Corporate Bonds

Highlights GFIS Portfolio: Our GFIS model fixed income portfolio has essentially matched the benchmark in the six months since inception. Our strategic below-benchmark duration stance has given up much of the strong Q4/2016 excess return performance over the past couple of months as bond yields have drifted lower. Corporate bonds contributed positively to performance, particularly after our upgrade of U.S. Investment Grade and High-Yield in late January. Upsizing Positions: The weightings in our model portfolio appear to have been too small versus our benchmark index to generate any meaningful outperformance. This week, we increase our positions for our highest conviction views: staying below-benchmark portfolio duration, underweighting U.S. Treasuries, overweighting U.S. corporate debt and underweighting Italian government debt. Tactical Overlay: Our current Tactical Overlay trades have been very successful over the life of the model bond portfolio, with 9 of 12 positions currently in the money with an average return of 0.45%. We are maintaining these positions for now, even as we alter the model portfolio. Feature Last September, we introduced a new element into our global bond strategy framework - a model portfolio that allows us to track the combined performance of our individual recommendations. The first piece of this process was the introduction of our custom benchmark index that defined our investment universe, which is similar to the Barclays Global Aggregate but with a dedicated allocation to global high-yield corporate debt.1 The next component is presented in this Special Report, where we take an initial look at measuring the performance of our model portfolio. The final element (to be presented in another upcoming report) will be introducing a formal risk management system into our process to help guide the relative sizes of our suggested portfolio tilts. We intend to show the portfolio returns on a quarterly basis going forward, in line with the types of reporting mandates that a typical bond manager might face. However, our recommendations are meant to play out over a more strategic investment horizon of one full year, in line with our proven strength in analyzing medium-term macroeconomic and investment trends. Each individual quarterly report should be interpreted in that context as only a partial reflection of the full expected return from our portfolio if our market calls come to fruition. Overall Portfolio Performance Attribution: Winners & Losers Chart 1GFIS Model Portfolio Performance GFIS Model Portfolio Performance GFIS Model Portfolio Performance Our model portfolio has delivered a total return of -0.41% (hedged into U.S. dollars) since inception on September 20, 2016. This slightly underperformed our Global Fixed Income Strategy (GFIS) custom benchmark index by -2bps, but did outperform the Barclays Global Aggregate index that returned -0.85%. In terms of the main drivers of our returns, the government bond portion of our portfolio added +3bps of excess return versus our GFIS benchmark, while the spread product component subtracted -5bps (Chart 1). These are admittedly small numbers, essentially delivering a benchmark return in six months. In terms of our major asset allocation decisions, our below-benchmark overall duration stance served us well in the final quarter of 2016, adding +20bps of excess return during the run-up in global bond yields following the election victory of President Trump in November. After shifting to a neutral posture in early December, however, our decision to cut duration again in late January has hurt the performance of our model portfolio, as global bond yields have since fallen and eliminated much of our gains from duration positioning from Q4/2016. On the other hand, that same choice to lower duration exposure in late January coincided with our decision to raise exposure to U.S. corporate bonds (both investment grade and high-yield) and cut the allocations to U.S. Treasuries and Euro Area investment grade corporates. U.S. corporates have performed relatively well since then, helping pull the excess return from our overall spread product exposure, excluding U.S. Mortgage Backed Securities (MBS), into positive territory (Chart 1, bottom panel). Unfortunately, our underweight tilt on U.S. MBS - a sector that represents a hefty 14% of our benchmark index - has acted as a drag on our overall returns from spread product. However, MBS performance has started to lag both U.S. Treasuries and corporates of late, justifying our underweight stance. A more detailed performance attribution is presented in Table 1, which shows the excess returns broken down by the same government bond duration buckets and credit sectors that we regularly present in the model portfolio table in our Weekly Reports. We also show the average deviation from our GFIS benchmark index weightings (our "active" positions) over the period in question to give a sense of the bias of our tilts. Table 1A Detailed Breakdown Of The GFIS Model Performance An Initial Look At The Performance Of Our Model Bond Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio Within the government bond portion of our model portfolio, there were positive excess return contributions from the U.S. and Japan (Chart 2), largely coming from underweights at the very long end of the yield curves that reflect our bias for curve steepening in those markets. The 10+ year duration buckets in the U.S. and Japan added +8bps and +7bps of excess return, respectively. Also, our underweight position in Italy helped generate a small positive excess return of +3bps. Chart 2GFIS Model Portfolio Performance Attribution By Country Within Government An Initial Look At The Performance Of Our Model Bond Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio At the same time, our exposures in Europe proved to be an almost equivalent drag on returns, as we maintained an underweight in U.K. Gilts, and overweights in German and French sovereign debt, for a bit too long before the trends in those markets turned late last year (more bullishly for the U.K. and bearishly for core Europe). Within the spread product segment of the portfolio (Chart 3), our steady overweight to U.S. Investment Grade Financials and our large underweight to U.S. Investment Grade industrials late last year (which we reduced substantially in December) helped those segments deliver excess returns of +5bps and +2bps, respectively. Our decision to upgrade High-Yield in late January also added positively to our performance within the Ba-rated and B-rated credit tiers. Emerging market debt, where we have maintained only a neutral weighting, was the largest contributor to absolute returns within our portfolio and our benchmark, adding +30bps to both. Chart 3GFIS Model Portfolio Performance Attribution By Sector Within Spread Product An Initial Look At The Performance Of Our Model Bond Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio Detailed charts showing the total returns, yields, portfolio weights and excess returns for some of our best and worst performing sectors are presented in the Appendix on page 11. Bottom Line: Our GFIS model fixed income portfolio has essentially matched the benchmark in the six months since inception. Our strategic below-benchmark duration stance has given up much of the strong Q4/2016 excess return performance over the past couple of months as bond yields have drifted lower. Corporate bonds contributed positively to performance, particularly after our upgrade of U.S. Investment Grade and High-Yield in late January. Increasing The Sizes Of Our Highest Conviction Portfolio Recommendations Delivering only a benchmark-like return is hardly the goal we are aiming to achieve with our model portfolio. However, given how much our weightings have, in aggregate, mirrored those of our benchmark index so far, the results should not be a surprise. The average (mean) allocations to government debt and spread product over the six-month life our model portfolio are shown in Chart 4, alongside the average (mean) benchmark weightings. It is clear from that chart that our overall exposures have been far too similar to those of our GFIS benchmark index. In the parlance of portfolio management, we have been taking far too little tracking error versus our benchmark, so far, to generate any meaningful alpha. Or, more simply put, our recommended positions have been too small and, in many cases, have been offsetting each other. Chart 4Bigger Tilts Are Needed In The Model Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio The absence of a true risk management system, incorporating sector correlations and volatilities, has clearly been an issue so far. Our initial (and, admittedly, simple) attempt at sizing our recommendations was based on translating our "1 to 5" rankings from our traditional portfolio allocation tables into a factor that would scale up/down the individual country or sector weightings versus our benchmark.2 Clearly, this approach has not created portfolio weightings large enough to move the needle on performance. We will look to complete that final piece of our GFIS model portfolio framework - appropriate trade sizing and risk management - in the next couple of months. This will allow us to more properly size our relative positions going forward while maintaining enough overall deviation from the GFIS benchmark index (i.e. tracking error) to have a chance to generate meaningful outperformance. For now, however, we feel that we can comfortably increase the sizes of our current recommended tilts for our highest conviction views, which we discussed in our most recent Weekly Report.3 We are reducing our overall portfolio duration from the current 6.34 years (-0.64 years versus our GFIS benchmark index duration) to 5.75 years. After the recent decline in bond yields on the back of rising global geopolitical tensions and a modest soft patch of "hard" U.S. economic data, the entry point for reducing duration exposure even further is attractive. We are cutting our allocation to U.S. Treasuries from the current 14.6% (-3% versus the benchmark) to 10%, and placing the proceeds equally into U.S. Investment Grade and High-Yield corporate debt. This is to capitalize on the cyclical uptrend in U.S. growth and corporate profits, and additional Fed rate hikes, which we still see unfolding this year. We are cutting our allocation to Italian government debt from the current 3.5% (-0.8% versus the benchmark) to 1%, and placing the proceeds equally into Germany and Spain. This is to reduce exposure to the weakest link in the Euro Area, particularly as political risks will remain elevated in Italy leading up to the parliamentary elections that are due in 2018. We are maintaining the current sizes of the medium conviction views that we discussed last week - specifically, the overweight stance on Japanese government bonds (a low-beta market in a rising yield environment) and an underweight tilt on U.S. MBS (where valuations are stretched). The new weightings within our portfolio are shown in the model portfolio table on page 10. Bottom Line: The weightings in our model portfolio appear to have been too small versus our benchmark index to generate any meaningful outperformance. This week, we increase our positions for our highest conviction views: staying below-benchmark portfolio duration, underweight U.S. Treasuries, overweight U.S. corporate debt and underweight Italian government debt. Don't Forget About Our Tactical Overlays Our model portfolio is intended to be a reflection of the more medium-term, strategic fixed income investment views that stem from our regular analysis of trends in the global economy, inflation, monetary policy, etc. In other words, the positions in the portfolio are not intended to be changed too frequently. We also have chosen to stick with what we believe are more liquid markets in the portfolio, and without any use of derivatives of leverage to amplify returns beyond what the "fundamentals" suggest. Our recommendations that are shorter-term in nature (i.e. 0-3 months), or that may be in less liquid markets (i.e. New Zealand government bonds or U.S. TIPS), or that involve derivatives (i.e. Japanese CPI swaps or Sweden Overnight Index Swaps) are placed in our "Tactical Overlay Trades" list that appears in every Weekly Report. These recommendations have been performing extremely well since the inception of our model portfolio, as shown in Table 2.4 Table 2GFIS Tactical Overlay Trades Are Doing Well An Initial Look At The Performance Of Our Model Bond Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio 9 of the current 12 trades are making money, with an average total return of 0.45%. The most successful are the long U.S. TIPS/short U.S. Treasuries trade (+3.4%) and the short 10-year Portugal government bond versus German Bunds trade (+1.0%). While we have not made any attempt to put any position sizes on those trade ideas, in contrast to our model portfolio, it is clear that even a modest allocation to each of these trades would have generated a meaningful positive return "overlay" on top of what was generated by our model portfolio. Bottom Line: Our current Tactical Overlay trades have been very successful over the life of the model bond portfolio, with 9 of 12 positions currently in the money with an average return of 0.45%. We are maintaining these positions for now, even as we alter the model portfolio. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@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 For example, a "5 of 5" ranking would generate a portfolio allocation that was 1.75x the benchmark index weight, while a "1 of 5" ranking would apply a 0.5x factor to the index weight. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Song Remains The Same", dated April 11, 2017, available at gfis.bcaresearch.com 4 Please note that in Table 2, the returns on the trades that were initiated before the inception of our model portfolio on September 20th, 2016 are shown from that date and not from the date that the trade was initiated. This is to allow an "apples-to-apples" comparison to our model portfolio performance. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index An Initial Look At The Performance Of Our Model Bond Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio Appendix - Selected Sectors From The GFIS Model Portfolio Appendix 1 Appendix 1 Appendix 2 Appendix 2 Appendix 3 Appendix 3 Appendix 4 Appendix 4 Appendix 5 Appendix 5 Appendix 6 Appendix 6 Appendix 7 Appendix 7 Appendix 8 Appendix 8

Highlights Duration: The recent strength in bond markets appears to be a flight to quality driven by heightened political uncertainty. Underlying economic growth remains solid, and investors should fade the recent moves by adding to duration underweights. Quality Spreads: It might be wise to take advantage of current tight quality spreads to hedge the risk of the corporate interest expense tax deduction being repealed. Credit Curve: There is a substantial spread advantage to extending maturity within an allocation to investment grade corporate bonds. Further, this spread advantage should dissipate as Treasury yields move higher. Feature Political risks dominated the headlines last week, sparking what looks like a textbook flight-to-quality in financial markets. The 10-year Treasury yield broke below its long-standing 2.3% floor to end the week at 2.24%, and the S&P 500 declined by just over 1%. Another telltale sign of a flight-to-quality is that the term structure of implied equity volatility inverted (Chart 1). That is, implied volatility on 1-month S&P 500 index options rose above 3-month implied vol. We know the playbook here. Politically driven risk-off episodes that are unlikely to materially impact economic growth should be faded. This means staying at below-benchmark duration and overweight spread product, while favoring curve steepeners and TIPS breakeven wideners. We don't have to look that far back to identify another politically driven risk off episode. The Brexit vote from early last summer also caused the equity volatility term structure to invert, and drove the 10-year Treasury yield down to 1.37%, well below the fair value dictated by global economic fundamentals. Following the Brexit vote the 10-year Treasury yield was 58 bps expensive according to our 2-factor Treasury model.1 Presently, the 10-year yield appears 30 bps expensive (Chart 2), and much like in the aftermath of the Brexit vote, the deviation from fair value looks to be driven by spiking political uncertainty. Chart 1Inverted Vol Term Structure Inverted Vol Term Structure Inverted Vol Term Structure Chart 210-Year Treasury Yield Fair Value 10-Year Treasury Yield Fair Value 10-Year Treasury Yield Fair Value Now, the Global Economic Policy Uncertainty Index has been above normal levels since Donald Trump's election last November (Chart 2, bottom panel), and as long as the reading from that index is elevated the risk of another flight-to-quality episode in financial markets will remain high. However, spikes in policy uncertainty that do not coincide with economic deterioration have historically tended to mean-revert in relatively short order. We anticipate that Treasury yields will rise as policy uncertainty eases in the months ahead. Chart 3The Fed Is Being Priced Out The Fed Is Being Priced Out The Fed Is Being Priced Out Coincident with the drop in long-dated Treasury yields, the overnight index swap curve is now priced for only 39 bps of rate hikes between now and the end of the year (Chart 3). That's barely more than one 25 basis point hike! We previously recommended shorting January 2018 Fed Funds Futures on March 21,2 and would advise investors who have not yet entered this trade to do so now from even more attractive levels. We calculate that a short January 2018 Fed Funds Futures trade will return 20 bps (from current levels) in the event that the Fed hikes twice more this year, and 45 bps in the event of three more hikes. In our view, growth will be strong enough to support at least two more rate hikes this year. Bottom Line: The recent strength in bond markets appears to be a flight to quality driven by heightened political uncertainty. Underlying economic growth remains solid, and investors should fade the recent moves by adding to duration underweights. Are Markets Sniffing Out A Slowdown? Of course, bond markets could just be rallying in response to slowing U.S. economic growth. After all, the Atlanta Fed's GDPNow forecast is calling for a measly 0.5% annualized GDP growth in Q1. In stark contrast, the New York Fed's GDP Nowcast is calling for robust growth of 2.6% in Q1 and 2.1% in Q2 (Chart 4). How do we square the two? The answer relates to the ongoing debate between so-called "soft" and "hard" data. The New York Fed model incorporates a great deal more "soft data" than the Atlanta Fed model. In other words, it incorporates a wider swathe of survey data than the Atlanta Fed model, which relies more heavily on actual production and spending statistics. We think it would be unwise to dismiss the more positive economic message being sent by survey data. First, surveys tend to lead actual spending so we should expect some divergence whenever the economy reaches a turning point. Second, "hard data" are often revised after the fact and there are question marks about whether residual seasonality has biased Q1 growth lower during the past few years. The minutes from the March FOMC meeting showed that participants "noted that residual seasonality might have exaggerated the increase" in the PCE price deflator in January and February. The corollary of an unduly strong PCE price deflator is unusually weak real consumer spending. Real consumer spending was indeed weak in January and February, as was the headline retail sales figure for March. However, the weakness in March retail sales was concentrated in gasoline stations and auto sales. The more stable retail sales control group - a measure that excludes autos, gas stations and building materials - ticked higher in March (Chart 5). While the recent decline in auto sales should not be dismissed, it is too soon to call for a broad slowdown in consumer spending. Finally, as was recently noted by our colleagues at BCA's Global Investment Strategy service,3 even with bad weather having been a large drag on employment growth in March, aggregate hours worked still grew 1.5% in Q1 (Chart 6). This means that productivity growth would need to be negative in order to achieve the Atlanta Fed's 0.5% forecast. Given that aggregate hours worked were biased lower due to weather in the first quarter, and that quarterly productivity growth has averaged approximately +0.7% (annualized) since 2010, overall GDP growth forecasts closer to 2% seem more reasonable going forward. Chart 4Soft Data Versus Hard Data Soft Data Versus Hard Data Soft Data Versus Hard Data Chart 5Weak Auto Sales Are A Concern Weak Auto Sales Are A Concern Weak Auto Sales Are A Concern Chart 6Aggregate Hours Still Robust Aggregate Hours Still Robust Aggregate Hours Still Robust No Deflation Here GDP growth in the neighborhood of 2% is sufficient to keep measures of core inflation gradually trending higher. Higher inflation, in turn, will eventually translate into increased inflation expectations and higher long-dated Treasury yields. While last week's release showed that core CPI actually contracted in March, we note that this followed two months of extremely strong inflation (Chart 7). Taking a step back, it still appears as though measures of core inflation put in a cyclical bottom in early 2015 (Chart 8). While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Chart 7March CPI Is An Anomaly March CPI Is An Anomaly March CPI Is An Anomaly Chart 8Inflation Still Trending Higher Inflation Still Trending Higher Inflation Still Trending Higher One final point relevant to the inflation outlook is that last week President Trump refused to rule out re-appointing Janet Yellen as Fed Chair when her current term expires early next year. If we can take the President at his word, then this potentially removes what was an important tail risk for the inflation outlook and the reflation trade more generally. If Trump were to appoint a staunch hawk as Fed Chair, then a much tighter Fed policy would likely halt the uptrend in core inflation. This would also cause the Treasury curve to bear-flatten and risk assets to sell off. However, an FOMC hewing closer to the status quo would allow inflation to trend higher, prolonging the reflation trade. Bottom Line: We don't see enough evidence to call for a slowdown in economic growth or inflation. Growth in the neighborhood of 2% going forward will be sufficient to send inflation expectations and long-dated nominal yields higher. Corporate Bond Positioning: Credit Rating & Maturity In last week's report we performed an assessment of the corporate credit cycle and concluded that corporate bonds should perform well relative to Treasuries this year, but are at risk next year once inflationary pressures start to bite and the Fed speeds up the pace of tightening.4 This week, we consider the implications of this outlook for positioning across the corporate bond quality and maturity spectrums. Quality Spreads Chart 9Quality Spreads Are Tight Quality Spreads Are Tight Quality Spreads Are Tight Obviously, lower rated corporate bonds offer a spread advantage relative to more highly rated bonds. This spread advantage is usually worth chasing unless the default outlook is worsening and overall corporate spreads are widening. At the moment, the option-adjusted spread (OAS) advantage in the Barclays High-Yield index relative to the Investment Grade index is 274 bps, about 100 bps below its long-run average. Further, Baa-rated investment grade corporate bonds currently offer a spread advantage of 77 bps over Aa-rated bonds, about 20 bps below the long-run average. Even though these quality spreads are somewhat tight by historical standards, the mere fact that the quality spread is positive means there is an advantage to moving down the quality spectrum as long as default risk is benign. For this reason, it is more relevant to consider the additional compensation for moving down in quality relative to our expectations for default losses during the next 12 months.5 In Chart 9 we see that quality spreads are in fact tighter than average, even after adjusting for default loss expectations, although there have also been extended periods when they were even tighter than current levels. Although the risk/reward trade-off for moving down in quality is not all that attractive by historical standards, given our view that corporate spreads will be well behaved this year, we are fairly agnostic about moving down in quality on a 6-12 month investment horizon. There is, however, one additional factor to consider with regards to positioning across the credit quality spectrum. Corporate tax reform, some form of which our Geopolitical strategists still see as having a high probability of being passed before the end of this year,6 will involve some combination of lower tax rates and the repeal of some deductions. One deduction that is very much at risk is that of corporate interest expense. If implemented, it seems likely that corporate interest deductibility would be phased out over time. That is, the interest on outstanding corporate bonds would remain tax deductible, and only the interest on newly issued debt would be excluded from the deduction. While the gradual phase-out would prevent a wave of defaults related to a sudden surge in tax expense, the provision very clearly favors large highly-rated firms relative to small lower-rated firms, whose interest expense makes up a larger proportion of total expenses. Investors with longer time horizons might be wise to take advantage of current tight quality spreads (i.e. move up in quality) to hedge the risk of the corporate interest expense tax deduction being repealed. Credit Curve Considerations Turning to the corporate bond term structure, we see that the OAS advantage in long-maturity investment grade corporate bonds is extremely high relative to history (Chart 10). As we discussed in a 2013 report,7 the two main drivers of the credit OAS curve are differences in duration and expected default losses. A greater difference in duration between the long-maturity and intermediate-maturity investment grade corporate bond indexes leads to a greater OAS advantage in the long-maturity index. Conversely, an increase in perceived default risk causes the OAS curve to flatten, as short-maturity credits are perceived to be at greater risk of default. We find that the majority of the spread advantage in long-dated corporate bonds represents compensation for duration risk. If we look at OAS per unit of duration rather than outright OAS, the credit curve no longer appears steep (Chart 10, panel 2). Digging a little deeper, we see that the difference in duration between the long-maturity and intermediate-maturity indexes has been steadily increasing since 1990. In the early 1990s the increase was at least partially attributable to actual changes in the maturity structure of the indexes themselves (Chart 10, panel 3). However, in recent years the increased duration spread is entirely the result of lower Treasury yields (Chart 10, bottom panel). It follows that if Treasury yields continue to trend lower, then the corporate OAS curve will remain very steep. Higher Treasury yields would reduce the difference in duration between the intermediate and long maturity indexes, causing the OAS curve to flatten. After adjusting for differences in duration, we also need to consider the default outlook. By performing a regression of the difference in OAS per unit of duration between the long-maturity and intermediate-maturity indexes on our measure of expected default losses, we find that the amount of spread per unit of duration at the long-end of the curve looks somewhat attractive given our outlook for default losses (Chart 11). Chart 10OAS Term Structure Is Steep OAS Term Structure Is Steep OAS Term Structure Is Steep Chart 11Higher Defaults = Flatter OAS Curve Higher Defaults = Flatter OAS Curve Higher Defaults = Flatter OAS Curve Adding it all up, there is a compelling case to be made for favoring long-maturity investment grade corporate bonds relative to short maturities. Not only is the spread advantage substantial on its face, but the OAS curve should flatten if Treasury yields move higher - as we expect they will. The OAS curve also appears too steep relative to our assessment of default risk. Bottom Line: There is a substantial spread advantage to extending maturity within an allocation to investment grade corporate bonds. Further, this spread advantage should dissipate as Treasury yields move higher. Investors should favor long-maturity issues over short-maturity issues within an overweight allocation to investment grade corporate bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our 2-factor Treasury model is based on Global Manufacturing PMI and bullish sentiment toward the U.S. dollar. For further details please see U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 3 Please see Global Investment Strategy Weekly Report, "Talk Is Cheap: EUR/USD Is Heading Toward Parity", dated April 14, 2017, available at gis.