Europe

Highlights U.S. Treasuries: The downturn in U.S. inflation looks to be stabilizing, while the U.S. economy continues to churn along at an above-potential growth pace. Treasury yields are now at risk of a repricing of both inflation expectations and Fed rate hike probabilities. Treasury-Bund Spread: The "leadership" of the global bond market is likely to switch back to the U.S. from Europe in the next few months, which will lead to an underperformance of Treasuries. We are entering a new Tactical Overlay trade this week, shorting 10-year U.S. Treasuries versus 10-year German Bunds. Central Bank Balance Sheets: Central banks with large amounts of maturing bonds on their balance sheets, like the Fed and the Bank of Japan, have had no choice but to signal a slower pace of future bond buying. The ECB is in a similar boat, as its holdings of German debt approach issuer limits in the ECB portfolio. A slower pace of ECB bond buying is certain in 2018, to the detriment of European government bond market performance. Chart 1UST Yields Have Some##br## Catching Up To Do UST Yields Have Some Catching Up To Do UST Yields Have Some Catching Up To Do Feature Is the surprising 2017 downdraft in U.S. inflation starting to bottom out? The latest set of readings on growth in prices and wages provides some evidence that the decline may be over. Core PCE inflation rose on a year-over-year basis in June for the first time since January. In July, Average Hourly Earnings had the largest monthly increase since October of last year (Chart 1). With oil prices up 16% off the mid-June lows, and the trade-weighted U.S. dollar down nearly 5% over the same period, the stars are aligned for a pickup in U.S. inflation in the coming months. A sustained rebound in realized inflation would be the catalyst for a renewed rise in U.S. Treasury yields, particularly with U.S. economic data starting to show more upside surprises. With the market only priced for 28bps of Fed rate hikes over the next twelve months, Treasuries are exposed to any improvement in U.S. growth and inflation. Treasuries are certainly due for a bit of catchup to the moves in global bond yields seen over the past couple of months. Rate hike expectations have ratcheted higher in a number of countries that have left policy rates at very low levels as growth has accelerated, such as Canada, the U.K. and Sweden (bottom panel). This has put mild upward pressure on government bond yields in those markets. Yields in the Euro Area have also been rising, not because of rate hike expectations but rather a growing belief that the European Central Bank (ECB) will soon begin paring back the pace of its asset purchases. Reduced central bank buying by the Fed, ECB and the Bank of Japan (BoJ) remains a major threat to the global bond market. It will likely take higher yields to entice other investors to absorb the supply of global duration risk currently taken down by central banks. This is a longer-term factor that will place a gently rising floor underneath global bond yields. In the meantime, the path of least resistance for bond yields in the next 6-12 months remains upward as expectations for U.S. inflation and Fed rate hikes shift higher. The Fed Will Soon Be Back In Play Chart 2Low Unemployment, ##br##But With A Low Equilibrium Rate Low Unemployment, But With A Low Equilibrium Rate Low Unemployment, But With A Low Equilibrium Rate The July U.S. employment report released last week showed continued strength in hiring activity. The headline number of +209k jobs created was above expectations, bringing the 2017 monthly average up to +184k which is almost identical to the +187k average seen in 2016. The headline U-3 unemployment rate dipped back to a cyclical low of 4.3%, in line with the lows of the previous two business cycles (Chart 2). The broader U-6 measure was unchanged at 8.6% - within hailing distance of the low seen during the last business cycle (8.0% in 2007). Yet despite the historically low levels of unemployment, wage inflation is still only holding steady and not yet accelerating. The annual growth rate of Average Hourly Earnings remains stuck around 2.5%, while other measures like the Employment Cost Index are also showing little upward momentum. Yet as long as wage growth is not decelerating, the Fed is likely to remain confident that inflation should eventually drift back up to the central bank's 2% target IF the economy grows in line with its forecasts and additional spare capacity in labor markets is absorbed. The Fed has been openly debating the appropriate level of the real funds rate in recent weeks. Measures such as the Laubach-Williams "R-star" have been cited as evidence that the Fed may be getting very close to a neutral funds rate. However, this is only true if realized inflation stays at current levels. If inflation begins to reaccelerate, additional interest rate increases would be needed to restore the real Fed funds rate back even to current levels. More increases would be needed to get the real funds rate back to even just the current R-star estimate of -0.2%. A level of the real funds rate above R-star could even be necessary if realized inflation was above the Fed's target, as occurred in the late-1990s and mid-2000s when the U.S. Employment/Population ratio climbed higher alongside a steadily growing economy (bottom panel). For now, however, we see the Fed as remaining in a wait-and-see mode, holding off on any additional rate hikes until higher inflation begins to manifest itself in the actual data. In the meantime, market expectations for U.S. inflation are already starting to drift higher. The 10-year TIPS breakeven is at 1.80%, up +13bps since June 16th. The model for breakevens developed by our sister publication, U.S. Bond Strategy, based on financial market variables has also increased by 6bps to 1.82% over the same period, suggesting that current breakevens are now essentially at fair value. (Chart 3). While breakevens remain well below the 2.5% level that we deem to be consistent with the Fed's inflation mandate, this shift in the direction of expectations is critical given the current low level of Treasury yields.1 Chart 3A Weaker USD Should Soon##br## Boost Growth & Inflation A Weaker USD Should Soon Boost Growth & Inflation A Weaker USD Should Soon Boost Growth & Inflation The sharp decline in financial market volatility seen across risk assets over the past few months can largely be traced back to that pullback in realized U.S. inflation since February. Interest rate volatility has collapsed alongside the drop in inflation, as investors have priced in a less hawkish Fed outlook. This also triggered a bout of U.S. dollar weakness that has helped boost demand for assets that typically suffer during periods of U.S. dollar strength, like Emerging Market equities and credit. If inflation begins to soon perk up again, as we expect, then Fed rate hikes will come back into play and both bond volatility and the U.S. dollar will increase, providing a challenge to the current stable return profiles for both equities and corporate credit. We still see the Fed only slowly nudging the funds rate up towards equilibrium levels over the next year, unless inflation rises at a much faster rate than both the Fed and markets expect. Coming at a time when the U.S. economy will continue to churn along at a steady above-potential pace, risk assets can continue to outperform Treasuries even with some appreciation of the U.S. dollar, although with a higher level of market volatility. We still see a December rate hike as the most likely next move on rates by the Fed, with an announcement on reducing the Fed's balance sheet, which has been well-telegraphed, likely in September. This sequence will give the Fed time to assess developments in inflation while still incrementally "normalizing" its monetary policy by beginning to reduce the reinvestment of maturing bonds in its portfolio. A shift to more hawkish Fed expectations would open up the potential for a tactical widening of the spread between U.S. Treasuries and German Bunds. The current spread is too low relative to differentials at the short ends of the respective yield curves, and is holding at the rising trendline that began in 2014 (Chart 4, top panel). At the same time, the gap between the Citigroup economic data surprise indices for the U.S. and Euro Area is starting to widen in a direction that should trigger a wider Treasury-Bund spread (middle panel) - especially given the large net long positions still seen in Treasury bond futures (bottom panel). A tactical widening of the Treasury-Bund spread is not inconsistent with our views on the ECB (Chart 5). We still expect some additional upward pressure on Euro Area bond yields as the ECB announces a tapering of its asset purchases at next month's monetary policy meeting. However, there has already been a considerable adjustment higher in European yields since ECB President Mario Draghi's relatively hawkish Portugal speech in June - one that was not matched by U.S. Treasuries. The next move in "leadership" for global bonds will come from a return of U.S. inflation and Fed hawkishness, not from Europe. Chart 4Higher Volatility On The Horizon? Higher Volatility On The Horizon? Higher Volatility On The Horizon? Chart 5Position For A Tactically Wider UST-Bund Spread Position For A Tactically Wider UST-Bund Spread Position For A Tactically Wider UST-Bund Spread On the back of this, we are opening up a new trade in our Tactical Overlay portfolio this week, going short 10-year U.S. Treasuries vs 10-year German Bunds. Bottom Line: The downturn in U.S. inflation looks to be stabilizing, while the U.S. economy continues to churn along at an above-potential growth pace. Treasury yields are now at risk of a repricing of both inflation expectations and Fed rate hike probabilities. The "leadership" of the global bond market is likely to switch back to the U.S. from Europe in the next few months, which will lead to underperformance of Treasuries. Thus, we are entering a new Tactical Overlay trade this week, shorting 10-year U.S. Treasuries versus 10-year German Bunds. The State Of The "QE5" The current coordinated cyclical upturn in global growth, combined with booming equity and credit markets, is forcing central bankers to contemplate shifting to a less dovish monetary policy stance. Only the Fed and the Bank of Canada have actually raised interest rates since the oil-driven deflation scare of 2014/15. Yet policymakers in regions that have undertaken asset purchase programs - the U.S., Euro Area, the U.K., Japan and Sweden which we will call the "QE5"- also must consider policy moves that will impact the future size, and composition, of central bank balance sheets. The sums involved are enormous and will have major implications for financial markets. In Table 1, we present data first published in the 2017 BIS Annual Report published in late June (that we have since updated ourselves), showing the details of the QE5's balance sheets.2 A few numbers stand out from the table: Table 1The State Of The "QES" Central Bank Balance Sheets The Global Duration "Hot Potato" Shifts Back To The U.S. The Global Duration "Hot Potato" Shifts Back To The U.S. The Fed owns 13% of U.S. general government debt, with an average maturity of 8.0 years; 43% of the holdings mature within two years The BoJ owns 40% of Japanese general government debt, with an average maturity of 6.9 years; 49% of the holdings mature within two years The Bank of England owns 25% of U.K. general government debt, with an average maturity of 12.0 years; 20% of the holdings mature within two years The Riksbank owns 15% of Swedish general government debt, with an average maturity of 5.0 years; 37% of the holdings mature within two years The ECB owns 17% of Euro Area general government debt, with an average maturity of 8.0 years; the specific maturity structure is not publically known, however, as the ECB does not provide the same level of detail on its bond holdings as the other QE5 central banks. It is clear from the data that the Fed essentially has little choice but to begin the process of letting bonds run off its balance sheet, given that nearly half of its holdings will mature by 2019. With the U.S. economy at full employment, there is little need for the Fed to continue sending an unnecessarily dovish message by rolling over its bond holdings and maintaining such a large balance sheet. Similar arguments can be made for the Bank of England and the Riksbank, with both the U.K. and Sweden at full employment and a large share of bond holdings set to mature within two years. Chart 6BoJ Will Peg JGB Yields And Hope ##br##For A Weaker Yen BoJ Will Peg JGB Yields And Hope For A Weaker Yen BoJ Will Peg JGB Yields And Hope For A Weaker Yen Japan is a unique case, as always. With the economy still struggling to avoid deflation, even with an unemployment rate below 3%, the BoJ must maintain a hyper-easy monetary policy to keep the yen weak enough to generate some imported inflation (Chart 6). Yet the sheer size of its balance sheet, and its bond holdings, makes it increasingly difficult to roll over all of its maturing debt without severely impairing liquidity in the JGB market. Thus, it is no surprise that the BoJ has chosen to shift to a "yield curve" target that aims to peg the benchmark 10-year JGB yield at 0% - a policy which, presumably, would entail only buying bonds when there is upward pressure on yields from growth and inflation. The BoJ has already "tapered" to an annualized rate of bond buying of 70 trillion yen in 2017 - below the central bank's official 80 trillion yen per year target - and even slower amounts of buying could occur in the next couple of years as the maturing bonds in the BoJ's portfolio are not fully replaced. Which brings us to the ECB. The current economic expansion has been impressive in its scope and breadth, with even perpetual laggards like Italy enjoying a solid cyclical upturn. Although inflation remains below the ECB's 2% target, core inflation has clearly bottomed out and is even slowly accelerating in some countries, like Germany and Spain (Chart 7). The central bank has been sending out signals that an adjustment in its monetary policy settings will likely be needed soon. The markets have interpreted this as a sign that the ECB will announce a tapering of its asset purchases in 2018. The ECB has to be a little surprised, and perhaps nervous, over the market reaction to this shift in its communication with the markets. Longer-term bond yields rose sharply, with the benchmark 10-year German Bund more than doubling in a matter of weeks in late June and early July. The central bank has been clear in stating that no change in short-term interest rates is imminent, and there has been very little movement in shorter maturity bond yields. Yet the euro has appreciated 5% since Mario Draghi's Portugal speech on June 26th, following the rise in long-term bond yields rather than the typical short-rate moves that guide currency fluctuations (Chart 8). Chart 7The Case For A Less Accommodative ECB The Case For A Less Accommodative ECB The Case For A Less Accommodative ECB Chart 8Could A Stronger Euro Delay The Taper? Could A Stronger Euro Delay The Taper? Could A Stronger Euro Delay The Taper? The surge in the euro has largely been due to capital inflows by global investors chasing the improving growth in the Euro Area, combined with some short covering of the large short positioning on the currency from earlier this year. Without the support of actual interest rate hikes that more sustainable boost the attractiveness of the currency, additional gains in the euro may be hard to come by - especially if the Fed soon shifts back to a more hawkish stance, as we discussed earlier in this report. As long as the rising euro does not materially impact broader Euro Area financial conditions through falling equity prices or wider corporate credit spreads, the ECB can continue on a path towards signaling a slower pace of asset purchases next year. They essentially have no choice on that front, given the approaching constraints on its bond buying program. The ECB has set internal rules that its asset purchases must: a) be allocated across the Euro Area countries according to the weights of the ECB "Capital Key"; and b) not result in the ECB owning more than 33% of any single countries stock of government debt. Following the first rule means buying far more German and French debt than Spanish or Austrian debt. Yet if they continue to follow the first rule, the second rule will be violated for some countries, most notably Germany. In Chart 9, we show the share of government bonds owned by the ECB for Germany, France, Italy and Spain. We also show projections for the ownership shares based on four scenarios for the pace of ECB asset purchases in 2018. If the ECB was to maintain the current €60bn/month rate of buying, then the 33% threshold for Germany would be breached next year (the green dotted line in the top panel) and the limit would almost be reached for Spain (the green dotted line in the bottom panel). Given these projections, it is perhaps no surprise that the ECB is sending signals about a taper even with inflation still south of the 2% ECB target. The ECB has already starting altering the composition of its monthly asset purchases, buying a lower share of German bonds between April and June, while buying a larger share of French and Italian bonds in excess of the Capital Key limits (Chart 10). To continue to do this would invite potential political criticism of the ECB's policies from Germany and other "hard money" countries in the Euro Area that do not wish to subsidize the high deficit governments. Chart 9ECB Holdings Of German Debt ##br##Approaching Limits ECB Holdings Of German Debt Approaching Limits ECB Holdings Of German Debt Approaching Limits Chart 10This Is Politically Unsustainable This Is Politically Unsustainable This Is Politically Unsustainable For that reason, we consider it to be very unlikely that the ECB will maintain the same level of bond purchases next year, but while also moving away from the Capital Key as the weighting scheme. The single country issuer limit could be raised from 33%, but this is also not a sustainable solution as it would potentially create the same problems faced by the other QE5 countries where the central bank ends up absorbing increasing shares of new government bond issuance, impairing market liquidity. We see the ECB as having no choice but to reduce the pace of asset purchases next year. We expect a true taper announcement next month that sets a date when the pace of buying goes to zero. The most "dovish" decision we can envision is a reduction in the pace of buying to €40bn/month that is maintained for all of 2018. This would be an identical move to the decision made last December, but even this would result in the ECB coming very close to the 33% issuer limit for Germany (the black dotted line in the top panel of Chart 9). Net-net, we see the ECB buying fewer Euro Area government bonds in 2018, no matter what. This will continue to put a rising floor underneath bond yields, with risks of bigger increases if inflation begins to accelerate in line with the ECB's projections. Bottom Line: Central banks with large amounts of maturing bonds on their balance sheets, like the Fed and the Bank of Japan, have had no choice but to signal a slower pace of future bond buying. The ECB is a similar boat, as its holdings of German debt approach issuer limits in the ECB portfolio. A slower pace of ECB bond buying is certain in 2018, to the detriment of European government bond market performance. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The Fed targets a growth rate of 2% on the headline Personal Consumption Expenditure (PCE) deflator, but the inflation rate reference in TIPS pricing is the growth of the headline Consumer Price Index (CPI). Given that the spread between headline PCE and headline CPI inflation has averaged around 50bps in recent years, a CPI inflation rate of 2.5% would be consistent with the Fed's stated inflation target. 2 http://www.bis.org/publ/arpdf/ar2017e4.pdf Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Global Duration "Hot Potato" Shifts Back To The U.S. The Global Duration "Hot Potato" Shifts Back To The U.S.

Highlights The bottom in the dollar will have to wait for clearer signs that U.S. inflation has hit a trough. DXY is unlikely to punch below its May 2016 low. We examine balance of payments dynamics across the G10. This analysis shows that while the euro has long-term upside, it is too early to bet on any move above 1.20. The Japanese balance of payment dynamics will deteriorate as the BoJ keeps pressing on the gas pedal. Markets will have to price out rate hikes from the U.K. Feature Our most recent attempt at selling EUR/USD ended promptly in failure, as the euro is currently supported by a perfect storm of factors, making the timing of a reversal of its powerful bull run a tricky exercise. On the one hand, European politics continue to enjoy a re-rating among investors. As 2017 began, observers were worried that France was about to fall under the control of populists - euro-skeptic politicians like Marine Le Pen. This could well have spelled the end of the euro. Instead, the French electorate delivered a pro-market outcome with Emmanuel Macron clinching the keys to the Elysée Palace, and his centrist, pro-reform party now controlling Parliament. Meanwhile, German politics remain steady, and the Italian political risk has been pushed back to 2018. On the other hand, investors started the year expecting a hyperactive Trump presidency that would deliver de-regulation and tax reforms. Instead, the U.S. has a Twitterer-in-Chief and a chaotic White House that has been able to only achieve political paralysis. While political developments have grabbed the most headlines, economics have played an even more crucial role. Most importantly, inflation dynamics have been at the crux of the euro's rally. Namely, U.S. inflation has been a big source of disappointment, as the core PCE deflator has fallen from 1.9% in late 2016 to 1.5% today - a move away from the Federal Reserve's 2% target. As a result, the dollar and interest rates have moved away from discounting the Fed's path as implied by the "dot plot" (Chart I-1). However, our work on capacity utilization and financial conditions highlights that the U.S. inflation slowdown has been a reflection of the lagged impact of massive financial tightening in late 2014, and subsequent deceleration in economic activity. In fact, improvements in both capacity utilization and financial conditions witnessed since then point to a turnaround in inflation this fall (Chart I-2). Chart I-1Downward Move In Inflation Rate Expectations Downward Move In Inflation Rate Expectations Downward Move In Inflation Rate Expectations Chart I-2U.S. Inflation To Trough Soon U.S. Inflation To Trough Soon U.S. Inflation To Trough Soon What should investors do in the meantime? The market will only believe the Fed's hiking intensions once inflation rears its head again. After so many false starts and disappointments, signs that inflation might be coming will not be enough, as narratives of a near-permanent state of zero percent inflation are taking hold of the general discourse. Because investors have purged their excess dollar longs and are now heavily positioned for a euro rally, the dollar downside is currently limited, and a significant breach below the May 5, 2016 low in the DXY is unlikely. However, the dollar-rebound camp will have to wait for clear evidence that U.S. inflation is exiting its doldrums. This is a story for the fall. A Look At Balance-Of-Payments Dynamics The U.S. Chart I-3U.S. Balance Of Payments U.S. Balance Of Payments U.S. Balance Of Payments The U.S. current account deficit has been hovering below -2% of GDP for most of the post-great-financial-crisis period, and therefore has played little to no role in explaining the dollar's moves since 2011. However, the U.S. basic balance (current account plus net foreign direct investments) registered a sharp improvement in 2015 on the back of a surge in net FDI into the U.S. Despite a small pullback in the past 18 months, the U.S. basic balance remains consistent with levels recorded during the dollar bull market of the 1990s (Chart I-3). Portfolio flows in the U.S. have moved back into positive territory after a period of net outflows in 2015 and 2016. Yet, the total amount of net portfolio flows remains very low by historical standards, suggesting investors have not wagered aggressively on the U.S. economy's outperformance. Together, the aggregate U.S. balance-of-payment paints a neutral picture for the U.S. The deep imbalances in the current account and basic balance that prevailed prior to the financial crisis have been purged, but portfolio flows into the U.S. do not show any excessive optimism. In fact, the recent period of dollar weakness will likely help the U.S. balance of payments: It should support the trade balance, and make FDI and portfolio flows more attractive going forward as easing U.S. financial conditions help economic activity and asset returns. The Euro Area Chart I-4Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments Since the euro area crisis, the region's current account has surged to a very large surplus of 3.5% of GDP (Chart I-4). This mostly reflects a large correction of imbalances in peripheral nations. Countries like Spain and Italy have seen their own current account balances morph from deficits of 10.2% of GDP and 3.8% of GDP in 2008 and 2011, respectively, to surpluses of 1.9% of GDP and 2.7% of GDP today. The large contraction in imports on the back of moribund domestic demand has been the key driver of this phenomenon. The euro area remains an exporter of FDIs, experiencing near-constant outflows since 2004. As a result, the euro area's basic balance has not experienced as pronounced an improvement as the current account. It is still nonetheless in surplus - something that did not prevent EUR/USD from experiencing a 25% decline from June 2014 to March 2015. Net portfolio flows in the euro area have moved into deeply negative territory, reflecting massive outflows from the bond market. European investors have also been avid buyers of foreign equities, despite the recent increase in foreign buying of euro area stocks. In aggregate, we would interpret the current balance-of-payments dynamic in Europe as potentially supportive of the euro down the line. Aggregate portfolio flows are so depressed that there is a greater likelihood they will improve than deteriorate. However, while the basic balance and portfolio flows bottomed in 2000, the euro was not able to rally durably until 2002. Together, this suggests the euro is unlikely to re-test parity this cycle, but could remain capped below 1.20 for a few more quarters. Japan Chart I-5Japan Balance Of Payments Japan Balance Of Payments Japan Balance Of Payments Thanks to large investment income emanating from a net international investment position of 62% of GDP, Japan sports a current account surplus 2.5% of GDP greater than its trade balance. However, as the country continues to export capital abroad, it still carries a 3.1%-of-GDP deficit in terms of net FDI. This means that the Japanese basic balance of payments remains around 0% of GDP (Chart I-5). Meanwhile, net portfolio flows into Japan have improved greatly in 2017, explaining the yen's strength this year. While we see more upside for equity inflows into Japan, the efforts by the Bank of Japan to suppress JGB yields are likely to result into continued outflows on the fixed-income front. Since BCA is calling for higher global bond yields, fixed income portfolio outflows are likely to grow bigger, making the recent improvement in the Japanese balance of payments a fleeting phenomenon. This will weigh on the yen. We continue to expect the JPY to be one of the worst-performing currencies over the next 12-18 months. The U.K. Chart I-6U.K. Balance Of Payments U.K. Balance Of Payments U.K. Balance Of Payments Financing the U.K.'s current account deficit of 4% of GDP has taken center stage in the wake of the Brexit vote last year. However, while the trade-weighted pound has depreciated 12% since then, the British basic balance of payments has improved and moved back into positive territory. Net FDI inflows lie behind this stunning development. FDI into the U.K. has been surging since 2016 (Chart I-6). However, the recent slowdown in M&A deals into the U.K. points to a potential end for this GBP support. The key costs of controlling the free movement of people in the U.K. - a demand of Brexit voters - will be the loss of passporting rights for the financial services sector. Since this sector has been the biggest magnet for FDI in the U.K., net FDI could soon become a drag on the basic balance of payments. In contrast to FDI, net portfolio flows into the U.K. have followed the anticipated post-Brexit script, falling from 5% of GDP in Q2 2016 to zero earlier this year. This development was the biggest contributor to the pound's weakness last year. Going forward, the case for the Bank of England to turn hawkish is likely to dissipate as the inflation pass-through from the weak pound dissipates (see below). For the pound to rally further, a continued expansion in global liquidity will be necessary. However, we anticipate global liquidity to deteriorate for the remainder of 2017 as the Fed begins the runoff of its balance sheet, and the PBoC keeps tightening the screws on the bubbly Chinese real estate market. Hence, we would position ourselves for pound weakness against the USD in the second half of 2017. Canada Chart I-7Canada Balance Of Payments Canada Balance Of Payments Canada Balance Of Payments Canada runs a current account deficit of 3% of GDP. This is not a new development. Canada has been running a current account deficit since 2009 (Chart I-7), as weakness in the CAD from 2011 to 2016 was counterbalanced by weak export growth to the U.S. and poor oil prices. From a balance-of-payment perspective, the capacity of the CAD to rally may be limited. A surge in FDI to boost the basic balance of payments is unlikely. In 2001, the Canadian dollar was much cheaper than at present, and the impact of the tech bubble was still influencing M&A inflows into the country. In 2008, oil was trading near US$150/bbl. Today, Canada is a high-cost oil producer in a world of cheap oil, making Canadian oil plays unattractive, at least much more so than in 2007-2008. Additionally, net portfolio inflows into the country are already at near-record high levels, explaining the strong performance of the CAD since January 2016. However, going forward, oil prices are unlikely to double once more, and the combination of elevated Canadian indebtedness along with bubbly house prices and rising interest rates will create headwinds for the Canadian economy. Such an outcome would hurt expected returns on Canadian assets, and thus portfolio flows. However, if the hole in Canadian banks' balance sheets proves much bigger than BCA anticipates, this could prompt a repatriation of funds held abroad by banks - assets that currently equal nearly 50% of their balance sheets, temporarily helping the CAD. Australia Chart I-8Australia Balance Of Payments Australia Balance Of Payments Australia Balance Of Payments While the Australian trade balance has moved back in positive territory, the current account remains in deficit, burdened with negative international incomes associated with a negative net international investment position of -60% of GDP. Yet, because the current account has nonetheless improved, the Australian basic balance of payments is back in positive territory, as net FDI inflows have remained steady around 4% of GDP (Chart I-8). From a balance-of-payments perspective, the Australian dollar looks good. The current account balance is likely to remain well supported as the capex needs of Western Australia have decreased - exerting downward pressure on imports - but new mines are coming online and generating revenues and exports. Meanwhile, portfolio flows in Australia are quite depressed, suggesting some long-term upside as investors seem to be underweight Australian assets. That being said, the Aussie is currently trading at 12% above its long-term fair value. Moreover, any tightening in global liquidity thanks to the Fed and the PBoC could increase the cost of financing Australia's large negative net international investment position, and cause a last down leg in metals prices and the AUD. New Zealand Chart I-9New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand's current account has been stable at around -3% of GDP since 2010. While New Zealand has been a constant magnet for FDI (Chart I-9), the positive balance in this account has not been able to lift the national basic balance of payments above the zero line. Interestingly, despite still-higher interest rates offered by New Zealand compared to the rest of the G10, the kiwi has been experiencing net portfolio outflows so far this year, potentially explaining why NZD/USD has not been able to break out like AUD/USD. Balance-of-payment dynamics looks supportive for the AUD relative to the NZD, as Australia runs a positive basic balance while New Zealand does not. Additionally, while Australian portfolio flows are very depressed, New Zealand's could suffer more downside. Mitigating these positives for AUD/NZD, the New Zealand economy is much stronger than that of Australia, and the Reserve Bank of New Zealand is in much better position to increase rates than the Reserve Bank of Australia is.1 Switzerland Chart I-10Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland Balance Of Payments The Swiss franc may be expensive relative to its purchasing power parity, and it may also be contributing to the country's strong deflationary tendencies, but it does not seem to be hampering its international competitiveness. The Swiss trade balance is at a massive 6% of GDP. Additionally, thanks to the international income generated by Switzerland's gigantic net international investment position of 127% of GDP, the country runs an incredible current account surplus of around 11% of GDP (Chart I-10). Being a nation with a steady current account surplus, Switzerland re-exports much capital abroad, generating a nearly permanent deficit in its net FDI account. However, this deficit is not enough to generate a basic balance-of-payments deficit. Instead, the BBoP still stands at 6% of GDP, creating a long-term support for the CHF. In terms of portfolio flows, Switzerland has historically run a deficit, reflecting its status as a capital exporter. Only at the height of the euro area crisis did Switzerland experience net portfolio inflows. Today, portfolio flows continue to leave the country, albeit at a slower pace than before the euro area crisis. Over the next 12 months, the CHF is likely to experience continued downside against both the euro and the USD, as the Swiss National Bank remains steadfast in its fight against domestic deflationary forces. However, from a long-term perspective, Switzerland will continue to run a balance-of-payments surplus that will support the structural upward trend in the real trade-weighted CHF. Sweden Chart I-11Sweden Balance Of Payments Sweden Balance Of Payments Sweden Balance Of Payments The Swedish trade balance recently moved into deficit territory, but the nation's current account remains in a healthy surplus of more than 4% of GDP, reflecting large amounts foreign income extracted by Sweden's thanks to its large amount of assets held abroad - a legacy of decades of current account surpluses. The net FDI balance has recently moved into positive territory, as Sweden possesses some of the strongest long-term economic fundamentals in Western Europe. Thanks to this development, the basic balance of the largest Nordic economy is at its highest level in eight years (Chart I-11), representing a long-term positive for the cheap SEK. Finally, portfolio flows into Sweden are at a neutral level. However, we expect the Riksbank to begin increasing rates early next year, putting it well ahead of its European peers. This should result in growing inflows into the country, supporting the SEK, at least against the EUR and the GBP. Norway Chart I-12Norway Balance Of Payments Norway Balance Of Payments Norway Balance Of Payments Due to the collapse in oil prices since 2014, the Norwegian trade surplus has melted from a gargantuan 15% of GDP to a more modest 5% of GDP (Chart I-12). However, falling oil prices and North-Sea production have also resulted in a collapse of FDIs into the country. Because of these developments, the Norwegian basic balance of payments has fallen into deficit for the first time in more than 20 years. This combination could explain why the NOK has been trading at its deepest discount to long-term fair value in decades. Ultimately, the constantly positive BBoP has historically been one of the key drivers of the krone. Without this support, since the Norges Bank stands among the most dovish central banks in the G10, the NOK does need a greater-than-normal discount. Norway too has historically experienced net portfolio outflows, also a consequence of its massive current account surplus. Thus, we do not read today's relatively small portfolio outflows as a positive. Instead, they simply reflect the deterioration in the current account and basic balance. Putting it all together, while balance-of-payment dynamics do explain why the NOK is trading at a historically large discount to fair value, we remain positive on this currency relative to the euro. When all is said and done, even accounting for these exceptional factors, the NOK is too cheap. Additionally, BCA does expect oil prices to move back toward US$60/bbl, which should help move the basic balance back into positive territory. Bottom Line: Balance-of-payment dynamics rarely have much impact on G10 currencies in the short run. However, in the long run, they can become paramount. Using this framework, while the USD could experience some upside in the next 12 months or so, any such upside is likely to mark the last hurrah of the bull market: the U.S. balance of payments is relatively neutral, but Europe's is currently excessively handicapped by extremely depressed portfolio flows. This latter situation is likely to be reversed in the coming years. The yen balance-of-payment dynamics will become increasingly tenuous if the BoJ continues on its current policy path. Among commodity currencies, the AUD has the best long-term profile in terms of balance-of-payment dynamics. Finally, the SNB faces a Herculean task: While it is currently keeping the CHF at bay in order to alleviate deflationary tendencies in Switzerland, the country's perennially strong balance of payment will ultimately prove too great a hurdle to overcome. The CHF could overtake the yen as the true risk-off currency of the world in future. BoE Is Stuck With Low Rates For Now In our January 13 Special Report titled, "GBP: Dismal Expectations,"2 we discussed why fears of any calamity that Brexit could bring to the British economy was overdone, and thus why buying the pound was an attractive opportunity. So far, our view has been validated, as cable has rallied by almost 8%. However, although we stand by our analysis on a cyclical horizon, a tactical selloff in the pound may be due. At the beginning of the year, the U.K. economy outperformed almost every forecast. Since then, expectations have risen along with the pound, but the British economy has shifted from star performer to disappointment (Chart I-13). For example, house price growth has collapsed to levels not seen since the euro area crisis (Chart I-14, top panel). Furthermore, the rapid rise in inflation has also caused a contraction in real disposable income comparable to that of 2012 (Chart I-14, bottom panel). Chart I-13Shift In U.K. Surprises Shift In U.K. Surprises Shift In U.K. Surprises Chart I-14Cracks In The U.K. Cracks In The U.K. Cracks In The U.K. Rate expectations have become too lofty. After the 2016 collapse in the pound, both headline and core inflation rose above the BoE's target. Consequently, rate expectations spiked, particularly after three MPC members voted for hikes. But can this rate of inflation continue? Looking at individual components of inflation, it is clear that the pound selloff was an important culprit behind the inflation surge. Thus, as the pass-through from the currency dissipates, inflation will also subside (Chart I-15). Falling inflation and weaker growth are already forcing the BoE to retreat from its relative hawkishness. Yesterday, as the "Old Lady" curtailed both its growth and wage forecast for 2017 and 2018, only two members voted for a hike. Political dynamics have also supported cable so far this year. Today, the U.K. policy uncertainty index is at par with that of the U.S. as the Trump White House continues to be in disarray, and the outlook for tax reform and/or infrastructure spending looks grim (Chart I-16). But the U.S. is not the country engaging in its most contentious and significant treaty negotiation in 50 years. Instead, the U.K. is this country, with a weakened government at its helm following its recent electoral debacle. Thus, we would expect a reversal of the currently pro-pound relative political uncertainty indexes, as Brexit negotiations heat up in the coming quarters. Chart I-15U.K. Inflation Is Peaking U.K. Inflation Is Peaking U.K. Inflation Is Peaking Chart I-16Does Trump Really Trump Brexit? Does Trump Really Trump Brexit? Does Trump Really Trump Brexit? While policy and political considerations are likely to hurt the pound this fall, for GBP/USD to correct, a fall in the euro will be needed as well. In the meantime, investors may look to continue to buy EUR/GBP. Since July 7th, we have been anticipating this cross to hit the 0.93 level. This analysis confirms this view. Bottom Line: The U.K. economy should be able to weather its exit from the European Union. This should help the pound on a cyclical horizon. However, the pound has become overbought and interest rate expectations are too elevated, as the market has forgotten that a price still has to be paid for Brexit. GBP/USD is too dependent on the EUR/USD dynamics to short cable outright right now. As such, investors may keep buying EUR/GBP for now, and look to sell GBP/USD near 1.33. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled "GBP: Dismal Expectations", dated January 13, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The U.S. has shown some signs of strength this week, however the data remains mixed: Both headline PCE and core PCE beat expectations, coming in at 1.4% and 1.5% respectively; While the headline ISM manufacturing number weakened, the Price Paid component rebounded to 62. Initial jobless claims beat expectations by 2,000; however, continuing claims underperformed; Factory orders improved on a monthly basis. While the U.S. is still in an inflation slump, we believe that inflation is close to bottoming out. The depreciation in the greenback and the rally in risk assets have greatly eased financial conditions, creating support for the economy. This should push the greenback up as the markets begin to reprice Fed hikes. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Euro appreciation has continued. While the general tone of data remains strong, some leading indicators are showing early cracks: Unemployment, a lagging indicator, decreased to 9.1%, outperforming expectations; Headline inflation remained steady at 1.3%, however core inflation increased to 1.2%; GDP numbers came in as expected, growing at a 0.6% quarterly rate, and a 2.1% annual rate; However, German and EMU Markit Manufacturing PMIs both underperformed expectations. Momentum is on the euro's side, which traded above 1.19 on Wednesday. The euro area owes much of its economic growth to the 25% depreciation since mid-2014. While data has surprised to the upside, the ECB remains the central bank of the peripheries, where inflation has failed to emerge as strongly. Rate differentials will weigh on the euro towards the end of the year, but momentum could continue to push the euro up in the coming weeks. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Japanese data came in positive: Overall household spending yearly growth came in above expectations at 2.3% Japan's job-to-applicants ratio came in at 1.51. Above expectations and growing from the previous month. The unemployment rate fell to 2.8%, coming in below expectations of 3%. These two last data points are important, as they show that the Japanese labor market is getting increasingly tight. However, as evidenced by the last 2 years, inflation will not be able to rise sustainably without a depreciating yen, even if the labor market is tight. Thus, the recent selloff in USD/JPY will only incentivize authorities to remain very accommodative while other central banks are exiting maximum accommodation, reinforcing our negative cyclical view on the yen. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data in the U.K. was mixed this week: Both Markit Manufacturing and Markit Services PMI beat expectations coming in at 55.1 and 53.8 respectively. However both consumer credit and mortgage approvals fell from the previous month and underperformed expectations. Up to yesterday the pound had gained almost 2% during the week, however following the interest rate decision by the BoE, the pound fell by roughly 1%. The reason for this fall, was that the BoE is becoming less hawkish. Not only did the number of MPC members voting for a hike decrease from 3 to 2, but the bank also lowered its forecast for growth and wages. We believe this will start a trend toward a less hawkish BoE, which will weigh on the pound on the short term. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Momentum is showing signs of topping out. The MACD is rolling over, and is converging with the Signal line; and the RSI is weakening from deeply overbought levels. This week, AUD has displayed broad-based weaknesses. Despite one key blotch, data relevant to Australia has been good: TD Securities Inflation increased at a 2.7% rate in July; Chinese Caixin Manufacturing PMI came out better than expected at 51.1; Building permits increased at a striking 10.9% monthly rate. They contracted at a 2.3% yearly pace, a sharp improvement over the the previous month's 18.7% contraction. However, the trade balance underperformed missed expectations by a large margin, coming in at AUD856mn, compared to the expected AUD1,800mn. The recent RBA statement highlighted that the recent appreciation in the Australian dollar "is expected to contribute to subdued price pressures", and "is weighing on the outlook for output and employment". This could add substantial pressure on the AUD in the near future. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Even as the dollar has fallen, the kiwi has depreciated by almost 1.4% this week, as New Zealand data has come in weak: Both the ANZ Activity outlook and the ANZ business confidence came in below the previous month reading at 40.3% and 19.4 respectively. The participation rate came below expectations at 70%. Meanwhile employment also came below expectations contracting by 0.2% Month-on-Month. Overall we continue to be bearish on commodity currencies in general and the kiwi in particular. Recently, the Chinese authorities have been getting tougher on credit excesses. This could be the trigger for a risk off period in emerging markets, which wouldweigh on the NZD. That being said, we are more bearish on AUD/NZD, as the kiwi economy is on much stronger footing than the Australian one. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD has displayed some considerable broad-based weakness this week following weak data releases: Industrial Product Price contracted monthly by 1% in June; The Raw Material Price Index also contracted, at 3.7%; However, the Markit Manufacturing PMI saw an increase to 55.5 from 54.7. Markets have priced in a 75% probability of a hike by the end of this year by the BoC, compared to 42% for the Fed. Although we agree with the market's perception of the BoC, we disagree that the probability of the Fed hiking is this low. We therefore believe the CAD could correct further in the upcoming weeks. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been positive: The KOF leading indicator came at 106.8, beating expectations. Real retail sales grew by 1.5% year on year, increasing from last month number and beating expectations. The SVME Purchasing Manager Index came in very strong at 60.9, beating expectations and also increasing from last month's reading. While data was positive, EUR/CHF went vertical this week, rising by more than 3%. At this point EUR/CHF is the most overbought it has been in more than 4 years, and at least a small correction seems overdue. The SNB will be satisfied with a depreciating currency, as this dramatic fall should help ease deflationary pressures in the alpine country. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data has been mixed in Norway: The Labor forced survey, which measures unemployment, came in at 4.3% outperforming expectations of 4.5%. The above data point was confirmed by the registered unemployment reading, which also outperformed expectations, coming in at 2.8%. However retail sales contracted by 0.6% month-on-month. Even as the dollar continues to fall, USD/NOK has stayed relatively flat this week. Curiously this has also happened amid rising oil prices. Overall, we expect USD/NOK to rally in the fall, as the Norwegian economy remains tepid, and inflation is not likely to rise above target any time soon, while investors are still underestimating the Fed's will to push interest rates higher. That being said, we are bearish on EUR/NOK, as this cross trades as a mirror image of oil, and the OPEC deal should continue to remove excess supply from the market and push prices higher. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Sweden has been generating substantial inflationary pressures, and increasing economy activity is likely to support these pressures, hence the Riksbank's recent hawkishness. With China tightening policy, SEK strength could be a story of rate differentials going forward, appreciating against EUR, AUD, NZD and NOK, as the Riksbank is likely to become increasingly nervous in the face of rising inflationary pressures. However, as the market currently underprices the risk of a more hawkish Fed, the picture for USD/SEK is less clear. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The neutral real rate of interest, R*, is low in most economies, and will only rise gradually over the coming years. Currency movements tend to dampen differences in neutral rates across countries. The fact that R* is higher in the U.S. will limit further downside risk for the dollar. While a variety of structural forces will cap the increase in the neutral real rate, the neutral nominal rate could rise more briskly as inflation picks up. As such, investors should reduce duration risk and increase exposure to inflation-linked securities. We are closing our long GBP/JPY trade for a gain of 9.9% and opening a new trade going short EUR/GBP. EUR/USD will trade in a range of $1.10-to-$1.20 over the next 6-to-9 months before moving lower in the second half of next year. Feature Where Is Neutral? As the global economy continues to recover, central banks are increasingly turning to the question of how to best normalize monetary policy. A key issue in this debate concerns the level of the neutral real rate of interest, commonly referred to as R*. If central banks raise rates too far above the neutral rate, growth could stall. If they don't raise rates enough, inflation could accelerate. The concept of the neutral rate is somewhat difficult to grasp, and we apologize in advance that this report is more abstract than what we are normally accustomed to writing. However, we think that readers who stick with the logic of the piece will be well rewarded with the practical implications that it provides. A Conceptual Framework In thinking about the neutral rate, it is worthwhile to recall the familiar macro identity which states that the difference between what a country saves and what it invests is equal to its current account balance.1 Since one country's current account surplus is another's deficit, globally, the current account balance must equal zero. This, in turn, implies that globally, savings must equal investment. What happens when desired global savings exceed desired investment? The answer is that interest rates will fall.2 Lower rates will incentivize firms to undertake more investment projects, while discouraging household savings. Investment will rise and savings will decline by just enough to ensure that the global savings-investment identity is satisfied. The discussion above aptly captures what happened to the global economy after the financial crisis. The desire of households to boost savings and firms to cut capital spending led to a sharp and sustained drop in the neutral rate. Those who understood this point back in 2010, when the 10-year Treasury yield briefly hit 4%, made a lot of money by being long bonds when most others were fretting about the inflationary effects of QE and large government budget deficits. The Exchange Rate As A Mitigating Force The ability of countries to export their excess savings abroad by running current account surpluses implies that the neutral rate has a large global component. To appreciate this point, consider a simple thought experiment. Suppose the global trading system completely breaks down and every country ends up with a trade balance of zero. For the sake of argument, let us ignore the immense economic dislocations that this would cause and focus simply on the arithmetic impact that this would have on aggregate demand. The U.S. trade deficit currently stands at $567 billion (3% of GDP). Getting rid of it would add about six million jobs. This would likely cause the economy to overheat, forcing the Fed to raise rates. In contrast, the German economy would fall into a deep recession if its €224 billion (7.1% of GDP) trade surplus vanished. The ECB would not be able to raise rates for years. Thus, in the absence of trade, the neutral rate would be higher in the U.S. and lower in the euro area. This simple thought experiment illustrates why the neutral rate partly depends on the value of a country's currency.3 If a country's currency strengthens, all things equal, its neutral rate will fall. The extent to which the currency appreciates will depend on how long the forces causing neutral rates to diverge across countries are expected to persist. In general, if the forces are more structural than cyclical in nature, currencies will adjust to a greater degree (Chart 1).4 Chart 1The Longer The Interest Rate Gap Persists, The Bigger The Exchange Rate Overshoot The Future Of The Neutral Rate The Future Of The Neutral Rate The discussion above helps make sense of currency movements over the past three years. A key reason the dollar began to strengthen against the euro in the second half of 2014 is that investors became convinced that the neutral rate in the U.S. would exceed that of the euro area for a very long period of time. The rally in the euro this year largely reflects a reappraisal of that view. Stronger euro area growth has convinced many investors that the neutral rate in the region may not be as low as previously imagined. The Outlook For The Neutral Rate The savings-investment balance provides a useful framework for thinking about how the neutral rate will evolve over the coming years. With this framework in mind, let us consider the various forces affecting the neutral rate and how they might change over time. The Debt Supercycle Today, almost 60% of Americans want to save more money according to a recent Gallop poll; before the financial crisis, that number was less than 50% (Chart 2). A slower pace of debt accumulation implies less spending and more desired savings. It is possible that households will become more willing to take on debt as the memories of the Great Recession fade. However, a return to the reckless lending standards of the pre-crisis period is unlikely. Thus, while the end of the deleveraging cycle in the U.S. will push up R*, it will remain low by historic standards. Globally, efforts to reduce leverage have been more halting. In fact, in many emerging markets, debt levels are higher today than in 2008 (Chart 3). This will weigh on R*. Chart 2Return To Thrift Return To Thrift Return To Thrift Chart 3EM Debt At All-Time Highs EM Debt At All-Time Highs EM Debt At All-Time Highs The "Amazonification" Of The Economy Chart 4Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Technological progress is nothing new, but unlike past inventions which typically replaced man with machine, many of today's innovations appear to be reducing the need for both labor and physical capital.5 Companies like Amazon are laying waste to America's retail sector. Uber and Airbnb are providing ways to use the existing stock of capital more efficiently. Fewer shopping malls, taxis, and hotels means less investment, and less investment means a lower neutral rate. Inequality One of the distinguishing features of the "Amazon economy" is that it is dominated by a few winner-take-all firms. This has generated huge payoffs for their owners, but paltry returns for everyone else. While this is not the only trend fueling income inequality, it has certainly exacerbated it. Rising inequality redistributes income from households that tend to live paycheck-to-paycheck to those who save a lot (Chart 4). This increases aggregate desired savings, leading to a lower neutral rate. However, rising inequality may also generate a political backlash. Donald Trump's ability to take over the Republican party was partly driven by the disillusionment of Republican voters over the GOP's pro-business positions on issues such as immigration and trade. Historically, populism has been associated with larger budget deficits. To the extent that budget deficits soak up savings, they lead to a higher neutral rate. Rising populism could also lead to stronger calls for anti-trust policies. Our sense is that we are slowly moving in this direction. Slower Population Growth Demographic shifts can be tricky to assess because they affect savings and investment in offsetting ways and over different time horizons (Chart 5). A decrease in the growth rate of the population will reduce the incentive to expand capacity. Less investment means a lower neutral rate. Slower population growth may also lead to higher savings for a while, as a larger fraction of the population enters its peak saving years (ages 30-to-50). This also means a lower neutral rate. Eventually, however, aging will push more of the population into retirement, increasing the number of people who are dissaving rather than saving. Rising government spending on health care and pensions could also lead to larger fiscal deficits, further depleting national savings. We may be approaching this outcome. Chart 6 shows that the global "support ratio" - defined as the number of workers relative to the number of consumers - has peaked globally and will start falling sharply over the coming years. Chart 5An Aging Population Eventually Pushes Up Interest Rates The Future Of The Neutral Rate The Future Of The Neutral Rate Chart 6The Ratio Of Workers To Consumers Have Peaked The Ratio Of Workers To Consumers Have Peaked The Ratio Of Workers To Consumers Have Peaked Slower Productivity Growth As with population growth, slower productivity growth is likely to depress R* at first, but could raise R* over time (Chart 7). Initially, slower productivity growth will prompt firms to curb investment spending. It could also lead to less consumer spending, as households react to the prospect of smaller gains in real incomes. All this implies a lower neutral rate. Eventually, however, chronically weak income growth is likely to deplete national savings, leading to a higher neutral rate. The U.S. and a number of other economies may be getting increasingly close to that inflection point (Chart 8). Chart 7A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run The Future Of The Neutral Rate The Future Of The Neutral Rate Chart 8Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Lower Commodity Prices Swings in commodity prices may also generate offsetting pressures on the neutral rate that manifest themselves over different time horizons. At the outset, lower commodity prices tend to depress investment spending in the resource sector. This implies a lower neutral rate. Over time, however, lower commodity prices may generate new investment opportunities in downstream industries that use fuel as an input. Lower commodity prices also put money into the pockets of poorer households who are likely to spend it. This raises the neutral rate. Investment Implications Given the conflicting forces affecting R*, it is difficult to have much certainty over how it will evolve. Our best guess is that R* will increase over the next few years, as the scars from the financial crisis recede, deleveraging headwinds abate, fiscal deficits in some economies widen, and population aging and lower productivity growth make more of a dent in national savings. However, the rise in R* is likely to be gradual and from what is currently a very low base. Where we do have greater conviction is on two points: First, the neutral nominal rate will rise more quickly than the neutral real rate, as inflation picks up in most economies. As discussed last week, central banks have a strong incentive to try to engineer more inflation in situations where the economy needs a low real rate to maintain full employment.6 Getting inflation up has been a struggle ever since the financial crisis began, but now that spare capacity around the world is dissipating, central banks are likely to gain more traction over monetary policy. As such, investors should reduce duration risk and increase exposure to inflation-linked securities. Second, the forces pushing down R* outside the U.S. will remain more pronounced than those in the U.S. This, in turn, will provide some support to the beleaguered U.S. dollar. Investors, in particular, may be getting too optimistic about the ability of the ECB to engineer a full-fledged tightening cycle. The euro area is further behind the U.S. in the deleveraging process, suggesting that desired private-sector savings will remain higher there. The overall stance of fiscal policy is also much tighter in the euro area. The IMF estimates that the euro area's structural primary budget surplus currently stands at 0.7% of GDP, compared to a deficit of 1.9% in the U.S. Thus, fiscal policy is currently adding 2.6% of GDP more to aggregate demand in the U.S. than in the euro area. The Fund expects this relative contribution to increase to nearly 4% of GDP by the end of the decade (Chart 9). Furthermore, investment spending has more scope to fall in the euro area. According to the OECD, gross fixed capital formation is actually higher in the euro area than in the U.S. as a share of GDP, despite the fact that potential GDP growth is slower in the euro area (Chart 10). Chart 9Fiscal Policy Is More Stimulative In The U.S. The Future Of The Neutral Rate The Future Of The Neutral Rate Chart 10Euro Area Investment Spending: Higher Than In The U.S. Euro Area Investment Spending: Higher Than In The U.S. Euro Area Investment Spending: Higher Than In The U.S. The appreciation of the euro has led to a tightening in euro area financial conditions in recent weeks, whereas U.S. financial conditions have continued to ease (Chart 11). This will cause relative growth to shift back in favor of the U.S. later this year. Chart 11Diverging Financial Conditions##br## Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Chart 12The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area The 30-year U.S. Treasury yield is currently 95 basis points higher than the 30-year GDP-weighted euro area government bond yield. This gap in yields does not strike us as being especially large considering that both the neutral rate and long-term inflation expectations are lower in the euro area. We expect EUR/USD to trade in a range of $1.10-to-$1.20 over the next 6-to-9 months before moving lower in the second half of 2018, by which time the Fed will be forced to pick up the pace of rate hikes. The resurgent euro has approached all-time highs against the pound, abetted by a somewhat more dovish-than-expected BoE meeting this week. Yet, with U.K. inflation above target and the unemployment rate at the lowest level since 1975, the Bank of England may need to deliver more than the mere 36 basis points in rate hikes the market is expecting over the next two years. Holston, Laubach and Williams estimate that R* is 1.6 percentage points higher in the U.K. than in the euro area (Chart 12). As such, the balance of risks now favor a stronger pound over a cyclical horizon of 12 months. With that in mind, we are closing our long GBP/JPY trade for a gain of 9.9% and opening a new short EUR/GBP position (Note: The returns of all closed trades are displayed at the back of this report). Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 The difference between what a country saves and what it invests is also equal to the difference between what it earns and what it spends. To see this, note that S=Y-C-G where S is national savings, Y is national income, C is personal consumption, and G is government spending. Hence, the identity S-I=CA can be re-written as Y-(C+G+I)=CA where CA is the current account balance. 2 An obvious question is what happens if desired savings exceed desired investment, but interest rates are already equal to zero. In that case, income will contract. Workers will lose their jobs, making it impossible for them to save. Firms will suffer lower profits or even incur losses in the face of flagging demand. Governments will see tax revenues dry up and spending on welfare programs escalate. This means that household, corporate, and government savings will all decline. Of course, since firms are likely to reduce investment in response to slower growth, this could usher in a vicious cycle where falling demand leads to higher unemployment and even less spending - in other words, a recession or even a depression. 3 Suppose, for example, that the interest rate in Country A were to rise above that of Country B for a period of say, ten years. Country A's currency would appreciate. This would reduce net exports in Country A, leading to a decline in aggregate demand. This, in turn, would prevent the neutral rate in Country A from rising as much as it otherwise would. On the flipside, the cheapening of Country B's currency would push up its neutral rate. 4 In the extreme case where the structural forces are expected to last forever, currencies will adjust to the point where the neutral rate across countries is equalized. Intuitively, this must happen because it is impossible for currency-hedged, risk-adjusted interest rates to be lower in one country than in another for an indefinite amount of time. 5 From a neoclassical economics perspective, one might imagine a "production function" that includes labor, physical capital, and digital capital. Many of today's innovations are raising the return on digital capital relative to those on labor and physical capital. This generates outsized rewards to the owners of this particular form of capital (i.e., internet companies), while potentially undercutting the income of workers and owners of physical capital. 6 Please see Global Investment Strategy Weekly Report, “A Secular Bottom In Inflation,” dated July 28, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature This is the first of two Special Reports on Electric Vehicles. In this report, we will look at the current costs of ownership of a typical mass-market EV, including and excluding subsidies, versus a similar Internal Combustion Engine Vehicle (ICEV). Based on current manufacturing costs and battery capabilities, EVs carry a significantly higher total cost per mile, even including current subsidies. Electric Vehicles have galvanized the interest of consumers, investors, and governments for several years now. We touched on the subject in our Special Report "Electric Vehicle Batteries", published September 20, 2016, where we noted that there were many misconceptions regarding batteries in general and EV batteries in particular. Despite the current cost and utility disadvantages of EVs, we expect governments (especially Europe and China) will continue to provide subsidies (carrots) and mandates (sticks) to further the adoption of EVs for the purposes of reducing CO2 emissions and tailpipe particulate pollution. The longer-term hope is that by forcing the EV market to expand, meaningful technological breakthroughs on batteries will eventually enable EVs to exceed ICEVs on a cost and utility basis. In our second report, we will look at the potential issues associated with adoption of EVs and the investment implications for the auto industry and energy markets. Cost Comparison: EV Vs. ICEV We estimated the difference in cost of ownership of a Chevy Bolt EV (known as the Opel Ampera-e in Europe) and two equivalent Internal Combustion Engine Vehicles (ICEVs), the Chevy Sonic and the Opel Astra, over 160,000 km or 100,000 miles (Table 1). Depreciation is an important consideration in cost of ownership, and we expect EVs to depreciate much more rapidly than ICEVs, a cost that many consumers either ignore or simply fail to incorporate into their purchase decisions. Table 1Comparison Of Costs Of Ownership Between EV And ICEV Automobiles Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership There are many unknowns, such as actual selling price, actual manufacturing cost, etc., in this exercise which may add or subtract a thousand dollars or more to the net results. Under realistic assumptions, those probably cancel out. In summary, EVs are more expensive than ICEVs: Excluding subsidies, the net difference is about $16,100 in the U.S., $18,500 in Germany, and $13,200 in France. After subsidies, the difference is about $6,600 in New York State, $13,900 in Germany, and $6,000 in France. Even if electricity were free, after subsidies, the difference in cost of ownership in the U.S. (NY) would be $3,400, $3,200 in Germany, and $600 in France. The U.S. Federal subsidy of $7,500 is designed to be phased out once a manufacturer sells 200,000 vehicles, which would happen quickly if EVs are to become main stream. Therefore, the total premium cost of ownership of an EV over a comparable ICEV in the U.S. should be assumed to be $16,100 less state subsidy, if any. European subsidies are probably more politically acceptable, even though they will become quite costly if EV sales accelerate as many predict. GM is believed to be losing $9,000 with every Bolt it sells. If so, and if GM changed its pricing to deliver the company's average Gross Margin of around 13%, assuming it currently allows a 10% markup by dealers and discounts the vehicle by 10%, the price of the car would need to be raised to around $48,300 from its current MSRP of $37,500. This would increase the cost of ownership by nearly $11,000 (Table 2), or $0.11 per mile. To make the Bolt's ownership costs - after subsidies - competitive with GM's Opel Astra in France, the Bolt's manufacturing costs would need to be cut by about $14,750 or 34%. Table 2Comparison Of Costs Of Ownership Between EV And ICEV Automobiles, ##br##If GM Sold Bolt At Average Corporate Profitability Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership Note that although we have focused on the Bolt, the common denominator for all EVs is the cost of batteries, which are a commodity. As such, our estimates probably hold for similarly sized vehicles and the differential costs of ownership are likely larger for larger EVs. As we will show in Part 2, integrated auto manufacturers probably have a significant cost advantage over "pure play" EV vendors such as Tesla, because outside of the drive train, they are able to use many of the same components they manufacture for ICEVs. Batteries: A Review All assumptions regarding EV technology are predicated on continued improvements in the cost, durability, and performance of batteries. The leading battery technology for EVs is a Lithium Ion technology (Illustration 1), and there really are no proven near-term alternatives worth discussing. Illustration 1Lithium Ion Technology Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership In our Special Report "Electric Vehicle Batteries", we concluded that: Although the consensus view is that EV battery prices have experienced rapid (8 - 14% per annum) price declines over the past few years, we found no evidence to support that position; Battery durability is at least as important as price, and batteries will not likely last much more than 100,000 miles (160,000 km); Planned expansion of EV battery manufacturing capacity may significantly exceed demand by 2020, resulting in the collapse of EV battery prices and heavy losses for battery manufacturers. We continue to stand by those conclusions, and would like to stress that recent stories such as "China Is About to Bury Elon Musk in Batteries"1 and "10 Battery Gigafactories Are Now in the Works and Elon Musk May Add 4 More"2 are more or less consistent with our comment that "even though there is no reason to expect significant price improvements due to technological shifts, battery prices might drop due to oversupply - at least as long as manufacturers are willing to sell batteries at a loss."3 It seems likely now that China may follow the path it took to the solar industry and mass produce batteries, likely at a loss. The exact motivation for them to do so is uncertain, but this would be moot from the perspective of a western auto manufacturer or consumer. Finally A Reliable Battery Price Data Point! As we will demonstrate in Part 2 of our EV report, excluding the cost of the battery, it should be slightly cheaper to manufacture an EV than a similar ICEV. The EV drive train is much simpler and should be less expensive than that of an ICEV (Illustration 2), offset slightly by the need for a somewhat more robust chassis and suspension due to the weight of the battery, the requirement for electric powered air conditioning, and regenerative braking. Illustration 2Key Components Of A Bolt EV Drive Unit Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership The battery is the most expensive part of an EV and responsible for the higher vehicle prices, and that is likely to remain the case even as manufacturing efficiencies allow EV prices to decline. Unfortunately, the cost of EV batteries is subject to much more speculation than should be the case: many articles cite speculative forecasts, projections, anecdotes, and so on, but without hard data backing them up. Fortunately, we finally have a data point: GM lists the cost of the Bolt EV battery pack as $15,734 for a 60 kWh unit, or $262/kWh.4 Some reports claim the battery cells cost $145/kWh,5 however, battery cells are not the same thing as a battery pack, which is a fully assembled unit complete with wiring, electronics, and a cooling system. Peer reviewed research suggests the cost of the battery pack is about 50% greater than the cost of the battery cells,6 however, we note the same article suggests that ratio will remain the same as battery prices drop. This is unlikely as there is no reason to believe the largely mechanical battery pack will decline proportionately any more than the cost of an engine or transmission will decline. Most likely, the battery pack assembly, excluding the cells, will decline only slightly. EV vendors likely oversize their battery pack in order to limit stress on the batteries (Illustration 3). In other words, the actual capacity of the battery is likely somewhat larger than the rated or useable capacity. If GM is indeed paying $145/kWh for its cells and its pack costs are 50% more than its cell costs and it is oversizing its pack by 20%, the cost of the pack works out to $261/kWh. Illustration 3Oversizing Battery To Account For Capacity Fade Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership The reports which cite a $145/kWh cell price further suggest GM believes cells will cost $100/kWh in 2022, which implies a potential battery cost reduction of $2,700 (assuming the packs are not oversized) over the next 5 years (Table 3). The aforementioned research paper states: "The pure material costs for the VDA-type batteries are estimated to be currently about 50 EUR/kWh ($67.50), which seems to be the lower possible limit at long term." Even if the difference between materials cost and selling price is only 20%, that implies a lower limit of $81/kWh for the cells, meaning savings of $64/kWh are possible. This has not prevented some commentators from suggesting batteries will decline in price by 77% (or $112, implying $33/kWh pricing) by 2030.7 Regardless, savings of $64/kWh work out to $3,840 assuming a 60 kWh pack, or $4,680 assuming the pack is 20% oversized. Even if the pack cost were to decline a similar amount, the cost savings (assuming 50% for the pack, 20% oversized) would only be $7,000. Table 3GM Aims To Cut The Battery Cost By $2,700 By 2022 Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership According to press reports, at the onset GM will lose $9,000 for every Bolt it sells.8 Since the major difference in costs between an EV and an ICEV is the battery pack, the $262 price cited above is probably not representative of the true cost. It may be that part of GM's commercial strategy is to show EV buyers that a replacement battery pack is not overwhelmingly expensive, and it is therefore willing to offer them at a loss. After all, the vehicle comes with a 100,000-mile, 8-year warranty on the battery, and we doubt many consumers would spend $15,734 (plus labor) to replace the battery on an 8-year-old EV. Therefore, GM is probably not going to sell that many replacements, so they won't suffer many losses by offering a replacement battery below its cost. The price differential between a Bolt and a Chevy Sonic, which is a similar vehicle manufactured in the same factory, is about $22,300. If we include the reported $9,000 expected loss, the "true" difference in price is $31,300. We believe that most likely the actual cost of the battery pack of the Bolt is much higher than $15,734. GM Confirms That Batteries Get Used Up Although the Bolt battery pack is covered by an 8-year 100,000-mile warranty, that warranty considers the potential for degradation of up to 40%: "Like all batteries, the amount of energy that the high voltage 'propulsion' battery can store will decrease with time and miles driven. Depending on use, the battery may degrade as little as 10% to as much as 40% of capacity over the warranty period."9 We highlight "all batteries" because this is the fate of all existing battery technologies. We further note that the amount of degradation will depend on the driving habits of the user: if the car is "lightly used" (i.e. traveled much less than 12,000 miles/year), chances are the battery degradation will be at the low end of the scale, whereas if the car is used a lot, chances are it will be at the high end of the scale. The average U.S. driver travels ~13,500 miles (22,000 km) per year,10 meaning the average driver with a single car would exceed the warranty on the Bolt in less than 8 years and, most likely, battery degradation would be closer to 40% than to 10%. Assuming a normal distribution, half of drivers would likely exceed the average annual miles driven, and as a result, their battery degradation would be even greater and happen even sooner, since they would be stressing the battery system through deeper and more frequent charging. Of course, if you were to travel 100,000 miles in 5 years, your battery warranty would expire. A major motivation for buying an EV is the expectation that it will save money on gasoline, which is true as shown in Table 1. However, the more you drive, the faster you use up the battery, and the sooner you would be faced with buying an expensive replacement battery. As such, drivers who drive a lot would be best to be cautious about purchasing an EV, as their costs of ownership due to battery degradation/replacement would be even higher. The Bolt has a purported range of 238 miles, but that range is achieved only when the battery is new and likely measured under ideal circumstances. Use of air conditioning, extreme temperatures (i.e. winter), etc., would probably trim the range significantly, likely to well below 200 miles. Assuming a reasonable usage for the vehicle, an 8-year-old Bolt would probably have a range closer to 100 miles than to 200 miles. This would significantly affect resale value as a vehicle with a range of 100 miles has much less utility than one with 200 miles. Difference In Cost Of Ownership: Chevy Bolt Vs. ICEV Calculating costs of ownership is subject to numerous assumptions, and this is especially the case with respect to an emerging technology such as EVs. Because we have a significant amount of information from GM on the cost and operating characteristics of the Bolt, and because GM makes "mass market" ICEVs which are roughly comparable to the Bolt, we thought it would be a uniquely useful benchmark for a cost of ownership analysis. We are neither making a claim that the Bolt or any EV will be commercially successful, nor are we endorsing it in any way; we are simply identifying the Bolt as representative of a typical mass-market EV. In our analysis we assume: The Chevy Bolt is a typical mass market EV; The sales price of the Bolt is roughly the same in the U.S.11 and Europe12 at $37,495; The Bolt is comparable to the Sonic in North America and the Opel Astra in Europe (Table 4); There are no direct financial subsidies associated with EVs; and After 100,000 miles, both the EV and the comparable ICEV have a similar residual value. Table 4The Bolt Is Much More Expensive Than Similarly-Sized GM ICEVs Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership As we noted above, GM is believed to be taking a $9,000 loss associated with each Bolt sold. This is not sustainable if the firm expects to sell a lot of them. Most likely, either the company sees a path to significant cost reduction over the life of the product, or the company will artificially limit supply and use profits from its other products to subsidize the sales of Bolts. For the purpose of this analysis, we will assume the company and its rivals believe they can sell such vehicles at a reasonable profit in the future. The difference in the cost of ownership for similar vehicles is mainly associated with purchase cost, fuel costs, repair costs, and resale value. Insurance, parking, and so on would be a wash and annual repair and maintenance bills on most new cars are quite modest, so it would not significantly tilt the balance. Although EV enthusiasts tend to highlight the fact EVs do not require oil changes, the significantly increased weight of the battery means EVs require more frequent tire replacement than an equivalent ICEV.13 For example, modern ICEVs require an oil change every 10,000 miles. At $70/oil change this works out to $700, similar in price to a set of tires. Furthermore, the repair experience with EVs is extremely limited, and if we are to take Tesla as an example, they do not fare as well as many had hoped.14 We address the likely higher depreciation rates of EVs below. Estimating Electric Power Costs For An EV Charging a battery is not 100% efficient as losses occur in the charger and at the battery. Batteries get warm as they are charged, and that is a sign of inefficiencies in the charging process. As smartphone and notebook owners are aware, aged batteries produce a lot more heat when they are charged because the charging becomes less efficient as the batteries age. A new EV with a "slow" charger (see below) is about 85% efficient,15,16 while the figure is almost certainly lower for an aged battery. Assuming the system were 100% efficient, the Bolt vehicle goes 238 miles on 60 kWh, averaging about 0.25 kWh/mile, or approximately 25,000 kWh for 100,000 miles. Assuming lifetime average efficiency of 80% (85% when new, 75% when old), lifetime power consumption would be about 31,250 kWh. EV advocates note there are numerous "free" public charging stations. This is true, but there are far fewer public charging stations than there are EVs, which means the average EV owner pays for her electricity (Chart 1). Regardless, somebody has to pay for the electricity, and it is unreasonable to assume that "free charging" will persist if EVs gain significant market share, which apparently they have been doing in the past few years, especially in the U.S. and the EU (Chart 2). Chart 1Globally, EVs Outnumber Charging Stations By 6 To 1 Globally, EVs Outnumber Charging Stations By 6 To 1 Globally, EVs Outnumber Charging Stations By 6 To 1 Chart 2EV Market Share Is Increasing, Especially In Europe EV Market Share Is Increasing, Especially In Europe EV Market Share Is Increasing, Especially In Europe Furthermore, although many utilities have "time of use" utility rates which are lower in the evening when an EV is being charged, there is reason to question whether those can coexist with significant EV market penetration, a subject we will address in Part 2. Regardless, average power rates incorporate discounted time of use power to some extent, so that is the figure we use. Net Operating Costs: U.S. The Bolt17 is roughly comparable to a Chevy Sonic18 in terms of size, and the vehicles are made in the same factory. The difference in price is about $22,300. At 25/33 mpg, fuel use of the Sonic over 100,000 miles would be about 3,600 gallons (13,627 liters), costing about $9,000, assuming a gasoline price of $2.50 per gallon ($0.66/liter), which is slightly higher than the current nationwide average of ~$2.30/gallon. Assuming lifetime power consumption of 31,250 kWh and an average electricity price in the U.S. of $0.104/kWh,19 electric power costs for the Bolt would be around $3,250, for a net "fuel costs savings" of $5,700 in favor of the Bolt. However, the substantially higher initial purchase price and faster depreciation still results in the Sonic costing about $16,100 less over the duration of the vehicles' 100,000 miles (160,000 km). Put another way, the Bolt's total operating costs would average about $0.38 per mile, 73% higher than the $0.22/mile cost of the Sonic. Net Operating Costs: Europe In Europe, both fuel and electricity costs are typically much higher than in the U.S., but ICEVs also tend to be more fuel efficient. The Bolt is roughly equivalent to an Opel Astra, which costs €16,700 ($19,160) in France and consumes 4.4 litres/100 km20 (53 MPG). The difference in price between the Bolt and the Astra is about $18,300, a smaller premium than in the U.S. comparison. However, even though gasoline prices are more than twice as expensive in Europe than in the U.S., fuel costs for the Astra are moderated by the car's higher fuel efficiency, approximating $10,500 for the first 100,000 miles. Energy costs and EV subsidies vary widely across the EU. Because the economic impact of EVs would be roughly proportional to GDP, we decided to look at the largest EU economies excluding the UK. It happens that EV sales in Italy are negligible, with total market share less than 0.1%,21 and EV subsidies in the country are somewhat opaque. Therefore, we confined our analysis to Germany and France. Assuming lifetime power consumption of 31,250 kWh, the electric power costs of the Bolt would be around $5,350 in France, which has low power prices, for net energy savings of $5,100. In Germany, where power prices of $0.34/kWh are considerably higher, the Bolt and the Astra would have energy costs that are roughly equal. In France, EVs' ownership costs would be $13,200 (49%) higher than the ICEV; in Germany, EV ownership costs would be $18,500 (68%) higher. Bolt Vs Sonic Cost Of Ownership: Impact Of Subsidies In the U.S., there is a federal subsidy of $7,500 and some states also have an EV incentive. In New York State, the subsidy is $2,000, meaning the net increased cost of owning the Bolt instead of a Sonic drops to around $6,600. Note that the federal subsidy is designed to "phase out" once a manufacturer sells 200,000 vehicles. GM hopes to sell 30,000 EVs in 2017 despite only launching U.S.