Corporate Profits

Highlights Brazilian President Michel Temer has been accused of crimes much worse than what got his predecessor impeached; Further instability is likely, with low probability that Temer's impeachment would restart reforms; Only a technocratic government, or brand new election, could produce a market-friendly outcome. Odds are that Brazil's public debt load will continue to escalate, and that in two years or so the debt-to-GDP ratio will spiral out of control. Without structural reforms and higher commodities prices, Brazilian financial markets are looking into the abyss. Stay put on Brazilian financial markets. Feature Investors cheered the impeachment of Brazil's President Dilma Rousseff, bidding up Brazilian assets for over a year despite the challenging macroeconomic context. BCA's Emerging Markets Strategy and Geopolitical Strategy services have repeatedly cautioned investors not to buy the hype. Brazil was already "priced for political perfection" on May 12, 2016 when Rousseff was removed from office to face trial by the senate over fiscal accounting irregularities.1 And yet, the political context has been far from perfect. As we wrote last May: "It is highly unlikely that the political dysfunction within Brazil's political class will end with a Temer administration, at least not anytime soon." The latest corruption revelations have directly implicated acting president Michel Temer of the Brazilian Democratic Movement Party (PMDB) as well as Senator Aecio Neves, the leader of centrist and investor-friendly Brazilian Social Democratic Party (PSDB) and a key Temer ally in Congress. The market has placed a massive bullish bet in the abilities of the tentative Temer-Neves (PMDB-PSDB) entente cordiale to push through largely unpopular fiscal reforms through Congress. These reforms, none of which have passed yet (!), are now likely to stall until either an early election is called (best case scenario) or until the current government's mandate expires in October 2018. We have expected Brazil's political rally to dissipate. As we argued in 2016, without a new election, the interim government has no mandate for painful structural reforms. We are sticking to this view today. What Is Going On In Brazil? According to revelations in the Brazilian press, President Temer was caught in an audio recording asking the chairman of JBS Group - the world's largest meatpacker - to continue making payments to the former President of the Chamber of Deputies Eduardo Cunha, who was jailed for corruption in 2016. Cunha, a former Temer ally and member of PMDB, was indicted in the large scale "Operation Car Wash" corruption scandal involving the state-owned oil company Petrobras. The payments by JBS were allegedly meant to ensure that Cunha did not spill the beans on his co-conspirators. Cunha had previously disclosed that he possessed compromising information about several senior politicians linked to the Petrobras scandal. JBS Chairman Joesley Batista, himself under investigation, recorded a conversation with Temer on March 7 as part of his plea bargain negotiations with law enforcement officials. According to press reports, Temer asked Batista to continue payments to ensure Cunha's silence. As part of the same investigation, Senator Aecio Neves - the darling of the Brazilian investment community who narrowly lost the presidential election to Rousseff in 2014 - was filmed soliciting two million reals ($638,000) from Batista. This is not his first brush with the law, Neves was also under corruption investigation when he was the governor of the state of Minas Gerais. Neves's apartment has since been raided by the police as the corruption probe against Brazilian politicians reaches a fever pitch. How serious are the charges against the Temer and his ruling coalition? They are deadly serious. As an aside, we have been puzzled that investors have never posed the following question: how was it possible that the entire political and especially congressional system is so corrupt but Temer - the long-serving head of the largest party in the congress and one of the most shrewd politicians in Brazil - has not been involved in this corruption scheme. President Dilma Rousseff, former leader of the left-wing Workers Party (PT) and successor to President Inácio "Lula" da Silva, was impeached and removed from power for a lot less. There was never any actual evidence that Rousseff was personally involved in Operation Car Wash, at least at the time of her impeachment. In fact, the strongest legal case against Rousseff was that she failed to uphold the so-called Fiscal Responsibility Law. Essentially, Rousseff was impeached and removed from power because she stimulated the economy for political gain. A charge that practically every president in Brazil's history has been guilty of (if not every leader in the world!). Temer and Neves are accused of much greater crimes. If the reporting of the Brazilian press is accurate, Neves personally profited and continues to profit from Operation Car Wash. And Temer is then directly involved, to this day, in obstruction of justice and witness intimidation. These are not crimes by association or mere technicalities resulting from politically charged fiscal profligacy. Rather, they are serious crimes that could end with lengthy jail terms, let alone removal from power. Rousseff claimed that her removal from power was a coup d'état. She was correct to characterize it as such. Unlike in the U.S., where a president removed from power is replaced with the vice president from the same party, in Brazil vice presidents are often appointed from a coalition partner. As such, Vice President Temer replaced Rousseff and proceeded to alter Brazilian policy in a dramatic fashion. He abandoned the PMDB legislative alliance with left-wing PT, turned to the centrist PSDB for votes in Congress and proceeded to enact orthodox, conservative, supply-side reforms. While these are absolutely the reforms that Brazil needs, we never accepted the view that they are reforms that Brazilians want. In fact, Rousseff won the 2014 election against Neves, with Temer as her running mate, by campaigning on a populist platform against precisely these types of supply-side reforms. Bottom Line: We hate to tell our clients "we told you so," but Temer's 180-degree turn in policy was never going to work. Not without an election that bolsters his political mandate to enact painful structural reforms. We also cautioned our clients that corruption in Brazilian Congress was endemic and severe and would therefore not magically disappear with Rousseff's removal from power. As such, "impeachment was no panacea,"2 especially not when many members of Congress voting against Dilma were under investigation for corruption themselves! The high level of corruption is not because of a moral failing particular to Brazilian mentality. Rather, corruption is a feature of Brazil's fractured and regionalized politics that depend on side-payments and pork barreling to grease the wheels of legislative process. Rousseff's crimes appear paltry when compared to the (yet unproven) allegations against Temer and Neves. J-Curve Of Structural Reforms Amidst the 2016 political crisis, we argued that the only positive outcome for Brazilian politics and markets in the long-term would be a new election (Figure I-1).3 Why? Because we understood how painful fiscal reforms would have to be to deal with Brazil's disastrous fiscal position (Chart I-1). Without a new election, the interim Temer administration would not have the political capital to enact painful reforms. Figure I-1Brazil: Our Take On Possible Political Scenarios ##br##Before Former President Rousseff Was Impeached Brazil: Politics Giveth And Politics Taketh Away Brazil: Politics Giveth And Politics Taketh Away Chart I-1Brazil's Fiscal Position Brazil's Fiscal Position Brazil's Fiscal Position The market has disagreed with us for a full year now. However, the rally based on political hopes was always unsustainable. First, investors have misunderstood the nature of political corruption in Brazilian politics and just how intrinsic the problem has been. In retrospect, Rousseff may have been the least corrupt major politician in Brazil! Second, investors have ignored the message of our J-Curve of structural reforms (Diagram I-1). Diagram I-1Structural Reforms Are Painful: ##br##Stylized Representation Brazil: Politics Giveth And Politics Taketh Away Brazil: Politics Giveth And Politics Taketh Away Reform is always and everywhere painful, otherwise it would be the form. Every government pursuing reforms has to get through the "danger zone" on our J-curve of structural reform. As reforms are passed and enacted, they begin to "bite." This is when the protests against reforms mount and the government loses its political capital. If the policymakers in charge of the reform effort are already starting with low political capital - as the Temer and his congressional coalition most certainly did in August 2016 - than the "danger zone" is essentially insurmountable. We have disagreed with the market as it has confused Rousseff's removal from power with widespread support for reforms that amount to economic austerity. As we often repeated in client meetings, "a vote for impeachment is not a vote for austerity." With general election only roughly one year away in October 2018, we doubted that the Temer administration would have the political capital to push through such reforms. After all, every government wants to be reelected and pursuing painful reforms ahead of the elections is not feasible election winning strategy. What has the Temer coalition managed to do thus far? It must have done a lot, given the positive market performance over the past 12 months? False. The market has rallied despite remarkably shoddy evidence of actual reforms. As we predicted in our analyses throughout 2016, the post-Rousseff Brazilian policymakers have been dogged by lack of political capital. Out of five major reform efforts, only two have passed - oil-auction legislation (Production Sharing Agreement Bill) and a fiscal-spending cap. We do not wish to claim that the latter is insignificant but as we discuss below they are insufficient to stabilize Brazil's public debt load. The main three reform efforts that would have significant long-term effect on Brazil's fiscal sustainability - social security reform, labor reform, and tax reform - have stalled and are now likely to fail (Table I-1). Table I-1President Temer's Proposed Structural Reforms & Their Status Brazil: Politics Giveth And Politics Taketh Away Brazil: Politics Giveth And Politics Taketh Away Brazilian Senator Ricardo Ferraço, of the centrist PSDB, in charge of drafting the labor reform report for the Senate, has already canceled the work on the proposal. Ferraço issued a statement that said, "the institutional crisis we are facing is devastating and we need to prioritize finding a solution. Everything else is secondary now." This is a major blow against labor reforms, which already passed the lower house in April. We suspect that it will largely be impossible to restart and, more importantly, pass the reforms without an election that gives a new government a political mandate. Alternatively, a technocratic government led by technocrats without political ambitions, could try to enact reforms until the next election. Without a new election or a technocratic government, members of centrist PSDB and center-left PMDB will start to distance themselves from the allegedly corrupt Temer administration. It makes no political sense for Congressmen like Ferraço to sacrifice their own political capital on the cross of austerity just a year from the start of the electoral campaign in the summer of 2018. Bottom Line: The results made clear by Figure I-1 are not surprising and were eminently forecastable. However, the market ignored the structural realities of Brazilian politics, as well as the theoretical foundation of successful structural reforms, and charged ahead regardless. Without fiscal reforms outlined in Table I-1, however, Brazil will likely end up in a debt trap very soon. A Perilous Fiscal Situation Brazil's fiscal position and public debt remain on an unsustainable trajectory. In fact, there has been limited fiscal improvement compared to what financial markets have priced in. In particular: The constitutional amendment by Brazilian President Michel Temer's government that introduced a cap on government spending was a dilution of the Fiscal Responsibility Law adopted in 2000 which stipulated that the government had to run primary fiscal surpluses. Capping government expenditure growth to the inflation rate de facto represents a relaxation of structural fiscal policy. Under the new fiscal rules, the government is targeting not the primary fiscal deficit (and, by extension, public debt), but only government expenditures. This implies that in a case where government revenues fall short of projections, the government is not obliged to rein in spending. On the whole, Temer's government has relaxed rather than tightened structural fiscal rules. While this makes sense because the economy is in a depression and needs fiscal relief, it has been bad news for government creditors. As a final point, the former President Dilma Rousseff was impeached for violating this exact same law that the current government has now relaxed. The fiscal balance has stabilized around 9% of GDP in the past year, but this has been due to one-off temporary measures. With nominal GDP growth at around 5%, the bulk of the 16% rise in collected income taxes from a year ago came from one-off measures such as the repayment of funds by the Brazilian Development Bank (BNDES) to the government, taxes on foreign asset repatriation and other temporary actions (Chart I-2). In short, Temer's government has resorted to one-off measures to improve the country's fiscal position. Unless the economy and tax collection recover strongly in the next 12 months, Brazil's fiscal position will worsen substantially, and public debt servicing will become unsustainable. Furthermore, the federal government's transfers to states have surged as the latter are facing their own fiscal crises due to revenue shortfalls. Local governments are reluctant to curb spending amid the ongoing depression, and will continue to pressure the federal government for more transfers. This will worsen public debt dynamics. Importantly, the social security deficit, presently at 2.4% of GDP, will continue to escalate without meaningful reforms (Chart I-3). According to IMF estimates,4 the social security deficit will reach 14% of GDP by 2021 if no reforms are implemented. This is assuming robust economic recovery this year and solid growth in the years ahead. Given social security reforms are unlikely to occur and economic growth will continue to underwhelm amid heightened political uncertainty, odds are that the impact of the social security deficit on the public debt dynamics will be worse than the IMF projections suggest. Moreover, the gap between local currency interest rates and nominal GDP growth remains extremely wide (Chart I-4). To offset this, the government has to run primary surpluses. The primary deficit is currently 2.3% of GDP. Chart I-2Income Tax Collection Has Been ##br##Boosted By One-Off Measures Income Tax Collection Has Been Boosted By One-Off Measures Income Tax Collection Has Been Boosted By One-Off Measures Chart I-3Brazil's Social Security System ##br##Is On Unsustainable Track Brazil's Social Security System Is On Unsustainable Track Brazil's Social Security System Is On Unsustainable Track Chart I-4An Untenable Gap An Untenable Gap An Untenable Gap That said, tightening fiscal policy amid the ongoing economic depression is politically suicidal. Finally, our public debt simulation suggests that unless economic growth recovers strongly, Brazil's public debt-to-GDP ratio will rise above 90% of GDP by the end of 2019 - in both our baseline and most pessimistic scenarios. Notably, our baseline scenario assumes nominal GDP growth of 5.5% in 2017, and 7% in both 2018 and 2019 (Table I-2). These are not bearish assumptions, but and could prove optimistic given the escalating political crisis. This debt simulation assumes that interest rates will stay above 10%, but it also assumes no bailout for public banks and state-owned companies, or a rise in transfers to state governments. Table I-2Brazil: Public Debt Sustainability Scenarios 2017-2019 Brazil: Politics Giveth And Politics Taketh Away Brazil: Politics Giveth And Politics Taketh Away Bottom Line: Odds are that Brazil's public debt load will continue to escalate, and that in two years or so the debt-to-GDP ratio will spiral out of control. The Economy, Corporate Profits And Markets There has been no recovery in either the economy or corporate profits (excluding commodities companies). Brazilian share prices have rallied massively in the past 17 months, yet profits in companies leveraged to the domestic business cycle have continued to shrink. Specifically, EPS for consumer staples companies and banks have dropped a lot in local currency terms, despite the equity market rally (Chart I-5). It is normal that share prices lead profits by six to 12 months, but the current rally in Brazil is already 16 months old. In short, the discrepancy between share prices and EPS is unprecedented and unsustainable. Ongoing profit weakness is consistent with a lack of recovery in domestic demand, which is corroborated by the macro data: retail sales volumes, manufacturing production and capital goods imports have not grown at all; their pace of contraction has simply moderated (Chart I-6). Chart I-5No Recovery In Corporate Profits ##br##In Non-Commodities Sectors No Recovery In Corporate Profits In Non-Commodities Sectors No Recovery In Corporate Profits In Non-Commodities Sectors Chart I-6No Recovery In Economy No Recovery In Economy No Recovery In Economy In Brazil, key to its financial markets is the exchange rate. If and when the currency appreciates, interest rates will decline and share prices will rally and the economy will eventually revive - and vice versa. In turn, the exchange rate is driven not by the interest rate differential versus the U.S., as shown in Chart I-7, but by commodities prices, with which it strongly correlates (Chart I-8). Chart I-7Interest Rate Differential And ##br##Exchange Rate: No Correlation Interest Rate Differential And Exchange Rate: No Correlation Interest Rate Differential And Exchange Rate: No Correlation Chart I-8BRL Is Sensitive To Commodities Prices BRL Is Sensitive To Commodities Prices BRL Is Sensitive To Commodities Prices BCA's Emerging Markets Strategy team believes commodities prices have peaked and will decline in the months ahead. This, along with renewed political turmoil, warrants a bearish stance on the Brazilian currency. While the central bank has large foreign currency reserves and could sell U.S. dollars to support the real, this cannot preclude a selloff in the nation's financial markets. Selling foreign currency by a central bank entails withdrawing local currency from the banking system, tighter local liquidity and higher interest rates. Hence, a central bank can defend the exchange rate from depreciation if it tolerates higher interbank rates. Higher interest rates will, however, be devastating for Brazil. If the central bank of Brazil, having used its international reserves to defend the currency, decides to inject local currency liquidity into the system to bring down local rates, the outcome will be currency depreciation. In a nutshell, a central bank cannot control both the exchange rate and local interest rates if the nation has an open capital account structure. Remarkably, Chart I-9 contends that in Brazil, the exchange rate correlates with central bank lending to commercial banks. If the central bank lends to commercial banks, the currency depreciates, and vice versa. Facing the choice between currency depreciation and higher local rates, the Brazilian central bank will choose the former because of its perilous public debt situation as well as the imperative of a revival in credit growth. Hence, the Brazilian central bank is unlikely to defend the currency on a sustainable basis. If the currency depreciates, local bonds, sovereign and corporate U.S. dollar credit and share prices will sell off too. Bottom Line: Without structural reforms and higher commodities prices, Brazilian financial markets are looking into the abyss. Investment Recommendations Politics has fueled the rally in Brazilian assets since early 2016, and now politics taketh away. With the political tailwinds reversing, investors will have nothing left to base their decisions on but the terrible macroeconomic picture. We maintain our bearish stance on Brazilian financial markets: We continue to short the BRL versus both the U.S. dollar and the Mexican peso. The real is not cheap at all while the peso offers good value (Chart I-10). Chart I-9Central Bank's Liquidity Provision ##br##To Banks Vs. Exchange Rate Central Bank's Liquidity Provision To Banks Vs. Exchange Rate Central Bank's Liquidity Provision To Banks Vs. Exchange Rate Chart I-10BRL Is Not Cheap, MXN Is BRL Is Not Cheap, MXN Is BRL Is Not Cheap, MXN Is Dedicated EM equity and credit investors should continue underweighting Brazil in their respective portfolios. Finally, local rates will be under upward pressure as the currency depreciates. We remain offside this market. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Santiago E. Gomez, Consulting Editor santiago@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Brazil: Priced For Political Perfection," dated May 12, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Brazil: Impeachment Is No Panacea," dated April 26, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Brazil's Political Honeymoon Is Over," dated August 18, 2016, available at gps.bcaresearch.com. 4 Cuevas et al., IMF Working Paper: Fiscal Challenges of Population Aging in Brazil, March 2017