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 5 We calculate expected default losses using the Moody's baseline forecast for the default rate and our own forecast of the recovery rate. 6 Please see Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017", dated April 5, 2017, available at gps.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "On The Term Structure Of Credit Spreads", dated July 10, 2013, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

I am honored to join BCA Research as Senior Vice President of the U.S. Investment Strategy service. I have been researching and writing about the economy and financial markets for more than 30 years. I joined BCA Research from LPL Financial in Boston, MA where I served as the firm’s Chief Economic Strategist. At LPL I helped to manage more than $120 billion in client assets and provided more than 14,000 financial advisors and 700+ financial institutions with insights on asset allocation, global financial markets and economics. Prior to LPL, I served in similar functions at PNC Advisors, Stone & McCarthy Research, Prudential Securities, and the Congressional Budget Office in Washington, DC. I look forward to meeting you and providing quality research in the years to come. John Canally, Senior Vice President U.S. Investment Strategy Highlights We are not changing our view on Treasury markets or our stocks over bonds call despite the news that the Fed will begin shrinking its balance sheet later this year. The Fed's action is marginally dollar positive. For the major industrialized economies, the so-called "hard" data are moving in line with the "soft" survey data for the most part. Retail sales and industrial production have accelerated, although "hard" data on business capital spending remains weak. We introduce our Bond Duration checklist this week. These are the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio stance. We continue to favor U.S. equites over bonds in 2017 and recommend keeping duration short of benchmark. Despite outsized performance from high-yield corporate bonds in 2016, investors should favor stocks over high-yield over the coming year. We introduce the BCA Beige Book Monitor this week. This metric provides a quantitative look at the qualitative, or "soft" data in the Fed's Beige Book. The Beige Book is due out Wednesday, April 19. Feature Chart 1Weak Data And More Weighed ##br##On Risk Assets Weak Data And More Weighed On Risk Assets Weak Data And More Weighed On Risk Assets U.S. stocks stumbled and Treasury yields slumped last week with the 10-year Treasury yield hitting a 2017 low. The drop in yields came despite news from the FOMC that the Fed is prepared to shrink its balance sheet later this year, a bit sooner than the market expected. Comments from Fed Chair Yellen - who expressed concern that the Fed's independence is "under threat"- should have jolted the bond market, but didn't. Not yet at least. Geopolitics played a role in the week's market action as well, the main culprits being upcoming French elections, the aftermath of President Trump's missile attack on Syria and ongoing tensions in North Korea. The looming Q1 earnings reporting season weighed on risk assets as well. The dollar ended lower last week. Trump told the Wall Street Journal he prefers a weak dollar. Those comments and the tepid data helped to offset the safe-haven bid generated by the geopolitical events of the week (Chart 1). The "hard" vs "soft" data debate will continue this week and likely for some time thereafter. "Hard" data on housing and manufacturing for March as well as the U.S. leading indicator are due out this week. Of course, the ultimate set of "hard" data is the corporate earnings data. Nearly 70 S&P 500 firms will report Q1 results and provide guidance for Q2 and beyond this week. "Soft" data on the PMI, Philly Fed and Empire State manufacturing sector for April will undoubtedly keep the debate going. Our view is that the hard data will catch up with the upbeat surveys in the U.S. This week we review the key economic indicators for the major advanced economies, which highlight that the global growth acceleration remains on track. We also introduce a Duration Checklist designed to help separate "signal from noise" in the bond market. Most of the items on the Checklist remain bond-bearish. Fed plans to shrink its balance sheet is not particularly negative for bond prices, but it certainly won't be supportive. The main risk to our bond-bearish view remains geopolitics, including the first round voting and results in the French election due on Sunday, April 23. Balance Sheet Bedlam? Maybe Not The release of Minutes from the FOMC's March meeting contained a robust discussion of the Fed's balance sheet. Until recently, most market participants had assumed that the Fed would maintain the size of its balance sheet via reinvesting through at least late 2017/early 2018. The latest FOMC minutes suggest that, assuming the economy continues to track the Fed's forecast, the FOMC will allow its balance sheet to shrink this year. The FOMC will achieve this by ceasing reinvestment of both its MBS and Treasury holdings at the same time. No decision has been made about whether the reinvestments will end all at once or will be phased out over time (tapered). Chart 2 shows that when QE1 ended in 2010 and QE2 ended in 2011, U.S. equities underperformed bonds. It's important to note, however, that underperformance didn't occur in a vacuum. The European debt crisis, the U.S. rating downgrade and debt ceiling debates all weighed on risk assets after QE1 and QE2 ended. Other factors played a role as well, such as weak economic growth and policy uncertainty. Amid QE3, U.S. equities surged in 2013, returning 32.4%, while bonds fell 8.5%. But in late 2013, the Fed announced that purchases would be tapered over the course of 2014. QE3 finally ended in late 2014. Stocks and bonds battled it out over 2014 and 2015, with stocks beating bonds by 3%. Chart 2Reminder What Happened When QE1, QE2 & QE3 Ended Reminder What Happened When QE1, QE2 & QE3 Ended Reminder What Happened When QE1, QE2 & QE3 Ended Bottom Line: Our view remains that Fed balance sheet run-off won't have a big impact on Treasury yields, although may lead to a widening of MBS spreads. What matters more for Treasury yields than the size of the balance sheet is the expected path of short rates. As for equities, while geopolitical risks are ever-present, the U.S. economy is in far better shape today than it was when QE1, QE2 and QE3 ended. U.S. corporate earnings are pointing higher as well. While we've clearly entered a new part in the Fed cycle, the news on the Fed's balance sheet does not change our view that U.S. stocks will outperform bonds this year. All else equal, the dollar should get a small boost from a shrinking Fed balance sheet, supporting our view that the dollar will rise 10% this year. Overplaying The Soft Data And Underplaying Geopolitics...In 2018 Chart 3Global Pick-Up On Track Global Pick-Up On Track Global Pick-Up On Track Traders and investors have been giving up on the global reflation story of late, sending the 10-year Treasury yield down to the bottom end of this year's trading range. Missile strikes, upcoming French elections and U.S. saber rattling regarding North Korea have lifted the allure of safe havens such as government bonds. At the same time, the Fed was unwilling to revise up the 'dot plot', doubts are growing over the ability of the Trump Administration to deliver any stimulus and a few recent U.S. data releases have disappointed. It is difficult to forecast the ebb and flow of safe-haven demand for bonds, especially related to North Korea and Syria. However, our geopolitical team holds a high-conviction view that angst over Eurozone elections this year are overblown. The Italian election in 2018 is more of a threat. While we cannot rule out an even stronger safe-haven bid from developing in the coming weeks, the global cyclical economic backdrop remains negative for government bond markets. For the major industrialized economies, the so-called "hard" data are moving in line with the "soft" survey data for the most part. For example, retail sales growth continues to accelerate, reaching 4.7% in February on a year-over-year basis (Chart 3). This follows the sharp improvement in consumer confidence. Manufacturing production growth is also accelerating to the upside, in line with the PMIs. The global manufacturing sector is rebounding smartly after last year's recession, which was driven by the collapse in oil prices and a global inventory correction. Readers may be excused for jumping to the conclusion that the rebound is largely in the energy space, but this is not true. Production growth in the energy sector is close to zero on a year-over-year basis, and is negative on a 3-month rate of change basis (Chart 4). The growth pickup has been in the other major sectors, including consumer-related goods, capital goods and technology. In the U.S., non-energy production has boomed over the three months, rising 5.2% at annual rates (Chart 5). The weak spot has been in capital goods orders (Chart 3). We only have data for the big three economies - the U.S., Japan and the Eurozone - but growth is near to zero or slightly negative for all three. These data are perplexing because they are at odds with an acceleration in the production of capital goods (noted above) and a pickup in capital goods imports for 20 economies (Chart 3, third panel). Nonetheless, improving CEO sentiment, strengthening profit growth and activity surveys all suggest that capital goods orders will "catch up" in the coming months. Chart 4Manufacturing Rebound Is Not About Energy Manufacturing Rebound Is Not About Energy Manufacturing Rebound Is Not About Energy Chart 5U.S.: Non-Energy Production Surging U.S.: Non-Energy Production Surging U.S.: Non-Energy Production Surging That said, one risk to our positive capex outlook in the U.S. is that the Republicans could fail to deliver on their promises to cut taxes and boost infrastructure spending. This is not our base case, but current capex plans could be cancelled or put on indefinite hold were there to be no corporate tax cuts or immediate expensing of capital expenditures. Duration Checklist: What We're Watching BCA's Global Fixed Income Strategy service recently introduced a "Duration Checklist" designed to keep us focused on the most relevant factors while trying to sift out the signal from the noise (Table 1).1 These are the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio stance. Naturally, leading and coincident indicators for global growth feature prominently in the top section of the Checklist (Chart 6). All four of these indicators appear to have topped out except the Global Leading Economic Indicator (GLEI), suggesting that the period of maximum growth acceleration has past. Nonetheless, all four are still consistent with robust growth for at least the near term. Table 1Stay Bearish On Treasuries & Bunds The Great Debate Continues The Great Debate Continues Chart 6Some Warning From Leading Indicators Some Warning From Leading Indicators Some Warning From Leading Indicators The rapid decline in the diffusion index, based on the 22 countries that comprise our GLEI, is concerning. The LEIs for two major economies and two emerging economies dipped slightly in February, such that roughly half of the country LEIs rose and half fell in the month. While it is too early to hit the panic button, the diffusion index is worth watching closely; a decline below 50 for several months would indicate that a peak in the GLEI is approaching. The remainder of the items on the checklist are related to growth, inflation pressure, central bank stance, investor risk-taking behavior and bond market technicals. We are focusing on the U.S. and Eurozone at the moment because we believe these two economies will be the main driver of global yields over the next 12 months. In the U.S., the Fed is tightening and market expectations are overly benign on the pace of rate hikes in the coming years. Upside pressure on global yields should intensify later this year, when the ECB announces the next "tapering" of its asset purchase program. All of the economic growth, inflation pressure and risk-seeking indicators on the Checklist warrant a check mark for the U.S., although this is not the case for the Eurozone inflation indicators. From a technical perspective, the Treasury and bund markets no longer appear as oversold as they did after the rapid run-up in yields following last November's U.S. elections. Large short positions have largely unwound. This removes one of the largest impediments to a renewed decline in global bond prices. For the U.S., we expect that the 10-year yield to rise to the upper end of the recent 2.3%-2.6% trading range in the next couple of months, before eventually breaking out on the way to the 2.8%-3% area by year-end. Bottom Line: A number of political pressure points and some modest U.S. data disappointments have triggered an unwinding of short bond positions. Nonetheless, the global manufacturing revival and growth impulse remain in place, and the majority of items on our Checklist suggest that the recent bond rally represents a consolidation phase rather than a trend reversal. Keep duration short of benchmark within fixed-income portfolios. Favor Stocks Over Junk Bonds Table 2A New Trend In Junk Vs. Stocks? The Great Debate Continues The Great Debate Continues We continue to favor U.S. equities over bonds in 2017 and recommend keeping duration short of benchmark. But what about U.S. equities versus high-yield bonds? As a reminder, favoring corporate bonds over equities was a long-running BCA theme during the early stages of the economic recovery.We noted that corporate bonds were likely to outperform equities in a prescient Special Report published in late-2008,2 and we continued to favor corporate bonds until late-2012 when we shifted towards strong dividend-paying stocks. Table 2 highlights that our corporate bond vs equity recommendations have worked out well over the past several years. The table presents the annual total return for the S&P 500 and high-yield corporate bonds (as well as the difference between the two), and it shows that the former underperformed the latter from 2008 to 2011 (and again in 2012 in risk-adjusted terms). However, stocks materially outperformed high-yield bonds from 2013-2015, which followed our recommendation to favor the S&P Dividend Aristocrats index over corporate bonds in our November 2012 Special Report.3 But Table 2 also shows that the trend of stock outperformance reversed last year, with high-yield bonds having somewhat outpaced the S&P 500 in total return terms. Does this imply that investors are witnessing the beginning of a new uptrend in corporate bond outperformance versus equities? In our view, the answer is 'no'. Chart 7 presents our simple framework for the relative performance of stocks vs high-yield corporate bonds, which suggests that investors should favor the former over the latter. Panel 1 highlights that the trend in stocks vs high-yield is generally the same as that vs 10-year Treasuries, with a few notable exceptions of sustained difference. The first exception was from 2002 to 2004, when stocks significantly outperformed government bonds but were flat vs high-yield. The second exception occurred during the early part of this expansion, which again saw high-yield corporate bonds post equity-like returns. Chart 7Major Valuation Advantage Needed For High-Yield To Outperform Stocks Major Valuation Advantage Needed For High-Yield To Outperform Stocks Major Valuation Advantage Needed For High-Yield To Outperform Stocks Panel 2 suggests that both of these circumstances were fueled by a substantial high-yield valuation advantage over stocks. The panel illustrates the gap between the speculative-grade corporate bond yield-to-worst and the S&P 500 12-month forward earnings yield, which was elevated and fell materially in both of the cases of sustained divergence shown in panel 1. The key point for investors is that last year's outperformance of junk bonds is unlikely to continue. While the compression of the junk/stock yield gap did lead the former to outperform last year, the gap was not high to begin with and is currently not that far away from its historical lows. This suggests that there is no reason to expect the stock/junk relative performance trend to deviate from the overall stock/government bond trend, which we expect to rise further over the coming 6-12 months. Bottom Line: Despite outsized performance from high-yield corporate bonds in 2016, investors should continue to favor stocks over high-yield over the coming year (but favor both over Treasuries and cash). Introducing The BCA Beige Book Monitor Chart 8BCA Beige Book Monitor: ##br##A "Hard" Look At "Soft" Data BCA Beige Book Monitor: A "Hard" Look At "Soft" Data BCA Beige Book Monitor: A "Hard" Look At "Soft" Data The Fed's Beige Book is released eight times a year, two weeks ahead of each FOMC meeting. It was first released in 1983. The Beige Book's predecessor was the Red Book, first produced in 1970. The Beige Book itself got a makeover from the Fed in early 2017. The Fed changed the way the information was presented across the 12 Fed districts, but, according to the Fed, the Beige Book will continue to provide "an up-to-date depiction of regional economic conditions based on anecdotal information gathered from a diverse range of business and community contacts." In addition to the Beige Book, FOMC officials also review what is now known as the "Teal Book" at each meeting. The Teal Book combined the "Green Book" - a review of current economic and financial conditions - and the "Blue Book"- which provided context for FOMC members on monetary policy actions. As noted in the Fed's own description, the Beige Book is "soft data". In discussing the Beige Book, the financial press often notes the number of districts where growth is expanding and contracting or describes the pace of overall activity (modest, moderate etc). The BCA Beige Book Monitor takes a more quantitative approach to all the qualitative data in the Beige Book. We began by searching the document for all the words we could think of that signify strength: Strong, strength, rise, increase, accelerate, fast, expand, advance, positive, robust, optimistic, up, etc. We then counted up all the words that denote weakness: Weak, fell, slow, decelerate, decrease, decline, soft, negative, pessimistic, down, contract, etc. Next, we subtracted the number of weak words from the strong words to calculate the BCA Beige Book Monitor. The Monitor begins in 2005, so it covers the time period from the middle of the 2001-2007 expansion, through the Great Recession (2007-2009) and the recovery since 2009. A more streamlined approach, using the words "strong" and "strength" (and their derivatives like stronger, strengthened, etc) as proxy for all the strong words and the word "weak" as a proxy for all the weak words, showed the same results. We adopted this simpler approach. Chart 8, panels 1 and 2, shows the BCA Beige Book Monitor versus real GDP and CEO Confidence. The BCA Beige Book monitor does a good job explaining GDP, but it is more timely. The Monitor leads CEO confidence, especially around turning points. We intend to do more work with the Beige Book Monitor and present it to you in future editions of this publication. We also track mentions of other key words in the Beige Book. For example changes in mentions of "inflation" words in the Beige book track, and sometimes lead, core inflation (Panel 3). Mentions of the "strong dollar" track the dollar itself, although tends to be lagging (Panel 4). We'll be watching for those inflation words and mentions of the dollar in the Beige Book this week. The Beige Book will also help to shed some qualitative light on the recent weakness in capital spending and C&I loans. Has the uncertainty about the timing, scope and scale of Trump's legislative agenda (taxes, infrastructure and the repeal of Obamacare, etc) had an impact on corporate spending or borrowing? We'll find out this week. Bottom Line: Although technically it is "soft" data, the Beige Book is a major input on monetary policy decision making for the FOMC. As we showed last week, the rise in "inflation" words in the Beige Book has certainly captured the Fed's attention, and confirms the "hard" we've seen on inflation. The next FOMC meeting is on May 2-3, and neither we nor the consensus expects a hike at that meeting. Despite the apparent flare-up in geopolitics last week and the run of disappointing economic data, we continue to expect the Fed to raise rates 2 more times in 2017. 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 Jonathan LaBerge Vice President, Special Reports jonathanl@bcaresearch.com 1 Please see Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017, available at gfis.bcaresearch.com 2 Please see Global Investment Strategy Special Report, "Value And The Cycle Favor Corporate Debt Over Equities," dated November 14, 2008, available at gis.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report, "The Search For Yield Continues: Aristocrats Or High Yield?" dated November 5, 2012, available at usis.bcaresearch.com