-wide in summer 2017. Combined with prior Volt sales of over 150,000 units, GM should exhaust its federal subsidies in early 2018. Subsidies vary considerably across the EU.22 In France, there is a subsidy of €6,300 ($7,200)23 associated with the purchase of an EV, while Germany24 has a €4,000 ($4,600) incentive. Besides subsidies, there are other benefits of owning an EV including reserved or even free parking spaces, often including free charging. These are offset to some extent by the limited range of EVs which may disqualify them from purchase by some. It remains to be seen how long EV subsidies will persist. They may be affordable to governments as long as the number of vehicles sold remains small, but they would become very costly if EV sales accelerate. For example, about 2 million new passenger cars are registered in France every year. If only half of those were EVs, subsides would total $7.2B. Money for roads, infrastructure maintenance, policing, and so on have to come from somewhere, and if ICEV sales decline substantially, European governments' huge gasoline tax revenues would also deteriorate; in such an environment, it is reasonable to assume that EV subsidies would eventually disappear and be replaced by taxes. It seems highly unlikely to us that a massive subsidy program would be a politically acceptable solution in the U.S. auto market; however, it may very well be that over the near term subsidies persist in the EU where concerns over climate change have greater political weight. Cost Of Ownership: Depreciation Depreciation of the EV is almost certainly going to be much higher than the ICEV, which accounts for some of the higher cost of ownership. We believe that most EV batteries will be substantially degraded after 160,000 km (100,000 miles), and we doubt there will be many EVs on the road past about 200,000 km or 15 years of operation. In contrast, the average age of a vehicle in the EU is over 10.5 years,25 while the average age of a vehicle in the U.S. is 11.6 years.26 The overwhelming majority of EVs on the road today are still under warranty and, in either event, relatively new, which means consumers lack the information to understand the inherent issues of battery degradation. As more consumers have experience with EVs, the problems of degradation and replacement cost (i.e. the high cost of depreciation) will likely temper demand. This would be the case even if battery costs drop significantly: few consumers would invest even $5,000 into repairing a 10-year-old vehicle, and an EV with a 100 mile (160 km) range is significantly less useful than one with a 200 mile (320 km) range. Rapid depreciation has been the experience of Nissan Leaf owners who are discovering their vehicles have lost 80% of their value after only 3 years.27 EV advocates suggest that degradation is not an issue and that, in any event, batteries are getting better and better. This flies in the face of what essentially every consumer has experienced with mobile phones, notebook computers, or any other cordless device. We believe GM has better insights into the issue than EV advocates do and, in any event, we see no evidence for significant improvements in battery life. If, indeed, significant improvements are made to batteries, prior-generation EVs (including today's Bolt) will plummet in value. That said, consumer understanding of battery degradation is not likely to be a factor for EV adoption over the near term. Conclusion: Costs Of Ownership Assuming similar depreciation and excluding subsidies, the net difference in cost of ownership over 160,000 km (100,000 miles) between a Bolt and an equivalent ICEV is about $16,100 in the U.S., $13,200 in France, and $18,500 in Germany, in favor of the ICEV. After subsidies, an optimistic analysis suggests the difference in cost of ownership to travel 100,000 miles (160,000 km) between a Bolt EV and a roughly similar ICEV is about $6,600 in the U.S. (New York), $6,000 in France, and $13,900 in Germany, in favor of the ICEV. Electric power costs for the Bolt are around $3,250 in the U.S., $10,600 in Germany, and around $5,350 in France. Even if electricity were free, after subsidies, the difference in cost of ownership would be $3,400 in the U.S. (NY), $3,200 in Germany, and $600 in France. GM is believed to be losing $9,000 with every Bolt it sells. If so, and it wanted to sell the vehicle at its average Gross Margin of around 13%, it would sell for closer to $48,300, which would increase cost of ownership by about $11,000. In other words it would take a cost reduction of around $14,750 (about 34%) of likely manufacturing cost before the cost of ownership would favor the Bolt in France after subsidies. As noted above in our discussion of battery costs, GM expects a $2,700 cost saving associated with battery cells by 2022. Given that it is losing money on the vehicle, it is hard to believe they will immediately pass these savings on to the consumer. Even if they did, cost of ownership would still favor the ICEVs. Brian Piccioni, Vice President Technology Sector Strategy brianp@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Johanna El-Hayek, Research Assistant johannah@bcaresearch.com 1 https://www.bloomberg.com/news/articles/2017-06-28/china-is-about-to-bury-elon-musk-in-batteries 2 https://www.greentechmedia.com/articles/read/10-battery-gigafactories-are-now-in-progress-and-musk-may-add-4-more 3 Please see Technology Sector Strategy Special Report "Electric Vehicle Batteries", dated September 20, 2016. 4 http://insideevs.com/heres-how-much-a-chevrolet-bolt-replacement-battery-costs/ 5 http://insideevs.com/gm-chevrolet-bolt-for-2016-145kwh-cell-cost-volt-margin-improves-3500/ 6 https://www.researchgate.net/publication/260339436_An_Overview_of_Costs_for_Vehicle_Components_Fuels_and_Greenhouse_Gas_Emissions 7 https://www.bloomberg.com/news/articles/2017-05-26/electric-cars-seen-cheaper-than-gasoline-models-within-a-decade 8 https://www.bloomberg.com/news/articles/2016-11-30/gm-s-ready-to-lose-9-000-a-pop-and-chase-the-electric-car-boom 9 https://electrek.co/2016/12/07/gm-chevy-bolt-ev-battery-degradation-up-to-40-warranty/ 10 http://www.carinsurance.com/Articles/average-miles-driven-per-year-by-state.aspx 11 http://www.chevrolet.com/byo-vc/client/en/US/chevrolet/bolt-ev/2017/bolt-ev/features/trims/?section=Highlights§ion=Fuel%20Efficiency§ion=Dimensions&styleOne=388584 12 https://electrek.co/2016/12/15/chevy-bolt-ev-europe-june-2017-opel-ampera-e-gm/ 13 The Bolt weighs almost 800 pounds (360 kg) more than a similar sized Chevrolet Sonic. 14 http://www.consumerreports.org/cars-tesla-reliability-doesnt-match-its-high-performance/ 15 https://www.veic.org/docs/Transportation/20130320-EVT-NRA-Final-Report.pdf 16 http://teslaliving.net/2014/07/07/measuring-ev-charging-efficiency/ 17 http://www.chevrolet.com/bolt-ev-electric-vehicle 18 http://www.chevrolet.com/sonic-small-car 19 https://www.eia.gov/electricity/state/ 20 http://www.opel.fr/vehicules/gamme-astra/astra-5-portes/points-forts.html#trim-edition 21 http://www.eafo.eu/content/italy 22 https://www.iea.org/publications/freepublications/publication/GlobalEVOutlook2017.pdf pages 53-55 23 http://insideevs.com/overview-incentives-buying-electric-vehicles-eu/ 24 https://electrek.co/2016/04/27/germany-electric-vehicle-incentive-4000/ 25 http://www.acea.be/statistics/tag/category/average-vehicle-age 26 http://www.autonews.com/article/20161122/RETAIL05/161129973/average-age-of-vehicles-on-road-hits-11.6-years 27 http://blog.caranddriver.com/tesla-aside-resale-values-for-electric-cars-are-still-tanking/ Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership Commodity Prices and Plays Reference Table Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights The euro area's growth prospects, adjusted for population, are no different to any other major developed economy. If the euro area continues its recovery to just the mid-point of its long-term relative growth cycle... ...the yield spread between long-dated bonds in the euro area and the U.S. will compress to around -50 bps from today's -150 bps... ...and euro/dollar will eventually rally to over 1.30. Stay overweight euro area Financials and Retailers versus U.S. Financials and Retailers. Feature ChartThe Euro Area Has Surged Because Expectations ##br##For The Euro Area's 'Terminal' Interest Rate Have Surged The Euro Area Has Surged Because Expectations For The Euro Area's 'Terminal' Interest Rate Have Surged The Euro Area Has Surged Because Expectations For The Euro Area's 'Terminal' Interest Rate Have Surged Feature The latest GDP releases confirm that the euro area has comfortably outperformed other major developed economies this year. Yet among mainstream equity indexes the Eurostoxx50, which is up 6%, has comfortably underperformed both the MSCI World index1 and the S&P500, which are up 9% and 11%. Why? One clue comes from the technology-heavy NASDAQ 100, which is up 21%. Whereas euro area equities have a negligible exposure to technology, the S&P500 has more than a quarter of its market capitalization in the strongly performing tech and biotech sectors (Chart I-2). Then there is the effect of the surging euro. The largest euro area companies are multinationals earning dollars. In dollar terms, euro area profit growth2 has indeed outperformed U.S. profit growth by about 10%. But converted back into euros - the base currency of the Eurostoxx50 - the outperformance has become an underperformance (Chart I-3). Chart I-2When Technology Outperforms, The Eurostoxx50 Underperforms When Technology Outperforms, The Eurostoxx50 Underperforms When Technology Outperforms, The Eurostoxx50 Underperforms Chart I-3Euro Area Profits Have Outperformed In Dollars, ##br##But Not In Euros Europe: First Among Equals Europe: First Among Equals Play Relative Economic Performance Through Bonds And Currencies Chart I-4Euro Area Banks Have Outperformed U.S. Banks Euro Area Banks Have Outperformed U.S. Banks Euro Area Banks Have Outperformed U.S. Banks The salutary lesson is that sector and currency effects always swamp relative economic performance in predicting or explaining the relative performance of mainstream equity indexes. To play the euro area's economic outperformance, global equity investors must drill down to the more domestically driven euro area sectors, financials and retailers. An overweight position in these two domestic sectors versus their equivalents in, say, the U.S. has outperformed this year, and should continue to do so (Chart I-4). But the best way to play relative economic performance is through other asset classes. Focus not on equities, but on government bonds and currencies. In line with the euro area's superior economic performance this year, the spread between long-dated bond yields in the euro area and U.S. has compressed by 45bps, and euro/dollar is up 12%. The good news is that these trends can ultimately run much further. He That Is Without Structural Problem, Cast The First Stone... Chart I-5For American Men, Labour Force ##br##Participation Rate Is Collapsing For American Men, Labour Force Participation Rate Is Collapsing For American Men, Labour Force Participation Rate Is Collapsing The obvious pushback to the longer-term narrative is: what about the euro area's much discussed structural difficulties? To which our response is yes, the euro area does face undoubted long-term challenges. Integrating 19 disparate nations into the confines of an ever closer financial, economic, and ultimately political union is a task that comes with difficulties and risks, especially in the political dimension. Having said that, the euro area is not the only major economy contending with major financial, economic and political challenges in the coming years. To paraphrase the Bible, "he that is without structural problem among you, let him cast the first stone at the euro area." The United Kingdom will spend the next few years struggling to define and redefine the meaning of Brexit, then trying to negotiate it, and then grappling to implement it - whatever 'it' ends up being. The whole process is fraught with financial, economic and political challenges and dangers. Looking West, the United States is suffering a major structural downtrend in its labour participation rate; for American men especially, the participation rate is collapsing (Chart I-5), which creates its own political problems. Looking East, Japan is suffering a chronically low and declining birth rate. And China must wean itself off a decade long addiction to debt-fuelled growth. We could go on... Seen in this light, are the euro area's structural challenges really any harder (or easier) than those faced by the other major economies? The Euro Area Is An Economic Equal One important differentiator across the major developed economies is population growth. A population that is growing boosts headline output. On the other hand, it also adds to the number of people who must share the economy's income and resources. Conversely, a population that is shrinking weighs on headline output, but it reduces the number of people who must share the income and resources. Therefore, what matters for standards of living - and the consequent political implications - is the evolution of GDP per head. In a similar vein, a growing population means that a firm will see rising sales. But absent a rise in productivity, the firm will have to employ more staff and capital to deliver those increased sales - in other words, issue more shares. Therefore, what matters for earnings per share is the evolution of productivity, which once again means GDP per head. Some people consider a shrinking population as a particular problem. They argue that when a population is shrinking, the economy needs to shed workers and capital, which can be hard to do. But a growing population can also create disruptions and pains: specifically, resources such as housing and public services might struggle to keep pace with rapidly rising demand. Consider the United Kingdom. In the 1980s and 90s, the population grew at a very sedate 2% per decade. But since the millennium, population growth has almost quadrupled to 7.5% per decade. The resulting strain on housing and public services was a major factor behind the vote for Brexit - which of course, now carries its own disruptive consequences. Chart I-6The Euro Area Is An Economic Equal The Euro Area Is An Economic Equal The Euro Area Is An Economic Equal Therefore, population shrinkage or growth is a problem only if it is sudden or extreme. More modest changes in either direction are neither good nor bad per se. But to assess progress in living standards and indeed equity market profitability, it is crucial to measure economic growth adjusted for population change. On this population adjusted basis, the structural growth prospects of the euro area are not meaningfully different to other developed economies such as the U.K. and the U.S. The euro area is an equal, and recently it has been the first among equals. Over the longer term, the euro area and the U.S. have generated identical growth in real GDP per head (Chart I-6). Within the bigger picture, the euro area has underperformed through multi-year periods encompassing around half the time; and it has outperformed through the multi-year periods encompassing the other half. Seen in this light, the post-2008 phase of poor performance was the impact of back to back recessions separated by an unusually short gap, with the second of the two recessions the direct result of policy errors specific to the euro area. In other words, the euro area's 2008-14 economic underperformance was not structural; it was cyclical. Prospects For Bond Yield Spreads And The Euro If the euro area continues its recovery to just the mid-point of its long-term relative cycle, then recent investment trends ultimately have much further to run. Unsurprisingly, relative interest rate expectations closely follow relative real GDP per head. Relative interest rate expectations 2 years out between the euro area and United States have compressed from -230 bps last December to -185 bps today. Relative interest rates expectations 5 years out have compressed more, to -150 bps today (Feature Chart). This makes perfect sense. Clearly, the ECB will not hike interest rates any time soon, but expectations for the long-term 'terminal' rate have correctly gone up from overly-pessimistic levels. Nevertheless, to reach the mid-point of its long-term cycle, the gap between euro area and U.S. interest rate expectations must ultimately get to around -50 bps (Chart I-7). The implication is that the yield spread between long-dated bonds in the euro area3 and the U.S. will also compress to around -50 bps (Chart I-8). Therefore, on a 2-year horizon, stay underweight euro area bonds - especially German bunds - in a European and global bond portfolio. This also carries repercussions for euro/dollar, given that it closely tracks relative interest rate expectations. The mid-cycle gap of -50 bps equates to euro/dollar at over 1.30 (Chart I-9). And an overshoot to the top of the cycle implies over 1.50. Chart I-7Relative GDP Per Head Leads Relative Interest Rate Expectations Relative GDP Per Head Leads Relative Interest Rate Expectations Relative GDP Per Head Leads Relative Interest Rate Expectations Chart I-8...And Bond Yield Spreads ...And Bond Yield Spreads ...And Bond Yield Spreads Chart I-9Relative Interest Rate Expectations Drive Euro/Dollar Relative Interest Rate Expectations Drive Euro/Dollar Relative Interest Rate Expectations Drive Euro/Dollar But trends do not unfold in straight lines. They are punctuated by regular setbacks. The recent surge in euro/dollar has taken its 65-day fractal dimension towards its lower limit, which suggests excessive short-term herding. That said, we could now be at the mirror-image turning point in ECB policy to that of the summer of 2014. Then, Draghi pre-announced QE; now, he may pre-announce its demise. In which case, fundamentals will override the 65-day fractal signal just as they did three years ago (Chart I-10). Nonetheless, we would not be surprised if euro/dollar first revisited the 1.10-1.15 channel before resuming its long march upwards. Chart I-10Excessive Short-Term Herding In Euro/Dollar, But... Excessive Short-Term Herding In Euro/Dollar, But... Excessive Short-Term Herding In Euro/Dollar, But... Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In local currency terms. 2 Based on 12 month forward earnings per share. 