Corporate Bonds

Highlights For the time being, our cyclical stance is to underweight the globally-sensitive Energy, Materials and Banks sectors versus Healthcare - in both the equity and credit asset-class. Combined with our expectation of a weakening pound/euro, this necessarily means the following European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands and Sweden. Underweight: Italy, Spain, and Norway. We anticipate shifting to a more cyclical sector (and country) allocation by the late summer, especially on dips. Feature It is worth reminding readers that picking mainstream equity markets1 is overwhelmingly about the industry sectors and dominant stocks that you are buying, wittingly or unwittingly. Picking equity markets is seldom about the prospects of the underlying domestic economies or head-to-head valuations.2 Chart of the WeekGlobal Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) Global Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) Global Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) The usual top-down approach to picking stock markets ignores two dominant features of these markets. First, they have huge variations in their sector exposures. Second, large industry sector groups like Energy, Banks, Healthcare and Technology tend to move en masse under the influence of global or regional rather than domestic drivers. The combination of these two features means that for most stock markets, the sector (and dominant company) impact swamps the effect that comes from the domestic economy. Right now, by far the most important consideration for country pickers is the relative outlook for the globally-sensitive Energy and Banks sectors versus the more defensive Healthcare. As an example, consider the choice between Spain and Switzerland. Spain's IBEX is at the mercy of its huge weighting to Banks, dominated by Santander and BBVA; while Switzerland's SMI is at the mercy of its similarly dominant weighting in the Healthcare sector, via Novartis and Roche. Box I-1 - Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks (Chart 2). France (CAC) is underweight Banks and Basic Materials (Chart 3). Italy (MIB) is overweight Banks (Chart 4). Spain (IBEX) is overweight Banks (Chart 5). Netherlands (AEX) is overweight Technology, underweight Banks (Chart 6). Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy (Chart 7). And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound (Chart 8). Switzerland (SMI) is overweight Healthcare, underweight Energy (Chart 9). Sweden (OMX) is overweight Industrials (Chart 10). Denmark (OMX20) is overweight Healthcare and Industrials (Chart 11). Norway (OBX) is overweight Energy (Chart 12). The U.S. (S&P500) is overweight Technology, underweight Banks (Chart 13). It follows that if Banks underperform Healthcare, it is highly likely that Spain's IBEX will underperform Switzerland's SMI, irrespective of the performances of the Spanish and Swiss domestic economies. For long-term investors, the large skews in sector exposure also mean that a head-to-head comparison of country valuations can be very misleading. At first glance, Spain, trading on a forward price to earnings (PE) multiple of 15.5, appears 15% cheaper than Switzerland, trading on a multiple of over 18. But this head-to-head difference just reflects the impact of forward PEs of Banks at 11 and Healthcare at 18. The Bank sector's lower multiple does not necessarily make it better value than Healthcare. Unlike two developed economies - whose long-term growth prospects tend to be broadly similar - two industry sectors could end up experiencing very different structural growth outcomes. Which would justify very different multiples. Despite its low multiple, a structural underweight to Banks might nonetheless be a good strategy if the sector's structural growth outlook is poor. In such a case, the low multiple is potentially a value trap. Picking Stock Markets The Right Way To reiterate, the decision to overweight or underweight a mainstream equity index should not be based on your view of the country's underlying economy - unless, of course, the country is the potential source of a major tail-risk event. Instead, the decision should be based on your over-arching sector view, combined with the country's skews to specific dominant stocks and sectors (Box I-1). Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7, Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12 and Chart I-13 should leave readers in absolutely no doubt. A market's dominant sector skew is by far the most important determinant of its relative performance. Chart I-2Germany (DAX) Is Overweight Chemicals,##br## Underweight Banks Germany (DAX) Is Overweight Chemicals, Underweight Banks Germany (DAX) Is Overweight Chemicals, Underweight Banks Chart I-3France (CAC) Is Underweight Banks##br## And Basic Materials France (CAC) Is Underweight Banks And Basic Materials France (CAC) Is Underweight Banks And Basic Materials Chart I-4Italy (MIB) Is Overweight Banks Italy (MIB) Is Overweight Banks Italy (MIB) Is Overweight Banks Chart I-5Spain (IBEX) Is Overweight Banks Spain (IBEX) Is Overweight Banks Spain (IBEX) Is Overweight Banks Chart I-6Netherlands (AEX) Is Overweight Technology,##br## Underweight Banks Netherlands (AEX) Is Overweight Technology, Underweight Banks Netherlands (AEX) Is Overweight Technology, Underweight Banks Chart I-7Ireland (ISEQ) Is Overweight Airlines (Ryanair) ##br##Which Is, In Effect, Underweight Energy Ireland (ISEQ) Is Overweight Airlines (Ryanair) Which Is, In Effect, Underweight Energy Ireland (ISEQ) Is Overweight Airlines (Ryanair) Which Is, In Effect, Underweight Energy Chart I-8The U.K. (FTSE100) Is Effectively ##br##Underweight The Pound The U.K. (FTSE100) Is Effectively Underweight The Pound The U.K. (FTSE100) Is Effectively Underweight The Pound Chart I-9Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Switzerland (SMI) Is Overweight Healthcare, Underweight Energy Switzerland (SMI) Is Overweight Healthcare, Underweight Energy Chart I-10Sweden (OMX) Is ##br##Overweight Industrials Sweden (OMX) Is Overweight Industrials Sweden (OMX) Is Overweight Industrials Chart I-11Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Denmark (OMX20) Is Overweight Healthcare And Industrials Denmark (OMX20) Is Overweight Healthcare And Industrials Chart I-12Norway (OBX) Is ##br##Overweight Energy Norway (OBX) Is Overweight Energy Norway (OBX) Is Overweight Energy Chart I-13The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks The U.S. (S&P500) Is Overweight Technology, Underweight Banks The U.S. (S&P500) Is Overweight Technology, Underweight Banks Which brings us to the key consideration for country allocation right now: how to allocate to the sectors that feature most often in the skews: Energy and Banks versus Healthcare. For Energy relative performance, note the very strong recent connection with the global 6-month credit impulse. The downswing in the impulse - heralding a very clear growth pause - lines up with the setback in energy and resource prices and the underperformance of these globally-sensitive equity sectors (Chart of the Week and Chart I-14). Meanwhile, in the most recent mini-cycle, Banks' relative performance is tracking the bond yield almost tick for tick (Chart I-15). There are two reasons. For banks, lower bond yields presage both slimmer net interest margins and weaker economic growth. Chart I-14Commodity Price Inflation Is Just Tracking ##br##The Global 6-Month Credit Impulse Commodity Price Inflation Is Just Tracking The Global 6-Month Credit Impulse Commodity Price Inflation Is Just Tracking The Global 6-Month Credit Impulse Chart I-15Financials Are Just Tracking ##br##The Bond Yield Financials Are Just Tracking The Bond Yield Financials Are Just Tracking The Bond Yield So for both Energy and Banks relative performance the overriding question is: when will this mini-downswing end? To answer this question, we note that we are 4-5 months into the global mini-downswing, whose average duration tends to be around 8-9 months. On this basis, now is a little too early to switch to an aggressively pro-cyclical sector allocation. But we would look for potential opportunities by the late summer, especially on sharp dips. Hence, for the time being our cyclical stance is to underweight the globally-sensitive Energy (and Materials) and Banks versus Healthcare. Combined with our expectation of a weakening pound/euro, this necessarily means the following European country allocation: Overweight: France,3 Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands, and Sweden. Underweight: Italy, Spain, Netherlands and Norway. Clearly, if you have a different cyclical and over-arching sector view, you will arrive at a different country allocation. That's fine. The important point is that the stock and sector skew approach is the right way to pick between mainstream equity indexes. Financials Drive The European Credit Market Finally, an over-arching sector view is also highly relevant for the European corporate credit market. In the euro area, the credit market is heavily skewed towards bank and other financial sector bonds, which account for almost half of euro area corporate bonds by value. By comparison, the U.S. credit market is not so skewed to one dominant sector. Hence, the outlook for the European credit asset-class hinges on the prospects for one sector: Financials (Chart 16). With the European high yield credit spread already close to a 20-year low, we would again wait for a better opportunity before adding aggressively to the European credit asset-class. Chart I-16Mirror Image: European High Yield Credit Spread And Bank Equity Prices Mirror Image: European High Yield Credit Spread And Bank Equity Prices Mirror Image: European High Yield Credit Spread And Bank Equity Prices Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In the developed world. 2 Please also see the three European Investment Strategy Special Reports 'Picking 5 European Countries The Right Way' November 13, 2014, 'Picking Countries The Right Way: Part 2' March 26, 2015 and 'Picking Countries The Right Way: Part 3' November 12, 2015. 3 But expect a small near-term countertrend underperformance in the CAC40. See page 11. Fractal Trading Model* There are no new trades this week. Last week's trade, long nickel / short palladium has made an encouraging countertrend move at the classic limit of a trend. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-17 Long Nickel / Short Palladium Long Nickel / Short Palladium The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Risk Budgeting: We are introducing a more formal risk measurement element to our model global bond portfolio. This is to identify if our individual views are potentially creating too much volatility, in aggregate, but also as a way to express the conviction of our individual recommendations through allocation of a "risk budget". Tracking Error Of Our Portfolio: We are setting our maximum allowable tracking error, or excess volatility of our portfolio versus our benchmark index, at 100 basis points. Our current tracking error is just under ½ of that limit. We estimate that our highest conviction views at the moment - staying below-benchmark on duration risk, overweighting U.S. corporates, underweighting both U.S. Treasuries and Italian government debt - contribute nearly 4/5ths of our overall portfolio tracking error. Feature Last September, we introduced a model portfolio framework to Global Fixed Income Strategy.1 This was done to better communicate our investment research into actionable ideas more in line with the day-to-day decisions and trade-offs made by professional bond managers. We followed that up with the addition of performance measurement tools to more accurately track the returns of our model bond portfolio versus a stated benchmark.2 We are now initiating the final piece of our model bond portfolio framework in this Special Report - introducing a risk management component to identify cumulative exposures and guide the relative sizes of our suggested tilts. Our goal is to translate our individual investment recommendations into the language of a "risk budget", i.e. how much of the desired volatility of the portfolio would we suggest placing into any single trade idea. This will allow our readers to apply our proposed tilts - based on how much conviction (i.e. "risk") we allocate to each position - to their own portfolios which may have different risk limits and return expectations. For example, our current recommendation to overweight U.S. corporate debt, both Investment Grade (IG) and High-Yield (HY) represents nearly 1/3 of our estimated total portfolio risk, by far our largest source of potential volatility both in absolute terms and versus our benchmark index (Table 1). Overweighting U.S. corporates, both versus U.S. Treasuries and Euro Area equivalents, is one of our highest conviction trades at the moment. A client who may choose to run a lower risk portfolio can still follow our recommendation by placing enough into U.S. corporates so that 33% of the desired portfolio volatility will come from those positions. Table 1Risk Allocation In Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio In the rest of this Special Report, we will discuss some of the various ways to measure fixed income portfolio risk, apply them to our model portfolio, and introduce some measures to monitor our aggregate portfolio volatility. Going forward, we will closely watch our established metrics and position sizes to ensure that the combination of our individual investment recommendations that we discuss on a week-to-week basis does not create a portfolio that is potentially more volatile than desired. Risk Measurement In Fixed Income Portfolios While investors are typically focused on meeting return targets for their portfolios, the other side of the equation - managing portfolio volatility - is often less stressed. This is especially true during bull markets for any asset class. Investors may become complacent if returns meet or exceed their targets when, in fact, excess returns may have actually been earned through overly risky positions that could have easily not worked in the investors' favor. In the current macro environment, where many financial asset prices are at new highs with stretched valuations and with most of the major global central banks incrementally moving towards less accommodative monetary policy stances, risk management should be even more important for investors. Overly concentrated positioning could now lead to considerable portfolio losses, especially if measuring risk with a metric that is flawed or incomplete, which can lead to a false sense of security. With that in mind, we consider some typical risk measurement metrics used by fixed income investors: Duration: Duration is usually the most popular risk metric for fixed income portfolios as it measures interest rate sensitivity. Duration is defined as the percentage change in a portfolio or asset resulting from a one percentage point change in interest rates. While it provides a solid base understanding of interest rate risk, it does make a simplifying assumption that there is a linear relationship between interest rates and bond prices. Value-At-Risk: Value-At-Risk (VaR) is a statistical technique that measures the loss of an investment, or of an entire portfolio, over a certain period with a given level of confidence. However, there are two considerable flaws with this approach. First, the VaR output suggests a portfolio can lose at least X%, it does not actually indicate how big the potential loss could be. Instead, using a measure such as Historical VaR, if a portfolio has a long enough track record, can better quantify potential losses. Second, VaR is highly susceptible to estimation errors. Certain assumptions on correlations and the normality of return distributions can have a substantial impact on VaR readings. Table 2Value At Risk Of Our Benchmark Adding A Risk Management Framework To Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio In Table 2, we show the Historical VaR (HVAR) of our benchmark index, calculating the potential monthly loss using data going back to 2005. On that basis, the worst expected monthly loss for our benchmark is -1.6% (using a 95% confidence interval) and -2.1% (using a 99% confidence interval). Tracking Error: Tracking error measures the volatility of excess returns relative to a certain benchmark. It is a standard risk measure used by a typical "real money" bond manager with a benchmark performance index, like a mutual fund. Tracking error does not offer information on alpha generation (i.e. how much you can expect to beat your benchmark based on your current investments), it simply indicates how much more volatile a portfolio is expected to be versus its benchmark. As our model portfolio returns are measured on a relative basis to our stated bond benchmark index, tracking error is quite appropriate as our main risk metric. A Historical Examination Of Our Portfolio When we first created our model portfolio, we also introduced a benchmark index against which we could measure our performance. Our customized benchmark differs from typical multi-sector measures like the Barclays Global Aggregate Index in that it has a broader scope, including sectors that can have credit ratings below investment grade such as High Yield corporates. The benchmark does, however, exclude smaller regions that we only occasionally discuss such as Sweden, Portugal, Norway and New Zealand. These smaller markets offer comparatively poor liquidity and we want our benchmark to be as investible as possible. Nevertheless, our customized benchmark has been highly correlated to the Barclays Global Aggregate Index over the past decade. As our portfolio has not had a full year of return data, its history is quite limited. Still, in our first performance review conducted two months ago, we indicated that our portfolio had been very closely tracking our customized benchmark. We have since increased our positions in our highest conviction views and our tracking error has risen noticeably and now sits at just over 40bps (Chart 1). Within our model portfolio, we are setting an expected excess return target of 100bps per year. That means that we are setting a goal of beating our benchmark index returns by one full percentage point per year. Given that we are measuring our performance versus currency-hedged benchmarks that are primarily rated investment grade or better, 100bps of annual excess return is a reasonable target. We are also setting a limit where the excess return/tracking error ratio should aim to be equal to 1 each year. This is under the simple assumption that we want an equal amount of return over our benchmark for our expected excess volatility versus our benchmark. On that basis, we are setting our tracking error "limit" at 100bps per year. That suggests that our current tracking error is relatively low. However, correlations between the individual components of our benchmark index have been rising over the past couple of years (Chart 2). Therefore, running a relatively low overall level of risk at a time where diversification among the positions within our portfolio is now harder to achieve, and when the valuations on most government bond and credit markets look rich, is prudent. Chart 1Higher Tracking Error, But Still Well Below Our Target Higher Tracking Error, But Still Well Below Our Target Higher Tracking Error, But Still Well Below Our Target Chart 2Correlations Across Fixed Income Sectors Have Been Rising Correlations Across Fixed Income Sectors Have Been Rising Correlations Across Fixed Income Sectors Have Been Rising This is another way that we can control the overall riskiness of our model portfolio. Not only by how much of our risk budget (tracking error) that we want to allocate to each of our recommended positions, but also how big of a risk budget do we want to run at any given point in time. If we see more assets trading at cheap valuations, then we could choose to run a higher tracking error than when most assets look expensive. Bottom Line: We are introducing a more formal risk measurement element to our model global bond portfolio. This is to identify if our individual views are potentially creating too much volatility, in aggregate, but also as a way to express the conviction of our individual recommendations through allocation of a "risk budget". We are setting our maximum allowable tracking error, or excess volatility of our portfolio versus our benchmark index, at 100 basis points. Measuring The Contribution To Risk From Our Market Tilts In our model portfolio, we include a wide range of geographies and sectors from the global fixed income universe. Understanding the risk contribution of each position to the overall portfolio provides a clearer picture as to where our potential risks lie, and by how much. To measure the risk contribution of each of our individual recommendations to our overall portfolio volatility, we used the following formula: wA * E CovAB * wB Where W = the weight of any single asset in our portfolio and COV is the covariance between the asset and other assets in the portfolio. As such, an asset's contribution to risk is a function of its weight in the portfolio and its covariance with the other assets. Importantly, since we are measuring our model portfolio performance in terms of excess returns, we examined each position's contribution to risk relative to the benchmark. All calculations begin in late 2005, when return data is available for all of the assets in our portfolio. The results are summarized in Table 1 on Page 1. Our portfolio tilts are based off of our four highest conviction themes. They include: Stronger global growth led by the U.S. The U.S. economy should expand at a faster pace in the latter half of the year on the back of a rebound in consumption and strong capital spending, all supported by solid income growth and easy financial conditions. We have expressed this theme through our overweight allocation to U.S. corporate debt. While our U.S. Corporate Health Monitor is flashing that balance sheets are becoming increasingly strained, easy monetary conditions and an expansionary economic backdrop should continue to support excess returns for U.S. corporates. More Fed rate hikes than expected. We expect U.S. economic and corporate profit growth to remain robust due to accommodative monetary conditions, diminishing slack and resilient consumption. As such, the Fed will continue tightening policy by more than what markets are currently pricing in. This theme is expressed through an underweight position in U.S. Treasuries, which accounts for 17% of our volatility versus 24% for that of the benchmark. This wide spread relative to the benchmark is a substantial source of our tracking error, but one that we are comfortable running given our view that U.S. Treasury yields are too low. Chart 3Realized Bond Volatility Has Been Declining Realized Bond Volatility Has Been Declining Realized Bond Volatility Has Been Declining Rising tapering risks in Europe. Our expectation is that the European Central Bank (ECB) will be forced to announce a slower pace (tapering) of bond buying starting next year, given the current robust economic expansion in Europe that is rapidly absorbing spare capacity. An ECB taper announcement is expected to lead to rising longer-term global bond yields, mostly via rising term premia. We are expressing that view in our portfolio through our overall underweight interest rate duration stance. Our current portfolio duration is 5.6 years versus our benchmark duration of 7.0 years. That is a large tilt that represents a significant portion of our tracking error, but given our view that U.S. Treasuries also look overvalued, running a large overall duration underweight does correlate to our conviction level. Rising geopolitical risks and banking sector issues in Italy. Geopolitical risks remain elevated leading up to parliamentary elections in 2018, and Italian banks remain undercapitalized with non-performing loans still in an uptrend. Therefore, we are underweight Italian debt, though this is a smaller deviation of portfolio risk versus our benchmark (around 2%), given the smaller size of Italy in our benchmark. Purely looking at geography and sector selection, our four highest conviction views make up almost 80% of the active portfolio risk that we are "running" in our model portfolio. That number may seem high but, as described earlier, our realized portfolio volatility has been quite low (Chart 3). That suggests that there could be some degree of underlying diversification within our recommended portfolio given lower correlations of certain assets to the rest of the portfolio. This is a topic that we will investigate more deeply in future Weekly Reports. Bottom Line: We estimate that our highest conviction views at the moment - staying below-benchmark on duration risk, overweighting U.S. corporates, underweighting both U.S. Treasuries and Italian government debt - contribute nearly 4/5ths of our overall portfolio tracking error. Patrick Trinh, Associate Editor Patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Introducing Our Recommended Global Fixed Income Portfolio", dated September 20 2016, available at gfis.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "An Initial Look At The Performance Of Our Model Bond Portfolio", dated April 18 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Table 4 Adding A Risk Management Framework To Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio

Highlights Duration & TIPS: The recent downtrend in nominal Treasury yields has been driven entirely by inflation that has come in weaker than expected. We are inclined to view inflation's weakness as transitory and suggest investors maintain a below-benchmark portfolio duration stance, as well as an overweight allocation to TIPS versus nominal Treasury securities. Corporate Debt & The Economy: High corporate debt levels are not indicative of over-investment on the part of the corporate sector. As such, they do not suggest an elevated risk of recession. Corporate Debt & Credit Spreads: While a supportive Fed will keep corporate spreads low for the time being, rising leverage is starting to send a worrying message. Feature It's All About Inflation Chart 1End Of The Trump Trade? End Of The Trump Trade? End Of The Trump Trade? Treasury securities have reversed a lot of their post-election sell off during the past few weeks, and the 10-year yield is now only 38 basis points above where it was last November (Chart 1). A quick glance at the 10-year's real and inflation components reveals that weaker inflation is the culprit. The real 10-year Treasury yield remains 31 bps above its pre-election level, but the 10-year TIPS breakeven inflation rate is now only 7 bps higher (Chart 1, bottom panel). This explains a lot about the broader financial environment. Stable growth and low inflation create a fertile breeding ground for risk assets, and corporate bond spreads are indeed considerably tighter than prior to the election. The average spread on the investment grade corporate bond index is currently 113 bps, down from 135 bps in November. The average junk spread is currently 365 bps, down from 489 bps. What explains the large drop in inflation breakevens? One reason is that they had simply overshot the fair value implied by other financial instruments (Chart 2). Our financial model- based on the oil price, the exchange rate and the stock-to-bond total return ratio - shows that the 10-year breakeven rate was around 20 bps too high earlier this year. It is now almost exactly in line with our model's fair value. The most likely explanation for the overshoot is that markets started to discount a much more stimulative fiscal policy in the immediate aftermath of the election. The potential for large tax cuts at a time of already tight labor markets caused investors' inflation expectations to ramp up. While tax cuts are still likely, it now appears as though they will occur much later and be smaller in scale than was originally thought. Falling oil prices have also exacerbated the drop in breakevens by causing the fair value reading from our model to roll over (Chart 2, bottom panel). Our commodity strategists do not think oil prices will stay this low for much longer.1 OPEC 2.0 production cuts and sustained growth in emerging market trade volumes will cause oil inventories to fall this year, leading to a rebound in prices. The second explanation for this year's drop in the inflation component of yields is that the core inflation data have disappointed during the past couple of months. After reaching 1.8% in February of this year, 12-month trailing core PCE inflation has deviated sharply from the uptrend that had been in place since mid-2015. As of April, it had fallen back to 1.5%, well below the level implied by our Phillips Curve inflation model (Chart 3). Chart 2TIPS Financial Model TIPS Financial Model TIPS Financial Model Chart 3A Phillips Curve Inflation Model A Phillips Curve Inflation Model A Phillips Curve Inflation Model With the labor market continuing to tighten and the dollar having depreciated in recent months, we are inclined to view the recent drop in core inflation as transitory. In fact, even after making some adjustments to the estimation interval (see Box), our Phillips Curve inflation model still projects that core PCE inflation will reach 2% by the end of this year in a base case scenario where the unemployment rate, the exchange rate and survey inflation expectations are all unchanged. Box: Incorporating Different Regimes Into Our Inflation Model As has been explored in depth in prior reports,2 we have been modeling core PCE inflation using a Phillips Curve model that is inspired by one that Janet Yellen mentioned in a 2015 speech.3 Essentially, we model core inflation using lagged inflation, the gap between the unemployment rate and the Congressional Budget Office's estimate of the natural unemployment rate, relative non-oil import prices and a survey measure of inflation expectations. Previously we estimated the coefficients for this model using the longest time interval we could obtain - starting in October 1979. However, a recent Fed paper by Jeremy Nalewaik4 motivated us to refine this approach. Nalewaik shows that core PCE inflation has been driven by different factors in different regimes, and that those regimes can be defined by whether inflation expectations were well-anchored or highly volatile. Specifically, in the 1970s, 1980s and early 1990s, inflation expectations were highly volatile and explained much more of the variation in actual core inflation than they did in the 1960s or from the mid-1990s until the present day. We confirmed this result by splitting our sample into two periods - 1979 to 1995, and 1995 to present. Our results show that inflation expectations were a much more significant driver of core inflation in the 1979-1995 regime than they are in the current regime (Table 1). As such, we have decided that the coefficients calculated using the 1995-present interval are probably more representative of the current environment. Applying these coefficients to the four scenarios we examined in our May 2 report, our model now projects that core PCE inflation will reach 2.03% by year end in our "base case" scenario, 1.93% in our "strong dollar" scenario, 1.97% in our "bad NAIRU" scenario and 1.87% in our "deflation case" scenario. Table 1BCA Phillips Curve Model* Of Core** PCE Inflation Under Different Regression Intervals Low Inflation And Rising Debt Low Inflation And Rising Debt Where Are Yields Headed From Here? We see two potential scenarios that could play out between now and the end of the year. The first is that core inflation rebounds during the next few months and ends the year closer to our model's fair value estimate. The inflation component of yields would move higher in this scenario and real yields would probably also increase. The 10-year real yield closely tracks our 12-month fed funds discounter, which measures the number of rate hikes the market expects during the next year (Chart 4). The discounter currently sits at 49 bps, meaning that the market expects fewer than 2 rate hikes during the next 12 months. This would certainly be revised higher if inflation were to rebound. Chart 4Fed Wants Wider Breakevens Fed Wants Wider Breakevens Fed Wants Wider Breakevens The second possible scenario is that while U.S. growth stays close to its current 2% pace, inflation simply does not bounce back. In other words, core PCE ends the year closer to 1.5% than to 2% and a large residual opens up between inflation and our Phillips Curve model. While TIPS breakevens would be unlikely to rise in this scenario, the downside is also probably limited unless inflation were to fall below its current 1.5%. If this second scenario plays out the Fed would also probably react by adopting a more dovish policy stance. This would cause the market's rate hike expectations, and 10-year real yields, to fall. But even here the downside would appear to be limited. With the market currently priced for a mere 39 bps of hikes between now and the end of 2017 and only another 24 bps for all of 2018, there simply isn't much scope for a large dovish re-rating of the Fed. Additionally, if the Fed were to adopt a sufficiently dovish reaction function in the face of persistently low inflation, it is possible that lower rate hike expectations could spur a recovery in long-maturity TIPS breakeven inflation rates. If the market believes that the Fed will stay dovish enough for inflation to recover to target, then the positive correlation between real yields and inflation breakevens could reverse. There are recent precedents for this (Chart 4, bottom panel). In 2011 and 2012, the Fed's Operation Twist caused rate hike expectations and real yields to fall, but also led to wider TIPS breakevens. The reverse scenario played out in 2015 when the market decided that the Fed was adopting an overly hawkish policy stance. This caused TIPS breakevens to fall as real yields rose. The conclusion here is that even if inflation stays stubbornly low for the remainder of the year, and the Fed responds by guiding the market toward a shallower rate hike path, then it is possible that some of the downside in real yields will be mitigated by rising TIPS breakevens. In our view, the risk/reward trade-off between the two scenarios outlined above suggests that investors should maintain a below-benchmark duration stance. Bottom Line: The recent downtrend in nominal Treasury yields has been driven entirely by inflation that has come in weaker than expected. We are inclined to view inflation's weakness as transitory and suggest investors maintain a below-benchmark portfolio duration stance, as well as an overweight allocation to TIPS versus nominal Treasury securities. Even in a scenario where inflation stays low despite continued above-trend economic growth, we view the downside in yields from current levels as limited. It's Late In The Game For Corporate Credit With last week's release of the U.S. Financial Accounts (formerly Flow of Funds) we are able to update some of our preferred credit cycle indicators. One concerning development is that net corporate leverage - defined as total debt less cash as a percent of EBITD - ticked higher for the second consecutive quarter in Q1 (Chart 5). Chart 5Corporate Balance Sheets Continue To Add Leverage Corporate Balance Sheets Continue To Add Leverage Corporate Balance Sheets Continue To Add Leverage As we have observed in previous reports,5 there is a strong correlation between net leverage and spreads. In fact, we are only able to identify one other period in which spreads were able to tighten as leverage rose. That period was in the late 1980s, immediately following the crash and subsequent rebound in oil prices. As is shown in Chart 5, net leverage correlates strongly with both corporate spreads and the default rate. However, in the late 1980s the collapse of the energy sector caused spreads to widen too far. Spreads then benefited from a "payback period" as energy prices recovered and defaults ebbed during the following two years. But in the background, net leverage only managed to level-off for a brief period before continuing to trend higher. The uptrend in leverage culminated in the 1990 default cycle and recession. We see a similar dynamic playing out at the moment. Spreads (and the default rate) are currently benefiting from the payback period following the 2014 collapse and subsequent recovery in commodity prices. But so far leverage has not managed to cease its upward march. What Is Leverage Telling Us Right Now? As was mentioned above, net leverage has now increased for two consecutive quarters. To see what this has meant historically, we looked at excess investment grade corporate bond returns over 6-month periods following different changes in net leverage. For example, we found that after leverage has increased for two consecutive quarters, the average (annualized) 6-month excess return to investment grade corporate bonds has been -190 bps, and also that corporate bonds outperformed Treasuries in 45% of those 6-month periods (Table 2). Table 26-Month Investment Grade Corporate Excess Returns* ##br##Following A Rise In Net Corporate Leverage** (1973 To Present) Low Inflation And Rising Debt Low Inflation And Rising Debt Conversely, in 6-month periods after leverage has declined for two consecutive quarters, average (annualized) excess returns came in at +120 bps, and corporate bonds outperformed Treasuries in 61% of those episodes (Table 3). Table 36-Month Investment Grade Corporate Excess Returns* ##br##Following A Decline In Net Corporate Leverage** (1973 To Present) Low Inflation And Rising Debt Low Inflation And Rising Debt Not surprisingly, the late 1980s episode was one that defied the above statistics. In fact, investment grade corporate bonds outperformed Treasuries by an annualized 5% in the 6-month span between September 1986 and March 1987, even though leverage had previously increased for 4 consecutive quarters. For this reason we remain comfortable with our overweight in corporate bonds for now, especially since the Fed is likely to remain sufficiently accommodative to support higher inflation and hence continued economic growth. However, it is obvious that trends in leverage will be critical to monitor going forward. Where Is Leverage Heading? A rebound in corporate profits would help stem the uptrend in leverage, and the outlook for that is good. Not only did our measure of EBITD diverge negatively from S&P 500 operating profits in the first quarter, but other leading profit indicators such as the growth in business sales less inventories suggest that EBITD should catch up to S&P 500 profits, and not the reverse (Chart 6). What remains unclear is whether the looming rebound in profit growth will be enough to cause leverage to fall. While debt growth has been rolling over (Chart 5, bottom panel), we think it will remain at a reasonably high level going forward. Meanwhile, the historical evidence suggests that net leverage does not usually reverse its uptrend unless first prompted by a recession. Turning to debt, the ratio of corporate debt to GDP is definitely eyebrow raising (Chart 7), as it is now very close to levels observed at the peak of the past two cycles. However, one important caveat is in order. While corporate debt levels have grown quickly, corporate investment has not. Chart 6Profit Growth Will Improve Profit Growth Will Improve Profit Growth Will Improve Chart 7Investment Is Coming Back Investment Is Coming Back Investment Is Coming Back The corporate financing gap - capital expenditures less internally generated revenue - is a good proxy for the amount of debt issued to fund investment. In the second panel of Chart 7 we see that it has only just moved into positive territory and is well below the levels observed at the end of the last two recoveries. The obvious conclusion is that most corporate debt issuance has not been used to finance investment, but rather has been used to buy back equities. This is bad news from the perspective of corporate bondholders who would certainly prefer more people below them in the capital structure, but it also means that high corporate debt levels are not indicative of over-investment on the part of the corporate sector. As such, high corporate debt levels do not suggest that the risk of recession is elevated. They merely suggest that corporations' capital structures have shifted in favor of shareholders over bondholders. Going forward, we see potential for a moderation in the amount of corporate debt issuance used to fund buybacks. This has already started to occur as evidenced by our buyback proxy (Chart 7, panel 3) - simply the difference between net issuance and the financing gap shown in panel 2. Not surprisingly, this buyback proxy is highly correlated with the difference between the equity risk premium and corporate bond spreads. However, any moderation in share buybacks will be at least partially offset by an increase in debt issuance to fund investment. Corporate investment has seen a revival during the past few quarters, and leading indicators such as ISM New Orders surveys suggest it will continue trending up (Chart 7, bottom panel). Bottom Line: While a supportive Fed will keep corporate spreads low for the time being, rising leverage is starting to send a worrying message. Unless strong profit growth causes leverage to reverse course, it will likely be appropriate to scale back on credit risk either later this year or early next year, once the monetary back-drop becomes less supportive. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, "Strong EM Trade Volumes Will Support Oil", dated June 8, 207, available at ces.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers", dated May 3, 2017, and "The Fed Doctrine", dated May 30, 2017, both available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 4 https://www.federalreserve.gov/econresdata/feds/2016/files/2016078pap.pdf 5 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The current economic and profit environment supports our stance of favoring stocks over bonds. The Fed will need to see more evidence to alter its gradual path for rates. Although valuations remain elevated, they are not a great market timing tool. Margins are expanding according to the S&P 500 data, and we expect this to continue in the second half of the year. But a peak in margins next year could be the justification to scale back on overweight positions in stocks, in anticipation of slower EPS growth. Corporate balance sheets continued to deteriorate in the first quarter, but that is not enough to warrant cutting back on corporate bond positions within fixed-income portfolios. Watch real short-term rates and bank C&I lending standards, as an exit warning. Feature Environment Remains Supportive For Stocks Over Bonds Investors are wondering whether the equity and currency/bond markets are living on different planets. The dollar and Treasurys seem to be priced for sluggish economic growth, less inflation and no fiscal stimulus. Yet, the S&P 500 is stubbornly holding above the 2,400 level. Many believe that the only reason that stocks got to this level in the first place is the prospect of tax cuts, deregulation and infrastructure spending. If true, then it is only a matter of time before equity investors capitulate. We look at it another way. Yes, equities initially received a boost following the U.S. election on hopes for tax reform. But indicators such as the ratio of small-to-large-cap stocks, or high-tax companies relative to the S&P 500, suggest that the stock market has priced out all chances of any tax reform. The overall stock market has performed well despite this because of the favorable profit backdrop. The fact that Corporate America can generate such profits despite a lackluster economy is impressive. Moreover, the recent softening in inflation has led many to believe that the Fed can proceed even more slowly than the market previously believed, leading to a bond rally. This is quite a bullish backdrop for equities. One does not have to conclude that the bond and stock markets are living on different planets. The backdrop is also positive for corporate bonds versus Treasurys, despite the fact that corporate health continues to deteriorate (see below). Turning to politics, the political consequences of the extraordinary U.K. general election are still not clear. The outcome of the election does not change our core views on the U.S. dollar, equity or bond markets. The dollar has rallied, Treasury yields are higher and U.S. equity prices moved up as this report was being prepared on Friday, June 9. Looking ahead, the coalition-building process in the U.K. will take time as the horse-trading between parties proceeds. Nonetheless, our high conviction view is that the investment implications are in fact already self-evident and do not require foresight into the eventual make-up of the U.K. government. A key takeaway for investors is that, aside from Brexit, domestic fiscal policy is the driving issue in British politics. Austerity is dead in Britain and investors should expect its economic policy - under whatever leadership ultimately gains power - to swing firmly to the left on fiscal, trade, and regulatory policy. Moreover, the Brexit process will continue, albeit of a potentially more "softer" variety and with a somewhat higher probability of eventual reversal.1 Will They Or Won't They? A 25-basis point rate hike is likely this week, but the FOMC will need more evidence on the direction of inflation and the economy before significantly changing the timing and pace of rate hikes or economic forecasts. The market is fully pricing in the anticipated 25-basis point rate bump, but beyond that, there is not much agreement between the Fed and the market on interest rates or economic projections. Nonetheless, as the Fed prepares its June forecast and dot plots, policymakers and the market are on the same page in terms of the labor market, inflation, and the economy in the next few years. The unemployment rate (4.3% in May 2017) is below the Fed's forecasts for 2017 (4.5%) and longer run (4.7%). The consensus outlook for the unemployment rate keeps it below the Fed's path through the end of 2018 (Chart 1, panel 3). Even assuming that the 120,000 pace of job growth in the past three months persists, the unemployment rate would remain below the Fed's view of NAIRU (Chart 2). Our unemployment rate projections are based on a stable labor force participation rate and a 1% gain in the working age population. Chart 1Fed, Market And Reality##BR##Not Too Far Apart Fed, Market And Reality Not Too Far Apart Fed, Market And Reality Not Too Far Apart Chart 2The Unemployment Rate##BR##Under Various Monthly Job Count Scenarios The Unemployment Rate Under Various Monthly Job Count Scenarios The Unemployment Rate Under Various Monthly Job Count Scenarios However, a closer look at what policymakers have said about prices and the trajectory of inflation in recent years suggests that the market and the Fed are not that far apart. At +1.7% in April, the PCE deflator remains near the FOMC's projection of 1.9% for this year and 2.0% in the long run. Bloomberg consensus estimates for inflation for this year and next are above the top end of the Fed's forecast range (Chart 1, panel 2). The FOMC's May minutes state that "participants generally continued to expect that inflation would stabilize around the Committee's two percent objective over the medium run as the effects of transitory factors waned." The market is still concerned that the traditional Phillips curve model may be broken and that inflation may never accelerate even with the economy below the Fed's estimate of full employment. We will discuss the Phillips curve in a post-GFC world in an upcoming edition of The Bank Credit Analyst. As we discussed in last week's report,2 GDP growth in 2017 is on track to exceed the Fed's 2017 target (2.1%) and is already running ahead of the Fed's GDP projection (1.8%) for the long term. The consensus forecast for GDP in 2018 and 2019 is at the upper end of the Fed's range set in March (Chart 1, panel 1). Despite the general agreement between the Fed and the market on certain aspects, they diverge on the outlook for the fed funds rate in the next 18 months (Chart 3). As of June 9, the Fed sees a total of six quarter-point rate hikes by the end of 2018. The market sees just two in the same period. The Fed and market are still far apart on rates in 2019. However, the disconnect between the Fed and the market is not as large as it was in early 2015. This disagreement was a major factor in the equity market pullback in the first few months of 2016 (Chart 3). Neither the recent weakness in the economic data nor softer-than-expected inflation readings will be enough to prompt a significant shift from the Fed in terms of the 'dot plot'. The economic surprise index has been declining for 63 days since peaking in early- to mid-March, but remains consistent with slow growth, not a recession. Economic data tends to disappoint for an average of 90 days after the economic surprise index is above 40, as it was in late 2016/early 2017 in the wake of the U.S. election (Chart 4). Chart 3Disconnect Between Fed##BR##And Market On Rates Disconnect Between Fed And Market On Rates Disconnect Between Fed And Market On Rates Chart 4Economic Surprise Index Has Rolled Over##BR##Since Early To Mid March Economic Surprise Index Has Rolled Over Since Early To Mid March Economic Surprise Index Has Rolled Over Since Early To Mid March Bottom Line: It would take a significant deterioration in the economy and labor market and in the benign inflation environment to alter the Fed's gradual rate hike plan. A backdrop of gradual hikes and eventually, a smaller balance sheet, will continue to foster the conditions under which stocks have outperformed bonds since 2009. We believe that the recent Treasury rally is overdone because the market has gone too far in revising down the path of Fed rate hikes. A re-evaluation of the outlook could see bond yields jump, sparking a small equity correction. This is not enough of a risk to scale back on equities versus bonds. Valuations, Earnings And Margins: An Update U.S. equities remain overvalued and would be even more extended if not for low rates. However, they are attractively priced relative to competing assets, such as corporate bonds and Treasurys. Valuation is not a great tool to time market turning points and, absent a significant deterioration in the economic, profit and margin environment, we don't foresee a sustained pullback in stocks. Looking beyond our tactical 6-12 month window, above-average market multiples alone imply below-average returns for stocks across a strategic time horizon. Our BCA valuation indicator has deteriorated since we last published it in March 2017 and shows that U.S. equities remain expensive.3 Individually, two of the three components of the Valuation index remain in overvalued territory. The Earnings Group remains at a record high (aside from the tech bubble). The Balance Sheet group shows the same profile. Only the Yield Group, which compares stock prices with various nominal and real interest rates, suggests that equities are undervalued. Thus, U.S. stock prices are vulnerable to a sharp jump in rates, which supports our view that U.S. equity markets will perform well in an economic and inflation backdrop that allows the Fed to raise interest rates and unwind its balance sheet gradually (Chart 5). While tax cuts and infrastructure spending might provide the equity market with a "sugar high", it probably would not last long because fiscal stimulus would bring forward Fed rate hikes. Moreover, Chart 6 shows that U.S. stocks remain favorably priced relative to competing assets such as corporate bonds, Treasurys and residential housing. That said, equity valuation measures such as price-to-book or price-to-sales make the market vulnerable to shocks. Chart 5U.S. Stocks##BR##Are Overvalued... U.S. Stocks Are Overvalued... U.S. Stocks Are Overvalued... Chart 6Stocks Look Less Expensive##BR##Relative To Competing Assets Stocks Look Less Expensive Relative To Competing Assets Stocks Look Less Expensive Relative To Competing Assets Inflated valuations alone are not enough to trigger a bear market or even a significant correction in U.S. equities. Outside of aggressive Fed tightening, we will become more defensive when profits come under pressure. On this score, the decline in Q4 profits according to the NIPA data is concerning. We are in a period where margins based on the NIPA data are diverging from the S&P's measure. Like corporate earnings, there is more than one data source for profit margin data, and the data itself is a mix of art and science. In the long run, the S&P-based margin data and the data derived from the NIPA accounts tend to move together. Over shorter time horizons, however, these two metrics may diverge. The NIPA margins peaked in 2014 and have moved steadily lower since then, but