Highlights High Conviction Views: The global cyclical backdrop remains negative for government bond markets, and the recent declines in yields will not be sustained. We continue to recommend a below-benchmark overall duration stance, favoring U.S. corporate debt with underweight exposures to U.S. Treasuries and Italian government debt, as our highest conviction views. Medium Conviction Views: Staying overweight global inflation protection, French government bonds versus Germany, and Japanese Government Bonds (JGBs) versus the rest of the developed bond markets, while remaining underweight U.S. Mortgage Backed Securities, are recommendations that we hold with a more moderate conviction level. Euro Area Bond Distortions: The ECB's negative interest rate and asset purchase programs have created significant distortions in the German bond yield curve that are not as evident in the Euro Area swap rate curve, especially at shorter maturities. ECB tapering will be the trigger for a reversal of these trends. Feature Chart of the WeekWhy Are Yields Falling? Why Are Yields Falling? Why Are Yields Falling? After publishing two Special Reports in the past two weeks, this Weekly Report is our first opportunity to comment on the markets in April. We find it somewhat surprising that government bonds in the developed world have rallied as much as they have since the most recent peak last month, with the benchmark 10-year U.S. Treasury and German Bund seeing yield declines of -29bps and -22bps, respectively. Most of the move in Treasuries has been in the real yield component, while Bunds have seen a more even split between declines in real yields and inflation expectations. This has occurred despite minimal changes in actual growth or inflation pressures in either the U.S. or Europe (Chart of the Week). The price action in the Treasury market after last week's U.S. Payrolls report is a sign that the bond backdrop remains bearish. Yields initially fell all the way to 2.26% after the March increase in jobs fell short of expectations, before subsequently rebounding sharply to end the day at 2.38%. While intraday yield reversals on Payrolls Fridays are as typical as the sun setting in the west, a 12bp swing is one of the larger ones in recent memory (perhaps because investors eventually noticed the weather-related distortions in the data or, more importantly, that the U.S. unemployment rate had fallen to 4.5%). We continue to favor a pro-growth bias for bond investors, staying below-benchmark on overall duration and selectively overweight on corporate credit (favoring the U.S.). Ranking Our Current Market Views, By Conviction We have seen little in the economic data over the past few weeks to change our main strategic market views and portfolio recommendations. We summarize our main opinions below, ranked in order of our conviction level: Highest conviction views: Below-benchmark on overall portfolio duration exposure (for dedicated bond investors). Global bond yields have more room to rise alongside solid economic growth, tightening labor markets, inflation expectations drifting higher and central banks moving to slightly less accommodative monetary policies, on the margin. While the sharp upward momentum in coincident bond indicators like the global ZEW sentiment index has cooled of late, the solid upturn in the BCA Global Leading Economic Indicator continues to point to future upward pressure on real yields (Chart 2). The recent pullback in yields also appears to have run too far versus the trend in global data surprises, which remain elevated (bottom panel). One factor that we see having a potentially huge negative impact on global bond markets is the European Central Bank (ECB) announcing a move to a less accommodative policy stance later this year. A taper of asset purchases starting in 2018 is the more likely outcome than any hike in policy interest rates, which we see as more of a story for 2019. This should help push longer-dated bond yields higher within the Euro Area, and drag up global bond yields more generally. Underweight U.S. Treasuries. We still expect the Fed to deliver at least two more hikes this year, and there is still room for U.S. inflation expectations to rise further and put bear-steepening pressure on the Treasury curve. Our two-factor model for the benchmark 10-year Treasury yield, which uses the global purchasing managers index (PMI) and investor sentiment towards the U.S. dollar as the explanatory variables, indicates that yields are now about 18bps below fair value. From a technical perspective, the Treasury market no longer appears as oversold as it did after the rapid run-up in yields following last November's U.S. elections. The large short positions indicated by the J.P. Morgan duration survey and the Commitment of Traders report for Treasury futures have largely been unwound, while price momentum has flipped into positive territory (Chart 3). This removes one of the largest impediments to a renewed decline in Treasury prices, and we expect that the 10-year yield to rise to the upper end of the recent 2.30%-2.60% trading range in the next couple of months, before eventually breaking out on the way to the 2.80%-3% area by year-end. Chart 2Maintain A Defensive Duration Posture Maintain A Defensive Duration Posture Maintain A Defensive Duration Posture Chart 3Stay Underweight U.S. Treasuries Stay Underweight U.S. Treasuries Stay Underweight U.S. Treasuries Underweight Italian government bonds, versus both Germany and Spain. Italian government debt continues to suffer from the toxic combination of sluggish growth and weak domestic banks. The OECD leading economic indicator for Italy is declining, in contrast to the stable-to-rising trends in Germany and Spain (Chart 4). Meanwhile, the 5-year credit default swaps (CDS) for the major banks in Italy remain elevated around 400bps, in sharp contrast to the declining CDS in Germany and Spain which are now at 100bps. It is no coincidence that the widening trend in Italy-Germany and Italy-Spain spreads began around the same time last year that Italian bank CDS started to disengage from the rest of Europe (bottom panel). Markets understand that the undercapitalized Italian banking system will need government assistance at some point, which will add to the Italian government's already huge debt/GDP ratio of 133%. Political uncertainty in Italy, with parliamentary elections due by the spring of 2018 and populist parties like the anti-euro Five-Star Alliance holding up well in the polls, will also ensure that the risk premium on Italian bonds stays wide both in absolute terms and relative to other Peripheral European markets. Overweight U.S. corporate bonds, versus both U.S. Treasuries and Euro Area equivalents. The positive case for U.S. corporate debt is built upon two factors - the cyclical decline in default risk and the marginal improvement in balance sheet metrics. The latest estimates from Moody's are calling for a decline in the U.S. speculative grade corporate default rate to 3.1% this year. This leaves our measure of default-adjusted spreads in U.S. high-yield at levels that our colleagues at our sister publication, U.S. Bond Strategy, have shown to have a high probability of delivering positive excess returns over Treasuries in the next 12 months.1 Add to that the recent change in trend of our U.S. Corporate Health Monitor (CHM), which appears largely driven by some more positive numbers coming from lower-rated issuers in the Energy space given the recovery in oil prices, and the optimistic case for U.S. corporate debt is compelling. This is in contrast to our Euro Area CHM, which shows that the improving trend in balance sheet metrics has stalled of late (Chart 5, top panel). Chart 4Stay Underweight Italy Stay Underweight Italy Stay Underweight Italy Chart 5Stay Overweight U.S. Corporates vs Europe Stay Overweight U.S. Corporates vs Europe Stay Overweight U.S. Corporates vs Europe The difference between the U.S. and European CHMs has proven to be a good directional indicator for the relative return performance between the two markets, and is currently pointing to continued outperformance of both U.S. investment grade and high-yield debt versus European equivalents (bottom two panels). The threat of an ECB taper also hangs over the Euro Area investment grade corporate bond market, given the large buying of that debt by the central bank over the past year that has helped dampen both yields and spreads. Chart 6Stay Overweight Inflation Protection Stay Overweight Inflation Protection Stay Overweight Inflation Protection Medium-conviction views: Overweight inflation protection (both inflation-linked bonds and CPI swaps) in the U.S., Euro Area and Japan. In the U.S., the breakeven inflation rate on 10-year TIPS looks a bit too wide relative to our shorter-term model based on financial variables. However, underlying U.S. inflation pressures remain strong (Chart 6, top panel), particularly given the evidence that conditions in the labor market are getting progressively tighter. We expect inflation expectations to eventually rise back to levels consistent with the Fed's 2% inflation target on headline PCE inflation (which is around 2.5% on 10-year TIPS breakevens that are priced off the CPI index). The reflation story is somewhat less compelling in Europe and Japan, although CPI swaps are now at levels consistent with the underlying trends in realized inflation in both regions (bottom two panels). We continue to view long positions in CPI swaps in Europe and Japan as having a positive risk/reward skew given the tightening labor market in the former and the yen-negative monetary policies in the latter. Long France government bonds (10yr OATs) versus Germany (10yr Bunds). This is purely a call on the upcoming French election, which our political strategists believe will not end in a victory for the populist Marine Le Pen. While Le Pen has seen a recent bump in support heading into the first round of voting on April 23rd, her strong anti-euro position will eventually prove to be her undoing in the run-off election on May 7th (Chart 7). We first made this recommendation back in early February, and even though France-Germany spreads have been volatile since then as both Le Pen and the far-left candidate Jean-Luc Melenchon have seen a pickup in their poll numbers, the yield differentials are essentially at the same levels.2 We take this as a sign that the market believes current spreads are enough to compensate for the likely probability that either candidate could win the French presidency. Overweight JGBs Vs. the Global Treasury index. The argument here is a simple one - in an environment where there is cyclical upward pressure on global bond yields, favor the lowest-beta bond market (Chart 8). Persistently low inflation will prevent the Bank of Japan (BoJ) from making any changes to its current hyper-accommodative policies this year, especially the 0% cap on the benchmark 10-year JGB yield.3 The lack of yield limits the prospects for JGBs on a total return basis, but relative to other government bond markets, JGBs should outperform over the next 6-12 months as non-Japanese yields rise further. Chart 7Stay Overweight France Vs Germany Stay Overweight France Vs Germany Stay Overweight France Vs Germany Chart 8Stay Overweight Low-Beta JGBs Stay Overweight Low-Beta JGBs Stay Overweight Low-Beta JGBs Underweight U.S. Agency Mortgage-Backed Securities (MBS). Investors should remain underweight U.S. MBS, as spreads remain tight by historical standards. Our colleagues at U.S. Bond Strategy note that nominal MBS spreads have been flat in recent weeks as the option cost, which is the compensation for expected prepayments, has tightened to offset a widening in the option-adjusted spread (OAS).4 Chart 9Stay Underweight U.S. MBS Stay Underweight U.S. MBS Stay Underweight U.S. MBS We tend to think of the OAS as being influenced by trends in net issuance while the option cost is linked to mortgage prepayments (Chart 9). Looking ahead, the supply of MBS should increase further when the Fed starts to shrink its balance sheet later this year (as was mentioned in the minutes of the March FOMC meeting that were released last week), leading to a wider OAS. At the same time, refinancing applications should stay low as Treasury yields and mortgage rates rise. This will keep downward pressure on the option cost component of spreads. But with the option cost already near its historical lows, it is unlikely to completely offset the widening in OAS going forward. We see little value in U.S. MBS at current spread levels. Bottom Line: The global cyclical backdrop remains negative for government bond markets, and the recent declines in yields will not be sustained. We continue to recommend a below-benchmark overall duration stance, favoring U.S. corporate debt with underweight exposures to U.S. Treasuries and Italian government debt, as our highest conviction views. Staying overweight global inflation protection, French government bonds versus Germany, and Japanese Government Bonds (JGBs) versus the rest of the developed bond markets, while remaining underweight U.S. Mortgage Backed Securities, are recommendations that we hold with a more moderate conviction level. How Much Has The ECB Distorted The European Bond Market? Last week, Benoit Coeure of the ECB Executive Board gave a speech entitled "Bond Scarcity and the ECB Asset Purchase Program."5 That title piqued our interest, as that exact topic has come up in several of our conversations with clients this year. In his speech, Coeure discussed how the huge rally at the short-end of the German government bond curve over the past year has been at odds with what has occurred in the Euro swap curve, where interest rates are much higher for shorter-maturity swaps. Typically, German yields and Euro swap rates move in tandem, with the only differences being a function of technical factors like fixed-rate corporate debt issuance or government bond repo rates - and, on occasion, shifts in the perceived health of Euro Area banks that are the counterparties to any interest rate swap. The latter has become much less of an issue in recent years given the regulatory changes to the swap market, where trading has moved to centralized exchanges to reduce counterparty risks. In this environment, the difference between German bond yields and Euro swap rates, a.k.a the swap spread, should be relatively modest. Yet as can be seen in Chart 10, there has been a notable divergence at the shorter-maturity portions of the respective yield curves, where swap rates are rising but bond yields remain subdued. We can also see the divergences in the slopes of the relative yield curves, with the Euro Area swap curve much flatter than the German bond curve, particularly at longer maturities (Chart 11). Chart 10Large Distortions At The Front End Of The German Curve Large Distortions At The Front End Of The German Curve Large Distortions At The Front End Of The German Curve Chart 11Euro Area Swap Curves Are Generally Flatter Euro Area Swap Curves Are Generally Flatter Euro Area Swap Curves Are Generally Flatter Coeure argued that part of this distortion can be attributed to ECB asset purchases, especially after the decision taken last December to allow bond buying at yields below the -0.4% ECB deposit rate. This created a more favorable demand/supply balance for German debt, especially given the dearth of short-dated issuance. In addition, Coeure noted that there have been substantial safe-haven flows into shorter-dated German bonds (including treasury bills) by non-Euro Area entities. Some of this demand comes from large institutional investors like sovereign wealth funds and currency reserve managers, who are worried about political risks in France and Italy, and about the general rising trend in global bond yields, and are thus seeking the safety of low duration German debt. But some of the demand for short-dated German paper also comes from non-Euro Area banks, who have excess liquidity that needs to be parked in Euros but do not have access to the ECB deposit facility for the excess reserves of Euro Area banks. We can see this in Chart 12, which shows ECB data for the relative government bond ownership trends for Germany, France and Italy. The data is broken into holdings for bonds with maturities of one year or less (short-term) and bonds with maturities greater than one year (long-term). It is clear that the non-Euro area buyers own a much larger share of short-term German paper, around 90%, than in France and Italy, while Euro Area entities own nearly 80% of long-term bonds in all three countries. Coeure is correct in pointing out that there is an excess demand condition for short-dated core European debt, exacerbated by foreigners who need Euro-denominated safe assets - particularly GERMAN safe assets, if those investors are at all worried about redenomination risks given the rise of anti-euro populist parties in Europe.6 It is clear that the economic messages sent by looking at the German bond and Euro swap curves are very different. The flatter swap curve is more consistent with a steadily growing Euro Area economy where economic slack is being steadily absorbed and inflation pressures are building (albeit slowly). Also, the sovereign spread differentials within Europe do not look as problematic using swaps as the reference rate rather than German bonds. That is the case in France, where spreads versus swaps look in line with the averages of the past few years (Chart 13). This contrasts with the yield differentials versus Germany, which have reportedly gone up as investors have priced in a higher sovereign risk premium before the French presidential election. Chart 12French Bond Valuations Look More Subdued vs Swaps The Song Remains The Same The Song Remains The Same Chart 13French Bond Valuations Look More Subdued vs Swaps French Bond Valuations Look More Subdued vs Swaps French Bond Valuations Look More Subdued vs Swaps The story is a little different for Italy, where bond spreads versus both German bonds and Euro Area swaps have risen for all but the shortest maturities (Chart 14). This could be consistent with an interpretation that Italy's banking sector woes will add to the nation's longer-term fiscal stresses (as discussed earlier in this report), but not in a way that raises immediate default risks (which is why the 2-year Italy vs swap spread is well-behaved). Regardless of the "bias of interpretation", one thing that is clear is that the ECB's extraordinary monetary policies have created distortions in Euro Area bond markets. These may start to unwind, though, if the ECB begins to signal a shift towards a tapering of asset purchases next year, as we expect. The distortions in Euro area government bond yields (and, by association, swap spreads) have occurred alongside both the cuts in ECB policy rates into negative territory and the expansion of its balance sheet to purchase government bonds (Chart 15). As the ECB moves incrementally towards less accommodative monetary policy, we would expect to see front-end Euro swap spreads narrow in absolute terms and relative to longer-tenor spreads, and the German bond curve to flatten toward levels seen in the swap curve. Chart 14Only Short-Dated Italian Bond Valuations Look More Subdued vs Swaps Only Short-Dated Italian Bond Valuations Look More Subdued vs Swaps Only Short-Dated Italian Bond Valuations Look More Subdued vs Swaps Chart 15ECB Policies Have Caused The Distortions In Euro Swap Spreads ECB Policies Have Caused The Distortions In Euro Swap Spreads ECB Policies Have Caused The Distortions In Euro Swap Spreads Bottom Line: The ECB's negative interest rate and asset purchase programs have created significant distortions in the German bond yield curve that are not as evident in the Euro Area swap rate curve, especially at shorter maturities. ECB tapering will be the trigger for a reversal of these trends. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "Our Views On French Government Bonds", dated February 7, 2017, available at gfis.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Staying Behind The Curve, For Now", dated March 21, 2017, available at gfis.bcaresearch.com 4 Please see BCA U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 5 http://www.ecb.europa.eu/press/key/date/2017/html/sp170403_1.en.html 6 Coeure noted that, at the time that the ECB began its asset purchase program in March 2015, the share of German bonds of less than TWO years maturity held by foreigners was 70%, but that rose to 90% by the 3rd quarter of 2016. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Song Remains The Same The Song Remains The Same Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Bond market positioning is no longer at a bearish extreme and the economy is quickly approaching full employment. We expect Treasury yields will soon break through the upside of their post-election trading range. Maintain below-benchmark duration. Fed's Balance Sheet: The unwinding of the Fed's balance sheet is only important for Treasury yields if it impacts the market's rate hike expectations. However, the extra supply of MBS should lead to wider MBS spreads. Credit Cycle: Corporate spreads are in a "payback period" from 2014's energy shock that will allow them to tighten as corporate profits rebound, even though corporate leverage continues to trend higher. The weakening state of corporate balance sheets means spreads are at risk once monetary policy turns less accommodative. Feature The bond bear market has been on pause for the past few months, with Treasury yields confined to a trading range since last November's post-election sell off. While yields have not moved meaningfully higher during this time, firm floors have also formed beneath both the 5-year and 10-year yields (Chart 1). Even after last Friday's disappointing payrolls number, the 10-year did not move below 2.3% and the 5-year did not move below 1.8%. Trading Range About To Break? Our sense is that the current consolidation phase in Treasuries is approaching its end and yields will soon head higher. Global growth indicators have continued to improve during the past few months, and as we noted in last week's report,1 our 2-factor Treasury model, based on Global PMI and U.S. dollar sentiment, pegs fair value for the 10-year yield at 2.54%. We attribute the recent leveling-off in yields to technical shifts in bond positioning and sentiment. Earlier this year, net positions in Treasury futures and asset manager duration allocations were deep in "net short" territory (Chart 2). Extreme short positioning usually leads to a period of bond market strength until short positions are washed out. Now that bond market positioning is closer to neutral, a key impediment to further yield increases has been removed. Chart 1Poised For A Breakout? Poised For A Breakout? Poised For A Breakout? Chart 2Positioning Has Normalized Positioning Has Normalized Positioning Has Normalized The elevated level of economic surprises has also been flagged as a potential roadblock to the bond bear market. Extended readings from the economic surprise index tend to mean revert as investor expectations are revised higher in the face of improving data. However, our research suggests that the change in Treasury yields tends to lead the economic surprise index by 1-2 months (Chart 2, bottom panel). Given this relationship, we suspect that the bond market has already discounted a lot of mean reversion in the economic surprise index. Chart 3Approaching Full Employment Approaching Full Employment Approaching Full Employment Finally, last week's employment report should not be taken as a signal that U.S. economic growth is weakening. Bad weather in the northeast played a key role in the low March payrolls number - only 98k jobs added. But more importantly, at this stage of the cycle we should expect payroll growth to slow and wage pressures to increase as we approach full employment. As can be seen in Chart 3, the late cycle trends of slowing payroll growth and rising wages are very much in place. Further, even broad measures of labor market tightness, such as the U6 unemployment rate,2 are quickly approaching levels that suggest the economy is operating at full employment. Increasingly it is measures of labor market utilization, wage growth and inflation that will guide the Fed's decision making, and these measures continue to improve. It was even noted in the minutes from the March FOMC meeting that "tight labor markets [are] increasingly a factor in businesses' planning". The minutes also reported that: Business contacts in many Districts reported difficulty recruiting workers and indicated that they had to either offer higher wages or hire workers with lower qualifications than desired Accordingly, surveys show that households are increasingly describing jobs as "plentiful" (Chart 3, panel 3) and small businesses are indeed ramping up their compensation plans (Chart 3, bottom panel). At this stage of the cycle, continued progress on measures of labor market utilization, wage growth and inflation will be sufficient for the Fed to continue lifting rates, pushing Treasury yields higher. Bottom Line: Bond market positioning is no longer at a bearish extreme and the economy is quickly approaching full employment. We expect Treasury yields will soon break through the upside of their post-election trading range. Maintain below-benchmark duration. The Fed Will Shrink Its Balance Sheet This Year Last week's release of the minutes from the March FOMC meeting also contained some new information about how the Fed plans to deal with its large balance sheet. To summarize, we learned that: The Fed intends to start shrinking its balance sheet later this year (assuming growth maintains its current pace). The Fed will shrink its balance sheet by ceasing the reinvestment of both its MBS and Treasury holdings at the same time. Still no decision has been made about whether reinvestments will stop entirely or whether they will be phased out over time ("tapered"). On February 28, we published a detailed report about the Fed's balance sheet policy.3 In that report we explained why the winding down of the balance sheet will not have much of an impact on Treasury yields, but could lead to a material widening in MBS spreads. The new information received last week does not change either of these conclusions. The minutes did make clear that the Fed favors what Governor Lael Brainard recently called a "subordination strategy" for dealing with its balance sheet.4 [A subordination strategy] would prioritize the federal funds rate as the sole active tool away from the effective lower bound, effectively subordinating the balance sheet. Once federal funds normalization meets the test of being well under way, triggering an end to the current reinvestment policy, the balance sheet would be set on autopilot, shrinking in a gradual, predictable way until a "new normal" has been reached, and then increasing in line with trend increases in the demand for currency thereafter. Under this strategy, the balance sheet might be used as an active tool only if adverse shocks push the economy back to the effective lower bound. Essentially, the Fed is trying to de-emphasize the size of the balance sheet and would rather investors focus on the fed funds rate to assess the stance of monetary policy. For our part, we think it would be unwise to "fight the Fed" on this issue. For Treasury yields, we observe that the real 10-year Treasury yield closely tracks changes in the expected number of rate hikes during the next 12 months, while the inflation component of the 10-year yield tracks changes in realized inflation (Chart 4). These two relationships will continue to determine trends in bond yields going forward, and Fed balance sheet shrinkage is only important if it impacts the expected pace of rate hikes or inflation. The Fed's "subordination strategy" should ensure that the act of winding down the balance sheet does not have much of an impact on the expected pace of rate hikes. Ironically, if Treasury yields were to rise sharply following the announcement of balance sheet runoff, then the ensuing tightening of financial conditions would probably lower the expected pace of rate hikes and bring Treasury yields back down again. The story for MBS is somewhat different. Nominal MBS spreads remain tight by historical standards and closely track implied interest rate volatility (Chart 5). But we can also think of nominal MBS spreads as being split between the option cost, which is the compensation for expected prepayments, and the option-adjusted spread (OAS), which tends to correlate with net supply (Chart 5, panel 2). Chart 4Focus On Rate Expectations Focus On Rate Expectations Focus On Rate Expectations Chart 5Stay Underweight MBS Stay Underweight MBS Stay Underweight MBS In recent weeks, the OAS has widened alongside rising net issuance, but this has been offset by a sharp decline in the option cost. This is generally the pattern we would expect to play out as the Fed lifts rates and removes itself from the MBS market. The increased supply of MBS should lead to wider OAS, but refinancing applications should also stay low as Treasury yields and mortgage rates rise (Chart 5, bottom panel). However, netting it all out, the option cost component of MBS spreads is already near its historical lows and the OAS could move materially wider just to catch up to net issuance. In prior reports,5 we have also made the case that rate volatility should rise as the fed funds rate moves further away from the zero-lower-bound. Investors should stay underweight MBS. Bottom Line: The unwinding of the Fed's balance sheet is only important for Treasury yields if it impacts the market's rate hike expectations. However, the extra supply of MBS should lead to wider MBS spreads. Checking In On The Credit Cycle We continue to recommend overweight allocations to both investment grade and high-yield corporate bonds. This optimistic outlook is predicated on low inflation and a Fed that will support risk assets by remaining sufficiently accommodative until inflationary pressures are more pronounced. We think this "reflationary window" will stay open at least until core PCE inflation is firmly anchored around 2% and long-maturity TIPS breakevens reach the 2.4% to 2.5% range.6 Behind the scenes, however, leverage is building in the nonfinancial corporate sector. In this week's report we take a look at several different indicators of corporate credit quality and conclude that once the support from low inflation and accommodative monetary policy vanishes, it is very likely that corporate defaults will start to increase and corporate spreads will widen. If our anticipated timeline plays out, we will be looking to scale back on credit risk in 2018. Corporate Health Vs. The Yield Curve Our Corporate Health Monitor (CHM, see Appendix for further details) has been signaling deteriorating nonfinancial corporate health since late 2013 (Chart 6), and moved even deeper into 'deteriorating health' territory in Q4 of last year. Chart 6Corporate Health Is Deteriorating, But Monetary Policy Remains Supportive Corporate Health Is Deteriorating, But Monetary Policy Remains Supportive Corporate Health Is Deteriorating, But Monetary Policy Remains Supportive Periods when the CHM is in 'deteriorating health' territory are marked by shaded regions in Chart 6. We see that these regions usually correspond with periods when corporate spreads are widening. Even in the current episode, corporate spreads have yet to regain their mid-2014 tights. However, the bottom panel of Chart 6 shows that periods of deteriorating corporate health and wider corporate spreads are typically preceded by a very flat (often inverted) yield curve. This makes sense because a flat yield curve usually signals that interest rates are high and monetary policy is tight. Tight policy and elevated rates lead to more stringent bank lending standards and increase firms' interest burdens. With the curve still quite steep, we think the risk of sustained spread widening is minimal. However, if the CHM is still above zero when the yield curve is flatter, no support will remain for excess corporate bond returns. Net Leverage & The Payback Period We would further argue that the CHM will almost certainly be in 'deteriorating health' territory once the yield curve is close to flat. In Chart 7 we see that net leverage (defined as: total debt minus cash, as a percent of EBITD) is not only positively correlated with spreads, but also 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. Chart 7The Uptrend In Leverage Will Only Be Broken By Recession The Uptrend In Leverage Will Only Be Broken By Recession The Uptrend In Leverage Will Only Be Broken By Recession Closer inspection of Chart 7 reveals that the period between 1986 and 1989 is the only period when corporate spreads tightened even though leverage remained in an uptrend. In the late 1980s, leverage and corporate spreads both shot higher as a collapse in the energy sector caused overall corporate earnings to contract (Chart 7, bottom panel). But then the energy sector recovered just as quickly, and earnings growth bounced back. This caused spreads to tighten for a couple of years, even though the trend in net leverage only ever managed to flatten-off. Debt growth stayed robust during this time, despite the wild fluctuations in earnings. If any of this sounds familiar, it should. The energy sector collapse of 2014 caused net leverage and spreads to shoot higher, and now spreads have started to tighten again as earnings have rebounded. Notice that just like in the late-1980s, net leverage has not reversed its uptrend. We believe that corporate spreads have entered a "payback period" very similar to the late 1980s. Spreads can tighten as earnings rebound, but because the economy is not in recession, debt growth will remain solid and leverage will continue to trend higher. Once inflationary pressures start to bite and Fed policy becomes less accommodative, the payback period will end and spreads will head wider. Debt Growth Chart 8Bond Issuance Is Back Bond Issuance Is Back Bond Issuance Is Back Although we have made the case that the corporate sector does not delever unless prompted by a recession, it is notable that net corporate bond issuance was negative in Q4 of last year and the growth rate in bank lending to the corporate sector has slowed sharply. We do not think this cycle is different, and expect corporate debt growth (both bonds and loans) to rebound in the coming months. We chalk up weak corporate bond issuance in 2016Q4 to uncertainty surrounding the U.S. election. In fact, we see that gross corporate bond issuance has already rebounded strongly in January and February of this year (Chart 8). Turning to bank loans, we observe that the outright level of outstanding bank loans only contracts following a recession, and that the rate of increase follows bank lending standards with a lag (Chart 9). In other words, Commercial & Industrial (C&I) loan growth is still responding to the surge in defaults that resulted from the energy sector's 2014 collapse. Now that defaults have waned, this process will soon be thrown into reverse. In fact, our model of the 6-month rate of change in C&I lending - based on private non-residential fixed investment, small business optimism and corporate defaults - points to an imminent bottoming in C&I loan growth (Chart 10). Chart 9Loan Growth Follows Lending Standards Loan Growth Follows Lending Standards Loan Growth Follows Lending Standards Chart 10BCA C&I Loan Growth Model BCA C&I Loan Growth Model BCA C&I Loan Growth Model Bottom Line: Corporate spreads are in a "payback period" from 2014's energy shock that will allow them to tighten as corporate profits rebound, even though corporate leverage continues to trend higher. The weakening state of corporate balance sheets means spreads are at risk once monetary policy turns less accommodative. Ratings Trends & Shareholder Friendly Activities Chart 11Shareholder Friendly Activity Has Ebbed Shareholder Friendly Activity Has Ebbed Shareholder Friendly Activity Has Ebbed Our assessment of the cyclical back-drop for corporate spreads is primarily based on the combination of balance sheet quality - as determined by our Corporate Health Monitor and its underlying components - and the stance of monetary policy - as determined by the slope of the yield curve and C&I lending standards (among other factors). However, ratings migration and "shareholder friendly" activities have also historically provided advance notice of turns in the credit cycle. Net transfers to shareholders, i.e. payments to shareholders in the form of dividends and buybacks, are a direct transfer of capital from bondholders to equityholders. These transfers tend to rise late in the cycle, just before defaults start to increase and spreads start to widen (Chart 11). Net transfers to shareholders had been moving higher, but have recently rolled over. Similarly, ratings downgrades related to shareholder transfers have also moderated (Chart 11, panel 2). Historically, ratings migration related to "shareholder friendly" activities has been a more reliable indicator of the credit cycle than overall ratings migration. It has tended to move into "net downgrade" territory later in the cycle, closer to the onset of recession (Chart 11, panel 3). Ratings trends and transfers to shareholders are not flagging any imminent risk of spread widening. However, there is the additional risk that downgrades have simply not kept pace with the actual deterioration in credit quality of the nonfinancial corporate sector. Using firm-level data, we calculated the percent of high-yield rated companies with net debt-to-EBITDA ratios above 5. We see that actual ratings migration is too low relative to the number of highly-levered firms (Chart 11, bottom panel). It is possible that ratings agencies have already incorporated the rebound in energy prices and profit growth into their assessments while the actual debt-to-EBITDA data are lagging, but this is still a risk that bears monitoring. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Reflation Window Still Open", dated April 4, 2017, available at usbs.bcaresearch.com 2 The U6 unemployment rate is a broader measure than the headline (U3) unemployment rate. It also includes those "marginally attached" to the labor force and those working part-time for economic reasons. 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 4 https://www.federalreserve.gov/newsevents/speech/brainard20170301a.htm 5 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com Appendix Chart 12Corporate Health Monitor Components Corporate Health Monitor Components Corporate Health Monitor Components Box 1: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole (Chart 12). These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The rally in risk assets appears to have stalled, raising fears that the misnamed "Trump Trade" has ended. Investors are attaching too much importance to the reality show in Washington and not enough to the fundamentals underpinning the acceleration in global growth and corporate earnings. For now, these fundamentals are strong, and should remain so for the next 12 months. Beyond then, the impulse from easier financial conditions will dissipate and policy will turn less friendly, setting the stage for a major slowdown - and possibly a recession - in 2019. Stay overweight global equities and high-yield credit, but be prepared to reduce exposure next spring. Feature Risk Assets Hit The Pause Button After rallying nearly non-stop following the U.S. presidential election, risk assets have stalled since early March (Chart 1). The S&P 500 has fallen by 1.8% after hitting a record high on March 1st. Treasury yields have also backed off their highs and credit spreads have widened modestly. Globally, the picture has been much the same (Chart 2). The yen - a traditionally "risk off" currency - has strengthened, while "risk on" currencies such as the AUD and NZD have faltered. EM currencies have dipped, as have most commodity prices. Only gold has found a bid. Chart 1A Pause In Risk Assets In The U.S.... A Pause In Risk Assets In The U.S.... A Pause In Risk Assets In The U.S.... Chart 2...And Globally ...And Globally ...And Globally The key question for investors is whether all this merely represents a correction in a cyclical bull market for global risk assets, or the start of a more sinister trend. We think it is the former. Global Growth Still Solid For one thing, it would be a mistake to attach too much significance to the unfolding reality show in Washington. As we discussed in last week's Q2 Strategy Outlook,1 the recovery in global growth and corporate earnings began a few months before last year's election and would have likely continued regardless of who won the White House (Chart 3). For now, the global growth picture still looks reasonably bright. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 4). Consumer confidence is also soaring. If history is any guide, this will translate into stronger consumption growth in the months ahead (Chart 5). Chart 3Recovery Predates President Trump Recovery Predates President Trump Recovery Predates President Trump Chart 4Global Growth Backdrop Remains Solid Global Growth Backdrop Remains Solid Global Growth Backdrop Remains Solid Chart 5Rising Consumer Confidence Will Provide A Boost To Consumption Rising Consumer Confidence Will Provide A Boost To Consumption Rising Consumer Confidence Will Provide A Boost To Consumption The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 6 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will stay sturdy for the remainder of 2017. Stronger global growth should continue to power an acceleration in corporate earnings over the remainder of the year. Global EPS is expected to expand by 12.5% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 7 shows that the global earnings revisions ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Chart 6Easing Financial Conditions Will Support Activity In 2017 Easing Financial Conditions Will Support Activity In 2017 Easing Financial Conditions Will Support Activity In 2017 Chart 7Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Gridlock In Washington? As far as developments in Washington are concerned, it is certainly true that the failure to repeal and replace the Affordable Care Act has cast doubt on the ability of Congress to implement other parts of President Trump's agenda. Despite reassurances from Trump that a new health care bill will pass, we doubt that the GOP can cobble together any legislation that jointly satisfies the hardline views of the Freedom Caucus and the more moderate views of the Republicans in the Senate. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for Trump and the Republican Party. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). According to the Congressional Budget Office, the proposed legislation would have caused 24 million fewer Americans to have health insurance in 2026 compared with the status quo. The bill would have also reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. Now, that would have warranted lower bond yields and a weaker dollar. Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet Granted, the political fireworks over the past month serve as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy This is not to say that the "Trump Trade" won't fizzle out. It will. But that will be a story for 2018 rather than this year. This is because the disappointment for investors will stem not from the failure to cut taxes, but from the underwhelming effect that tax cuts end up having on the economy. The highly profitable companies that will benefit the most from lower corporate taxes are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the tax cuts will simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 8From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 8). In his Special Report on U.S. fiscal policy, my colleague Martin Barnes argues that "it is a FALLACY to describe overall non-defense discretionary spending as massively bloated and out-of-control."2 As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and major fiscal stimulus but end up getting neither. Investment Conclusions Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors should stay overweight global equities and high-yield credit at the expense of government bonds and cash. We prefer European and Japanese equities over the U.S., currency-hedged (See Appendix). As we discussed in detail last week, global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months. By historic standards, it will probably be a mild one. However, with memories of the Great Recession still fresh in most people's minds and President Trump up for re-election in 2020, the response could be dramatic. This will set the stage for a period of stagflation in the 2020s. Chart 9 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 9Market Outlook For Major Asset Classes The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com 2 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies And Fantasies," dated April 5, 2017, available at bca.bcaresearch.com. Appendix Tactical Global Asset Allocation Monthly Update We announced last week that we are making major upgrades to our Tactical Asset Allocation Model. In the meantime, we will send you a concise update of our recommendations every month based on a combination of BCA's proprietary indicators as well as our own seasoned judgement (Appendix Table 1). Appendix Table 2Global Asset Allocation Recommendations (Percent) The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet In a Special Report published last year, we laid out the quantitative factors that have historically predicted stock market returns. Appendix Chart 1 updates the output of that model for the U.S. It currently shows a slightly above-average return profile for the S&P 500 over the next three months. Appendix Chart 1S&P 500: Above Average Returns Over The Next 3 Months The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet Applying this model to the rest of the world yields a somewhat more positive picture for Europe and Japan, given more favorable valuations and easier monetary conditions in those regions. The technical picture has also improved in Europe and Japan. This is especially true with respect to price momentum: After a long period of underperformance, euro area equities have outpaced the U.S. by 11.5% in local-currency terms since last summer’s lows. Japanese stocks have suffered over the past few months, but are still up 12.5% against the U.S. over the same period (Appendix Chart 2). Turning to government bonds, the extreme bearish sentiment and positioning that prevailed in February and early March has been largely reversed, suggesting that the most recent rally in bonds could run out of steam (Appendix Chart 3). Looking ahead, yields are likely to rise anew on the back of strong economic growth and rising inflation. Thus, an underweight allocation to government bonds is warranted, particularly in the U.S. Appendix Chart 2Relative Performance Of Euro Area ##br##And Japanese Equities Troughed Last Summer Relative Performance Of Euro Area And Japanese Equities Troughed Last Summer Relative Performance Of Euro Area And Japanese Equities Troughed Last Summer Appendix Chart 3Rally In Bonds Could Soon Peter Out Rally In Bonds Could Soon Peter Out Rally In Bonds Could Soon Peter Out Clients should consult our Q2 Strategy Outlook for a more detailed discussion of the global investment outlook. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Chart 1Is Inflation Heating Up? Is Inflation Heating Up? Is Inflation Heating Up? In past reports we have argued that as long as inflation (and inflation expectations) are below the Fed's target, then the "reflation trade" will remain in vogue. In other words, with inflation still too low, the Fed has an incentive to back away from its hawkish rhetoric whenever risk assets sell off and financial conditions tighten. But with inflation heating up - the last two monthly increases in core PCE are close to the highest seen in this recovery (Chart 1) - will the Fed become less responsive? Not yet! Year-over-year core PCE is still only 1.75% (the Fed's target is 2%) and the cost of inflation protection embedded in long-dated TIPS remains too low (panel 2). In fact, the uptrend in TIPS breakevens lost some of its momentum last month alongside wider credit spreads and the S&P 500's first monthly decline since October. In this environment, we are inclined to add credit risk as spreads widen and believe a "buy the dips" strategy will work until inflation pressures are more pronounced. On a 6-12 month horizon we continue to recommend: below-benchmark duration, overweight spread product, curve steepeners and TIPS breakeven wideners. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 15 basis points in March. The index option-adjusted spread widened 3 bps on the month and, at 118 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 fact, leverage showed a marked increase in Q4 2016 even though spreads moved tighter. The measure of gross leverage (total debt divided by EBITD) shown in Chart 2 increased in the fourth quarter even though total debt grew at an annualized rate of only 0.3%. However, EBITD actually contracted at an annualized rate of 7% in Q4 causing leverage to rise. The quarterly decline in EBITD looks anomalous, and the year-over-year trend is improving (panel 4). In fact, we would not be surprised to see leverage stabilize this year as profits rebound.1 But similarly, we also expect that the recent plunge in debt growth will reverse. Historically, it has been very rare for leverage to fall unless prompted by a recession. We will take up this issue in more detail in next week's report. Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3), and we remain overweight. This week we also downgrade the Retailers and Packaging sectors, which have become expensive, and upgrade Cable & Satellite, which appears cheap. Table 3A Reflation Window Still Open Reflation Window Still Open Table 3B Reflation Window Still Open Reflation Window Still Open High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 25 basis points in March. The index option-adjusted spread widened 20 bps on the month and, at 383 bps, it is currently 136 bps below its historical average. Given the favorable policy back-drop described on page 1, we view the recent widening in junk spreads (Chart 3) as an opportunity to increase exposure to the sector. In fact, in a recent report2 we tested a strategy of "buying dips" in the junk bond market in different inflationary regimes. The strategy involved buying the High-Yield index whenever spreads widened by 20 bps or more in a month and then holding that position for 3 months. We defined the different inflationary regimes based on the St. Louis Fed's Price Pressures Measure (PPM).3 We found that our "buy the dips" strategy yielded positive excess returns 65% of the time in a very low inflation regime (PPM < 15%), 59% of the time in a low inflation regime (15% < PPM < 30%), 44% of the time in a moderate inflation regime (30% < PPM < 50%) and only 25% of the time in a high inflation regime (50% < PPM < 70%). Currently, the reading from the PPM is 13%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in March. The conventional 30-year MBS yield rose 6 bps on the month, driven entirely by a 6 bps increase in the rate component. The compensation for prepayment risk (option cost) declined by 6 bps, but this was exactly offset by a 6 bps widening in the option-adjusted spread. As a result, the zero-volatility spread was flat on the month. The option-adjusted spread represents expected excess returns to MBS assuming that prepayments fall in line with expectations. On this basis, MBS look more attractive than they have for some time (Chart 4). However, net MBS issuance also surged in Q4 2016 (panel 4) and should remain robust this year despite higher mortgage rates.4 Interest rates have not been a deterrent to mortgage demand since the financial crisis. The limiting factors have been a lack of household savings and restrictive bank lending standards. Both of these headwinds continue to gradually fade. The option-adjusted spread still appears too low relative to issuance. Nominal MBS spreads are linked to rate volatility (bottom panel), and volatility should increase as the fed funds rate moves further off its zero-bound.5 The wind-down of the Fed's MBS portfolio - which we expect will begin in 2018 - should also pressure implied volatility higher as the private sector is forced to absorb the increased supply, some of which will be convexity-hedged. 