Correlations

Highlights Duration: Treasury yields will continue to rise as a December Fed rate hike is priced in. A surge in bullish dollar sentiment between now and December would cause us to back away from our below-benchmark duration stance. Spread Product: Maintain a neutral allocation to spread product, favoring convexity over credit risk. A surge in bullish dollar sentiment between now and December would cause us to downgrade spread product relative to Treasuries. TIPS: The increased sensitivity of TIPS breakevens to core inflation argues for a continued overweight position in TIPS relative to nominal Treasuries. Sovereign Debt: Continue to favor U.S. corporate credit over USD-denominated sovereign government debt within a neutral allocation to spread product. Feature About one month ago, we outlined how we expected our investment strategy to evolve over the remainder of this year and into 2017.1 Our continued expectation that the Fed will lift rates in December leads us to maintain below-benchmark portfolio duration and a neutral allocation to spread product2 until a December rate hike has been fully discounted by the market. Chart 1Dollar Sentiment: A Key Indicator Dollar Sentiment: A Key Indicator Dollar Sentiment: A Key Indicator Beyond December, our investment strategy will depend largely on how the dollar responds to an upward re-rating of rate expectations. Strong dollar appreciation would likely cause us to reverse our below-benchmark duration stance and become even more cautious on spread product. Conversely, a tame dollar could mean that the sell-off in bonds and rally in spreads have further to run. The dollar has appreciated by close to +2% since early September and bullish sentiment toward the dollar has also edged higher (Chart 1). However, so far the increases appear muted compared to the rapid dollar appreciation that occurred in the run-up to last December's rate hike. The reason we care about the dollar is that a stronger currency represents a tightening of financial conditions that acts to depress expectations of future economic growth. This can spell trouble for risk assets and also lower the market-implied odds of future rate hikes. For example, spread product was performing well last year until rate hike expectations started to move higher in late October. As the market began to anticipate a December Fed rate hike, it did not take long for the combination of higher rate expectations and increasingly bullish dollar sentiment to weigh on risk assets (Chart 2). The Market Vane survey of bullish sentiment toward the dollar surged above 80% last December, and this tightening of financial conditions is what prompted the sell-off in spread product and sharp decline in Treasury yields that kicked off 2016. Chart 2More Bullish Dollar Sentiment Is A Risk For Spread Product More Bullish Dollar Sentiment Is A Risk For Spread Product More Bullish Dollar Sentiment Is A Risk For Spread Product With last year's example in mind, the relevant question for current investment strategy is: How much dollar appreciation can the market tolerate before Treasury yields reverse their uptrend and credit spreads start to widen? To answer that question we make an assessment of U.S. and global growth relative to this time last year. All else equal, if U.S. growth is improved compared to last year, then it should require a greater dollar appreciation to have a similar impact on yields and spreads. Relatedly, if the growth outlook outside of the U.S. is improved, then it would mean that the dollar's reaction to rising U.S. rate expectations might not be as strong. On this note, there is some evidence pointing toward a more resilient U.S. and global economy than at this time last year. In the U.S., our preferred leading indicators suggest that growth contributions from capital spending, housing, net exports, government spending and inventories should all move higher in the coming quarters (Chart 3). This should act to offset a likely moderation in consumer spending growth (Chart 4). All in all, the domestic U.S. growth outlook appears similar to - if not slightly better than - what was seen at this time last year. There is more cause for optimism in the global growth indicators. The aggregate global PMI and LEI are tracking close to levels seen last year, but rising diffusion indexes suggest that further increases are likely (Chart 5). Already, manufacturing PMIs in all the major economic blocs have entered clear uptrends (Chart 5, bottom two panels). This suggests that the global growth outlook is actually much brighter than at this time last year, and improved diffusion indexes suggest that the global recovery has also become more synchronized. Chart 3U.S. Growth Outlook Improving... bca.usbs_wr_2016_10_25_c3 bca.usbs_wr_2016_10_25_c3 Chart 4...Outside Of Consumer Spending bca.usbs_wr_2016_10_25_c4 bca.usbs_wr_2016_10_25_c4 Chart 5Global Growth On The Upswing Global Growth On The Upswing Global Growth On The Upswing The implication of a U.S. economic outlook that is broadly similar to last year and an improved outlook for global growth is that the U.S. dollar may not react as strongly to rising Fed rate hike expectations in 2016 as it did in 2015. If this turns out to be the case, then the performance of spread product should also be more resilient and the uptrend in Treasury yields is less likely to reverse. Bottom Line: We continue to track the dollar and dollar sentiment closely to inform our near-term investment strategy. While dollar sentiment has edged higher, it has not yet reached the elevated levels seen last year. A more synchronized global growth recovery makes such a spike in bullish dollar sentiment less likely this time around. What Is A High Pressure Economy? Chart 6What A "High Pressure Economy" Looks Like bca.usbs_wr_2016_10_25_c6 bca.usbs_wr_2016_10_25_c6 Fed Chair Janet Yellen introduced a new buzzword to the market two weeks ago when she suggested in a speech3 that "it might be possible to reverse the adverse supply-side effects [of the financial crisis] by temporarily running a 'high-pressure economy' with robust aggregate demand and a tight labor market." Some investors took this to mean that the Fed would be increasingly tolerant of inflation overshooting its 2% target. We think this interpretation is incorrect, although we do think that Yellen's description of a "high pressure economy" provides a lot of information about the Fed's reaction function. More than anything, Yellen's speech was a response to recent trends in the labor market. The downtrend in the unemployment rate started to abate late last year, even though the economy has continued to add jobs at an average pace of just under +200k per month. A sharp rebound in the labor force participation rate has prevented the unemployment rate from falling, despite robust job growth (Chart 6). It is this dynamic that Yellen refers to when she talks about a "high pressure economy". Essentially, her theory suggests that, despite the low unemployment rate, the economy might be able to continue to add jobs without inflation spiking higher. Put differently, the unemployment rate might be less useful as an input to the Fed's forecast of future inflation than in past cycles. The key implication for investors is that if the Fed doesn't trust the unemployment rate to provide a signal about future inflation, then it is forced to rely on the actual inflation data for guidance. In our view, core PCE and core CPI inflation are now the two most important inputs to the Fed's reaction function. On that note, while last week's September core CPI release was soft, both core CPI and core PCE remain in uptrends that began in early 2015. Further, diffusion indexes suggest that these uptrends will persist (Chart 7). The Fed's increased focus on core inflation also has implications for our TIPS call. The sensitivity of TIPS breakevens to realized core inflation has shifted higher since the Great Recession (Chart 8). In our view, this has occurred because of how the zero-lower-bound on interest rates has constrained the Fed's ability to influence investor expectations. Chart 7The Inflation Uptrend Is Intact bca.usbs_wr_2016_10_25_c7 bca.usbs_wr_2016_10_25_c7 Chart 8TIPS Breakevens & Core Inflation TIPS Breakevens & Core Inflation TIPS Breakevens & Core Inflation When the fed funds rate was well above the zero-lower-bound, investors could reasonably assume that the Fed would act to offset any temporary price shocks. As such, long-maturity TIPS breakevens remained in a relatively narrow range and were mostly influenced by perceptions about the stance of Fed policy. In a zero-lower-bound world, investors can reasonably question whether the Fed has the ability to offset a deflationary price shock. As such, inflation expectations are increasingly driven by the actual inflation data rather than the Fed. With the Fed and the market both increasingly taking their cues from the actual inflation data, it means that the Fed will likely remain sufficiently accommodative for core PCE to return to target and also that TIPS breakevens will move higher alongside the trend in realized inflation. Bottom Line: The increased sensitivity of TIPS breakevens to core inflation argues for a continued overweight position in TIPS relative to nominal Treasuries. Sovereign Credit: A Dollar Story Chart 9Sovereign Debt & The Dollar Sovereign Debt & The Dollar Sovereign Debt & The Dollar As noted above, in the current environment the path of the U.S. dollar takes on increased importance for our entire portfolio strategy. However, there is one sector of the fixed income market where the dollar is always paramount - USD-denominated sovereign debt. Specifically, we refer to the Barclays Sovereign index which consists of the U.S. dollar denominated debt of foreign governments, mostly emerging markets.4 In the long-run, the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the dollar and bullish sentiment toward the dollar (Chart 9). When the dollar appreciates it makes USD-denominated debt more expensive to service from the perspective of a foreign issuer, and therefore causes sovereign debt to underperform domestic alternatives. As stated above, we do not anticipate a near-term spike in the dollar, like what was witnessed near the end of last year. However, given that the Fed is much further along in its tightening cycle than other major central banks, the long-run bull market in the U.S. dollar should remain intact. This will continue to be a major headwind for sovereign debt. Further, the recent performance of sovereign debt relative to U.S. credit has bucked its traditional correlations with the dollar. Notice that the beta between sovereign excess returns and the dollar has moved into positive territory (Chart 9, bottom two panels). Historically, the correlation does not remain at these levels for long and sovereign debt should underperform as the more typical negative correlation is re-established. At present, there is not even an attractive valuation argument for sovereign debt relative to U.S. credit. The spread differential between the Sovereign index and an equivalently-rated, duration-matched U.S. credit index is well below zero (Chart 10), and only the USD-debt of Hungary, South Africa, Colombia and Uruguay offer spreads that appear attractive relative to the U.S. Credit index (Chart 11). Chart 10No Spread Pick-Up In Sovereigns No Spread Pick-Up In Sovereigns No Spread Pick-Up In Sovereigns Chart 11USD-Denominated Sovereign Debt By Issuing Country Dollar Watching: An Update Dollar Watching: An Update Bottom Line: Continue to favor U.S. corporate credit over USD-denominated sovereign government debt within a neutral allocation to spread product. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 We favor negatively convex assets (MBS) over credit within a neutral allocation to spread product, on the view that negatively convex assets will outperform as yields head higher in advance of a December rate hike. In anticipation of a December Fed rate hike we are also maintain a short position in the December 2017 Eurodollar futures contract as well as positions in 2/10 and 10/30 curve flatteners. The three trades have returned: +20bps, -23bps and +4bps respectively. 3 http://www.federalreserve.gov/newsevents/speech/yellen20161014a.htm 4 The largest issuers in the Barclays Sovereign Index are: Mexico (22%), Philippines (14%) and Colombia (11%). Fixed Income Sector Performance Recommended Portfolio Specification

Highlights It is premature to position for an equity market handoff from liquidity to growth. Cyclical sectors have overshot the mark in recent months. There is scant evidence from macro variables that cyclical sector earnings validation will materialize, especially if the U.S. dollar continues its stealth appreciation. Defensive sectors are primed to resume their market leadership role. Feature Rotational Correction Beneath the surface, equity markets have behaved as if a handoff to growth from liquidity is underway. Since July, defensives have not benefited from the broad market consolidation and increased volatility (Chart 1). Instead, cyclical sectors have celebrated the easing in financial conditions in recent months. The bounce in oil prices, commensurate narrowing in corporate bond spreads and firming inflation expectations have provided enough fuel for cyclical vs. defensive outperformance. Other financial markets appear to corroborate such a view. The equity-to-bond ratio has firmed. Inflation expectations have risen, partly reflecting commodity price appreciation. Gold prices are down. The Fed is itching to lift interest rates. Long-term global government bond yields have climbed. Even the U.S. dollar is testing the top end of its recent range (Chart 1). All of these factors would suggest that the growth outlook is steadily improving. If so, then a rethink of our defensive portfolio positioning would be imperative. Sectoral trends have reached a critical point. Defensive sectors have unwound overbought conditions, and are close to hitting oversold levels (Chart 2). The interest rate-sensitive consumer discretionary, financials and utilities sectors have already hit deeply oversold levels on the latest blip up in Treasury yields (Chart 2). Cyclical sectors are just starting to roll over from overbought levels. Chart 1The U.S. Dollar Is A Critical Influence The U.S. Dollar Is A Critical Influence The U.S. Dollar Is A Critical Influence Chart 2End Of Rotational Correction? bca.uses_sr_2016_10_17_c2 bca.uses_sr_2016_10_17_c2 These dynamics reflect a rotational equity market correction. Indeed, there have been many episodes in the past few years when countertrend sector swings occurred, but each was fleeting and the economy's need for liquidity stayed as strong as ever, ultimately propelling defensive shares back to a leadership position. Is this time different? Below, we revisit a range of indicators that we use to help forecast and time durable shifts in the cyclical vs. defensive trade off. Cyclical Vs. Defensive Checklist Update In our March, 2016 Special Report on cyclical vs. defensive sector strategy, we outlined a checklist of factors that would trigger the need for more aggressive positioning rather than simply riding out the anticipated countertrend move: Broad-based U.S. dollar weakness, particularly against emerging market currencies in countries with large current account deficits. An end to Chinese manufacturing sector deflation. A decisive upturn in global manufacturing purchasing manager's indexes. A return to growth in global export volumes and prices. A resynchronization in global profitability such that U.S. profits were not the only locomotive. A rebound in global inflation expectations. China credibly addressing banking sector weakness to the point where economic growth can reaccelerate rather than move laterally. Of this checklist, items 1, 2, 4, 5 and 7 remain unfulfilled, while items 3 and 6 have moved from a deep negative to a more neutral setting. Financial Variables Offer Modest Cyclical Sector Hope... Financial variables that typically lead the cyclical vs. defensive share price ratio have improved, on the margin, as noted in our March 29th Special Report. Commodity prices bounced on the back of the pause in the U.S. dollar rally, aided more recently by hopes for oil market supply restraint, while developed world equities have lagged behind their emerging market counterparts. The latter is notable, because goods producing cyclical sectors have a tight link with manufacturing-intensive emerging market economies (Chart 3). However, we do not recommend extrapolating these financial market messages, especially since the greenback and commodity prices are starting to reverse. It is also worth noting the bounce in emerging market currencies has been modest, and pales in comparison with the scale of the previous slide (Chart 3). In other words, we are not convinced that EM currency moves are signaling that countries are gaining better access to global funding. Moreover, the back up in global bond yields has not yet produced any meaningful steepening in the U.S. yield curve, which would be a reliable confirming indication that U.S. growth expectations were improving. At the moment, the yield curve is signaling that defensive sectors are now undershooting (Chart 4). Chart 3Some Financial Variables Have Firmed... bca.uses_sr_2016_10_17_c3 bca.uses_sr_2016_10_17_c3 Chart 4... But Not All bca.uses_sr_2016_10_17_c4 bca.uses_sr_2016_10_17_c4 ... But There Is Still A Dearth Of Fundamental Support Financial variables are only useful when confirmed by economic variables. Global manufacturing surveys have stabilized, but are oscillating around the boom/bust line rather than recording incremental gains. Inventory destocking may have finally run its course, based on the trough in the U.S. business sales-to-inventory ratio (Chart 5, top panel), but it is premature to forecast improvement in final demand. Keep in mind that ex consumption, the U.S. economy is in recession. Heavy truck sales have been an excellent business cycle indicator for decades. Truck orders tend to be an early indicator for activity. Heavy truck orders peaked in 2015, and the shipments-to-inventory ratio is heading rapidly toward recession levels (Chart 5). The risk is that employment cools. Corporate employment decisions are profit-motivated. Wages are currently rising much faster than nominal GDP. That is never a good environment for the labor market (Chart 6). True, wages are up, but productivity is down. While broad-based labor market weakness has yet to materialize, the risks are skewed to the downside. Sinking profits and rising wages warn that the unemployment rate is headed higher (shown inverted, Chart 6). Goods producing employment is rolling over relative to service sector employment, which is often a leading indicator of cyclical vs. defensive relative performance momentum (Chart 7, middle panel). Chart 5Cyclicals Have Overshot Fundamentals bca.uses_sr_2016_10_17_c5 bca.uses_sr_2016_10_17_c5 Chart 6Buy Cyclicals When The Economy Overheats bca.uses_sr_2016_10_17_c6 bca.uses_sr_2016_10_17_c6 Chart 7Mixed Signals bca.uses_sr_2016_10_17_c7 bca.uses_sr_2016_10_17_c7 The time to tilt portfolios in favor of cyclical sectors is when profits and profit margins are expanding at a rate such that the labor market is steadily tightening, creating a self-reinforcing consumption/economic feedback loop that feeds into rising inflation pressures, i.e. when the corporate sector is in a position of financial strength. Defensives often outperform when the unemployment rate is rising. Consumers are still much stronger than the corporate sector, and should remain so even if job growth recedes. Consumer balance sheets have been repaired and savings rates are up. Conversely, the BCA Corporate Health Monitor is deep in deteriorating health territory (Chart 5), as profits are contracting and free cash flow is eroding. That divergence is reflected in economic data. For instance, the producer price index is still deep in deflation relative to the consumer price index, albeit the rate of decay has lessened. The upshot is that a meaningful pricing power advantage exists for businesses that sell to consumers rather than to other businesses. Defensives are much more consumer-oriented than deep cyclical sectors, and move in line with relative pricing power (Chart 7). Little Help From Abroad It does not appear as if external forces will take up any slack from lackluster U.S. growth. The all important emerging market PMI has edged back to the boom/bust line, reflecting the tailwind from monetary easing. However, emerging market inventories have spiked in the last two months (shown inverted, Chart 8), warning against getting too excited about growth. It is notable that emerging markets, and China, have failed to begin deleveraging (Chart 9). Chart 8Global: From Negative To Neutral bca.uses_sr_2016_10_17_c8 bca.uses_sr_2016_10_17_c8 Chart 9A Bearish Credit Impulse A Bearish Credit Impulse A Bearish Credit Impulse The global credit impulse is negative, especially in commodity-dependent developing economies (Chart 9). It is no wonder that global export prices continue to deflate, and export volumes have slipped back into negative territory (Chart 10). The message is that developed country domestic demand is not yet sufficiently robust to boost global final demand. Instead, growth will continue to be redistributed through foreign exchange resets. While China has opened the fiscal taps, the economic outlook is still only for stabilization rather than growth acceleration. Money growth has surged and the Chinese Keqiang index has climbed off its lows (Chart 11), but we are reluctant to extrapolate these signals. Chart 10Still Deflating Still Deflating Still Deflating Chart 11Not Ready To Bet On China Acceleration Not Ready To Bet On China Acceleration Not Ready To Bet On China Acceleration Credit growth continues to sink and loan demand remains anemic (Chart 11). The speed of the debt build up since the financial crisis has been breathtaking, and undoubtedly included capital misallocation. While the unknown scale of the non-performing loan implications for the banking system is cause for concern, it is notable that the growth in fixed asset investment projects started has rolled over (Chart 11), and the authorities recently introduced measures to curb house price inflation. The Chinse manufacturing sector price deflator is still below zero (Chart 11). Now that the U.S. dollar is perking back up, the pressure on the authorities to reduce prices and/or further devalue the yuan will increase, representing another headwind for global cyclical companies, especially given the recent relapse in exports. Another bout of deflationary stress would cause risk premiums to rise for global cyclical equities, which garner a significant portion of revenue from abroad. Interest coverage is already razor thin, and free cash flow growth is deeply negative (Chart 12). U.S.-sourced profits are still outpacing earnings from the rest of the world, despite the pause in the U.S. dollar bull market over the past year. Now that the U.S. dollar is quietly grinding higher, the outlook is for ongoing U.S. profit outperformance. That is conducive to defensive sector outperformance (Chart 13). In all, it appears as if a technical adjustment has occurred in equity markets, rather than a fundamentally-driven trend change. In fact, the cyclical vs. defensive share price ratio appears to now be overshooting after having undershot. Worrisomely, most of this overshoot reflects a surge in tech stocks, and to a lesser extent, energy, as both industrials and materials have rolled over in relative performance terms (Chart 14). We expect leadership to revert back to non-cyclical sectors once the current rotational correction has run its course, given the lack of confirmation from the bulk of the macro variables on our checklist. Chart 12Risk Premiums Will Stay High Risk Premiums Will Stay High Risk Premiums Will Stay High Chart 13No Turn Yet No Turn Yet No Turn Yet Chart 14Deep Cyclicals: A One Trick Pony Deep Cyclicals: A One Trick Pony Deep Cyclicals: A One Trick Pony Bottom Line: Now is not the time to chase momentum in recent outperformers, as defensives are about to reclaim the leadership role from cyclical sectors, based on a broad range of macro, valuation and financial market indicators.

Equities, bonds and commodities are becoming suddenly, unusually, and dangerously correlated. But it cannot last.

Our Treasury yield fair value model suggests that the 10-year Treasury yield has an additional +19bps of upside. Stay at below benchmark duration.

When earnings growth negatively diverges from GDP growth, the gap rarely closes <i>via</i> a rebound in profit growth. The most notable feature of prior episodes is weak corporate pricing power and the current period is no different; an ongoing profit margin squeeze means earnings in the next few months risk being a disappointment.

Since 2014, market expectations of the Fed funds rate has been the primary driver of banks stock performance. Investors' heightened focus about the positive role of interest rate hikes on bank profitability has some merit because when interest rates are near the zero lower bound, net interest margins are unduly suppressed. However, a breakout in bank stocks requires much more than a hawkish Fed outlook: without a significant pick-up in top-line growth, there is no impetus for bank stocks to sustain rallies.

It's hard to make a case for attractive returns from any asset class over the next year. We dial down risk a bit but ending our overweight on junk bonds. Investors should pick up yield where they can but without taking excessive risk.

The deepening interconnectedness of the "global eco-system" brought front-and-center by NY Fed President Dudley will keep inflation at the consumer level synchronized in the world's largest economies. The importance of global variables in the evolution of local inflation rates will remain elevated.

Using long-term real rates, Uncovered Interest Rate Parity still works for exchange rate determination. Currencies are also affected by the global risk appetite and commodity prices. Intermediate-term fundamentals for EUR/USD are pointing up, but the timing is not optimal to buy it yet. However, the long-term outlook for the euro remains poor. Currently, USD/JPY has room to rally in the short term. Long-term factors will also continue to weigh on the yen.

Yield and Protector Portfolios should continue to benefit in current environment. Equities face seasonal headwinds.