Highlights Portfolio Strategy Upgrade the financials sector to overweight. This year's consolidation phase is drawing to a close as inflation expectations stabilize. Lift the S&P banks index to overweight. Leading indicators of credit creation are signaling a reacceleration as the year progresses. Trim the S&P health care sector to neutral via profit-taking in medical equipment stocks. Recent Changes S&P Financials - Upgrade to overweight from neutral. S&P Banks Index - Upgrade to overweight from underweight. S&P Health Care - Downgrade to neutral. S&P Health Care Equipment - Downgrade to neutral. Table 1 Girding For A Breakout? Girding For A Breakout? Feature Chart 1Yields Are Not Yet Restrictive Yields Are Not Yet Restrictive Yields Are Not Yet Restrictive The S&P 500 is challenging the top end of its range. A playable breakout looks increasingly probable, albeit the exact timing is difficult. First quarter profit results have been strong, corporate guidance has been solid and monetary conditions are unlikely to become tight enough in the short run to dent renewed profit optimism. The latest string of economic disappointments is seen as providing the Fed with ample leeway, and investors are willing to overlook ongoing sluggishness because earnings are outperforming the economy via margin expansion. As discussed in detail in recent weeks, earnings growth is supported by a broad-based recovery in sales and pricing power. Top-line growth is critical to sustaining the overall equity market overshoot given sky-high valuations. Indeed, the appeal of equities stems from their attractiveness relative to other asset classes rather than in absolute terms. History shows that an asset preference shift can take time to play out, and push valuations higher than seems justified on fundamentals alone as long as recession is not an imminent risk. The Treasury market can provide clues as to when vulnerabilities will intensify. According to BCA's Treasury Bond Valuation Model, yields usually need to be at least one standard deviation above normal before stocks, and the economy, are at risk of a major downturn (Chart 1). At those turning points, inflation concerns are typically running hot, forcing the Fed to tighten enough to slow growth and undermine economic activity. This simple rule of thumb warned of the most recent stock market peaks, as well as equity slumps in the early-1990s, 1987, and the early-1980s, and supported bond vs. equity outperformance. Recently, the 10-year Treasury yield has returned to fair value, and the U.S. dollar has come off the boil. The implication is that there is no monetary roadblock to halt the upward momentum in equities at the moment. There is ample room for yields to rise before becoming restrictive, especially if the primary driver is the real component. In this light, we will continue with our program of transitioning to a more balanced equity portfolio from its previous defensive tilt. This week we downgrade a defensive sector to neutral and redeploy capital into the financials sector. Upgrade The Financials Sector... The financials sector has given back roughly 50% of its post-election surge this year. The main culprits have been a calming in Fed interest rate hike expectations, a flattening yield curve and softening inflation expectations. Moribund credit creation has also created earnings uncertainty (Chart 2). Nevertheless, the corrective phase appears to be drawing to a close, because financials sector profits are increasingly likely to surpass those of the overall corporate sector going forward. Traditionally, the financials sector benefited from a strong U.S. dollar. A strong dollar exerted downward pressure on interest rates, which spurred domestic economic strength, loan demand and a steepening yield curve. However, since the GFC, the opposite has been true. Zero interest rates and intense deflationary risks were exacerbated by U.S. dollar appreciation, as the corporate sector and commodities suffered. In other words, with the economy operating on a knife's edge between deflation and inflation, a strong currency weighed heavily on financial shares. Thus, the hiatus in the U.S. dollar bull market is a significant positive catalyst, if it arrests the decline in inflation expectations. The yield curve is making an effort to stabilize, suggesting that the risks of falling back close to the deflationary precipice are low. There are already signs of a positive reversal in euro area financials, which had led the U.S. financial sector on the way down after peaking late last year (Chart 2). The euro area has been in a deleveraging phase with acute deflationary risks, underscoring that the signal from share price stabilization in this region is worth noting. The key to a sustained recovery in sector profits is economic reacceleration. Corporate sector profits are healing as a consequence of the pickup in global final demand and the peak in the U.S. dollar, which should ensure that labor market slack does not imminently build. That is necessary to sustain credit quality and generate faster credit demand, and can be illustrated through the positive correlation between the output gap and relative share price performance (Chart 3), at least until the gap grows too large to generate inflationary pressures and by extension, tight monetary policy. Chart 2Earnings Uncertainty... Earnings Uncertainty... Earnings Uncertainty... Chart 3...But A Narrowing Output Gap... ...But A Narrowing Output Gap... ...But A Narrowing Output Gap... Leading economic indicators are consistent with erring on the side of optimism (Chart 4). Our proxy for the supply/demand balance for C&I loans confirms a positive bias for future loan growth (Chart 4). The upturn in the financial sector sales/employment ratio is encouraging (Chart 4). Productivity improvement has begun prior to a reacceleration in loan creation, suggesting that additional upside looms as balance sheets expand. Any unlocking of the regulatory shackles would be a bonus. Strength in our Financials Cyclical Macro Indicator confirms that profits should best those of the overall corporate sector. The financial sector is contributing more to overall GDP growth than it did even during the credit binge/housing bubble (Chart 5), despite the headwind of ultralow interest rates. Chart 4...And Leading Indicators ##br##Are Positive Offsets ...And Leading Indicators Are Positive Offsets ...And Leading Indicators Are Positive Offsets Chart 5Market Cap ##br##Gains Loom Market Cap Gains Loom Market Cap Gains Loom Even though financials represent an ever increasing share of the broad economy, the sector still garners less than its historic median market cap weight (Chart 5). The upshot is that if the economy stays resilient, the correction in relative share price performance should fully reverse, and we recommend further upgrading allocations to overweight via the heavyweight bank group. ...And Bank On Faster Growth Bank profit growth is supported by three main pillars: the quantity, price and quality of credit. All three are set to improve. While seven out of eight lending categories are experiencing a negative credit impulse, forward looking indicators are sending a more positive message. Business and consumer confidence have skyrocketed (Chart 6). If the revival in animal spirits lifts real economic activity later this year, capital demands could finally break out of their slump and reinvigorate moribund loan growth (Chart 6). Importantly, our U.S. Capital Spending Indicator (CSI) snapped back into positive territory. This primarily reflects both the firming in the ISM manufacturing survey and tightness in the labor market. Credit growth has not yet troughed, but should recover in the second half of the year based on our CSI's reading (Chart 6, top panel). Other leading indicators are heralding a pickup in credit demand. A steepening yield curve and the soaring ISM new orders index have an excellent track record in leading the Fed's Senior Loan Officer Survey for overall credit demand (Chart 6). Solid house price inflation and a tight labor market should ensure that consumer credit growth also firms (Chart 7), pointing to the potential for a broad-based bank balance sheet expansion. Overall household leverage has fallen back to 2003 levels and the household debt-service ratio is at multi-decade lows. Chart 6A Turning Point For Loans... A Turning Point For Loans… A Turning Point For Loans… Chart 7...As Demand Recovers …As Demand Recovers …As Demand Recovers Bank deposits are still growing, outpacing nominal GDP by 200bps, and the sector is extremely well capitalized. The loan-to-deposit ratio remains low by historical standards (Chart 8). Bank holdings of risk free securities comprise about 15% of the sector's assets, well above the historic average (Chart 8). The upshot is that there is plenty of firepower to crank up credit creation. True, a rundown in Treasury holdings would result in mark-to-market losses, but banks are well positioned to navigate through rising interest rates. According to the FDIC, net interest income as a share of total revenue has climbed steadily at commercial banks with assets greater than $1bn (Chart 9). Thus, if a better economy and rising inflation materialize in the back half of the year, then higher interest rates will boost profitability (Chart 9). Chart 8Banks Have Dry Powder Banks Have Dry Powder Banks Have Dry Powder Chart 9A Durable NIM Expansion A Durable NIM Expansion A Durable NIM Expansion Table 2 shows a sample of the four largest U.S. banks' earnings sensitivity to interest rate changes. Banks profit from overall rising interest rates in two ways: reinvesting at higher yields and assets repricing at a faster pace than deposits. Table 2Top Four Banks' Interest Rate Sensitivities Girding For A Breakout? Girding For A Breakout? Thus, a steepening yield curve would signal that bank profit estimates should experience a re-rating, provided the yield lift at the long end of the curve was gradual and did not choke off growth via a sudden spike (Chart 9). In terms of credit quality, non-performing loans and charge-offs are sinking from already low levels. It would take a significant deterioration in the labor market to warn that credit quality was about to become a profit drag (Chart 10). Chart 10Credit Quality Is Not An Issue, For Now Credit Quality Is Not An Issue, For Now Credit Quality Is Not An Issue, For Now Importantly, the reserve coverage ratio has climbed to near 100%, as non-current loans have fallen faster than banks have released reserves. Historically, credit quality improvement has been positively correlated with rising valuations (Chart 10). This message is corroborated by return on equity (ROE). Bank ROE has recouped most of the losses since the GFC on the back of recovering productivity gains. However, valuations do not yet reflect the ROE improvement. History shows that after a financial crisis, it can take a prolonged period of improved ROE before investors reward the sector with a valuation expansion, as occurred in the early-1990s (Chart 7, bottom panel). Bottom Line: Boost the S&P financials sector to overweight from neutral. Lift the S&P banks index to overweight. The ticker symbols for the stocks in the S&P banks index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Take Health Care Equipment Down A Notch We are making room for the financials sector upgrade by trimming the health care sector to neutral. As discussed in recent weeks, a modest shift away from a defensive to a more balanced portfolio has been on our radar and the surge in equities over the past week suggests that the consolidation phase is now ending in a bullish fashion, as expected. At the beginning of the year we added the S&P health care equipment (HCE) index to our high-conviction overweight list for three main reasons: valuations had undershot owing to health care reform uncertainty, domestic sales were set to improve and leading indicators of foreign sourced revenue also painted a rosy picture. What has changed? Relative share prices have undergone a V-shaped snapback, all of which can be attributed to a valuation expansion. A flurry of recent M&A activity has also buoyed relative valuations, as takeover premiums have been significant. Relative performance is now at a natural spot to expect a breather. On the operating front, a number of positive profit drivers are still intact. The industry's shipments-to-inventories ratio remains at multi-decade highs and the backlog of medical equipment orders is robust (top and bottom panels, Chart 11). HCE exports are primed to accelerate in the coming months likely irrespective of the U.S. dollar's move. In particular, Europe matters most to S&P HCE constituents, as roughly half of international sales originate in the old continent. Forward-looking indicators of European demand are upbeat, especially with the surge in German medical equipment orders (Chart 11). However, domestic sales indicators have downshifted. New health care facility construction has dropped sharply, warning that investment in medical equipment may soon follow suit (Chart 12, second panel). Consumables demand growth may also take a breather. Consumer outlays at hospitals have nosedived on a growth rate basis. This suggests that the growth in patient visits has dried up, and may be a warning that medical equipment new order growth will also decelerate (Chart 12). Moreover, as outlined in recent Weekly Reports, the broad corporate sector has regained pricing power, but medical equipment suppliers have lagged. Chart 12 shows that relative selling prices are contracting at an accelerating pace. This is significant, as deflation concerns could undermine revenues, and halt the valuation expansion. If domestic medical equipment demand cools, then it will sustain downward pressure on industry activity (Chart 13). Already, medical equipment industrial production (IP) has collapsed, in marked contrast with the expansion in overall IP. Chart 11Export Prospects Are Positive... Export Prospects Are Positive... Export Prospects Are Positive... Chart 12...But Domestic Blues... ...But Domestic Blues... ...But Domestic Blues... Chart 13...Will Weigh On Activity ...Will Weigh On Activity ...Will Weigh On Activity Worrisomely, the HCE new orders-to-inventories ratio has also lost steam, warning that a recovery in future production growth may not be imminent. The implication is that productivity gains are petering out, denting our confidence in a further valuation re-rating. Bottom Line: Downgrade the S&P health care equipment index and remove it from the high-conviction overweight list for an 9% gain. This also pushes the broad health care index to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HCEP: MDT, ABT, DHR, SYK, BDX, BSX, ISRG, BAX, ZBH, EW, BCR, IDXX, HOLX, VAR. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. There are also some worrying signs in our global forward-looking growth indicators for 2018, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. first-quarter economic data. They also went too far in pricing out U.S. fiscal action. It is positive for risk assets that centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. Italian elections could be troublesome, but that is a story for next year. The fact that China finally appears willing to apply pressure to Pyongyang is good news. North Korea might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. Disappointing U.S. Q1 real GDP growth largely reflects weather and seasonal adjustment factors. The deceleration in bank credit growth is also temporary. The window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals remain constructive. Importantly, signs of improving pricing power in the U.S. corporate sector are finally emerging, which should allow margins to expand somewhat in the coming quarters. The bond rally has depressed yields to a level that makes fixed-income instruments highly vulnerable to a reversal of the factors that sparked the rally. Market expectations for the fed funds rate are far too benign. The ECB will announce the next tapering step later this year, and may remove the negative deposit rate. But the central bank will not be in a position to lift the refi rate for some time. Yield spreads will shift in a way that allows one last upleg in the U.S. dollar. The recent pullback in oil prices will not last, as OPEC and Russia manage global stockpiles lower this year. Feature Chart I-1Reflation Trades Returning? Reflation Trades Returning? Reflation Trades Returning? Traders and investors gave up on the global reflation story in early April, sending the 10-year U.S. Treasury yield below the year's trading range. Missile strikes, European elections and U.S. saber rattling regarding North Korea lifted the allure of safe havens such as government bonds (Chart I-1). At the same time, the Fed was unwilling to revise up the 'dot plot', doubts grew over the ability of the Trump Administration to deliver any stimulus and U.S. data releases disappointed. The major equity indexes held up well against the onslaught of bad news, but looked increasingly vulnerable as April wore on. The market gloom was overdone in our view, and it appears that financial markets have now returned to a 'risk on' phase. It is difficult to forecast the ebb and flow of geopolitical news so we cannot rule out another bout of risk aversion. Nonetheless, the global economic backdrop remains upbeat and tensions regarding North Korea have eased. President Trump also unveiled his Administration's tax reform plan, raising hopes of a fiscal boost to the economy. Moreover, investors have read too much into the distorted U.S. first quarter data, and our corporate pricing power indicators support our constructive earnings view in 2017. There are clouds hanging over the outlook for 2018, but the backdrop will favor risk assets for most of this year. Investors should remain overweight equities versus bonds and cash, and bullish the dollar. Geopolitics Weigh On Risk Tolerance President Trump's military show of force in Asia and comments about "losing patience" with North Korea have the world on edge. The U.S. has acted tough with the regime before, but nothing beyond economic sanctions ever materialized. The balance of power vis-à-vis China and the military threat to South Korea made North Korea a stalemate. Nonetheless, our geopolitical team argues that the calculus of the standoff is changing. Most importantly, the rogue regime is getting closer to being capable of hitting the U.S. with long-range missiles. Second, China is unhappy with the increased U.S. military presence in its backyard that North Korea is inviting. China also sees North Korea's missile tests as a threat to its own security. Third, the U.S. is prepared to use the threat of trade sanctions as leverage with Beijing. It is demanding that China use its own economic leverage to convince North Korea to freeze its nuclear and missile programs. We do not believe that an attack on North Korea is imminent. But doing nothing is not an option either. Our base case is that the U.S. military's muscle-flexing is designed to force North Korea to the negotiating table. The fact that China finally appears willing to apply pressure to Pyongyang is good news. Over the next four years, the North might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. The safe-haven bid in the Treasury market will moderate if Kim Jong-un agrees to negotiations. That said, this is probably North Korea's last chance to show it can be pragmatic. A failure of negotiations would induce a real crisis in which the U.S. contemplates unilateral action. It would be a bad sign if North Korea's long-range missile tests continue, are successful, and show greater distances. Chart I-2Macron Appears Set For Victory Macron Appears Set For Victory Macron Appears Set For Victory Turning to Europe, investors breathed a sigh of relief following the first round of the French Presidential election. The pre-election polls turned out to be correct, and our Geopolitical Team has no reason to doubt the polls regarding the second round (Chart I-2). We expect Macron to sweep to victory on May 7 because Le Pen will struggle to get any voters from the candidates exiting the race. What should investors expect of a Macron presidency? A combination of President Macron and a right-leaning National Assembly should be able to accomplish some reforms. Several prominent center-right figures have already come out in support of Macron, perhaps to throw their name in the ring for the next prime minister. This is positive for the markets as it means that French economic policy will be run by the center-right, with an ultra-Europhile as president. Over in the U.K., the big news in April was Prime Minister Theresa May's decision to hold a snap election, which reduces the risk of a "hard Brexit". The current slim 12-seat majority that the Conservatives hold in Parliament has made May highly dependent on a small band of hardline Tories who would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. If the Conservatives are able to increase their seats in Parliament - as current opinion polls suggest is likely - May will have greater flexibility in reaching an agreement with Brussels and will face less of a risk that Parliament shoots down the final deal. U.S. Fiscal Policy: Positive For 2017, But Long-Term Negative Chart I-3Long-Term U.S. Budget Pressures Long-Term U.S. Budget Pressures Long-Term U.S. Budget Pressures The drama will be no less interesting in Washington in the coming weeks. As we go to press, Congress is struggling to pass a bill to keep the U.S. government running through the end of fiscal year 2017 (the deadline is the end of April). We expect a deal will get done, but a partial government shutdown lasting a few weeks could occur. Separately, Congress will need to approve an increase in the debt ceiling by July-September in order for the Treasury to avoid defaulting on payments. Both events could see temporary safe-haven flows into Treasurys. However, markets may have gone too far in pricing-out tax cuts or fiscal stimulus. For example, high tax-rate companies have given back all of their post-election equity gains. Even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. "Dynamic scoring" will be used to support the argument that the tax cuts will self-funding through faster growth. We also expect that Trump will get his way on at least a modest amount of infrastructure spending. The so-called Trump trades may wither again in 2018, but we see a window this year in which the stock-to-bond total return ratio lifts as growth expectations rebound. Looking further ahead, it seems likely that the U.S. budget deficit is headed significantly higher. Health care and pension cost pressures related to population aging are well known (Chart I-3). A recent Special Report by BCA's Martin Barnes highlighted that "it is not reasonable to believe that there can be tax cuts and increases in defense spending and domestic security, while protecting entitlement programs and preventing a massive rise in the budget deficit."1 There is simply not enough non-defense discretionary spending to cut. Larger U.S. Federal budget deficits could lead to a widening fiscal risk premium in Treasury yields, although that may take years to show up. Perhaps more importantly, the U.S. government sector will be a larger drain on the global pool of available savings in the coming years. We highlight in this month's Special Report, beginning on page 20, that there are several key macro inflection points under way that will temper the "global savings glut" and begin to place upward pressure on global bond yields. A Temporary Soft Patch Or Something Worse? The first quarter GDP report for the U.S. is due out as we go to press, and growth is widely expected to be quite weak. The retail sales and PCE consumer spending data have fed concerns that the U.S. economy is running out of gas, despite the surge in the survey data such as the ISM. We believe that growth fears are overdone. Financial markets should be accustomed to weak readings on first quarter GDP. Over the past 22 years, the first quarter has been the weakest of the four on 12 occasions, or 55% of the time. Second quarter GDP growth has been faster than Q1 growth 70% of the time. A large part of the depressed Q1 GDP growth rate and lackluster "hard data" readings likely reflect poor seasonal adjustment and weather distortions. The "soft" survey data are more consistent with the labor market. Aggregate hours worked managed to increase by 1.5% at an annualized rate in Q1. If GDP growth really was barely above zero, this would imply an outright decline in the level of labor productivity. Even in a world where structural productivity growth is lower than it was in the past, this strikes us as rather implausible. The March reading of the Conference Board's Leading Economic Indicator provided no warning that underlying growth is about to trail off, although a couple of the regional Fed surveys have pulled back from their recent highs. With April shaping up to be warmer than usual across the U.S., we expect a bounce back in the weather-impacted "hard" data in May and June. What about the slowdown in commercial and industrial loan growth and corporate bond issuance late in 2016 and into early 2017? This is a worry, but it partly reflects the lagged effects of the contraction in capital spending in the energy patch. C&I loan growth is still responding to the surge in defaults that resulted from the energy sector's 2014 collapse. Now that the defaults have waned, this process will soon go into reverse. Higher profits more recently have permitted these firms to pay back old bank loans, while also enabling them to finance new capital expenditures using internally-generated funds. In addition, the rising appetite for corporate debt has allowed more companies to access the bond market. According to Bloomberg, the U.S. leveraged-loan market saw $434 bn in issuance in Q1, the highest level on record (Chart I-4). The rest we chalk up to uncertainty surrounding the U.S. election. The recent spikes in the political uncertainty index correspond with the U.K.'s vote to leave the European Union as well as the U.S. election in November. There has been a close correlation between these spikes and the deceleration in C&I loan growth. CEOs are also holding back on capex in anticipation of new tax breaks from Congress. The good news is that bond issuance has rebounded strongly in January and February of this year (Chart I-5). The soft March U.S. CPI release also appeared to be quirky, showing a rare decline in the core price level in March (Chart I-6). However, the March reading followed two months of extremely strong gains and it still appears as though measures of core inflation put in a cyclical bottom in early 2015. 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 I-4U.S. Bank Credit Slowdown Is Temporary U.S. Bank Credit Slowdown Is Temporary U.S. Bank Credit Slowdown Is Temporary Chart I-5U.S. Corporate Bond Issuance Is Rebounding U.S. Corporate Bond Issuance Is Rebounding U.S. Corporate Bond Issuance Is Rebounding Chart I-6U.S. Inflation: Sogginess Won't Last U.S. Inflation: Sogginess Won't Last U.S. Inflation: Sogginess Won't Last Global Economic Data Still Upbeat For the major industrialized economies as a group, 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 4½% in February on a year-over-year basis (Chart I-7). 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 that 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 I-8). 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 six months to March (Chart I-9). Chart I-7Global Pick-Up On Track Global Pick-Up On Track Global Pick-Up On Track Chart I-8Manufacturing Rebound Is Not About Energy Manufacturing Rebound Is Not About Energy Manufacturing Rebound Is Not About Energy Chart I-9U.S.: Non-Energy Production Surging U.S.: Non-Energy Production Surging U.S.: Non-Energy Production Surging The weak spot on the global data front has been capital goods orders (Chart I-7). We only have data for the big three economies - the U.S., Japan and the Eurozone - but growth is near 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 I-7, third panel). Improving CEO sentiment, accelerating profit growth and activity surveys all suggest that capital goods orders will catch up in the coming months. That said, one risk to our positive capex outlook in the U.S. is that the Republicans fail to deliver on their promises. 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 spending. As for China, the economic data are holding up well and deflationary pressures have eased. Fears of a debt crisis have also ebbed somewhat. That said, fiscal and monetary stimulus is fading and it is a worrying sign that money and credit growth have decelerated because they tend to lead production. Our China experts believe that growth will be solid in the first half of the year, but they would not be surprised to see a deceleration in real GDP growth in the second half that would weigh on commodity prices. Bond Market Vulnerable To Fed Re-Rating A rebound in the U.S. activity data in the coming months should keep the Fed on track to raise rates at least two more times in 2017. A May rate hike is unlikely, but we would not rule out June. The bond market is vulnerable to a re-rating of the path for the fed funds rate because only 45 basis points of tightening is priced for the next 12 months. This is far too low if growth rebounds as we expect. The FOMC also announced that it intends to start shrinking its balance sheet later this year by ceasing to reinvest both its MBS and Treasury holdings. Our bond strategists do not think this by itself will have much of an impact on Treasurys because yields will continue to be closely tied to realized inflation and the expected number of rate hikes during the next 12 months (Chart I-10). Fed policymakers are 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. It is a different story for mortgage-backed securities, however, where spreads will be pressured wider by the lack of Fed purchases. All four of our main forward-looking global economic indicators appear to have topped out, except the Global Leading Economic Indicator (GLEI), suggesting that the period of maximum growth acceleration has past (Chart I-11). Nonetheless, all four are still consistent with robust growth. They would have to weaken significantly before they warned of a sustained bond bull market. Chart I-10Shrinking Fed Balance Sheet: ##br##Bearish For Bonds? Shrinking Fed Balance Sheet: Bearish For Bonds? Shrinking Fed Balance Sheet: Bearish For Bonds? Chart I-11Leading Indicators: ##br##Some Worrying Signs Leading Indicators: Some Worrying Signs Leading Indicators: Some Worrying Signs The rapid decline in the diffusion index, based on the 22 countries that comprise our GLEI, is the most concerning at the moment. 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 bottom line is that global bond yields have overshot on the downside: underlying U.S. growth is not as weak as the Q1 figures suggest; market expectations for the fed funds rate are too benign; the Republicans will push ahead with tax cuts and infrastructure spending; the global economy has healthy momentum, and the majority of the items on our Duration Checklist suggest that the bond bear market will resume; the ECB will announce another tapering of its asset purchase program this autumn, placing upward pressure on the term premium in bond yields across the major markets; and 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. 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. We recommend keeping duration short of benchmarks within fixed-income portfolios. One Last Leg In The Dollar Bull Market Chart I-12ECB In No Hurry To Lift Rates ECB In No Hurry To Lift Rates ECB In No Hurry To Lift Rates While we see upside for the money market curve in the U.S., the same cannot be said in the Eurozone. The economic data have undoubtedly been robust. The composite PMI is booming and capital goods orders are in a clear uptrend. Led by gains in both manufacturing and services, the composite PMI rose from 56.4 in March to 56.7 in April, a six-year high. The current PMI reading is easily consistent with over 2.0% real GDP growth (Chart I-12). This compares favorably to the sub-1% estimates of trend growth in the euro area. Private sector credit growth reached 2½% earlier this year, the fastest pace since July 2009. Despite this good news, the ECB is in no rush to lift interest rates. The central bank will taper its asset purchase program further in 2018, but ECB President Draghi has made it clear that he will not raise the refi rate until well after all asset purchases have been completed, which probably will not be until late 2019 at the earliest (although the ECB could eliminate the negative deposit rate to ease the pressure on banks). Unemployment is still a problem in Spain and Italy, while core CPI inflation fell back to just 0.7% in March. The euro could strengthen further in the near term if Macron wins the second round of the French elections, easing euro break-up fears. Nonetheless, we expect the euro to trend lower on a medium-term horizon versus the dollar as rate expectations move further in favor of the greenback. Some real rate divergence is already priced into money and currency markets, but there is room for forward real spreads to widen further, possibly pushing the euro to parity versus the dollar before this cycle is over. We are also bullish the dollar versus the yen for similar reasons. On a broad trade-weighted basis, we still expect the dollar to rally by another 10%. Positive Signs For U.S. Corporate Pricing Power Chart I-13U.S. Corporations Gaining Pricing Power U.S. Corporations Gaining Pricing Power U.S. Corporations Gaining Pricing Power Turning to the equity market, it is still early days for Q1 U.S. earnings, but the results so far are positive for a pro-risk asset allocation. After a disappointing Q4, positive Q1 earnings surprises for the S&P 500 are on track to match their highest level in two years, with revenue surprises also materially higher than previous quarters. At the industry level, banks and capital goods companies stand out: the former registered an earnings beat of nearly 8%, and it was nearly 12% for the latter. We highlighted the positive 2017 outlook for U.S. corporate profits in our March 2017 Monthly Report. Earnings growth is in a catch-up phase following last year's profit recession, which was related to energy prices and a temporary slowdown in nominal GDP growth relative to aggregate labor costs. Proprietary indicators from our sister publication, the U.S. Equity Sectors Strategy service, confirm our thesis. First, deflation pressures appear to be abating. A modest revival in corporate pricing power is underway according to our Pricing Power Proxy (Chart I-13). It is constructed from proxies for selling prices in almost 50 industries. Importantly, the rise in the Proxy is broadly-based across industries (as shown by the diffusion index in the chart). As a side note, the Profit Proxy provides some evidence that recent softness in core CPI inflation will not last. Second, the upward march of wage growth appears to be taking a breather (Chart I-13). Average hourly earnings growth has softened in recent months. Broader measures, such as the Atlanta Fed Wage Tracker, tell a similar story. We do not expect wage growth to decelerate much given tightness in the labor market. Nonetheless, the combination of firming pricing power and contained wage growth (for now) suggests that margins will continue to expand modestly in the first half of the year. Our model even suggests that U.S. EPS growth has a very good shot at matching perpetually-optimistic bottom-up estimates for 2017 (Chart I-14). Many companies have supported per share profits in this expansion via share buybacks, often funded through debt issuance. This has generated some angst that companies are sacrificing long-term earnings growth potential for short-term EPS growth. This appeared to be the case early in the expansion, but the story is less compelling today. Chart I-15 compares the cumulative dollar value of equity buybacks and dividends in this expansion with the previous three expansion phases. The cumulative dollar values are divided by cumulative nominal GDP to make the data comparable across cycles. By this metric, capital spending has lagged previous expansion, but not by much. While capital spending growth has been weak, the same is true for GDP. Chart I-14U.S. Profit Model Is Very Upbeat U.S. Profit Model Is Very Upbeat U.S. Profit Model Is Very Upbeat Chart I-15U.S. Corporate Finance Cycle Comparison May 2017 May 2017 Dividend payments have been stronger than the three previous expansions. Buyback activity was also more aggressive compared with the 1990s and 2000s, although repurchase activity has been roughly in line with the expansion that ended in 2007. Net equity issuance since 2009, which includes the impact of IPOs, share buybacks and M&A activity, has not been out of line with previous expansions (positive values shown in Chart I-15 represent net equity withdrawals). CFOs have not been radically different in this cycle in terms of apportioning funds between capital spending and returning cash to shareholders. Nonetheless, buybacks have boosted EPS growth by almost 2% over the past year according to our proxy (Chart I-16). We expect this tailwind to continue given the positive reading from our Capital Structure Preference Indicator (third panel). Firms have a financial incentive to issue debt and buy back shares when the indicator is above zero. Stronger global growth should continue to power an acceleration in corporate earnings outside the U.S. over the remainder of the year. Chart I-17 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. Our profit indicators remain constructive for the U.S., Eurozone and Japan. Chart I-16Incentive To Buy Back ##br##Stock Remains Strong Incentive To Buy Back Stock Remains Strong Incentive To Buy Back Stock Remains Strong Chart I-17Global Profit ##br##Growth On The Upswing Global Profit Growth On The Upswing Global Profit Growth On The Upswing It is disconcerting that the rally in oil prices has faltered in recent days as investors worry that increased U.S. shale production will thwart OPEC's plans to trim bloated inventories. A breakdown in oil prices could spark a major correction in the broader equity market. Indeed, commercial oil inventories finished the first quarter with a minimal draw. The aim of last year's agreement between OPEC and Russia to remove some 1.8mn b/d of oil production from the market in 2017 H1 was to get visible inventories down to five-year average levels. They are well short of that goal. Without trimming stockpiles to more normal levels, storage capacity remains too close to topping out, which raises the risk of another price collapse. This is an extremely high-risk scenario for states like Saudi Arabia, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. This is the reason why our commodity strategists expect the OPEC/Russia production cuts to be extended when OPEC meets on May 25. This will significantly raise the odds that OECD commercial oil stocks will be drawn down to more normal levels. We expect WTI and Brent to trade on either side of $60/bbl by December, and to average $55/bbl to 2020. Investment Conclusions Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. Admittedly, some of the U.S. data have been disappointing given the extremely upbeat survey numbers. There are also some worrying signs in our global forward-looking growth indicators, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. economic data in the first quarter. They also went too far in pricing out U.S. fiscal action. As for European political risk, centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. There are legitimate reasons to be concerned about the economic and profit outlook in 2018. Nonetheless, we believe that the window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals are constructive. The passage of market-friendly fiscal policies in the U.S. later in 2017 will be icing on the cake. Perhaps more importantly, we are finally seeing signs that pricing power in the U.S. corporate sector is improving, allowing margins to expand somewhat in the coming quarters. Our profit models remain upbeat for the major advanced economies and for China. It has been frustrating for those investors looking for an equity buying opportunity. Despite the surge in defensive assets such as gold and Treasurys, the major equity bourses did not correct by much. Value remains stretched in all of the risk asset classes. Nonetheless, investors should stay positioned for another upleg in the stock-to-bond total return ratio in the coming months. Perhaps the largest risk lies in the bond market. The rally has depressed yields to a level that makes bonds highly vulnerable to a reversal of the factors that sparked the rally. Within an underweight allocation to fixed-income in balanced portfolios, investors should overweight investment- and speculative-grade corporate bonds in the U.S. and U.K. We are more cautious on Eurozone corporates as the ECB's support for that sector will moderate. Looking ahead to next year, our bond strategists foresee a shift to underweight credit given the advanced nature of the releveraging cycle in the U.S. corporate sector. Our other recommendations include: Within global government bond portfolios, overweight JGBs and underweight Treasurys. Gilts and core Eurozone bonds are at benchmark. Underweight the periphery of Europe. Overweight European and Japanese equities versus the U.S. in currency-hedged terms. Continue to favor defensive over cyclical equity sectors in the U.S. for now, but a shift may be required later this year. Overweight the dollar versus the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market. Recent underperformance is a buying opportunity. Value has improved and cyclical conditions favor small caps. Stay exposed to oil-related assets, and favor oil to base metals within commodity portfolios. Mark McClellan Senior Vice President The Bank Credit Analyst April 27, 2017 Next Report: May 25, 2017 1 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies and Fantasies," dated April 5, 207, available at bca.bcaresearch.com II. Beware Inflection Points In The Secular Drivers Of Global Bonds The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart II-1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart II-1Global Disequilibria May 2017 May 2017 The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart II-2Global Shifts In The Saving ##br##And Investment Curves May 2017 May 2017 The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart II-2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart II-3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart II-3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart II-3Demographics Are A Structural Headwind For Global Capex May 2017 May 2017 (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart II-4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart II-2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart II-5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart II-6). The same is true, although to a lesser extent, in the emerging world. Chart II-4Working-Age Population Ratios Have Peaked Working-Age Population Ratios Have Peaked Working-Age Population Ratios Have Peaked Chart II-5Labor Share Of Income Has Dropped Labor Share Of Income Has Dropped Labor Share Of Income Has Dropped Chart II-6Hollowing Out Hollowing Out Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart II-7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart II-8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart II-7Economic Integration And ##br##Falling Capital Goods Prices Economic Integration And Falling Capital Goods Prices Economic Integration And Falling Capital Goods Prices Chart II-8Macro Impact Of ##br##Labor Supply Shock Macro Impact Of Labor Supply Shock Macro Impact Of Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart II-9Working-Age Population ##br##To Shrink In G7 And China Working-Age Population To Shrink in G7 and China Working-Age Population To Shrink in G7 and China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart II-9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart II-10Globalization Peaking? Globalization Peaking? Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart II-10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart II-11 presents the data for China and three of the major advanced economies. Chart II-11Income And Consumption By Age Cohort Income And Consumption By Age Cohort Income And Consumption By Age Cohort The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart II-11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart II-11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. The results are shown in Chart II-12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart II-12Aging Will Undermine Aggregate Saving Aging Will Undermine Aggregate Saving Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Chart II-13Demographics And Capex Requirements May 2017 May 2017 Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart II-13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too Chart II-14China's Savings Rates Have Peaked... China's Savings Rates Have Peaked... China's Savings Rates Have Peaked... China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart II-14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart II-15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart II-15...Suggesting That External Surplus Will Shrink ...Suggesting That External Surplus Will Shrink ...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: The main points we made in this report are summarized in Table II-1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. Table II-1Key Secular Drivers May 2017 May 2017 No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook.7 Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Chart II-16Market Expects Negative Short-Term Rates For A Long Time Market Expects Negative Short-Term Rates For A Long Time Market Expects Negative Short-Term Rates For A Long Time Another way of looking at this is presented in Chart II-17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart II-17Forward Rates Very Low Vs. History Forward Rates Very Low Vs. History Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan Senior Vice President The Bank Credit Analyst 1 It is true that observed household savings rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol. 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3 in the IMF World Economic Outlook (April 2017). 5 In other words, while the household savings rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e. savings across the household, government and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014). 7 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. III. Indicators And Reference Charts The modest correction in April did not improve equity valuation by much in any of the major markets. Our U.S. valuation metric is still hovering just below the +1 sigma mark, above which would signal extreme overvaluation. Measures such as the Shiller P/E ratio are flashing red on valuation, but our indicator takes into consideration 11 different valuation measures. Technically, the U.S. equity market still has upward momentum, while our Monetary indicator is neutral for stocks. The Speculation index indicates some froth, although our Composite Sentiment indicator has cooled off, suggesting that fewer investors are bullish. The U.S. net revisions ratio is hovering near zero, but it is bullish that the earnings surprise index jumped over the past month. First-quarter earnings season in the U.S. has got off to a good start, while the global earnings revisions ratio has moved into positive territory for the first time in six years (see the Overview section). Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500, although it is now so elevated that it suggests that there could be little 'dry power' left to buy the market. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. In contrast to the U.S., the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway and has some ways to go. We remain overweight both the Eurozone and Japanese markets relative to the U.S. on a currency-hedged basis. April's rally in the U.S. bond market dragged valuation close to neutral. However, we believe that the market is underestimating the amount of Fed rate hikes that are likely over the next year. Now that oversold technical conditions have been absorbed, this opens the door the next upleg in yields. Bonds typically move into 'inexpensive' territory before the monetary cycle is over. The trade-weighted dollar remains quite overvalued on a PPP basis, although less so by other measures. Technically, the dollar has shifted down this year to meet support at the 200-day moving average and overbought conditions have largely, but not totally, been worked off. We still believe there is more upside for the dollar, despite lofty valuation readings, due to macro divergences. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights It is difficult to judge how much of the recent unwind of the Trump Trades has been due to data disappointments versus rising geopolitical tensions. We do not believe that an attack on North Korea is imminent. Rather, U.S. military muscle-flexing is designed to force the rogue state to the negotiating table. On the economic front, the U.S. "hard" data have disappointed surveys in Q1. However, we believe this largely reflects weather and seasonal adjustment distortions. The Leading Economic Indicator and our new Beige Book Monitor support this view. Our profit growth model is very bullish for earnings this year, and is supported by our proxies for corporate pricing power. The latter is improving relative to wage growth recently, suggesting that there is more upside for margins this year. Returning cash to shareholders has not been particularly strong in this expansion relative to past expansions, contrary to popular belief. Nonetheless, buyback activity will continue to boost EPS growth by about 2 percentage points. Cyclical conditions and a significant improvement in relative valuation suggests that investors should continue to favor small over large cap stocks. Feature Treasury yields fell to their lowest level last week since just after the U.S. Presidential election. The solid start to the Q1 earnings reporting season was not enough to offset the disappointing economic reports and geopolitical fears, leaving U.S. equity prices mostly lower on the week (Chart 1). We thought that the "hard" data would improve to meet the accelerating "soft" data, but that clearly didn't occur last week. Unusual weather in March may have been a factor. We will return to the outlook for the economy and corporate profits later in the report. Chart 1Q1 Growth Disappoints Q1 Growth Disappoints Q1 Growth Disappoints It is difficult to judge how much of the bond rally has been due to data disappointments versus rising geopolitical tensions. President Trump's military show of force in Asia and comments about "losing patience" with North Korea have the world on edge. The U.S. has acted tough with the regime before, but nothing beyond economic sanctions ever materialized. The balance of power vis-à-vis China and the military threat to South Korea made North Korea a stalemate. Nonetheless, our geopolitical team argues that the calculus of the standoff is changing. Most importantly, the rogue regime is getting closer to being capable of hitting the U.S. with long-range missiles. Second, China is unhappy with the increased U.S. military presence in its backyard that North Korea is inviting. China also sees North Korea's missile tests as a threat to its own security. Third, the U.S. is prepared to use the threat of trade sanctions as leverage with Beijing. It is demanding that China use its own economic leverage to convince North Korea to freeze its nuclear and missile programs. We do not believe that an attack on North Korea is imminent. But doing nothing is not an option either. Our base case is that the U.S. military's muscle-flexing is designed to force North Korea to the negotiating table. Over the next four years, the North might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. That said, this is probably North Korea's last chance to show it can be pragmatic. A failure of negotiations would induce a real crisis in which the U.S. contemplates unilateral action. It would be a bad sign if North Korea's long-range missile tests continue, are successful, and show greater distances.1 The market's political focus will likely turn back to Washington this week. Congress has until April 28 to pass a bill to keep the U.S. government running through the end of fiscal year 2017. Our Geopolitical Strategy Service continues to expect a deal to get done, but a partial government shutdown lasting a few weeks could occur. Separately, Congress will need to approve an increase in the debt ceiling by July-September in order for the Treasury to avoid defaulting on payments. While the negotiations surrounding both of events could weigh on Treasury yields in the near term, our view is that they are unlikely to prevent an uptrend in yields over the coming 6-12 months. As for North Korea, the safe-haven bid in the Treasury market will moderate if Kim Jong-un agrees to negotiations. But, near term, this situation is a huge wildcard. We cannot rule out another wave of risk aversion in financial markets. As this week's publication goes to press, the results of the first round of the French presidential election are being tabulated. Please consult BCA's Daily Insight on Monday, April 24, 2017 for our first take on the election results. A Temporary Soft Patch Or Something Worse? In last week's report, we wrote that the weak readings from the "hard" economic data would soon catch up with the surging "soft" economic data. In fact, the opposite has occurred since mid-April. Is this the start of a prolonged weak patch in the U.S. economy? Or is the softness perhaps related to weather and poor seasonal adjustment? We favor the later explanation for now. The first quarter GDP report is due out this Friday, April 28. The Bloomberg consensus is looking for just a 1.2% gain in the quarter after the 2.1% increase in Q4 2016. The Atlanta Fed's "GDP Nowcast" puts Q1 GDP at just 0.5% (Chart 1). The New York Fed's "Nowcast" is at 2.7%. Both estimates have been moving consistently lower since early March, dragging down 10-year Treasury yields (with U.S. stock prices along for the ride). Financial markets should be used to weak readings on first quarter GDP by now. Between 1950 and 1996, Q1 GDP was the weakest quarter of the year in just 14 of 47 years, or 30% of the time (Table 1). Q2 growth was stronger than Q1 growth about half the time. This is just about what you would expect if the U.S. Bureau of Economic Analysis' (BEA) seasonal adjustment program was functioning properly. But something has gone awry since 1997, despite the government statisticians' recent attempts to correct the problem. Over the past 20 years, the first quarter has been the weakest GDP reading of the year 10 times, or 50% of the time, and Q2 GDP growth has been faster than Q1 growth 70% of the time. Table 1The Gap Between GDP Growth In Q1 And Q2 Has Widened In The Past 20 Years Spring Snapback? Spring Snapback? A recent study by the staff at the Federal Reserve Bank of Cleveland2 suggests that the main culprits in this anomaly are in the private investment and government consumption components of GDP. More specifically, the Cleveland Fed cites defense spending as the key driver of the weakness in Q1 GDP relative to other quarters. We'll expand on this theme in next week's U.S. Investment Strategy report, but for now our view remains that the weakness in U.S. economic growth is temporary. The March reading of the Conference Board's Leading Economic Indicator provided no warning that underlying growth is about to trail off, although a couple of the regional Fed surveys have backed off of their recent highs. With April shaping up to be warmer than usual across the U.S., we expect a bounce back in weather-impacted "hard" data like retail sales, housing starts and industrial production. The April update of our Beige Book Monitor, which we introduced last week, confirms that the economy is stronger than the GDP data suggest (Chart 2). The Monitor is simply the difference between the percentage of "strong" versus "weak" descriptors for growth in the document. Chart 2BCA Beige Book Monitor Upbeat For Growth BCA Beige Book Monitor Upbeat For Growth BCA Beige Book Monitor Upbeat For Growth The Monitor edged higher in April to 65%, from 51% in the March reading. "Weather" was mentioned 18 times, after just 6 mentions in March. More than two thirds of the 18 mentions of weather in April cited it as having a negative impact on economic activity. This supports our view that weather had a non-negligible impact on the hard data in March. Thus, if the weather in the first three weeks of April persists into the final week of the month, the stage is set for a noticeable improvement in U.S. economic data released in May. All else equal, this should temper fears that the U.S. economic expansion has lost momentum, supporting stock prices and allowing the recent bond rally to unwind (depending on geopolitics). The soft March CPI also appeared to be quirky, revealing that the core measure actually contracted in March (Chart 3). We note, however, that the weak March reading followed two months of extremely strong gains. In addition, it still appears as though measures of core inflation put in a cyclical bottom in early 2015. 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. Our "inflation words" indicator based on the Beige Book remains in an uptrend (Chart 2). Chart 3Has U.S. Inflation Peaked? Has U.S. Inflation Peaked? Has U.S. Inflation Peaked? A rebound in the activity data in the coming months should keep the Fed on track to raise rates at least two more times in 2017. A rate hike in next month is unlikely, but we would not rule out June if the economic data firm as we expect. Positive Signs For U.S. Corporate Pricing Power Another 82 S&P 500 companies report first quarter results this week, making it the busiest week of the season. The consensus for Q1 earnings growth remains near 10% on a 4-quarter trailing basis. That forecast is likely to be met. We highlighted the positive 2017 outlook for U.S. corporate profits in the April 10, 2017 Weekly Report. The U.S. experienced a profit recession in 2016 that did not coincide with an economic recession. Oil prices were part of the story, but we have seen this pattern occur several time since the late 1990s; nominal GDP growth (a proxy for top line growth) decelerates temporarily relative to labor compensation growth. Margins get squeezed but, since the economy manages to avoid a recession, nominal GDP growth subsequently rebounds relative to labor compensation. This resulted in a 'catch up' phase when earnings-per-share growth accelerated sharply and equity returns were favorable. We believe that U.S. earnings are in the same type of catch-up phase now, which has been accentuated by the rebound in oil prices. Proprietary indicators from our sister publication, the U.S. Equity Strategy service, confirm our thesis. First, deflation pressures appear to be abating. A modest revival in corporate pricing power is underway according to our Pricing Power Proxy (Chart 4). It is constructed from proxies for selling prices in almost 50 industries. Importantly, the rise in the Proxy is broadly based across industries (as shown by the diffusion index in the chart). As a side note, the Proxy provides some evidence that softness in core CPI will not last. At the same time, the upward march of wage growth appears to be taking a breather (Chart 4). Average hourly earnings growth has softened in recent months. Broader measures, such as the Atlanta Fed Wage Tracker, tell a similar story. We do not expect wage growth to decelerate much given tightness in the labor market. Nonetheless, the combination of firming pricing power and contained wage growth (for now) suggests that margins will continue to expand modestly in the first half of the year. Our model even suggests that U.S. EPS growth has a very good shot at matching (perpetually optimistic) bottom-up estimates for 2017 (Chart 5). Chart 4Corporate Sector Gaining ##br##Some Pricing Power Corporate Sector Gaining Some Pricing Power Corporate Sector Gaining Some Pricing Power Chart 5Profit Model##br## Is Very Bullish Profit Model Is Very Bullish Profit Model Is Very Bullish Companies have supported per share profits in this expansion in part via share buybacks, often funded through debt issuance. This has generated some angst that companies are sacrificing long-term earnings growth potential for short-term EPS growth. This appeared to be the case early in the expansion, but the story is less compelling today. Chart 6 compares the cumulative dollar value of equity buybacks and dividends in this expansion with the previous three expansion phases. The cumulative dollar values are divided by cumulative nominal GDP to make the data comparable across cycles. By this metric, capital spending has lagged previous expansion, but not by much. While capital spending growth has been weak, the same has been true for GDP growth. Chart 6Comparison Of Corporate Outlays Across Four Economic Expansion Phases Spring Snapback? Spring Snapback? Dividend payments have been stronger than the three previous expansions. Buyback activity was also more aggressive compared with the 1990s and 2000s, although repurchase activity has been roughly in line with the expansion that ended in 2007. Net equity withdrawal since 2009, which includes the net impact of IPOs, share buybacks and M&A activity, has not been out of line with previous expansions. Bottom Line: CFOs have not been radically different in this cycle in terms of apportioning funds between capital spending and returning cash to shareholders. Buyback Tailwind To Continue How important are buybacks to EPS growth? Chart 7 (second panel) presents a rough proxy for the historical impact of equity withdrawal that is based on the S&P 500 divisor. It is the difference between EPS growth and growth in total dollar earnings. When the line is above zero, it means that EPS growth has been lifted above dollar earnings growth via equity withdrawals. Chart 7Buybacks Adding Almost ##br##2 Percentage Points To EPS Growth Buybacks Adding Almost 2 Percentage Points To EPS Growth Buybacks Adding Almost 2 Percentage Points To EPS Growth This proxy must be taken with a grain of salt due to the manner in which the divisor is calculated. Nonetheless, it suggests that buybacks have boosted EPS growth by 2 percentage points in the year to 2016Q4. We expect that buyback activity will continue to be a mild tailwind in the coming quarters given the positive reading from our Capital Structure Preference Indicator (Chart 7, third panel). This Indicator is defined as the equity risk premium minus the default adjusted high-yield corporate bond yield. When the indicator is above zero, there is financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The Indicator is currently positive, although not as high as it was in 2015. Bottom Line: Buybacks have not had an outsized impact on EPS growth in this cycle, but the good news is that this tailwind is likely to continue. Capitalization Strategy: Stick With Small Caps The relative performance of U.S. small vs large cap stocks surged following the November election, but has since retraced about two-thirds of its post-election gains and has recently been trading below its 200-day moving average. Small cap stocks have been one of several "Trump trades" that have waned over the past three months, but our view is that several positive tailwinds for small cap relative performance continue to warrant an overweight stance: Panel 1 of Chart 8 highlights that our cyclical capitalization indicator has moved sharply into positive territory following the election, and has remained positive despite the recent weakness in small cap relative performance. Small cap stocks have been a reliably high-beta segment of U.S. capital markets since the middle of the last economic cycle (panel 2), which argues for a bullish stance given our overweight positions in U.S. equities versus bonds. Our relative valuation indicator for U.S. small caps has moved back towards neutral valuation territory, which is a significant change from the conditions that prevailed in the early part of the U.S. economic recovery. Chart 9 shows that the indicator was consistently elevated from 2009 until early-2015, but has since fallen back to zero. While relative prices have accounted for some of this adjustment, the relative (trailing) earnings trend for small cap stocks remains in an uptrend and has recently risen to an all-time high, despite a disappointing Q1. Chart 10 highlights one risk to the small cap trade that will be important to monitor. The chart shows the NFIB's outlook survey along with the percentage of respondents citing "red tape" as the most important problem facing their business. The consistent rise in concerns about red tape under the Obama administration, especially the strong rise that began in 2010, suggests that small firms have found elements of the Affordable Care Act to be particularly burdensome for their business. This suggests that a portion of the sharp rise in the outlook for small businesses following the election has occurred due to expectations that the ACA will be repealed, in turn implying that confidence may wither following the failure of the American Health Care Act (AHCA) to even be subjected to a vote in the House. Chart 8Beta And The Cycle Argue ##br##For Small Caps Beta And The Cycle Argue For Small Caps Beta And The Cycle Argue For Small Caps Chart 9Small Caps Are##br## No Longer Expensive Small Caps Are No Longer Expensive Small Caps Are No Longer Expensive Chart 10Watch The Change Of A "Trump Slump" ##br##In Small Business Sentiment Watch The Change Of A "Trump Slump" In Small Business Sentiment Watch The Change Of A "Trump Slump" In Small Business Sentiment While several planned policies of the Trump administration have indeed been delayed due to the failure of the AHCA, we remain of the view that a legislative agenda that at least appears to be pro-business remains in place. As such, our view is that it is too early to abandon a bullish bias towards small cap stocks, especially given the major improvement in relative valuation that we noted above. Bottom Line: Cyclical conditions and a significant improvement in relative valuation suggests that investors should continue to favor small over large cap stocks. The failure of the AHCA may cause a near-term pullback in small business confidence, but we doubt that this will be sustained over the coming 6-12 months. 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 BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 2 "Lingering Residual Seasonality in GDP Growth," Federal Reserve Bank of Cleveland, March 28, 2017.

Highlights Portfolio Strategy The consumer staples recovery is sales-driven, underscoring that additional outperformance lies ahead. The lagging hypermarkets and retail food industries are starting to play catch up, reflecting a shift in consumer spending patterns. Use the drubbing in air freight shares to upgrade to overweight. Recent Changes S&P Air Freight & Logistics - Upgrade to overweight from neutral. Table 1Sector Performance Returns (%) Pricing Power Comeback Pricing Power Comeback Feature Equities caught a bid last week, after holding at the bottom end of their tactical trading range. The overall consolidation phase likely has further to run, but should ultimately be resolved in a positive fashion. Chart 1Ongoing Margin Expansion Ongoing Margin Expansion Ongoing Margin Expansion Real economic performance continues to lag relative to exuberant 'soft' economic survey data, while the odds of meaningful pro-cyclical U.S. fiscal largesse fade. Inflation expectations are softening as commodity prices dip, while the yield curve is narrowing. These factors are likely to sustain ambiguity about the durability and strength of the expansion. But in the background, the corporate sector continues to heal slowly, aided by the hiatus in the U.S. dollar bull market. The latter is enabling some corporate pricing power revival. Our pricing power diffusion index has surged alongside our pricing power proxy (Chart 1, second panel). The broadening of selling price inflation bodes well for the sustainability of corporate sector pricing power gains. We have updated our industry group pricing power gauges (see Table 2), comprising the respective CPI, PPI, PCE and commodity year-over-year changes for 60 industry groups. The table details the most recent annual and 3-month pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Our analysis reveals that ¾ of the industries tracked are experiencing rising selling prices, and half are also besting overall inflation rates. Only 14 of 60 industries are in outright deflation, versus 19 in January and 23 last September. Importantly, 31 of 60 industry groups are enjoying a rising pricing trend, a 50% increase from last quarter, 9 are moving laterally and only 20 are fading. The implication is that upward momentum in pricing power is gathering steam. Importantly, the rate of selling price inflation is outpacing wage bill growth, which heralds some incremental near-term torque for profit margins (Chart 1, bottom panel). Are there any themes of note? Cyclical sectors continue to dominate the table with energy and materials taking the top two spots, although recent corrective action in the commodity pits suggests that these gains may peter out. The technology sector is a notable exception within deep cyclicals, as most tech sub-groups still have to slash prices (Table 2). Early cyclicals (or interest rate-sensitives) also show strength, with banks, insurers, and media-related groups managing to lift selling prices at a decent rate. Select defensives like health care and utilities are expanding pricing power, but the overall consumer staples and telecom services sectors are lagging. Table 2Industry Group Pricing Power Pricing Power Comeback Pricing Power Comeback Adding it all up, there are tentative signs that the profit advantage may be starting to slowly shift away from defensives. In that light, we are closely monitoring several factors that could expedite a transition to a more balanced portfolio from our current defensive bias. First, the gap between hard and soft data remains unusually wide (Chart 2). The longer hard data takes to play catch up, the less likely the Fed will be re-priced more aggressively. History shows that until this gap narrows, defensive sectors are likely to retain the upper hand in terms of relative performance (Chart 2), while financials could continue to languish owing to uncertainty about the path of future Fed policy. Second, commodity prices and the U.S. dollar - especially versus emerging market (EM) currencies - are still signaling that the cyclical/defensive ratio has more downside (Chart 3). Finally, within the context of the current broad equity market consolidation, it should continue to pay to remain with a defensive over cyclical portfolio tilt for a little while longer (Chart 4, top panel). Chart 2The Gap ##br##Is Closing The Gap Is Closing The Gap Is Closing Chart 3Monitoring The U.S. ##br##Dollar And Commodities1 Monitoring The U.S. Dollar And Commodities Monitoring The U.S. Dollar And Commodities Chart 4Stick With Defensives##br## For A While Longer Stick With Defensives For A While Longer Stick With Defensives For A While Longer Nevertheless, we will likely use this phase to make additional portfolio adjustments. The wide gap between emerging/developing markets performance and the cyclical/defensive share price ratio has narrowed significantly year-to-date, suggesting that defensive outperformance may be in the late stages. In sum, equity markets are in a transition phase and we are further tweaking our intra-industrials positioning after using recent underperformance to upgrade to neutral. We are also updating our high-conviction consumer staples view, and two unloved staples sub-groups. The Consumer Staples Sector Remains Appealing As part of this year's defensive sector leadership, the consumer staples sector has confounded its critics and registered a solid year-to-date relative performance gain. We expect additional near-term upside on the back of both internal and external drivers. Consumer staples companies are enjoying a revenue renaissance. Domestically, non-discretionary retail sales are gaining market share from discretionary outlays (Chart 5), reflecting consumers structurally ingrained propensity to save vs. spend since the financial crisis. Even exports are contributing to rising revenues, despite the U.S. dollar's appreciation (Chart 5). Easing monetary conditions in the emerging markets are underpinning domestic demand, benefiting U.S. staples exporters. Improving demand and cost containment are boosting operating profit margins (Chart 5, fourth panel). This should ensure that the sector continues to register meaningful free cash flow growth, a refreshing difference with the overall corporate sector. Meanwhile, external factors also point to a further relative performance recovery. The bond-to-stock ratio is joined at the hip with relative performance momentum, and a mean reversion phase is unfolding (Chart 6). Geopolitical uncertainty, the risk of a cooling in economic momentum following the downturn in the Economic Surprise Index could fuel flows into this non-cyclical sector. Chart 5Domestic And International##br## Positive Demand Drivers Domestic And International Positive Demand Drivers Domestic And International Positive Demand Drivers Chart 6Financial Variables ##br##Reinforce Staples Bid Financial Variables Reinforce Staples Bid Financial Variables Reinforce Staples Bid There is both valuation and technical motivation for capital inflows. Chart 6 shows that our Technical Indicator has troughed near one standard deviation below the historical mean. Every time this has occurred in the last decade, a sizable relative share price recovery has ensued. There are no valuation roadblocks, countering the assertion that defensive sectors are all overvalued in relative terms (Chart 6). As a result, this sector remains a high-conviction overweight, especially with two previous lagging groups now exhibiting signs of a recovery. Hypermarket Green-Shoots The hypermarkets industry is sprouting a number of green-shoots that should further propel the recent advance in relative share price performance. The industry is enjoying profit margin support on two fronts. Import prices are still deflating (Chart 7), and the nascent rebuilding in Asian manufacturing inventories suggests that pricing pressure will persist. On the revenue front, Wal-Mart recently noted that store traffic continues to improve, albeit aided by discounting. A tight labor market is supporting aggregate wage growth, especially those in lower income brackets, which is supportive of total hypermarkets sales. Importantly, the need to slash prices to attract more customers should abate courtesy of improving demand. The overall retail sales price deflator has climbed into positive territory. Hypermarket sales growth is highly correlated with overall retail selling price inflation (Chart 8). Chart 7Input Costs Will Remain Contained Input Costs Will Remain Contained Input Costs Will Remain Contained Chart 8Low Profit Hurdle Low Profit Hurdle Low Profit Hurdle At least some of the improvement in pricing power reflects an easing in food industry deflation, which implies that the intensity of price wars with food retailers will diminish. Total outlays on food and beverages are climbing as a share of total consumer spending after falling for six consecutive years (Chart 8). These elements are captured by our hypermarkets earnings pressure gauge, which is signaling a rosier sales and EPS growth backdrop (Chart 8, fourth panel). If the border adjustment tax continues to lose momentum, the risk premium for this group should narrow. Food Retailers Are Down, But Not Out Elsewhere, the drubbing in food retailers looks overdone. The relative share price ratio is at a multi-decade low. Investor fears have concentrated on industry selling price deflation, which has weighed on already razor thin profit margins. Nevertheless, a turnaround is afoot, and we would lean against extreme bearishness. As noted previously, consumer spending on food and beverages are gaining a foothold relative to overall outlays. That is supporting a reacceleration in grocery store same-store sales. With the unemployment rate this low, wage inflation is expected to sustain recent gains. Rising incomes are synonymous with higher consumer spending power. Thus, the rebound in industry sales has more upside (Chart 9). The upshot of consumers' increased food appetite is that the food CPI is exiting deflation (Chart 10). That should go a long way in allaying investor profit margin concerns. Chart 9Buy The Wash ##br##Out In Food Retailers... Buy The Wash Out In Food Retailers... Buy The Wash Out In Food Retailers... Chart 10...Because The Deflation##br## Threat Is Diminishing ...Because The Deflation Threat Is Diminishing ...Because The Deflation Threat Is Diminishing Previous pricing pressure forced grocers to refocus on productivity. The industry's total wage bill has cooled significantly. Our productivity proxy, defined as sales/employee, is accelerating, hitting growth rates last seen more than five years ago, when share prices were trading at much higher valuations (Chart 10). Bottom Line: We reiterate our overweight stance both in the S&P hypermarkets and the compellingly valued S&P food retail index. The ticker symbols for the stocks in these indexes are: WMT, COST and KR, WFM, respectively. Air Freight Stocks Will Spread Their Wings The sell-off in transportation stocks has progressed to the point where pockets of value are materializing. Specifically, air freight and logistics stocks have been pummeled, trading down to the bottom of their post-GFC trading range (Chart 11). This is a playable opportunity. Relative performance has returned to levels first reached in the depths of the GFC. Bears have pushed valuations and technical conditions to extremely washed out levels. Both the forward P/E and price-to-sales ratios have collapsed, trading significantly below their historical means and at a steep discount to the S&P 500 (Chart 11). To be sure, a number of forces have fueled the selling. Industry activity is running below capacity, as evidenced by weakness in industry average weekly hours worked (Chart 11). The loss of momentum in internet sales compared with bricks and mortar retail sales may be causing some concern about the pace of future land deliveries (Chart 11). Walmart's news that it is offering an in-store pick up option for online orders has also spooled investors. Amazon's push for its own delivery service is a longer-term yellow flag. Nevertheless, deeply discounted valuations and depressed earnings growth expectations imply that these drags are already reflected in prices. In fact, more recently analysts have pushed the net earnings revision ratio back into positive territory. We expect additional upside as global trade improves. While we were concerned about global trade last November when we downgraded to neutral, there is more evidence now that global revenue ton miles will reaccelerate. The surge in BCA's boom/bust indicator and advance in the business sales-to-inventories (S/I) ratio are both signaling that global trade will continue to recover (Chart 12). The sustainability of the S/I improvement looks solid. The global manufacturing PMI has shot higher on the back of a synchronized developed and emerging market final demand improvement, which heralds accelerating global export volumes (Chart 12). hiatus in the U.S. dollar bull market has also provided much needed reflationary relief to the emerging world. We expect these global forces to overwhelm recent domestic freight demand concerns. Importantly, global exports have been positively correlated with air freight pricing power and the current message is to expect price hikes to stick (Chart 13, third and fourth panels). Keep in mind that air freight companies typically command greater pricing power when the supply chain is lean and lead times begin to lengthen, because companies will pay up to ensure product/parts availability. Chart 11Grim News Is Well Discounted Grim News Is Well Discounted Grim News Is Well Discounted Chart 12Recovering Global Trade... Recovering Global Trade... Recovering Global Trade... Chart 13...Is A Boon To Air Freight Pricing Power ...Is A Boon To Air Freight Pricing Power ...Is A Boon To Air Freight Pricing Power In sum, a durable recovery in global trade should ignite an earnings led relative outperformance phase in the S&P air freight & logistics index. Bottom Line: Boost exposure to overweight in the S&P air freight & logistics sub-group. The ticker symbols for the stocks in this index are: BLBG: S5AIRFX - UPS, FDX, CHRW, EXPD. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Portfolio Strategy Operating leverage could surprise on the strong side this year, based on the message from our pricing power and wage growth indicators. REITs are experiencing a playable recovery following the Fed-induced sell-off earlier this year, and overweight positions will continue to pay off. Energy services activity is set to steadily accelerate this year, powering an earnings-led share price outperformance phase. Recent Changes There are no changes to our portfolio this week. Table 1 Operating Leverage To The Rescue? Operating Leverage To The Rescue? Feature Volatility has climbed to the highest level since the U.S. election, signaling that the broad market is not yet out of the woods. As stocks recalibrate to a cooling in economic growth momentum and an escalation in geopolitical threats, downside risks should be reasonably contained by mounting signs of a healthier corporate sector. Last week we posited that stronger top line revenue growth is necessary to sustain the profit upcycle, and provide justification for historically rich valuations. Chart 1 shows sales and EPS growth over the long-term. Chart 1Joined At The Hip Joined At The Hip Joined At The Hip Obviously, the two move closely together, with earnings enjoying more powerful growth phases when revenue accelerates. Since 1960, regression analysis shows that operating leverage for the S&P 500's is 1.4X. In other words, a 5% increase in sales growth typically leads to 7% EPS growth. When sales are initially recovering from a deep slump operating leverage can be even higher, with earnings often rising two to three times as fast as revenue. Clearly, that is not sustainable, but can give the illusion of powerful and sustained growth for brief periods of time. At the current juncture, there are reasons to expect investors to embrace the durability of the profit expansion. Our corporate pricing power proxy has vaulted higher. Importantly, the breadth of this surge has been impressive, which bodes well for its staying power (Chart 2, second panel). On the flip side, rising labor costs look set to take a breather. Compensation growth has crested, and according to our diffusion index, fewer than half of the 18 industries tracked have higher wages than last year. The wage growth diffusion index provides a reliable leading indication for the trend in labor expenses. In other words, pricing power is rising on a broad basis while wage inflation is decelerating on a broad basis. Consequently, there are decent odds that resilient forward operating margin expectations can be matched (Chart 2, bottom panel). Elsewhere, a revival in animal spirits, the potential for easier fiscal policy and prospects for a hiatus in the U.S. dollar bull market bode well for brisk business activity. While the budding recovery in global trade could sputter if protectionism proliferates, our working assumption is that the U.S. Administrations' bark will be worse than its bite. Thus, a self-reinforcing sales and profit upcycle could be materializing. The objective message from our S&P 500 EPS model concurs (Chart 3), underscoring that high single digit/low double digit profit growth could be broadly perceived as attainable this year. Chart 2Profit Margins Can Expand Profit Margins Can Expand Profit Margins Can Expand Chart 3Few Sectors Control The Fate Of S&P 500 EPS Few Sectors Control The Fate Of S&P500 EPS Few Sectors Control The Fate Of S&P500 EPS True, our model has recently shown tentative signs of cresting, but difficult comparisons will only arise later this year. Indeed, Q3 and Q4 2016 were all-time high EPS numbers, implying that 12% estimated growth rates are a tall order (Chart 3, middle panel). Importantly, dissecting the profit growth sectorial contribution is instructive. Calendar 2017 over 2016 S&P 500 earnings growth is concentrated in four sectors: tech, energy, health care and financials comprise over 87% of the incremental profit growth expected (Chart 3, bottom panel). The upshot is that there is a high degree of concentration risk to fulfilling overall profit growth expectations. Energy profits are wholly dependent on the oil price, and financial sector profit optimism appears to have embedded a healthy increase in both interest rates and capital markets activity. In addition, tech sector earnings are heavily influenced by the U.S. dollar. Consequently, it will be critical for monetary conditions to stay loose, otherwise estimates will be at risk of downward revisions. Adding it up, the corporate sector sales pendulum is finally swinging in a positive direction, which should support the cyclical overshoot in stocks for a while longer, notwithstanding our expectation that the current corrective phase has further to run. This week we are updating our high-conviction overweight views on both the lagging energy services index and REIT sector. Revisiting REITs REITs have staged a mini V-shaped rebound after being punished alongside rising bond yields and worries about aggressive Fed rate hikes earlier this year. As outlined in recent Weekly Reports, the reflation theme is likely to lose steam in the second half of the year as economic momentum cools, providing additional impetus for capital inflows into the more stable income profile of REITs. Even if the economy proves more resilient and Treasury yields move higher, there are few barriers to additional outperformance. Our Technical Indicator, a combination of rates of change and moving average divergences, is extremely oversold. Forward intermediate and cyclical relative returns from current readings have been solid, as occurred in 2004, 2008 and 2014 (Chart 4). REIT valuations are more than one standard deviation below normal, according to our gauge. This suggests that poor operating performance and/or higher discount rates are already expected. There may be a limit as to how high bond yields can climb, given that they are already deep in undervalued territory according to the BCA 10-year Treasury Bond Valuation Index (Chart 4). Regardless, history shows that REITs have typically had a more positive than negative correlation with bond yields. The inverse correlation has only been in place since the financial crisis, when zero interest rate policies pushed massive capital flows into all yield generating assets. Chart 5 shows that prior to 2008, REITs outperformed during periods of both rising and falling Treasury yields. Chart 4Unloved And Undervalued Unloved And Undervalued Unloved And Undervalued Chart 5No Concrete Correlation Pre GFC No Concrete Correlation Pre GFC No Concrete Correlation Pre GFC Similarly, REITs have a solid track record during periods of rising inflation pressures. Since 1975, there have been six periods of rising core PCE inflation: REITs have enjoyed meaningful rallies during five of these phases (Chart 6). Hard assets tend to hold their stock market value well when overall inflation moves higher, with REIT net asset values providing solid support to share price performance. Chart 6Buy REITs In Times Of Inflation Buy REITs In Times Of Inflation Buy REITs In Times Of Inflation Looking ahead, REITs should continue to enjoy success in boosting rental rates. Occupancy rates continue to rise (Chart 7). The unemployment rate is low, consumption is decent and businesses are growing increasingly confident. That is a recipe for higher rental demand. Our Rental Rate Composite has crested on a growth rate basis, but the advance in the CPI for homeowner's equivalent rent, a good proxy for REITs, suggests that the path of least resistance remains higher (Chart 7). REIT supply growth has also leveled off, which provides additional confidence that rental inflation will remain solid. Nevertheless, there are some areas of concern. Banks are tightening lending standards on commercial real estate loans. Some sub-categories are experiencing a mild deterioration in credit quality. For instance, Chart 8 shows that delinquency rates in the retail and office spaces have edged higher. Retail and mall REITs are likely under structural pressure owing to online competition from the likes of Amazon. Chart 7Rental Demand##br## Is Solid Rental Demand Is Solid Rental Demand Is Solid Chart 8Watch Delinquencies As ##br##Banks Tighten Credit Standards Watch Delinquencies As Banks Tighten Credit Standards Watch Delinquencies As Banks Tighten Credit Standards Overall vacancy rates are still very low (Chart 8), but if credit becomes too tight, then the relentless advance in commercial property prices may cool. For now, our REIT Demand Indicator is not signaling any imminent stress. In fact, the economy is strong enough to expect occupancy rates to keep climbing, to the benefit of underlying property valuations and rental income (Chart 7, bottom panel). In sum, the budding rebound in REIT relative performance should be embraced as the start of a sustained trend. Total return potential is very attractive on a relative basis. Bottom Line: REITs remain a very attractive high-conviction overweight. Energy Servicers Are Cleaning Up Their Act We put the S&P energy services index on our high-conviction overweight list at the start of the year, because three critical factors that typically lead to a playable rally existed, namely; the global rig count had hit an inflection point, oil supplies were easing and global oil production growth had begun to decelerate. While the pullback in oil prices has undermined relative performance for the time being, there is scope for a full recovery, and more. Oil prices have firmed, underpinned by a revival in the geopolitical risk premium following the U.S. bombing campaign in Syria. There is already a wide gap between share prices and oil prices (Chart 9, top panel), and a narrowing is probable, especially as earnings drivers reaccelerate. There are tentative signs that capital spending cuts are finally reversing. The global rig count has rebounded, and is a good leading indicator for investment (Chart 10). This message is corroborated by our Global Capex Indicator, which has recently surged anew (Chart 10). Chart 9Room For ##br##Margin Improvement... Room For Margin Improvement... Room For Margin Improvement... Chart 10...As Deflation Eases ##br##And Capex Rebounds ...As Deflation Eases And Capex Rebounds ...As Deflation Eases And Capex Rebounds The longer that oil prices can stay in their current trading range, or beyond, the more time E&P balance sheets have to heal and the greater the odds that the cost of capital will be reduced. Against this backdrop, there are high odds that previously mothballed exploration projects will be restored. The V-shaped recovery in the global oil rig count, albeit from a very low base, will eventually absorb excess capacity and allow the industry to escape deflation. A major improvement in day rates is unlikely given the scale of the previous capacity boom, but even a modest pricing power improvement should provide a nice boost given high operating leverage. EBITDA margins have considerable room to improve if pricing power grows anew (Chart 9, bottom panel). Importantly, the shifting composition of global production will allow service companies with domestic exposure to shine. Shale oil producers should recapture lost market share, given that the onus to rebalance markets has been taken on by OPEC. OPEC production is contracting, while non-OPEC output is starting to recover (Chart 11, bottom panel), culminating in a widening in the Brent-WTI oil price spread. Production restraint is helping to rebalance physical oil markets. Total OECD inventory growth is reversing, and anecdotal reports are surfacing that floating storage is rapidly being depleted. Oil supply at Cushing is on the cusp of contracting, which is notable given that this has had a high correlation with relative share price performance for the past decade (oil supply shown inverted, Chart 11). On a global basis, global inventory drawdowns have been correlated with a firming industry relative profitability, and vice versa. OECD oil supply growth is rapidly receding, which augurs well for an extension of budding earnings outperformance (Chart 12, middle panel). Chart 11Receding Inventories ##br##Should Boost Performance... Receding Inventories Should Boost Performance… Receding Inventories Should Boost Performance… Chart 12...EPS And##br## Valuations ...EPS And Valuations ...EPS And Valuations The rise in clean tanker rates reinforces that oil demand is rising quickly enough to expect additional inventory depletion (Chart 12, bottom panel). Typically, tanker rates and energy service relative valuations are positively correlated. Adding it up, a rising global rig count, decelerating inventories and restrained oil production continue to bode well for a playable rally in the high-beta S&P energy services group. Bottom Line: We reiterate our high-conviction overweight stance in the S&P energy services index. The ticker symbols for the stocks in this index are: BLBG: S5ENRE - SLB, HAL, BHI, NOV, FTI, HP, RIG. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Chinese capex and EM domestic demand will falter again in the second half of this year. This is not contingent on a growth slowdown in the advanced economies, but due to a further slowdown in bank lending in EM and lower commodities prices. The direction of EM share prices in absolute terms and relative to the S&P 500 is determined by EPS trajectory, not equity valuations. We expect EM EPS to drop in absolute terms and to underperform U.S. EPS. India's deleveraging cycle is well advanced, especially when compared with other EM economies. Maintain an overweight position in Indian equities within the EM universe. Continue betting on yield curve steepening. Stay long the Czech koruna versus the euro. Feature EM/China growth will relapse in the second half of this year. Share prices, presuming they are forward-looking, will roll over beforehand. Chinese interest rates have risen, which typically heralds a downtrend in the mainland's credit impulse and business cycle (Chart I-1). Chinese interest rates are shown as an annual percentage change, inverted and advanced. This is a typical relationship between interest rates and credit cycles, and there is currently no reason why it will play out any differently in China. Given the mainland has a lingering credit bubble, rising borrowing costs and regulatory tightening of banks and the shadow banking system are guaranteed to lead to a relapse in credit origination, and in turn economic growth. China's yield curve has been flattening in recent months. This often precedes a selloff in both EM share prices and industrial metals (Chart I-2). Chart I-1China: Interest Rates ##br##And Credit/Business Cycles China: Interest Rates And Credit/Business Cycles China: Interest Rates And Credit/Business Cycles Chart I-2A Flattening Yield Curve In China Is ##br##A Bad Omen For EM And Commodities A Flattening Yield Curve In China Is A Bad Omen For EM And Commodities A Flattening Yield Curve In China Is A Bad Omen For EM And Commodities The Chinese yield curve has been experiencing bear flattening - front-end rates have risen more than long-term rates. Bear flattening in yield curves typically occurs before a major top in growth, when current conditions are still robust but the fixed-income market begins to question growth sustainability going forward. A flattening yield curve is consistent with our assessment: a lack of follow-through from last year's stimulus combined with the recent policy tightening will cause growth to downshift materially very soon. EM narrow (M1) money growth has rolled over decisively, and historically it has been a good leading indicator for EM earnings per share (EPS) (Chart I-3). The former has historically led the latter by about nine months. Chart I-3EM EPS To Roll Over In the Second Half 2017 EM EPS To Roll Over In the Second Half 2017 EM EPS To Roll Over In the Second Half 2017 The same is true in the case of China - the M1 impulse (the second derivative of M1) leads industrial profits by about six months and heralds an imminent reversal (Chart I-4). Chart I-4China's Industrial Profit Growth Recovery Is At A Risk China's Industrial Profit Growth Recovery Is At A Risk China's Industrial Profit Growth Recovery Is At A Risk The commodities currency index (an equally weighted average of AUD, NZD and CAD) has relapsed against the greenback. This index points to global growth deceleration in the second half of this year (Chart I-5). Similarly, these commodities currencies also lead commodities prices, and presently signal a top in the commodities complex (Chart I-6). Chart I-5Commodities Currencies Signify Weakness In Global Trade Commodities Currencies Signify Weakness In Global Trade Commodities Currencies Signify Weakness In Global Trade Chart I-6Commodities Currencies Point To Relapse In Commodities Prices Commodities Currencies Point To Relapse In Commodities Prices Commodities Currencies Point To Relapse In Commodities Prices In EM ex-China, Korea and Taiwan, bank loan growth has still been decelerating despite the global growth recovery of the past 12 months (Chart I-7, top panel). Besides, retail sales volume growth in EM ex-China, Korea and Taiwan has not ameliorated yet (Chart I-7, bottom panel). All of these economic aggregates are equity market cap-weighted. Similarly, auto sales in EM ex-China, Korea and Taiwan have been stabilizing at very low levels but have not recovered at all (Chart I-8). Hence, we infer that domestic demand in EM ex-China has stabilized, but it has not recovered. For example, manufacturing production in Brazil, Russia, South Africa and Indonesia has been rather subdued (Chart I-9). Chart I-7EM Ex-China, Korea And Taiwan: ##br##Domestic Demand Has Not Recovered EM Ex-China, Korea And Taiwan: Domestic Demand Has Not Recovered EM Ex-China, Korea And Taiwan: Domestic Demand Has Not Recovered Chart I-8EM Ex-China, Korea And Taiwan: ##br##Auto Sales Are Stabilizing At Low levels EM Ex-China, Korea And Taiwan: Auto Sales Are Stabilizing At Low levels EM Ex-China, Korea And Taiwan: Auto Sales Are Stabilizing At Low levels Chart I-9Synchronized Global Recovery? Synchronized Global Recovery? Synchronized Global Recovery? As EM ex-China credit growth decelerates further due to the lingering credit excesses and poor banking system health, their domestic demand will disappoint. This is a major risk to the EM profit outlook. Bottom Line: Chinese and EM domestic demand and by extension corporate earnings will falter again in the second half of this year. This view is not contingent on a growth slowdown in the advanced economies but will be the outcome of further slowdown in bank lending in EM and lower commodities prices. A reversal in Chinese imports from other EM is the link that explains how a relapse in the mainland's growth in the second half this year will hurt the rest of the world in general, and EM in particular. Profits Hold The Key Chart I-10Profits, Not Valuations, Hold The Key Profits, Not Valuations, Hold The Key Profits, Not Valuations, Hold The Key Emerging markets' relative performance versus the S&P 500 has historically been driven by EPS (Chart I-10). In the past 12 months, EM EPS has improved modestly but has not outperformed U.S. EPS in U.S. dollar terms. Consistently, EM stocks have failed to outperform the S&P 500 in common currency terms; they have been flat at low levels in the past 12 months. An important message from this chart is that equity valuations are not critical to EM versus U.S. relative equity performance. It is all about corporate profit cycles. The widely held view within the investment community is that EM stocks are cheaper than those in the U.S., and therefore will outperform based on more attractive valuations. The fact that EM stocks are indeed cheaper versus the S&P 500 only reflects the fact that U.S. equity valuations are expensive and EM equity valuations are neutral in absolute terms. Equity valuations may affect the degree of out- and underperformance, but they do not determine the direction of relative performance as vividly illustrated by Chart I-10. The same can be said about EM stocks' absolute performance. Equity valuations do not determine the direction of share prices; the latter rise when profits expand, and fall when EPS contracts. However, valuations affect the magnitude of the move in equity prices: cheap valuations and growing EPS will produce a larger rally compared to neutral equity valuations and identical growth in EPS. We discussed EM equity valuations at great length in our Weekly Report published two weeks ago.1 In absolute terms, EM equity valuations are presently neutral. Therefore, they have no bearing on the direction of share prices. If EM EPS expands, stocks will continue to rally. If EPS growth stalls or turns negative, EM stocks will stumble. As Charts I-3 and I-4 on page 3 illustrate, EM EPS will soon relapse. In addition, U.S. return on equity (RoE) remains well above EM's RoE (Chart I-11), reflecting better equity capital utilization in the U.S. versus the EM. Looking forward, one variable that has had a reasonably good track record in gauging relative performance of EM versus U.S. share prices is the ratio of industrial metals to U.S. lumber prices (Chart I-12). Industrial metals prices are a proxy for economic growth in China/EM, while U.S. lumber prices are indicative of America's business cycle. Industrial metals prices (the LMEX index) have lately underperformed U.S. lumber prices, pointing to renewed EM underperformance versus the S&P 500. Chart I-11EM RoE Is Below U.S. RoE EM RoE Is Below U.S. RoE EM RoE Is Below U.S. RoE Chart I-12EM Stocks To Underperform The S&P 500 EM Stocks To Underperform The S&P 500 EM Stocks To Underperform The S&P 500 Our view is that EM EPS growth will contract again within a cyclical investment horizon (over the next 12 months). While not all sectors' earnings are set to shrink, our view is that banks' profits will decline driven by credit growth deceleration and a rise in non-performing loans in a number of countries. Besides, commodities producers' EPS will drop anew if, as we expect, commodities prices head south again. Table I-1 illustrates the weights of each EM equity sector within total EM-listed companies' profits. Financials account for 24%, while energy and materials comprise 7.5% each of the aggregate EM equity market cap, respectively. In aggregate, these sectors make up 50% of EM EPS and 40% of the stock index. Table I-1EM Sectors: Equity Market Caps ##br##And EPS's Share Of Total EPS Signs Of An EM/China Growth Reversal Signs Of An EM/China Growth Reversal We remain positive on the technology/internet sector's growth outlook. While this sector's weight in terms of both market cap and EPS is very large, it is not yet sufficient to lift the overall EM equity index if other large sectors falter. In fact, technology/internet stocks have already rallied dramatically and are presently overbought. They will likely correct along with the rest of the universe. Nevertheless, we continue to recommend an overweight stance in technology stocks within the EM benchmark. Bottom Line: The direction of EM share prices in absolute terms and relative to the S&P 500 is determined by EPS trajectory, not equity valuations. We expect EM EPS to drop in absolute terms and to underperform U.S. EPS. Consistently, we maintain our long-standing strategy of being short EM / long the S&P 500. Taking Profits On Short Korean Auto Stocks Initiated on July 3, 2013, this recommendation has generated a 35% gain (Chart I-13, top panel). Notably, Korean auto stocks have failed to rally in the past 12 months. Furthermore, Korean auto stocks have underperformed the overall EM equity index by a whopping 22% since our recommendation (Chart I-13, bottom panel). For dedicated investors, we recommend lifting the allocation to this sector from underweight to neutral. In regard to allocation to the KOSPI overall, we maintain our overweight stance within an EM equity portfolio for now. Geopolitical volatility could create near-term disturbance but the primary trend in Korea's relative performance against the EM benchmark is up (Chart I-14). Within the KOSPI, we continue to overweight technology stocks, companies with exposure to DM growth and domestic industries. Meanwhile, companies with exposure to China's capital spending should be avoided. Chart I-13Take Profits On Short ##br##Korean Stocks Recommendation Take Profits On Short Korean Stocks Recommendation Take Profits On Short Korean Stocks Recommendation Chart I-14Korean Equities ##br##Relative To EM Overall Korean Equities Relative To EM Overall Korean Equities Relative To EM Overall Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM Equity Valuations Revisited", dated March 29, 2017, link available on page 21. India: Beyond De-Monetization The growth-dampening effects from India's de-monetization program are beginning to dissipate. Both services and manufacturing PMIs are recovering (Chart II-1). As more cash is injected back into the system, consumer sector growth will improve. Beyond the recovery in consumption, however, capital spending - the key driver of productivity and non-inflationary growth - is still anemic because of structural reasons that began well before de-monetization was announced (Chart II-2). Chart II-1PMIs Are Recovering PMIs Are Recovering PMIs Are Recovering Chart II-2Capital Spending Is Depressed Capital Spending Is Depressed Capital Spending Is Depressed Public Banks: Is Deleveraging Advanced? The Indian authorities appear serious about restructuring their public banks, and the banking downturn cycle is likely approaching its final stages (Chart II-3). As and when India's public banks find themselves on more solid footing, industrial credit growth will pick up meaningfully and capital expenditures will follow. The previous credit boom that occurred in the infrastructure, mining, and materials sectors left a large number of failed and stalled projects. Chart II-4 shows the number of stalled projects remains stubbornly high and is not yet declining. These mal-investments have ended up as non-performing loans primarily on public banks' balance sheets: Non-performing loans (NPLs) currently amount to 11.8% and distressed assets (DRA) stand at around 4% of total loans on Indian public banks' balance sheets. This has forced public banks to curtail credit growth to the industrial sector (Chart II-5). Chart II-3Bank Credit Growth Is At All Time Low Bank Credit Growth Is At All Time Low Bank Credit Growth Is At All Time Low Chart II-4Plenty Of Projects Stalled Plenty Of Projects Stalled Plenty Of Projects Stalled Chart II-5Bank Credit Growth To Industries Is Contracting Bank Credit Growth To Industries Is Contracting Bank Credit Growth To Industries Is Contracting Public banks' NPLs and DRAs have spiked because the Reserve Bank of India (RBI) is forcing commercial banks to acknowledge and provision for these bad loans via the central bank's Asset Quality Review (AQR) program. This is eroding public banks' capital and constraining their ability to grow their loan book. However, the program is bullish for India's economy in the long run and stands in stark contrast to other EM countries where authorities are turning a blind eye on banks attempting to window dress their NPLs. India's government and the RBI are currently working with commercial banks and proposing measures to recover loans from defaulters. The government is also injecting capital into public banks. It has announced 100 billion INR in capital injections for this fiscal year and will inject more if needed. It is also forcing banks to raise more capital by ridding their books of non-core businesses. We have performed a scenario analysis on public banks (presented in Table II-1) to gauge their stock valuations. In all scenarios, we assume that DRAs will be constant at 5% of total loans, and also assume a 70% recovery rate on DRAs. We examine various scenarios for NPLs - the latter vary from 12-15% of total loans (the current actual NPL rate is 11.8%). Equity valuations are very sensitive to the recovery rate on NPLs. We stress test for recovery rates of 30%, 40%, 50% and 60%. If one assumes a 12% NPL ratio and a recovery rate of 60%, public bank stocks would be 30% cheap - their adjusted (post provisions, capital impairment, and recapitalization) price-to-book value (PBV) ratio will be 0.7, which is 30% less than its historical mean PBV ratio for public banks of 1.0. By contrast, assuming a 15% NPL ratio and a 30% recovery rate, banks' equity valuations would be 50% expensive - their adjusted (post provisions, capital impairment, and recapitalization) PBV ratio would be 1.5. Table II-1Under/Overvaluation (In %) Of Public Banks Stocks For A Given NPL Ratio And Recovery Ratio* Signs Of An EM/China Growth Reversal Signs Of An EM/China Growth Reversal Our bias is to believe that the NPL ratio is somewhere between 14-15% and the recovery rate near 40%. In such a case, public bank stocks would presently be 10-20% expensive. This does not offer a great buying opportunity at current levels, but suggests the downside is probably smaller than in other EM bank stocks. Overall, India is much more advanced in terms of recognizing and provisioning for NPLs as well as re-capitalization of its banking system than many other EM countries. Therefore, we believe India's deleveraging cycle is well advanced, especially when compared with other EM economies. Due to this and the fact that this economy is not exposed to China/commodities prices, we still recommend an overweight position in Indian equities within the EM universe. Inflation And Fixed-Income Strategy While headline inflation is easing due to temporarily lower food prices, core inflation remains sticky. The central government's overall and current expenditures - which often drive inflation - are rising rapidly (Chart II-6). Likewise, state governments' current expenditures are also booming and state development loans - borrowing by state governments - are growing at an extremely fast pace. In addition, in June 2016, the Indian central government announced it will raise salaries, allowances and pensions of government employees by 23%. The central government also raised the minimum wage for non-agriculture laborers by 42% in August 2016, and the Ministry of Labor followed by doubling the minimum wage of agricultural workers in March 2017. All of this will entail accumulating inflationary pressures, even if oil and food prices remain tame. The central bank hiked the reverse repo rate last week to absorb excess liquidity from the banking system. Even though it cited service sector inflation as a concern, we believe it will lag behind accumulating inflationary pressures. This warrants a steeper yield curve. Investors should continue to bet on yield curve steepening by paying 10-year swaps / receiving 1-year swap rates (Chart II-7). Chart II-6Government Expenditures Are Rising Government Expenditures Are Rising Government Expenditures Are Rising Chart II-7Bet On A Yield Curve Steepening Bet On A Yield Curve Steepening Bet On A Yield Curve Steepening Rising inflationary pressures and higher bond yields could weigh on Indian stocks in absolute terms, but will likely not preclude them outperforming the EM equity benchmark. Ayman Kawtharani, Associate Editor aymank@bcaresearch.com Stay Long Czech Koruna Versus Euro On September 28th 2016, we recommended going long CZK / short EUR on the back of expectations that the Czech National Bank (CNB) would abandon its currency peg. Last week, the CNB has floated the koruna. We expect this currency to appreciate versus the euro further and suggest keeping this position. Inflationary pressures in the Czech economy are genuine and heightening. The 1.5% appreciation in the koruna versus the euro since last week will not tighten monetary conditions enough to cap inflation. As such, we expect the CNB to eventually start raising interest rates, leading to further koruna appreciation versus the euro (Chart III-1). The output gap is turning positive, which historically has led to a rise in core inflation (Chart III-2). Chart III-1The Czech Koruna Has More Catch-Up To Do The Czech Koruna Has More Catch-Up To Do The Czech Koruna Has More Catch-Up To Do Chart III-2Output Gap And Inflation Output Gap And Inflation Output Gap And Inflation The labor market is tight - the Czech unemployment rate is the lowest in Europe. Both wages and until labor costs growth are robust and trimmed-mean consumer price inflation is accelerating (Chart III-3). The CNB's foreign exchange reserve accumulation has generated an overflow of liquidity in the Czech financial/banking system (Chart III-4). Chart III-3Inflationary Pressures Are Broad-Based Inflationary Pressures Are Broad-Based Inflationary Pressures Are Broad-Based Chart III-4Money And Credit Growth Are Very Strong Money And Credit Growth Are Very Strong Money And Credit Growth Are Very Strong The rapid expansion of liquidity has led to strong credit growth (Chart III-4, bottom panel), and a rapid appreciation in real estate prices. This warrants higher interest rates to prevent the formation of a bubble. Furthermore, the Czech economy has been benefiting from the recovery in European economic growth in general and manufacturing in particular. Tourist arrivals have also been robust. Notably, the nation's current account surplus stands at 1% of GDP. Chart III-5The Koruna Is Mildly Cheap The Koruna Is Mildly Cheap The Koruna Is Mildly Cheap With regards to currency valuations, the koruna is silently cheap and as such has further room to appreciate (Chart III-5). Either the koruna will gradually appreciate over the next few months, tightening monetary conditions to an extent where the CNB does not need to hike interest rates, or the CNB is eventually forced to hike rates considerably. The latter will push up the value of the Czech currency. We suspect that the CNB is still intervening in the forex market in order to prevent a dramatic appreciation in the koruna. The central bank has stated in its last press conference that it stands ready to intervene to mitigate exchange rate fluctuations if needed. However, in an economy with open capital account, the central bank cannot target the exchange rate and interest rates simultaneously. If the CNB desires to cap inflation, it has to hike interest rates or allow the currency to appreciate considerably. If it chooses the former, the koruna will still rally dramatically. Bottom Line: Stay long the Czech koruna versus the euro. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The earnings rebound underway in Corporate America is being driven by more than just higher oil prices. S&P 500 profit margins have stabilized recently, but remain in secular decline. We remain bullish on the dollar and the other "Trump Trades" have legs as well. Uncertainty around tax policy may be restraining business capital spending and C&I loan growth. Feature Chart 1Excluding Energy Earnings Rebounding Excluding Energy Earnings Rebounding Excluding Energy Earnings Rebounding The so-called "Trump trades" have either stalled or partially reversed. The failure to reform Obamacare has dented hopes that the Administration and GOP will get a tax reform package done this year. The S&P 500 is not far off its all time high, but Treasury yields have returned to the bottom of the trading range and the dollar has weakened (although it has risen over the past 3 weeks). We still believe that the Republicans will at least push through tax cuts and some infrastructure spending this year, which will be stimulative for the economy. However, the 12-month outlook for the stock-to-bond ratio does not hinge solely on U.S. fiscal policy. As we have highlighted in the past, the underlying fundamentals for equities are positive, despite the fact that we see more dollar upside (see below). First quarter earnings season is about to kick off, and it should be another good one. Before we discuss the outlook for profits, let's review the fourth quarter of 2016. S&P 500 firms posted profit growth of 6% on a 4-quarter moving total year-over-year basis. The Q4 reading beat consensus bottom-up expectations at the start of earning season but were roughly in line with expectations at the start of Q4 2016 itself. The fourth quarter increase was the best year-over-year EPS gain since Q3 2014 - just after the oil price peak- and the first year-over-year increase in the 4-quarter sum since Q3 2015. Energy sector earnings posted a 6% advance in Q4, as oil prices averaged close to $49 per barrel in Q4 2016, up 17% from Q4 2015. It was the first time that oil prices posted a year-over-year increase in a quarter since Q2 2014. Part of the acceleration in earnings reflects the rise in oil prices from the Q1 2016 bottom, but higher energy prices are not the only factor driving the turnaround (Chart 1). Overall, 9 of the 11 S&P 500 sectors saw positive year-over-year profit gains in Q4 2016, led by technology (13%), financials (12%) and utilities (10%). In addition, Consumer Discretionary, Financials and Health Care all posted solid earnings figures in the last year. Earnings momentum has also picked up in Materials, Real Estate and Utilities, although profit growth in these sectors is also benefiting from favorable comparisons. Eighty-eight percent of technology firms posted Q4 results that beat expectations, as did 80% of health care companies and 75% of financials, so the market was caught somewhat off guard by the pace of the upturn in earnings outside of energy. While earnings grew at 6% year-over-year in Q4 2016, revenues grew just 4% due to low nominal GDP growth last year (although the latter rebounded late in the year). Ten of 11 sectors posted year-over-year revenue increases in Q4, but the revenue gain just matched consensus estimates with only half of firms posting revenues that exceeded already low expectations. In short, the market didn't expect much and didn't get much from revenues in Q4. The Marginal Way: A Top Down View Looking ahead, a secular downtrend in margins will be a headwind for earnings growth in the coming years, as we highlighted in the February 27, 2017 Weekly Report. A "mean reversion" process for margins is underway, as a tight labor market pushes up wages but firms have difficulty passing along the cost pressure in a poor environment for pricing power. For large cap U.S. companies, global GDP is a better proxy for revenue than U.S. GDP. Nominal global GDP growth fell 6% year-over-year in 2015, but rebounded to a 2%+ increase in 2016 and the World Bank expects global GDP to accelerate rapidly to a 6% increase here in 2017. Thus, there is scope for U.S. corporate revenue growth to pick up after a long period of deceleration. Indeed, the risks for global growth are to the upside of consensus estimates in our view (Chart 2). For those industries and sectors with mainly domestic sales (utilities, telecom), U.S. GDP is a better proxy for top line sales. At just 3.0%, U.S. nominal GDP growth was disappointing in 2016, running 340 basis points below its long-term average (6.4%) and nearly a full percentage point shy of the 2010-2014 (post Great Recession but pre-oil price decline) average of 3.8%. We expect nominal GDP growth to accelerate this year, even absent potentially growth-enhancing legislation from Congress on tax cuts, tax reform and infrastructure. Compensation costs represent two thirds of business costs, and various measures of wage gains are slowly climbing as the U.S. economy approaches full employment. Average hourly earnings rose 2.7% in March 2017 versus a year ago, up from a low of 1.5% hit in 2012. The Employment Cost Index is accelerating as well. The Atlanta Fed's Wage tracker has been trending higher for 7 years, not coincidentally, along with service sector inflation. The Atlanta Fed wage tracker shows the same pattern for both job stayers and job seekers (Chart 3). Chart 2Global Growth Accelerating Global Growth Accelerating Global Growth Accelerating Chart 3Wage Pressures Building Wage Pressures Building Wage Pressures Building The quit rate from the BLS's JOLTs data has hit a new cycle high and is within striking distance of an all-time high. This is significant because a high quit rate means that job prospects are favorable and that employees are jumping to new jobs in search of higher wages. In addition, mentions of wages, skilled labor, and shortages in the Fed's Beige Book have been on the upswing for four years (Chart 4). Labor costs are rising faster than selling prices in the non-financial corporate sector, as highlighted by the downtrend in BCA's Profit Margin Proxy (Chart 5, Panel 1). The mean reversion process will continue, but that does not preclude periods of margin expansion. Indeed, margins rose in the third and fourth quarters on a four quarter moving total basis according to S&P data and we would not be surprised to see this continue early in 2017 as nominal GDP growth recovers from last year's depressed pace (Chart 5, Panel 2). Chart 4"Inflation Words" On The Rise "Inflation Words" On The Rise "Inflation Words" On The Rise Chart 5Bullish Profit Model Bullish Profit Model Bullish Profit Model What about the dollar? As we discuss below, BCA believes that the dollar bull market still has legs. A stronger dollar is both a blessing and a curse for margins. All else equal, a stronger dollar lowers the cost of imported goods and thereby boosts margins for import-intensive firms. On the other hand, a strong dollar undermines profits earned overseas. The net impact of dollar strength is negative for overall corporate profits. However, our quantitative work highlights that it does not take much in the way of stronger growth to offset the negative impact on profits from a rise in the dollar. Investors are also concerned about the impact of higher interest rates on corporate income statements, especially given all the corporate debt that has been accumulated. While we agree with the conventional wisdom that interest costs as a percent of sales have likely bottomed for the cycle, and will undermine margins if yields rise, research by the monthly Bank Credit Analyst revealed that it will require a large increase in interest rates to 'move the dial' on interest payments.1 This is because of a long maturity distribution and the fact that the average yield-to-maturity is still so far below the average coupon in the corporate debt indices that average coupons will continue to erode as debt rolls over in the coming years. Chart 6 shows that interest payments as a fraction of GDP will be roughly flat even if the yield curve shifts up by another 100 basis points in the near term. It would require a 200-300 basis point rise in yields to see a meaningful impact on interest payments over the next 1-2 years. The implication is that rising interest costs won't be a key driver of profit margins in our investment horizon. Chart 6U.S. Corporate Sector Interest Payment Projection U.S. Corporate Sector Interest Payment Projection U.S. Corporate Sector Interest Payment Projection Despite our secular view on profit margins, we remain upbeat for EPS growth this year. Our profit model remains constructive. Indeed, EPS growth for the year may not trail (perennially overly optimistic) bottom-up estimates for the year, currently at 10%. In short, we see a potential for upside surprise on earnings this year, although growth will not be as high as our short-term profit model suggests (Chart 5, Panel 3). Bottom Line: We certainly would not rule out a pullback in the S&P 500 on disappointment surrounding a lack of follow-through by Congress and the Trump Administration on a tax cut, tax reform and an infrastructure package. However, fears around margin contraction, the sustainability of the earnings rebound and valuations are overdone. Earnings estimates almost always come down over the course of the year. Moreover, while above-average valuations suggest below average-returns over the next decade, valuation tells us little about returns over the next 12 months. We continue to favor stocks over bonds in 2017. Is The Dollar Bull Over? The dollar has firmed over the past couple of weeks but it remains below the December high in trade-weighted terms. Is this just a consolidation phase? Or has the dollar peaked for this cycle because the maximum policy divergence between the Fed and the other major central banks is now in the price? Indeed, the global growth outlook outside of the U.S. has brightened at a time when some of the so-called "hard" U.S. economic data have disappointed and the promised Trump fiscal stimulus appears to be on the ropes. The European Central Bank (ECB) has already tapered its asset purchase program once and is expected to do so again early in 2018. Some are even speculating that the ECB will lift rates in the not-to-distant future. This raises the possibility that the bund yield curve begins to converge with the Treasury curve, placing upward pressure on the euro versus the dollar. The Eurozone economic data have certainly been stellar so far this year. The PMIs for manufacturing and services both pulled back a bit in March, but remain at levels consistent with continued above-trend growth. The uptrend in capital goods orders bodes well for investment spending over the coming months (Chart 7). In addition, private-sector credit growth has accelerated to the fastest pace since the 2008-09 financial crisis. Our real GDP model for the Eurozone, based on our consumer and business spending indicators, remains quite upbeat for the first half of the year. The Eurozone unemployment rate is falling fast and there is less spare capacity in European labor markets today than was the case in the U.S. when the Fed first hinted at tapering its asset purchases in 2013 (Chart 8). Chart 7Solid Eurozone##br## Economic Data Solid Eurozone Economic Data Solid Eurozone Economic Data Chart 8Less Spare Capacity In Europe Now ##br##Vs. Pre-Taper Tantrum U.S. Less Spare Capacity In Europe Now Vs. Pre-Taper Tantrum U.S. Less Spare Capacity In Europe Now Vs. Pre-Taper Tantrum U.S. Nonetheless, the calm readings on Euro Area core inflation suggest that the ECB does not have to rush to judgment on asset purchases, especially given upcoming elections. Our diffusion index for the components of the CPI points to some upside for core inflation in the coming months, but it fell back to 0.7% in March according to the flash estimate. The ECB will probably not feel comfortable announcing the next tapering until September of this year. But even then, policymakers will apply a heavy dose of "forward guidance" on the outlook for short-term rates in order to avoid an outsized impact on Eurozone bond yields. Some tapering is presumably already discounted in rates and the euro. Chart 9Market Is Reassessing The FOMC Market Is Reassessing The FOMC Market Is Reassessing The FOMC It will be much longer before the Bank of Japan is in any position to begin removing monetary accommodation. We expect that the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year, and probably much longer. True, deflationary forces appear to have eased somewhat. Japan is also benefiting from the faster global growth on the industrial side. Nonetheless, the domestic demand story is less positive, with consumer confidence and real retail sales growth languishing. Wages continue to struggle as well. This year's round of Japanese wage negotiations was particularly disappointing, with many manufacturing companies offering pay raises only half as large as those of last year. We continue to see this as the only way out of the low-inflation trap for Japan - keeping Japanese nominal interest rates depressed versus the rest of the world, thus making the yen weaken alongside increasingly unattractive interest rate differentials. On the U.S. side, we believe that the market has over-reacted when the FOMC signaled last month that it was not yet prepared to adjust the 'dot plot.' The market is discounting only two rate hikes over the next 12 months, down by about 10 basis points since the FOMC meeting (Chart 9). The market view is too complacent for three reasons. First, we expect the U.S. "hard" to catch up with the more robust "soft" data readings in the coming months. Second, the FOMC did not signal a more dovish mindset last month. The key message from the March meeting was that the Fed now sees inflation as having finally reached its 2% target, as highlighted by the decision to strip the reference to the "current shortfall of inflation" from the statement. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. The poor (weather-related) March payroll report does not change the Fed outlook. The important point is that the market appears to be at full employment based on FOMC committee projections. In fact at 4.5% in March (the lowest since May 2007) the rate is below the median and midpoint of the FOMC's long-run forecast, of respectively 4.7% and 4.85%. Finally, the market is underestimating the prospects for stimulative tax cuts and infrastructure spending. The Republican's desire to cut taxes will dominate fears of blowing out the budget deficit. The resulting stimulus will add pressure on the FOMC to tighten monetary conditions. Bottom Line: Our views on U.S. fiscal policy and the outlook for the major central banks paint a bullish picture for the dollar and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms as yield spreads move further in favor of the greenback, but a move of that magnitude wouldn't be a major headwind for U.S. corporate earnings growth and would pale in comparison to the hit earnings took from the 20-25% gain in the dollar in late 2014 through early 2016. Our view remains that the U.S. bond bear phase is not yet over. Revisiting "Weak" U.S. CAPEX The BCA Model for business investment tracks broad capex swings and has been trending down for several months now. Our past research shows that sustainable capital spending cycles only get underway once businesses see clear evidence that consumer final demand is on the upswing. Comments from management during the recent Q4 2016 earnings reporting season were upbeat, but cautious, and there is some evidence (the recent rollover in C&I) loans that businesses may be delaying some portion of capital spending until after tax cuts and or tax reform is enacted by Congress. Part of the macroeconomic narrative for many investors over the past several years is that U.S. growth has been slow this cycle because private investment has been weak. The prolonged nature of "weak" U.S. investment during this economic recovery has been offered as evidence of deep-seated structural problems by many market participants, and arguably remains a factor driving the continued prevalence of the secular stagnation narrative. Two elements of the "weak investment" narrative are undeniably true. First, overall investment has indeed grown at a sluggish pace over the past eight years relative to previous economic expansions. Second, residential investment has certainly been weak by any measure, which is to be expected given that housing was at the epicenter of the subprime financial crisis. However, Chart 10 presents a different perspective about the "weakness" of investment by examining the trend in non-residential fixed asset investment (i.e., capex). The chart shows that, relative to GDP, capex has not been weak at all this cycle: it experienced a V-shaped recovery over the past several years, and has risen either back to its post-1980 average (in nominal terms) or to a new high (in real terms). This highlights that growth in investment, abstracting from the housing effect, has been weak in absolute terms because consumption has been weak, rather than because of some other unexplained structural force. Chart 10Investment Has Not Been Weak Relative To GDP Investment Has Not Been Weak Relative To GDP Investment Has Not Been Weak Relative To GDP More recently, Chart 10 shows that there has been a decline in the capex-to-GDP ratio, which has been a concerning sign for some investors that U.S. growth may be faltering. Until the beginning of last year, this deceleration could have been simply blamed on a collapse in resource investment following the sharp decline in the price of oil that began in mid-2014. But Chart 11 shows that this ceased to be the case through to the fourth quarter, as real capex excluding mining structures has also decelerated sharply. The slowdown in capex last year is echoed by a sharp recent slowdown in U.S. bank lending, and a detailed analysis suggests they may both be (at least somewhat) related to the same cause. Chart 12 presents the 3-month annualized rate of change in commercial & industrial (C&I) loans, along with the U.S. Economic Policy Uncertainty Index. The recent spikes in the latter correspond with the U.K.'s vote to leave the European Union as well as the U.S. election in November, and the chart clearly shows a close correlation between these spikes and the deceleration in C&I loan growth. Indeed, C&I lending had begun to pick up again following the Brexit vote, only to decelerate again after November. Chart 11Oil Accounts For Some, But Not All, ##br##Of Recently Weak CAPEX Oil Accounts For Some, But Not All, Of Recently Weak CAPEX Oil Accounts For Some, But Not All, Of Recently Weak CAPEX Chart 12Tax Rule Certainty May Spur Bank##br## Lending And Investment Tax Rule Certainty May Spur Bank Lending And Investment Tax Rule Certainty May Spur Bank Lending And Investment Uncertainty over Brexit represented legitimate CEO concern about a potential global macro shock, but our view is that the recent uncertainty following the U.S. election has not been driven by fear. This is a crucial distinction with implications for the economic outlook: if the recent uptick has been driven by a dearth of information about how business-friendly fiscal policy will become as a result of the election, then investors are more likely observing uncertainty over how much and when to invest rather than whether to invest. If true, this suggests that weak bank lending and growth in non-resource capex in Q4 has merely been deferred until rule clarity emerges and firms are confident that they will benefit from any investment-related changes to the tax code. In short, far from being a bearish signal about economic activity, recent trends in C&I lending and non-resource capex may actually indicate that firms plan on responding positively to corporate tax relief, suggesting that overall economic growth may improve once the details of the plan are known. Bottom Line: A detailed analysis of recent weakness in C&I lending and non-resource capex points to policy-related uncertainty as the culprit, rather than impending economic weakness or a broad-based contraction in activity. This argues that some capex spending is pent up, and that economic growth will improve following the establishment of tax rule certainty by the Trump administration and/or congressional leadership. 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 The Bank Credit Analyst Monthly Report "Global Debt Titanic Collides With Fed Iceberg?", dated February, 2017, available at bca.bcaresearch.com

Highlights Portfolio Strategy A window has opened up for utilities outperformance. Upgrade to overweight on a short-term (1-3 month) view. Leading indicators of beverage sales have improved, heralding an upgrading in depressed expectations. Stay overweight. The pullback in consumer finance stocks appears to be contagion from the overall financial sector selloff than a reflection of deteriorating industry-specific fundamentals. Buy on weakness. Recent Changes S&P Utilities - Boost to overweight from neutral on a tactical basis. Table 1 Great Expectations? Great Expectations? Feature Our view remains that stocks are in a consolidation phase, waiting for economic/profit confirmation that earnings will grow into the latest valuation expansion. Thin equity market risk premia can be justified if the economy has embarked on an extended and strong non-inflationary growth path that will spawn robust corporate profitability. Chart 1A Second Half Squeeze? A Second Half Squeeze? A Second Half Squeeze? On this note, the third mini-economic up-cycle since the Great Recession has been underway since last year. The first two bursts of economic strength fizzled quickly, eventually requiring a new dose of stimulus to reinvigorate growth. The current up-cycle may have more legs given that the rest of the world is now participating and the U.S. economy at full employment, but it would be dangerous to become complacent. The stock-to-bond ratio has crested on a growth rate basis, and its mean reversion properties suggest that key macro gauges such as the ISM index may cool as the year progresses (Chart 1). Odds of growth-propelling fiscal stimulus, that equities have already bought and paid for, may now fade following Congress' failure to move on health care reform. Total bank credit growth is decelerating on a broad basis. Chart 1 shows that of the 8 major bank loan categories, only 1 has a positive credit impulse (the annual change in the 52-week rate of change), the other 7 are negative, i.e. it isn't simply C&I loan weakness driving the credit deceleration. Traditionally, credit and economic growth move together, so the current gap warrants close attention. Meanwhile, the reflationary impulse over the past 18 months from China is set to fade as the authorities tap the brakes, particularly in the housing market, which may throw a wrench into new construction. Chinese property prices have been especially correlated with global economic up-cycles. Real estate inflation downturns have been important global economic signals (Chart 1). Consequently, the second half of the year may 'feel' slower from a growth perspective and challenge the reflation hypothesis. Some trepidation about the durability/breadth of the economic expansion is becoming evident in internal market behavior. Our Intermediate Equity Indicator (IEI) has continued to weaken as breadth and participation thin (Chart 2). If the IEI drops below zero, the odds of a meaningful pullback will rise substantially. Keep in mind there is a lot of air between the S&P 500 index and its 40-week moving average. The number of S&P 500 groups with a positive 52-week rate of change has pulled back to post-Great Recession lows (Chart 2). Last week we showed a composite of relative industry and sector performance that also heralded a choppy period ahead for the broad averages. All of these factors suggest that a tactical consolidation needs time to play out, especially with first quarter reporting season fast approaching and optimism in the outlook bursting at the seams. While trading sentiment is not overly stretched, the truest measure of sentiment is asset valuations and expectations. On this front, our Global Economic Sentiment Index, which contrasts equity and government bond valuations in the major economies, has reached the 'extreme optimism' zone (Chart 3, middle panel). Such a reading does not automatically foretell of an imminent major equity peak, but reinforces that there is little margin for disappointment. Chart 2Deteriorating Internals Deteriorating Internals Deteriorating Internals Chart 3Early Signs Of Overconfidence? Early Signs Of Overconfidence? Early Signs Of Overconfidence? In addition, the trend in analyst earnings expectations is also consistent with an overriding theme of exuberance. Cyclical earnings estimates have tentatively peaked after a steep upgrade over the last few quarters, and are now sitting below 5-year growth expectations, suggesting overwhelming confidence in the longevity of the expansion. The last three times that cyclical (12-month) profit growth estimates diverged negatively from lofty long-term estimates was in 2000, 2007 and 2015 (Chart 3). Each episode coincided with ebullient global economic sentiment, and heralded market turbulence, with varying lags. The point is that when financial conditions tighten enough to undermine the cyclical growth outlook but fail to dent conviction in the long-term outlook, it is a signal of overconfidence. The good news is that financial conditions have remained historically easy and should only tighten gradually, such that the risk of a policy-induced slowdown is not acute. In sum, we expect the tactical consolidation phase to persist, especially if economic momentum cools. Exuberant expectations argue for a digestion phase, which should continue to broadly support defensive over cyclical sector positioning, a stance that has paid off nicely since late last year. We may look to selectively increase cyclical and financial sector exposure in the coming weeks if the U.S. dollar remains tame and inflation expectations perk back up, but for now, we are making a tactical addition to the defensive side of the ledger. Utilities Are Powering Up We booked sizable gains in the S&P utilities index and downgraded to neutral last summer, because of our view that bond yields were bottoming on the back of economic stabilization. Since then, relative performance collapsed by 20%, but it has recently started showing some signs of life. Is it time to re-enter this overweight position on a tactical basis? The short answer is yes. There are five reasons to buy utilities at the current juncture with a tactical (1-3 month) time horizon. A possible cooling in economic momentum will redirect capital into the sector. Last week we highlighted that the economically-sensitive transportation index may be heralding mean reversion in key activity gauges, such as the ISM manufacturing index (Chart 4). If the run of positive economic surprises reverses, utilities stocks should receive a sizeable relative performance boost. Transport stock underperformance typically means utility stock outperformance (Chart 4, bottom panel). A cycle-on-cycle analysis of relative utilities performance and the ISM manufacturing survey reveals that is pays to overweight utilities when the latter hits the current level. This has occurred seven times since the early 1990s, and the S&P utilities sector outperformed in the subsequent 3 and 6 months by an average of 3 and 5%, respectively. Only one period generated negative returns (Table 2). Chart 4Utilities Win When Transports Lose Utilities Win When Transports Lose Utilities Win When Transports Lose Table 2Contrary Alert: Buy Utilities Great Expectations? Great Expectations? Market-based inflation expectations have crested, aided by the dip in oil prices. Relative share prices have been inversely correlated with inflation expectations, owing to the link to long-dated Treasury yields. Importantly, the University of Michigan's survey inflation expectations, both short and long term, have been drifting lower signaling that the recent backup in CPI headline inflation will likely prove transitory (inflation expectations shown inverted, Chart 5). The flattening yield curve is also sending a tactical buy signal for utilities stocks (shown inverted, Chart 5). Natural gas prices are strengthening. Nat gas prices are the marginal price setter for non-regulated utilities, and the recent price spike has boosted utilities pricing power. Sell-side analysts have taken notice, aggressively ratcheting EPS numbers higher. Nevertheless, the relative EPS growth bar still remains low, signaling that a relative profit outperformance period looms (Chart 6). Chart 5External Support As... External Support As... External Support As... Chart 6... Earnings Recover ... Earnings Recover ... Earnings Recover One risk to our tactically bullish utilities view is stagnant electricity generation growth. However, if overall output growth recedes in the next quarter or two, then the non-cyclical power demand profile will shine through, offsetting low utility utilization rates in absolute terms. Bottom Line: There is scope for a playable relative performance rally in the coming one-to-three months. Boost the niche S&P utilities sector to overweight. Soft Drinks Are About To Pop Indiscriminate selling of all consumer staples immediately after the Trump victory restored value in a number of defensive consumer groups. They have stealthily outperformed for most of this year. Chart 7 shows a number of valuation yardsticks. Soft drink stocks are yielding more than both 10-year Treasurys and the broad market. Similarly, the relative P/S and P/E ratios have dipped comfortably below their respective historical means. From a technical standpoint, relative share price momentum has been pushed to a bearish extreme (Chart 7). Against this valuation and technical backdrop, any whiff of operating traction should trigger a playable outperformance phase. Industry pricing power has rebounded smartly, exiting the deflation zone (Chart 8). This firming in selling prices appears to be demand driven. Growth in relative consumer outlays on food and non-alcoholic beverages has improved. Actual industry sales growth has returned to positive territory and beverage output growth is outpacing other non-durable goods industries (Chart 8). While export trends have been a sore spot for beverage companies, the tide should soon turn. The greenback has depreciated versus emerging market (EM) currencies since mid-December, permitting EM central banks to ease monetary policy. That heralds a recovery in consumer goods exports and a reversal of negative translation FX effects (Chart 9, middle panel). Chart 7Cheap And Washed Out Cheap And Washed Out Cheap And Washed Out Chart 8Inflection Point Inflection Point Inflection Point Chart 9Export Drag Should Reverse Export Drag Should Reverse Export Drag Should Reverse The improvement in top-line leading indicators is particularly noteworthy given that cost inflation remains muted. Food input prices are contracting and ethylene prices, a primary packaging ingredient, are also deflating. With headcount under control (Chart 9, bottom panel), there is scope for margin expansion at a time when overall profit margins face a steady squeeze from rising wage inflation. This brightening backdrop, especially in relative terms, has not yet been embraced by the analyst community. Not only are earnings slated to trail the broad market by 7% in the coming year, but 5-year relative EPS growth has plummeted to all-time lows. Such pessimism is unwarranted. All of this implies that while recent beverage shipment growth has been soft, a recovery is likely as the year progresses. That will set the stage for a series of positive surprises, supporting share price outperformance. Bottom Line: The compellingly valued S&P soft drinks index has troughed and has a very attractive reward/risk profile. Were we not already overweight, we would lift exposure to above benchmark today. The ticker symbols for the stocks in the S&P soft drinks index are: BLBG: S5SOFD-KO, PEP, MNST, DPS. Consumer Finance: Cast Aside, But For No Good Reason Like all financials, consumer finance stocks have underperformed the broad market in recent weeks. High intra-financial sector correlations are understandable early in a corrective phase, especially given the magnitude of the initial post-election rally. However, as time passes, correlations should recede because significant discrepancies exist among industry profit drivers. For instance, any meaningful broad market correction could undermine capital markets activity via reduced appetite for new equity issues, less M&A activity and smaller trading fees, taking a bite out of investment banking profits. Elsewhere, banks have been riding hopes for higher net interest margins and an easing regulatory burden. However, without any corresponding improvement in credit growth they are now giving back those gains because bond yields have stalled, the yield curve has narrowed and expectations for deregulation are being watered down to a dilution of terms These factors justify the pullback in both banks and capital markets stocks, even if temporary. On the flipside, the consumer finance group has also been dragged down, even though leading indicators of profitability have continued to improve. As shown in past research, the credit card interest rate spread has low sensitivity to shifts in the yield curve. As such, receivables growth matters more to profits than the slope of the yield curve. Whether consumers embark on debt-financed consumption is heavily dependent on job security, debt-servicing costs, and household wealth. When consumer comfort rises, the personal savings rate tends to decline, indicating a greater propensity to spend. Household net worth has set a new all time high on the back of buoyant financial markets and recovery in house prices (Chart 10). Debt service payments remain historically depressed as a share of disposable income, underscoring that the means to re-leverage exist (Chart 10). Typically credit card charge-offs stay muted until well after debt servicing requirements hit a much higher level, either through reduced incomes or higher interest rates, or a combination of the two. At the moment, both are working in favor of credit quality, not against it. In fact, house prices have reaccelerated sharply in the past few months, which heralds share price outperformance (Chart 11, top panel). Moreover, the steady increase in housing starts bodes well for additional gains in outlays on durable goods, a positive omen for consumer credit demand. Chart 10Credit Quality Remains Strong Credit Quality Remains Strong Credit Quality Remains Strong Chart 11Bullish Leading Indicators Bullish Leading Indicators Bullish Leading Indicators The latter is already growing at a solid clip, in contrast with other lending categories such as C&I loan growth (Chart 11), which is weak and dragging down total bank credit. The surge in consumer income expectations points to an expanded appetite for debt (Chart 11). Consequently, the sell-off in the S&P consumer finance index should be treated as indiscriminate contagion from the rest of the financials sector rather than a reflection of deteriorating fundamentals. Recent value creation represents a buying opportunity. Bottom Line: Stick with a high-conviction overweight in the S&P consumer finance index. The ticker symbols for the stocks in the S&P consumer index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Renewed deflationary pressures indicate that the Hong Kong dollar may have once again become expensive. The currency peg will stay and domestic prices will adjust as a release valve. Developing deflationary pressures and slowing rent growth may reinforce one other. Rising risk free interest rate calls for higher rental yield, which can only be achieved via lower home prices. Remain short HK government bonds relative to US Treasurys; Remain short HK property investors relative to benchmark. More evidence that China's profit cycle is in an upturn. Feature The election of Hong Kong's Chief Executive this past weekend garnered little coverage among the global mainstream media. Carrie Lam easily beat her competitors, purportedly with blessings from Beijing. However, she will face an uphill battle to reunite the citizens of Hong Kong, who have become increasingly divided in recent years. As a regional financial hub heavily exposed to global forces, local politics barely matter for Hong Kong's economy and financial markets. Nonetheless, the significance of politics has clearly been on an upward trajectory in recent years, which could impact investors' long-term risk perceptions for a market that has historically been largely viewed as an "apolitical" Laissez Faire system. On the economic front, also largely ignored has been Hong Kong's inflation statistics released early last week, which showed that headline consumer price inflation dropped by 0.1% in February, the first negative reading since August 2009. While one single data point certainly does not denote a trend, odds are high that deflationary forces are re-emerging in Hong Kong, with important implications for asset prices, particularly for the currency and local real estate market. Budding Deflation... Chart 1Deflation Is Coming Back Deflation Is Coming Back Deflation Is Coming Back The negative February CPI reading was largely attributed to some poverty relief factors, declining vegetable prices and the base effect due to the Chinese New Year holiday. However, headline CPI has been decelerating since the peak of 2011 (Chart 1). Indeed, after briefly dipping below zero at the height of the global financial crisis and then roaring back in the aftermath on improving growth, consumer prices in Hong Kong have been in a prolonged period of disinflation. In fact, February's negative CPI figure is just a continuation of a well-established trend rather than an anomaly caused by one-off factors. Moreover, falling inflation and developing deflation is rather broad-based. It is true that the nosedive in fresh food prices has clearly played a role in dragging down headline CPI. However, price inflation has been trending lower in almost all major components of the consumption basket such as housing, eating out and other miscellaneous services (Chart 1, bottom panel). Meanwhile, consumer durable goods inflation has been stuck in negative territory for more than 10 years. Interestingly, amid strengthening global growth momentum, most major economies have been experiencing bouts of reflation, particularly in sectors associated with commodities prices - intensifying disinflationary/deflationary pressures in Hong Kong are a notable exception. It means that inflation dynamics in Hong Kong are likely rooted in unique domestic factors. ...Indicates An Expensive Hong Kong Dollar In our view, a key factor behind Hong Kong's budding deflationary pressure is the exchange rate. As the Hong Kong dollar is pegged to the U.S. dollar, the relative shift in price levels between Hong Kong and the rest of the world cannot be adjusted through a change in the nominal exchange rate. Therefore, the adjustment must be achieved in real terms through price changes. Chart 2 shows that prior to 1983 when the currency board system was established, Hong Kong inflation largely followed that in the U.S., while the exchange rate fluctuated against the dollar. Since the 1983 currency peg, Hong Kong inflation has been swinging around the U.S. level, with the economy alternating between inflationary booms and deflationary busts. A new factor that has also become increasingly important in Hong Kong's inflation dynamics is China's price levels, which also relates to the exchange rate. Chart 3 shows Hong Kong headline inflation has outpaced Chinese inflation since 2013, and the RMB's depreciation against the Hong Kong dollar in recent years has put further downward pressure on local Hong Kong price levels. Chart 2Exchange Rate And Inflation Tango Exchange Rate And Inflation Tango Exchange Rate And Inflation Tango Chart 3Hong Kong Inflation: The China Factor Hong Kong Inflation: The China Factor Hong Kong Inflation: The China Factor In short, renewed deflationary pressures indicate that the Hong Kong dollar may have once again become expensive, and therefore domestic price levels have begun to adjust as the release valve. It remains to be seen how long the adjustment process will last. From investors' point of view, a few observations are in order: There is little risk that the Hong Kong dollar peg will break, unless it is a voluntary policy choice by the authorities. Hong Kong's solid banking sector is not prone to financial crises, and its massive fiscal and foreign exchange reserves give the government plenty of fire powder to defend the exchange rate in the event of a speculative attack, let alone the mighty official reserves held in mainland China (Chart 4). We remain convinced that Hong Kong's ultra-low interest rates compared with the U.S. are unjustified and unsustainable (Chart 5). Hong Kong 10-year government bond yields are still 84 basis points lower than their U.S. counterparts, which probably reflects upward pressure on the Hong Kong dollar to appreciate against the U.S. dollar, partially driven by Chinese capital outflows. In this vein, budding deflationary pressures in Hong Kong further diminish the odds of an upward move of the HKD against the U.S. dollar. Remain short Hong Kong government bonds against U.S. Treasurys with comparable durations. Historically Hong Kong's flexible and largely Laissez Faire system has been able to stomach drastic swings in domestic price levels induced by the currency peg. The rising grassroots anti-establishment movement in recent years suggests the side effects of the Hong Kong system may have become increasingly unpopular. It will be interesting to see if any deflationary growth downturn in Hong Kong triggers a populist backlash that leads to a change in Hong Kong's exchange rate scheme. Chart 4Ample Resources To Defend HKD Peg Ample Resources To Defend HKD Peg Ample Resources To Defend HKD Peg Chart 5HK Rates Should Move Higher HK Rates Should Move Higher HK Rates Should Move Higher Real Estate: Sky's The Limit? Another key reason behind Hong Kong's falling CPI inflation is rent, which has also turned sharply lower in recent months (Chart 1, bottom panel). This is in stark contrast to home prices, which have continued to rally strongly. After a temporary pullback last year, Hong Kong real estate prices have roared back to new record highs. Looking forward, the outlook for Hong Kong's real estate sector looks decisively bearish. First, Hong Kong's real estate market has become increasingly detached from economic fundamentals. Home prices have dramatically outpaced household income, in greater proportion than the previous housing bubble peak in the late 1990s (Chart 6). Therefore, it is not surprising that both transactions and construction activity have declined substantially to near-record lows. Thinning transaction activity suggests that ordinary local households may have been priced out, underscoring frothy market conditions. The saving grace is that the dramatic increase in prices has not led to euphoria in housing demand and transactions, which should limit financial sector risk should home prices decline. Second, developing deflationary pressures and slowing rent growth may reinforce one other, potentially creating a downward spiral. Meanwhile, risk-free interest rates, driven by Federal Reserve policy, will likely edge higher. This is an especially poor combination for Hong Kong real estate investors. Historically, higher risk-free yields should lead to higher rental yields (Chart 7). With falling rents, the only way for rental yields to go up is via lower prices. Chart 6Housing Market: Soaring Prices, Falling Volume Housing Market: Soaring Prices, Falling Volume Housing Market: Soaring Prices, Falling Volume Chart 7Rental Yield Will Be Pushed Higher Rental Yield Will Be Pushed Higher Rental Yield Will Be Pushed Higher From a big-picture vantage point, Hong Kong deflation and Fed tightening will lead to much higher real interest rates in Hong Kong, which amounts to significant tightening in monetary conditions. This will create further headwinds for both the Hong Kong domestic economy and property prices. The bottom line is that the risk in Hong Kong home prices is tilted to the downside. The market may have been boosted by an influx of capital from the mainland, which may sustain the bubble for a while longer. However, investors should not chase the market. Chart 8The Widening Valuation Gap The Widening Valuation Gap The Widening Valuation Gap Budding deflationary pressures also bode poorly for profits and equity prices. However, Hong Kong stocks are more heavily exposed to China and the global cycle than local business conditions, and therefore should not be impacted materially. Moreover, Hong Kong stock multiples historically have tracked their U.S. counterparts closely - the valuation gap has widened sharply since 2013 (Chart 8). This should further limit the downside in Hong Kong stocks. Meanwhile, we expect property owners such as REITs to underperform the broader market. A Word On Chinese Profits The latest numbers show Chinese industrial profits jumped by over 30% in the first two months of the year compared with a year ago, a sharp acceleration from recent months, as predicted by our model (Chart 9). The strong profit recovery has important implications. For equity earnings, the upturn in the profit cycle is also confirmed by bottom-up analysts. Net earnings revisions have been lifted, which has historically led to acceleration in forward earnings growth (Chart 10). Remain positive on Chinese H shares. From a macro perspective, rising earnings should lead to stronger investment, especially in the manufacturing and mining sectors. This should further boost domestic demand and prolong the ongoing mini cycle upturn. The profit recovery also helps alleviate financial stress in the banking system, as it will reduce the pace of accumulation of non-performing loans (NPL). Importantly, profits are rising particularly strongly in some of the hardest hit sectors in previous years, such as steelmakers and coal miners, which were precisely where the increase in NPLs were the most rampant. We will follow up on this issue in upcoming reports. Chart 9China's Profit Cycle Upturn China's Profit Cycle Upturn China's Profit Cycle Upturn Chart 10Chinese Equity Earnings Will Accelerate Chinese Equity Earnings Will Accelerate Chinese Equity Earnings Will Accelerate Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations