Asset Allocation

Highlights The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. Fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. Tax cuts and the spending deal will result in fiscal stimulus of about 0.8% of GDP in 2018 and 1.3% in 2019. The latest U.S. CPI and average hourly earnings reports caught investors' attention. However, most other wage measures are consistent with our base-case view that inflation will trend higher in an orderly fashion. If correct, this will allow the FOMC to avoid leaning heavily against the fiscal stimulus. Stronger nominal growth and a patient Fed are a positive combination for risk assets such as corporate bonds and equities. The projected peak in S&P profit growth now occurs later in the year and at a higher level compared with our previous forecast. The bad news is that the fiscal stimulus and budding inflation signs imply that investors cannot count as much on the "Fed Put" to offset negative shocks. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range, partly reflecting the U.S. fiscal shock. That said, extreme short positioning and oversold conditions suggest that a consolidation phase is likely in the near term. Loose fiscal and tight money should be bullish for the currency. However, angst regarding the U.S. "twin deficits" problem appears to be weighing on the dollar. We do not believe that fiscal largesse will cause the current account deficit to blow out by enough to seriously undermine the dollar. We still expect a bounce in the dollar, but we cannot rule out further weakness in the near term. Fiscal stimulus could extend the expansion, but the more important point is that faster growth in the coming quarters will deepen the next recession. For now, stay overweight risk assets (equities and corporate bonds), and below benchmark in duration. Feature The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. This has not come as a surprise to BCA's Geopolitical Strategy, which has been flagging the shift away from fiscal conservatism and towards populism for some time, particularly in the U.S. context.1 The move is wider than just in the U.S. In Germany, the Grand Coalition deal was only concluded after Chancellor Merkel conceded to demands for more spending on everything from education to public investment in technology and defense. The German fiscal surplus will likely be fully spent. There is no fiscal room outside of Germany, but the austerity era is over. Japan is also on track to ease fiscal policy this year. The big news, however, is in the U.S. President Trump is moving to the middle ground in order to avoid losing the House in this year's midterm elections. Deficit hawks have mutated into doves with the passage of profligate tax cuts, and Congress is now on the brink of a monumental two-year appropriations bill that will add significantly to the Federal budget deficit (Chart I-1). The deficit will likely rise to about 5½% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast for that year. This includes the impact of the tax cuts, as well as outlays for disaster relief ($45 billion), the military ($165 billion) and non-defense discretionary items ($131 billion), spread over the next two years. A deal on infrastructure spending would add to this already-lofty total. Chart I-1U.S. Budget Deficit To Reach 5 1/2 % In 2019 There is also talk in Congress of re-authorizing "earmarks" - legislative tags that direct funding to special interests in representatives' home districts. Earmarks could add another $50 billion in spending over 2018 and 2019. While not a major stimulative measure, earmarks could further reduce Congressional gridlock and underscore that all pretense of fiscal restraint is gone. Chart I-2Substantial Stimulus In The Pipeline Chart I-2 presents an estimate of U.S. fiscal thrust, which is a measure of the initial economic impulse of changes in government tax and spending policies.2 The IMF's baseline, done before the tax cuts were passed, suggested that policy would be contractionary this year (about ½% of GDP), and slightly expansionary in 2019. Incorporating the impact of the tax cuts and the Senate deal on spending, the fiscal impulse will now be positive in 2018, to the tune of 0.8% of GDP. Next year's impulse will be even larger, at 1.3%. These figures are tentative, because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. A lot can change in the coming months as Congress hammers out the final deal. Moreover, the impact on GDP growth will be less than these figures suggest, because the economic multipliers related to tax cuts are less than those for spending. Nonetheless, the key point is that fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. The Fed's Dilemma Chart I-3U.S. Inflation Green Shoots Textbook economic models tell us that the combination of expansionary fiscal policy and tightening monetary policy is a recipe for rising interest rates and a stronger currency. However, it is not clear how much of the coming pickup in nominal GDP growth will be due to inflation versus real growth, given that the U.S. already appears to be near full employment. How will the Fed respond to the new fiscal outlook? We do not believe policymakers will respond aggressively, but much depends on the evolution of inflation. January's 0.3% rise in the core CPI index grabbed investors' attention, coming on the heels of a surprisingly strong average hourly earnings report (AHE). The 3-month annualized core inflation rate surged to 2.9% (Chart I-3). Among the components, the large rent and owners' equivalent rent indexes each rose 0.3% in the month, while medical care services jumped by 0.6%. Also notable was the 1.7% surge in apparel prices, which may reflect 'catch up' with the perky PPI apparel index. More generally, it appears that the upward trend in import price inflation is finally leaking into consumer prices. That said, investors should not get carried away. Most other wage measures, such as unit labor costs, are not flashing red. This is consistent with our base-case view that inflation will trend higher in an orderly fashion over the coming months. Moreover, the Fed's preferred measure, core PCE inflation, is still well below 2%. If our 'gradual rise' inflation view proves correct, it will allow the FOMC to avoid leaning heavily against the fiscal stimulus. We argued in last month's Overview that the new FOMC will strive to avoid major shifts in policy, and that Chair Powell has shown during his time on the FOMC that he is not one to rock the boat. It is doubtful that the FOMC will try to head off the impact of the fiscal stimulus on growth via sharply higher rates, opting instead to maintain the current 'dot plot' for now and wait to see how the stimulus translates into growth versus inflation. Stronger nominal growth and a patient Fed is a positive combination for risk assets such as corporate bonds and equities. Chart I-4 provides an update of our top-down S&P operating profit forecast, incorporating the economic impact of the new fiscal stimulus. We still expect profit growth to peak this year as industrial production tops out and margins begin to moderate on the back of rising wages. However, the projected peak now occurs later in the year and at a higher level compared with our previous forecast, and the whole profile is shifted up. Most of this improvement in the profit outlook is already discounted in prices, but the key point is that the earnings backdrop will remain a tailwind for stocks at least into early 2019. Chart I-4The Profile For S&P EPS Growth Shifts Up The End Of The Low-Vol Period That said, the U.S. is in the late innings of the expansion and risk assets have entered a new, more volatile phase. We have been warning of upheaval when investor complacency regarding inflation is challenged, because the rally in risk assets has been balanced precariously on a three-legged stool of low inflation, depressed interest rates and modest economic volatility. All it took was a couple of small positive inflation surprises to spark a reset in the market for volatility. The key question is whether February's turmoil represented a healthy market correction or a signal that a bear market is approaching. The good news is that the widening in high-yield corporate bond spreads was muted (Chart I-5). This market has often provided an early warning sign of an approaching major top in the stock market. The adjustment in other risk gauges, such as EM stocks and gold, was also fairly modest. This suggests that equity and volatility market action was largely technical in nature, in the context of extended investor positioning, crowded trades and elevated valuations. There has been no change in the items on our checklist for trimming equity exposure. We presented the checklist in last month's Overview. Our short-term economic growth models for the major countries remain upbeat and our global capital spending indicators are also bullish (Chart I-6). Industrial production in the advanced economies is in hyper-drive as global capital spending growth accelerates (Chart I-7). Chart I-5February's Volatility Reset Chart I-6Near-Term Growth Outlook Still Solid... Chart I-7... Partly Due To Capex Acceleration Nonetheless, it will be difficult to put the 'vol genie' back into the bottle. The surge in bond yields has focused market attention on the leverage pressure points in the system. One potential source of volatility is the corporate bond space. This month's Special Report, beginning on page 17, analyses the vulnerability of the U.S. corporate sector to rising interest rates. We conclude that higher rates on their own won't cause significant pain, but the combination of higher rates and a downturn in earnings would lead to a major deterioration in credit quality. Moreover, expansionary fiscal policy and recent inflation surprises have limited the Fed's room to maneuver. Under Fed Chairs Bernanke and Yellen, markets relied on a so-called "Fed Put". When inflation was low and stable, economic slack was abundant and long-term inflation expectations were depressed then disappointing economic data or equity market setbacks were followed by an easing in the expectations for Fed rate hikes. This helped to calm investors' nerves. We do not think that the Powell FOMC represents a regime shift in terms of the Fed's reaction function, but the rise in long-term inflation expectations and the January inflation report have altered the Fed's calculus. The new Committee will be more tolerant of equity corrections and tighter financial conditions than in the past. Indeed, some FOMC members would welcome reduced frothiness in financial markets, as long as the correction is not large enough to undermine the economy (i.e. a 20% or greater equity market decline). The implication is that we are unlikely to see a return of market volatility to the lows observed early this year. Bonds: Due For Consolidation Chart I-8Market Is Converging With Fed 'Dots' A lot of adjustment has already taken place in the bond market. Market expectations for the Fed funds rate have moved up sharply since last month (Chart I-8). The market now discounts three rate hikes in 2018, in line with the Fed 'dot plot'. Expectations still fall short of the Fed's plan in 2019, but the market's estimate of the terminal fed funds rate has largely converged with the Fed's dots. Meanwhile, the latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that investors cut bond allocations to the lowest level in the 20-year history of the report. All of this raises the odds that the rise in U.S. and global bond yields will correct before the bear phase resumes. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range. The 10-year TIPS breakeven rate has jumped to 2.1% even as oil prices have softened, signaling that the market is seeing more evidence of underlying inflationary pressure. This breakeven rate will likely rise by another 30 basis points and settle back into its pre-Lehman trading range of 2.3-2.5%. Importantly, the latter range was consistent with stable inflation expectations in the pre-Lehman years. The upward revision to our 10-year nominal yield target is due to a higher real rate assumption. In part, this reflects the fact that we have been impressed by last year's productivity performance. We are not expecting a major structural upshift in underlying productivity growth, for reasons cited by our colleague Peter Berezin in a recent report.3 Nonetheless, capital spending has picked up and Chart I-9 suggests that productivity growth should move a little higher in the coming years based on the acceleration in growth of the capital stock. Equilibrium interest rates should rise in line with slightly faster potential economic growth. Should we worry about a higher fiscal risk premium in bond yields? In the pre-Lehman era, academic studies suggested that every percentage point rise in the government's debt-to-GDP ratio added three basis points to the equilibrium level of bond yields. We shouldn't think of this as a 'default risk premium', because there is little default risk for a country that can print its own currency. Rather, higher yields reflect a crowding-out effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Plentiful economic slack negated the need for any crowding out as government debt exploded in aftermath of the Great Recession. Moreover, quantitative easing programs soaked up more than all of net government issuance for the major economies. Chart I-10 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative in each of 2015, 2016 and 2017. The flow will swing to a positive figure of US$957 billion this year and US$1,127 billion in 2019. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private sector issuance for available savings. Chart I-9U.S. Productivity Should Improve Modestly Chart I-10Government Bond Supply Is Accelerating The bottom line is that duration should be kept short of benchmarks within fixed-income portfolios, although we would not be surprised to see a consolidation phase or even a counter-trend rally in the near term. Dollar Cross Currents As mentioned earlier, standard theory suggests that loose fiscal policy and tight money should be bullish for the currency. However, the U.S. situation is complicated by the fact that fiscal stimulus will likely worsen the "twin deficits" problem. The current account deficit widened last year to 2.6% of GDP (Chart I-11). The fiscal measures will result in a jump in the Federal budget deficit to roughly 5½% in 2019, up from 3½% in last summer's CBO baseline projection. As a ballpark estimate, the two percentage point increase will cause the current account deficit to widen by only 0.3 percentage points. Of course, this will be partly offset by the continued improvement in the energy balance due to surging shale oil production. The poor international investment position is another potential negative for the greenback. Persistent U.S. current account deficits have resulted in a huge shortfall in the country's international investment account, which has reached 40% of GDP (Chart I-12). This means that foreign investors own a larger stock of U.S. financial assets than U.S. investors own abroad. Nonetheless, what matters for the dollar are the returns that flow from these assets. U.S. investors have always earned more on their overseas investments than foreigners make on their U.S. assets (which are dominated by low-yielding fixed-income securities). Thus, the U.S. still enjoys a 0.5% of GDP net positive inflow of international income (Chart I-12, bottom panel). Chart I-11A U.S. Twin Deficits Problem? Chart I-12U.S. Net International Investment Interest income flowing abroad will rise along with U.S. bond yields. This will undermine the U.S. surplus on international income to the extent that it is not offset by rising returns on U.S. investments held abroad. We estimate that a further 60 basis point rise in the U.S. Treasury curve (taking the 10-year yield from 2.9% to our target of 3½%) would cause the primary income surplus to fall by about 0.7 percentage points (Chart I-13). Adding this to the 0.3 percentage points from the direct effect of the increased fiscal deficit, the current account shortfall would deteriorate to roughly 3½% of GDP. While the deterioration is significant, the external deficit would simply return to 2009 levels. We doubt this would justify an ongoing dollar bear market on its own. Historically, a widening current account deficit has not always been the dominant driver of dollar trends. What should matter more is the Fed's response to the fiscal stimulus. If the FOMC does not immediately respond to head off the growth impulse, then rising inflation expectations could depress real rates at the short-end of the curve and undermine the dollar temporarily, especially in the context of a deteriorating external balance. The dollar would likely receive a bid later, when inflation clearly shifts higher and long-term inflation expectations move into the target zone discussed above. At that point, policymakers will step up the pace of rate hikes in order to get ahead of the inflation curve. The bottom line is that we still believe that the dollar will move somewhat higher on a 12-month horizon, but we can't rule out a continued downtrend in the near term until inflation clearly bottoms. It will also be difficult for the dollar to rally in the near term in trade-weighted terms if our currency strategists are correct on the yen outlook. The Japanese labor market is extremely tight, industrial production is growing at an impressive 4.4% pace, and the OECD estimates that output is now more than one percentage point above its non-inflationary level (Chart I-14). Investors are betting that a booming economy will give the monetary authorities the chance to move away from extraordinarily accommodative conditions. Investors are thus lifting their estimates of where Japanese policy will stand in three or five years. Chart I-13U.S. Fiscal Stimulus ##br##Impact On External Deficit Chart I-14Yen Benefitting From ##br##Domestic And Foreign Growth Increased volatility in global markets is also yen-bullish, especially since speculative shorts in the yen had reached near record levels. The pullback in global risk assets triggered some short-covering in yen-funded carry trades. Finally, the yen trades at a large discount to purchasing power parity. A strong Yen could prevent dollar rally in trade-weighted terms in the near term. Finally, A Word On Oil Oil prices corrected along with the broader pullback in risk assets in February. Nonetheless, the fundamentals point to a continued tightening in crude oil markets in the first half of 2018 (Chart I-15). Chart I-15Oil Inventory Correction Continuing OPEC's goal of reducing OECD inventories to five-year average levels will likely be met late this year. OPEC and Russia's production cuts are pretty much locked in to the end of June, when the producer coalition will next meet. Even with U.S. shale-oil output increasing, solid global demand will ensure that OECD inventories will continue to draw through the spring period. Over the past week, comments from Saudi and Russian oil ministers indicate they are more comfortable with extending OPEC 2.0's production cuts to end-2018, which, along with strong global demand growth, raises the odds Brent crude oil prices will exceed $70/bbl this year and possibly next year. Whether this is the result of the Saudi's need for higher prices to support the Aramco IPO, or it reflects an assessment by OPEC 2.0 that the world economy can absorb such prices without damaging demand too much, is not clear. Markets have yet to receive forward guidance from OPEC 2.0 leadership indicating this is the coalition's new policy, but our oil analysts are raising the odds that it is, and will be adjusting their forecast accordingly this week. Investment Conclusions The combination of an initially plodding Fed and faster earnings growth this year provides a bullish backdrop for the equity market. Treasury yields will continue to trend higher but, as long as the Fed sticks with the current 'dot plot', the pain in the fixed-income pits will not prevent the equity bull phase to continue for a while longer. Nonetheless, the fiscal stimulus is arriving very late in the U.S. economic cycle. The fact that there is little economic slack means that, rather than extending the expansion and the runway for earnings, stimulus might simply generate a more exaggerated boom/bust scenario; the FOMC sticks with the current game plan in the near term, but ends up falling behind the inflation curve and then is forced to catch up. The implication is 'faster growth now, deeper recession later'. Timing the end of the business cycle keeps coming back to the inflation outlook. If the result of the fiscal stimulus is more inflation but not much more growth, then the Fed will be forced to step harder and earlier on the brakes. Our base case is that inflation rises in a gradual way, but it has been very difficult to forecast inflation in this cycle. The bottom line is that our recommended asset allocation is unchanged for now. We are overweight risk assets (equities and corporate bonds), and below benchmark on duration. We will continue to watch the items in our Exit Checklist for warning signs (see last month's Overview). We are likely to trim corporate bond exposure within fixed-income portfolios to neutral or underweight in advance of taking profits on equities. The dollar should head up at some point, although not in the near term. The yen should be the strongest currency of the majors in the next 3-6 months. In currency-hedged terms, our fixed-income team still believes that JGBs are the best place to hide from the bond bear market. Gilts and Aussie governments also provide some protection. The worst performers will likely be government bonds in the U.S., Canada and Europe. Mark McClellan Senior Vice President The Bank Credit Analyst February 22, 2018 Next Report: March 29, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 The fiscal thrust is defined as the change in the cyclically-adjusted budget balance, expressed as a percent of GDP. 3 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. II. Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector We estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator. The re-leveraging of the corporate sector has been widespread across industries and ratings. The credit cycle has entered a late stage and we are biased to take profits early on our overweight corporate bond positioning. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. Nonetheless, the starting point for interest coverage ratios is low. The interest coverage ratio for the U.S. non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning south. Our profit indicators are more likely to give an early warning sign than the economic data. We remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. February's "volatility" tremors focused investor attention on leveraged pressure points in the financial system, at a time when valuation is stretched and central banks are turning down the monetary thermostat. The market swoon may have simply reflected the unwinding of crowded volatility-related trades, but the risk is that there are other landmines lurking just ahead. The corporate sector is one candidate. Equity buybacks have not been especially large compared to previous cycles after adjusting for the length of the expansion (i.e. adjusting for cumulative GDP over the period, Chart II-1).1 But the expansion has gone on for so long that cumulative buybacks exceed the previous three expansions in absolute terms (Chart II-1, bottom panel). One would expect a lot of financial engineering to take place in an environment where borrowing costs are held at very low levels for an extended period. But, of course, one should also expect there to be consequences. Chart II-1Cycle Comparison: Corporate Finance Trends Chart II-2Corporate Bond Spreads And Leverage As Chart II-2 shows, corporate spreads tend to follow the broad trends in leverage, albeit with lengthy periods of divergence. The chart suggests that current spreads are far too narrow given the level of corporate leverage. Balance sheet health is obviously not the key driver of corporate bond relative returns at the moment. Nonetheless, this will change as interest rates rise and investors begin to worry about the growth outlook rather than squeezing the last drop of yield out of spread product. In this Special Report, we estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. But first, we review recent trends in leverage and overall balance sheet health. BCA's Corporate Health Monitors BCA's top-down Corporate Health Monitor (CHM) has been a workhorse for our corporate bond strategy for almost 20 years (Chart II-3). It is based on six financial ratios constructed from the U.S. Flow of Funds data for the entire non-financial corporate sector (Table II-1). The top-down CHM shifted into "deteriorating health" territory in 2014 on the back of rising leverage and an eroding return on capital.2 Chart II-3Top Down U.S. Corporate Health Monitor Table II-1Definitions Of Ratios That Go Into The CHMs The downward trend in the return on capital since 2007 is disturbing, as it suggests that there is a surplus of capital on U.S. balance sheets that is largely unproductive and not lifting profits. This can also be seen in the run-up in corporate borrowing in recent years that has been used to undertake share buybacks. If a company's best investment idea is to take on debt to repurchase its own stock, rather than borrow to invest in its own business, then the expected internal rate of return on investment must be quite low. This is a longer-term problem for corporate health. Alternatively, financial engineering may reflect misaligned incentives, such as stock options, rather than poor investment opportunities. The good news is that profit margins bounced back in 2017, which was reflected in a small decline in our top-down CHM toward the zero line over the past year (although it remained in 'deteriorating' territory). While the top-down CHM has been a useful indicator to time bear markets in corporate bond relative performance, it tells us nothing about the distribution of credit quality. In 2016 we looked at the financials of 1,600 U.S. companies to obtain a more detailed picture of corporate health. After removing ones with limited history or missing data, our sample shrank to a still-respectable 770 companies from across the industrial and quality spectrum. We then constructed an overall Corporate Health Monitor for all companies in the sample, as well as for the nine non-financial industries. We refer to these indicators as bottom-up CHMs, which we regard as complements to our top-down Health Monitor. The companies selected for our universe provided a sector and credit-quality composition that roughly matched the Barclays corporate bond indexes. In our first report, published in the February 2016 monthly Bank Credit Analyst, we highlighted that the financial ratios and overall corporate health looked only a little better excluding the troubled energy and materials sectors. The level of debt/equity was even a bit higher outside of the commodity industries. The implication was that, at the time, corporate credit quality had deteriorated across industrial sectors and levels of credit quality. Profitability Drove Improving Health In 2017... An update of the bottom-up CHMs shows that corporate financial health improved in 2017 for both the investment-grade (IG) and high-yield (HY) sectors (Chart II-4 and Chart II-5). The IG bottom-up Monitor remains in "deteriorating health" territory, but HY Monitor moved almost all the way back to the neutral line by year end. Leverage continued to trend higher last year for both IG and HY, but this was more than offset by a strong earnings performance that was reflected in rising operating margins, interest coverage and debt coverage. Chart II-4Bottom-Up IG CHM Chart II-5Bottom-Up HY CHM These improvements were particularly evident in the sub-investment grade universe. Our industry high-yield CHMs fell significantly in 2017 from elevated (i.e. poor) levels all the way back to the neutral line for Consumer Discretionary, Energy, Industrials, Materials and Utilities (not shown). The high-yield Technology and Health Care sector CHMs are also close to neutral. ...But The Earnings Runway Is Limited Unfortunately, the profit tailwind won't last forever. At some point, earnings growth will stall and this cycle's debt accumulation will start to bite in the context of rising interest rates. While interest coverage (EBIT divided by interest payments) improved last year for most industries, it remains depressed by historical standards. This is despite ultra-low borrowing rates and a robust earnings backdrop. U.S. companies are not facing an imminent cash crunch that would raise downgrade/default risk, but depressed interest coverage suggests that there is less room for error than in previous years. Table II-2Widespread Re-Leveraging Now that government bond yields have bottomed for the cycle and the "green shoots" of inflation are beginning to emerge, it begs the question of corporate sector exposure to rising interest costs. The sensitivity is important because Moody's assigns a weight of between 20% and 40% for the leverage and coverage ratios when rating a company, depending on the industry. Downgrade risk will escalate if corporate borrowing rates continue rising and, especially, if the U.S. economy enters a downturn. Comparing the level of debt or leverage across industries is complicated by the fact that some industries perpetually carry more debt than others due to the nature of the business. Moody's uses different thresholds for leverage when rating companies, depending on the industry. Thus, the change in the leverage ratio is perhaps more important than its level when comparing industries. Table II-2 shows the change in the ratio of debt to the book value of equity from our bottom-up universe of companies from 2010 to 2017. Leverage rose sharply in all sectors except Utilities. The worse two sectors were Communications and Consumer Discretionary, where leverage rose by 81 and 104 percentage points, respectively. Highest Risk Sectors We expect a traditional end to the business cycle; the Fed overdoes the rate hike cycle, sending the economy into recession. The industrial sectors with the poorest financial health and the greatest earnings "beta" to the overall market are most at risk in this macro scenario. We first estimate earnings betas by comparing the peak-to-trough decline in EPS for each sector to the overall decline in the non-financial S&P 500 EPS, taking an average of the last two recessions (we could not include the early 1990s recession due to data limitations). Not surprisingly, Materials, Technology, Consumer Discretionary and Energy sport the highest earnings beta based on this methodology (Chart II-6). Chart II-6Earnings Beta Chart II-7 presents a scatter plot of 2017 leverage versus the industry's earnings beta. Consumer Discretionary stands out on the high side on both counts. Materials and Energy are also high-beta industries, but have lower leverage. Communications is a high-debt industry with a medium earnings beta. These same industries stand out when comparing the earnings beta to the interest coverage ratio (the lower the interest coverage ratio the more risky in Chart II-8). Chart II-7Leverage Vs. Earnings Beta Chart II-8Interest Coverage Ratio Vs. Earnings Beta Of course, a sector's sensitivity to rising interest rates will depend on both the level of debt and its maturity distribution. Higher rates will not have much impact in the near term for firms that have little debt to roll over in the next couple of years. Chart II-9 presents the percentage of total debt that will come due over the next three years by industry. Consumer Discretionary, Tech, Staples and Industrials are the most exposed to debt rollover. To further refine the analysis, we estimate the change in the interest coverage ratio over the next three years for a 100 basis point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt. We make the simplifying assumptions that companies do not issue any more debt over the three years, and that EBIT is unchanged, in order to isolate the impact of higher interest rates. For the universe of our companies, the interest coverage ratio would drop from about 4 to 2½, well below the lows of the Great Recession (denoted as "x" in Chart II-10). The Consumer Staples, Tech and Health Care are affected most deeply (Chart II-11 and Chart II-12). Chart II-9Debt Maturing In Next ##br##Three Years (% Of Total) Chart II-10Interest Coverage Ratio ##br##Headed To New Lows Chart II-11Interest Coverage By ##br##Sector (IG Plus HY) Chart II-12Interest Coverage By ##br##Sector (IG Plus HY) Recession Shock Of course, the decline in interest coverage will be much worse if the Fed steps too far and monetary tightening sparks a recession. Looking again at Charts II-10 to II-12, "o" denotes the combination of a 100 basis point interest rate shock and a mild recession in which the S&P 500 suffers a 25% peak-to-trough decline in EPS. We estimate the decline in EPS based on the industry's earnings beta to the overall market. The overall interest coverage ratio falls even further into uncharted territory below two. The additional shock of the earnings recession makes little difference to earnings coverage for the low beta sectors such as Consumer Staples and Health Care. The coverage ratio falls sharply for the Communications and Industries, although not to new lows. It is a different story for Consumer Discretionary and Materials. The combination of elevated debt and a high earnings beta means that the interest coverage ratio would likely plunge to levels well below previous lows for these two industries. Corporate bond investors and rating agencies will certainly notice. Signposts Our top-down Corporate Health Monitor is one of the key indicators we use to identify cyclical bear phases for corporate bond excess returns. A shift from "improving" to "deteriorating" health has been a reliable confirming indicator for periods of sustained spread widening. The other two key indicators are (Chart II-13): Chart II-13Key Cyclical Drivers Of Corporate Excess Returns Bank lending standards for Commercial & Industrial loans: Banks begin to tighten up on lending standards when they realize that the economy is slowing and credit quality is deteriorating as a result. By making it more difficult for firms to roll over bank loans or replace bond financing, more restrictive standards reinforce the negative trend in corporate credit quality. We traditionally view lending standards as a confirming indicator for a turn in the credit cycle, since tightening standards are typically preceded by deteriorating corporate health and restrictive monetary policy. Restrictive monetary policy: This is the most difficult of the three indicators for which to determine critical values. We had a good idea of the level of the neutral real fed funds rate prior to 2007. Since then, our monetary compass is far less certain because the neutral rate has likely declined for cyclical and structural reasons. The real fed funds rate has moved just slightly into restrictive territory if we take the Laubach-Williams estimate at face value (Chart II-13, third panel). That said, we would expect the 2/10 Treasury yield curve to be closer to inverting if real short-term interest rates are indeed in restrictive territory. Taking the two indicators together, we conclude that monetary policy is not yet outright restrictive. Historically, all three indicators had to be flashing red in order to justify a shift to below-benchmark on corporate bonds within fixed-income portfolios. Only the CHM is negative at the moment, but this time we are unlikely to wait for all three signals to take profits. Poor valuation, lopsided positioning, financial engineering and uncertainty regarding the neutral fed funds rate all argue in favor of erring on the side of caution and not trying to closely time the peak in excess returns. The violent unwinding of short-volatility trades in January highlighted the potential for a quick and nasty repricing of corporate bonds spreads on any disappointments regarding the default rate outlook. Conclusion Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator as businesses continued to pile up debt and return cash to shareholders. Our sample of individual companies reveals that the re-leveraging of the corporate sector has been widespread across industries and ratings. We have clearly entered the late stage of the credit cycle. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. However, debt levels are elevated and the starting point for interest coverage ratios is low. This means that, for any given size of recession, the next economic downturn will have a larger negative impact on corporate health than in the past. The interest coverage ratio for the non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning and the profit boom is over. Last month's Overview listed the top economic indicators we are watching in order to time our exit from risky assets. Inflation expectations will be key; A rise in the 10-year inflation breakeven rate above 2.3% would be a warning that the FOMC will need to ramp up the speed of rate hikes to avoid a large inflation overshoot. While we are also watching a list of economic indicators, they have not provided any lead time for corporate spreads in the past (since the latter are themselves leading indicators). Our profit indicators are probably more likely to give an early warning sign than the economic data. Indeed, the profit outlook will be particularly important in this cycle because of the heightened sensitivity of corporate financial health changes in the macro backdrop. None of our earnings indicators are flashing a warning sign at the moment. A recent Special Report on corporate pricing power found that almost 80% of the sectors covered are lifting selling prices, at a time when labor costs are still subdued.3 These trends are captured by our U.S. Equity Strategy service's margin proxy, which remains in positive territory (Chart II-14). The margin proxy fell into negative territory ahead of the start of the last three sustained widening phases in U.S. corporate bonds. Chart II-14For Corporate Spreads, Watch Our Margin Proxy The bottom line is that we remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. We expect to pull the trigger later this year but the timing is uncertain. Mark McClellan Senior Vice President The Bank Credit Analyst 1 The accumulation of equity buybacks, net equity withdrawal, dividends and capital spending are all adjusted by the accumulation of GDP during the expansion to facilitate comparison across business cycles. 2 The Monitor is an average of six financial ratios that are used by rating agencies to rate individual companies. We have applied the approach to the entire non-financial corporate sector, using the Fed's Flow of Funds data. To facilitate comparison with corporate spreads, the ratios are inverted so that a rising CHM indicates deteriorating health. The CHM has a very good track record of heralding trend changes in investment-grade and high-yield spreads over many cycles. 3 Please see BCA U.S. Equity Strategy Service Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com. III. Indicators And Reference Charts Volatility returned to financial markets in February. The good news is that it appears to have been a healthy technical correction that has tempered frothy market conditions, rather than the start of an equity bear phase. The VIX has shot from very low levels to above the long-term mean, indicating that there is less complacency among investors. This is confirmed by the pullback in our Composite Sentiment Indicator, although it remains at the high end of its historical range. Our Composite Speculation Indicator is also still hovering at a high level, suggesting that frothiness has not been fully washed out. Similarly, our Equity Valuation Indicator has pulled back, but remains close to our threshold for overvaluation at +1 standard deviations. Our Equity Technical Indicator came close, but did not give a 'sell' signal in February (i.e. it remained above its 9-month moving average). Our Monetary Indicator moved slightly further into 'restrictive' territory in February. We highlight in the Overview section that monetary policy will become a significant headwind once long-term inflation expectations have fully normalized. It is constructive that the indicators for near-term earnings growth remain upbeat; both the net revisions ratio and the earnings surprise index continue to point to further increases in 12-month forward earnings estimates. Our Revealed Preference Indicator (RPI) returned to its bullish equity signal in February, following a temporary shift to neutral in January. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are bullish on stocks in the U.S., Europe and Japan. However, the WTP for the U.S. market appears to have rolled over, suggesting that flows are becoming less constructive for U.S. stocks. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. At the margin, the WTP indicator suggest that flows favor the European and Japanese markets to the U.S. Treasurys moved closer to 'inexpensive' territory in February, but are not there yet. Extended technicals suggest a period of consolidation, but value is not a headwind to a continuation in the cyclical bear phase. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights The euro is cheap. To cease being cheap, EUR/USD needs to approach 1.35. Euro area bonds are expensive. To cease being expensive, the yield spread between the euro area and U.S. long bond needs to compress from -135 bps to -40 bps. Never pick mainstream stock markets on the basis of seeming cheapness. Sector effects, step changes in sector valuations and currency effects make relative valuations very difficult to interpret. Always pick mainstream stock markets on the basis of the sector and currency biases you wish to express. Overweight Denmark's OMX and Ireland's ISEQ on a 6-9 month horizon. Feature A very common question we get asked is: are European investments attractively priced compared to those elsewhere in the world? To which the current answers are: yes for the euro currency; no for euro area government bonds; and highly unlikely for the aggregate European stock market. That said, we can still identify individual European stock markets that are well placed to outperform major equity indexes, including the S&P500, over the coming 6-9 months. Chart of the WeekWhen Healthcare Outperforms, Denmark's OMX Outperforms The S&P 500 The Euro Is Cheap... Says The ECB We can confidently claim that the euro is cheap because the ECB's own indicators say so.1 According to the ECB, the euro needs to appreciate at least 7% to cancel the euro area's over-competitiveness versus its top 19 trading partners. In terms of EUR/USD this translates to 1.32. Admittedly, 1.32 encapsulates a spectrum of fair values for the individual euro area economies: 1.45 for Germany; around 1.30 for France, Spain and Netherlands; and around 1.20 for Italy (Chart I-2). Chart I-2The Euro Needs To Appreciate 7% To Cancel The Euro Area's Over-Competitiveness The ECB indicators also assume that the euro began its life close to fair value. This seems plausible. Twenty years ago, the euro area's constituent economies were broadly in internal balance and had a lot in common. Remarkably, Germany and Italy scored identically on total debt as a share of GDP as well as on exports as a share of GDP. Furthermore, euro area trade was in external balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. After its birth, the euro first became extremely undervalued in the dot com bubble, then extremely overvalued in the global credit boom, and most recently, extremely undervalued again. Seen in this bigger picture, the euro's current ascent is just a recovery from an extreme undervaluation, an argument that even Mario Draghi made at the last ECB press conference: "Movements in the exchange rate, to the extent that it is justified by the strengthening of the economy, is part of nature." At what level would EUR/USD cease to be cheap? Based on the average of the ECB's three competitiveness indicators, EUR/USD needs to approach 1.35. Euro Area Bonds Are Expensive The yield spread between the euro area and U.S. long bond stands at an extreme -135 bps.2 This compares with an average -40 bps through the twenty year life of the euro - indicating that euro area government bonds are very expensive relative to U.S. T-bonds. Over the completion of this cycle, this yield spread is highly likely to compress to its long-term average of -40 bps, given that the yield spread just tracks relative real GDP per head - which is itself mean-reverting (Chart I-3). Interestingly, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-4), so the real interest rate differential has averaged zero. This means that the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. have been identical through the past twenty years. Growth in real GDP per head has also been identical (Chart I-5). Chart I-3Euro Area-U.S.: Average Interest ##br##Rate Differential = -40bps Chart I-4Euro Area-U.S.: Average Inflation ##br##Differential = -40bps Chart I-5The Euro Area And U.S. Have Generated##br## Identical Growth Per Head The past twenty years provide a good template for what the future holds, at least in relative terms if not in absolute terms. This is because 1999-2018 captures multiple manias and crises, some centred in Europe, some in the U.S. With no difference in neutral real rates over the past two decades, is there any reason to expect the future neutral rate to be meaningfully lower in the euro area compared to the U.S.? Our starting assumption has to be no. This assumption would be at risk if the existential threat to the euro resurfaced. Looking at the political calendar, the immediate concern might be the Italian election on March 4. Specifically, the anti-establishment Five Star Movement and Northern League could poll well enough to hold some sway in the next government and ruffle the markets. However, while both the Five Star Movement and Northern League have agendas that are unashamedly disruptive, anti-establishment and anti-austerity, neither party is standing on an anti-euro platform. Unless there is a major change in emphasis, the Italian election should not pose an existential threat to the euro. Our central expectation is that the euro area versus U.S. yield spread has the scope to compress substantially from its current -135 bps. In other words, euro area government bonds are very expensive relative to U.S. T-bonds. Never Pick Stock Markets On The Basis Of Seeming Cheapness Compared with currencies and bonds, stock markets are much less connected with their domestic economies. Mainstream stock markets are eclectic collections of multinational companies, with each stock market possessing its own unique fingerprint of sector and industry skews. Therefore, a head-to-head comparison of European stock market valuations either with each other or with non-European stock markets is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, Financials and Personal Products (Chart I-6) - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the cheaper sector. By extension, a stock market with a lower valuation because of its sector fingerprint is not necessarily a cheaper stock market. Chart I-6Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem with this standard deviation approach is that it assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations can and do undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a debt super-cycle ends. Therefore, comparing a bank valuation after a debt super-cycle with the valuation during a debt super-cycle is like comparing an apple with an orange. Another issue for stock markets that contain multinational companies is the so-called 'currency translation effect'. A multinational company will intentionally diversify its sales and profits across multiple major currencies - say, euros, dollars and yen - but of course its primary stock market listing will be in just one currency - say, euros. So when the other currencies weaken versus the euro, the company's profit growth (quoted in its home currency of euros) will necessarily weaken too. If investors anticipate this effect - because they see that the euro is structurally cheap today - they might downgrade the stock market's profit growth expectations. Thereby, they will also downgrade the stock market's valuation. Pulling together these complexities of sector effects, step changes in sector valuations and currency effects, we offer some very strong advice: picking stock markets on the basis of relative valuation is a wrong and very dangerous way to invest. The correct and safe way to invest is to pick stock markets on the basis of the sector and currency biases you wish to express (Chart I-7). This brings us to one of the major advantages of investing in Europe. The plethora of stock markets - each with their own unique fingerprint of sector and industry skews - means that there are always European bourses worth overweighting, whatever your economic outlook. Right now, two of our sector recommendations are to overweight Healthcare and to underweight Energy. Please review our report Beware The Great Moderation 2.0 for the underlying thesis, which we will not repeat here.3 If these sector recommendations pan out as we expect, Denmark's OMX is highly likely to outperform the S&P500 given the OMX's substantial overweighting to Healthcare (Chart of the Week). Likewise, Ireland's ISEQ is highly likely to outperform the S&P500 given the ISEQ's substantial underweighting to Energy via its large exposure to budget airline Ryanair (Chart I-8). Chart I-7Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs.##br## 3 Tech Stocks! Chart I-8When Energy Underperforms, Ireland's ##br##ISEQ Outperforms The S&P 500 Overweight Denmark's OMX And Ireland's ISEQ. A final salutary observation illustrates the importance of the sector approach to picking stock markets. As a result of favourable sector biases - overweight Healthcare, underweight Energy - a 50:50 combination of Denmark and Ireland has kept pace with the S&P500 over the past 20 years, while the Eurostoxx50 has been left a very long way behind (Chart I-9). Chart I-9Sector Biases Helped Denmark's OMX And Ireland's ISEQ, But Hindered The Eurostoxx 50 Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Available at https://www.ecb.europa.eu/stats. The ECB calculates three Harmonised Competitiveness Indicators for the euro area versus its top 19 trading partners based on unit labour costs (ULCs), GDP deflators, and consumer price indices (CPIs), with the latest readings referring to Q3 2017 for ULCs and GDP deflators and January 2018 for CPIs. Updating these for the euro's move to February 20 2018, the three indicators suggest that the trade-weighted euro is still undervalued by 7%, 12% and 7% respectively. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 Please see the European Investment Strategy Weekly Report 'Beware The Great Moderation 2.0' published on February 1, 2018 and available at eis.bcaresearch.com. ­­ Fractal Trading Model* This week our fractal model has produced a very interesting finding. The 130-day fractal dimension for the U.S. 10-year T-bond is approaching a level which has consistently signalled a technical inflection point. This suggests that the recent sell-off in bonds might be close to running its course. We are not putting on a countertrend position yet, but expect to do so within the next few weeks. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights The call on EM local bonds boils down to the outlook for EM exchange rates. Forthcoming EM currency depreciation will halt the rally in local bonds. EM currencies positively correlate with commodities prices but not with domestic real interest rates. Widening U.S. twin deficits are not a reason to be long EM currencies. There has historically been no consistent relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. For investors who have to be invested in EM domestic bonds, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Feature The stampede into EM local currency bonds has persisted even amid recent jitters in global equity markets. Notably, surging U.S./DM bond yields have failed to cause a spike in EM local yields, despite past positive correlations (Chart I-1). Chart I-1Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? The main reason is the resilience of EM currencies. The latter have not sold off even during the recent correction in global share prices. In high-yielding EM domestic bond markets, total returns are substantially affected by exchange rates. Not only do U.S. dollar total returns on local bonds suffer when EM currencies depreciate, but also weaker EM exchange rates cause spikes in domestic bond yields (Chart I-2). Consequently, the call on EM local bonds, especially in high-yielding markets, boils down to the outlook for EM exchange rates. Chart I-2EM Currencies Drive EM Local Yields We are negative on EM currencies versus the U.S. dollar and the euro. The basis for our view is two-fold: Strong growth in the U.S. and higher U.S. bond yields should be supportive of the greenback vis-à-vis EM currencies; the same applies to euro area growth and the euro against EM exchange rates; Weaker growth in China should weigh on commodities prices and, in turn, on EM currencies. So far, this view has not played out. In fact, negative sentiment on the U.S. dollar has recently been amplified by concerns about America's widening fiscal and current account deficits. In fact, one might argue that EM local bonds stand to benefit from the potential widening in U.S. twin deficits and the flight out of the U.S. dollar. We address the issue of U.S. twin deficits first. Twin Deficits And The U.S. Dollar... The recent narrative that the dollar typically depreciates during periods of widening twin deficits is not supported by historical evidence. We are not suggesting that twin deficits lead to currency appreciation. Our argument is that twin deficits have historically coincided with both appreciation and depreciation of the U.S. dollar. Chart I-3 exhibits the relationship between the U.S. dollar and the fiscal and current account balances. It appears that there is no consistent relationship between the fiscal and current account balances and the exchange rate. Chart I-3No Stable Relationship Between U.S. Twin Deficits And Dollar To produce a quantitative measure of the twin deficits, we sum up both the fiscal and current account balances. Chart I-4 demonstrates the relationship between the latter measure and the trade-weighted U.S. dollar. This analysis encompasses the entire history of the floating U.S. dollar since 1971. Chart I-4Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar The vertical lines denote the tax cuts under former U.S. President Ronald Reagan in 1981 and 1986, and under former U.S. President George W. Bush in 2001 and 2003. As can be seen from Chart I-4, there is no stable relationship between the twin deficits and the greenback. In the 1970s, there was no consistent relationship at all; In the first half of the 1980s, the twin deficits widened substantially, but the dollar rallied dramatically. The tailwind behind the rally was tightening monetary policy and rising/high real U.S. interest rates; From 1985 through 1993, there was no consistent relationship between America's twin deficits and the currency; From 1994 until 2001, the greenback appreciated as the twin deficits narrowed, particularly the fiscal deficit; From 2001 through 2011, the dollar was in a bear market as the twin deficits expanded; From 2011 until 2016, the shrinking-to-stable twin deficits were accompanied by a U.S. dollar rally. Bottom Line: We infer from these charts that there has historically been no stable relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. ... And A Missing Variable: Interest Rates Twin deficits are often associated with rising inflation. In fact, a widening current account deficit can mask hidden price pressures. In particular, an economy that over-consumes - consumes more than it produces - can satisfy its demand via imports without exerting pressure on the economy's domestic productive capacity. Booming imports will lead to a widening trade deficit rather than higher consumer price inflation. Hence, in an open economy, over-consumption can lead to a widening current account deficit, rather than rising inflation. A currency is likely to plunge amid widening twin deficits if the central bank is behind the inflation curve. In such a case, the low real interest rates would undermine the value of the exchange rate. If the central bank, however, embarks on monetary tightening that is adequate, the currency can in fact strengthen amid growing twin deficits. In this scenario, rising real interest rates would support the currency. With respect to the U.S. dollar today, its future trajectory depends on the Fed, and the market's perception of its policy stance. If the market discerns that the Fed is behind the curve, the greenback will plummet. By contrast, if the market reckons that the Fed policy response is appropriate, and U.S. real interest rates are sufficiently high/rising, the dollar could in fact appreciate amid widening twin deficits. Specifically, the U.S. dollar was in a major bull market in the early 1980s, with Reagan's tax cuts in 1981 and the ensuing widening of the country's twin deficits doing little to thwart the dollar bull market (Chart I-4). In turn, the Bush tax cuts in 2001 and 2003 were followed by a major dollar bear market. The main culprit between these two and other episodes was probably real interest rates. U.S. real interest rates/bond yields rose between 1981 and 1985, generating an enormous dollar rally. In the decade of the 2000s, by contrast, U.S. real interest rates fell and that coincided with a major bear market in the greenback (Chart I-4). Overall, the combination of U.S. twin deficits and real bond yields together, help better explain U.S. dollar dynamics than twin deficits alone. We agree that America's twin deficits will widen materially. That said, odds are that the Fed commits to further rate hikes and that U.S. bond yields continue to rise. In fact, not only are U.S. inflation breakeven yields climbing, but TIPS (real) yields have also spiked significantly. Rising real yields, which in our opinion have more upside, should support the U.S. dollar. As a final point, if the Fed falls behind the curve and the dollar continues to tumble, the markets could begin to fear a material rise in U.S. inflationary pressures. That scenario would actually resemble market dynamics that prevailed before the 1987 stock market crash. Although this is a negative scenario for the U.S. currency and is, by default, bullish for EM exchange rates and their local bonds, this is not ultimately an optimistic scenario for global risk assets. Bottom Line: Twin deficits are not solely sufficient to produce a currency bear market. Twin deficits accompanied by a central bank that is behind the inflation curve - i.e., combined with low/falling real interest rates - are what generate sufficient conditions for currency depreciation. EM Currencies And Commodities Many EM exchange rates - such as those in Latin America, as well as South African, Russian, Malaysian and Indonesian currencies - are primarily driven by commodities prices. Not surprisingly, the underlying currency index of the EM local bond benchmark index (the JPM GBI index) - which excludes China, India, Korea and Taiwan - positively correlates with commodities prices (Chart I-5). Hence, getting commodities prices right is of paramount importance to the majority of high-yielding EM local bonds. We have the following observations: First, investors' net long positions in both oil and copper are extremely elevated (Chart I-6). The last datapoint is as of February 16. Any rebound in the U.S. dollar or mounting concerns about China's growth could produce a meaningful drop in commodities prices as investors rush to close their long positions. Second, we maintain that China's intake of commodities is bound to decelerate, as decelerating credit growth and local governments' budget constraints lead to curtailment of infrastructure and property investment (Chart I-7). Chart I-5EM Currencies Positively Correlate ##br##With Commodities Prices Chart I-6Investors Are Very Long##br## Copper And Oil Chart I-7Slowdown In ##br##China's Capex Strong growth in the U.S. and EU will not offset the decline in China's intake of raw materials (excluding oil). China accounts for 50% of global demand for industrial metals. America's consumption of industrial metals is about 6-7 times smaller. For crude oil, China's share of global consumption is 14% compared with 20% and 15% for the U.S. and EU, respectively. We do not expect outright contraction in China's crude imports or consumption. The point is that when financial markets begin to price in weaker mainland growth or the U.S. dollar rebounds, oil prices will retreat as investors reduce their record high net long positions. Finally, even though EM twin deficits have ameliorated in recent years, they remain wide (Chart I-8). In turn, the majority of these countries have been financing their deficits by volatile foreign portfolio flows, as FDIs into EM remain largely depressed. If commodities prices relapse and EM currencies depreciate, there will be a period of reversal in foreign portfolio inflows into EM. While EM real local bonds yields are reasonably high, they are unlikely to prevent outflows if the U.S. dollar rallies. In the past, neither high absolute EM real yields nor their wide spreads over U.S. TIPS prevented EM currency depreciation (Chart I-9). Chart I-8AEM Twin Deficits Have Ameliorated ##br##But Are Still Wide Chart I-8BEM Twin Deficits Have Ameliorated ##br##But Are Still Wide Chart I-9EM Local Real Yields Do Not ##br##Drive Their Currencies EM Local Bonds: Country Allocation Strategy Chart I-10 attempts to identify pockets of value in EM domestic bonds. It exhibits the sum of current account and fiscal balances on the X axis, and domestic bond yields deflated by headline inflation on the Y axis. Chart I-10Identifying Pockets Of Value In EM Domestic Bonds Markets in the upper-right corner should be favored as they offer high real yields and maintain healthy fiscal and current account balances. Bond markets in the lower-left corner should be underweighted. They have low inflation-adjusted yields and large current account and fiscal deficits. Based on these metrics as well as fundamental analysis, our recommended country allocation for EM domestic bond portfolios has been and remains: Overweights: Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Neutral: Brazil, Mexico, Indonesia, Hungary, Chile and Colombia. Underweights: Turkey, South Africa and Malaysia. The below elaborates on Brazil, Russia and South Africa. Russia Fiscal and monetary policies are extremely tight. While they are curtailing the economic recovery, they are very friendly for creditors. Interest rates deflated by both headline and core consumer price inflation are at their highest on record, government spending is lackluster, and the new fiscal rule has replenished the country's foreign currency reserves (Chart I-11). Besides, the government's budget assumption for oil prices is very conservative - in the low-$40s per barrel for this year and 2019. Commercial banks have been increasing provisions, even though the NPL ratio is falling. In fact, Russia is well advanced in terms of both corporate and household deleveraging as well as banking system adjustment. On the whole, having experienced two large recessions in the past 10 years and having pursued extremely orthodox fiscal and monetary policies, Russian markets have become much more insulated from negative external shocks than many of their peers. In brief, Russian financial markets have become low-beta markets,1 and they will outperform their EM peers in a selloff even if oil prices slide. Brazil Brazilian local bonds offer the highest inflation-adjusted yields. However, unlike Russia, Brazil has untenable public debt dynamics, and its politics remain a wild card. The public debt-to-GDP ratio is 16% in Russia and 80% in Brazil. The fiscal deficit in Brazil stands at a whopping 8% of GDP, and interest payments on public debt are equal to 6% of GDP. Without major fiscal reforms, Brazil's public debt will continue to surge and will likely reach almost 100% of GDP by the end of 2020. High real interest rates are not only holding back the recovery but are also making public debt dynamics unsustainable. Chart I-12 illustrates that nominal GDP growth is well below local government bond yields. Chart I-11Continue Favoring ##br##Russian Local Bonds Chart I-12Brazil: Borrowing Costs Are Dreadful ##br##For Public Debt Dynamics Brazil needs either much higher nominal growth or major fiscal tightening to stem the surge in the public debt-to-GDP ratio. The necessary fiscal reforms - social security restructuring or primary budget surpluses - are not politically feasible right now. Meanwhile, materially higher nominal growth can be achieved only if interest rates are brought down quickly and drastically and the currency is devalued meaningfully. Hence, the primary risk to Brazilian local bonds is the exchange rate. The currency is at risk from potentially lower commodities prices on the external side, and continuous public debt deterioration, debt monetization or drastic interest rate cuts on the domestic side. Remarkably, Chart I-13 demonstrates that historically real interest rates in Brazil do not explain fluctuations in the real. The currency, rather, positively correlates with commodities prices (Chart I-14). Chart I-13Brazil: No Relationship Between##br## Real Yields And Currency Chart I-14The Brazilian Real And ##br##Commodities Prices It is possible that policymakers find an optimal balance between these adjustment paths, and financial markets continue to rally. However, with the current government lacking any political capital and great uncertainty surrounding the October presidential elections; the outlook is very risky, We recommend a neutral allocation to Brazilian local bonds for EM domestic bond portfolios. South Africa The South African rand and fixed-income markets have surged in the wake of Cyril Ramaphosa's win of the ANC leadership elections and his taking over of the presidency from Jacob Zuma. This has been devastating to our short rand and underweight local bonds positions. Chart I-15The South African Rand And Metals Prices There is no doubt that President Ramaphosa will adopt some market-friendly policies. This will constitute a major change from Zuma's handling of the economy in the past nine years. Yet the outlook for the rand is also contingent on global markets. If commodities prices do not relapse and EM risk assets generally perform well, the rand will continue strengthening, and local bond yields will decline further. However, if metals prices begin to drop and EM currencies sell off, it will be hard for the South African currency to rally further (Chart I-15). While we acknowledge the potential for positive political announcements and actions from the new political leadership, the main drivers of the rand, in our opinion, remain the trends in the U.S. dollar and commodities prices. Some investors might be tempted to compare South Africa to Brazil in terms of political headwinds turning into tailwinds. From a political vantage point, it is a fair comparison. Nevertheless, investors should put Brazil's rally into perspective. If commodities prices did not rise in 2016-2017, the Brazilian real would not have rallied. In brief, external tailwinds are as - if not more - important for EM high-yielding currencies than domestic political developments. Positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our bet on yield curve steepening in South Africa. This position was stipulated by unorthodox macro policies of the previous government. This trade has been flat since its initiation on June 28, 2017. Weighing pros and cons, we are reluctant to upgrade the South African rand and its fixed-income market at the moment because of our negative view on metals prices and EM currencies versus the U.S. dollar. Investment Conclusions The broad trade-weighted U.S. dollar is at record oversold levels (Chart I-16). Given the forthcoming U.S. fiscal stimulus, the Fed will likely lift its dots and the greenback will rebound. This is bearish for EM currencies, especially if China's growth slows and commodities prices roll over, as we expect. EM exchange rate depreciation will halt the rally in local bonds, especially in high-yielding markets. Foreign holdings of EM local bonds are elevated (Table I-1). Hence, risks of unwinding of some positions are not trivial. Chart I-16The U.S. Dollar Is Due For A Rally Table I-1Foreign Ownership Of EM Local Bonds Is High Nevertheless, as we have argued in the past, EM local bonds offer great diversification benefits to all type of portfolios, as their correlations with many asset classes are low. For domestic bond investors who have to be invested, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. As to the sovereign and corporate credit markets, asset allocators should compare these with U.S. corporate credit. Consistent with our negative view on EM currencies and equities vis-à-vis their U.S. counterparts, we recommend favoring U.S. corporates versus EM sovereign and corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report, titled "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy Synchronized global capex growth and higher interest rates are two key themes that will continue to dominate this year. Three high-conviction calls are levered to the former theme and two to the latter. A special situation completes our sextet. Reinstate the S&P construction machinery & heavy truck index to the high-conviction overweight list. We also reiterate our high-conviction underweight call in the newcomer S&P telecom services sector. Recent Changes S&P Construction Machinery & Heavy Truck - Add back to high-conviction overweight list. Table 1 Feature Chart 1Market Bounced Smartly Equities regained their footing last week, as volatility took a breather. There are high odds that the technical, mostly-sentiment driven, pullback that we have been flagging since January 22nd is nearly over, as the market smartly bounced off the 200-day moving average (top panel, Chart 1).1 A consolidation/absorption phase is looming and, according to our "buy the dip" cycle-on-cycle analysis, a retest of the recent lows is likely before the market gets out of the woods (please refer to Chart 1 from last week's publication). While inflation expectations, crude oil prices and financial conditions are all tightly linked with and weighing on the S&P 500 (second and third panels, Chart 1), a number of tactical high-frequency financial market indicators suggest that the cyclical SPX bull market remains intact. First, SPX e-mini futures positioning is an excellent leading indicator of market momentum, and the current message is positive (net speculative positions are advanced by 40 weeks, Chart 2). Second, bond market internal dynamics suggest that this mini "risk off" episode is an isolated one and not a precursor to a real tremor. The high yield bond ETF outperformed the long dated Treasury bond ETF (bottom panel, Chart 3). It would be unprecedented for an equity market downdraft to morph into a fully blown bear market without junk bonds sinking compared with the ultimate risk free asset. Even when adjusted for its lower duration, the high yield bond ETF remained resilient versus the 3-7 year Treasury bond ETF (top panel, Chart 3). Chart 2Futures Positioning... Chart 3...Junk Bonds... Third, the calmness in the TED spread corroborates the message from the bond market. Were a systemic risk to materialize, the TED spread should have widened and not come in as it did in the past two weeks (Chart 4). Put differently, quiet interbank markets are a healthy sign. Chart 4...And TED Spread All Flashing Green Finally, relative valuations have corrected not only on an absolute basis (please refer to the bottom panel of Chart 2A from last week's Report), but also controlled for equity market volatility. In fact, Chart 5 shows that both the VIX-adjusted Shiller P/E and the 12-month forward P/E have returned to the neutral zone. Meanwhile, two key macro indicators we track are also flashing green. Chart 6 shows momentum in money velocity or how fast "one unit of currency is used to purchase domestically-produced goods and services".2 Historically, velocity of M2 money stock has been positively correlated with stock market momentum. The recent spike in this indicator suggests that the longevity of the business cycle remains intact, and investors with a cyclical (9-12 month) investment horizon should start "buying the dip", as we suggested on February 8th.3 Another yield curve-type macro indicator confirms this buoyant business cycle message: real GDP growth is easily outpacing real interest rates, as per the 10-year TIPS market (Chart 7). In other words, real rates are not yet restrictive enough to choke off GDP growth, despite the recent 35bps increase. Were this spread to plunge below the zero line, it would predict recession. Thus, the recent widening underscores that recession is not imminent. Chart 5Valuations Return To Earth Chart 6Money Velocity... Chart 7...And Yield Curve Emit Bullish Signal Under such a backdrop, the upshot is that earnings will remain upbeat in 2018 and continue to underpin equity prices. This week we revisit our 2018 high-conviction call list and reinstate one sector to the overweight column. Chart 8Both Themes Remains Intact The Themes Two key BCA themes formed the cornerstone of our 2018 high conviction call list: Synchronized global capex upcycle Higher interest rates Last autumn, we started to articulate the synchronized global capital spending macro theme4 that, despite still flying under the radar, will likely dominate this year. Both advanced and emerging economies are simultaneously expanding gross fixed capital formation (middle panel, Chart 8). As a result, we reiterate our cyclical over defensive portfolio bent,5 and continue to tie three high-conviction overweight calls to this theme. Similarly, late last year we started to highlight BCA's U.S. Bond Strategy view of a higher 10-year yield on the back of rising inflation expectations for 2018 (bottom panel, Chart 8). Back in late-November we posited that if BCA's constructive crude oil view pans out then inflation and rates may get an added boost. Two high-conviction calls remain levered to this theme. Finally, a special situation rounds up our call this year. But before we update the call list and make a small tweak, a quick housekeeping note is in order. Taking The Tally Early this year, we added trailing stops to our high-conviction call list as a risk management tool. The goal was to help protect profits as a number of our calls were showing outsized gains for such a short time span. Our tactically souring view of the overall market also compelled us to introduce this risk management metric. As a result of the recent careening in the SPX, half of our calls got stopped out with lofty double digit gains since inception a mere two and a half months ago. Namely, our speculative underweights in the S&P semi equipment and S&P homebuilders registered gains of 20% and 10%, respectively. The high-conviction underweight in the S&P utilities sector got called at an 18% gain, and our high-conviction overweight call in the S&P construction machinery & heavy truck (CMHT) index got stopped out at the 10% mark. (Please refer to page 15 for the closed trades table). Last week we added the S&P telecom services sector as a high-conviction underweight replacing the S&P utilities sector, and now that the worst is likely behind us, we are reinstating the S&P CMHT index to the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Construction Machinery & Heavy Truck (Overweight, Capex Theme) The capex upcycle is underpinning machinery stocks. Not only are expectations for overall capital outlays as good as they get (Chart 9), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans in these two key machinery client segments would rekindle industry sales growth. Recent news of oil majors accelerating their capex plans is a step in the right direction. This machinery end-demand improvement is not only a U.S. phenomenon, but also a global one. The middle panel of Chart 9 shows Caterpillar's global machinery sales to dealers hitting a decade high. Tack on the drubbing in the U.S. dollar and related commodity price inflation and the ingredients are in place for a global machinery export boom. While most of the countries we track enjoy a sizable rebound in machinery orders, Japan's machine tools orders have surged to an all-time high confirming that machinery global end demand is brisk (bottom panel, Chart 9). Finally, our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (fourth panel, Chart 9). Reinstate the S&P CMHT index to the high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Energy (Overweight, Capex Theme) The S&P energy sector is a key beneficiary of our synchronized global capex theme. The Dallas Fed manufacturing outlook survey is firing on all cylinders and, given the importance of oil to the state of Texas, it serves as an excellent gauge for oil activity. Importantly, the capital expenditures part of the survey hit its highest level in a decade, and capex intentions in the coming six months are also probing multi-year highs. The overall message is that the budding recovery in energy capital budgets will likely gain steam (second panel, Chart 10). Following the late-2015/early-2016 drubbing in oil prices, energy projects ground to a halt and only now are green shoots appearing (middle panel, Chart 10). Recent news that Exxon Mobil would bump domestic capital spending up to $50bn over the next five years is encouraging. New projects/investments comprise 70% of this figure. OECD oil stocks are receding steadily and so are U.S. crude oil inventories. OPEC 2.0 remains in place and will likely balance the oil market by continuing to constrain supply. Our Commodity & Energy Strategy service is still penciling in higher oil prices for 2018. On the demand side, emerging markets/Chinese demand is the key determinant of overall oil demand, and the news on this front is encouraging and consistent with BCA's synchronized global growth theme: following the recent lull, non-OECD demand is growing anew by roughly 1.5mn bbl/day. The upshot is that S&P energy relative revenues will climb out of the recent trough (bottom panel, Chart 10). The ticker symbols for the stocks in this index are: BLBG: S5ENRS - XLE: US. Chart 9Construction Machinery & Heavy Truck ##br##(Overweight, Capex Theme) Chart 10Energy (Overweight, Capex Theme) Software (Overweight, Capex Theme) The S&P software index is another clear capex upcycle beneficiary. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand keep on hitting fresh recovery highs, underscoring that software related outlays will likely follow them higher. Rebounding bank loan growth also corroborates the upbeat spending message and signals that businesses are beginning to loosen their purse strings (Chart 11). Reviving animal spirits suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs (middle panel, Chart 11). Such ebullience is positive for a pickup in software outlays. It has also rekindled software M&A activity, and pushed take out premia higher. Meanwhile, the structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Tax reform is another bonus for this group that benefits from cash repatriation, which will likely result in increased shareholder friendly activities. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. Banks (Overweight, Higher Interest Rates Theme) The S&P banks index remains a core overweight portfolio holding and there are high odds of additional relative gains in the coming quarters beyond the current 10% relative return mark since the November 27th, 2017 inception. All three key drivers of bank profits, namely price of credit, loan growth and credit quality, are simultaneously moving in the right direction. On the price front, BCA expects the 10-year yield will continue to rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think that inflation expectations have more room to run, likely pushing the 10-year Treasury yield close to 3.25% (top panel, Chart 12). C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM remains squarely above the 50 boom/bust line and consumer confidence is still buoyant. Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (third panel, Chart 12). Finally, credit quality remains pristine despite some pockets of weakness in auto loans (especially subprime) and credit card debt. At this stage of the cycle, with a closed unemployment gap, NPLs will remain muted. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.  Chart 11Software (Overweight, Capex Theme) Chart 12Banks (Overweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) We downgraded the S&P telecom services index to underweight and added it to the high-conviction underweight list last week, filling the void left by the S&P utilities sector.6 Three main reasons are behind our dislike for this fixed income proxy sector: BCA's 2018 rising interest rate theme, both our Cyclical Macro Indicator (CMI) and our sales model send a distress signal, and a profit margin squeeze is looming. The top panel of Chart 13 shows that high dividend yielding telecom services stocks and the 10-year yield are nearly perfectly inversely correlated. In fact, telecom services stocks are prime beneficiaries of disinflation/deflation and vice versa. BCA's bond market view remains that the 10-year yield will continue to rise likely piercing through 3% and weigh heavily on this fixed income proxied sector. Our CMI has melted and relative consumer outlays on telecom services have also taken a nosedive (second & third panels, Chart 13), warning that revenue growth will be hard to come by for telecom carriers. In fact, while nearly all of the GICS1 sectors have come out of the top line growth lull of late-2015/early-2016, telecom services sales growth has relapsed. Worrisomely, our S&P telecom services revenue growth model remains deep in contractionary territory, waving a red flag (bottom panel, Chart 13). Finally, still steeply deflating selling prices are a major headwind for the sector's top and bottom line growth prospects and coupled with a still expanding wage bill, suggest that a profit margin squeeze is looming. The ticker symbols for the stocks in this index are: VZ, T, CTL. Pharmaceuticals (Underweight, Special Situation) Weak pricing power fundamentals, a soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics will sustain downward pressure on pharma stocks. Industry selling prices remain soft (Chart 14). In the context of a bloated industry workforce, the profit margin outlook darkens significantly. If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, as we expect, then industry margins will remain under chronic downward pressure. Our dual synchronized global economic and capex growth themes bode ill for this safe haven index. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the elevated ISM manufacturing index is signaling that pharma profits will underwhelm in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, second panel, Chart 14). A depreciating currency is also synonymous with pharma profit sickness (bottom panel, Chart 14). While pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases, they are still contracting (middle panel, Chart 14), warning that global pharma demand is ill. Finally, even on the operating metric front, the outlook is dark. Pharma industrial production is nil and our productivity proxy remains muted, warning that the valuation derating phase is far from over. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Chart 13Telecom Services ##br##(Underweight, Higher Interest Rates Theme) Chart 14Pharmaceuticals ##br##(Underweight, Special Situation) 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 https://fred.stlouisfed.org/series/M2V 3 Please see BCA U.S. Equity Strategy Insight, "Buy The Dip," dated February 8, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Manic Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights Spread Product: TIPS breakeven inflation rates are holding firm despite the correction in equity markets. Remain overweight spread product versus Treasuries for now, but be prepared to reduce exposure once long-maturity TIPS breakevens reach our target range of 2.4% to 2.5%. Volatility: While implied interest rate volatility could increase further in the near-term, its upside will be limited by a flattening yield curve in the second half of this year. Municipal Bonds: After-tax muni yields are near the high-end of their historical ranges relative to investment grade corporate bonds. MBS: The option-adjusted spread offered by a conventional 30-year Agency MBS is tight relative to its own history, but appears quite attractive relative to an investment grade corporate bond. Feature Chart 1Corporate Spreads Are Stoic The stock market is down and volatility is up dramatically. At least so far the pass through to credit spreads has been relatively mild (Chart 1), but this does not make us more optimistic. Rather, our sense is that last week's market action is yet another sign that we are approaching the end of the credit cycle. Same Loop, Different Day Last week's equity sell off is best viewed through the lens of the Fed Policy Loop that we introduced in 2015 (Chart 2).1 The Fed Policy Loop is a framework for understanding the interplay between monetary policy and risk assets. Its recent dynamics can be summarized as follows: The perception of easy Fed policy fuels the outperformance of risk assets, and seven months of falling inflation between last January and August kept that perception in place for all of 2017. The end result is that financial conditions eased dramatically - stock prices soared and credit spreads tightened. But easing financial conditions also sow the seeds of their own destruction. Easier financial conditions eventually beget stronger growth and stronger growth eventually begets higher inflation (Chart 3). Last week the market finally caught a whiff of inflation and started to price-in a more hawkish Fed reaction function. Chart 2The Fed Policy Loop Chart 3Financial Conditions Lead Growth And Growth Leads Inflation On a positive note, the Loop framework also tells us that the Fed will eventually ease policy in response to tighter financial conditions and this will allow the risk-on rally to resume. While this is undoubtedly true, the Fed's breaking point is also a lot higher when inflationary pressures are more pronounced. This is why we have repeatedly stressed that our cyclical call on spread product hinges on the path of long-dated TIPS breakeven inflation rates.2 Chart 4No Correction Here Last year, when the 10-year TIPS breakeven inflation rate was down around 1.6% - well below the 2.4% to 2.5% range that is consistent with inflation anchored around the Fed's target - the market understood that the Fed's tolerance for tighter financial conditions was quite low. This made it very difficult for risk assets to sell off meaningfully. But now, with the 10-year TIPS breakeven rate at 2.05% and the 5-year/5-year forward breakeven rate at 2.27%, the Fed can clearly tolerate more market pain. The bad news from a cyclical perspective is that, despite the equity correction, the market's assessment of inflationary pressure in the economy has barely budged. Long-maturity TIPS breakeven inflation rates are holding firm, as are the prices of crude oil and other commodities - prices that tend to correlate with TIPS breakeven rates (Chart 4).3 In other words, last week's correction didn't give our overweight spread product position any further room to run. While it may take a few more sessions, our sense is that the market and the Fed will hash out a new equilibrium in the near-term and that the true bear market in risk assets won't occur until inflationary pressures are even more pronounced. We continue to look for a range of 2.4% to 2.5% on long-maturity TIPS breakeven inflation rates before we scale back our cyclical overweight exposure to spread product. The inflation data take on extra significance between now and then, as each incoming report will help confirm or deny the message priced into TIPS breakevens. Every weak inflation print buys the credit cycle more time, every strong print hastens its demise. Next up: tomorrow morning's CPI. Don't Fear Rising Rate Vol The return of volatility was the other big story last week. The VIX index of implied equity volatility was as low as 9 in early January, but stood at 33 as of last Friday's market close. With rising inflation starting to weaken the "Fed put" in risk assets we think it is unlikely that equity volatility will return to its previous cycle lows.4 But what about the volatility in rates markets? The MOVE index of implied interest rate volatility also jumped last week, and its path going forward is of critical importance for Treasury yields. Chart 5 shows that the Kim & Wright estimate of the term premium embedded in the 10-year Treasury yield is highly correlated with the MOVE index, while the expectations component implied by that term premium is the mirror image of the fed funds rate. It follows that a surge in rate volatility would lead to much higher Treasury yields, particularly if the Fed continues to hike. However, it would be quite unusual for the MOVE index to increase significantly while the Fed is lifting rates. To see this we can simply observe the tight correlation between the MOVE index and the slope of the yield curve (Chart 6). The crucial question then becomes: Does the slope of the yield curve drive volatility or does volatility drive the slope of the curve? Chart 5Volatility And The Term Premium Chart 6Volatility And The Yield Curve Like most things in economics, the answer is a little bit of both. Chart 7Forecasters In Agreement It is relatively straightforward to see why higher rate volatility might lead to a steeper yield curve. To the extent that the slope of the yield curve reflects a term premium to compensate investors for the extra price risk in a long-dated bond, then investors should demand greater compensation to bear that extra risk when rate volatility is elevated. But that analysis ignores the other reason why the yield curve might be steep. Namely, the yield curve might be steep because the market expects the Fed to hike rates substantially. It would seem logical to expect that investors would be more uncertain about a forecast that calls for many rate hikes than they would be about a forecast that calls for only a few rate hikes. It therefore follows that an environment where the market expects a large change in the fed funds would also be an environment of elevated rate volatility. The two-way causation between rate volatility and the slope of the yield curve is reinforced by the fact that both trends also correlate with forecaster uncertainty about the macro environment. Chart 7 shows that the dispersion of individual forecasts for the 3-month T-bill rate and GDP growth correlate with both the MOVE volatility index and the slope of the yield curve. At the moment, disagreement amongst professional forecasters remains low relative to history. All in all, our sense is that once long-maturity TIPS breakeven inflation rates reach our target fair value range of 2.4% to 2.5% they are unlikely to move much higher. Fed hawkishness will ramp up considerably and the yield curve will be much more likely to flatten. This means that while implied interest rate volatility could increase further in the near-term, its upside will be limited by a flattening yield curve in the second half of this year. We are not overly concerned about a huge spike in rate volatility leading to a blow-out in bonds. Two Attractive Ways To De-Risk As stated in the first section of this report, the higher that TIPS breakeven inflation rates rise the closer we get to calling the end of the credit cycle. If current trends continue, then it is likely we will begin to de-risk the spread product side of our recommended portfolio in the not-too-distant future. With that in mind, we have identified two lower risk spread sectors that are starting to look attractive. 1) Municipal Bonds Like all spread sectors, at first blush municipal bonds appear quite expensive relative to Treasuries. Chart 8 shows Aaa-rated municipal bond yields, adjusted for the top marginal tax rate, relative to equivalent-maturity Treasury yields. The message is quite clear. Municipal bonds offer far less excess compensation relative to Treasuries than has been typical in the past. However, the valuation picture changes completely when we consider municipal bonds versus investment grade corporates. Chart 9 once again shows Aaa-rated municipal bond yields, adjusted for the top marginal tax rate, but this time relative to equivalent-duration corporate bonds. We do not attempt to match credit quality in Chart 9, so Aaa-rated municipal bonds are being compared to the corporate bond index which has an average credit rating of A3/Baa1. Chart 8Munis Expensive Versus Treasuries Chart 9Munis Cheap Versus Corporates Chart 9 shows that after-tax muni yields are near the high-end of their historical ranges relative to investment grade corporate bonds. In fact, a 10-year Aaa-rated municipal bond currently offers only 13 bps less yield than an equivalent duration A3/Baa1-rated corporate bond. In addition, whenever the after-tax yield on a 10-year Aaa-rated municipal bond has exceeded the yield on a 10-year corporate bond in the past, it has been a fairly good signal that investment grade corporates are too expensive and due for a correction. Not only did municipal bonds look more attractive than corporates before the crisis in 2007, but also before corporates sold off in 2011 and 2014 (Chart 9, bottom panel). Agency MBS Chart 10An Opportunity In MBS? As with munis, the option-adjusted spread (OAS) offered by a conventional 30-year Agency MBS is tight relative to its own history, but appears quite attractive relative to investment grade corporate bonds (Chart 10). Further, in a rising rate environment the risk of a large increase in mortgage refinancings is low and this should keep MBS spreads well contained. The biggest potential risk for MBS spreads is that a large spike in Treasury yields causes MBS duration to extend, and sparks a spread widening. In our report from two weeks ago we introduced a model for excess MBS returns in an attempt to quantify what sort of increase in Treasury yields would be necessary to make duration extension a meaningful risk for MBS.5 We modeled monthly excess returns for conventional 30-year MBS relative to duration-matched Treasuries using the following equation: Formula The monthly change in Treasury yields enters the equation with a positive sign because it proxies for refinancing risk. Higher yields lead to lower refis, and lower refis lead to MBS outperformance. The squared change in yields enters the equation with a negative sign because it proxies for extension risk. If yields rise too much during the month, then MBS duration will extend and the sector will underperform. Chart 11Refi Risk Is Low From that equation we calculated that, holding the change in OAS flat, it would take a monthly increase in yields of at least 72 bps to lead to negative monthly excess returns. However, in January this appeared not to work very well. The duration-matched Treasury yield in our equation increased only 38 bps in January and the OAS was virtually flat, but MBS still managed to underperform Treasuries by 16 bps on the month. Upon further investigation, the reason our model failed in January is that mortgage refinancings actually increased on the month even though Treasury yields rose (Chart 11). This behavior is unusual and we would not expect it to persist going forward. However, we also made one modification to our model that we expect will lead to more accurate results on a real-time basis. Specifically, we removed the intercept term from the prior model and replaced it with a 1-month lag of the average index OAS. The rationale is that since the intercept term is in the equation to capture the carry return in an MBS trade, we should use a more accurate measure of MBS carry rather than relying on the regression to calculate the historical carry. Our new equation is as follows: Formula Chart 12 Interestingly, using our new equation we find that the monthly increase in Treasury yields required to spark MBS underperformance is now a function of the current average OAS of the MBS index. This would seem to make sense. If the carry buffer is higher, then it should take a greater duration extension for capital losses to overcome the carry and lead to negative excess returns. The relationship between the required monthly increase in yields and the index OAS is illustrated in Chart 12. At the current average index OAS of 31 bps, our equation suggests that a monthly increase in Treasury yields of 58 bps or higher is required for extension risk to become meaningful. Bottom Line: Both municipal bonds and Agency MBS are starting to look attractive relative to investment grade corporate bonds. We stand ready to upgrade these sectors at the expense of investment grade corporate bonds when the time comes to de-risk our spread product portfolio. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 3 For further details on the correlation between TIPS breakevens and commodity prices please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com 4 Please see BCA Research Special Report, "The Return Of Vol", dated February 6, 2018, available at bca.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Relentless selling in utilities stocks is overdone and we are compelled to lift exposure to neutral. Operating metrics have turned the corner for the better, but a still challenging macro backdrop suggests that it is too soon to boost to an overweight stance. A rising interest rate backdrop, the sinking Cyclical Macro Indicator and near collapse in our sales growth model along with high chances of a profit margin squeeze, suggest that telecom services stocks are a sell. Recent Changes S&P Utilities - Upgrade to neutral for a gain of 15%. S&P Telecom Services - Downgrade to underweight, and add to high-conviction underweight list today. S&P Utilities - Removed from high-conviction underweight list last week for a gain of 18%.1 S&P Semiconductor Equipment - Removed from high-conviction underweight list last week for a gain of 20%.2 S&P Homebuilding - Removed from high-conviction underweight list last week for a gain of 10%.3 Feature Chart 1Time To Start 'Buying The Dip' Panic selling persisted last week, and equities struggled for direction, as the battle between liquidity withdrawal and stellar profit growth rages on. As we wrote in a recent report, the market will test the new Fed Chairman's resolve and this must have been an unnerving first week for Powell at the helm of the Fed.4 The 10% tactical pullback that we had been flagging in recent publications with the tech sector correctly sniffing it out has materialized, and our strategy is to start "buying the dip" as we do not foresee recession in the coming 9-12 months. While an undershoot cannot be ruled out given the emotional nature of recent market action, a number of indicators we track suggest that it would be a mistake to get extremely bearish at the current juncture. First and foremost, empirical evidence suggests that investors with a cyclical 9-12 month investment horizon should start to buy this correction (Chart 1). We analyzed SPX data back to the early-1960s and identified daily falls of 4% or more. There have been 16 such occurrences. In our sample we excluded the 1982 and 2015 incidents that rounded up to 4%, but were a hair below that level. For 1987 we included only one datapoint for the Black Monday crash and omitted occurrences very close to that date. Similarly, in the autumn of 2008 we only used the first large daily decline in our study and excluded other sizable downdrafts that were clustered around Lehman's collapse. We decided to exclude such clustered datapoints as they would skew our results to the upside. This analysis clearly demonstrates that it pays to "buy the dip" (top panel, Chart 1), and on average the SPX rises roughly 14% in the ensuing 12 months following the steep daily pullback (bottom panel, Chart 1). Interestingly, within a few weeks of the mini-crash empirical evidence suggests that markets typically retest those beaten-down levels and tend to hold above them. The implication is that investors have some time to deploy cash and/or reposition portfolios in order to take advantage of the recent pullback. Second, credit spreads have been surprisingly quiet. Bond spreads across the risk spectrum are extremely sensitive to risk off phases and one would have expected a sharp widening in spreads during the recent turmoil (fourth panel, Chart 2A). Chart 2ANo Systemic Risk Evident Chart 2BLatent Buying Power Third, the U.S. dollar has remained muted despite recent stock market jitters. A soft greenback is purely redistributive and represents a boost to global growth (third panel, Chart 2A). Fourth, short equity market positions are pinned near all-time highs representing latent dry powder (Chart 2B). Fifth, the VIX has gone vertical surging beyond the 50 level. Both the jump in the VIX and the explosion in trading volumes signal that capitulation was likely hit (second panel, Chart 2A). Finally, the recent market swoon along with rising EPS estimates have knocked down valuations pushing them to a 16 handle on a 12-month forward P/E basis (bottom panel, Chart 2A). In other words, all these indicators suggest that the bulk of the selling may have already occurred, and an absorption/consolidation phase will likely take place in the next few weeks. In fact, the recent let-up of soft data and simultaneous perkiness of hard data also corroborates that a lateral move is in the cards for the broad market (Chart 3). Chart 3Consolidation Phase Ahead We are willing to ride out the volatility and selectively look for opportunities to put cash to work, given our view that the longevity of the business cycle remains intact. Our core strategy remains to stay heavily focused on financials and industrials that benefit from our two key 2018 themes: higher interest rates and synchronized global capex upcycle. The energy sector also provides excellent value and a positive cyclical earnings outlook, based on BCA's upbeat crude oil view and rising odds of a virtuous capex upcycle. Meanwhile, health care remains our core defensive sector underweight. This sector still has to contend with political backlash against its multi-decade resilient selling price backdrop. With regard to the niche fixed income proxies, we are making a small tweak this week lifting the bombed-out utilities sector to neutral from underweight and locking in gains of 15% since inception. We are also downgrading defensive telecom stocks from neutral to underweight. Enough Is Enough In Bombed-Out Utilities In mid-summer we downgraded utilities to a below benchmark allocation, and subsequently on November 27th we were compelled to add it to our 2018 high-conviction underweight list, doubling down on our bearishness toward this fixed income proxy sector. These moves have paid handsome dividends and added alpha to our portfolio. Last week we crystalized gains by obeying our trailing stop that got triggered on our high-conviction list, registering 18% gains for the utilities underweight call. And, today we recommend an upgrade to a neutral stance to the niche S&P utilities sector, booking 15% gains since the July 24th inception, as indiscriminate selling has gone way too far in our opinion. Chart 4 shows that relative utilities performance has hit rock-bottom, plumbing all-time lows. In fact, the relative share price ratio has been so downbeat that if history at least rhymes a temporary relief rebound is in sight. Such oversold levels in our composite technical indicator have marked previous troughs (bottom panel, Chart 5). Tack on a gap down in relative valuations right at the neutral zone, and the implication is that it does not pay to be bearish from current washed out relative share price levels. Chart 4Unloved... Chart 5...And Under-owned Utilities... On the operational front, nat gas prices are no longer reeling and should boost industry pricing power as they are the marginal price setter for utilities (top two panels, Chart 6). Electricity production is also staging a slingshot recovery. This demand increase should also underpin utilities selling prices. Resource utilization is on the rise, up roughly 700bps from the 2016 trough. Once again the removal of excess slack should at least put a floor under industry producer price inflation. Indeed, our utilities sector productivity proxy has caught on fire recently pushing four year highs as both industry output and employment restraint are aiding our gauge. The upshot is that sell side analyst pessimism has likely hit a trough (bottom panel, Chart 6). All of these positives signal that we should take a punt and boost exposure all the way to overweight, nevertheless a challenging macro backdrop keeps us on the sidelines for now. Chart 7 shows that utilities stocks are the mirror image of the global manufacturing PMI survey. In other words, relative share prices move inversely with the ebb and flow of global growth, showcasing their ultimate safe-haven status. Similarly, increasing capital outlays are negatively correlated with utilities stocks, and given our synchronized global growth and global capex themes, utilities have limited cyclical upside. Finally, this high dividend yielding sector also suffers when Treasury bond yields shoot higher, as competing risk free assets become more appealing. Higher interest rates is one of BCA's key 2018 themes, and any resumption of the 10-year Treasury selloff will continue to weigh on relative performance (bottom panel, Chart 7). Chart 6...Are Coming Back To Life... Chart 7...But Do Not Get Carried Away Netting it all out, relentless selling in utilities stocks is overdone and we are compelled to lift exposure to neutral. Operating metrics have turned the corner for the better, but a still challenging macro backdrop suggests that it is too soon to boost to an overweight stance. Bottom Line: Take profits of 15% and lift the S&P utilities sector to a benchmark allocation. Trim Telecom Services To Underweight We are filling the void from the upgrade in the S&P utilities sector by downgrading the S&P telecom services sector to underweight, and also adding it to the high-conviction underweight list. This defensive sector swap preserves our bearishness toward safe haven assets as both sectors have a similar weight in the SPX. Three main reasons are behind our dislike for this fixed income proxy sector: BCA's 2018 rising interest rate theme Both our Cyclical Macro Indicator (CMI) and our sales model send a distress signal A profit margin squeeze is looming The top panel of Chart 8 shows that high dividend yielding telecom services stocks and the 10-year yield are nearly perfectly inversely correlated. In fact, telecom services stocks are prime beneficiaries of disinflation/deflation and vice versa (bottom panel, Chart 8). BCA's bond market view remains that the 10-year yield will continue to rise on the back of rising inflation expectations, and this represents a bearish backdrop for the telecom services sector. Our CMI has melted and relative consumer outlays on telecom services have also taken a nosedive (top two panels, Chart 9), warning that revenue growth will be hard to come by for telecom carriers. In fact, while nearly all of the GICS1 sectors have come out of the top line growth lull of late-2015/early-2016, telecom services sales growth has relapsed. Worrisomely, our S&P telecom services revenue growth model remains deep in contractionary territory, waving a red flag (bottom panel, Chart 9). Still steeply deflating selling prices are a major headwind for the sector's top and bottom line growth prospects and coupled with a still expanding wage bill, suggest that a profit margin squeeze is looming (fourth panel Chart 10). Chart 8No Dial Tone Chart 9Models Say Shy Away Chart 10Looming Margin Squeeze The sell side analyst community does not share this dire earnings picture. Net earnings revisions have gone vertical likely on the back of the recent tax reform. However, increasing industry slack underscores that beyond any one time gains from a lower corporate tax rate, organic EPS growth will be anemic at best. In fact, telecom services weekly hours worked do an excellent job of forecasting the sector's net earnings revision ratio and the current message is grim for profits (bottom panel, Chart 10). Adding it up, a rising interest rate backdrop, the sinking CMI and near collapse in our sales growth model along with high chances of a profit margin squeeze, suggest that a fresh bear phase is likely in the S&P telecom services sector. Bottom Line: Downgrade the S&P telecom services sector to a below benchmark allocation. We are also adding it to our high-conviction underweight list. The ticker symbols for the stocks in this index are: T, VZ, CTL. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight, "Stocks Take An Escalator Up, And An Elevator Down," dated February 7, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Insight, "Housekeeping In Turbulent Times," dated February 9, 2018, available at uses.bcaresearch.com. 3 Ibid. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Will The Market Test Powell?" dated November 13, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights The spike in volatility last week led to a sharp correction in equities. However, the bull market in equities is not over yet. The Fed's response to the selloff will be critical. Policymakers will closely monitor financial conditions. The most overvalued assets are at greatest risk during a selloff. Feature Financial markets did not give new Fed Chair Jay Powell a warm welcome last week. Volatility spiked, and risk assets fell sharply. Nonetheless, BCA's view is that strong economic growth and stout earnings growth will keep the bull market intact. The selloff is reminiscent of the 7% drop in the S&P 500 in May of 2006.1 Back in the spring of 2006, then Chairman Ben Bernanke had just taken the helm at the Federal Reserve. Global growth was strong, the U.S. dollar was selling off and global share prices were surging and overbought. From May through June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish, allowing U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM assets. The February 2018 may not play out exactly like May 2006. That said, there are enough similarities to draw parallels. Global growth is robust and inflationary pressures are accumulating. Bond yields are rising, and the greenback is selling off. A new Fed Chairman just took over the reins, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. The Fed's response to the tighter financial conditions will be crucial. The May 2006 selloff turned out to be just a correction in a bull market that lasted another 18 months. Still, investors today are also concerned about what to sell first as the end of the expansion draws closer. A Shake Up BCA strategists believe that the market turmoil since last week reflects a technical correction from overbought and over complacent levels, but the cyclical bull run is not yet over.2 Nonetheless, investors should note that the bull market is entering its late stages. The low inflation and low volatility era is ending as the U.S. economy begins to face late-cycle, supply-side constraints, especially in the labor market. Therefore, the equity advance will be associated with higher volatility than in the past few years. Chart 1 shows that the VIX soared by roughly four times more on February 5 than expected, based on the decline in equity prices. This suggests that the spike in volatility caused the stock market plunge, rather than the other way around. The relatively muted reaction in the past few days of other risk gauges, such as junk bonds, EM stocks, and gold prices, is consistent with this thesis. Chart 1Last Monday's VIX Spike Was Abnormally Large Importantly, the implosion of volatility funds is unlikely to reverberate across the global financial system in the same way as it did during the 2007-2009 financial crisis. The mortgage crisis a decade ago was so toxic that the losses were concentrated in the books of highly leveraged financial institutions. However, that does not appear to be the current case with volatility funds. The cyclical underpinnings for the bull market in equities is intact. The odds of a recession remain low (Chart 2). Corporate earnings continue to come in above expectations, aided by a wave of share buybacks linked to the U.S. Tax Cut and Jobs Act (Chart 3). Global economic growth remains upbeat as well. Chart 2Odds Of A Recession##BR##Remain Low Chart 3Buybacks, Surging Capex##BR##Raising The Bar For 2018 EPS Growth Chart 4U.S. Equities And Vol##BR##Climbed Through The 1990s This does not mean that everything will be smooth sailing. Last week's selloff marked an inflection point in the low-volatility world that has prevailed in the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Volatility will stay elevated relative to what investors have come to anticipate. As the experience of the 1990s shows, stocks can still climb when volatility trends higher (Chart 4), but this is going to make for a more challenging investment environment. Bottom Line: Rising volatility does not mean the end of the bull market or the economic expansion. Bear markets outside of recessions are rare, and our view remains that the odds of a recession this year or next remain low. Moreover, the additional dose of fiscal stimulus passed by Congress late last week may extend the expansion into 2020. Stay overweight stocks versus bonds.3 The Policy Response The Fed's reaction to this new regime will be critical. The 7.2% drop in equities last week occurred on Jay Powell's first as Chairman of the Fed. Chart 5 shows that it is not unusual for the equity markets to be in turmoil in the early months of a new Fed Chair's tenure. BCA expects that Powell and his FOMC colleagues will adopt Janet Yellen's gradual approach to raising rates this year. Nonetheless, the January readings on average hourly earnings suggest that supply-side constraints are beginning to bite. The runway for low inflation and easy monetary policy may not be as long as some had hoped. Just like Yellen, Jay Powell will seek a consensus among his colleagues. The composition of the FOMC will probably shift in a more hawkish direction, but the evolution will be slow. In the meantime, the recommendations of career Fed staff will represent an important and often underappreciated source of continuity. Last week, several Fed speakers reinforced that the central bank will continue to monitor incoming economic and financial data, and react accordingly. The stock market rout has led to some tightening in financial conditions, but FCIs in the U.S. remain more expansionary than they were six months ago (Chart 6). As a result, U.S. economic growth is poised to accelerate even more in the first half of the year (Chart 7). This will push the unemployment rate further below NAIRU and ultimately force up wage and price inflation. Chart 5New Fed Chairs##BR##And The Equity Market Chart 6Decline In Equity Market##BR##Tightened Financial Conditions However, at 2.1% on February 8, the 10-year TIPS breakeven yield was still below the 2.4 to 2.5% range where markets need to worry about the Fed falling behind the curve (Chart 8). A shift above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would signal that the FOMC will have to boost the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We will likely take some money off the table if core inflation rises, even if it is still below 2%, when the TIPS breakeven reaches 2.4%. Chart 7Lagged Effect Of Easier##BR##Monetary Conditions Will Boost Growth Chart 8Breaking Down##BR##The Rise In Yields A sustained move above 3% on the nominal 10-year Treasury yield will require a more durable increase in inflation. Ultimately, we think core inflation will move4 above 2%, forcing the Fed to lift interest rates into restrictive territory. However, this probably will be a story for 2019 rather than 2018. Stocks tend to peak about six months before the start of a recession (Table 1). If the next recession occurs in late 2019, as we forecast, the equity bull market could last a while longer. The additional fiscal impulse from the spending bill passed by Congress last week may extend the expansion into early 2020. A modest overweight on global risk assets is warranted for now, but investors should consider reducing their risk exposure later this year. Table 1Too Soon To Get Out Bottom Line: The Fed and the market are now in agreement on rate hikes in 2018. BCA's U.S. Bond Strategists' stance is that the 2/10 curve will flatten from here, as the upside in long maturity yields will be limited once the TIPS breakeven inflation rates reach our target fair value range of 2.4-2.5%. Nonetheless, at that point, the nominal 10-year yield5 is likely to be between 3.0 and 3.25%. Stay underweight duration for now. Where Do We Go From Here? Clients have asked our view on the appropriate order in which to reduce risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the most over-valued ones are at greatest risk, and thus profits should be taken here first. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time span? We include multiple measures because there is no widely accepted approach. More than one time period was used in some cases to capture regime changes. Table 2 provides our best approximation for nine asset classes. The approaches range from sophisticated methods6 developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (i.e. oil), to simple deviations from a time trend (i.e. real raw industrial commodity prices and gold). Table 2Valuation Levels For Major Asset Classes We averaged the valuation readings where there were multiple estimates for a single asset class. The results are shown in Chart 9. Chart 9Valuation Levels For Major Asset Classes By far, U.S. equities stand out as the most expensive at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads follow at 0.7, tracked closely by U.S. Treasuries (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are very expensive in absolute terms based on the fact that government bonds are pricey. Oil is sitting very close to fair value, despite the rapid price run up in the past couple of months. This makes oil exposure doubly attractive because the fundamentals point to higher prices when the underlying asset is not expensive. Historical analysis around equity market zeniths provides an alternative approach to the sequencing question. Table 3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table 3Asset Class Leads & Lags Vs. Peak In S&P 500 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, tech stocks or small-cap versus large-cap relative returns. Sometimes they reached their zenith before the S&P 500, and sometimes after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyze due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time was long and variable. The U.S. corporate bond market offers the most consistent lead/lag relationship. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio before we scale back on equities. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over as expected to the EM economies. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of China's economy in the coming months. Oil is a different story. OPEC 2.0 will likely cut back on supply in the face of an economic downturn, which will help keep prices elevated.7 Therefore, we may not trim energy exposure this year. In terms of equities, our recommended portfolio is still overweight cyclicals for now. Our themes of a synchronized global capex boom, rising bond yield, and firm oil price means we will stay overweight in the industrials, energy and financial sectors. Utilities and homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. Our U.S. Equity Strategists have already started a gradual shift away from cyclicals toward defensives. This transition will continue in the coming months as we reduce risk. We will also shift small caps to neutral on earnings disappointments and elevated debt levels.8 Bottom Line: The economic expansion is not over, but investors are already wondering what to sell first as the next peak in equities nears. Market participants should look to trim credit exposure before scaling back on equities, and BCAs' U.S. Equity Strategy service is already scaling back on cyclicals and reduced small caps to neutral from overweight last month. At under $60/ barrel WTI, oil is 5% below our Commodity & Energy Strategy's target of $63/bbl. Moreover, global inventories will continue to draw on the back of OPEC supply restraint as shale production growth alone will not satisfy stronger global demand driven by stronger global economic growth. If prices hit the low $70 range, supply restraint and demand growth will ebb, capping incremental upside. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Insight "Buy The Dip," published February 8, 2018. Available at uses.bcaresearch.com. 2 Please see BCA Research's Global Investment Strategy Special Report "The Return Of Vol," published February 6, 2018. Available at gis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Watching Five Risks," published January 24, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 6 Please see BCA Research's The Bank Credit Analyst Monthly Report, published January 25, 2018. Available at bca.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Vs. The Fed," published February 8, 2018. Available at ces.bcaresearch.com. 8 Please see BCA Research's U.S. Equity Strategy Weekly Report "Too Good To Be True?," published January 22, 2018. Available at uses.bcaresearch.com.

Highlights Chart 1Waiting For A Signal TIPS breakeven inflation rates are fast approaching our end-of-cycle targets (Chart 1). The 10-year and 5-year/5-year rates are currently 2.14% and 2.36% respectively, only slightly below our target range of 2.4% to 2.5%. If this trend continues it is highly likely that we will start to slowly reduce the credit risk in our portfolio in the coming weeks. Already, we find that some lower risk spread products (Foreign Agency bonds and Munis) are attractively valued relative to corporates. But there are also risks to exiting credit too early. First and foremost is that the recent widening in TIPS breakevens might reverse before it bleeds into higher core inflation. As we noted in last week's report, the St. Louis Fed's Price Pressures Measure is still supportive of an overweight allocation to corporate bonds (Chart 1, bottom panel) and core PCE inflation has only just risen to 1.5% year-over-year.1 Investors should maintain below-benchmark duration and an overweight allocation to corporate bonds for now, but be wary that the time to make end-of-cycle preparations is drawing nearer. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 72 basis points in January. The average index option-adjusted spread tightened 7 bps on the month, and currently sits at 85 bps. Investment grade corporate bond spreads continue to tighten, and with each additional basis point the evidence of extreme overvaluation grows. As of today, the 12-month breakeven spread for an A-rated corporate bond has only been tighter 3% of the time since 1989 (Chart 2). The same measure for a Baa-rated bond has only been tighter 4% of the time (panel 3). Further, the average spread on the Foreign Agency bond index is now 3 bps greater than the average spread of an equivalent-duration corporate bond, despite having an average credit rating that is three notches higher (Aa2/Aa3 versus A3/Baa1). Even a 10-year Aaa-rated Municipal bond now offers 7 bps greater after-tax yield than a duration-equivalent corporate bond for investors in the top marginal tax bracket (see page 9). The bottom line is that with such poor value in investment grade corporate spreads, we only need to see a stronger signal from our inflation indicators before reducing exposure.2 Depending on how inflation (and TIPS breakevens) evolve, that time could come relatively soon. The Federal Reserve's Senior Loan Officer Survey, released yesterday, showed that lending standards for commerical & industrial (C&I) loans eased somewhat in the fourth quarter of 2017, and also noted that banks expect to ease standards further on C&I loans to large and middle-market firms in 2018. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 149 basis points in January. The average index option-adjusted spread tightened 24 bps on the month, and currently sits at 324 bps. Last week's equity sell-off and spike in the VIX suggest that some near-term junk spread widening could be in the cards (Chart 3). However, we expect it is still a bit too soon to move out of junk bonds for the cycle. That decision will be made based on whether our inflation indicators continue to rise in the coming weeks and/or months, suggesting that the monetary policy back-drop is becoming less accommodative. In terms of value, high-yield corporates offer better risk-adjusted value than their investment grade brethren. The 12-month breakeven spread for a Ba-rated high-yield bond has currently been tighter than it is today 14% of the time since 1995. The same figure comes in at 25% for a B-rated bond and 31% for a Caa-rated bond. Similar measures for investment grade corporates are significantly lower (see page 3). Further, assuming a default rate of 2.35% for the next 12 months and a recovery rate of 51%, we calculate that a position in high-yield bonds will return 209 bps in excess of Treasuries if spreads stay flat at current levels. Another 100 bps of spread tightening would imply an excess return of just over 6%, but this would bring junk spreads to all-time tight valuations and is probably too optimistic. Remain overweight high-yield for now. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 15 basis points in January. The conventional 30-year zero-volatility MBS spread narrowed 2 bps on the month, all concentrated in the compensation for prepayment risk (option cost). The option-adjusted spread (OAS) was flat on the month, and currently sits at 29 bps. After having widened for most of last year, the OAS for a conventional 30-year mortgage bond is now more attractive relative to an equivalent-duration investment grade corporate bond than at any time since 2014 (Chart 4). This makes MBS a reasonably attractive sector for investors looking to shift away from corporate bonds and de-risk their spread product portfolios. Further, there would appear to be very little risk of spread widening in the MBS sector. First, the schedule of run-off from the Fed's mortgage portfolio is already well known, and likely in the price. Second, mortgage refinancings are likely to stay contained in a rising interest rate environment (bottom panel). Finally, the risk of duration extension in MBS only becomes material when Treasury yields spike higher very quickly - on the order of 72 bps or more in a month - as we showed in last week's report.3 Investors should stay at neutral on MBS for now, but stand ready to increase exposure when the time comes to move out of corporate bonds for the cycle. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 42 basis points in January. Sovereign bonds outperformed by 118 bps, Local Authorities by 67 bps, Foreign Agencies by 54 bps, Domestic Agencies by 8 bps and Surpranationals by 3 bps. USD-denominated Sovereign bonds continue to look expensive compared to Baa-rated U.S. Credit (Chart 5), yet they still managed to deliver almost identical excess returns during the past 12 months because of the U.S. dollar's large depreciation. Going forward, with the dollar's rapid decline unlikely to accelerate, we would avoid Sovereign bonds in favor of U.S. corporates. Valuation is more attractive elsewhere in the Government-Related index. Foreign Agency bonds now offer greater spreads than equivalent-duration U.S. corporate bonds, despite benefitting from higher credit quality (panel 4). Local Authority spreads also look attractive compared to recent history (bottom panel). We continue to recommend overweight allocations to both sectors. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 12 bps and 16 bps of option-adjusted spread, respectively. We much prefer Agency-backed MBS and CMBS which are also relatively low risk and offer option-adjusted spreads of 29 bps and 40 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 53 basis points in January (before adjusting for the tax advantage). The average AAA-rated Municipal / Treasury (M/T) yield ratio was flat on the month. Two market technicals spurred Muni outperformance in January. First, supply plunged after many advance refunding issues were pulled forward in anticipation of the U.S. tax bill (Chart 6). Second, the repeal of the state and local tax deduction led to increased demand for Munis, as evidenced by the recent jump in fund inflows (panel 3). In terms of credit quality, state and local government net borrowing as a percent of GDP likely fell to 0.9% in 2017 Q4 - assuming that corporate tax revenues are held constant. This is consistent with current low yield ratios (panel 4). Meanwhile, tax revenue growth should stay strong in the coming quarters due to recent increases in property prices and retail sales. While M/T yield ratios remain low compared to history, excessive valuations in investment grade corporate bonds mean that Munis are starting to look attractive by comparison. For example, for investors in the top marginal tax bracket, we calculate that the after-tax yield on a Aaa-rated municipal bond is 7 bps higher than the duration-equivalent yield offered by the investment grade corporate bond index, even though the corporate bond index offers an average credit rating of only A3/Baa1. While the bottom panel shows that this yield differential has been higher in the past, it is nevertheless an indication that we are approaching the end of the credit cycle. Stay underweight Munis for now, though an upgrade is likely when it comes time to exit our corporate bond overweights. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear steepened out to the 10-year maturity point in January, as bond markets started to price-in a rebound in inflation. The 2/10 slope steepened 7 basis points on the month and the 5/30 slope flattened 11 bps. The 2/10 slope steepened even further in the first five days of February and currently sits at 69 bps, up from its recent low of 50 bps. More near-term curve steepening is possible if long-maturity TIPS breakeven inflation rates continue to widen, especially since the Fed's median projected rate hike path for the next 12 months is already fully discounted (Chart 7). However, the yield curve is much more likely to be flatter by the end of the year than it is today. In large part because the upside in long-maturity yields will be limited once TIPS breakeven inflation rates reach our target fair value range of 2.4% to 2.5%. In terms of positioning, we continue to advocate a long position in the 5-year bullet versus a short position in a duration-matched 2/10 barbell. The 5-year continues to look very cheap on the curve (panel 3), or put differently, our model suggests that the 2/5/10 butterfly spread is currently priced for 29 bps of 2/10 curve flattening during the next six months (panel 4).4 This seems excessive for the time being. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 75 basis points in January. The 10-year TIPS breakeven inflation rate increased 15 bps on the month. At 2.14% and 2.36%, respectively, the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are still below our target range of 2.4% to 2.5%, but only modestly so. The big run-up in TIPS breakeven rates coincided with a jump in oil prices and, as we discussed in a recent report, this is no coincidence (Chart 8).5 The Fed has an asymmetric ability to influence inflation - it has an unlimited ability to tighten policy but its ability to ease policy is restricted by the zero-lower bound on interest rates. It is for this reason that when TIPS breakeven inflation rates become un-anchored to the downside, they also become much more sensitive to swings in commodity prices. In these environments the market sees inflation as increasingly determined by price pressures in the economy and not by the Fed's reaction function. The logical conclusion is that we should expect the tight correlation between oil prices and long-maturity TIPS breakeven rates to persist until breakevens reach our target fair value range of 2.4% to 2.5%. At that point, it is unlikely that further increases in commodity prices would filter through to long-maturity breakevens, because the market would anticipate a tightening response from the Fed. Stay overweight TIPS versus nominal Treasury securities for now. We will reduce exposure when our fair value target of 2.4% to 2.5% is achieved. ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in January. The index option-adjusted spread (OAS) for Aaa-rated ABS tightened 2 bps on the month and now stands at 33 bps, only 6 bps above its all-time low (Chart 9). All in all, a 33 bps spread is still reasonably attractive for a sector that is Aaa rated with an average duration of 2. By way of comparison, the intermediate maturity Aaa Credit index offers an OAS of only 17 bps and has an average duration above 3. However, credit trends are clearly shifting against the Consumer ABS sector. The consumer credit delinquency rate has put in a bottom, albeit from a very healthy level, and the trend in the household debt service ratio suggests that delinquencies will continue to rise (panel 3). Further, the Federal Reserve's Senior Loan Officer Survey shows that lending standards on auto loans have tightened on net in each of the past 7 quarters, while credit card lending standards have tightened for 3 consecutive quarters. Even though lending standards on both auto loans and credit cards moved slightly closer to net easing territory in the fourth quarter of 2017, the reading from lending standards is still consistent with a rising delinquency rate (bottom panel). We retain a neutral allocation to consumer ABS due to still attractive spreads for a low-duration, high credit quality sector. However, if the uptrend in consumer delinquencies is sustained then our next move will probably be to reduce allocation to this sector. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 7 bps on the month and currently sits at 59 bps. The spread is now only 8 bps above the lowest level seen since the inception of the index in 2000 (Chart 10). Much like in the Consumer ABS sector, historically low CMBS spreads are observed at a time when lending standards are tightening in the commercial real estate (CRE) sector. The Federal Reserve's most recent Senior Loan Officer Survey shows that lending standards for nonfarm nonresidential CRE loans have tightened for 10 consecutive quarters, though they have been tightening less aggressively of late (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in January. The index option-adjusted spread narrowed 1 bp on the month and currently sits at 40 bps. With an average spread of 40 bps and an average duration of around 5, this sector is not quite as attractive as Consumer ABS on a spread per unit of duration basis. However, it still offers greater expected compensation than a position in Conventional 30-year residential MBS which has an option-adjusted spread of 29 bps and a similar duration. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 3.01% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 3.06%. The Global PMI actually ticked down in January, but only slightly from 54.5 to 54.4. This small decline was more than offset in our model by the large drop in dollar sentiment, which just moved into "net bearish" territory (bottom panel). Of the four major economic blocs, PMIs increased in the U.S. and Japan, ticked down from an extremely high level in the Eurozone and held steady in China. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.84%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 4 For further details on our model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Portfolio Strategy Recovering energy related capex and upbeat oil prices are a powerful tonic for the S&P integrated oil & gas index. Augment positions to overweight. A diverging crude/refined product inventory backdrop, narrowing Brent-WTI crude oil spread, and extreme analyst optimism warn that the easy money has been made in refiners. Lock in profits and downgrade to a benchmark allocation. Recent Changes S&P Integrated Oil & Gas - Upgrade to overweight. S&P Oil & Gas Refining & Marketing - Book profits of 9% and downgrade to neutral today. Table 1 Feature Chart 1Vertigo Alert Equities have been rising at a dizzying speed year-to-date, as investors have extrapolated the tax reform EPS tailwind far into the future in a very short time span. The risk of a tactical, and likely short lived, 5-10% pullback is very high. Putting this potential correction in perspective is in order. A drop in the SPX to near its 50-day moving average would set the market back 6%, to near the 2,700 mark. As a reminder, the S&P 500 crossed 2,700 on January 3, 2018. A 10% drawdown would push the market below 2,600, a level first surpassed on Black Friday (Chart 1). While steep stock price increases are not unprecedented, at the current juncture all of our tactical indicators suggest that caution is warranted (please refer to the January 22 and January 29 Weekly Reports for more details). The way we recommend defending against such exuberance is to book gains in high-beta pair trades, institute trailing stops to the high-conviction list high flyers (see page 19) and make some subsurface changes to intra-sector positioning. From a cyclical perspective we remain constructive on the broad market and given our view of no recession in the coming 9-12 months our investment strategy is to "buy the dip". Chart 2 shows our S&P 500 EPS model using trailing EPS data directly from Standard & Poor's. Calendar 2017 profit growth is on track to hit 17% year-over-year. Chart 3 shows our S&P 500 EPS model using IBES trailing EPS data. We decided to regress the same variables on the IBES trailing EPS dataset since the market trades on the forward EPS from IBES. According to IBES, calendar 2017 EPS growth will hit 12%, so there is a 5% delta between the two datasets. Our understanding of the difference between the two numbers is what each provider considers one time I/S items. Currently, IBES bottom-up forecasts pencil in 18% growth in calendar 2018 and our model suggests that 21% is possible (Chart 3). S&P forecasts call for a 23% calendar 2018 increase and our model is pointing toward 24% (Chart 2). Chart 2No Matter The Data Set... Chart 3...EPS Will Shine In 2018 Irrespective of what data one uses the signal is clear: EPS will have a blowout year in 2018. Studying such EPS reacceleration phases is very interesting. Since the mid-1980s there have been four other periods where EPS exhibited breakneck growth (excluding the GFC, Chart 3). Importantly, we analyzed what the prevalent macro conditions were in all four iterations and Charts A1-A4 in the Appendix on page 16 detail the results. In all iterations, the 10-year Treasury yield was rising, the ISM manufacturing survey was well above the 50 boom/bust line, the U.S. dollar was falling, and crude oil prices were increasing. Currently, we believe reaching and even surpassing the 20% EPS growth rate number in 2018 is likely, given the similarities between the current macro backdrop and these four prior periods (Chart 4). However, this does not necessarily mean that there will be no stock market volatility and equites will increase uninterruptedly in a straight line. Chart 5 shows how the S&P 500 performed in these four periods and in all of them short-term tactical pullbacks occurred. We think 2018 will prove no different. This week we update our view on a deep cyclical sector and tweak our intra-sector positioning. Chart 4Favorable Macro Conditions... Chart 5...But Don't Get Carried Away Stay Long Energy... We put the S&P energy sector on our high-conviction overweight list in late-November as a key beneficiary of our synchronized global capex theme.1 Since then, the broad energy complex has bested the S&P 500 by over 3%, and our macro indicators suggest that more gains are in store for this deep cyclical sector. The Dallas Fed manufacturing outlook survey is firing on all cylinders and, given the importance of oil to the state of Texas, it serves as an excellent gauge for oil activity. Importantly, the capital expenditures part of the survey hit the highest level in a decade. Similarly, capex intentions in the coming six months are also probing multi-year highs and signaling that the budding recovery in energy capital budgets will likely gain steam (middle panel, Chart 6). Following the late-2015/early-2016 drubbing in oil prices, energy projects ground to a halt and only now are green shoots appearing (bottom panel, Chart 6). Indeed, rising oil prices are providing a much needed assist. Higher crude prices make more global projects economical and coupled with the steadily lower breakeven costs of shale oil suggest that EPS and sales growth normalcy is likely to return to this commodity complex. Moreover, the indiscriminate selling of the U.S. dollar explains part of the oil price rise, but other macro forces are also at play (Chart 7). Chart 6Capex Theme Beneficiary Chart 7Catch Up Phase Looming Chart 8Levered To Global Growth##BR## And Rising Inflation Similar to "Dr. Copper", crude oil prices are an excellent global growth barometer. In fact, oil price swings move in lockstep with the ebb and flow of global output growth and the current message is positive (Chart 8). Not only is our proprietary measure of global Industrial Production rising, but the multi-year high in the forward looking global manufacturing PMI survey also suggests that more good news on the global economic front lies ahead. As unemployment gaps close around the world, with more and more countries following in the U.S.'s footsteps toward full employment, inflation is bound to reaccelerate. Recently, the 10-year U.S. Treasury yield has been on a tear driven mostly by rising inflation expectations. Higher interest rates is another key BCA theme for 2018 and energy stocks also stand to benefit from this rising interest rate backdrop. Historically, relative share prices have been positively correlated both with bond yields and inflation expectations and the current message is to expect a catch up phase in the former (bottom panel, Chart 8). Beyond an enticing macro backdrop, favorable industry supply/demand dynamics are a harbinger of sunnier energy days. OECD oil stocks are receding steadily and so are U.S. crude oil inventories. The implication is that relative share prices will remain well bid (oil inventories shown inverted, middle panel, Chart 9). OPEC 2.0 remains in place and will likely balance the oil market by continuing to constrain supply. Our Commodity & Energy Strategy service is still penciling in higher oil prices for 2018. On the demand side, emerging markets/Chinese demand is the key determinant of overall oil demand, and the news on this front is encouraging and consistent with BCA's synchronized global growth theme: following the recent lull, non-OECD demand is growing anew roughly by 1.5mn bbl/day. The upshot is that S&P energy relative revenues will climb out of the recent trough (bottom panel, Chart 9). Our energy profit model does an excellent job capturing all of these different forces and is signaling that energy EPS will easily outpace the SPX and continue to capture a larger share of the broad market's earnings pie (Chart 10). Chart 9Favorable Supply/Demand Backdrop Chart 10EPS Model Flashing Green Bottom Line: We reiterate our high-conviction overweight call in the S&P energy index. ...Boost The Integrated Oil & Gas Index To Overweight, But... Factors are falling into place for the heavyweight S&P integrated oil & gas index to generate outsized returns in the coming year, and we are compelled to lift this beaten-down energy sub-index to an above benchmark allocation. Investment spending and relative performance are one and the same for this capital-outlay-reliant group. The time to buy these capital intensive high-operating leverage stocks is during a capex upcycle when a virtuous EPS cycle takes root. The opposite is also true. Earlier this decade, the energy sector's share of the U.S. stock market reported capex pie got halved to 16% (top panel, Chart 11). While we are not calling for a return to the heyday of triple digit oil, even a modest renormalization of capital spending would go a long way. Recent news that Exxon Mobil would bump domestic capital spending to $50bn over the next five years is a step in the right direction. New projects/investments comprise 70% of this figure. The company cited the new U.S. tax law as a reason behind the announcement, and tax reform has the potential to drive industry capex plans/budgets. Our sense is that more announcements like the Exxon Mobil one may be brewing and could serve as a catalyst to unlock excellent value in the S&P integrated oil & gas index. Meanwhile, higher oil prices will result in a pickup in global energy project outlays. The top panel of Chart 12 shows that the global oil & gas rig count is rebounding from an extremely depressed level. Encouragingly, these investments will likely pay dividends and translate into cash flow growth extending the virtuous upcycle (bottom panel, Chart 12). Chart 11Buy Oil Majors Chart 12Prime Beneficiary Of Rising Capex As we mentioned earlier in the energy section, BCA still has a sanguine 2018 oil view, and if it pans out, it will continue to underpin not only the broad energy space, but also oil majors. Action in the commodity pits corroborates that the path of least resistance is higher both for the underlying commodity and relative share prices. Crude oil net speculative positions just hit a record high as a percent of open interest (bottom panel, Chart 13). Similarly, consensus on oil just breached the 50 line and is now in bullish territory, signaling that momentum in the relative share price ratio will gain steam in the coming months (middle panel, Chart 13). Adding it up, recovering energy related capex coupled with upbeat oil prices are a powerful tonic for the S&P integrated oil & gas index. Under such a backdrop a valuation rerating phase is looming (Chart 14). Chart 13Encouraging Oil Market Dynamics Chart 14Cheap With A 150bps Dividend Carry Bottom Line: Boost the S&P integrated oil & gas index to overweight. This index also sports a 150bps positive dividend carry. The ticker symbols for the stocks in this index are: XOM, CVX & OXY. ...Take Profits In Refiners While we recommend upgrading the S&P integrated oil & gas index to overweight, we are booking gains of 9% in the niche S&P oil & gas refining & marketing index and downgrading to a benchmark allocation. We upgraded refiners to overweight in early September, as a way to capitalize on the havoc that hurricane season dealt to refining capacity. Since then, our portfolio has benefited handsomely from the run up in refining stocks, but we do not want to overstay our welcome in this niche space as refinery runs have now returned to normal (Chart 15). Moreover, a number of headwinds signal that the easy gains are already behind this group. First, refining margins are under pressure as the Brent-WTI crude oil spread is steadily narrowing. Historically, refining margins and this oil price spread have been joined at the hip and the current message is negative for margins. A diverging inventory backdrop also points toward margin trouble ahead. Refined product inventories are outpacing crude oil supplies, warning that a further softening in crack spreads is in the cards (bottom panel, Chart 16). In fact, crude oil inventories are whittled down, whereas gasoline and distillate fuel stocks are built up (middle panel, Chart 15). This inventory accumulation represents, at the margin, a challenging pricing outlook for refiners. Chart 15Return To Normalcy... Chart 16...But Cracks Are Forming Worrisomely, sell side analysts have been extrapolating a euphoric EPS backdrop far into the future with five year profit forecasts pushing all-time highs. While tax reform represents a one-time boost to EPS in 2018, we cannot comprehend how this highly cyclical industry with razor thin margins can attain 34% EPS growth for the next 3-5 years, outpacing the overall market by a staggering 20 percentage points (Chart 17). Putting this sky-high long-term EPS growth number in perspective is instructive. Typically, relative share prices hit a wall when such analyst optimism reigns. The tech sector in the late 1990s, biotech stocks twice in 2001 and 2014, and semi equipment stocks late last year all suffered a major setback when long-term profit forecasts catapulted near the 25% mark (Chart 17). (As a reminder chip equipment stocks are a high-conviction underweight and have benefitted our portfolio by 17.2% since the November 27th inception, please see page 19.) Finally, from a technical perspective, a bearish pennant formation with lower highs has formed and is warning that a breakdown is possible in the relative share price ratio in the coming quarters (top panel, Chart 16). Nevertheless, we refrain from turning outright bearish on refiners as there is a sizeable offset. Refined product consumption is as firm as ever. Gasoline demand remains upbeat and this indicator has historically been positively correlated with relative share prices, relative 12-month forward EPS and relative valuations (Chart 18). Chart 17Watch Out Down Below Chart 18Consumption Is A Positive Offset Any let-up in demand or a further jump in refined product inventories could prove deflationary for refiners and were that to take place we would not hesitate to further prune exposure to a below benchmark allocation. Bottom Line: Lock in profits of 9% in the S&P oil & gas refining & marketing index and downgrade to neutral. The ticker symbols for the stocks in this index are: PSX, VLO, MPC and ANDV. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Appendix Chart A1 Chart A2 Chart A3 Chart A4 Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

The GAA DM Equity Country Allocation model is updated as of January 31, 2018. The model has made large shifts in country allocations. The U.S. is upgraded to neutral from previously the largest underweight, driven largely by technical conditions. It seems dramatic, but as shown in Chart 2, the model did have similar large shifts in the past as well. Canada also has received a large increase to overweight driven by extremely attractive valuation. To fund these upgrades, the previously largest overweight in Italy is cut in half (mainly driven by liquidity and valuation) and Australia is back to underweight (trading places with Canada). As a result, the model now is overweight the Netherlands, Italy, Germany, Canada and Spain, neutral on the U.S. and underweight Japan, the U.K., France, Australia and Sweden as shown in Table 1. As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed its benchmark by 99 bps in January, largely driven by the Level 2 model which outperformed by 207 bps, thanks to the underweights in the U.K., Japan and Canada vs. the overweights in Italy, the Netherlands and Germany. Since going live in January 2016, the overall model has outperformed the benchmark by 190 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 570 bps. The Level 1 model has performed in line with the MSCI world benchmark. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of January 31, 2018. The model continues to be bullish on global growth as seen by a 10% aggregate overweight in the cyclical sectors. The model continues to hold equal underweights in consumer staples, health care, telecom and utilities stocks. Looking forward, we believe improving global growth dynamics, and rising equity markets will help us maintain an aggregate cyclical pro-growth bias. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com