3 Euro area average over 10-year sovereign yield, weighted by sovereign issue size. Fractal Trading Model* This week's trade is to position for an underperformance of Chinese shares versus the emerging markets benchmark. Target a 2.5% profit target and stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Short MSCI China / Long MSCI EM Short MSCI China / Long MSCI EM * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Feature Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update When Central Banks Turn Hawkish It seems almost as though, when central bank governors gathered in Portugal for the ECB's annual confab in late June, they agreed to start sounding more hawkish. ECB President Mario Draghi's speech included the line: "The threat of deflation is gone and reflationary forces are at play." Bank of Canada Governor Stephen Poloz went ahead and on July 12 announced Canada's first rate hike in seven years. Indeed, BCA's Central Bank Monitors (Chart 1) suggest that, with the exceptions of Japan and possibly the euro area, all major developed central banks need to tighten monetary policy. Does this matter for risk assets, such as equities? Historical evidence suggests not, as long as the central bank is tightening because it is confident about the outlook for growth and unconcerned about financial risks (rather than, for example, reacting to a sharp rise in inflation). Equity markets typically move up in the early stages of a tightening cycle (Chart 2); it is only when the central bank tightens excessively (usually later in the cycle) that risk assets start to anticipate that this will trigger a recession. Even in the U.S. which, after four rate hikes since December 2015, is the furthest advanced in tightening, the real effective Fed Funds Rate is still -0.3%, below the 0.3% that the Fed believes to be the neutral real rate at the moment (Chart 3). The Fed expects the neutral rate to rise to 1% in the longer run. Chart 1Most Central Banks Need To Tighten Most Central Banks Need To Tighten Most Central Banks Need To Tighten Chart 2Equities Usually Rise During Rate Hike Cycle Equities Usually Rise During Rate Hike Cycle Equities Usually Rise During Rate Hike Cycle Chart 3Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative But the order in which central banks tighten will be a major driver of currencies (as has been clear with the sharp appreciation of the CAD and AUD in recent weeks). Our current asset recommendations are based on the belief that the market has become too complacent about the speed at which the Fed will tighten (with futures pricing only 26 bp of hikes over the next 12 months), and too nervous about the ECB (Chart 4). As the market starts to understand that the Fed has fallen a little behind the curve, and that the ECB will remain cautious (given continuing weakness in peripheral economies, and a lack of underlying inflationary pressures), we expect to see the dollar begin to appreciate again. A key to all this is whether the recent softness in U.S. inflation data (core PCE inflation has fallen from 1.8% YoY to 1.4% since January) proves to be temporary. A rebound in inflation would allow the Fed to continue to hike without bringing the real rate close to the neutral level yet. It is worth remembering that inflation is a lagging indicator: the recent weakness is largely a reflection of last year's soggy GDP growth (Chart 5), as well as some transitory technical factors (particularly drug and wireless data prices). The recent dollar depreciation should also boost inflation via the import price channel over the coming months (Chart 6). Chart 4Markets Views On Fed And ECB Have Diverged Markets Views On Fed And ECB Have Diverged Markets Views On Fed And ECB Have Diverged Chart 5Inflation Lags GDP Growth Inflation Lags GDP Growth Inflation Lags GDP Growth Chart 6Dollar Deprecation Will Raise Prices Dollar Deprecation Will Raise Prices Dollar Deprecation Will Raise Prices However, with global equities having produced a total return of 35% since their recent bottom in February last year, and 17% year to date, valuations are unattractive and, on some measures, sentiment is quite optimistic (Chart 7). What catalysts are there left to give risk assets further upside? We see two. First, earnings. The Q2 U.S. results season has seen 77% of S&P 500 companies surprising on the upside at the sales line, with EPS rising 7% compared to the same quarter in 2016. Most of our indicators suggest that earnings have further to rise this year (Chart 8), yet the consensus EPS forecast for 2017 as a whole remains at just over 10%, where it has been since January. Strong earnings momentum is likely to remain a positive at least through the end of the year. Second, tax cuts. Our Geopolitical Strategy service1 remains optimistic that the U.S. Congress will pass tax legislation to come into effect in early 2018. The failure to repeal Obamacare means that the Republican Party will need a big legislative win going into the mid-term elections in November 2017. Tax cuts (which the market is no longer pricing in - Chart 9) is one policy on which there is little disagreement within the GOP. Chart 7Are Investors Getting Too Optimistic? Are Investors Getting Too Optimistic? Are Investors Getting Too Optimistic? Chart 8Earnings Can Still Surprise On Upside Earnings Can Still Surprise On Upside Earnings Can Still Surprise On Upside Chart 9No One Expects Tax Cuts Any More No One Expects Tax Cuts Any More No One Expects Tax Cuts Any More None of the recession indicators we highlighted in our most recent Quarterly 2 (global PMIs, the shape of the yield curve, or credit spreads) are pointing to a downturn in the next 12 months. So, given the environment described above, we are happy to remain overweight equities versus bonds, and to maintain our pro-risk and pro-cyclical tilts. But we continue to warn of the risk of a recession in 2019 - probably triggered by the Fed needing to tighten more aggressively - and might look to lower our risk profile in the first half of next year. Equities: We favor DM equities over EM. An appreciating dollar, rising interest rates, weak industrial metals prices this year and uncertain growth prospects for China all represent headwinds for EM equities. Our strong dollar view points to an overweight in U.S. equities in USD terms but, in local currencies, our preference is for euro area and Japanese equities. Both are relatively high-beta, have strongly cyclical earnings momentum, and central banks that are likely to stay dovish. In Japan, the falling popularity rating of the Abe administration might compel it to ramp up fiscal spending to boost the economy, which would help the Bank of Japan in its efforts to rekindle inflation. Chart 10Everyone Has Turned Bullish On The Euro Everyone Has Turned Bullish On The Euro Everyone Has Turned Bullish On The Euro Fixed Income: Our macro outlook, with faster rate hikes and rebounding inflation in the U.S., is very negative for rates. We are underweight government bonds, short duration and prefer inflation-linked bonds to nominal ones. Valuations in credit are no longer particularly attractive but, with a 100 bp spread for U.S. investment grade bonds and a 230 bp default-adjusted spread for high-yield, returns are likely to be satisfactory as long as the economic cycle continues to improve. Currencies: Our fundamental view of the dollar is that relative monetary policy and interest rates point to further appreciation, especially against the yen and euro. The timing of the dollar's rebound, though, is harder to pinpoint. The euro could rise further over the next couple of months. However, given speculators' large net long positions in the euro - a big turnaround from the start of the year (Chart 10) - the likely announcement by the ECB in September or October of a reduction in its asset purchases might be the catalyst for a reversal (as a classic "buy the news, sell the rumor" event), particularly if Mario Draghi dresses it up as a "dovish tapering." Commodities: Oil inventories have begun to draw down in line with our expectations (Chart 11). Continued discipline by OPEC producers until next March, combined with a slowdown in the growth of U.S. shale production (reflecting the weaker crude price this year) should bring inventories down further (despite production increases in such countries as Libya and Iran), and push the price of WTI above $55 a barrel by year end. Industrial commodity prices have rebounded somewhat in the past six weeks, mainly on the back of moderately brighter economic data out of China (Chart 12). But, given uncertain prospects about the sustainability of this growth, especially beyond the Communist Party Congress in the fall, and amid some signs of weakness in Chinese monetary and credit aggregates,3 we remain cautious about the outlook for metals prices over the next 12 months. Chart 11Oil Inventories Will Draw Down Further in Oil Inventories Will Draw Down Further in Oil Inventories Will Draw Down Further in Chart 12Tick-Up In Chinese Data? Tick-Up In Chinese Data? Tick-Up In Chinese Data? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bca.research.com. 2 Please see BCA Global Asset Allocation, "Quarterly Portfolio Review," dated July 3, 2107, available at gaa.bcaresearch.com. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com. Recommended Asset Allocation

Highlights Structural Bond Backdrop: The secular global bond market outlook is slowly deteriorating on the margin. The structural forces that have driven down bond yields over the past few decades are in the process of stabilizing or even slowly reversing. With central banks moving away from "emergency" stimulative monetary policies that were designed to fight imminent deflation risks that are no longer needed, the path of least resistance for global bond yields is up. Central Bank Liquidity & Volatility: The current low volatility backdrop is a function of solid global economic growth and accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but monetary policies will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds for the rest of 2017. Feature The End Of The Bond Bull Market, One Year Later In July of last year, BCA put its flag in the ground and declared the end of the 35-year global bond bull market.1 This was not a view that a new fixed income bear market was about to immediately unfold. Rather, we concluded that all the bond-bullish factors of the past few decades - aging populations, anemic productivity growth, structurally declining global inflation rates - were more than fully reflected in the level of bond yields seen after the shocking result of the U.K. Brexit referendum. Even in the most pessimistic of future scenarios for the global economy, a 10-year U.S. Treasury yield at 1.37% or a 10-year German Bund yield at -0.18% (the intraday lows seen immediately after the Brexit vote) discounted an awful lot of bad news. Chart of the WeekA Less Market-Friendly##BR##Backdrop On The Horizon? A Less Market-Friendly Backdrop On The Horizon? A Less Market-Friendly Backdrop On The Horizon? We believed that central bankers would likely respond to the uncertainties created by the growing wave of political populism evidenced by Brexit (and, later, Trump) by keeping monetary settings as loose as possible for as long as possible. Overly accommodative policy would provide a reflationary tailwind to global growth - especially if governments also looked to placate voter uprisings with looser fiscal policy. Coming at a time when many of the powerful structural factors that have acted to suppress bond yields in recent decades were starting to lose potency, the risks were tilted toward a cyclical rise in yields that could turn into something longer lasting. Roll the tape forward one year, and some parts of our prediction have already come to fruition. The major developed economy central banks have generally leaned on the dovish side. Policy rates have been kept well below "equilibrium" - in some cases, below zero. Only the U.S. Federal Reserve has been able to raise interest rates a handful of times, and even then while still maintaining a bloated balance sheet left over from the QE era. More importantly, the European Central Bank (ECB) and the Bank of Japan (BoJ) have continued with asset purchase programs that have added a combined $3.5 trillion in monetary liquidity over the past two years. That massive dose of money printing has helped keep global bond yields low while supporting a coordinated economic recovery that has underwritten equity and credit bull markets worldwide (Chart of the Week). The structural aspects of our long-term call on global bonds are less evident in the current economic data, but we are even more convinced that the tide is turning. This week, we are including a pair of additional Special Reports, recently authored by BCA's Chief Global Strategist, Peter Berezin, and Mark McClellan, Chief Strategist for our flagship publication, The Bank Credit Analyst. Mark discusses how many of the secular drivers of the current low level of global bond yields - aging populations; excess global savings, especially from China; the absorption of low-cost labor from the emerging world; globalization of world trade and supply chains - are waning or may even be reaching an inflection point. Peter takes an even more provocative stand in his report, laying out a case for why the current backdrop of low global productivity growth will eventually lead to higher real interest rates and faster inflation. In this Weekly Report, we tackle the more immediate issue of the shifting outlook for central bank policies and what it implies for the current state of low market volatilities. The growth rate of the "G-3" aggregate balance sheet has already peaked which, combined with early warning signs on future growth signaled by measures like our diffusion index of global leading economic indicators, suggests that a turning point in the current low volatility, pro-risk backdrop may start to unfold in the months ahead - but not before government bond yields move higher on the back of rebounding inflation and central bank tightening actions. Are Central Banks To Blame For Low Volatility? Perhaps the hottest topic among investors at the moment is what to make of the exceptionally low levels of market volatility. The so-called "fear gauge" - the U.S. VIX index - fell into single digits last month to the lowest level since 1993. This is not the only measure of market volatility that is probing historic lows, however. In Chart 2, we show the range of realized total return volatilities for major global asset classes dating back to 1999. The current volatilities all sit very close to the low end of the historical range, from bonds to equities to currencies to commodities. Part of this can simply be chalked up to the broad-based acceleration of global growth seen over the past year, which has supported stable earnings-driven equity bull markets. Chart 2It's Not Just The VIX ... All Market Volatilities Are Historically Low Transitioning To A Less Bond-Friendly World Transitioning To A Less Bond-Friendly World The slow response of central banks to this upturn is an even bigger factor, helping keep bond volatility depressed. Low rates of realized inflation, and restrained levels of expected inflation, have allowed policymakers to maintain accommodative monetary policies and not engineer slower growth to cool overheating economies. Corporate profits have enjoyed a cyclical boost as a result, to the benefit of equities and corporate credit. For the VIX index, which is based on option-implied volatilities for the S&P 500, the current low level is consistent with a more stable environment for economic growth and corporate profits. The standard deviations of the growth rates of U.S. real GDP and reported S&P earnings have fallen to the lowest levels seen since 1990 (Chart 3). Against this backdrop, it is no surprise that the realized volatility of the S&P 500 is also depressed (bottom panel). The previous dovish biases of central bankers have also played a role in helping keep volatility low. Interest rates been kept at low levels relative to policymakers' own estimates of "neutral". Asset purchase programs in Europe and Japan have acted as a signaling mechanism to markets to delay expectations of future interest rate increases, helping suppress bond yield levels and bond price volatility. This has acted to boost risk-seeking behavior among investors seeking adequate investment returns given rock-bottom risk-free interest rates. In the U.S., policymakers still have strong memories of the mid-2000s period where predictable monetary policy, even during a tightening cycle, led to an extended period of low market volatility and encouraged risk-taking behavior fueled by excessive leverage. A greater focus on "financial stability" issues has likely played a hand in the timing of the Fed's rate hikes earlier this year, given that growth and inflation data were not rapidly accelerating (especially prior to the June rate hike). In other words, the Fed was seeing soaring equity prices, tightening credit spreads and a weaker U.S. dollar as an easing of financial conditions that could set the stage for more rapid economic growth, and more "frothy" investor behavior, down the road. The Fed can take some comfort in the fact that some signs of speculative excesses in the U.S. corporate bond market are not at levels seen during the credit boom of the prior decade. Our preferred measure of corporate balance sheet leverage, debt less cash relative to the EBITD measure of earnings, is rising but remains below prior peaks despite the current lower level of corporate borrowing rates (Chart 4). Inflows into corporates from foreign buyers are far below the levels seen in the mid-2000s, while domestic retail buying of corporate bond funds is within historic norms (middle panel). Some signs of excess are appearing, however, with the share of leveraged loan issuance taken up by so-called "covenant-lite" deals offering reduced protection for lenders soaring to a record high earlier this year (bottom panel). Chart 3A Low VIX Reflects More Stable Growth & Earnings A Low VIX Reflects More Stable Growth & Earnings A Low VIX Reflects More Stable Growth & Earnings Chart 4Not At 2000s Credit Bubble Levels...Yet Not At 2000s Credit Bubble Levels...Yet Not At 2000s Credit Bubble Levels...Yet The Fed will never explicitly say that monetary policy is being tightened to cool off booming financial markets. However, numerous Fed officials have mentioned signs of stretched market valuations in their public speeches in recent months. This suggests that there is growing concern about leaving monetary policy too accommodative for too long and potentially fueling future asset bubbles. We remain of the view that faster growth and rebounding inflation will prompt the next wave of Fed rate hikes over the next year - which is not currently discounted in financial markets, leading us to maintain a below-benchmark recommended duration stance in the U.S. Yet the very easy level of financial conditions will also play a role in the Fed's next move. In many ways, the current backdrop is similar to 2014. Realized U.S. inflation was falling rapidly then, but financial conditions were easing and leading economic indicators were rising, even as the Fed was tapering its QE purchases to zero (Chart 5). At the beginning of the Fed's tapering process in the spring of 2014, there was barely one 25bp rate hike priced into the Overnight Index Swap (OIS) curve. As the Fed began to taper its bond buying, even while inflation was falling, investors got the hint that the Fed was serious about becoming less accommodative and began to price in more future rate hikes (bottom panel). Chart 52014 Revisited? 2014 Revisited? 2014 Revisited? Chart 6The ECB Will Taper Next Year The ECB Will Taper Next Year The ECB Will Taper Next Year We see a similar dynamic playing out in Europe in the coming months as the markets begin to more seriously price in a slower pace of ECB bond purchases in 2018, which the central bank is likely to formally announce next month (Chart 6). In Japan, the BoJ has already been buying bonds at a slower pace this year after shifting to a bond yield target from a quantitative purchase target last September (Chart 7). Combined with the additional Fed hikes that are likely to come, in addition to the Fed beginning to "normalize" the size of its swollen balance sheet (Chart 8), the central bank liquidity backdrop is about to become much less friendly for financial markets. Chart 7The BoJ Has Already Tapered The BoJ Has Already Tapered The BoJ Has Already Tapered Chart 8Let The Fed Runoff Begin Let The Fed Runoff Begin Let The Fed Runoff Begin We have seen the lows in market volatility for this business cycle. This will become a bigger issue for risk assets after monetary policy becomes even less accommodative and economic data begins to slow in response, likely sometime in the first half of 2018. Until then, the current healthy pace of global growth will put more upward pressure on bond yields than downward pressure on equity or credit market valuations over the rest of the year. Bottom Line: The current low volatility backdrop is a function of solid global economic growth with accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but the monetary policy backdrop will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Third Quarter 2016 Strategy Outlook, "The End Of The 35-Year Global Bond Bull Market", dated July 8th 2016, available at gis.bcaresearch.com. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Structural Bond Backdrop: The secular global bond market outlook is slowly deteriorating on the margin. The structural forces that have driven down bond yields over the past few decades are in the process of stabilizing or even slowly reversing. With central banks moving away from "emergency" stimulative monetary policies that were designed to fight imminent deflation risks that are no longer needed, the path of least resistance for global bond yields is up. Central Bank Liquidity & Volatility: The current low volatility backdrop is a function of solid global economic growth and accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but monetary policies will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds for the rest of 2017. Feature The End Of The Bond Bull Market, One Year Later In July of last year, BCA put its flag in the ground and declared the end of the 35-year global bond bull market.1 This was not a view that a new fixed income bear market was about to immediately unfold. Rather, we concluded that all the bond-bullish factors of the past few decades - aging populations, anemic productivity growth, structurally declining global inflation rates - were more than fully reflected in the level of bond yields seen after the shocking result of the U.K. Brexit referendum. Even in the most pessimistic of future scenarios for the global economy, a 10-year U.S. Treasury yield at 1.37% or a 10-year German Bund yield at -0.18% (the intraday lows seen immediately after the Brexit vote) discounted an awful lot of bad news. Chart of the WeekA Less Market-Friendly##BR##Backdrop On The Horizon? A Less Market-Friendly Backdrop On The Horizon? A Less Market-Friendly Backdrop On The Horizon? We believed that central bankers would likely respond to the uncertainties created by the growing wave of political populism evidenced by Brexit (and, later, Trump) by keeping monetary settings as loose as possible for as long as possible. Overly accommodative policy would provide a reflationary tailwind to global growth - especially if governments also looked to placate voter uprisings with looser fiscal policy. Coming at a time when many of the powerful structural factors that have acted to suppress bond yields in recent decades were starting to lose potency, the risks were tilted toward a cyclical rise in yields that could turn into something longer lasting. Roll the tape forward one year, and some parts of our prediction have already come to fruition. The major developed economy central banks have generally leaned on the dovish side. Policy rates have been kept well below "equilibrium" - in some cases, below zero. Only the U.S. Federal Reserve has been able to raise interest rates a handful of times, and even then while still maintaining a bloated balance sheet left over from the QE era. More importantly, the European Central Bank (ECB) and the Bank of Japan (BoJ) have continued with asset purchase programs that have added a combined $3.5 trillion in monetary liquidity over the past two years. That massive dose of money printing has helped keep global bond yields low while supporting a coordinated economic recovery that has underwritten equity and credit bull markets worldwide (Chart of the Week). The structural aspects of our long-term call on global bonds are less evident in the current economic data, but we are even more convinced that the tide is turning. This week, we are including a pair of additional Special Reports, recently authored by BCA's Chief Global Strategist, Peter Berezin, and Mark McClellan, Chief Strategist for our flagship publication, The Bank Credit Analyst. Mark discusses how many of the secular drivers of the current low level of global bond yields - aging populations; excess global savings, especially from China; the absorption of low-cost labor from the emerging world; globalization of world trade and supply chains - are waning or may even be reaching an inflection point. Peter takes an even more provocative stand in his report, laying out a case for why the current backdrop of low global productivity growth will eventually lead to higher real interest rates and faster inflation. In this Weekly Report, we tackle the more immediate issue of the shifting outlook for central bank policies and what it implies for the current state of low market volatilities. The growth rate of the "G-3" aggregate balance sheet has already peaked which, combined with early warning signs on future growth signaled by measures like our diffusion index of global leading economic indicators, suggests that a turning point in the current low volatility, pro-risk backdrop may start to unfold in the months ahead - but not before government bond yields move higher on the back of rebounding inflation and central bank tightening actions. Are Central Banks To Blame For Low Volatility? Perhaps the hottest topic among investors at the moment is what to make of the exceptionally low levels of market volatility. The so-called "fear gauge" - the U.S. VIX index - fell into single digits last month to the lowest level since 1993. This is not the only measure of market volatility that is probing historic lows, however. In Chart 2, we show the range of realized total return volatilities for major global asset classes dating back to 1999. The current volatilities all sit very close to the low end of the historical range, from bonds to equities to currencies to commodities. Part of this can simply be chalked up to the broad-based acceleration of global growth seen over the past year, which has supported stable earnings-driven equity bull markets. Chart 2It's Not Just The VIX ... All Market Volatilities Are Historically Low Transitioning To A Less Bond-Friendly World Transitioning To A Less Bond-Friendly World The slow response of central banks to this upturn is an even bigger factor, helping keep bond volatility depressed. Low rates of realized inflation, and restrained levels of expected inflation, have allowed policymakers to maintain accommodative monetary policies and not engineer slower growth to cool overheating economies. Corporate profits have enjoyed a cyclical boost as a result, to the benefit of equities and corporate credit. For the VIX index, which is based on option-implied volatilities for the S&P 500, the current low level is consistent with a more stable environment for economic growth and corporate profits. The standard deviations of the growth rates of U.S. real GDP and reported S&P earnings have fallen to the lowest levels seen since 1990 (Chart 3). Against this backdrop, it is no surprise that the realized volatility of the S&P 500 is also depressed (bottom panel). The previous dovish biases of central bankers have also played a role in helping keep volatility low. Interest rates been kept at low levels relative to policymakers' own estimates of "neutral". Asset purchase programs in Europe and Japan have acted as a signaling mechanism to markets to delay expectations of future interest rate increases, helping suppress bond yield levels and bond price volatility. This has acted to boost risk-seeking behavior among investors seeking adequate investment returns given rock-bottom risk-free interest rates. In the U.S., policymakers still have strong memories of the mid-2000s period where predictable monetary policy, even during a tightening cycle, led to an extended period of low market volatility and encouraged risk-taking behavior fueled by excessive leverage. A greater focus on "financial stability" issues has likely played a hand in the timing of the Fed's rate hikes earlier this year, given that growth and inflation data were not rapidly accelerating (especially prior to the June rate hike). In other words, the Fed was seeing soaring equity prices, tightening credit spreads and a weaker U.S. dollar as an easing of financial conditions that could set the stage for more rapid economic growth, and more "frothy" investor behavior, down the road. The Fed can take some comfort in the fact that some signs of speculative excesses in the U.S. corporate bond market are not at levels seen during the credit boom of the prior decade. Our preferred measure of corporate balance sheet leverage, debt less cash relative to the EBITD measure of earnings, is rising but remains below prior peaks despite the current lower level of corporate borrowing rates (Chart 4). Inflows into corporates from foreign buyers are far below the levels seen in the mid-2000s, while domestic retail buying of corporate bond funds is within historic norms (middle panel). Some signs of excess are appearing, however, with the share of leveraged loan issuance taken up by so-called "covenant-lite" deals offering reduced protection for lenders soaring to a record high earlier this year (bottom panel). Chart 3A Low VIX Reflects More Stable Growth & Earnings A Low VIX Reflects More Stable Growth & Earnings A Low VIX Reflects More Stable Growth & Earnings Chart 4Not At 2000s Credit Bubble Levels...Yet Not At 2000s Credit Bubble Levels...Yet Not At 2000s Credit Bubble Levels...Yet The Fed will never explicitly say that monetary policy is being tightened to cool off booming financial markets. However, numerous Fed officials have mentioned signs of stretched market valuations in their public speeches in recent months. This suggests that there is growing concern about leaving monetary policy too accommodative for too long and potentially fueling future asset bubbles. We remain of the view that faster growth and rebounding inflation will prompt the next wave of Fed rate hikes over the next year - which is not currently discounted in financial markets, leading us to maintain a below-benchmark recommended duration stance in the U.S. Yet the very easy level of financial conditions will also play a role in the Fed's next move. In many ways, the current backdrop is similar to 2014. Realized U.S. inflation was falling rapidly then, but financial conditions were easing and leading economic indicators were rising, even as the Fed was tapering its QE purchases to zero (Chart 5). At the beginning of the Fed's tapering process in the spring of 2014, there was barely one 25bp rate hike priced into the Overnight Index Swap (OIS) curve. As the Fed began to taper its bond buying, even while inflation was falling, investors got the hint that the Fed was serious about becoming less accommodative and began to price in more future rate hikes (bottom panel). Chart 52014 Revisited? 2014 Revisited? 2014 Revisited? Chart 6The ECB Will Taper Next Year The ECB Will Taper Next Year The ECB Will Taper Next Year We see a similar dynamic playing out in Europe in the coming months as the markets begin to more seriously price in a slower pace of ECB bond purchases in 2018, which the central bank is likely to formally announce next month (Chart 6). In Japan, the BoJ has already been buying bonds at a slower pace this year after shifting to a bond yield target from a quantitative purchase target last September (Chart 7). Combined with the additional Fed hikes that are likely to come, in addition to the Fed beginning to "normalize" the size of its swollen balance sheet (Chart 8), the central bank liquidity backdrop is about to become much less friendly for financial markets. Chart 7The BoJ Has Already Tapered The BoJ Has Already Tapered The BoJ Has Already Tapered Chart 8Let The Fed Runoff Begin Let The Fed Runoff Begin Let The Fed Runoff Begin We have seen the lows in market volatility for this business cycle. This will become a bigger issue for risk assets after monetary policy becomes even less accommodative and economic data begins to slow in response, likely sometime in the first half of 2018. Until then, the current healthy pace of global growth will put more upward pressure on bond yields than downward pressure on equity or credit market valuations over the rest of the year. Bottom Line: The current low volatility backdrop is a function of solid global economic growth with accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but the monetary policy backdrop will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Third Quarter 2016 Strategy Outlook, "The End Of The 35-Year Global Bond Bull Market", dated July 8th 2016, available at gis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Transitioning To A Less Bond-Friendly World Transitioning To A Less Bond-Friendly World

Highlights EUR/USD is likely to correct over the course of the coming weeks, however, the picture remains too murky to be aggressive. The dollar move since 2015 is still in line with previous sideways consolidations. Economic developments suggest that the USD is more likely to break out than breakdown over the next 12 months. Inflation will hold the keys to the next big trend. The RBA is hampered by a high degree of labor underutilization, and the roll-over in the Chinese Keqiang index bodes poorly for the AUD. Feature The euro's recent strength has been nothing short of stunning. Abandoning our "dollar correction" stance at the end of May was clearly a mistake.1 Now that EUR/USD has punched back above its 2015 high, it is time to reflect whether this year's dollar decline was indeed a correction or whether the euro's bear market is over, in which case EUR/USD could move back above its PPP fair value of 1.33. A Dollar Move Chart I-1The Dollar Is Weak Against Everything The Dollar Is Weak Against Everything The Dollar Is Weak Against Everything The rally in EUR/USD has been more than just a period of euro strength: it has been reflective of a broad-based decline in the USD. As Chart I-1 illustrates, the plunge in the dollar's advance/decline line indicates the greenback has been weak against pretty much everything out there. While the White House's failures and its lack of action on the fiscal stimulus front have played a role in explaining the dollar's weakness, the Federal Reserve's absence of credibility among market participants has been an even greater factor. Weak U.S. inflation, with core CPI at 1.7% and core PCE at 1.4%, implies that the Fed is not achieving its 2% inflation target. Thus, the probability of another rate hike in December has now fallen below 50%, and the OIS curve only anticipates one interest rate hike per year for the next two years. We can add color by looking at specific contracts. At the end of 2016, the December 2019 Eurodollar futures sported a nearly 2.6% implied rate. Today, the same contract trades below 2%. This seems too complacent. For one, U.S. financial conditions have massively eased in response to the collapse in the dollar and the rally in risk assets. This suggests U.S. growth should perk up toward 3% for the remainder of 2017 (Chart I-2). Chart I-2Financial Conditions Will Support Growth Financial Conditions Will Support Growth Financial Conditions Will Support Growth Moreover, this is not happening in a vacuum. The official U.S. output gap is more or less closed, and our Composite Capacity Utilization Gauge - which incorporates both the traditional capacity utilization measure along with the unemployment gap - has now moved decisively into "no slack" territory. Under such circumstances, accelerating growth is likely to put heightened pressures on existing resources, raising the risk of a resumption in inflation. Also, in and of itself, this indicator has historically displayed long leads on inflation. Based on this measure, inflation should bottom during the third quarter of 2017 (Chart I-3). With the narrative that inflation is low forever well-entrenched in the market, an inflation surprise in the fall is a growing threat that would prompt a violent repricing of the Fed's path toward something closer to the "dots." This would support a rebound in the DXY. Would this rebound be playable? Our bias is to say yes. The U.S. labor market is still much tighter than the rest of the G10. The U.S. unemployment remains 2.7 percentage points below its 10-year moving average, versus 0.3 percentage points for the rest of the G10 (Chart I-4). Hence, U.S. rates have more upside relative to other advanced economies. This suggests that peak monetary divergences have yet to be seen. Moreover, from a technical perspective, it is far from clear that the dollar bull market is over. While the dollar A/D line has swooned, it has yet to break down - a pattern reminiscent of the second half of the 1990s, when the dollar bull market also experienced a long pause before powering ahead again (Chart I-5). Chart I-3The Trough In Inflation Is Coming The Trough In Inflation Is Coming The Trough In Inflation Is Coming Chart I-4The U.S.: In A Tighter Spot The U.S.: In A Tighter Spot The U.S.: In A Tighter Spot Chart I-5Too Early To Tell If The Greenback Is Dead Too Early To Tell If The Greenback Is Dead Too Early To Tell If The Greenback Is Dead Bottom Line: The euro's strength has been a reflection of generalized weakness in the USD. So far, the USD's weakness in 2017 continues to look and smell like a correction, similar to the action in the late 1990s. However, we cannot be dogmatic: the USD will remain under the thralls of inflationary dynamics in the U.S. The easing in U.S. financial conditions, along with the elevated level of resource utilization, suggests U.S. inflation will pick up this fall, which should prompt a repricing of the Fed's path by investors. The Euro Specifics When it comes to that specifics of the euro, the economic fundamentals are in favor of the dollar right now. First, it is undeniable the euro area inflation has been surprising to the upside relative to that of the U.S. However, this is principally a reflection of the lagging stimulative impact of the 25% collapse in the euro from April 2014 to March 2015. Its 12% appreciation since then points to a reversal of this dynamic (Chart I-6). Second, aggregate relative financial conditions (FCI) tell a similar story. The tightening in euro area FCI relative to the U.S. also points to a slowdown in relative growth in favor of the U.S. Most crucially though, this tightening in relative FCI also portends a change in relative inflation dynamics. As Chart I-7 illustrates, the change in relative FCI has been a reliable leading indicator of comparative inflation dynamics. At this juncture, it argues that inflation in Europe should slow down relative to the U.S. Chart I-6Inflation Surprises Will Move##br## From Europe To The U.S. Inflation Surprises Will Move From Europe To The U.S. Inflation Surprises Will Move From Europe To The U.S. Chart I-7FCIs Point To A Reversal ##br##Of Inflation Fortunes FCIs Point To A Reversal Of Inflation Fortunes FCIs Point To A Reversal Of Inflation Fortunes This makes sense. The U.S. has had trouble generating much inflation despite the U6 unemployment rate standing at 8.5% - a level at which wages and inflation accelerated in previous cycles. Meanwhile, the euro area's labor underutilization remains very high, especially outside Germany. This suggests that euro area inflation could be vulnerable to the tightening in financial conditions that has materialized in the wake of the euro's rally. In other words, the euro's strength is doing the ECB's job while the dollar's weakness is undoing some of the Fed's tightening. Third, the trading action around the release of the German Ifo survey this past Tuesday was very interesting. The Ifo came in at 116, another record reading and substantially above market expectations, yet the euro fell on the news until it was rescued by the Fed. What is fascinating is that, while the German Ifo is near record highs, the Belgian Business Confidence (BCC) survey has begun to sag (Chart I-8). Because Belgium is a logistical center deeply intertwined within European supply chains, the BCC has been an even better leading indicator of European growth trends than the Ifo. The current extreme gap between the Ifo and the BCC confirms that Europe owes a lot of its current health to Germany's boom - and indicates that the rest of the euro area is already suffering blowbacks from the euro's rally. Fourth, euro area equities have eradicated all of their gains for the year relative to U.S. equities. This is happening exactly as the euro area economic surprise index has rolled over against its U.S. counterpart (Chart I-9). This corroborates the economic risks created by the tightening of FCI in Europe versus the U.S. Fifth, the EUR/USD is trading at its greatest premium to our preferred intermediate-term fair value measure since December 2009 (Chart I-10). This measures incorporate real rate differentials at both the short end and long end of the curve, global risk aversion, and commodity prices, suggesting that the EUR/USD has dissociated from most reasonable guides.2 Chart I-8European Growth Is About Germany European Growth Is About Germany European Growth Is About Germany Chart I-9Stocks Are Sending A Dark Omen For The Euro Stocks Are Sending A Dark Omen For The Euro Stocks Are Sending A Dark Omen For The Euro Chart I-10Euro And Fair Value Euro And Fair Value Euro And Fair Value Bottom Line: European financial conditions have tightened considerably, especially relative to the U.S. This suggests European inflation will once again lag that of the U.S. Moreover, the pain of tighter FCIs is rearing its head: European stocks are once again underperforming the U.S., and the relative economic surprise index has markedly rolled over. We are thus experiencing a euro overshoot. Timing Chart I-1Skewed Positioning In EUR/USD Skewed Positioning In €/$ Skewed Positioning In €/$ These fundamental considerations do point to a weaker EUR/USD, but they provide little guidance in terms of timing the end of the euro bull run. Most metrics we follow are in fact pointing to trouble ahead. As we highlighted, euro longs are at all-time highs, while euro shorts have been massively purged. This suggests that chasing any further gains in the euro could be a high-risk proposition (Chart I-11). Additionally, the euro's fractal dimension is fully indicative of massive groupthink, and warns that both short-term and long-term investors are both positioned on the long side of the trade (Chart I-12). While the paucity of willing sellers in the market has been a key ingredient bidding up the euro, this also makes the currency vulnerable to a buying exhaustion phase as potential future buyers are already in the market, and will not be there to support it in the coming months. However, because of this very scarcity of sellers, only a few new buyers are necessary to bid up the euro further. Therefore, with the euro having broken above its 2015 high, a rally toward 1.2 could materialize in the blink of an eye. Because of this risk, we have been shorting the euro through the EUR/SEK, EUR/CAD, and EUR/NOK pairs, a strategy that has paid off. This week, for traders with greater liquidity needs, we recommend a tactical speculative short EUR/USD bet, with a tight stop at 1.182 and a target 1.12. Chart I-12Groupthink In Action Groupthink In Action Groupthink In Action Bottom Line: The euro is displaying signs of massive groupthink on the long side. Moreover, speculators are excessively long. Our preferred strategy is still to play a euro correction on its crosses, where the risk reward ratio seems more attractive. However, we are opening a tactical short EUR/USD bet this week with a tight stop. The Almighty AUD In a Special Report published four weeks ago, we positioned Australia in the middle of the pack within G10 central banks in terms of hiking sequence.3 Essentially, while Australia does not suffer from as much slack as the euro area and Switzerland, and from as much uncertainty as the U.K., or as severely entrenched inflation expectations as Japan, it still suffers from much more labor underutilization than Canada, Sweden, or New Zealand. As Chart I-13 illustrates, labor underutilization in Australia is still hovering near 20-year highs, underpinning low wage growth and policy rates. This weakness in wages is likely to continue to weigh on core inflation (Chart I-14). Chart I-13The Root Cause Of The RBA's Dovishness The Root Cause Of The RBA's Dovishness The Root Cause Of The RBA's Dovishness Chart I-14Wages Continue To Weigh On Core CPI Wages Continue To Weigh On Core CPI Wages Continue To Weigh On Core CPI Furthermore, while being deeply embedded in the Asian business cycle has helped Australia avoid a recession since 1991, this also means that Australian inflation has been greatly influenced by regional dynamics. Thus, based on recent trends, Aussie headline inflation could endure another down leg, especially as the AUD has rallied 16% since January 2016 (Chart I-15). This means that on all fronts, Australian inflationary pressures will remain muted. The recent speech by Governor Philip Lowe focusing on the flatness of the Australian Philips curve highlights that all these concerns are at the forefront of the Reserve Bank of Australia's mind. As a result, we continue to expect Australian interest rates to lag those in the U.S. As Chart I-16 illustrates, when the unemployment gap - as measured by the difference between unemployment and its 10-year moving average - is greater in Australia than in the U.S., the RBA lags the Fed. This also highlights that the AUD is at risk of a sharp correction once the broad USD rally resumes, especially as its recent strength is completely out of line with policy differentials. Chart I-15The Asian Inflation Anchor The Asian Inflation Anchor The Asian Inflation Anchor Chart I-16The Labour Market Points To A Weaker AUD The Labour Market Points To A Weaker AUD The Labour Market Points To A Weaker AUD Beyond the USD's own weakness, the rebound in the Chinese economy has been the main reason behind the Australian dollar's rally - despite the continued dovish bias of the RBA. Australian exports expressed in U.S. dollar terms have surged in response to the Chinese mini boom in late 2016/early 2017 (Chart I-17). However, this positive for the Australian economy and Australian profits is dissipating: the Chinese Keqiang index has rolled over, and Beijing is likely to continue to limit speculative excesses in Chinese real estate - a key source of demand for Australian exports. Chart I-17China's Boost Is Dissipating China's Boost Is Dissipating China's Boost Is Dissipating Moreover, the Australian dollar is trading 10% above its PPP, has moved out of line with interest rate differentials, and investors are massively long this currency; yet Australia still sports a negative international investment position of 60% of GDP. This combination makes the Aussie's strength untenable. When EM stocks break, a view espoused by our Emerging Market Strategy sister service, the AUD should prove the greatest victim within the G10 FX space. Bottom Line: Inflationary pressures in the Australian economy remain muted as labor underutilization remains plentiful. As a result, the RBA is likely to keep a dovish tone at least until the end of the year. The rebound in Chinese activity has been the key factor that has supported the AUD this year. However, the recent rollover in China's Keqiang index indicates this pillar of support to growth and profits is vanishing. The AUD will prove the greatest victim of any EM weakness or risk-off event. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Bloody Potomac", dated May 19, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled, "In Search Of A Timing Model", dated July 22, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. Dollar U.S. data was somewhat mixed recently: Continuing and initial jobless claims both came in higher than expected; New home sales also increased at a lesser-than-anticipated pace, with home prices also fairing worse than investors hoped for; However, durable goods increased by very solid 6.5%; Building permits and housing starts, however, are also growing robustly. The DXY has hit a crucial point. It has given up all of its gains since 2015 and even from mid-2016. The greenback has previously fared well at this level, and a buying opportunity should emerge when U.S. inflation picks up as positioning is skewed against the dollar. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Data in core Europe is still firm, although it is becoming increasingly mixed: Headline inflation is staying at the consensus figure of 1.3% and core inflation came in higher than expected at 1.2%; PPI is increasing at a 2.4% pace annually; The IFO survey was robust, with the current assessment, business climate and expectations all beating expectations; However, ZEW survey was weaker than expected; PMIs were also weaker across the board. The recent strength in the euro was also compounded by weakness in the U.S. The euro has failed to appreciate nearly as much against commodity currencies due to higher global growth. Given its much lofty momentum, we are reluctant to bet on more euro upside. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Japanese trade balance worsened as exports and imports grew at 9.7% and 15.5% respectively; However, the all-industry activity index declined by 0.9% in May; The Leading Economic Indicator increased by only 0.4 to 104.6; The Coincident Index, however, declined to 115.8 from 117.1; USD/JPY has been declining recently due to softer U.S. data and lower bond yields. However, we remain yen bears as the absence of inflation remains the key challenge facing the Japanese economy. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data out of the U.K. was mixed: Real retail sales expanded at a 2.9% annual pace, with the 'ex-Fuel' measure expanding at 3%; PPI managed to increase by 2.9%; However, CPI came in at 2.6%, falling short of the 2.9% expected. GBP/USD has managed to appreciate close to 10% since the beginning of the year, while depreciating around 5% against EUR in the same time period. We still believe the pound has more short-term downside against the euro, and longer-term downside against the greenback. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The economic data flow in Australia saw a somewhat softer patch this week: RBA trimmed-mean CPI increased at a 1.8% pace, in line with consensus but below the previous data point; Headline CPI, however, increased by 1.9%, which was less than expected; Both the export price index and the import price index contracted 5.7% and 0.1% quarterly. Weaker data from the U.S. is helping the AUD sustain its gains, however, external pressures from China are proving to be even more paramount to the Aussie's strength. Domestically, however, the Australian economy remained challenged by persistent underemployment. We therefore believe the RBA is unlikely to follow the Bank of Canada in 2017. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Data out of New Zealand has been mixed: Visitor Arrivals increased at a 17.3% annual pace; The trade balance improved slightly, and both exports and imports also increased; The Global Dairy Trade price index increased by 0.2%; However, CPI came in at 1.7%, disappointing consensus by 0.2%, and falling short of the previous 2.2% figure. While the NZD has strengthened against the USD, it has lagged the euro and the rest of the commodity currency complex. WHile the RBNZ is better placed than the RBA to increase rates, it will continue to lag the BoC and the Fed this year. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The Canadian economy continues to exhibit signs of strength: Wholesale sales increased at a 0.9% monthly pace in May; Manufacturing shipments increased at a 1.1% monthly pace; Foreign portfolio investment in Canadian securities also increased to USD 29.46 bn; The CAD has experienced an unbelievable couple of months, appreciating more than 9% in the process. Weak U.S. data, a hawkish BoC, and somewhat stronger oil, have all added to the CAD's gains. We believe that the BoC will stay hawkish and Saudi Arabia will remain adamant in reducing oil inventories to their 5-year average by the end of the year. While these factors will limit the CAD downside this year, it is now vulnerable to a short-term pullback. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Swiss data has been mixed: Trade balance disappointed at 2,813 mn; UBS Consumption Indicator improved to 1.38 from 1.32; However, the ZEW Survey's Expectations increased to 34.7 from 20.7. EUR/CHF has appreciated more than 2% this past week, while USD/CHF has also been strong. This weakness is welcomed by the SNB, but more softness is needed before durable inflation trend can emerge in the Alpine Confederation. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Norway's recent labor force survey showed that the unemployment rate fell to 4.3%, better than the consensus 4.5%. Along with rebounding oil prices, this has been a key source of support for the NOK. BCA Energy Strategists continue to believe that oil inventories will be reduced to their 5-year average by the end of the year, which should warrant a healthy degree of downside for EUR/NOK. Against the dollar, the picture will become less positive once U.S. inflation picks up again. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 This week's data in Sweden has been somewhat weak: PPI increased at a 4.8% annual pace, less than the previous 7.2%; Consumer confidence decreased to 102.2, below the expected 103.1, and less than the previous 102.6; Unemployment rate increased to 7.4% from 7.2; However, the trade balance increased by 4.2 bn from the previous month. These explain the recent softness in the krona in recent days, however, we doubt that this represents the end of the period of weakness in EUR/SEK. The SEK's appreciation has been the result of an aggregate strengthening in Swedish data, especially on the inflation front, which has prompted a hawkish switch in the Riksbank's rhetoric. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

The performance of European stocks relative to the U.S. has been dismal in the post-Lehman period. However, the Eurozone economy is performing impressively, profit growth is accelerating and margins are rising. This points to a period of outperformance for Eurozone stocks, at least in local currency terms. Standard valuation measures based on index data suggest that Eurozone stocks are cheap to the U.S. Nonetheless, the European market almost always trades at a discount, due to persistent lackluster profit performance. In Part II of our series on valuation, we approach the issue from a bottom-up perspective, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The ETS software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction. Investors can be confident that they will make money on a 12-month horizon by taking a position when the new bottom-up indicator reaches +/-1 standard deviations over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of fundamental or technical factors. Valuation alone does not justify overweight Eurozone positions at the moment, although we like the market for other reasons. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. Total returns in the European equity market have bounced relative to the U.S. since 2016 in both local-currency and common currency terms (Chart II-1). However, this has offset only a tiny fraction of the dismal underperformance since 2007. In local currencies, the relative EMU/U.S. total return index is still close to its lowest level since the late 1970s. Compared with the pre-Lehman peak, the U.S. total return index is more than 96% higher according to Datastream data, while the Eurozone total return index is only now getting back to the previous high-water mark when expressed in U.S. dollars (Chart II-2). Chart II-1EMU Stocks Lag Massively... EMU Stocks Lag Massively... EMU Stocks Lag Massively... Chart II-2...Due To Depressed Earnings ...Due To Depressed Earnings ...Due To Depressed Earnings The yawning return gap between the two equity markets was almost entirely due to earnings as market multiples have moved largely in sync. Earnings-per-share (EPS) generated by U.S. companies now exceed the pre-Lehman peak by about 19%. In contrast, earnings produced by their Eurozone peers are a whopping 48% below their peak (common currency). This reflects both a slower recovery in sales-per-share growth and lower profit margins. Operating margins in Europe have been on the upswing for a year, but are still depressed by pre-Lehman standards. Margin outperformance in the U.S. is not a sector weighting story; in only 2 of 10 sectors do European operating margins exceed the U.S. The return-on-equity data tell a similar story. Nonetheless, a turning point may be at hand. Chart II-3Europe Trades At A Discount Europe Trades At A Discount Europe Trades At A Discount The Eurozone economy has been performing well, especially on a per-capita basis, and forward-looking indicators suggest that growth will remain above-trend for at least the next few quarters. U.S. profit margins have also been (temporarily) rising, but the Eurozone economy has more room to grow because there is still slack in the labor market. There is also more room for margins to rise in the Eurozone corporate sector than is the case in the U.S., where the profit cycle is further advanced. Traditional measures of value based on the MSCI indexes suggest that European stocks are on the cheap side. But are they really that cheap? Based on index data, Eurozone stocks trade at a hefty discount across most of the main valuation measures (Chart II-3). This is the case even for normalized measures such as price-to-book (P/B). However, Eurozone stocks have almost always traded at a discount. There are many possible explanations as to why there is a persistent valuation gap between these two markets, including differences in accounting standards, discount rates and sector weights. The wider use of stock buybacks in the U.S. also favors American stock valuations relative to Europe. But most important are historical differences in underlying corporate fundamentals. U.S. companies on the whole were significantly more profitable even before the Great Financial Crisis (Chart II-3). U.S. companies also tend to have lower leverage and higher interest coverage. Better profitability metrics in the U.S. are not solely an artifact of sector weighting either. RoE and operating margins are lower in Europe even applying U.S. sector weights to the European market.1 Why corporate Europe has been a perennial profit under-achiever is beyond the scope of this paper. U.S. companies reaped most of the benefit from productivity gains over the past 25 years, with the result that the capital share of income soared while the labor share collapsed. European companies were less successful in squeezing down labor costs. Measuring Value In the first part of our two-part Special Report on valuation, published in July 2016, we took a top-down approach to determine whether Eurozone stocks are cheap versus the U.S. after adjusting for different sector weights and persistent differences in the underlying profit fundamentals. A regression approach that factored in various profitability measures performed reasonably well, but the top-down "mechanical" approach that relied on a 5-year moving average provided the most profitable buy/sell signals historically. We approach the issue from a bottom-up perspective in Part II of our series, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction when trying to gauge valuation across countries. The web-based platform uses over 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries, allowing clients to find stocks with winning characteristics at the global level. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top-decile of stocks ranked using the "BCA Score" methodology have outperformed stocks in the bottom decile by over 25% a year.2 The BCA Score includes all 24 factors when ranking stocks, but we are interested in developing a valuation metric that provides valued added on its own and is at least as good as the top-down index-based measure developed in Part I. The five valuation measures in the ETS database are trailing P/E, forward P/E, price-to-book, price-to-sales and price-to-cash flow. We combine all of the Eurozone and U.S. companies that have total assets of greater than $1 billion into one dataset. The ETS platform then ranks the stocks from best to worst on a daily basis (i.e. cheapest to most expensive), using an equally-weighted average of the five valuation measures. The average score for U.S. stocks is subtracted from the average score for European stocks, and then divided by the standard deviation of the series. This provides a valuation metric that fluctuates roughly between +/- 2 standard deviations. Chart II-4 presents the resulting bottom-up indicator, along with our previously-published top-down valuation measure. A high reading indicates that European stocks are cheap to the U.S., while it is the opposite for low readings. Chart II-4Eurozone Equity Relative Valuation Indicators Eurozone Equity Relative Valuation Indicators Eurozone Equity Relative Valuation Indicators The underlying bottom-up data extend back to 2000. However, the bursting of the tech bubble in the early 2000's causes major shifts in relative valuation among sectors and between the U.S. and Eurozone that skew the indicator when constructed using the entire data set. We obtain a cleaner indicator when using only the data from 2005. As with any valuation indicator, it is only useful when it reaches extremes. We calculated the historical track record for a trading rule that is based on critical levels of over- and under-valuation. For example, we calculated the (local currency) excess returns over 3, 6, 12 and 24-month horizon generated by (1) overweighting European stocks when that market was one and two standard deviations cheap versus the U.S. market, and (2) overweighting the U.S. when the European market was one and two standard deviations expensive (Table II-1). Table II-1Value Indicator: Trading Rule Returns And Batting Average August 2017 August 2017 The trading rule returns were best when the indicator reached two standard deviations cheap or expensive, providing average returns of almost 11 percent over 12 months. The trading rule returns when the indicator reached +/-1 standard deviation were not as good, but still more than 3% on 12- and 24-month horizons. Table II-1 also presents the trading rule's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. The batting average ranged from 50% on a 3-month horizon to 68% over 24 months when buy/sell signals are triggered at +/- 1 standard deviation. The batting average is much higher (80-100%) using +/- 2 standard deviations as a trigger point, although there were only five months over the entire sample when the indicator reached this level. The charts and tables in the Appendix present the results of the same analysis at the sector level. The results are equally as good as the aggregate valuation indicator, with a couple of exceptions. European stocks are cheap to the U.S. in the Energy, Financials, and Utilities sectors, while U.S. stocks offer better value in Consumer Discretionary, Consumer Staples, Health Care, Industrials and Technology. Materials, Real Estate, and Telecommunications are close to equally valued. Sharpening The Buy/Sell Signals We then augmented the valuation analysis by adding information on company fundamentals, such as EPS growth and profit margins among others. The ETS software ranked the companies after equally-weighting the valuation and fundamental factors. However, this approach yielded poor results in terms of the trading rule. This is because, for example, when European stocks reach undervalued levels relative to the U.S., it is usually because the European earnings fundamentals have underperformed those of the U.S. companies. Thus, favorable value is offset by poor fundamentals, muddying the message provided by valuation alone. In contrast, adding some information from the technical factors in the ETS model does add value, at least when using +/-1 standard deviations as the trigger point for trades (Chart II-5). Excess returns to the trading rule rise significantly when the medium-term momentum and long-term mean reversion factors are included in the valuation indicator (Table II-2). The batting average also improves. Chart II-5Indicators: Value And Value With Technical Information Indicators: Value And Value With Technical Information Indicators: Value And Value With Technical Information Table II-2Value And Technical Indicator: Trading Rule Returns And Batting Average August 2017 August 2017 Adding technical information does not improve the trading rule performance when +/-2 sigma is used as the trigger point. Investment Conclusions Our new ETS platform provides investors with a unique way of picking stocks by combining top-down macro themes with company-specific information. It also allows us to develop valuation tools that avoid some of the pitfalls of index data by comparing stocks on a head-to-head basis. Historical analysis using a trading rule demonstrates that the new bottom-up valuation indicator provides real value to investors. We would normally evaluate its track record using stretching analysis, where we use only the historical information available at each point in time when determining relative value. However, the relatively short history of the available data precludes this test because we need at least a few cycles to best gauge the underlying volatility in the data. Still, investors can be fairly confident that they will make money on a 12-month horizon by taking a position when the bottom-up indicator reaches +/-1 sigma over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of the fundamental or technical factors. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. At the moment, the top-down version proposes that European stocks are somewhat cheap to the U.S., while the bottom-up indicator points to slight overvaluation. Considering the two together suggests that valuation is close enough to fair value that investors cannot make the decision on value alone. Valuation indicators need to be near extremes to be informative. Our global equity strategists recommend overweighting Eurozone stocks versus the U.S. at the moment, although not because of valuation. Rather, the Eurozone economy and corporate earnings have more room to grow because of lingering labor market slack. This also means that the ECB can keep rates glued to the zero bound for at least the next 18 months while the Fed hikes, which will place upward pressure on the dollar and downward pressure on the euro. Mark McClellan Senior Vice President The Bank Credit Analyst Appendix: Trading Rule Returns By Sector Chart II-6, Chart II-7, Chart II-8, Chart II-9, Chart II-10, Chart II-11, Chart II-12, Chart II-13, Chart II-14, Chart II-15, Chart II-16. Chart II-6Consumer Discretionary Consumer Discretionary Consumer Discretionary Chart II-7Consumer Staples Consumer Staples Consumer Staples Chart II-8Energy Energy Energy Chart II-9Financials Financials Financials Chart II-10Health Care Health Care Health Care Chart II-11Industrials Industrials Industrials Chart II-12Materials Materials Materials Chart II-13Real Estate Real Estate Real Estate Chart II-14Utilities Utilities Utilities Chart II-15Technology Technology Technology Chart II-16Telecommunication Telecommunication Telecommunication 1 Please see The Bank Credit Analyst Special Report, "Are Eurozone Stocks Really That Cheap?" July 2016, available at bca.bcaresearch.com. 2 Please see Equity Trading Strategy Special Report, "Introducing ETS: A Top Down Approach to Bottom-Up Stock Picking," December 2, 2015, available at ets.bcaresearch.com.