Inflation/Deflation

Highlights Duration: The global economic recovery is more synchronized than at any time since 2011. This suggests that foreign demand will be less of an impediment to the bond bear market and that Treasury yields will rise once U.S. data start to surprise on the upside. Stay at below-benchmark duration. MBS: Agency MBS option-adjusted spreads have widened significantly and no longer look expensive. With Treasury yields moving higher and mortgage refinancings likely to stay depressed, we advise upgrading MBS from underweight to neutral. Economy & Inflation: The U.S. economic data are starting to outperform beaten-down expectations. Survey data point to further GDP acceleration in the second half of this year and we expect inflation will soon follow growth higher. Feature Chart 12-Factor Treasury Model The relationship between the global breadth of economic growth, the value of the dollar and the outlook for Treasury yields has been a running theme in this publication.1 To summarize, stronger global growth pressures bond yields higher (and vice-versa). But how that growth is distributed across different countries matters as well. For example, if global growth is mostly concentrated in the U.S., then yield spreads will widen between the U.S. and the rest of the world and the dollar will appreciate as money pours in from overseas. Investors then respond to a stronger dollar by downgrading their U.S. growth and rate hike expectations. This caps the upside in long-dated U.S. Treasury yields. Conversely, if global growth is more evenly spread out throughout the world, then the dollar will come under less upward pressure when U.S. growth accelerates and Treasury yields can rise further. We developed a simple two-factor model to show how the trade-off between global growth and the exchange rate impacts the U.S. 10-year Treasury yield (Chart 1). The model uses the Global Manufacturing PMI as its proxy for global growth and a survey of bullish sentiment toward the dollar as its proxy for growth synchronization. So far this year, the Global PMI has moved higher and sentiment toward the dollar has become less bullish. Both developments have bond-bearish implications and our model now pegs fair value for the 10-year Treasury yield at 2.65%, 28 bps above the current 10-year yield. In Sync The Global PMI came in at 53.2 in September, the same as in August, but still a strong reading compared to recent history (Chart 2). But the most stunning detail of the September PMI releases is that 33 out of the 36 countries we track had PMIs above the 50 boom/bust line. As a result, our Global PMI Diffusion Index hit 90% for only the second time since 2011 (Chart 2, panel 1). The elevated reading of our diffusion index leads us to two market related observations. First, stronger growth outside of the U.S. explains why the 10-year Treasury yield is only 8 bps lower than at the start of the year despite U.S. economic data that have severely undershot expectations (Chart 2, bottom panel). Second, it suggests that when U.S. economic data inevitably start to surprise on the upside - a process which is only now beginning (see Economy & Inflation section below) - the dollar will appreciate by less than it would have when our PMI diffusion index was near 50. This removes a huge impediment from the bond bear market. In Chart 3 we see that the recent peak in 7-10 year U.S. bond yields occurred at 2.54% on Dec 16th. On that same date the spread between 7-10 year U.S. bond yields and average 7-10 year yields in the rest of the world was 178 bps, and bullish sentiment toward the dollar was above 80%. With the global recovery now more synchronized than it was last year, we anticipate that by the time U.S. yields take out that prior peak, the yield spread and dollar bullish sentiment will still be lower than they were last December. This means that less foreign capital will be encouraged into the U.S. and yields will rise even further. Chart 2Broad Based Recovery Chart 3Spreads Less Of A Constraint Where Is Growth Coming From? Considering the major economic blocs, the biggest change during the past year has been the surging Eurozone PMI (Chart 4). The U.S. PMI is still firmly above the 50 boom/bust line but has actually moderated in 2017. The Japanese PMI is similarly entrenched above 50 and while the Chinese PMI was weak earlier this year, it has rebounded during the past four months. At roughly 20%, China carries the largest weight in the Global PMI. The outlook for the Chinese economy is therefore crucial for the path of bond yields. On that note, while the Chinese PMI has been strong in recent months, a couple of warning signs are beginning to flash (Chart 5). Chart 4Global Manufacturing PMIs Chart 5Chinese Monetary Conditions Commodity prices - which correlate strongly with Chinese PMI - have declined since early September, although they remain above levels seen last year and do not yet pose a major risk. What's more important is that monetary conditions are starting to tighten (Chart 5, panel 2). If tighter monetary conditions persist, then we should expect growth to slow. The mild tightening in monetary conditions that has already occurred will probably lead to some near-term moderation in Chinese growth. But our China Investment Strategy service thinks it's unlikely that monetary conditions will tighten enough to cause a meaningful slowdown.2 Our China strategists note that with GDP growth within the government's target range, inflation exceedingly low and signs that financial excesses have been reigned in, there should not be much appetite for draconian policy tightening. We would also add that the causes of this year's tightening in monetary conditions have been relatively benign. The monetary conditions index shown in Chart 5 has fallen because the trade-weighted RMB is no longer depreciating and because real interest rates have moved a tad higher. Crucially, the RMB has only stabilized, it is not appreciating in trade-weighted terms. Also, the nominal policy rate remains flat at a low level. The increase in real interest rates resulted purely from weaker consumer price inflation. Bottom Line: The global economic recovery is more synchronized than at any time since 2011. This suggests that foreign demand will be less of an impediment to the bond bear market and that Treasury yields will rise once U.S. data start to surprise on the upside. Stay at below-benchmark duration. Buy The News In MBS Last week we upgraded our allocation to Agency MBS from underweight to neutral, noting that spreads had become more attractive during the past few months. In all likelihood this is the result of the market pricing in the wind-down of the Fed's balance sheet.3 With the Fed's plans now well known (and unlikely to change), there is an opportunity to increase MBS exposure from a more attractive starting point. After having sold the rumor, we think it's time to buy the news. The Value Proposition Chart 6OAS Look Attractive To be clear, we are not forecasting stellar excess returns from Agency MBS. But with spreads compressed across the entire U.S. fixed income universe, we would note that the option-adjusted spread (OAS) differential between conventional 30-year Agency MBS and investment grade corporate bonds (in duration-matched terms) has risen back to levels last seen in 2014 (Chart 6). The lagged OAS differential is a decent predictor of relative returns between MBS and corporate credit, and at current levels it suggests that MBS could even outperform corporate bonds at some point during the next 12 months (Chart 6, panel 2). This year's decline in Treasury yields has also biased OAS differentials between MBS and corporate bonds wider. Because of negative convexity, MBS duration is positively correlated with yields (Chart 6, bottom panel). If yields rise from here, as we expect they will, then MBS duration will also extend. This means that MBS OAS will start to appear less and less attractive relative to duration-matched comparables. In other words, MBS are less likely to cheapen relative to other spread product in an environment of rising Treasury yields. The Drivers Of MBS Spreads A simplified formula for excess MBS returns, relative to duration-matched Treasuries, could be written as follows: Excess Return = Starting OAS - Duration*(Change in nominal spread) + 0.5*Convexity*(Change in yield) 2 That is, OAS is the correct measure of MBS carry because it adjusts for expected losses due to prepayments. However, it is the change in the nominal spread (not the OAS) that will determine capital gains and losses during the investment horizon. On that note, we observe that nominal MBS spreads have rarely been tighter during the past 30 years (Chart 7). However, it is also hard for us to see a catalyst for significantly wider nominal spreads during the next 6-12 months. The two factors that correlate most closely with nominal MBS spreads are credit spreads and mortgage refinancings. Chart 7Nominal MBS Spreads Are Driven By Credit Spreads And Refinancings On credit spreads, we have repeatedly outlined why they are unlikely to widen materially in the absence of more significant inflationary pressure.4 As for refis, we are also hard pressed to see much upside for three main reasons: First, changes in mortgage rates are the number one driver of refinancings (Chart 8). Refis only increase when mortgage rates fall, making the proposition of refinancing more attractive. As yields rise during the next 6-12 months, refis will stay low. Second, the distribution of outstanding mortgages across the coupon stack impacts how sensitive refis are to changes in rates. The second panel of Chart 8 shows our measure of "moneyness", aka the dispersion of outstanding mortgages around the current coupon rate.5 Given today's dispersion levels we can calculate that even if the current coupon mortgage rate falls back to its recent low of 2.24%, our measure of moneyness would not get back to its late-2016 peak. For our moneyness indicator to rise back to 2013 levels the current coupon mortgage rate would have to fall all the way to 1.68%. Needless to say, we would characterize that risk as low. Third, the final factor that can impact the pace of mortgage refinancing is the seasoning of outstanding mortgages. Typically, we think of mortgages between 30 and 60 months old as being the most likely to refinance. Given that net mortgage origination was close to zero between 30 and 60 months ago and that mortgage purchase applications were at multi-year lows (Chart 9), most of the outstanding mortgage universe probably falls outside of this zone. Chart 8Refis Will Stay Low Chart 9Most Mortgages Are Not Yet Seasoned Bottom Line: Agency MBS option-adjusted spreads have widened significantly and no longer look expensive. With Treasury yields moving higher and mortgage refinancings likely to stay depressed, we advise upgrading MBS from underweight to neutral. Economy & Inflation Bring On The Upside Surprises As was alluded to in the opening section of this report, after have disappointed expectations year-to-date, we are just now starting to see U.S. economic data surprise to the upside (see Chart 2). The most recent datapoints that caught our eye were the ISM manufacturing and non-manufacturing PMIs.6 Our inclination is to mostly ignore last Friday's employment report as an outlier due to the recent hurricanes.7 The ISM non-manufacturing survey jumped to 59.8 in September, its highest level since 2005. Taken together with other survey indicators that tend to track GDP growth - the BCA Beige Book Indicator and the BCA Composite New Orders Indicator - the case is quite strong for further GDP acceleration in the third and fourth quarters (Chart 10). Of course the pressing issue for bond markets is whether that growth acceleration translates into higher inflation. On that note, we would suggest that the weak inflation we have seen during the past six months was a reaction to the growth slowdown witnessed in 2015 and the first half of 2016. The stronger ISM manufacturing index, in particular, sends a powerful signal that inflation is poised to put in a bottom (Chart 11). Chart 10Survey Indicators Of U.S. Growth Chart 11Inflation Lags Growth Bottom Line: The U.S. economic data are starting to outperform beaten-down expectations. Survey data point to further GDP acceleration in the second half of this year and we expect inflation will soon follow growth higher. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Another Update", dated January 31, 2017, available at usbs.bcaresearch.com 2 Please see China Investment Strategy Special Report, "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 3 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Return Of The Trump Trade", dated October 3, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 5 For each coupon bucket in the Bloomberg Barclays Conventional 30-year Agency MBS index we calculate the squared deviation between its coupon and the current coupon rate. We then weight those squared differences by the market capitalization of each coupon bucket. 6 These are different than the Markit PMI that is included in our 2-factor Treasury model. 7 Please see BCA Daily Insights, "U.S. Jobs Report: All Noise, No Signal", dated October 6, 2017, available at din.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Economic Outlook: Global growth will stay strong over the next 12 months, with the U.S. surprising on the upside. Unfortunately, the global economy will succumb to a recession in 2019. Stagflation will become a major problem in the 2020s. Portfolio Strategy: We are sticking with our pro-risk stance for the time being, but are trimming our overweight recommendations to global equities and high-yield credit. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S., euro area, and Canadian government bonds; stay neutral the U.K., Australia, and New Zealand; overweight Japan. Equities: Favor cyclicals over defensives, but look to turn outright bearish on stocks late next year. For now, stay overweight the euro area and Japan relative to the U.S. in local-currency terms. In the EM universe, Chinese H-shares will outperform. Currencies and Commodities: While the recent dollar rebound has further to run, oil-sensitive currencies and the yuan will hold their ground against the greenback. It is too early to buy gold. Feature I. Global Macro Outlook: Reflation, Recession, And Stagflation The economic outlook over the coming years can be summarized in three words: reflation, recession, and stagflation. Reflation A Broad-Based Recovery Global growth is firing on all cylinders. The OECD estimates that all 46 of the economies that it tracks will see positive growth this year, the first time this has happened since 2007. Most leading economic indicators remain upbeat (Chart 1). This has left analysts scrambling to revise up their global GDP growth forecasts (Chart 2). Chart 1Most Leading Economic Indicators Remain Upbeat Chart 2Global Growth Has Accelerated The acceleration in global growth has occurred against the backdrop of tame inflation, which has allowed most central banks to keep interest rates at exceptionally low levels. Not surprisingly, risk assets have reacted positively. These goldilocks conditions should remain in place for the next 12 months. While most economies are growing at an above-trend pace, there is still plenty of spare capacity around the world. This means that inflation in countries such as the U.S. - where the labor market has returned to full employment - is likely to rise only gradually, as excess demand is satiated through higher imports. Such a redistribution of demand from countries with low levels of spare capacity to those with high levels is a win-win outcome for the global economy. Recession Running Out Of Room Unfortunately, all good things must come to an end. Weak productivity growth across most of the world is likely to cause bottlenecks to emerge over time, and this will cause inflation to move higher (Chart 3). Output gaps in the main developed economies would actually be higher today than at the height of the Great Recession had potential GDP grown at the rate the IMF projected back in 2008 (Chart 4). This is a testament to just how exceptionally weak potential growth has been. Chart 3Productivity Growth Has Slowed Across The Globe Chart 4Weak Supply Growth Has Narrowed Output Gaps U.S. growth will surprise to the upside over the next 12 months, leading to an unwelcome burst of inflation in late 2018 or early 2019. Financial conditions have eased sharply this year thanks to lower bond yields, narrower credit spreads, a weaker dollar, and a surging stock market. Changes in financial conditions lead growth by around 6-to-9 months, implying that U.S. growth could reach 3% early next year (Chart 5). This could take the unemployment rate down to 3.5% by end-2018, more than a full point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. The unemployment rate could fall even further if Congress succeeds in passing legislation to cut taxes, as we expect it will. Our geopolitical team estimates that the GOP proposal would reduce federal revenues by $1.1-to-$1.2 trillion over ten years, or about 0.5% of GDP.1 In order to appease moderates, the final bill is likely to scale back the size of the tax cuts and shift more of the benefits to middle class households. Under the current proposal, the top 1% of taxpayers would receive 50% of the tax benefits (Chart 6). Our best bet is that the legislation will be enshrined into law in early 2018. Chart 5Easier Financial Conditions Will Boost U.S. Growth Chart 6Republican Tax Would Disproportionately Benefit The Top 1% Welcome To The Steep Side Of The Phillips Curve The so-called Phillips curve, which depicts the relationship between unemployment and inflation, tends to become quite steep once unemployment falls to very low levels (Chart 7). It is easy to see why: When spare capacity is high, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The 1960s provide a useful lesson in that regard. Just like today, inflation hovered below 2% during the first half of that decade, even though unemployment was trending downward over this period. To most observers back then, the Phillips curve would have also seemed defunct. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 8). The kink in the Phillips curve had been reached. Inflation ultimately made its way to 6% in 1970, four years before the first oil shock struck. Chart 7U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve Chart 8Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Many commentators have questioned the relevance of the sixties template on the grounds that the U.S. economy was less open to the rest of the world back then, trade unions had greater bargaining power, inflation expectations were not as well anchored, and the deflationary effects of new technologies were not as pervasive. We discussed these arguments in a report published earlier this month, concluding that they are not nearly as persuasive as one might think.2 The Difficulty Of Achieving A Soft Landing Rising inflation will compel the Fed to hike rates aggressively starting late next year in order to push the unemployment rate back towards NAIRU. A turn towards hawkishness is especially likely if Janet Yellen is replaced by someone such as former Fed Governor Kevin Warsh, whom betting markets now think has a 40% chance of becoming the next Fed chair (Chart 9). The problem for whoever ends up running the Fed is that it is very difficult to raise the unemployment rate by just a little bit. Modern economies are subject to massive feedback loops. When unemployment begins rising, households lose confidence and reduce spending. This prompts firms to slow hiring, leading to even less spending. The U.S. has never averted a recession in the post-war era whenever the unemployment rate has increased by more than one-third of a percentage point (Chart 10). Chart 9Who Will The Next Fed Chair Be? Chart 10Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Lofty valuations are likely to exacerbate the adverse feedback loop described above during the next downturn. As growth slows, risk asset prices will tumble. This will cause business investment spending to dry up. Given America's dominant role in global financial markets, the U.S. recession will spread like wildfire to the rest of the world. Stagflation The Doves Reassert Control The next recession will probably be more painful for Wall Street than for Main Street. Fed-induced downturns tend to be swift but short-lived. The subsequent recoveries are usually V-shaped, rather than the elongated U-shaped recoveries that follow financial crises. Nevertheless, central banks around the world will undoubtedly start slashing rates again, perhaps even restarting their QE programs. Traumatized by the Great Recession, central bankers will overreact. The hawks will be blamed for the recession and forced to turn tail. The doves will reassert control. Fiscal policy will be significantly eased. This will be particularly the case if the next recession coincides with Trump's re-election campaign, brewing populism in Europe, and the spectre of military conflict in a variety of hotspots around the planet. Structural Forces Will Boost Inflation Meanwhile, millions of baby boomers will be in the process of leaving the workforce. This will lead to slower income growth, but not to slower spending growth - spending actually rises late in life due to spiraling health care costs (Chart 11). An increase in spending relative to income tends to push up prices. A recent IMF research report estimated that population aging has been highly deflationary over the past few decades, but will be very inflationary over the coming years (Chart 12). Chart 11Savings Over The Life Cycle Chart 12Demographic Shifts: From Highly Deflationary To Highly Inflationary All this suggests that the dip in inflation during the next recession will be fleeting. As the recovery from the shallow recession unfolds, inflation will reaccelerate. Of course, at that point, central banks could step in to aggressively quell inflationary pressures. However, they are unlikely to do so. After the next recession-induced burst of fiscal stimulus, debt levels will be even higher than they are now. The temptation to inflate away this debt will intensify. And, in an environment of anemic real potential GDP growth, the means to generate inflation will become available: Central banks will simply need to keep rates below their "neutral" level. Central bankers will rationalize their actions on the grounds that higher inflation will allow them to bring real interest rates deeper into negative territory in the event of another economic downturn. A growing chorus of eminent economists has begun to argue that a 2% inflation target is too low. For example, just this week, Larry Summers stated that "I think we probably need to adjust our monetary policy framework ... to [one] that provides for higher nominal rates during normal times, so there's more room to cut rates during downturns."3 II. Financial Markets As with the economic outlook, the three words reflation, recession, and stagflation guide our views of where financial markets are heading over the coming years. We continue to maintain a pro-risk stance, but are trimming our overweight recommendation to equities and high-yield credit due to the fact that valuations have gotten stretched and we are entering the last innings of the business-cycle expansion (Table 1). Table 1BCA's Tactical Global Asset Allocation Recommendations* Equities Sticking With Bullish ... For Now Recessions and bear markets tend to go hand-in-hand (Chart 13). None of our recession timing indicators are warning of an imminent downturn, suggesting that the cyclical global equity bull market has further room to run (Chart 14). Chart 13Recessions And Bear Markets Usually Overlap Chart 14AThis Business Cycle Has Further To Run Chart 14BThis Business Cycle Has Further To Run Strong growth in corporate earnings continues to underpin the rally in equities. The MSCI All-Country World index has increased by 11.9% in the first 9 months of the year, only slightly more than the 9.1% gain in earnings. As a result, the forward P/E ratio has only risen from 15.7 at the start of the year to 16.1 (Table 2). Table 2Earnings-Backed Price Appreciation Favor Cyclicals Over Defensives Above-trend global growth should boost profits over the next 12 months. We favor cyclical sectors over defensives, and are expressing this view through our long global industrial stocks/short utilities trade recommendation. The trade is up 0.9% since we initiated it last Friday and up 2.3% since I previewed it at BCA's annual New York Investment Conference earlier the same week. Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. Our model predicts that global capex will grow at the fastest pace in six years (Chart 15). This should benefit industrial stocks. On the flipside, rising global yields will hurt rate-sensitive utilities (Chart 16). Chart 15Global Capex On The Upswing Chart 16Higher Bond Yields Will Hurt Utilities Financials should also outperform. Banks, in particular, will benefit from steeper yield curves, faster credit growth, and ongoing declines in nonperforming loans. Energy stocks are also attractive. As discussed below, we continue to maintain a generally upbeat view on the direction of oil prices. Prefer DM Over EM, Europe And Japan Over The U.S. While it is a close call, we see more upside for DM than EM stocks, as the former are less vulnerable to a dollar rebound and an increasingly hawkish Fed. Emerging market equities have had a good run over the past year, and are due for a breather. Our favorite EM equity idea for the fourth quarter is to be long Chinese H-shares. H-shares are heavily tilted toward financials and deep cyclicals, two sectors that we like. They also trade at a mere seven-times forward earnings and one-times book value (Chart 17). Within the DM space, European and Japanese equities should outperform U.S. stocks in currency-hedged terms. The sector composition of both the European and Japanese market is tilted toward stocks that will gain the most from strong global growth and increased capital spending. As our European strategists have documented, the European stock market is dominated by large multinationals whose fortunes are tied more to the global economy than to domestic prospects. This is largely true for the Japanese stock market as well. If our prediction for a somewhat weaker euro and yen comes to pass, profits in both regions will benefit from the currency translation effect. Valuations in Europe and Japan are also generally more attractive than in the U.S, even if one adjusts for different sector weights (Chart 18). Chart 17Chinese H-Shares: A Valuation Snapshot Chart 18U.S. Stocks Look Pricey Small Cap Value Trumps Large Cap Growth Style-wise, we prefer small cap value over large cap growth. Value stocks generally do better in environments where cyclicals are outperforming defensives, while small caps tend to be high-beta bets on global growth (Chart 19). U.S. small caps will disproportionately benefit from cuts to statutory corporate taxes, since smaller companies typically have less ability to game the tax code in their favor. Timing The Next Bear Market As one looks beyond the next 12 months, the skies begin to darken for global equities. The stock market usually sniffs out recessions before they happen, but the lead time is quite variable and generally not that long (Table 3). For example, the S&P 500 peaked only two months before the start of the Great Recession in December 2007. Chart 19Favor Cyclicals And Value Plays Table 3Stocks And Recessions: Case-By-Case Chart 20Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment If the next recession begins in the second half of 2019, global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities are likely to fall 20%-to-30% peak-to-trough. While other global bourses are generally not as expensive, their higher-beta nature means that they will probably face similar if not worse declines. The fact that correlations tend to rise during risk-off episodes will only add to the bloodshed. Stocks And Stagflation If the experience of the 1970s is any guide, equities perform poorly in stagflationary environments (Chart 20). Investors tend to see stocks as a riskier substitute for bonds. When nominal bond yields rise, the dividend yield offered by stocks becomes less attractive. In theory, the increase in the nominal value of corporate net worth resulting from higher inflation should generate enough capital gains over time to compensate for the wider gap between dividend yields and bond yields. In practice, due to "money illusion" and other considerations, that does not fully occur, requiring that stocks become cheaper so that their expected return can rise. The Long-Term Outlook For Profit Margins A complicating factor going into the next decade will be what happens to profit margins. S&P 500 operating margins are close to their all-time highs (Chart 21). While margins will undoubtedly fall during the next recession, their subsequent recovery is likely to be encumbered by a number of shifting structural forces. A slew of labor-saving technological innovations depressed labor's share of income over the past few decades. So did the entry of over one billion new workers into the global labor force following the collapse of the Berlin Wall and China's transition to a capitalist economy. The fixation of central banks on bringing down inflation may have led to higher unemployment than what would otherwise have been the case, thereby undermining the bargaining power of workers. All this may change during the next decade. China's labor force has peaked and is on track to decline by over 400 million workers by the end of the century - a larger decline than the entire U.S. population (Chart 22). A shift towards persistently more expansionary monetary policy could also keep the labor market fairly tight. Chart 21U.S. Profit Margins Are Close To All-Time Highs Chart 22China On Course To Lose More Than 400 Million Workers Technological innovation will persist, but the firms that benefit from it are likely to attract more scrutiny from regulators. Republican voters - the traditional defenders of corporate America's God-given right to make a buck - are growing increasingly wary of big business. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to be liberal on social issues and conservative on economic ones. Very few voters actually share this configuration of views (Chart 23). The Democratic Party's "Better Deal" moves it to the left on many economic issues. This runs the risk of leaving the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. Bottom Line: Investors should stay overweight global equities, but trim exposure from moderate overweight to small overweight due to rising business-cycle risk, and look to get outright bearish late next year. The long-term outlook for equities is poor, especially in the U.S. where valuations are highly stretched. Chart 24 presents a stylized sketch of how we think the major stock market indices will evolve over the coming years. Chart 23An Absence Of Libertarians Chart 24Market Outlook: Equities Fixed Income Above-trend GDP growth and rising inflation are likely to push up long-term bond yields in most economies over the next few quarters, as flagged by our Central Bank Monitors (Chart 25). Bond yields will fall during the next recession and then begin to inexorably rise higher as stagflationary forces intensify (Chart 26). Looking out over the next 12 months, our regional allocation recommendations are as follows: Chart 25Our Central Bank Monitors Point To Growing Pressures To Tighten Chart 26Market Outlook: Bonds Underweight The U.S., Euro Area, And Canada Chart 27Canada Enjoys Robust Growth We remain underweight U.S. Treasurys in a global fixed-income portfolio. The market is pricing in only 44 basis points in Fed hikes between now and the end of next year, well below the 100 basis points of hikes implied by the dots in the Summary of Economic Projections. The U.S. yield curve has flattened since the start of the year. This should change over the next 12 months, as inflation expectations rebound from currently depressed levels. The yield curve in the euro area should steepen more than in the U.S., since the ECB has pledged not to raise rates until well after its asset purchase program is complete - something that is unlikely to happen until the end of next year. This implies that the 2-year spread between the two regions will widen in favor of the U.S., which should be bullish for the dollar. Canadian bond yields are likely to rise further (Chart 27). The unemployment rate has fallen to a nine-year low and the Bank of Canada expects the output gap to be fully closed by the end of this year. The economy grew by 3.7% year-over-year in the second quarter, well above the BoC's estimate of potential real GDP growth of 1.5%. The Bank's most recent Business Outlook Survey points to continued robust growth ahead. The bubbly housing market remains a concern, but delaying withdrawal of monetary accommodation risks exacerbating the problem. Neutral On Gilts And Aussie And Kiwi Bonds In contrast to most other developed economies, leading indicators point to slower U.K. growth in the months ahead (Chart 28). This undoubtedly reflects the ongoing uncertainty over Brexit negotiations, which are likely to drag on for quite some time. Core inflation has surged to 2.7% on the back of the sharp depreciation of the pound, but market expectations suggest that it is about to roll over. Nevertheless, with 10-year gilts fetching just 1.35%, the downside for yields is limited. The cheap pound should also prop up exports, partly offsetting the impact of diminished market access to the rest of the EU. The unemployment rate stands at 4.3%, slightly below the Bank of England's estimate of NAIRU. One way or another, the uncertainty over Brexit will fade, allowing gilt yields to move higher. As with gilts, the outlook for Australian and New Zealand bonds is mixed. Strong global growth should boost commodity prices. This will help the Australian economy. The unemployment rate in Australia has fallen to 5.6%, but involuntary part-time employment is high and wage growth has been stagnant. Industrial capacity utilization remains low, as reflected in a fairly large output gap (Chart 29). The market expects the RBA to deliver 38 basis points in rate hikes over the next 12 months. We think that's about right. New Zealand's 10-year yield stands at a relatively generous 2.96%, which makes it difficult to be too bearish on kiwi bonds. However, we do not see much scope for yields to fall from current levels. Nominal GDP is growing at over 5% and retail sales are expanding at nearly 7% (Chart 30). The terms of trade have risen to their highest level since the 1970s. The output gap is now fully closed and core inflation is edging higher. Despite this good news, the policy rate remains at a record low of 1.75%. We concur with market expectations that the RBNZ will start raising rates next year. Chart 28U.K. Growth Is Slowing Chart 29There Is Still Slack In The Australian Economy Chart 30New Zealand: Upbeat Indicators Overweight JGBs CPI swaps predict that inflation in Japan will average only 0.5% over the next twenty years. As we argued last week, this is far too low.4 The secular drivers of deflation are fading and inflation will begin to surprise to the upside over the coming years (Chart 31). However, the path between here and there will be a choppy one. Considering that deflationary expectations remain deeply entrenched, the Bank of Japan is unlikely to abandon its yield curve targeting regime for at least the next few years. As government bond yields rise elsewhere in the world, 10-year JGBs will be the default winners. Investors thinking of going short Japanese government bonds should focus on 20-year or 30-year maturities, which are not subject to the BoJ's cap. Credit: Still Overweight, But Trimming Back Exposure High-yield credit spreads have fallen back near their post-recession lows after widening in the wake of the global manufacturing recession (Chart 32). We see little scope for further spread compression. Our U.S. Corporate Health Monitor remains in deteriorating territory (Chart 33), and higher Treasury yields will put downward pressure on corporate bond prices even if spreads remain constant. Nevertheless, the default-adjusted spread on U.S. high-yield debt of 212 basis points is still large enough to warrant a modest overweight to credit, especially since banks have started to loosen lending standards again. Chart 31Japan: Fading Deflationary Forces Chart 32High-Yield Spreads Have Narrowed Chart 33U.S. Corporate Health Continues To Deteriorate Our Global Fixed Income Strategists prefer U.S. over European credit, given that spreads are lower in Europe, and the tapering of ECB asset purchases could reduce the demand for spread product. Currencies And Commodities The Dollar: Comeback Kid? Charts 34 and 35 show our expectations about the future path of the major currencies and commodities. Chart 34Market Outlook: Currencies Chart 35Market Outlook: Commodities BCA's Global Investment Strategy service went long the dollar in October 2014. We reiterated our bullish stance before the U.S. presidential elections, controversially arguing that "Trump Will Win And The Dollar Will Rally."5 Unfortunately, we remained long the dollar over the course of this year, which turned out to be a mistake. Strong growth abroad, weaker-than-expected inflation readings in the U.S., and the fizzling of the "Trump Trade" all contributed to dollar weakness. Technicals also played a role. Sentiment was extremely bullish towards the dollar at the start of the year, but extremely bearish towards the euro (Chart 36). The reversal of these technical trends helps explain why the euro appreciated a lot more than what one would have expected based simply on changes in interest rate differentials (Chart 37). Chart 36Euro: Long Positions Are Getting Stretched Chart 37The Euro Has Overshot Interest Rate Spreads Of course, if the spread between U.S. and euro area interest rates continues to narrow, it is likely that EUR/USD will strengthen. We are skeptical that it will. For one thing, financial conditions have eased sharply in the U.S. since the start of the year, but have tightened in the euro area (Chart 38). This suggests that U.S. growth will surprise on the upside whereas euro area growth could begin to disappoint. Chart 38U.S. Versus Euro Area Diverging Financial Conditions The five-year, five-year forward OIS spread between the two regions stands at 87 basis points in nominal terms, and 25 basis points in real terms. The five-year forward spread is even lower if one calculates a GDP-weighted bond yield for the euro area rather than looking at the expected path of interbank rates. Such a small spread is inconsistent with the fact that the neutral rate is substantially higher in the U.S.6 We expect EUR/USD to fall to $1.15 by the end of 2017, and potentially decline further in 2018 as the Fed picks up the pace of rate hikes. The dollar is also likely to strengthen against the yen, as Treasury yields rise relative to JGB yields. We see less downside for the British pound and the Swedish krona against the greenback. This is reflected in our long GBP/EUR and long SEK/CHF trade recommendations, both of which remain in the black. Upside For Oil-Sensitive Currencies Our energy strategists still see further upside for crude oil prices, owing to favorable supply and demand conditions. They point to the fact that official forecasts by the EIA have consistently underestimated oil demand. They also note that compliance with OPEC 2.0 production cuts has been remarkably good, and that estimates of how much new shale output will hit the market over the next 12 months are too optimistic. Additionally, they believe that the decline in production from conventional oil fields around the world - especially offshore fields, where there has been a dearth of new investment in recent years - could be larger than expected.7 Geopolitical risks in Iraq, Libya, and Venezuela could also adversely affect supply. Firmer demand and lackluster supply will lead to further drawdowns in OECD oil inventories, which should be supportive of prices (Chart 39). We recently took profits of 13.8% on our recommendation to go long the December-2017 Brent oil futures contract, but are maintaining exposure to oil through our long CAD/EUR and RUB/EUR positions, as well as through our bias towards cyclical equities. Resilient Chinese Economy Should Support Metal Prices And The RMB Recent Chinese data have been on the soft side, giving rise to fears that the economy is heading towards a major slowdown. We are more optimistic. While growth has clearly slowed since the start of the year, it remains at an above-trend pace, as evidenced by numerous real-time measures of economic activity (Chart 40). Chart 39Falling Oil Inventories Should Lead To Higher Crude Prices Chart 40Chinese Economy: No Need To Be Pessimistic Even the housing market has managed to stay resilient, despite widespread predictions of imminent doom (Chart 41). The share of households planning to buy a new home remains close to all-time highs. The amount of land purchased by developers - a good leading indicator for housing starts - is accelerating. Reflecting these developments, property stocks are surging. Financial conditions have tightened, but so far this has largely bypassed the real economy. In fact, long-term bank lending to nonfinancial institutions has accelerated since the start of the year (Chart 42). The recently announced cuts to reserve requirements for small business loans should facilitate this trend. Chart 41Chinese Housing Market Remains Resilient Chart 42Credit To Real Economy And Profit Rebound Bode Well For Capex Meanwhile, industrial profits have rebounded, as rampant producer price deflation last year has given way to modest price gains this year. Increased retained earnings will give Chinese companies the wherewithal to spend more on capital equipment. A recovery in global trade should also help stoke export growth. (Chart 43). Despite strengthening this year, our indicators suggest the yuan is still in undervalued territory (Chart 44). Buoyant economic growth should alleviate capital flight and reduce the pressure on the authorities to engineer a further depreciation of the currency. This, in turn, should help support metal prices and other EM currencies, even in a setting where the dollar remains well bid. Chart 43Positive Global Trade Momentum: A Tailwind For Chinese Exports Chart 44The Chinese Yuan Is Undervalued Chart 45Gold: Waiting For Drivers Of Sustained Price Appreciation Buy Gold ... But Not Yet Lastly, a few words on gold. Gold does well in situations where real rates are falling and the dollar is weakening (Chart 45). That's not the environment we find ourselves in today. Gold will have its day in the sun, but probably not before the stagflationary era begins in earnest after the next recession. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This revenue loss is measured against a baseline where a number of tax breaks, which are currently set to expire, are extended. Please see BCA Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 3 Summers, Lawrence, H. (@LHSummers). "Great piece by @jasonfurman in today's @WSJ: The U.S. can no longer afford deficit-increasing tax cuts." 01 Oct 2017. Tweet. 4 Please see Global Investment Strategy Weekly Report, "Three Tantalizing Trades," dated September 29, 2017. 5 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016. 6 Please see Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017. 7 Please see Commodity & Energy Strategy, "OPEC 2.0 Will Extend Cuts to June 2018," dated September 21, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Either China's growth will slump soon, capping budding inflationary pressures, or policymakers will have to hike interest rates meaningfully to tackle inflation. If the PBoC drags its feet and does not hike interest rates amid rising inflation, the RMB will come under major selling pressure. EM/China corporate profits have expanded predominantly due to price increases. However, rapid price increases warrant higher interest rates. The latter is a formidable risk to share prices. The U.S. dollar has made a major bottom. Stay short select EM currencies. The EM equity rally momentum remains strong but the risk-reward is quite unfavorable. We expect the external backdrop - metals prices and portfolio flows to EM - to deteriorate inhibiting the current easing cycle in Peru. Stay underweight this bourse within the EM universe (page 13). Feature A key question for investors at the current juncture is whether the global economic backdrop is moving toward inflation or deflation - or whether it will remain in its present "goldilocks" state. One can cite numerous examples that support each of the three scenarios. Proponents of deflation cite low consumer price inflation in the U.S., euro area and Japan, as well as very weak money growth in China and the U.S. as being leading indicators of budding deflationary pressures. Advocates of goldilocks - improving growth with low inflation - point to robust global trade and low consumer price inflation, as well as benign financial market dynamics in the form of higher share prices and low bond yields. Last but not least, inflationists can cite very tight labor markets among advanced economies as well as rising core and services consumer price inflation rates in China (Chart I-1). Chart I-1China: Inflation Is Grinding Higher At BCA's annual conference in New York held last week, the broad consensus was that there is a lack of considerable inflationary pressures worldwide amid improving global growth. This is consistent with the goldilocks outcome currently priced by the financial markets - i.e., a combination of robust growth and low inflation. Given the current pricing in financial markets, one economic variable that could disturb benign global financial dynamics is inflation. This report examines inflationary dynamics in China and briefly touches on the U.S. and euro area inflation outlooks. Our take is as follows: Unless China's money and credit growth slow further and generate another deflationary slump in China and world trade, the odds are that the balance both globally and within China will tilt toward inflation in the next 12 months. To be clear, our main theme remains that a material slowdown in China's growth will dampen China/EM growth, derail the EM corporate profit recovery and cap inflationary pressures in China, at least. Therefore, to some extent, this report is counter-factual - it examines what may happen if a meaningful growth deceleration in China does not transpire. Our analysis also addresses the question of what may happen if policymakers in China allow money/credit to accelerate again, without permitting the economy to slow too much. The short response: Inflation is already slowly but surely rising in China and it will soon become a constraint, limiting Chinese policymakers' options. China/Asia Recovery: Prices Or Volumes? China's industrial revival, as well as Asia's export recovery over the past 12-18 months, has largely been due to price increases amid modest volume growth. In particular: China's manufacturing production volume growth has not improved at all, but manufacturing producer prices have surged, producing substantial recovery in nominal output growth (Chart I-2). This is strictly within manufacturing, and does not include mining and ferrous metal production, where output cuts have led to surging prices for raw materials. In brief, one can observe higher inflation beyond the steel and coal industries. Furthermore, producer price inflation has improved for consumer goods (Chart I-3, top panel), and for the first time in 17 years ex-factory producer price deflation has ended in durable consumer goods as well as in electronics goods and communication equipment (Chart I-3, middle and bottom panels). Chart I-2China's Industrial Recovery: Surging ##br##Prices Amid Subdued Volume Growth Chart I-3China: Producer Price ##br##Inflation Is Broad-Based Notably, China's core (ex-food and energy) consumer price inflation has moved above 2%, and consumer services price inflation has risen to 3% (Chart I-1 on page 1). Importantly, these consumer inflation measures have risen, even though food prices are deflating in China and energy prices are stable. This entails that consumer price inflation pressures are genuine and reasonably broad-based. In Asian trade, the dichotomy between prices and volumes is especially apparent in the case of Korea's exports. The U.S. dollar value of Korean exports has mushroomed, but there has been only modest revival in export volumes (Chart I-4). Remarkably, both the 2014-'15 slump and the 2016-'17 recovery in Korean exports were largely due to prices, not volumes. The latter have been expanding modestly in recent years, while prices crashed in 2013-'15 and surged in 2016-'17. Finally, Korean and Taiwanese export prices as well as U.S. import prices from Asia have risen in the past 12-18 months, following years of deflation (Chart I-5). Chart I-4Korean Export Recovery: Prices Versus Volumes Chart I-5Asian Export Prices: A Reversal? Beyond higher prices for steel and other commodities, Korea's export prices are climbing because