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 22 basis points in March. The high-beta Sovereign and Foreign Agency sectors outperformed by 71 bps and 41 bps, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors outperformed by 9 bps and 15 bps, respectively. Local Authorities underperformed the Treasury benchmark by 17 bps. The performance of Sovereigns has been stellar this year, as the sector has benefited from a 3% depreciation in the trade-weighted dollar (Chart 5). However, the downtrend in the dollar looks more like a temporary reversal than an end to the bull market. With U.S. growth on a strong footing, there is still scope for global interest rate differentials to move in favor of the dollar. Potential fiscal policy measures - such as lower tax rates and a border-adjusted corporate tax - would also lead to a stronger dollar, if enacted. As such, we do not believe the current outperformance of Sovereigns can be sustained. We continue to recommend overweight allocations to Foreign Agencies and Local Authorities, alongside underweight allocations to the rest of the Government-Related index. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 24 basis points in March (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio declined 2% on the month and remains firmly anchored below its post-crisis average. This year's decline in M/T yield ratios has been concentrated at the short-end of the curve (Chart 6), and long maturities now offer a significant valuation advantage. This week we recommend favoring the long-end of the Aaa Muni curve (10-year maturities and beyond) versus the short-end (maturities up to 5 years). Overall, M/T yield ratios appear fairly valued on a tactical basis. While fund inflows have ebbed in recent weeks (panel 4), this has occurred alongside a plunge in gross issuance (bottom panel). The more concerning near-term risk for Munis is that yield ratios have already discounted a substantial improvement in state & local government net borrowing (panel 3). However, we expect net borrowing to decline during the next couple of quarters on the back of rising tax revenues. State & local government tax receipts decelerated throughout most of 2015 and 2016 alongside falling personal income growth and disappointing retail sales. However, both income growth and retail sales have moved higher in recent months, and this should soon translate into accelerating tax receipts and lower net borrowing. Longer term, significant risks remain for the Muni market.6 Chief among them is that state & local government budgets now finally look healthy enough to increase investment spending. Not to mention the significant uncertainty surrounding the potential for lower federal tax rates and plans to invest in infrastructure. 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 underwent a small parallel shift upward in March, roughly split between a bear-steepening leading up to the FOMC meeting on March 15 and a bull-flattening from the meeting until the end of the month. Overall, the 2/10 Treasury slope flattened 1 basis point on the month and the 5/30 slope ended the month 1 bp steeper. Our recommended position long the 5-year bullet and short the 2/10 barbell - designed to profit from a steeper yield curve - returned +3 bps in March and is up 7 bps since inception on December 20. In addition, we also entered a short January 2018 fed funds futures trade on March 21.7 The performance of this trade has so far been flat. In a recent report,7 we identified the main cyclical drivers of the slope of the yield curve as: The fed funds rate (higher fed funds rate = flatter curve) Inflation expectations (higher inflation expectations = steeper curve) Interest rate volatility (higher volatility = steeper curve) Unit labor costs (higher unit labor costs = flatter curve) We concluded that even though the Fed is in the process of lifting the funds rate, the yield curve likely has room to steepen as long-maturity TIPS breakevens recover to levels more consistent with the Fed's inflation target (Chart 7). In addition, interest rate volatility has likely bottomed for the cycle and the uptrend in unit labor costs could level-off if productivity growth continues to rebound. The recent decline in bullish sentiment toward the dollar has also not yet been matched by a steeper 5/30 slope (bottom panel). TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 6 basis points in March. The 10-year TIPS breakeven rate declined 5 bps on the month and, at 1.97%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. While the catalyst for the recent softening in TIPS outperformance seems to be the hawkish re-rating of Fed rate hike expectations, the uptrend in TIPS breakevens was probably due for a pause in any case. Breakevens had become stretched relative to our TIPS Financial Model - based on the dollar, oil prices and the stock-to-bond total return ratio. However, measures of pipeline inflation pressure - such as the ISM prices paid survey (Chart 8) - still point toward wider breakevens and, as was noted on the front page of this report, recent core inflation prints have been quite strong. All in all, growth appears strong enough that core inflation should continue its gradual uptrend and, more importantly, the Fed will be keen to accommodate an increase in both realized core inflation and TIPS breakevens, which remain below target. This means that in the absence of a material growth slowdown, long-maturity TIPS breakevens should continue to trend higher until they reach the 2.4% to 2.5% range that historically has been consistent with the Fed's inflation target. In a baseline scenario where the unemployment rate is 4.7% at the end of the year and the dollar remains flat, our Phillips curve model8 predicts that year-over-year core PCE inflation will be 2.02% at the end of this year. ABS: Maximum Overweight Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +22 bps. Aaa-rated issues outperformed the Treasury benchmark by 16 bps on the month, and non-Aaa issues outperformed by 26 bps. The index option-adjusted spread for Aaa-rated ABS tightened 5 bps on the month. At 48 bps, the spread remains well below its average pre-crisis level (Chart 9). 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, it is usually an indication that there is growing concern about ABS collateral credit quality. As such, this week we scale back our recommended allocation to ABS from maximum overweight (5 out of 5) to overweight (4 out of 5). While credit card charge-offs remain well below pre-crisis levels, net losses on auto loans have started to trend higher (bottom panel). We continue to favor Aaa-rated credit cards over Aaa-rated auto loans, despite the modest spread advantage in autos (panel 3). Further, the spread advantage in Aaa consumer ABS relative to other high-quality spread product is becoming less compelling. Aaa ABS now only provide a 12 bps option-adjusted spread cushion relative to conventional 30-year Agency MBS and offer a slightly lower spread than Agency CMBS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency commercial mortgage-backed securities underperformed the duration-equivalent Treasury index by 10 basis points in March, dragging year-to-date excess returns down to +16 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 4 bps on the month, but remains below its average pre-crisis level. Commercial real estate prices are still growing strongly, and prices in both major and non-major markets have re-gained their pre-crisis peaks (Chart 10). However, lending standards are tightening and, more recently, loan demand has rolled over (panel 4). This suggests that credit risk is starting to increase in commercial real estate, as do CMBS delinquencies which have put in a bottom (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in March, bringing year-to-date excess returns up to +16 bps. The index option-adjusted spread for Agency CMBS tightened 2 bps on the month, and currently sits at 53 bps. The option-adjusted spread on Agency CMBS looks attractive compared to other high-quality spread product: Agency MBS = 36 bps, Aaa consumer ABS = 48 bps, Agency bonds = 18 bps and Supranationals = 22 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 2.54% (Chart 11). Our 3-factor version of the model, which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.28%. 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. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.35%. 1 For further detail on the medium-term profit outlook please see The Bank Credit Analyst, February 207, dated January 26, 2017, available at bca.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 8, 2017, available at usbs.bcaresearch.com 3 A composite of 104 economic indicators designed to capture the probability of PCE inflation exceeding 2.5% during the subsequent 12 months. https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure 4 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 8 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)

Highlights Recommended Allocation Quarterly - April 2017 Quarterly - April 2017 The sweet spot of non-inflationary accelerating growth is likely to continue. European politics will fade as a risk, and Trump should still be able to get tax cuts through. We continue to be positive on risk assets on a one-year horizon, though returns are unlikely to be as good as in the past 12 months and there is a risk of the next recession arriving in 2019. Our portfolio tilts are generally pro-risk and pro-cyclical. We are overweight equities versus fixed income. We move overweight euro area equities, which should benefit from inexpensive valuations, higher beta and a falling political risk premium. Within fixed income, we prefer credit over government bonds, and raise high-yield debt to overweight on improved valuations. We expect the dollar to appreciate further, which makes us cautious on emerging market assets and industrial commodities. Feature Overview No Reasons To Turn Cautious Markets have paused for breath following the reflation trade that began a year ago and that was given an extra boost by the election of Donald Trump in November. Since the turn of the year, the dollar, U.S. 10-year Treasury yields, credit spreads and (to a degree) equities have all eased back a little (Chart 1). We don't think the risk-on rally is over, but the going will undoubtedly get tougher from here. The momentum of global growth cannot continue to rise at the same pace, with the Global PMI already at its highest level since 2011 (Chart 2). Global equities, therefore, are unlikely to return the 16% over the next 12 months, that they have over the past 12. Chart 1A Pause For Breath A Pause For Breath A Pause For Breath Chart 2Growth Momentum Must Slow From Here Growth Momentum Must Slow From Here Growth Momentum Must Slow From Here Nonetheless, we see nothing that is likely to stop risk assets continuing to outperform over the one-year horizon: Growth is likely to rise further. While the initial pick-up was in "soft" data such as consumer sentiment and business confidence, signs are emerging that "hard" data such as household spending and production are now also improving (Chart 3). Models developed by our colleagues on The Bank Credit Analyst indicate that real GDP growth in the U.S. this year will come in above 3% and in the euro area above 2% (Chart 4),1 compared to consensus forecasts of 2.2% and 1.6% respectively. Chart 3Hard Data Also Not Picking Up Hard Data Also Not Picking Up Hard Data Also Not Picking Up Chart 4GDP Growth Could Beat Consensus GDP Growth Could Beat Consensus GDP Growth Could Beat Consensus For now, this growth is unlikely to prove inflationary. In the U.S. the diffusion index for PCE inflation shows more prices in the basket falling than rising; in the eurozone, the rise to 2% in headline inflation in January was temporary, mainly because of higher oil prices, and core inflation remains at only 0.7%. The U.S. output gap will close soon, but the eurozone's is still deeply negative (Chart 5). We see the Fed raising rates twice more this year, in line with its dots, though it may have to accelerate the pace next year if the Trump administration succeeds in passing fiscal stimulus. The ECB, however, is unlikely to raise rates until 2019 and will taper asset purchases only slowly.2 Misplaced worries that it will tighten more quickly than this have recently dragged on European equities and strengthened the euro. We think the market is wrong to price out the probability of a tax cut in the U.S. just because of the Trump administration's failure to reform healthcare. Our Geopolitical strategists argue that Republicans in Congress (even the Freedom Caucus) are united behind the idea of cutting taxes, even if these are not funded by tax reforms or spending cuts (they can be justified on the grounds of "dynamic scoring").3 We see a cut in corporate and personal taxes passing before year-end to take effect in 2018. And Trump has not abandoned the idea of infrastructure spending. The market no longer expects any of this: the prices of stocks that would most benefit from lower corporate taxes or from government spending have reverted to their pre-election levels. European political risk is likely to wane. The market continues to worry about the possibility of Marine Le Pen winning the French Presidential election, as shown in the spread of OATs over Bunds (which has widened to 60-80 bp from 20 bp last summer). We think this very unlikely: polls show her consistently at least 20 points behind Emmanuel Macron in the second round of voting (Chart 6). While Italian politics remain a risk, the parliamentary election there is unlikely to take place until March 2018. Brexit is a threat to the U.K., but should have minimal impact on the eurozone. We retain, therefore, our pro-cyclical and pro-risk tilts on a 12-month time horizon. We have even added a little more beta to our recommended portfolio by raising high-yield bonds to overweight (since their valuations now look more attractive after a recent sell-off) and by going overweight eurozone stocks (paid for by notching down our double-overweight in U.S. stocks). The eurozone has consistently been a higher beta (Chart 7), more cyclical equity market than the U.S. and, once the political risks (at least temporarily) subside, should be able to outperform for a while. Chart 5Eurozone Output Gap Still Very Negative Eurozone Output Gap Still Very Negative Eurozone Output Gap Still Very Negative Chart 6Can Le Pen Really Win From Here? Can Le Pen Really Win From Here? Can Le Pen Really Win From Here? Chart 7Eurozone Is A High Beta Stock Market Eurozone Is A High Beta Stock Market Eurozone Is A High Beta Stock Market But we warn that the good times may not last for long. Tax cuts in the U.S. would add stimulus to an economy already at full capacity. The Fed might have to raise rates sharply next year (although the timing might depend on how President Trump tries to affect monetary policy, for example whom he appoints as Fed chair to replace Janet Yellen next February). U.S. recessions have typically come two or three years after the output gap turns positive (Chart 5). As Martin Barnes, BCA's chief economist, recently wrote,4 that may point to next recession arriving as soon as 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Chart 8Expensive, But Not At An Extreme Expensive, But Not At An Extreme Expensive, But Not At An Extreme Aren't You Worried About U.S. Equity Valuations? Valuation is a poor timing tool in the short term but, when it reaches extremes, it has historically added value. The valuation metrics we watch show that U.S. equities are expensive, but not at the extreme levels that have historically warranted an outright sell or underweight. First, according to MSCI, U.S. equities are currently trading at 24.4 times 12-month trailing earnings, and 25.7 times 10-year cyclically-adjusted earnings; both measures are about one standard deviation from their 10-year averages. Second, U.S. equities are trading at a premium to global equities, but the premium to the developed markets is in line with the 10-year average (Chart 8, panel 1), while the premium to emerging markets is about 1.5 standard deviations from the 10-year average (panel 2). Third, equities are cheap compared to fixed income: the earnings yield is still higher than the yields on both 10-year government bonds and investment grade corporate bonds, and the yield gaps are currently only slightly lower (more expensive) than their respective 10-year averages (panels 3 and 4). In the long run, the 10-year cyclically-adjusted PE (CAPE) has had relatively good forecasting power for 10 year forward returns. Currently, the regression indicates 143% (9.3% annualized) total returns over the next 10 years. This could be on the optimistic side given that we are no longer in an environment of declining bond yields and margins are elevated compared to the 1990s. That said, we have cut our U.S. equity overweight by half, partly due to valuation concerns. Is EM Debt Attractive? Chart 9Avoid EM Debt Avoid EM Debt Avoid EM Debt Emerging market debt has continued its run from last year, with sovereign and local currency debt providing YTD returns of 3% and 2% respectively. Over long periods, EM debt has displayed the ability to provide substantial returns while also providing robust diversification benefits to a 50/50 DM equity/bond portfolio, even more so than EM equities.5 However, over the cyclical horizon, we remain bearish on EM debt both in absolute terms and relative to global equities. EM fixed income markets have been able to defy deteriorating fundamentals for some time, but this is unsustainable. After years of leveraging, credit excesses will need to be unwound. Decelerating credit growth will be enough to dampen economic growth and damage emerging markets' ability to service their debt. Risks in EM sovereign debt markets are high. Historical returns have shown negative skewness and fat tails, suggesting high vulnerability to large downswings. This is particularly concerning given that yields are one standard deviation lower than their long-term average (Chart 9). While EM local currency debt is more fairly priced and has a more favorable risk/return profile than its sovereign debt counterpart, local currency debt returns are even more heavily influenced by their currencies. Above-trend growth in the U.S. leading to additional rate hikes, as well as rising U.S. bond yields and softer commodity prices will add further downward pressure to EM currencies. For EM dedicated investors, we suggest overweight positions in low beta/defensive markets. Regions that are less susceptible to currency weakness with high yields and low foreign funding requirements include Russia, India and Indonesia. How Will The Fed Shrink Its Balance Sheet, And Does It Matter? After the Fed's third rate hike, attention is turning to when it will begin to reduce its balance sheet. This has grown to $4.5 trillion, up from $900 billion before the Global Financial Crisis. Assets currently include $2.5 trillion of Treasury securities and $1.8 trillion of mortgage-related securities. Since asset purchases ended in October 2014, the Fed has rolled over maturing bonds to maintain the size of the balance sheet. The FOMC statement last December committed to maintaining this policy "until normalization of the level of the federal funds rate is well under way". The market takes this to mean 1-1.5%, a level likely to be reached by year-end. The view of BCA's fixed income team6 is that the Fed will start by ceasing reinvestment of Agency bonds and mortgage-backed securities (MBS) in 2018, at the same time reducing excess bank reserves on the liability side of the balance sheet (Chart 10). This will worry markets to a degree and the Fed will need to be careful how it communicates the policy: for example what size it thinks its balance sheet should ultimately be. It may also need to skip a rate hike or two in the first months of the shrinkage. The MBS market is likely to suffer from the increased supply. But the only historical precedent - the BoJ's unwinding of its 2000-3 QE - is reassuring: this had no discernible effect on rates or the yen (Chart 11). Chart 10Fed Will Cut MBSs First Fed Will Cut MBSs First Fed Will Cut MBSs First Chart 11Nobody Noticed The BoJ Taper Nobody Noticed The BoJ Taper Nobody Noticed The BoJ Taper When Will ECB Taper? Chart 12Recovery Not Permanent Recovery Not Permanent Recovery Not Permanent Euro area growth is recovering and headline inflation has hit the ECB's 2% target (Chart 12). Investors are wondering how rapidly the ECB will taper its asset purchases and when it will raise rates. Our view is that the ECB will move only slowly. The pickup in inflation is mostly driven by the base effect and by the rise in energy prices. The failure of core inflation, which remains below 1%, to pick up appreciably suggests that underlying price pressures are weak. The current program has the ECB purchasing EUR 60 Bn of assets each month until December 2017. Markets have recently become more hawkish with regards to the likely path of policy: currently futures are pricing in the first hike only 19 months away versus an expectations in January of 44 months. We expect the ECB to remain more dovish than that, given weak underlying inflation, political uncertainty, and banking system troubles. We think the ECB will announce around September this year a taper of its asset purchases in 2018. However, it is not clear whether it will cut them to, say EUR 30 Bn a month, or whether it will reduce the amount steadily each month or quarter. But we don't see an interest rate hike soon, since the euro area economy is not expected to reach full employment until 2019. Ewald Novotny, president of the Austrian central bank, spooked markets by suggesting a hike before complete withdrawal of asset purchases but, in our view, that would will send a confusing signal to investors. Nowotny has long been hawkish and we think his view is untypical of ECB council members. If our analysis is correct, ECB policy should be positive for euro area equities and bearish for the euro over the next 12 months. Will REIT Underperformance Continue? Chart 13Underweight REITs Underweight REITs Underweight REITs Relative REIT performance has continued its downtrend, underperforming the broad index by 5% YTD. While valuations have become more attractive and rental income is still robust, we expect the decline to continue given unsupportive macro factors. We previously argued that real estate is in a sweet spot, where economic growth was sufficient to generate sustainable tenant demand without triggering a new supply cycle.7 This is no longer the case. Office completions increased substantially over the past quarter and apartment completions remain in an uptrend. As we expect growth to remain robust in the U.S., the likelihood is that these two trends remain in place. REIT relative performance peaked at the beginning of August, shortly after long-term interest rates bottomed. REITs have historically outperformed when yields are falling and inflation is low (Chart 13). However, long-term rates should continue to rise over the cyclical horizon, primarily due to higher inflation expectations. Additionally, REITs typically benefit from increasing central bank asset purchases, as increased liquidity and lower interest rates boost real estate values. With the Fed clearly in tightening mode and the strong likelihood of ECB tapering next year, slowing asset purchases will be a considerable headwind to REIT performance. Within REITs, we maintain our sector tilts. Continue to favor Industrials, which will benefit in a rising USD environment and provide considerable income. Maintain underweight position in Apartments, due to rising completions and a low absorption ratio. Additionally, we continue to favor trophy over non-trophy markets given more stable rent growth as well as geopolitical risks in Europe and potential Washington disappointments. Global Economy Overview: The global economy has continued to recover from its intra-cycle slowdown in late 2015 and early 2016. Economic surprise indexes have everywhere surprised significantly on the upside since mid-2016 (Chart 14, panel 1). Although "hard" data (consumption, production etc.) have lagged "soft" data (consumer sentiment, business confidence), the former also have begun to recover recently. Although there are few negative indicators, it will get harder to beat expectations. U.S.: Lead indicators continue to improve, with the manufacturing ISM at 57.7 and new orders at 65.1. Sentiment quickly turned bullish after the presidential election, and hard data has now started to follow, with personal consumption expenditure rising 4.7% year on year and capital goods orders (+2.7% YoY in February) growing for the first time since 2014. With steady wage growth, continuing employment improvements, and a likely pick-up in capex, we expect 2017 GDP growth to beat the current consensus expectations of 2.2%. For now inflation remains quiescent, with core PCE inflation stuck at around 1.8%, below the Fed's 2% target. Euro Area: Leading indicators, such as PMIs, have rebounded in Europe too (Chart 15), suggesting that the consensus 2017 GDP forecast of 1.6% is achievable. Inflation has picked up, with the headline CPI 2.0% for the Eurozone in January, but core inflation remains low at 0.7% and headline fell back to 1.5% in February. However, the recent slowdown in bank loan growth (new credit creation is 36% below the level six months ago) suggests that continuing weakness in the banking sector is likely to keep growth sluggish. Chart 14How Long Can Growth Continue To Surprise? How Long Can Growth Continue To Surprise? How Long Can Growth Continue To Surprise? Chart 15A Synchronized Global Growth Rebound A Synchronized Global Growth Rebound A Synchronized Global Growth Rebound Japan is a tale of two segments. International-oriented data have recovered, with IP up 3.7% (Chart 15, panel 2) and exports +5.4% year on year. But domestic demand remains weak: wages are rising only 0.5% YoY (despite a tight labor market), which is holding back household spending (-1.2% YoY in January). Core inflation has shown the first signs of picking up, but remains very low at 0.1% YoY. Emerging Markets: The effects of China's reflationary policies from early 2016 continue to boost activity (Chart 15, panel 3). But the excess liquidity they triggered worries the authorities, who have clamped down on real estate purchases and capital outflows, slowed fiscal spending, and tightened monetary policy. China will prioritize stability until the Party Congress in the fall, but the impact of reflation on commodity prices and on other emerging markets will fade. Interest rates: The Fed is likely to hike twice more this year in line with its "dot plot", unless inflation surprises significantly to the upside. This, plus an acceleration of nominal GDP growth to 4.5-5%, should push the 10-year bond yield above 3% by year end. The ECB will not be as hawkish as the market expects (futures markets indicate a rate hike by end-2018), since Mario Draghi expects headline inflation to fall back once the oil price stabilizes and is concerned about political risk especially in Italy. Consequently, rates are unlikely to rise as quickly as in the U.S. The Bank of Japan will keep its 0% yield target for 10-year JGB for the foreseeable future. Global Equities Global equities continued to make impressive gains in Q1 2017, after a strong 2016. The price appreciation since the low in February 2016 has been driven by both multiple expansion and earnings growth, roughly in equal proportion, as shown in Chart 16, panel 1. Chart 16Earnings Improving But Valuation Stretched Earnings Improving But Valuation Stretched Earnings Improving But Valuation Stretched Equity valuation is expensive by historical standards but, as an asset class, equities are still attractively valued compared to bonds (see the "What Our Clients Are Asking" section on page 6). In this "TINA" (There Is No Alternative) world, we remain overweight equities versus bonds. Within equities, we maintain our call of favoring DM equities versus EM equities despite of the 6% EM outperformance in Q1, which was supported by attractive valuations. About half of that outperformance came from the appreciation of EM currencies versus the USD. Our house view is that the USD will strengthen further versus the EM currencies. Within EM, we have been more positive on China and remain so on a 6-9 month horizon. The only adjustment we make now is to upgrade euro area equities to overweight by reducing half of our large overweight in the U.S. so that now we are equally overweight the U.S. and euro area (see details on the next page). In terms of global sector positioning, we maintain a pro-cyclical tilt. Our largest overweight in Healthcare panned out very well in Q1 but the overweight in Energy did not, due to the drop in oil prices. Our Energy strategists believe this was caused by one-off technical factors on the supply side, and argue that the oil price will soon revert to $55 a barrel. Euro Area Equities: A Cheaper Alternative To The U.S. Political risks related to elections in some eurozone countries are receding. The ECB is likely to maintain its easy monetary policies, while the Fed is on track to normalize interest rates in the U.S. We have had a large overweight of 6 percentage points (ppts) on U.S. equities while being neutral on the euro area. We upgrade the eurozone to overweight by 3 ppts, so that we are now equally overweight the U.S. and the euro area. The following are the reasons: First, the relative performance of total returns between eurozone and the U.S. equities is at its lowest since 1987. Since April 2015, when the most recent brief period of eurozone outperformance ended, eurozone equities have underperformed the U.S. by over 16% in common currency terms (Chart 17, panel 1), while the euro lost only about 4% versus the USD over the same period. Second, eurozone equities are trading at a 22% discount to the U.S., compared to the five-year average discount of 17% (panel 3). Third, eurozone equities have lower margins than the U.S., but the profit margin in the eurozone has been improving (panel 2). Lastly, the PMIs in the euro area have been improving (panel 4) and this improvement is faster than the global aggregate PMI (panel 5), which implies - based on the close correlation between PMIs and earnings growth - that profitability in the eurozone should improve at a faster pace than the global average. Sector Allocation: We have had a relatively pro-cyclical tilt in our global sector positioning, overweight three cyclical sectors (Energy, Industrials and Info Tech) plus Healthcare, while underweight three defensive sectors (Consumer Staples, Telecoms and Utilities) as well as Consumer Discretionary. We have been neutral on Financials and Materials. After very strong performance in 2016, cyclical sectors underperformed in Q1 2017 (Chart 18, panel 1). The underperformance of cyclicals versus defensives can be largely attributed to the polar-opposite performance of Energy and Healthcare (Chart 19). Going forward, we maintain our current sector positioning for the following reasons: Chart 17Earnings Growth At Lower Valuation Earnings Growth At Lower Valuation Earnings Growth At Lower Valuation Chart 18Maintain The Cyclical Tilt Maintain The Cyclical Tilt Maintain The Cyclical Tilt Chart 19Global Sector Performance Quarterly - April 2017 Quarterly - April 2017 First, Energy was the only sector which fell in Q1, largely due to the decline in oil prices. BCA's Energy and Commodity Strategy attributes the oil price weakness to inventory buildup related to the production rush before the OPEC agreement to cut production, and therefore expects the WTI oil price to return to the $50-55 range. Energy stocks should benefit once oil prices turn back up. Chart 20Relative Factor Performance Relative Factor Performance Relative Factor Performance Second, the relative profitability between cyclicals and defensives is underpinned by global economic conditions, as represented by the global PMI. The PMI is on track to recover further, which bodes well for the profit outlook for cyclicals versus defensives. Third, our pro-cyclical tilt in sector positioning is hedged by an overweight in Healthcare (a defensive sector) and underweight in Consumer Discretionary (a cyclical). Smart Beta Update: No Style Bet Q1 2017 saw some significant performance reversals in the five most enduring factors: quality, minimum volatility, momentum, value, and size (Chart 20, panels 2-6). Quality and Momentum performed the best, outperforming the global benchmark by over 200 bps in Q1. The star performer in 2016, the Value factor, performed the worst, underperforming by 190 bps. According to the findings in our Special Report,8 recent factor performance seems to be pricing in a "Goldilocks" environment in which growth is rising and inflation falling. We have shown that it is very difficult to time the shift in factor performance cycles and so have advocated an equal weight in the five factors (Chart 20, panel 1) for long-term investors. We reiterate this view. Government Bonds Maintain slight underweight duration. Our 2-factor model made up of global PMI and U.S. dollar sentiment indicates the current fair value of the 10-year Treasury yield is 2.4% (Chart 21). While this suggests bonds are currently correctly priced, we still expect that long-term yields will rise over a cyclical horizon. The long end should grind higher given improving growth, rising equity prices and renewed "animal spirits." Additionally, large net short positions have been unwound, allowing for another leg higher in yields. Overweight TIPS vs. Treasuries. Diffusion indexes for both PCE and CPI inflation shifted into negative territory, suggesting realized inflation will soften in the near term. Nevertheless, with headline and core CPI readings of 2.7% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 22). This trend should continue as a result of cost-push inflation driven by faster wage growth. Very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Euro area growth is stable, but expectations of a rate hike from the ECB are premature (Chart 23). While the central bank opened the door slightly to a less-accommodative policy stance, it is unlikely that the ECB will hike until full employment is reached. Our expectation is for a tapering of asset purchases to occur in 2018. Once tapering is complete, rate hikes will follow by approximately 6-12 months. The implication is upward pressure on European bond yields and wider spreads for peripheral government debt. Chart 2110-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model Chart 22Inflation Has Bottomed Inflation Has Bottomed Inflation Has Bottomed Chart 23Will the ECB Hike Soon? Will the ECB Hike Soon? Will the ECB Hike Soon? Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 24). Over the last quarter, the indicator worsened, as profit margins, return-on-capital and liquidity declined. However, leverage did improve slightly. The trend toward weaker corporate health has been firmly established over the past 12 quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. The U.S. is in a self-reinforcing, low-inflation recovery. Economic growth should accelerate throughout 2017, with strong consumer spending, rising capex intentions, and still accommodative monetary policy. The potential sell-off from rate hikes this year should be fairly mild given that the market is already close to pricing in three. Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. Expect low but positive excess returns (Chart 25). Shift to overweight in high-yield debt. Our default model is showing improvement due to elevated interest coverage, a robust PMI reading, declining job cut announcements, softening lending standards and a rising sales/inventory ratio. The recent backup in yields has made junk bond valuations more attractive. The default adjusted spread, calculated by subtracting an ex-ante estimate of default losses from the average spread, is now approximately 220bps (Chart 26). Chart 24Balance Sheets Deteriorating Balance Sheets Deteriorating Balance Sheets Deteriorating Chart 25A Supportive Backdrop A Supportive Backdrop A Supportive Backdrop Chart 26High Yield: Valuations Becoming More Attractive High Yield: Valuations Becoming More Attractive High Yield: Valuations Becoming More Attractive Commodities Chart 27Upside To Resource Prices Limited Upside To Resource Prices Limited Upside To Resource Prices Limited Secular Perspective: Bearish A slowdown in Chinese activity, led by its transition to a services economy, coupled with unfavorable global demographics, will continue to constrain demand for commodities. This slack in demand coupled with excess capacity will continue to limit the upside in resource prices and prolong the commodities bear market which began in 2012 (Chart 27). Cyclical Perspective: Neutral Energy markets have moved from excess supply to excess demand, and so we remain positive on oil. But, with the impact of Chinese fiscal stimulus waning, excess supply in the metals market will persist, putting downward pressure on prices. Our divergent outlook for energy vs metals gives us an overall neutral view for commodities over the cyclical horizon. Energy: With a synchronized upturn in global growth and inflation, both OECD and non-OECD demand will remain strong. Following Saudi Arabia's production cuts, we expect the OPEC agreement to be honored by all members, including Russia. With strengthening demand and falling production, storage should draw through the year. We expect the oil-USD divergence to persist as improving fundamentals override the stronger dollar. Base Metals: With Chinese government spending slowing from 24% growth year on year in January 2016 to only 4%, the country's fiscal impulse has ended. Tightening in Chinese liquidity conditions have led to higher borrowing rates for the real estate sector, which is dampening its demand for materials. At the same time, inventories for key metals such as copper and steel have risen. We expect metals prices to correct over the coming months. Precious Metals: Gold has rallied 10% from last December, and another 4% following the Fed's March rate hike. These were responses to the dovish nature of the hike and continuing political risk. We expect the Fed to turn more hawkish in coming weeks, sending the dollar and real yields higher, thereby holding back the gold price from rising much further. Currencies Chart 28Return Of The Dollar Return Of The Dollar Return Of The Dollar USD: The last Fed meeting resulted in a dovish hike, as evidenced by the subsequent fall in the dollar. However, as the U.S. economy nears full employment, we expect a more hawkish tone from FOMC members in the coming weeks which will push the dollar up (Chart 28). The Fed continues to be data dependent, and sees the recent synchronized global upturn as an opportunity to deliver hikes in line with market expectations. Euro: As the economy stabilizes, as evidenced by rising headline inflation, stronger retail sales and improving PMI numbers, the ECB has opened the window for reducing monetary accommodation. However, since the economy is expected to reach full employment only in 2019, we expect rates to be kept low even after the tapering of ECB asset purchases starts next year. This will add further downward pressure on the euro. Yen: The Bank of Japan will continue its highly accommodative monetary policy, centered on its 0% yield target for 10-year government bonds, because Japanese growth and inflation is lagging the global upturn. Japan is benefitting from global growth, as seen in the improvement in its manufacturing PMI, but domestic demand remains weak as consumer confidence and retail sales stagnate. Continued downward pressure on relative interest rates will drive the only reliable source of inflation: a weaker yen. EM: A more hawkish Fed and rising bond yields will tighten global liquidity conditions, making it difficult for emerging nations that run current account deficits. The rising threat of protectionism could affect EM exports and create a new wave of deflationary pressure, forcing central banks to engineer currency devaluation. The fact that commodity prices have risen, yet EM currencies have remained weak, is a clear indications that EM fundamentals are weak. Alternatives Overweight private equity / underweight hedge funds. Leading indicators suggest that global growth continues to improve. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a boost to returns. Additionally, surveys suggest that managers are planning on increasing their allocation percentage toward private equity over the rest of the year. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 29). Overweight direct real estate / underweight commodity futures. Demand for commercial real estate (CRE) assets remains robust but the increase in completions is worrying. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 30). Overweight farmland & timberland / underweight structured products. The potential for trade wars, geopolitical risk in Europe and concerns over an equity market correction have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, the end of the 35-year bull market in bonds presents a substantial headwind. Structured products also tend to outperform during recessions, which is not our base case (Chart 31). Chart 29PE: Tied To Real Growth PE: Tied To Real Growth PE: Tied To Real Growth Chart 30Commodities: A Secular Bear Market Commodities: A Secular Bear Market Commodities: A Secular Bear Market Chart 31Structured Products Outperform In Recessions Structured Products Outperform In Recessions Structured Products Outperform In Recessions Risks To Our View Our pro-cyclical pro-risk tilts are based on the premise that global growth will remain strong over the next 12 months. We do not see many risks to this view: leading indicators suggest that consumption and capex are likely to continue to rebound. The one major indicator that suggests downside risk is loan growth. In the U.S., loans to firms have slowed to 5.4% from over 10% last summer, and in the euro area the meager pickup in corporate loan growth seems to have faltered (Chart 32). There may be some special factors: oil companies that borrowed in early 2016 when in difficulty no longer need to tap credit lines, and U.S. companies may be holding back to see details of tax cuts. But loan growth needs to be watched closely. More granularly, our country and sector preferences - in particular, our cautious views on Emerging Markets and industrial commodities - are based partly on the expectation that the U.S. dollar will appreciate further. If the global expansion remains highly synchronized (Chart 33) this might instigate all G7 central banks to tighten, allowing the Fed to raise rates without appreciating the dollar. However, we expect continuing divergences in growth and monetary policy to push the dollar up further. Finally, some indicators suggest that investors have become too positive on the outlook for stocks (Chart 34). Sentiment has in the past not been a reliable indicator of stock market peaks, but excess euphoria could trigger a short-term correction. Chart 32Why Is Bank Loan Growth Slowing? Why Is Bank Loan Growth Slowing? Why Is Bank Loan Growth Slowing? Chart 33Could Synchronized Growth Push Down USD? Could Synchronized Growth Push Down USD? Could Synchronized Growth Push Down USD? Chart 34Are Investors Too Euphoric? Are Investors Too Euphoric? Are Investors Too Euphoric? 1 Please see The Bank Credit Analyst, March 2017, page 33, available at bca.bcaresearch.com 2 Please see What Our Clients Are Asking: When Will The ECB Taper? on page 9 of this report for a full explanation of why we think this. 3 Please see Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was", dated March 8, 2017, available at gps.bcaresearch.com 4 Please see BCA Special Report titled "Beware The 2019 Trump Recession", dated March 7, 2017, available at bca.bcaresearch.com 5 Please see Global Asset Allocation Strategy Special Report, "EM Asset Allocation: Is There Any Reason To Own Stocks?," dated November 27, 2012, available at gaa.bcaresearch.com. 6 Please see Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet," dated February 28, 2017, available at gfis.bcaresearch.com. 7 Please see Global Asset Allocation Strategy Special Report, "REITs Vs. Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights Economic Outlook: The global economy is in a reflationary window that will stay open until mid-2018. Growth will then slow, culminating in a recession in 2019. While the recession is likely to be mild, the policy response will be dramatic. This will set the stage for a period of stagflation beginning in the early 2020s. Overall Strategy: Investors should overweight equities and high-yield credit during the next 12 months, while underweighting safe-haven government bonds and cash. However, be prepared to scale back risk next spring. Fixed Income: For now, stay underweight U.S. Treasurys within a global fixed-income portfolio; remain neutral on the euro area and the U.K.; and overweight Japan. Bonds will rally in the second half of 2018 as growth begins to slow, but then begin a protracted bear market. Equities: Favor higher-beta developed markets such as Europe and Japan relative to the U.S. in local-currency terms over the next 12 months. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is close to a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks in the middle of next year. Feature Reflation, Recession, And Then Stagflation The investment outlook over the next five years can be best described as a three-act play: First Act: "Reflation" (The present until mid-2018) Second Act: "Recession" (2019) Third Act: "Stagflation" (2021 onwards) Investors who remain a few steps ahead of the herd will prosper. All others will struggle to stay afloat. Let us lift the curtain and begin the play. Act 1: Reflation Reflation Continues If there is one chart that best encapsulates the reflation theme, Chart 1 is it. It shows the sum of the Citibank global economic and inflation surprise indices. The combined series currently stands at the highest level in the 14-year history of the survey. Consistent with the surprise indices, Goldman's global Current Activity Indicator (CAI) has risen to the strongest level in three years. The 3-month average for developed markets stands at a 6-year high (Chart 2). Chart 1The Reflation Trade In One Chart The Reflation Trade In One Chart The Reflation Trade In One Chart Chart 2Current Activity Indicators Have Perked Up Current Activity Indicators Have Perked Up Current Activity Indicators Have Perked Up What accounts for the acceleration in economic growth that began in earnest in mid-2016? A number of factors stand out: The drag on global growth from the plunge in commodity sector investment finally ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7% off the level of U.S. real GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 3). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus. The era of fiscal austerity ended. Chart 4 shows that the fiscal thrust in developed economies turned positive in 2016 for the first time since 2010. Financial conditions eased in most economies, delivering an impulse to growth that is still being felt. In the U.S., for example, junk bond yields dropped from a peak of 10.2% in February 2016 to 6.3% at present (Chart 5). A surging stock market and rising home prices also helped buoy consumer and business sentiment. Chart 3Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Chart 4The End Of Fiscal Austerity? Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 5Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Fine For Now... Looking out, global growth should stay reasonably firm over the next 12 months. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 6). The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 7 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will remain sturdy for the remainder of 2017. Chart 6Global Growth Will Stay Strong In The Near Term Global Growth Will Stay Strong In The Near Term Global Growth Will Stay Strong In The Near Term Chart 7Easing Financial Conditions Will Support Activity Easing Financial Conditions Will Support Activity Easing Financial Conditions Will Support Activity ... But Storm Clouds Are Forming Home prices cannot rise faster than rents or incomes indefinitely; nor can equity prices rise faster than earnings. Corporate spreads also cannot keep falling. As the equity and housing markets cool, and borrowing costs start climbing on the back of higher government bond yields, the tailwind from easier financial conditions will dissipate. When that happens - most likely, sometime next year - GDP growth will slow. In and of itself, somewhat weaker growth would not be much of a problem. After all, the economy is currently expanding at an above-trend pace and the Fed wants to tighten financial conditions to some extent - it would not be raising rates if it didn't! The problem is that trend growth is much lower now than in the past - only 1.8% according to the Fed's Summary of Economic Projections. Living in a world of slow trend growth could prove to be challenging. The U.S. corporate sector has been feasting on credit for the past four years (Chart 8). Household balance sheets are still in reasonably good shape, but even here, there are areas of concern. Student debt is going through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 9). Together, these two categories account for over two-thirds of non-housing related consumer liabilities. Chart 8U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit Chart 9U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem The risk is that defaults will rise if GDP growth falls below 2%, a pace that has often been described as "stall speed." This could set in motion a vicious cycle where slower growth causes firms to pare back debt, leading to even slower growth and greater pressure on corporate balance sheets - in other words, a recipe for recession. Act 2: Recession Redefining "Tight Money" "Expansions do not die of old age," Rudi Dornbusch once remarked, "They are killed by the Fed." On the face of it, this may not seem like much of a concern. If the Fed raises rates in line with the median "dot" in the Summary of Economic Projections, the funds rate will only be about 2.5% by mid-2019 (Chart 10). That may not sound like much, but keep in mind that the so-called neutral rate - the rate consistent with full employment and stable inflation - may be a lot lower now than in the past. Also keep in mind that it can take up to 18 months before the impact of tighter financial conditions take their full effect on the economy. Thus, by the time the Fed has realized that it has tightened monetary policy by too much, it may be too late. As we have argued in the past, a variety of forces have pushed down the neutral rate over time.1 For example, the amount of investment that firms need to undertake in a slow-growing economy has fallen by nearly 2% of GDP since the late-1990s (Chart 11). And getting firms to take on even this meager amount of investment may require a lower interest rate since modern production techniques rely more on human capital than physical capital. Chart 10Will The Fed's 'Gradual' Rate Hikes End Up Being Too Much? Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 11Less Investment Required Less Investment Required Less Investment Required Rising inequality has also reduced aggregate demand by shifting income towards households with high marginal propensities to save (Chart 12). This has forced central banks to lower interest rates in order to prop up spending. From this perspective, it is not too surprising that income inequality and debt levels have been positively correlated over time (Chart 13). Chart 12Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Chart 13U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP Then there is the issue of the dollar. The broad real trade-weighted dollar has appreciated by 19% since mid-2014 (Chart 14). According to the New York Fed's trade model, this has reduced the level of real GDP by nearly 2% relative to what it would have otherwise been. Standard "Taylor Rule" equations suggest that interest rates would need to fall by around 1%-to-2% in order to offset a loss of demand of this magnitude. This means that if the economy could withstand interest rates of 4% when the dollar was cheap, it can only withstand interest rates of 2%-to-3% today. And even that may be too high. Consider the message from Chart 15. It shows that real rates have been trending lower since 1980. The real funds rate averaged only 1% during the 2001-2007 business cycle, a period when demand was being buoyed by a massive, debt-fueled housing bubble; fiscal stimulus in the form of the two Bush tax cuts and the wars in Iraq and Afghanistan; a weakening dollar; and by a very benign global backdrop where emerging markets were recovering and Europe was doing well. Chart 14The Dollar Is In The Midst Of Its Third Great Bull Market The Dollar Is In The Midst Of Its Third Great Bull Market The Dollar Is In The Midst Of Its Third Great Bull Market Chart 15The Neutral Rate Has Fallen The Neutral Rate Has Fallen The Neutral Rate Has Fallen Today, the external backdrop is fragile, the dollar has been strengthening rather than weakening, and households have become more frugal (Chart 16). And while President Trump has promised plenty of fiscal largess, the reality may turn out to be a lot more sobering than the rhetoric. Chart 16Return To Thrift Return To Thrift Return To Thrift End Of The Trump Trade? Not Yet The failure to replace the Affordable Care Act has cast doubt in the eyes of many observers about the ability of Congress to pass other parts of Trump's agenda. As a consequence, the "Trump Trade" has gone into reverse over the past few weeks, pushing down the dollar and Treasury yields in the process. We agree that the "Trump Trade" will eventually fizzle out. However, this is likely to be more of a story for 2018 than this year. If anything, last week's fiasco may turn out to be a blessing in disguise for the Republicans. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play The GOP's proposed legislation would have reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. That would have warranted lower bond yields and a weaker dollar. The failure to pass an Obamacare replacement serves as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy Where the disappointment will appear is not during the legislative process, but afterwards. The highly profitable companies that will benefit the most from corporate tax cuts are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the corporate tax cuts may simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 17From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Chart 18Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 17). As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and lavish fiscal stimulus only to get neither. Euro Area: A 12-Month Window For Growth The outlook for the euro area over the next 12 months is reasonably bright, but just as in the U.S., the picture could darken later next year. Euro area private sector credit growth reached 2.5% earlier this year. This may not sound like a lot, but that is the fastest pace of growth since July 2009. A further acceleration is probable over the coming months, given rising business confidence, firm loan demand, and declining nonperforming loans. Conceptually, it is the change in credit growth that drives GDP growth. Thus, as credit growth levels off next year, the euro area's credit impulse will fall back towards zero, setting the stage for a period of slower GDP growth (Chart 18). In contrast to the U.S., the ECB is likely to resist the urge to raise the repo rate before growth slows. That's the good news. The bad news is that the market could price in some tightening in monetary policy anyway, leading to a "bund tantrum" later this year. As in the past, the ECB will be able to defuse the situation. Unfortunately, what Draghi cannot do much about is the low level of the neutral rate in the euro area. If the neutral rate is low in the U.S., it is probably even lower in the euro area, reflecting the region's worse demographics and higher debt burdens. The anti-growth features of the common currency - namely, the inability to devalue one's currency in response to an adverse economic shock, as well as the austerity bias that comes from not having a central bank that can act as a lender of last resort to solvent but illiquid governments - also imply a lower neutral rate. Chart 19Anti-Euro Sentiment Is High In Italy Anti-Euro Sentiment Is High In Italy Anti-Euro Sentiment Is High In Italy Indeed, it is entirely possible that the neutral rate is negative in the euro area, even in nominal terms. If that's the case, the ECB will find it difficult to keep inflation from falling once the economy begins to slow late next year. The U.K.: And Now The Hard Part The U.K. fared better than most pundits expected in the aftermath of the Brexit vote. Nevertheless, it would be a mistake to assume that the Brexit vote has not cast a pall over the economy. The pound has depreciated by 11% against the euro and 16% against the dollar since that fateful day, while gilt yields have fallen across the board. Had it not been for this easing in financial conditions, the economic outcome would have been far worse. As the tailwind from the pound's devaluation begins to recede next year, the U.K. economy could suffer. Slower growth in continental Europe and the rest of the world could also exacerbate matters. The severity of the slowdown will hinge on the outcome of Brexit negotiations. On the one hand, the EU has an interest in taking a hardline stance to discourage separatist forces elsewhere, particularly in Italy where pro-euro sentiment is tumbling (Chart 19). On the other hand, the EU still needs the U.K. as both a trade partner and a geopolitical ally. Investors may therefore be surprised by the relatively muted negotiations that transpire over the coming months. In fact, news reports indicate that Brussels has already offered the U.K. a three year transitional deal that will give London plenty of time to conclude a free trade agreement with the EU. In addition, the EU has dangled the carrot of revocability, suggesting that the U.K. would be welcomed back with open arms if enough British voters were to change their minds. Whatever the path, our geopolitical service believes that political risk actually bottomed with the January 17 Theresa May speech.2 If that turns out to be the case, the pound is unlikely to weaken much from current levels. China And EM: The Calm Before The Storm? The Chinese economy should continue to perform well over the coming months. The Purchasing Manager Index for manufacturing remains in expansionary territory and BCA's China Leading Economic Indicator is in a clear uptrend (Charts 20 and 21). Chart 20Bright Spots In The Chinese Economy Bright Spots In The Chinese Economy Bright Spots In The Chinese Economy Chart 21Improving LEI Points To Further Growth Acceleration Improving LEI Points To Further Growth Acceleration Improving LEI Points To Further Growth Acceleration Moreover, there has been a dramatic increase in the sales of construction equipment such as heavy trucks and excavators, with growth rates matching levels last seen during the boom years before the global financial crisis. Historically, construction machinery sales have been tightly correlated with real estate development (Chart 22). Reflecting this reflationary trend, the producer price index rose by nearly 8% year-over-year in February, a 14-point swing from the decline of 6% experienced in late-2015. Historically, rising producer prices have resulted in higher corporate profits and increased capital expenditures, especially among private enterprises (Chart 23). Chart 22An Upturn In Housing Construction? An Upturn In Housing Construction? An Upturn In Housing Construction? Chart 23Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits The key question is how long the good news will last. As in the rest of the world, our guess is that the Chinese economy will slow late next year, setting the stage for a major growth disappointment in 2019. Weaker growth abroad will be partly to blame, but domestic factors will also play a role. The Chinese housing market has been on a tear. The authorities are increasingly worried about a property bubble and have begun to tighten the screws on the sector. The full effect of these measures should become apparent sometime next year. Fiscal policy is also likely to be tightened at the margin. The IMF estimates that China benefited from a positive fiscal thrust of 2.2% of GDP between 2014 and 2016. The fiscal thrust is likely to be close to zero in 2017 and turn negative to the tune of nearly 1% of GDP in 2018 and 2019. The growth outlook for other emerging markets is likely to mirror China's. The IMF expects real GDP in emerging and developing economies to rise by 5.1% in Q4 of 2017 relative to the same quarter a year earlier, up from 4.2% in 2016 (Table 2). The biggest acceleration is expected to occur in Brazil, where the economy is projected to grow by 1.4% in 2017 after having contracted by 1.9% in 2016. Russia and India should also see better growth numbers. Table 2World Economic Outlook: Global Growth Projections Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play We do not see any major reason to challenge these numbers for this year, but think the IMF's projections will turn out to be too rosy for 2018, and especially, 2019. As BCA's Emerging Market Strategy service has documented, the lack of structural reforms in EMs over the past few years has depressed productivity growth. High debt levels also cloud the picture. Chart 24 shows that debt levels have continued to grow as a share of GDP in most emerging markets. In EMs such as China, where banks benefit from a fiscal backstop, the likelihood of a financial crisis is low. In others such as Brazil, where government finances are in precarious shape, the chances of another major crisis remains uncomfortable high. Japan: The End Of Deflation? If there is one thing investors are certain about it is that deflationary forces in Japan are here to stay. Despite a modest increase in inflation expectations since July 2016, CPI swaps are still pricing in inflation of only 0.6% over the next two decades, nowhere close to the Bank of Japan's 2% target. But could the market be wrong? We think so. Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 25). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. Over the past quarter century, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at only 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 26). Chart 24What EM Deleveraging? What EM Deleveraging? What EM Deleveraging? Chart 25Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Chart 26Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seems to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous cycle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Unfortunately, external events could conspire to sabotage Japan's escape from deflation. If the global economy slows in late-2018 - leading to a recession in 2019 - Japan will be hard hit, given the highly cyclical nature of its economy. And this could cause Japanese policymakers to throw the proverbial kitchen sink at the problem, including doing something that they have so far resisted: introducing a "helicopter money" financed fiscal stimulus program. Against the backdrop of weak potential GDP growth and a shrinking reservoir of domestic savings, the government may get a lot more inflation than it bargained for. Act 3: Stagflation Who Remembers The 70s Anymore? By historical standards, the 2019 recession will be a mild one for most countries, especially in the developed world. This is simply because the excesses that preceded the subprime crisis in 2007 and, to a lesser extent the tech bust in 2000, are likely to be less severe going into the next global downturn than they were back then. The policy response may turn out to be anything but mild, however. Memories of the Great Recession are still very much vivid in most peoples' minds. No one wants to live through that again. In contrast, memories of the inflationary 1970s are fading. A recent NBER paper documented that age plays a big role in determining whether central bankers turn out to be dovish or hawkish.3 Those who experienced stagflation in the 1970s as adults are much more likely to express a hawkish bias than those who were still in their diapers back then. The implication is the future generation of central bankers is likely to see the world through more dovish eyes than their predecessors. Even if one takes the generational mix out of the equation, there are good reasons to aim for higher inflation in today's environment. For one thing, debt is high. The simplest way to reduce real debt burdens is by letting inflation accelerate. In addition, the zero bound is less likely to be a problem if inflation were higher. After all, if inflation were running at 1% going into a recession, real rates would not be able to fall much below -1%. But if inflation were running at 3%, real rates could fall to as low as -3%. The Politics Of Inflation Political developments will also facilitate the transition to higher inflation. In the U.S., the presidential election campaign will start coming into focus in 2019. If the economy enters a recession then, Donald Trump will go ballistic. The infrastructure program that Republicans in Congress are downplaying now will be greatly expanded. Gold-plated hotels and casinos will be built across the country. Of course, several years could pass between when an infrastructure bill is passed and when most new projects break ground. By that time, the economy will already be recovering. This will help fuel inflation. As the economy turns down in 2019, the Fed will also be forced to play ball. The market's current obsession over whether President Trump wants a "dove" or a "hawk" as Fed chair misses the point. He wants neither. He wants someone who will do what they are told. This means that the next Fed chair will likely be a "really smart" business executive with little-to-no-experience in central banking and even less interest in maintaining the Federal Reserve's institutional independence. The empirical evidence strongly suggests that inflation tends to be higher in countries that lack independent central banks (Chart 27). This may be the fate of the U.S. Chart 27Inflation Higher In Countries Lacking Independent Central Banks Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Europe's Populists: Down But Not Out Whether something similar happens in Europe will also depend on political developments. For the next 18 months at least, the populists will be held at bay (Chart 28). Le Pen currently trails Macron by 24 percentage points in a head-to-head contest. It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. In Germany, support for the europhile Social Democratic Party is soaring, as is support for the common currency itself. For the time being, euro area risk assets will be able to climb the proverbial political "wall of worry." However, if the European economy turns down in 2019, all this may change. Chart 29 shows the strong correlation between unemployment rates in various French départements and support for Marine Le Pen's National Front. Should French unemployment rise, her support will rise as well. The same goes for other European countries. Chart 28France And Germany: Populists Held At Bay For Now France And Germany: Populists Held At Bay For Now France And Germany: Populists Held At Bay For Now Chart 29Higher Unemployment Would Benefit Le Pen Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Meanwhile, there is a high probability that the migrant crisis will intensify at some point over the next few years. Several large states neighboring Europe are barely holding together - Egypt being a prime example - and could erupt at any time. Furthermore, demographic trends in Africa portend that the supply of migrants will only increase. In 2005, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2015 revision, the UN doubled its estimate to 4 billion. And even that may be too conservative because it assumes that the average number of births per woman falls from 5.1 to 2.2 over this period (Chart 30). Chart 30Population Pressures In Africa Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play The existing European political order is not well equipped to deal with large-scale migration, as the hapless reaction to the Syrian refugee crisis demonstrates. This implies that an increasing share of the public may seek out a "new order" that is more attuned to their preferences. European history is fraught with regime shifts, and we may see yet another one in the 2020s. The eventual success of anti-establishment politicians on both sides of the Atlantic suggests that open border immigration policies and free trade - the two central features of globalization - will come under attack. Consequently, an inherently deflationary force, globalization, will give way to an inherently inflationary one: populism. The Productivity Curse Just as the "flation" part of stagflation will become more noticeable as the global economy emerges from the 2019 recession, so will the "stag." Chart 31 shows that productivity growth has fallen across almost all countries and regions. There is little compelling evidence that measurement error explains the productivity slowdown.4 Cyclical factors have played some role. Weak investment spending has curtailed the growth in the capital stock. This means that today's workers have not benefited from the same improvement in the quality and quantity of capital as they did in previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. Most prominently, the gains from the IT revolution have leveled off. Recent innovations have focused more on consumers than on businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. Human capital accumulation has also decelerated, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart 32). Educational achievement, as measured by standardized test scores in mathematics, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart 33).5 Given that test scores are extremely low in most countries with rapidly growing populations, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart 31Productivity Growth Has Slowed In Most Major Economies Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 32The Contribution To Growth From Rising Human Capital Is Falling Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 33Math Skills Around The World Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Productivity And Inflation The slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on (Chart 34). Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Chart 34A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation.6 One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a decade during which productivity growth slowed and inflation accelerated. Financial Markets Overall Strategy Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors with a 12-month horizon should stay overweight global equities and high-yield credit at the expense of government bonds and cash. Global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months, followed by a gradual recovery that sees the restoration of full employment in most countries by 2021. At that point, inflation will take off, rising to over 4% by the middle of the decade. The 2020s will be remembered as a decade of intense pain for bond investors. In relative terms, equities will fare better than bonds, but in absolute terms they will struggle to generate a positive real return. As in the 1970s, gold will be the standout winner. Chart 35 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 35Market Outlook For Major Asset Classes Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Equities Cyclically Favor The Euro Area And Japan Over The U.S. Stronger global growth is powering an acceleration in corporate earnings. Global EPS is expected to expand by 12% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 36 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. We prefer euro area and Japanese stocks relative to U.S. equities over a 12-month horizon. We would only buy Japanese stocks on a currency-hedged basis, as the prospect of a weaker yen is the main reason for being overweight Japan. In contrast, we would still buy euro area equities on a U.S. dollar basis, even though our central forecast is for the euro to weaken against the dollar over the next 12 months. Our cyclically bullish view on euro area equities reflects several considerations. For starters, they are cheap. Euro area stocks currently trade at a Shiller PE ratio of only 17, compared with 29 for the U.S. (Chart 37). Some of this valuation gap can be explained by different sector weights across the two regions. However, even if one controls for this factor, as well as the fact that euro area stocks have historically traded at a discount to the U.S., the euro area still comes out as being roughly one standard deviation cheap compared with the U.S. (Chart 38). Chart 36Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Chart 37Euro Area Stocks Are A Bargain... Euro Area Stocks Are A Bargain... Euro Area Stocks Are A Bargain... Chart 38...No Matter How You Look At It ...No Matter How You Look At It ...No Matter How You Look At It European Banks Are In A Cyclical Sweet Spot Of course, if euro area banks flounder over the next 12 months as they have for much of the past decade, none of this will matter. However, we think that the region's banks have finally turned the corner. The ECB is slowly unwinding its emergency measures and core European bond yields have risen since last summer. This has led to a steeper yield curve, helping to flatter net interest margins. Chart 39 shows that the relative performance of European banks is almost perfectly correlated with the level of German bund yields. Our European Corporate Health Monitor remains in improving territory, in contrast to the U.S., where it has been deteriorating since 2013 (Chart 40). Profit margins in Europe have room to expand, whereas in the U.S. they have already maxed out. The capital positions of European banks have also improved greatly since the euro crisis. Not all banks are out of the woods, but with nonperforming loans trending lower, the need for costly equity dilution has dissipated (Chart 41). Meanwhile, euro area credit growth is accelerating and loan demand continues to expand. Chart 39Performance Of European Banks And Bond Yields: A Good Fit Performance Of European Banks And Bond Yields: A Good Fit Performance Of European Banks And Bond Yields: A Good Fit Chart 40Corporations Healthier In The Euro Area Corporations Healthier In The Euro Area Corporations Healthier In The Euro Area Chart 41Cyclical Background Positive For Bank Stocks Cyclical Background Positive For Bank Stocks Cyclical Background Positive For Bank Stocks Beyond a 12-month horizon, the outlook for euro area banks and the broader stock market look less enticing. The region will suffer along with the rest of the world in 2019. The eventual triumph of populist governments could even lead to the dissolution of the common currency. This means that euro area stocks should be rented, not owned. The same goes for U.K. equities. EM: Uphill Climb Emerging market equities tend to perform well when global growth is strong. Thus, it would not be surprising if EM equities continue to march higher over the next 12 months. However, the structural problems plaguing emerging markets that we discussed earlier in this report will continue to cast a pall over the sector. Our EM strategists favor China, Taiwan, Korea, India, Thailand, Poland, Hungary, the Czech Republic, and Russia. They are neutral on Singapore, the Philippines, Hong Kong, Chile, Mexico, Colombia, and South Africa; and are underweight Indonesia, Malaysia, Brazil, Peru, and Turkey. Fixed Income Global Bond Yields To Rise Further We put out a note on July 5th entitled "The End Of The 35-Year Bond Bull Market" recommending that clients go structurally underweight safe-haven government bonds.7 As luck would have it, we penned this report on the very same day that the 10-year Treasury yield hit a record closing low of 1.37%. We continue to think that asset allocators should maintain an underweight position in global bonds over the next 12 months. In relative terms, we favor Japan over the U.S. and have a neutral recommendation on the euro area and the U.K. Chart 42The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months Underweight The U.S. For Now We expect the U.S. 10-year Treasury yield to rise to around 3.2% over the next 12 months. The Fed is likely to raise rates by a further 100 basis points over this period, about 50 bps more than the 12-month discounter is currently pricing in (Chart 42). In addition, the Fed will announce later this year or in early 2018 that it will allow the assets on its balance sheet to run off as they mature. This could push up the term premium, giving long Treasury yields a further boost. Thus, for now, investors should underweight Treasurys on a currency-hedged basis within a fixed-income portfolio. The cyclical peak for both Treasury yields and the dollar should occur in mid-2018. Slowing growth in the second half of that year and a recession in 2019 will push the 10-year Treasury yield back towards 2%. After that, bond yields will grind higher again, with the pace accelerating in the early 2020s as the stagflationary forces described above gather steam. Neutral On Europe, Overweight Japan Yields in the euro area will follow the general contours of the U.S., but with several important qualifications. The ECB is likely to roll back some of its emergency measures over the next 12 months, including suspending the Targeted Longer-Term Refinancing Operations, or TLTROs. It could also raise the deposit rate slightly, which is currently stuck in negative territory. However, in contrast to the Fed, the ECB is unlikely to hike its key policy rate, the repo rate. And while the ECB will "taper" asset purchases, it will not take any steps to shrink the size of its balance sheet. As such, fixed-income investors should maintain a benchmark allocation to euro area bonds. Chart 43A Bit More Juice Left A Bit More Juice Left A Bit More Juice Left A benchmark weighting to gilts is also warranted. With the Brexit negotiations hanging in the air, it is doubtful that the Bank of England would want to hike rates anytime soon. On the flipside, rising inflation - though largely a function of a weak currency - will make it difficult for the BoE to increase asset purchases or take other steps to ease monetary policy. We would recommend a currency-hedged overweight position in JGBs. The Bank of Japan is committed to keeping the 10-year yield pinned to zero. Given that neither actual inflation nor inflation expectations are anywhere close to that level, it is highly unlikely that the BoJ will jettison its yield-targeting regime anytime soon. With government bond yields elsewhere likely to grind higher, this makes JGBs the winner by default. High-Yield Credit: Still A Bit Of Juice Left The fact that the world's most attractive government bond market by our rankings - Japan - is offering a yield of zero speaks volumes. As long as global growth stays strong and corporate default risk remains subdued, investors will maintain their love affair with high-yield credit. Thus, while credit spreads have fallen dramatically, they could still fall further (Chart 43). Only when corporate stress begins to boil over in late 2018 will things change. Nevertheless, investors will continue to face headwinds from rising risk-free yields in most economies even in the near term. This implies that the return from junk bonds in absolute terms will fall short of what is delivered by equities over the next 12 months. Currencies And Commodities Chart 44Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Will Support The Greenback We expect the real trade-weighted dollar to appreciate by about 10% over the next 12 months. Historically, changes in real interest rate differentials have been the dominant driver of currency movements in developed economies. The past few years have been no different. Chart 44 shows that the ascent of the trade-weighted dollar since mid-2014 has been almost perfectly matched by an increase in U.S. real rates relative to those abroad. Interest rate differentials between the U.S. and its trading partners are likely to widen further through to the middle of 2018 as the Fed raises rates more quickly than current market expectations imply, while other central banks continue to stand pat. Accordingly, we would fade the recent dollar weakness. As we discussed in "The Fed's Unhike," the March FOMC statement was not as dovish as it might have appeared at first glance.8 Given that monetary conditions eased in the aftermath of the Fed meeting - exactly the opposite of what the Fed was trying to achieve - it is likely that the FOMC's rhetoric will turn more hawkish in the coming weeks. The Yen Has The Most Downside, The Pound The Least Among the major dollar crosses, we see the most downside for the yen over the next 12 months. The Bank of Japan will continue to keep JGB yields anchored at zero. As yields elsewhere rise, investors will shift their money out of Japan, causing the yen to weaken. Only once the global economy begins to teeter into recession late next year will the yen - traditionally, a "risk off" currency - begin to rebound. The euro will also weaken against the dollar over the next 12 months, although not as much as the yen. The ECB's "months to hike" has plummeted from nearly 60 last summer to 26 today (Chart 45). That seems too extreme. Core inflation in the euro area is well below U.S. levels, even if one adjusts for measurement differences between the two regions (Chart 46). The neutral rate is also lower in the euro area, as discussed previously. This sharply limits the ability of the ECB to raise rates. Chart 45Market's Hawkish View Of The ECB Is Too Extreme Market's Hawkish View Of The ECB Is Too Extreme Market's Hawkish View Of The ECB Is Too Extreme Chart 46Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Unlike most currencies, sterling should be able to hold its ground against the dollar over the next 12 months. The pound is very cheap by most metrics (Chart 47). The prospect of contentious negotiations over Brexit with the EU is already in the price. What may not be in the price is the possibility that the U.K. will move quickly to reach a deal with the EU. If such a deal fails to live up to the promises made by the Brexit campaign - a near certainty in our view - a new referendum may need to be scheduled. A new vote could yield a much different result than the first one. If the market begins to sniff out such an outcome, the pound could strengthen well before the dust settles. EM And Commodity Currencies The RMB will weaken modestly against the dollar over the coming year. As we have discussed in the past, China's high saving rate will keep the pressure on the government to try to export excess production abroad by running a large current account surplus. This requires a weak currency.9 Nevertheless, a major devaluation of the RMB is not in the cards. Much of the capital flight that China has experienced recently has been driven by an unwinding of the hot money flows that entered the country over the preceding years. Despite all the talk about a credit bubble, Chinese external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 48). At this point, most of the hot money has fled the country. This suggests that the pace of capital outflows will subside. Chart 47Pound: Cheap By All Accounts Pound: Cheap By All Accounts Pound: Cheap By All Accounts Chart 48Hot Money In, Hot Money Out Hot Money In, Hot Money Out Hot Money In, Hot Money Out A somewhat weaker RMB could dampen demand for base and bulk metals. A slowdown in Chinese construction activity next year could also put added pressure on metals prices. Our EM strategists are especially bearish on the South African rand, Brazilian real, Colombian peso, Turkish lira, Malaysian ringgit, and Indonesian rupiah. Crude should outperform metals over the next 12 months. This will benefit the Canadian dollar and other oil-sensitive currencies. However, Canada's housing bubble is getting out of hand and could boil over if domestic borrowing costs climb in line with rising long-term global bond yields. A sagging property sector will limit the ability of the Bank of Canada to raise short-term rates. On balance, we see modest downside for the CAD/USD over the coming year. The Aussie dollar will suffer even more, given the country's own housing excesses and its export sector's high sensitivity to metal prices. Finally, a few words on the most of ancient of all currencies: gold. We do not expect bullion to fare well over the next 12 months. A stronger dollar and rising bond yields are both bad news for the yellow metal. However, once central banks start slashing rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?" dated January 25, 2017, and Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 3 Ulrike Malmendier, Stefan Nagel, and Zhen Yan, "The Making Of Hawks And Doves: Inflation Experiences On The FOMC," NBER Working Paper No. 23228 (March 2017). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education And Growth In The 21st Century," dated February 24, 2011, available at bca.bcaresearch.com. 6 Note to economists: We can think of this relationship within the context of the Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. In the standard setup where the saving rate is fixed, slower population and productivity growth will always result in a lower equilibrium real interest rate. However, consider a more realistic setup where: 1) the saving rate rises initially as the population ages, but then begins to decline as a larger share of the workforce enters retirement; and 2) habit persistence affects consumer spending, so that households react to slower real wage growth by saving less rather than cutting back on consumption. In that sort of environment, the neutral rate could initially fall, but then begin to rise. If the central bank reacts slowly to changes in the neutral rate, or monetary policy is otherwise constrained by the zero bound on interest rates and/or political considerations, the initial effect of slower trend GDP growth will be deflationary while the longer-term outcome will be inflationary. 7 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "The Fed's Unhike," dated March 16, 2017, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Spread Product: Any near-term correction in risk assets is likely to be fleeting. Investors should take the opportunity to increase credit exposure and maintain overweight spread product allocations on a 6-12 month horizon. Duration: Our 2-factor Global PMI model pegs fair value for the 10-year Treasury yield at 2.54%. Economy: U.S. economic growth will remain solidly above-trend this year, helped along by renewed strength in both residential and non-residential investment. Above-trend growth will ensure that inflation remains in its current gradual uptrend. Feature Chart 1Back Above 400 bps Back Above 400 bps Back Above 400 bps The reflation trade has come under question during the past couple of weeks. The S&P 500 is 1.7% off its recent high, the VIX has bounced and the average spread on the Bloomberg Barclays High-Yield index is back above 400 basis points (Chart 1). After such a move, it is reasonable to ask if the economic landscape has changed enough to warrant a reversal of our current overweight spread product allocation. We think not, and we advise investors to buy the dips, adding credit risk to their portfolios from more attractive levels. This week we examine why risk assets are vulnerable to a near-term correction, but also why these corrections are likely to be short lived. On a 6-12 month investment horizon we continue to recommend a pro-risk portfolio characterized by: below-benchmark duration, overweight spread product, curve steepeners and TIPS breakeven wideners. Three Catalysts For A Near-Term Sell Off... Three main factors suggest that risk assets might continue to correct in the near-term. The first is that Fed rate hike expectations might be increasing too quickly. Chart 2 shows the fed funds rate that is priced into the overnight index swap curve for the end of this year. The lower dashed horizontal line is the level consistent with one more rate hike between now and the end of the year. The higher dashed horizontal line is the level consistent with two more rate hikes between now and the end of the year. We see that risk assets were able to handle the shift in rate expectations up to the lower dashed line with no trouble. The yield curve steepened and the cost of inflation compensation rose (Chart 2, bottom panel). But now, as rate expectations approach the higher dashed line, the reflation trade is starting to fray. The yield curve has started to flatten and TIPS breakevens are rolling over. A second reason why risk assets might sell-off in the near-term is the still elevated level of economic policy uncertainty (Chart 3, top panel). Last Friday, markets hung on every word related to the likelihood of a new healthcare bill being passed. Now that the bill has failed, attention will turn quickly to tax reform. It is very likely that risk assets will suffer if it appears as though tax reform will be delayed or scrapped altogether. Importantly, it is the opinion of our Geopolitical Strategy service that tax reform will be passed before the end of the year.1 Chart 2How Much Hawkishness Can Markets Take? How Much Hawkishness Can Markets Take? How Much Hawkishness Can Markets Take? Chart 3Correction Catalysts? Correction Catalysts? Correction Catalysts? A third reason why risk assets are vulnerable to a near-term correction is that investors have bought into the reflation trade, and sentiment is extremely bullish (Chart 3, bottom panel). Surveys of investors conducted by Yale University show that 99% of investors expect the Dow to increase during the coming year, while simultaneously only 47% of investors characterize the stock market as "not too high" relative to its fundamental value. The divergence in itself suggests that the equity rally is built on a shaky foundation. It seems likely that either confidence needs to wane or valuations need to correct for the rally to be prolonged. ...But The Fed Cycle Trumps Them All In previous reports2 we outlined the four phases of the Fed Cycle (see Box), and observed that in all likelihood we are currently in Phase I. Box: The Four Phases Of The Fed Cycle Chart 4Stylized Fed Cycle Keep Buying Dips Keep Buying Dips The four phases of the Fed Cycle are illustrated in Chart 4 and defined as follows: Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium (or neutral) level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. In Phase I, the Fed has begun to remove monetary accommodation but still needs inflation to rise back to target. In other words, if risk assets sell off and financial conditions start to tighten the Fed will adopt a more dovish policy stance to ensure that the recovery persists and inflation continues to trend higher. We note that core PCE inflation is running at 1.74% year-over-year, still below the Fed's 2% target. Further, the St. Louis Fed Price Pressures Measure3 is signaling only a 19% chance that PCE inflation will exceed 2.5% during the next twelve months, and market-based measures of inflation compensation are well below levels that are consistent with the Fed's inflation target (Chart 5). Chart 5Fed Still Needs Higher Inflation Fed Still Needs Higher Inflation Fed Still Needs Higher Inflation In this environment, if risk assets sell off because of overly aggressive rate hike expectations, fiscal policy disappointments or over-extended sentiment, the Fed will quickly adopt a more dovish policy stance, lending support to the reflation trade. Of course, if any of the catalysts for the market correction also cause a severe contraction in economic growth, then the reflation trade would face a more lasting setback. However, none of the three reasons for a market correction listed above seem likely to have significant pass-through effects on the economy. Even if fiscal stimulus turns out to be much less than was previously anticipated, there appears to be sufficient momentum in economic growth to maintain inflation on its upward trajectory (see section titled "Above-Trend Growth: Aided By Housing & Capex" below). It follows from this analysis of the Fed Cycle that a strategy of "buying the dips" should work whenever we are in an environment where the Fed needs inflation to move higher. It is only when inflation is more firmly anchored around the Fed's target that the Fed will be less willing to support markets, making a "buy the dips" strategy less effective. To test this theory, we devised a trading rule for high-yield bonds where we buy the High-Yield index whenever spreads widen by 20 bps or more during a month. We then hold that position for a period ranging from 1 to 3 months and calculate excess returns relative to duration-matched Treasuries during that period. Our goal is to see if the effectiveness of this "buy the dips" strategy differs depending on the stage of the Fed Cycle. For this test we define the stages of the Fed Cycle using the aforementioned St. Louis Fed Price Pressures Measure, which we split into four ranges: 0% to 15%: An environment of very limited inflation pressure most consistent with Phase IV of the Fed Cycle. 15% to 30%: Still muted inflation pressures. Roughly consistent with Phase I of the Fed Cycle. 30% to 50%: Rising inflation pressures, but still less than a 50% chance that PCE will exceed 2.5% in the coming 12 months. This likely coincides with some Phase I periods and some Phase II periods of the Fed Cycle. 50% to 70%: Strong inflation pressures, and a good chance of inflation overshooting the Fed's target. Most likely coincides with Phase II or Phase III of the Fed Cycle. We indeed find that a "buy the dips" strategy is more effective when inflation pressures are lower (Table 1). A strategy of buying the junk index after spreads widen by at least 20 bps and holding it for three months produces positive excess returns 65% of the time when the St. Louis Fed Price Pressures Measure is between 0% and 15%. This same strategy works 59% of the time when the Price Pressures Measure is between 15% and 30%, 44% of the time when the Measure is between 30% and 50% and only 25% of the time when the Measure is between 50% and 70%. Table 1High-Yield Corporate Bond Returns* Achieved By Holding The Junk Index Following ##br##A 20 BPs Widening In High-Yield Corporate OAS** Under Different Ranges##br## Of The St. Louis Fed Price Pressure Measure*** (February 1994 To Present) Keep Buying Dips Keep Buying Dips With the Price Pressures Measure at only 19% currently, we advise investors to increase exposure to spread product on any near-term correction. Bottom Line: Any near-term correction in risk assets is likely to be fleeting. Investors should take the opportunity to increase credit exposure and maintain overweight spread product allocations on a 6-12 month horizon. Above-Trend Growth: Aided By Housing & Capex For the analysis of the Fed cycle performed above to be applicable, we must have confidence in the view that GDP will continue to grow at an above-trend pace. That is, growth must at least be strong enough to remove slack from the labor market and cause inflation to trend gradually higher. This has mostly been the case since measures of core inflation bottomed in early 2015 and we see no evidence at the moment to suggest it is about to change. In fact, measures of global growth most relevant for Treasury yields have hooked up strongly in recent months, and our model now suggests that fair value for the 10-year U.S. Treasury yield is 2.54% (Chart 6). At the time of publication the 10-year yield was 2.40%. The fair value reading from our model moved higher during the past month even though PMIs in both the U.S. and Japan ticked down. This negative move was offset by an acceleration in Eurozone PMI and a decline in bullish sentiment toward the dollar (Chart 6, bottom two panels). Less bullish dollar sentiment is a signal that the global recovery is becoming more synchronized which means that U.S. Treasury yields must rise more quickly for a given level of global growth.4 Returning to the U.S. growth outlook specifically, a recent BCA Special Report 5 showed that cyclical spending as a percent of overall GDP is an excellent leading indicator of economic downturns (Chart 7). Cyclical spending has been relatively firm as a percent of GDP during the past couple of years, and would have been stronger if not for stagnant residential investment (Chart 7, panel 3) and contracting non-residential investment in equipment & software (Chart 7, bottom panel). However, leading indicators suggest that both of these factors should shift from being sources of disappointment to sources of strength in the coming months. Chart 610-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model Chart 7Cyclical Spending Is Firm... Cyclical Spending Is Firm... Cyclical Spending Is Firm... Chart 8 shows the year-over-year change in each of the three cyclical components of GDP as a percent of overall growth alongside a reliable leading indicator. Consumer confidence suggests that consumer spending on durables will remain firm (Chart 8, panel 1). Our composite indicator of New Orders surveys also points to a rebound in nonresidential investment on equipment & software (Chart 8, panel 2). In prior reports we observed that nonresidential investment was held back by the 2014 oil price shock and should recover now that oil prices have found a floor.6 Also, any potential benefit from a more favorable tax and regulatory environment under the new federal government would only increase the upside for capex. Residential investment as a percent of GDP also rolled over last year, but homebuilder confidence has been trending sharply higher during the past few months (Chart 8, bottom panel). Home construction will be strong this year, despite the recent increase in mortgage rates. As was recently observed by our U.S. Investment Strategy service,7 the constraint on housing demand since the financial crisis has not come from un-affordable monthly mortgage payments. In fact, we calculate that even if mortgage rates rise by another 200 bps from current levels, the mortgage payment as a percent of income for the median household would still be below its long-run average (Chart 9). Chart 8...And Likely To Increase ...And Likely To Increase ...And Likely To Increase Chart 9Higher Rates Won't Kill Housing Higher Rates Won't Kill Housing Higher Rates Won't Kill Housing Rather, the constraint on housing demand has come from insufficient savings on the part of potential first time homebuyers relative to required down payments. This constraint can only subside as household savings increase and mortgage lending standards ease, two trends that are ongoing. Finally, housing supply is approaching historically low levels relative to demand (Chart 9, bottom panel) even including the "shadow inventory" from foreclosed properties which has now mostly vanished in any case. With supply at such depressed levels and demand likely to remain firm, it is no wonder that homebuilders are feeling more confident. Bottom Line: U.S. economic growth will remain solidly above-trend this year, helped along by renewed strength in both residential and non-residential investment. Above-trend growth will ensure that inflation remains in its current gradual uptrend. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was", dated March 8, 2017, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 3 A composite of 104 economic indicators designed to capture the probability of PCE inflation exceeding 2.5% during the subsequent 12 month period. https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure 4 A more detailed explanation of the inverse relationship between dollar sentiment and Treasury yields can be found in the U.S. Bond Strategy Weekly Report, "Dollar Watching: Another Update", dated January 31, 2017, available at usbs.bcaresearch.com 5 Please see BCA Special Report, "Beware The 2019 Trump Recession", dated March 7, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Investment Strategy Special Report, "U.S. Housing: What Comes Next?", dated March 27, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification