 4 Please see "Keystone XL, Dakota Access Could Cause Bottlenecks at U.S. Mid-Continent Storage Hubs, Shift Crude Prices," published on Genscape's blog February 14, 2017. Genscape is a near-real-time pipeline, storage and shipping monitoring service. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in

Special Report

Highlights Duration: Growth, inflation & investor risk-seeking behavior remain bond-bearish in both the U.S. & the Euro Area. Market technicals, both in terms of oversold momentum and heavy short positioning, are the biggest headwind to higher yields in the near-term. USTs vs. Bunds: U.S. Treasury yields will remain under upward pressure from a hawkish Fed with the U.S. economy operating at full employment. The opposite is true in Europe, at least until Euro Area inflation is much higher. Stay overweight core Europe versus the U.S. in global hedged bond portfolios Feature Chart of the WeekCan The Bond Selloff Continue? Last week brought the first serious test of the bond bear phase that has been in place since last July. The 10-year U.S. Treasury yield dipped as low as 2.33% after a benign January U.S. Payrolls report that substantially reduced the odds of a March Fed rate hike. German Bund yields also dipped as renewed worries about the upcoming French election triggered a flight to quality out of French and Peripheral sovereign debt. Even the chartists got in on the act, talking of an imminent breakdown below the "head & shoulders neckline" on the 10-year U.S. Treasury that would herald a 25bp decline in yields. Adding to the growing sense of nervousness among investors is a fear that the "Trumpflation" trade could soon run out of gas, with a correction of both elevated equity prices and bond yields likely in the absence of concrete economic news from the White House. Yet all it took was for Trump to simply mention that a "phenomenal" announcement on his tax plan was coming in the next few weeks to restart the Trump trades, pushing equity indices to new highs and driving up bond yields. Given all the conflicting forces at play in developed bond markets - accelerating growth, rising inflation, fiscal and political uncertainties, bearish bond investor positioning - we believe it is important to stay grounded by focusing only on the most relevant factors while trying to sift out the signal from the noise. This week, we are introducing a new "Duration Checklist" for both U.S. Treasuries and German Bunds, highlighting the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio duration stance. From this checklist, we can confirm that the bond-bearish backdrop remains intact, with more indicators pointing to higher yields in the U.S. relative to core Europe. Describing The Elements Of Our Checklist The individual components of bond yields that we typically monitor - term premia, inflation expectations and shifts in the market-implied path of policy rates - have all contributed to the rise in U.S. and European bond yields since last July (Chart of the Week). Some of the factors that have driven yields higher are global in nature, like faster economic growth and rising energy prices, while others are more country-specific, like rising wage inflation in the U.S. To account for those different factors, we need to include a variety of indicators in our new GFIS Duration Checklist. The goal of list is to answer the specific question: "what should we watch to maintain a below-benchmark duration stance in the U.S. and core Europe?" The items in the Checklist are shown in Table 1, broken down into the following groupings: Table 1Stay Bearish On Treasuries & Bunds Accelerating Global Growth: Here, we are looking at indicators that are pointing to a quickening pace of global economic growth that would put upward pressure on all developed market bond yields. Specifically, we are looking to see if: a) the annual growth in the global leading economic indicator (LEI) is accelerating; b) our diffusion index for the global LEI is above 50 (suggesting a majority of countries with an expanding LEI) and rising; c) the global ZEW economic sentiment index is increasing; d) the global data surprise index is moving higher; and e) our measure of the global credit impulse (the 6-month change in credit growth among the major economies, one of BCA's favorite leading economic signals) is expanding. These global indicators are all shown in Chart 2. The global LEI growth rate, the global ZEW index and global data surprises are all moving higher, consistent with upward pressure on bond yields, and thus warrant a "check" in our GFIS Duration Checklist. The LEI diffusion index is well above 50, but has hooked down slightly in the past few months, as has the global credit impulse. These moves are relatively modest, and it is not yet certain whether they represent a change in trend in these series. For now, we are giving these indicators a "check", but with a question mark attached. If we see additional declines in the diffusion index and the global credit impulse in the next few months, we would interpret that as a sign that the cyclical global upturn is in danger of losing momentum, thus reducing the upward pressure on bond yields. Accelerating Domestic Growth: These are economic data that are specific to each country that would be consistent with higher yields; a) manufacturing purchasing managers' indices (PMIs) that are above 50 and rising; b) expanding consumer confidence; c) rising business confidence; d) faster growth in corporate profits. The relevant data for the U.S. are shown in Chart 3, which shows that all elements are increasing in a fashion that is bearish for U.S. Treasuries. The popular perception is that the recent surge in business confidence (both for corporate CEOs and small business owners) is simply a "Trump effect" from the new president's pro-business economic platform. However, the acceleration in corporate profit growth, which our own models are suggesting will continue in the coming quarters, is a sign that there is a more fundamental reason for firms to feel more optimistic. Chart 2Global Growth Still Pointing To Higher Yields Chart 3U.S. Domestic Upturn Is Solid We give all the U.S. domestic growth indicators a "check" pointing to a need to stay below-benchmark U.S. duration. The specific Euro Area growth data is shown in Chart 4. Similar to the U.S., all the indicators are moving higher in a bond-bearish direction, warranting a "check" on the Euro Area Duration Checklist. The political tensions stemming from the busy election calendar in Europe this year represent a potential negative shock to confidence. As we discussed in our Special Report published last week, however, we do not foresee a populist election shock in France akin to Brexit or Trump that would derail the Euro Area economic expansion.1 Rising Domestic Inflation Pressures: These are data that are specific to each country that would be consistent with faster inflation and higher yields: a) the annual growth in the oil price, in local currency terms, is accelerating; b) wage inflation is rising; c) the unemployment gap (the difference between the unemployment rate and the full employment NAIRU rate) is closed or nearly closed; The U.S. inflation data is shown in Chart 5, with all the indicators warranting a bond-bearish "check" in our U.S. Duration Checklist. The rising trend in oil prices continues to put upward pressure on headline U.S. inflation, even with the strong U.S. dollar. Meanwhile, the unemployment gap is now closed and U.S. wage inflation is grinding higher. This should be consistent with additional modest gains in core inflation that will put upward pressure on the inflation expectations component of U.S. Treasury yields (bottom panel). Chart 4Euro Area Domestic Upturn Is Solid Chart 5U.S. Inflation Trends Still Bearish For USTs It is a different story in the Euro Area, as can be seen in Chart 6. While the rapid acceleration in the Euro-denominated price of oil is starting to feed through into faster headline inflation, there still exists a positive unemployment gap that is helping keep wage growth, and core inflation, muted. A continuation of the recent economic upturn will likely put more downward pressure on Euro Area unemployment, but, for now, only the oil price acceleration justifies a "check" in the Euro Area Duration Checklist. Chart 6Euro Area Inflation Is A Mixed Bag Central Bank Policy Stance: Here, we are not including any charts, but are only stating whether the central bank has a bias to tighten monetary policy. That is certainly the case in the U.S., where the Fed has already delivered a 25bp hike in December and continues to signal that up to three more hikes will occur in 2017 if the FOMC growth forecasts are realized. So we put a "check" in this box on the U.S. side of the checklist. The European Central Bank (ECB) continues to maintain an unusually accommodative monetary stance, using a combination of asset purchases, negative policy rates and dovish forward guidance. We continue to see a potential shift away from this super-easy policy bias in the latter half of the year - in response to the upturn in economic growth and acceleration of Euro Area inflation towards the ECB's 2% target - as the biggest risk for both Euro Area bonds, in particular, and global bonds, in general. For now, however, the ECB is signaling no imminent shift to a more hawkish stance, so we are placing an "x" in the central bank portion of the Euro Area checklist. Risk-Seeking Behavior In Financial Markets: Here, we are checking to see if pro-growth, pro-risk asset classes are outperforming and whether market volatilities are rising. Risk asset outperformance and stable vol suggests that investors are less interested in risk-free government bonds: a) the domestic equity index is rising but is not yet 10% above the 200-day moving average (a level that has coincided with post-crisis equity market and bond yield peaks); b) domestic corporate bond spreads are either flat or falling rapidly; c) domestic equity market volatility is low and falling rapidly. The U.S. indicators are shown in Chart 7, while the Euro Area data is shown in Chart 8. The story is the same in both regions, with equity markets in a bullish trend but not yet at a fully-stretched extreme, credit spreads (both for Investment Grade and High-Yield) tight, and equity market volatility at multi-year lows. We view these indicators as signs that investors are less interested in owning U.S. Treasuries and German Bunds than owning equities and corporate debt. This will help bond yields drift higher on the margin as economic growth and inflation rise in the coming months. Thus, we place a "check" on all three elements in both the U.S. and Euro Area Duration Checklists. Chart 7Risk-Seeking Behavior In The U.S. Chart 8Risk-Seeking Behavior In Europe Contrarians may look at those same charts and say that this is more of a sign that investors are too optimistic and are now exposed to any negative growth shock, potentially representing a trigger for a selloff of risk assets and a move into government debt. We prefer to view the bullish performance of growth-sensitive assets as a sign of underlying investor risk appetite. Domestic Bond Market Technicals: Here, we are simply looking at measures of price momentum and market positioning in government bonds, to assess if there is room for additional yield increases as investors reduce exposure: a) the domestic 10-year bond yield is not stretched to the upside versus the 200-day moving average; b) the domestic Treasury index total return momentum (26-week rate of change) is not stretched to the downside; c) bond investor positioning is not already short. The 10-year U.S. Treasury technicals are shown in Chart 9, while the German Bund technicals are shown in Chart 10. The story is quite simple here - the rapid run-up in global bond yields late last year has led to stretched, oversold conditions on both sides of the Atlantic. Sentiment remains bearish in U.S. Treasuries, with massive net shorts in bond futures, suggesting that an overhang of positions remains a major headwind to higher yields. While we do not have positioning data for Euro Area bond investors, the momentum charts for German Bunds look very similar to the U.S. Treasury charts. Clearly, we must place an "x" in all these boxes on both Duration Checklists. Chart 9Stretched Technicals In U.S. Treasuries... Chart 10...And In German Bunds So What Are The Checklists Telling Us? Adding it all up, and the vast majority of the indicators in both checklists are pointing to continued upward pressure on bond yields, justifying a below-benchmark duration stance. The lack of core inflation pressure in the Euro Area, however, suggests that there is less upward pressure on German Bund yields relative to U.S. Treasuries, thus we continue to recommend an overweight stance on Bunds versus Treasuries in global hedged bond portfolios. Oversold conditions suggest that yields will have a tough time rising quickly from here while the market continues to consolidate the late 2016 bond selloff. However, a major bond market reversal is unlikely given the solid upturn in global growth. Bottom Line: Growth, inflation & investor risk-seeking behavior remain bond-bearish in both the U.S. & the Euro Area. Market technicals, both in terms of oversold momentum and heavy short positioning, are the biggest headwind to higher yields in the near-term. Maintain a below-benchmark portfolio duration stance in the near term, favoring German Bunds over U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Our View On French Government Bonds", dated February 7, 2016, available at gfis.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 Rate Volatility: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Treasury Yields: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. MBS: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Feature Low interest rate volatility has been a constant feature of the investing landscape during the past few years. In fact, you need to go back to the 1970s to find another period when interest rate volatility was consistently at or below its current level (Chart 1). Not surprisingly, the implied volatility priced into Treasury options is also as low as it has been during the past 30 years, with the exception of the period just prior to the financial crisis in 2007 (Chart 2). Chart 1Yield Volatility: Lowest Since The 70s Chart 2Implied And Realized Yield Volatility Move Together This begs the question of whether the current low-vol environment can be sustained, or whether overly complacent investors are in for a shock. At the very least, we believe that rate volatility has already passed its cyclical trough and will start to move up this year. Investors should prepare themselves for higher volatility. In this week's report we examine the key macro drivers of interest rate volatility and discuss the implications of rising vol for both Treasury yields, and crucially, mortgage-backed securities. Macro Uncertainty & Rate Volatility Chart 3Macro Drivers Of Rate Volatility In a Special Report published in 2014,1 we posited that the long-term trends in volatility across all asset classes are largely driven by common macroeconomic factors. Specifically, investor uncertainty regarding the outlook for economic growth and monetary policy. A 2004 paper by Alexander David and Pietro Veronesi2 provides some theoretical justification for this view, as the authors observed that investors tend to overreact to new information when macro uncertainty is high, and underreact when uncertainty is low. To test the linkage between interest rate volatility and macro uncertainty we consider three measures of uncertainty. The first two measures, shown alongside the MOVE index of implied Treasury volatility in Chart 3, are measures of GDP growth and T-bill rate forecast dispersion. We measure dispersion - the disagreement among forecasters - by looking at individual forecasts of GDP growth and T-bill rates and calculating the difference between the 75th and 25th percentiles. The series shown in Chart 3 are equal-weighted averages of the forecast dispersion calculated for five different time horizons, ranging from the current quarter to four quarters ahead. As can be seen in the top two panels of Chart 3, implied interest rate volatility is higher when the disagreement among forecasters is greater, consistent with our thesis. The third measure of uncertainty we consider is the Global Economic Policy Uncertainty Index created by Baker, Bloom and Davis.3 This index tracks uncertainty about the macro environment by counting the number of mentions of certain key words in major global newspapers. Elevated readings from this index have also coincided with high rate volatility in the past (Chart 3, bottom panel). GDP Growth Forecast Dispersion Chart 4Forecast Dispersion & Corporate Lending Disagreement among GDP growth forecasts reached an all-time low in the fourth quarter of 2016, but has since recovered to slightly more typical levels. Historically, we have found that C&I lending standards and corporate sector balance sheet health correlate most closely with GDP growth forecast dispersion (Chart 4) and both measures suggest that forecast dispersion is biased upward. T-Bill Rate Forecast Dispersion T-bill rate forecast dispersion was abnormally low between 2011 and 2014 for two reasons. The first reason is quite simply the zero-lower-bound on interest rates. A short rate bounded at zero necessarily trimmed the distribution of possible T-bill rate forecasts, since forecasters logically assumed that further interest rate cuts were not possible. This impact will gradually dissipate the further the fed funds rate moves off zero. Chart 5Fed Says March Meeting Is Live The second reason for extremely low T-bill rate forecast dispersion was the Fed's forward guidance. During this timeframe the Fed was actively trying to convince the public that interest rates would remain low. The most obvious example being the "Evans Rule", where the Fed promised not to lift interest rates at least until the unemployment rate had fallen below a specific threshold. This activist forward guidance limited the range of conceivable T-bill rate forecasts and crushed interest rate volatility. Nowadays, the Fed is engaged in a different sort of forward guidance, trying to convince markets that every FOMC meeting is live and that rate hikes could occur at any moment. Essentially, the Fed is trying to inject volatility into the rates market. Just a few weeks ago, when asked about the low probability markets are assigning to a March rate hike (Chart 5), San Francisco Fed President John Williams replied flatly: "I don't agree. All our meetings are live." Global Economic Policy Uncertainty We have written a lot about the policy uncertainty index in recent reports,4 focusing specifically on how it has diverged from its historical relationships with many asset prices. At the very least, we expect that sustained elevated policy uncertainty will place upward pressure on asset price volatility at the margin. Bottom Line: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Rate Volatility & Treasury Yields Long-dated nominal Treasury yields can be decomposed in a few different ways. In recent reports we have focused on the decomposition of the nominal 10-year Treasury yield into its real and inflation components. By identifying different macro drivers for each component we concluded that nominal Treasury yields will increase this year, driven by a rising inflation component and relatively stable real yields.5 Alternatively, we can think of the nominal 10-year Treasury yield as consisting of an expectations component equal to the market's expected path of short rates over the next ten years, and a term premium that reflects all of the other market imbalances and uncertainties associated with taking duration risk. This second approach is complicated by the fact that it requires a model of ex-ante interest rate expectations and every commonly used model is fraught with its own unique difficulties.6 Setting that aside, if we use the Kim & Wright (2005)7 estimate of the 10-year term premium we observe an expectations component that generally tracks the fed funds rate and a term premium component that is correlated with implied Treasury volatility (Chart 6), although the latter correlation is less than perfect. This decomposition also suggests that nominal Treasury yields should rise. The Fed is much more likely to hike rates than cut them and we have concluded that rate volatility is likely to trend higher from current depressed levels. However, the relationship between rate volatility and the term premium is complicated. The main reason for the complicated relationship between interest rate volatility and the term premium is the fact that elevated interest rate volatility also tends to be correlated with high equity volatility (Chart 7). So while higher rate volatility puts upward pressure on the term premium, the associated increase in equity volatility tends to raise investor risk aversion and increase the perceived value of bonds as a hedge against equity positions. This mitigates some (or often all) of the impact of rising rate volatility on the term premium. Chart 6Which Way For The ##br##Term Premium? Chart 7MOVE & VIX Have Opposing##br## Impacts On Bond Yields Bottom Line: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. Rate Volatility & MBS The relationship between rate volatility and MBS is much more straightforward than for Treasury yields. We observe a tight correlation between nominal MBS spreads and the MOVE implied volatility index (Chart 8). Chart 8 suggests that, even in the near-term, MBS spreads are too low for current levels of rate vol. The relationship between MBS spreads and rate volatility is easily explained. The defining characteristic of a negatively convex asset, such as MBS, is that its duration is positively correlated with the level of interest rates (Chart 9). This correlation leads to increased losses when yields rise and lower gains when yields fall. It's not surprising that negatively convex assets perform best in low volatility environments. Chart 8MBS Spreads Are Linked To Vol Chart 9MBS Duration Moves With Yields We maintain an underweight allocation to MBS given that spreads are already low and that the volatility environment is poised to become less favorable. Further, if the Fed continues along its planned normalization path it is likely to cease the reinvestment of its MBS portfolio at some point in 2018. There are two reasons why this poses a risk for MBS. The first reason is that the unwinding of the Fed's MBS portfolio is likely to place upward pressure on implied volatility. While private investors often hedge their MBS positions by purchasing volatility, the Fed has no incentive to do so. It follows that by removing a large stock of MBS from private hands the Fed has also removed a large source of demand for volatility. When this supply is re-introduced into the market, demand for volatility is likely to increase. The second reason relates more directly to the supply and demand balance for MBS. In years when net MBS issuance (adjusted for Fed purchases) has been negative, excess MBS returns have tended to be positive (Chart 10). Further, while negative net MBS issuance (adjusted for Fed purchases) has been the norm since Fed asset purchases began in 2009 (Chart 11), this state of affairs will change once the Fed starts to unwind its MBS portfolio. Chart 10Annual MBS Excess Returns ##br## Vs. Net Supply Since 1989 Chart 11Net Issuance Will Turn##br## Positive In 2018 During the past three years the Fed has been buying between $20bn and $40bn MBS per month, just to keep its balance sheet stable. Net new MBS issuance will not be strong enough to overcome this hurdle in 2017, but net MBS issuance (adjusted for Fed purchases) will swing quickly into positive territory in 2018 if the Fed decides to let its MBS portfolio run down. Bottom Line: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "Volatility, Uncertainty And Government Bond Yields", dated May 13, 2014, available at usbs.bcaresearch.com 2 "Inflation and earnings uncertainty and volatility forecasts", Alexander David and Pietro Veronesi, Manuscript, Graduate School of Business, University of Chicago (2004). 3 Please see www.policyuncertainty.com for further details. 4 Please see Theme # 4 in U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Bond Volatility - The Unwelcome Guest That Will Not Leave", dated June 16, 2015, available at usbs.bcaresearch.com 7 Don H. Kim and Jonathan H. Wright, "An Arbitrage-Free Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates", FEDS 2005-33. https://www.federalreserve.gov/econresdata/feds/2005/index.htm Fixed Income Sector Performance Recommended Portfolio Specification