of skyrocketing DRAM semiconductor prices (Chart I-6). Price changes are much more important to corporate profits than volume changes. For example, a 5% rise in prices boosts corporate profits by much more than a 5% gain in output volume. By the same token, profits decline more when prices drop by 2% than when volumes fall by 2%. We discussed this phenomenon and illustrated an example in our January 28, 2016 report.1 Rising prices across various commodities and manufactured goods have allowed Chinese and Asian companies to deliver strong profits in the past 12 months. China's industrial profits have ballooned, even though output volume growth has been modest. On the whole, the enormous money/credit injection in China in the past two years has hindered lingering price deflation and led to rising prices for various goods and services. Chart I-7 illustrates that the recovery in corporate pricing power and, hence, mushrooming industrial corporate earnings can be attributed to the mainland's credit/money impulses. Chart I-6DRAM Semi Price Has ##br##Surged 4-Fold In Last 12 Months Chart I-7China: A Peak In Producer ##br##Prices And Industrial Profits? If pricing power deteriorates, as the money/credit impulse is signaling, corporate earnings will be at risk. In such a scenario, inflation will not be a problem, as deflationary pressures will resurface. However, corporate profits will shrink. Bottom Line: EM/China corporate profits have expanded predominantly due to price increases. Investors have celebrated it by flocking into EM/Chinese stocks. However, rapid price increases warrant higher interest rates. The latter is a formidable risk to share prices. Barring a material growth deceleration in China, which is our baseline view, odds are that inflation will rise further. Why Now? Inflation is rising in China because of rampant money/credit creation complemented with a weak productivity growth rate. In addition, policymakers have engineered a reversal in raw materials price deflation since early 2016. It is impossible to know if the Chinese economy has reached a point where growth rates of 6-6.5% and above will lead to inflation. It is hard to estimate potential GDP growth rates and output gaps for advanced countries, but it is practically impossible to do so in the case of China. Its economy has undergone multiple dramatic structural transformations in the past 30 years, changes that continue today. That said, it is possible to argue that China may have reached a point where further rampant money and credit creation leads to higher inflation. The key thesis is that productivity growth has slowed because of the following: Channeling credit to SOEs - which often misallocate capital - and to property markets does not boost productivity. Infrastructure projects will take years to produce productivity gains, even if they are well thought out. Chart I-8 illustrates that in recent years an increasing share of investment has been on structures and installations rather than equipment and new technologies. Investment in structures does not boost productivity as much as equipment purchases. Meanwhile, private capital spending has been in the doldrums over the past four years, as has been the case for manufacturing investment (Chart I-9). This argues for less efficiency/productivity and, thereby, diminished potential growth. Chart I-8Unfavorable Mix For Productivity Growth Chart I-9Private And Manufacturing Capex Remain Weak Historically, it was private investment and manufacturing capacity expansion that fostered productivity gains in China. Private projects are often more efficient than public investment, and it is much easier to achieve higher productivity in manufacturing than in the service sector. This is not to argue that there are no innovation and rapid technological changes in China. A lot of innovation and technological advancement is happening but it might not be sufficient to boost productivity growth above 6% (Chart I-10). China's extremely fast productivity gains in the past 20 years have largely been due to rapid expansion of manufacturing and construction. Manufacturing cannot rise fast because it is hard for China to gain more market share in global trade without causing political backslashes. In turn, construction has been driven by excessive credit expansion and property market speculation and policymakers want to reduce this. It is imperative to understand that in any country productivity is much lower in the service sector than in manufacturing and construction. A shift away from manufacturing and construction toward services will surely lead to much lower productivity and, hence, potential economic growth. If policymakers allow/encourage rapid money/credit expansion to achieve growth rates above 6-6.5% or so, the outcome will be inflation. Implications For Chinese Policymakers If economic growth does not slow, odds are that inflation will continue to rise in China due to a lower potential GDP growth rate. As such, policymakers will have to tackle inflation by raising interest rates. The deposit rate in China is at 1.5%, and is presently negative when deflated by core consumer price inflation (Chart I-11). This is occurring for the first time in ten years. Chart I-10Potential Growth = Labor Force + ##br##Productivity Growth Chart I-11China: Deposit Rate In ##br##Real Terms Is Negative If inflationary pressures continue building up and policymakers do not hike interest rates, households will become even more dissatisfied by negative deposit rates and opt for converting their RMB deposits into foreign currency, or buying real estate. Both scenarios will eventually lead to financial instability, which policymakers are trying to avoid. Chart I-12 demonstrates that the current level of foreign exchange reserves of US$ 3.3 trillion is equal to only 34% of household deposits and 15% of total (corporate and household) deposits, and 10% of our broad M3 money measure. In brief, the failure to proactively hike deposit rates will likely lead to capital flight. Policymakers realize that the Chinese banking system has created so much money that even the sheer size of foreign currency reserves is insufficient to defend the currency if and when households and companies choose to convert their liquid savings into foreign currency. This argues for higher interest rates in China, unless growth downshifts very soon and caps inflation. Bottom Line: Either China's growth will slump soon, capping budding inflationary pressures, or policymakers will have to hike interest rates meaningfully to avoid another run on the exchange rate. What About DM And Non-Asian EM? In the majority of non-Asian EM economies, inflation is either muted or under control. The exceptions are Turkey and central European economies. We have discussed the inflation outbreak in central Europe in detail in past reports (also see Chart I-13 below), and will be revisiting Turkey next week.2 Chart I-12Too Much Money Has Been Created Chart I-13Inflation Outbreak In Central Europe The basis is that there has been little recovery in Latin American economies as well as Russia and South Africa for inflationary pressures to transpire. While some may be prone to structural inflation, cyclical business conditions are still too weak to warrant rising pricing power. In the Euro Area, investors should closely monitor German wage dynamics. Manufacturing wages and core consumer price inflation in central Europe are ramping up (Chart I-13). If and when labor shortages and rising wages in central Europe discourage German manufacturing companies from relocating/outsourcing production to the former, it will put more pressure on the already very tight German labor market and will lead to higher wages. As a result, genuine inflation in the largest European economy will heighten. In the U.S., the tight labor market and vibrant growth argue for higher inflation ahead. The Trump administration's proposed tax cuts amid robust growth will boost demand and rekindle inflation. Bottom Line: Inflation expectations are very depressed worldwide, and it will not take much in the way of upward inflation surprises to re-price interest rate expectations and, consequently, financial assets. Financial Markets Ramifications The Foreign Exchange Market: The U.S. dollar has probably made a major bottom and will stage a multi-month rally (Chart I-14). Chart I-14Will The Greenback Find ##br##Support At Current Levels? The Federal Reserve will be the first central bank to hike interest rates if global inflation or inflation expectations rise. In turn, the European Central Bank and the People's Bank of China will likely move slower in tightening policy. Such a proactive policy stance of the Fed, especially relative to its peers, will benefit the greenback. Furthermore, the potential appointment of Kevin Warsh as Fed Chairman could lead to higher interest rate expectations in the U.S., and will be currency bullish. In short, the potential mix of tight monetary policies and easy fiscal policies is bullish for the dollar. In the interim, U.S. bond yields are likely to move higher. This is true in the near term, even if Chinese growth disappoints. It will take time until China's growth deceleration caps the upside in U.S./global bond yields. Consistent with our U.S. dollar view, we believe commodities prices have reached a major peak. In sum, the path of least resistance for the U.S. dollar is up. Stay long the U.S. dollar versus a basket of EM currencies: ZAR, TRY, MYR, IDR, BRL and CLP. Local Currency Bonds: As and when EM currencies depreciate versus the greenback and U.S. bond yields grind higher, EM high-yielding local currency bonds could sell off. Chart I-15 reveals that the spread between the EM-GBI local currency benchmark yield and five-year U.S. Treasurys has fallen to a 10-year low. The risk-reward is not attractive for U.S. dollar- and euro-based investors. EM credit versus U.S. investment grade bonds. On August 16, 2017, we advised shifting our underweight EM sovereign bonds recommendation away from U.S. high yield to U.S. investment grade corporate credit. This strategy remains intact. This is consistent with EM currencies depreciating versus the U.S. dollar, U.S. bond yields moving higher and commodities prices softening. Continue underweighting EM stocks versus DM: A stronger U.S. dollar and rising U.S. bond yields will reverse EM equities' relative outperformance versus DM. In fact, manufacturing PMIs certify that EM manufacturing growth remains subdued relative to DM (Chart I-16). Chart I-15EM Local Currency Bonds: Little Yield Advantage Chart I-16EM Equities Versus DM: A Sign Of Reversal? If this coincides with inflation or growth concerns in China, it will create a perfect storm for all EM risk assets. As to EM stocks' absolute performance, we are approaching a major top, even though the exact timing of a major relapse is uncertain. Flows into EM equities remain robust, but they will reverse if one or more of the following transpires: rising U.S. interest rate expectations, a stronger U.S. dollar, high and rising inflation in China and policy tightening, or the opposite - an imminent growth slump in China and a relapse in commodities prices. All in all, the EM equity rally momentum remains strong but the risk-reward is quite unfavorable. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Peru: External Backdrop Holds The Key The external environment has been and will remain key to the performance of Peruvian financial markets. The Peruvian bourse has rallied massively, outperforming the EM equity benchmark over the past year, even as domestic demand in Peru has been weakening. Despite stronger global growth and higher commodities prices, GDP growth along with consumer and capital growth have not recovered at all (Chart II-1). Meanwhile, bank loan growth remains very weak (Chart II-2). Chart II-1Peru: Weak Domestic Demand... Chart II-2...Corroborated By Weak Credit Growth If metals prices stay firm and strong capital flows in EM persist, Peru's currency will remain under appreciation pressure. This will provide the central bank with more room to ease policy by cutting interest rates and adding liquidity to the banking system as it accumulates foreign exchange reserves (Chart II-3). Continued policy easing by the central bank will in turn revive bank loan growth, and the economy will recover. Chart II-3FX Reserve Accumulation = Liquidity Easing Our baseline scenario, however, is that industrial metals prices in general and copper prices in particular will relapse materially in the next 12 months. Furthermore, odds are that U.S. bond yields will drift higher and the U.S. dollar will strengthen (as discussed on pages 11-12). Under such a scenario: The Peruvian sol would come under depreciation pressure if and when metals prices relapse (Chart II-4). With precious and industrial metals representing 60% of total exports, a drop in metals prices will lead to considerable deterioration in Peru's trade balance and FDI inflows will slump. The central bank is committed to maintaining a stable exchange rate due to high foreigner ownership of government local currency bonds and a still-partially dollarized economy. Hence, if the currency comes under attack, the central bank will defend the sol by selling its international reserves, which will deplete local currency liquidity (Chart II-3). Consequently, local rates will rise and banks will curtail bank loan growth, which in turn will preclude any recovery in domestic demand. Overall, the external environment and its impact on the exchange rate holds the key for a domestic-led recovery. A relapse in industrial metals and copper prices and ensuing depreciation pressure on the currency will undo the recent loosening in monetary policy and stall a potential domestic demand recovery. In terms of financial markets strategy, we recommend the following: Despite domestic demand weakness, the Peruvian equity market has been on a tear, led by banking and mining stocks. Given our negative view on industrial metals and copper prices, we recommend staying underweight Peruvian equities relative to the EM benchmark (Chart II-5). Chart II-4Terms Of Trade Dictate The Currency Chart II-5Has Peru's Relative Equity Performance Peaked? With respect to our absolute call on bank stocks and our relative trade versus Colombian banks, we recommend closing both trades with large losses. Finally, we recommend being long Peru credit relative to Brazilian sovereign credit. Public debt burden is much lower in Peru (24% of GDP) than in Brazil (74% of GDP). Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Corporate Profits: Recession Is Bad, Deflation Is Worse," dated January 28, 2016, link available at ems.bcaresearch.com 2 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, and Emerging Markets Strategy Weekly Report, dated September 6, 2017; pages 15-18; links are available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Oil Breakout: Bond markets have been slow to discount the impact of higher oil prices on global inflation, which should lead to steeper yield curves and additional increases in inflation expectations. Trump Trade: The proposed U.S. tax cut plan will result in wider budget deficits and, potentially, faster U.S. inflation with the U.S. economy already near full employment. The Fed is likely to respond to this with even tighter monetary policy, although not by enough to flatten the Treasury curve by as much as is currently discounted. ECB Taper: The ECB will announce a slower pace of asset purchases at the policy meeting later this month, which should bear-steepen European yield curves via widening term premia on longer-dated debt. Feature A More "Normal" Bond Market Chart of the WeekLike Deja Vu All Over Again Global bond yields have bounced very sharply off the September lows. The benchmark 10-year U.S. Treasury yield hit a 3-month intraday high of 2.37% yesterday, while the 10-year German Bund yield touched 0.5% last week. Bond markets have returned to focusing on traditional fundamentals, like growth and inflation, after spending a few weeks worrying about nuclear tensions with North Korea and other political matters. On that note, the global economic news continues to point towards continued solid growth, rising inflation pressures and, in response, less accommodative monetary policy. There is scope for additional increases in bond yields, as markets are still pricing in too much pessimism on inflation and too little hawkishness from central bankers. The latter is especially true in the U.S. where the Federal Reserve is sticking with its plans to deliver another 100bps of rate hikes by the end of 2018 if its growth and inflation forecasts are realized. The odds of that happening would increase substantially if the Trump Administration can successfully deliver tax cuts, which would represent a very rare occurrence of a fiscal stimulus coming at a time of full employment in the U.S. The announcement last week of the Trump tax cut proposals did send a whiff of the old "Trump trade" dynamic through financial markets. The U.S. Treasury curve bear-steepened, the U.S. dollar rallied, inflation expectations rose and the S&P 500 blasted through the 2500 level to hit a new all-time high. Stocks of companies that pay higher tax rates outperformed, just like they did after the election of President Trump nearly one year ago (Chart of the Week). Add in some additional reflationary pressure from Brent oil prices approaching $60/bbl, and it is no surprise that yield curves in most Developed Markets (not just the U.S.) steepened. With this reflationary backdrop, amid tight labor markets and a solid pace of coordinated global growth, we continue to recommend fixed income investors maintain a defensive duration posture, while favoring spread product over government bonds. Yields will continue to rise in the next 6-12 months, but led more by the long-end initially. In particular, we expect government bond yield curves to extend the recent trend of bear-steepening, for three reasons: rising inflation expectations, increased optimism on U.S. fiscal policy and what it means for the Fed, and the upcoming announcement of a tapering of bond purchases by the European Central Bank (ECB). Are Bond Investors Too Complacent On The Inflationary Impact Of Higher Oil Prices? We have received a surprisingly small amount of criticism from the BCA client base about our bearish strategic view on global government bonds in recent months. Perhaps that is because our clients also have a negative opinion on duration risk. At our annual investment conference in New York last week, we conducted polls which showed that a majority of the attendees expect the 10-year U.S. Treasury yield to rise to between 2.5% & 3% by this time next year. At the same time, only 1 in 4 respondents felt that being short duration in U.S. Treasuries was the "contrarian" trade that was most likely to succeed over next 12 months - perhaps because betting on higher yields is not really a contrarian opinion right now! Yet we wonder how aggressively investors in aggregate, and not just BCA clients, are positioned for a rising yield environment. The market is only discounting 40bps of Fed rate hikes over the next twelve months, even as the U.S. economic data flow continues to improve and the Trump Trade is coming back in style (Chart 2). Survey data shows that professional bond managers are running only small duration underweights, yet speculators are still running very net long positions in Treasury futures. In other Developed Markets, there are not a lot of rate hikes priced outside of Canada - where the central bank actually is tightening policy - despite our Central Bank Monitors all calling for policymakers to become less dovish, if not more outright hawkish, as we discussed last week.1 In their defense, bond investors have had a lot of non-economic factors to digest in the past couple of months - not the least of which is judging how much of an "apocalypse premium" to price into bond yields given the nuclear saber rattling between D.C. and Pyongyang. Yet when stepping back away from the headlines and tweets, bond markets have been noting the implications of rising oil prices in a typical manner - higher inflation expectations and steeper yield curves. Oil prices have risen over $10/bbl since the June lows, led by a combination of rising demand on the back of an expanding global economy and a diminished supply response that has seen excessive inventories start to be wound down (Chart 3). BCA's commodity strategists have been expecting such a move to unfold, and prices have already risen into the $55-60/bbl range (on Brent crude) that they were calling for towards year-end. While a move beyond $60/bbl is not currently expected, any additional upside surprises in global growth can only tighten the supply/demand balance in an oil-bullish direction. At a minimum, oil prices can consolidate recent gains, providing a floor to inflation expectations. Already, the breakeven rate on 10-year TIPS in the U.S. have risen 18bps off the June lows, which has prevented the slope of the Treasury curve from flattening even as the 2-year Treasury yield hit an 9-year high last week (Chart 4). We expect to see more bear-steepening of the Treasury curve in the next few months as realized inflation rates begin to grind higher and the Fed will be relatively slow to respond - they'll need to see the inflation pick up first before delivering more rate hikes. This will result in higher market-based inflation expectations (i.e. wider TIPS breakevens) as investors price in a greater chance that inflation will sustainably return to the Fed's 2% target. While oil is not the only factor that matters for U.S. inflation, it is a lot harder for investors to believe that core PCE inflation can rise to 2% without higher oil prices. Chart 2A Revival Of The Trump Trade? Chart 3A Bullish Supply/Demand Backdrop For Oil Chart 4Oil Vs. The U.S. Yield Curve A similar dynamic is taking place in other countries. Inflation expectations (linkers or CPI swaps) are rising alongside rising energy prices in the Euro Area (Chart 5), U.K. (Chart 6), Canada (Chart 7) and Australia (Chart 8). The moves in expectations are largest in countries experiencing stronger growth (the Euro Area and Canada), and more modest where growth is mixed (the U.K.) and where realized inflation is still very low (Australia). Yield curves have generally steepened in response to the reflationary rise in oil prices except for Canada, where the central bank has already delivered two surprise rate hikes over the summer and markets have priced in nearly three more hikes over the next year. Yet even there, global reflation will put steepening pressure on the Canadian yield curve without additional hawkishness from the Bank of Canada. Chart 5Oil Vs. The German Yield Curve Chart 6Oil Vs. The U.K. Yield Curve Chart 7Oil Vs. The Canada Yield Curve Chart 8Oil Vs. The Australia Yield Curve Japan, as always, remains the outlier to global trends. While oil prices have been rising even in yen terms, inflation expectations have remained subdued and the JGB yield curve has stayed flat (Chart 9). With the Bank of Japan targeting a 0% yield on the benchmark 10-year JGB as part of its current monetary policy framework, the link between energy prices, inflation expectations and the slope of the yield curve will remain broken in Japan. This makes JGBs a very low-beta government bond market, and we continue to recommend an overweight stance on Japan given our bias toward a defensive portfolio duration posture. Chart 9Oil Vs. The Japan Yield Curve Net-net, we see oil as continuing to provide a steepening, reflationary bias to global bond yields in the next few months, as the impact of the rise in energy prices feeds through into faster rates of headline inflation. How central banks respond will determine what curves do beyond that but, for now, the bias is towards steeper curves. Bottom Line: Bond markets have been slow to discount the impact of higher oil prices on global inflation, which should lead to steeper yield curves and additional increases in inflation expectations. How Will The Trump Tax Plan Impact The Treasury Curve? Ask The Fed Another factor that will put steepening pressure on global yield curves, especially in the U.S., is the likelihood of the Trump fiscal stimulus coming to fruition. The White House has chosen to refocus its policy efforts on getting aggressive tax cuts implemented. This is low-hanging fruit for a president that needs a legislative victory after fighting a losing battle on health care reform. Last week, the latest Trump tax plan was unveiled, which is centered on delivering large cuts on corporate taxes, reducing the number of personal income tax brackets, eliminating many large tax deductions, allowing companies to fully expense investment spending at an accelerated rate, and introducing a territorial tax system that would exempt U.S. corporate taxes on the foreign earnings of U.S. companies. The Tax Policy Center unveiled its initial assessment of the Trump tax plan last Friday, which is expected to reduce U.S. federal tax revenue by $2.4 trillion over the next ten years and another $3.2 trillion in the following decade.2 The White House is betting on so-called "dynamic scoring" of the tax plan to recoup some of that lost revenue via higher economic growth, although that is filled with unrealistic expectations to prevent an unwanted surge in federal deficits. More likely, the Trump plan would result in a major increase in federal budget deficits over the next decade, similar to the levels estimated by Moody's last year in its own analysis of the Trump fiscal platform.3 In Chart 10, we show how periods of widening federal budget deficits typically coincide with periods of U.S. Treasury curve steepening. Usually, this is merely the business cycle at work, with deficits widening during economic downturns as tax revenues plunge and counter-cyclical government expenditure increases. What is also at work is the monetary policy cycle, with the Fed delivering rate cuts during recessions when the output gap is widening and inflation pressures are diminishing, thus bull-steepening the yield curve. Chart 10Forwards Pricing Too Much UST Curve Flattening Yet the current Trump tax proposal comes at a time when the U.S. economy is operating close to full employment with the output gap essentially closed (middle panel). This means that any impetus to U.S. economic growth from the fiscal easing can cause inflation pressures to build up in a manner different than typical periods of widening budget deficits. This should initially impart steepening pressures on the Treasury curve, but in a bearish fashion via higher longer-term inflation expectations. However, the eventual path for the Treasury curve will be determined by how much the Fed responds to the fiscal easing via tighter monetary policy. Typically, the slope of the Treasury curve is highly negatively correlated to the real fed funds rate (adjusted by headline inflation), with a higher real rate coinciding with a flatter curve and vice versa (bottom panel). Right now, the market is discounting only a modest rise in real U.S. policy rates, looking at the difference between forward Overnight Index Swap (OIS) rates and forward CPI swap rates. That market-implied "real rate" is expected to stay in a modest range between 0% and 1% until well into the next decade. The Fed is also forecasting a rise in the real funds rate to 0.75%, but over a much faster time horizon - within two years - than the market. This is in the context of U.S. core inflation sustainably returning to the Fed's 2% target, which will allow the Fed to eventually raise rates to its current "terminal" rate projection of 2.75%. Thus, when simply eyeballing the relationship between real rates and the slope of the curve in Chart 10, the risk is that real rates will be higher than the market expects over time, and the Treasury curve will be flatter, all else equal. Yet when looking at the slope of the Treasury curve that is currently priced into the forwards, as shown in the bottom panel of Chart 10, a substantial flattening is already discounted over the next decade. Admittedly, the correlation between the real funds rate and the slope of the curve has changed over past decades, and the curve can likely be flatter for a lower level of real yields than in years past. Yet, even allowing for that, the market does seem to be discounting a very aggressive rise in real interest rates over the coming decade - one that is unlikely to be realized unless the Fed delivers a much higher path of interest rates then they are currently projecting. Which brings us back to the Trump fiscal stimulus. If the corporate tax cuts do provide a boost to economic growth next year via increased investment spending and hiring activity, in a way that also overheats the U.S. economy and boosts core inflation, then the Fed may be forced to raise rates at a faster pace than planned. This would result in a much flatter yield curve and would raise the risks of a recession in 2019, which is a scenario we think is highly plausible, especially if there is a change at the top of the FOMC. Late last week, it was revealed that President Trump had interviewed several candidates for the position of Fed Chair. Former Fed governor Kevin Warsh and current governor Jerome Powell were the names that caught the market's attention. Warsh has been a vocal critic of the Fed's slow unwind from the unusual post-crisis monetary policies, and is thus considered a monetary hawk who would want to raise rates higher, and faster, than the current FOMC. Powell is more pragmatic and would likely maintain the status quo at the Fed. The possibility of a more hawkish Fed chair has shown up in online prediction markets, where the "prices" of candidates that are perceived to be more hawkish (Warsh, John Taylor) rose while the prices of the more dovish candidates (Janet Yellen, Gary Cohn) fell (Chart 11). Right now, the online punters have Warsh in the lead, but the intraday "trading" has been volatile. The intersection of U.S. fiscal policy and monetary policy will be critical to determine the future path of U.S. bond yields over the next year. Right now, it appears that there is too much flattening priced into the Treasury curve relative to the expected path of the funds rate and inflation, as the Fed is unlikely to raise real rates much beyond their current projections. That could change if the Trump tax cuts can deliver a faster pace of productivity growth and higher equilibrium real interest rates. Although the post-war history of the U.S. shows that tax cuts by themselves do not raise the potential growth rate of the economy unless they lead to a major increase in investment spending, and even then the impact takes years to be seen (Chart 12). Chart 11Will The Next Fed Chair Be A Hawk? Chart 12Tax Cuts Do Not Always Boost Growth For now, we think it makes more sense to bet against the substantial flattening in the forwards by positioning for a steeper Treasury curve. Bottom Line: The proposed U.S. tax cut plan will result in wider budget deficits and, potentially, faster U.S. inflation with the U.S. economy already near full employment. The Fed is likely to respond to this with even tighter monetary policy, although not by enough to flatten the Treasury curve by as much as is currently discounted. ECB Tapering: Steepening Yield Curves Through The Term Premium The other major factor that should steepen global yield curves in the next several months is the expectation of a change in policy from the ECB. The central bank has been gently preparing the market since the early summer for a shift to a less accommodative policy stance, in response to robust economic growth and slowly rising core inflation (Chart 13). A decision on the changes to the asset purchase program will take place at the October 26th ECB policy meeting. This will involve a reduction in the monthly pace of bond buying and, likely, some guidance as to when the asset purchase program will end. A change in short-term interest rates is highly unlikely before the bond purchases have been fully tapered, as this would go against the current forward guidance from the ECB that states that interest rates will remain at low levels well after the purchases have stopped. As we have discussed throughout this year, we see the ECB having no choice but to begin tapering its asset purchase program. The deflationary tail risks from 2014/15 have faded and, perhaps more importantly, the ECB is running into operational constraints on which bonds it can continue to buy. A likely outcome will be an announcement that the pace of bond buying will slow from the current €60bn/month to least ½ of that pace starting in January 2018. At mid-year, the policy will likely be reevaluated and, if the economy has not slowed materially and/or inflation rolled over, a full tapering of the bond buying would be announced, ending at the end of 2018 or in the first quarter of 2019. A rate hike would not take place until late 2019, which is where the market is currently priced. In the absence of rate hikes, most of the impact on Euro Area bond yields from the tapering will come from a widening of the term premium on longer-maturity bonds. If the pace of growth slows to zero, this could result in the benchmark 10-year German Bund yield returning all the way back to 1% (bottom two panels). This would still be a very low yield by historical standards, in line with structurally lower growth rates and high government debt levels in Europe. But the path to that 1% yield would be very damaging for bond returns as Euro Area yield curves bear-steepen. While the link between our estimates of the term premiums in the major developed markets is not airtight, there has been a loose correlation between them during the post-crisis "quantitative easing" era (Chart 14). If recent history is any guide, a slower pace of ECB bond buying should coincide with steeper global yield curves, all else equal. All else is likely NOT equal, as an unruly response of risk assets and currency markets to a tapering could alter the likely path of growth and inflation expectations and, eventually, interest rates. But, at this moment, an ECB taper is more likely to result in steeper global yield curves. Chart 13An ECB Taper Will Result In##BR##Higher Term Premia In Europe... Chart 14...And Perhaps In Other##BR##Bond Markets, As Well Bottom Line: The ECB will announce a slower pace of asset purchases at the policy meeting later this month, which should bear-steepen European yield curves via widening term premia on longer-dated debt. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "BCA Central Bank Monitor Chartbook: The Less Dovish Rhetoric Is Justified", dated September 26th 2017, available at gfis.bcaresearch.com. 2 http://www.taxpolicycenter.org/sites/default/files/publication/144971/a_preliminary_analysis_of_the_unified_framework_0.pdf 3 https://www.economy.com/mark-zandi/documents/2016-06-17-Trumps-Economic-Policies.pdf Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Oil prices have hit our target, but more upside is likely. President Trump's tax proposal has arrived and the Trump trades have responded. Surging M&A activity is not a sign of a market top. The supports are all in place for a robust period of U.S. capital spending. We expect another solid earnings season in Q3, with little impact from the hurricanes. Feature The S&P 500, Treasury yields and the dollar all rose last week, with the S&P hitting a new all-time high, even as 10-year Treasury yields hit a 2-month high. The sweet spot for risk assets has been extended by the rise in oil prices and rising prospects for tax cuts in the U.S. M&A activity will continue, which is market bullish because it has not yet reached frothy levels. Moreover, capex is blasting off, which will give growth (and EPS) another boost. The downtrends in both Treasury yields and the dollar this year are over, and they both have more upside given that economic growth and underlying inflation are both improving. Moreover, the FOMC is still in a position to deliver on a December rate hike with 2-3 additional hikes in 2018, which will be a wake-up call for bonds and will reverse this year's dollar weakness. More Upside In Oil Prices Last week, both Brent ($57.50/bbl) and WTI ($51.60/bbl) hit the midpoints of the ranges set by our commodity and energy strategists earlier this year. This milestone provides us with an opportunity to revisit BCA's stance on the oil market. OPEC's deal to cut production will be extended to at least June 2018. Based on BCA's latest assessment of the global oil market,1 OPEC 2.0 will fall short of reducing visible inventories to their 5-year average if the coalition's production cut agreement expires which was initially agreed upon in March 2018. Extending OPEC 2.0's cuts through December 2018 would nudge OECD commercial inventories closer to levels originally targeted by OPEC 2.0 at the end of last year (Chart 1). Therefore, in 2018 we expect WTI to average slightly less than $57.50/bbl and Brent to average just under $59/bbl. Accordingly, there is a higher risk that prices will exceed the upper end of our WTI range ($45/bbl to $65/bbl) with greater frequency next year. Furthermore, BCA's Commodity & Energy Strategy team has raised its global oil demand forecasts for both 2017 and 2018; increased demand will support prices in the next 12 months (Chart 2). Chart 1OPEC 2.0 Needs To Extend Cuts,##BR##To Reduce Global Inventories Chart 2Base Case For BCA Oil Supply-Demand Balances##BR##Reflects June 2018 Expiry Of OPEC 2.0 Cuts Geopolitical risks in Iraq and an escalation in supply disruptions add to BCA's bullish view. The Kurd's vote for independence from Iraq last week will elevate tensions in the region and could trigger a civil war. If a war breaks out over Kirkuk, it will lead to production cuts. Furthermore, civil war in Iraq would reduce the flow of FDI into Iraq's oil infrastructure, further crimping output. Moreover, Russia, which supports the Kurd's fight, would also benefit from high oil prices. Oil production wildcards in 2017 mostly favored more oil output. However, in 2018, supply disruptions will curtail global oil output. Bottom Line: Additional supply cuts, higher demand, elevated tensions in Iraq and a normal spate of supply disruptions, all suggest that there is upside risk to our $45-$65 stance on WTI. A risk to this forecast is a sharply higher dollar linked to expansionary fiscal policy. Tax Cuts Imminent Chart 3Trump Trades Making A Comeback As BCA's Geopolitical Strategy service predicted last month, President Trump's long-awaited tax plan will likely be enacted in Q1 2018. Trump and the Republicans in Congress, still desperate for a legislative win after again failing to repeal and replace Obamacare, introduced the proposal last week. However, the plan must clear several hurdles before it becomes law. First, the proposals may run afoul of both deficit hawks and moderates in the Congress' Republican caucus. The initial framework has tax decreases, but no revenue or spending offsets. The implication is that the package would blow out the deficit, alienating the fiscal conservatives. Moderates may not like the lack of cuts for the middle class. Democrats have not yet had their say. The CBO still must score the legislation, and even with dynamic scoring2 which counts on stronger economic growth to boost revenues and reduce outlays for automatic stabilizers and some social programs, it will add to the deficit. This may also cause an uproar in Congress. Nonetheless, on a positive note, Trump has the support of the influential House Ways and Means Committee, as well as the Senate Finance Committee. This was not the case with the Obamacare repeal and replace when the President and his GOP allies were at odds. First and foremost, the GOP-led Congress needs to pass a budget resolution, expected by the end of October. Congress considers the President's request as it formulates a budget resolution, which both houses of Congress must pass. Bottom Line: Investors should watch the response of Congressional Republicans to Trump's tax proposals. A lukewarm reception would indicate that investors' renewed optimism may be premature. The Trump trades have made a comeback in the past two weeks and will continue to be profitable if the current proposal (or something similar) is signed into law in Q1 2018 (Chart 3). If Trump and the GOP could extend the tax cuts into broader tax reform, it would provide a lift to corporate M&A activity. Little Froth From M&A Market U.S. merger and acquisition (M&A) volume peaked along with U.S. equity prices in the late 1990s and mid-2000s, but another top in the current deal market does not signal a top in equity prices. Deal volume (in dollars) and relative to market cap peaked in 1999, again in 2007, and more recently in mid-2015, before a 13% pullback in the S&P 500 in late 2015 and early 2016 (Chart 4). Although not shown on the chart, deal volume surpassed its late 1980s' pinnacle in 1995, five years before equity markets reached record highs in 2000. Through August, corporate takeovers relative to GDP matched those prior heights, but remained below the 1999, 2007 and 2015 tops as a percentage of market cap. Furthermore, global or cross-border M&A, a better indicator of market zest than U.S.-only activity, has not eclipsed the peaks in 2007. Measured against both global GDP and market cap, worldwide corporate combinations are below their 2015 zenith and well below the 2007 peak. At just 7% in 2016, the GDP-based metric was significantly under the mid-2000s pinnacle of 10%. That said, it is difficult to analyze this in context as the time series does not reach back to the late 1990s, which were the boom years for M&A. Bottom Line: Booming M&A activity is not a sign of froth in equity markets but it is a sign that animal spirts are stirring. Overall net equity withdrawal (which includes the net impact of IPOs, share buybacks, and M&A) has not been out of line with previous economic expansions (Chart 5). Stay overweight stocks versus bonds. The uptrend in capital spending is another sign of a shift in animal spirits. Chart 4Roaring M&A Volume Not##BR##A Sign Of A Market Peak Chart 5Comparison Of Corporate Outlays Across Four Economic Expansion Phases Capital Spending Blasting Off The capital spending outlook remains bright despite the recent loss of momentum in industrial production, as indicated by BCA's aggregate for IP in the advanced economies (Chart 6). This is disconcerting because global and regional industrial production are important indicators of both economic growth and corporate earnings. The recent softening is due to a few factors. Much of it is linked to weakness in the U.S. where hurricanes affected the August figures. However, most of our leading indicators remain constructive. Chart 7 presents simple models for real GDP growth for the G4 economies based on our household and capital spending indicators. Real GDP growth will continue to accelerate for the G4 economies, according to the model. BCA's aggregate consumer indicator for the G4 appears to have peaked, but the capex indicator is blasting off. The bullish capital spending reading is unanimous across the major economies. Robust capital goods imports for our 20-country aggregate supports the view that "animal spirits" are stirring in boardrooms in the advanced economies. These imports and BCA's capital spending indicators suggest that the small pullback in advanced-economy industrial production will not last, purchasing managers' indexes will remain elevated, and the acceleration in global export activity is only starting (Chart 7). Despite the lack of progress in Washington on repealing Obamacare and enacting tax cuts, even the U.S. small business sector has shifted into a higher gear in terms of hiring and capital spending, according to the NFIB survey (not shown). Moreover, both BCA's real and nominal U.S. capex models, driven by sturdy capital goods orders, elevated ISM readings and surging sentiment on capex, point to strong business spending in the next few quarters (Chart 8). Chart 6Animal Spirits Are Stirring... Chart 7...Contributing To Stronger G4 Economic Growth Chart 8Prospects For U.S. Capex Are Good Bottom Line: Business capital spending remains sturdy and it will lift overall GDP in 2H despite the recent severe weather. BCA's U.S. Equity Strategy strategists note3 that U.S. industrial machinery manufacturers should be particularly well positioned to see earnings growth outpace the rest of the S&P 500. Stay overweight industrials. Moreover, above-potential GDP growth will keep the Fed on track for gradual tightening this year, and supports BCA's position of stocks over bonds. Stout capital spending will be a theme as the Q3 earnings season unfolds in the next six weeks. Will Hurricanes Impact Q3 Earnings? Chart 9Strong EPS Growth Ahead,##BR##Will Start To Slow Soon The Q3 earnings season will be above average and the BCA Earnings model predicts EPS growth will hit roughly 20% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 9). The consensus anticipates a 6% year-over-year increase in EPS in Q3 2017 versus Q3 2016, and 12% for 2017. Energy and technology will likely lead the way in earnings growth in Q3, and utilities and telecom will again be the laggards. The favorable profit picture for Q3 and the rest of the year partly reflects the rebound in oil prices, which are expected to swell the energy sector's EPS by 134%. The positive picture also mirrors the sweet spot of rising top-line growth and still muted labor costs, which are driving a countercyclical rally in profit margins. Investors and corporate executives will focus in Q3 on the improving economic conditions in Europe and the EM, the U.S. dollar, the sustainability of margins, and the impact of Hurricanes Harvey and Irma. President Trump's tax proposal will also be vetted during conference call Q&A's, as investors drill managements on the implications of tax cuts on their operations. Rising interest rates may also demand attention from some analysts because the 10-year Treasury yield in Q3 2017 was 45 bps above Q2 2016 and rose sharply in the final weeks of the third quarter. Guidance from CEOs and CFOs on trends in Q4 2017 and beyond are more important than the actual Q3 results (Chart 10). Investors should guard against managements' over-optimism because earnings growth forecasts almost always move lower over time. Chart 10Unusual Stability In '17 And '18 EPS Estimates In Q3, as in Q2, firms with elevated overseas sales should benefit from the improved growth profile in Europe, Japan and the EM. Global GDP growth projections for this year and next have steadily perked up, in sharp contrast with prior years when forecasters have relentlessly lowered GDP estimates. The U.S. dollar, which has been only a small drag on EPS in recent quarters, should become a modest plus in Q3; the dollar is down by 3% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (September 6), mentions of a "strong dollar" declined by 4% compared with a year ago, indicating that the stronger currency has faded as a primary concern of managements in recent months. Nonetheless, BCA's view is that the dollar will appreciate by another 10% in the next 12-18 months. The appreciation would trim EPS growth by roughly 2.5 percentage points, although most of this would occur next year due to lagged effects. Another up leg in the dollar, on its own, should not provide a substantial headwind for the stock market. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. The timely enactment of Trump's tax proposal would boost the greenback. Investors are skeptical that margins can advance in Q3 for the fifth consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next quarter or two, but the secular "mean reversion" of margins will resume beyond that time. The effect of Harvey and Irma on Q3 results will be muted for the S&P 500 and most sectors, but several weather-sensitive industries (insurance, airlines, chemicals, refining, leisure, etc.) will see significant disruptions. Charts 11A and 11B show that the impact of major hurricanes does not alter the pre-landfall trajectory of S&P 500 earnings forecasts. Earnings estimates for the energy, industrial and utilities sectors (relative to the S&P) tend to move higher after storms, while relative EPS growth in the materials and staples sectors lag behind. Chart 11AImpact Of Major Hurricanes##BR##On Forward EPS Estimates... Chart 11B...Is Muted For S&P 500##BR##And Most Sectors Bottom Line: Look for another solid performance for earnings and margins in Q3 and the rest of 2017, supporting our stocks-over-bonds stance for this year. However, it may be tougher sledding in 2018 when earnings growth begins to moderate and margins begin to "mean revert". Higher inflation, a more active Fed and a stronger dollar will be headwinds for earnings starting in the early part of 2018. FOMC Unified Yet Divided Chart 12Recent Inflation Readings##BR##Challenge The Fed's View U.S. inflation is likely to trend higher over the coming months as a variety of one-off factors that depressed inflation earlier this year fall out of the equation. That said, the August PCE deflator challenges that view (Chart 12). Core PCE inflation slowed further to 1.3%, down from 1.4% last month. In fact, core PCE inflation of 1.3% is at the exact same level as when the Fed delivered its first rate hike in December 2015. Moreover, the diffusion index dipped back to zero, implying the price weakness was widespread. The rollover in the PCE this year is consistent with the soft CPI readings. However, Fed officials highlight the trend in underlying inflation (Chart 12, panel 4) as they make the case for gradual rate hikes. Risk assets are unlikely to suffer if inflation rises towards the Fed's target against the backdrop of stronger growth. However, if inflation moves above the Fed's target due to brewing supply bottlenecks, the Fed will have little choice but to pick up the pace of rate hikes. This could unsettle markets and sow the seeds for the next recession, which we tentatively expect to occur in the second half of 2019. The market is pricing in only 42 basis points of hikes between now and the end of next year. FOMC voting members agree that the path for the normalization of monetary policy should be gradual. However, the path of inflation has provoked squabbling in the past month (Diagram 1) in the Fed and regional branches. Even though the Fed is path-dependent rather than data-dependent, the consensus remains that low inflation is due to temporary factors and higher consumer prices should soon rebound, justifying a December 2017 rate hike. FRBNY President William Dudley remains committed to further gradual rate hikes, although he has been recently surprised by the shortfall of inflation from the FOMC's 2% long-run objective. Fed Chair Janet Yellen confidently backed Dudley's optimism, stating that "low inflation likely reflects factors whose influence should fade over time." But she also struck a cautious tone by highlighting the risks around the uncertainty for the inflation outlook. Yellen even conceded that the Fed would not rule out pausing its gradual rate hike cycle given that they "may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with the inflation objective, or even fundamental forces driving inflation". Diagram 1Unified On Gradual Path But Divided On Inflation Path To manage risks, Chair Yellen offered a prescription of scenarios to strengthen the case for a gradual path: "Moving too quickly risks over adjusting policy to head off projected developments that may not come to pass. A gradual approach is particularly appropriate in light of subdued inflation and a low neutral real interest rate, which imply that the FOMC will have only limited scope to cut the federal funds rate should the economy be hit with an adverse shock. But we should also be wary of moving too gradually. Without further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession." In contrast, dovish FOMC members are apprehensive about the outlook for higher inflation. Governor Lael Brainard, known for her influence on the consensus at the FOMC, needs more confirmation that inflation is moving towards the 2% objective. FRB Chicago President Charles Evans, a dove, but mostly in line with the FOMC consensus, also is skeptical about inflation overshooting its 2% target and is worried about a potential policy mistake. Even FRB Minneapolis President Kashkari, the most dovish and a known dissenter, does not see inflation spiraling out of control given that the economy is unlikely to overheat anytime soon. Not surprising, FOMC hawks Esther George (Kansas City) and Patrick Harker (Philadelphia) noted in speeches late last week that policy was still accommodative and that gradual rate hikes are in order. Ultimately, a pickup in inflation is required to convince the doves at the Fed that even gradual rate hikes are required. BCA's stance is that inflation will pick up over the next year as the unemployment rate falls further and the output gap closes. Bottom Line: The Fed is likely to raise rates in December and three or four more times in 2018. We recommend investors remain underweight duration. Nonetheless, the Treasury market remains unconvinced about the Fed's view on rates and inflation. The implication for investors is that although 10-year Treasury bond yields have risen sharply in recent weeks, we see more upside in yields. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Will Extend Cuts To June 2018," September 21, 2017. Available at ces.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," May 31, 2017. Available at gps.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Insight "Accelerating Global Manufacturing Means More Machines", dated September 22, 2017. Available at uses.bcaresearch.com.

Dear Client, I had the pleasure of speaking at BCA's Annual New York conference on Monday, where I offered the following trade recommendations. This week's report is a summary of my remarks. Please note we will be publishing our Q4 Strategy Outlook and monthly tactical asset allocation recommendation table next Wednesday. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Go short the December 2018 fed funds futures contract. Go long global industrial stocks versus utilities. Go short 20-year JGBs relative to their 5-year counterparts. Feature Trade #1: Go Short The December 2018 Fed Funds Futures Contract The hurricanes are likely to dent activity in the third quarter, but leading economic indicators are pointing to faster growth starting in Q4. This can be seen in a variety of measures, including the Conference Board's LEI (Chart 1). U.S. financial conditions have eased sharply this year, thanks to a decline in government bond yields, narrower credit spreads, a weaker dollar, and rising equity prices. Changes in our FCI lead growth by about 6-to-9 months. If history is any guide, U.S. growth will rise to about 3% in the first half of 2018 (Chart 2). Growth could even temporarily rise above that level if Congress enacts significant unfunded tax cuts, as we expect it will. Chart 1U.S. Leading Economic Indicator Pointing Higher Chart 2Easier Financial Conditions Will Boost U.S. Growth Contrary to popular belief, the Phillips curve is far from dead. It has just been dormant for the better part of 30 years because the unemployment rate has hovered along the flat side of the curve. The closest the economy came to overheating was in the late 1990s, but any inflationary pressures back then were choked off by turmoil in emerging markets, a surging dollar, and collapsing commodity prices.1 If U.S. growth accelerates over the next few quarters, the unemployment rate is likely to fall to 3.5% by the end of next year - well below the Fed's end-2018 projection of 4.1%, and even below the low of 3.8% reached in 2000. At that point, the U.S. economy will find itself on the steep side of the Phillips curve (Chart 3). Chart 3U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve As Chart 4 illustrates, our wage survey indicator - a propriety measures that combines the results of 13 separate employer surveys - is pointing to faster wage growth. Rising wages should boost consumer spending. With the output gap all but extinguished, faster demand growth will lead to higher inflation. This is already being telegraphed by the ISM manufacturing index (Chart 5). Chart 4Survey Data Point To Higher Wage Growth Ahead Chart 5Strong ISM Signaling A Rise In Inflation If inflation accelerates, there is little reason why the Fed would not continue raising rates in line with the dots, which call for one more hike in December and three hikes in 2018. That's 100 basis points of hikes between now and the end of next year, considerably more than the 40 bps that the market is currently discounting. We went short the December 2018 fed funds futures contract three weeks ago. The trade has gained 20 basis points so far, but my discussion this morning suggests that it has plenty of juice left. Trade #2: Go Long Global Industrial Stocks Versus Utilities Economists are a bit like stock market analysts - they are generally too optimistic. As a result, they usually end up having to revise their growth estimates down over time. That has not been the case this year: Global growth estimates have been marching higher (Chart 6). Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. We are starting to see that now. A variety of indicators - including capital goods orders and capex intention surveys - are pointing to further gains in business spending. This is captured in our model estimates, which project that global capex will grow at the fastest pace in six years (Chart 7). Chart 6Global Growth Estimates Accelerating Despite Stalled U.S. Growth Chart 7Global Capex On The Upswing A burst of capital spending should benefit global industrial stocks. Conversely, rising global yields will hurt rate-sensitive utilities (Chart 8). Industrials are no longer cheap, but relative to utilities, valuations do not seem especially stretched, implying further room for re-rating (Chart 9). Chart 8Higher Bond Yields Will Hurt Utilities Chart 9Relative Valuations Are Not Stretched Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts The deflationary mindset remains firmly entrenched in Japan. CPI swaps are pricing in inflation of only 0.5% over the next twenty years (Chart 10). Not only do investors expect the Bank of Japan to continue to miss its 2% target, they don't even think that inflation will rise from today's miserly levels. They could be in for a big surprise. Many of the structural drivers of deflation in Japan are fading. Land prices have stopped falling for the first time in 25 years, and bank balance sheets are in good shape (Chart 11). Goods prices are also rising again, thanks in part to a cheaper yen (Chart 12). Profit margins have soared, giving firms the wherewithal to pay their workers more. Chart 10Deflationary Mindset Remains Deeply Entrenched... Chart 11A...But Deflationary Pressures Are Abating Chart 11B Chart 12ACorporate Pricing Power Has Improved Chart 12B Companies have been reluctant to raise wages, but that may be starting to change. Our wage trend indicator is showing signs of life (Chart 13). As in the U.S., the Phillips curve in Japan tends to become kinked at very low levels of unemployment. Japan's unemployment rate now stands at 2.8%, almost a full percentage point below 2007 levels. As the labor market heats up, companies will have to compete more intensively for a shrinking pool of available workers. This could spark a tit-for-tat cycle where wage hikes by one company lead to hikes by others. Chart 13ATentative Signs of Wage Growth Chart 13B Chart 14Demographic Inflection Point? The government has been hoping for such a bidding war to break out. It will get its wish. The ratio of job openings-to-applicants has soared, and is now even higher than at the peak of the bubble in 1990 (Chart 14). Amazingly, Japan's labor market has tightened over the past few years despite tepid GDP growth and a steady influx of women into the labor force. However, now that female participation in Japan exceeds U.S. levels, this tailwind to labor supply will dissipate. Meanwhile, the retirement of aging Japanese baby boomers will accelerate. The largest number of births in Japan occurred between 1947 and 1949. These workers will reach 70 over the next two years, the age at which most Japanese retire. How should investors play this theme? Considering that inflation is still far from the Bank of Japan's 2% target, it is doubtful that the BoJ will abandon its yield curve targeting regime any time soon. But as inflation expectations begin to rise, ultra long-term yields - which are not subject to the BOJ's cap - will increase. This suggests that shorting 20-year JGBs relative to their 5-year counterparts will pay off in spades. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights We highlighted last month that investors should remain slightly overweight risk assets, but should also hold safe havens given the preponderance of risks. Some of the risks have since faded and the sweet spot for equities is continuing, but the potential for a correction remains elevated. Geopolitics will no doubt remain a threat for 'risk on' trades, although we may be at peak tensions with respect to North Korea. Our models point to an acceleration in growth in the major economies. Our capital spending indicators suggest that animal spirits are stirring in the business sector. In the U.S., fiscal stimulus is back on the table and investors are looking beyond the negative short-term impact of the hurricanes to the growth-enhancing rebuilding that will follow. It is also positive for the stock-to-bond return ratio that our bullish oil scenario is playing out. Stay long oil-related plays. There is a good chance that this year's downtrend in the dollar and government bond yields is over. The rise in both may be halting, but the risks are to the upside now that disappointments on U.S. growth and inflation have likely ended (notwithstanding the hurricane-distorted economic data in the near term). The Phillips curve is not dead. We do not expect Fed balance sheet normalization on its own to be a major headwind for risk assets. The bigger threat is a sudden and sharp re-assessment of the outlook for interest rates in the major countries. Our base-case view is that inflation will only grind higher in the major countries. It should be slow enough that the associated backup in bond yields does not derail the rally in risk assets, but the danger of a sharper bond market adjustment means that investors should continue to be on the conservative side. Feature It was 'risk on' in financial markets in September, despite a less dovish tone among the major central banks. The reason is that the synchronized global growth outlook continues to gather momentum, supporting the earnings backdrop, but inflation remains dormant in the major countries outside of the U.K. Investors believe that calm inflation readings will allow central banks to proceed cautiously and avoid taking risks with growth, extending the expansion in GDP and earnings. The North Korean situation changes from day to day, but investors appear to be more comfortable with it at the margin. In the U.S., fiscal stimulus is back on the table and investors are looking beyond the negative short-term impact of the hurricanes to the growth-enhancing rebuilding that will follow. Finally, rising oil prices will lift earnings in the energy patch. These developments spurred investors to embrace risk assets and carry trades again in September. However, value is poor and signs of froth are accumulating. For example, equity investors are employing record amounts of margin debt to lever up investments. The Bank for International Settlements highlighted in its Quarterly Review that margin debt outstanding in 2015 was higher than during the dotcom boom (and it has surely increased since then). The global volume of outstanding leveraged loans continues to set new highs even as covenant standards slip. Risk assets are being supported by a three-legged stool: solid earnings growth, low bond yields and depressed bond market volatility. The latter is a reflection of current market expectations that dormant inflation will continue to constrain central bankers. We agree that the economic growth and earnings outlook is positive on a 6-12 month horizon. The main item that could upset the sweet spot for risk assets, outside of a geopolitical event, is an awakening in inflation. This would shatter the consensus view that the bond market will remain well behaved. Markets are priced for little change in the inflation backdrop even in the long term. Our base-case view is that inflation will grind higher in the major countries, although it should be slow enough that the associated backup in bond yields does not derail the rally in risk assets in the next 6-12 months. But the risk of a sharper bond market adjustment means that investors should continue to be conservative (although slightly tilted to risk-over-safety). Getting Used To North Korea It appears that investors are becoming increasingly desensitized to provocation from the rogue state. Our geopolitical experts argued that the risk of a full-out war with the U.S. was less than 10%, but they warned that there could be a market-rattling political crisis or even a military skirmish before Pyongyang returned to the negotiating table. However, we may be at peak tensions now, based on several key developments over the past month. First, both China and Russia, two North Korean allies, have turned up the pressure. China appears to be enforcing sanctions according to Chinese trade data vis-à-vis North Korea (Chart I-1). Both China and Russia have also agreed to reduce fuel supplies. And there is evidence that U.S. and North Korea have held unofficial diplomatic talks behind the scenes. The implication is that North Korea is responding to pressure now that its critical fuel supplies are at risk. Chart I-1China Getting Tougher With NK We cannot rule out more goading from Kim Jong Un, especially with a busy political calendar in Asia this fall: the Korean Worker's Party's anniversary on October 10, the Chinese midterm leadership reshuffle on October 11-25, Japanese elections on October 22, and Trump's visit to the region in mid-November. Nevertheless, it would require a major provocation (i.e. a direct attack on the U.S. or its allies) for Pyongyang to escalate tensions from current levels. This would require the North to be very reckless with its own strategic assets, given that the U.S. would likely conduct a proportional retaliation against any serious attack. The recent backup in Treasury yields and yen pullback suggest that investors do not think tensions will escalate that far. We agree, but obviously the situation is fluid. Trump Trades Back In Play? U.S. politics have also become more equity-friendly and bond-bearish at the margin. The risk of a debt ceiling standoff has been delayed until December following President Trump's deal with the Democrats. We do not think that this represents a radical shift toward bipartisanship, but it is warning from the President that the GOP had better get cracking on tax legislation. The House Budget committee passed a FY2018 budget resolution in late July that included "reconciliation instructions" for tax legislation. Such a budget resolution approved by the Congress as a whole would allow for tax cuts that are not fully offset by spending cuts, with the proviso that the tax reductions sunset after a defined number of years. It is difficult to see tax legislation being passed before year end, but the first quarter of 2018 is certainly possible. Markets will begin to price in the legislation well before it is passed, which means that the so-called Trump trades are likely to see a revival. In particular, the legislation should favor small caps and boost the dollar. This year's devastating hurricane activity will also lift U.S. growth in 2018. History shows that natural disasters have only a passing effect on the U.S. economy and financial markets. Following the short-term negative economic impact, rebuilding adds to growth with the Federal government footing part of the bill. A 2016 Congressional Budget Office (CBO) report found that federal spending after major hurricanes can add as much as 0.6% to GDP. CBO notes that the lion's share of the economic impact is in the first year after a storm, with most of those expenditures helping victims to obtain food and shelter, fund search and rescue operations, and protect critical infrastructure. Federal outlays for public infrastructure occur after the first year and provide a much smaller lift to GDP (Chart I-2). Chart I-2Federal Government Outlays For Hurricane Relief Oil: Inventories Are Correcting Chart I-3Oil Inventory Correction To Lift Prices It is also positive for the stock-to-bond return ratio that our bullish oil scenario is playing out. Our energy strategists highlight that global oil demand is booming, at a time when the U.S. Energy Information Administration (EIA) lowered its estimated shale oil output by 200,000 bpd for the third quarter. This confirms our contention that the EIA has overestimated the pace of the shale production response during 2017. Taken together, these factors helped to improve the global net demand/supply balance by 600,000 bpd. The drawdown in global oil inventories is thus likely to continue (Chart I-3). Looking to next year, crude prices could go even higher with an extension of the OPEC/Russian production cuts beyond March 2018 and continued strong growth in global oil demand. The synchronized global expansion is reflected in rising oil demand from all parts of the world. Soft Industrial Production Readings Won't Last We have highlighted global and regional industrial production as important indicators of both economic growth corporate earnings. It is therefore a little disconcerting that our aggregate for industrial production in the advanced economies has suddenly lost momentum (Chart I-4). We are inclined to fade the recent softening for a few reasons. First, much of it is due to weakness in the U.S. where hurricanes affected the August figures. Second, most of our leading indicators remain very constructive. Chart I-5 present a simple model for real GDP growth for the G4 economies based on our consumer and capital spending indicators. Real GDP growth will continue to accelerate for the G4 economies as a group according to the model. Our aggregate consumer indicator appears to have peaked at a high level, but the capex indicator is blasting off. The bullish capital spending reading is unanimous across the major economies (Chart I-6). Chart I-4Animal Spirits Are Stirring... Chart I-5...Contributing To Stronger G4 Economic Growth Chart I-6Capital Goods Indicators Are Surging The Eurozone is particularly strong on both the consumer and business fronts, suggesting that euro strength has not undermined growth. Conversely, the U.K. is at the weak end of the spectrum based on the drop in its consumer spending indicator. This is the main reason why we do not believe the Bank of England will be able to make good on its warning of a rate hike this year (see below). Robust capital goods imports for our 20-country aggregate supports the view that animal spirits are stirring in boardrooms in the advanced economies (Chart I-4, third panel). These imports and our capital spending indicators suggest that the small pullback in advanced-economy industrial production will not last, purchasing managers' indexes will remain elevated, and the acceleration in global export activity is just getting started. Even U.S. small business sector has shifted into a higher gear in terms of hiring and capital spending according to the NFIB survey. These trends will favor industrial stocks, especially versus utilities. Central Banks Shedding Dovish Feathers The synchronized global growth pickup is also reflected in our Central Bank Monitors, which are all near or above the zero line (Chart I-7). The Monitors gauge pressure on central banks to adjust policy. Current readings are consistent with the relatively more hawkish tone by central bankers in Canada, the U.S., the Eurozone and the U.K. Chart I-7Central Bank Monitors Support Less Dovish Policymakers The violent reaction in the gilt market to the Bank of England's hint that it could hike rates in the next few months highlights the vulnerability of bond markets to any shift by central bankers in a less dovish direction. In this case, we do not believe the BoE will be able to follow through with its rate hike plan. The leading economic indicators are softening and inflation is about to roll over now that the pound has bottomed. In contrast, bunds are quite vulnerable to a more hawkish tilt at the European Central Bank (ECB). Eurozone policymakers confirmed at their September meeting that they plan to announce in October a reduction in the asset purchase program, to take effect in 2018. The ECB revised up its growth forecast for 2017, and left the subsequent two years unchanged. The inflation forecast was trimmed by 0.1 percentage points in 2018 and 2019. The fact that this year's surge in the euro was not enough to move the needle much on the ECB's projections speaks volumes about the central bank's confidence in the current European economic expansion, as well as its comfort level with the rising currency. Our fixed income strategists believe that the full extent of ECB tapering is not yet fully discounted in the European bond market. Phillips Curve: It's Not Dead, Just Resting Chart I-8U.S. Inflation Turning to the Fed, the bond market did not get the dovish tone it was expecting from September's FOMC meeting. Policymakers left a December rate hike on the table, as Chair Yellen downplayed this year's lagging inflation data as well as the impact of the hurricanes on the economy. Not surprisingly, the odds of a December rate hike have since jumped to 70%. The Fed announced its plan to begin shrinking its balance sheet beginning in October. In the press conference, Yellen tried to disassociate balance sheet policy from the rate outlook. Balance sheet adjustment will be on autopilot, such that short-term interest rates will be the Fed's main policy instrument going forward. While the Fed plans to deliver another rate increase in December, it will require at least a small rise in inflation. Policymakers were no doubt pleased that annual CPI core inflation edged up in August and the 3-month rate of change has moved back to 2% (Chart I-8). The CPI diffusion index also moved above the zero line, indicating that the soft patch in the inflation data may be over, although the diffusion index for the PCE inflation data fell back to the zero line. Table I-1 presents the major contributors to the 0.9 percentage point decline in the year-over-year headline CPI inflation rate since February. Energy accounts for the majority of the decline, at 0.6 percentage points. New cars, shelter, medical services and wireless telephone services account for the remainder. The deflationary wireless price effect is now unwinding, but medical services is a wildcard and our shelter model suggests that this large part of the CPI index will probably not help to lift inflation this year. Thus, higher inflation must come largely from non-shelter core services, which is the component most closely correlated with wages. Investors remain unconvinced by Yellen's assertion that the soft patch in the inflation data reflects transitory factors. Indeed, market-based long-term inflation expectations remain well below the Fed's target, and they even fell a little following the FOMC meeting. Table I-1Contribution To Change In Headline ##br##Inflation (February -August, 2017) One FOMC member is becoming increasingly alarmed by the market's disbelief that the Fed will hit the 2% target even in the long run (Chart I-9). In a recent speech, Governor Brainard noted that both market-based and survey evidence on inflation expectations have drifted lower in the post-Lehman years. More recently, long-term inflation breakeven rates and CPI swaps have been surprisingly sticky in the face of the rebound in oil prices. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, then inflation's long-run trend would be altered and monetary policy would become less effective. Japan is a glaring example of what could be the endpoint. Brainard's fears have not yet affected the FOMC consensus, which is loath to throw the Phillips curve model into the dust bin just yet. We agree that the Phillips curve is not dead. Peter Berezin, Chief Strategist for the BCA Global Investment Strategy Service, argued in a recent Special Report that the often-cited reasons for why the Phillips curve has become defunct - decreased union bargaining power, a more globalized economy, and technological trends - are less convincing than they appear. The Fed simply has to be patient because the U.S. is only now reaching the kinked part of the Phillips Curve (Chart I-10). Chart I-9Worrying Trends For The FOMC Chart I-10U.S. Wage Growth Accelerates Once The Unemployment Rate Falls Below 5% (1997-2017) Moreover, our global fixed income team has made the case that the global output gap must be taken into consideration.1 Chart I-11 presents the percentage of OECD economies that have an unemployment rate below the NAIRU rate, along with inflation in the services and goods sectors of the developed markets. While the correlation between this global NAIRU indicator and realized inflation rates declined in the years after the recession, the linkages have improved over the past couple of years. The fact that the global NAIRU indicator is only now back to pre-Lehman levels suggests that inflationary pressure could finally be near an inflection point. Market expectations for the path of real GDP growth and the unemployment rate are roughly in line with the FOMC's central tendency forecast. However, the wide gulf between the FOMC and the market on the path of interest rates remains a potential catalyst for a correction in risk assets if market rates ratchet higher. Fed balance sheet runoff could also be problematic in this regard. QE Unwind: How Much Of A Risk? Many investors equate the surge in asset prices in the years after the Great Financial Crisis with central bank largesse. Won't a reversal of this policy be negative for both bonds and stocks? Fed balance sheet runoff, together with ECB tapering and less buying by the Bank of Japan, will certainly change the supply/demand backdrop for the G4 government bond markets in 2018. We have updated our projection for the net flow of government bonds available to the private sector, taking into consideration the supply that is absorbed by central banks and other official institutions (Chart I-12). The top panel shows that the net supply of Treasurys to the private sector never contracted in recent years, but the bottom panel highlights that the net supply of G4 government bonds as a group was negative for 2015, 2016 and 2017. Central banks and other official buyers had to bid-away bonds from the private sector during these years. Chart I-11Global Slack Matters Chart I-12Major Swing In Government ##br##Bond Supply In 2018 We project that the net supply will swing from a contraction of almost $600 billion in 2017 to a positive net flow of almost US$200 billion next year. The Fed's projected runoff accounts for most of the swing. The supply/demand effect might push up term premia a little. Nonetheless, as discussed in this month's Special Report beginning on page 19, the balance sheet unwind is not the key threat to bonds and stocks. Rather, the main risk is the overly benign central bank outlook that is priced into the bond market. Real 5-year bond yields, five years forward, are still extremely depressed because the market has discounted negative real short-term interest rates out to 2022 in the U.S. and 2026 in the Eurozone (Chart I-13). Chart I-13Real Forward Short-Term Rates Time For The Nikkei To Shine Equity bourses took September's backup in bond yields in stride. Indeed, the S&P 500 and Nikkei broke to new highs during the month. The Euro Stoxx 50 also sprang to life, although has not yet reached fresh highs in local currency terms. The solid earnings backdrop remains a key support for the market. We highlighted our EPS forecasts in last month's report. Nothing of significance has changed on this front. The latest data suggest that operating margins may be peaking, but the diffusion index does not suggest an imminent decline (Chart I-14). Meanwhile, our upbeat economic assessment discussed above means that top line expansion should keep EPS growing solidly into the first half of 2018 at the global level. EPS growth will likely decelerate toward the end of next year to mid-single digits. Chart I-14Operating Margins Approaching A Peak? We still see a case for the Nikkei to outperform the S&P 500, at least in local currencies. Japan is on the cheap side according to our top-down indicator (Chart I-15). Japanese earnings are highly geared to economic growth at home and abroad. Japanese EPS is in an uptrend versus the U.S. in both local and common currencies (Chart I-16). We do not expect to see a peak in EPS growth until mid-2018, a good six months after the expected top in the U.S. Moreover, an Abe win in the October 22 election would mean that policy will remain highly reflationary in absolute terms and relative to the U.S. Chart I-15Valuation: Japan Cheap To The U.S., But Not Europe Chart I-16Japanese Earnings Outperforming The U.S. European stocks are a tougher call. On the plus side, the economy is flying high and there are no warning signs that this is about to end. There is hope for structural reform in France after Macron's election win this year. We give Macron's proposed labor market reforms high marks because they compare favorably with those of Spain and Germany, which helped to diminish structural unemployment in those two countries. Many doubt that Macron's reforms will see the light of day, but our geopolitical team believes that investors are underestimating the chances. The German election in September poured cold water on recent enthusiasm regarding accelerated European integration. This is because Merkel will likely have to deal with a larger contingent of Euroskeptics in the grand coalition that emerges in the coming months. However, we do not expect political developments in Germany to be a headwind for the Eurozone stock market. On the negative side, European stocks do not appear cheap to the U.S. after adjusting for the structural discount (Chart I-15). Moreover, this year's euro bull phase will take a bite out of earnings. As noted in last month's Overview, euro strength so far this year will lop three to four percentage points off of EPS growth by the middle of next year. Our model suggests that this will be overwhelmed by the robust economic expansion at home and abroad, but profit growth could fall to 5%, which is likely to be well short of that in the U.S. and Japan (local currency). Still, a lot of the negative impact of the currency on profits may already be discounted as forward earnings have been revised down. On balance, we remain overweight European stocks versus the U.S. (currency hedged). However, it appears that Japan has more latitude to outperform. Dollar: Finally Finding A Floor? Chart I-17Has The Dollar Found Bottom? The Fed's determination to stick with the 'dot plot' may have finally placed a floor under the dollar. Before the September FOMC meeting, the market had all but priced out any rate hikes between now and the end of 2018. Both the U.S. economic surprise index and the inflation surprise index have turned up relative to the G10 (Chart I-17). The dollar has more upside if we are past the period of maximum bond market strength and moving into in a window in which U.S. economic and inflation surprises will 'catch up' with the other major economies. Technically, investors appear to be quite short the dollar, especially versus the euro. Bullish sentiment on the euro is highlighted by the fact that the currency has deviated substantially from the interest rate parity relationship. Euro positioning is thus bullish the dollar from a contrary perspective. Nonetheless, our currency experts are more bullish the dollar versus the yen. Given that inflation expectations have softened in Japan and wage growth is still lacking, the Bank of Japan will have to stick with its zero percent 10-year JGB target. The yen will be forced lower versus the dollar as the U.S. yield curve shifts up. We also like the loonie. The Bank of Canada (BoC) pulled the trigger in September for the second time this year, lifting the overnight rate to 1%. Policymakers gave themselves some "wiggle room" on the outlook, but more tightening is on the way barring a significant slowdown in growth, another spike in the C$, or a housing meltdown. The statement said that the loonie's rise partly reflected the relative strength of the Canadian economy, which implies that it is justified by the fundamentals. It does not appear that the C$ has reached a "choke point" in the eyes of the central bank. Investment Conclusions: We highlighted in our last issue that investors should remain slightly overweight risk assets, but should also hold safe haven assets given the preponderance of risks. Some of the risks have since faded and the sweet spot for risk assets is continuing. We remain upbeat on global economic growth and earnings. Nonetheless, both stocks and bonds remain vulnerable to any upside surprises on inflation, especially in the U.S. While the positive trends in stock indexes and corporate bond spreads should continue over the coming 6-12 months, there is a good chance that this year's downtrend in the dollar and government bond yields is over. The rise in both may be halting, but the risks are to the upside now that disappointments on U.S. growth and inflation have likely ended (notwithstanding the hurricane-distorted economic data in the near term). The Phillips curve is not dead, which means that it is only a matter of time before inflation begins to find a little traction. Higher oil prices will also provide a tailwind for headline inflation. Geopolitics will no doubt remain a threat for 'risk on' trades, but we may be past the worst in terms of North Korean tension. We also do not expect Fed balance sheet normalization to be a major headwind for risk assets. Nonetheless, the anticipated swing the supply of G4 government bonds to private investors would serve to add to selling pressure in the fixed-income space if inflation is rising in the U.S. and/or Europe at the same time. In other words, the risk relates more to expected policy rates than the Fed's balance sheet. Stay overweight stocks versus bonds, long oil related plays, slightly short in duration in the fixed income space, and long inflation protection. We also recommend returning to long positions on the U.S. dollar. Mark McClellan Senior Vice President The Bank Credit Analyst September 28, 2017 Next Report: October 26, 2017 1 Please see BCA Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017, available at gis.bcaresearch.com II. Liquidity And The Great Balance Sheet Unwind Liquidity is the lifeblood of the economy and financial markets, but it is a slippery concept that means different things to different people. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. The bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated. Asset sales could lead to a shortage of short-term high-quality assets, unless it is offset with increased T-bill issuance. However, a smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Liquidity has been an integral part of BCA's approach to financial markets going back to the early days of the company under the tutelage of Editor-in-Chief Hamilton Bolton from 1949 to 1968. Bolton was ahead of his time in terms of developing monetary indicators to forecast market trends. Back then, the focus was on bank flows such as the volume of checks cashed because capital markets were still developing and most credit flowed through the banking system. Times changed, monetary policy implementation evolved and financial markets became more important and sophisticated. When money targeting became popular among central banks in the 1970s, central bank liquidity analysis focused more on the broader monetary aggregates. These and other monetary data were used extensively by Anthony Boeckh, BCA's Editor-in-Chief from the 1968 to 2002, to forecast the economy and markets. He also highlighted the importance of balance sheet liquidity (holdings of liquid assets), and its interplay with rising debt levels. Martin Barnes continued with these themes when writing about the Debt Supercycle in the monthly Bank Credit Analyst. "Liquidity" is a slippery concept, and it means different things to different people. In this Special Report, we describe BCA's approach to liquidity and highlight its critical importance for financial markets. We provide a list of indicators to watch, and also outline how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. A Primer On Liquidity We believe there are four types of liquidity that are all interrelated: Central Bank Liquidity: Bank reserves lie at the heart of central bank liquidity. Reserves are under the direct control of the central bank, which are used as a tool to influence general monetary conditions in the economy. The latter are endogenous to the system and also depend on the private sector's desire to borrow, spend and hold cash. Bullish liquidity conditions are typically associated with plentiful bank reserves, low interest rates and strong growth in the monetary aggregates. Balance Sheet Liquidity: A high level of balance sheet liquidity means that plenty of short-term assets are available to meet emergencies. The desire of households, companies and institutional investors to build up balance sheet liquidity would normally increase when times are bad, and decline when confidence is high. Thus, one would expect strong economic growth to be associated with declining balance sheet liquidity, and vice versa when the economy is weak. Of course, deteriorating balance sheet liquidity during good times is a negative sign to the extent that households or business are caught in an illiquid state when the economy turns down, jobs are lost and loans are called. Financial Market Transaction Liquidity: This refers to the ability to make transactions in securities without triggering major changes in prices. Financial institutions provide market liquidity to securities markets through their trading activities. Funding Liquidity: The ability to borrow to fund positions in financial markets. Financial institutions provide funding liquidity to borrowers through their lending activities. The conditions under which these intermediaries can fund their own balance sheets, in turn, depend on the willingness of banks and the shadow banking system to interact with them. The BIS definition of funding liquidity is a broad concept that captures a wide range of channels. It includes the capacity of intermediaries that participate in the securitization chain to access the necessary funding to originate loans, to acquire loans for packaging into securities, and finance various kinds of guarantees. The availability and turnover of collateral for loans is also very important for generating funding liquidity, as we discuss below. These types of liquidity are interrelated in various ways, and can positively or negatively reinforce each other. It is the interaction of these factors that determines the economy's overall ease of financing. See Box II-1 for more details. BOX II-1 How Liquidity Is Inter-Related Central bank liquidity, which is exogenously determined, is the basis for private liquidity creation (the combination of market transaction and funding liquidity). The central bank determines the short-term risk-free rate and the official liquidity that is provided to the banking system. If the central bank hikes rates or provides less official liquidity, appetite for private lending begins to dry up. Private sector liquidity is thus heavily influenced by monetary policy, but can develop a life of its own, overshooting to the upside and downside with swings in investor confidence and risk tolerance. Financial market liquidity and funding liquidity are closely interrelated. When times are good, markets are liquid and funding liquidity is ample. But when risk tolerance takes a hit, a vicious circle between market transaction and funding liquidity develops. The BIS highlights the procyclical nature of private liquidity, which means that it tends to exhibit boom-bust cycles that generate credit excesses that are followed by busts.1 The Great Financial Crisis of 2008 is a perfect example. The Fed lifted the fed funds rate by 400 basis points between 2004 and 2006. Nonetheless, the outsized contraction in private liquidity, resulting from the plunge in asset prices related to U.S. mortgage debt, was a key driver of the crash in risk asset prices. Liquidity Indicators: What To Watch (1) Monetary Liquidity Key measures of central bank liquidity include the monetary base and the broad money aggregates, such as M1 and M2 (Chart II-1). Central banks control the amount of reserves in the banking system, which is part of base money, but they do not control the broad monetary aggregates. The latter is determined by the desire to hold cash and bank deposits, as well as the demand and supply of credit. Box II-2 provides some background on the monetary transmission process and quantitative easing. BOX II-2 The Monetary Transmission Process And Qe Before the Great Recession and Financial Crisis, the monetary authorities set the level of short-term interest rates through active management of the level of bank reserves. Reserves were drained as policy tightened, and were boosted when policies eased. The level of bank reserves affected banks' lending behavior, and shifts in interest rates affected the spending and investment decisions of consumers and businesses. Of course, it has been a different story since the financial crisis. Once short-term interest rates reached the zero bound, the Fed and some other central banks adopted "quantitative easing" programs designed to depress longer-term interest rates by aggressively buying bonds and thereby stuffing the banking system with an excessive amount of reserves. Many feared the onset of inflation when QE programs were first announced because investors worried that this would contribute to a massive increase in credit and the overall money supply. Indeed, there could have been hyper-inflation if banks had gone on a lending spree. But this never happened. Banks were constrained by insufficient capital ratios, loan losses and intense regulation, while consumers and businesses had no appetite for acquiring more debt. The result was that the money multiplier - the ratio of broad money to the monetary base - collapsed (top panel in Chart II-1). Bank lending standards eventually eased and credit demand recovered. Broad money growth has been volatile since 2007 but, despite quantitative easing, it has been roughly in line with the decade before. The broad aggregates lost much of their predictive power after the 1980s. Financial innovation, such as the use of debit cards and bank machines, changed the relationship between broad money on one hand, and the economy or financial markets on the other. Despite the structural changes in the economy, investors should still keep the monetary aggregates and the other monetary indicators discussed below in their toolbox. While the year-to-year wiggles in M2, for example, have not been good predictors of growth or inflation on a one or two year horizon, Chart II-2 shows that there is a long-term relationship between money and inflation when using decade averages. Chart II-1The Monetary Aggregates Chart II-2Long-Run Relationship Between M2 And Inflation Other monetary indicators to watch: M2 Divided By Nominal GDP (Chart II-3): When money growth exceeds that of nominal GDP, it could be interpreted as a signal that there is more than enough liquidity to facilitate economic activity. The excess is then available to purchase financial assets. Monetary Conditions Index (Chart II-3): This combines the level of interest rates and the change in the exchange rate into one indicator. The MCI has increased over the past year, indicating a tightening of monetary conditions, but is still very low by historical standards. Dollar Based Liquidity (Chart II-3): This includes Fed holdings of Treasurys and U.S. government securities held in custody for foreign official accounts. Foreign Exchange Reserves (Chart II-3): Central banks hold reserves in the form of gold, or cash and bonds denominated in foreign currencies. For example, when the People's Bank of China accumulates foreign exchange as part of its management of the RMB, it buys government bonds in other countries, thereby adding to liquidity globally. Interest Rates Minus Nominal GDP Growth (Chart II-4): Nominal GDP growth can be thought of as a proxy for the return on capital. If interest rates are below the return on capital, then there is an incentive for firms to borrow and invest. The opposite is true if interest rates are above GDP growth. Currently, short-term rates are well below nominal GDP, signaling that central bank liquidity is plentiful. Chart II-3Monetary Indicators (I) Chart II-4Monetary Indicators (II) (2) Balance Sheet Liquidity Chart II-5 presents the ratio of short-term assets to total liabilities for the corporate and household sectors. It is a measure of readily-available cash or cash-like instruments that make it easier to weather economic downturns and/or credit tightening phases. The non-financial corporate sector is in very good shape from this perspective. The seizure of the commercial paper market during the GFC encouraged firms to hold more liquid assets on the balance sheet. However, the uptrend began in the early 1990s and likely reflects tax avoidance efforts. Households are also highly liquid when short-term assets are compared to income. Liquidity as a share of total discretionary financial portfolios is low, but this is not surprising given extraordinarily unattractive interest rates. The banking system is being forced to hold more liquid assets under the new Liquidity Coverage Ratio requirement (Chart II-6). This is positive from the perspective of reducing systemic risk, but it has negative implications for funding liquidity, as we will discuss below. Chart II-5Balance Sheet Liquidity Chart II-6Bank Balance Sheet Liquidity (3) Financial Market Transaction Liquidity: Transactions volumes and bid-ask spreads are the main indicators to watch to gauge financial market transaction liquidity. There was a concern shortly after the GFC that the pullback in risk-taking by important market-makers could severely undermine market liquidity, leading to lower transaction volumes and wider bid-ask spreads. The focus of concern was largely on the corporate bond market given the sharply reduced footprint of investment banks. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 (Chart II-7). This represents a decline from over 10% of market cap to only 0.3%. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if market-making dealers fail to adequately match sellers with buyers during market downturns. Yet, as highlighted by BCA's Global Fixed Income Strategy team, corporate bond markets have functioned well since the dark days of the Lehman crisis.2 Reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads. Other market participants, such as Exchange Traded Funds, have taken up the slack. Daily trading volume as a percent of market cap has returned to pre-Lehman levels in the U.S. high-yield market, although this is not quite the case for the investment-grade market (Chart II-8). Chart II-7Less Market Making Chart II-8Corporate Bond Trading Volume That said, it is somewhat worrying that average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed. This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. Thus, it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing. The bottom line is that financial market liquidity is not as good as in the pre-Lehman years. This is not a problem at the moment, but there could be some dislocations in the fixed-income space during the next period of severe market stress when funding liquidity dries up. (3) Funding Liquidity: There are few direct measures of funding liquidity. Instead, one can look for its "footprint" or confirming evidence, such as total private sector credit. If credit is growing strongly, it is a sign that funding liquidity is ample. Box II-3 explains why international credit flows are also important to watch for signs of froth in lending. BOX II-3 The Importance Of International Credit Flows The BIS highlights that swings in international borrowing amplify domestic credit trends. Cross border lending tends to display even larger boom-bust cycles than domestic credit, as can be seen in the major advanced economies in the lead up to the GFC, as well as some Asian countries just before the Asian crisis in the late 1990s (Chart II-9). When times are good, banks and the shadow banking system draw heavily on cross-border sources of funds, such that international credit expansion tends to grow faster during boom periods than the credit granted domestically by banks located in the country. Since G4 financial systems intermediate a major share of global credit, funding conditions within the G4 affect funding conditions globally, as BIS research shows.3 This research also demonstrates that financial cycles have become more highly correlated across economies due to increased financial integration. Booms in credit inflows from abroad are also associated with a low level of the VIX, which is another sign of ample funding liquidity conditions (Chart II-10). These periods of excessive funding almost always end with a financial crisis and a spike in the VIX. Chart II-9International Credit Is Highly Cyclical Chart II-10International Credit Booms Lead Spikes In The VIX Other measures of funding liquidity to watch include: Chart II-11Market Measures Of Funding Liquidity Libor-OIS Spread (Chart II-11): This is a measure of perceived credit risk of LIBOR-panel banks. The spread tends to widen during periods of banking sector stress. Spreads are currently low by historical standards. However, libor will be phased out by 2021, such that a replacement for this benchmark rate will have to be found by then. Bond-CDS Basis (Chart II-11): The basis is roughly the average difference between each bond's yield spread to Treasurys and the cost of insuring the bond in the CDS market. Arbitrage should keep these two spreads closely aligned, but increases in funding costs tied to balance sheet constraints during periods of market stress affect this arbitrage opportunity, allowing the two spreads to diverge. The U.S. high-yield or investment grade bond markets are a good bellweather, and at the moment they indicate relatively good funding liquidity. FX Basis Swap (Chart II-11): This is analogous to the bond-CDS basis. It reflects the cost of hedging currencies, which is critically important for international investors and lending institutions. The basis swap widens when there is financial stress, reflecting a pullback in funding liquidity related to currencies. The FX swap basis widened during the GFC and, unlike other spreads, has not returned to pre-Lehman levels (see below). Bank Leverage Ratios (Chart II-12): The ratio of loans to deposits is a measure of leverage in the banking system. Banks boost leverage during boom times and thereby provide more loans and funding liquidity to buy securities. In the U.S., this ratio has plunged since 2007 and shows no sign of turning up. Primary Dealers Securities Lending (Chart II-13): This is a direct measure of funding liquidity. Primary dealers make loans to other financial institutions with the purpose of buying securities, thereby providing both funding liquidity and market liquidity. Historically, shifts in dealer lending have been correlated with bid-ask spreads in the Treasury market. Securities lending is also correlated with the S&P 500, although it does not tend to lead the stock market. Dealer loans soared prior to 2007, before collapsing in 2008. Total loans have recovered, but have not reached pre-crisis highs, consistent with stricter regulations that forced the deleveraging of dealer balance sheets. Chart II-12U.S. Bank Leverage Chart II-13Securities Lending And Margin Debt NYSE Margin Debt (Chart II-13): Another direct measure of funding liquidity. The uptrend in recent years has been steep, although it is less impressive when expressed relative to market cap. Bank Lending Standards (Chart II-14): These surveys reflect bank lending standards for standard loans to the household or corporate sectors, but their appetite for lending for the purposes of securities purchases is no doubt highly correlated. Lending standards tightened in 2016 due to the collapse in oil prices, but they have started to ease again this year. Table II-1 provides a handy list of liquidity indicators split into our four categories. Taking all of these indicators into consideration, we would characterize liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as the period just prior to the Lehman event. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the GFC, is still a long way from the pre-Lehman go-go years according to several important indicators such as bank leverage. Moreover, the Fed is set to begin the process of unwinding the massive amount of monetary liquidity provided by its quantitative easing program. Chart II-14Bank Lending Standards Table II-1Liquidity Indicators To Watch Fed Balance Sheet Shrinkage: What Impact On Liquidity? Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart II-15 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. Chart II-16 presents our forecast for how quickly the Fed's balance sheet will contract. Following last week's FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasurys and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasurys and $20 billion per month for MBS. Chart II-15G4 Central Bank Balance Sheets Chart II-16Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.4 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). In terms of the impact of balance sheet shrinkage on overall liquidity conditions, it is useful to think about the four categories of liquidity described above. (1) Monetary Liquidity The re-absorption of excess reserves will mean that base money will contract (i.e. the sum of bank reserves held at the Fed and currency in circulation). However, we do not expect this to have a noticeable impact on the broader monetary aggregates, credit growth, the economy or inflation, outside of any effect it might have on the term premium in the bond market. The reasoning is that all those excess reserves did not have a major impact on growth and inflation when they were created in the first place. This was because the credit channel of monetary policy was blocked by a lack of demand (private sector deleveraging) and limited bank lending capacity (partly due to regulation). Banks were also less inclined to lend due to rising loan losses. Removing the excess reserves should have little effect on banks' willingness or ability to make new loans. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. Asset purchases supported both the economy and risk assets in part via a weaker dollar and to the extent that the policy lifted confidence in the system. But most importantly, QE depressed long-term interest rates, which are used to discount cash flows when valuing financial assets. QE boosted risk-seeking behavior and the search for yield, partly through the signaling mechanism that convinced investors that short-term rates would stay depressed for a long time. The result was a decline in measures of market implied volatility, such as the MOVE and VIX indexes. Could Bond Yields Spike? The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. As highlighted in the Overview section, there will be a sharp swing in the flow of G4 government bonds available to the private sector, from a contraction of US$800 billion in 2017 to an increase of US$600 billion in 2018. Focusing on the U.S. market, empirical estimates suggest that the Fed's shedding of Treasurys could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio. The BCA U.S. Bond Strategy service argues that growing bank demand for Treasurys in the coming years will absorb much of the net flow of Treasurys that the Fed is no longer buying.5 As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but the point is that forward guidance will help to limit the impact of the shrinking Fed balance sheet on bond yields. Indeed, the Fed is trying hard to sever the link in investors' minds between balance sheet policy and signaling about future rate hikes, as highlighted by Chair Yellen's Q&A session following the September FOMC meeting. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. That said, much depends on inflation. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. (2) Funding Liquidity Chart II-17Tri-Party Repo Market Has Shrunk By unwinding its balance sheet, the Fed will be supplying securities into the market and removing cash. This will be occurring at a time when transactions in the tri-party repo market have fallen to less than half of their peak in 2007 due to stricter regulation (Chart II-17). This market has historically been an important source of short-term funding, helping to meet the secular rise in demand for short-term, low-risk instruments, largely from non-financial corporations, asset managers and foreign exchange reserve funds. If the Fed drains reserves from the system and T-bill issuance does not increase substantially to compensate, a supply shortage of short-maturity instruments could develop. We can see how this might undermine the Fed's ability to shift short-term interest rates higher under its new system of interest rate management, where reverse repos and the interest rate paid on reserves set the floor for other short-term interest rates. However, at the moment we do not see the risk that fewer excess reserves on its own will negatively affect funding liquidity. Again, any impact on funding liquidity would likely be felt via a sharp rise in interest rates and pullback in the portfolio balance effect, which would occur if inflation turns up. But this has more to do with rising interest rates than the size of the Fed's balance sheet. Indeed, balance sheet shrinkage could actually improve funding liquidity provided via the bilateral repo market, securities-lending, derivatives and prime brokerage channels. These are important players in the collateral supply chain. A recent IMF working paper emphasizes that collateral flows are just as important in credit creation as money itself.6 Collateral refers to financial instruments that are used as collateral to fund positions, which can be cash or cash-like equivalents. Since pledged collateral can be reused over and over, it can generate significantly more total lending than the value of the collateral itself. The Fed's overnight reverse-repo facility includes restrictions that the collateral accessed from its balance sheet can only be used in the tri-party repo system. Thus, the Fed's presence in the collateral market has reduced the "velocity of collateral." Table II-2 shows that the reuse rate of collateral, or its velocity, has fallen from 3.0 in 2007 to 1.8 in 2015. Table II-2Collateral Velocity The combination of tighter capital regulations and Fed asset purchases has severely limited the available space on bank balance sheets to provide funding liquidity. Regulations force banks to carry more capital for a given level of assets. Fed asset purchases have forced a large portion of those assets to be held as reserves, limiting banks' activity in the bilateral repo market. There is much uncertainty surrounding this issue, but it appears that an unwind the Fed's balance sheet will free up some space on bank balance sheets, possibly permitting more bilateral repo activity and thus a higher rate of collateral velocity. It may also relieve concerns about a shortage of safe-haven assets. Nonetheless, we probably will not see a return of collateral velocity to 2007 levels because stricter capital regulations will still be in place. What About Currency Swaps? Some have argued that this removal of cash could also lead to an appreciation of the U.S. dollar. In particular, Zoltan Pozsar of Credit Suisse has observed a correlation between U.S. bank reserves and FX basis swap spreads.7 There is also a strong correlation between FX swap spreads and the U.S. dollar (Chart II-18). Chart II-18FX Basis Swap And Reserves One possible chain of events is that, as the Fed drains cash from the market, there will be less liquidity in the FX swap market. Basis swap spreads will widen as a result, and this will cause the dollar to appreciate. In this framework, the unwinding of the Fed's balance sheet will put upward pressure on the U.S. dollar. However, it is also possible that the chain of causation runs in the other direction. The BIS has proposed a model8 where a stronger dollar weakens the capital positions of bank balance sheets. This causes them to back away from providing liquidity to the FX swap market, leading to wider basis swap spreads. In this model, a strong dollar leads to wider basis swap spreads and not the reverse. If this is the correct direction of causation, then we should not expect any impact on the dollar from the unwinding of the Fed's balance sheet. At the moment it is impossible to tell which of the above two theories is correct. All we can do is monitor the correlation between reserves, FX basis swap spreads and the dollar going forward. Conclusions: Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity has recovered from the Great Financial Crisis lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. However, we believe that the bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high-quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Mark McClellan Senior Vice President The Bank Credit Analyst Ryan Swift Vice President U.S. Bond Strategy 1 D. Domanski, I. Fender and P. McGuire, "Assessing Global Liquidity," BIS Quarterly Review (December 2011). 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Global Interest Rate Strategy For The Remainder Of 2017," dated July 18, 2017, available at gfis.bcaresearch.com 3 E. Cerutti, S. Claessens and L. Ratnovski, "A Primer on 'Global Liquidity'," CEPR Policy Portal (June 8, 2014). 4 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017). 5 Please see BCA U.S. Bond Strategy Weekly Report, "The Great Unwind," dated September 19, 2017, available at usbs.bcaresearch.com 6 M. Singh, "Collateral Reuse and Balance Sheet Space," IMF Working Paper (May 2017). 7 Alexandra Scaggs, "Where would you prefer your balance sheet: Banks, or the Federal Reserve?" Financial Times Alphaville (April 13, 2017). 8 S. Avdjiev, W. Du, C. Koch, and Hyun S.Shin, "The dollar, bank leverage and the deviation from covered interest parity," BIS Working Papers No.592 (Revised July 2017). III. Indicators And Reference Charts Equity indexes in the U.S. and Japan broke out to new highs in September. European stocks surged as well. Investors embraced risk assets in the month on a solid earnings backdrop, strong economic indicators, continuing low inflation and revived hopes for fiscal stimulus in the U.S. and Japan, among other factors. Our indicators do not warn of any near-term stumbling blocks for the bull market. Our monetary indicator continues to hover only slightly on the restrictive side. Our equity composite technical indicator may be rolling over, but it must fall below zero to send a 'sell' signal. The speculation index is elevated, but bullish equity sentiment is only a little above the long-term mean. Meanwhile, the S&P 500 tends to increase whenever the 12-month forward EPS estimate is rising. The latter is in a solid uptrend that should continue based on the net revisions ratio and the earnings surprise index. Valuation remains poor, but has not yet reached our threshold of overvaluation. Our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in August for the second consecutive month. We introduced the RPI in the July report. It 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 also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and Japanese WTPs are trending sideways, and Europe could be rolling over. While this is a little worrying because they indicate that flows into equity markets have moderated recently, the indicators have to clearly turn down to provide a bearish signal for stocks. Flows into the U.S. appear to be more advanced relative to Japan and the Eurozone, suggesting that there is more "dry powder" available to buy the latter two markets than for the U.S. market. Oversold conditions for the U.S. dollar are being worked off, but our technical indicator is still positive for the currency. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys is at neutral. Bond valuation is also at neutral based on our long-standing model. However, other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still more than 30 basis points on the expensive side. Stay below benchmark in duration. 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 Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##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 In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors - one of our favorite and long-standing indicators to assess the potential for monetary policy changes. The broad conclusion - the Monitors are all at or above the threshold signaling that tighter monetary policy is required, validating the recent hawkish shift by policymakers. Feature September has been an active month for central bankers. The Bank of Canada hiked rates again, the European Central Bank gave strong hints that a tapering of its asset purchase program will soon be announced, and the Bank of England warned that tighter policy might soon be required. Just last week, the Federal Reserve began the process of reducing its massive balance sheet while also making no changes to its plans to hike interest rates several times over the next year. This is setting up a potential nasty surprise for bond markets. Investors have became deeply skeptical about the possibility of policymakers shifting in a more hawkish direction without an obvious trigger from faster inflation. Yet the global economy is in a synchronized expansion with the largest share of countries operating at (or beyond) full employment since the pre-crisis years. Inflation is in the process of stabilizing, or grinding higher, in most of the major economies. In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors - one of our favorite indicators to assess the potential for monetary policy changes. The broad conclusion - the Monitors are all at or above the threshold signaling that tighter policy is required, validating the recent hawkish shift by policymakers (Chart of the Week). Chart of the WeekGrowing Pressures To Tighten, According To Our Central Bank Monitors An Overview Of The BCA Central Bank Monitors Chart 2Upward Pressure On Global Bond Yields The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Currently, the Monitors are all near or above the zero line, providing context for why central bankers have shifted towards a more hawkish bias of late. Actual rate hikes are still not likely over the next few months outside of the Fed and BoC (we remain skeptical on the potential for the BoE to realistically tighten policy). More importantly, the underlying growth and inflation pressures indicated by the Monitors suggest that policymakers will maintain a hawkish bias (or, at best, a neutral tone) in their communications with the markets. One new addition to the individual country sections in this Chartbook are charts showing the Monitors, broken into growth and inflation components. The conclusion from these new charts is that the current level of the overall Monitors is a reflection of strong economic growth in all countries, with the inflation components giving more mixed signals. The Fed Monitor: Neutral For Now, Likely To Head Higher Again Our Fed Monitor has drifted lower over the past several months, and now sits just slightly above the zero line, calling for no imminent need to change U.S. monetary policy (Chart 3A). FOMC members have been sending more balanced messages in their recent speeches, specifically noting the confusing mix of what appears to be a U.S. economy operating at full employment but with slowing core inflation (Chart 3B). Chart 3AU.