Gold

Highlights As widely expected, the Fed raised the policy rate by 25bps last week. The central bank is also forecasting an additional rate hike for 2018, but one less for 2020. The labor market typically continues to improve after the economy reaches full employment, wage inflation begins to accelerate after the economy achieves full employment, while prices rise only gradually. Gold and Treasuries were the big winners and the dollar was the big loser in previous trade spats. Feature The dollar rose 1%, but gold, the S&P 500, and U.S. Treasury yields sunk last week amid a busy calendar of U.S. economic data and the Fed's new forecasts. The stats and the FOMC projections confirmed that the U.S. economy is already at full employment and that the market is underpricing the number of Fed hikes planned for this year. Meanwhile, U.S. President Trump's meeting with North Korea leader Kim Jong Un provided some relief on the geopolitical front, but there is still uncertainty on trade over impending tariffs on China. Chart 1Watch The 2.3% To 2.5% Level##BR##On TIPS Breakevens Watch The 2.3% To 2.5% Level On TIPS Breakevens Watch The 2.3% To 2.5% Level On TIPS Breakevens BCA's base case remains that U.S. equities will not be subject to an over-aggressive Fed until mid-2019 and that increasing bond yields are not a threat. That said, the timing is uncertain and depends importantly on how inflation and inflation expectations shift in the coming months. Inflation is only gradually moving higher at the moment and the Fed is willing to tolerate an overshoot of the 2% target. However, some inflation hawks at the Fed are worried given that the economy is already at full employment and expected to accelerate this year. The uptrend in inflation could suddenly become steeper in this macro environment. Alarm bells will ring when inflation hits 2.5% and the central bank will switch from normalizing policy to targeting slower growth, putting risk assets under pressure. We are also on the watch for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will become more aggressive in leaning against above-trend growth and a falling unemployment rate (Chart 1). That would be an important signal to trim exposure to risk assets. Although Trump's meeting with Kim lowered geopolitical risk, BCA's strategists note that the secular decline in U.S.-China ties and the "apex of globalization"1 are more relevant subjects than what happens on the Korean peninsula. While North Korea may still stir up concern, we recommend that investors monitor U.S.-China trade tensions, the East and South China Seas, and Taiwan. Elsewhere, U.S.-Iran tensions are the key understated geopolitical risk to markets. Moreover, BCA's Geopolitical Strategy service expects that trade-related uncertainty will persist at least until the U.S. mid-term elections in November.2 Two More In '18 As widely expected, the Fed raised the policy rate by 25bps last week. The central bank is also forecasting an additional rate hike for 2018, but one less for 2020 (Chart 2). Chart 2FOMC And Market Mostly##BR##Aligned On Economy And Rates FOMC And Market Mostly Aligned On Economy And Rates FOMC And Market Mostly Aligned On Economy And Rates Instead of three, the Fed now expects to deliver a total of four rate hikes in 2018. For 2019, the Fed continues to project a further three rate hikes. And for 2020, the Fed now believes only one rate hike will be warranted, down from two hikes in its previous forecast. What this means is that the Fed has simply brought forward one rate hike from 2020 to 2018. It left its median projection for the level of the Fed funds rate in 2020 unchanged at 3.375%. Moreover, the Fed kept its estimate of the neutral rate unchanged at 2.875%. In other words, the Fed is forecasting a marginally faster pace to rate hikes, but it has not changed its outlook for the full extent of the tightening cycle. This minor change to the policy outlook should not disrupt financial markets. Prior to last week's FOMC meeting, Fed funds futures were already pricing a 50% probability of a fourth rate hike this year. The bigger question is whether more upward adjustments to the interest rate outlook lie ahead. On this front, there are inconsistencies in the Fed's economic projections. In terms of the long-run steady state, the Fed believes the potential growth rate of the economy is 1.8% and NAIRU is 4.5%. Yet the Fed is forecasting real GDP growth of 2.4% and 2.0% (i.e. above-trend) for 2019 and 2020, respectively, but expects both the jobless rate and core inflation to remain steady at 3.5% and 2.1%, respectively. Above-trend growth should imply a further decline in the unemployment rate. And a jobless rate that's well below NAIRU should imply an acceleration in inflation. In turn, this should mean a higher path for interest rates. But rather than higher interest rates, the inconsistency in the Fed's economic forecasts can also be resolved in other ways. First, the Fed could simply be too optimistic on growth. If growth is weaker, then unemployment and inflation forecasts could be proven right. Second, the Fed's estimates of trend growth and NAIRU may be incorrect. If trend growth is higher and NAIRU is lower, the pressures on resource utilization and inflation will be less. Bottom Line: The tweaks to the Fed's interest rate projections are too small to have a material impact on financial market pricing. However, there is a risk that the inconsistencies in the Fed's economic forecasts will be resolved with more hawkishness in 2019. This could then prove problematic for global risk assets, depending on the evolution of inflation. Are We There Yet? The U.S. economy reached full employment in Q1 2017. The unemployment rate crossed below the Fed's measure of NAIRU in March 2017, a whopping 93 months after the start of the current expansion. Chart 3 shows that in the long expansions3 in the 1980s and 1990s, the economy reached full employment sooner; 54 months in the 1980s and 72 months in the 1990s expansion. After the economy attained full employment in the 1980s and 1990s, an average of another 27 months passed before the unemployment rate troughed. This means that the trough will occur in mid-2019 and our view is that the rate will bottom at around 3.5% in mid-2019.4 Moreover, the 1980s' economic recovery lasted another 34 months once the economy hit full employment and another 47 months once full employment was breached in the 1990s. If this historical pattern holds, then the next recession will begin in late 2020. This date is consistent with our prior work5 on the start date of the next downturn. Chart 3The Economy At Full Employment In Long Cycles The Economy At Full Employment In Long Cycles The Economy At Full Employment In Long Cycles The labor market typically continues to improve after the economy reaches full employment. Initial claims for unemployment insurance, as a share of the labor force, move lower for another two years, on average, after labor market slack disappears (Chart 4, panel 2). The monthly non-farm payrolls job count follows a similar pattern and it does not turn negative for another four years (panel 3). The Conference Board's jobs easy/hard to get shows that the labor market is hotter than in the previous long expansions (panel 4). The conclusion is that the labor market will continue to tighten for another year or so, consistent with our outlook. Wage inflation begins to accelerate after the economy achieves full employment. Chart 5 shows increases in the average hourly earnings (AHE), the Employment Cost Index (ECI), and compensation per hour after the unemployment rate fell below NAIRU in the 1980s and 1990s. However, unit labor costs (ULCs) did not accelerate in those years until well after the economy hit full employment. Many of these measures of wage inflation are also on the upswing today. However, none of the indicators are rising as quickly as they did in the 1980s and 1990s (See Appendix Table 1 for more details on performance of labor market, wage and inflation metrics after the economy reaches full employment). Inflation initially remained tame even after labor market slack was taken up in the previous two long expansions. Chart 6 shows that neither headline nor core CPI accelerated sharply after the economy arrived at full employment in the '80s and '90s. However, headline CPI inflation began rising not long after full employment was reached. It took a little longer for core inflation to perk up. Moreover, inflation tends to peak as the unemployment rate troughs. This occurs, on average, about three years after the unemployment rate crosses below NAIRU. Chart 4The Labor Market When##BR##The Economy Is At Full Employment The Labor Market When The Economy Is At Full Employment The Labor Market When The Economy Is At Full Employment Chart 5Wages And Compensation When##BR##The Economy Is At Full Employment Wages And Compensation When The Economy Is At Full Employment Wages And Compensation When The Economy Is At Full Employment Chart 6Inflation When The Economy##BR##Is At Full Employment Inflation When The Economy Is At Full Employment Inflation When The Economy Is At Full Employment Bottom Line: The U.S. economy has been at full employment since early 2017, but investors should be patient if they expect a marked acceleration in inflation. Inflation is already at the Fed's target and BCA expects two more rate hikes this year and at least three more increases in 2019 as inflation moves closer to 2.5%. Stay underweight duration. The labor market is as tight as it was at this point of the previous two long expansions. Moreover, the trends in inflation and wages are similar, although from a lower level. That said, while inflation is more muted today, interest rates are much, much lower, and the Fed does not want a major overshoot. If we follow the same path as the previous two long expansions, then inflation will rise only gradually, and the next recession is a ways off. But watch for an acceleration in ULC, because in the average of the last two long expansions, an acceleration in ULC coincided with an acceleration in core CPI inflation. That would cause the Fed to become more aggressive. Trump's Focus On China The U.S. is an old hand at trade wars and economic conflicts, with an endgame of dollar depreciation and compromises on trade.6 Since 1970 there have been seven major trade disputes involving tariffs, including the one that began in March of this year. Some were brief and several of those periods overlapped. Moreover, many other factors affected investment returns, including recessions, wars, major terrorist attacks, and financial crises. As a result, these periodic trade tiffs make it difficult to discern the implications for the financial markets. During episodes of trade-related uncertainty, stocks underperform Treasuries, the dollar falls both pre- and post-dispute, and gold performs much better both during and after. Treasuries are the most consistent performer, and this asset class beat stocks during five of the six periods. Meanwhile, the dollar fell during 5 of the 6 trade spats (Table 1). Chart 7 shows the performance of a wider set of U.S. financial assets before, during, and after trade tensions erupt. Table 1U.S. Stocks, Treasuries, The Dollar, Gold And Trade Disputes The Economy At Full Employment The Economy At Full Employment Chart 7U.S. Financial Assets And Trade Spats U.S. Financial Assets And Trade Spats U.S. Financial Assets And Trade Spats We begin our discussion of trade spats and their implication for financial markets in the early 1970s. In August 1971, with the dollar steeply overvalued, President Richard Nixon abandoned the gold standard and imposed a 10% surcharge on all dutiable imports. The purpose of the tariff was to force the U.S. allies to appreciate their currencies against the dollar. Some appreciation occurred as a result of the Smithsonian Agreement, but the effects were short-lived. The U.S. could not afford to alienate its allies amid the Cold War and removed the restrictions four months later. Table 1 shows that S&P 500 increased by nearly 40% in the year prior to the 1971 trade spat, but the economy was recovering from the 1969-70 recession. Equities easily beat Treasuries (+17%), the dollar declined by 3%, and gold jumped by 22%. However, during late 1971, the S&P 500 underperformed Treasuries, the dollar dropped by 5%, and gold was little changed. In the 12 months after the trade issue was resolved, U.S. stocks beat bonds, the dollar continued to move lower, and gold surged. This occurred as inflation ramped up. In a trade dispute episode during the 1980s, then President Reagan and a Democrat-leaning Congress became concerned with trade deficits and a sharply rising dollar. The Plaza Accord in 1985 consisted of a German and Japanese promise, once again, to appreciate their currencies. From 1985-89, a U.S.-Japan trade war was waged over Japan's growing share of the U.S. market and certain unfair trade practices affecting goods such as cars, semiconductors, and electronics (Chart 8). The combination of yen appreciation, voluntary export restraints and tariffs, resulted in compromises, and in the early 1990s the U.S. removed Japan from its list of targets. Chart 8The U.S.-Japan Trade Spat In The 1980s The U.S.-Japan Trade Spat In The 1980s The U.S.-Japan Trade Spat In The 1980s During the 1985-89 dispute, the U.S. stock market crashed, economic growth surged, inflationary pressures mounted, and the Fed hiked rates. Nevertheless, stocks crushed bonds as the dollar tumbled by 40% and gold soared by 30% (Table 1). Note that gold fell in the year before the trade dispute began and in the year after it ended. In the late 1990s, a series of trade disputes erupted between the U.S. and the European Union, most significantly on a tax device that allowed companies reduced taxes on profits derived from export sales. The EU won its case against the U.S. at the WTO and the U.S. eventually repealed the offending provisions in its tax code. At the same time, from 1999-2001, the U.S. contested EU policies on banana imports. Then in March 2002, President George W. Bush imposed steel tariffs affecting Europe, but these were subsequently reversed in December 2003 in the face of retaliatory threats. Trade tension in the late 1990s and early 2000s developed alongside the tech boom, the 2001 recession and recovery, and the first Gulf War. The 10-year Treasury outperformed the S&P 500 as Bush's steel tariffs were in effect, but the early part of this period coincided with the accounting scandals that buffeted U.S. equity markets. The U.S. dollar dropped nearly 25%, although the Fed cut rates in 2002 and 2003. Gold climbed 34% in this period, outpacing both stocks and bonds. President Trump's trade positions are reminiscent of both Nixon's and Reagan's policies and his trade team includes a notable veteran of the U.S.-Japan trade war, U.S. Trade Representative Robert Lighthizer. The focus, however, is not entirely the same. True, there is still a fixation on privileged manufacturing industries like steel and autos, both in the Section 232 actions on steel and aluminum and in the NAFTA renegotiation. But there is today a heightened focus on China's abuses of the international trade system, in particular its technology theft and intellectual property violations (the Section 301 actions). For investors, the critical issue is to separate the two areas of focus. The U.S. grievances with Europe, NAFTA, and Japan will cause more volatility this year and beyond, but are ultimately more manageable than those with China. U.S.-China trade tensions are caught up in a Great Power rivalry that will likely persist throughout this century, making trade tensions a permanent feature of the relationship going forward.7 China's rapid military growth and technological acquisition threaten U.S. global dominance. China will view any imposition of tariffs by the U.S., or demands for dramatic RMB appreciation, as a strategic attempt to derail China's rise. Moreover, while Congress will not attack President Trump for retreating from the trade war with the allies, it will attack President Trump for compromising on China. Recent U.S. elections have swung on Rust Belt Midwestern states that resent America's deindustrialization. In 2020, Democrats will attempt to reclaim their credibility as defenders of American workers and "fair trade," especially against China. President Trump stole their thunder with his protectionist platform. There is unlikely to be a "trade dove," and especially not a "China dove," in the White House from 2020-24. Bottom Line: The U.S. has historically used punitive trade measures to force its allied trading partners to appreciate their currencies versus the dollar. It has also sought to protect politically sensitive industries. Today, however, the trade war with China is inextricably tied to a strategic conflict that will play out over decades. Trump will likely impose Section 301 tariffs on China after June 15 and any deal to avoid confrontation will merely delay the decision on tariffs until after November's mid-term elections. Investors should recall that bonds beat stocks, the dollar fell, and gold rose during previous periods of trade tension. We also note that shifts in correlations between key U.S. asset classes tend to occur as trade spats begin and end, especially in the past 30 years (Chart 9). Moreover, gold usually continues to climb and the dollar falters even after these disputes are resolved. Chart 9U.S. Asset Class Correlations During Trade Disputes U.S. Asset Class Correlations During Trade Disputes U.S. Asset Class Correlations During Trade Disputes John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014. Available at gps.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," published April 4, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Bank Credit Analyst Monthly Report, published March 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Tightening Up", published May 14, 2018. Available at usis.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report, "Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000," published March 30 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," published April 12, 2017. Available at gps.bcaresearch.com. 7 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," published March 14, 2018. Available at gps.bcaresearch.com. Appendix Appendix Table 1Key Labor Market And Inflation Indicators At Full Employment The Economy At Full Employment The Economy At Full Employment

Highlights Italy is a live drama. However, both Italy and Brussels have constraints that should lead to a compromise on fiscal stimulus. Italy will not leave the euro in the foreseeable future, and the European Central Bank has little incentive not to continue accepting Italian bonds. With the recent capitulation in the Italian bond market, the euro could experience a brief respite, potentially rallying toward 1.18 to 1.19. However, for the euro to endure a more durable bottom, global bond yields need to stop falling. Until then, EUR/USD could move toward 1.12. Falling bond yields imply more downside for EUR/JPY and EUR/CHF as well. NOK/SEK is not yet a buy. The trend in gold prices can be used to gauge where the fed funds rate stands vis-à-vis r-star. Feature In July 64AD, the Great Fire of Rome erupted, causing untold damage to the great imperial capital. Various Roman sources suggest that Emperor Nero started the fire to clear land in order to build himself a new palace, the Domus Aurea.1 This fire was a calamity, and was followed by a period of economic tumult and currency debasement. However, Rome recovered, the empire conquered more nations, and ultimately survived another 412 years. We have held a bearish view on the euro for 2018, expressed by recommending investors buy DXY and sell EUR/CAD, EUR/JPY and EUR/CHF. However, this view is underpinned by economic divergences and a softening in global growth. Our negative bias on the euro has greatly benefited from the fire that has engulfed Italian politics and bond markets. Taking stock of this week's political theatre, does it still make sense to be short the euro, and by extension long the dollar? As we foresee more downside in global bond yields, we think yes. However, while Italy is currently burning, it is not at risk of causing a collapse of the euro area. Pricing an end to the "empire" is thus an inappropriate reason to stay short the euro. The Italian Job Italy has once again become a trouble spot for investors. The M5S / Lega Nord coalition's manifesto proposes blowing out the fiscal deficit to above 7% of GDP by instituting a flat tax regime, increasing spending and undoing pension reforms instigated by the Monti government in 2012. In response to these developments, president Mattarella has removed the proposed finance minister, Paolo Savona, arguing he was too anti-euro and that abandoning the euro area was unconstitutional. He went on to nominate Carlo Cottarelli, nicknamed "Mr. Scissors," as a caretaker prime minister tasked with leading a technocratic government until new elections are implemented. However, the coalition rightfully argued that this move was executed under a false pretext, as its current policy proposal does not include leaving the euro area. Even before the drama had fully blossomed, Italy on Monday had been put on downgrade watch by Moody's. In light of the political developments, investors then worried that a new election would result in Italy potentially exiting the euro area. Italian 2-year yields spiked to a spread of 350 basis points against German Schatz. This implied a perceived probability of 11% that Italy will choose to exit the euro area over the course of the next two years. Another possible outcome discounted by investors was that the European Central Bank would stop accepting BTPs as repo collaterals, or stop buying them in its Asset Purchase Program. Chart I-1Italian Support For The Euro##br## Is Low But Well Above 50% Italian Support For The Euro Is Low But Well Above 50% Italian Support For The Euro Is Low But Well Above 50% Which of these two risks is more likely to materialize? We think the current implied probability of Italy electing to leave the euro over the coming two years is very low. Italians exhibit the lowest support toward the euro of any eurozone member state. However, a majority of Italians, 59% of them, still support the common currency (Chart I-1). In response to this constraint, the very nimble Five Star Movement, while still hell-bent on fiscal profligacy, has already greatly downplayed its Euroscepticism. While Lega Nord still has more Eurosceptic inclinations, it has not put leaving the euro area at the core of its coalition agreement with M5S. BCA has a great degree of confidence in this view, but it is important to not be dogmatic. BCA's Geopolitical Strategy service recommends investors closely follow the statements of these two parties over the course of the summer. The second risk is more real. The fiscal proposal of the coalition would blow the Italian budget deficit from 2.3% to more than 7% of GDP. Ratings agencies are already putting Italy on downgrade watch. Italy has a credit rating of Baa2, and only bonds with ratings of Baa3 or better are eligible at the ECB. It is possible that the central bank, in coordination with Brussels, exerts the same kind of pressure as it did in August 2011 when Jean Claude Trichet and Mario Draghi wrote a letter to Silvio Berlusconi demanding his resignation in exchange for financial market support for Italy. Despite this risk, we expect Italy to ultimately play ball and not blow up the deficit to 7% of GDP - simply because of economic constraints. These constraints are also likely to create an additional limit on the willingness and capacity of Italy to leave the euro area. The arguments we made in a joint Special Report with BCA's Geopolitical Strategy service titled "Europe's Divine Comedy Part II: Italy In Purgatorio," published in June 2017, remain valid: Italy will feel the pain from its transgressions before it can implement them.2 This is happening today as we write. Essentially, Italy's problem is rooted in the poor health of its banking system. Italian banks have capital in the order of EUR165 billion and NPLs of EUR130 billion, leaving EUR35 billion in excess capital. However, Italian commercial banks hold approximately EUR350 billion in BTPs. Thus, any decline in BTP value of 10% or more would render the Italian banking system insolvent (Chart I-2). Since suggesting abandoning the euro or conducting policy that exclude Italian debt from the ECB's window would cause a greater than 10% fall in BTP prices, this would kill off credit issuance in Italy as the banking sector would not have the wherewithal to extend new loans. This would prompt a large collapse in the credit impulse, and thus GDP growth (Chart I-3). The ensuing painful recession would cause Italians to backtrack on their intentions to leave the euro area. If Italy's credit rating and its access to the ECB is the reason for the collapse in BTP prices, the same dynamics will also force the Italian government to adopt a more realistic fiscal policy. This is why we do not believe the current M5S/Lega Nord government will be able to blow up the budget by as much as it currently wants. Chart I-2The Italian Constraints Lies##br## In The Banking Sector The Italian Constraints Lies In The Banking Sector The Italian Constraints Lies In The Banking Sector Chart I-3Credit Trends Explain##br## Italian Growth Credit Trends Explain Italian Growth Credit Trends Explain Italian Growth There are, however, incentives for Brussels to be more lenient on Italy. Italy is not Greece. The Troika had room to play hardball with Greece. Greek debt was EUR346 billion, or 10% of Germany's GDP (the perceived ultimate backer). The same cannot be said about Italy. Rome's debt stands at EUR2383 billion or 70% of Germany's GDP. In other words, as J. Paul Getty once said, "If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem." Italy is the EU's problem. Chart I-4If You Owe The Bank 442 Billion, ##br##That's The Bank's Problem If You Owe The Bank 442 Billion, That's The Bank's Problem If You Owe The Bank 442 Billion, That's The Bank's Problem This problem is most evident in the Target 2 of the Bank of Italy. The Italian national central bank owes EUR442 billion to the Eurosystem, the most of any nation (Chart I-4). Claims on Italy can also be found on the balance sheets of commercial banks across Europe. French, Spanish, German, and Dutch commercial banks have Italian exposure of EUR426 billion, with EUR310 billion held by French banks alone. Italy's problems are definitely Europe's problem. A collapse of Italy could therefore impair the entire European banking sector. This means that the EU and the ECB have a strong built-in incentive to be lenient toward Italy. As a result, we expect that Brussels will be forced to accept a larger Italian deficit than 3% of GDP, as it did at the turn of the millennium when France and Germany were also in violation of the Stability and Growth Pact. The ECB could also make a conditional exception in terms of accepting Italian bonds. So What? The Italian situation remains fluid. While an election this summer, as early as July 29th, has been touted, efforts to form a government are still taking place. No matter what happens, the constraints on both Italy and the European institutions suggest that both sides of the table will have to come to a compromise regarding Italian public spending. The EU will have to tolerate a greater than 3% of GDP deficit, and the Five Star Movement, with whoever it coalesces, will not be able to blow up the budget deficit above 7% of GDP. Investors have made a mistake by pricing in an Italian exit. Hence, Italian 2-year yields could experience downside in the coming week. In fact, the daily move in Italian 2-year yields on Tuesday was the largest on record, despite what are still very low levels of interest rates by historical standards (Chart I-5). This suggests that May 29th represented a day of capitulation in the Italian bond market, at least on a short-term basis. As a result, the very oversold euro, which has declined more or less without a pause for the past 29 trading days, could stage a relief rally as investors re-evaluate the Italian risks (Chart I-6). Chart I-5Capitulation In The BTP Market Capitulation In The BTP Market Capitulation In The BTP Market Chart I-6The Euro Short-Term Rebound Can Continue The Euro Short-Term Rebound Can Continue The Euro Short-Term Rebound Can Continue This begs a crucial question: Is it time to bail on our various short bets on the euro as well as our long bet on the DXY? While a temporary resolution in Italy could easily prompt a euro rally toward 1.18-1.19, many issues that have prompted us to implement these views have yet to fully play out. For example, the euro's fair value, as implied by real short rate differentials, the slope of the euro area yield curve relative to the U.S. and growth differentials between the rest of the world and the U.S. - as captured by the price of copper relative to the price of lumber - still pegs an equilibrium for EUR/USD at 1.12 (Chart I-7). Chart I-7The Euro Has Yet To Purge Its Previous Excesses The Euro Has Yet To Purge Its Previous Excesses The Euro Has Yet To Purge Its Previous Excesses Additionally, while traders have capitulated on Italian bonds, investors have yet to capitulate on the euro. Speculators are still very long, and investor sentiment is still not consistent with a bottom (Chart I-8). Additionally, the trend in relative inflation still points toward a weaker euro, as it portends to an easing of European monetary policy relative to the U.S. (Chart I-9). The tension in Italy and the widening spreads in innocent Spain could play toward the ECB adjusting its forward guidance toward no hike for longer than is currently priced into the EONIA curve. Chart I-8No Capitulation Here No Capitulation Here No Capitulation Here Chart I-9Inflation Dynamics Point To A Lower EUR/USD Inflation Dynamics Point To A Lower EUR/USD Inflation Dynamics Point To A Lower EUR/USD However, the most important question right now for the euro is the direction of bond yields. Much will depend on the performance of bonds over the course of the coming months. Bottom Line: Italy is a political landmine, and the recent drama has weighed on the euro, causing EUR/USD to depreciate much faster than we anticipated. However, markets are currently embedding too-large a risk premium of an Italian exit. Both Italy and the EU will not stay as intransigent as they currently pretend, suggesting the market action will force a political compromise on the thorny question of deficits. As a result, while a rally in coming weeks of EUR/USD toward 1.18-1.19 is a very probable scenario, we anticipate the euro's weakness to end closer to 1.12 than currently recorded levels. All About Bond Yields BCA believes that bond yields are globally on a cyclical upswing, being lifted by the fact that global central banks are slowly but surely exiting the emergency stimulus measures put in place directly after the great financial crisis. Moreover, we also expect inflation to slowly come back, especially in the U.S. and Canada, also justifying higher yields. In response to these forces, BCA's three factor bond model, based on global manufacturing PMIs, the U.S. employment-to-population ratio and the dollar's bullish sentiment, suggests the fair value of 10-year Treasurys is at 3.3%, 46 basis points above current yields. However, markets do not move in a straight line. The bond market is especially prone to reversals as interest rates are a key determinant of the cost of capital. Thus, higher yields slow global economic activity, diminishing the reason why yields increased in the first place, creating a stop-and-go pattern. This time is no exception. In fact, Ryan Swift has been arguing in BCA's U.S. Bond Strategy service that after their sharp up-move from 2.04% to 3.11%, bond yields have downside on a short-term basis.3 A few factors explain why bond yields could experience a bit more downside in the coming months: Bond aggregates have been oversold (Chart I-10), with their 100-day rate of change hitting levels associated with a subsequent rebound in prices. This rebound is underway and doesn't look to have yet been fully played out. Chart I-10Bonds Were Too Oversold To Keep Falling In A Straight Line Bonds Were Too Oversold To Keep Falling In A Straight Line Bonds Were Too Oversold To Keep Falling In A Straight Line Positioning remains too skewed. Speculators are still very short Treasurys, and duration surveys conducted by J.P. Morgan Chase suggest there is still more room to surprise investors, prompting them to lighten their short-duration calls (Chart I-11). The changes in 10-year U.S. yields are very correlated with the U.S. surprise index. However, this economic indicator is highly mean-reverting. The increase in investors' expectations suggests there is room for disappointment on the economic front for market participants. Ryan's autoregressive model for economic surprises, which captures the mean-reverting behavior of this series, suggests that surprises will deteriorate further in the coming weeks (Chart I-12). Chart I-11Still No Capitulation In ##br##Bond Positioning Still No Capitulation In Bond Positioning Still No Capitulation In Bond Positioning Chart I-12Economic Surprise Index U.S. Surprise ##br##Index Can Mean-Revert Further Economic Surprise Index U.S. Surprise Index Can Mean-Revert Further Economic Surprise Index U.S. Surprise Index Can Mean-Revert Further Global growth continues to show signs of deterioration, as the diffusion index of our global leading economic indicators highlights that only 24% of the world's major economies are experiencing expanding LEIs (Chart I-13). Moreover, the deliquescence of EM carry trades funded in yen also points toward additional deceleration in global industrial activity, and export volumes growth out of Asia continues to slow (Chart I-13, bottom panels). Here, the recent performance of gold is most revealing. The yellow metal is a good gauge of global liquidity conditions, and it tends to perform well when bond yields, especially real rates, weaken. However, despite a fall in real yields in recent weeks, and despite the rising geopolitical risks associated with Italy and the re-emergence of trade wars, gold prices are softer than expected. This implies that bond yields have not yet fallen enough to put a floor under global growth. So why does the absolute trend in Treasury yields matter for EUR/USD? Simply because since 2008, EUR/USD has performed very poorly when bond yields have declined, displaying an average annualized rate of return of -6.3% as well as a median return of -9.7%, and weakening two-thirds of the time (Table I-1). This essentially confirms our previous analysis showing that generally, the euro is a rather pro-cyclical currency. This also suggests that even if the euro could experience a temporary rally in response to a re-pricing of Italian exit risk, it will be hard for the common currency to rally durably so long as bond yields have downside. Chart I-13Global Growth Is Slowing Signs##br## Of Soft Global Growth Global Growth Is Slowing Signs Of Soft Global Growth Global Growth Is Slowing Signs Of Soft Global Growth Table I-1Bond Rallies And The Currency Market Rome Is Burning: Is It The End? Rome Is Burning: Is It The End? Table I-1 also shows that the yen has experienced large upside in a falling yield environment, and most importantly has risen in all instances against the USD. As a result, we remain comfortable with our January 12, 2018 recommendation to sell EUR/JPY.4 Not only does EUR/JPY weaken 83% of the time when bond yields fall, but as Chart I-14 shows, relative positioning in EUR/JPY has more room to deteriorate, as previous excesses on the long side tend to be followed by periods of excessive short positioning. Moreover, as the bottom panel illustrates, a reversal in the performance of momentum stocks also comes hand in hand with a weak EUR/JPY. Chart I-15 also highlights that rising dollar funding costs tend to lead to a weaker EUR/JPY. Chart I-14EUR/JPY Is Still Vulnerable EUR/JPY Is Still Vulnerable EUR/JPY Is Still Vulnerable Chart I-15Funding Pressure Point To A Weaker EUR/JPY Funding Pressure Point To A Weaker EUR/JPY Funding Pressure Point To A Weaker EUR/JPY Table I-1 further shows that despite our positive long-term view on EUR/CHF, if we believe that yields could correct further, it is intellectually coherent to be short EUR/CHF on a tactical basis, as the pair has also fallen in 83% of the occurrences of bond market rallies. We are thus sticking with this short-term trade. Chart I-16CAD Benefits From A Valuation Cushion CAD Benefits From A Valuation Cushion CAD Benefits From A Valuation Cushion Table I-1 however, is more mixed for our short EUR/CAD bet. EUR/CAD rallies on half the instances where bond yields weaken, and generates an average annualized gain of 1%. Yields are therefore an unreliable gauge of this cross's trend. Instead, we continue to favor the CAD over the EUR on the basis of relative monetary policy dynamics and valuations. The Canadian economy has no slack, core inflation is at 1.9%, and the Bank of Canada just re-opened the door to hiking rates this year - essentially a mirror image to the euro area. Also, while EUR/USD is overvalued by 4.9% based on our preferred model, USD/CAD is overvalued by 14% based on our model using oil and relative rate expectations (Chart I-16). We are therefore sticking with this position, even though we are likely to experience volatility after a straight move down from 1.61 to 1.5. Yesterday's announcement that the White House is imposing tariffs on steel and aluminium on Canada and the EU is likely to be a crucial contributor to this episode of volatility. Finally Table I-1 shows that our negative view on commodity currencies is the correct one to hold in the current context, especially regarding the AUD, which within this group suffers by the greatest extent when yields fall. Additionally, this analysis confirms our assessment regarding NOK/SEK. We were long this pair, and continue to foresee upside for the Norwegian krone relative to the Swedish krona on a cyclical basis. However, we closed this trade as NOK/SEK was getting very overbought. Adding another justification for this tactical decision, a falling yield environment has been associated with this cross weakening in 83% of cases and depreciating on average by a 4.9% annualized rate - or 5.7% if we take the median fall. We will therefore wait to see a stabilization in bond yields before re-opening our NOK/SEK trade. Bottom Line: The rebound in bond prices expected by our U.S. bond strategist has further to run, as the global economy is experiencing a soft patch and U.S. economic surprises have additional downside. This suggests that EUR/USD is likely to depreciate more, prompting us to stick with our 1.12 target for now. EUR/JPY and EUR/CHF possess ample downside as well. While commodity currencies all weaken when bond yields decline, the AUD declines most often, and by the greatest extent. NOK/SEK can correct further before resuming its uptrend; only once bond yields stabilize will we buy this cross again. Gold, The Fed And R-star Following last week's report where we discussed the interaction of the dollar, the fed funds rate, and r-star,5 we received a few questions regarding the implication of this analysis for the gold market. While the message of this analysis was very clear for the dollar - the dollar weakens when the Fed increases rates and the fed funds rate is below the r-star, but strengthens significantly when the Fed lifts rates above r-star - the implications for gold of the interaction between rates and r-star is much murkier. Table I-2 shows the returns of gold, as well as the batting averages of the results, under the four states explored last week. We use medians instead of means, as average returns have been distorted by a few outliers. Table I-2Gold And The Interaction Between ##br##Rates And R* Rome Is Burning: Is It The End? Rome Is Burning: Is It The End? This table highlights that the best environment to hold gold has been the same environment that was harshest to the dollar: a rising fed funds rate, but one that stands below the neutral rate. Essentially, this suggests that in this environment, despite the efforts of the Fed to tighten monetary conditions, global liquidity remains plentiful, which fuels both global growth and gold prices. In this context, gold rallies 76% of the time by a median annualized rate of 14.4%. Chart I-17Gold As A Gauge For R* Gold As A Gauge For R* Gold As A Gauge For R* Perplexingly, there is no clear implications in the other states. When the fed funds rate rises and stands above the neutral rate, gold falls by a median annualized rate of 1.3%, but this only works 55% of the time. This probably reflects the fact that when the real fed funds rate rises in this environment, while in and of itself this should hurt gold, the growing incidence of accidents in global financial markets and the global economy helps gold, undoing the damage created by tighter monetary policy. When the fed funds rate is falling, gold's annualized returns are mixed, but most importantly the distribution of returns is no better than random. So while this analysis does not provide a clear signal for gold next year, it does help us generate a useful inference. If the Fed is indeed soon set to lift interest rates above the neutral rate, as the Laubach-Williams measure of r-star implies, the violent rally that gold experienced in 2017 should taper off. If gold were to continue to rally vigorously, maintaining its strong trend despite higher rates (Chart I-17), this would imply that the fed funds rate is still below r-star. As a corollary, the business cycle would have greater upside, the dollar greater downside, and EM assets should prove more resilient than we anticipate. Bottom Line: Where we stand in the interest rate cycle is less useful for calling the gold market than it is for calling the dollar. While a rising fed funds rate that stands below the neutral rate creates a very supportive environment for gold, other combinations are more opaque. However, this can help generate useful insights on the equilibrium rate. If faced with higher interest rates, gold remains on the strong upward trend it experienced in 2017, this would mean that U.S. policy is still accommodative as the fed funds rate would still be below r-star. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Tacitus, the main source describing the fire, was unsure of the veracity of these allegations. 2 Please see Foreign Exchange Strategy and Geopolitical Strategy Special Report, titled "Europe's Divine Comedy Part II: Italy In Purgatorio", dated June 21, 2017, available at fes.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, titled "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, and the Weekly Report, titled "The Yen's Mighty Rise Continues... For Now", dated February 16, 2018, both available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was generally weak this week: Q1 GDP growth was revised down to an annualized pace of 2.2%, profit growth was weak; Core personal consumption expenditure grew at a 2.3% quarterly pace, underperforming expectations of 2.5%; Core PCE inflation came in line with expectations at 1.8%. The March number was revised down to 1.8% as well from 1.9% previously; However, the U.S. labor market continues to tighten, with both continuing and initial jobless claims falling more than expected. Washington is ramping up its hawkish stance on trade, implementing its steel and aluminum tariffs on the EU, Canada, as well as Mexico. The U.S. is nonetheless likely to fare better than the rest of the G-10 in the current soft patch for global growth as it is a less cyclical economy. Furthermore, with the dollar recoupling with rate differentials, Fed hikes will serve as an important tailwind for the greenback for the rest of this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Amidst the surfeit of political angst across Italy and Spain, some positive economic data have contributed to some relief to the euro's persistent decline this month. German headline and harmonized inflation surprised to the upside, both coming in at 2.2%; German unemployment declined to 5.2%; German retail sales increased by 2.3% on a monthly pace; Spanish harmonized inflation came in at 2.1%, beating expectations; Euro area headline and core inflation came in at 1.9% and 1.1%, respectively, an improvement over previous figures; Unemployment also declined to 8.5% from 8.6%, but came in higher than the expected 8.4%. In addition to abating political anxiety in Italy, ECB Executive Board Member Sabine Lautenschläger, noted that "all the conditions for inflation to kick in are in place". While these factors provided a relief for the euro, it is likely that interest rate differentials, waning global growth, and a labor market replete with slack will keep the upside in the euro capped for the remainder of this year. The longer-run outlook, however, is bullish, as the common currency remains cheap across several valuation metrics. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Retail trade yearly growth came in above expectations, coming in at 1.6%. It also increased from 1% last month. However, large retailer's sales growth surprised negatively, coming in at -0.8%. Moreover, the jobs/applicants ratio also underperformed expectations, coming in at 1.59. Finally, the consumer confidence index also surprised to the downside, coming in at 43.8. USD/JPY has fallen by roughly 1%, as political risks originating from Italy have helped safe heaven assets like the yen. Overall, we continue to be bullish on this cross on a tactical basis, given that we expect a slowdown in global growth to accentuate the current risk off environment. However the BoJ will likely intervene if the yen keeps going up, which makes a bearish stance on the yen appropriate on a cyc lical basis. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Yen's Mighty Rise Continues... For Now - February 16, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been negative Total Business Investment yearly growth underperformed expectations, coming it at 2%. Nationwide Housing Prices yearly growth also surprised negatively, coming in at 2.4%. Finally, mortgage approvals also surprised to the downside, coming in at 62.455 thousand. GBP/USD has fallen by roughly 0.6% this week. As of this week, we have reached the target of our tactical short GBP/USD trade with a tk% gain. While the rally in the dollar could certainly continue, pushing cable lower in the process, it is more prudent to adopt a more neutral stance toward this cross, given that it has depreciated by more than 7% since its highs on mid-April. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics- March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was on the weak side: Building permits contracted by 5% in monthly terms, and only increased by 1.9% in yearly terms, much less than the previous 15.6% and the expected 4.1%; Private sector credit grew by 0.4% in monthly terms, in line with expectations; Private capital expenditure also grew by only 0.4%, a weaker result than the expected 0.7%. After a meaningful fall, AUD/USD has been relatively flat for the last month. Markets seem to be fully aware of the slack currently hampering the Australian economy. The Australian interest rates futures curve continues to flatten, pricing in a lower probability of any hikes. Furthermore, U.S. trade protectionism is becoming more aggressive, which may pose a further threat to the AUD as Australian growth is highly levered to global trade. We remain bearish on this antipodean currency in both the short and the long term. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 NZD/USD has rallied by roughly 1% this week. Overall, we are negative on the NZD versus the U.S. dollar, given that pro-cyclical currencies like the kiwi tend to suffer in periods of heightened volatility and increasing risks. Continued trade tensions, as well as slowing global growth and political risks emanating from Italy will likely perpetuate the current environment going forward, hurting the kiwi in the process. That being said we are positive on this currency against the Australian dollar, as Australia's economy is much more sensitive to the Chinese industrial cycle than New Zealand's. Therefore a slowdown in emerging markets should weigh more heavily on the AUD than on the NZD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data was disappointing this week: Industrial product price increased by 0.5% in monthly terms in April; The Raw Material Price Index increased 0.7%; The current account decreased to CAD-19.5 billion in Q1 of 2018; Quarterly GDP growth came in at 1.3%, disappointing expectations. On Wednesday, the CAD was buoyed by the BoC's hawkish monetary policy statement. According to the statement, the Governing Council will now take a "gradual" approach to policy adjustments, as opposed to the "cautious" one noted in previous statements. In addition, the reference to continued monetary accommodation and labor market slack was also removed. However, the White House announced on Thursday the imposition of tariffs on Canadian exports, which erased most of Wednesday's gain. While this adds substantial risk to the view, the outlook for trade negotiations is still murky, and could surprise on the upside. The CAD still remains cheap on key valuation metrics, with an economy exhibiting less slack than other G-10 counterparts. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 More Than Just Trade Wars - April 6, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance outperformed expectations, coming in at 2,289 million. This measure also came in above last month figure. However, the KOF leading indicator underperformed expectations, coming in at 100. It also decreased substantially from last month's reading. Finally, yearly GDP growth also surprised negatively, coming in at 2.2%. EUR/CHF has depreciated by roughly 1.5% this week. Overall, this cross should continue to depreciate given that we expect the current period of risk aversion to persist. Even if Italian political risks start to subside, investors will still have to worry about trade tensions, slowing global growth, and the deleterious impact of lower bond yields on this cross. This should help safe-haven assets like the franc outperform. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Retail sales growth outperformed expectations, coming in at 0.5%. Moreover the Norges Bank credit indicator came in line with expectations, at 6.3%. USD/NOK has rallied by nearly 1.2% this week, as the rise in the dollar coupled with lower oil prices, have resulted in a toxic combination for the krone. Overall, we are positive on the krone relative to other commodity currencies. The krone has a large NIIP and current account surplus which makes it more resilient to terms of trade shocks. Moreover, oil should outperform other commodities given that it is more levered to DM growth than to the Chinese industrial cycle and given that the supply backdrop for crude is more favorable. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden has improved: Retail sales beat expectations, growing at a 0.6% monthly pace and a 3.6% annual pace; GDP growth accelerated to 3.3% in Q1 of 2018, higher than the 2.9% growth recorded last year; The trade balance declined by SEK6.5 billion in May; Consumer confidence also suffered slightly to 98.5 from 101. The SEK has strengthened substantially against the euro since its multi-year lows this month. Political woes subsided the euro, while rosy data from Sweden lifted the krona. Against the dollar, the SEK has weakened in recent weeks, due to the greenback's recent surge. We expect the SEK to remain strong against the euro for the remainder of this year, owing to cheap valuations and resurging inflationary pressures. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The Fed Vs. The Market: The market believes the Fed will deliver on its "gradual" rate hike pace in a status quo economic scenario. But investors also view the odds of the Fed slowing the pace of hikes as greater than the odds of it hiking more quickly. Dovish Catalysts: The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. Hawkish Catalysts: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Feature In last week's report we recommended that nimble investors should position for a near-term (0-3 month) decline in Treasury yields.1 Since then, the 10-year Treasury yield has fallen from 3.06% to 2.93% but we are not yet ready to remove our recommendation. The two criteria we named in last week's report - extended net short bond positioning and a high likelihood of negative data surprises - remain in place. As such, we expect bond yields to fall further in the near-term, though we remain bond bears on a cyclical (6-12 month) investment horizon. This week we turn to Fed policy, and specifically the following three questions: What does the Fed mean when it says it will make "further gradual adjustments" to the stance of monetary policy? How do "gradual adjustments" relate to what is currently priced in the market? What factors would cause the Fed to deviate from its "gradual" path, leading to either a faster or slower pace of tightening? The Market Trusts The Fed...To A Point We have noted in previous reports that the Fed's "gradual" pace of rate hikes is quite clearly defined as one 25 basis point rate hike per quarter. The Fed has tightened policy at this pace since December 2016, with the exception of last September when it announced the winding down of its balance sheet in place of a hike. It seems to us that the Fed's policy intentions have rarely been more transparent. The Fed will continue to lift rates by 25 bps per quarter until either (i) something breaks in the economy causing the Fed to slow down, or (ii) inflation pressures mount causing the Fed to speed up. But what about market pricing? To be consistent with the Fed's "gradual" pace of one hike per quarter the market would need to be priced for 50 bps of tightening during the next six months, 100 bps of tightening during the next 12 months, etc... Chart 1 shows that the market believes the Fed will deliver on its "gradual" pace for the next six months, but that it will fall somewhat short during the next year. Looking beyond the next 12 months, the market is not priced for the Fed to deliver on its "gradual" hike pace during the next 18 or 24 months either (Chart 2). Chart 1The Fed Versus The Market Part I The Fed Versus The Market Part I The Fed Versus The Market Part I Chart 2The Fed Versus The Market Part II The Fed Versus The Market Part II The Fed Versus The Market Part II A more realistic interpretation of Charts 1 and 2 is that while the market believes the Fed will deliver on its "gradual" hike pace in a status quo economic scenario, investors also view the odds of something breaking in the economy as greater than the odds that inflation will force the Fed to move faster. We also agree that the odds of something breaking are greater than the odds that inflation will force the Fed's hand. However, we would still favor a cyclical (6-12 month) below-benchmark duration stance because the market is not priced for the most likely status quo / "gradual" rate hike environment. Identifying Breaking Points How will we be able to tell if something is breaking in the economy that will cause the Fed to slow its pace of hikes? Candidate 1: Domestic Economic Growth One way is to simply monitor leading indicators of U.S. economic growth, particularly the contribution of cyclical spending to overall GDP (Chart 3). The cyclical sectors of the economy (consumer spending on durable goods, residential investment and investment on equipment & software) are most sensitive to interest rates and often provide an early warning sign for the overall economy. At the moment we see no evidence that cyclical spending is poised to slow meaningfully. Recent data showed solid gains in April retail sales, while consumer sentiment remains near its all-time high (Chart 4, panel 1). On the investment side, core durable goods orders were stronger than expected in April and the regional manufacturing PMIs that have been released so far in May (Philadelphia, New York, Richmond and Kansas City) have all increased (Chart 4, panel 2). Recent housing data have been more disappointing relative to expectations, but even here we continue to see steady growth in building permits and a continued contraction in outstanding supply. Supply increases typically precede a decline in construction activity (Chart 4, bottom panel). Chart 3Domestic Economy Looks Strong Domestic Economy Looks Strong Domestic Economy Looks Strong Chart 4Focus On Cyclical Sectors Focus On Cyclical Sectors Focus On Cyclical Sectors Candidate 2: The Financial Markets Even if U.S. economic growth is robust, it is conceivable that a sharp tightening of financial conditions - a falling stock market, widening credit spreads and/or an appreciating dollar - could cause the Fed to slow its pace of hikes. After all, the Fed would interpret a large enough tightening of financial conditions as a signal that economic growth will slow in the future. To assess this risk we turn to our Fed Monitor (Chart 5). Our Fed Monitor is a composite of many different variables that fall into one of three categories (i) economic growth, (ii) inflation and (iii) financial conditions. It is constructed in such a way that a reading above zero means the Fed should be tightening policy and a reading below zero means the Fed should be easing. Chart 5Fed Monitor Recommends Tighter Policy Fed Monitor Recommends Tighter Policy Fed Monitor Recommends Tighter Policy The bottom panel of Chart 5 shows that we have in fact seen a relatively large tightening of financial conditions since the equity market sold off in February. However, our overall Fed Monitor has barely ticked down, and remains solidly above zero. There is an important message here. The Fed can tolerate more tightening in financial conditions when economic growth and inflation are higher. When a similar tightening of financial conditions occurred in 2015, it did in fact drive our overall Fed Monitor below zero. This is because the economic growth and inflation components of the Monitor provided less of an offset (Chart 5, panels 3 & 4). Now, with stronger readings from those components, the Fed will need to see a much larger tightening of financial conditions before reacting. We will pay close attention to our Fed Monitor going forward for any signs that a sell-off in financial markets might be severe enough to spook the Fed. Another financial market signal that bears monitoring is the slope of the yield curve (Chart 6). It is no secret that an inverted yield curve always precedes a recession, and the Fed could interpret a very flat curve as a signal that monetary policy is becoming restrictive. In fact, Atlanta Fed President Raphael Bostic said two weeks ago that: Chart 6Not Flat Enough To Worry The Fed Not Flat Enough To Worry The Fed Not Flat Enough To Worry The Fed I have had extended conversations with my colleagues about a flattening yield curve. It is my job to make sure that [yield curve inversion] doesn't happen. In contrast, the minutes from the May FOMC meeting reveal a more balanced tone from the committee as a whole. "Several" participants thought "it would be important to monitor" the slope of the curve, while "a few" thought that the slope of the curve could be less important this cycle because of several special factors. These factors include: depressed term premiums because of large central bank balance sheets and reductions in investors' estimates of the longer-run neutral real interest rate. Our sense is that the yield curve is a good economic indicator simply because it reflects market expectations about the path of the fed funds rate. When the curve is inverted, and long-maturity yields are below short-maturity yields, it means that investors expect rate cuts to occur in the future. In contrast, a very steep yield curve indicates that the market expects a large number of rate hikes. When the stance of monetary policy is perceived to be close to neutral, investors will expect very little future movement in the fed funds rate and the yield curve will be very flat.2 In an ideal world, the Fed will move the funds rate close to its neutral level by the time that inflation stabilizes around its 2% target. In other words, the Fed will not be overly concerned with a very flat yield curve as long as inflation is close to its target. A very flat curve will only worry policymakers if it coincides with below-target inflation, because that would suggest that the market does not believe that the Fed will hit its inflation goal. With inflation already close to the Fed's target, we don't think a flat yield curve will cause the Fed to turn dovish any time soon. Candidate 3: Foreign Economic Growth One final factor that could eventually cause the Fed to slow its pace of rate hikes is weak foreign economic growth. Here we already see mounting signs of stress. Chart 7 shows that while the U.S. Leading Economic Indicator is the strongest it has been in several years, our Global Leading Economic Indicator excluding the U.S. has begun to contract. This divergence in growth between the U.S. and the rest of the world is reminiscent of the 2014/15 period when the dollar came under strong upward pressure. Not surprisingly, the dollar is once again starting to appreciate (Chart 7, panel 2). Much like in 2014/15, a strengthening dollar is already putting pressure on Emerging Markets where CDS spreads are widening and currencies are weakening (Chart 7, bottom panel). As an aside, while USD-denominated Sovereign bond spreads have widened, they remain expensive compared to similarly-rated U.S. corporate bonds (Chart 8). We continue to recommend an underweight allocation to USD-denominated Sovereign debt. Turning back to U.S. monetary policy, the key reason the Fed might concern itself with weak foreign economic growth is that the resultant strengthening of the dollar will eventually cause financial conditions to tighten and domestic economic growth to slow. This is exactly what occurred in 2014/15, though unfortunately the Fed waited until the strong dollar culminated in a sell-off in equity and credit markets before it adopted a more dovish policy stance (Chart 9). We would once again expect the Fed to wait for divergent growth between the U.S. and the rest of the world (and the resultant stronger dollar) to be reflected in financial conditions indexes and domestic equity and credit markets before it responded by slowing the pace of hikes. Chart 7Global Growth Divergences##br## Are Back Global Growth Divergences Are Back Global Growth Divergences Are Back Chart 8Sovereigns Still##br## Expensive Sovereigns Still Expensive Sovereigns Still Expensive Chart 9Growth Divergences Led To ##br##Market Turmoil In 2014/15 Growth Divergences Led To Market Turmoil In 2014/15 Growth Divergences Led To Market Turmoil In 2014/15 Bottom Line: The Fed would slow its pace of rate hikes if the cyclical sectors of the U.S. economy started to slow, financial conditions tightened significantly, or if the slope of the yield curve moved close to zero while inflation was below the Fed's target. The most likely catalyst for the Fed to adopt a more dovish policy in the next 6-12 months is a persistent divergence between U.S. and foreign economic growth that leads to a stronger dollar and culminates in significantly tighter financial conditions, as in 2014/15. What Would Make The Fed Hike More Quickly? The most obvious factor that would make the Fed increase its pace of rate hikes to greater than 25 bps per quarter would be if inflation rose above its 2% target and continued to accelerate. It is unclear how much of an inflation overshoot the Fed is willing to tolerate before it increases the pace of hikes, but our sense is that it's fairly substantial. The Fed has gone out of its way in recent months to stress the "symmetric" nature of its 2% inflation target and, as long as inflation expectations remained well contained, we think the Fed would stick with its "gradual" rate hike pace as long as core PCE inflation is below 2.5%. Inflation pressures in the economy would have to change dramatically for core PCE inflation to break above 2.5%. Chart 10 shows two hypothetical scenarios for year-over-year core PCE inflation. One scenario where core PCE inflation rises 0.2% every month going forward, and another where it rises 0.15% every month. In the 0.2% per month scenario, year-over-year core PCE inflation eventually levels off at around 2.4%. In the 0.15% per month scenario it levels off at 1.8%. Monthly core PCE inflation has only printed above 0.2% seven times since 2015 (Chart 11), meaning that we would need to see a huge shift in the inflation data for it to start worrying policymakers. Chart 10How Much Overshoot Will Fed Tolerate? How Much Overshoot Will Fed Tolerate? How Much Overshoot Will Fed Tolerate? Chart 11Prints Above 0.2% Have Been Rare Prints Above 0.2% Have Been Rare Prints Above 0.2% Have Been Rare Another important factor that we have flagged in recent research is the price of gold.3 We noted that the gold price tends to rise when Fed policy eases and fall when it becomes more restrictive. We also observed that Fed policy can ease/tighten in two ways: The Fed can alter market expectations about the pace of rate hikes The market can revise its assessment of the equilibrium (or neutral) fed funds rate Chart 12Gold Has Led The Fed Gold Has Led The Fed Gold Has Led The Fed Notice that the decline in the gold price between 2013 and 2016 foreshadowed downward revisions to the Fed's estimate of the long-run equilibrium fed funds rate, and that those estimates have leveled-off alongside the price of gold since then (Chart 12). It follows that an upside break-out in the price of gold would be a signal that monetary policy is becoming easier, and that current estimates of the equilibrium fed funds rate need to be revised up. This is another signal we are monitoring that could lead to a quicker pace of rate hikes from the Fed. Bottom Line: A significant overshoot of the Fed's inflation target would cause the Fed to increase its pace of rate hikes, but the odds of this occurring during the next 6-12 months are low. An upside break-out in the price of gold would suggest that the equilibrium fed funds rate needs to be revised higher, and could lead to a more rapid pace of hikes. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 2 In practice, the term premium in long-dated Treasury yields will lead to a slightly positive yield curve slope when monetary policy is perceived to be neutral. 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Bond Bear Market: TIPS breakeven inflation rates are still below target, and this gives us high conviction that Treasury yields will increase on a cyclical horizon. If we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will likely occur between 3.35% and 3.52%. Interest Sensitive Spending: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond Yields & Gold: A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Feature Chart 1The Bear Is Back The Bear Is Back The Bear Is Back After a brief pause in March, the cyclical bond bear market has resumed. The 10-year Treasury yield even briefly broke above 3% last week, with its 27 basis point rise off the early-April lows evenly split between the compensation for inflation protection and the 10-year real yield (Chart 1). To mark the occasion of the 10-year Treasury yield breaking above 3% for the first time since early 2014, this week we update our roadmap for the Two-Stage Cyclical Bond Bear Market, which we first outlined in late February.1 Specifically, we consider the questions of where the 10-year Treasury yield might be by the end of this year, and where it might ultimately peak for the cycle. On the second question we think bond investors can glean important information from trends in the price of gold. Tracking The Two-Stage Bear Market In our report from February we described how the cyclical Treasury bear market will proceed in two stages. The first stage is characterized by the re-anchoring of inflation expectations. Stage 1: The Re-Anchoring Of Inflation Expectations The 10-year TIPS breakeven inflation rate and the 5-year/5-year forward TIPS breakeven inflation rate currently sit at 2.17% and 2.25%, respectively. Historically, when core inflation is well anchored around the Fed's target, both of those breakeven rates have traded in a range between 2.3% and 2.5% (Chart 2). This means that nominal Treasury yields still have room to rise as the market prices in a more realistic outlook for inflation. That could happen sooner rather than later. Core PCE inflation increased 0.15% in March, causing the 12-month rate of change to jump from 1.57% to 1.88% (Chart 2, bottom panel). Meanwhile, the annualized 3-month and 6-month rates of change remain well above the Fed's 2% target. Looking further out, we see inflationary pressures continuing to build in the U.S. economy. The employment data now clearly show very little slack in the labor market, and this appears to be finally filtering through to wages. The Employment Cost Index for Wages & Salaries rose 0.9% in the first quarter, its largest quarterly increase since 2007. The year-over-year growth rate in the index moved up to 2.7%, from 2.6% in Q4, and is right in line with its predicted value based on the prime age employment-to-population ratio (Chart 3).2 Chart 2Stage 1 Almost Complete Stage 1 Almost Complete Stage 1 Almost Complete Chart 3Faster Wage Growth Ahead A Signal From Gold? A Signal From Gold? As long as TIPS breakeven inflation rates remain below our target range we have high conviction that Treasury yields will increase, driven by a re-anchoring of inflation expectations. Once our TIPS breakeven target is met, the cyclical bond bear market will transition to stage two. Stage 2: The Terminal Fed Funds Rate After inflation expectations are re-anchored around the Fed's target, the most important question for bond investors becomes: How high will the Fed need to lift the policy rate to keep inflation from moving well above target? Or alternatively: What is the terminal (or peak) fed funds rate for this cycle (see Box)? Box: The Terminal Fed Funds Rate & The Equilibrium Fed Funds Rate Please note that in this report we refer to two separate, though related, concepts. We define the terminal fed funds rate as the peak fed funds rate for the business cycle. We also define the equilibrium fed funds rate as the fed funds rate that is consistent with neither an accommodative nor a restrictive monetary policy. The terminal fed funds rate is almost certainly higher than the equilibrium fed funds rate because monetary policy will likely turn restrictive before the end of the economic cycle. Chart 4Treasury Yield Models Treasury Yield Models Treasury Yield Models We can show why this question is so important using a simple model of Treasury yields based on expectations for changes in the fed funds rate and the MOVE index of implied rate volatility. The latter is a proxy for the term premium embedded in Treasury yields (Chart 4). For example, if we assume that the equilibrium fed funds rate - the rate consistent with neither accommodative nor restrictive monetary policy - is approximately 3%, and that by the end of this year the yield curve will price in a return to neutral monetary policy by the end of 2019. That would be consistent with a 10-year Treasury yield between 3.03% and 3.19% by the end of this year, assuming also that the MOVE index ranges between its current level and its historical low. This result can be seen in Table 1 by looking at the rows consistent with three rate hikes in 2018 and a 12-month discounter of 75 bps by year end. We could also assume that the equilibrium fed funds rate is 3%, but that the market will start to price in a restrictive monetary policy by the end of 2019 - i.e. a fed funds rate above its equilibrium level. That result would be consistent with a 10-year Treasury yield between 3.35% and 3.52% by the end of this year, once again assuming that the MOVE index ranges between its current level and its historical low. The bottom line is that with TIPS breakeven inflation rates still below target, we have high conviction that yields will increase on a cyclical horizon. Beyond that, if we assume that a 3% fed funds rate is roughly consistent with a neutral monetary policy stance, then we should expect the cyclical peak in the 10-year Treasury yield to be in a range between 3.35% and 3.52%. Tracking The Equilibrium Fed Funds Rate Using Nominal GDP And Gold It's worth pointing out that both examples in the prior section assumed that the MOVE index will either stay flat or decline. The reason for that assumption is that both examples assume a relatively low equilibrium fed funds rate of 3%. In other words, both examples assume that monetary policy will turn restrictive once the fed funds rate moves above 3%, causing economic growth to slow. If that assumption proves to be correct, and with the 10-year Treasury yield already close to 3%, the yield curve will undoubtedly flatten as the fed funds rate is raised. A flatter yield curve is highly correlated with lower implied rate volatility. In order for implied rate volatility to move meaningfully higher, and for us to see a much higher 10-year Treasury yield (as is shown in the bottom third of Table 1), the market will need to start discounting a higher equilibrium fed funds rate. Put differently, investors would have to believe that the fed funds rate necessary to slow economic growth and inflation is much higher than 3%. It is only in that scenario that the cyclical peak for the 10-year Treasury yield will significantly exceed the 3.35% to 3.52% range posited in the prior section. Table 1Treasury Yield Projections Under Different Scenarios A Signal From Gold? A Signal From Gold? But how can we decide whether or not the equilibrium fed funds rate is higher than 3%? One imperfect way is to simply track economic growth and look for signs that it is about to slow. Cyclical Nominal GDP Growth Chart 5 shows that one good signal of a recession is when nominal GDP growth falls below the fed funds rate. While this is a fairly reliable recession indicator, it is not always a good method for determining when monetary policy turns restrictive. For example, prior to the last recession nominal GDP growth started to wane when it was still far above the level of the fed funds rate. If we had been waiting for the fed funds rate to exceed nominal GDP growth we would have missed the inflection point toward slower growth. The method worked better prior to the 1990 recession when the fed funds rate was lifted above the pace of nominal GDP growth while the latter was still accelerating. That configuration gave a much clearer real-time signal of restrictive monetary policy. Chart 5Cyclical Spending Suggests That Monetary Policy Remains Accommodative Cyclical Spending Suggests That Monetary Policy Remains Accommodative Cyclical Spending Suggests That Monetary Policy Remains Accommodative A more refined version of this approach is to track only the cyclical sectors of the economy - those sectors that are most sensitive to interest rates. Growth in those sectors - consumer spending on durable goods, residential investment and nonresidential investment for equipment and software - tends to deteriorate prior to major downturns in overall nominal GDP (Chart 5, bottom panel). This method gives us a slightly earlier warning that monetary policy has turned restrictive. On that note, we observe that while cyclical spending as a percent of overall GDP is still in an uptrend, its rate of increase has declined during the past few quarters (Chart 6). This is mostly due to somewhat weaker consumer spending on durables. But we doubt that cyclical spending is in danger of rolling over any time soon. Chart 7 shows that the fundamentals underpinning the key cyclical sectors of the economy remain robust: Consumer sentiment is elevated compared to history, and income growth has started to move higher (Chart 7, top panel). The latter will be helped along by recently enacted tax cuts during the next few months. New orders for core durable goods already display solid growth, and survey indicators give no signal of imminent deterioration (Chart 7, panel 2). On residential investment, homebuilder confidence is near historical highs (Chart 7, panel 3), while mortgage purchase applications so far seem immune from the effects of higher interest rates (Chart 7, bottom panel). Chart 6Cyclical Spending Still Rising... Cyclical Spending Still Rising... Cyclical Spending Still Rising... Chart 7...And Fundamentals Remain Sound ...And Fundamentals Remain Sound ...And Fundamentals Remain Sound At the moment, this analysis tells us that monetary policy is probably still accommodative. Once the cyclical sectors of the economy start to slow, that will give us a signal that monetary policy is restrictive and that we are probably near the cyclical peak in Treasury yields. Inflation, Uncertainty And The Price Of Gold But is there another method we can use to track the equilibrium fed funds rate and the stance of monetary policy in real time? We think there is, and it relates to investors' perceptions of inflationary pressures in the economy. First, we recognize that when inflationary pressures are higher, the equilibrium fed funds rate is also higher. In other words, the Fed needs to lift rates further before monetary policy becomes restrictive and inflation starts to flag. This intuition is confirmed by the historical relationship between long-run inflation forecasts and the short-term interest rate (Chart 8). More interestingly, we also observe that uncertainty about the long-run inflation forecast is positively related to implied interest rate volatility, the slope of the yield curve and the price of gold (Chart 9). Once again, this is intuitive. If investors are more uncertain about the long-run inflation outlook they will demand a greater risk premium to bear inflation risk in the long-run, thus driving long-dated bond yields higher. Chart 8Inflation Forecasts &##br## Interest Rates Inflation Forecasts & Interest Rates Inflation Forecasts & Interest Rates Chart 9Inflation Uncertainty Drives##br## The Term Premium Inflation Uncertainty Drives The Term Premium Inflation Uncertainty Drives The Term Premium The gold price is positively correlated with inflation uncertainty because gold is in many ways the "anti-Fed" asset. Since it is perceived to be a long-run store of value, investors will bid up the gold price whenever there is a heightened risk that the Fed might "fall behind the curve" allowing inflation to overshoot its target. Conversely, the gold price tends to fall when the perception is that the Fed is "ahead of the curve" and is maintaining an overly restrictive monetary policy. Chart 10Gold Has Led The Fed Gold Has Led The Fed Gold Has Led The Fed This is why bond investors would be wise to heed the signal from gold. A sharply rising gold price signals that the fed funds rate is running further below its equilibrium level. This could occur because the Fed is cutting rates to levels that the market deems too low. Or, it could occur because the market now believes that the equilibrium fed funds rate is higher. A sharply falling gold price gives the exact opposite signal. It tells us that either the Fed is lifting the funds rate too far above equilibrium, or that the market is revising down its assessment of the equilibrium rate. This chain of events played out before our eyes during the past few years. The gold price started to fall sharply in early 2013, and continued its decline until late 2015 (Chart 10). A signal that investors were discounting a more restrictive monetary policy stance during that timeframe. But the Fed was not lifting rates during that period. In fact, with hindsight it now seems obvious that the gold price was falling because the market was revising down its assessment of the equilibrium fed funds rate. Investors should also note that the falling gold price signaled a lower equilibrium fed funds rate well before the Fed started to revise down its median forecast for the interest rate that is expected to prevail in the "longer run".3 Tracking the price of gold would have given us a much timelier signal than waiting for the Fed. Chart 10 also shows that the gold price has rebounded since early 2016, but has been confined to a trading range during the past few months. Not coincidentally, this rebound has coincided with the Fed ceasing the downward revisions to its estimate of the equilibrium fed funds rate. Going forward, we think that bond investors would be wise to closely track the price of gold. A significant move higher in the gold price would be a strong signal that the Fed is not tightening policy quickly enough to contain inflationary pressures. In other words, it would signal that the equilibrium fed funds rate should be revised higher. This would drive up implied interest rate volatility, apply steepening pressure to the yield curve, and lead to a higher end-of-cycle target for the 10-year Treasury yield. Bottom Line: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond investors should also track the price of gold. A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 208, available at usbs.bcaresearch.com 2 In a recent report we showed that nonfarm payrolls need to increase by 110k or more per month to drive the prime age employment-to-population rate higher, leading to faster wage growth. For further details please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 018, available at usbs.bcaresearch.com 3 The Fed's projection of the interest rate expected to prevail in the "longer run" is essentially its estimate of the equilibrium fed funds rate. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights We re-examine our Yield and Protector portfolios to find out which assets will hold up best if there is a material correction. Our tactical view on gold is neutral, but the risk in gold prices will remain skewed to the upside this year. Are tariffs on aluminum and steel the start of a trade spat or a trade war? Feature Fears of a trade war and a hawkish tone from Fed Chair Jay Powell at his first Humphrey Hawkins testimony to Congress pushed the U.S. equity market lower last week. The ten-year Treasury yield barely budged however, buffeted by a more hawkish Fed on one side and a trade-induced slowdown in global growth on the other. The dollar was modestly higher last week, but oil and gold prices moved lower. The S&P 500's 4% loss in February was the worst single month since October 2016 and worst February since 2009. Both investment-grade and high-yield credit spreads widened last week, and have yet to return to their late January lows. Moreover, at 22, the VIX remained elevated relative to start of the year, consistent with our view that markets have entered a more volatile, late-cycle phase. With the 2.8% run-up in the S&P 500 since the February 8 low, investors are less concerned that the early February pullback in risk assets was a signal that the equity bull market is over and a recession is right around the corner. Nonetheless, some clients with a more strategic outlook are considering paring back risk now. Others want to know how to protect gains while still participating in the bullish tone for the market BCA expects in the next 12 months. Our Yield and Protector portfolios might provide a way for investors to protect against the downside while still participating in the S&P 500. Preparing For A Pullback BCA recommends investors stay overweight on equities and U.S. spread product, but expects that positions should be moved to neutral later this year and then to underweight sometime in 2019.1 Long-term investors should already consider paring back their exposures to both asset classes given that valuations are stretched. We have periodically recommended that a variety of investments be added as portfolio "insurance" to help guard against a material correction in equities. We recently highlighted two forms of insurance: our Yield and Protector Portfolios. We introduced the Yield Portfolio in October 20142 and first discussed the Protector Portfolio in October 2015.3 This week, we revisit the issue by comparing both portfolios with a more common form of insurance: shifting from cyclical to defensive stocks within an equity allocation. The Yield Portfolio (YP) emphasizes "high quality carry", along with some protection via TIPS (25% of the Portfolio), if inflation begins to surprise on the upside after investors are conditioned to expect only deflation shocks. The YP performs well in an environment of slow nominal growth, no recession and gradual interest-rate hikes. On the other hand, the Protector Portfolio (PP) is designed to provide insulation against both deflationary (gold and trade-weighted dollar) and inflationary (TIPS) tail risks. Therefore, the PP may underperform risk assets for a time if tail risks keep receding. Still, it has done well during the equity rally and conservative investors should consider adopting it. As discussed in the section below, our tactical view on gold is neutral, but the BCA Commodity & Energy Strategy notes that the risk in gold prices will remain skewed to the upside this year. Charts 1, 2, and 3 show a breakdown of the relative performance of S&P 500 defensives along with our Yield and Protector Portfolios. Panels 2 and 3 of Charts 1, 2 and 3 present the rolling one-year beta and alpha of each strategy versus the S&P 500. Alpha is presented as the difference between the actual year-over-year excess return of the portfolio (versus short-term Treasury bills) and what would have been expected given the portfolio's beta. This measure is also referred to as "Jensen's alpha." Chart 1S&P 500 Defensives##BR##A Modestly Low Beta Option S&P 500 Defensives A Modestly Low Beta Option S&P 500 Defensives A Modestly Low Beta Option Chart 2A Lower Beta##BR##Than Defensives A Lower Beta Than Defensives A Lower Beta Than Defensives Chart 3A Beta Near Zero,##BR##And Positive Alpha A Beta Near Zero, And Positive Alpha A Beta Near Zero, And Positive Alpha Based on the historical beta of the three portfolios versus the S&P 500, defensive stocks are the most correlated with the overall equity market. Our PP had a negative correlation to the broad market until earlier this year, when it turned slightly positive. BCA's YP is somewhere in between, with a positive but relatively low beta. This is consistent with the equity composition of the three portfolios (shown in Table 1). Note that our protector portfolio is composed entirely of non-equity assets. Table 1A Breakdown Of Three##BR##Portfolio Insurance Options A Golden Opportunity? A Golden Opportunity? After accounting for their lower betas, all three portfolios have outperformed the S&P in risk-adjusted terms since the onset of the global economic recovery. However, the three portfolios have experienced a relative decline versus the S&P 500 since Trump's election. This has occurred due to passive rather than active underperformance. In other words, they have underperformed because they failed to keep up with the S&P 500 rather than because of losses in absolute terms. We draw two important conclusions from Charts 1, 2 and 3 for U.S. multi-asset investors. First, the lower beta of our YP and PP compared with S&P defensives means that the former represent a better insurance against a sell-off in the equity market rather than the latter. Secondly, the persistently positive volatility-adjusted returns for our insurance portfolios highlights an investor preference for these assets in the past few years. However, since late 2017 when investors began to significantly upgrade the prospects for global growth and U.S. corporate profits, all three portfolios struggled to outperform the S&P 500 on a risk-adjusted basis. BCA's forecast implies that these portfolios may continue to struggle in the next year or so. For now, our investment bias towards equities over government bonds makes us less inclined to favor a low beta position within a balanced portfolio. Our analysis suggests that clients who anticipate the need for portfolio insurance in the coming year should back our YP and PP over a defensive-sector allocation. We would likely extend this recommendation to all clients if there is any material progression towards the sell-off triggers identified in the Bank Credit Analyst's February 2018 publication.4 Bottom Line: Investors seeking protection against a potential equity market sell-off should look to our Yield and Protector Portfolios over defensive-sector positioning. We do not currently recommend these portfolios for all clients, but we may do so if our key sell-off triggers are breached. Gold Bugged Our tactical view on gold is neutral, but the BCA Commodity & Energy Strategy notes that the risk in gold prices will remain skewed to the upside this year. The yellow metal is supported by increasing inflation and inflation expectations, heightened geopolitical risks and greater volatility in equity markets.5 However, the higher inflation and inflation expectations will be countered by Fed rate hikes, which will boost the U.S. dollar and lift real rates in our base case. Strategically, we expect that gold will provide a good hedge against any downturn in equities when the bull market turns bear in 2H19. Chart 4 shows that the price of gold in real terms is still very expensive. On a nominal basis, gold is at the top end of a trading channel initiated in early 2012 (Chart 5). There has been a significant gap between the model value and the actual price of gold for the past four years. The real price of gold remains elevated, although inflation has been well contained. Chart 4Model Suggests Gold Is Overvalued Model Suggests Gold Is Overvalued Model Suggests Gold Is Overvalued Chart 5Testing Top End Of A Downward Channel Testing Top End Of A Downward Channel Testing Top End Of A Downward Channel However, the macro environment BCA envisions for 2018 is also supportive for gold (Table 2). Gold tends to perform well when oil prices rise and as the 2/10 Treasury curve steepens. Moreover, gold prices tend to go up when the U.S. economy benefits from fiscal thrust and tax cuts. Furthermore, the soundings on the February ISM manufacturing index support higher gold prices. When the headline index is above 60 as it was in February (60.8), gold climbs by an average of 31%. Even 12 months after ISM is above 60, gold returns are over 20%. The elevated level of ISM new orders (64.2) and price (74.2) indices in February also suggest solid increases for gold. Finally, gold prices climb in the late stages of an economic expansion, such as the current one that began in 2009.6 Even so, our 6 to 12-month view on gold is that it will take its cues from Fed policy and policy expectations. The Fed is not behind the curve on inflation, and inflation expectations and measured inflation remain low. Our CPI and PCE models (Chart 6) show only a modest acceleration in inflation by year-end, which will be sufficient to keep the Fed on track this year as it continues to shrink its balance sheet and boost rates four times. Thus, there is no pressing need to hold gold as a hedge against inflation in the next year. Nonetheless, for those investors too concerned about a pullback that turns into a correction or a bear market, we note that gold has a 33% weight in our Protector Portfolio. Table 2Favorable Macro Backdrop For Gold A Golden Opportunity? A Golden Opportunity? Chart 6BCA's Inflation Models Show Only##BR##Modest Acceleration Through Year-End BCA's Inflation Models Show Only Modest Acceleration Through Year-End BCA's Inflation Models Show Only Modest Acceleration Through Year-End Bottom Line: Gold is expensive in real terms relative to a set of fundamentals that have explained its real price since 1970. However, it may have a better value on a strategic basis or as part of a portfolio designed to protect against falling equity prices. Moreover, our macro backdrop forecast for the next 12 months supports higher gold prices. Keep gold as a strategic portfolio hedge. Trade Off BCA's Geopolitical Strategy team has long argued that two sources of geopolitical risk this year are China's trade surplus and Trump's position on trade relations with China, Canada and Mexico. Specifically, the view is that weak poll numbers may lead Trump to trigger trade disputes with important trading partners such as China, Mexico and Canada. However, our geopolitical analysts also point out that investors should not confuse a trade spat with a trade war. There are very few legal or constitutional constraints on Trump over trade issues (Table 3). It will be his decision whether to adopt sweeping tariffs (trade war) as opposed to a more targeted approach (trade spat). Clearly, the former is more disruptive and raises more uncertainty, so this is the key distinction to keep in mind. Presidents Nixon, Reagan, Bush (II) and Obama all imposed temporary tariffs on items (including steel and aluminum, and including by citing national security concerns) without triggering a trade war. Late last week, Trump indicated that he would announce tariffs on steel and aluminum this week. He implied that he would go for a broad-based approach of penalizing all steel and aluminum imports, which points toward the more aggressive approach. But the details (whether he exempts U.S. allies and partners or narrows the scope of goods) will not be certain until he issues his official proclamation. Table 3Trump Faces Few Constraints On Trade A Golden Opportunity? A Golden Opportunity? Steel and aluminum get the headlines, but account for only a small share of U.S. trade and GDP7 (Chart 7). BCA is more concerned about the Administration's stance on more deeper issues, like the WTO, NAFTA, or (in China's case) intellectual property and state-owned enterprises.8 The issues here are harder to quantify, have few precedents, and have more structural and ideological issues which are at stake. The U.S. has a massive trade surplus in services and in intellectual property,9 so a prolonged disruption would pose a serious threat to the U.S. economy, at least in the short term. Trump's decision on intellectual property trade with China is due on August 12, but could occur earlier. BCA's stance on U.S.-China relations is bearish in the long run.10 We place high odds on an eventual trade war, but the timing is a tougher call. Investors should not view China's proportional retaliation on an item-by-item basis as the start of a trade war. BCA's view is that China's leadership will try to offer reforms and investment opportunities to pacify Trump. However, there is a risk either that China offers no reforms (in which case Xi Jinping's rampant Communism exacerbates trade conflicts) or that Trump may introduce broad sweeping measures that give China no choice but to respond in kind, leading to a trade war. Our Geopolitical Strategy service notes that the probability of Trump abrogating NAFTA is as high as 50%. The seventh round of NAFTA talks concludes this week; an eighth round is scheduled for late March. Negotiations could drag on right to the Mexican election on July 1, but if they are not looking more optimistic by this spring then the risk of the U.S. (or Mexico) walking away will rise. The U.S. economy has been largely unaffected by NAFTA and would likely experience no disruption if Trump abrogated the deal and began negotiations on bilateral trade agreements with Canada and Mexico (Chart 8). Chart 7Steel And Aluminum In Perspective Steel And Aluminum In Perspective Steel And Aluminum In Perspective Chart 8U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA Bottom Line: Elevated trade tensions with China,11 Canada and Mexico are near-term risks to global growth. From now through April could be a decisive time for the Trump Administration with China and NAFTA. We are bearish on U.S.-China relations in the long term. If Trump abandons NAFTA, the implications for the U.S. economy would be muted, although U.S. inflation may push higher. Such a decision would also send a clear signal to other key U.S. allies. However, if Trump stands by NAFTA, then it signals that he has sided with the establishment on trade. This would be bullish for risk assets and would lower geopolitical risk premia. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," published February 23, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Ice Storm", published October 20, 2014. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "A Tenuous Relief Rally", published on October 12, 2015. Available at usis.bcaresearch.com. 4 Please see BCA Research's Bank Credit Analyst Monthly Report, February 2018. Available at bca.bcaresearch.com. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Gold Still Shines Despite Threat Of Higher Inflation", published February 1, 2018. Available at ces.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View", published October 16, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Global Aluminum Deficit Set To Ease", published March 1, 2018. Available at ces.bcaresearch.com. 8 Please see BCA Research's Geopolitical Strategy Weekly Report, "America Is Roaring Back", published January 31, 2018. Available at gps.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Can The Service Sector Save The Day?", published June 5, 2017. Available at usis.bcaresearch.com. 10 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin", published January 18, 2017. Available at gps.bcaresearch.com. 11 Please see BCA Research's Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China", published February 28, 2018. Available at gps.bcaresearch.com.

Highlights As the Fed proceeds with its policy tightening this year, higher real rates and a stronger USD will weigh on silver and platinum prices, and, to a lesser extent, palladium prices. Offsetting these downward pressures, silver, and to a lesser extent platinum, could take their lead from the gold market, and outperform on the back of increased equity volatility and understated geopolitical risks this year.1 Palladium, as always, will march to its own drummer, as this market's defining feature remains chronic physical deficits and depleted inventories, which will prevent prices from reacting too severely to tighter Fed policy this year. Energy: Overweight. Supply-demand fundamentals still are supportive of crude oil prices overall, and continued backwardation in forward curves. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, which gains as backwardation becomes more pronounced, is up 47.4% since inception on November 2, 2017. Base Metals: Neutral. Base metals remain well supported by still-strong global growth, estimates of which were revised higher by the IMF in its most recent World Economic Outlook. Precious Metals: Neutral. Fed tightening this year will weigh on silver and platinum, less so palladium (see below). Our long gold portfolio hedge is up 7.9%. Ags/Softs: Underweight. The USDA revised down its forecast of U.S. corn ending stocks in the latest WASDE on the back of an upwards revision to U.S. corn exports. Feature The term "precious metals" is something of a misnomer: Gold, silver, and platinum-group metals (PGMs) - chiefly platinum and palladium - do not constitute a single asset class, and should not be treated as such (Chart of the Week). Nevertheless, as with most commodity markets we cover, the evolution of these markets is highly sensitive to U.S. financial variables, particularly as regards monetary policy. Palladium is something of an outlier: It behaves more like an industrial metal, while silver, and to a lesser extent platinum, are more sensitive to the fundamental drivers of gold prices - i.e., the evolution of the USD's broad trade-weighted index (USD TWIB), and real U.S. interest rates. Palladium's demand is dominated by its use in catalytic converters in gasoline-powered cars, whereas industrial applications form a more limited source of demand for platinum and silver (Chart 2). Chart of the WeekA Schism In Precious Metals A Schism In Precious Metals A Schism In Precious Metals Chart 2Industrial Uses Dominate Palladium Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So Gold, silver, and, to a more limited extent platinum are cointegrated in the long run, meaning their prices follow their own random walks, even though they share a long-term trend. Palladium, on the other hand, is more responsive to the physical realities of the automobile market - chiefly, demand for gasoline-powered cars. In our econometric analysis of the behavior of PGMs and silver, we use the CRB Metals Index as a proxy for industrial activity. We find that while all three are sensitive to changes in the CRB Metals Index, palladium prices are significantly more responsive (i.e., elastic) to industrial activity than platinum and silver (Table 1). Table 1Palladium Behaves Like An Industrial Metal Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So Furthermore, while gold prices impact both silver, and, to a lesser extent platinum, they are not significant when it comes to the palladium market. Bullish Fundamentals Tightened Palladium Market Palladium registered a 60% gain in 2017. Its forward curve has been backwardated since June (Chart 3). This backwardation - i.e., spot prices trade higher than deferred prices - is a symptom of a tight market. In fact, according to Thomson Reuters GFMS data, the palladium market has been in a chronic deficit since 2007, with the 2017 deficit the largest since 2000. The culprit in this case has been strong demand and stagnant supply. While supply has been growing ~ 1% year-over-year (yoy) over the past 5 years, demand growth has averaged 1.7% yoy over the same period. Palladium demand over this period has been driven by its growing use in automobile catalytic converters, most notably in China, where sales of gasoline-powered cars exceed those of diesel-powered cars, which typically use platinum in their catalytic converters (Chart 4). Chart 3Tight Fundamentals In##BR##The Palladium Market Tight Fundamentals In The Palladium Market Tight Fundamentals In The Palladium Market Chart 4Growing Demand For##BR##Autocatalysts Dominated In The Past... Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So Growth in global demand for palladium-based autocatalysts averaged 4.8% yoy in the past 5 years. The use of palladium for autocatalysts now makes up more than 75% of global palladium demand, up from 56% 10 years ago. Chinese demand for palladium used in autocatalysts grew from 10% of global demand in 2007 to more than a quarter of global demand last year. Given autocatalysts' oversized contribution to demand growth, the palladium market is highly dependent on car sales. Our modelling highlights global car production as a significant explanatory variable when it comes to palladium prices. Most significant are the U.S. and Chinese markets, which are the largest markets for gasoline-powered cars. While vehicle sales in China were strong in 2016, they have slowed considerably and recorded yoy declines in the most recent November and December data (Chart 5). Slowing demand growth for cars in China likely comes on the back of the phasing out of tax cuts on small vehicles. This will limit the upside for palladium prices from China's industrial demand. Growth in car sales in the U.S. has been even more muted, contracting in 2017 for the first time since 2009. However, a more concerted adoption of gasoline-powered cars in Europe - largely in response to efforts by cities to reduce emissions of particulate matter from diesel engines, and the highly publicized emissions-testing scandals involving European carmakers - will, at least partially, mitigate the negative impact of slowing demand from the top two gasoline-powered markets. On the supply side, global mine supply has been relatively stagnant over the past 5 years, expanding an average 1.2% yoy during this period. Russia, South Africa and Canada account for almost 90% of total palladium mine supply. And while Russian and South African supplies have been relatively flat over the years, Canadian palladium has grown to account for ~11% of global supply in 2017, up from 4% in 2010. Global palladium supply has been supported by metal recovered from autocatalyst scrap, which has been averaging 4.8% yoy growth in supply over the past 5 years. In fact, the share of palladium recovered from autocatalyst scrap has almost doubled in the past 10 years, and now makes up almost 20% of total supply. Growth in this source of supply has come down significantly (Chart 6). However, we expect palladium's exorbitant price and elevated steel prices to incentivize an increase in the metal's recovery from scrap. Indeed, GFMS expects recycled palladium to pave record highs this year and to surpass 2 million ounces next year. Chart 5...But Beware Of Slowing Gasoline Car Sales ...But Beware Of Slowing Gasoline Car Sales ...But Beware Of Slowing Gasoline Car Sales Chart 6Palladium Needs Restocking Palladium Needs Restocking Palladium Needs Restocking Strong demand, combined with limited supply growth, has weighed on palladium inventories. Furthermore, ETF holdings of palladium have come down sharply while net speculative long positions have skyrocketed. Given that stocks are so low, we do not expect a severe fall in prices. Bottom Line: Palladium behaves like an industrial metal and is especially sensitive to changes in demand for automobiles. While the stars were aligned for palladium last year - a weak USD, low real interest rates, and bullish fundamentals - car sales in the U.S. and China have been slow recently. Even so, a physical deficit will prevent a crash in the palladium market this year. Platinum Trading At A Discount To Palladium In contrast with palladium's remarkable performance last year, platinum was up a mere 3.4% in 2017. In fact palladium, which usually trades at a discount to platinum, has been more expensive since October (Chart 7). This can be attributed to differences in fundamentals. Palladium's market conditions have been significantly tighter than platinum. Greater demand for the physical metal than supply put the market in deficit last year, which supported platinum prices. As with palladium, catalytic converters are a major demand source for platinum; however, they account for ~ 40% of platinum demand - considerably less than the roughly 80% share of palladium demand accounted for by catalytic converter demand. Europe is the largest market for diesel cars, and, while total vehicle sales in Europe have remained healthy, diesel-powered cars have been losing market share since the Volkswagen emissions-rigging scandal came to light in 2015 (Chart 8). This hit platinum use in autocatalysts particularly hard. In addition, weaker demand from its second use - jewelry - is keeping a lid on platinum prices (Chart 9). In fact, Chinese demand for the white metal, which accounts for more than 50% of global platinum jewelry demand, has been falling. Despite weakening demand, global balances remained in deficit on the back of muted supply. Chart 7Platinum Now Cheaper Than Palladium Platinum Now Cheaper Than Palladium Platinum Now Cheaper Than Palladium Chart 8EU Diesel Car Market Losing Momentum EU Diesel Car Market Losing Momentum EU Diesel Car Market Losing Momentum Chart 9Platinum Jewelry Losing Its Appeal Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So Platinum's market balance could be at risk if carmakers start using more of it in catalytic converters, now that it trades at a discount to palladium. Platinum is a superior material for autocatalysts, but palladium has been traditionally favored on a cost basis. Platinum's lower price incentivizes carmakers to switch to this metal. According to Johnson Matthey, it will be two years before the impact of such substitution begins to affect the palladium market. Bottom Line: Subdued demand for platinum jewelry combined with the loss of market share for diesel-powered cars in Europe will keep a lid on the platinum market this year. However, platinum follows gold, and this could support prices if equity investors hedge market volatility and future corrections by purchasing the metal. Silver Follows Gold Silver, and, to a lesser extent, platinum are not as exposed to the industrial business cycle as palladium. These metals' prices instead move in line with gold (Chart 10). Our modeling reveals that a 1% increase in gold prices is associated with a 0.76 pp increase in silver prices. Thus gold's spillovers to the silver market are significant. Even so, there are periods when this relationship disconnects. This is because, although industrial uses do not account for as large a share of silver demand as they do for palladium, such fundamentals do account for a significant source of demand. Thus, in addition to the financial factors which drive gold, silver's industrial applications give it some exposure to economic activity. In fact, a 1% increase in the CRB Metals Index is associated with a 0.17pp increase in silver prices. This explains why, in some instances, silver's cointegration with gold weakens. As a practical matter, gold is a superior hedge against equity downfalls than silver (Chart 11). While gold month-on-month (mom) returns outperform S&P 500 mom returns almost 80% of the time in periods of decreasing equity returns, the ratio for silver comes in at a lower 67%. On the other hand, gold mom returns outperform S&P 500 returns less than 30% of the time during periods when equities are increasing, while silver outperforms the stock market almost 40% of the time. Chart 10Silver And Gold##BR##Move In Tandem Silver And Gold Move In Tandem Silver And Gold Move In Tandem Chart 11Gold Outperforms Amid Equity Downfalls,##BR##Not During Rising Stocks Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So In addition, although both gold's and silver's correlations with the S&P 500 become large and negative when the S&P 500 decreases in yoy terms, this negative correlation in the case of gold is significantly larger than for silver (Chart 12). In fact, along with silver's relatively weaker negative correlation with the S&P 500 during periods of negative equity returns, silver also exhibits a relatively stronger positive correlation with equities during periods of positive returns. While silver is an effective hedge against geopolitical and economic crises, gold's hedging ability remains superior (Chart 13). Silver and gold post similar returns during geopolitical crises; however, gold returns are significantly higher during economic crisis. Chart 12Negative Correlations More##BR##Pronounced During Equity Downfalls Negative Correlations More Pronounced During Equity Downfalls Negative Correlations More Pronounced During Equity Downfalls Chart 13Gold Is A##BR##Superior Protection Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So This supports the finding that silver's hedging ability is hampered by its use in industrial applications, which make it more responsive to the business cycle than gold. Bottom Line: Gold and silver prices are cointegrated. However, given silver's industrial applications, it is more sensitive to business activity. This explains the periods of divergence in the two precious metals, and limits silver's ability to hedge against economic crises and falling equities. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 For a discussion of the gold market fundamentals, please see Commodity & Energy Strategy Weekly Report titled "Gold Still Shines Despite Threat Of Higher Rates," dated February 1, 2018. Available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So Trades Closed in 2018 Summary of Trades Closed in 2017 Silver, Platinum At Risk As Fed Tightens; Palladium Less So Silver, Platinum At Risk As Fed Tightens; Palladium Less So

Highlights Even though our baseline scenario calls for four rate hikes out of the Fed this year - more than markets have priced in - gold will be supported by increasing inflation and inflation expectations, heightened geopolitical risks, and greater volatility in equity markets. Further out, we expect gold will provide a good hedge against a likely equity downturn, as the bull market turns into a bear market in 2H19. For now, keep gold as a strategic portfolio hedge. Energy: Overweight. After popping above $70 and $66/bbl last week, Brent and WTI prices retreated ~ $2.00/bbl on the back of a stronger USD and increased rig counts in the U.S. shales, particularly in the prolific Permian Basin, where 18 rigs were added. We continue to expect Brent and WTI prices to average $67 and $63/bbl this year. Base Metals: Neutral. Spot copper continues to trade on either side of $3.20/lb on the COMEX. We remain neutral, given our view upside risk - chiefly supply-side disruptions at the mine and refined levels - will be balanced on the downside by a stronger USD and a slowdown in China. Precious Metals: Neutral. Gold will draw support from rising inflation and inflation expectations this year and next (see below). Ags/Softs: Underweight. NAFTA negotiations ended this week in Montreal with the U.S. rejecting proposals from Canada to advance the talks. However, the U.S. side stated it would seek "major breakthroughs" at the next round of negotiations in Mexico City beginning February 26, according to agriculture.com. Feature Gold Price Risks Skewed To The Upside Price risk in gold will remain skewed to the upside this year, even as our base case scenario calls for limited gains from here. Higher inflation and inflation expectations, which normally would be bullish for gold, will be countered by Fed policy-rate hikes, which will boost the USD and lift real rates in our base case (Chart of the Week). Inflation's Revival Would Support Gold ... Despite above-trend global growth last year, subdued inflation limited the Fed's willingness to proceed with interest rate normalization in earnest. However, we do not put this down to structural forces, and instead expect core inflation to be near its bottom.1 In fact, inflation's soft readings are typical of the expected 18-month lag between U.S. economic growth and a pick-up in inflation, and as our Global Investment Strategists point out, several key indicators including the ISM manufacturing index, the New York Fed's Inflation Gauge, as well as BCA's proprietary pipeline inflation index are already moving in this direction (Chart 2).2 Chart of the WeekInflation And U.S. Financial Variables Matter Inflation And U.S. Financial Variables Matter Inflation And U.S. Financial Variables Matter Chart 2Signs Of Life In U.S. Inflation Signs Of Life In U.S. Inflation Signs Of Life In U.S. Inflation Inflation tends to pick up once the unemployment rate falls below the 5% mark. With the latest unemployment reading coming in at 4.1%, the U.S. economy has reached the steep end of the Phillips Curve - a workhorse model used by the Fed, which depicts the trade-off between unemployment and inflation. Indeed, BCA's Global Investment Strategists expect the U.S. unemployment rate to continue falling to a 49-year low of 3.5% by year-end. These further declines in the unemployment rate will push up wages, pressuring service inflation (Chart 3). At the same time, we expect the lagged impact of the weak USD will begin to show up in goods price inflation, along with higher energy prices. While some components of the Fed's preferred inflation gauge may face a slowdown in price pressure - most notably rent - this will likely be mitigated by accelerating prices in other components, such as health care, which we expect will return to its historic trend. In fact, U.S. inflation expectations - supported by higher energy prices and a strong December core CPI reading - have already started to increase (Chart 4). As our U.S. Bond Strategists point out, by the time core inflation returns to the Fed's target, the 10-year TIPS breakeven inflation rate will be between 2.4% and 2.5%.3 Chart 3At The Steep End Of The Philips Curve At The Steep End Of The Philips Curve At The Steep End Of The Philips Curve Chart 4A Breakout In Inflation Expectations A Breakout In Inflation Expectations A Breakout In Inflation Expectations Thus the 2018 inflation outlook is showing signs that it is in the process of bottoming, and will soon begin its ascent. We expect core PCE inflation, the Fed's preferred gauge, to reach the central bank's 2% target by year-end. This pick-up in inflation and inflation expectations is positive for gold, which we've shown to be an attractive hedge against rising prices. However, inflation's comeback will likely embolden the Fed to proceed more aggressively with its hiking cycle. ... But A Hawkish Fed Counters Inflation ... While our modelling showcases an inverse relationship between real rates and gold prices, what is crucial to our outlook is our expectation of how the Fed will proceed with its interest rate normalization process this year. Given that gold's correlation with inflation is strengthened during periods of low real rates, the ideal condition for gold would be for the Fed to stay behind the inflation curve. But we are not expecting that just yet.4 Rather than waiting to see the "whites of inflation's eyes," our expectation is the Fed will tighten ahead of inflation. This has in fact already materialized with three hikes in 2017 amid muted inflation. Upward surprises in U.S. growth, coupled with an upward trend in inflation will keep the Fed on its normalization path with greater confidence. We expect four rate hikes in 2018 - above both market expectations and what is implied by the "dot plot". Net, the pre-emptive Fed rate hikes we expect will lead to higher real rates, and will limit gold's upside this year. ... As Does A Stronger Greenback An increase in U.S. real rates vis-à-vis other economies, as well as a shift in the composition of global growth to favor the U.S., will support the USD. In addition to higher real rates, this would also limit gold's upside in 2018. Stronger growth ex-U.S. last year weakened the USD. This year, we expect the U.S. economy to outperform. Financial conditions have eased in the U.S. relative to the rest of the world, while fiscal policy is expected to be comparatively more favorable in the U.S. The U.S. surprise index has reflected this shift in comparative growth, outperforming most regions (Chart 5).5 While the Euro has been exceptionally resilient, the fallout from a stronger currency will eventually begin to show up in slower growth. The EUR/USD cross has diverged from the spread in expected policy rates, leaving the euro looking expensive (Chart 6). Since the beginning of the year, spreads have widened in favor of the dollar, while the USD has weakened. Although we do not expect the ECB to hike until mid-2019, our expectation of four Fed rate hikes this year will support the greenback. This will push spreads back in line. Such decoupling is not the norm, and we expect a 5% appreciation in the dollar in broad trade weighted terms.6 Chart 5Economic Surprises Favor The U.S. Economic Surprises Favor The U.S. Economic Surprises Favor The U.S. Chart 6EUR Looks Expensive EUR Looks Expensive EUR Looks Expensive Still, The Fed Could Surprise, And Tilt Dovish Chart 7A Policy Change Would##BR##Tolerate Higher Inflation A Policy Change Would Tolerate Higher Inflation A Policy Change Would Tolerate Higher Inflation A risk to our base case outlook is a change in the Fed's monetary policy framework. Here we note an increasing number of statements advocating the exploration of an alternative policy framework have been emerging from the Fed. This line of attack observes the Fed's current 2% inflation target is unsatisfactory, as it is too close to the zero-lower bound on interest rates, thus constraining the Fed's ability to exercise expansionary monetary policy when rates are low.7 Alternative policy proposals include price-level targeting, as well as an increase in the inflation target. Additionally, former Fed Chair Bernanke recently proposed a temporary price level target be implemented during low-rate periods.8 The net effect of these alternatives would be a higher inflation rate - above the current 2% target (Chart 7). If the Fed were to adopt a new monetary policy framework, it will likely occur before the next recession - in order to allow it to better respond to economic weakness. While we do not expect a regime change this year, these discussions and an eventual shift, may make the Fed more dovish this year, and more likely to tolerate higher inflation in the future. This would be an upside risk to gold, as it would assume its role as a store-of-value against higher inflation. The net effect of such a policy change - were it to occur - would be higher inflation expectations, lower real rates, and a weaker USD, all of which would bid up the gold market. Bottom Line: The revival of U.S. inflation and inflation expectations will bolster gold. However, our expectation that the Fed will continue hiking ahead of a realized uptick in inflation, and more aggressively than is currently priced in the market, will increase real rates and limit gold's upside potential. A stronger USD on the back of higher real rates, as well as a shift in global growth in favor of the U.S., will work against gold this year. Geopolitical Risks: Understated In 2018 We expect geopolitical risks to support gold prices this year. Gold's safe-haven attributes will be highlighted by a combination of events spread across the calendar year, which we believe will put a floor under the metal's price (Chart 8).9 Political and economic policy uncertainty will remain elevated this year (Chart 9). Our Geopolitical Strategists see this year's gold-relevant risks stemming from two main factors: (1) U.S. political risks, and (2) Exogenous tail risks. The former is likely to be a more significant source of upside pressure. Chart 8Gold Outperforms During##BR##Geopolitical Crises Gold Still Shines Despite Threat Of Higher Rates Gold Still Shines Despite Threat Of Higher Rates Chart 9Elevated Policy Uncertainty##BR##Supports Gold Elevated Policy Uncertainty Supports Gold Elevated Policy Uncertainty Supports Gold U.S. Foreign Strategy Risks Will Keep Gold Bid U.S. political risks are rooted in President Trump's strategic decisions, and boil down to two mutually exclusive schemes ahead of the midterm elections: Domestic Strategy or Foreign Strategy (Table 1). Our Geopolitical strategists note: "... policymakers often play "two-level games," with the domestic arena influencing what is possible in the international one. As Donald Trump loses political capital on the domestic front, his options for affecting policy will become constrained. However, the U.S. constitution places almost no constraints on the president when it comes to foreign policy."10 Trump's propensity to take on a more aggressive stance in foreign policy - which would be boosted by an unfavorable outcome in the immigration bill - will set the stage for a volatile year, supporting gold via its ability to hedge against geopolitical risks (Chart 10). Table 1Trump's Two-Level Game Gold Still Shines Despite Threat Of Higher Rates Gold Still Shines Despite Threat Of Higher Rates Chart 10Trump Will Look To Revive His Political Capital Trump Will Look To Revive His Political Capital Trump Will Look To Revive His Political Capital In addition to the U.S. political risks, many low-probability high-impact risks will keep volatility elevated this year and could support gold as a strategic portfolio hedge in 2018. Most notable are the following: A meaningful slowdown in China would have a negative impact on the global economy, as well as increase the risk of a monetary policy mistake in the U.S. The Fed's monetary policy decision is important for EM growth, while EM growth contributes to U.S. inflation, this feedback system makes the expected slowdown in Chinese growth relevant to the U.S. monetary stance. If China slows more than expected, this would reduce the global demand for commodities and goods, diminishing U.S. inflation expectations, potentially forcing the Fed to reassess its rate hike pace. If no adjustments are made, the Fed risks overshooting the equilibrium interest rate, increasing the risk of an equity correction. A downward rate hike adjustment, would keep the USD and real rates at low levels. A global oil-supply disruption caused by a collapse of the Venezuelan economy would lead to a short-lived spike in oil prices (Chart 11). In low-spare-capacity environments - as we are in today - oil prices become more responsive to supply shocks. Based on our simulations, a 600k b/d drop in Venezuelan oil supply in 2018 could spike oil prices by ~$10/bbl, leading to higher cost-push inflation. Our modelling shows U.S. CPI is highly responsive to oil price variation. This spike in headline inflation would push gold prices higher. Chart 11Cost-Push Inflation Risk From Venezuela Collapse Gold Still Shines Despite Threat Of Higher Rates Gold Still Shines Despite Threat Of Higher Rates In addition to U.S.-Iran tensions, we see other potential catalysts to instability in the Middle East - mainly regarding a severe deterioration of the U.S.-Turkish relationship, and Iraqi-Kurdish clashes ahead of Iraqi elections. Lastly, Europe: Italian elections and Euro-skepticism are a longer-term risk; however, news around the Italian elections in March has the potential to fuel talk of a potential breakup, which could lift gold.11 Bottom Line: Increased tensions due to Trump's controversial foreign strategy (China and Iran), as well as exogenous tail risks throughout the year will keep risks elevated in 2018, supporting gold prices. In fact our geopolitical strategists believe risks are understated this year, increasing the utility of gold's ability to hedge against political turmoil. Gold Outperforms In Equity Bear Markets In addition to its ability to hedge against rising inflation and increased geopolitical risks, gold outperforms during equity downturns and amid market volatility.12 Specifically, during periods of negative equity returns, gold outperformed the S&P500 79% of the time, with an average excess return of 3.7%. Furthermore, gold outperforms equities 60% of the time in periods of rising VIX with an average excess monthly return of 1.6% in these periods, and only 30% of the time in decreasing VIX periods with an average monthly excess return of -1.8% (Chart 12).13 We expect the equity bull market to remain intact throughout 2018. An equity downturn is not expected before 2H19. Nevertheless, we expect volatility to increase this year as investors fret about the sustainability of the bull market, and amid heightened geopolitical tensions. Moreover, domestic U.S. developments - e.g., the evolution of Special Counsel Robert Mueller's investigation; a larger-than-expected Democrat win in the midterm elections or a Fed policy mistake - could affect investor sentiment and trigger a rise in volatility and a temporary sell-off in S&P 500. In our view, consumer confidence is a key contributor to the current equity bull market and currently stands at very elevated levels (Chart 13). Thus, any meaningful disappointment could derail this high-confidence environment. Chart 12Gold Outperforms Amid##BR##Volatility & Equity Downturns Gold Still Shines Despite Threat Of Higher Rates Gold Still Shines Despite Threat Of Higher Rates Chart 13High Confidence##BR##Environment At Risk High Confidence Environment At Risk High Confidence Environment At Risk Therefore, we believe the larger-than-expected tail risks and the monetary and political risks in the U.S. are not fully reflected in the gold market (Chart 14). The above risks assessment would suggest a fatter right tail in out-of-the-money gold options. Chart 14Rising Volatility Will Support Gold Rising Volatility Will Support Gold Rising Volatility Will Support Gold Chart 15Understated Geopolitical Risks This Year Understated Geopolitical Risks This Year Understated Geopolitical Risks This Year Bottom Line: While geopolitical risks were overstated in 2017, they are understated this year (Chart 15). Thus we do not expect a repeat of last year's low-VIX high-confidence environment. Rather gold will gain support from increased equity volatility this year. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see BCA Research The Bank Credit Analyst Special Report titled "The Impact of Robots on Inflation," dated January 25, 2018, available at bca.bcaresearch.com. 2 Please see BCA Research Global Investment Strategy Weekly Report titled "Three Tantalizing Trades - Four Months On," dated January 19, 2018, available at gis.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy Weekly Report titled "It's Still All About Inflation," dated January 16, 2018, available at usbs.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 5 Please see BCA Research Global Investment Strategy Weekly Report titled "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018, available at gis.bcaresearch.com. 6 Please see BCA Research Global Investment Strategy Weekly Report titled "The Indefatigable Euro," dated January 26, 2018, available at gis.bcaresearch.com. 7 Please see "Fed Officials See Benefits In Letting Inflation Run Above Target," dated January 19, 2018, available at Bloomberg.com. 8 Please see https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/ 9 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 10 Please see BCA Research Geopolitical Strategy Weekly Report titled "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 11 For a comprehensive analysis of this issue, please see BCA Research Geopolitical Strategy Special Report titled "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 12 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 13 Excess returns = (Gold - S&P 500) monthly returns. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Gold Still Shines Despite Threat Of Higher Rates Gold Still Shines Despite Threat Of Higher Rates Trades Closed in 2018 Summary of Trades Closed in 2017 Gold Still Shines Despite Threat Of Higher Rates Gold Still Shines Despite Threat Of Higher Rates

Dear Client, This is our last report of 2017. We will be back on January 4, 2018, with our customary recap of recommendations made this year. We wish you and your loved ones the very best this lovely season has to offer. Sincerely, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Highlights With GDP growth accelerating in ~ 75% of countries monitored by the IMF, we expect commodity demand - particularly for crude oil and refined products - to remain strong in 2018. On the supply side, OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will maintain its production discipline, which will force commercial oil inventories lower in 2018. As a result, we expect oil markets to continue to tighten in 2018, keeping upside risk to prices from unplanned production outages acute. This was clearly demonstrated in separate incidents in the U.S. and North Sea in the past two months, which removed more than 400k b/d from markets since November. Geopolitical risk will remain elevated, particularly in Venezuela, where operations at the state oil company were paralyzed after senior military officers assumed leadership positions there. Beyond 2018, we believe OPEC 2.0 will endure as a coalition. It will manage production and provide forward guidance consistent with a strategy to keep WTI and Brent forward curves backwardated. This will provide a supportive backdrop for the Saudi Aramco IPO, expected toward the end of next year, and will limit the volume of hedging U.S. shale-oil producers are able to effect. In turn, this will limit the number of rigs U.S. E&Ps can profitably deploy. Energy: Overweight. Our Brent and WTI call spreads in 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 53.8%. We will retain these exposures into 2018. Base Metals: Neutral. We expect base metals to be supported through 1Q18, after which reform measures in China could crimp supply and demand, as we discuss below. Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge against inflation and geopolitical risk, even though inflation remains quiescent (see below). Ags/Softs: Underweight. Fed policy will be critical to ag markets in 2018. We expect as many as four rate hikes next year, as the Fed continues with rates normalization (see below). Feature Our updated balances model indicates global oil markets will continue to tighten in 2018, as demand growth accelerates and OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - maintains production discipline (Chart of the Week). Earlier this week, IMF noted improving employment conditions globally, which will continue to support aggregate demand and the synchronized global expansion in manufacturing and trade (Chart 2 and Chart 3).1 This acceleration of GDP growth rates globally will continue to support income growth and commodity demand generally. Oil-exporters have not participated in the global economic expansion to the extent of other economies, according to the Fund, which can be seen in the trade data (Chart 3). However, imports by Middle East and African countries are moving higher, and look set to post year-on-year (yoy) growth in the near future. Chart of the WeekOil Balances Will Continue to Tighten In 2018 Oil Balances Will Continue to Tighten In 2018 Oil Balances Will Continue to Tighten In 2018 Chart 2Global Upturn Boosts Manufacturing, ##br##Commodity Demand... Global Upturn Boosts Manufacturing, Commodity Demand... Global Upturn Boosts Manufacturing, Commodity Demand... The combination of continued production discipline from OPEC 2.0 and expanding incomes boosting demand will force crude and product inventories lower, particularly those in the OECD, which are the primary target of the producer coalition (Chart 4). Chart 3...And Global Trade ...And Global Trade ...And Global Trade Chart 4OECD Inventories Will Fall Below 5-year ##br##Average In BCA's Supply-Demand Assessment OECD Inventories Will Fall Below 5-year Average In BCA's Supply-Demand Assessment OECD Inventories Will Fall Below 5-year Average In BCA's Supply-Demand Assessment Unplanned Outages Mounting; Risk Remains Acute Unlike many forecasters, we continue to expect inventories to draw in 1Q18. This expectation is the direct result of our supply-demand modelling, and also is supported by our expectation that the risk of unplanned outages is increasing. This already has been demonstrated in the U.S. and U.K. North Sea, where more than 400k b/d of pipeline flows in November and December were lost. Of far greater moment, however, is the potential for unplanned outages in Venezuela. We believe the state-owned oil company there is one systemic malfunction away from shutting down exports entirely - e.g., a breakdown in pumping stations - as happened in 2002. Reuters reports the government of Nicolas Maduro appears to be consolidating power via an "anti-corruption" campaign, and is installing senior military officials with little or no industry experience in leadership roles inside PDVSA.2 Reuters notes, "The ongoing purge, in which prosecutors have arrested at least 67 executives including two recently ousted oil ministers, now threatens to further harm operations for the OPEC country, which is already producing at 30-year-lows and struggling to run PDVSA units including Citgo Petroleum, its U.S. refiner." The news service goes on to report, "Executives that remain, meanwhile, are so rattled by the arrests that they are loathe to act, scared they will later be accused of wrongdoing." We have Venezuela output at just under 1.90mm b/d, and expect it to decline to a little more than 1.70mm b/d by the end of 2018. Brent Expected To Average $67/bbl In 2018 We continue to forecast average Brent prices of $67/bbl and WTI at $63/bbl next year, given our assessment of global supply-demand balances, which drive our fundamental price forecasts: We expect global crude and liquids supply to average 100.23mm b/d in 2018, vs 100.01mm b/d expected by the U.S. EIA, while we have global demand coming in at 100.29mm b/d on average next year, vs the 99.97mm b/d expected by EIA (Chart 5 and Chart 6). Chart 5BCA's Expected Crude Oil Supply Vs. EIA's BCA's Expected Crude Oil Supply Vs. EIA's BCA's Expected Crude Oil Supply Vs. EIA's Chart 6BCA's Expected Demand Exceeds EIA's In 2018 BCA's Expected Demand Exceeds EIA's In 2018 BCA's Expected Demand Exceeds EIA's In 2018 Our expectations translate into a 2.55mm b/d increase in supply next year, vs a 1.67mm b/d increase in demand yoy (Table 1). Running the EIA's supply-demand assessments through our fundamental pricing models produces average Brent and WTI prices of $49/bbl and $47/bbl, respectively. EIA is expecting a 2.04mm b/d increase in supply next year, vs a 1.63mm b/d increase in demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Fundamentals Remain Bullish Heading Into 2018 Oil Fundamentals Remain Bullish Heading Into 2018 In line with our House view, we are expecting some USD strengthening on the back of as many as four interest-rate hikes by the Federal Reserve in the U.S. (Chart 7). As we've noted in the past, we expect these effects to be felt more in 2H18. Along with higher U.S. shale-oil production driven by higher prices - we expect shale output to go up 0.97mm b/d next year to 6.64mm b/d - a stronger USD will keep Brent and WTI prices below $70/bbl next year. Oil Beyond 2018: OPEC 2.0 Endures OPEC 2.0 will remain an enduring feature of the oil market going forward, in our view. Allowing the coalition to fade away, and returning the global oil market to a production free-for-all once again serves neither KSA's nor Russia's interests. Following the IPO of Saudi Aramco toward the end of 2018, KSA will, we believe, want to maintain stability in the market, by demonstrating to capital markets that OPEC 2.0 can manage crude-oil supplies in a way that is not disruptive to its new-found investors. It is important to remember the Aramco IPO is only the beginning of the process of transforming KSA from a crude resource exporter into a vertically integrated global refining and marketing colossus. To eclipse Exxon as the world's largest refiner, Aramco would benefit from continued access to capital markets throughout the following decades, as well reliable cash flows to lower its cost of capital, service debt, and maintain whatever dividends it envisions. This cannot occur if oil markets are continually at risk of collapsing because production cannot be managed in a business-like manner. While Russia has not embarked on the same sort of transformation of its resource industry as KSA, it still has a very strong interest in maintaining stability in the crude oil markets, given its dependence on hydrocarbon exports. The Russian rouble moves in near-lock-step with Brent prices - since 2010, Brent prices explain ~80% of the movement in the rouble (Chart 8). It is obvious a collapse in global crude oil prices would, once again, have devastating effects on Russia's economy, as it did in 2009 and 2014. Such a collapse would trigger inflation domestically, as the cost of imports skyrockets, and threaten civil unrest as incomes and GDP are hobbled and foreign reserves evaporate. Chart 7Stronger USD Limits Oil-Price Appreciation In 2018 Stronger USD Limits Oil-Price Appreciation In 2018 Stronger USD Limits Oil-Price Appreciation In 2018 Chart 8Russia Cannot Afford An Oil Price Collapse Russia Cannot Afford An Oil Price Collapse Russia Cannot Afford An Oil Price Collapse Both KSA and Russia have a deep interest in maintaining oil's pre-eminent position as a transportation fuel for as long as possible. For this reason, neither wants to encourage prices that are too high - $100/bbl+ prices greatly encouraged the development of shale technology in the U.S. - nor too low, given the dire consequences such an outcome would have for both their economies. The common goals of KSA and Russia cannot be achieved by allowing OPEC 2.0 to dissolve, leaving member states to produce at will in the sort of production free-for-all that characterized the OPEC market-share war of 2014 - 15. To the extent possible, OPEC 2.0 must continue to manage member states' production in a manner that does not permit inventories to once again fill to the point where the only way to moderate over-production is to push prices through cash costs, so that enough output is shut in to clear the market. The most obvious way for these goals to be accomplished is by keeping markets relatively tight. This can be done by keeping commercial oil inventories worldwide low enough to keep Brent and WTI forward curves backwardated - particularly in highly visible OECD and U.S. storage facilities. A backwardated forward curve means the average price over a typical 2- or 3-year hedge horizon is lower than the spot price received by OPEC 2.0 producers. The deeper the backwardation, the lower the average price a U.S. shale producer can lock in by hedging. This limits the number of rigs that can be deployed by shale producers. This will require continual communication with markets to assure them sufficient spare capacity and easily developed production can be brought to market to alleviate any temporary shortage. In the meantime, OPEC 2.0 members with flexible storage will need to communicate these barrels will be readily available to the market. This management and forward-guidance should be easier for OPEC 2.0 to execute on, following its recent success in keeping some 1.0mm b/d of production off the market - largely in KSA and Russia - and member states' existing spare capacity and storage. We continue to expect the daily working dialogue of the OPEC 2.0 member states - most especially KSA and Russia - to deepen as time goes by, and for tactics and strategy to evolve as each gains comfort operating with the other. Whether OPEC 2.0 can pull this off remains to be seen. However, given the success of the coalition over the past two years, we are inclined to believe they will continue to develop a durable modus operandi supporting this outcome. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com Opposing Forces: Stay Neutral Metals In 2018 Chart 9Strong Global Demand Will Neutralize ##br##Impact of China Slowdown Strong Global Demand Will Neutralize Impact of China Slowdown Strong Global Demand Will Neutralize Impact of China Slowdown While we expect more upside to metal prices in the first half of 2018, slowing growth in China and a stronger USD will prevent a repeat of this year's stellar performance. While a deceleration in China is - ceteris paribus - most definitely a headwind to metal prices, we believe the impact may pan out differently this time around. The silver lining comes from the Communist Party's commitment to environmental reforms, which, in many cases, will manifest themselves in the form of less supply of the refined product, or demand for the ores. Either way, this alone is a positive for metals. China's Environmental Reforms Will Dominate in 1Q18 China's commitment to cleaning its air is currently shaping up in the form of winter cuts in major steel- and aluminum-producing provinces. While policies are hard to predict, we will keep monitoring the development and implementation of reforms from within China to assess how they will impact the markets. Outcomes from the Annual National People's Congress in March will give us a clearer indication of what to expect in terms of policy. For now, we see these reforms putting a floor under metal prices, at least in the beginning of 2018. Robust Global Demand Offsets Stronger USD & Slower Chinese Growth Xi's reforms will turn into a headwind for metal prices as they begin to impact the real economy in 2H18. Signs of weakness have already emerged in measures of industrial activity such as the Li Keqiang and Chinese PMI (Chart 9). In addition, the real estate sector has been showing some weakness since the beginning of the year. Annual growth rates in real estate investment and floor-space started are decelerating - a worrisome sign. Nonetheless, domestic demand remains robust, and policymakers in Beijing are approaching economic reforms gradually and with caution. Consequently we do not expect a major policy mistake to derail the Chinese economy. While Chinese growth will likely slow from above trend levels, a hard landing is most probably not in the cards. Another bearish risk comes from a stronger USD. We see the Fed as more committed to interest-rate normalization than markets expect, and consequently would not be surprised to see up to four rate hikes next year. Inverting the yield curve is a policy mistake incoming Chair Jerome Powell will try to avoid; however, we expect inflation to bottom in the first half of next year, giving the Fed room to accelerate its path of rate hikes. This will result in a stronger USD, which is bearish for commodities priced in U.S. dollars. In any case, these bearish factors will likely be offset by strong global growth, supported by a robust U.S. economy. Bottom Line: Xi's reforms will dominate metal markets in 2018 as bullish supply side environmental reforms duel against bearish demand-side economic reforms. Robust global growth will neutralize the impact of downside pressures. Stay neutral, but beware of modest USD strength. Low Inflation Retards Gold's Advance Once again, reality confounded theory: Inflation failed to emerge this year, even as systematically important central banks remained massively accommodative, and some 70% of the economies tracked by the OECD reported jobless rates below the commonly used estimate of the natural rate of unemployment (Chart 10). Chart 10Massive Monetary Accommodation Failed ##br##To Spur Inflation In The U.S. Massive Monetary Accommodation Failed To Spur Inflation In The U.S. Massive Monetary Accommodation Failed To Spur Inflation In The U.S. These fundamentals should be inflationary and supportive of gold. To date, they haven't been. We Expect Inflation To Revive The global economy has endured decades of low inflation going back at least to the 1990s. This has been driven by numerous factors. First, the expansion of the global value chain (GVC) over the past three decades has synchronized inflation rates worldwide, as our research and that of the BIS has found. As a result, U.S. wages and goods' inflation are now more dependent on global spare capacity. With the global output gap now almost closed, this disinflationary force will dissipate.3 Second, most measures of labor-market slack are now pointing toward tighter conditions, which, we expect, will strengthen the Phillips curve trade-off between inflation and unemployment next year. Inflation is a lagging indicator: Wage inflation lags the unemployment rate, and CPI inflation lags wage inflation. Investors should expect inflation to show up in 2018.4 Lastly, one-off technical factors, which depressed inflation last year - e.g. drop in cellphone data charges and prescription drug prices - also will fade. Once these big one-offs are no longer in annual percent-change calculations, inflation rates will rise. The Fed's Choppy Waters Against this backdrop, the Fed is embarking on a rates-normalization policy, which we believe will result in U.S. central bank's policy rate being increased up to four times next year. The risk of a policy error is high. Should the Fed proceed with its rate hikes while inflation remains quiescent, real interest rates will increase. This would depress gold prices, and, at the limit, threaten the current economic expansion by tightening monetary conditions well beyond current levels, potentially lifting unemployment levels. If, on the other hand, the Fed deliberately keeps rate hikes below the rate of growth in prices - i.e., it stays "behind the curve" - it risks being forced to implement steeper rate hikes later in 2018 or in 2019 to get stronger inflation under control. This could tighten monetary conditions suddenly, and threaten the expansion, pushing the U.S. economy into recession. There's a lot riding on how the Fed navigates these difficult conditions. Geopolitical Risks Will Support Gold On the geopolitical side, the risks we've identified in our October 12, 2017 publication - i.e. (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration, and (3) ongoing conflicts in the Middle East-- will add a geopolitical risk premium to gold prices, supporting the metal's role as a safe haven.5 Bottom Line: We remain neutral precious metals, but still recommend investors allocate to gold as a strategic portfolio hedge against inflation and geopolitical risk. U.S. Policies Will Weigh On Ags In 2018 U.S. monetary and trade policy will dominate ags next year. Our modelling reveals that U.S. financial factors - real rates and the USD - are significant in explaining ag price behavior (Chart 11).6 Given that we expect the Fed to hike interest rates more aggressively than what the market is currently pricing in, we see grains as vulnerable to the downside. In addition, the risk that NAFTA is abrogated by the U.S. would weigh on ag markets, as Canada and Mexico are among the U.S.'s top three ag export destinations. Chart 11Bearish U.S. Monetary And Trade Policies ##br##Amid Healthy Inventories Will Weigh On Ags Bearish U.S. Monetary And Trade Policies Amid Healthy Inventories Will Weigh On Ags Bearish U.S. Monetary And Trade Policies Amid Healthy Inventories Will Weigh On Ags We expect ag markets will remain well supplied next year, and inventories will moderate the impact of supply-side shocks - most notably in the form of a La Nina event. The probability of a La Nina currently stands above 80%, and is expected to last until mid-to-late spring. U.S. Monetary Policy Is Relevant With U.S. inflation rates still subdued, there has been much talk about how soon the Fed will be able embark on its tightening cycle. A weaker-than-expected USD has been favorable for ag markets this year, and thus kept U.S. ag exports competitive. However, if and when the economy reaches the kink in the Philipps Curve, and inflation begins its ascent, the Fed will be able to proceed with its rate-hiking cycle. With the New York Fed's Underlying Inflation Gauge at a cycle high, we expect this scenario to unfold in the first half of 2018. This would give incoming Fed Chairman Jerome Powell ample room to hike rates which would - ceteris paribus - bear down on ag prices. FX Developments In Other Major Exporters Will Also Be Bearish The effects of higher U.S. interest rates are translated to ag markets via the exchange-rate channel. Commodities are priced in USD, thus a stronger USD vis-à-vis the currency of a major ag exporter will, all else equal, increase the profitability of farmers competing against U.S. exporters in international markets. Among the ag-relevant currencies, we highlight the Brazilian Real, EUR, Russian Rouble, and Australian Dollar as most likely to depreciate vis-à-vis the USD in 2018. Termination Of NAFTA Is A Risk For American Farmers U.S. farmers are keeping a close eye on NAFTA renegotiations, and rightly so. Canada and Mexico are the U.S.'s second and third largest agricultural export markets - accounting for 15% and 13% of U.S. agricultural exports in 2016, respectively. In fact, corn, rice, and wheat exports to Mexico accounted for 26%, 15%, and 11% share of U.S. exports of those commodities, respectively. However, as BCA Research's Geopolitical Strategy service points out, the long-run impact depends on the underlying reason for the termination of the trade agreement. If Trump is merely a "pluto-populist" - as they expect - NAFTA will simply be replaced by bilateral trade agreements, with no lasting economic disturbance. The risk is that Trump is a genuine populist. If this turns out to be the case, tariffs and a rejection of the WTO would make U.S. exports less competitive, and would become a bearish force in ag markets.7 The risk of a collapse in the NAFTA trade deal would be devastating for U.S. farmers. In fact, in a bid to reduce reliance on the U.S., Mexican Economic Minister Ildefonso Guajardo recently announced that they are working on a Mexico-European Union trade deal.8 In addition, Mexico signed the world's largest free trade agreement with Japan, and is currently exploring the opportunity to join Mercosur. Bottom Line: Weather-induced volatility is possible in the near term, as a La Nina event threatens to reduce yields. Nevertheless, U.S. financial conditions and trade policy will dominate ag markets in 2018. With markets underestimating the Fed's resolve regarding interest rate hikes, we see some upside to the USD. This will keep a lid on ag prices next year. 1 Please see "The year in Review: Global Economy in 5 Charts," published on the IMF Blog December 18, 2017. https://blogs.imf.org/2017/12/17/the-year-in-review-global-economy-in-5-charts/ 2 Please see "Paralysis at PDVSA: Venezuela's oil purge cripples company," published by reuters.com December 15, 2017. 3 The IMF estimates the median output gap for 20 advanced economies reached -0.1% in 2017 and will rise to +0.3% in 2018. Please see BIS https://www.bis.org/publ/work602.htm. The Bank for International Settlements in Basel describes the GVC as "cross-border trade in intermediate goods and services." 4 The U.S. unemployment has been under its estimated NAIRU for 9 consecutive months now. 5 Please see Commodity and Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 6 Our modelling indicates that U.S. financial factors are important determinants of agriculture commodity price developments. More specifically, a 1% move in the USD TWI and a 1pp change in 5 year real rates are associated with a 1.4%, and an 18% change in the CCI Grains & Oilseed Index, in the opposite direction. 7 Please see Global Investment Strategy Special Report titled "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gis.bcaresearch.com. 8 Please see "Mexico sees possible EU trade deal as NAFTA talks drag on," dated December 13, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Oil Fundamentals Remain Bullish Heading Into 2018 Oil Fundamentals Remain Bullish Heading Into 2018 Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Oil Fundamentals Remain Bullish Heading Into 2018 Oil Fundamentals Remain Bullish Heading Into 2018 Trades Closed in Summary of Trades Closed in

In late-August we initiated a liquidity-to-growth handoff levered market-neutral trade: long S&P energy/short global gold miners. Over the past four months this trade is up 18.3% and we think the easy money has already been made in this market-neutral trade, despite the still favorable relative macro backdrop. The Fed and other G7 central banks are simultaneously tightening monetary policy, either through rate hikes or reduced asset purchases or a combination thereof. This is de facto negative for the shiny metal and gold mining equities as interest rates are headed higher (second panel). Meanwhile, on the relative operating front, energy stocks have the upper hand versus gold miners as global oil majors have returned to profitability in the new era of $50/bbl oil, suggesting that the worst is behind the industry. Notwithstanding the still-supportive context, this was a tactical three-to-six month pair trade that has mostly played out and we would not like to overstay our welcome. Should a broad market pullback to occur in the upcoming quarter, and the ratio to trade significantly lower, we would not hesitate to reinstate this pair trade. Our cyclical strategy is to "buy the broad market dip" and remain opportunistic on a tactical basis. Bottom Line: Lock in 18.3% profits in the long S&P energy/short global gold miners pair trade and move to the sidelines for now; see Monday's Weekly Report for more details. Lock In Profits In The Long Energy/Short Gold Producers Trade Lock In Profits In The Long Energy/Short Gold Producers Trade

Highlights Portfolio Strategy The easy money has already been made in the liquidity-to-growth theme-levered long S&P energy/short global gold miners pair trade. Lock in profits and move to the sidelines, for now. Similarly, book gains in the long S&P materials/short S&P utilities market-neutral trade. A stealthy macro shift, at the margin, suggests that a more challenging phase lies ahead for this relative share price ratio. Recent Changes Book 18.3% profits in the long S&P energy/short global gold miners pair trade today. Take profits in excess of 8.6% in the long materials/short utilities pair trade today. Table 1 EPS And "Nothing Else Matters" EPS And "Nothing Else Matters" Feature Equities continued to defy gravity last week, vaulting to fresh all-time highs. Seasonality (or the pending Santa rally) appears to have trumped any "buy on rumor sell the tax news" jitters, at a time when macro data continue to surprise to the upside. Heading into 2018, easier fiscal policy will likely offset some of the uneasiness of the Fed's ongoing tightening cycle as we postulated in early October.1 Synchronized global economic and capex growth remain the key macro themes that dominate markets. The latest GDP revisions in the G3 confirm our global capex upcycle bias: U.S., euro area and, especially, Japanese gross fixed capital formation are on fire (Chart 1). Importantly, once the tax bill related dust settles, profits will come back to the forefront as a key stock market driver. In that regard, the news on the EPS front is ebullient and, along with the forward multiple, all that matters. Table 2 shows annual SPX returns going back to 1979, and breaks down the composition of the capital (not total) return into two components: forward earnings growth and the forward P/E multiple (January 1979 is the first IBES data point for forward EPS SPX estimates). Chart 1Synchronized Global Capex Synchronized Global Capex Synchronized Global Capex Table 2Disentangling SPX Returns EPS And "Nothing Else Matters" EPS And "Nothing Else Matters" Currently, sell side analysts expect 11% EPS growth for 2018, and our sense is that 8-12% EPS growth is achievable next year, a message that our SPX EPS macro model corroborates (Chart 2). Keep in mind that there is no tax cut penciled into our EPS model's numbers. Chart 2SPX EPS Macro Model Flashing Green SPX EPS Macro Model Flashing Green SPX EPS Macro Model Flashing Green What is interesting from the multiple/EPS analysis is that over the last four decades when forward profit growth was in this high single-digit / low double-digit range (ten iterations), the multiple expanded modestly (on average, adding 2.6 percentage points to the market's return) and EPS did the heavy lifting (explaining, on average, roughly 80% of the S&P 500's 12.9% average annual return, Table 3). If we consider periods when EPS growth was positive but below 8% (eleven iterations), SPX returns are close to 10%, on average, with EPS and the multiple contributing almost equally to the market's return. One caveat is that two recessionary years and the dot com bust are part of this segment skewing the results to the downside (Table 3).2 Table 3Disentangling SPX Returns Continued EPS And "Nothing Else Matters" EPS And "Nothing Else Matters" Nevertheless, if history at least rhymes, were EPS growth to stay positive next year and hit the 8-12% mark, then a profit driven low double-digit broad equity market return is likely. If profits disappoint and grow between 0-8%, barring recession, empirical evidence suggests that equity returns will still prove healthy. Adding it up, the path of least resistance is higher for equities on a cyclical 9-12 month horizon. Granted, since Brexit the SPX has rallied in a near straight line up and a healthy and temporary pause for breath is likely in Q1/2018. As a result, this week we are booking impressive gains in two tactical market-neutral trades we initiated in late-August and mildly de-risking our portfolio. Lock In Profits In The Long Energy/Short Gold Producers Trade In late-August we initiated a liquidity-to-growth handoff levered market-neutral trade: long S&P energy/short global gold miners. Over the past four months this trade is up 18.3%. It also sports a positive annual dividend carry of 200bps. With the equity market overshoot phase likely going on hiatus sometime in early 2018 is it still prudent to hold this high-octane intra-commodity and market-neutral trade? The short answer is no. Nothing in terms of macro data has changed to trip up this pair trade. If anything, the handoff of global liquidity to economic growth has gained steam in the past few months. Global GDP, IP, manufacturing PMIs, global trade (Chart 3) and gross capital formation are all growing simultaneously across all of the G7 and most of the EMs. Even China's economy seems to have stabilized. The Fed announced its plans to wind down its balance sheet as expected in September and the BoE and BoC have both tightened monetary policy. Even the ECB announced a halving of the size of its monthly purchases in late-October (but extended it for nine months). All these central bank (CB) moves suggest that, at the margin, the global liquidity injection is reversing, with CBs actually mopping up liquidity. This is de facto negative for the shiny metal and gold mining equities as interest rates are headed higher (Chart 4). Chart 3Brisk Global Growth... bca.uses_wr_2017_12_18_c3 bca.uses_wr_2017_12_18_c3 Chart 4...Higher Rates... ...Higher Rates... ...Higher Rates... Moreover, geopolitical uncertainty is steadily receding, especially now that the Senate also passed a tax bill, and a final bill will likely soon be signed into law.3 Historically in times of duress, safe haven assets are bid up and vice versa, and the current low policy uncertainty backdrop is conducive to additional gains in the relative share price ratio (policy uncertainty shown inverted, Chart 5). Meanwhile, on the relative operating front, energy stocks have the upper hand versus gold miners. The oil and gas rig count has resumed its advance and remains 150% clear of the lows hit during the depths of the global manufacturing recession of late-2015/early-2016. Anecdotes of global oil majors comfortably registering positive EPS, in the new era of $50/bbl oil, and reinstating stock buybacks and eliminating scrip dividends (RDS, BP & ENI) suggest that the worst is behind the industry. In contrast, safe haven asset demand is in retreat and will continue to weigh on global gold ETF flows. Anecdotally, the BITCOIN/ICO/cryptocurrency mania may also steal some of bullion's thunder, as this mania is capturing investor's imagination. Either a flare up in global geopolitical risk or a global growth scare could cause investors to start shifting capital into gold ETFs. Our relative EPS models do an excellent job in capturing this energy positive/gold negative backdrop and continue to suggest that energy profits will outpace gold mining EPS (Chart 6). Chart 5...And Diminishing Uncertainty##br## Still Bode Well For The Trade ...And Diminishing Uncertainty Still Bode Well For the Trade ...And Diminishing Uncertainty Still Bode Well For the Trade Chart 6But We Do Not Want To##br## Overstay Our Welcome But We Do Not Want To Overstay Our Welcome But We Do Not Want To Overstay Our Welcome If these different macro and operational forces all emit an unambiguously bullish signal for S&P energy shares compared with global gold miners, why book profits? Our sense is that there are high odds of a pullback in Q1/2018 and from a portfolio management and risk perspective it is prudent to lock in handsome profits in excess of 18.3% in a four month period. There are high odds that most of these key drivers are reflected in relative share prices versus late-August. Relative valuations are pricier today and technicals are also flashing yellow (bottom panel, Chart 4). We deem that the easy money has already been made in this market-neutral trade, despite the still favorable relative macro backdrop. This was a tactical three-to-six month pair trade that has mostly played out and we would not like to overstay our welcome. Were the broad market pullback to occur in the upcoming quarter, and the ratio to trade significantly lower, we would not hesitate to reinstate this pair trade. Our cyclical strategy is to "buy the broad market dip" and remain opportunistic on a tactical basis. Bottom Line: Lock in 18.3% profits in the long S&P energy/short global gold miners pair trade and move to the sidelines for now. Take Profits In Materials Vs. Utilities Similar to booking gains in the liquidity-to-growth levered market-neutral long S&P energy/short global gold miners pair trade, we also recommend taking profits in the reflation levered long S&P materials/short S&P utilities pair trade. Since its late-August inception this market-neutral trade has generated returns in excess of 8.6% and added alpha to our portfolio. While overall macro conditions continue to underpin the relative share price ratio, some cracks are appearing on the surface. Global reflation has matured and synchronized global growth is as good as it gets. The ISM manufacturing and services surveys have ticked down in sympathy recently, warning that the easy gains are behind this market neutral trade (Chart 7). Worrisomely, our relative sector Cyclical Macro Indicators are sniffing out this marginal shift in the macro backdrop and suggest that a more challenging phase lies ahead for the relative share price ratio (Chart 8). BCA's view remains that a sizable selloff in the bond markets is the most likely scenario in 2018. This is one of our key themes for next year, and given that this trade typically moves in lockstep with interest rates, the path of least resistance is higher. Nevertheless, the fact that this ratio has not kept up with the slingshot recovery in the stock-to-bond (S/B) ratio is slightly disconcerting. The top panel of Chart 9 shows that the gap between the S/B and the materials/utilities ratios has widened further since late-August. Chart 7As Good As It Gets? As Good As It Gets? As Good As It Gets? Chart 8Fatigue Signs Fatigue Signs Fatigue Signs Chart 9More Balanced Backdrop=Move To The Sidelines More Balanced Backdrop=Move To The Sidelines More Balanced Backdrop=Move To The Sidelines On the operating front, our relative EPS models are also showing signs of fatigue. Materials profits cannot expand indefinitely at the breakneck pace observed since the 2016 trough, at a time when utilities EPS have stabilized. Currently, the relative earnings models suggest that materials are on an even keel with utilities (Chart 9). Tack on rising odds of a healthy broad market pullback in Q1/2018, and from a risk management perspective we would rather de-risk the portfolio a notch by locking in near double-digit gains since inception in this volatile pair trade. Bottom Line: Book gains of 8.6% in the long S&P materials/short S&P utilities pair trade. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 For reference and completion purposes Table 3 also tabulates the results during EPS contractions (nine iterations) and in profit boom times, i.e. forward EPS growth north of 12% (nine iterations). 3 Please see BCA U.S. Equity Strategy & Geopolitical Strategy Special Report, "Tax Cuts Are Here - Equity Sector Implications," dated December 11, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.