Europe

Highlights Lesson 1: Don't fear the end of the debt super cycle. Lesson 2: The ECB will ultimately target the long-term bond yield. Lesson 3: Financials will structurally underperform. Lesson 4: Personal Products (Beauty) will structurally outperform. Feature Striking similarities exist between the post debt super cycle economies in the euro area and Japan. Feature ChartPersonal Products Will Outperform Structurally... Financials Will Not bca.eis_sr_2016_11_03_s1_c1 bca.eis_sr_2016_11_03_s1_c1 In many regards, the euro area looks remarkably like Japan with a 17 year lag. Line up the 2007 peak in the euro area credit boom with the 1990 peak in the Japan credit boom - and the subsequent evolutions of many economic and financial metrics also line up almost perfectly: for example, the policy interest rate; the 10-year bond yield; inflation; and nominal GDP (Chart I-2, Chart I-3, Chart I-4, Chart I-5). Chart 2Striking Similarities Between The Euro Area... bca.eis_sr_2016_11_03_s1_c2 bca.eis_sr_2016_11_03_s1_c2 Chart 3...And Japan, Advanced By 17 Years ...And Japan, Advanced By 17 Years ...And Japan, Advanced By 17 Years Chart I-4Striking Similarities Between The Euro Area... Striking Similarities Between The Euro Area... Striking Similarities Between The Euro Area... Chart I-5...And Japan, Advanced By 17 Years bca.eis_sr_2016_11_03_s1_c5 bca.eis_sr_2016_11_03_s1_c5 This is very useful because if the euro area continues in Japan's footsteps, Japan's experience can teach us several important lessons about the euro area economy and financial markets out to the year 2034. Lesson 1: Don't Fear The End Of The Debt Super Cycle Does the euro area economy have "lost decades" ahead of it? Not exactly. Japan's so-called lost decades describe its stagnant nominal GDP since the mid-1990s. But this emphasis on nominal income is misleading (Chart I-6). The average citizen's standard of living does not depend on nominal GDP or even on real GDP. What truly matters is real GDP per head combined with the absence of extreme income inequality. Real incomes must grow and the growth must be reasonably distributed across society. On both counts, the euro area can be encouraged by Japan's experience. Since the late 1990s, Japan's real GDP per head has averaged close to 1% growth a year, broadly in line with the expected real productivity growth in a developed economy. This is exactly the real growth rate to be expected when there is no artificial and unsustainable tailwind from credit expansion. It is an economy's natural state of growth when the debt super cycle comes to an end, as it did in Japan more than 20 years ago.1 And it is good growth because it comes entirely from productivity improvements. Mankind's persistent ability to learn, experiment, and innovate produces more and/or better output from a fixed set of inputs. Furthermore, unlike other major economies, income inequality in Japan has not increased through the past 20 years and remains amongst the lowest in the developed world (Chart I-7). Again, this is not surprising. It is credit expansions that inflate bubbles in financial assets and exacerbate income and wealth inequalities. Therefore, unlike bad growth fuelled by credit booms, real growth that comes from productivity improvements is sustainable and unpolarising. The first lesson from Japan is that the euro area can expect structural growth in real GDP per head of around 1% a year. Chart I-6What ##br##"Lost Decades"? bca.eis_sr_2016_11_03_s1_c6 bca.eis_sr_2016_11_03_s1_c6 Chart I-7Income Inequality In Japan ##br##Has Not Increased bca.eis_sr_2016_11_03_s1_c7 bca.eis_sr_2016_11_03_s1_c7 Lesson 2: The ECB Will Ultimately Target The Long-Term Bond Yield One objection to Lesson 1 is that in a highly indebted economy, nominal GDP growth does matter. As debt is a nominal amount, it is nominal incomes that determine the ability to service and repay the high level of debt. So given a free choice, policymakers would prefer to have inflation at 2% or 4% rather than at -1%; and nominal GDP growth at 3% or 5% rather than zero. Unfortunately, policymakers do not have this free choice. Contrary to what central bankers promise, inflation and nominal GDP growth cannot be dialled up or down at will to hit a point-target. As we explained in The Case Against Helicopters,2 inflation is a notoriously non-linear phenomenon which is extremely difficult, if not impossible, to control. As a reminder, look at the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. The big problem is that both the broad money supply M and its velocity V - whose product determines nominal GDP - are highly non-linear. M is non-linear because the commercial banking system money multiplier - the ratio of loans to reserves - is non-linear (Chart I-8). At a tipping point of inflation, the onus suddenly flips from lending as little as possible to lending as much as possible. Chart I-8The Money Multiplier Is Non-Linear bca.eis_sr_2016_11_03_s1_c8 bca.eis_sr_2016_11_03_s1_c8 Admittedly, the central bank (in cahoots with the government) could by-pass the commercial banking system to control the money supply M directly. But it can do nothing to change the extreme non-linearity of the other driver of nominal GDP, the velocity of money V. Again, at a tipping point of inflation, the onus suddenly flips to spending money - both newly created and pre-existing balances - as fast as possible. At which point, nominal GDP growth and inflation suddenly and uncontrollably phase-shift from ice to fire with little in between. Therefore in the highly indebted euro area economy with near-zero inflation, the prudent course of action is not to risk uncontrolled inflation with so-called "helicopter money". Instead, the second lesson from Japan is to expect the ECB ultimately to emulate the BoJ and target the long-term bond yield. But which bond yield? Most likely, it would be the euro area synthetic 10-year yield, which the ECB already calculates and publishes, or a close proxy. In combination with the ECB's (as yet unused) OMT program - whose mere presence limits individual sovereign yield spreads - expect euro area government bond yields to remain structurally well anchored. Lesson 3: Financials Will Structurally Underperform Japanese financial sector profits today stand at less than half their level in 1990. For euro area financial sector profits, the concerning thing is that their evolution is tracking the Japanese experience with a 17 year lag. If euro area financial profits continue to follow in Japan's footsteps, expect no sustained growth over the next 17 years (Chart I-9). Chart I-9Euro Area Financial Profits May Experience No Sustained Growth bca.eis_sr_2016_11_03_s1_c9 bca.eis_sr_2016_11_03_s1_c9 In a post debt super cycle world, banks lose the lifeblood of their business: credit creation. And this becomes a multi-decade headwind to financial sector profit growth and share price performance. Euro area financials face two other headwinds similar to those in post debt super cycle Japan. As explained in Lesson 2, high indebtedness makes the economy hyper-sensitive to rising bond yields. The upshot is that the interest rate term-structure, which drives banks' net lending margins, cannot sustainably steepen. Also, just like Japan's 'zombie' banks, many European banks will take a long time to fully recognise the extent of their non-performing loans. The consequent squeeze on new lending combined with a requirement for additional capital further weighs down banks' return on equity. So the third lesson from Japan is that euro area financials is not a sector to buy and hold for the long term. Rather, it is a sector to play for periodic strong countertrend rallies. Now is not the time for such a play. Lesson 4: Personal Products (Beauty) Will Structurally Outperform Over the past 20 years, Japan's nominal GDP has gone sideways. But over this same period, the sales of skin cosmetics and beauty products have almost tripled (Chart I-10). This has helped the personal products sector to outperform very strongly. While Japanese financial profits have halved since 1990, Japanese personal products profits have quintupled (Feature Chart). Once again, the useful thing is that euro area personal product profits are uncannily tracking the Japanese experience with a 17 year lag. If euro area personal product profits continue to follow in Japan's footsteps, expect them to almost triple over the next 17 years (Chart I-11). Chart I-10Beauty Sales Have Boomed In Japan bca.eis_sr_2016_11_03_s1_c10 bca.eis_sr_2016_11_03_s1_c10 Chart I-11Euro Area Personal Products Profits Might Triple bca.eis_sr_2016_11_03_s1_c11 bca.eis_sr_2016_11_03_s1_c11 The very strong growth in beauty sales and profits in Japan is an extended example of the phenomenon known as the lipstick effect. Our Special Report Buy Beauty: The Lipstick Effect Stays Put3 provides the detail. But in a nutshell, the demand for beauty products and cosmetics - epitomised by lipstick - experiences a surge when the economic environment feels harsh. For many people, the post debt super cycle world of 1% real income growth with high indebtedness and no more bingeing on credit does feel like an extended hangover - at least compared to the spendthrift era that preceded it. Hence, it creates the ideal backdrop for an extended play of the lipstick effect, as witnessed in Japan. The fourth lesson from Japan is that euro area personal products is a sector to buy and hold for the long term. Expect profits to trend up at around 6% a year, and the sector to strongly outperform the broader market. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Admittedly, after the debt super cycle ended in Japan, government levering was needed to counter the impact of aggressive de-levering in the private sector. But in the euro area, this will not be needed to the same extent as the de-levering in the private sector is not as aggressive. 2 Please see the European Investment Strategy Weekly Report 'The Case Against Helicopters' published on May 5, 2016, available at eis.bcaresearch.com 3 Please see the European Investment Strategy Special Report 'Buy Beauty: The Lipstick Effect Stays Put' published on April 14, 2016, available at eis.bcaresearch.com Fractal Trading Model This week's recommended trade is to go short French banks versus the CAC40. 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. * 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 bca.eis_sr_2016_11_03_s2_c1 bca.eis_sr_2016_11_03_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_sr_2016_11_03_s2_c2 bca.eis_sr_2016_11_03_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_sr_2016_11_03_s2_c3 bca.eis_sr_2016_11_03_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_sr_2016_11_03_s2_c4 bca.eis_sr_2016_11_03_s2_c4 Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations bca.eis_sr_2016_11_03_s2_c5 bca.eis_sr_2016_11_03_s2_c5 Chart II-6Indicators To Watch - Interest Rate Expectations bca.eis_sr_2016_11_03_s2_c6 bca.eis_sr_2016_11_03_s2_c6 Chart II-7Indicators To Watch - Interest Rate Expectations bca.eis_sr_2016_11_03_s2_c7 bca.eis_sr_2016_11_03_s2_c7 Chart II-8Indicators To Watch - Interest Rate Expectations bca.eis_sr_2016_11_03_s2_c8 bca.eis_sr_2016_11_03_s2_c8

Highlights U.S. Corporates: U.S. corporate debt, both Investment Grade and High-Yield, is fully priced for an improvement in economic growth and profits. Tight valuations offer no yield cushion before the expected December Fed rate hike. Maintain a defensive up-in-quality stance on U.S. corporates, favoring Investment Grade over junk. Euro Area Corporates: Euro Area corporate bonds are not as expensive as U.S. equivalents, but are by no means cheap. The likely extension of the ECB QE program until at least the latter half of 2017 will help keep valuations at rich levels, especially for Investment Grade issuers where the ECB is directly buying bonds. Stay defensive in Euro Area corporates, favoring Investment Grade over High-Yield. Feature Better Global Growth Not Necessarily Better For Corporate Bonds Back in July of this year, BCA put its flag in the ground and called an end to the 35-year global bond bull market after government bond yields hit historic lows following the shocking U.K. Brexit vote.1 Yields have steadily crept up since we made that declaration, due to a combination of changing cyclical factors (improving global growth, modest increases in inflation), some signs of diminished political concerns (no immediate global spillovers from a more drawn-out Brexit process, the fall in the odds of victory of the "anti-status-quo" candidate in the U.S. presidential election, Donald Trump) and structural factors (worries about less accommodative monetary policies, a political shift towards greater deficit-financed government spending). While government bond yields have been rising from depressed levels, corporate bond returns on either side of the Atlantic Ocean have at the same time lost considerable momentum, both in absolute terms and relative to sovereign debt (Chart of the Week). This is a bit of a surprise given the recent improvement in global growth data that is now appearing in a broadening number of countries (Chart 2), which would suggest a potential brighter outlook for corporate earnings. However, credit valuations and the liquidity backdrop matter, and a potential cyclical improvement in profits may not benefit corporate bond performance at a time of tight spreads and greater uncertainty about future central bank policies. Chart of the WeekIs The Party Ending For Corporate Bonds? bca.gfis_wr_2016_11_01_c1 bca.gfis_wr_2016_11_01_c1 Chart 2A Broadening Pickup In Global Growth A Broadening Pickup In Global Growth A Broadening Pickup In Global Growth With credit spreads currently priced for a near-perfect backdrop of low volatility and highly accommodative central banks, we continue to recommend an overall defensive posture in "Trans-Atlantic" corporate bonds, favoring Investment Grade (IG) over High-Yield (HY) in both the U.S. and Euro Area. Chart 3U.S. Corps Are Now ONLY A 'Tina' Trade U.S. Corps Are Now ONLY A 'Tina' Trade U.S. Corps Are Now ONLY A 'Tina' Trade U.S. Corporates: Stretched Valuations, Especially For Junk Bonds U.S. corporate bonds have been one of the biggest beneficiaries of the so-called "TINA" (There Is No Alternative) trade, where investors have been forced into riskier assets out of low-yielding government bonds. The return performance for both investment grade (IG) and high-yield (HY) debt has been outstanding, with the former up 8.2% year-to-date and the latter up +15.9%. The fundamental backdrop for corporate debt, however, has shown few signs of any improvement that would justify such strong returns, according to our U.S. Corporate Bond Checklist (Chart 3): 1.Corporate balance sheets are deteriorating: Our U.S. Corporate Health Monitor (CHM), an amalgamation of various bottom-up credit metrics applied to top-down corporate profit data, continues to signal that balance sheets are worsening. This trend has been ongoing for more than two years and shows no signs of slowing, with companies continuing to ramp up leverage to record highs at a time of increasing downward pressure on profit margins. 2.Bank lending standards are slowly tightening: The U.S. Federal Reserve's Senior Bank Loan Officer Survey has begun to flash that a greater number of U.S. banks are tightening lending standards on commercial & industrial loans. The net number is still low within the history of this series, and is largely the result of tightening standards on domestic energy companies suffering from the lower oil prices of the past two years. Nonetheless, the highly cyclical nature of lending standards suggests that a move back to easier standards may not happen at this advanced stage of the multi-year credit cycle. 3.Monetary conditions are tighter, but remain stimulative: Our U.S. Monetary Conditions Index (MCI), which is a weighted combination of short-term interest rates and the U.S. dollar, remains at an accommodative level, even after the 18% rise in the trade-weighted dollar since the trough in 2014 and the Fed's lone rate hike last year.2 Interest rates are far more important in our MCI calculation than the dollar (by a 10/1 ratio), however, so it would take an exceptionally large move in the dollar to push the MCI to restrictive territory after just a single 25bp rate hike. Yet with the Fed clearly in a slow hiking cycle that could deliver at least another 75bps of rate hikes by the end of 2017, the MCI will continue in a tightening direction that has historically been correlated with wider corporate bond spreads. With only an easy money backdrop supportive of narrower credit spreads, there is a growing risk that U.S. corporates could respond poorly to a December Fed rate hike that we expect - especially if that also coincides with renewed strength in the U.S. dollar. Already, the Fed's trade-weighted dollar index has risen by 3.2% during the recent Treasury market selloff, as the market-determined probability of a December hike has risen to 66%. This remains below the peaks seen in the run-up to the rate hike at the end of 2015, which coincided with a big widening of corporate credit spreads (Chart 4). One major difference from a year ago is that the Fed is not signaling the same degree of monetary tightening after the next hike. The FOMC median interest rate projections (the "dots") were indicating another 100bps of hikes following the December 2015 rate increase, and are now only signaling another 50bps of hikes after the Fed's expected next move in December. This is keeping both the 2-year Treasury yield and the dollar well below the peaks seen at the end of last year, helping prevent a breakout in market volatility and credit spreads. So if there is a fresh spike in volatility and/or the dollar, it would be striking the corporate credit markets at a time when valuations look stretched. We can see that in a number of indicators. U.S. corporate bond excess returns have far exceeded the levels suggested by domestic capacity utilization, which are relevant for corporates given their long-standing correlation to profit margins (Chart 5). Our colleagues at our sister publication, U.S. Bond Strategy, have calculated that a 0.4% improvement in capacity utilization has historically coincided with a 100bps tightening in HY bond spreads over a 1-year period; thus, utilization would have to rise to 77.2% by next February (a level last seen in March 2015 when the annual growth rate of Industrial Production was 2.5 percentage points faster than the current pace) to justify HY spreads at current levels.3 In other words, junk bonds are already priced for a significant recovery in U.S. economic growth and corporate profits. Chart 4U.S. Corps Not Responding To A Rising USD...Yet bca.gfis_wr_2016_11_01_c4 bca.gfis_wr_2016_11_01_c4 Chart 5Ignoring The Signal From Capacity Utilization bca.gfis_wr_2016_11_01_c5 bca.gfis_wr_2016_11_01_c5 U.S. corporate bond excess returns over duration-matched Treasuries during the past twelve months have been strongly positive: +316bps for IG and +844bps for HY. Our past work analyzing U.S. credit cycles has shown that such a positive return performance usually occurs during the deleveraging stage of the corporate credit cycle, typically during recessions when profits are falling and growth in company debt stalls or even contracts (Charts 6 & 7). Chart 6Investment Grade Corporate Annual Excess Return* Corporate Bond Update: Slim Pickings For Value Investors Corporate Bond Update: Slim Pickings For Value Investors Chart 7High-Yield Annual Excess Return* Corporate Bond Update: Slim Pickings For Value Investors Corporate Bond Update: Slim Pickings For Value Investors Chart 8Spreads Ignoring The Usual Credit Cycle Spreads Ignoring The Usual Credit Cycle Spreads Ignoring The Usual Credit Cycle The current environment is one of declining corporate profits but with debt growth still expanding, similar to the credit spread widening backdrop around the 2000 and 2008 U.S. recessions (Chart 8). This sends a similar message to the relationship of credit returns with capacity utilization, with corporate bonds now priced for a strong rebound in profit growth that may be difficult to achieve over the next year. A similar situation exists in the equity market, where the consensus bottom-up expectation is for overall profit growth to surge to +13% in 2017 and +11% in 2018.4 That would represent a sharp rebound from the profit declines witnessed in 2015 and the first half of 2016. Chart 9A Stretched Rally In U.S. Junk A Stretched Rally In U.S. Junk A Stretched Rally In U.S. Junk Some may argue that such a significant rebound in overall corporate earnings could happen just from the impact of better outlook for profits in the Energy sector given the recent recovery in oil prices. However, it appears that U.S. corporate bond valuations already more than fully discount a higher crude price. The 2016 rally in U.S. junk bonds has been led by the massive tightening of spreads of oil-related names, with the benchmark Bloomberg Barclays High-Yield Energy index returning 33% year-to-date as spreads have collapsed. However, the current Energy index OAS is at 550bps - levels last seen during the 2015 counter-trend rally in oil prices after the 2014 plunge (Chart 9, middle panel) That rally took the Brent crude price of oil up to $67/bbl, well above the current price hovering around $50/bbl. Our Commodity strategists continue to see $60/bbl as being the ceiling for the oil price range over the next year, as prices above that would begin to draw supply back into the market from U.S. shale companies and other global oil producers with higher break-even prices. Thus, U.S. HY energy debt already discounts an oil price that is unlikely to be achieved in the medium-term. A similar situation exists when looking at non-Energy junk spreads, which are highly correlated with macro volatility measures like the VIX index and which already fully reflect the current low volatility backdrop (Chart 9, bottom panel). We are concerned about a pick-up in volatility in the near-term from either a political surprise like a Trump victory on November 8 or, more likely, market jitters when the Fed delivers on a rate hike in December. With our fundamental VIX model, which is based off the lagged impact of rising corporate leverage and tightening monetary conditions, continuing to signal that the fair value level of the VIX is around 20, credit markets are not prepared for a potential rise in volatility in the next few months. Challenging Valuations At All Levels When we look at our various valuation gauges for U.S. corporate debt, it is difficult to find many areas where credit looks cheap. With regards to IG debt, our preferred measure of valuation is the 6-month breakeven spread, which shows how much spreads would need to widen to full offset the carry advantage of owning IG debt over duration-matched U.S. Treasuries, assuming spread volatility is maintained at recent levels. That breakeven spread now sits at a mere 9bps (Chart 10, top panel), well below the long-run mean. In other words, IG excess returns can easily turn negative with only a modest widening of spreads. For HY debt, our preferred valuation metric is the default-adjusted spread, where we subtract expected default losses estimated by our default rate and recovery rate models from the current junk spread. That adjusted spread is now only 69bps - a level more than one standard deviation below the long-run mean that we consider to be overvalued (bottom panel). With spreads at such depressed levels relative to expected default losses, the historical probability of junk delivering positive excess returns over the next year is extremely low. We see a similar stretched valuation backdrop when looking at credit spreads among sectors and ratings cohorts. Within the IG universe, the OAS for Financials, Industrials and Utilities have fully converged (Chart 11, top panel), while credit spread curves are near the tranquil 2005-2007 period of historically low volatility that we do not expect to be repeated (bottom panel). Within sectors, our U.S. IG relative value model only sees attractive spreads in the debt of Banks, Energy, Metals & Mining, Building Materials, Technology and Airlines. Chart 10Expensive Valuations, Especially For Junk Expensive Valuations, Especially For Junk Expensive Valuations, Especially For Junk Chart 11Not Much Difference To Choose From Here bca.gfis_wr_2016_11_01_c11 bca.gfis_wr_2016_11_01_c11 Bottom Line: U.S. corporate debt, both Investment Grade and High-Yield, is fully priced for an improvement in economic growth and corporate profits. Tight valuations offer no yield cushion before the expected December Fed rate hike. Maintain a defensive up-in-quality stance on U.S. corporates, favoring Investment Grade over junk. Euro Area Corporates: ECB Buying Keeping IG Rich While Junk Fundamentals Worsen Turning towards Europe, a similar story of expensive corporate credit valuations exists, although not to the same magnitude as in the U.S. Of course, valuations may not matter for Euro Area IG with the European Central Bank (ECB) buying corporate debt as part of their quantitative easing (QE) asset purchase program. That surge in QE buying (both real and anticipated by investors) helped drive both yields and spreads for Euro Area IG sharply lower between March and June of this year. Since then, however, both yields and spreads have gone up moderately (Chart 12), reflecting both the rising global yield backdrop and the worsening situation for Euro Area banks whose debt dominates the IG market. Chart 12Euro Area Corporate Bond Rally Has Stalled bca.gfis_wr_2016_11_01_c12 bca.gfis_wr_2016_11_01_c12 Chart 13Euro Area Valuations Are Not That Cheap Euro Area Valuations Are Not That Cheap Euro Area Valuations Are Not That Cheap The rise in Euro Area corporate credit spreads comes at a time when investors have grown increasingly concerned about a potential tapering of the ECB's QE when the current program expires in March of next year. As we discussed in our previous Weekly Report, we expect the ECB to announce in December an extension of the government bond QE to at least September 2017, likely with some additional changes to the rules of the QE program to avoid hitting any self-imposed purchase limits.5 This could help keep spreads anchored near current levels, all else equal. Of course, all else is never equal, and the liquidity story can be trumped by expensive valuations, as we currently see in U.S. junk bonds. Using the same metrics for U.S. IG and HY credit spreads that we presented earlier shows that both the breakeven spread for Euro Area IG, and the default-adjusted spread for Euro Area HY, are below the long-run mean (Chart 13). Euro Area junk valuations are not as stretched as U.S. junk valuations on this basis, but they are hardly cheap. A similar story exists when looking at Euro Area IG corporates grouped by credit rating, with spread curves looking as flat as the U.S. curves shown earlier (Chart 14). Our Euro Area IG sector relative value model (Table 1 on Page 11) is also showing a handful of sectors with comparatively cheap spreads, ranging from commodity-focused industries (Energy, Metals & Mining) to financial groups (Insurers, Banks). However, the "cheapness" in the latter likely represents some degree of risk premium on Euro Area banks, whose poor profitability and capital adequacy issues are now well known to investors. Euro Area bank spreads may stay cheaper for longer until those problems begin to be addressed. Chart 14Euro Area Credit Spread Curves Are Flat Euro Area Credit Spread Curves Are Flat Euro Area Credit Spread Curves Are Flat Table 1Euro Area Investment Grade Corporate Sector Spread Valuations Corporate Bond Update: Slim Pickings For Value Investors Corporate Bond Update: Slim Pickings For Value Investors One final note on the relative value between Euro Area and U.S. corporates: the bottom-up Corporate Health Monitors for both regions that we introduced earlier this year continue to show gaps favoring Euro Area IG over U.S. equivalents (Chart 15), and U.S. HY over Euro Area equivalents (Chart 16). The relative balance sheet trends are showing up in the relative investment performance across the Atlantic, with Euro Area IG starting to outperform U.S. IG, and Euro Area HY lagging the returns in U.S. HY. We continue to recommend allocations based on these relative valuation trends, keeping the lightest weighting on Euro Area junk bonds that score poorly on all relative balance sheet metrics. Chart 15Favor Euro Area IG Over U.S. IG bca.gfis_wr_2016_11_01_c15 bca.gfis_wr_2016_11_01_c15 Chart 16Euro Area Junk Is Unattractive Vs. The U.S. bca.gfis_wr_2016_11_01_c16 bca.gfis_wr_2016_11_01_c16 Bottom Line: Euro Area corporate bonds are not as expensive as U.S. equivalents, but are by no means cheap. The likely extension of the ECB QE program until at least the latter half of 2017 will help keep valuations at rich levels, especially for Investment Grade issuers where the ECB is directly buying bonds. Stay up in quality in Euro Area corporates, favoring Investment Grade over High-Yield. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Weekly Report, "A Note On The Long-Term Outlook For Global Bonds", dated July 27, 2016, available at gfis.bcaresearch.com and usbs.bcaresearch.com 2 A neutral reading of the MCI is the zero line is consistent with a U.S. economy without any output gap, growing at its potential rate, and with unemployment at full employment levels. 3 Please see BCA U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated Nov 1, 2016, available at usbs.bcaresearch.com 4 Source: Thomson Reuters I/B/E/S 5 Please see BCA Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated Oct 25, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Corporate Bond Update: Slim Pickings For Value Investors Corporate Bond Update: Slim Pickings For Value Investors Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Central Banks Still In The Driving Seat Markets continue to obsess about every move from the three major DM central banks. With two of them (the Fed and the ECB) likely to withdraw accommodation cautiously over the coming 12 months, the upside for risk assets is limited. The Fed is signaling that it will probably hike in December and the futures market is pricing in a 70% probability of that happening (roughly the probability one month before the rate rise in December last year). Inflation expectations have picked up recently (Chart 1) and core PCE inflation ticked up to 1.7% in August, within "hailing distance", as Fed vice-chair Stanley Fischer put it, of the Fed's 2% target. There is a political angle, too: having forecast four rate rises for the year, the Fed would endanger its credibility (and risk an audit from Congress) if it failed to deliver even one. At the same time, with growth in the Eurozone running a little above trend, the ECB is likely to announce in December an extension to its asset purchase program beyond March 2017 but eventually at a slower pace (a "tapering"). Reflecting these factors, government bond yields have moved up in recent months (Chart 2), and the trade-weighted dollar has strengthened by 4% since mid-August. None of these moves are good for risk assets, which have consequently moved sideways since August. But neither do they presage a big selloff since central banks will err on the side of caution. Inflation in the U.S. is unlikely to jump: wage growth will be kept under control by a gradual rise in the participation rate, which will prevent unemployment falling much further (Chart 3). The Fed's leaders continue to sound dovish. Janet Yellen even raised the question in a recent speech of "whether it might be possible to reverse these adverse supply-side effects [from the 2007-9 Global Financial Crisis] by temporarily running a 'high-pressure economy'", though she emphasized this was a suggestion for further economic research not her view. More practically, the FOMC will have a more dovish tilt in 2017, as the three regional Fed presidents who voted for a hike in September rotate out. Chart 1Have Inflation Expectations Bottomed? bca.gaa_mu_2016_10_31_c1 bca.gaa_mu_2016_10_31_c1 Chart 2Bond Yields Moving Higher bca.gaa_mu_2016_10_31_c2 bca.gaa_mu_2016_10_31_c2 Chart 3Core Workers Reentering The Labor Force bca.gaa_mu_2016_10_31_c3 bca.gaa_mu_2016_10_31_c3 Meanwhile, economic data remain somewhat sluggish. The U.S. manufacturing and non-manufacturing ISMs both rebounded sharply in September, suggesting that the very weak August prints were, as we suggested, an anomaly. Q3 U.S. real GDP growth come in at 2.9%, but the New York Fed's NowCast points to a slowdown to 1.4% in Q4. The Citi Economic Surprise Index (Chart 4) has also turned down again recently, with notable weakness in consumer spending and housebuilding. We expect this sluggish pace to continue through 2017: consumption should hold up as wage rises come through, but it is hard to forecast a strong recovery in capex, given the low capacity utilization rate (Chart 5), even if investment in the mining and energy sectors bottoms out next year. Eurozone growth could stutter too. It is driven substantially by credit growth, but historically European banks have tended to curtail lending after their share prices have fallen, as has been the case recently (Chart 6). Chinese growth has stabilized (at least in the GDP data, which seems to come in regularly at 6.7%, bang in the middle of the government's target range), thanks to the government's reflation policy from earlier this year. While the Chinese authorities have now reined back a little on stimulus, given their worries about the run-up in house prices,1 they offer an option since they would undoubtedly reflate again should growth slow. Chart 4Data Surprising Negatively Again bca.gaa_mu_2016_10_31_c4 bca.gaa_mu_2016_10_31_c4 Chart 5Hard To See More CAPEX Indeed bca.gaa_mu_2016_10_31_c5 bca.gaa_mu_2016_10_31_c5 Chart 6Share Prices Influence Lending bca.gaa_mu_2016_10_31_c6 bca.gaa_mu_2016_10_31_c6 All this suggests that returns from investment assets will be low, but positive, over the coming 12 months. With economic growth anemic but stable, bond yields prone to drift up, and equities expensive (but not as expensive as bonds), we expect risk-adjusted returns from the major asset classes to be broadly similar. We continue to recommend therefore a neutral weighting between bonds and equities, and suggest that investors look to pick up extra return through tilts to investment-grade corporate credit, inflation-linked over nominal bonds, and alternative assets such as real estate and private equity. Equities: Our preference remains for U.S. equities over European ones in USD terms. The dollar is likely to strengthen further, and the worst is not over for Eurozone banks - the time to buy into them will be at the point of maximum pain, which may come if German or Italian banks have to be bailed out by their governments. We continue to recommend a small (currency-hedged) overweight on Japan. The Bank of Japan's new policy to cap 10-year government bond yields at 0% has worked so far: the yen has weakened to JPY 104 to the dollar and equities have risen moderately. We expect further fiscal or wage-control measures from the government to give inflation an extra push. We remain wary of EM equities: earnings growth is negative, loan growth has started to slow (with the credit impulse having a high correlation with earnings and economic growth), and there is still little sign of structural reform. Some sectors in EM - notably IT and Healthcare - are attractive, however. Fixed Income: U.S. Treasury bond yields are likely to rise further - our model suggests fair value is a little below 2% (Chart 7) - and so we remain underweight duration. A moderate pickup in inflation suggests that TIPs will outperform nominal bonds (as described in detail in our recent Special Report).2 We lowered our recommendation in high-yield corporate debt to neutral last month because, at 65 BPs, the default-adjusted spread no longer offers sufficient return to justify the risk. At the start of the year it was 400 BPs (Chart 8). We continue to like investment-grade debt, where the spread over government bonds is 120 BPs in the U.S. and 100 BPs in the Eurozone, higher than at any point in 2005-2006 during the last expansion. Chart 7Treasury Yields Could Rise Further bca.gaa_mu_2016_10_31_c7 bca.gaa_mu_2016_10_31_c7 Chart 8Junk No Longer Offers Enough Return Junk No Longer Offers Enough Return Junk No Longer Offers Enough Return Currencies: We expect the U.S. dollar to continue to appreciate given the differential in growth and monetary conditions between the U.S. and other developed economies. The dollar looks expensive, but is nowhere near the over-bought levels it got to at the peak of previous rallies in 1985 and 2002 (Chart 9). China seems likely to allow a further weakness of the RMB against the dollar, repegging it to a trade-weighted currency basket. This could push down other emerging market currencies too particularly if, like Brazil recently, they try to cut rates to boost growth. Chart 9USD Not As Overvalued As In The Past bca.gaa_mu_2016_10_31_c9 bca.gaa_mu_2016_10_31_c9 Commodities: Oil has probably overshot in the short-term on expectations that Saudi Arabia and Russia will cap, or even cut, production. We think this talk has been overhyped and that the OPEC meeting in November could prove a disappointment. Nonetheless, we still see the equilibrium level for crude over the next two years at USD 50 a barrel, the marginal cost for U.S. shale producers. Industrial commodities are likely to fall further (they peaked in June) if we are right that the dollar appreciates. We continue to like gold as an inflation hedge, but short-term are nervous because it, too, is negatively correlated with the dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see China Investment Strategy "Housing Tightening: Now And 2010" dated October 13, 2016, available at cis.bcaresearch.com 2 Please see Global Asset Allocation Special Report "TIPS For Inflation-Linked Bonds," dated October 28, 2016, available at gaa.bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights With inflation probably having bottomed, especially in the U.S., investors are starting to worry about inflation tail-risk and wonder whether inflation-linked bonds (ILBs) are an efficient way to hedge this risk. This Special Report explains how ILBs work in different countries and analyzes their performance characteristics over time. We find that ILBs, a rapid growing asset class, can be a beneficial addition to a balanced global portfolio even though recent history does not show as strong portfolio diversification benefits as a longer history. The lower nominal duration of ILBs is a useful feature for portfolio duration management. ILBs have proven to be a good inflation hedge in a rising inflationary environment, but they underperform nominal bonds in a disinflationary environment. As such, the balance between ILBs and nominal bonds should be managed tactically based on an investor's views on inflation dynamics and valuation. Overweight U.S. TIPS; avoid U.K. linkers. Australian TIBS are a cheap yield enhancer, but higher yielding Mexican Udibonos are a dangerous yield trap. Feature BCA's view is that the 35-year bull market in bonds is ending and that the path of least resistance for bond yields globally is up.1 Even though the level of inflation in the U.S. is still below the Fed's target of 2%, we think it's clear that U.S. inflation has bottomed for this cycle. Globally, loose monetary policy together with the likelihood of more fiscal stimulus, present the risk of higher inflation down the road. Global Asset Allocation has recommended investors to overweight U.S. TIPS (Treasury Inflation Protected Securities) relative to nominal U.S. government bonds throughout 2016. Many clients have asked for details on how TIPS work, whether there are similar securities in other countries, and how ILBs fit into a balanced global portfolio. In this Special Report, we take a detailed look at inflation-linked bond markets globally and recommend some strategies for asset allocators to use them to help navigate a world of low returns and possibly higher inflation. 1. What Are Inflation-Linked bonds (ILBs)? Inflation Protection: Inflation-linked bonds are designed to hedge inflation risk by indexing the bonds' principal to the official inflation index in the issuer country. While the methodology and what the bonds are called differ from country to country, the underlying concept is the same: the holders of ILBs will get the stated real return even in an inflationary environment since both the nominal face value and the nominal coupon payments change based on an official inflation measure. Deflation Floor: In the case of sustained deflation such that the final nominal face value falls below the initial face value, however, the repayment of principal at maturity is guaranteed in the majority of the countries, but not, for example, in the U.K., Canada, Brazil, or Mexico (Table 1). Table 1Basic Information Of Global ILB Markets TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Inflation Measure: ILBs are linked to actual inflation with a time lag. As shown in Table 1, the inflation measure used varies slightly by country: in the U.S. it's the non-seasonally adjusted CPI; in the U.K. it's the retail price index (RPI); while in the euro area, France and Italy both have ILBs linked to local CPI ex tobacco and EU HICP ex tobacco, with the former primarily for domestic retail investors. The time lag is three months in most countries, but can vary from one to eight months as shown in Table 1. A Rapidly Growing Asset Class: The earliest recorded ILBs were issued by the Commonwealth of Massachusetts in 17802 during the Revolutionary War. Finland introduced indexed bonds in 1945, Israel and Iceland in 1955. Brazil introduced its indexed bonds in 1964 and has become the largest ILB market in the emerging markets and the third largest globally. When the U.K. issued its first "linkers", it originally used eight months of inflation lag to make sure the next coupon payment is known at the current coupon payment date. In 1991 Canada issued its first ILBs and the "Canadian Model", which uses a three-month lag to the inflation index and calculates a daily index ratio using linear extrapolation, has been adopted widely since; even the U.K. adopted it in 2005. The largest ILB market now is the U.S. TIPS with a market cap of USD 1.2 trillion. TIPS were first issued in 1997, using the Canadian model. Chart 1 shows the evolution of the ILB markets globally. Since the Bloomberg Barclays Universal Government Inflation-linked Bond Index was constructed in July 1997, the market cap has increased to over USD 3.2 trillion from a mere USD 145 million at the end of 1997. It's worth noting that the actual amount of ILBs outstanding globally is slightly larger than this because not all debts are included in the index.3 Even though many countries have issued ILBs, and emerging markets (EM) grew very fast in the 2000s, the global market is still dominated by the top three countries (the U.S., U.K., and Brazil) with a combined share of 70% of global market cap. Chart 1ILBs: A Fast Growing Asset Class bca.gaa_sr_2016_10_28_c1 bca.gaa_sr_2016_10_28_c1 Chart 2U.S. BEI Vs. Inflation Expectations bca.gaa_sr_2016_10_28_c2 bca.gaa_sr_2016_10_28_c2 Country Differentiation: Nominal government bonds come with different features in different countries, and the same is true with ILBs. Table 2 shows that even though the U.S. accounts for 43.6% of the developed markets (DM) index in terms of market cap, it contributes only 28.8% to overall duration while the U.K. accounts for 53% of the overall duration, because the U.K. linkers have much longer duration than the U.S. TIPS. The Canadian real return bonds (RRBs) have the second longest average duration at 16 years. Table 2Key Features of the Bloomberg Barclays Government ILB Indexes* TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds 2. How Do ILBs Compare To Nominal Bonds? Break-Even Inflation (BEI) And Inflation Expectations: The difference between the yield on a nominal bond and the yield on a comparable ILB (a comparator) is defined as the BEI, the market-based inflation rate at which an investor is indifferent between holding a real or a nominal bond. If realized inflation over an ILB's life turns out to be higher than the BEI at purchase, then holding the ILB is better than holding its nominal counterpart. BEI on its own is not an accurate gauge of inflation expectations, because it is the sum of inflation expectations, the inflation risk premium, and the liquidity premium. One of the long-term inflation expectation measures that the U.S. Fed keeps track of is the five-year forward five-year inflation calculated using the Fed's own fitted yield curves.4 Even this measure, however, contains the inflation term premium and the relative supply/demand of 10-year BEI vs 5-year BEI. Three important observations from Chart 2 for investors to pay attention to when assessing the inflation outlook are: U.S. breakeven inflation rates have been consistently below the Fed's inflation target of 2% since 2014 (panel 4); The CPI swaps markets priced in a much higher inflation rate than the TIPS market and the Fed's measure derived from fitted curves (panels 2 & 3), largely caused by the supply and demand imbalance in the inflation swaps market: there is excess demand to receive inflation, but no natural regular payer of inflation other than the U.S. Treasury via TIPS, therefore a higher fixed rate has to be paid to receive inflation; The 10-year inflation expectation from the Cleveland Fed's model5 (panel 1), exhibits very different behavior from the other measures. It has been below the 2% target since 2011. This model attempts to combine survey-based inflation expectations and that derived from the CPI swaps market. It's intended to be a "superior" measure of inflation expectations from a monetary policy perspective.6 For investors, however, it's advisable to take into account all these measures when assessing inflation dynamics. Duration and Yield Beta: Duration is measured as the bond price change in relation to the yield change. Chart 3 shows that ILBs have higher duration than their nominal counterparts. These two durations, however, are not directly comparable because ILB duration is related to "real yield" while nominal bond duration is related to "nominal yield". The conversion from one to another is not straightforward because the relationship between real and nominal yields can be complex.7 In practice, however, we can run a simple regression to get ILB's yield beta to change in nominal yield.8 Some practitioners simply assume 0.5 in the emerging market.9 Our research shows that in the developed market the relationship between real yield and nominal yield can vary over different time periods and in different countries, but the moving 3-year and 5-year yield betas are always less than 1 and mostly above 0.5, which is the full sample average.(Chart 4). This is a useful feature for duration management and curve positioning. For example, everything else being equal, 1) replacing nominal government bonds with comparable ILBs can reduce portfolio duration, and 2) replacing a short-dated nominal bond with a longer-dated ILB could maintain the same duration. Chart 3Average Government Bond Duration Average Government Bond Duration Average Government Bond Duration Chart 4ILBs' Yield Beta TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Total Return: By design, ILBs should do well in an inflationary environment and they should outperform their nominal bonds when realized inflation is higher than the break-even inflation rate. How have ILBs performed in the real world? Unfortunately, we do not have a long enough data history to cover different inflation cycles. Chart 5 confirms that in nominal terms ILBs outperform their nominal counterparts when inflation rate trends higher. What's interesting, however, is that it is disinflation, rather than deflation, that hurts ILBs the most. Within the available data history, only 2009 experienced a brief deflation scare globally, yet the rebound in ILBs actually led economies out of the deflationary environment. Over the long run, U.K. linkers have underperformed nominal gilts since their first issuance in 1981 when inflation was running at 12%. Since 1997 when the Bloomberg/Barclays ILB indexes were constructed, however, ILBs have performed slightly better than their nominal comparable bonds in most countries, with the exception of the euro area where ILBs have fared slightly worse (Chart 5). Risk-Adjusted Return: On a risk-adjusted basis, the available data history shows that ILBs performed slightly better in the U.S. and Australia, and also the DM aggregate on a hedged basis, but slightly worse in the euro area, the U.K. and Canada. It's worth emphasizing, however, that in either case the difference is not significant (Table 3). Chart 5ILB Performance Vs Inflation ILB Performance Vs Inflation ILB Performance Vs Inflation Table 3ILBs Approximately Equal To Nominal Bonds TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds 3. What's The Role Of ILBs In A Balanced Portfolio? Bridgewater Associate showed that adding ILBs to a balanced euro zone stock/bond portfolio significantly improved the efficient frontier over the very long run, from 1926 to 2010.10 Since there were no ILBs in the early part of that history, ILB returns were calculated based on inflation. Our research, based on data from the Bloomberg/Barclays Inflation-Linked Government Bond Index with a much shorter history, however, does not yield the same results, probably because the much shorter recent history does not include any highly inflationary periods from which ILBs benefit the most. Table 4 shows the statistics of replacing a certain portion of the nominal bonds with comparable ILBs in a DM 60/40 stocks/bonds portfolio. On a standalone basis, the hedged USD DM ILBs are less volatile and have the best risk-adjusted return of 1.3 in the sample period (Portfolio 8). When combined with equities, however, the nominal bonds are a slightly better diversifier than the ILBs. Why? The answer lies in the correlation. Chart 6 shows that the ILBs have much higher correlation with equities than the nominal bonds do with equities. This makes sense because equities could rise in an inflationary environment if the higher inflation were driven by stronger growth, while inflation is always bad for nominal bonds. Again, the differences in risk-adjusted returns are not significant, varying from 0.77 to 0.7 (Portfolios 2-6) in line with the findings in Section 2. Table 4Balanced Global Portfolio Statistics* TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Chart 6Global Stocks-Bonds Correlations bca.gaa_sr_2016_10_28_c6 bca.gaa_sr_2016_10_28_c6 4. Inflation Has Bottomed BCA's Fixed Income Strategy team has written extensively about the outlook for U.S. and global inflation.11 We concur with their view that, even though inflation in most DM countries is still below the targets set by their central banks (Chart 7), in most countries it has probably bottomed (top three panels in Chart 7), and especially in the U.S., where all indicators point to rising wage pressures as labor market slack diminishes (Chart 8). Chart 7Inflation Still Below Target Inflation Still Below Target Inflation Still Below Target Chart 8Accelerating Wage Pressure bca.gaa_sr_2016_10_28_c8 bca.gaa_sr_2016_10_28_c8 5. Investment Implications Overweight U.S. TIPS Over Nominal Treasuries: We have shown that ILBs outperform comparable nominal bonds in a rising inflation environment and have argued that inflation has bottomed in the U.S. These views support our recommendation to overweight U.S. TIPS relative to nominal U.S. Treasuries. In addition, our TIPS valuation models (Chart 9) show that breakeven inflation rates in the U.S. are still below fair values based on underlying economic and financial drivers. Being the largest ILB market with a market cap of over USD 1.2 trillion, TIPS are very easy to trade. Currently, only five-year TIPS have a negative yield, so there are plenty of opportunities for investors to preserve real purchasing power by holding longer maturity TIPS. Avoid U.K. Linkers: The U.K. linkers market is the second largest after the U.S., with a market cap of about USD 810 billion. Unfortunately, these linkers are among the most expensively priced real return bonds, with negative yields at all maturities (Chart 10, panel 3). For example, 10-year linkers are currently yielding -1.98%, which means that investors are guaranteed to lose 18% of real purchasing power in 10 years by holding the bonds to maturity. Granted, the U.K. linkers have always traded at a premium to U.S. TIPS and many other ILB markets due to the nature of the U.K. pension schemes which link pension liabilities to inflation (CPI or RPI). With insatiable appetite from pension funds, demand greatly exceeds what the linkers and inflation swaps markets can supply. U.K. real yields have been driven lower and lower, causing an increasing funding gap which in turns drives yield further down.12 In addition, our fair value model (Chart 10, panels 1 and 2) shows that the U.K. linkers' current breakeven rates are above fair value. The collapse in the linkers' yields after the Brexit vote is also consistent with a skyrocketing in the CPI swaps rate, indicating that the probable rise in inflation due to the collapse of the GBP has now largely been priced in (panel 4). Investors who are not constrained by U.K. pension regulations should avoid U.K. linkers. Chart 9Overweight U.S. TIPS bca.gaa_sr_2016_10_28_c9 bca.gaa_sr_2016_10_28_c9 Chart 10Avoid U.K. Linkers bca.gaa_sr_2016_10_28_c10 bca.gaa_sr_2016_10_28_c10 Yield Enhancement From Australia, Not From Mexico: The U.S. TIPS market is liquid but yields are low, albeit higher than U.K. linkers. Among the smaller markets with higher yields, we prefer Australian Treasury Indexed Bonds (TIBS) over Mexican Udibonos, even though the 10-year Udibonos have a higher yield of 2.8% compared to the 10-year TIBS yield of 0.62%. As shown in Chart 11 and Chart 12, the Australian TIBS are very cheap while the Mexican Udibonos are very expensive. The BEI in Mexico is above the central bank's target of 3% while in Australia it's still at the lower end of the target range of 2-3%. Chart 11 Australian TIBS: A Cheap Yield Enhancer bca.gaa_sr_2016_10_28_c11 bca.gaa_sr_2016_10_28_c11 Chart 12 Mexico ILBS: Too Expensive Mexico ILBS: Too Expensive Mexico ILBS: Too Expensive 6. ETFs Some of our clients always want to know if there are ETFs for the asset classes we cover. For ILBs, the most liquid ETF is the iShares TIPS Bond ETF with an AUM of USD 19 billion and an expense ratio (ER) of 20 bps. For non-U.S. global ILBs, the SPDR Citi International Government Inflation-Protected Bond ETF has an AUM of USD 620 million and an expense ratio of 50bps. The Appendix on page 14 gives a sample list of the exchange traded ILB funds. For more information about ETFs, please see BCA's newly launched Global ETF Strategy service. AppendixSample List Of ILB ETFs*** TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Xiaoli Tang Associate Vice President xiaolit@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "The End of the 35-year Bond Bull Market," July 5, 2016, available at gis.bcaresearch.com. 2 Robert Shiller, "The Invention of Inflation-Linked Bonds in Early America," NBER Working Paper 10183, December 2003. 3 Barclays Index Methodology, July 17, 2014. 4 Refet S. Gurkaynak et al., "The TIPS Yield Curve and Inflation Compensation," May 2008, Federal Reserve publication. 5 Joseph G Haubrich et al., "Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps," Working Paper 11-07, March 2011, Federal Reserve Bank Of Cleveland. 6 Joseph G. Haubrich And Timothy Bianco, "Inflation: Nose, Risk, and Expectations," Economic Commentary, June 28, 2010, Federal Reserve Bank Of Cleveland. 7 Francis E. Laatsch and Daniel P. Klein, "The nominal duration of TIPS bonds," Review of Financial Economics 14 (2005). 8 Mattheu Gocci, "Understanding the TIPS Beta," University of Pennsylvania, 2013. 9 Thor Schultz Christensena and Eva Kobeja, "Inflation-Linked Bond from emerging markets provide attractive yield opportunities," Danske Capital, May 2015. 10 Werner Kramer, "Introduction to Inflation-Linked Bonds," Lazard Asset Management, 2012.

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights Chart 1Model Weights bca.gis_taami_2016_10_28_c1 bca.gis_taami_2016_10_28_c1 In October, the model outperformed global equities in USD and local-currency terms; it also outperformed the S&P 500 in local-currency terms, while performing in line with the S&P in USD terms. For November, the model trimmed its allocation to cash and stocks and boosted its weighting in bonds (Chart 1). The model increased its weighting in French, Dutch, and Swedish stocks at the expense of the U.S., Japan, Germany, Switzerland, New Zealand, and Emerging Asia. Within the bond portfolio, allocation to New Zealand and the U.K. was increased, while the allocation to U.S., Australian and Spanish paper was reduced. The risk index for stocks deteriorated in October, while the bond risk index improved noticeably. Feature Performance In October, the recommended balanced portfolio gained 0.6% in local-currency terms, and was down 1% in U.S. dollar terms (Chart 2). This compares with a loss of 1.4% for the global equity benchmark, and a 1% loss for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we do provide recommendations from time to time. The higher allocation to EM stocks in October was timely, but the boost to bonds was a drag on the model's performance. Weights The model cut its allocation to stocks from 67% to 66% and increased its bond weighting from 21% to 26%. The allocation to cash was decreased from 12% to 8%, while commodities remain excluded from the portfolio (Table 1). The model reduced its allocation to New Zealand equities by 3 points, Emerging Asia by 2 points and U.S., Japan, Germany and Switzerland by 1 point each. Meanwhile, it increased allocation to Dutch, French and Swedish stocks by 4 points, 3 points and 1 point, respectively. In the fixed-income space, the allocation to U.K. and New Zealand paper was increased by 6 points and 5 points respectively, while allocation to Australia, Spain and the U.S. was cut by 3 points, 2 points and 1 point, respectively. Chart 2Portfolio Total Returns bca.gis_taami_2016_10_28_c2 bca.gis_taami_2016_10_28_c2 Table 1Model Weights (As Of October 27, 2016) Tactical Asset Allocation And Market Indicators Tactical Asset Allocation And Market Indicators Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The dollar appreciated in October and investors should position for additional dollar strength. Our Dollar Capitulation Index seems to be breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation bca.gis_taami_2016_10_28_c3 bca.gis_taami_2016_10_28_c3 Capital Market Indicators Our model continues to exclude commodities from the portfolio. The risk index for this asset class remains at the highest level in over two years (Chart 4). For the first time since June 2014, the risk index for global equities is above the neutral line (Chart 5). The higher overall risk reflects deteriorating liquidity and momentum readings. Our model cut its weighting in equities for the third month in a row. Chart 4Commodity Index And Risk Commodity Index And Risk Commodity Index And Risk Chart 5Global Stock Market And Risk bca.gis_taami_2016_10_28_c5 bca.gis_taami_2016_10_28_c5 The value component of the risk index for U.S. stocks improved in October, but this was overshadowed by worsening liquidity and momentum readings. The model slightly trimmed its allocation to U.S. equities (Chart 6). Even after the latest small uptick in the risk index for Dutch equities, it remains one of the lowest among the model's universe. The allocation to this bourse was increased. (Chart 7). Chart 6U.S. Stock Market And Risk bca.gis_taami_2016_10_28_c6 bca.gis_taami_2016_10_28_c6 Chart 7Netherlands Stock Market And Risk bca.gis_taami_2016_10_28_c7 bca.gis_taami_2016_10_28_c7 The risk index for U.K. stocks declined slightly in October, but remains firmly in high-risk territory both compared to its own history and its global peers. This asset class remains excluded from the portfolio (Chart 8). The model slightly upgraded Swedish equities, despite a worsening risk index. The continued favorable liquidity backdrop remains a boon for Swedish stocks (Chart 9). Chart 8U.K. Stock Market And Risk U.K. Stock Market And Risk U.K. Stock Market And Risk Chart 9Swedish Stock Market And Risk bca.gis_taami_2016_10_28_c9 bca.gis_taami_2016_10_28_c9 After declining for four consecutive months, the overall risk index for bonds is not at extreme high-risk levels anymore. The increase in yields has helped completely unwind overbought conditions, as per our momentum indicator. The model used the latest selloff to increase its allocation to bonds (Chart 10). The risk index for U.S. Treasurys declined markedly in October, but a few other markets also feature improved risk readings. As a result, the model downgraded U.S. Treasurys (Chart 11). Chart 10Global Bond Yields And Risk bca.gis_taami_2016_10_28_c10 bca.gis_taami_2016_10_28_c10 Chart 11U.S. Bond Yields And Risk bca.gis_taami_2016_10_28_c11 bca.gis_taami_2016_10_28_c11 The selloff in New Zealand bonds has pushed the momentum indicator into oversold territory, boosting the allocation to this asset class (Chart 12). The risk index for euro area bonds remains firmly in the high-risk zone even after a notable decline. However, there are select bond markets in the common-currency area that have relatively more favorable risk readings (Chart 13). Chart 12New Zealand Bond Yields And Risk bca.gis_taami_2016_10_28_c12 bca.gis_taami_2016_10_28_c12 Chart 13Euro Area Bond Yields And Risk bca.gis_taami_2016_10_28_c13 bca.gis_taami_2016_10_28_c13 Within the euro area, Italian bonds feature a risk reading that has fallen below the neutral line. While the cyclical indicator continues to move into more bond-negative territory, it is currently being offset by the oversold reading on the momentum indicator (Chart 14). U.K. gilt yields moved up as the post-Brexit inflation backdrop became gilt-unfriendly and growth surprised on the upside. Now, with momentum moving from overbought to oversold over just a couple of months, any negative economic surprises could potentially weigh on gilt yields. The model has added this asset class to the portfolio (Chart 15). Chart 14Italian Bond Yields and Risk bca.gis_taami_2016_10_28_c14 bca.gis_taami_2016_10_28_c14 Chart 15U.K. Bond Yields And Risk bca.gis_taami_2016_10_28_c15 bca.gis_taami_2016_10_28_c15 A more hawkish Fed could push the dollar higher. The 13-week momentum measure for the USD remains above, but close to the neutral line. The recovery of the 40-week rate of change from mildly negative levels which have represented a floor since 2012 would suggest that a new leg in the dollar bull market is in the offing (Chart 16). Both the 13-week and 40-week momentum measures for the euro are below the neutral line (Chart 17). Growing monetary divergences could continue weighing on EUR/USD before the technical indicators are pushed into more oversold territory. Fears of hard Brexit knocked down the pound. The 13-week rate of change is now close to its post-Brexit lows, while the 40-week rate of change measure is at the most oversold level since 2000 (excluding the great recession). At these technical levels the pound seems overdue to find a temporary bottom (Chart 18). Chart 16U.S. Trade-Weighted Dollar* bca.gis_taami_2016_10_28_c16 bca.gis_taami_2016_10_28_c16 Chart 17Euro Euro Euro Chart 18Sterling Sterling Sterling Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Highlights The appearance of two virtuous circles will cause the real broad trade-weighted dollar to strengthen by 10% over the next 12 months. The Fed's efforts to run a "high pressure" economy will create a self-reinforcing cycle where accelerating wage growth boosts household spending, leading to faster wage growth and even more spending. Stronger growth will prompt the market to price in more rate hikes over the coming years, propelling the dollar higher. A rising dollar will boost activity in the euro area and Japan. An improved economic outlook will push up inflation expectations in these economies, causing real rates to fall. This, in turn, will usher in a second virtuous circle in which lower real rates put further downward pressure on the euro and the yen, leading to even faster growth. Global equities are likely to struggle in the near term, as investors discount a more aggressive path for Fed tightening. Once the dust has settled, however, higher beta markets such as Europe and Japan should outperform in local-currency terms. We are closing our long Treasurys/short German bunds trade for a gain of 18%. Feature The Dollar Is Heading Higher Chart 1Most Forecasters Expect Household ##br## Spending Growth To Slow bca.gis_wr_2016_10_28_c1 bca.gis_wr_2016_10_28_c1 The appearance of two virtuous circles will cause the real broad trade-weighted dollar to strengthen by 10% over the next 12 months. The first virtuous circle will push up real yields in the U.S., while the second will push down real yields in key economies such as Europe and Japan. Taken together, this will cause real yield differentials to widen sharply in favor of the U.S., sending the greenback higher. Virtuous Circle #1: Accelerating wage growth boosts U.S. consumption, leading to even faster wage growth and more spending. This forces the Fed to hike rates more than what the market is currently discounting. Real personal consumption has grown by 3% since mid-2013, even as the rest of the economy has expanded by a middling 0.7%. Most analysts expect consumption growth to decelerate next year to around 2.4%, based on Bloomberg estimates (Chart 1). There is no shortage of reasons for why consumer spending may slow. The drop in energy prices since mid-2014 has saved households an annualized $120 billion at the pump, and an additional $30 billion in the form of lower utility bills - equivalent to around 1% of disposable income. This has given households scope to increase spending on other items. Now that oil prices appear to have bottomed, this windfall will cease to grow. Rising asset prices have also stoked consumption. The S&P/Case-Shiller 20-City home price index has risen by 37% since early 2012, while the Wilshire 5000 index has gained 54% (Chart 2). Largely due to these developments, household net worth has increased from 538% of disposable income to 637% over this period, according to the Fed's Flow of Funds accounts. Looking out, we expect U.S. equities to deliver only 2%-to-3% real total returns over the coming decade. Home price appreciation should also flatten out, now that real home prices have moved back above their pre-bubble levels (Chart 3). Chart 2Rising Asset Prices Have Inflated Household Net Worth bca.gis_wr_2016_10_28_c2 bca.gis_wr_2016_10_28_c2 Chart 3U.S. House Prices Are Not Cheap Anymore U.S. House Prices Are Not Cheap Anymore U.S. House Prices Are Not Cheap Anymore Meanwhile, banks are starting to tighten lending standards in some consumer credit categories (Chart 4). Most notably, auto loan standards have tightened markedly, following a number of years of sharp easing. This could pose a headwind to vehicle sales in the coming year. Growth in aggregate hours worked has also decelerated over the past five quarters (Chart 5), a trend that should persist. We expect payroll growth to slow to around 100,000 a month in the next few years, as remaining labor market slack is absorbed. However, therein lies the upside for consumer spending. As the labor market begins to overheat, wage growth is likely to accelerate further (Chart 6). A one percent increase in wage growth boosts aggregate household income by as much as 120,000 additional jobs per month. Chart 4Consumer Lending ##br##Standards Are Starting To Tighten Consumer Lending Standards Are Starting To Tighten Consumer Lending Standards Are Starting To Tighten Chart 5Deceleration In ##br##Aggregate Hours Worked bca.gis_wr_2016_10_28_c5 bca.gis_wr_2016_10_28_c5 Chart 6Diminished Labor Market Slack ##br##Should Boost Wages bca.gis_wr_2016_10_28_c6 bca.gis_wr_2016_10_28_c6 Our sense is that the U.S. labor market is now approaching full employment. Granted, the employment-to-population ratio for prime-aged workers is still 2.3% below its pre-recession levels. However, as Chart 7 illustrates, this particular metric was trending lower even before the Great Recession began, suggesting that much of its decline is structural in nature. The data seems to bear this is out. Among the 23 million Americans between the ages of 25-to-54 who are currently out of the labor force, only 10.6% report wanting a job. This number is not much higher than before the crisis (Chart 8). The vast majority of nonparticipants are either homemakers, taking care of dependents, in school, claim they are ill or disabled, or have taken early retirement (Chart 9). Chart 7A Structural Downtrend In Labor ##br##Market Engagement bca.gis_wr_2016_10_28_c7 bca.gis_wr_2016_10_28_c7 Chart 8Not Many Potential ##br##Workers On The Sidelines bca.gis_wr_2016_10_28_c8 bca.gis_wr_2016_10_28_c8 Chart 9Most Who Do Not Work ##br##Choose Not To Work Two Virtuous Dollar Circles Two Virtuous Dollar Circles If the late 1990s is any guide, an overheated labor market is likely to push up labor's share of national income, allowing household earnings to grow more quickly than GDP. Back then, growth in aggregate wages and salaries among private-sector workers reached nearly 10% (Chart 10). Such blockbuster gains are improbable this time around owing to both lower structural productivity and slower labor force growth. Nevertheless, nominal wage growth could still rise to 5%-6% from the current lackluster pace of 3.7%, helping to bolster consumer spending. In addition, the experience of the 1990s suggests that a tight labor market will particularly benefit less-skilled workers (Chart 11).1 This is simply because less-educated workers are typically the first to be fired, and the last to be hired. Since poorer households tend to spend a larger share of their incomes, this will have a disproportionately large impact on consumption. Chart 10Lesson From The 1990s bca.gis_wr_2016_10_28_c10 bca.gis_wr_2016_10_28_c10 Chart 11The Real Beneficiaries Of A Tight Labor Market Two Virtuous Dollar Circles Two Virtuous Dollar Circles Would higher wage growth cause firms to reduce investment spending? The evidence says otherwise. Business investment has grown sluggishly in this economic recovery, even though profit margins have risen sharply. Thus, high corporate profitability is not a precondition for greater investment spending. If anything, business capex tends to increase during periods when the labor share of income is rising (Chart 12). This reflects the fact that business investment represents what economists call "derived demand." Firms typically expand capacity only when they feel that final demand for their goods or services will increase. Put differently, if consumers spend more, firms will invest more. Chart 12Firms Invest More When Workers Earn More Firms Invest More When Workers Earn More Firms Invest More When Workers Earn More The end result could be the emergence of a virtuous circle in which rising wages push up consumer spending, causing firms to hire more workers and invest in new capacity leading, in turn, to even faster wage growth. In fact, it is possible that the Fed's decision to let the economy run hot for a while pushes it towards an equilibrium where both aggregate demand and the neutral rate of interest - r* - are permanently higher. Chart 13 shows how such multiple equilibria can arise. Chart 13Double-Crossed: Multiple Equilibria In A Keynesian Demand Model Two Virtuous Dollar Circles Two Virtuous Dollar Circles Of course, at some point, the Fed would need to step in to cool things down by hiking rates more quickly than inflation is rising. This would translate into an increase in real interest rates, the consequence of which would be a stronger dollar. This is not just a theoretical possibility: The dollar has, in fact, tended to strengthen meaningfully whenever the labor share of income is rising and the jobless rate has fallen below its full employment level (Chart 14). Virtuous Circle #2: A stronger dollar boosts activity in the euro area and Japan. This pushes up inflation expectations in those economies, causing real rates to fall. Lower real rates put downward pressure on the euro and the yen, leading to even faster growth. How can stronger growth lead to higher real rates in the U.S. but lower real rates in Europe? The answer stems from the economics of liquidity traps. As discussed above, the U.S. economy is nearing full employment. As such, the Fed is no longer constrained by the zero lower bound on nominal interest rates. In contrast, inflation is well below target in both the euro area and Japan (Chart 15). This means that neither the ECB nor the BoJ will raise rates, even if growth picks up. What stronger growth will do in both economies is eat away at deflationary pressures. The upshot will be higher inflation expectations, lower real rates, and a weaker euro and yen. Chart 14Virtuous Dollar Circle #1 In Action bca.gis_wr_2016_10_28_c14 bca.gis_wr_2016_10_28_c14 Chart 15ECB And BoJ: In No Position To Tighten bca.gis_wr_2016_10_28_c15 bca.gis_wr_2016_10_28_c15 Admittedly, high levels of unemployment in Southern Europe will limit the extent to which stronger demand in those economies translates into higher inflation. Nevertheless, the region will still benefit from a weaker euro - and the boost to external competitiveness that this brings. Moreover, with the German unemployment rate at a 25-year low, a cheaper currency will generate more meaningful inflation in Europe's largest economy. This would help erode Germany's gigantic 8% of GDP current account surplus, which has been a key force in propping up the euro. It would also facilitate the "internal devaluation" that Southern Europe has to undertake without the need for grinding deflation in that region. We doubt that either the BoJ or the ECB would do anything to abort this virtuous circle. For his part, Governor Kuroda has stated that he wants inflation to rise above 2% in order to make up for the fact that inflation has consistently run short of the BoJ's target. To back up this pledge, the BoJ is giving the Ministry of Finance a blank check by promising to undertake unlimited bond purchases while keeping the 10-year yield pegged at zero. Thus, not only does the Japanese government need not worry about paying any interest on its debt, it also does not have to worry about repaying the principal, since the BoJ is buying more bonds than the government is issuing. Mario Draghi is also likely to lean into any inflationary tailwind. We expect the ECB to extend its asset purchase program at its December meeting for another six months, which is currently set to end in March 2017. The Governing Council may also signal that it will consider expanding the eligibility rules for bond purchases and modifying the existing capital key allocation. Investment Conclusions Two weeks ago, we argued that in the absence of Fed tightening, U.S. growth could reach 2.8% next year on the back of a turn in the inventory cycle, a pickup in business investment, and increased fiscal spending at the federal, state, and local levels.2 Consistent with Chair Yellen's desire to run a "high pressure" economy, the Fed would welcome faster growth, even if this pushes core inflation temporarily above 2%. However, memories of the 1970s have not fully gone away. Many of Yellen's FOMC colleagues, including former doves such as John Williams and Eric Rosengren, are already clamoring for higher rates. This means that if growth does pick up, the Fed will continue emptying the punch bowl. We expect the FOMC to raise rates twice next year, in addition to the 25 basis-point hike we are penciling in for December. This pales in comparison to the mere 54 basis points in hikes the market is pricing in through to end-2018 (Chart 16). Chart 16Market Rate Expectations Further Out Remain Muted bca.gis_wr_2016_10_28_c16 bca.gis_wr_2016_10_28_c16 Chart 17 shows that rate differentials between the U.S. and its trading partners have widened over the past four months, even as the dollar has traded sideways. Thus, even if rate differentials remain broadly constant, a case can be made for a stronger dollar over the coming months. The analysis above, however, suggests that rate differentials are likely to widen further. This should turbocharge any dollar rally. A 10% appreciation in the real broad trade-weighted dollar index may sound like a lot, but keep in mind that the dollar has weakened by 2% since January. Thus, we are only talking about a rise of 8% from where it was earlier this year. As Chart 18 shows, this would still leave the greenback 3% and 15% below its 2002 and 1985 peaks, respectively. Chart 17U.S. Rate Hikes Will Push Up The Dollar U.S. Rate Hikes Will Push Up The Dollar U.S. Rate Hikes Will Push Up The Dollar Chart 18Still Far From Past Peaks bca.gis_wr_2016_10_28_c18 bca.gis_wr_2016_10_28_c18 Chart 19Japanese And European Stocks Tend To Outperform In A Rising Yield Environment Japanese And European Stocks Tend To Outperform In A Rising Yield Environment Japanese And European Stocks Tend To Outperform In A Rising Yield Environment The current high sensitivity of the dollar to changes in interest rate differentials means that most of the tightening in financial conditions that the Fed will need to achieve over the next few years is likely to come through a stronger currency rather than higher bond yields. Nevertheless, yields are likely to drift higher. Consistent with the views of our Global Fixed Income Strategy service,3 at this point, we see more upside for Treasury yields than for yields in most other developed markets. With that in mind, we are closing our long Treasurys/short German bunds trade for a gain of 18%. Turning to equities, the need for the market to price in a more aggressive path for Fed tightening poses near-term downside risks to global stocks. We remain tactically cautious. Once the dust has settled, however, higher beta equity markets are likely to outperform. As my colleague Anastasios Avgeriou has highlighted, European and Japanese stocks generally do well in a rising yield environment (Chart 19). Moreover, as Chart 20 illustrates, such an environment could benefit global banks shares, which remain among the most despised sectors of the market.4 Chart 20AHigher Yields Would Benefit Banks... Higher Yields Would Benefit Banks... Higher Yields Would Benefit Banks... Chart 20B... As Would Steeper Yield Curves bca.gis_wr_2016_10_28_c20b bca.gis_wr_2016_10_28_c20b Our bullishness does not fully extend to emerging markets. An appreciating dollar could hurt EMs in three ways. First, a stronger dollar could weigh on commodity prices. Second, it could punish EM borrowers with significant dollar liabilities. Third, Fed rate hikes are liable to reduce global dollar liquidity, making it difficult for a number of emerging economies to attract enough foreign capital to finance their current account deficits. Some emerging markets rank higher on this list of vulnerabilities than others. China, for instance, ranks relatively low, given its current account surplus, moderate levels of external debt, and its status as a net commodity importer. As such, while we expect the RMB to weaken against the dollar, it is likely to strengthen on a trade-weighted basis. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 For example, see Harry J. Holzer, Steven Raphael, and Michael A. Stoll, "Employers In The Boom: How Did The Hiring Of Less-Skilled Workers Change During The 1990s?," The Review of Economics and Statistics, Vol. 88:2 (2006), pp. 283-299. 2 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. 3 Please see Global Fixed Income Strategy Weekly Report, "Return Of The Bond Vigilantes," dated October 18, 2016, available at gfis.bcaresearch.com. 4 Please see Global Alpha Sector Strategy , "The Great (Debt) Wall Of China," dated May 27, 2016, available at gss.bcaresearch.com. Strategy & Market Trends* Tactical Trades Strategic Recommendations Closed Trades

Highlights The perceived shape of Brexit is the single most important driver of the pound and most U.K. assets. The U.K. Courts are due to deliver landmark legal rulings, which have huge implications for the perceived shape of Brexit. Expect an eventual soft Brexit if the Courts decide against the U.K. government and deem that triggering Article 50 requires parliamentary approval. Expect a much harder Brexit if the Courts decide in favour of the U.K. government. Tactical investors should consider owning some very short-term call options on pound/dollar or a combination of call and put options. Feature Within the next two weeks, the U.K. High Court will deliver a landmark legal ruling which will have huge implications for the future of the U.K. and Europe. Chart of the WeekDifferent Levels Of Brexit Mean Different Levels Of The Pound bca.eis_wr_2016_10_27_s1_c1 bca.eis_wr_2016_10_27_s1_c1 The U.K. High Court will rule whether Prime Minister Theresa May can start the legal process to exit the EU using the so-called 'royal prerogative' - the power granted to governments to make decisions without a vote from parliament. If May cannot use the royal prerogative, she will require an Act of Parliament to trigger Article 50 of the Lisbon Treaty. The High Court judgement hinges on a fundamental issue. Triggering Article 50 necessarily means that the current government will overturn previous parliamentary decisions - the European Communities Act (1972) and European Union Act (2011). Does the constitution permit a government to overturn parliamentary decisions, take away treaties, and remove the population's legal rights without obtaining parliamentary approval? Although we are not legal experts, the court could regard that as overstretching government authority. If the High Court's judgement does go against the U.K. government, expect pound/dollar to rally immediately by about 4-5 cents. Conversely, a judgement in favour of the government could see the pound sell off by about 1-2 cents. Given the possibility of this gapping, tactical investors should consider owning some very short-term call options on pound/dollar, or a combination of call and put options. Nevertheless, the story will not end with the High Court. Whichever side loses will appeal the decision and take the case to the Supreme Court, which is expected to respond by the end of the year. This ultimate pronouncement of law will have a landmark bearing on the shape of Brexit and, thereby, the future of the U.K. and the other EU 27. Where Is The Pound Headed Longer-Term? For investors, the spectrum of Brexit possibilities - no Brexit, 'soft' Brexit, 'hard' Brexit, or 'very hard' Brexit - will be the single-most important driver of the pound, and by extension, other U.K. assets. Of course, U.K. asset prices ultimately depend on economic and financial fundamentals. But Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7 illustrate that by far the most important fundamental for all U.K. assets right now is the perceived hardness of Brexit, as captured in the pound's value. Chart I-2Harder Brexit Means The Eurostoxx600 ##br##Underperforms The FTSE100... bca.eis_wr_2016_10_27_s1_c2 bca.eis_wr_2016_10_27_s1_c2 Chart I-3...And The FTSE250 ##br##Underperforms The FTSE100 ...And The FTSE250 Underperforms The FTSE100 ...And The FTSE250 Underperforms The FTSE100 Chart I-4Harder Brexit Means U.K. ##br##Goods Exporters Outperform... bca.eis_wr_2016_10_27_s1_c4 bca.eis_wr_2016_10_27_s1_c4 Chart I-5Harder Brexit Means ##br##Retailers Underperform... bca.eis_wr_2016_10_27_s1_c5 bca.eis_wr_2016_10_27_s1_c5 Chart I-6...Travel And Leisure Underperforms... bca.eis_wr_2016_10_27_s1_c6 bca.eis_wr_2016_10_27_s1_c6 Chart I-7...And Real Estate Underperforms bca.eis_wr_2016_10_27_s1_c7 bca.eis_wr_2016_10_27_s1_c7 Pound/dollar has (so far) traded at three distinct levels, based on three distinct levels of perceived Brexit severity: near 1.50 before the Brexit vote; near 1.30 after the Brexit vote but perceiving a soft Brexit; and near 1.20 after Theresa May announced that she would trigger Article 50 by next March and was contemplating a hard Brexit (Chart of the Week). Hence the (post-appeal) outcome of the legal case against the government carries great significance. If the government loses, and requires a parliamentary vote to trigger Article 50, several consequences follow. Theresa May's end-March deadline for firing the Brexit starting gun would become very difficult to meet, severely delaying the whole process. Would the government even win a parliamentary majority? If in doubt, would the government call a snap General Election to try and beef up its majority? The current batch of parliamentarians has a strong bias for staying in the EU, but it would be difficult to fly in the face of the referendum result. On the other hand, the checks and balances of parliament are there precisely to stop the country walking over the cliff-edge that a very hard Brexit would be. All the while, with investment slowing and higher inflation from the weaker pound squeezing household real incomes, the economic headwinds from the U.K.s limbo status would be becoming more apparent. Given the high stakes and likely irreversibility of the formal legal process, parliamentarians would rightfully want to examine and approve the U.K.'s negotiating hand. It seems that Parliament would almost certainly water down or delay Brexit before voting it through. Hence, if the government loses its legal case after appeal, Brexit will likely end up in a soft form. And pound/dollar will ultimately elevate to 1.35. Conversely, if the government wins its legal case after appeal, Theresa May will be on course to trigger Article 50 early next year, as promised. At which point, the EU 27's optimal game-theoretical first play is to be very aggressive - effectively opening with a very hard Brexit offer as described in the next section. Whereupon, pound/dollar would find its fourth, even lower, new level: near 1.10. Two Myths About Brexit It is important to debunk a couple of common myths about Brexit. First, that the U.K.'s current position as the EU 28's second largest economy will force the remaining EU 27 to give the U.K. a special status - allowing access to the three freedoms of goods, services, and capital but with controls on the fourth freedom of movement: people. This belief is misplaced. The biggest worry for the EU 27 is that a special status for Britain could catalyse other countries, under populist pressure, to ask for equivalent deals. The EU 27 does not want to give Marine Le Pen the opportunity to say "let's follow the Brits, they've negotiated a great deal." Hence, the U.K. will not get special treatment. Quite the contrary, it must be seen to be paying a substantial price for Brexit. Even for Anglophile Angela Merkel, protecting the indivisibility of the four freedoms and the integrity of the EU is the overriding priority. If the U.K. restricts free movement of people, it almost certainly means a hard Brexit: substantially restricted access to the single market. The U.K. would then have to negotiate a free trade agreement (FTA) with the EU. Given the current difficulty that Canada is experiencing in negotiating a FTA, this might not be a straightforward process for the U.K either. Furthermore, as a FTA does not usually cover services, it would handicap the services-heavy U.K. economy, while perfectly suiting the goods-heavy German economy. A second common belief is that the pound will act as an automatic economic stabilizer. That irrespective of a very tough deal from the EU 27, a weaker sterling will soothe the pain of a very hard Brexit by making British exports more competitive. Granted, the weaker pound will boost the demand for the U.K.'s goods exports. But total U.K exports are much less sensitive to devaluations compared to when the pound tumbled out of the Exchange Rate Mechanism in 1992. Then, just a quarter of the U.K's exports were services; today that proportion is approaching a half (Chart I-8) With the exception of tourism, these services tend to be high value-added financial and business services. Cutting their price will not significantly boost the demand for them. Chart I-8Almost Half Of U.K. Exports Are Services Almost Half Of U.K. Exports Are Services Almost Half Of U.K. Exports Are Services Meanwhile, U.K. consumers will feel distinctly poorer as the sterling prices of food and energy rise (Chart I-9), squeezing real household incomes and spending. In turn, this will leave the Bank of England with a major headache. How best to support real spending: defend the plunging pound to keep a lid on food and energy prices, or cut interest rates? Chart I-9Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Investment Reductionism For U.K. Assets The charts throughout this report show that the strategy for many U.K. investments reduces to an overriding question. Will the U.K largely retain access to the single market, defining a soft Brexit? Or will the U.K. largely lose access to the single market, defining a hard Brexit? In a soft Brexit: Sterling would rally 10%, taking pound/dollar to 1.35. The Eurostoxx600 and S&P500 would outperform the FTSE100. Within U.K. equities, sterling earners would outperform dollar earners, favouring small and mid-cap over large cap. The FTSE250 would outperform the FTSE100. The heavily domestic-focused retailers, travel and leisure, and real estate sectors would outperform the market. Goods exporters, such as the apparel sector would become less competitive and underperform the market. In a hard Brexit, expect the exact opposite of the above. Pound/dollar would slump 10% to 1.10, and so on. To determine which strategy to follow, await the post-appeal Supreme Court judgement on how Article 50 must be triggered, due at the end of the year. If Article 50 requires parliamentary approval, expect a soft Brexit. If it doesn't require parliamentary approval, expect the Brexit game theory to become hard and aggressive. Right now this is a coin toss, but forced to choose, we expect events may eventually prevent a damaging hard Brexit. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* This week's trade is another commodity pair trade: long copper / short tin. 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 10 Long Copper / Short Tin Long Copper / Short Tin * 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 bca.eis_wr_2016_10_27_s2_c1 bca.eis_wr_2016_10_27_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c2 bca.eis_wr_2016_10_27_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c3 bca.eis_wr_2016_10_27_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c4 bca.eis_wr_2016_10_27_s2_c4 Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c5 bca.eis_wr_2016_10_27_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c6 bca.eis_wr_2016_10_27_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c7 bca.eis_wr_2016_10_27_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c8 bca.eis_wr_2016_10_27_s2_c8

Highlights ECB Monetary Policy: Euro Area inflation will likely remain below the European Central Bank (ECB) 2% target for the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing (QE) asset purchase program beyond the current March 2017 expiration date. ECB QE Changes: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints, which have bearish implications for Euro Area bond yields, are overstated. Country Allocation: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Feature After spending the past couple of months fretting over the next move by the U.S. Federal Reserve or the Bank of Japan, investors' attention shifted to Europe last week. With the current European Central Bank (ECB) government bond quantitative easing (QE) program set to expire in March of next year, the markets were seeking any sort of guidance on whether the ECB will end the program as scheduled, or extend the program beyond March - perhaps with a reduction ("taper") in the size of the bond buying. ECB President Mario Draghi provided no new information at the post-meeting press conference last Thursday, leaving bond investors in limbo until the December meeting when the results of the ECB's assessment of their QE program will be published. Some alterations of the program will likely be announced, but it is too soon for the ECB to consider ending their QE program. With regards to the title of this Weekly Report - the most likely outcome is that the ECB will extend the QE program past March 2017, but will tinker with the rules of QE in an effort to pretend that the central bank is still following a prudent logic for its purchases. Fears of an early taper are overstated, and this makes core European government debt a potential oasis of safety while global bond yields remain in a bear phase. Plenty Of Reasons For The ECB Not To Taper This talk of a tapering of ECB asset purchases following the scheduled end of the current QE program seems premature. After all, neither the ECB's own economic forecasts, nor those of its Survey of Professional Forecasters, are calling for inflation to get close to the 2% target until at least 2018 (Chart of the Week). The ECB staff will prepare a new set of forecasts for the December policy meeting that will include projections for 2019 - perhaps these new estimates will have inflation finally reaching the 2% goal. But in the absence of a credible forecast of inflation returning to target, the ECB will be hard pressed to signal any move to a less-accommodative monetary policy. Headline Euro Area inflation is currently only 0.4%, despite a recent increase in the oil price denominated in Euros, which has been a reliable directional indicator for Euro Area inflation (Chart 2). Chart of the WeekNo Need For An ECB Taper bca.gfis_wr_2016_10_25_c1 bca.gfis_wr_2016_10_25_c1 Chart 2European Inflation Is Stubbornly Low bca.gfis_wr_2016_10_25_c2 bca.gfis_wr_2016_10_25_c2 The steady decline in the Euro Area unemployment rate over the past three years has coincided with a move higher in overall labor compensation, but this has been purely a "volume" effect resulting from steadily increasing employment growth. With the entire region not yet at full employment, there has been minimal upward pressure on wages or inflation in domestically focused sectors like services (bottom panel). In other words, the lack of Euro Area inflation is a direct function of the excess capacity in Euro Area product and labor markets. According to the IMF, the Euro Area output gap will not close until 2020, which will limit any rise in inflation over the rest of the decade (Chart 3). It will take a more prolonged period of above-trend economic growth to close the output gap, reducing the Euro Area unemployment rate below the full employment NAIRU level, before any recovery in wages or core inflation can take place (bottom panel). This lack of realized inflation is weighing on Euro Area inflation expectations and creating some potential credibility problems for the ECB. As we have discussed in earlier Weekly Reports, inflation expectations in much of the developed economies seem to follow an "adaptive" process, where expectations are formed in lagged response to actual inflation.1 If central banks are fully credible in their ability to use monetary policy to fight inflation (and demand) shortfalls, then those forward-looking expectations should eventually gravitate towards the central bank inflation target. However, if there is a large and persistent shock to realized inflation, then inflation expectations can deviate from the central bank target for an extended period. Using a 5-year moving average of realized headline CPI inflation as a proxy for inflation expectations is a reasonably good (albeit simple) approximation of this adaptive process (Chart 4). The current 60-month moving average for Euro Area headline inflation is 0.6%, not far from the 5-year Euro Area CPI swap rate of 0.9%. However, if the ECB's inflation forecasts for the next two years come to fruition (1.2% in 2017, 1.6% in 2018), then the 5-year moving average will continue to decline, as those higher inflation figures would not offset the sharp fall in inflation witnessed over the past few years. Chart 3Excess Capacity Holding Inflation Down bca.gfis_wr_2016_10_25_c3 bca.gfis_wr_2016_10_25_c3 Chart 4Inflation Expectations Will Stay Low bca.gfis_wr_2016_10_25_c4 bca.gfis_wr_2016_10_25_c4 Simply put, the ECB's current projections are not consistent with inflation expectations hitting the 2% target by 2018, and likely even beyond that. The ECB will be presenting new projections in December, but it would take a significant upgrade of their growth and inflation forecasts to "move the needle" on longer-term inflation expectations. Perhaps a move away from fiscal austerity across the Euro Area could trigger an upgrade on growth expectations, as that would imply a faster pace of growth and a more rapidly narrowing output gap. However, while the topic of greater fiscal spending has been heating up in the halls of governments in Washington, London and Tokyo, there has been little sign that Euro Area governments are about to open the fiscal spigots anytime soon (and certainly not before elections in Germany and France in 2017). Chart 5European Banks Getting More Cautious? European Banks Getting More Cautious? European Banks Getting More Cautious? ECB Still Needs To Support Loan Growth The state of Euro Area banks, and what it means for future lending activity, is another factor for the ECB to consider before contemplating any move to a less-accommodative monetary policy. The current growth rates of money and credit are showing no signs of significant deceleration (Chart 5). The latest ECB Euro Area bank lending survey, released last week, did show a modest decline in the net number of banks reporting easier lending standards to businesses, as well as a reduction in the number of banks reporting increasing loan demand from firms. The ongoing hit to European bank profitability from the current negative interest rate environment could be playing a role in the banks moving to a less easy environment for lending. As can be seen in the bottom panel of Chart 5, there is a reliable leading relationship between Euro Area bank equity prices and the growth in bank lending to businesses. The downturn in Euro Area bank stocks in 2016, which has been driven by declining profit expectations, could pose a risk to credit growth in the months ahead. According to a special question asked within the ECB's bank lending survey, a net 82% of respondents reported that the ECB's negative deposit rate has damaged banks' net interest income over the past six months.2 In that same survey, a net 12% of banks reported a boost to loan demand from the ECB's negative interest rate policy, and a net 15% of banks reported that the additional liquidity provided by the ECB bond purchases went towards extending loans to businesses. So while negative interest rates may be hurting bank profit margins, the impact of the ECB's QE is helping offset that to some degree by providing banks with capital gains on their bond portfolios that can be used to finance lending. So without any sign that inflation will soon approach the ECB's target, thus requiring a potential tapering of QE or even a move away from negative interest rates, the prudent course for the ECB to take to support Euro Area credit demand, and economic growth, is to continue with the QE program beyond the March 2017 expiration date. That will require some changes to the ECB's rules of the program, but, in the end, these are only self-imposed constraints. Bottom Line: Euro Area inflation will likely remain below the ECB 2% target over the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing asset purchase program beyond the current March 2017 expiration date. The ECB Has Some Policy Options To Avoid A Taper Tantrum Core European bond yields have been depressed by the ECB's QE program, which have acted to push down both the future expected path of interest rates and the term premium (Chart 6). This has helped anchor real bond yields in negative territory, even with inflation expectations at such low levels. But any signs of potential slowing of the pace of QE buying could quickly unwind this effect, which makes the ECB's next steps so critical for the path of global bond yields. In Chart 7, we show the level and growth rate for the ECB's monetary base, along with five potential future scenarios: The ECB ends their QE program in March 2017, as currently planned; The ECB extends QE for six months to September 2017, at the current pace of €80bn in bond buying per month; The ECB extends QE program for twelve months to March 2018, at a pace of €80bn per month; The ECB extends QE to September 2017, but reduces the pace of purchases to €60bn per month; The ECB extends QE to March 2018, but cuts to €60bn per month. Chart 6ECB QE Still Holding Down Yields bca.gfis_wr_2016_10_25_c6 bca.gfis_wr_2016_10_25_c6 Chart 7ECB Needs To Keep The Monetary Base Growing bca.gfis_wr_2016_10_25_c7 bca.gfis_wr_2016_10_25_c7 As can be seen in the bottom panel of Chart 7, the growth rate of the ECB's monetary base (and the asset side of their balance sheet) will decelerate sharply in 2017 & 2018 if the ECB does end the QE program as scheduled next March. Extending the program, however, does push out the rapid deceleration phase for monetary base into 2018. This is of critical importance for the Euro Area bond market, as both the outright level and term premium component of German Bund yields have been broadly correlated with the growth rate of the monetary base (Chart 8). In other words, extending the ECB QE program into the future is most important to prevent a "taper tantrum" in European bonds, by signalling to the markets that the ECB wishes to maintain low interest rates for longer. The ECB could even announce a reduction in the pace of purchases, along with an extension, and bond yields should remain well-behaved. This will also help prevent an unwanted appreciation of the Euro, the value of which currently reflects the far easier monetary stance in Europe (Chart 9). Chart 8An ECB Taper Would Be Bad For Bunds An ECB Taper Would Be Bad For Bunds An ECB Taper Would Be Bad For Bunds Chart 9An Easy-For-Longer ECB Will Weigh On The Euro bca.gfis_wr_2016_10_25_c9 bca.gfis_wr_2016_10_25_c9 Given the persistent debates within the ECB (and between the ECB and some Euro Area governments) about the long-run merits of QE, the combination of both an extension and reduction in QE purchases could be the compromise option that satisfies all parties. Alternatively, the ECB could choose to maintain the pace of bond purchases but alter the selection rules governing the program. Given the recent concerns in bond markets that the ECB is "running out of bonds to buy", changing the rules of the QE program is a sensible way for the central bank to free itself from the self-imposed shackles on its bond purchases. There are three options that the ECB can consider: Moving away from strictly allocating the bond purchases according to the ECB "capital key", which essentially weights the bond purchases by the size of each economy; Raising the issuer limits on QE, which limits the ECB to holding no more than 33% of any single issuer or individual bond issue; Reducing the current yield floor on QE, which prevents the ECB from buying any bonds with yields below the ECB deposit rate, which is currently -0.4%; We think option 1 is the least likely to occur, as this would imply buying a greater share of countries with more problematic debt profiles, like Italy or Portugal. There is little chance of such a strategy being well received by the governments in Berlin and Brussels, and the ECB would likely wish to avoid a major political confrontation by allowing larger deviations from the capital key Option 2 is an easier solution to implement. The 33% issuer constraint was always an arbitrary level that was aimed more at bonds with so-called "collective action clauses", where a majority of bondholders can force a decision on all bondholders in the event of a debt restructuring. It is understandable why the ECB would not want to become to decision-making counterparty in the event of a future messy bond restructuring in Europe. However, the ECB's ownership percentages within each Euro Area country are nowhere near the 33% limit at the moment (Chart 10) and, at the current pace and composition of buying, that 33% limit will not even be reached for Germany anytime soon.3 There is room for the ECB to raise the issuer limits, as it has already done for some other parts of its asset purchase programs, like bonds issued by European Union supranationals.4 Chart 10ECB Holdings Are Far From The 33% Issuer Limit The ECB's Next Move: Extend & Pretend The ECB's Next Move: Extend & Pretend Chart 11Lowering The Yield Floor For QE Makes Sense The ECB's Next Move: Extend & Pretend The ECB's Next Move: Extend & Pretend Option 3 is the most binding constraint of all on the ECB purchases, as very large shares of the European government bond market are now trading below the ECB's -0.4% deposit rate (Chart 11). In the case of Germany, nearly 70% of all QE-eligible debt is trading below the ECB's yield floor, which has raised investor concerns that the ECB will soon be unable to buy enough German debt at the current pace of purchases. However, that yield floor constraint is completely arbitrary - there is nothing stopping the ECB from buying bonds trading at a yield below the deposit rate, other than (we suspect) a desire to impose some sort of price discipline on the QE buying to make the ECB appear more credible with its purchases. Chart 12The QE Yield Floor Can Be Changed The ECB's Next Move: Extend & Pretend The ECB's Next Move: Extend & Pretend If the ECB decided to lower the yield floor below the current -0.4% deposit rate, this would open up a greater share of the core European bond markets to QE buying (Chart 12). This would also change the current market narrative that the ECB will soon run out of German bonds to buy. In the end, the most likely path the ECB will take following its December re-assessment of its QE program is a combination of lowering the yield floor on QE bond purchases below -0.4% and raising the issuer limits above 33%. There appears to be plenty of leeway for the ECB to alter their purchases, but without necessarily reducing the monthly pace of buying. Combined with an extension of the end-date of the QE program beyond March, this should alleviate any concerns that the ECB will soon hit a wall with its asset purchases. Bottom Line: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints are overstated. Investment Implications: Move To An Above-Benchmark Stance On Core European Bonds With the ECB having no need to end its QE program early, the case for moving to an overweight stance on core Europe is a strong one. As we noted in our last Weekly Report, favoring bond markets of countries with the lowest inflation rates is a logical investment strategy in the current environment of a modest cyclical upturn in global growth and inflation.5 That justifies our current below-benchmark recommendation on U.S. and U.K. government debt, as both realized inflation and expected inflation are rising in both countries. That leaves the Euro Area and Japan as possible candidates to move to above-benchmark weightings, given their defensive properties as low-beta bond markets. Although with the Bank of Japan now pegging the Japanese government bond (JGB) yield curve with a 10-year yield at 0%, we do not see a compelling investment case for overweighting JGBs as a defensive trade. If an investor wants safety at a 0% yield - with no chance of a capital gain from a decline in yields - than owning T-bills, or even gold, is just as viable as owning JGBs. We recently upgraded Japan to neutral in our recommended portfolio allocation, and we see no reason to move from that. Thus, core European bonds stand out as the candidate to upgrade as a defensive trade during the current bond bear phase, which we expect will continue until at least December when the Fed is expected to deliver another rate hike in the U.S. We see a case for moving to above-benchmark for both Germany and France, but especially so in the latter. The beta of bond returns between France and both the U.S. (Chart 13) & U.S.(Chart 14) is very low, making French bonds a good market to favor at the expense of U.S. Treasuries and U.K. Gilts in currency-hedged bond portfolios. Chart 13French Bonds Are Low Beta To USTs... French Bonds Are Low Beta To USTs... French Bonds Are Low Beta To USTs... Chart 14...And To U.K. Gilts bca.gfis_wr_2016_10_25_c14 bca.gfis_wr_2016_10_25_c14 Bottom Line: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Why Are Global Inflation Expectations Still So Low", dated March 1, 2016, available at gfis.bcaresearch.com. 2 The Q4 2016 ECB Euro Area Bank Lending Survey can be found at https://www.ecb.europa.eu/stats/pdf/blssurvey_201610.pdf. 3 Please note that the denominator in the percentages shown in Chart 10 include only bonds with maturities that are eligible for ECB QE purchases, omitting bonds that will mature in less than 2 year and more than 30 years. 4 For more details on that change to the supranational issuer limits, please see https://www.ecb.europa.eu/mopo/implement/omt/html/pspp-qa.en.html. 5 Please see BCA Global Fixed Income Strategy Weekly Report, "Return Of The Bond Vigilantes", dated October 18, 2016, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The ECB's Next Move: Extend & Pretend The ECB's Next Move: Extend & Pretend Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The U.S. is not yet a "high-pressure" economy, but slack is dissipating. U.S. growth, while not torrid, will remain high enough to push interest rates higher. The euro area continues to exhibit tepid domestic demand growth, and slack there remains higher than in the U.S. Monetary divergences will grow, weighing on EUR/USD. The Canadian economy displays underlying weaknesses which will prevent the BoC from hiking for an extended period of time. Stay long USD/CAD, but favor the CAD to the AUD and the NZD on a USD rally. Feature Following Janet Yellen's Boston speech last week, a new phrase has entered the lexicon of investors: "high-pressure economy". The speech was originally interpreted as a clarion call to let the economy overheat in order to absorb the slack created by the shock of 2008. However, Yellen still sees some slack in the economy. In her eyes, an easy monetary stance, at this point, will not cause an overheating, it will only bring back to the marketplace workers that had left the labor force. Chart I-1Drying Global Liquidity bca.fes_wr_2016_10_21_s1_c1 bca.fes_wr_2016_10_21_s1_c1 We have sympathy toward this view, especially when put in an international context where global capacity utilization remains depressed. Also, countries like China, Saudi Arabia, and Mexico have been intervening in the FX markets to preempt or limit downside to their currencies, tightening global liquidity conditions (Chart I-1). Nonetheless, the Fed Chair also highlighted that the FOMC did not want the U.S. economy to overheat as the domestic slack gets absorbed. Doing so would raise the risk that the Fed will have to then overcompensate by tightening rates very aggressively. This would prompt another recession. U.S.: Not High Pressure Yet, But... No indicator suggests that there is a burning need to quickly ratchet U.S. rates higher. However, domestic economic conditions are falling into place to justify a slow move toward higher rates. Our aggregate U.S. capacity utilization gauge is showing a dissipation of U.S. economic slack (Chart I-2, top panel). This is a side-effect of the tepid growth in the capital stock of U.S. businesses this cycle, which limits the expansion of the supply-side of the economy (Chart I-2, bottom panel). Meanwhile, household consumption should remain robust. Not only did 2015 register the strongest growth in the median household's real income since 1967, consumption is unlikely to slow much. In fact, vehicle-miles traveled and the Federal income tax receipts are both pointing toward healthy consumption (Chart I-3). Despite punky construction starts, housing activity shows signs of improvement. Housing inventories are near record lows and construction has underperformed household formation. Moreover, building permits are hooking upward, while housing affordability remains generous (Chart I-4). Additionally, the NAHB survey also points toward a rising share of residential activity in the economy (Chart I-4, bottom panel). Finally, capex intentions are slowly recovering. Moreover, the BCA House view is that the U.S. profit contraction is past its nadir. Going forward, capex and inventories are unlikely to subtract as much from growth as they did in 2015 and 2016. They may even become accretive to GDP growth. Chart I-2Vanishing U.S. Slack Vanishing U.S. Slack Vanishing U.S. Slack Chart I-3Positive Signs For The U.S. Consumer bca.fes_wr_2016_10_21_s1_c3 bca.fes_wr_2016_10_21_s1_c3 Chart I-4Residential Investment Will Improve bca.fes_wr_2016_10_21_s1_c4 bca.fes_wr_2016_10_21_s1_c4 Limited slack and a continued economic expansion imply a high likelihood of a Fed hike this year, and maybe two more next year if no shocks to financial conditions emerge. With markets currently pricing in 65 basis points of rate hikes by the end of 2019, this should lift rates across the curve. Higher interest rates on U.S. assets should drive private inflows into the country, pushing the U.S. dollar higher (Chart I-5). From a technical perspective, the U.S. capitulation index is breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart I-6). Thus, we continue to position ourselves for additional dollar strength this cycle. Chart I-5Flows Into The U.S. ##br##Are Set To Grow bca.fes_wr_2016_10_21_s1_c5 bca.fes_wr_2016_10_21_s1_c5 Chart I-6Favorable Technical ##br##Backdrop For The Greenback bca.fes_wr_2016_10_21_s1_c6 bca.fes_wr_2016_10_21_s1_c6 Bottom Line: The household sector remains healthy, and U.S. economic slack is dissipating. Hence, the Fed will try, rightfully or wrongly, to push rates higher this year and next, lifting the dollar in the process. Euro Area: Less Pressure A dollar rally could be painful for the euro. Yet, the euro is cheap and supported by a current account surplus of 3.3% of GDP (Chart I-7). What to do with this conflicting picture? For a currency to embark on a durable bull market, productivity growth needs to be stronger than that of its trading partners. A strong currency makes the tradeable-goods sector less competitive, hampering growth. A positive terms-of-trade shock, like that undergone by commodity producers during the previous decade can also do the trick. Neither of these statements currently describe the euro area. Another avenue for a country to withstand a strong currency is for growth to be domestically driven. If household consumption is the main locomotive, exporters' loss of market share do not hurt activity as much. This is true until the domestic economy enters a recession, an event usually driven by higher policy rates. This is why when the share of salaries in the U.S. economy expands, the dollar undergoes cyclical bull markets (Chart I-8). More salaries in the national income means more consumption. Chart I-7Euro ##br##Supports Euro Supports Euro Supports Chart I-8Domestically-Driven Growth##br## Is Good For A Currency Domestically-Driven Growth Is Good For A Currency Domestically-Driven Growth Is Good For A Currency In the euro area, GDP growth is above trend, but, in recent quarters, final private domestic demand has been weak (Chart I-9). In fact, last quarter, net exports were the main contributor to growth. This could explain why, since 2015, stronger European business surveys vis-à-vis the U.S. were unable to boost EUR/USD (Chart I-10). Chart I-9European Consumption##br## Isn't Strong Relative Pressures And Monetary Divergences Relative Pressures And Monetary Divergences Chart I-10If EUR/USD Could Not ##br##Rally Then, When Will It? bca.fes_wr_2016_10_21_s1_c10 bca.fes_wr_2016_10_21_s1_c10 We do expect eurozone final domestic demand to remain tepid. Yes, the credit impulse has improved, but this amelioration will prove temporary. The previous rebound in credit flows reflected the movement from a large contraction to a small expansion. Today, the dismal performance of euro area bank stocks - which have been a good leading indicator of European loan growth - points to slowing credit growth (Chart I-11). Fiscal policy is also moving from a small positive to a small negative. Work by the ECB staff shows that the cyclically adjusted budget balance in Europe fell by 0.3%, from -1.7% to -2.0% of GDP in 2016. Aggregate cyclically-adjusted budget balances are forecasted to improve to -1.8% and -1.6% of GDP in 2017 and 2018, respectively, representing a 0.2% fiscal drag each year. While a small number, we have to keep in mind that euro area trend growth is between 0.5% and 1%. This suggests that the European economy remains ill-equipped to handle a stronger euro. Moreover, the European economy exhibits much more slack than the U.S. economy. While total hours worked in the U.S. are 14% above Q1 2010 levels, in Europe, they are only 1.5% above such levels (Chart I-12), a gap much greater than demographics alone would have suggested. This means that monetary divergence will continue between Europe and the U.S. Chart I-11Euro Area Credit Impulse Will Weaken bca.fes_wr_2016_10_21_s1_c11 bca.fes_wr_2016_10_21_s1_c11 Chart I-12Less Capacity Pressures In Europe Less Capacity Pressures In Europe Less Capacity Pressures In Europe In fact, this week, the ECB did little to dispel this notion. Beyond trying to squash ideas of a sudden end to the QE program or any imminent tapering, president Draghi communicated that December will be the month when the real action occurs. Based on current trends, we expect the ECB to extend its QE program beyond March, but to hint at a tapering of purchases later in 2017. The ECB will also make it very clear that rates will remain as low as they currently are for an extremely long time. Thus, while the ECB might be slowly moving away from its hyper-stimulative stance, it will not do so as fast as the Fed. Therefore, policy divergences should continue to weigh on EUR/USD. Technicals are also pointing toward a lower euro. Not only has EUR/USD broken down its 1-year old series of higher lows, the euro's capitulation index, the intermediate-term momentum indicator, and the euro's A/D line are forming negative divergences with EUR/USD (Chart I-13). An interesting way to play the euro's weakness is to go short EUR/CZK, a position championed by our Emerging Market Strategy service.1 A floor at 27 has been set under EUR/CZK since November 2013. Yet, this floor looks increasingly untenable. Speculators are beginning to pile in. This week, 2-year Czech yields temporarily dipped below those of Swiss 2-year bonds, the current holder of the world's lowest yield. To fight appreciation pressures, the Czech National Bank (CNB) is accumulating a lot of reserves by buying euros, which is fueling a surge in the money supply (Chart I-14, top panel). Chart I-13Worrying Euro ##br##Technicals Worrying Euro Technicals Worrying Euro Technicals Chart I-14CZK: Reserves Expansion##br## Leading To Inflation bca.fes_wr_2016_10_21_s1_c14 bca.fes_wr_2016_10_21_s1_c14 This accumulation of reserves, in turn, is fanning inflationary forces in the Czech economy. The output gap is closing and core inflation already is increasing at a rate of 1.8% p.a. Easy financial conditions and expanding credit growth are likely to boost already-accelerating unit labor costs and wages (Chart I-14, bottom panel). This means that the 2% inflation target is likely to be hit as early as Q2 2017 according to the CNB. We expect this goal to be handily surpassed if the floor stays in place. Thus, we expect the CNB to abandon the floor within the next twelve months and we are shorting EUR/CZK. Finally, while we are bearish EUR/USD, we do believe that the euro will outperform the pound and commodity currencies. Moreover, despite poorer fundamentals, the euro could also temporarily outperform the SEK and the NOK if the dollar strengthens. The latter two are more sensitive to the USD than the euro is. Bottom Line: EUR/USD is at risk from the broad dollar rally. It is also likely to suffer from the tepid state of the euro area's final domestic demand, fueling monetary-policy divergences with the U.S. A speculative opportunity to short EUR/CZK is emerging, as the CNB's peg is outliving its usefulness. Canada: Falling Pressure USD/CAD has become more correlated with movements in rate differentials than with the vagaries of oil prices (Chart I-15). This puts the actions of the Bank of Canada in sharper focus. As expected, this week, the BoC left policy rates unchanged at 0.5%. More interesting was the quarterly monetary report. The economy has rebounded from the slump induced by the Q2 Alberta wildfires, and many key gauges of the Canadian economy have improved (Chart I-16). Yet, the BoC is looking the other way. Chart I-15CAD: Now More Rates Than Oil bca.fes_wr_2016_10_21_s1_c15 bca.fes_wr_2016_10_21_s1_c15 Chart I-16The BoC Is Looking The Other Way... bca.fes_wr_2016_10_21_s1_c16 bca.fes_wr_2016_10_21_s1_c16 The BoC is now forecasting the Canadian output gap to close in mid-2018; in July, this was expected to happen in the second half of 2017. This is because the BoC cut the expected Canadian growth rate by a cumulative 0.5% over the next two years. There have been some worrying developments warranting a more cautious forecast. While the Trudeau government's new childcare benefits are currently being rolled out and new infrastructure spending is to be implemented in 2017, the Canadian private sector's finances are increasingly shaky. The aggregate debt-servicing costs of the non-financial private sector is at record highs, with generous contributions from both households and the corporate sector (Chart I-17). The aggregate credit impulse has responded to this handicap, contracting by 7% of potential GDP, a move driven by the corporate sector (Chart I-18). While not as dramatic, the pace of debt accumulation by the household sector has also weakened. Recent administrative measures to cool the housing market - put in place by various provincial entities as well as the federal government - could accentuate this trend. Chart I-17...Rightfully So bca.fes_wr_2016_10_21_s1_c17 bca.fes_wr_2016_10_21_s1_c17 Chart I-18Collapsing Canadian Credit Impulse Collapsing Canadian Credit Impulse Collapsing Canadian Credit Impulse Another problem for Canada has been its loss of competitiveness. Non-oil Canadian exports have not responded as expected to the fall in the CAD. This is because many Canadian manufacturers have set up factories in Mexico and other EMs, or are competing with firms operating out of these nations. With these countries' currencies witnessing devaluations as deep as, or deeper than the loonie's, it is no wonder that Canada has lost market shares in the U.S. (Chart I-19). This means that Canadian rates will remain low for longer, making Canada another contributor to global monetary divergences vis-a-vis the U.S. The BoC is right to be worried that the Canadian economy will take longer than anticipated to close its output gap. With the pass-through to inflation of a lower CAD dissipating, the BoC expects Canadian core inflation to remain well contained for the next two years. We see little cause to disagree. This means that despite trading at a premium to PPP, USD/CAD has upside. Moreover, the Canadian dollar's A/D line is rolling over, another factor pointing to upside for USD/CAD (Chart I-20). At this point, the biggest risk to our view is oil. If WTI can breakout above $52 - perhaps in response to an as-yet negotiated OPEC/Russia oil-production cut or freeze - this could mitigate the downside for the CAD. Thus, while we like USD/CAD, we think the CAD has upside against the AUD and the NZD, especially as the loonie is less sensitive to the USD and EM spreads than the two antipodean currencies. Chart I-19Canada Is Losing Competitiveness Relative Pressures And Monetary Divergences Relative Pressures And Monetary Divergences Chart I-20Falling CAD A/D Line Falling CAD A/D Line Falling CAD A/D Line Bottom Line: The Canadian economy is showing surprising signs of underlying weakness. With the CAD having recently been more correlated to rate differentials than to oil, USD/CAD could rally on monetary divergences. That being said, on the back of a strong USD, CAD is likely to outperform the AUD and NZD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Central European Strategy: Two Currency Trades", dated September 28, 2016, available at ems.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 bca.fes_wr_2016_10_21_s2_c1 bca.fes_wr_2016_10_21_s2_c1 Chart II-2USD Technicals 2 bca.fes_wr_2016_10_21_s2_c2 bca.fes_wr_2016_10_21_s2_c2 Policy Commentary: "The risks have changed in terms of overshooting what I think is full employment with implications for potential imbalances...Those imbalances might result in a reaction by the Fed that we end up having to tighten more quickly than I would like" - FOMC Voting Member Eric Rosengren (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_10_21_s2_c3 bca.fes_wr_2016_10_21_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_10_21_s2_c4 bca.fes_wr_2016_10_21_s2_c4 Policy Commentary: "An abrupt ending to bond purchases, I think, is unlikely...We remain committed to preserving a very substantial degree of monetary accommodation" - ECB President Mario Draghi (October 20, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_10_21_s2_c5 bca.fes_wr_2016_10_21_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_10_21_s2_c6 bca.fes_wr_2016_10_21_s2_c6 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_10_21_s2_c7 bca.fes_wr_2016_10_21_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_10_21_s2_c8 bca.fes_wr_2016_10_21_s2_c8 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_10_21_s2_c9 bca.fes_wr_2016_10_21_s2_c9 Chart II-10AUD Technicals 2 bca.fes_wr_2016_10_21_s2_c10 bca.fes_wr_2016_10_21_s2_c10 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 bca.fes_wr_2016_10_21_s2_c11 bca.fes_wr_2016_10_21_s2_c11 Chart II-12NZD Technicals 2 bca.fes_wr_2016_10_21_s2_c12 bca.fes_wr_2016_10_21_s2_c12 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 bca.fes_wr_2016_10_21_s2_c13 bca.fes_wr_2016_10_21_s2_c13 Chart II-14CAD Technicals 2 bca.fes_wr_2016_10_21_s2_c14 bca.fes_wr_2016_10_21_s2_c14 Policy Commentary: "Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swiss Franc Chart II-15CHF Technicals 1 bca.fes_wr_2016_10_21_s2_c15 bca.fes_wr_2016_10_21_s2_c15 Chart II-16CHF Technicals 2 bca.fes_wr_2016_10_21_s2_c16 bca.fes_wr_2016_10_21_s2_c16 Policy Commentary: "[On the effects of low interest rates on the housing market]...If you look at the recent past, the dynamics have been a bit more reassuring...[still]let's not forget, this disequilibrium that we have achieved remains very high" - SNB Vice-President Fritz Zurbruegg (October 12, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 bca.fes_wr_2016_10_21_s2_c17 bca.fes_wr_2016_10_21_s2_c17 Chart II-18NOK Technicals 2 bca.fes_wr_2016_10_21_s2_c18 bca.fes_wr_2016_10_21_s2_c18 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 bca.fes_wr_2016_10_21_s2_c19 bca.fes_wr_2016_10_21_s2_c19 Chart II-20SEK Technicals 2 bca.fes_wr_2016_10_21_s2_c20 bca.fes_wr_2016_10_21_s2_c20 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 27, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights When interest rates are ultra-low, central banks have no margin for policy error. A small loosening or tightening has the potential to produce either a stall or catastrophic turbulence. The analogy is flying a plane at high altitude. Bond investors should have a strong preference for U.S. T-bonds over German bunds (currency hedged). Currency investors should prefer the euro over the dollar. For equity investors, valuations do not appear structurally attractive anywhere, once a sufficient equity risk premium is factored in. But a setback in the region of 5-10% could create a tactical entry point. Feature As the ECB Governing Council convenes for its October monetary policy meeting, an experience familiar to pilots1 provides a perfect analogy for central banks' very limited margin for error. Pilots call the experience "flying in coffin corner." Chart of the WeekUnusually High Turbulence For The German 30-Year Bund Unusually High Turbulence For The German 30-Year Bund Unusually High Turbulence For The German 30-Year Bund Next time you're in a plane climbing to 35,000 feet, here's something to think about; or perhaps, not to think about. As the plane gains altitude, its stall speed increases while its upper speed limit simultaneously decreases. For the pilot, this means less and less margin for error (Figure I-1). The plane's stall speed is the minimum speed to generate sufficient lift. At higher altitude, as the air gets thinner, the stall speed increases. Meanwhile, the plane's upper speed limit is set by the speed of sound. Airliners cannot fly too close to the speed of sound because the sonic shockwave produces violent and catastrophic turbulence. At higher altitude, as the air temperature drops, so does the speed of sound. Which means the plane's upper speed limit decreases. By the time the plane has reached the rarefied atmosphere of 35,000 feet, these lower and upper speed limits are barely 25 knots (30mph) apart,2 leaving almost no room for flight data misinterpretation or pilot error.3 Hence, at high altitude pilots morbidly say they are "flying in coffin corner." Analogously, in the rarefied atmosphere of zero or near-zero interest rates, central bank policy is also in coffin corner. When short-term and long-term interest rates approach the zero bound, there is no room for economic data misinterpretation or policy error. A small loosening or tightening of monetary policy has the potential to produce either a stall or catastrophic turbulence (Figure I-2 and Chart of the Week). Figure I-1Flying At High Altitude ##br## Has No Margin For Error Flying At The Edge Flying At The Edge Figure I-2Monetary Policy At Ultra-Low Rates ##br##Has No Margin For Error Flying At The Edge Flying At The Edge Avoiding A Stall At today's zero or near-zero interest rates in the euro area, a small loosening of monetary policy risks stalling the banking system, and thereby stalling the economy. A bank's core business is simple. Take in deposits, and lend them out at a higher interest rate than the deposit-rate - with the difference in the two defining the bank's net interest margin. A part of the net interest margin is a compensation for the risk of non-performing loans. This should be profit-neutral if correctly priced. The other large part of the net interest margin comes from the interest rate term-structure, as loans tend to be long-term while deposits are short-term. Hence, all else being equal, the bank's profitability suffers as the term-structure flattens. For a while, the bank can protect its profitability by cutting the interest rate paid on short-term deposits to well below the policy rate. However, once the policy rate hits zero, this profit-protection strategy hits a wall - because a negative deposit rate would risk an exodus of deposits into cash or cash-substitutes. Alternatively, the bank could charge a higher rate to borrowers, but this would tighten credit conditions. The third possibility is for the bank to suffer a hit to its already-thin net lending margin, but this would also tighten credit conditions. The pressure on the bank's profitability and share price would increase the cost of equity, making it harder to raise capital (Chart I-2). Given that an insufficient capital buffer is a major constraint to euro area bank lending, this would be a de facto tightening of credit conditions. The paradox is that at the zero bound, the smallest additional monetary loosening - via interest rate cuts or QE - risks stalling euro area bank credit creation (Chart I-3). Thereby it risks stalling economic growth. Chart I-2The ECB's QE Has Hurt Bank Valuations The ECB's QE Has Hurt Bank Valuations The ECB's QE Has Hurt Bank Valuations Chart I-3The Interplay Between Bank Profits And Bank Credit Creation Flying At The Edge Flying At The Edge Avoiding Violent Turbulence An extended period of ultra-low interest rates, and a commitment to keep them structurally low, has compressed the yields on government bonds pushing up their prices. As competing asset classes, the prices of corporate bonds and equities have also increased. This phenomenon is called the Portfolio Balance Effect. The big problem is that the prices of riskier assets have increased by more than is justified by the portfolio balance effect alone. This distortion is the result of a behavioural finance phenomenon called Mental Accounting Bias. Mental Accounting Bias describes the irrational distinction between the return from an investment's yield and that from its capital growth. The distinction is irrational because the money that comes from yield and the money that comes from capital growth is perfectly fungible.4 Rationally, what should matter is an investment's total return. But psychologically, the distinction between yield and capital is very stark. Fears about self-control cause people to compartmentalise yield as spending money and capital as saving money. Hence, people who want their investments to generate spending money - say, retirees - have an irrational focus on yield. Traditionally, the safe income from cash and government bonds satiates the people who irrationally focus on yield. However, in recent years, central banks' extended experiments with ZIRP, NIRP and QE have forced these yield-focussed investors out of cash and government bonds into risky investments. And just like every distortion, this phenomenon has generated memes to justify the act: 'reach for yield', 'search for yield', and 'there is no alternative' (TINA). But the irrational focus on yield instead of total return has artificially bid up the prices of risky investments. To the point that they no longer offer a sufficient risk premium5 for the very real possibility of substantial losses over a 5-10 year horizon (Chart I-4 and Chart I-5). The unfortunate thing is that as central bankers have little expertise in psychology or behavioural finance, they have been blind to the very dangerous behavioural distortion that their monetary policy experiments have unwittingly unleashed. Chart I-4A Positive Yield On Equities##br## Can Produce A Negative 5-Year Return... bca.eis_wr_2016_10_20_s1_c4 bca.eis_wr_2016_10_20_s1_c4 Chart I-5...And Even A Negative ##br##10-Year Return bca.eis_wr_2016_10_20_s1_c5 bca.eis_wr_2016_10_20_s1_c5 The risk is that the smallest monetary tightening could trigger an aggressive unwinding of this behavioural distortion. Recall the violent turbulence in global financial markets at the start of the year after just one 25bps rate hike from the Federal Reserve. Now consider what might happen if the Fed hiked again and the ECB simultaneously announced a rapid tapering of its QE program. How Must The Pilots Fly? In a rarefied atmosphere, pilots have very little margin to alter speed without inducing a stall or violent turbulence. The same applies to central banks today. The ECB has the hardest piloting task. It is becoming difficult to justify the current aggressive pace of QE given the danger of stalling the euro area banking system; and given that the euro area's nominal GDP and nominal wage bill are both growing at a very respectable 3% (Chart I-6). But an abrupt end to the ECB's QE could create violent turbulence in QE-distorted financial markets. Chart I-6What Deflation Threat? Euro Area Nominal GDP And The Wage Bill Growing At 3% bca.eis_wr_2016_10_20_s1_c6 bca.eis_wr_2016_10_20_s1_c6 Hence, the ECB's best course of action is to hint at a very gradual deceleration of QE to start at some point in the second half of 2017. Turning to developed economy central banks in general, we remind readers of a very powerful observation. Since 2008, no major central bank has been able to hike interest rates by more than 1.75%. And every central bank that has hiked rates has had to start unwinding those hikes within a year, ultimately taking the policy rate to a new all-time low (Chart I-7 and Chart I-8). Chart I-7Since 2008, All Rate Hikes ##br##Have Been Quickly Reversed bca.eis_wr_2016_10_20_s1_c7 bca.eis_wr_2016_10_20_s1_c7 Chart I-8Will The U.S. Be ##br##Any Different? No bca.eis_wr_2016_10_20_s1_c8 bca.eis_wr_2016_10_20_s1_c8 Given the turbulence that rate hikes will generate in the financial markets and/or the economy, we fully expect the Federal Reserve to go through exactly the same experience. The important upshot is that global central bank policy through 2017-18 will be considerably less divergent than is discounted. Bond yields could creep higher in the short term. But on a 1-year horizon, bond investors should have a strong preference for U.S. T-bonds over euro area bonds, and especially over German bunds (currency hedged). Over the same horizon, currency investors should prefer the euro over the dollar. For equity investors, valuations do not appear structurally attractive anywhere once a sufficient equity risk premium is factored in. Moreover, the potential for ECB QE-tapering combined with expectations for a Fed rate hike could generate some near-term turbulence. That said, a setback in the region of 5-10% could create an excellent entry point for a 3-month trade. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week. Last week's long silver/short lead pair trade has bounced sharply. And the short U.K. A-rated corporate bonds trade has achieved its 4% profit target. 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-9 Long Silver / Short Lead Long Silver / Short Lead * 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. 1 Your author is a former pilot in the Royal Air Force reserve. 2 For an Airbus A330. 3 Tragically, a combination of flight data misinterpretation and pilot error at 35,000 feet was disastrous for Air France flight AF447 flying from Rio de Janeiro to Paris in June 2009. Going through a storm, the airspeed indicator started giving a false reading and the pilot took the wrong corrective action, resulting in a catastrophic stall. 4 Assuming no difference in tax treatment of income and capital gains. 5 Please see the European Investment Strategy Weekly Report "The Great Distortion... And How It will End" dated September 15, 2016 available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_10_20_s2_c2 bca.eis_wr_2016_10_20_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_10_20_s2_c3 bca.eis_wr_2016_10_20_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_10_20_s2_c4 bca.eis_wr_2016_10_20_s2_c4 Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c5 bca.eis_wr_2016_10_20_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c6 bca.eis_wr_2016_10_20_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c7 bca.eis_wr_2016_10_20_s2_c7 Chart II-8Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c8 bca.eis_wr_2016_10_20_s2_c8