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. When looking at the breakdown of our Monitor into its main inputs (Chart 3C), the growth component remains in a steady grinding uptrend. The inflation component had softened since the peak earlier this year, but the latest reading shows a slight uptick. Chart 3CPressure On The Fed From U.S. Growth. Is Inflation Next? Looking ahead, we expect realized U.S. inflation, which looks to be stabilizing after the downturn since the spring, to grind higher alongside a steadily expanding U.S. economy. With corporate profits and household incomes expanding, and with leading indicators steadily climbing, there is little reason to expect much sustained slowing of U.S. growth in the next few quarters. The next move in our Fed Monitor will likely be upward. The historical correlations between changes in our Fed Monitor and changes in U.S. Treasury yields suggest that any renewed increase in the Monitor should put more upward pressure on the front end of the yield curve than the back end (Chart 3D). This suggests that Treasury curve would bear-flatten as the market priced in more Fed rate hikes. However, we see a greater near-term risk of a bear-steepening of the curve given the low level of market-based inflation expectations. The Fed will want to see those rise - which will require signs of realized inflation rebounding - before delivering another rate hike, perhaps as soon as December. Chart 3DThe Fed Monitor Is Most Correlated To Shorter-Maturity USTs BoE Monitor: The Window Is Closing For A Rate Hike Our Bank of England (BoE) Monitor has been in the "tight money required" zone since the end of 2015 and has not signaled a need for easier monetary policy since 2012 (Chart 4A). This is unsurprising with the U.K. economy running beyond full employment for over three years alongside a steady rise in inflation (Chart 4B). Chart 4AU.K.: BoE Monitor Chart 4BTight Capacity In The U.K. The after-effects of the Brexit vote last year are still an issue for the U.K. economy and the BoE. The central bank eased monetary policy (rate cuts and QE) after the Brexit shock as insurance against the massive economic uncertainty. Yet that not only provided stimulus to an economy that was already operating beyond full employment, but also resulted in a 16% peak-to-trough decline in the British Pound. The result: a surge in headline U.K. inflation to 2.9%, well above the BoE's 2% target. The BoE sent a hawkish message at the policy meeting earlier this month, signaling that interest rates would have to rise if growth evolves in line with their forecasts. We are skeptical on that front: U.K. leading economic indicators have rolled over, real income growth has stagnated due the high inflation, and business confidence continues to be dragged down by Brexit uncertainties. Also, the greater stability in the trade-weighted Pound - now essentially flat versus year-ago levels - should result in some cooling off of the currency-driven surge in inflation, which the inflation component of our BoE Monitor is already signaling (Chart 4C). Chart 4CThe Inflation Component Of The BoE Monitor Has Collapsed We remain neutral on Gilts, as we expect the BoE to remain on hold and not follow through on their recent hawkish commentary (Chart 4D). Chart 4DThe Gilt/BoE Monitor Correlations Are Higher At The Long-End ECB Monitor: On Course For A 2018 Taper Our European Central Bank (ECB) Monitor has steadily climbed over the course of 2017 and now sits right on the zero line (Chart 5A). The solid and broad-based economic expansion in the Euro Area has soaked up spare capacity. The unemployment rate has fallen to an 8-year low of 9.1%, suggesting that the Euro Area economy is very close to full employment for the first time since the Great Recession (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BExcess Capacity In Europe Dwindling Fast Against that strong growth backdrop, core inflation has been grinding higher off the lows, but at 1.4% remains below the ECB 2% target for headline inflation. When looking at the components of our ECB Monitor, however, rising inflation pressures have been as important a reason behind the pickup in the Monitor as stronger growth (Chart 5C). Chart 5CGrowth Has Pushed The ECB Monitor Higher This Year The deflation threat that prompted the ECB to begin its own asset purchase program in 2015 has passed, and we expect the ECB to announce a tapering of the bond buying starting in January 2018. If growth and inflation evolve according to the ECB's forecasts - which is likely barring an additional major surge in the euro from current elevated levels - then there is a good chance that the asset purchase program will be wound down by the end of 2018. Interest rate hikes are still some time away, though. The market is currently discounting a first 25bp ECB rate hike around October 2019. We agree with that pricing, as the ECB will "follow the Fed playbook" and not begin rate hikes until well after the end of the asset purchase program. We remain underweight Euro Area government debt, with a bias towards bear-steepening of yield curves as inflation expectations should steadily climb higher and the ECB keeps policy rates unchanged (Chart 5D). Chart 5DStronger Bond/ECB Monitor Correlations At The Short-End BoJ Monitor: Creeping Higher, Surprisingly The Bank of Japan (BoJ) Monitor has steadily climbed throughout 2017 and now sits right on the zero line (Chart 6A). While overall inflation rates remain well below the 2% BoJ target, the steady economic expansion has absorbed spare economic capacity, with the unemployment rate now down to a mere 2.8% (Chart 6B). Both the growth and inflation components of our BoJ Monitor have been rising (Chart 6C). Chart 6AJapan: BoJ Monitor Chart 6BTight Labor Market, But Still No Inflation While the pickup in inflation off the lows is a welcome sight for the BoJ, there is no immediate pressure to shift to a less accommodative policy stance (Chart 6D). In fact, the central bank has already done its own version of a "taper" by moving to a 0% yield target on JGBs one year ago. Maintaining that yield level has required a slower pace of asset purchases by the central bank, which are running at an annualized pace of 70 trillion yen so far in 2017, below the 80 trillion yen target for the current QE program. Chart 6CTight Labor Market, But Still No Inflation We do not see the BoJ abandoning the 0% yield target anytime soon. By depressing JGB yields, the BoJ hopes to engineer additional weakness in the yen which will feed through into faster inflation and rising inflation expectations. This appears to be the only way to generate any inflation in Japan, even with such a low unemployment rate. Chart 6DLow Correlations Between the BoJ Monitor & JGB Yields It will require a rise in Japanese core inflation back towards 2% before the BoJ will even begin to discuss any real tapering of its QE program. Thus, JGBs will remain a low-beta "safe-haven" among Developed Market government bonds, where there is greater risk of central bank tightening actions that will push yields higher. Remain overweight. BoC Monitor: More Tightening To Come The Bank of Canada (BoC) Monitor has been comfortably above the zero line throughout 2017 (Chart 7A). The Canadian economy has shown robust growth, which has soaked up spare capacity (Chart 7B). The BoC is projecting that the output gap in Canada will likely be fully closed before the end of this year. The surprising surge in growth is likely to continue given the strength in the leading economic indicators and the robust readings from the BoC's own Business Outlook Survey. Chart 7ACanada: BoC Monitor Chart 7BStill Not Much Inflation In Canada The central bank has already responded to the faster-than-expected pace of growth with two 25bps rate hikes since July. This took place even without much of a pick-up in realized inflation or in the inflation component of our BoC Monitor (Chart 7C). Clearly, the BoC is focusing more on the rapidly accelerating economy, with real GDP growth surging to a 3.7% year-over-year pace in Q2. With the BoC Overnight Rate still at a very low level of 1%, well below the central bank's own estimate of the neutral "terminal" rate of 3%, there is room for additional rate hikes as long as growth remains robust. Chart 7CRising Growth Pressures On The BoC, Still No Inflation The surging Canadian dollar is not yet a concern for the BoC, as this reflects both the improving Canadian economy and the Fed taking a pause on its own rate hiking cycle. With the latter poised to resume in December and continue into 2018, the appreciation of the "Loonie" is likely to cool off, even if the BoC keeps raising rates. We have maintained an underweight stance on Canadian bonds, with a curve flattening bias, since mid-year (Chart 7D). We are sticking with that stance, even with the market now priced for nearly 70bps of additional rate hikes over the next year. If the Canadian economy continues to grow rapidly, and the Fed returns to hiking rates, the BoC can tighten to levels beyond current market pricing. Chart 7DA Rising BoC Monitor Typically Leads To A Flatter Canadian Yield Curve RBA Monitor: Conflicting Forces Our Reserve Bank of Australia (RBA) Monitor remains in "tighter policy required" territory (Chart 8A). Core inflation has picked up slightly, dragging market expectations along with it, but headline price growth has declined below 2% (Chart 8B). However, commodity prices continue to ease, survey-based measures of inflation expectations have pulled back and the inflation component of the RBA Monitor has retreated from the highs (Chart 8C). Chart 8AAustralia: RBA Monitor Chart 8BNo Inflation Pressures On The RBA The RBA is facing conflicting forces of an improving labor market and booming house prices, combined with high consumer indebtedness and nonexistent real wage growth. Though employment growth has recently spiked, part time employment as a percentage of total is just starting to roll over and underemployment remains elevated. Labor market conditions will need to tighten considerably for wages to rise and consumer confidence to recover. A wide output gap, mixed employment backdrop and a lack of inflation pressure will likely keep the policymakers on hold for longer than the market expects. Chart 8CRBA Facing Surging Growth Pressures & Cooling Inflation Pressures We are currently at a neutral stance on Australian government bonds, given the mixed economic backdrop. Instead, we prefer to maintain our 2yr/10yr yield curve flattener trade. The short end will remain anchored by an inactive RBA, with the long end facing downward pressure from soft inflation expectations and macro-prudential measures in the housing market dampening credit growth. Even if the RBA were to tighten policy as markets expect, the yield curve would flatten. Additionally, negative correlations between Australian yield curves and the RBA monitor have been more robust in the post-crisis era (Chart 8D). As labor markets continue to improve, the other components of the Monitor, such as wages, retail sales and consumer confidence, will follow. Chart 8DThe Entire Australian Curve Is Highly Correlated To Our RBA Monitor RBNZ Monitor: Rate Hikes Are Needed Our Reserve Bank of New Zealand (RBNZ) Monitor has been the strongest of all our Monitors, and is currently well into "tight money required" territory" (Chart 9A). The solid New Zealand economic expansion has fully absorbed spare capacity, and both headline core inflation are accelerating towards the RBNZ target (Chart 9B). Both the inflation and growth components are surging, contributing to the overall sharp rise in the RBNZ Monitor (Chart 9C). Chart 9ANew Zealand: RBNZ Monitor Chart 9BFull Employment & Rising Inflation In NZ So with growth and inflation looking perkier, why has the RBNZ not delivered on rate hikes this year? They central bank has highlighted "international uncertainties" related to geopolitical risks as well as trade tensions between China and the U.S. that could spill over into New Zealand exports to Asia. The central bank has also shown caution in its own growth and inflation forecasts, despite the signs of strength. Chart 9CHow Much Longer Can The RBNZ Ignore This? More likely, the RBNZ has been actively trying to avoid an unwanted surge in the currency that could derail the economy. Given the elevated geopolitical tensions with North Korea, it is likely that the RBNZ will stick with a dovish message - especially given the recent pickup in the currency. We have been running long positions in New Zealand government debt versus U.S. Treasuries and German Bunds in our Tactical Overlay portfolio since May. We've been heeding the commentary of the central bank rather than our own RBNZ Monitor, although the divergence between the two is becoming unsustainable (Chart 9D). The Q3 CPI inflation report due in October will be critical to assess the RBNZ's next move. We are sticking with our recommended trades, for now. Chart 9DNZ Bonds Are Vulnerable To Current Cyclical Growth & Inflation Pressures Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: As long as inflation shows signs of stabilizing during the next couple of months the Fed will lift rates again in December. Stay at below-benchmark duration and remain overweight TIPS versus nominal Treasuries. Credit Cycle: The process of corporate sector re-leveraging is well underway, but the corporate bond trade still has further to run. In fact, the second quarter decline in net leverage likely prolongs the length of time that overweight corporate bond positions will be profitable. Economy & Inflation: While households are no longer paying down debt, the pace of re-leveraging has so far been slow. With delinquency rates already starting to rise for certain classes of consumer credit, we see household debt growth as remaining tepid at best. Feature Janet Yellen struck a somewhat hawkish tone in her press conference following last week's FOMC meeting, as did the post-meeting statement and Summary of Economic Projections (SEP). Predictably, the bond market sold off and is now priced for 39 bps of rate hikes between now and the end of 2018 (Chart 1). While this is still well below the 100 bps predicted in the SEP, it proved sufficient to send the 2-year Treasury yield to a new cycle high (Chart 1, bottom panel). The Fed also announced the unwind of its balance sheet, as had been widely anticipated, and Yellen took great pains to stress that the pace of balance sheet reduction will not be altered unless the economy encounters a shock severe enough to send the fed funds rate back to zero. As was discussed in last week's report,1 this is a calculated move by the Fed meant to sever the link between the balance sheet and expectations about the future path of rate hikes. The SEP showed that most FOMC participants still expect to lift rates once more this year, and that only four out of 16 believe the Fed should stand pat, the same number as in June. However, expectations for one more hike this year are most likely contingent on inflation showing some further signs of strength. To see this, we note that the real fed funds rate is very close to at least one popular estimate of its equilibrium level (Chart 2). With inflation still below the Fed's target it is imperative that an accommodative monetary policy stance is maintained. Practically, this means keeping the real fed funds rate below equilibrium so that economic slack can be absorbed and inflation can rise. If inflation stays flat and the Fed hikes in December, then the real fed funds rate will move above the Laubach-Williams estimate of equilibrium. Chart 1Fed Pushes Yields Higher Chart 2Funds Rate Must Stay Below Neutral We calculate that if the Fed delivers a 25 basis point hike in December, then year-over-year core PCE inflation must rise from its current 1.41% to 1.63% for the real fed funds rate to stay below its neutral level (Chart 2, bottom panel). This squares with the Fed's central tendency forecast that calls for core PCE inflation between 1.5% and 1.6% by the end of the year. In our view, as long as inflation shows further signs of stabilizing and moves toward the Fed's central tendency range during the next couple of months, then the Fed will likely lift rates again in December. However, if inflation resumes its recent downtrend, then the Fed will take a pass. Inflation Expectations: Yellen vs. Brainard Perhaps the most interesting detail to emerge from last week's FOMC meeting is that the committee is so far rejecting Governor Lael Brainard's claim that inflation expectations have become unanchored to the downside. As we discussed in a recent report,2 inflation expectations are critical to the Fed's way of thinking about inflation. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, it would suggest that inflation's long run trend had been altered. This would make monetary policy much less effective, and a timely return of inflation to target much less likely. Governor Brainard views the recent weakness in inflation as suggesting that inflation expectations have in fact become unmoored. As evidence she points to the low levels of: TIPS breakeven inflation rates (Chart 3, top panel) Chart 3Inflation Expectations Household inflation expectations from the University of Michigan survey (Chart 3, panel 2) 5-year, 5-year forward CPI forecasts derived from the Survey of Professional Forecasters (SPF) (Chart 3, panel 3) In contrast, at her post-meeting press conference Chair Yellen pointed to median 10-year forecasts from the SPF as evidence that inflation expectations remain well-anchored (Chart 3, bottom panel). Although, she also admitted that she is unable to explain why inflation has fallen this year: I can't say I can easily point to a sufficient set of factors that explain this year why inflation has been this low. I've mentioned a few idiosyncratic things, but frankly, the low inflation is more broad-based than just idiosyncratic things. What matters for bond investors is that TIPS breakeven inflation rates, a measure of the compensation for inflation protection embedded in nominal bond yields, are well below levels that are usually seen when core inflation is well anchored around the Fed's target. At present, the 10-year TIPS breakeven inflation rate is 1.84%. We expect it will return to a range between 2.4% and 2.5% by the time that year-over-year core PCE inflation reaches 2%. In Yellen's view, inflationary pressures are strong enough for this process to play out with the Fed still being able to gradually lift rates, once more this year and then three more times in 2018. But the longer that inflation fails to rebound as Yellen expects, the more likely it becomes that the committee will come around to Brainard's view and scale back the pace of hikes. A slower expected pace of rate hikes will lend support to inflation and TIPS breakevens, and in either scenario we would expect TIPS breakevens to reach the 2.4% to 2.5% range by the end of the cycle. The uncertainty surrounds what level of real rates will be required to achieve that outcome. In that regard we are more inclined toward Yellen's view. Inflation will soon follow growth indicators higher,3 and the Fed will be able to deliver a pace of rate hikes similar to what it currently projects. But with so few rate hikes priced into the curve, we think the investment implications are the same in either scenario. Investors should stay at below-benchmark duration and remain overweight TIPS versus nominal Treasuries. Bonds In The Long-Run? The Fed's median projection for the level of longer-run interest rates also declined last week, from 3% to 2.75%. It is now only 8 bps above the 5-year, 5-year forward Treasury yield (Chart 4). Chart 4Fed Slowly Embracing A Low Neutral Rate In general, we think the 5-year, 5-year Treasury yield should be equal to the nominal interest rate expected to prevail in the longer-run plus a small risk premium. In that respect, the yield still looks a tad low compared to the Fed's forecast, although the gap has narrowed considerably. While we would not want to hinge our investment strategy on the accuracy of the Fed's longer-run interest rate forecast, it is notable that the Fed continues to price-in a future where the equilibrium interest rate remains depressed. Please see the Economy & Inflation section (below) for a discussion of the longer-run outlook for the fed funds rate. Corporate Credit Cycle Prolonged Second quarter Financial Accounts (formerly Flow of Funds) data were released last week, allowing us to update some of our credit cycle indicators. Chart 5 shows that, historically, three conditions must be met before the credit cycle turns and we experience a period of sustained corporate bond underperformance. Our Corporate Health Monitor (CHM) must be in "deteriorating health" territory, signaling that the corporate sector is aggressively taking on debt (Chart 5, panel 2). Monetary policy must be restrictive. This can be signaled by the real federal funds rate crossing above its equilibrium level (Chart 5, panel 3), or an inversion of the yield curve (Chart 5, panel 4). Banks must be tightening standards on commercial & industrial loans (Chart 5, bottom panel). So far this cycle only the first criterion has been met and while the CHM remains firmly in "deteriorating health" territory, it actually took a sizeable turn toward zero in Q2. The marginal improvement in corporate health was broad based across all six of our monitor's components (Chart 6). Even return on capital, which had been in free fall, managed to move higher (Chart 6, panel 3). Chart 5Credit Cycle Indicators Chart 6Corporate Health Monitor Components Box 1Corporate Health Monitor Components The slower pace of deterioration in corporate health can mostly be chalked up to surging profit growth. EBITD4 growth outpaced debt growth in Q2, sending our measure of net leverage lower (Chart 7). Year-over-year EBITD growth is now within striking distance of corporate debt growth for the first time since 2015 (Chart 7, bottom panel). Chart 7Can Leverage Reverse Its Uptrend? It is rare for corporate spreads to tighten while leverage is rising. So in that regard the tick lower in leverage probably extends the period of time we can remain overweight corporate bonds in a U.S. fixed income portfolio. Chart 8Profit Outlook Still Positive Since 1973, we calculate that investment grade corporate bonds have outperformed duration-equivalent Treasuries in 62% of six month periods, for an average annualized excess return of 45 bps. In prior research5 we showed that, during the same timeframe, when leverage rose for two consecutive quarters corporate bonds outperformed in only 45% of the following six month periods, for an average annualized excess return of -190 bps. This quarter's decline in leverage breaks a streak of two consecutive increases. But what about going forward? Further declines in leverage will depend on whether profit growth can sustain its recent strength. While some moderation is likely, our leading profit indicators suggest that growth will remain firm for the remainder of the year (Chart 8). Total business sales less inventories have hooked a tad lower, but are still consistent with solid profit growth (Chart 8, panel 1). Industrial production growth also rolled over last month, but that reflects temporary weakness related to Hurricane Harvey. Continued elevated readings from the ISM manufacturing index suggest that underlying demand is strong (Chart 8, panel 2). Meanwhile, dollar weakness continues to provide a tailwind for profit growth (Chart 8, panel 3), and our profit margin proxy has also ticked higher (Chart 8, bottom panel). Our profit margin proxy has risen due to weakness in unit labor costs. While tightening labor markets should cause the corporate wage bill to increase, a late-cycle rebound in productivity growth will ensure that unit labor cost growth stays muted compared to other wage growth measures. We made the case for a late-cycle rebound in productivity growth driven by stronger non-residential investment in a recent report.6 That being said, mounting wage pressures will likely cause margins to narrow next year, although a sharp margin-driven hit to profit growth is not likely in the next few quarters. Bottom Line: The process of corporate sector re-leveraging is well underway, but the corporate bond trade still has further to run. In fact, the second quarter decline in net leverage likely prolongs the length of time that overweight corporate bond positions will be profitable. Economy & Inflation: Household Re-leveraging Still A Slog As was noted above, both model-driven estimates and FOMC forecasts posit that the real equilibrium fed funds rate is very low by historical standards. One school of thought, secular stagnation, views the low equilibrium rate as a permanent state of affairs. While another, the "headwinds" thesis, claims that the fall-out from the financial crisis is keeping the equilibrium rate low for now, but that it will rise as the vestiges of the crisis start to fade. In this second theory, the major headwind keeping the equilibrium rate temporarily low would be the slow pace of household re-leveraging. Chart 9 shows the correlation between the Laubach-Williams estimate of the real equilibrium fed funds rate and growth in household debt. Household debt has only recently started to increase, and even today it is growing at a historically slow pace. So far this has not translated into strong enough growth to push the equilibrium interest rate higher, perhaps because the modest debt growth is occurring off quite a low base. Overall household debt is no longer falling relative to disposable income, but it has also not yet started to rise (Chart 9, panel 2). Whether you fall into the secular stagnation or headwinds camp, we would argue that the pace of household re-leveraging will remain tepid, keeping a lid on the equilibrium interest rate for quite some time. Household debt is dominated by housing, where still-tight lending standards and a lack of savings on the part of potential first-time homebuyers remain semi-permanent features of the economic landscape that will take a long time to disappear. Outside of housing, consumers have been adding debt fairly aggressively, especially in the non-revolving (auto loan and student loan) spaces (Chart 9, bottom panel). The problem is that in those areas where consumers have been adding debt (credit cards, auto loans and student loans), we are also seeing delinquency rates start to rise (Chart 10). Chart 9Household Debt & The Neutral Rate Chart 10Consumer Credit Delinquency Rates Delinquency rates are elevated compared to pre-crisis levels for both auto loans and student loans. For credit cards, where the re-leveraging is not as far advanced, delinquency rates remain low but have started to increase. It is only in the mortgage market, where re-leveraging has not occurred, that delinquencies remain low. The fact that delinquency rates have already started to increase for auto loans, student loans and credit cards suggests that there is limited scope to add further debt in those areas. Bottom Line: While households are no longer paying down debt, the pace of re-leveraging has so far been slow. With delinquency rates already starting to rise for certain classes of consumer credit, we see household debt growth as remaining tepid at best. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com 4 Earnings before interest, taxes and depreciation. 5 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 12, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification