CRE

Highlights The banks got the current earnings season off to a good start, … : Lending growth may be running in place, and net interest margins are under pressure, but positive operating leverage helped the banks beat expectations, and they are returning gobs of cash to their shareholders. … are quite constructive about the economy, … : The big banks’ CFOs and CEOs were uniformly bullish about the U.S. economy based on their perceptions of household and corporate health. … expect stellar credit performance to continue for the foreseeable future, … : Net charge-off and non-performing loan ratios are near all-time lows and the banks don’t see them rising any time soon. … and appear to be willing to extend loans in all categories except commercial real estate: Every bank sees unattractive competition in commercial real estate lending and plans to continue shrinking its CRE loan book. Nothing To See Here Two-fifths of the companies in the S&P 500 have now reported their quarterly earnings, and after this week the share will be two-thirds. At the aggregate level, it appears as if investors’ worst fears will not be realized, just as they weren’t in the first two quarters of the year. 2018’s greater than 20% year-on-year growth, powered by the sharp cut in the top corporate income tax rate, has rolled off, but earnings have yet to contract. They were projected to fall by a little over 3% at the beginning of this reporting season, but repeated practice has allowed corporate managements to hone their underpromise-and-overdeliver skills to a fine point, and we won’t be surprised if they avert an outright contraction. Chart 1Profit Margins Are Being Squeezed, ... Profit Margins Are Being Squeezed, ... Profit Margins Are Being Squeezed, ... Chart 2... But Neither Growing Compensation, ... ... But Neither Growing Compensation, ... ... But Neither Growing Compensation, ... Earnings growth has been stagnant this year (Chart 1, bottom panel), though revenues have grown a little faster than nominal GDP (Chart 1, top panel), with which they should converge over time. Profit margins have finally come under pressure, though it’s not exactly clear why. Employee compensation is businesses’ biggest expense by far, and while it has risen from its lows, its growth decelerated last quarter (Chart 2). Dollar strength is a headwind for U.S.-based multinationals, but the dollar only really moved last quarter, after ending the first half where it started the year (Chart 3). Dollar gains weigh on revenues just as surely as they do on profits, though we would not be at all surprised if the share of non-dollar expenses is a good bit smaller than the widely quoted 33-40% estimate of S&P 500 constituents’ foreign sales. Chart 3... Nor A Stronger Dollar Is A Clear-Cut Culprit ... Nor A Stronger Dollar Is A Clear-Cut Culprit ... Nor A Stronger Dollar Is A Clear-Cut Culprit Rate cuts have sparked a wave of mortgage refinancings, shifting wealth from mortgage investors to homeowners, who are more likely to spend it. Easier monetary conditions should help grease the skids for future earnings growth, both in the U.S. and abroad, and we expect the Fed will cut the fed funds rate by another 25 basis points when it meets this week. We have sympathy for the argument that since interest rates were not a meaningful constraint on growth, cutting them is not likely to provide much of a catalyst. Falling rates have provoked a wave of mortgage refinancings (Chart 4), however, so even if they don’t drive a big lending increase, they are already on their way to putting more money in the pockets of homeowners. Lower rates also reduce the risk of default by lowering debt-service costs for adjustable-rate borrowers, and by encouraging investors who need income to venture further out the risk curve, providing ample capital for borrowers seeking to extend their maturing obligations. Chart 4Putting More Money In Homeowners' Pockets Putting More Money In Homeowners' Pockets Putting More Money In Homeowners' Pockets Follow The Money Chart 5Bank Stocks Are Probing Resistance Bank Stocks Are Probing Resistance Bank Stocks Are Probing Resistance For two years, beginning in 2014, we reviewed the biggest banks’ earnings calls every quarter. The goal was to observe the give and take between bank management and sell-side analysts to gain some insight into the lending market and where it might be headed. We specifically sought information about banks’ willingness to lend, consumers’ and businesses’ appetite for credit, borrower performance, and the banks’ bottom-up perspective on the economy. We were also trying to glean insight into mortgage lending and what it might imply for residential investment. Studying the banks is a natural pursuit for a firm that was founded upon the insight that following money flows through the banking system would provide us with a window into the future direction of the economy and financial markets, and we return to it today. Our analysis is not meant to evaluate the banks’ own investment potential, though we note that they are testing resistance once again (Chart 5), and our Global Investment Strategy and U.S. Equity Strategy services both recommend overweighting them. This round of calls found bank management teams eager to ramp up their distributions to shareholders and optimistic about their ability to deploy technology to drive further efficiency gains. Big Banks Beige Book As a group, the banks were constructive on the economy. Despite widespread recession concerns, they do not see evidence of a looming slowdown from their interactions with consumers and businesses. Overall loan growth has remained around 5% over the last year and a half (Chart 6), while corporate and industrial (C&I) loan growth has ground to zero over the last thirteen weeks (Chart 7). The CEOs and CFOs do not see the C&I slump as the beginning of a worrisome trend, though, and global corporate bond issuance hit an all-time high in September, led by sizable issues from mega-cap U.S. companies. Businesses seeking credit are having no trouble getting it, though all the banks expressed an intention to continue cutting back their exposure to commercial real estate (CRE) loans. Chart 6Bank Lending Is Supporting Activity Without Risking Overheating Bank Lending Is Supporting Activity Without Risking Overheating Bank Lending Is Supporting Activity Without Risking Overheating Chart 7Lending Momentum Has Slowed, But It's Okay Lending Momentum Has Slowed, But It's Okay Lending Momentum Has Slowed, But It's Okay Another commercial real estate issue emerged across the calls: several of the biggest banks are consolidating their branch footprints. Prompted by questioning from one analyst, they touted branch closures as a way to enhance efficiency. We do not know if a reduction in bank demand for branch space would have an observable effect on demand for retail space across the country, but it certainly would in Manhattan. It seems possible that branch closures could pressure some retail lessors’ profitability, and thereby act as a drag on CRE whole-loan and CMBS performance at the margin. The Economy [C]onsumer spend and … confidence continue to be strong. I think business activity continues to be strong. I think it’s moderated somewhat because of … trade policy, but generally, I think the economy is solid. (Dolan, USB CFO) I think it’s fair to say that perhaps marginal investment is being impacted by trade fatigue in terms of the uncertainty, but … [there’s] still growth. … [T]he consumer is incredibly strong, … spending is strong, sentiment is strong, … credit is good. [I]t is true that [the recent ISM manufacturing and non-manufacturing surveys] were disappointing[,] so [there are] cautionary signs, but credit remains very good and there is still very healthy business activity. (Piepszak, JPM CFO) In general, our commercial customers continue to see moderate demand and no widespread issues related to trade uncertainty and interest rate changes. … [W]hile our customers are cautious, the most common concern they identify is their ability to hire enough qualified workers. (Shrewsberry, WFC CFO) Consumer payments up 6% year-to-date … [and 6% year-over-year 3Q growth in both our small business segment and total commercial loans] are tangible examples that the U.S. economy is still in solid shape, despite the worries and concerns about trade wars, capital investment slowdowns or other global macro conditions. (Moynihan, BAC CEO) Borrower Performance [W]e’ve had growth in the United States for the better part of 10 years [a]nd … credit is extraordinarily good. … [C]onsumer credit, commercial credit, wholesale is extraordinarily good, it can only get worse if you have a [turn in the] cycle. [Our guidance relates to expected performance across a full cycle.] We’re at the over-earning part of the cycle [beating the through-the-cycle expectation] in credit today, and [at] one point we’ll be at the under-earning part [pulling the full result down to our expectation]. (Dimon, JPM CEO) Our net charge-off rate remains near historic lows at 27 basis points (Chart 8). (Shrewsberry, WFC) Chart 8C&I Charge-Off Rates Are Near Their Historic Lows C&I Charge-Off Rates Are Near Their Historic Lows C&I Charge-Off Rates Are Near Their Historic Lows Credit quality remains stable, and we are not seeing any early indicators in our portfolio that cause us concern. (Cecere, USB CEO) Banks see no broad credit warning signs, but they're perfectly happy to let non-bank lenders take some commercial real estate share at this point of the cycle. We closely monitor our commercial portfolio for signs of weakness and credit quality indicators remain strong. (Shrewsberry, WFC) Lender Willingness [W]e are mindful that at some point, the industry will experience a credit downturn, and we remain disciplined in terms of origination quality and our long-term strategy of remaining within our defined credit box regardless of the competitive environment. (Cecere, USB) [Commercial] real estate banking [declined] as we remain selective, given where we are in the cycle. (Piepszak, JPM) [Commercial real estate lending] is one market where there’s late cycle behavior, there’s lots of non-bank competitors, … more than bank competitors. And so we really have to pick our spots in order to maintain our risk/reward, credit and pricing in loan terms quality. … I wouldn’t look for it to grow meaningfully until the cycle turns and our best customers have really interesting opportunities to put their own capital to work. (Shrewsberry, WFC) [Our declining commercial real estate lending is] really a function of [competition] that we’re not comfortable with. (Cecere, USB) Banks’ Real Estate Demand [C]ustomer behaviors are changing. The amount of transaction activity that’s happening in the branches is significantly less[.] In fact, … roughly 70, 80% of it goes through the digital channel today. So that gives us the opportunity to really reconfigure the branch network, both in terms of size and numbers[.] I think those trends are going to continue … , and … we may accelerate or increase some of [our right-sizing] activity[.] (Dolan, USB) Teller and ATM transactions declined 6% from a year ago, reflecting continued customer migration to digital channels. We’ve consolidated 130 branches in the first nine months of this year, including 52 branches in the third quarter. (Shrewsberry, WFC) [D]o we continue to work on real estate configurations that were down 50 million square feet from the start of 2010[?] [C]an we push [the occupancy rate] up, can we densify the space[?] (Moynihan, BAC) Investment Implications While rereading the April 2014 U.S. Investment Strategy that reviewed the big banks’ 1Q14 earnings calls, we were struck by how similar the picture is today. Back then, we described the central challenge for investors as choosing between mushy fundamentals and generous monetary policy that might be expected to inspire a valuation overshoot. As we do now, we anticipated that activity would soon pick up, providing markets with a fundamental boost, but we also had the sense that “policy settings are such that no much more than the status quo may be required to keep the party going.” We reiterated our equity overweight and our preference for spread product over Treasuries. Between inflection points, investing is an exercise in trend following, and there's no reason to believe that the monetary policy trend is about to change without clear advance notice. Although we are congenitally optimistic about our species and our country, we are not perma-bulls. We simply recognize that, between inflection points, investing is an exercise in trend following, no matter how uncomfortable it may make an investor to leave the portfolio dials alone for a while. As long as the monetary policy backdrop remains extremely accommodative across all of the major developed economies, and central banks are set to add even more accommodation before they start removing it, the bullish trend will remain in place. The prospective real returns of cash and highly-rated sovereign bonds are likely to remain negative for a while against that backdrop, encouraging investors to direct their marginal investment dollar to risk assets as long as a fundamental reversal is not imminent. We think a fundamental inflection is at least two years away, and therefore continue to believe that it is too early to de-risk investment portfolios. We reiterate our recommendation that investors remain at least equal weight equities in balanced portfolios, and at least equal weight spread product within their fixed-income allocations. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com

Feature This week, instead of our regular Weekly Report, we will answer clients’ most frequently asked questions (FAQs) from our recent marketing trip to the old continent. Table 1 lists these questions and below we will attempt to weave a cohesive piece and answer all of these interesting questions. Clients inquiring about “how is everyone else positioned” or the related “what is the general investor sentiment like” is by far the most FAQ we always get from the road and we purposefully omit it from Table 1. Table 1Most FAQs From The Road 10 Most FAQs From The Road 10 Most FAQs From The Road During our last three developed markets (DM) trips, while we cannot comment on the positioning question, with regard to general investor sentiment, Australia and New Zealand are off the charts bullish. On the opposite end of the spectrum, Europe is extremely bearish, especially continental Europe. The U.S. is somewhere in the middle. Chart 1Fed’s Pivot On Display Fed’s Pivot On Display Fed’s Pivot On Display With that out of the way, the recent broadening out of the U.S. yield curve inversion to the 10/fed funds rate took center stage in our client interactions, especially the implications of the inversion for sector positioning and the duration of the business cycle. To set the record straight, a yield curve inversion does not forecast recession. Instead, it explicitly signals that the market expects the Fed’s next move to be an interest rate cut (top panel, Chart 1). In that context, the yield curve has never had a false-positive reading. Even in May 1998, it accurately forecast that the Fed would decrease the fed funds rate as it actually did in the fallout of the LTCM meltdown later that year (bottom panel, Chart 1). As equity investors, what consumes us is the SPX’s performance following the yield curve inversion. On that front, mid-December last year we showed the results of our research and made a simple observation that the yield curve inversion almost always takes place prior to the S&P peak (Table 2, Charts 2 & 3). Table 2Yield Curve Inversions And S&P 500 Peaks 10 Most FAQs From The Road 10 Most FAQs From The Road Chart 2 Chart 3…And Then The SPX Peaks …And Then The SPX Peaks …And Then The SPX Peaks In addition, today we show the S&P 500’s return and the sector returns from the time the 10/2 yield curve slope inverts until the S&P peaks, and we summarize the results in Table 3. Table 3Sector Returns From Y/C Inversion To SPX Peak 10 Most FAQs From The Road 10 Most FAQs From The Road While every cycle is different, clearly it pays to have energy exposure more often than not. In contrast, high-yielding defensive sectors like utilities and telecom services fare poorly in these late-cycle iterations. Meanwhile, Table 4 highlights sector performance from the SPX peak until the U.S. recession hits. We first showed these results on May 22, 2018, and we are on track to publish a Special Report on May 5 on how to position portfolios at the onset of a Fed easing cycle, so stay tuned. Table 4Defensive Stocks Beat Late 10 Most FAQs From The Road 10 Most FAQs From The Road Investors remain infatuated with the recession signal that the yield curve inversion emits. Moreover, recent news of an onslaught of Unicorn IPOs that would bring stock supply to the equity market, near the $100bn mark on an annualized basis according to some estimates, have also brought forward recession fears, as smart money is cashing in on their investments. Chart 4 shows that $100bn per annum in IPOs has coincided with the SPX peak in the previous two cycles. Our long-held view remains that either a mega M&A deal in the tech or biotech space or Uber’s IPO at a stratospheric valuation could serve as the anecdote that confirms the current cycle’s peak. On the yield curve front specifically, the top panel of Chart 5 shows that the most important yield curve, the 10/2, has not yet inverted. Moreover, the 30/10 and the 30/5 slopes are steepening. True, we are late cycle, but we need all the slopes to invert to get a confirmation that the recession is a foregone conclusion. Chart 4Mind The Excess Supply Mind The Excess Supply Mind The Excess Supply Chart 510/2 Y/C Has Yet To Invert 10/2 Y/C Has Yet To Invert 10/2 Y/C Has Yet To Invert The Fed’s tightening cycle has not only inverted most parts of the yield curve starting early last December, but has inflicted some damage on profit margins. Following up from our recent profit margin work highlighting nil corporate pricing power at a time when wage costs are perking up, BCA’s Monetary Indicator signals more SPX margin pain in the coming months (Chart 6). In fact, sell-side estimates call for another three consecutive quarters of a year-over-year contraction in profit margins. Chart 6Margin Trouble Margin Trouble Margin Trouble In more detail, the earnings deceleration that commenced in Q4 2018 and is gaining steam is disconcerting. As a reminder, Q4 included the lower corporate tax rate and the Q/Q deceleration is not solely due to the tech sector profit warnings. Eight out of the 11 GICS1 sectors sharply decelerated, two modestly accelerated and only industrials steeply accelerated to a cyclical EPS peak growth rate (Table 5). This EPS breadth deterioration is eerily reminiscent of early-2015 (Chart 7) and is disquieting. Short-term caution is also warranted given the increase in investor complacency. The one sided positioning in the VIX futures market is worrisome. As a reminder, net speculative positions are now at a lower low than the February 2018 level when the VIX snapped to over 50 and caused a massive tremor in the equity market (net speculative positions shown inverted, Chart 8). Table 5Historical/Current/Future Earnings Growth Rates 10 Most FAQs From The Road 10 Most FAQs From The Road Chart 7Bad Breadth Bad Breadth Bad Breadth Chart 8Too Complacent Too Complacent Too Complacent But, before getting overly bearish there are some growth green shoots that suggest that Q2-to-Q3 will likely mark the trough in EPS/EBITDA growth and margins (Chart 9). Beyond these positive leading profit indicators, a resolution to the U.S./China trade tussle and China’s trifecta of policy easing measures will also aid in turning profit growth around and really power up U.S. cyclicals’ EPS growth rates. Following up from the January Fed meeting, on February 4 we penned a report titled “Don’t Fight The PBoC” and it is now clear with the recent manufacturing PMI release that China’s easing on all three fronts – credit (Chart 10), monetary (Chart 11) and fiscal (Chart 12) – is starting to pay some dividends. In that light, the U.S. cyclicals vs. U.S. defensives recent outperformance has more room to run. Chart 9Growth Green Shoots Growth Green Shoots Growth Green Shoots Chart 10Chineasing… Chineasing… Chineasing… Chart 11...On All… ...On All… ...On All… Chart 12…Fronts …Fronts …Fronts   Deep cyclicals have another major advantage this cycle compared with defensives. While at this stage of the business cycle one would expect capital intensive businesses to become debt saddled, cyclicals are still de-levering from the depths of the late-2015/early-2016 manufacturing recession, i.e. paying down debt and increasing cash flow. Defensives, however, are doing the exact opposite with relative cash flow growth problems and piling on debt. Thus, on a relative basis Chart 13 shows that the indebtedness profile clearly favors deep cyclicals vs. defensives. From a bigger picture perspective, while the U.S. has not really purged any debt and it has just shifted it around from the financial and household sectors to the non-financial business and government sectors (Chart 14), the near all-time high in non-financial business sector credit as a share of GDP is disconcerting (top panel, Chart 14). Clearly the excesses are in this segment of U.S. debt and it is unsurprising that debt saddled stocks have been underperforming equities with pristine balance sheets since the 2016 presidential elections (top panel, Chart 15). Such outperformance has staying power, especially given that we are late in the cycle and the Fed has raised interest rates to the point where parts of the yield curve are inverted and a default cycle looms large (bottom panel, Chart 15). Chart 13Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Chart 14U.S. Debt Profile Breakdown U.S. Debt Profile Breakdown U.S. Debt Profile Breakdown One sub-sector that epitomizes the current cycle’s excesses is commercial real estate (CRE). CRE prices have overshot the historical time trend by almost two standard deviations and it has already been three and a half years since they surpassed the previous all-time high (Chart 16). The recent pullback in the 10-year Treasury yield has pushed cap rates even lower and the bubble in CRE is further inflated. Looking back at the late-1980s pricking of that CRE bubble is instructive and when this cycle ends a big deflationary impulse will likely deal a blow to the CRE market.       Chart 15Hide In Pristine Balance Sheets Hide In Pristine Balance Sheets Hide In Pristine Balance Sheets Chart 16CRE Excesses Are A Yellow Flag CRE Excesses Are A Yellow Flag CRE Excesses Are A Yellow Flag Speaking of bubbles, the biggest bubble we currently see is not in equities, but in bonds. Table 6 shows that red is taking over and is reminiscent of mid-year 2016 when the 10-year U.S. Treasury yield troughed a hair above 1.3%. Globally, negative yielding debt is near all-time highs (Chart 17) and the excesses are even larger in the EM sovereign space and in select DM corporates. Mexico raising century debt in U.S. dollars, in cable and in euros is perplexing, as Mexico was at the epicenter of the 1982 LatAm crisis and again in 1994 with the Tequila crisis. Argentina also raising century debt recently in hard currency speaks to the magnitude of the current bond bubble. On the corporate side, Sanofi and LVMH placing negative yielding debt is beyond our understanding, or Total issuing a perpetual bond with a 1.75% coupon. Table 6Red Takes Over 10 Most FAQs From The Road 10 Most FAQs From The Road   Chart 17Bonds Are In A Bubble Bonds Are In A Bubble Bonds Are In A Bubble All of this is likely linked to the unintended consequences of global QE where fixed income investors are pushed out the risk spectrum and are forced into buying riskier credit. When this bond bubble gets pricked it will end in tears as it always does and the catalyst will likely be the next U.S. recession that will cause a global recession. While our cyclical 9-to-12 month equity market view is constructive and we believe the U.S. will avoid recession, our structural 1-to-3 year view is negative. Nevertheless, we constantly challenge our thesis and the biggest pushback to the negative structural view is the following: What if the Fed can engineer a soft landing in the U.S. as it did twice in the mid-1990s, and the business cycle runs hot for another 5 years (Chart 18)? What if the starting point of low interest rates with the real fed funds rates still close to zero is very stimulative for the U.S. economy as no recession has ever started with a fed funds rate perched near zero (Chart 19)? Finally, what if the late-2015/early-2016 manufacturing recession was actually an economic recession despite the fact that the NBER did not designate it as such and the business cycle got reignited, especially with President Trump’s election that lifted animal spirits? As a reminder, while S&P profits have contracted outside of an economic recession twice before, SPX sales had never achieved that feat, until late-2015/early-2016 (Chart 20). In other words, the revenue recession we had was unprecedented and felt like an economic recession. Chart 18The Fed Has Engineered A Soft Landing The Fed Has Engineered A Soft Landing The Fed Has Engineered A Soft Landing Chart 19Stimulative Real Rates Stimulative Real Rates Stimulative Real Rates Chart 20There Is Always A First Time There Is Always A First Time There Is Always A First Time If that were the case and the cycle were to extend into the 2020s, then the risk is that SPX EPS vault to $200 and valuations overshoot, i.e. the forward P/E multiple spikes to a 20 handle and the SPX catapults to 4,000. In that case, we would leave 1,000 points on the table and our SPX 3,000 view would be way offside. While this is a risk to our negative structural view, there are two sectors we really like for the long-term as we deem them secular growth plays and should do exceptionally well on a 10-year horizon: software and defense stocks. Three key drivers underpin our bullish view on software: galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A (Chart 21). Most importantly, the move to cloud computing and SaaS, the proliferation of AI, machine learning and augmented reality are not fads but enjoy a secular growth profile, and signal that capital outlays on software are in a structural uptrend. With regard to defense stocks, the three key pillars we highlighted in our “Brothers In Arms” Special Report on October 31, 2016 remain intact: the global rearmament is still gaining steam, a space race with manned missions to the moon now includes the U.S., China and India, and cybersecurity is a real threat for governments around the world (Chart 22). On all three fronts, defense stocks stand to benefit as they have beefed up their offerings to provide governments with a one-stop shop solution covering most of these needs. Chart 21Buy The Software Breakout Buy The Software Breakout Buy The Software Breakout Chart 22Defense Stocks Remain A Long-term Buy Defense Stocks Remain A Long-term Buy Defense Stocks Remain A Long-term Buy     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Anastasios Avgeriou, Vice President U.S. Equity Strategy An exploitable market- and industry-neutral opportunity has surfaced to generate alpha by going long the S&P homebuilding index/short the S&P REITs index. This ratio has only recently reclaimed its upward sloping long-term time trend, leaving ample room for additional gains as the business cycle is long in the tooth (Chart 1). Chart 1Ratio Is Only Back To Trend Line Ratio Is Only Back To Trend Line Ratio Is Only Back To Trend Line Four key pillars form the thesis for this intra-real estate pair trade: Favorable macro tailwinds for residential vs. commercial real estate (prices, credit, interest rates), Firm relative demand dynamics, Supportive relative supply backdrop, Compelling relative valuations and technicals. Of Prices, Credit And Rates... Commercial real estate (CRE) is in a slightly different stage of the real estate cycle than its brethren, the residential real estate sector. Chart 2 shows that real CRE prices have overtaken the previous top, whereas house prices deflated by inflation remain significantly below the 2006 zenith. In nominal terms, CRE prices are one standard deviation above the previous high, while residential real estate prices just recently made all-time highs. This makes the CRE sector extremely vulnerable, as there is no cushion for any potential mishap. Importantly, our CRE occupancy rate composite has peaked for the cycle and is actually contracting, warning that CRE prices will likely suffer the same fate (bottom panel, Chart 3). The residential occupancy rate is the mirror image of the CRE one. Not only are new plus existing home inventories extremely tight by historical standards in the housing market, but the ultra-low vacancy rate is also a harbinger of additional house price gains in the coming months (top two panels, Chart 3). Chart 2Trade Opportunity In Diverging... Trade Opportunity In Diverging... Trade Opportunity In Diverging... Chart 3...Real Estate Markets ...Real Estate Markets ...Real Estate Markets As with every bubble, ultra-cheap credit has fueled the excesses in the CRE sector. Total CRE credit outstanding has ballooned to over $2.1tn, and comprises more than half of the commercial banks' overall real estate loan portfolios (Chart 4). While CRE loan growth is no longer galloping north of 10%/annum, it is still expanding. The stock of residential real estate loans on U.S. commercial bank's balance sheets also hit fresh all-time highs recently, but CRE dwarfs its residential cousin both in growth and level terms. Real estate investors know all too well that, ultimately, rising interest rates prick bubbles and the specter of tightening monetary policy concentrates minds. While both sectors will suffer from rising interest rates, given that the excesses this cycle are concentrated in CRE, in a relative sense, residential real estate is more insulated from a hawkish Fed (Chart 5). Keep in mind that housing was at the epicenter of the Great Recession, a once in a life time crisis, whose ramifications are still reverberating across the financial system one decade later. We doubt another big bust looms large in the residential real estate market. Chart 5 also shows that relative share prices are not only positively correlated with the fed funds rate, but also with the 10-year Treasury yield. True, rising 10-year interest rates filter right through to 30-year fixed mortgages denting housing affordability, but homebuilders are less sensitive to interest rates than REITs. Thus, a rising interest rate backdrop, which remains one of BCA's key themes for the year, is not detrimental to the relative share price ratio, but conducive to relative gains. In more detail, rising interest rates are likely to cause more pain in CRE than in the residential market, given the different starting points for delinquencies. Chart 6 shows a steep divergence between the two real estate sectors in their respective delinquency rates. In fact, since data is available, the CRE delinquency rate has never been lower than its current 0.75%. The Fed continues to raise interest rates, but some CRE borrowers are having trouble serviving this debt as rental income growth (for more details refer to the supply section below) is under pressure. Thus, delinquency rates, charge-offs and foreclosures will shoot higher. Chart 4CRE Excesses This Cycle CRE Excesses This Cycle CRE Excesses This Cycle Chart 5Higher Interest Rates Are A Boon For The Ratio Higher Interest Rates Are A Boon For The Ratio Higher Interest Rates Are A Boon For The Ratio Chart 6Unsustainably Low CRE Delinquencies Unsustainably Low CRE Delinquencies Unsustainably Low CRE Delinquencies What About Relative Demand... On the demand front, our comparative demand proxy also corroborates the positive correlation of relative share prices with interest rates. Rising interest rates deal a blow to refinancing mortgage applications, but do not prohibit first-time homebuyers from making one of the largest purchase decisions of their lives (Chart 7). Moreover, there is a preference switch that is gaining steam on the horizon. The own versus rent dilemma has likely hit a multi-decade nadir. Rising job certainty and wages at a time when the economy is at full employment argue for a switch out of rent and into home ownership. Already, the ratio of home owners to renters has gone from 1.7 to 1.8 in the past 18 months; yet, it is still hovering near a generationally low level. Put differently, only 64.2% of the housing stock are owners and 35.8% are renters. This differential remains depressed and if there is a modest renormalization toward the historical mean, the ratio would have to revert closer to 1.9, and thus further lift relative share prices (Chart 8). Chart 7Relative ##br##Demand... Relative Demand... Relative Demand... Chart 8...Gauges Favor Residential Vs.##br## Commercial Real Estate ...Gauges Favor Residential Vs. Commercial Real Estate ...Gauges Favor Residential Vs. Commercial Real Estate ...And Supply Backdrops? The relative supply backdrop also favors homebuilders versus REITs. Multi-family housing starts have been running near previous cyclical peak levels and 33% above the historical mean for the better part of the past five years adding roughly 2mn apartment units in aggregate. In contrast, single family home construction has been in recovery mode and continues to trail its historical average, with single family housing starts also adding a similar amount of units since 2013. To put this number in perspective, on average single family home construction should be triple multi-family starts (Chart 9). This construction backdrop does not bode well for CRE prices relative to residential real estate prices. Another related source of CRE pricing pressures are CRE rents. Rental income is in danger of stalling from this massive multi-family supply overhang and so is REITs cash flow growth. The opposite is happening in residential housing. Household formation is still running higher than housing starts, underscoring that recent house price inflation rests on a solid foundation. Chart 9Mind The Massive CRE Supply Overhang Mind The Massive CRE Supply Overhang Mind The Massive CRE Supply Overhang Chart 10Alluring Entry Point Alluring Entry Point Alluring Entry Point Compelling Entry Point One final reason why we are warming up to this pair trade is valuations and technicals. Relative value has been restored with our Valuation Indicator correcting to one standard deviation below the historical mean, offering investors a great reward/risk tradeoff. Similarly, technicals are no longer waving a red flag; our Technical Indicator has also unwound extremely overbought conditions and recently sunk below the neutral line (Chart 10). Risks To Monitor Chart 11Monitor This Risk Monitor This Risk Monitor This Risk Nevertheless, there are two key risks that can put our thesis, and thus the relative share price ratio, offside. While both sectors are 100% domestically geared and appear insulated from all the trade war / protectionism risks, homebuilders have to contend with rising input costs both in terms of building materials (lumber in particular, as well as concrete and steel), but also with rising construction-related wage inflation. REITs, in contrast, are free of both such risks. Most importantly, the Fed's Senior Loan Officer Survey is waving yellow flags. Both in terms of demand for respective loans and bankers' willingness to extend credit, CRE has the upper hand. While loan officers are tightening standards in CRE and mortgage loans, they are more prudent with credit origination in residential housing than in CRE. Similarly in a relative sense, bankers are reporting a steeper decline in demand for residential mortgages than for CRE loans (Chart 11). Adding it up, four key drivers - favorable macro tailwinds for residential versus commercial real estate on the price, credit and interest rate fronts, firming relative demand dynamics, supportive relative supply backdrop and appealing relative valuations and technicals - argue for opening a long S&P homebuilders/short S&P REITs pair trade. Bottom Line: Initiate a long S&P homebuilding/short S&P REITs pair trade today. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com

Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined Bitcoin: Most Of It Has Been Mined Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut Governments Will Want Their Cut Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Where Low Rates Have Fueled House Prices Where Low Rates Have Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Rent Growth Is Cooling Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Low Volatility Is In High Demand Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Erosion Of Supply In The Stock Market Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Will Bitcoin Be DeFANGed? Will Bitcoin Be DeFANGed? Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 China's Holdings Of Treasurys: Largely Flat Since 2011 China's Holdings Of Treasurys: Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases BoJ Has Been Reducing Its Bond Purchases BoJ Has Been Reducing Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Yen Is Already Cheap... Yen Is Already Cheap... Chart 15...And Unloved ...And Unloved ...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Euro Area Economic Surprises Edging Lower Euro Area Economic Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Negative Credit Impulse In The Euro Area Will Weigh On Growth Negative Credit Impulse In The Euro Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials The Euro Has Strengthened More Than Justified By Interest Rate Differentials The Euro Has Strengthened More Than Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Euro Positioning: From Deeply Short To Record Long Euro Positioning: From Deeply Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The Q2 earnings season will be above average and the BCA Earnings model predicts EPS growth to hit 18% later this year before moderating in 2018. Are the NIPA and S&P profit measures sending different signals? Business capital spending remains in an uptrend despite businesses' reluctance to spend ahead of changes in corporate tax policy. The commercial real estate sector (CRE) is beginning to show early signs of stress. Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits, even for Republicans in an environment of populism. Feature Q2 Earnings Season Is Here Chart 1Strong Earnings Growth##BR##In 2017 Will Support Equities Strong Earnings Growth In 2017 Will Support Equities Strong Earnings Growth In 2017 Will Support Equities The Q2 earnings season will be above average and the BCA Earnings model predicts EPS growth to hit roughly 18% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 1). The consensus is anticipating an 8% year-over-year increase in EPS in Q2 2017 versus Q2 2016, and 11% for 2017. Energy, technology, and financials, all are forecast to lead the way in earnings growth in Q2, but utilities and telecom will be the laggards. The favorable profit picture for Q2 and the rest of the year reflects the rebound in oil prices, which are expected to boost energy sector EPS by 671%. 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. The focus in Q2 for investors and corporate executives will be on the improving economic conditions in Europe and EM, the U.S. dollar and the sustainability of margins. Guidance from CEOs and CFOs on trends in 2H 2017 and beyond are more important than the actual Q2 results. Note that guidance can be tracked using Chart 2. Investors should guard against managements' over-optimism because earnings growth forecasts almost always move lower over time. Chart 22017 EPS Estimates Rebounding And 2018 Stable 2017 EPS Estimates Rebounding And 2018 Stable 2017 EPS Estimates Rebounding And 2018 Stable In Q2, firms with high overseas sales should benefit from the improved growth profile in Europe and Japan. Global GDP growth projections for this year and next have steadily escalated, in sharp contrast with prior years when forecasters have relentlessly lowered GDP estimates. On the other hand, the U.S. dollar should be a modest drag on earnings in Q2; the dollar is up 2% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (May 31) mentions of a "strong dollar" were unchanged compared with a year ago, indicating that the stronger currency has faded as a primary concern of managements in recent months. Our view is that the dollar will appreciate by another 10%. This appreciation would trim EPS growth by roughly 2.5 percentage points, although most of this would occur in 2018 due to lagged effects. Another upleg 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. Investors are skeptical that margins can advance for the fourth consecutive quarter in Q2. Our view is that we are in a temporary sweet spot for margins and that should continue for the next quarter or two, but the secular "mean reversion" of margins will resume beyond that time. Bottom Line: Look for another solid performance for earnings and margins in Q2 and the rest of 2017, supporting our stocks-over-bonds stance for this year. However, investors should position their portfolios for decelerating earnings and compressed profit margins in 2018. Will The Real Profit Margin Stand Up While the markets focus on Q2 earnings, margins and corporate guidance for the next month or so, we take a broader view. For some time we have highlighted the importance of the mini-cycle in U.S. earnings growth; the corporate sector is in a catch-up phase following last year's profit recession, a trend that extends beyond the energy patch. EPS growth has surged this year on the back of slightly stronger sales and rising S&P 500 margins. The National Accounts (NIPA) data, on the other hand, paint a different picture. Earnings growth for the entire corporate sector fell sharply in the first quarter and margins continued to slide. If the NIPA data are telling the true story, then the equity market is in trouble because it suggests that the earnings outlook is much weaker than what is discounted in stock prices. There are many definitional differences that make it difficult to reconcile the NIPA and S&P data.1 Nonetheless, we can make some general observations. Chart 3 presents the four-quarter growth rate of NIPA profits2 and a proxy for aggregate S&P earnings. For the latter, we multiplied earnings-per-share by the divisor to obtain an estimate of the level of aggregate earnings in dollar terms (i.e. not on a per-share basis). The bottom panel of Chart 3 compares the level of profits, each indexed to be 100 in 2011 Q1. The charts highlight that while there have been marked differences in annual growth rates between the two measures, the levels were close to the same point in the first quarter of 2017. The dip in NIPA profit growth in Q1 was not reflected in the S&P measure. It appears that this is partly due to different profiles for profit growth in the energy and financials sectors. However, it does not appear that the difference in margins is linked to a significant divergence in aggregate profits. Most of the margin divergence is related to the denominator of the calculation (Chart 4). The NIPA denominator is corporate sector Gross Domestic Product (GDP). This is a value-added concept that is different from sales. It is not clear why, but GDP has grown much faster than sales since the end of 2014. We believe that the S&P data are painting a more accurate picture because sales are straight forward to measure, while value-added is complicated to construct. The slow growth of sales is not a bullish point for stocks. Nonetheless, it does not appear that financial engineering has distorted bottom-up company data to such an extent that the S&P data are falsely signaling strong profit growth. We expect the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the profit backdrop remains positive for stocks for now. The same is true in the Eurozone and Japan, where margins are also rising. It is worrying that a much of this year's advance in U.S. equity markets has been concentrated in only a few stocks, but that belies the breadth of the profit recovery (Chart 5). The proportion of S&P industry groups with rising earnings estimates is 75%, reflecting broad-based upgrades. Chart 3S&P And NIPA##BR##Profit Comparison S&P And NIPA Profit Comparison S&P And NIPA Profit Comparison Chart 4Denominator Explains##BR##S&P/NIPA Margin Divergence Denominator Explains S&P/NIPA Margin Divergence Denominator Explains S&P/NIPA Margin Divergence Chart 5Positive Earnings Revisions##BR##Are Broadly Based Positive Earnings Revisions Are Broadly Based Positive Earnings Revisions Are Broadly Based Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates. Bottom Line: The solid earnings backdrop is why we remain overweight stocks versus bonds and cash. Stay extra vigilant for warning signs of a bear market in view of the poor valuations. Valuation has never been good leading indicator for bear markets, but it may provide information on the risks. Capital Spending Check Up Business capital spending remains in an uptrend. Investors are concerned that the below expectations readings on capex in recent months may be the start of a new trend for a significant part of the economy. We look at it another way. Managements are postponing investment decisions until they get more clarity on federal tax policy. In short, corporations are struggling with how much and when spend, rather than whether to invest at all. The key supports for sustained corporate spending remain despite the tepid May durable goods report. C&I loan growth has ticked back up and our model (based on non-residential fixed investment, small business optimism and the speculative-grade default rate) suggests lending is poised to move higher on a 12-month basis (Chart 6). Our research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. While consumer expenditures were soft (+1.1% annualized gain) in Q1, household spending in Q2 accelerated and is on track to post 3%+ growth. We expect household spending to continue to improve in the second half of 2017.3 Moreover, the recent readings on core durable goods orders and shipments show that the uptrend that began in mid-2016 persists, despite the recent monthly wiggles in the data (Chart 7). Chart 6Model Points To##BR##Further Improvement Model Points To Further Improvement Model Points To Further Improvement Chart 7Capital Spending##BR##Remains In An Uptrend Capital Spending Remains In An Uptrend Capital Spending Remains In An Uptrend CEO confidence recently soared to a 13-year high in Q1, adding to the positive backdrop for capex. The last reading on this survey was taken in the first quarter of 2017 when managements eagerly anticipated that business-friendly legislation was pending. The next survey (due in mid-July) may show a bit more restraint from CEOs given the lack of legislative progress in Washington (Chart 7, top panel). Bottom Line: The fundamentals supporting solid business spending remain in place. However, our positive capex outlook in the U.S. could be blemished if the Republicans fail to deliver on their promises to cut taxes and boost infrastructure spending. Stressing The Commercial Real Estate Market The commercial real estate sector (CRE) is beginning to show early signs of stress. The recent softening in CRE does not suggest that recession is imminent, but investors should understand whether a sustained drop in CRE prices poses a risk to the global financial system. At best, business spending on construction is coincident with the overall economy, but most often lags due to long lead times required on projects (Chart 8). Chart 8Commercial Real Estate Lags Commercial Real Estate Lags Commercial Real Estate Lags Our colleagues in the Global Investment Strategy service4 highlighted the risks to the CRE market, noting that CRE-related debt is rising, prices have surpassed pre-recessionary levels, vacancy rates outside of the industrial sector are bottoming, and rent growth is losing steam (Chart 9). Likewise, we share Boston Fed President Rosengren's5 concern that if CRE's recent tailwinds (muted inflation, low financing rates, declining unemployment rate, robust economic growth in the U.S. relative to overseas developed economies, and favorable demographics) turn to headwinds, then the impact on the market and the wider economy may have a disproportionate impact on CRE. The BCA Beige Book Real Estate Monitor corroborates a softening in recent quarters. The monitor takes the real estate (both commercial and residential) comments from each Beige Book and uses the approach outlined in our April 17 publication6 (Chart 10). Chart 9Commercial Real Estate##BR##Indicators Softening Commercial Real Estate Indicators Softening Commercial Real Estate Indicators Softening Chart 10Introducing The##BR##Beige Book CRE Monitor Introducing The Beige Book CRE Monitor Introducing The Beige Book CRE Monitor Stretched CRE valuations may exacerbate any price declines in CRE if the markets sense that the tide is turning. Falling prices may lead to a drop in the value of collateral-backing CRE loans, which in turn, could cause lenders to restrict credit in the sector and spark an additional downturn in prices. Moreover, Table 1 highlights the risk that GSE reform may cause two large holders of CRE debt to begin to curtail lending. Small banks have more absolute exposure to CRE loans than large banks, according to the table, and overall, banks' share of CRE lending (53%) is nearly four times as high as GSE's exposure. Table 1Holders Of Commercial Real Estate Loans Summer Stress Out Summer Stress Out CRE's risks are evident in the latest round of bank CCAR stress tests. The Fed modeled a 15% drop in CRE prices through Q4 2018 in its "adverse" scenario and a 35% drop in the same period in its "severely adverse" scenario. The Fed7 found that under these scenarios, common equity Tier 1 capital ratio at the participating firms would drop from 12.5% (Q4 2016) to 9.2% and 7.2% respectively by Q1 2019. Bottom Line: Commercial real estate has benefitted from a Fed-led tailwind since the end of the 2007-2009 recession. That said, some of the tailwinds are turning to headwinds and investors should be prepared for a reversal in this sector sometime in the second half of 2018 as economic and earnings growth slows, which could set the stage for a recession in 2019. That said, it is a positive sign for the economy that the commercial real estate sector is one of the few areas showing any signs of stress, implying that the conditions for a recession in the next 6 to 12 months remain low. Is Dodd-Frank Dead? The Republicans' Financial CHOICE Act, which would roll back key aspects of the landmark Dodd-Frank Wall Street reform, has hurdles to overcome before its passage through the U.S. Senate. Two of BCA's publications have examined the impact on consumers, investors and financial markets. BCA's Geopolitical Strategy8 service noted that Republicans want to overturn Dodd-Frank to increase the financial sector's profits, credit growth, economic growth and animal spirits. A repeal would also satisfy the Republicans' ideological goal to reduce state involvement, which grew due to the law. Also, the CBO estimates that the proposed rewrite would cut the budget deficit by a net $22.3 billion over 10 years, in line with the GOP's political bent. The CHOICE Act would create an "escape hatch" to allow banks to maintain a capital-to-asset ratio of over 10% to bypass Dodd-Frank regulations. Financial companies that do not meet the 10% leverage ratio could either raise funds or remain subject to Dodd-Frank oversight, including required capital ratios, stress tests, living wills and other regulations. Critically, the 10% leverage ratio for those banks that opt out of Dodd-Frank would not be calculated using risk-weightings for different assets (whereas Dodd-Frank requires both risk-weighted and non-risk-weighted capital ratios to be maintained). Therefore, banks that opt out would be able to take on greater risk while still fulfilling minimum capital requirements. The intent is to boost lending, earnings and growth. According to the Geopolitical Strategy, if the bill becomes law, U.S. banks comprising an estimated $1.5 trillion in assets would become less restricted and eligible to adopt riskier trading practices. The greatest impact will be in areas with a higher concentration of small community banks and credit unions. These banks, with under $10 billion in assets, face the most difficulty in meeting Dodd-Frank's requirements and yet tend to meet the 10% leverage ratio (Chart 11). Chart 11Banks With $1.5 Trillion Could Gain Risk Appetite Summer Stress Out Summer Stress Out Other aspects of the bill would: Repeal the FDIC's liquidation fund: The private sector would take over responsibility for managing liquidations. Eliminate the Volcker Rule: Banks would be able to trade riskier assets on their own accounts and forge closer relationships with private equity and hedge funds. Audit the Fed: The Government Accountability Office (GAO) would audit the Fed's board of governors and regional banks, including their handling of monetary policy. Reshape the Consumer Financial Protection Board: The agency would have its powers neutered and funding dependent on the Congress, rather than transfers from the Fed. Cut penalties for violating regulations. Chart 12Small Banks Benefit##BR##From Bank Deregulation Small Banks Benefit From Bank Deregulation Small Banks Benefit From Bank Deregulation Investors could capitalize on financial sector reform by favoring small U.S. bank equities over large bank stocks. The share price of small banks relative to large banks, which rallied in the aftermath of Trump's election only to subsequently fall back, has recently perked up (Chart 12). Relative earnings have been flat in the same period. If Dodd-Frank is partially watered down, then these banks should see earnings improve, and drive up their share prices. BCA's U.S. Equity Strategy is positive on global bank equities. In particular, U.S. banks have better fundamentals than their counterparts in Europe and Japan - more capital, higher net interest margins, lower or equal NPL ratios. They also stand to benefit from relatively faster rising interest rates. BCA's Fiscal Note Financial Sector Index suggests that the flow of legislative and regulatory proposals is becoming less onerous on the financial sector. Chart 13 is an aggregation of the favorability scores, which assess whether the bill would be favorable to the financial sector. It provides a snapshot of the regulatory environment for the financial sector at any point. Chart 13Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Bottom Line: Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits, even for Republicans in an environment of populism. However, a bill focused on lightening the regulatory load on small banks has a chance of passing if tacked on to the budget process. Large banks would remain subject to closer scrutiny and stricter international standards. The post-election rally for bank stocks is mostly over. Investors have an opportunity to favor small banks versus large ones. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 The first problem is that the S&P data are expressed on a per-share basis. Moreover, the NIPA data adjusts for inventory and depreciation allowance. S&P margins are calculated using sales in the denominator, while we generally use GDP as the denominator for calculating NIPA profits. 2 The NIPA data shown include financials and profits earned overseas, as is the case for the S&P. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Still In The Sweet Spot", June 19, 2017, available at usis.bcaresearch.com. 4 Please see BCA's Global Investment Strategy Weekly Report "The Timing Of The Next Recession," published June 16, 2017, available at gis.bcaresearch.com. 5 "Trends In Commercial Real Estate", Eric S. Rosengren, at Risk Management for Commercial Real Estate Financial Markets Conference, NYU Stern School of Business, May 9, 2017. 6 Please see BCA's U.S. Investment Strategy Weekly Report, "The Great Debate Continues", published April 17, 2017, available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/publications/files/2017-ccar-assessment-framework-results-20170628.pdf 8 Please see BCA's Geopolitical Strategy Weekly Report "How Long Can The "Trump Put" Last?," published June 14, 2017, available at gps.bcaresearch.com.

Highlights Economic Outlook: Global growth will remain strong over the next 12 months, but will start to slow in the second half of 2018, potentially setting the stage for a recession in 2019. Overall Strategy: Investors should overweight equities and spread product for now. However, be prepared to pare back exposure next summer. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S. Treasurys, stay neutral Europe, and overweight Japan. Equities: Remain overweight developed market equities relative to their EM peers. Within the DM sphere, favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares have significant upside. Currencies: The selloff in the dollar is overdone. The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar, as does the euro. Commodities: Oil will rally over the coming months as global inventories decline. Gold will continue to struggle, before exploding higher towards the end of this decade. Feature I. Global Macro Outlook End Of The Global Manufacturing Recession Global growth estimates have been trending higher over the past 12 months, having bottomed last summer. Ironically, the collapse in oil prices in late 2014 was both the main reason for the deterioration in global growth as well as its subsequent rebound. Plunging oil prices led to a massive decline in capital spending in the energy sector and associated industries. In the U.S., energy capex dropped by 70% between Q2 of 2014 and Q3 of 2016. The economic fallout was even more severe in many other economies, especially emerging markets such as Russia and Brazil. The result was a global manufacturing recession and a pronounced slump in international trade (Chart 1). When thinking about oil and the economy, the distinction between levels and rates of change is important: While rapidly falling oil prices tend to be bad for global growth, lower oil prices are good for it. By the middle of 2016, the damage from the oil crash had largely run its course. What was left was a massive windfall for households, especially poorer ones who spend a disproportionate share of their paychecks at the pump. Industries that use oil as an input also benefited. Simply put, the oil crash went from being a bane to a boon for the global economy. A Solid 12-Month Outlook We expect global growth to remain firm over the next 12 months. Financial conditions in most countries have eased substantially since the start of the year thanks to rising equity prices, lower bond yields, and narrower credit spreads (Chart 2). Our empirical analysis suggests that easier financial conditions tend to lift growth with a lag of 6-to-9 months (Chart 3). This bodes well for activity in the remainder of this year. Chart 1The Manufacturing Recession Has Ended The Manufacturing Recession Has Ended The Manufacturing Recession Has Ended Chart 2Financial Conditions Have Eased Globally Financial Conditions Have Eased Globally Financial Conditions Have Eased Globally A number of "virtuous cycles" should amplify the effects of easier financial conditions. In the U.S., a tight labor market will lead to faster wage growth, helping to spur consumption. Rising household spending, in turn, will lead to lower unemployment and even faster wage growth. Strong consumption growth will also motivate firms to expand capacity, translating into more investment spending. Chart 4 shows that the share of U.S. firms planning to increase capital expenditures has risen to a post-recession high. Chart 3Easier Financial Conditions Will Support Growth Easier Financial Conditions Will Support Growth Easier Financial Conditions Will Support Growth Chart 4U.S. Firms Plan To Boost Capex U.S. Firms Plan To Boost Capex U.S. Firms Plan To Boost Capex The euro area economy continues to chug along. The purchasing manager indices (PMIs) dipped a bit in June, but remain at levels consistent with above-trend growth. The German Ifo business confidence index hit a record high this week. Corporate balance sheets in the euro area are improving and credit growth is accelerating. This is helping to fuel a rebound in business investment (Chart 5). The fact that the ECB has no intention of raising rates anytime soon will only help matters. As inflation expectations begin to recover, short-term real rates will fall. This will lead to a virtuous circle of stronger growth, and even higher inflation expectations. The Japanese economy managed to grow by an annualized 1% in the first quarter. This marked the fifth consecutive quarter of positive sequential growth, the longest streak in 11 years. Exports are recovering and both the manufacturing and non-manufacturing PMIs stand near record-high levels (Chart 6). Chart 5Euro Area Data Remain Upbeat Euro Area Data Remain Upbeat Euro Area Data Remain Upbeat Chart 6Japanese Economy Is Rebounding Japanese Economy Is Rebounding Japanese Economy Is Rebounding Chart 7China: Slight Slowdown, But No Need To Worry China: Slight Slowdown, But No Need To Worry China: Slight Slowdown, But No Need To Worry The Chinese economy has slowed a notch since the start of the year, but remains robust (Chart 7). Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production are rising at a healthy clip. Exports are accelerating thanks to a weaker currency and stronger global growth. Retail sales continue to expand, while the percentage of households that intend to buy a new home has surged to record-high levels. The rebound in Chinese exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 8). A better profit picture should support business capital spending in the coming months. Meanwhile, the Chinese government's "regulatory windstorm" - as the local press has called it - has largely bypassed the real economy. In fact, medium and long-term lending to nonfinancial corporations, a key driver of private-sector capital spending and physical commodity demand, has actually accelerated over the past eight months (Chart 9). Chart 8China: Higher Selling Prices Fueling A Rebound In Profits China: Higher Selling Prices Fueling A Rebound In Profits China: Higher Selling Prices Fueling A Rebound In Profits Chart 9China: Credit To The Real Economy Is Accelerating China: Credit To The Real Economy Is Accelerating China: Credit To The Real Economy Is Accelerating All Good Things Must Come To An End We remain optimistic about global growth over the next 12 months. Unfortunately, things are likely to sour in the second half of 2018, possibly setting the stage for a recession in the U.S. and several other countries in 2019. The odds of a recession rise when economies approach full employment (Chart 10). The U.S. unemployment rate now stands at 4.3% and is on track to break below its 2000 low of 3.8% next summer. A cursory look at the data suggests that the unemployment rate is usually either rising or falling (Chart 11). And once it starts rising, it keeps rising. In fact, there has never been a case in the postwar era where the three-month average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing. Chart 10Recessions Become More Likely When The Labor Market Begins To Overheat Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Chart 11Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Modern economies contain numerous feedback loops. When unemployment starts increasing, this fuels a vicious cycle where rising joblessness saps confidence and incomes, leading to less spending and even higher unemployment. History suggests that it is almost impossible to break this cycle once it starts. The Fed is well aware of the risks of letting the unemployment rate fall to a level where it has nowhere to go but up. Unfortunately, calibrating monetary policy in a way that achieves a soft landing is easier said than done. Changes in monetary conditions affect the economy with a lag of about 12-to-18 months. Once it has become obvious that a central bank has either loosened or tightened monetary policy too much, it is often too late to right the ship. The risks of a policy error are particularly high in today's environment where there is significant uncertainty about the level of the long-term neutral rate. Question marks about the future stance of fiscal policy will also complicate the Fed's job. We expect the Trump administration to succeed in passing legislation that cuts both personal and corporate income taxes later this year or in early 2018. The bill will be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This will generate a modest amount of fiscal stimulus over the next few years. That being said, the proposed changes to health care legislation could more than neutralize the effects of lower tax rates. The Senate bill, as currently worded, would lead to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Our base case is that Republicans in Congress fail to pass a new health care bill, thus leaving the Affordable Care Act largely unscathed. However, if they succeed, the overall stance of federal fiscal policy would likely shift from being somewhat accommodative, on net, to somewhat restrictive. This would expedite the timing of the recession. How Deep A Recession? If the U.S. does succumb to a recession in 2019, how bad will it be? Here, there is both good news and bad news. The good news is that financial and economic imbalances are not as severe today as those that existed in the lead-up to the past few recessions. The Great Recession was preceded by a massive housing bubble, associated with overbuilding and a sharp deterioration in mortgage lending standards (Chart 12). Today, residential investment stands at 3.9% of GDP, compared to a peak of 6.6% of GDP Q1 of 2006. Lending standards, at least judging by FICO scores, have remained fairly high over the course of the recovery. In relation to income and rents, home prices are also much lower today than they were a decade ago. Likewise, the massive capex overhang that preceded the 2001 recession is largely absent at present. Chart 12No New Bubble In The U.S. Housing Sector No New Bubble In The U.S. Housing Sector No New Bubble In The U.S. Housing Sector Chart 13Consumer Credit: Making A Comeback... Consumer Credit: Making A Comeback... Consumer Credit: Making A Comeback... The bad news is that cracks in the economy are starting to form. In contrast to mortgage debt, student debt has gone through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 13). Not surprisingly, this is starting to translate into higher default rates (Chart 14). The fact that this is happening when the unemployment rate is at the lowest level in 16 years is a cause for concern. Meanwhile, the ratio of corporate debt-to-GDP has risen above 2000 levels and is closing in on its 2007 peak (Chart 15). Chart 14...With Defaults Starting To Rise In Some Categories ...With Defaults Starting To Rise In Some Categories ...With Defaults Starting To Rise In Some Categories Chart 15U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit We are particularly worried about the health of the commercial real estate (CRE) market. CRE prices currently stand 7% above pre-recession levels in real terms, having risen by a staggering 82% since the start of 2010 (Chart 16). U.S. financial institutions hold $3.8 trillion in CRE loans, $2 trillion of which are held by banks. As a share of GDP, the outstanding stock of CRE bank loans in most categories is near pre-recession levels (Chart 17). Chart 16Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 17CRE Debt Is Rising CRE Debt Is Rising CRE Debt Is Rising The retail sector is already under intense pressure due to the shift in buying habits towards E-commerce. Vacancy rates in the apartment sector have started to tick higher and rent growth has slowed (Chart 18 and Chart 19). The number of apartment units under construction stands at a four-decade high, despite a structurally subdued pace of household formation (Chart 20). Most of these units are likely to hit the market in 2018, which will result in a further increase in vacancy rates. Vacancies in the office sector are also likely to rise, given the recent increase in the number of new projects in the pipeline. On the flipside, demand growth for new office space is set to weaken, as a tighter labor market leads to slower payroll gains. Chart 18Vacancy Rates Are Bottoming Outside The Industrial Sector... Vacancy Rates Are Bottoming Outside The Industrial Sector... Vacancy Rates Are Bottoming Outside The Industrial Sector... Chart 19...While Rent Growth Is Losing Steam ...While Rent Growth Is Losing Steam ...While Rent Growth Is Losing Steam If vacancy rates across the CRE sector start rising in earnest, real estate prices will fall, leading to a decline in the value of the collateral backing CRE loans. This could prompt lenders to pull back credit, causing prices to fall further. Seasoned real estate investors are no strangers to such vicious cycles, and if the next one begins late next year when growth is slowing because the economy is running out of spare capacity and financial conditions are tightening, it would further add to the risks of a recession. Chart 20Apartment Supply Is Surging, But Will There Be Enough Demand? Apartment Supply Is Surging, But Will There Be Enough Demand? Apartment Supply Is Surging, But Will There Be Enough Demand? Gauging The Global Spillover Effects What repercussions would a U.S. recession have for the rest of the world? Simply based on trade flows, the answer is "not much." U.S. imports account for less than 5% of global ex-U.S. GDP. Thus, even a significant decline in U.S. spending abroad would not make much of a dent in overseas growth. More worrisome are potential financial spillovers. As the IMF has documented, these have been the dominant drivers of the global business cycle in the modern era.1 Chart 21Global Debt Levels Are Still High Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Correlations across global markets tend to increase when risk sentiment deteriorates. Thus, if U.S. stocks buckle in the face of rising recessionary risks, risk assets in other economies are sure to suffer. The fact that valuations are stretched across so many markets only makes the problem worse. A flight towards safety could trigger a pronounced decline in global equity prices, wider credit spreads, and lower property prices. This, in turn, could lead to a sharp decline in household and corporate net worth, resulting in tighter financial conditions and more stringent lending standards. Elevated debt levels represent another major source of vulnerability. Total debt as a share of GDP is greater now than it was before the Great Recession in both advanced and emerging markets (Chart 21). High debt burdens will prevent governments from loosening fiscal policy in countries that are unable to issue their own currencies. The monetary transmission mechanism also tends to be less effective in the presence of high debt. This is especially the case in today's environment where the zero lower-bound on nominal interest rates remains a formidable challenge. The presence of these fiscal and monetary constraints implies that the severity of the next recession could be somewhat greater than one might expect based solely on the underlying causes of the downturn. II. Financial Markets Overall Strategy The discussion above implies that the investment outlook over the next few years is likely to be of the "one step forward, two steps back" variety. The global economy is entering a blow-off stage where growth will get better before it gets worse. We are bullish on global equities and spread product over the next 12 months, but expect to turn bearish on risk assets next summer. Until then, investors should position for a stronger dollar and higher bond yields. We recommend a slight overweight allocation to developed market equities over their EM peers. Within the DM sphere, we favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares stand out as offering an attractive risk-reward profile. Comparing government bonds, we are underweight U.S. Treasurys, neutral on European bonds, and overweight Japan. These recommendations are broadly in line with the output of our in-house quantitative models (Table 1 and Chart 22). Table 1BCA's Tactical Global Asset Allocation Recommendations* Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Chart 22Message From Our U.S. Stock Market ##br##Timing Model Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Equities Earnings Are Key Earnings have been the main driver of the global equity bull market. In fact, the global forward P/E ratio has actually declined slightly since February, despite a 3.9% gain in equity prices (Chart 23). Strong global growth should continue to boost corporate earnings over the next 12 months. Consensus bottom-up estimates call for global EPS to expand by 14% in 2017 and a further 11% in 2018. The global earnings revision ratio moved into positive territory earlier this year for the first time in six years (Chart 24). Chart 23Earnings Have Been The Main Driver ##br##Of The Global Equity Bull Market Earnings Have Been The Main Driver OfThe Global Equity Bull Market Earnings Have Been The Main Driver OfThe Global Equity Bull Market Chart 24Global Earnings Picture ##br##Looks Solid Global Earnings Picture Looks Solid Global Earnings Picture Looks Solid Global monetary conditions generally remain favorable. Our U.S. Financial Conditions Index has loosened significantly. Historically, this has been a bullish signal for stocks.2 Excess liquidity, which we define as M2 growth less nominal GDP growth, is also still well above the zero line, a threshold that has warned of a downturn in stock prices in the past. Chart 25Individual Investors Are Not Overly Bullish On U.S. Equities But... Individual Investors Are Not Overly Bullish On U.S. Equities But... Individual Investors Are Not Overly Bullish On U.S. Equities But... Sentiment is stretched, but not excessively so. The share of bullish respondents in the AAII's weekly poll of individual investors stood at 29.7% this week (Chart 25). This marked the 18th consecutive week that optimism has been below its long-term average. Market Vane's survey of traders and Yale's Investor Confidence index paint a more complacent picture, as do other measures such as the VIX and margin debt (Chart 26). Nevertheless, as long as earnings continue to grow and monetary policy remains in expansionary territory, sentiment can remain elevated without being a significant threat to stocks. Overweight The Euro Area And Japan Over The U.S. Regionally, earnings revisions have been more positive in Europe and Japan than in the U.S. so far this year. Net profit margins are also lower in Europe and Japan, which gives these two regions more room for catch-up. Moreover, unlike the Fed, neither the ECB nor the BoJ are likely to raise rates anytime soon. As we discuss in greater detail in the currency section of this report, this should lead to a weaker euro and yen, giving European and Japanese exporters a further leg up in competitiveness. Lastly, valuations are more favorable in the euro area and Japan than in the U.S., even if one adjusts for differing sector weights across the three regions (Chart 27). Chart 26...There Are Signs Of Complacency ...There Are Signs Of Complacency ...There Are Signs Of Complacency Chart 27U.S. Valuations Seem Stretched Relative ##br##To Other Bourses Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Mixed Outlook For EM Earnings growth in emerging markets has accelerated sharply. Bottom-up estimates imply EPS growth of 20% in 2017 and 11% in 2018 for the EM MSCI index. Our EM strategists believe this is too optimistic, given the prospect of a stronger dollar, high debt levels across the EM space, poor corporate governance, and the lack of productivity-enhancing structural reforms. These problems warrant a slight underweight to emerging markets in global equity portfolios. Nevertheless, considering the solid backdrop for global growth, EM stocks should still be able to deliver positive real total returns over the next 12 months. Within the EM space, we favor Russia, central Europe, Korea, Taiwan, India, Thailand, and China. Chinese H-shares, in particular, remain quite attractive, trading at only 7.1-times forward earnings and 1.0-times book value. Favor Cyclicals Over Defensives ... For Now Looking at global equity sectors, upward revisions have been largest for industrials, materials, financials, and real estate. Revisions for energy, health care, and telecom have been negative. We expect cyclical stocks to outperform defensives over the next 12 months. Energy stocks will move from being laggards to leaders, as oil prices rebound. Financials should also do well, as steeper yield curves, increased M&A activity, and falling nonperforming loans bolster profits. Equity Bear Market Will Begin Late Next Year As growth begins to falter in the second half of 2018, stocks will swoon. U.S. equities are likely to fall 20% to 30% peak to trough, marking the first sustained bear market since 2008. Other stock markets will experience similar declines. Global equities will eventually recoup most of their losses at the start of the 2020s, but the recovery will be a lackluster one. As we have argued extensively in the past, global productivity growth is likely to remain weak.3 Population aging will deplete savings, leading to higher real interest rates. The next recession could also propel more populist leaders into power. None of these things would be good for stocks. Against today's backdrop of lofty valuations, global stocks will deliver a total real return in the low single-digit range over the next decade. Fixed Income Bonds Have Overreacted To The Inflation Dip We turned structurally bearish on government bonds on July 5th, 2016. As fate would have it, this was the very same day that the U.S. 10-year Treasury yield dropped to a record closing low of 1.37%. The dramatic bond selloff that followed was too much, too fast. We warned at the start of this year that bond yields were likely to climb down from their highs. At this point, however, the pendulum has swung too far in the direction of lower yields. Chart 28 shows that almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained resilient, suggesting that investors' views of global growth have not changed much. This helps explain why stocks have been able to rally to new highs. The fall in inflation expectations has been largely driven by the decline in commodity prices. Short-term swings in oil prices should not affect long-term inflation expectations, but in practice they do (Chart 29). If oil prices recover in the second half of this year, as we expect, inflation expectations should shift higher as well. This will translate into higher bond yields. Chart 28Inflation Expectations Declined This Year, ##br##But Real Yields Remained Resilient Inflation Expectations Declined This Year, But Real Yields Remained Resilient Inflation Expectations Declined This Year, But Real Yields Remained Resilient Chart 29Low Oil Prices Drag Down##br## Inflation Expectations Low Oil Prices Drag Down Inflation Expectations Low Oil Prices Drag Down Inflation Expectations U.S. Treasurys Are Most Vulnerable Tightening labor markets should also boost inflation expectations. This is particularly the case in the U.S., where the economy is quickly running out of surplus labor. Some commentators have argued that the headline unemployment rate understates the true amount of economic slack. We are skeptical that this is the case. Table 2 compares a wide variety of measures of labor market slack with where they stood at the height of the business cycle in 2000 and 2007. The main message from the table is that the unemployment rate today is broadly where one would expect it to be based on these collaborating indicators. Table 2Comparing Current Labor Market Slack With Past Cycles 12-MONTH Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull If the U.S. has reached full employment, does the absence of wage pressures signal that the Phillips curve is dead? We don't think so. For one thing, wage growth is not that weak. Our wage growth tracker has risen from a low of 1.2% in 2010 to 2.4% at present (Chart 30). In fact, real wages have been rising more quickly than productivity for the past three years (Chart 31). Unit labor cost growth is now just shy of where it was at the peaks of the last two business cycles (Chart 32). Chart 30Stronger Labor Market ##br##Is Leading To Faster Wage Growth Stronger Labor Market Is Leading To Faster Wage Growth Stronger Labor Market Is Leading To Faster Wage Growth Chart 31Real Wages Now Increasing Faster##br## Than Productivity Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Chart 32Unit Labor Cost Growth Close ##br##To Previous Two Peaks Unit Labor Cost Growth Close To Previous Two Peaks Unit Labor Cost Growth Close To Previous Two Peaks The evidence generally suggests that the Phillips curve becomes "kinked" when the unemployment rate falls towards 4%. In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 4.5% to 3.5% does. The experience of the 1960s is illustrative in that regard. Chart 33 shows that much like today, inflation in the first half of that decade was well anchored at just below 2%. However, once the unemployment rate fell below 4%, inflation took off. Core inflation rose from 1.5% in early 1966 to nearly 4% in early 1967, ultimately making its way to 6% by 1970. The Fed is keen to avoid a repeat of that episode. In a recent speech, New York Fed President and FOMC vice chairman Bill Dudley warned that "If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation ... Then the risk would be that we would have to slam on the brakes and the next stop would be a recession." If U.S. growth remains firm and inflation rebounds in the second half of this year, as we expect, the Fed will get the green light to keep raising rates in line with the "dots." The market is not prepared for that, as evidenced by the fact that it is pricing in only 27 basis points in rate hikes over the next 12 months. We are positioned for higher rate expectations by being short the January 2018 fed funds contract. The ECB And The BoJ Will Not Follow The Fed's Lead Could better growth prospects cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl? We doubt it. Investors are reading too much into Mario Draghi's allegedly more "hawkish" tone. There is a huge difference between removing emergency measures and beginning a full-fledged tightening cycle. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 34). Chart 33Inflation In The 1960s Took Off ##br##Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Chart 34Euro Area: Labor Market Slack##br## Is Still High Outside Of Germany Euro Area: Labor Market Slack Is Still High Outside Of Germany Euro Area: Labor Market Slack Is Still High Outside Of Germany At this point, the market is pricing in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 25 months at present (Chart 35). Investors now expect real yields in the U.S. to be only 16 basis points higher than in the euro area in five years' time.4 This is below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 36). Chart 35ECB: Markets Are Pricing In Too Much Tighteninh ECB: Markets Are Pricing In Too Much Tighteninh ECB: Markets Are Pricing In Too Much Tighteninh Chart 36The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area As for Japan, while the unemployment rate has fallen to a 22-year low of 2.8%, this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Bank Of England's Dilemma Gilts are a tougher call. The equilibrium rate is higher in the U.K. than in most other developed economies. Inflation has risen, although that has largely been a function of a weaker currency. Fiscal policy is turning more accommodative, which, all things equal, would warrant a more bearish view on gilts. The big wildcard is Brexit. Chart 37 shows that the U.K. is the only major country where growth has faltered this year. Worries over Britain's future relationship with the EU have likely contributed to the slowdown. Ongoing Brexit angst will keep the Bank of England on hold, justifying a neutral weighting on gilts. Stay Short Duration ... For Now In summary, investors should keep global duration risk below benchmark levels over the next 12 months. Regionally, we recommend underweighting U.S. Treasurys, overweighting Japan, and maintaining a neutral position towards euro area and U.K. government bonds. Reflecting these recommendations, we are closing our short Japanese, German and Swiss 10-year bond trade for a gain of 5.3% and replacing it with a short 30-year U.S. Treasury bond position. As global growth begins to slow in the second half of next year, global bonds will rally. However, as we discussed at length in our Q2 Strategy Outlook, the rally will simply represent a countertrend move in what will turn out to be a structural bear market.5 The 2020s, in short, could end up looking a lot like the 1970s. Spread Product: Still A Bit Of Juice Left While we prefer equities to high-yield credit on a risk-adjusted basis over the coming months, we would still overweight spread product within a global asset allocation framework. The option-adjusted spread of the U.S. high-yield index offers 200 basis points above the Treasury curve after adjusting for expected defaults, roughly in line with the mid-point of the historical data (Chart 38). Corporate defaults are likely to trend lower over the next 12 months, spurred by stronger growth and a rebound in oil prices. Chart 37U.K. Is Lagging Its Peers U.K. Is Lagging Its Peers U.K. Is Lagging Its Peers Chart 38Default-Adjusted Junk Spreads Are At Historical Average Default-Adjusted Junk Spreads Are At Historical Average Default-Adjusted Junk Spreads Are At Historical Average As with all our other views, the picture is likely to change sharply in the second half of next year. At that point, corporate spreads will widen, warranting a much more defensive stance. Currencies And Commodities The Dollar Bull: Down But Not Out Our long-standing dollar bullish view has come under fire over the past few months. The Fed's broad trade-weighted dollar index has fallen 4.6% since December. Momentum in currency markets can be a powerful force, and so we would not be surprised if the dollar remains under pressure over the coming weeks. However, over a 12-month horizon, the greenback will strengthen, as the Fed raises rates more quickly than expected while most other central banks stand pat. When all is said and done, the broad-trade weighted dollar is likely to peak next summer at a level roughly 10% higher than where it is today. That would still leave it substantially below prior peaks in 1985 and 2000 (Chart 39). The U.S. trade deficit has fallen from a peak of nearly 6% of GDP in 2005 to 3% of GDP at present (Chart 40). Rising shale production has reduced the demand for oil imports. A smaller trade deficit diminishes the need to attract foreign capital with a cheaper currency. Chart 39The Dollar Is Below Past Peaks The Dollar Is Below Past Peaks The Dollar Is Below Past Peaks Chart 40The U.S. Trade Deficit Has Halved Since 2005 The U.S. Trade Deficit Has Halved Since 2005 The U.S. Trade Deficit Has Halved Since 2005 Sentiment and speculative positioning towards the dollar have swung from extremely bullish at the start of the year to being more neutral today (Chart 41). In contrast, long euro speculative positions and bullish sentiment have reached the highest levels in three years. Our tactical short euro/long dollar trade was stopped out this week for a loss of 1.6%. However, we continue to expect EUR/USD to fall back towards parity by the end of the year. We also expect the pound to weaken against the dollar, but appreciate slightly against the euro. Now that the Bank of Japan is keeping the 10-year JGB yield pinned to zero, the outlook for the yen will be largely determined by what happens to yields abroad. If we are correct that Treasury yields - and to a lesser extent yields in Europe - rise, the yen will suffer. Commodity Currencies Should Fare Well Higher commodity prices should benefit currencies such as the Canadian and Aussie dollars and the Norwegian krone. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. While shale output continues to rise, this is largely being offset by falling production from conventional oil fields. Consequently, oil inventories should fall in the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 42). Chart 41USD: Sentiment And Positioning ##br##Are Not Lopsided Anymore USD: Sentiment And Positioning Are Not Lopsided Anymore USD: Sentiment And Positioning Are Not Lopsided Anymore Chart 42Falling Oil Inventories Should Lead ##br##To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices The outlook for industrial metals is not as upbeat as for oil, but metal prices should nevertheless rebound over the coming months. We suspect that much of the recent weakness in metal prices can be attributed to the regulatory crackdown on shadow banking activity in China. Many Chinese traders had used commodities as collateral for loans. As their loans were called in, they had no choice but to liquidate their positions. Today, speculative positioning in the commodity pits has returned to more normal levels (Chart 43). This reduces the risk of a further downdraft in commodity prices. BCA's China strategists expect the Chinese authorities to relax some of their tightening measures. This is already being seen in a decline in interbank lending rates and corporate bond yields (Chart 44). Chart 43Commodities: Long Speculative Positions Returning ##br##To More Normal Levels Commodities: Long Speculative Positions Returning To More Normal Levels Commodities: Long Speculative Positions Returning To More Normal Levels Chart 44China: Some Relief##br## After Recent Tightening Action? China: Some Relief After Recent Tightening Action? China: Some Relief After Recent Tightening Action? One key reason why the authorities have been able to let interest rates come down is because capital outflows have abated. Compared to late 2015, economic growth is stronger and deflationary pressures have receded. The trade-weighted RMB has also fallen by 7.5% since then, giving the economy a competitive boost. As such, the seeming can't-lose bet on further yuan weakness has disappeared. We still expect the RMB to depreciate against the dollar over the next 12 months, but to strengthen against most other currencies, including the euro and the yen. If the yuan remains resilient, this will limit the downside risk for other EM currencies. Nevertheless, at this point, much of the good news benefiting EM currencies has been priced in. Across the EM universe, in addition to the Chinese yuan, we like the Mexican peso, Taiwan dollar, Indian rupee, Russian ruble, Polish zloty, and Czech koruna. Lastly, a few words on the most timeless of all currencies: gold. We expect bullion to struggle over the next 12 months on the back of a stronger dollar and rising bond yields. However, once the Fed starts cutting rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For example, please see Box 4.1: Financial Linkages and Spillovers in "Spillovers and Cycles in the Global Economy," IMF World Economic Outlook, (April 2007). 2 Please see Global Investment Strategy Weekly Report, "The Message From Our Stock Market Timing Model," dated May 5, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; Global Investment Strategy - Strategy Outlook, "First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters), First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters)," dated January 6, 2017; and Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 U.S. minus euro area 5-year/5-year forward real bond yields. Real bonds yields are calculated as a difference between nominal yields and the CPI swap rate. Euro area yields refer to a GDP-weighted average of Germany, France, the Netherlands, Belgium, Austria, Italy, and Spain. 5 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The FOMC statement reaffirmed that the Fed remains in hiking mode. If the Fed keeps raising rates in line with the "dots," monetary policy will move into restrictive territory by early 2019. By then, the unemployment rate will have fallen to a level where it has nowhere to go but up. Unfortunately, history suggests that once unemployment starts rising, it keeps rising. The good news is that today's economic imbalances are not as formidable as those that existed in the lead-up to the past few recessions. The bad news is that cracks are starting to form. We are especially worried about the health of the U.S. commercial real estate sector. Remain overweight global equities for now, but look to significantly pare back exposure next summer. Feature The U.S. Expansion Is Getting Long In The Tooth Chart 1How Low Can It Go? How Low Can It Go? How Low Can It Go? The current U.S. expansion has now reached eight years, making it the third longest in the post-war era. History teaches that expansions do not die of old age. Rather, they are usually murdered by some combination of Fed tightening and the unwinding of the imbalances that were built up during the boom years. Thinking about the present, there is good and bad news on both fronts. Let's start with the Fed. This week's FOMC statement reaffirmed that the Fed remains in hiking mode. The good news is that real rates are still very low by historic standards, suggesting that the economy is unlikely to stall out this year. The bad news is that the Fed has less scope to raise rates than in the past. Chart 1 shows estimates of the real neutral rate developed by Fed researchers Thomas Laubach and Kathryn Holston, along with John Williams, President of the San Francisco Fed and Janet Yellen's close confidante. Their calculations suggest that the real neutral rate has plummeted over the past decade in the U.S. and the euro area, with lesser declines recorded in Canada and the U.K. In the U.S., the real neutral rate currently stands at 0.4%. Assuming the Fed raises interest rates in line with the "dots," rates will move into restrictive territory in early 2019. Given that monetary policy affects the real economy with a lag of 12-to-18 months, the Fed may not realize that it has raised rates too much until it is too late. The Downside Of A Low Unemployment Rate One might argue that this justifies a "go-slow" approach to tightening monetary policy. There is certainly validity to this view, but it is not without its drawbacks. The unemployment rate has now fallen to 4.3%, 0.4 points below the Fed's estimate of NAIRU. As Chart 2 illustrates, the odds of a recession rise when the unemployment rate reaches such low levels. Some commentators have argued that the headline unemployment rate understates the amount of economic slack. We are skeptical that this is the case. Table 1 compares a wide variety of measures of labor market slack with where they stood at the height of the business cycle in 2000 and 2007. The main message of the table is that the unemployment rate today is broadly where one would expect it to be based on these collaborating indicators. Taken together, these indicators suggest that slack is comparable to what it was in 2007, albeit still above the levels seen in 2000. Chart 2 Table 1Comparing Current Labor Market Slack With Past Cycles The Timing Of The Next Recession The Timing Of The Next Recession As we noted last week, the easing in U.S. financial conditions over the past six months is likely to boost growth in the second half of this year (Chart 3). If growth does accelerate, the unemployment rate - which is already 0.2 points below where the Fed thought it would be at the end of this year when it made its December 2016 projections - will fall below 4%. There is a high probability that this will fuel inflation, reversing the largely technically-driven decline in most core inflation measures over the past few months. Chart 3U.S.: Easy Financial Conditions Will Support Growth In H2 2017 U.S.: Easy Financial Conditions Will Support Growth In H2 2017 U.S.: Easy Financial Conditions Will Support Growth In H2 2017 The market is not pricing this in at all. In fact, 2-year breakeven inflation rates have tumbled by 87 basis points since March. A bit more inflation would be a welcome development. Not only have market-based projections of inflation fallen since the Great Recession, but long-term survey-based measures have dipped as well (Chart 4). Of course, one can have too much of a good thing. The experience of the 1960s is illustrative in that regard. Chart 5 shows that much like today, inflation in the first half of that decade was well anchored at just below 2%. However, once the unemployment rate fell below 4%, inflation soared. Core inflation rose from 1.5% in early 1966 to nearly 4% in early 1967, ultimately making its way to 6% by 1970. Chart 4Inflation Could Use A Boost Inflation Could Use A Boost Inflation Could Use A Boost Chart 5Inflation In The 1960s Took Off ##br##Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% If the Fed today wants to avoid the same fate, it will have to take steps to lift the unemployment rate back up to NAIRU. Unfortunately, history suggests that it is difficult to raise the unemployment rate a little bit without inadvertently raising it by a lot. Once unemployment starts to rise, a vicious circle tends to erupt where increasing joblessness leads to slower income growth, falling confidence, and ultimately, less spending and higher unemployment. In fact, there has never been a case in the post-war era where the three-month moving average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing (Chart 6). Chart 6Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Imbalances Are Growing The vicious circle described above tends to be amplified when there are large imbalances in the economy. The good news is that today's imbalances are not as formidable as those that existed in the lead-up to the past few recessions. The bad news is that cracks are starting to form. The ratio of household debt-to-disposable income is still close to post-recession lows, but this is largely because mortgage debt continues to be weighed down by a depressed homeownership rate (Chart 7). In contrast, consumer credit is rebounding: Student debt is going through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 8). Not surprisingly, this is starting to translate into higher default rates (Chart 9). The fact that this is happening at a time when the unemployment rate is at the lowest level in 16 years is a cause for concern. Chart 7Low Homeownership Rate Keeping A Lid On Mortgage Debt Low Homeownership Rate Keeping A Lid On Mortgage Debt Low Homeownership Rate Keeping A Lid On Mortgage Debt Chart 8Consumer Credit: Making A Comeback... Consumer Credit: Making A Comeback... Consumer Credit: Making A Comeback... Chart 9...With Defaults Starting To Rise In Some Categories ...With Defaults Starting To Rise In Some Categories ...With Defaults Starting To Rise In Some Categories Meanwhile, the ratio of corporate debt-to-GDP has risen above 2000 levels and is closing in on its 2007 peak (Chart 10). Contrary to the widespread notion that "wages aren't rising," real wages are increasing more quickly than corporate productivity (Chart 11). As the labor market continues to tighten, corporate profitability could suffer, setting the stage for rising defaults and increasing layoffs. Chart 10U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit Chart 11Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Worries About Commercial Real Estate We are particularly worried about the health of the commercial real estate (CRE) market. CRE prices currently stand 7% above pre-recession levels in real terms, having risen by a staggering 82% since the start of 2010 (Chart 12). Financial institutions hold $3.8 trillion in CRE loans, $2 trillion of which are held by banks. As a share of GDP, the outstanding stock of CRE bank loans in most categories is near pre-recession levels (Chart 13). Chart 12Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 13CRE Debt Is Rising CRE Debt Is Rising CRE Debt Is Rising Going forward, the fundamental underpinnings for the CRE market are likely to soften. The retail sector is already under intense pressure due to the shift in buying habits towards eCommerce. CMBX spreads in this space are rising. Vacancy rates in the apartment sector have started to tick higher and rent growth has slowed (Chart 14 and Chart 15). The number of apartment units under construction stands at a four-decade high according to Census data, despite a structurally subdued pace of household formation (Chart 16). Most of these units are likely to hit the market in 2018, which will result in a further increase in vacancy rates. Chart 14Vacancy Rates Are Bottoming Outside The Industrial Sector... Vacancy Rates Are Bottoming Outside The Industrial Sector... Vacancy Rates Are Bottoming Outside The Industrial Sector... Chart 15...While Rent Growth Is Losing Steam ...While Rent Growth Is Losing Steam ...While Rent Growth Is Losing Steam Chart 16Apartment Supply Is Surging, But Will There Be Enough Demand? Apartment Supply Is Surging, But Will There Be Enough Demand? Apartment Supply Is Surging, But Will There Be Enough Demand? There are fewer signs of overbuilding in the office sector. Nevertheless, vacancy rates are likely to rise, given the recent increase in the number of new projects in the pipeline. On the flipside, demand growth for new office space is set to weaken, as a tighter labor market leads to slower payroll gains. The Fed estimates that the U.S. needs to add only 80,000 workers to payrolls every month to keep up with a growing labor force, down from about 150,000 in the two decades preceding the Great Recession.1 The secular shift towards increased office density and teleworking will only further depress office demand over time. Chart 17Tighter Lending Standards Could Lead To Lower CRE Prices Tighter Lending Standards Could Lead To Lower CRE Prices Tighter Lending Standards Could Lead To Lower CRE Prices The one bright spot is industrial real estate. Thanks to a revival in U.S. manufacturing, vacancy rates remain low and rent growth is rising. However, if the U.S. economy does accelerate over the remainder of the year, the dollar is likely to strengthen, putting a dent in the profitability of U.S. manufacturing companies. Standing back, how worried should investors be about the CRE sector? For now, there is limited cause for concern. U.S. financial institutions have been tightening lending standards on CRE loans for seven straight quarters. Consequently, the average loan-to-value ratio for newly securitized loans has fallen about four points to 60% since 2015, and is now down eight points compared to 2007. However, if vacancy rates keep rising, real estate prices will fall, leading to a decline in the value of the collateral backing CRE loans. This could prompt lenders to pull back credit, causing prices to fall further (Chart 17). Seasoned real estate investors are no strangers to such vicious cycles, and if the next one begins at a time when growth is slowing because the economy is running out of spare capacity and financial conditions are tightening, it could easily trigger a recession. Fiscal Policy To The Rescue? Could looser fiscal policy delay the day of reckoning? The answer is yes, but much will depend on when the stimulus arrives and what form it takes. The best-case scenario is that fiscal policy is eased just as the economy is beginning to slow of its own accord. A burst of stimulus that arrives on the scene too early would be less desirable, although not necessarily counterproductive, since it would allow the Fed to step up the pace of rate hikes, thereby giving it more scope to cut rates later in response to slower growth. In practice, however, calibrating the amount of monetary tightening that is necessary to offset a given amount of fiscal loosening is difficult to achieve. This is especially the case in today's environment where another fight over the debt ceiling looms large, a new health care bill is making its way through the Senate, and Trump's tax agenda remains heavy on promises but short on specifics. Our expectation is that Congress will pass a "balanced" budget which equates revenues with expenditures over the 10-year budget horizon. How this affects growth is hard to predict with any certainty. On the one hand, spending cuts tend to depress aggregate demand more than tax cuts raise demand. In economic parlance, the fiscal multiplier for government spending is larger than for taxes. On the other hand, the tax cuts are likely to be front-loaded, while the spending cuts will be back-dated. If history is any guide, this means that the latter will never see the light of day. In addition, some of the budgetary impact from cutting statutory tax rates will be paid for through dynamic scoring, the questionable practice of assuming that lower personal and corporate tax rates will significantly spur growth. On balance, we expect fiscal policy to turn modestly stimulative over the next few years. However, given the uncertainty involved, there is a risk that the Fed either raises rates too much - thereby choking off growth - or by not enough, causing the unemployment rate to fall to a level where it has nowhere to go but up. Both outcomes could trigger a recession. Investment Conclusions Right now, our recession timing model, as well as the models maintained by various regional Fed banks, assign a low probability of a severe slowdown in the coming months (See Box 1 for details). These models, however, tend to send reliable signals only over a fairly short horizon. Looking further ahead, we see a heightened probability of weaker growth in the second half of 2018, which could set the stage for a recession in 2019. The good news is that today's economic imbalances are not as daunting as they were in the late innings of many past economic expansions. Thus, the 2019 recession is not likely to be especially severe. The bad news is that valuations across most markets are quite stretched. Thus, like the 2001 recession, the financial market impact could be disproportionally large compared to the economic impact. We are still overweight global equities, but will be looking to significantly reduce exposure by next summer. Once the equity bear market begins - most likely late next year - a 20%-to-30% retracement in U.S. stocks is probable. Given that correlations across stock markets tend to rise when risk sentiment is deteriorating, it is likely that other global bourses will also suffer if U.S. stocks weaken. Indeed, considering that most stock markets have a beta to the S&P 500 that exceeds one, other regions could suffer even more than the U.S. As the U.S. economy falls into recession, the Fed will stop raising rates. This will cause the dollar to weaken, although not before it has appreciated by about 10% in trade-weighted terms from current levels. Thus, while we remain bullish on the dollar over the next 12 months, we are much less sanguine about the greenback over the long haul. As the dollar weakens, the yen and euro will strengthen, imparting deflationary pressures on those economies. If our timing for the next recession proves correct, neither the ECB nor the BoJ will hike rates for the remainder of the decade. The Bank of England is a tougher call. The neutral rate of interest is higher in the U.K. than in continental Europe. Last week's election results represented a clear rejection of fiscal austerity. A more expansionary fiscal stance would give the BoE some scope to raise rates. A weaker pound has also given the economy a much needed competitive boost. With inflation picking up, it is not surprising that the BoE struck a more hawkish tone this week. Nevertheless, Brexit negotiations are liable to drag on for some time, which will constrain the ability of the BoE to tighten monetary policy. Stay long GBP/EUR and GBP/JPY over the next 12 months, but remain short GBP/USD. Housekeeping Note: Closing Our Tactical S&P 500 Short Hedge As noted above, we remain cyclically overweight global equities over a 12-month horizon. However, on occasion, we have put on a tactical hedge whenever equities appeared to be technically overbought. Such a situation arose six weeks ago. While the stock market did dip briefly shortly after we initiated the trade, it subsequently rallied back. At the time of initiation, we indicated that the trade would have a lifespan of six weeks. The clock has now run out, and we are closing the trade for a loss of 2%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Rhys Bidder, Tim Mahedy, and Rob Valletta, "Trend Job Growth: Where's Normal?" FRBSF Economic Letter, 2016-32, Federal Reserve Bank Of San Francisco (October 24,2016), and Daniel Aaronson, "Estimating The Trend In Employment Growth," Chicago Fed Letter, No. 312, Federal Reserve Bank Of Chicago (July 2013). BOX 1 The Message From Our Recession Timing Model Chart Box 18Near-Term Recession Risk Remains Low Near-Term Recession Risk Remains Low Near-Term Recession Risk Remains Low Our recession timing model is based on eight variables: The Conference Board's Leading Economic Indicator, the Coincident Economic Indicator, the fed funds rate, inflation expectations, the unemployment rate, oil prices, credit spreads, and the yield curve. We use a logistic regression framework to model the probability of a recession. Currently, our model shows that the odds of a recession are low (Chart Box 18, panel 1). Only one of the components, namely, a rising fed funds rate, is signaling a risk of a recession. The various models developed by regional Federal Reserve banks also show very low near-term odds of a recession (panels 2 and 3). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

While we expect both direct and indirect exposure to generate solid risk-adjusted returns, favor direct given its overall portfolio impact, lower correlation to financial assets and better inflation protection.

REITs have been climbing a wall of worry in recent years, as the group has had to overcome chronic concerns about potential supply growth and low cap rates. To be sure, the group typically experiences a boom/bust cycle. However, outside multifamily dwellings, REIT supply growth has been subdued globally: our proxy for global construction growth has been remarkably subdued since the Great Recession. Low cap rates have been an issue for years, but the proliferation of negative interest rates around the world and persistently high economic uncertainty argues against expecting a sudden reversal. Instead, low interest rates are spurring strong commercial real estate demand (bottom panel), which has propelled commercial property prices to new highs. In the absence of a sudden and unanticipated surge in overall inflation, the forces that have supported the REIT bull market should remain intact. Stay overweight and please see yesterday's Special Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5REITS-SPG, AMT, PSA, CCI, PLD, HCN, EQIX, VTR, AVB, EQR, WY, BXP, HCP, VNO, O, GGP, DLR, ESS, HST, KIM, SLG, FRT, MAC, EXR, VDR, IRM, AIV. REITs Are Still Attractive REITs Are Still Attractive

Commercial real estate and REITs have benefited greatly from accommodative monetary policy. Though they are approaching a peak, our analysis shows that they remain in a "goldilocks" scenario and still offer plenty of upside.