the BEA-derived profit data are not closely watched by investors and are subject to significant revision. On the other hand, margins based on S&P data are followed closely by the markets, are not subject to revision and have been moving higher since end of 2015. In the past 55 years, the peak in NIPA margins has often led the S&P data at peaks; the caveat is that it is unclear whether the NIPA data led in real time because of the endless revision process for GDP and profit data.4 The margin series based on S&P data tends to lead heading into margin troughs, but it is not a reliable signal. During the long economic expansion in the 1960s, both indicators topped out around the same time (1966-67). The NIPA derived margins peaked in 1975 as the S&P margins troughed, and later in the decade, the zenith in NIPA margins peaked three years before the S&P version. Similar to the current decade the long expansion in the 1980s saw a mid-decade collapse in oil prices and margins. In the late 80s, NIPA and S&P measures peaked almost simultaneously, which was three years before the crest in equity prices. The 1990s saw unabated margin expansion through 1997 for NIPA margins; the expansion in S&P-based margins lasted until 1999 (Chart 7). Chart 7Margins, Like Profits Are Mix Of Art & Science Margins, Like Profits, Are Mix Of Art & Science Margins, Like Profits, Are Mix Of Art & Science History also shows that falling margins do not always mean declining EPS growth. In the past 40 years, when the U.S. economy was not in recession, corporate EPS growth was very high on average when margins rose. It was mostly a wash when margins dropped, with slightly negative EPS growth on average. There were two episodes (late-1990s and mid-2000s) when margins fell, but EPS growth was strongly positive (Chart 8). The stock market can also rise significantly even after margins peak for the cycle. Chart 8EPS Can Grow Even As Margins Contract EPS Can Grow Even As Margins Contract EPS Can Grow Even As Margins Contract According to S&P data we are in a phase of climbing margins and we expect EPS growth to further accelerate into year end, peaking at just under 20%, before moderating in 2018. If profit growth decelerates in 2018 and the S&P measure of margins begins to narrow again, it would send a strong signal to trim exposure, especially given lofty equity valuations (Chart 9). Chart 9Profit Growth And Margins Both Rising Profit Growth And Margins Both Rising Profit Growth And Margins Both Rising Bottom Line: Rich valuations in U.S. equities will be overlooked as most investors are focused on the S&P and not the NIPA margins. EPS growth will decelerate sharply when margins resume their mean reversion, which could be the catalyst for a major correction or bear market in stock prices. We do not expect this scenario to play out until 2018 at the earliest. Meanwhile, rising margins and profits trump expensive multiples for U.S. equities. Stay long. Corporate Bonds: Kindling And Sparks Last week's U.S. Flow of Funds release allows us to update BCA's Corporate Health Monitor (CHM) for the first quarter (Chart 10). The level of the CHM moved slightly deeper into "deteriorating health territory." The deterioration in the Monitor over the past few years is largely reflected in the profit-related components of the CHM, including the return on capital, cash flow coverage and free cash flow-to-total debt. Chart 10Deteriorating Since 2015, But... Deteriorating Since 2015, But... Deteriorating Since 2015, But... The Monitor has been a reliable indicator for the trend in corporate bond spreads over the years. Indeed, it is one of the oldest and most reliable indicators in BCA's stable of indicators. However, spreads have trended tighter over the past year even as the CHM began to signal deteriorating health in early 2015. Why the divergence? The CHM is only one of three key items on our checklist to underweight corporate bonds versus Treasurys. The other two are tight Fed policy (i.e. real interest rates that are above the neutral level) and the direction of bank lending standards for C&I loans. On its own, balance sheet deterioration only provides the kindling for a spread blowout. A blowout requires a spark. Investors do not worry about high leverage or a profit margin squeeze, for example, until the outlook for defaults sours. The latter occurs once inflation starts to rise and the Fed actively targets slower growth via higher interest rates. Banks see trouble on the horizon and respond by tightening lending standards, thereby restricting the flow of credit to the business sector. Defaults start to rise, buttressing banks' bias to curtail lending in a self-reinforcing negative feedback loop. The three items on the checklist usually occurred at roughly the same time in previous cycles because a deteriorating CHM is typically a late-cycle phenomenon. But this has been a very different cycle. High stock prices and rock-bottom bond yields have encouraged the corporate sector to leverage up and repurchase stock. At the same time, the subpar, stretched-out recovery has meant that it has taken longer than usual for the economy to reach full employment. Even now, inflationary pressures are so muted that the Fed can proceed quite slowly. It will be some time before real short-term interest rates are in restrictive territory. As for banks, they tightened lending standards a little in 2015/16 due to the collapse of energy prices, but this has since reversed. As an aside, recent weakness in the growth rate of C&I loans has contributed to concerns over the health of the U.S. recovery. However, the easing in lending standards this year points to an imminent rebound in C&I loan growth (Chart 11). Our model for C&I loans, based on non-residential fixed investment, small business optimism and the speculative-grade default rate, supports this view. Chart 11C&I Loan Growth Set To Rebound C&I Loan Growth Set To Rebound C&I Loan Growth Set To Rebound The implication is that, while corporate health has deteriorated, we do not have the spark for a sustained corporate bond spread widening. Indeed, Moody's expects that the 12-month default rate will trend lower over the next year, which is consistent with constructive trends in corporate lending standards, industrial production and job cut announcements (all good indicators for defaults). Chart 12 presents a valuation metric that adjusts the HY OAS for 12-month trailing default losses (i.e. it is an ex-post measure). In the forecast period, we hold today's OAS constant, but the 12-month default losses are a shifting blend of historical losses and Moody's forecast. The endpoint suggests that the market is offering about 200 basis points of default-adjusted excess yield over the Treasury curve for the next 12 months. This is roughly in line with the mid-point of the historical data. In the past, a default-adjusted spread of around 200 basis points provided positive 12-month excess returns to high-yield bonds 74% of the time, with an average return of 82 basis points. It is also a positive sign for corporate bonds that the net transfer to shareholders, in the form of buybacks, dividends and M&A activity, has eased on a 4-quarter moving average basis (although it ticked up in Q1 on a 2-quarter basis; Chart 13). As a result, ratings migration has improved (i.e. easing net downgrades), especially for shareholder-friendly rating action, which is a better indicator for corporate spreads. The moderating appetite to "return cash to shareholders" may not last long, but for now it supports our overweight in both investment- and speculative-grade bonds versus Treasurys. That said, excess returns are likely to be limited to the carry given little room for spread compression. Chart 12Still Some Value In##BR##High-Yield Corporates Still Some Value In High-Yield Corporates Still Some Value In High-Yield Corporates Chart 13Net Transfers To Shareholders##BR##Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Within balanced portfolios, we recommend favoring equities to high-yield at this stage of the cycle, for reasons we outlined in the April 17, 2017 Weekly Report. In a nutshell, value is not good enough in HY relative to stocks to expect any sustained period of outperformance in the former, assuming that the bull market in risk assets continues. Bottom Line: Corporate balance sheets are still deteriorating but risk assets, including corporate bonds, should continue to outperform Treasurys and cash in the near term. We will look to downgrade risk assets when core inflation moves closer to the Fed's 2% target, which would trigger a more aggressive FOMC tightening campaign and tighter bank lending standards. Favor equities to high yield, but within fixed-income portfolios, overweight investment- and speculative-grade corporates versus Treasurys. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see the Geopolitical Strategy Client Note "U.K. Election: The Median Voter Has Spoken, published on June 9, 2017. Available at gps.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Can The Service Sector Save The Day?" June 5, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Investment Strategy Weekly Report "How Expensive Are U.S. Stocks", dated March 13, 2017 available at usis.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report, "Growth, Inflation and the Fed", May 8, 2017. Available at usis.bcaresearch.com.

Highlights Chart 1Something's Got To Give Something's Got To Give Something's Got To Give Last Friday's disappointing employment report reinforced the bond market's recent strength. The 10-year Treasury yield reached a new 2017 low of 2.15%, the 10-year TIPS breakeven inflation rate broke below 1.8% and the overnight index swap curve is now priced for only 47 bps of rate hikes during the next 12 months. Increasingly, the bond market is discounting two different future states of the world that cannot possibly coexist. Decelerating wage growth has caused the market to expect fewer Fed rate hikes, while concurrently, the cost of long-maturity inflation protection has fallen and the yield curve has flattened (Chart 1). This means the market expects that poor wage growth and inflation will cause the Fed to back away from its expected pace of two more rate hikes this year, but also that this relent will not be sufficient to prompt a recovery in economic growth or inflation. This dichotomy cannot exist for long. Either wage growth and inflation will bounce back in the second half of the year allowing the Fed to lift rates twice more in 2017 (our base case expectation), or inflation will continue to disappoint in which case the Fed will slow its pace of hikes. In both cases long-maturity Treasury yields should head higher, led by an increasing cost of inflation compensation. Stay at below benchmark duration. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 37 basis points in May. The index option-adjusted spread tightened 3 bps on the month and, at 113 bps, it remains well below its historical average (134 bps). Limited inflationary pressure will keep monetary policy accommodative enough to ensure excess returns consistent with carry. However, corporate spreads have already discounted a substantial improvement in leverage (Chart 2) and we do not see much potential for spread tightening from current levels. BEA data show that EBITD contracted in Q1, causing the annual growth rate to tick back below zero (panel 4). Meanwhile, gross issuance has been strong so far this year, suggesting that leverage will show an uptick in Q1 when the Flow of Funds data are released later this week. This aligns with our observation that, historically, net leverage - defined as total debt less cash as a percent of trailing EBITD - has never declined unless prompted by a recession. In other words, the corporate sector never voluntarily undertakes deleveraging, it only starts to pay down debt when forced by a severe economic contraction. For now, rising leverage will limit the amount of spread tightening, but shouldn't lead to negative excess returns. That will only occur when inflationary pressures are more pronounced and the Fed steps up the pace of tightening - probably sometime next year. Energy related sectors still appear cheap on our model (Table 3), and have outperformed the overall corporate index this year even though the oil price has fallen. Remain overweight. Chart Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 48 basis points in May. The index option-adjusted spread tightened 8 bps on the month and, at 362 bps, it is currently 18 bps above its 2017 low. While the average spread on the junk index is a mere 38 bps above its post-crisis low, our estimate of the default-adjusted high-yield spread is 204 bps, only slightly below its historical average (Chart 3). Assuming our forecast for default losses is correct, a default-adjusted spread in this range has historically coincided with positive 12-month excess returns to high-yield bonds 74% of the time, with an average excess return of 82 bps. Our estimate of 12-month forward default losses is calculated using Moody's baseline assumption for the speculative grade default rate, which stands at 2.96%. We also incorporate an expected recovery rate of 47%. This expectation for a continued decline in the default rate squares with trends in corporate lending standards (which are once again easing), industrial production (which is accelerating) and job cut announcements (which are trending lower). Weak first quarter profit growth will be a headwind if it persists, but we expect it will recover alongside the broader economy in Q2. Overall, with muted inflationary pressures, an improving default back-drop and still moderate valuations, we think junk bonds will deliver small positive excess returns during the next 12 months. Stay overweight. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 14 basis points in May. The compensation for prepayment risk (option cost) rose 2 bps on the month, but this was entirely offset by a 2 bps tightening in the option-adjusted spread (OAS). The most important issue for mortgage investors at the moment is when and how the Fed will cease the reinvestment of its MBS portfolio. We have written extensively on this topic in recent weeks,1 and through Fed communications have learned the following: The unwinding of the balance sheet will start before the end of this year (assuming the economic outlook does not deteriorate substantially) Both MBS and Treasury securities will be impacted The process will be "tapered" with monthly caps set on the amount of securities that will be allowed to run off. The caps will gradually increase according to a pre-set schedule. MBS OAS are already starting to look attractive, especially relative to Aaa-rated credit (Chart 4). But we are hesitant to move back into MBS at current levels. OAS have further upside relative to trends in net issuance (panel 4), and the increased supply from the end of Fed reinvestment will only add to the widening pressure. Remain underweight. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 11 basis points in May, bringing year-to-date excess returns up to 86 bps. The Foreign Agency and Local Authority sectors outperformed by 18 bps and 38 bps, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors outperformed by 7 bps and 9 bps, respectively. The Sovereign sector underperformed the Treasury benchmark by 12 bps on the month. Sovereigns underperformed in May even though the broad trade-weighted dollar depreciated by 1.4%. Similarly, Mexican debt - which carries the largest weighting in the Sovereign index - underperformed duration-equivalent Treasuries by 22 bps, even though the peso continued to appreciate versus the dollar (Chart 5). With U.S. growth likely to rebound following a weak Q1, the trade-weighted U.S. dollar should appreciate in the second half of this year. Meanwhile, our Emerging Markets Strategy thinks that Mexico's central bank could deliver another 25 bps rate hike, but it won't be long before tighter policy becomes a drag on consumer spending.2 The peso could stay well-bid for now, but the longer run trend is for a weaker peso versus the U.S. dollar. The Foreign Agency and Local Authority sectors continue to offer attractive spreads, after adjusting for credit rating and duration, compared to most U.S. corporate sectors. We continue to recommend overweight positions in Foreign Agencies and Local Authorities within an overall underweight allocation to the Government-Related Index. Municipal Bonds: Cut To Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 85 basis points in May (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio declined 8% on the month, and is now more than one standard deviation below its post-crisis mean. In a recent report,3 we noted that the current weakness in state & local government revenue growth mostly reflected the fall-out from the mid-2014 commodity price slump. As such, we expect that revenue growth will rebound in the months ahead and that state & local government net borrowing will decline. However, this eventuality is now fully discounted in M/T yield ratios (Chart 6, panel 3). Further, M/T yield ratios benefited from a steep decline in issuance during the past few months (bottom panel), and the recent uptick in visible supply suggests that the tailwind from declining issuance is about to shift. Factor in the uncertainty surrounding tax reform and a potential infrastructure program, and it is difficult to make the case for much tighter yield ratios. We recommend investors reduce municipal bond exposure to underweight (2 out of 5). Investors should continue to capture the premium in long-maturity munis relative to short maturities (panel 2), and also favor the debt of commodity-dependent states where tax revenues should grow more quickly. In particular, Aaa-rated Texas General Obligation bonds offer a premium of 14 bps versus the overall Aaa muni curve at the 10-year maturity point. The average premium offered by other Aaa-rated states is -0.6 bps. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve shifted lower and flattened in May. The 2/10 slope flattened 8 basis points and the 5/30 slope flattened 3 bps. For the second consecutive month yields remained stable out to the 2-year maturity point, but declined further out the curve. As stated on the first page of this report, the recent flattening of the Treasury curve indicates that the market expects the Fed will maintain a policy that is too restrictive for inflation to return to target. We think this is flat out wrong. Either core inflation will turn higher in the second half of this year, allowing the Fed to lift rates twice more in 2017. Or, core inflation will remain depressed. In the latter scenario, the Fed would adopt a more dovish policy stance until inflation starts to rise. In either case, the cost of inflation compensation at the long-end of the curve is not high enough, and it will cause the curve to steepen as it rises (Chart 7). We previously documented that the positive correlation between TIPS breakeven rates and the slope of the yield curve still holds during Fed rate hike cycles.4 We continue to recommend positioning for a steeper 2/10 curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. This trade returned 0 bps in May, but is still 26 bps in the money since inception on December 20, 2016. While this trade no longer benefits from the extreme cheapness of the 5-year bullet relative to the rest of the curve (panel 3), it will continue to outperform as TIPS breakevens widen and the curve steepens in the second half of the year. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 107 basis points in May. The 10-year TIPS breakeven rate fell 11 bps on the month and, at 1.79%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. A series of disappointing inflation reports have led to weakness in TIPS breakevens so far this year. Year-over-year trimmed mean PCE inflation fell to 1.75% in April, all the way from a peak of 1.91% as recently as January (Chart 8). As we discussed in two recent reports,5 a Phillips Curve model- based on lagged inflation, the employment gap, non-oil import prices and inflation expectations - forcefully predicts that core inflation will trend higher for the remainder of the year (panel 4). In a base case scenario in which both the unemployment rate and the trade-weighted dollar remain flat at current levels, the model projects that core PCE inflation will exceed 2% by the end of this year. In fact, we find it difficult to create a set of reasonable economic assumptions that don't result in core PCE inflation at (or above) the Fed's 1.9% forecast by year end. While we anticipate a rebound in core inflation between now and the end of the year, if that rebound does not seem to be materializing by the end of the summer, the Fed is likely to adopt a more dovish policy stance. Such a policy shift would lend support to TIPS breakeven wideners. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in May, bringing year-to-date excess returns up to +52 bps. The index option-adjusted spread for Aaa-rated ABS tightened 7 bps on the month, and remains well below its average pre-crisis level. In a recent report, we highlighted that consumer balance sheets are in their best shape since prior to the start of the housing bubble.6 As such, consumer ABS should remain a relatively low risk investment. However, some signs of stress are beginning to emerge, particularly in the sub-prime auto space. According to the Federal Reserve's Senior Loan Officer Survey, credit card lending standards tightened in Q4 of last year, but have since reverted into net easing territory (Chart 9). In contrast, auto loan lending standards continue to tighten and net losses on auto loans appear to have bottomed for the cycle. At least so far, auto ABS are not discounting much deterioration in credit quality. After adjusting for volatility, Aaa-rated auto ABS do not offer much of a spread pick-up relative to Aaa-rated credit card ABS (panel 3) and the spread differential between non-Aaa auto ABS and Aaa auto ABS has fallen to one standard deviation below its post-crisis mean. We continue to recommend that investors favor Aaa-rated credit cards over Aaa-rated auto loans within an overall overweight allocation to consumer ABS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 33 basis points in May, bringing year-to-date excess returns up to +52 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 4 bps on the month, but remains below its average pre-crisis level (Chart 10). Apartment and office building prices are growing strongly, but retail sector property prices have been close to flat during the past year (bottom panel). Tighter lending standards and falling demand also suggest that credit stress is starting to mount in the commercial real estate sector. So far, this stress has manifested itself in rising retail and office delinquency rates, while multi-family delinquencies remain low (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 31 basis points in May, bringing year-to-date excess returns up to +50 bps. The index option-adjusted spread for Agency CMBS tightened 5 bps on the month, and currently sits at 49 bps. The option-adjusted spread on Agency CMBS still looks attractive compared to other high-quality spread product: Agency MBS = 36 bps, Aaa consumer ABS = 39 bps, Agency bonds = 17 bps and Supranationals = 19 bps. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.49% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.41%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound. The U.S. PMI has dipped lower in recent months, but remains firmly entrenched above the 50 boom/bust line. Meanwhile, the Eurozone PMI continues to surge ahead. China's PMI is the real source of concern. It has recently dipped below 50, and there is a risk that tighter monetary policy could lead to further contraction in the near term (bottom panel).7 For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.15%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Fed Doctrine", dated May 30, 2017, U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers", dated May 23, 2017, U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017 and U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017. All available at usbs.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report, "A Time To Be Contrarian", dated April 5, 2017, available at ems.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Will The Fed Stick To Its Guns?", dated May 16, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Fed Doctrine", dated May 30, 2017 and U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers", dated May 23, 2017. Both available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Fed Doctrine", dated May 30, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "Past Peak Pessimism", dated May 9, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon) Current Recommendation

Highlights Overall Investment Grade (IG) Corporates: An update of our regional sector relative value models shows that it has become increasingly difficult to find industries where debt looks cheap. Maintain overweight allocations to U.S. & U.K. IG, and stay underweight Euro Area IG, but keep overall spread risk close to neutral levels. U.S. IG: Within U.S. Investment Grade corporate debt allocations, upgrade Energy names (Oil Field Services, Integrated) and Cable & Satellite to overweight, while downgrading Consumer Cyclical sectors (Retailers) and Other Industrials to Underweight. Euro IG: Stay underweight and keep spread risk (i.e. DTS) close to index levels. Reduce exposure to Cable & Satellite, Electric Utilities and Natural Gas Utilities. U.K. IG: Stay overweight U.K. IG but keep overall spread risk near index levels. Feature Chart of the WeekCandidates For Additional Spread Convergence Candidates For Additional Spread Convergence Candidates For Additional Spread Convergence Back on January 24th, we published a Special Report that introduced specific Investment Grade (IG) corporate bond sector allocations for the U.S., Euro Area and U.K. to our model portfolio framework.1 The recommended weightings were based on the output from our sector relative value models for each region. We had presented those models on a semi-regular basis in the past, but without any specific numerical allocation among the sectors. By attaching actual weightings to each sector, within a "fully invested" model portfolio, we are now able to more accurately measure the aggregate success of our recommendations. In this follow-up report, we discuss the performance of our sector tilts since January, refresh our relative value models and present changes to our allocations. The broad conclusion is that, while our calls have done well over the past few months and our IG portfolios have outperformed the broad IG bond indices, it remains difficult to find compellingly cheap sectors (particularly in non-financial industries) given the overall tight level of corporate bond spreads. This is especially true in the Euro Area, where we see the poorest risk/reward tradeoff for IG exposure relative to the U.S. and U.K. We are more comfortable recommending an overweight stance on U.S. and U.K. IG corporates versus Euro Area equivalents, in line with our overall allocation in our main model portfolio. Given the tight overall level of spreads in all three regions, however, we are focusing our recommendations on sectors that have cheaper valuations but with riskiness closer to the overall IG indices - like Energy in the U.S. and Wireless in both the Euro Area and U.K. (Chart 1). Good Performance From Our Sector Tilts The performance of our sector recommendations has been reasonably solid since January (Chart 2). Our U.S. sector tilts added +5bps of excess return versus duration-matched U.S. Treasuries, coming mostly from our overweights in Energy and Financials. Within the Euro Area, we were able to generate +9bps of excess return versus government debt, also mainly from above-benchmark allocations to Energy and Financial names. In the U.K., our call to overweight Bank debt provided essentially all of our +23bps of outperformance versus Gilts. These strong excess returns came on top of a very strong performance for corporate debt since January 24th. Excess returns for IG in the U.S., Euro Area and U.K. were 0.9%, 1.3% and 1.3%, respectively. The detailed breakdown of the returns by sector are shown in Appendix Tables at the back of this report. To determine the success rate of our sector tilts, we can define "winners" as sectors where we had an active view (i.e. not neutral) and where the relative performance of the sector versus the overall IG corporate index was in the direction of that active view. For example, our decision to go underweight Diversified Manufacturing in the Euro Area was a good one, as that sector had an excess return of 0.7%, well below that of the overall Euro Area IG index (a 1.3% excess return). We can define "losers" in the same way, where the relative sector performance went against our active allocation. In Chart 3, we show the "winners" and "losers" for our U.S., Euro Area and U.K. sector allocations since late January. Our success rate was quite good, as we had far more winners than losers in all three regions. Chart 2 Chart 3 The Big Picture For Corporate Credit: Favorable Business Cycle, But Valuations Are Not Cheap We have been maintaining an overall overweight allocation to IG corporates since late January. This was based on a view that global economic activity was accelerating, which would support faster profit growth. This would provide cyclical relief for stressed corporate balance sheets in the U.S. Euro Area & U.K. corporates would also benefit from a better profit backdrop, with the added bonus of central bank asset purchases helping to improve the supply/demand balance for IG debt. Yet spreads have already tightened substantially throughout the IG universe. This reflects declining macro volatility and the ongoing investor stretch for yield after the rise in global government bond yields earlier this year faded significantly. The result is that there is now far less dispersion among corporate sectors, by industry or by credit quality, then we've seen in recent years (Charts 4, 5 & 6). Coming at a time of high corporate leverage, and with central bank liquidity growth starting to roll over as we discussed in last week's Weekly Report, we are recommending an "up in quality" bias to sector allocations and credit exposure, while favoring U.S. and U.K. corporates over Euro Area equivalents.2 Chart 4Tight Spreads, Flat Credit Curve##BR##In The U.S. Tight Spreads, Flat Credit Curve In The U.S. Tight Spreads, Flat Credit Curve In The U.S. Chart 5Tight Spreads, Flat Credit Curve##BR##In The Euro Area Tight Spreads, Flat Credit Curve In The Euro Area Tight Spreads, Flat Credit Curve In The Euro Area Chart 6Tight Spreads, Flat Credit Curve##BR##In The U.K. Tight Spreads, Flat Credit Curve In The U.K. Tight Spreads, Flat Credit Curve In The U.K. Bottom Line: An update of our regional sector relative value models shows that it has become increasingly difficult to find industries where debt looks cheap. Maintain overweight allocations to U.S. & U.K. IG, and stay underweight Euro Area IG, while keep overall spread risk close to neutral levels. U.S. Investment Grade: Stay Overweight, But Be Selective In Tables 1A and 1B, we present the results of our U.S. IG sector valuation model as of May 31st.3 We are maintaining an overweight recommendation on U.S. IG in our overall model portfolio, as we continue to see the backdrop for U.S. economic growth being much friendlier for corporate debt versus Treasuries. Credit spreads are very tight, however, so we are maintaining some degree of caution in our sector recommendations. Chart Chart Specifically, we are aiming to favor industries with option-adjusted spread (OAS) at or above that of the overall U.S. IG index, but with a positive valuation from our U.S. IG relative value model. We also wish to keep the aggregate level of spread risk, using our preferred "duration times spread" (DTS) metric, in line with that of the overall U.S. IG index. As can be seen in the scatter diagram in Chart 7, which plots the model valuations versus the DTS score for each sector, there are precious few non-financial sectors that offer attractive spreads that are not riskier than the overall index. Chart 7 Our model has shown some improvement in value within the sub-sectors of the Energy space, which is a consequence of the softness in oil prices over the past few months. With our commodity strategists calling for a recovery in oil prices back up towards to $55-60 range by year-end, we see this an opportunity to raise our allocations to Energy by upgrading the Independent and Integrated sub-sectors to overweight from neutral. At the same time, we are reducing the size of our prior overweights in Refining and Midstream to keep the overall Energy sector allocation to no more than two times that of the U.S. IG Energy index - a pure risk management move on our part. We are also upgrading some of our prior underweights in the Communications sectors to neutral (Media & Entertainment, Wirelines & Wireless) and to overweight (Cable & Satellite), given relatively attractive valuations in those areas. By the same token, we are cutting Other Industrials to underweight from neutral with valuations now looking unattractive. All of our U.S. sector changes result in an upgrade of our weighting to the broad Industrials grouping by 5 percentage points to 58.6%. We are reducing our large overweight to U.S. Banks by an equivalent amount to "fund" this new allocation within our 100% invested model IG portfolio. The net result of all these changes is that our U.S. IG portfolio has an overall DTS score of around 9, in line with that of the U.S. IG benchmark index. Thus, we are not making any changes to our aggregate recommended spread risk, in line with our top-down views on the overall level of credit spreads and curves, as described earlier. Bottom Line: Within U.S. Investment Grade corporate debt allocations, upgrade Energy names (Oil Field Services, Integrated) and Cable & Satellite to overweight, while downgrading Consumer Cyclical sectors (Retailers) and Other Industrials to Underweight. Euro Area Investment Grade: Not Much Value Left, Remain Underweight In Tables 2A and 2B, we show the output from our Euro Area IG sector valuation model. The scatter diagram showing the model residuals versus the individual sector DTS scores is shown in Chart 8. Chart Chart Chart 8 Finding value has become a problem in Europe, with only a few sectors (most notably, Metals & Mining, Oil Field Services, Life Insurance and P&C Insurance) showing a double-digit spread residual from our model. All those sectors also offer wider spreads than the overall Euro Area IG index, but the Insurers stand out as being much riskier from a DTS perspective. That is a function of the wide spread for the overall Insurance sector, which is nearly double that of the overall Euro Area IG index. We see no reason to change our existing allocations to those sectors in our model portfolio, keeping Metals & Mining and Oil Field Services at overweight and the Insurers at neutral (a prudent tradeoff between wide spreads and high risk). It would likely take a meaningful rise in European interest rates before any serious compression in Insurance spreads could unfold, given the struggles that industry faces from low yields on its fixed income investment assets. A rise in European bond yields could unfold later this year if the European Central Bank (ECB) signals that a tapering of its asset purchase program will begin next year. We see that scenario as increasingly likely, given the overall strength of the Euro Area recovery. The ECB will only shift its stance gradually, due to the lack of immediate inflation concerns. Any signal that that fewer bond purchases are in the offing, however, will pose a major risk for European corporates given the large ECB buying of that debt over the past year. We see very few necessary changes to our Euro Area allocations at the moment, as our overall portfolio DTS is in line with the IG benchmark index (around 6). We do recommend cutting Cable & Satellite and Utilities (Electric & Natural Gas) to underweight. Bottom Line: With corporate spreads at tight levels, and with few sectors showing compelling value, we are comfortable in remaining underweight Euro Area corporates, while keeping spread risk (i.e. DTS) close to index levels. Reduce Cable & Satellite, Electric Utilities and Natural Gas Utilities to underweight. U.K. Investment Grade: Stay Overweight, Focusing On Financials In Tables 3A and 3B, we present our update U.K. IG sector model, with the scatterplot of model residuals versus DTS scores shown in Chart 9. Not much has changed in terms of which sectors appear cheap in our model versus the late January levels. Financials, in general, have the cheapest spreads on an absolute basis, especially the Insurers. Although the cheap valuation on the Insurance debt mirrors the same problem highlighted above for the Euro Area insurers - interest rates that are too low to generate acceptable investment returns on the insurers' portfolios. Chart Chart Chart 9 We are maintaining our overall modest overweight allocation to U.K. IG, while keeping overall spread risk close to index levels. While the political and security risks within the U.K. are significant at the moment, there is no threat of the Bank of England moving to a less accommodative monetary policy anytime soon. A backdrop of churning economic growth, an undervalued British Pound and a central bank maintaining hyper-easy monetary policy is still a decent one for U.K. corporate debt. In terms of sector allocation changes based on our U.K. IG sector valuation model, we recommend upgrading Health Care and REITs to overweight, downgrading Other Industrials to neutral and cutting Tobacco to underweight. Bottom Line: Stay overweight U.K. IG but keep overall spread risk near index levels. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework", dated January 24 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30 2017, available at gfis.bcaresearch.com. 3 Our valuation framework assesses the attractiveness of each IG sector within a cross-sectional analysis. The OAS for each sector is regressed against common risk factors (interest rate duration, credit quality) with the residual spread determining the valuation of each sector. Appendix Image Image Image

Highlights Increased regulatory scrutiny on the domestic financial sector may continue to create some headline risks and financial volatility, but the real economic impact should be marginal. The recent regulatory crackdown has mainly caused liquidity issues in the domestic market rather than any sort of real growth issue. Chinese shares listed overseas will continue to grind higher. Domestic A shares will remain largely trendless. Domestic corporate bonds are starting to look attractive after the most recent panic selloff. Feature Chinese domestic stocks and bonds have taken a beating of late as the authorities ramped up scrutiny to rein in excesses in the country's financial sector. While it is warranted to control accumulated financial risk - especially associated with shadow banking activity - the "campaign" style administrative crackdown has caused widespread confusion and mini-panics among domestic investors. The actions and corresponding reactions illustrate the authorities' primitive control tools, which are increasingly at odds with the rapidly developing financial sector, and how blanket actions can spur undue financial volatility and provoke unintended consequences. For now, we expect the economic fallout to be limited, unless the financial crackdown causes further spikes in interest rates and a sudden halt in credit flows. Chinese shares listed overseas will continue to grind higher in the absence of a major policy mishap that short-circuits the broad growth improvement and the profit cycle upturn. Domestic A shares will remain largely trendless, while the more richly valued bubbly segments of the market will continue to deflate. Domestic corporate bonds are starting to look attractive after the most recent panic selloff. What Do They Want To Achieve? Policymakers' primary focus has been on cracking down on excessive speculation in financial markets and restricting lending activities that are not in compliance with legal and regulatory requirements. Financial sector deregulation in recent years has increasingly blurred the lines between banks, insurance companies, brokers and trust companies, and regulators are constantly challenged to monitor all the increasingly sophisticated moving parts. From the banking sector's point of view, regulators are concerned that lenders have been aggressively boosting their exposure to other banks and non-bank financial institutions instead of providing credit to the "real economy." Overall commercial banks' claims on other banks and non-bank financial institutions have increased from 12% of their total assets in 2006 to over 25% as of January 2017, while their liabilities to other banks and non-bank financial firms have increased from 7% to 12% (Chart 1). Smaller banks are even more dependent on interbank financing for loanable funds. Interbank transactions and repo activities account for about 14% of smaller lenders' total source of funding, compared with 2% for large banks (Chart 2). Some small banks regularly borrow at lower costs through the interbank market or use negotiable certificate of deposits to purchase "wealth management products" offering higher returns issued by other banks or financial institutions. The duration mismatch leads to constant pressure to roll over these short-term financial instruments. The increasing interdependence among the country's financial institutions also creates the risk of a chain reaction in the financial system should some type of credit event erupt. Chart 1Increasing Interdependence Among Financial Institutions China: Financial Crackdown And Market Implications China: Financial Crackdown And Market Implications The Chinese authorities have long regarded preventing systemic financial risk as a top priority, and the recent growth improvement has provided a window of opportunity for some housecleaning without a major adverse impact on the economy. Therefore, it is unlikely that regulators will back off from tightening regulatory supervision going forward. Overall, the authorities will continue to discourage overtrading within the financial system, and enforce full disclosure of off-balance-sheet items and shadow lending activities. The saving grace is that tightened macro prudential measures have already begun to curtail banks' aggressive expansion to non-bank financial institutions. Commercial banks' claims to these firms have slowed sharply since last year's peak (Chart 3). Meanwhile, the recent rise in interbank rates should also further discourage the perceived "risk-free" funding arbitrage to play the interest rate gap between long- and short-dated financial assets. All of this reduces the pressure of an escalation in the regulatory crackdown. Chart 2Smaller Banks Depend More On##br## Wholesale Funding Smaller Banks Depend More On Wholesale Funding Smaller Banks Depend More On Wholesale Funding Chart 3Banks' Exposure To Non-Bank Financial Firms ##br##Has Been Scaled Back Banks' Exposure To Non-Bank Financial Firms Has Been Scaled Back Banks' Exposure To Non-Bank Financial Firms Has Been Scaled Back Should Investors Be Concerned? In essence, banks' rising claims to other financial institutions means a lengthening of the credit intermediation channel, in which financing goes from credit providers through multiple layers of intermediaries to reach final borrowers in the real economy. In other words, banks, instead of lending directly to borrowers, channel loans to trust companies or securities brokers, who in turn transfer the funds to the real economy through "shadow banking" activities such as trust loans or various forms of "wealth management products", typically at higher rates. From this perspective, cracking down on lending excesses within the financial system in of itself should not have a material impact on credit flows to final corporate borrowers. In fact, streamlining the financial intermediation channel holds the promise of increasing accessibility to bank credit for the corporate sector and reducing its funding cost, which should benefit the overall economy in the long run. In the near term, liquidity tightening and the regulatory crackdown could push up interest rates and disrupt credit flows, which should be closely monitored to assess near-term negative impact on the economy. So far, the impact does not appear material. Chart 4Regulatory Crackdown ##br## Has Not Interrupted Credit Flows Regulatory Crackdown Has Not Interrupted Credit Flows Regulatory Crackdown Has Not Interrupted Credit Flows Interbank rates have increased by about 100 basis points across the board since the beginning of this year, and 10-year government bond yields have risen by 50 basis points - both of which pale in comparison to the significant improvement in overall business activity. Nominal GDP growth expanded by 11.8% in the first quarter, compared with 9.6% in Q4, 2016. Furthermore, the central bank early this week re-started its medium-term lending facility (MLF), which was designed to avoid liquidity overkill in the domestic financial sector. Overall, the risk of overtightening of liquidity is not high. The regulatory crackdown since early this year has not had a meaningful impact on credit expansion. Banks' claims to other financial institutions have slowed sharply, but overall loan growth has been rather stable. Importantly, medium- and long-term loans to the corporate sector, pivotal for overall capital spending, have in fact accelerated (Chart 4). In short, increased regulatory scrutiny on the domestic financial sector may continue to create some headline risks and financial volatility, but the real economic impact should be marginal. We expect the authorities to remain highly vigilant and avoid policy overkill. Reading Market Tea Leaves There have been some notable divergences among different classes of Chinese stocks (Chart 5). Chinext, the domestic small-cap venture board, has suffered heavy losses of late, while large-cap A shares have been much more resilient. Meanwhile, offshore Chinese shares have barely felt any pressure at all. H shares have moved higher of late, while Chinese firms listed in the U.S. have decisively broken out. The divergence between onshore and offshore Chinese stocks' performance confirms the recent regulatory crackdown has mainly caused liquidity issues in the domestic market rather than any sort of real growth issue. Barring major policy mistakes, we expect the Chinese economy to stay buoyant, as discussed in detail in our recent report.1 As such, a few investment conclusions can be drawn. Tighter liquidity will likely continue to place downward pressure on domestic stock prices, but the downside is limited by overall buoyant activity and improving profits. We expect the broad-A share market will remain narrowly range-bound. Overseas-listed Chinese shares are not subject to domestic liquidity constraints, and will likely continue to grind higher supported by growth improvement, profit recovery and low valuation multiples. The small-cap Chinext market has long been viewed as the more speculative segment of the domestic financial market, with higher multiples and greater volatility than large-cap A shares. As such, this market will remain vulnerable to domestic liquidity tightening. Even after the most recent selloff, the bourse's trailing price-to-earnings ratio and price-to-book ratio are still at 38.4 and 4.6, respectively, much higher than for broader onshore and offshore Chinese stocks. The recent selloff in the onshore corporate bond market has also been driven by liquidity pressure, which in our view is overdone. While it's true that economic acceleration justifies higher yields, corporate spreads have also widened sharply, which is at odds with the broad growth acceleration and profit recovery. In addition, after the most recent selloff, Chinese corporate spreads are significantly higher than in most other major markets (Chart 6). In the near term, tighter liquidity may continue to induce more selling pressure in the domestic bond market. Cyclically we expect Chinese corporate bond spreads to narrow. Chart 5Diverging Market Trends Diverging Market Trends Diverging Market Trends Chart 6The Sharp Spike In Chinese Corporate ##br##Spreads Is Overdone The Sharp Spike In Chinese Corporate Spreads Is Overdone The Sharp Spike In Chinese Corporate Spreads Is Overdone Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Has China's Cyclical Recovery Peaked?" dated May 5, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart 1Rate Hikes Lagging Wage Growth Rate Hikes Lagging Wage Growth Rate Hikes Lagging Wage Growth Last Friday's GDP report showed that the U.S. economy grew a meagre 0.7% (annualized) in the first quarter of 2017, well below levels necessary to sustain an uptrend in inflation. However, our forward looking indicators still point to U.S. growth of around 2% during the next few quarters. It is likely that faulty seasonal adjustments suppressed Q1 GDP growth. Q1 growth has averaged -0.1% during the past 10 years, while Q2 growth has averaged more than 2%. Q2 growth has also exceeded Q1 growth in 8 of the last 10 years. For its part, the Bloomberg Barclays Treasury index has provided an average return of close to 1% during the past 10 Q1s and an average return of 0.4% during the past 10 Q2s. Treasury returns have been greater in the first quarter than in the second quarter in 6 out of the past 10 years. Investors would be wise to ignore Q1 GDP and stay focused on the uptrends in wage growth and inflation that are likely to persist (Chart 1). With the market priced for only 38 bps of rate hikes between now and the end of the year, there is scope for the Fed to send a hawkish surprise. Stay at below-benchmark duration and short January 2018 Fed Funds Futures. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 23 basis points in April. The index option-adjusted spread tightened 2 bps on the month and, at 116 bps, it remains well below its historical average (134 bps). While supportive monetary policy will ensure excess returns consistent with carry, investors should not bank on further spread compression as spreads have already discounted a substantial improvement in leverage (Chart 2). In a recent report,1 we noted that net leverage (defined as: total debt minus cash, as a percent of EBITD) is positively correlated with spreads, and also that it has never reversed its uptrend unless prompted by a recession. In other words, the corporate sector never voluntarily undertakes deleveraging, it only starts to pay down debt when forced by a severe economic contraction. We conclude that debt growth will likely continue to outpace profit growth (panel 4), even as profits rebound over the course of this year. If our anticipated timeline plays out, we will be looking to scale back on credit risk in 2018, when inflationary pressures are more pronounced and the Fed steps up the pace of tightening. Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3). Further, our commodity strategists expect OPEC production cuts will be extended through to the end of the year, and that $60/bbl remains a reasonable target for oil prices. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Time Of The Season Time Of The Season Table 3BCorporate Sector Risk Vs. Reward* Time Of The Season Time Of The Season High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 62 basis points in April. The index option-adjusted spread tightened 12 bps on the month and, at 371 bps, it is currently 27 bps above its 2017-low. Wider junk spreads in recent months appear to be largely related to flight-to-safety flows driven by elevated global political uncertainty. We find it notable that spreads tightened following the market-friendly result of the first round of the French election. While political uncertainty remains, we view current spreads as attractive on a 6-12 month horizon. In a recent report,2 we tested a strategy of "buying dips" in the junk bond market and found that it produced favorable results in a low-inflation environment. With the St. Louis Fed's Price Pressures Measure still suggesting only a 6% chance of PCE inflation above 2.5% during the next 12 months, we think this strategy will continue to work. Moody's recorded 21 defaults in Q1 (globally) down from 41 in the first quarter of 2016, with the improvement attributable to recovery in the commodity sectors. While commodity sectors still accounted for half of the defaults in Q1, Moody's predicts that the retail sector will soon assume the mantle of "most troubled sector." According to Moody's, nearly 14% of retail issuers are trading at distressed levels. Moody's still expects the U.S. speculative grade default rate to be 3% for the next 12 months, down from 4.7% for the prior 12 months. Based on this forecast we calculate the High-Yield default-adjusted spread to be 207 bps (Chart 3), a level consistent with positive excess returns on a 12-month horizon more than 70% of the time. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in April. The conventional 30-year MBS yield fell 10 bps on the month, driven by an 11 bps decline in the rate component. The compensation for prepayment risk (option cost) rose by 2 bps, but this was partially offset by a 1 bp tightening in the option-adjusted spread (OAS). Since the middle of last year the MBS OAS has widened alongside rising net issuance, but this has been offset by a falling option cost (Chart 4). This is exactly the price behavior we would expect to see in an environment where mortgage rates are moving higher and the market is starting to discount the Fed's eventual exit from the MBS market. Higher mortgage rates suppress refinancings, and this will ensure that the option cost component of spreads remains low. However, higher mortgage rates are also unlikely to halt the uptrend in net MBS issuance, since the main constraint on housing demand this cycle has been insufficient household savings, not un-affordable mortgage payments.3 This means that OAS still have room to widen alongside greater net issuance. The winding down of the Fed's mortgage portfolio - a process that is likely to begin later this year - will only add to the supply that the market needs to absorb. How will the opposing forces of low option cost and widening OAS net out? The option cost component of spreads is already close to its all-time low, while the OAS is still 16 bps below its pre-crisis mean. We think it is unlikely that a lower option cost can fully offset OAS widening. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 2 basis points in April, bringing year-to-date excess returns up to 75 bps. The high-beta Sovereign and Foreign Agency sectors outperformed by 8 bps and 1 bp, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors outperformed by 7 bps each. Local Authorities underperformed the Treasury benchmark by 23 bps. Since the beginning of the year, excess returns from the Sovereign sector have been supported by a weakening U.S. dollar (Chart 5). Mexican debt, in particular, has benefited from a 10% appreciation of the peso relative to the U.S. dollar (panel 3). A stronger peso obviously makes Mexico's USD-denominated debt easier to service and has led to year-to-date excess returns of 402 bps for Mexican sovereign debt relative to U.S. Treasuries. Mexican debt accounts for 21% of the Sovereign index. Our Emerging Markets Strategy service thinks that Mexico's central bank could deliver another 50 bps of rate hikes, because inflation is above target, but also maintains that further rate hikes will soon start to squeeze consumer spending.4 Conversely, the Fed has scope to hike rates much further. Sovereigns no longer appear expensive on our model, relative to domestic U.S. corporate sectors. But we still expect them to underperform as the dollar resumes its bull market. Local authorities and Foreign Agencies still offer lucrative spreads on our model, and we remain overweight those spaces within an overall underweight allocation to the Government-Related index. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in April (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio was flat on the month, but has fallen 15% since peaking shortly after the U.S. election (Chart 6). The sparse details of the Trump administration's proposed tax reform plan, released last week, did not include any specific mention of the municipal bond tax exemption, but did call for the elimination of "targeted tax breaks" leaving some to wonder if the tax exemption is in play. It is too soon to tell whether repealing the tax exemption will be part of the final tax reform plan, although its repeal would be at odds with the President's stated desire to spur infrastructure spending. For this reason, we suspect the tax exemption will ultimately survive. Assuming the tax exemption survives, the proposed repeal of the Alternative Minimum Tax and of the state & local government income tax deduction should both increase demand for tax-exempt municipal bonds. However, this positive impact will be offset by lower tax rates. All in all, it is too soon to know how this will all shake out, but the considerable uncertainty makes us reluctant to take strong directional bets in the municipal bond market for now. Meanwhile, Muni mutual fund inflows have totaled more than $9 billion since the beginning of the year, while total issuance is at a 12-month low. Strong inflows and low supply likely explain why yield ratios are testing the low-end of their post-crisis trading range. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve shifted lower in April, with the 2/10 slope flattening by 12 basis points and the 5/30 slope steepening by 6 bps. The 5-year Treasury yield declined 12 bps on the month, while the 10-year yield fell 11 bps. The 2-year yield actually ticked 1 bp higher. Significant outperformance in the 5-year part of the curve means that our recommendation to favor the 5-year bullet over a duration-matched 2/10 barbell has returned 27 bps since inception on December 20, 2016. This 5-year bullet over duration-matched 2/10 barbell trade is designed to profit from 2/10 curve steepening, which has not yet materialized. Instead, the trade has performed well because the 2/5/10 butterfly spread has moved much closer to our estimate of fair value (Chart 7). The 5-year bullet still looks moderately cheap on the curve, but no longer offers an exceptional valuation cushion. For our trade to outperform from here we will likely need to see some 2/10 curve steepening. We continue to hold the 5-year bullet over duration-matched 2/10 barbell trade, because we still expect the 2/10 slope to steepen. This steepening will be driven by wider long-maturity TIPS breakevens which should eventually catch up to leading pipeline inflation measures (see next page). In a recent report,5 we outlined the main drivers of the slope of the yield curve on a cyclical horizon and concluded that wider breakevens can cause the nominal curve to steepen even with the Fed in the midst of hiking rates. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 25 basis points in April. The 10-year TIPS breakeven rate declined 5 bps on the month and, at 1.92%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Our Financial Model of TIPS breakevens - which models the 10-year TIPS breakeven rate using the stock-to-bond total return ratio, the price of oil and the trade-weighted dollar - attributes the recent decline in breakevens to weakness in the stock-bond ratio and the fact that the 10-year breakeven rate was already quite elevated compared to fair value (Chart 8). Both core and trimmed mean PCE inflation dropped sharply in March, and are now running at 1.6% and 1.8% year-over-year, respectively (bottom panel). This decline is likely to reverse in the coming months. Crucially, pipeline inflation measures, such as the ISM prices paid index, are holding firm at high levels (panel 4). We remain overweight TIPS versus nominal Treasuries on the view that growth will be strong enough to keep measures of core inflation on a steady upward trajectory, eventually converging with the Fed's 2% inflation target. In that environment, TIPS breakevens should eventually return to their pre-crisis range. In last week's report,6 we considered the possibility that TIPS breakevens might not return to their pre-crisis trading range, even if measures of core inflation remain strong. The most likely reason relates to structural rigidities in the repo market that have made it more costly to arbitrage the difference between real and nominal rates. For now, we consider this simply a risk to our overweight view. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in April, bringing year-to-date excess returns up to +33 bps. Aaa-rated issuers outperformed the Treasury benchmark by 10 bps on the month, while non-Aaa issues outperformed by 13 bps. The index option-adjusted spread for Aaa-rated ABS tightened 1 bp on the month, and remains well below its average pre-crisis level. Banks are now tightening lending standards on both auto loans and credit cards. While we do not expect this recent development to have much of an impact on consumer spending,7 it is usually an indication that there is growing concern about ABS collateral credit quality. This concern is echoed by the fact that net losses on auto loans are trending sharply higher (Chart 9). Credit card charge-offs remain subdued for now - and we continue to recommend that investors favor Aaa-rated credit cards over Aaa-rated auto loans - but even in the credit card space quality concerns are starting to mount. Capital One reported a 20% drop in earnings in Q1 versus the same quarter in 2016, and noted that it has been tightening underwriting standards against a back-drop of credit card loans growing faster than income. We remain overweight ABS for now, as the securities still offer attractive spreads compared to other high-quality spread product, but we are closely monitoring credit quality metrics for signs of rising stress. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in April, bringing year-to-date excess returns up to +19 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month, and is fast approaching its average pre-crisis level. Apartment and office building prices are growing strongly, but as in the corporate space, the retail sector is a major drag (Chart 10). Tighter lending standards and falling demand also suggest that credit stress is starting to mount, but while office and retail delinquencies are rising multi-family delinquencies remain low (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in April, bringing year-to-date excess returns up to +19 bps. The index option-adjusted spread for Agency CMBS widened 1 bp on the month, and currently sits at 54 bps. The option-adjusted spread on Agency CMBS looks attractive compared to other high-quality spread product: Agency MBS = 35 bps, Aaa consumer ABS = 46 bps, Agency bonds = 17 bps and Supranationals = 20 bps. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.59% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.43%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we are inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. It should also be noted that the fair value readings from both the 2-factor and 3-factor models are calculated using FLASH PMI estimates for April. These estimates will be revised later today when the actual PMI data are released. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.32%. 1 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 4 Please see Emerging Markets Strategy Weekly Report, "A Time To Be Contrarian", dated April 5, 2017, available at ems.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Feature Table 1Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Don't Worry About The Tepid Data Risk assets are likely to continue to grind higher. Two of the catalysts we cited for this in our most recent Quarterly1 have half happened: European political risk is lifting now that Marine Le Pen looks most unlikely to win in the second round of the French presidential election (polls give her less than 40% of the vote); and the Trump administration announced its tax cut plan (which, though details are still sparse, we expect to be passed in some form this year). As a result, the MSCI All Country World Index hit a record high in late April and the S&P 500 is only 1% below its high. But both growth and inflation have surprised somewhat to the downside in the past couple of months. The Citi Economic Surprise Index for the U.S. has fallen sharply, though surprises remain fairly positive elsewhere (Chart 1).Q1 U.S. real GDP growth came in at an annualized rate of only 0.7%. This has pushed bond yields down (with the US Treasury 10-year yield falling back to 2.2%), consequently weakening the dollar. We are not unduly worried about the tepid data. It is mainly due to technical factors. Corporate loan growth in the U.S., for example (Chart 2), mostly reflects just the lagged effect of last year's slowdown on banks' willingness to lend, as well as energy companies repaying credit lines they tapped in early 2016 when short of working capital. The weakness in auto sales (Chart 3) is most likely caused by the end of the car replacement cycle which began in 2010, rather than reflecting any generalized deterioration in consumer behavior. Moreover, there seem to be problems with seasonal adjustment of data caused by the extreme swings in the economy in 2008 and 2009: Q1 has been the weakest quarter for U.S. GDP in six out of the past 10 years, and has on average been 2.3 ppts lower than Q2.2 There were no such distortions prior to 1996. Chart 1U.S. Growth Has Surprised To The Downside U.S. Growth Has Surprised To The Downside U.S. Growth Has Surprised To The Downside Chart 2Weaker Loan Growth Is Mostly Technical... Weaker Loan Growth Is Mostly Technical... Weaker Loan Growth Is Mostly Technical... Chart 3...And The Slowdown In Autos Is Just The End Of A Replacement Cycle ...And The Slowdown In Autos Is Just The End Of A Replacement Cycle ...And The Slowdown In Autos Is Just The End Of A Replacement Cycle A consequence of the wobbly data is that markets have become too complacent about the Fed raising rates, with futures markets now projecting only about 40 bps of hikes over the next 12 months (Chart 4). Our view is that wages will gradually move up this year, pushing core PCE inflation to 2% by year end, which will cause the Fed to raise rates twice before end-2017 and once early in 2018 (though the latter rise could be postponed if the Fed starts to reduce its balance-sheet and forgoes one quarter's hike to judge the impact of this on the market). By contrast, we do not see the ECB hiking before 2019 at the earliest, with ECB President Draghi reiterating that he sees core inflation staying low and remains concerned about the fragile banking systems in peripheral European markets and about Italian politics. We also believe Bank of Japan governor Kuroda when he says he has no plans to change the BoJ's 0% target for the 10-year JGB yield. All this implies that the dollar is likely to appreciate further in the next 12 months as interest rate spreads widen (Chart 5). Chart 4Fed Is Likely To Hike Faster Than This Fed Is Likely To Hike Faster Than This Fed Is Likely To Hike Faster Than This Chart 5Interest Differentials Suggest Further Dollar Strength Interest Differentials Suggest Further Dollar Strength Interest Differentials Suggest Further Dollar Strength The next catalyst for equities to rise further could be earnings. Q1 U.S. earnings are surprising significantly on the upside, with EPS growth of 11.7% year on year and 75% of companies beating analysts' estimates.3 BCA's proprietary model suggests that S&P 500 operating earnings this year could grow by over 20% (Chart 6). If anything, upside surprises to earnings have been even stronger in the euro zone and Japan. With none of the standard indicators signaling any risk of recession over the next 12 months (Chart 7), we remain overweight equities versus bonds. We continue to warn, though, that the Goldilocks scenario of healthy growth and stable inflation may not last for long. A combination of tax cuts, wage growth accelerating as labor participation hits a ceiling, and the Fed falling behind the curve (perhaps when President Trump - given that he recently confessed "I do like a low interest rate policy" - appoints a dovish replacement for Janet Yellen as Fed Chair) could cause inflation to rise unexpectedly next year, forcing the Fed to raise rates sharply, triggering a recession in 2019. Chart 6U.S. Earnings Could Grow 20% This Year U.S. Earnings Could Grow 20% This Year U.S. Earnings Could Grow 20% This Year Chart 7No Sign Of A Recession On The Horizon No Sign Of A Recession On The Horizon No Sign Of A Recession On The Horizon Equities: In a risk-on environment, euro zone equities should continue to outperform, due to their higher beta (averaging 1.3 against global equities over the past 20 years, compared to 0.9 for the U.S.), more cyclical earnings, and modestly cheaper valuations (forward PE is at a 18.9% discount to the U.S.). Japanese equities should also do well as interest rates rise again globally (except in Japan where the BoJ will stick to its 0% yield target on 10-year bonds), which should push down the yen and boost earnings. We remain overweight Japanese equities on a currency-hedged basis. We are underweight EM equities, which are likely to be weighed down over the next 12 months by the stronger dollar, and by a slowdown in China which should cause commodity prices to fall. Fixed Income: We expect the 10-year U.S. Treasury yield to reach 3% by year-end: a pickup in real growth, slightly higher inflation and two more Fed hikes can easily add 70 bps to the yield over the next eight months. Euro zone yields will also rise, though not by as much. This implies a negative return from G7 sovereign bonds for the first time since 1994. We continue to prefer corporate credit, with a preference for U.S. investment-grade debt over high-yield bonds (which have stretched valuations) and over European corporate debt (which will be negatively affected by the tapering of ECB purchases next year). Currencies: As described above, we do not believe that the dollar appreciation which began in 2014 is over, due to divergences in monetary policy. We would look for a further 5-10% appreciation of the dollar over the coming 12 months, though the rise is likely to be bigger against the yen and emerging market currencies than against the euro. Commodity currencies such as the Australian dollar also look vulnerable and overvalued. The British pound will be driven by the vicissitudes of the Brexit negotiations in the short-run but looks undervalued in the long run if, as we expect, the EU eventually agrees a moderately satisfactory trade deal with the U.K. Commodities: We continue to believe that the equilibrium level for oil is $55 a barrel, and that an extension of the OPEC production agreement beyond June and a drawdown in inventories in the second half will bring WTI crude back to that level - with the risk of even $60-65 temporarily if there are any unforeseen supply disruptions. We remain more cautious on industrial commodities, which will be hurt by a mild withdrawal of monetary and fiscal stimulus in China. Following its 6.9% GDP print in Q1, Chinese growth is likely to slow moderately. However, with the Party Congress coming up in the fall, growth will not be allowed to slow excessively - and, indeed, there are signs that central government spending has begun to accelerate recently (Chart 8). We remain positive on gold as a long-term hedge against the tail risk of inflation. As our recent Special Report on Safe Havens demonstrated,4 gold has historically provided good returns during recessions, particularly those associated with high inflation (Chart 9). Chart 8China Is Withdrawing Stimulus - Or Is It? China Is Withdrawing Stimulus - Or Is It? China Is Withdrawing Stimulus - Or Is It? Chart 9Gold Glisters When Inflation Rises Gold Glisters When Inflation Rises Gold Glisters When Inflation Rises Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Global Asset Allocation, "Quarterly Portfolio Outlook: No Reasons To Turn Cautious," dated 3 April 2017, available at gaa.research.com 2 For detailed analysis of the problems with seasonal adjustment, please see U.S. Investment Strategy, "Spring Snapback?" dated April 24, 2017, available at usis.bcaresearch.com 3 So far about half of U.S. companies have reported. 4 Please see Global Asset Allocation, "Safe Havens: Where To Hide Next Time?" dated April 21, 2017, available at gaa.bcaresearch.com. Recommended Asset Allocation

Highlights Duration: The market is now priced for only 30 bps of rate hikes between now and the end of the year, despite little evidence that growth is actually slowing. Stay at below-benchmark duration and remain short the January 2018 Fed Funds Futures contract. TIPS: Although we still expect TIPS breakevens to widen as inflation rises, this week we review possible arguments for why breakevens might have shifted to a permanently lower post-crisis equilibrium. Remain overweight TIPS versus nominal Treasuries. Corporate Valuation: Our Default-Adjusted Spread remains at reasonably attractive levels, suggesting that corporate spreads will tighten in the coming months if the economic recovery remains on track. Remain overweight corporate bonds within U.S. fixed income portfolios. Feature Chart 1Yields Lower Since March FOMC Yields Lower Since March FOMC Yields Lower Since March FOMC In last week's report we argued that recent bond market strength was caused by a politically-induced flight-to-quality. In particular, we noted that the term structure of implied equity volatility had inverted - investors were paying more to hedge equity positions over a 1-month horizon than over a 3-month horizon. But political tensions have eased somewhat during the past week. President Trump promised to unveil his administration's tax reform plan this Wednesday, and the first round of the French election resulted in centrist candidate Emmanuel Macron securing a significant advantage over far-right candidate Marine Le Pen. As a consequence, 1-month implied equity vol fell back below 3-month vol, and the bond rally ebbed with the 10-year Treasury yield edging up to 2.29% from 2.17% at this time last week. Nonetheless, bond yields are still far below the levels seen following the last FOMC meeting in mid-March. Since that meeting, the 10-year Treasury yield has fallen 27 bps, split between a 12 bps decline in the real yield and a 15 bps drop in the cost of inflation compensation (Chart 1). Real Yields Are Too Low As shown in the top panel of Chart 1, the 10-year real yield is tightly linked to the number of rate hikes discounted in the overnight index swap curve during the next 12 months. Further, the drop in both of these series since mid-March occurred alongside a string of economic data disappointments, as evidenced by the sharp fall in the Economic Surprise Index (Chart 2). Our assessment, however, is that the mean reversion in the surprise index represents excessively optimistic expectations rather than a trend change in the pace of U.S. growth. Chart 2Disappointments Are Discounted Disappointments Are Discounted Disappointments Are Discounted To test this theory, we looked at the New York Fed's Nowcast for Q1 GDP growth and noted that it has been revised lower from 2.96% (as of March 24) to 2.65% (as of April 20). We observed that the data releases responsible for the bulk of the downward revision were: Real consumer spending Retail sales and food services Import & Export growth Housing starts As can be seen in Chart 3, with the exception of real consumer spending, all of the other data disappointments represent small corrections from elevated levels. As for real consumer spending, we noted last week that the recent weakness is probably explained by problems with Q1 seasonal adjustments.1 Taking a step back, U.S. growth still appears to be on solid footing. The BCA Beige Book Monitor, introduced last week by our U.S. Investment Strategy service,2 scans the Federal Reserve's Beige Book3 for the words "strong" and "weak" (and their derivatives like stronger, weakened, etc...). The Monitor is the number of "strong" words less the number of "weak" words, and it has been an excellent coincident indicator of GDP growth since the mid-1990s (Chart 4). At present, the Beige Book Monitor is sending a robust signal for U.S. growth. Similarly, despite supposed weakness in housing starts and trade data, our preferred leading indicators point to continued strength in both the residential investment and net export components of GDP (Chart 4, bottom 2 panels). Chart 3What Weak Data? What Weak Data? What Weak Data? Chart 4Growth Still Looks Strong Growth Still Looks Strong Growth Still Looks Strong Bottom Line: The market is now priced for only 30 bps of rate hikes between now and the end of the year, despite little evidence that growth is actually slowing. We still expect the Fed will lift rates by at least 50 bps between now and the end of the year. Stay at below-benchmark duration and remain short the January 2018 Fed Funds Futures contract. TIPS Breakevens: How Far From Fair Value? As was mentioned above, the cost of 10-year inflation compensation has also declined since mid-March alongside some weakness in the headline non-seasonally adjusted Consumer Price Index (see Chart 1). Our Financial Model of TIPS Breakevens - which models the 10-year TIPS breakeven rate using the stock-to-bond total return ratio, the price of oil and the trade-weighted dollar - attributes the recent decline to weakness in the stock-to-bond ratio and the fact that the 10-year breakeven rate was already quite elevated compared to our model's fair value (Chart 5). The 10-year breakeven rate is still somewhat wide compared to our model's fair value, but much less so. We remain overweight TIPS versus nominal Treasuries on the view that growth will be strong enough to keep measures of core inflation on a steady upward trajectory, eventually converging with the Fed's 2% inflation target. The fair value reading from our TIPS Financial Model should also trend gradually higher in this environment. Historically, core PCE inflation anchored around the Fed's 2% inflation target has corresponded with a 5y5y TIPS breakeven inflation rate in the range of 2.4% to 2.5% (current value 1.89%) and a 5y5y CPI swap rate between 2.8% and 2.9% (current value = 2.31%) (Chart 6). These remain our target levels for TIPS breakevens and CPI swaps, respectively. Chart 5TIPS Financial Model TIPS Financial Model TIPS Financial Model Chart 6Still Below Target Still Below Target Still Below Target However, we must also consider the possibility that these target ranges, based on the mid-2000s, may no longer be applicable. Put differently, it is possible that the market for inflation protection underwent a structural shift following the financial crisis and the appropriate level for long-maturity TIPS breakeven rates when core PCE is anchored around 2% might now be lower. A Structurally Lower Inflation Risk Premium? It is common to think of the 10-year TIPS breakeven inflation rate as: TIPS Breakeven Inflation = Inflation Expectations + Inflation Risk Premium The inflation risk premium is the extra return required by nominal bond investors to bear the risk that future inflation will differ from expected inflation. In theory, this premium can be influenced by uncertainty about the inflation outlook, but also by structural factors that make it more or less attractive to include TIPS in a portfolio. For example, any asset that is negatively correlated with equities is more valuable as a hedge in the context of an overall portfolio and investors should demand less of a risk premium to hold that asset. As one recent Fed paper4 noted, the correlation between long-maturity TIPS breakeven rates and equities has shifted from being negative in the 1980s to being sharply positive in recent years. This means that TIPS have become less valuable as a hedge against equity positions. All else equal, this should increase the yield that investors demand to hold TIPS and thus lower the TIPS breakeven inflation rate. We acknowledge the strong positive correlation between equities and TIPS breakevens, but are inclined to view it as more of a cyclical phenomenon. Chart 7 shows that the correlation between inflation expectations5 and equities was negative when inflation was above the Fed's 2% target in the 1980s and also that the correlation becomes more positive when the Fed eases and more negative when the Fed tightens (Chart 7, bottom panel). Chart 7Correlation Between Breakevens & Equities Is Cyclical Correlation Between Breakevens & Equities Is Cyclical Correlation Between Breakevens & Equities Is Cyclical In other words, when inflation is low the Fed has an incentive to maintain an accommodative monetary policy. It does not react strongly when inflation rises, and this supports increases in both inflation expectations and equity prices. However, when inflation becomes too high, the correlation between inflation expectations and equity prices shifts because higher inflation now signals a more rapid pace of Fed tightening which tends to depress equities. It therefore seems likely that the correlation between TIPS breakevens and equity prices will weaken as inflation rises and the Fed tightens policy. So we do not view this as a compelling reason for why TIPS breakevens might be permanently lower. Structural Limits To Arbitrage? A potentially more interesting line of argument comes from a 2010 paper by Fleckenstein, Longstaff and Lustig.6 In this paper, the authors document a persistent arbitrage opportunity between TIPS and nominal Treasury bonds. Investors can earn risk-free returns using inflation swaps and TIPS to replicate the cash flows from a nominal Treasury bond. The authors also find that this arbitrage opportunity biases TIPS breakeven rates lower, and that this bias worsens in times of increased financial market volatility. Chart 8Repo Market Less Efficient Repo Market Less Efficient Repo Market Less Efficient Specifically, the authors demonstrate that the size of the downward bias in TIPS breakevens increases as repo market fails trend higher. The rationale being that repo fails occur when market participants are unable to acquire specific Treasury collateral. This is taken as a signal that the supply of government bonds is constrained, which makes it more difficult to take advantage of the arbitrage between TIPS and nominal Treasuries. Interestingly, repo fails have been trending higher since the financial crisis as repo market activity has been reduced by strict post-crisis regulations (Chart 8). The case has been made that new regulations - specifically the Supplementary Leverage Ratio which forces dealer banks to set aside a fixed amount of capital for any assets they hold, regardless of riskiness - have caused dealers to shy away from low margin businesses such as making markets in repo.7 It is conceivable that reduced activity in the repo market has resulted in less available collateral and increased fails. If this is the new state of affairs, then it is possible that TIPS breakevens will be permanently lower in the post-crisis world because lack of liquidity in the repo market has reduced the attractiveness of arbitraging the difference between nominal and real yields. So far, we are reluctant to draw any sweeping conclusions from this analysis. In fact, if the Fed believes that the fair value for long-maturity TIPS breakevens is between 2.4% and 2.5%, then does the "limits to arbitrage" argument even matter? Also, Manmohan Singh of the IMF has argued that the act of the Fed unwinding its balance sheet would free up balance sheet space for dealer banks, mitigating some of the regulatory burden and leading to a more efficient repo market.8 If this is correct, then repo fails could decline as the Fed starts to let its balance sheet run down, a process that is likely to start later this year. For now, we consider the theory of a permanently lower equilibrium for TIPS breakevens a risk to our view that merits further research in the coming weeks. Corporate Bond Valuation Update With the release of the Moody's Default Report for March we were able to update our High-Yield Default-Adjusted Spread (Chart 9). Our Default-Adjusted Spread is equal to the average option-adjusted spread from the Bloomberg Barclays High-Yield index less a 12-month forecast of default losses. That 12-month forecast is based on Moody's baseline forecast for the speculative grade default rate and our own forecast of the recovery rate. Chart 9Default-Adjusted Spread Default-Adjusted Spread Default-Adjusted Spread Moody's data show that the speculative grade default rate was 4.7% for the 12 months ending in March, and the baseline forecast calls for it to fall to 3% during the next 12 months. Using this forecast we calculate that the current Default-Adjusted Spread is 228 bps. Our analysis shows that excess returns for both Investment Grade and High-Yield corporate bonds are usually positive unless the Default-Adjusted Spread is below 100 bps. The relationship between excess returns and the Default-Adjusted Spread for both Investment Grade and High-Yield corporates is shown graphically in Charts 10 & 11 and also in Tables 1 & 2. Chart 1012-Month Excess Investment Grade Returns ##br##Vs. Ex-Ante Default-Adjusted Spread (2003 - Present) Will Breakevens Ever Recover? Will Breakevens Ever Recover? Chart 1112-Month Excess High-Yield Returns Versus Ex-Ante ##br##Default-Adjusted Spread (2003-Present) Will Breakevens Ever Recover? Will Breakevens Ever Recover? Table 112-Month Investment Grade Excess Returns & Ex-Ante Default-Adjusted Spread Will Breakevens Ever Recover? Will Breakevens Ever Recover? Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Will Breakevens Ever Recover? Will Breakevens Ever Recover? Given our relatively optimistic outlook for U.S. growth, we tend to view current valuation levels as attractive and see scope for spread tightening during the next few months. However, the weakening state of corporate balance sheets means spreads are at risk once inflation starts to bite and monetary policy turns less accommodative, possibly as early as next year.9 Bottom Line: Our Default-Adjusted Spread remains at reasonably attractive levels, suggesting that corporate spreads will tighten in the coming months if the economic recovery remains on track. Remain overweight corporate bonds within U.S. fixed income portfolios. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Fade The Flight To Safety", dated April 18, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Investment Strategy Weekly Report, "The Great Debate Continues", dated April 17, 2017, available at usis.bcaresearch.com 3 According to the Fed, the Beige Book provides "an up-to-date depiction of regional economic conditions based on anecdotal information gathered from a diverse range of business and community contacts." 4 Chen, Andrew Y., Eric C. Engstrom, and Olesya V. Grishchenko (2016). "Has the inflation risk premium fallen? Is it now negative?," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, April 4, 2016, http://dx.doi.org/10.17016/2380-7172.1720 5 In order to benefit from more back-data, in Chart 7 we use the Cleveland Fed's measure of inflation expectations rather than TIPS breakeven rates. Details about the Cleveland Fed's methodology can be found here: https://www.clevelandfed.org/en/our-research/indicators-and-data/inflation-expectations.aspx 6 Fleckenstein, Matthias, Francis A. Longstaff, and Hanno Lustig (2010). "Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle", NBER Working Paper No. 16358. September 2010. JEL No. E6,G12,G14. http://www.nber.org/papers/w16358 7 https://www.forbes.com/sites/lbsbusinessstrategyreview/2016/03/11/why-are-big-banks-offering-less-liquidity-to-bond-markets/#64286f5729de 8 https://ftalphaville.ft.com/2017/04/24/2187716/guest-post-why-shrinking-the-fed-balance-sheet-may-have-an-easing-effect/ 9 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification