Monetary

Dear Client, In addition to an abridged Weekly Report, we are also including a Special Report written by our Global ETF Strategy team. BCA's Global ETF Strategy, launched in September joins comprehensive ETF analysis with BCA's global macroeconomic thematic research: its aim is to help clients connect the dots from BCA themes to individual ETF ticker symbols with real-time market expressions of our views. The team is currently producing a series of reports on smart-beta ETF selection, whereby they examine the key factors recognized by academia and investment practitioners as persistent drivers of market performance. In this second installment, the team focuses on dividend-focused funds. Although the team finds that dividends do not qualify as a true standalone factor consistently explaining equity returns, dividend policy can add to multi-factor models' explanatory power at the margin. Given the popularity of dividend investing, we think dividend policy could be a fruitful subject for further research. Best regards, Lenka Martinek Feature U.S. financial markets breathed a collective sigh of relief last week when the FOMC followed through on a fully discounted 25 bps rate hike, but did not increase the number of expected rate hikes for the year. In other words, the Fed successfully delivered a "dovish hike", thus reassuring investors that the policy sweet spot - the period when interest rates are rising but have not become restrictive - will last a while longer (Chart 1). Chart 1A "Dovish Hike" Chart 2Low Structural Unemployment Rate The Fed's assessment of the economy is not very different from our own, though there were a few details in the economic projections worth highlighting. First, the estimate for the structural rate of unemployment was scaled down further by a tenth of a percentage point to 4.7%. This may seem minor, but it suggests that policymakers believe the labor market has more running room before wage inflation moves higher. Granted, any forecast for structural unemployment should be taken with a dose of salt, but our bias throughout this cycle - and as outlined in our November Special Report - has been to expect wage inflation to lag relative to past cycles due to structural factors (Chart 2). And as can be seen in Chart 3, Japan provides a roadmap: in that country, demographic factors helped push the unemployment rate to below 3% without creating inflationary pressures. Of course, the U.S. economy is very different from Japan and we do not expect unemployment to drop as low. However, as occurred in Japan, we would not be surprised to see the FOMC trim its forecast for the structural unemployment rate further in the coming quarters. A related point is that the Fed also adjusted the wording of the FOMC statement regarding its inflation targets. The statement said that the Fed was looking for a "sustained" return to 2% inflation, while also referring to its inflation target as a "symmetric" one. Our interpretation is that the Fed is trying to clarify that it will not react too aggressively if core inflation were to drift somewhat above 2%. Clearly, the Fed is beginning to see the balance of risks toward higher inflation. That makes sense, given that the economy is operating close to full employment. However, we maintain that a sustained rise in inflation above the Fed's 2% core PCE target is not imminent. Indeed, the message from last week' CPI report reinforces our view that with the exception of a few components, inflation is very well contained (Chart 4). Our diffusion index of the major inflation components is in negative territory. Importantly, price surveys continue to show that businesses are not able to easily raise prices. For example, despite the continued optimism in the headline components of the NFIB small businesses survey, small businesses have not been able to - and do not yet anticipate being able to - raise prices. This reinforces our long-held view that after a long period of disinflation - and outright deflation in the retail sector - inflation expectations are extremely well-anchored and savvy consumers know how to extract a better deal. Core PCE inflation may converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot should not be a major driver of investment decision-making over the next 6-12 months. Chart 3Japan: A Low Unemployment Rate ##br##And Little Wage Inflation Chart 4Inflation ##br##Still Low In the end, it is Fed Chair Yellen's least sophisticated remarks that provide the best summation. During the FOMC press conference, she stated that "the simple message is the economy is doing well". Indeed, the moderate pace of growth that has prevailed since the beginning of the recovery means that the typical imbalances and pressure points that accumulate in the advanced stages of a business cycle are so far still absent. The backdrop overwhelmingly favors stocks relative to government bonds on a cyclical horizon. To be sure, equities are expensive, but as we wrote last week, relative to competing assets, valuations are not extreme. The greater near-term risk continues to be a phase of economic and earnings disappointments that could develop later this year, since there remains a tremendous amount of optimism in the business community regarding regime change in Washington. Note that the policy uncertainty index remains very elevated (Chart 5) and Trump's "skinny budget", which aims to slash spending across all discretionary items save military and veterans affairs, will be contested. Our geopolitical team notes that Democrats could threaten a government shutdown later this year to try to force Republicans' hand at removing the most controversial elements of the budget. Democrats can filibuster parts of the appropriations process which makes the concrete budget allocations. Chart 5Political Uncertainty Still Elevated On this basis, we remain skeptical that fiscal policy will be clean fuel for the equity bull market. However, we adhere to Yellen's "simple message" that the economy is on a stable footing. That implies that Washington disappointments will most likely lead to equity setbacks rather than a painful breakdown. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommendation weightings for the major asset classes are unchanged: neutral equity exposure at 60% (benchmark 60%), neutral Treasury allocation at 30% (benchmark 30%) and cash at 10% (benchmark 10%). The diffusion index of the three components for The Equity Model remained neutral. The technical component "buy" signal strengthened, with sturdy advances for both the breadth & trend and momentum indicators. The monetary component, which measures overall liquidity conditions within the financial and economic system and designed to lead equity prices, is slightly more bullish and still favorable for equities. The earnings-driven component continues to give a cautious signal. Real operating earnings remain at a significant distance from positive economic expectations which have moved higher yet again. Moreover, earnings momentum is still sluggish, based on our earnings diffusion index, which compares nominal earnings growth relative to four key macro proxies for business costs. The model's recommendation for bonds remains at benchmark which still fits with our neutral qualitative stance for Treasuries in balanced portfolios since November 7, 2016. Although the cyclical component of the bond model is more constructive than the valuation component, the further deterioration in the technical component maintains the "sell" signal for Treasuries firmly in place. Chart 6Portfolio Total Returns Chart 7Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009. Highlights Factor attribution began a half-century ago with the Capital Asset Pricing Model ("CAPM"). Although the CAPM itself has been superseded, selected factors have exerted a consistent influence on equity performance. The empirical evidence does not support including dividends among the proven factors, yet dividend-focused funds are the most numerous in the smart-beta universe. The ambiguity surrounding dividends' effect on equity performance leaves plenty of room for smart-beta purveyors to build a better mousetrap, but our own research suggests that they will have to do so with something other than purely dividend-related metrics. Reflecting the fact that many of the dividend funds already incorporate multi-factor inputs, we evaluate them based on their exposure to all of the metrics within our Equity Trading Strategy service's multi-factor model. Feature Welcome to the second installment of our series on smart-beta ETF selection. Over the course of the series, we intend to examine the factors widely recognized by academia and investment practitioners as persistent drivers of equity performance. Each Special Report will weigh the evidence for the factor's efficacy, consider the metrics that best reveal its presence and compare our ideal metrics with the metrics utilized by our proprietary Equity Trading Strategy ("ETS") multi-factor model. It will then evaluate the menu of smart-beta ETFs using either our ETS model's metrics or an augmented version of them. The series began last month with a review of the Value factor, enshrined by Fama and French's research, and the current subset of Value smart-beta ETFs.1 This month we examine Dividend smart-beta ETFs. Subsequent installments will examine Quality, Momentum and Volatility,2 and we will likely wrap up the series with a review of Multi-Factor smart-beta ETFs. This installment provides some background on factor investing and the smart-beta process before subjecting Yield (Dividends) to scrutiny to determine whether or not it really constitutes a standalone equity factor. Back To The Beginning The ubiquity of beta in discussions of investing performance originates from the Capital Asset Pricing Model ("CAPM"), as advanced by William Sharpe and other researchers in the early 1960's. The CAPM posits that the expected return of stock XYZ is solely a function of XYZ's riskiness relative to the overall equity market. XYZ's riskiness is a function of its covariance with the market, and is represented in the CAPM's simple linear model as the coefficient "beta.3" The elegantly simple CAPM holds that any stock's expected return (E(rs)) is the sum of the risk-free rate (rf) and the product of its beta (ßs) and the difference between the expected market return (E(rm)) and the risk-free rate (rf): E(rs) = rf + ßs x (E(rm) - rf) As noted by several researchers, including Eugene Fama and Kenneth French,4 CAPM's return predictions are woefully errant when applied to stocks. As Chart 1 indicates, the returns projected by the CAPM bear little relationship to empirical results. It turns out that low-beta stocks have systematically outperformed high-beta stocks on a risk-adjusted basis (Chart 2), just as low-book-multiple stocks have crushed high-book-multiple stocks without regard for beta (Chart 3). This is powerful evidence for value, and for the low-volatility factor that we will examine in a subsequent report, but it is damning for the simple application of the CAPM to stocks. Chart 1CAPM Sounded Great In Theory ... Chart 2... But It Flopped In Practice Chart 3Low-Book-Multiple Stocks Systematically ##br##Flout CAPM Predictions A New Vocabulary Despite its empirical shortcomings, the CAPM provides an intuitive way of conceptualizing the risk-return tradeoff, and it paved the way for the asset-pricing research that followed it. The notion that individual securities' risks come in two flavors, market and idiosyncratic, is a critical element of portfolio theory and its thou-shalt-diversify commandment. It is also the basis, as we shall see, for beta, alpha and the factor-investing approach enabled by smart-beta ETFs. For that application, let us add an alpha term to the CAPM to account for the component of realized returns that cannot be explained by market exposures: rs = rf + ßs x (E(rm) - rf) + a Rearranging terms to solve for alpha shows it to be the difference between the realized return and the return expected by CAPM: a = rs - (rf + ßs x (E(rm) - rf)) From CAPM To Factors To Smart Beta In today's accepted usage, alpha is the ex-post difference between portfolio and benchmark return, adjusted for risk. It is the component of return attributed to portfolio manager skill, whereas beta is the return accruing to simple market exposure. As return-attribution research has uncovered the systematic factors underpinning performance, beta has claimed an increasing share of the pie from alpha. The salubrious effect for investors, especially those who employ third-party managers, has been to demystify the sources of portfolio returns. Beta's expanding share has also opened the door to a middle course between purely active and purely passive portfolio management strategies. Factor research has made it possible to join the main advantages of passive strategies - transparency, predictability and low cost - with active strategies' aim of delivering a risk-adjusted return profile distinct from those offered by cap-weighted benchmarks. Investors have embraced the factor approach and traditional asset managers have obliged them with a torrent of smart-beta ETF choices. Both should put investors on alert: according to the late Barton Biggs, there is no investment idea so good that it can't be destroyed by too much money, and fund company enthusiasm may correlate more closely with its own profits than its clients'. Biggs' admonition is always on our mind, but we don't think the established factors are in imminent danger of losing their zest. Factor excess returns are not new news. 25 years after Fama and French's paper, low-book-multiple stocks continue to outperform high-book-multiple stocks and smaller stocks continue to outperform larger stocks. We do not see the comparatively modest aggregate smart-beta ETF AUM as a catalyst for bidding away the returns that have durably accrued to factors. Are Dividends Really An Equity Factor? For the purposes of this report, our first objective is to determine whether or not Dividends can properly be considered a factor alongside the big five (Value, Quality, Momentum, Volatility and Size). Unable to find compelling evidence for their inclusion, we do not think they should. Yield may be a promising factor in fixed income, but extending the concept to equities is problematic. Across all capitalization buckets for the last 20 years, it cannot even be said that dividend payers outperform non-dividend payers (Chart 4). The empirical record for more sophisticated slicing and dicing is mixed, depending on the level of granularity. Breaking the universe of U.S. equities into non-dividend payers and dividend payers, and then segmenting the latter by yield into the lowest three deciles, the median four deciles and the highest three deciles, Fama and French's 90-year dataset supports the idea that higher-yielding stocks generate higher total returns (Chart 5). The breakout is neatly consistent, with dividend payers outperforming non-dividend payers, and each yield cohort of the dividend payers outperforming the lower-yielding cohorts beneath it (Chart 6, top panel). Zoom into the dividend payers at the quintile and decile levels, however, and the consistency disappears as the tidy staircase pattern begins instead to resemble a jagged picket fence (Chart 6, lower panels). Chart 4Dividends Have Been Hazardous To Investors' ##br##Wealth Over The Last 20 Years ... Chart 5... Though They've Rewarded Investors ##br##Over Nine Decades Chart 6Not Ready For A Close-Up Adjusting for risk makes the picture even murkier. While the non-payers and the lowest-yielding cohorts always post the smallest risk-adjusted returns, they are the only cohorts the highest-yielders manage to beat. The median 40 is the winner among our 30-40-30 cohorts, while the fourth and the second quintiles bracketing the median 40 easily outpace the top quintile, and the eighth, fourth and seventh deciles break away from the rest of the decile pack (Chart 7). It should come as no surprise that our long top 30%/short bottom 30% litmus test failed to reveal any viable excess return strategies based on dividend yields. Our attempts to develop simple portfolio construction rules based on markers of dividend quality and sustainability failed to conclusively advance the dividend cause. Long/short strategies founded on dividend growth added no value to a simple portfolio built from dividend yield and change in share count (Chart 8). Payout ratio metrics, which might shed some light on both quality and sustainability, provided pretty solid results, but they weren't enormous winners (Chart 9). Our analysis left us unable to conclude that Yield merits inclusion among the established equity factors. Chart 7No Theme To Risk-Adjusted Return Profiles Chart 8No Viable Long/Short Dividend-Growth Strategy ... Chart 9... But Payout Ratios Work Pretty Well An Ideal Dividend Index The fact that the way forward for dividend strategies is not obvious is good news for smart-beta sponsors. The ambiguity leaves plenty of room for developing better index-construction methods. Some sources of improvement might include: A means of identifying and sidestepping "yield traps," high and/or growing yields that are actually a distress signal. A way to review historical metrics to gain a sense of ongoing dividend growth. An evaluation of a dividend's source, valuing dividends supported by operating cash flows more highly than those supported by financing activities or asset dispositions. A process for limiting sector exposures, and an awareness of the most auspicious backdrops for taking on exposure to specialized yield plays like mortgage REITs, MLPs and BDCs. Ticking off every item on this wish list, however, would necessarily involve infringing on other factors' turf. Quality, Value, Size and Volatility could all spill into the process of assessing dividend quality and sustainability. Given that our attempts at creating our own tests to measure up to the wish list came up empty, it seems that a cross-disciplinary approach might be the only option. Even if the indexes are not based completely on dividend-derived metrics, it may be possible for a few dividend accents to add some incremental value to the overall stew. Smart-Beta Fund Evaluation These issues were on our mind when we set out to define the metrics that we would use to evaluate the indexes created by our Dividend smart-beta ETF subset. The two payout metrics in the ETS model, dividend yield and change in shares outstanding, are pretty thin gruel for evaluating the dividend ETFs. The ETS payout metrics were selected based on their interaction with the Value, Safety, Quality, Momentum and Sentiment metrics, 23 in all, that comprise the rest of the stock-level inputs into our model. They were not intended to be stand-alone measures. Many of the ETFs in our subset explicitly screen for Quality, Value and/or Low Volatility. They could just as accurately be described as multi-factor funds in a dividend-first wrapper, and we have therefore deployed the entire ETS model to evaluate them. To assess whether or not their constituent selection process consistently improves upon a simple dividend strategy, we compare their ETS scores to those of VIG, the Vanguard Dividend Appreciation ETF, which tracks the NASDAQ US Dividend Achievers Select Index of stocks (ex-REITs and LPs) with at least 10 consecutive years of dividend increases. First Trust Rising Dividend Achievers ETF (RDVY) RDVY's ETS scores have stood out from its smart-beta peers' since the fund's inception at the beginning of 2014. Its concentrated 50-stock portfolio allows it to focus on exposure to its preferred growth and sustainability metrics. Only stocks that have grown their dividends over 3- and 5-year periods, and their non-zero earnings per share over a 3-year period, make it through the growth filters. The sustainability filters admit only stocks with cash-to-debt ratios of at least 50% and dividend payout ratios of 65% or less. Chart 10Good Things Come To Those Who Wait Although the fund has outperformed VIG since inception, its relative performance has not been nearly as consistent as its relative ETS scores (Chart 10). It has taken a 40% surge over the 12 months ended February 28th to put RDVY over the top. We recognize that performance can be capricious, however, and place more weight on RDVY's consistently stellar relative ETS scores, which are 20% more, on average, than its smart-beta peers'.5 RDVY's 50-basis-point ("bps") expense ratio exceeds the 36-bps group average, but we think its screens and concentration are worth the incremental 14 bps. The fund is on the smaller side with $127 million of AUM, and daily turnover of just over $2 million, but larger investors can make use of the creation/redemption unit process to transact in larger volumes without concern. We recommend RDVY for investors seeking large- and mid-cap dividend exposure. FlexShares Quality Dividend Index Fund (QDF) QDF stands second to RDVY on an ETS score basis. Its relative scores have been remarkably stable, rarely falling below 110% en route to averaging 113% of the aggregate Dividend smart-beta score. QDF's selection process is proprietary, and it incorporates measures of cash flow, profitability, and management's skill at deploying capital and financing its activities. The mix has enabled QDF to outperform VIG from the get-go, and steadily pad its lead ever since (Chart 11). Its 37-bps expense ratio is right in line with the group's and its $1.7 billion AUM and $5 million average daily turnover provide a nice sense of ballast. We recommend QDF, along with RDVY, as the best Dividend smart-beta options. Chart 11Wire-To-Wire Outperformance WisdomTree MidCap Dividend Fund (DON) O'Shares FTSE US Quality Dividend ETF (OUSA) WisdomTree has been a pioneer in creating dividend-weighted indexes, but the formula it's applied to selecting constituents for DON, its mid-cap dividend ETF, has not found favor with the ETS model. The fund's constituents have repeatedly earned an aggregate ETS score below 40, holding its relative score below 80% for extended periods. OUSA is a newer fund, with less than a year of history, but its ETS scores have been noticeably weak. We would avoid OUSA until it compiles enough of a track record to permit more conclusions about its process and we would advise investors seeking targeted mid-cap exposure to gain it via funds other than DON. Dividends' Curious Attraction Our work in researching this Special Report has brought dividends' many contradictions to light. In countries like the U.S., where ordinary income is taxed at a higher rate than capital gains, dividends represent an especially tax-inefficient way of redeeming a portion of one's investment. Either share buybacks or sales to third parties would yield more after-tax cash. Humans feel a strong pull to book gains, and steadily redeeming portions of a successful investment has an intuitive emotional appeal: "Let's quit while we're ahead, let's go while the getting is good." It's exactly the wrong thing to do with investments, however. If the quarterly dividend flow assuages the remorse over a mistaken investment, encouraging an investor to stick with a losing position, it's even worse. It is possible that dividends, even though they're small, help reinforce our innate resistance to selling losers and letting winners run. From management's perspective, legacy dividend payments can act as handcuffs. Fearful of issuing a signal that is sure to be interpreted negatively by the market, firms take pains to refrain from cutting dividends. Dividend declarations, then, are a part of the capital budgeting process that is not rooted in economics. A rigorously utility-maximizing visitor from outer space may have found the oil majors' borrowing to fund their dividends in the midst of the severe downturn in crude prices to be very odd indeed. All of these shortcomings may help explain why we were unable to find clear evidence that dividends exert a clear and consistent influence on stock prices. And yet, dividends are enormously popular, with dividend funds by far outnumbering every other flavor of smart-beta ETF. We, too, like to think of positions in balanced portfolios on a total-return basis, as does our U.S. Investment Strategy service, which has successfully recommended the Dividend Aristocrats much longer than we have. Total return is important, but we are increasingly leaning toward the view that specialty dividend plays, purchased at the right point of the cycle, are the best way for an investor to capture income from equity holdings. Such an all-or-nothing approach may well be superior to the one-foot-in, one-foot-out stance that is embodied by the average 2% large-cap dividend yield. Our U.S. Investment Strategy service has successfully surfed the cyclical wave in mortgage REITs, and we are attempting to do so now with the inclusion of BIZD, the business development company ETF, in our U.S. portfolios. Adding cycle analysis would make our smart-beta studies too long, but we are conducting research into the interaction between factor performance and cycle phases, and we will share our findings with our clients in standalone Special Reports if they are insightful enough to merit their attention. Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com Jennifer Lacombe, Research Analyst Global ETF Strategy Jenniferl@bcaresearch.com Philippe Morissette, Associate Vice President Equity Trading Strategy philippem@bcaresearch.com 1 Please see Global ETF Strategy/Equity Trading Strategy Special Report, "Smart-Beta ETF Selection, Part I - Value Funds," published February 15, 2017, at etf.bcaresearch.com. 2 Size may be too straightforward to allow for an index-construction edge. 3 Stock XYZ's beta is equal to the covariance of its returns with the market's returns, divided by the variance of the market's returns, where its covariance with the market equals its returns' correlation with the market's times the product of XYZ's volatility and the market's volatility. 4 Fama, Eugene F. and French, Kenneth R., "The Capital Asset Pricing Model: Theory and Evidence," Journal of Economic Perspectives, Volume 18, Number 3 (Summer 2004), pp. 25-46. 5Befitting its benchmark status, VIG’s ETS scores have averaged 99.8% of the entire subset’s since inception.

Dear Client, In addition to this brief note concerning Wednesday's FOMC meeting, we will be sending you a Special Report written by my colleague Brian Piccioni, head of BCA's Technology Strategy service. Brian discusses the investment implications of what could be one of the most profound technological developments of the 21st century: CRISPR, a radical new technique for genetic engineering. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy The dollar and U.S. Treasury yields fell sharply in the aftermath of Wednesday's FOMC meeting, while equities rallied. Indeed, so pronounced was the asset market reaction that financial conditions eased markedly for the day, making the Fed's actions an "unhike" of sorts. The FOMC meeting produced several dovish surprises. First, the number of participants who expected four rate hikes or more did not increase, as some observers had anticipated. Second, the estimate for the structural rate of unemployment was scaled down further by a tenth of a percentage point to 4.7%. Third, the FOMC statement said that the Fed was looking for a "sustained" return to 2% inflation, while also referring to its inflation target as a "symmetric" one. Fourth, Minneapolis Fed President Kashkari dissented in favor of keeping rates unchanged, which few people had expected. Having said all this, the market's reaction still seems rather excessive. The key message from the March meeting was that the Fed now sees inflation as having finally reached its 2% target. This was reflected in the decision to strip the reference to the "current shortfall of inflation" from the statement. Consistent with this, the FOMC raised its growth forecast for 2018 from 2.0% to 2.1%. In addition, it lifted its inflation forecast for this year from 1.8% to 1.9%. The median projection for the funds rate also edged up from 2.9% to 3% for 2019. The mean dot rose 9 bps in both 2018 and 2019, while the modal dot increased by 25 bps in both years. None of this is particularly dovish. As far as the reference to the Fed's "symmetric" target is concerned, this is something that Chair Yellen and other FOMC officials have stressed many times before. All it means is that the Fed will not react too aggressively if core inflation were to drift somewhat above 2%. It does not mean that the Fed will purposely try to engineer an inflation overshoot. If the Fed had wanted to do that, it would have lifted its 2019 inflation forecast. It didn't do that and the inflation forecast remains stuck at 2.0%. Why, then, did the FOMC bother massaging the language? The answer is that the Fed simply wanted to reassure the public and the investment community that it would maintain its "go slow" approach to raising rates. After all, investors were pricing in only a small probability of a March hike just a few weeks ago. A "hawkish hike" could have led to an excessive tightening in financial conditions, similar to what happened during the taper tantrum. However, given that financial conditions actually eased significantly in response to the FOMC's decision, it is likely that Fed speeches will lean in a less dovish direction over the coming weeks. The implication for investors is that the dollar is likely to rebound. Indeed, the longer-term risk to the dollar is not that the Fed turns out be too dovish, but that it turns out to be too hawkish - that it raises rates so much that the economy begins to roll over. However, with interest rates still low in absolute terms, this is more of a risk for late 2018 or 2019 than it is for the next 12 months. As such, investors should continue to cyclically overweight global equities, favouring stock markets such as those in Europe and Japan that have a "higher beta" to global growth than the U.S. A modest bearish tilt towards long-term government bonds is also warranted. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com

Highlights Fed: The Fed will deliver another rate hike tomorrow, but we do not expect a signal that a higher trajectory for the funds rate is necessary. The Fed wants to see higher inflation expectations and will remain as accommodative as possible until that happens. Maintain a below-benchmark allocation to U.S. Treasuries within global fixed income portfolios. ECB: The ECB opened the door slightly to a less-accommodative policy stance last week, although the talk of a rate hike is premature. A 2018 taper is the more probable scenario, likely to be introduced at the September 2017 policy meeting. This will raise longer-dated European bond yields and widen spreads for both Peripheral European government debt and Euro Area corporate bonds. Reduce Euro Area IG to below-benchmark. U.S. High-Yield: U.S. junk bond spreads have widened even though default rate indicators continue to show improvement. With valuations now looking more attractive, we upgrade U.S. High-Yield from neutral to overweight. Feature Chart of the WeekStill A Positive Backdrop ##br##For U.S. Corporates After a run of smooth sailing for the markets so far in 2017, investors will have a lot of event risk to chew over this week. A slew of central bank meetings - the Fed on Wednesday followed by the Bank of England, Bank of Japan and Swiss National Bank all on Thursday - provide opportunities for policymakers to respond to the rising trends in global growth and inflation. Only the Fed is expected to make a change, though, delivering a now fully priced rate hike. Throw in the Dutch elections on Wednesday and the G20 finance ministers meeting in Germany at the end of the week and there are plenty of potentially market-moving headlines that can hit the tape. While there has been selling pressure on all global bonds during the bear phase since last July, U.S. Treasuries still remain most exposed to additional losses in the near term given the combination of improving growth, booming asset markets, a whiff of Trumpian "animal spirits" and a Fed that still appears to be playing catch-up to the overall positive U.S. macro backdrop. A bigger potential move in yields could occur if and when the European Central Bank (ECB) shifts to a less accommodative monetary stance - a taper of asset purchases first, not a rate hike, in our view - although that will likely require more evidence that medium-term Euro Area inflation expectations are sustainably moving back to the ECB's 2% target (Chart of the Week). For now, we continue to see a more negative near-term environment for U.S. Treasuries over core European debt, and a more positive environment for U.S. corporate bonds than European equivalents. As we have discussed in recent Weekly Reports, the time is coming for a shift out of core European government debt into U.S. Treasuries, although we prefer to wait for that switch until after the French elections. After the recent back-up in U.S. High-Yield spreads that has restored some value to junk bonds, however, we are upgrading our allocation to U.S. High-Yield this week to above-benchmark, while downgrading Euro Area Investment Grade corporate bonds to neutral from above-benchmark. Simply put, we prefer to take our growth-sensitive spread risk in U.S. corporates over European equivalents. Fed Vs. ECB: Dawn Of Hawkish? Some investors and financial media pundits have been asking if the Fed has fallen "behind the curve" with regards to U.S. monetary policy, especially after another solid Payrolls report and with U.S. inflation expectations holding firm despite a pullback in oil prices. In our view, being a little bit behind the curve is exactly where the Fed wants to be, allowing the economic upturn to blossom and inflation expectations to continue drifting towards the Fed's 2% target. We do not anticipate that the Fed will shift to a more aggressively hawkish stance this week, with no signal that rates will rise in 2017 more than is currently projected (three times by year-end). However, we do expect some acknowledgement of the positive macro backdrop both in the U.S. and abroad, justifying the need to move sooner by hiking now. This is especially true with the U.S. dollar still well off the 2017 peak and not providing much of a tightening in monetary conditions that could postpone a Fed rate hike. Any surprise shift higher in the Fed's interest rate projections (the "dots") would not be taken well by the Treasury market, particularly after last week's European Central Bank (ECB) meeting where a message that was merely less dovish than expected sent European bond yields sharply higher. A more hawkish shift by either central bank would be premature right now, as bond markets are not yet signaling that significantly higher real interest rates are necessary. It is important to note that most of the rise in Treasury yields since last July, and virtually all of the rise in German Bund yields, has come from rising inflation expectations rather than higher real yields (Chart 2 & Chart 3). Also, the market expectation for the real terminal policy rate - where interest rates should end up at the end of the tightening cycle - remains around 0% in the U.S. and -1% in Europe, using our proxy measure of the 5-year Overnight Index Swap (OIS) rate, 5-years forward minus the equivalent forward inflation rate from the TIPS and CPI swap markets (bottom panel of both charts). In other words, markets are only expecting a cyclical rise in interest rates in response to faster inflation, not a structural rise in interest rates because of faster potential economic growth. Chart 2Rising Inflation Explains ##br##Most Of The Rise In U.S. Yields... Chart 3...And All Of The Rise##br## In European Yields On that front, the winds are shifting in a fashion that is more bearish for Treasuries, at least in the near term. In Chart 4, we show the relationship between inflation expectations and oil prices for the U.S. and Euro Area. As can be seen in the bottom panel, the correlation between oil and expectations remains high in the Euro Area, but has fallen to zero in the U.S., where inflation expectations are increasingly influenced by domestic price pressures (i.e. rising wage growth and faster core inflation). Chart 4U.S. Inflation Now Not Just About Oil, ##br##Unlike Europe This remains a key element underpinning of our current below-benchmark call on U.S. Treasuries, particularly versus core European bonds. U.S. yields are likely to have more upside from higher inflation expectations with the Fed likely to stay as accommodative as possible by hiking rates at a slower pace than inflation is rising. At some point, monetary policy will become restrictive, particularly if the U.S. dollar bull market resumes with gusto as the Fed is delivering additional rate hikes and expectations for U.S. growth and inflation moderate, capping the current cyclical rise in Treasury yields. We are still some time away from that point, however. Bottom Line: The Fed will deliver another rate hike tomorrow, but we do not expect a signal that a higher trajectory for the funds rate is necessary. The Fed wants to see higher inflation expectations, and will remain as accommodative as possible until that happens. Maintain a below-benchmark allocation to U.S. Treasuries within global fixed income portfolios. ECB Begins The Path To Tapering The ECB last week put a relatively positive spin on the Euro Area economy, while declaring that the worst of the deflationary pressures have passed. President Draghi sounded less downbeat on the Euro Area economy than he has for some time, citing the broadening Euro Area economic upturn that was pushing down unemployment and absorbing economic slack. The ECB only slightly raised its growth forecast for 2017 and 2018, though, raising both figures by 0.1 percentage points to 1.8% and 1.7%, respectively. This would still be sufficient to remove additional slack from the economy, with the ECB currently estimating trend growth of around 1% in the Euro Area. A look at the details of those projections showed that real consumer spending is only expected to grow by 1.4% this year and next, even as the Euro Area unemployment rate is projected to fall below 9% in 2018 on the back of steady job gains. Capital spending is also expected to pick up in the next couple of years, but the projections were downgraded slightly from previous forecasts. These numbers seem a bit too cautious compared to the recent improvements seen in consumer and business confidence in the Euro Area (Chart 5), and to the more positive tone on the economy expressed in the ECB policy statement and in Draghi's press conference following the meeting. Perhaps this is simply central bank prudence at work, particularly in an environment where there is still considerable uncertainty about politics within the Euro Area and global trade in the Trumpian era. Whatever the reason, it now seems likely that growth will at least match, if not exceed, the relatively low bar set by the ECB. This is important, as the central bank is already projecting that the Euro Area will reach full employment by 2019, when the unemployment rate is projected to fall to 8.4%. The ECB expects wage pressures to rise as a result, helping boost core inflation up to 1.8% within two years (Chart 6). This would be consistent with the rising path of interest rates currently discounted in the Euro Overnight Index Swap (OIS) curve where rates are now expected to start going up in the middle of next year, with the negative rate era ending in 2019 (bottom panel). Chart 5ECB Too Pessimistic On ##br##Euro Area Growth? Chart 6ECB Will Not Hike Rates Before ##br##Full Employment Is Reached The ECB knows that interest rates will have to rise if its core inflation forecast pans out, as this would almost certainly mean that headline inflation and inflation expectations would be at the ECB target of "at or just below" 2%. Yet it is still too soon to discuss that scenario, with core inflation struggling to surpass 1% and the 5-year CPI swap rate, 5-years forward at similar levels. The ECB did slightly alter its forward guidance in its policy statement to suggest that it was now much less likely that additional monetary easing would be needed to boost growth, and that it would no longer be necessary to use "all instruments" to fight deflation in Europe. This was taken as a hawkish surprise by the markets, particularly after media reports indicated that some members of the ECB discussed raising interest rates before the tapering of the ECB's asset purchases. As we discussed in our previous Weekly Report, the current backdrop in Europe looks similar in many respects to the U.S. prior to the "Taper Tantrum" episode in 2013.1 We see the ECB following a similar path to what the Fed did during the Tantrum, by signaling a tapering of asset purchases several months in advance, then raising interest rates after the taper is complete. Many clients have asked us if it is possible for the ECB to raise short-term interest rates before starting a tapering of asset purchases. This question also came up at last week's ECB meeting, and President Draghi reiterated the view that rates would be expected to "remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases." This fits with the ECB's unemployment and inflation scenarios, which do not project a return to full employment - which would justify a rate hike - until 2019. A rate hike too soon would result in an unwanted tightening in financial conditions in Europe that could threaten the current economic upturn. We do not believe that investors could neatly separate the impact of a rate hike from that of a taper. A tightening is a tightening, as can be seen in the strong correlation of our Euro Area months-to-hike measure and the term premium on 10yr German Bund yields in recent years (Chart 7).2 If the ECB were to deliver a rate hike, even a modest one of less than the typical 25bp increment, while maintaining the current pace of bond buying, it would send a contradictory message given the ECB's benign inflation outlook for the next couple of years. Clearly, the market is already a bit confused, as the months-to-hike has been rapidly declining, even as shorter-dated bond yields in core Europe stay low and the term premium on longer-dated government debt has stopped rising. We still see a taper next year as a more likely scenario, to be announced at the September 2017 ECB meeting, with a rate hike to occur within 6-12 months of the completion of the taper. This would allow the ECB to reduce the pace of monetary expansion in line with a less deflationary backdrop in Europe, while leaving the rate hike for a more traditional move when full employment is reached in 2019. In Chart 8, we present some potential tapering scenarios and what it would mean for the growth rate of the ECB's monetary base. We show the base case for this year of €60bn/month in asset purchases that ends in December (a "full-stop" with no tapering), along with alternative scenarios of a pace of tapering that reduces the bond buying to zero within six months (i.e. a €10bn/month reduction until June 2018) and with a full taper over 12 months (i.e. a €5bn/month reduction until December 2018). We also show an additional scenario where the ECB decides to extend the asset purchases into 2018 at the same current pace of €60bn/month. Chart 7A Rate Hike Before Tapering ##br##Is A Confusing Message Chart 8Taper Or Not, ECB Effect ##br##On Bund Yields Fading... The bottom panels of Chart 8 show the annual growth rate of the monetary base under the different scenarios, and how that maps into longer-term German bond yields through a widening term premium. Importantly, the growth rate of the ECB's monetary base would decelerate even if there was no taper next year, which would put upward pressure on European bond yields. Unless the ECB is willing to raise the pace of bond buying next year, which would only occur if there was an unexpected downturn in the Euro Area economy before full employment is reached, then the writing is on the wall for Euro Area government bond yields. They are moving higher. The same goes for Peripheral European debt and even Euro Area Investment Grade corporate debt, which the ECB has also been buying. A slowing pace of ECB buying will put upward pressure on both yields and spreads next year (Chart 9), although a better Euro Area economy that improves corporate profits and tax revenues will help mitigate the rise in yields. It is possible that the ECB could alter the composition of its purchases while tapering, choosing to continue to buy more shorter-dated bonds to limit the potential of an unwanted rise in the Euro. As can be seen in Chart 10, the typical indicators that correlate to the EUR/USD currency pair - the relative balance sheets of the Fed and ECB, and the 2-year interest rate differential between European and U.S. interest rates - are still pointing to an extended period of Euro weakness. It would take a combination of rate hikes in Europe and rate cuts in the U.S. to turn EUR/USD around on a sustainable basis. While the tapering announcement will likely push the Euro immediately higher, such a move will not last without a more fundamental change in relative interest rates. Chart 9...And For European ##br##Spread Product, Too Chart 10Tapering Will Not Sustainably ##br##Boost The Euro Bottom Line: The ECB opened to door slightly to a less-accommodative policy stance last week, although the talk of a rate hike is premature. A 2018 taper is the more probable scenario, likely to be introduced at the September 2017 policy meeting. This will raise longer-dated European bond yields and widen spreads for both Peripheral European government debt and Euro Area corporate bonds. Reduce Euro Area Investment Grade to below-benchmark. The Value Is Back In U.S. High-Yield One of our key themes for 2017 is that the uptrend in the U.S. High-Yield default rate is due for a pause.3 With the first quarter of the year nearly complete, all the indicators that make up our U.S. Default Rate Model are showing noticeable improvement (Chart 11). Interest coverage remains elevated A strong U.S. Manufacturing PMI points to a rebound in after-tax cash flow Lending standards have rolled over and are now just barely in "net tightening" territory An improving sales/inventory ratio portends a return to positive industrial production growth Job cut announcements have fallen back to 2011 levels on a trailing 12-month basis Chart 11Default Rate Indicators Are Showing Improvement Meantime, even though the default outlook continues to improve, junk spreads have actually widened during the past couple of weeks. The average option-adjusted spread on the Bloomberg Barclays U.S. High-Yield index has widened from a low of 344bps up to 378bps (Chart 12). Some of that spread increase is likely attributable to declining oil prices, as energy sector credits have indeed underperformed the overall index. However, the underperformance of the energy sector did start before the sharp drop in oil prices (Chart 12, bottom panel). In any event, our commodity strategists are not expecting the current decline in oil prices to persist and their estimates show that the oil market has recently shifted from an environment of excess supply to one of excess demand. U.S. crude oil inventories are poised to decline later this month and the OPEC / non-OPEC production deal negotiated by the Kingdom of Saudi Arabia and Russia at the end of last year should be met with high compliance.4 If this view is correct, then the energy sector will not drag overall junk spreads wider in the months ahead. The combination of wider junk spreads and an improving default outlook has led to an increase in our preferred gauge of value for high-yield bonds - the default-adjusted spread (Chart 13). The default-adjusted spread is calculated by subtracting an ex-ante estimate of default losses from the average spread on the Bloomberg Barclays U.S. High-Yield index. Chart 12Energy Contributed To Junk Sell-Off Chart 13Some Value Returns To High-Yield To arrive at an estimate of default losses we use the Moody's baseline forecast for the default rate and our own forecast for the recovery rate based on the historical relationship between recoveries and defaults. With the release of February's default report, the Moody's baseline default rate forecast fell to 3.14% for the next 12 months. Based on this forecast, we estimate that the recovery rate will be 44%. Combining the default and recovery rate forecasts gives an estimate for default losses of 3.14% x (1- 0.44) = 176bps for the next 12 months. Since the average option-adjusted spread of the Bloomberg Barclays U.S. High-Yield index is currently 378bps, we calculate the default-adjusted spread to be: 378 bps - 176bps = 202bps. A default-adjusted spread of 202bps is 60bps higher than the reading of 142bps that prevailed just last week. This 60bps spread advantage makes a considerable difference in terms of projected excess returns. Chart 14 shows the relationship between 12-month excess returns and the starting default-adjusted spread. We observe a reasonably strong correlation and note that, using a linear regression, an extra 60bps of spread translates to an extra +251bps of excess return on average over a 12-month period. Chart 1412-Month Excess High-Yield Returns Vs. Ex-Ante Default-Adjusted Spread (2002 - Present) Table 1 provides more detail in terms of what excess returns have historically been associated with different levels of the default-adjusted spread. We see that when the default-adjusted is between 100 bps and 150bps, high-yield bonds earn positive excess returns 64% of the time over the following 12 months. When the default-adjusted spread is between 200bps and 250bps, high-yield earns a positive 12-month excess return 71% of the time. Table 112-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Given our upbeat assessment of the trend in defaults and a wider junk spread than we have seen in a while, we think it is a good time to upgrade high-yield from neutral to overweight. The key near-term risk to this view is that the Fed will be more hawkish than we anticipate at this week's meeting. If the Fed's median forecast is revised up to four hikes in 2017, then it is possible that the recent bout of junk spread widening will have a bit further to run. However, given still-low inflation readings, the Fed would eventually be forced to back away from its hawkish rhetoric and support renewed spread tightening. In our view, the main risk to upgrading junk this week is that we are a bit too early. Bottom Line: U.S. junk bond spreads have widened even though default rate indicators continue to show improvement. With valuations now looking more attractive, we upgrade U.S. High-Yield from neutral to overweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Will The Hawks Walk The Talk?", dated March 7, 2017, available at gfis.bcaresearch.com 2 Last week, we presented the Euro Area months-to-hike measure. We discovered that our measure was not calibrated for the current era of negative interest rates in Europe, and the months-to-hike indicated was actually signaling the "months until interest rates turned positive." We have since corrected our methodology to show the months until one full 25bp rate hike was priced in from the current negative levels, which is what is shown in Chart 7 of this report. This does not change the direction of the months-to-hike indicator, but it does bring forward to date of the first rate hike versus what was presented last week. 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, "Fed's Pre-Emptive Hike Will Hit Gold, Not Oil", dated March 9, 2017, available at ces.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: The Fed will lift rates this week, but will likely leave its median forecast for three hikes this year unchanged. With inflation still below target the Fed has an incentive to take it easy. Curve steepeners, TIPS breakeven wideners and overweight spread product positions will benefit. Duration: The growth outlook is improving and the 10-year Treasury yield could soon move higher, breaking out of its recent trading range. An already elevated economic surprise index should not be a deterrent. High-Yield: Junk spreads have widened even though default rate indicators continue to show improvement. With valuations now looking more attractive, we upgrade high-yield from neutral to overweight. Feature Chart 1How Much Hawkishness ##br##Can Markets Take? In early November, just prior to the U.S. election, money markets were still only discounting one rate hike before the end of 2017. The Fed has already raised rates once since then and the market is now almost priced for another three hikes before year-end (Chart 1). Encouragingly, financial markets digested the shift up to two 2017 rate hikes without much of a hiccup - the yield curve steepened, TIPS breakevens widened and junk spreads tightened - but the journey from two to three hikes has not gone down quite as easily (Chart 1, bottom panel). The yield curve has now started to flatten, breakevens have leveled off and junk spreads have edged wider. The worry is that a further shift in expectations - from three to four hikes in 2017 - might cause markets to choke. Fed Will Take It Slow Markets are already priced for a rate hike at this week's FOMC meeting along with no change to the Fed's median forecast for three hikes in 2017. As such, we would not expect much of a market reaction if that outcome is delivered. If the Fed were to increase its median forecast from three to four hikes in 2017, then we would anticipate at least some tightening of financial conditions. In other words, we would expect the yield curve to flatten, TIPS breakevens to narrow, the dollar to strengthen and credit spreads to widen. As we have written several times,1 with core inflation and TIPS breakevens still below target, the Fed must ensure that the economic recovery continues. It will therefore be quick to back away from any nascent hawkishness if financial conditions start to tighten. With markets already showing some signs of stress, we expect the Fed to err on the side of caution this week. This means the Fed will lift rates, but also leave the median forecast of three 2017 rate hikes unchanged. This notion that the Fed should be lifting rates, but only very slowly, is confirmed by our Fed Monitor (Chart 2). The Fed Monitor is a composite of 32 indicators that track the evolution of U.S. economic growth, inflation pressures and financial market conditions. Historically, a positive reading from the monitor has coincided with rate hikes, and vice versa. Chart 2BCA Fed Monitor Suggests A Slow Pace Of Rate Hikes The Fed Monitor just recently moved above zero, suggesting that only modestly tighter monetary policy is required. As an aside, we view the strongly positive readings from the Fed Monitor in 2011 and 2012 as anomalous and an artifact of the zero-lower-bound on interest rates. Since interest rates could not be lowered as much as would have been necessary (according to the Fed Monitor) in 2009, they also could not be raised as quickly as the monitor suggested in 2011. With the base effects from the financial crisis now out of the data, the Fed Monitor should go back to providing a useful signal about the future course of monetary policy. Chart 3BCA Fed Monitor Components We gain further insight from splitting the Fed Monitor into its three key components: growth, inflation and financial conditions (Chart 3). The growth component has accelerated strongly into positive territory but the inflation component still suggests that an easy policy stance is required. Financial conditions are also consistent with modest Fed tightening but have ticked down in recent weeks as the market has discounted a more rapid pace of hikes. Judging from the prior two cycles, an acceleration of the inflation component will be necessary for the Fed to deliver on its current expected path of rate hikes. While the Fed has sometimes started to lift rates with the inflation component below zero, that component has always surged into positive territory soon after hikes began (Chart 3, panel 2). While economic growth is accelerating, below-target inflation means that the Fed must continue to nurture the economic recovery. Investors should position for a steeper curve, wider TIPS breakevens and tighter credit spreads until inflationary pressures are more pronounced. This means at least until long-maturity TIPS breakevens reach the 2.4% to 2.5% range and core PCE inflation is firmly anchored around 2%. Bottom Line: The Fed will lift rates this week, but will likely leave its median forecast for three hikes this year unchanged. With inflation still below target the Fed has an incentive to take it easy. Curve steepeners, TIPS breakeven wideners and overweight spread product positions will benefit. Consolidation Complete? The 10-year Treasury yield has been stuck in a tight range below 2.6% since mid-December (Chart 4), but recent trends in the economic data suggest that it could be on the verge of breaking through this key resistance level. Economic surprises are positively correlated with changes in the 10-year Treasury yield and currently appear extended (Chart 4, bottom panel). While not a mean-reverting series by construction, economic surprises tend to follow a mean reverting pattern because investors revise their expectations higher as the economic data outperform. Eventually, expectations are bound to become excessive and the series will mean revert. However, we have found that economic surprises are usually first reflected in Treasury yields. In fact, changes in the 10-year Treasury yield tend to lead the economic surprise index by several weeks. This means that stagnant yields during the past few months have already foreshadowed a reversal in the surprise index. In other words, some mean reversion in economic surprises is already in the price and should not prevent yields from rising in the coming weeks. More important is that economic growth should be sustainably above trend on a 6-12 month horizon. This will continue to put upward pressure on inflation and ensure that the Fed remains in a rate hike cycle. Judging from recent data, not only is growth sustainably above trend, but it is probably even accelerating. Last week's February employment report showed that nonfarm payrolls rose by 235k, the second consecutive month of gains above 200k. The rate of change of employment growth is now threatening to reverse the downtrend that started in early 2015, and aggregate hours worked have accelerated suggesting that GDP growth will be strong in Q1 (Chart 5). Chart 410-Year Yield Facing Resistance Chart 5Labor Market Points To Stronger Growth... Financial conditions are also supportive of a further acceleration in growth. We found that the financial conditions component of our Fed Monitor provides a strong indication of near-term trends in GDP growth (Chart 6). This highlights that growth should be strong during the next few months but also that the Fed must respond to any tightening in financial conditions if it wants growth to remain robust. Chart 6...So Do Financial Conditions Bottom Line: The growth outlook is improving and the 10-year Treasury yield could soon move higher, breaking out of its recent trading range. An already elevated economic surprise index should not be a deterrent. The Value Is Back In High-Yield One of our key themes for 2017 is that the uptrend in the high-yield default rate is due for a pause.2 With the first quarter of the year nearly complete, all the indicators that make up our Default Rate Model are showing noticeable improvement (Chart 7). Chart 7Default Rate Indicators Are Showing Improvement Interest coverage remains elevated A strong Manufacturing PMI points to a rebound in after-tax cash flow Lending standards have rolled over and are now just barely in "net tightening" territory An improving sales/inventory ratio portends a return to positive industrial production growth Job cut announcements have fallen back to 2011 levels on a trailing 12-month basis Meantime, even though the default outlook continues to improve, junk spreads have actually widened during the past couple of weeks. The average option-adjusted spread on the Bloomberg Barclays High-Yield index has widened from a low of 344 basis points up to 378 bps (Chart 8). Some of that spread increase is likely attributable to declining oil prices, as energy sector credits have indeed underperformed the overall index. However, the underperformance of the energy sector also started before the sharp drop in oil prices (Chart 8, bottom panel). In any event, our commodity strategists are not expecting the current decline in oil prices to persist and their estimates show that the oil market has recently shifted from an environment of excess supply to one of excess demand. U.S. crude oil inventories are poised to decline later this month and the OPEC / non-OPEC production deal negotiated by the Kingdom of Saudi Arabia and Russia at the end of last year should be met with high compliance.3 If this view is correct, then the energy sector will not drag overall junk spreads wider in the months ahead. The combination of wider junk spreads and an improving default outlook has led to an increase in our preferred gauge of value for high-yield bonds - the default-adjusted spread (Chart 9). The default-adjusted spread is calculated by subtracting an ex-ante estimate of default losses from the average spread on the Bloomberg Barclays High-Yield index. Chart 8Energy Contributed To Junk Sell-Off Chart 9Some Value Returns To High-Yield To arrive at an estimate of default losses we use the Moody's baseline forecast for the default rate and our own forecast for the recovery rate based on the historical relationship between recoveries and defaults. With the release of February's default report, the Moody's baseline default rate forecast fell to 3.14% for the next 12 months. Based on this forecast we estimate that the recovery rate will be 44%. Combining the default and recovery rate forecasts gives an estimate for default losses of 3.14% x (1- 0.44) = 176 bps for the next 12 months. Since the average option-adjusted spread of the Bloomberg Barclays High-Yield index is currently 378 bps, we calculate the default-adjusted spread to be: 378 bps - 176 bps = 202 bps. A default-adjusted spread of 202 bps is 60 bps higher than the reading of 142 bps that prevailed just last week. This 60 bps spread advantage makes a considerable difference in terms of projected excess returns. Chart 10 shows the relationship between 12-month excess returns and the starting default-adjusted spread. We observe a reasonably strong correlation and note that, using a linear regression, an extra 60 bps of spread translates to an extra +251 bps of excess return on average over a 12-month period. Chart 1012-Month Excess High-Yield Returns Vs. ##br##Ex-Ante Default-Adjusted Spread (2002 - Present) Table 1 provides more detail in terms of what excess returns have historically been associated with different levels of the default-adjusted spread. We see that when the default-adjusted is between 100 bps and 150 bps, high-yield bonds earn positive excess returns 64% of the time over the following 12 months. When the default-adjusted spread is between 200 bps and 250 bps, high-yield earns a positive 12-month excess return 71% of the time. Table 112-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Given our upbeat assessment of the trend in defaults and a wider junk spread than we have seen in a while, we think it is a good time to upgrade high-yield from neutral to overweight. The key near-term risk to this view is that the Fed will be more hawkish than we anticipate at this week's meeting. If the Fed's median forecast is revised up to four hikes in 2017, then it is possible that the recent bout of junk spread widening will have a bit further to run. However, given still-low inflation readings, the Fed would eventually be forced to back away from its hawkish rhetoric and support renewed spread tightening. In our view, the main risk to upgrading junk this week is that we are a bit too early. Bottom Line: Junk spreads have widened even though default rate indicators continue to show improvement. With valuations now looking more attractive, we upgrade high-yield from neutral to overweight. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see Commodity & Energy Strategy Weekly Report, "Fed's Pre-Emptive Hike Will Hit Gold, Not Oil", dated March 9, 2017, available at ces.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights U.S. equity valuations are historically high, based on a variety of metrics. However, relative to competing assets and global equity peers, U.S. stock valuations are not an extreme. For U.S.-based investors, our upbeat view on the U.S. dollar implies that efforts to diversify globally may come up short. The Fed will allow its Agency bond and MBS portfolios to run off starting in 2018, but it is much more uncertain whether it will ever cease the reinvestment of its Treasury holdings. Feature The S&P 500 remains near record highs, despite a modest setback last week. And the only period when stocks were more expensive was during the halcyon days of the dot-com bubble. Have stock prices outpaced fundamentals, and if so, how much of a risk does this present over the cyclical horizon? And should U.S. investors look further afield than domestic markets for a relative deal? On a historical basis, it is hard to argue that U.S. equities are anything other than expensive. A preferred valuation metric is the cyclically adjusted P/E ratio (CAPE), see Chart 1. Based on this metric, stocks are expensive, trading at their highest valuation outside of the dot-com bubble. However, valuing equities is a complicated issue, and the CAPE is not without its weaknesses. Examining a broad array of valuation indicators provides a slightly different message; U.S. stocks are expensive in absolute terms based on historic relationships, but are less stretched relative to both other asset classes and other equity indexes. Expensive, But... Our BCA valuation index captures the message from a broad range of metrics in one gauge (Chart 2). The valuation index was constructed using 11 different measures in an attempt to approach valuation from multiple angles. Decomposing the index into its three major components - earnings, balance sheet metrics and yield - show that stocks prices are well into expensive territory in absolute terms based on traditional fundamentals: Chart 1(Part I) U.S. Stocks Are Expensive ##br##Relative To History Chart 2(Part II) U.S. Stocks Are Expensive Relative ##br##To History Earnings Group: There are five inputs to the earnings component of our valuation indicator, including trailing price/earnings ratio, price/sales, market cap as a share of GDP. The second panel of Chart 2 shows that the aggregate of the Earnings Group indicators sits at historical highs, excluding the tech bubble. Balance Sheet Metrics: This component includes measure of the market value of equities relative to corporate net worth, both using market value (replacement cost) and historical cost. This measure of valuation has the same profile as the Earnings Group. Yield Group: The yield group compares the price of stocks to interest rates, nominal and real, government and corporate. Of the three groups, it is this Yield Group that gives a less expensive reading on equities (bottom panel of Chart 2). Overall, the Valuation Indicator is already well into "overvalued territory". There is only one episode since 1970 when the indicator has reached a significantly more extreme reading (the dot-com bubble). ...Not So On A Relative Basis Stocks are expensive on an absolute basis, but are far more appealing in relative terms. The current earnings yield on stocks is well above the real corporate bond yield and corporate bond spreads are historically very tight, despite the erosion in balance sheet health (our corporate health monitor has been deteriorating for several months). And compared to housing returns, stocks look downright cheap (Chart 3). Within the U.S., we expect stocks to be the biggest beneficiary of investment flows in the next year or two, in part because equity market value is the most appealing. Meanwhile, relative to global peers, U.S. equities valuations have been climbing since 2009 (Charts 4 and Chart 5). This eight-year rise in valuations now leaves U.S. P/Es at the higher end of the historical range relative to G10 ex-U.S. equities. U.S. stocks are especially expensive relative to Japanese equities. In any case, standard valuation measures have always been lower in Japan, with the exception of price-forward earnings. As our Bank Credit Analyst monthly publication points out, Japanese companies generally have a much higher interest coverage ratio compared to Corporate America. Nonetheless, they tend to come up short in terms of profitability. Operating margins in the U.S. have typically been double that of Japan. Japan's return-on-equity (RoE) has been dismal because of low levels of corporate leverage and loads of low-yielding cash sitting on balance sheets. Nonetheless, the valuation gap is at an extreme, with Japanese equities appearing to be a screaming value relative to U.S. stocks. Chart 3Stocks Look Less Expensive Relative To Competing Assets Chart 4(Part I) U.S. Outperformance Phase Can Continue Chart 5(Part II) U.S. Outperformance Phase Can Continue A similar, albeit less extreme, valuation case can be made for European stocks relative to the U.S. Eurozone stocks have also almost always traded at a discount to U.S. equities and this continues to be the case. Stocks have gotten even more expensive, more quickly, in the U.S. over the past year. But relative valuations are not near historic extremes. Tack on the fact that BCA's view is that the dollar will continue to appreciate over the next six-twelve months. For U.S.-based investors, the coming rise in the domestic currency implies that efforts to diversify globally may come up short, despite better value in major foreign markets. It is important to note that BCA does not view valuation measures as market timing tools. They are only useful at extremes. The bottom line is that U.S. equities are certainly far from cheap, but are not so expensive in relative terms to warrant an allocation change on this basis. We believe that equity returns should outperform Treasuries, cash and high-quality corporate bonds over the next 1-2 years as the bond bear market plays out. The Fed's Balance Sheet: What's Next? Recently we have received a number of client questions about the Fed's balance sheet and how it will evolve during the next few years. In response, we reprint below work from our U.S. Bond Strategy team, who recently addressed the topic in detail. The Fed's Stated Plan The most up-to-date guidance we have received about the Fed's balance sheet plans comes from Janet Yellen's recent Congressional testimony: "The FOMC has annunciated that its longer run goal is to shrink our balance sheet to levels consistent with the efficient and effective implementation of monetary policy. And while our system evolves and I can't put a number on that, I would anticipate a balance sheet that's substantially smaller than at the current time. In addition, we would like our balance sheet to again be primarily Treasury securities, whereas as you pointed out, we have substantial holdings of mortgage-backed securities." From this, and similar statements from other Fed officials, we conclude that the Fed will allow its balance sheet to shrink once the fed funds rate is somewhere in the range of 1% to 1.5%. Surveys also show that the median primary dealer expects the Fed will change its balance sheet policy when the target fed funds rate is 1.38%. As such, and under reasonable assumptions for the pace of rate hikes, we think it is very likely that the Fed will start to let its balance sheet shrink sometime in 2018. MBS First, Treasuries Maybe Later Yellen's statement to Congress also makes clear that the Fed would be more comfortable with a balance sheet that consists entirely of Treasury securities. For this reason, the central bank will start by simply ceasing the reinvestment of its Agency bond and MBS portfolios. At least initially, the Fed will continue to reinvest the proceeds from its maturing Treasury portfolio. Yellen also left open the possibility that reinvestment could be "tapered" rather than just halted altogether. While this is possible, and in fact 70% of primary dealers think that reinvestments will be phased out over time while only 14% think they will be ceased all at once, it seems to us like a needless complication. We expect that reinvestments of Agency bonds and MBS will end all at once sometime in 2018. As for the Fed's holdings of Treasury securities, it is much less clear whether the Fed will allow these balances to run down. In a Report in 2014,1 we describe in detail the differences between the Fed's pre-crisis mode of operation, when bank reserves were scarce, and the Fed's current mode of operation with large bank reserve balances. As of now, the Fed has stated that it intends to eventually drain bank reserves from the system and return to its pre-crisis mode of operation, but there are several possible advantages to running a system with an outsized Fed balance sheet and large bank reserve balances. None other than Ben Bernanke pointed out a few of those reasons in a blog post last fall.2 In our view, the most compelling is that regulatory changes have increased private sector demand for safe, short-maturity, liquid assets in recent years. If the Treasury department is unwilling to supply T-bills in sufficient numbers, then the Fed can supply safe, short-maturity, liquid assets to the market by purchasing long-maturity Treasury securities and replacing them with bank reserves. Chart 6Reserves Can Be Drained Fairly Quickly Of course, we take the Fed at its word when it says that it would like to eventually drain excess bank reserves from the system. But even in that case, the steady growth of currency in circulation means that bank reserves will decline over time even if the Fed keeps the asset side of its balance sheet flat. For example, Chart 6 shows what would happen to bank reserves if the amount of currency in circulation grows at a conservative 5% per year pace, and if the Fed decides to allow its Agency bond and MBS portfolios to run off at the beginning of next year while keeping its Treasury portfolio flat. We assume that MBS runs off the Fed's balance sheet at a pace of $15 billion per month, slightly below the recent pace of MBS reinvestment. During the past three years, the Fed has reinvested between $20bn and $40bn MBS each month with an average monthly reinvestment of $32bn. In this scenario, outstanding bank reserves would decline to zero by the end of 2025. At that point the Fed would have to start adding to its Treasury holdings just to keep pace with the amount of currency in circulation. Bottom Line: While it is very likely that the Fed will allow its Agency bond and MBS portfolios to run off starting in 2018, it is much more uncertain whether it will ever cease the reinvestment of its Treasury holdings. If the Fed does allow its Treasury holdings to run down as well, it will have to start buying Treasuries again before 2025. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report "Cleaning Up After The 100-Year Flood", dated June 10, 2014, available at usbs.bcaresearch.com. 2 https://www.brookings.edu/blog/ben-bernanke/2016/09/02/should-the-fed-keep-its-balance-sheet-large/

Highlights We discuss three "battles" that will shape the investment landscape in the euro area over the remainder of the decade. Battle #1: Reflation Versus Deleveraging - Reflation will triumph over the next 12 months. For the time being, this justifies an overweight position in euro area equities. Beyond then, the outlook is likely to darken. Battle #2: Hawks Versus Doves - The doves will win. Germany will reluctantly accept an overheated economy and higher inflation. Stay short the euro. Battle #3: Globalists Versus Populists - Marine Le Pen will lose this year's election, but Europe's populist parties will finally gain the upper hand by the end of the decade. Buy gold as a long-term hedge. Feature Market Update Global equities are technically overbought in the short term, but the longer-term cyclical (12-month) trend remains to the upside. Chart 1 illustrates the "reflation trade" in a nutshell. The Citigroup global economic and inflation surprise indices have surged and now stand at their highest combined level in the 14-year history of the series. While tracking estimates for Q1 U.S. GDP growth have fallen, this is mainly because of negative contributions from government spending, net exports, and inventories. Taken together, these three factors have shaved about 1.4 percentage points off of Q1 growth according to the Atlanta Fed's GDPNow model (Chart 2). Private final domestic demand is still growing at a reasonably robust 2.6% pace, and forward-looking indicators such as the ISM indices suggest that this number could rise over the next few quarters. Chart 1The Reflation Trade In One Chart Chart 2Underlying U.S. Growth Is Still Healthy As such, it is not too surprising that U.S. equities have had little trouble digesting the prospect of a March Fed rate hike. The market is still pricing in less than three rate increases this calendar year. Four hikes would not be out of the question. Investors should remain positioned for a stronger dollar and higher Treasury yields. We continue to favor higher beta developed markets such as the euro area and Japan over the U.S. on a currency-hedged basis. The Battle For Europe History is often shaped by great battles. Sometimes these are of the military variety. But often they transcend physical conflict, pitting competing ideas, interests, and trends against one another. In the remainder of this week's report, we discuss three economic and political battles that will determine Europe's fortunes over the next 12 months and beyond. Battle #1: Reflation Versus Deleveraging The euro area grew faster than the U.S. in 2016, the first time this has happened since 2008. While the U.S. is likely to resume pole position in 2017, we still expect the euro area economy to expand at an above-trend pace. That should be enough to keep unemployment on a downward trajectory. The euro area economic surprise index remains in positive territory. The composite PMI rose to 56 in February - the highest level since April 2011 - with the forward-looking "new orders" component hitting new cyclical highs. Capital goods orders continue to trend higher, which bodes well for investment spending over the coming months (Chart 3). In addition, private-sector credit growth has sped up to the fastest pace since the 2008-09 financial crisis (Chart 4). All this is good news for the region. Investors should overweight euro area equities on a currency-hedged basis over the next 12 months. Chart 3Euro Area Growth Holding Up Well Chart 4Euro Area: Accelerating Private-Sector ##br##Credit Growth Beyond then, things look murkier. The ECB's Bank Lending Standards survey showed a modest tightening in lending standards for business loans in Q4 of 2016 (Chart 5). Private-sector debt levels also remain elevated across the region, which is likely to dampen credit demand (Chart 6). Both of these factors suggest that loan growth could begin to moderate later this year. Chart 5Slight Tightening In Lending Standards ##br##For Business Loans And Mortgages In Q4 Of 2016 Chart 6Still A Lot Of Debt If the positive impulse from rising credit growth does begin to fade, GDP growth will fall off. Whether that proves to be just another run-of-the-mill "mid-cycle slowdown" or something more nefarious will depend on the policy response. On the fiscal side, the period of extended austerity has ended. The fiscal thrust in the euro area turned positive last year, the first time this has happened since 2010. The European Commission is advising member states to loosen fiscal policy further this year, but the governments themselves are targeting a modest tightening (Chart 7). With a slew of elections slated for this year, budget overruns will be hard to avoid. Nevertheless, barring a significant economic slowdown, no major European economy is likely to launch a large fiscal stimulus program anytime soon. Thus, while fiscal policy will not be a drag on growth, it will not provide much of a tailwind either. Chart 7European Commission Recommending Greater Fiscal Expansion This puts the ball back in the ECB's court. As we discuss next, monetary policy is likely to stay highly accommodative. That should help extend the cyclical recovery into 2018. Battle #2: Hawks Versus Doves Jean Claude Trichet's decision to raise rates in 2011 would have gone down as the most disastrous blunder the ECB ever made, were it not for his even more disastrous decision to raise rates in 2008. Mario Draghi has gone out of his way to avoid repeating the mistakes of his predecessor. Nevertheless, the risk is that the improving growth backdrop instills a false sense of complacency. There is no doubt that Draghi has become more confident about the economic outlook. The ECB revised up its growth and inflation projections for 2017-18 at this week's meeting and signaled that it was unlikely to extend its targeted longer-term refinancing operations, or TLTROs. The ECB is also likely to further reduce the value of its monthly asset purchases in 2018 with a view towards phasing them out completely by the end of that year. It is possible that these steps could trigger a "taper tantrum" in European government debt markets of the sort the U.S. experienced in 2013. If that were to happen, we would see it as a buying opportunity. As Draghi stressed during his press conference, wage growth is anemic. Without faster wage growth, inflationary pressures will remain muted. Granted, euro area headline inflation reached 2.0% in February. However, this was mainly the result of base effects stemming from higher food and energy prices. Our expectation is that headline inflation will fall back close to 1% by the end of the year. This is where core inflation currently stands. One should also keep in mind that the trade-weighted euro has depreciated by 8% since mid-2014 (Chart 8). To the extent that a weaker euro has put upward pressure on import prices, this has caused core inflation to be higher than it would otherwise have been. In contrast, the trade-weighted U.S. dollar has appreciated by 24% over this period. Yet, despite the diverging path between the two currencies, core inflation in the euro area remains noticeably lower than in the U.S. This is true even if one excludes housing costs from the U.S. CPI in order to make it more comparable to the European estimate of inflation. Excluding shelter, U.S. core inflation is currently 43 basis points higher than in the euro area (Chart 9). The point is that the Fed is much further along the path to monetary policy normalization than the ECB. Chart 8A Stronger Dollar Has Restrained U.S. Inflation... Chart 9...Yet Core Inflation In The U.S. ##br##Is Still Higher, Even Excluding Housing If that were all to the story, it would be enough to justify the ECB's wait-and-see approach. But there is so much more. Start with the fact that the euro area's poor demographics, high debt levels, and dysfunctional institutions all imply that the neutral rate - the interest rate consistent with full employment - is lower there than in the U.S. How does one ensure that real rates can fall to a low enough level in the event of an economic slowdown? One solution is to target a higher inflation rate. If inflation is running at 1% going into a recession, it might be impossible to bring real rates down much below -1%. But if inflation is running at 3%, real rates can fall to as low as -3%. This implies that the ECB should actually target a higher inflation rate than the Fed. Then there are the internal constraints imposed by the common currency. Countries with flexible exchange rates can adjust to adverse economic shocks by letting their currencies depreciate. That is not possible within the euro area. If one or a few countries in the region are suffering while others are not, the unlucky ones have to engineer an "internal devaluation." This requires that wages and prices in the ill-fated countries decline in relation to those in the better-performing ones. However, if inflation is already low in the latter, outright deflation may be necessary in the former, something that only a deep recession can achieve. The travails experienced by the peripheral countries over the past eight years brought home this lesson in stark and painful terms. Will Germany accept higher inflation? There is little in its recent history to suggest that it won't. Mario Draghi was not the odds-on favorite to become ECB president. That job was supposed to go to Axel Weber, the former president of the Bundesbank. Weber met with Angela Merkel on February 10, 2011. During this meeting with the chancellor, he made it clear that he did not support the ECB's emergency bond buying. Merkel balked and so the next day Weber tendered his resignation. Six months after that, ECB board member and uber-hawk Jürgen Stark quit, leaving the ECB more firmly in the control of the doves.1 Chart 10Germans Turning Radically Europhile Merkel's preference for a less hawkish ECB leadership wasn't solely based on altruistic feelings towards her European compatriots. Politically, Merkel knew full well that Germany would be blamed for the breakup of the euro area. Economically, German taxpayers also stood to lose a lot from a breakup. It is easy to forget now, but Germany spent 8% of GDP during the global financial crisis on bailing out its own banks. All that effort would have been for naught if German banks had been forced to write off billions of euros in loans that they had extended to peripheral Europe. Critically, the demise of the euro would have also saddled German exporters with a much more expensive Deutsche Mark, thus blowing a hole through the country's gargantuan current account surplus. The calculus has not changed much over the last six years. Germany may not welcome higher inflation, but the alternative is much worse. If anything, the polls suggest that German voters have become even more Europhile since the euro crisis ended (Chart 10). This gives Draghi even more free rein. For investors, this implies that the ECB is unlikely to raise rates for the next two years, and perhaps not until the end of the decade. As inflation expectations across the euro area drift higher, real rates will fall. This will push down the value of the euro. We expect EUR/USD to approach parity over the course of this year. Battle #3: Globalists Versus Populists First Brexit, then Trump, and now Le Pen? The spread between French and German 10-year government bond yields briefly touched 68 basis points in February, the highest level since the euro crisis (Chart 11). While the spread has edged down since then, investors remain on edge. Betting markets are currently assigning a one-in-three chance that Le Pen will become president, close to the odds that they were giving Donald Trump before his surprise victory (Chart 12). Chart 11Investors Worried About The Coming ##br##French Election Chart 12Will Le Pen Rule? Wanna Bet? There is little doubt that populism is in a secular "bull market." However, that doesn't mean that every populist politician is going to win every single election. For all their faults, U.S. nationwide presidential election polls were not that far off the mark. The RealClearPolitics average had Clinton up by 3.2% going into the election. She won by 2.1 points. Where the polls fell flat was at the state level. They completely underestimated Trump support in the Rust Belt states of Pennsylvania, Ohio, Michigan, and Wisconsin. That's not an issue in France, where the presidential vote is tallied at the national level. Le Pen currently trails Macron by 26 percentage points in a head-to-head contest (Chart 13). It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. The only way that Le Pen could win is if one of the two leftist candidates drops out.2 However, given the animosity between Benoit Hamon and Jean-Luc Mélenchon, that is almost inconceivable. And even if that did occur, the odds would still favor Macron slipping into the final round. As such, investors should downplay risks of a populist uprising this year. Beyond then, things are likely to get messier. At some point, Europe will face another downturn, either of its own doing or the result of an external shock. Many voters have been reluctant to vote for populist leaders out of fear that the ensuing economic turmoil could leave them out of a job. But if they have already lost their jobs, that reason goes away. Chart 14 shows the strong correlation between unemployment in various French départements, and support for Marine Le Pen's National Front. If French unemployment rises, her support is likely to increase as well. The same goes for other European countries. Chart 13Macron Leads Le Pen By A Mile Chart 14Higher Unemployment Would Benefit Le Pen In addition, worries about large-scale immigration from outside Europe will continue to work to the advantage of populist leaders. Recent immigrants and their children have sometimes struggled to integrate into European society. This has manifested itself in the form of low labor participation rates, poor educational achievement, elevated involvement in criminal activity, and high welfare usage. The problem has been especially acute in European countries with very generous welfare states (Chart 15). Chart 15Many Immigrants To Europe Are Lagging Behind The reaction of establishment parties to mounting concerns about immigration has been completely counterproductive. Rather than acknowledging the problems, they have sought to censor uncomfortable "hatefacts" and stage show trials of populist leaders - such as the one Marine Le Pen will likely be subjected to for her alleged crime of tweeting graphic photos of terrorist atrocities. This strategy will backfire and the result will be a wave of populist victories towards the end of the decade. With that in mind, investors should consider buying some gold as a long-term hedge. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see BCA Geopolitical Strategy, “Europe: Game Was Changed A Long Time Ago,” in a Monthly Report, “Fortuna And Policymakers,” dated October 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, “Europe – Election Update, France,” in a Weekly Report, “Donald Trump Is Who We Thought He Was,” dated March 8, 2017, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The global economy has turned the cap and is on a sustainable uptrend. Yet, the AUD and CAD have over-discounted the improvements and are at risk of suffering a disappointment if global manufacturing activity remains firm but does not accelerate much. Moreover, the Australian and Canadian domestic economies remain too weak to justify rates moving in line with the Fed. Rate differentials will continue to weigh on both currencies. While the CAD is cheaper than the AUD and warrants an overweight position versus the Aussie, we are adding it to our short commodity currency basket trade. The ECB will not ease further, but it will not tighten this year either. Feature Since their February highs, the Australian and Canadian dollars have declined by 2.7% and 3.6% respectively. In May 2016, we wrote that commodity currencies could continue to perform well, but that ultimately, this strong performance would only prove transitory and that the AUD and the CAD would once again resume their downtrends.1 Is this recent weakness the beginning of a more pronounced selloff? We believe the answer is yes. How Great Is The Global Backdrop? Much ink has been spilled regarding the improvement in the global industrial sector. Global PMIs have perked up the world over, semi-conductor prices have been booming, metal prices have been on a tear, and Chinese excavator sales have been growing at a 150% annual rate (Chart I-1). It would seem that the world economy is out of the woods. This is true, but asset markets are not backward looking, they are forward looking. The improvement in global economic conditions that we have witnessed has driven the impressive rally in stocks, EM assets, commodity, and commodity currencies in 2016. But what matters for future asset markets' performance, and especially growth sensitive currencies like the AUD and the CAD, is future global growth. Where do we stand on that front? We do not expect an economic relapse like in 2015 and early 2016. Some key elements have changed in the global economy, suggesting it is not as hampered by deflationary forces as it once was: DM industrial capacity utilization has improved (Chart I-2). Also our U.S. composite capacity utilization indicator that incorporates both the manufacturing and service sectors has now moved into "no slack" territory. This suggests that deflationary forces that have so negatively affected the DM economy in 2015 and 2016 are becoming tamer. Chart I-1Signs Of An Economic Rebound Chart I-2Improving Global Capacity Utilization Commodity markets are much more balanced than in 2015-2016. Not only has excess capacity in the Chinese steel and coal sector been drained, but the oil market has moved from being defined by excess supply to a surplus of demand (Chart I-3). This suggests that commodities are unlikely to be the same deflationary anchors they were in the past two years. The global contraction in profits is over. Profits are a nominal concept, and in 2015 and 2016, U.S. nominal growth hovered around 2.5%, in line with the levels registered in the 1980, 1990, and 2001 recessions (Chart I-4). As a residual claim on corporate revenues, profits display elevated operating leverage. Thus, nominal GDP growth moving from 2.5% to 4% on the back of lessened deflationary forces will continue to support profits. Chart I-3Oil: From Excess Supply To Excess Demand Chart I-4Last Year Was A Nominal Recession This also means that the rise in capex intentions that began to materialize last summer is likely to genuinely support capex growth and the overall business cycle in the coming quarters, especially in the U.S. (Chart I-5). Additionally, the inventory cycle that has weighed on EM and DM economies is now over (Chart I-6). While growth is likely to be fine based on these factors, for the AUD and CAD to move higher, growth needs to accelerate further. The problem is that based on our Nowcast for global manufacturing activity, things are as good as they get now (Chart I-7). Chart I-5Improving DM ##br##Capex Outlook Chart I-6Inventories: From ##br##Drag To Boost Chart I-7If Global Industrial Activity Doesn't ##br##Improve, CAD and AUD Are Toast In China, which stands at the crux of the global manufacturing cycle, we see the following factors hampering further improvements: The Chinese fiscal impulse has rolled over. Fiscal stimulus does impact the economy with some lags. The peak in the Chinese boost was reached in November 2015, with government expenditures growing at a 24% annual rate, but today, they are growing at a 4% rate. The deleterious effect on growth of this tightening may soon be felt. Chinese liquidity conditions have deteriorated. Interbank borrowing rates are already rising (Chart I-8), and the PBoC has drained an additional RMB 90 billion out of the banking system this week alone. These dynamics could be aimed at cooling down the real estate bubble in the country. Falling activity in that sector would represent a significant drag on the industrial and commodity sectors globally. Chart I-8Tightening Chinese Liquidity Conditions Chart I-9The NZD Weakness Should Be A Bad Omen The fall in Chinese real rates may have reached its paroxysm in February. Commodity price inflation may have hit its peak last month, suggesting the same for Chinese producer prices. A slowing PPI inflation will raise real borrowing costs in that economy and further tighten monetary conditions. Corroborating these risks, Kiwi equities, a traditional bellwether of global growth continue to buckle down. In fact, the New Zealand dollar is offering the same insight. Being the G10 currency most sensitive to the combined effect of wider EM borrowing spreads and commodity prices, its recent fall may presage some problems in these spaces (Chart I-9). To be clear, we are not expecting a wholesale collapse in growth. Far from it, but an absence of acceleration or a mild deceleration, could have troubling effects on commodities. The case of oil this week is very telling. Inventories have been going up, but the frailty of the oil market was mostly a reflection of the extraordinary bullish positioning of investors (Chart I-10, left panel). The same is true for copper, investors are very long and thus, vulnerable to mild growth disappointments (Chart I-10, right panel). Chart I-10AInvestors Are Bullish Industrial Commodities Chart I-10BInvestors Are Bullish Industrial Commodities Oil is not the only commodity experiencing a large accumulation in inventories. China, the key consumer of metals, is now overloaded with large inventories of both iron ore and copper (Chart I-11). This combination of high bullishness and rising inventories represents a risk for metals, especially if the positive growth impulse in China slows somewhat from here. Chart I-11China Has ##br##Hoarded Metals Chart I-12Can Growth And Reflation Surprises Increase##br## As Policy Becomes Less Easy? Adding to these risks is the Fed. The Fed is on the path to increase rates a bit more aggressively than was recently anticipated by markets. U.S. real rates are responding in kind, and key gauges like junk bonds, gold, or silver are also highlighting that global liquidity conditions may begin to deteriorate at the margin. While this tightening is not a catastrophe, it is still happening in an environment of elevated global leverage and potentially decelerating growth. This is not the death knell for risk assets, but it does represent a risk for the asset classes that are not pricing in any potential rollover in the elevated level of global surprises and reflation (Chart I-12). Commodity currencies are not ready for this reality. To begin with, positioning on the key commodity currencies has rebounded substantially, and risk reversals on these currencies as well as EM currencies are at levels indicative of maximum bullishness amongst investors. Also, the Australian dollar is expensive relative to its fundamentals, including the terms of trade. This makes the Aussie very vulnerable to small shocks to metal or coal prices (Chart 13, left panel). The CAD is not as pricey as the AUD, but nonetheless, it has lost its previous valuation cushion (Chart I-13, right panel). It also faces its own set of risks. Chart I-13ANo Valuation Cushion In CAD And AUD Chart I-13BNo Valuation Cushion In CAD And AUD This set of circumstance highlights that the room for disappointment in these currencies is now large. Bottom Line: While 2016 was a dream come true for investors in commodity currencies, 2017 may prove to be a tougher environment. Global growth is not about to plunge, but for commodity currencies to rally more, global manufacturing activity needs to accelerate further. Here the hurdle is harder to beat. Not only is the Chinese reflationary impulse slowing exactly as the global manufacturing sector hits exceptional levels of strength, but the Fed is also marginally tightening its stance. This means that expensive currencies like the BRL and AUD, as well as the cheaper but still vulnerable CAD could suffer some downside if industrial growth temporarily flattens, an event we judge more likely than not. Domestic Considerations Chart I-14We Build Houses In Canada When it comes to the AUD and the CAD, global risk is skewed to the downside, but what about domestic considerations? Here again, signs are not as great as one might hope. When it comes to Canada, the capacity to withstand higher rates is limited. The elephant in the room is the risk posed by the U.S. border adjustment tax. BCA thinks that this tax could be implemented in a diluted form, one were apparels, food, energy, etc. are exempt from the deal. However, the industries representing the American "rust-belt" are likely to be fully covered. This means that machinery and cars in particular could be the key targets of the BAT. This is a huge problem for Canada. Take the car industry as an example. Canada exports C$80 billion in vehicles and parts to the U.S., or 15% of its merchandise exports, nearly 4% of GDP. The potential hit from this tax on the country could be large. Also, the Canadian economy is even more levered to house prices that the Australian one. As Chart I-14 illustrates, the share of residential investment in Canada is much higher than in Australia, despite the slower growth of the population in Canada than in the Australia. Additionally, Canadian consumption is much more geared to housing than in Australia. Canadian households are experiencing slower nominal and real wage gains than their Australian counterparts. Yet their consumption per head growth is similar to that of Australia, and their confidence is substantially higher, reflecting a stronger wealth effect in Canada than in Australia (Chart I-15). Furthermore, despite the rebound in commodity prices and profits in 2016, Canadian and Australian credit growth have been slowing sharply (Chart 16, top two panels); however, Canada suffers from a higher level of debt service payment than Australia, despite the fact that the Canadian household debt to disposable income is 170% versus 185% in Australia (Chart I-16, bottom panel). These factors amplify the negative potential of higher interest rates in Canada relative to Australia. But Australia also suffers from its own ills. Total hours worked continue to deteriorate in that country and job growth is even more heavily geared to the part-time sector than in Canada. Additionally, while Canada will benefit from a small amount of fiscal expansion in the coming years, Australia is tabled to experience a large degree of fiscal austerity (Chart I-17). In this context, it will be difficult for the Australian labor market to outperform that of Canada. Chart I-15Canadian Households Are ##br##More Levered To Housing Chart I-16Slowing Credit Growth In ##br##Canada And Australia Finally, while the Canadian core CPI is elevated at 2.1%, this largely reflects pass-through from the previous collapse in the CAD, and this is expected to dissipate as wage growth remains tepid at 1.2%. But the Australian situation is even more troubling. Australia has been incapable of generating much inflation, and the fall in hours worked suggests that the labor market may be easing, not tightening. With the 10% increase in the AUD from its trough in 2016, inflation is unlikely to rise enough to prompt the RBA to become much more hawkish in the coming months. Thus, we think that both Canadian and Australian rates will continue to lag U.S. ones, putting more downward pressures on the CAD and the AUD versus the USD, despite the recent improvement in trade balances in both nations. (Chart I-18). Moreover, even if the decline in Australian interest rate differentials relative to the U.S. were to be less pronounced than in Canada, the AUD is much more misaligned with differentials than the CAD, adding to the Aussie's vulnerability. Chart I-17Fiscal Policy: Canada Eases, ##br##Australia Tightens Chart I-18Rate Differentials Will Continue##br## To Help The USD Bottom Line: Domestic conditions remains challenging for Australia and Canada. In both nations, debt service payments are already elevated, suggesting it will be hard for the central bank to increase rates without prompting accidents. While Australia seems less geared to the housing sector than Canada, its labor market dynamics are poorer, it faces a more austere fiscal policy, and it has trouble generating any inflation. We expect rate differentials to continue to move against both the CAD and the AUD versus the USD. Investment Conclusions At this point, the CAD and AUD are essentially entering an ugly contest. For both of these currencies, the global backdrop could prove to be more difficult in 2017 than in 2016. Moreover, both these currencies are handicapped by fundamental domestic issues that will further prevent rates to rise vis-à-vis the U.S. As such, we are now adding the CAD to our short commodity currency basket trade against the USD. AUD/USD may move toward 0.65-0.60 and USD/CAD may rally toward 1.40-1.45. Comparatively, both the AUD and CAD suffer from different but equally important handicaps. The only thing that would put the CAD at the nicer end of the ugly contest are its valuations. Our PPP model augmented for productivity differentials continues to show that the CAD is cheap against the AUD, corroborating the message of our long-term fair value models (Chart I-19). Also, as we highlighted above, CAD is more in line with its IRP-implied fair value than the AUD. We therefore recommend investors overweight the CAD vis-à-vis the AUD. A Few Words On The ECB Yesterday, Draghi struck a cautious tone in Frankfurt. While he acknowledged that deflationary risks in the euro area have decreased relative to where they stood last year, the governing council still thinks downside risks, even if of a foreign origin, slightly overshadow upside risks to its forecast. While the ECB feels that there is less of a need to implement additional support to the economy in the future, it judges the current accommodative setting to still be warranted. We agree. It is true that headline inflation in Europe has moved to 2%, but core inflation, which strips the very important base effect in energy prices that has lifted HICP, remains flat at low levels. Moreover, wage growth in the euro area remains tepid, confirming the lack of persistent domestic inflationary pressures in Europe (Chart I-20). Thus, the ECB elected to maintain asset purchases to the end of December at EUR60 billion per months. Rates are also unlikely to rise until after the end of the purchase program. In this environment, while the trade-weighted euro may move higher, the cyclical outlook continue to be negative for EUR/USD as monetary policy divergences between the U.S. and Europe will grow as time passes. On a 3-month basis, if we are correct that global growth may not accelerate further, the potential for a correction in EM and commodity plays could provide a temporary fillip to the euro. As markets currently priced in less rate hikes from the ECB than the Fed, the scope for pricing out the anticipated rate hikes is lower in Europe than in the U.S. if risk assets experience a correction within a bull market. This means that DXY may weaken or stay flat even if the trade-weighted dollar rises during that time frame. Chart I-19AUD / CAD Is Expensive Chart I-20The ECB's Dilemma Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Pyrrhic Victories" dated April 29, 2016 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. economy continues to show resilience with the ADP employment change crushing expectations by 108,000. Although the USD did not react proportionately to this specific news, this is only a firmer signal of the confirmation for a rate hike next week. With the market pricing in almost a 100% probability of a hike, the Fed is unlikely to disappoint. What matters now is the messaging around the hike. In this regard, Trump's aggressive fiscal stance and the economy's consistent resilience is making a good case for the Fed to remain supportive of its forecasts. On a technical basis, the MACD line for the DXY is above the signal line, while also being in positive territory. Momentum is therefore pointing to a strong upward trend for the dollar in the short term. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB left its policy rates and asset purchase program unchanged. Although President Draghi acknowledged the euro area's resilience as risks have become "less pronounced", he also noted that risks still "remain tilted to the downside". In the press release, the Governing Council continued to highlight that they continue to expect "the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases". The message is therefore mixed. Growth is expected to remain resilient in the euro area, but significant domestic slack and global factors have forced the ECB to remain cautious. Cyclical risks to the euro are more to the downside than to the upside in the current environment. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has been mixed: Machine tool orders yearly growth came in at 9.1%, the highest level since the third quarter of 2015. Labor cash earnings yearly growth came above expectations at 0.5%. However GDP growth was disappointing, coming in at 1.2% against expectations of 1.6%. We continue to be bearish on the yen on a cyclical basis. Although there has been some improvement, economic data has still been too tepid for the Bank of Japan to even consider rolling back some of its most radical policies. After all, the BoJ has established that they now have a price level target instead of an inflation target, which means that inflation would have to overshoot 2% for a significant period of time in order to switch from their easing bias. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 After the vote in the House of Lords, Theresa May has been dealt yet another blow to her Brexit hopes as the upper house of the U.K. voted for giving parliament veto power over the final exit deal of Britain from the European Union. This news have been positive for the pound at the margin, as the perception of softer Brexit increases. The prime minister will now appeal this decision to the House of Commons. If she is defeated here, the pound could rally significantly. On the economic side, recent data has been disappointing: Market Services PMI not only went down from the previous month but also underperformed expectations, coming in at 53.3. Halifax house prices yearly growth came in at 5.1%, underperforming expectations. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 As expected, the RBA left its cash rate unchanged at 1.5%. The currency was little changed from this announcement. However, following last week's depreciation, the AUD followed through with further depreciation on Wednesday due to a strengthening greenback. This affected the AUD twofold: the appreciating dollar added pressure on the AUD, and on commodity prices which further exacerbated the AUD's decline - copper prices are down more than 4% and iron ore futures are down almost 3%. Risks are to the downside for the AUD: declining copper and iron ore prices foretell that the AUD's decline may continue; China's regulation on coal imports and energy production will further damage Australia's export market. On a shorter-term basis, the MACD line is below the signal line and indicates negative momentum. Additionally, the MACD line has breached negative territory, adding further downward momentum. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi continues to fall, and has now lost all of the gains from earlier this year. The outlook for the NZD against other commodity currencies is puzzling: on the one hand the NZD is very sensitive to emerging market spreads, which means that it would be the primary victim of the dollar bull market, as a rising dollar drains liquidity from EM and hurts fixed income instruments in these countries. On the other hand, domestic factors provide a tailwind for the NZD as strong inflationary pressures are emerging in the kiwi economy and New Zealand continues to be the star performer amongst its commodity peers. Overall, we are inclined to be tactically more bullish on the NZD against the AUD, as the NZD/USD has reached oversold levels, while AUD/USD has been firmer amidst the rally in the U.S. dollar. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Following up from last week's depreciation is an even weaker CAD this week. USD/CAD appreciated greatly amidst a large decline in oil prices after crude oil stocks increased by around 7 mn bbl more than the previous change and the consensus amount. This trend is likely to continue as rig counts continue to increase. A rising USD is likely to exacerbate the decline in the CAD as it will continue to weigh on oil prices. We have previously noted that the CAD will stay very affected by U.S. trade relations and rate differentials. This trend is likely to continue. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been encouraging: Unemployment continues to be very low at 3.3%. Headline inflation came in at 0.5%. At this level inflation now stands at its highest since 2011. Although these developments are positive, the SNB will continue to aggressively intervene in the currency and prevent further appreciation. The SNB has been keen on keeping their unofficial floor of 1.065 in EUR/CHF, even on the face of risk-off flows coming into Switzerland due to the European election cycle. In fact, the SNB reserves surged at the highest pace since December 2014, which indicates that the central bank has been having its hands full. For now the SNB will continue with this policy, however, we will continue to monitor Swiss data to assess whether a change in policy by the SNB is possible. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK rallied sharply following the 5% plunge in oil prices, as the rise in inventories came at almost 7 million barrels above expectations. The risk profile for the NOK is the opposite of the NZD. External factors should help the Norwegian economy vis-à-vis other commodity currencies, as oil should outperform industrial metals given that it has a lower beta to China and Emerging markets. On the other hand, the domestic situation has deteriorated. Nominal GDP is contracting, the output gap stands around -2% of potential GDP, and the credit impulse continues to be negative. Meanwhile, inflation is starting to recede, as the effect of the depreciation of the NOK on 2015 is dissipating. All of these factors should support a dovish bias from the Norges Bank, hurting the NOK going forward. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The krona will resume its cyclical downward trend as the USD continues to climb, being one of the currencies with the highest betas to the dollar. Our bullish case for the krona is weakened by the Riksbank's extremely cautious tone which, so to speak, stopped the krona in its tracks. EUR/SEK stopped its depreciation abruptly in the beginning of February and has since appreciated. Momentum, however, does seem to be slowing down for this cross as the Swedish economy remains inherently resilient. As a large proportion of Sweden's exports to the euro area are re-exported to EM, additional risks may emanate from China as any potential slowdown in the world's second largest economy could provide a risk to Sweden's industrial sector. This could add deflationary pressures to the economy, which can solidify the Riksbank's dovish stance even further. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The Fed's evident desire to lift its policy rate next week - presumably to get out ahead of inflation that has yet to show up in its preferred gauge - will weigh on gold. Oil ... not so much. This is because fundamentals once again are asserting themselves in the evolution of oil prices, something that has been evident even before markets balanced last year. Gold, meanwhile, remains exquisitely sensitive to Fed policy expectations and their effects on the USD and real rates, as with other currencies. Energy: Overweight. We are looking to re-establish our long WTI Dec/17 vs. short Dec/18 spread if it trades in contango again, i.e., if Dec/17 is less than Dec/18. We believe the combination of OPEC and non-OPEC adherence to their production Agreement will remain high, and demand likely will remain stout. Base Metals: Neutral. Spot copper is down ~ $0.10/lb on COMEX over the past week. We expect transitory supply issues in Chile and Indonesia to be resolved, and reflationary stimulus in China to wane going into the 19th National Congress of the Communist Party in the autumn, and, with it, copper demand. We remain neutral. Precious Metals: Neutral. Gold is weakening as the Fed's March meeting approaches next week, given the overwhelming expectation for a 25bp rate hike. We remain long volatility, expecting fiscal-policy uncertainty in the U.S. to be resolved over the next few months, and Fed policy drivers to become more focused. Ags/Softs: Underweight. We are not expecting significant changes in the USDA's estimates of stocks globally, and therefore remain underweight. Feature The choreographed messaging of voting and non-voting FOMC members asserting the need for a policy-rate hike over the past two weeks succeeded in pushing markets' expectations for such action to 88.6% as of Tuesday's close, up from 44.6% at the end of February. This despite the fact that the Fed's preferred inflation gauge - core PCE - has yet to show any sign of pushing up and thru the Fed's target of 2% growth yoy (Chart of the Week). Nor, for that matter, has core PCE shown any tendency to remain above 2% yoy growth over the past two decades (Chart 2). Chart of the WeekThe Fed's Preferred Inflation ##br##Gauge Still Quiescent Chart 2Core PCE Has Been ##br##Quiescent For Decades Between mid-December 2016 and the end of last month, gold prices rallied ~11.3% largely on the expectation the Fed would not raise rates until at least June, and, even then, would be constrained by uncertainty over what Congress and the Trump Administration would offer up in terms of fiscal policy later this year. Now, with the Fed succeeding in raising the market's expectation of a March rate hike, gold markets are left to re-calibrate the number of hikes to expect this year, and the likely implications for the USD and real rates. We believe the Fed will execute three rate hikes this year, but this will be highly dependent on how markets react to the now fully priced-in hike markets expect next week. Synchronized Growth, Inflation And Feedback Loops It is likely the Fed feels confident accelerating its rates normalization because, for the first time since the Global Financial crisis, we are getting a globally synchronized recovery in GDP. All else equal, this will give the U.S. central bank a bit of headroom to experiment with an earlier-than-expected rate hike. This synchronized growth also will provide a positive backdrop for commodity demand this year and next (Chart 3). The possibility of highly stimulative - or even just moderately stimulative - fiscal policy in the U.S. at a time when the economy is apparently at or close to full employment, will be positive for aggregate demand, and could be inflationary if its principal result is to lift real wages in the U.S. In addition to synchronized growth, we also are seeing evidence of synchronized inflation in the largest economies in the world (Chart 4). Chart 3Synchronized Global Growth ##br##Could Embolden The Fed Chart 4Synchronized Inflation Globally ##br##Likely Caught The Fed's Attention This synchronized growth and inflation is, we believe, important to the Fed, in that its effects constitute something of a global feedback loop. As we have noted in earlier research, the Fed is much more sensitive to how its policy actions affect other economies, given the deepening of global supply chains over the past two decades or so. Equally, policymakers are well aware the evolution of monetary policy and economic growth in other economies affects the U.S. growth and policy variables important to the Fed.1 Absent a policy shock in the U.S., Europe or China, the backdrop for EM growth should remain positive for at least 2017, even with reflationary stimulus waning in China, a left-tail risk to commodity prices that we identified in last week's publication.2 We expect the Fed's policy normalization to be tempered by continued monetary accommodation globally, which will be supportive of growth at the margin. This will keep global oil demand growth on track to average 1.50 - 1.60mm b/d this year and next, and, importantly for inflation and inflation expectations, keep EM oil demand growing. The income elasticity of per-capita oil consumption in EM economies typically is ~ 1.0, meaning a 1% increase in EM incomes is associated with a 1% increase in EM oil demand.3 EM growth accounts for close to 85% of the growth we expect in global oil demand this year. This is important, given EM oil demand, which we proxy with the U.S. EIA's non-OECD oil consumption time series, to be a common factor that explains the evolution of the CPI series shown above (Chart 5). EM oil demand is able to explain the synchronization of inflation in the three largest economies in the world is because incremental growth is occurring in the EM economies, and this is driving global growth. We continue to expect high compliance in the OPEC - non-OPEC production deal negotiated by the Kingdom of Saudi Arabia (KSA) and Russia at the end of last year, which will, against the backdrop of continued global growth, cause inventories to fall and for markets to backwardate. We believe last week's increase in U.S. crude oil inventories to be the last big build, and expect the decline to begin later this month. On average vessels leaving the Persian Gulf destined for the U.S. have a 45- to 50-day sailing period depending on multiple factors such route, weather and sea conditions. Therefore, the recent increase in U.S. crude oil inventories can be linked to the arrival of the final fleet of vessels in concert with the pre-OPEC agreement production surge undertaken by the GCC. Evidence of this phenomenon is apparent in the ~500k b/d increase in U.S. crude oil imports (374k b/d coming from Iraq) over the prior week. We expect OECD oil stocks to start declining this month and fall some 300mm bbl before the end of 2017. This supply-demand dynamic will continue to dominate financial-market influences on oil prices, as we argued in last week's publication (Chart 6).4 Gold, on the other hand, will continue to take its cue from Fed policy and policy expectations, particularly as regards expectations for the USD, which should strengthen at the margin, given the Fed's new-found hawkishness, and real rates, which also should strengthen (Chart 7). Chart 5EM Oil Demand Continues##br## To Drive Inflation Chart 6IF KSA And Russia Can ##br##Coordinate Production... Chart 7Gold Will Continue To Take##br## Its Cue From Fed Policy Bottom Line: Oil prices will continue to be dominated by supply-demand-inventory fundamentals, with monetary policy effects on the evolution of prices taking a secondary role. Gold prices will continue to take their cue from Fed policy and policy expectations. We look to re-establish our long Dec/17 WTI vs. short Dec/18 WTI spread if it trades thru flat (i.e., $0.00/bbl). Given our gold view, we remain long volatility via the put spreads and call spreads we recommended February 23 - i.e., long Jun/17 $1,200/oz puts vs. short $1,150/oz puts, and long $1,275/oz calls vs. short $1,325/oz calls. The position was up 15% as of Tuesday's close. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Reports "Global Inflation and Commodity Markets," dated August 11, 2016, and "Memo To The Fed: EM Oil, Metals Demand Key To U.S. Inflation," dated August 4, 2016, available at ces.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Gold's Known Unknowns, And Fat Tails," dated February 23, 2017, available at ces.bcaresearch.com. 3 Oil consumption frequently is employed to approximate EM income growth, given the income elasticity of demand for oil is ~ 1.0, meaning a 1% increase in income (GDP) produces an increase in demand for oil of approximately 1.0%. The OECD notes, "Non-OECD countries are found to have a higher income elasticity of oil demand than OECD countries. On average across countries, a one per cent rise in real GDP pushes up oil demand by half a per cent in OECD countries over the medium to long run, whereas the figure is closer to unity for most non-OECD countries." Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Days Of Oil Future's Past: Mean Reversion," dated March 2, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in

Highlights The Chinese government plans a smaller policy push in this year's budget, but is not aiming at a lower growth rate. Maintaining stability remains the priority over promoting growth and progress. Chinese growth has continued to accelerate. Odds of a relapse are low in the next one to two quarters. The sharp recovery in producer prices will likely support private sector investment. The regained strength in construction equipment sales of late could be a harbinger of increasing housing starts. The PBoC has both the willingness and resources to intervene and maintain control over the RMB exchange rate. The CNY/USD cross rate will remain largely determined by the broad trend of the dollar. Feature Chinese lawmakers and senior government officials are convening in Beijing this week for the annual plenary session of the People's Congress, China's parliament. The 3000-member Congress is expected to ratify Premier Li Keqiang's work report, approve his budget and endorse some key initiatives that the central government plans to unveil for the year. Overall, maintaining stability, both socially and economically, remains the focal point of Premier Li's work plan, but the government is planning a smaller policy push on growth in its budget compared with last year. Meanwhile, the latest growth figures out of China confirm that the economy has continued to build momentum. Odds of a near term relapse are low. Reading Policy Tea Leaves Premier Li's blueprint for 2017 offers little surprises, and we doubt that the government is aiming at a lower growth rate for the year. The minimum GDP growth target for 2017 was set at 6.5%, not much different from last year's target as well as realized GDP performance for the whole year (Table 1). Meanwhile, other key macro variables have also been adjusted slightly lower from last year's targets, but are slightly higher than last year's growth rates. For example, government agencies expect investment spending and broad money supply to grow by 9% and 12%, respectively, in 2017, a tick lower than last year's targets, but higher than a growth rate of 7.9% and 11.3%, respectively, in 2016. Furthermore, the government's growth priority is also reflected in a higher target for creating jobs. Table 1Table: The Growth Target China's growth recovery since mid-last year has given the government some comfort in staying the course on policy rather than engaging in fresh stimulus. On the fiscal front, there are some initiatives to reduce the corporate tax burden and administrative fees, but the overall budget deficit target will be maintained at 3%, unchanged from last year, which implies no fresh fiscal thrust to support the economy. Meanwhile, infrastructure spending on railways, waterways and highway construction is only expected to be marginally higher than last year's levels. On the monetary front, the Premier has pledged a prudent and neutral policy stance. Headline CPI is expected to increase by 3% in 2017, compared with 2.5% in December 2016. This reflects the government's eased concerns over deflation rather than an anticipation of inflation risk. Building on last year's efforts, the government continues to plan to remove excess capacity in certain industries. The focus remains on steelmakers and coalmines, but some other sectors are also being singled out such as construction materials, ship-building and coal-fire thermal industries. Last year's "de-capacity" campaign has led to a dramatic turnaround in business conditions in steelmakers and coalmines, which suggests the slack in the economy may not be as big as commonly perceived.1 These efforts deserve close attention in terms of their impact on other industries as well as on the overall economy. Finally, Premier Li has also pledged to further advance market-oriented reforms. The government plans to improve governance, reduce administrative red tape, simplify the tax code and increase private sector access to key industries. Meanwhile, the government intends to continue to push "mixed ownership" reforms, or partial privatization, among the country's state-owned enterprises (SOEs), including electricity, petroleum, natural gas, railways, civil aviation, telecom and military equipment. Financial sector reforms are being directed towards boosting the efficiency of financial resources, improving corporate sector access to financing, enhancing supervision over financial institutions and preempting financial risks. These reform initiatives are largely incremental, which probably underscores the authorities' preference for stability ahead of the Party Congress later this year. All in all, the central government plans a smaller policy push in this year's budget, and intends to let the economy run on its own momentum. Aggressive policy reflation is not in the cards unless a relapse in the economy threatens job creation. The government has reiterated its pledge for further reforms, but has so far offered few hopeful signs of bold steps. Overall, maintaining stability remains the priority over promoting growth and progress. China Growth Watch Key macro indicators to be released in the next several days will offer a reality check on how the Chinese economy has fared since the beginning of the year as the holiday seasonal factor wears off. Early indicators confirm that the economy has continued to accelerate. Real time activity trackers for the industrial sector, such as the daily coal intake at thermal power plants and average daily output at major steelmakers, have continued to accelerate (Chart 1). The sharp increase in imports compared with a year ago also confirmed strengthening domestic demand. The recovery in Chinese domestic activity is also reflected in neighboring countries. Sales to China from Korean and Taiwanese exporters have increased sharply from a year ago (Chart 2). As the biggest trading partner of these countries, China has played a pivotal role in the cyclical recovery of their respective economies. Chart 1Real Time Activity Monitor##br## Has Continued To Strengthen Chart 2A Sharp Turnaround##br## In Chinese Demand In short, the Chinese economy has demonstrated some remarkable strength of late. Last year's low base may have exaggerated the year-over-year comparison in some macro figures, but there is little doubt the economy's strong recovery has continued into the New Year. Looking forward, the risk is still tilted to the upside, at least over the next three to six months. First, purchasing manager indexes (PMIs) for both the manufacturing and service sectors have been above the 50 threshold, with broad-based improvement in all major components. BCA's China Leading Economic Indicator remains in a clear uptrend, heralding further improvement in macro numbers (Chart 3). Second, the sharp recovery in producer prices will likely support capital expenditure, especially among private enterprises. Some commentators have attributed China's rising PPI to the increase in global commodities prices rather than being a reflection of the Chinese business cycle. We disagree. While it is certainly true that the mining sector and materials producers have enjoyed the biggest boost in their pricing power since last year due to rising commodities prices, the improvement in Chinese PPI is rather broad-based. Our diffusion index for producer prices, which measures the percentage of sectors witnessing higher PPI, has also recovered strongly (Chart 4). In fact, the current reading suggests almost all sectors are experiencing rising output prices rather than only the resource sector. At a minimum, this should put a floor under capital expenditure in the manufacturing sector. Chart 3Strengthening LEI Points ##br##To Further Growth Acceleration Chart 4Broad-Based Improvement##br## In PPI Moreover, there has been a dramatic increase in the sales of construction equipment such as heavy trucks and excavators, with growth rates matching levels during the boom years prior to the global financial crisis. Historically, construction machines sales have been tightly correlated with real estate development (Chart 5). If history is any guide, the regained strength in construction equipment sales of late could be a harbinger of an impending boom in new housing starts. This means efforts to rein in housing activity since last October have done little to dampen developers' confidence.2 Meanwhile, we have highlighted the risk of slowing infrastructure construction by the state sector, which could weigh on overall capital spending3 - any improvement in real estate investment would offer an important offset. Ongoing housing sector development deserves close attention in the coming months. Finally, the growth outlook in other major developed economies has also improved, which should benefit Chinese exporters. A recent Special Report published by our sister publication, The Bank Credit Analyst, found broad-based evidence of improving activity across countries and industrial sectors.4 Retail sales, industrial production and capital spending are all showing more dynamism in the advanced economies, and orders and production are gaining strength for goods related to both business and household final demand. As far as China is concerned, a mini-cycle global upturn bodes well for exports. We were surprised by February's weak Chinese export numbers and for now, we suspect it reflects noise rather a trend. Unless protectionism backlash out of the U.S. derails normal trade links, we expect Chinese exports should continue to strengthen,5 which should allow the Chinese economy to gain additional momentum (Chart 6). Chart 5An Impending Boom In Housing Construction? Chart 6Chinese Exports: Better Days Ahead? Bottom Line: Chinese growth has continued to accelerate. Odds of a relapse are low in the one to two quarters. The RMB: Back In The Spotlight The Federal Reserve is well expected to raise its benchmark policy rate again next week, which has prompted a bidding up of the U.S. dollar against other majors as well as the RMB. In Premier Li Keqiang's work report presented to the People's Congress this week, the Chinese government appears to have omitted the usual commitment to maintain "exchange rate stability," which is being interpreted by some as a sign the government may allow for much greater fluctuations of the RMB against the dollar. To be sure, achieving a free-floating exchange rate has been China's long-stated reform target, and it is impossible to predict the exact next step of the People's Bank of China. However, a few broad judgements should still hold. First, we doubt the PBoC will tolerate unorderly fluctuations in the exchange rate in the near term. A weaker currency can be viewed as a reflection of domestic weakness. Moreover, sharper RMB depreciation begets greater capital outflows, which could quickly degenerate into a vicious circle - all of which is against the government's intentions of maintaining stability, especially ahead of the Party Congress late this year. Chart 7A Weak RMB, Or A Strong Dollar? Second, it is unlikely the PBoC will sacrifice domestic monetary policy independence in order to defend the exchange rate. The PBoC's recent policy tightening is as much a response to the stronger domestic economy as it is a forced response to higher U.S. interest rates. Tighter capital account controls will remain the dominant policy tool to deter domestic capital outflows and support the RMB if needed. Finally, fundamental factors do not support significant RMB depreciation against the dollar, given Chinese exporters' competitiveness and the country's large external surpluses. China's recent growth improvement should further weaken the case for a much cheaper RMB. In short, the PBoC has both the willingness and resources to intervene and maintain control over the exchange rate. The CNY/USD cross rate will remain largely determined by the broad trend of the dollar, and the RMB is unlikely to depreciate against the dollar more than other major currencies, if the dollar uptrend resumes (Chart 7). We will follow up on these issues in next week's report. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "The Myth Of Chinese Overcapacity," dated October 6, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening," dated February 16, 2017, available at cis.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "Global Growth Pickup: Fact Or Fiction?" dated February 23, 2017, available at bca.bcaresearch.com. 5 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Substituting certain imports with local production will ensure that Russia's inflation rate will become less sensitive to fluctuations in the exchange rate and more sensitive to local wages/unit labor costs. In such a scenario, the central bank will not need to pursue pro-cyclical monetary policy. This is on top of the counter-cyclical fiscal policy emerging from the new fiscal rule. Less pro-cyclical monetary and fiscal policies argue for more stability in the real economy than in the past. Altogether, this warrants a lower beta for Russian financial assets relative to EM benchmarks. Meanwhile, geopolitics is likely to remain a tailwind for Russia. Continue overweighting Russian stocks, ruble, local fixed-income and credit relative to their EM counterparts. A new trade: Go long the ruble and short crude oil. Feature Russian equities and the ruble have been high-beta bets on oil prices. While the positive correlation between crude prices and Russian financial markets is unlikely to change soon, the country's stock market and currency will likely become low-beta within the EM universe. Sound macro policies and some import substitutions will make inflation less sensitive to the exchange rate. As such, the central bank will not need to hike interest rates amid falling oil prices. The key point is that fiscal and monetary policies are becoming less pro-cyclical. This will reduce volatility in the real economy, which in turn will warrant a lower risk premium on Russian assets, particularly within the EM aggregates. Meanwhile, geopolitics is likely to remain a tailwind for Russia. Both Europe and the U.S. have lost appetite for direct confrontation. And while some of the exuberance immediately following Trump's victory will wear off, the U.S. and Russia are unlikely to revisit the 2014 nadir in relations. Orthodox Macro Policies... Russia has adhered to orthodox macro policies amid a severe recession over the past two years: On the fiscal front: The government has maintained constant nominal expenditure growth and substantially cut spending in real terms (Chart I-1). The fiscal deficit is still large at 3.8% of GDP, but it typically lags oil prices (Chart I-2). Hence, the recovery in oil prices over the past year should lead to a notable improvement in the budget balance. For 2017, the budget is conservative, as it assumes $/bbl 40 Urals. Early this year, the Ministry of Finance adopted a new fiscal rule where it will buy foreign currency when the price of oil is above the set target level of 2700 RUB per barrel ($40 oil price times 67 USD/RUB exchange rate) and sell foreign exchange when the oil price is below that level (Chart I-3). Chart I-1Russia Has Undergone ##br##Through Real Fiscal Squeeze... Chart I-2...Which Is Now Over Chart I-3Oil Price Threshold For ##br##The New Fiscal Rule The objective of this policy is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. With respect to monetary policy, Russia's central bank has been highly prudent. Unlike many other emerging countries, the central bank has refrained from injecting liquidity into the banking system (Chart I-4) and has maintained high real interest rates (Chart I-4, bottom panel). Chart I-5 demonstrates that the central bank's domestic assets have been flat, while the same measure has surged for many other EM central banks. Although this measure does not reflect central banks' net liquidity injections, it in general validates that Russia's monetary authorities have been more conservative than their counterparts in many developing countries. This is ultimately positive for the currency. Chart I-4Russian Central Bank: ##br##Tight Monetary Stance Chart I-5Russian Central Bank Has Been ##br##Conservative Among Its Peers Furthermore, the central bank has been forcing banks to acknowledge non-performing loans (Chart I-6, top panel) and has been reducing the number of dysfunctional banks by removing their licenses (Chart I-6, bottom panel). This assures that the credit system has already gone through a cleansing process, and a gradual credit recovery will commence soon. This is also in stark contrast with many other EM banking systems, where credit-to-GDP ratios continue to rise. In brief, Russia is advanced on the path of deleveraging (Chart I-7), while many EM countries have not even begun the process. Chart I-6Russian Central Bank Has ##br##Forced Banking Restructuring Chart I-7Russia Is Very Advanced ##br##In Its Deleveraging Cycle Bottom Line: The new fiscal rule will reduce fluctuations in the ruble. The central bank's ongoing tight policy stance will also put a floor under the ruble. Even though we expect oil prices to drop meaningfully in the months ahead, any ruble depreciation will be moderate. ... Plus Some Imports Substitution... The dramatic currency devaluation in 2014-15 and sanctions imposed on Russia by the West have led to the substitution of some imported goods with locally produced ones. First, the most visible import substitution has occurred in the agriculture sector. Chart I-8 suggests that in agriculture import substitution has been broad-based and significant. Second, while there has been some import substitution in the industrial sector, it has been less pronounced. Demand for industrial goods and non-staples (autos and furniture, for example) has plunged significantly. Hence, local production has also collapsed, but less so than imports (Chart I-9). Chart I-8Russia: Import ##br##Substitution In Agriculture Chart I-9Some Import ##br##Substitution In Manufacturing As domestic demand recovers, manufacturing production of industrial goods will increase. However, it is not clear how much of this demand recovery will be met by rising imports versus domestic production. On one hand, the ruble is not expensive, and argues for more import substitution going forward - i.e. relying more on domestic production rather than imports. On the other hand, Russia is hamstrung by a lack of manufacturing productive capacity, technology and know-how in many sectors to produce competitive products. FDI by multinational companies will likely rise from extremely low levels (Chart I-10), yet it is unlikely to be sufficient to make a major difference in terms of Russia's competitiveness. Third, the ruble depreciation has helped Russia increase oil and natural gas production (Chart I-11). Chart I-10Russia: Meager Net FDI Inflows Chart I-11Russia: Oil And Natural Gas Output Is Robust Finally, in an attempt to lessen dependence on foreigners, Russian President Vladimir Putin has been pushing the use of domestic technology. For example, Microsoft products will be replaced by locally developed software. Bottom Line: The combination of currency depreciation and trade sanctions has led to some import substitution. ...Will Make Inflation Less Sensitive To The Currency Chart I-12Russia: Unit Labor ##br##Costs Have Collapsed The collapse of the ruble has drastically reduced labor costs in Russia's manufacturing sector (Chart I-12). A diminished share of imports in domestic consumption - import substitution - will ensure Russia's inflation rate becomes less sensitive to fluctuations in the exchange rate and more sensitive to local wages/unit labor costs instead. Tame wages and some improvement in productivity - as output recovers - will cap Russian unit labor costs and restrain inflation in the medium term. In such a scenario, the central bank will not need to pursue pro-cyclical monetary policy - i.e., hike interest rates when oil prices drop and the ruble depreciates. Less pro-cyclical monetary and fiscal policies will diminish fluctuations in the economy, and economic visibility will improve. This bodes well for the nation's financial assets. We do not mean to suggest that the central bank of Russia will immediately pursue counter-cyclical monetary policy - i.e., that it will be able to cut interest rates when oil prices fall. While this would be ideal for the national economy, it is not a practical option for now. Bottom Line: Less pro-cyclical monetary and fiscal policies argue for more stability in the real economy than in the past. Altogether, this warrants a lower beta for Russian financial assets relative to EM benchmarks. The Growth Outlook The Russian economy is about to exit recession (Chart I-13, top panel), but growth recovery will be timid: Bank loans will recover after pronounced contraction over the past two years. The credit impulse - the change in bank loan growth - has already turned positive (Chart I-13, bottom panel). Retail sales volumes and auto sales have not yet recovered but manufacturing output growth is already positive (Chart I-14). Rising nominal and real wages argue for a pick-up in consumer spending (Chart I-14, bottom panel). Capital spending has collapsed both in absolute terms and relative to GDP (Chart I-15). Such an underinvested position and potential recovery in consumer spending warrant a pickup in investment outlays. The key difference between Brazil and Russia - the two economies that plunged into deep recession in the past 2-3 years - is public debt load and sustainability. Chart I-13Russia: Recovery Is At Hand Chart I-14Russia: Economic Conditions Chart I-15Russia: Capex Recovery Is Overdue The public debt-to-GDP ratio is 77% in Brazil and 16% in Russia, while fiscal deficits are 9% and 3.8% of GDP, respectively. Public debt could spiral out of control in Brazil1 in the next two years, while it is not an issue in Russia. Bottom Line: Russia is about to embark on a mild and gradual economic recovery, even if oil prices relapse. Russia Is In A Geopolitical Sweet Spot Geopolitical headwinds will continue to abate for Russia. We expect that some of the loftiest expectations of a U.S.-Russia détente will fail to materialize as the Trump Administration continues to face domestic pressures. However, the 2014 nadir in relations will not be revisited. Meanwhile, Russia will benefit from several geopolitical tailwinds: The path of least resistance for tensions between Russia and the West is down. The Trump administration is highly unlikely to increase sanctions against Russia. Congress is likely to open an investigation into allegations of Russian interference in the 2016 U.S. election, but we highly doubt that any genuine "smoking guns" linking the Kremlin to the election result will be found. As such, we expect the thaw in U.S.-Russia relations to continue, albeit haltingly and without any possibility that the two powers become allies. Washington has recently removed sanctions related to U.S. tech exports to Russia. While U.S. sanction can be easily removed by presidential decree, EU sanctions require a unanimous vote on behalf of the European council. A summary can be found bellow. Table I-1 Putin's support remains high (Chart I-16), giving him a sense of confidence that modest structural reforms and economic opening is possible without undermining his support base. Military intervention in Syria has largely been a success, from Moscow's point of view. Chart I-16Popularity Of Putin And Government None of the current candidates in the upcoming elections in Europe are overtly anti-Russia. In France, leading candidate Emmanuel Macron is mildly hawkish on Russia, but the other two candidates - Marine Le Pen and François Fillon are downright Russophile. In Germany, the historically sympathetic to Russia Socialist Democratic Party (SPD) has taken a lead against Angela Merkel's ruling party. Even if Angela Merkel retains her Chancellorship, it is likely that the Grand Coalition would have to give the SPD a greater role given their dramatic rise in polling. Despite two major diplomatic incidents between Turkey and Russia,2 relations between the two countries continue to improve. In fact, the Turkstream project - which will connect Russia with Turkey via the Black Sea - has been approved by both sides. This is a positive development for the Russian energy sector as the capacity of that pipeline is large, standing at 63 Bn cubic meters per year. In Syria, the two countries have gone from outright hostility to coordinating their military operations on the ground, a dramatic reversal. The Rosneft IPO was a success, a positive sign for foreign investments in Russia. While the issuance was conducted for budget reasons, it is a sign that Russia is willing to open itself to foreign investors. The caveat being that it will only do so selectively. Further evidence of this selective opening is the recent announcement by the head of the Finance Ministry debt department that the next Eurobond auction will be conducted privately. Past investments from western firms in Russia failed due to the fact that a large number of Western oil companies were complacent in their investment analysis and failed to do due diligence.3 Furthermore, foreign investments in Russia have often failed because it was caught in the cross fire between the Kremlin and the various oligarchs who brought in the foreign investment.4 Given that President Vladimir Putin has largely neutered oligarchs, FDI that arrives in the country will have full blessing of the government. Finally, we would expect western energy companies to be more selective in their foreign investments given the recent crash in oil prices. As BCA's Geopolitical Strategy has been warning since 2014, globalization is in a structural decline and protectionism may follow. The Trump administration has threatened to use tariffs against both geopolitical adversaries, like China, and allies, like Germany. The border adjustment tax, proposed by Republicans in Congress, is a protectionist measure that could launch a global trade war.5 Due to the fact that Russia exports commodities, we would expect Russia's export revenue stream to be unaffected compared to countries who export more elastic goods such as consumer products. Bottom Line: We expect geopolitical dynamics to play in Russia's favor going forward. These will mark a structural shift in how foreign investment is conducted in Russia and risk assets will continue re-pricing. Investment Conclusions Chart I-17Continue Overweighting Russian Stocks Russian stocks will outperform the EM equity benchmark in the months ahead (Chart I-17). Stay overweight. Typically, the Russian bourse has outperformed the EM index during risk-on phases and underperformed in risk-off episodes - i.e., Russia has been a high-beta market. This will likely change, and we expect Russia to outperform in a falling market. Also, maintain the long Russian stocks and ruble / short Malaysian stocks and ringgit trades. Continue overweighting Russian sovereign and corporate credit within the EM credit universe. Continue overweighing local currency bonds within EM domestic bond portfolios. A new trade: Go long the ruble and short oil. When oil prices drop, as BCA's Emerging Markets Strategy team expects to happen in the months ahead, the ruble might weaken too. However, adjusted for the carry, the aggregate long ruble/short oil position will prove profitable. Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Has Brazil Achieved Escape Velocity?", dated February 8, 2017, link available on page 14. 2 Turkey shot down a Russian Sukhoi Su-24 on November 24th 2015 and Andrei Karlov, the Russian ambassador to Turkey got shot dead by a Turkish police officer in Ankara on December 19th 2016. 3 The BP and TNK deal failed for obvious reasons. BP and TNK had already come in confrontation when in the mid-1990's BP had bought a 10 percent stake in Sidanco only to see TNK strip the company of its asset. Furthermore, TNK was involved in other mergers inside Russia, making extremely confusing to understand what assets it actually owned. 4 Putin's campaign to sideline Khodorkovsky and Berezovsky for example sometimes came at odds with foreign investment in Russia. 5 Please see BCA Geopolitical Strategy Special Report, "Will Congress Pass The Border Adjustment Tax," dated February 8, 2017, available at gps.bcaresearch.com.