Gov Sovereigns/Treasurys

Highlights High Conviction Views: The global cyclical backdrop remains negative for government bond markets, and the recent declines in yields will not be sustained. We continue to recommend a below-benchmark overall duration stance, favoring U.S. corporate debt with underweight exposures to U.S. Treasuries and Italian government debt, as our highest conviction views. Medium Conviction Views: Staying overweight global inflation protection, French government bonds versus Germany, and Japanese Government Bonds (JGBs) versus the rest of the developed bond markets, while remaining underweight U.S. Mortgage Backed Securities, are recommendations that we hold with a more moderate conviction level. Euro Area Bond Distortions: The ECB's negative interest rate and asset purchase programs have created significant distortions in the German bond yield curve that are not as evident in the Euro Area swap rate curve, especially at shorter maturities. ECB tapering will be the trigger for a reversal of these trends. Feature Chart of the WeekWhy Are Yields Falling? Why Are Yields Falling? Why Are Yields Falling? After publishing two Special Reports in the past two weeks, this Weekly Report is our first opportunity to comment on the markets in April. We find it somewhat surprising that government bonds in the developed world have rallied as much as they have since the most recent peak last month, with the benchmark 10-year U.S. Treasury and German Bund seeing yield declines of -29bps and -22bps, respectively. Most of the move in Treasuries has been in the real yield component, while Bunds have seen a more even split between declines in real yields and inflation expectations. This has occurred despite minimal changes in actual growth or inflation pressures in either the U.S. or Europe (Chart of the Week). The price action in the Treasury market after last week's U.S. Payrolls report is a sign that the bond backdrop remains bearish. Yields initially fell all the way to 2.26% after the March increase in jobs fell short of expectations, before subsequently rebounding sharply to end the day at 2.38%. While intraday yield reversals on Payrolls Fridays are as typical as the sun setting in the west, a 12bp swing is one of the larger ones in recent memory (perhaps because investors eventually noticed the weather-related distortions in the data or, more importantly, that the U.S. unemployment rate had fallen to 4.5%). We continue to favor a pro-growth bias for bond investors, staying below-benchmark on overall duration and selectively overweight on corporate credit (favoring the U.S.). Ranking Our Current Market Views, By Conviction We have seen little in the economic data over the past few weeks to change our main strategic market views and portfolio recommendations. We summarize our main opinions below, ranked in order of our conviction level: Highest conviction views: Below-benchmark on overall portfolio duration exposure (for dedicated bond investors). Global bond yields have more room to rise alongside solid economic growth, tightening labor markets, inflation expectations drifting higher and central banks moving to slightly less accommodative monetary policies, on the margin. While the sharp upward momentum in coincident bond indicators like the global ZEW sentiment index has cooled of late, the solid upturn in the BCA Global Leading Economic Indicator continues to point to future upward pressure on real yields (Chart 2). The recent pullback in yields also appears to have run too far versus the trend in global data surprises, which remain elevated (bottom panel). One factor that we see having a potentially huge negative impact on global bond markets is the European Central Bank (ECB) announcing a move to a less accommodative policy stance later this year. A taper of asset purchases starting in 2018 is the more likely outcome than any hike in policy interest rates, which we see as more of a story for 2019. This should help push longer-dated bond yields higher within the Euro Area, and drag up global bond yields more generally. Underweight U.S. Treasuries. We still expect the Fed to deliver at least two more hikes this year, and there is still room for U.S. inflation expectations to rise further and put bear-steepening pressure on the Treasury curve. Our two-factor model for the benchmark 10-year Treasury yield, which uses the global purchasing managers index (PMI) and investor sentiment towards the U.S. dollar as the explanatory variables, indicates that yields are now about 18bps below fair value. From a technical perspective, the Treasury market no longer appears as oversold as it did after the rapid run-up in yields following last November's U.S. elections. The large short positions indicated by the J.P. Morgan duration survey and the Commitment of Traders report for Treasury futures have largely been unwound, while price momentum has flipped into positive territory (Chart 3). This removes one of the largest impediments to a renewed decline in Treasury prices, and we expect that the 10-year yield to rise to the upper end of the recent 2.30%-2.60% trading range in the next couple of months, before eventually breaking out on the way to the 2.80%-3% area by year-end. Chart 2Maintain A Defensive Duration Posture Maintain A Defensive Duration Posture Maintain A Defensive Duration Posture Chart 3Stay Underweight U.S. Treasuries Stay Underweight U.S. Treasuries Stay Underweight U.S. Treasuries Underweight Italian government bonds, versus both Germany and Spain. Italian government debt continues to suffer from the toxic combination of sluggish growth and weak domestic banks. The OECD leading economic indicator for Italy is declining, in contrast to the stable-to-rising trends in Germany and Spain (Chart 4). Meanwhile, the 5-year credit default swaps (CDS) for the major banks in Italy remain elevated around 400bps, in sharp contrast to the declining CDS in Germany and Spain which are now at 100bps. It is no coincidence that the widening trend in Italy-Germany and Italy-Spain spreads began around the same time last year that Italian bank CDS started to disengage from the rest of Europe (bottom panel). Markets understand that the undercapitalized Italian banking system will need government assistance at some point, which will add to the Italian government's already huge debt/GDP ratio of 133%. Political uncertainty in Italy, with parliamentary elections due by the spring of 2018 and populist parties like the anti-euro Five-Star Alliance holding up well in the polls, will also ensure that the risk premium on Italian bonds stays wide both in absolute terms and relative to other Peripheral European markets. Overweight U.S. corporate bonds, versus both U.S. Treasuries and Euro Area equivalents. The positive case for U.S. corporate debt is built upon two factors - the cyclical decline in default risk and the marginal improvement in balance sheet metrics. The latest estimates from Moody's are calling for a decline in the U.S. speculative grade corporate default rate to 3.1% this year. This leaves our measure of default-adjusted spreads in U.S. high-yield at levels that our colleagues at our sister publication, U.S. Bond Strategy, have shown to have a high probability of delivering positive excess returns over Treasuries in the next 12 months.1 Add to that the recent change in trend of our U.S. Corporate Health Monitor (CHM), which appears largely driven by some more positive numbers coming from lower-rated issuers in the Energy space given the recovery in oil prices, and the optimistic case for U.S. corporate debt is compelling. This is in contrast to our Euro Area CHM, which shows that the improving trend in balance sheet metrics has stalled of late (Chart 5, top panel). Chart 4Stay Underweight Italy Stay Underweight Italy Stay Underweight Italy Chart 5Stay Overweight U.S. Corporates vs Europe Stay Overweight U.S. Corporates vs Europe Stay Overweight U.S. Corporates vs Europe The difference between the U.S. and European CHMs has proven to be a good directional indicator for the relative return performance between the two markets, and is currently pointing to continued outperformance of both U.S. investment grade and high-yield debt versus European equivalents (bottom two panels). The threat of an ECB taper also hangs over the Euro Area investment grade corporate bond market, given the large buying of that debt by the central bank over the past year that has helped dampen both yields and spreads. Chart 6Stay Overweight Inflation Protection Stay Overweight Inflation Protection Stay Overweight Inflation Protection Medium-conviction views: Overweight inflation protection (both inflation-linked bonds and CPI swaps) in the U.S., Euro Area and Japan. In the U.S., the breakeven inflation rate on 10-year TIPS looks a bit too wide relative to our shorter-term model based on financial variables. However, underlying U.S. inflation pressures remain strong (Chart 6, top panel), particularly given the evidence that conditions in the labor market are getting progressively tighter. We expect inflation expectations to eventually rise back to levels consistent with the Fed's 2% inflation target on headline PCE inflation (which is around 2.5% on 10-year TIPS breakevens that are priced off the CPI index). The reflation story is somewhat less compelling in Europe and Japan, although CPI swaps are now at levels consistent with the underlying trends in realized inflation in both regions (bottom two panels). We continue to view long positions in CPI swaps in Europe and Japan as having a positive risk/reward skew given the tightening labor market in the former and the yen-negative monetary policies in the latter. Long France government bonds (10yr OATs) versus Germany (10yr Bunds). This is purely a call on the upcoming French election, which our political strategists believe will not end in a victory for the populist Marine Le Pen. While Le Pen has seen a recent bump in support heading into the first round of voting on April 23rd, her strong anti-euro position will eventually prove to be her undoing in the run-off election on May 7th (Chart 7). We first made this recommendation back in early February, and even though France-Germany spreads have been volatile since then as both Le Pen and the far-left candidate Jean-Luc Melenchon have seen a pickup in their poll numbers, the yield differentials are essentially at the same levels.2 We take this as a sign that the market believes current spreads are enough to compensate for the likely probability that either candidate could win the French presidency. Overweight JGBs Vs. the Global Treasury index. The argument here is a simple one - in an environment where there is cyclical upward pressure on global bond yields, favor the lowest-beta bond market (Chart 8). Persistently low inflation will prevent the Bank of Japan (BoJ) from making any changes to its current hyper-accommodative policies this year, especially the 0% cap on the benchmark 10-year JGB yield.3 The lack of yield limits the prospects for JGBs on a total return basis, but relative to other government bond markets, JGBs should outperform over the next 6-12 months as non-Japanese yields rise further. Chart 7Stay Overweight France Vs Germany Stay Overweight France Vs Germany Stay Overweight France Vs Germany Chart 8Stay Overweight Low-Beta JGBs Stay Overweight Low-Beta JGBs Stay Overweight Low-Beta JGBs Underweight U.S. Agency Mortgage-Backed Securities (MBS). Investors should remain underweight U.S. MBS, as spreads remain tight by historical standards. Our colleagues at U.S. Bond Strategy note that nominal MBS spreads have been flat in recent weeks as the option cost, which is the compensation for expected prepayments, has tightened to offset a widening in the option-adjusted spread (OAS).4 Chart 9Stay Underweight U.S. MBS Stay Underweight U.S. MBS Stay Underweight U.S. MBS We tend to think of the OAS as being influenced by trends in net issuance while the option cost is linked to mortgage prepayments (Chart 9). Looking ahead, the supply of MBS should increase further when the Fed starts to shrink its balance sheet later this year (as was mentioned in the minutes of the March FOMC meeting that were released last week), leading to a wider OAS. At the same time, refinancing applications should stay low as Treasury yields and mortgage rates rise. This will keep downward pressure on the option cost component of spreads. But with the option cost already near its historical lows, it is unlikely to completely offset the widening in OAS going forward. We see little value in U.S. MBS at current spread levels. Bottom Line: The global cyclical backdrop remains negative for government bond markets, and the recent declines in yields will not be sustained. We continue to recommend a below-benchmark overall duration stance, favoring U.S. corporate debt with underweight exposures to U.S. Treasuries and Italian government debt, as our highest conviction views. Staying overweight global inflation protection, French government bonds versus Germany, and Japanese Government Bonds (JGBs) versus the rest of the developed bond markets, while remaining underweight U.S. Mortgage Backed Securities, are recommendations that we hold with a more moderate conviction level. How Much Has The ECB Distorted The European Bond Market? Last week, Benoit Coeure of the ECB Executive Board gave a speech entitled "Bond Scarcity and the ECB Asset Purchase Program."5 That title piqued our interest, as that exact topic has come up in several of our conversations with clients this year. In his speech, Coeure discussed how the huge rally at the short-end of the German government bond curve over the past year has been at odds with what has occurred in the Euro swap curve, where interest rates are much higher for shorter-maturity swaps. Typically, German yields and Euro swap rates move in tandem, with the only differences being a function of technical factors like fixed-rate corporate debt issuance or government bond repo rates - and, on occasion, shifts in the perceived health of Euro Area banks that are the counterparties to any interest rate swap. The latter has become much less of an issue in recent years given the regulatory changes to the swap market, where trading has moved to centralized exchanges to reduce counterparty risks. In this environment, the difference between German bond yields and Euro swap rates, a.k.a the swap spread, should be relatively modest. Yet as can be seen in Chart 10, there has been a notable divergence at the shorter-maturity portions of the respective yield curves, where swap rates are rising but bond yields remain subdued. We can also see the divergences in the slopes of the relative yield curves, with the Euro Area swap curve much flatter than the German bond curve, particularly at longer maturities (Chart 11). Chart 10Large Distortions At The Front End Of The German Curve Large Distortions At The Front End Of The German Curve Large Distortions At The Front End Of The German Curve Chart 11Euro Area Swap Curves Are Generally Flatter Euro Area Swap Curves Are Generally Flatter Euro Area Swap Curves Are Generally Flatter Coeure argued that part of this distortion can be attributed to ECB asset purchases, especially after the decision taken last December to allow bond buying at yields below the -0.4% ECB deposit rate. This created a more favorable demand/supply balance for German debt, especially given the dearth of short-dated issuance. In addition, Coeure noted that there have been substantial safe-haven flows into shorter-dated German bonds (including treasury bills) by non-Euro Area entities. Some of this demand comes from large institutional investors like sovereign wealth funds and currency reserve managers, who are worried about political risks in France and Italy, and about the general rising trend in global bond yields, and are thus seeking the safety of low duration German debt. But some of the demand for short-dated German paper also comes from non-Euro Area banks, who have excess liquidity that needs to be parked in Euros but do not have access to the ECB deposit facility for the excess reserves of Euro Area banks. We can see this in Chart 12, which shows ECB data for the relative government bond ownership trends for Germany, France and Italy. The data is broken into holdings for bonds with maturities of one year or less (short-term) and bonds with maturities greater than one year (long-term). It is clear that the non-Euro area buyers own a much larger share of short-term German paper, around 90%, than in France and Italy, while Euro Area entities own nearly 80% of long-term bonds in all three countries. Coeure is correct in pointing out that there is an excess demand condition for short-dated core European debt, exacerbated by foreigners who need Euro-denominated safe assets - particularly GERMAN safe assets, if those investors are at all worried about redenomination risks given the rise of anti-euro populist parties in Europe.6 It is clear that the economic messages sent by looking at the German bond and Euro swap curves are very different. The flatter swap curve is more consistent with a steadily growing Euro Area economy where economic slack is being steadily absorbed and inflation pressures are building (albeit slowly). Also, the sovereign spread differentials within Europe do not look as problematic using swaps as the reference rate rather than German bonds. That is the case in France, where spreads versus swaps look in line with the averages of the past few years (Chart 13). This contrasts with the yield differentials versus Germany, which have reportedly gone up as investors have priced in a higher sovereign risk premium before the French presidential election. Chart 12French Bond Valuations Look More Subdued vs Swaps The Song Remains The Same The Song Remains The Same Chart 13French Bond Valuations Look More Subdued vs Swaps French Bond Valuations Look More Subdued vs Swaps French Bond Valuations Look More Subdued vs Swaps The story is a little different for Italy, where bond spreads versus both German bonds and Euro Area swaps have risen for all but the shortest maturities (Chart 14). This could be consistent with an interpretation that Italy's banking sector woes will add to the nation's longer-term fiscal stresses (as discussed earlier in this report), but not in a way that raises immediate default risks (which is why the 2-year Italy vs swap spread is well-behaved). Regardless of the "bias of interpretation", one thing that is clear is that the ECB's extraordinary monetary policies have created distortions in Euro Area bond markets. These may start to unwind, though, if the ECB begins to signal a shift towards a tapering of asset purchases next year, as we expect. The distortions in Euro area government bond yields (and, by association, swap spreads) have occurred alongside both the cuts in ECB policy rates into negative territory and the expansion of its balance sheet to purchase government bonds (Chart 15). As the ECB moves incrementally towards less accommodative monetary policy, we would expect to see front-end Euro swap spreads narrow in absolute terms and relative to longer-tenor spreads, and the German bond curve to flatten toward levels seen in the swap curve. Chart 14Only Short-Dated Italian Bond Valuations Look More Subdued vs Swaps Only Short-Dated Italian Bond Valuations Look More Subdued vs Swaps Only Short-Dated Italian Bond Valuations Look More Subdued vs Swaps Chart 15ECB Policies Have Caused The Distortions In Euro Swap Spreads ECB Policies Have Caused The Distortions In Euro Swap Spreads ECB Policies Have Caused The Distortions In Euro Swap Spreads Bottom Line: The ECB's negative interest rate and asset purchase programs have created significant distortions in the German bond yield curve that are not as evident in the Euro Area swap rate curve, especially at shorter maturities. ECB tapering will be the trigger for a reversal of these trends. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "Our Views On French Government Bonds", dated February 7, 2017, available at gfis.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Staying Behind The Curve, For Now", dated March 21, 2017, available at gfis.bcaresearch.com 4 Please see BCA U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 5 http://www.ecb.europa.eu/press/key/date/2017/html/sp170403_1.en.html 6 Coeure noted that, at the time that the ECB began its asset purchase program in March 2015, the share of German bonds of less than TWO years maturity held by foreigners was 70%, but that rose to 90% by the 3rd quarter of 2016. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Song Remains The Same The Song Remains The Same Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Bond market positioning is no longer at a bearish extreme and the economy is quickly approaching full employment. We expect Treasury yields will soon break through the upside of their post-election trading range. Maintain below-benchmark duration. Fed's Balance Sheet: The unwinding of the Fed's balance sheet is only important for Treasury yields if it impacts the market's rate hike expectations. However, the extra supply of MBS should lead to wider MBS spreads. Credit Cycle: Corporate spreads are in a "payback period" from 2014's energy shock that will allow them to tighten as corporate profits rebound, even though corporate leverage continues to trend higher. The weakening state of corporate balance sheets means spreads are at risk once monetary policy turns less accommodative. Feature The bond bear market has been on pause for the past few months, with Treasury yields confined to a trading range since last November's post-election sell off. While yields have not moved meaningfully higher during this time, firm floors have also formed beneath both the 5-year and 10-year yields (Chart 1). Even after last Friday's disappointing payrolls number, the 10-year did not move below 2.3% and the 5-year did not move below 1.8%. Trading Range About To Break? Our sense is that the current consolidation phase in Treasuries is approaching its end and yields will soon head higher. Global growth indicators have continued to improve during the past few months, and as we noted in last week's report,1 our 2-factor Treasury model, based on Global PMI and U.S. dollar sentiment, pegs fair value for the 10-year yield at 2.54%. We attribute the recent leveling-off in yields to technical shifts in bond positioning and sentiment. Earlier this year, net positions in Treasury futures and asset manager duration allocations were deep in "net short" territory (Chart 2). Extreme short positioning usually leads to a period of bond market strength until short positions are washed out. Now that bond market positioning is closer to neutral, a key impediment to further yield increases has been removed. Chart 1Poised For A Breakout? Poised For A Breakout? Poised For A Breakout? Chart 2Positioning Has Normalized Positioning Has Normalized Positioning Has Normalized The elevated level of economic surprises has also been flagged as a potential roadblock to the bond bear market. Extended readings from the economic surprise index tend to mean revert as investor expectations are revised higher in the face of improving data. However, our research suggests that the change in Treasury yields tends to lead the economic surprise index by 1-2 months (Chart 2, bottom panel). Given this relationship, we suspect that the bond market has already discounted a lot of mean reversion in the economic surprise index. Chart 3Approaching Full Employment Approaching Full Employment Approaching Full Employment Finally, last week's employment report should not be taken as a signal that U.S. economic growth is weakening. Bad weather in the northeast played a key role in the low March payrolls number - only 98k jobs added. But more importantly, at this stage of the cycle we should expect payroll growth to slow and wage pressures to increase as we approach full employment. As can be seen in Chart 3, the late cycle trends of slowing payroll growth and rising wages are very much in place. Further, even broad measures of labor market tightness, such as the U6 unemployment rate,2 are quickly approaching levels that suggest the economy is operating at full employment. Increasingly it is measures of labor market utilization, wage growth and inflation that will guide the Fed's decision making, and these measures continue to improve. It was even noted in the minutes from the March FOMC meeting that "tight labor markets [are] increasingly a factor in businesses' planning". The minutes also reported that: Business contacts in many Districts reported difficulty recruiting workers and indicated that they had to either offer higher wages or hire workers with lower qualifications than desired Accordingly, surveys show that households are increasingly describing jobs as "plentiful" (Chart 3, panel 3) and small businesses are indeed ramping up their compensation plans (Chart 3, bottom panel). At this stage of the cycle, continued progress on measures of labor market utilization, wage growth and inflation will be sufficient for the Fed to continue lifting rates, pushing Treasury yields higher. Bottom Line: Bond market positioning is no longer at a bearish extreme and the economy is quickly approaching full employment. We expect Treasury yields will soon break through the upside of their post-election trading range. Maintain below-benchmark duration. The Fed Will Shrink Its Balance Sheet This Year Last week's release of the minutes from the March FOMC meeting also contained some new information about how the Fed plans to deal with its large balance sheet. To summarize, we learned that: The Fed intends to start shrinking its balance sheet later this year (assuming growth maintains its current pace). The Fed will shrink its balance sheet by ceasing the reinvestment of both its MBS and Treasury holdings at the same time. Still no decision has been made about whether reinvestments will stop entirely or whether they will be phased out over time ("tapered"). On February 28, we published a detailed report about the Fed's balance sheet policy.3 In that report we explained why the winding down of the balance sheet will not have much of an impact on Treasury yields, but could lead to a material widening in MBS spreads. The new information received last week does not change either of these conclusions. The minutes did make clear that the Fed favors what Governor Lael Brainard recently called a "subordination strategy" for dealing with its balance sheet.4 [A subordination strategy] would prioritize the federal funds rate as the sole active tool away from the effective lower bound, effectively subordinating the balance sheet. Once federal funds normalization meets the test of being well under way, triggering an end to the current reinvestment policy, the balance sheet would be set on autopilot, shrinking in a gradual, predictable way until a "new normal" has been reached, and then increasing in line with trend increases in the demand for currency thereafter. Under this strategy, the balance sheet might be used as an active tool only if adverse shocks push the economy back to the effective lower bound. Essentially, the Fed is trying to de-emphasize the size of the balance sheet and would rather investors focus on the fed funds rate to assess the stance of monetary policy. For our part, we think it would be unwise to "fight the Fed" on this issue. For Treasury yields, we observe that the real 10-year Treasury yield closely tracks changes in the expected number of rate hikes during the next 12 months, while the inflation component of the 10-year yield tracks changes in realized inflation (Chart 4). These two relationships will continue to determine trends in bond yields going forward, and Fed balance sheet shrinkage is only important if it impacts the expected pace of rate hikes or inflation. The Fed's "subordination strategy" should ensure that the act of winding down the balance sheet does not have much of an impact on the expected pace of rate hikes. Ironically, if Treasury yields were to rise sharply following the announcement of balance sheet runoff, then the ensuing tightening of financial conditions would probably lower the expected pace of rate hikes and bring Treasury yields back down again. The story for MBS is somewhat different. Nominal MBS spreads remain tight by historical standards and closely track implied interest rate volatility (Chart 5). But we can also think of nominal MBS spreads as being split between the option cost, which is the compensation for expected prepayments, and the option-adjusted spread (OAS), which tends to correlate with net supply (Chart 5, panel 2). Chart 4Focus On Rate Expectations Focus On Rate Expectations Focus On Rate Expectations Chart 5Stay Underweight MBS Stay Underweight MBS Stay Underweight MBS In recent weeks, the OAS has widened alongside rising net issuance, but this has been offset by a sharp decline in the option cost. This is generally the pattern we would expect to play out as the Fed lifts rates and removes itself from the MBS market. The increased supply of MBS should lead to wider OAS, but refinancing applications should also stay low as Treasury yields and mortgage rates rise (Chart 5, bottom panel). However, netting it all out, the option cost component of MBS spreads is already near its historical lows and the OAS could move materially wider just to catch up to net issuance. In prior reports,5 we have also made the case that rate volatility should rise as the fed funds rate moves further away from the zero-lower-bound. Investors should stay underweight MBS. Bottom Line: The unwinding of the Fed's balance sheet is only important for Treasury yields if it impacts the market's rate hike expectations. However, the extra supply of MBS should lead to wider MBS spreads. Checking In On The Credit Cycle We continue to recommend overweight allocations to both investment grade and high-yield corporate bonds. This optimistic outlook is predicated on low inflation and a Fed that will support risk assets by remaining sufficiently accommodative until inflationary pressures are more pronounced. We think this "reflationary window" will stay open at least until core PCE inflation is firmly anchored around 2% and long-maturity TIPS breakevens reach the 2.4% to 2.5% range.6 Behind the scenes, however, leverage is building in the nonfinancial corporate sector. In this week's report we take a look at several different indicators of corporate credit quality and conclude that once the support from low inflation and accommodative monetary policy vanishes, it is very likely that corporate defaults will start to increase and corporate spreads will widen. If our anticipated timeline plays out, we will be looking to scale back on credit risk in 2018. Corporate Health Vs. The Yield Curve Our Corporate Health Monitor (CHM, see Appendix for further details) has been signaling deteriorating nonfinancial corporate health since late 2013 (Chart 6), and moved even deeper into 'deteriorating health' territory in Q4 of last year. Chart 6Corporate Health Is Deteriorating, But Monetary Policy Remains Supportive Corporate Health Is Deteriorating, But Monetary Policy Remains Supportive Corporate Health Is Deteriorating, But Monetary Policy Remains Supportive Periods when the CHM is in 'deteriorating health' territory are marked by shaded regions in Chart 6. We see that these regions usually correspond with periods when corporate spreads are widening. Even in the current episode, corporate spreads have yet to regain their mid-2014 tights. However, the bottom panel of Chart 6 shows that periods of deteriorating corporate health and wider corporate spreads are typically preceded by a very flat (often inverted) yield curve. This makes sense because a flat yield curve usually signals that interest rates are high and monetary policy is tight. Tight policy and elevated rates lead to more stringent bank lending standards and increase firms' interest burdens. With the curve still quite steep, we think the risk of sustained spread widening is minimal. However, if the CHM is still above zero when the yield curve is flatter, no support will remain for excess corporate bond returns. Net Leverage & The Payback Period We would further argue that the CHM will almost certainly be in 'deteriorating health' territory once the yield curve is close to flat. In Chart 7 we see that net leverage (defined as: total debt minus cash, as a percent of EBITD) is not only positively correlated with spreads, but also has never reversed its uptrend unless prompted by a recession. In other words, the corporate sector never voluntarily undertakes deleveraging, it only starts to pay down debt when forced by a severe economic contraction. Chart 7The Uptrend In Leverage Will Only Be Broken By Recession The Uptrend In Leverage Will Only Be Broken By Recession The Uptrend In Leverage Will Only Be Broken By Recession Closer inspection of Chart 7 reveals that the period between 1986 and 1989 is the only period when corporate spreads tightened even though leverage remained in an uptrend. In the late 1980s, leverage and corporate spreads both shot higher as a collapse in the energy sector caused overall corporate earnings to contract (Chart 7, bottom panel). But then the energy sector recovered just as quickly, and earnings growth bounced back. This caused spreads to tighten for a couple of years, even though the trend in net leverage only ever managed to flatten-off. Debt growth stayed robust during this time, despite the wild fluctuations in earnings. If any of this sounds familiar, it should. The energy sector collapse of 2014 caused net leverage and spreads to shoot higher, and now spreads have started to tighten again as earnings have rebounded. Notice that just like in the late-1980s, net leverage has not reversed its uptrend. We believe that corporate spreads have entered a "payback period" very similar to the late 1980s. Spreads can tighten as earnings rebound, but because the economy is not in recession, debt growth will remain solid and leverage will continue to trend higher. Once inflationary pressures start to bite and Fed policy becomes less accommodative, the payback period will end and spreads will head wider. Debt Growth Chart 8Bond Issuance Is Back Bond Issuance Is Back Bond Issuance Is Back Although we have made the case that the corporate sector does not delever unless prompted by a recession, it is notable that net corporate bond issuance was negative in Q4 of last year and the growth rate in bank lending to the corporate sector has slowed sharply. We do not think this cycle is different, and expect corporate debt growth (both bonds and loans) to rebound in the coming months. We chalk up weak corporate bond issuance in 2016Q4 to uncertainty surrounding the U.S. election. In fact, we see that gross corporate bond issuance has already rebounded strongly in January and February of this year (Chart 8). Turning to bank loans, we observe that the outright level of outstanding bank loans only contracts following a recession, and that the rate of increase follows bank lending standards with a lag (Chart 9). In other words, Commercial & Industrial (C&I) loan growth is still responding to the surge in defaults that resulted from the energy sector's 2014 collapse. Now that defaults have waned, this process will soon be thrown into reverse. In fact, our model of the 6-month rate of change in C&I lending - based on private non-residential fixed investment, small business optimism and corporate defaults - points to an imminent bottoming in C&I loan growth (Chart 10). Chart 9Loan Growth Follows Lending Standards Loan Growth Follows Lending Standards Loan Growth Follows Lending Standards Chart 10BCA C&I Loan Growth Model BCA C&I Loan Growth Model BCA C&I Loan Growth Model Bottom Line: Corporate spreads are in a "payback period" from 2014's energy shock that will allow them to tighten as corporate profits rebound, even though corporate leverage continues to trend higher. The weakening state of corporate balance sheets means spreads are at risk once monetary policy turns less accommodative. Ratings Trends & Shareholder Friendly Activities Chart 11Shareholder Friendly Activity Has Ebbed Shareholder Friendly Activity Has Ebbed Shareholder Friendly Activity Has Ebbed Our assessment of the cyclical back-drop for corporate spreads is primarily based on the combination of balance sheet quality - as determined by our Corporate Health Monitor and its underlying components - and the stance of monetary policy - as determined by the slope of the yield curve and C&I lending standards (among other factors). However, ratings migration and "shareholder friendly" activities have also historically provided advance notice of turns in the credit cycle. Net transfers to shareholders, i.e. payments to shareholders in the form of dividends and buybacks, are a direct transfer of capital from bondholders to equityholders. These transfers tend to rise late in the cycle, just before defaults start to increase and spreads start to widen (Chart 11). Net transfers to shareholders had been moving higher, but have recently rolled over. Similarly, ratings downgrades related to shareholder transfers have also moderated (Chart 11, panel 2). Historically, ratings migration related to "shareholder friendly" activities has been a more reliable indicator of the credit cycle than overall ratings migration. It has tended to move into "net downgrade" territory later in the cycle, closer to the onset of recession (Chart 11, panel 3). Ratings trends and transfers to shareholders are not flagging any imminent risk of spread widening. However, there is the additional risk that downgrades have simply not kept pace with the actual deterioration in credit quality of the nonfinancial corporate sector. Using firm-level data, we calculated the percent of high-yield rated companies with net debt-to-EBITDA ratios above 5. We see that actual ratings migration is too low relative to the number of highly-levered firms (Chart 11, bottom panel). It is possible that ratings agencies have already incorporated the rebound in energy prices and profit growth into their assessments while the actual debt-to-EBITDA data are lagging, but this is still a risk that bears monitoring. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Reflation Window Still Open", dated April 4, 2017, available at usbs.bcaresearch.com 2 The U6 unemployment rate is a broader measure than the headline (U3) unemployment rate. It also includes those "marginally attached" to the labor force and those working part-time for economic reasons. 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 4 https://www.federalreserve.gov/newsevents/speech/brainard20170301a.htm 5 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com Appendix Chart 12Corporate Health Monitor Components Corporate Health Monitor Components Corporate Health Monitor Components Box 1: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole (Chart 12). These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The rally in risk assets appears to have stalled, raising fears that the misnamed "Trump Trade" has ended. Investors are attaching too much importance to the reality show in Washington and not enough to the fundamentals underpinning the acceleration in global growth and corporate earnings. For now, these fundamentals are strong, and should remain so for the next 12 months. Beyond then, the impulse from easier financial conditions will dissipate and policy will turn less friendly, setting the stage for a major slowdown - and possibly a recession - in 2019. Stay overweight global equities and high-yield credit, but be prepared to reduce exposure next spring. Feature Risk Assets Hit The Pause Button After rallying nearly non-stop following the U.S. presidential election, risk assets have stalled since early March (Chart 1). The S&P 500 has fallen by 1.8% after hitting a record high on March 1st. Treasury yields have also backed off their highs and credit spreads have widened modestly. Globally, the picture has been much the same (Chart 2). The yen - a traditionally "risk off" currency - has strengthened, while "risk on" currencies such as the AUD and NZD have faltered. EM currencies have dipped, as have most commodity prices. Only gold has found a bid. Chart 1A Pause In Risk Assets In The U.S.... A Pause In Risk Assets In The U.S.... A Pause In Risk Assets In The U.S.... Chart 2...And Globally ...And Globally ...And Globally The key question for investors is whether all this merely represents a correction in a cyclical bull market for global risk assets, or the start of a more sinister trend. We think it is the former. Global Growth Still Solid For one thing, it would be a mistake to attach too much significance to the unfolding reality show in Washington. As we discussed in last week's Q2 Strategy Outlook,1 the recovery in global growth and corporate earnings began a few months before last year's election and would have likely continued regardless of who won the White House (Chart 3). For now, the global growth picture still looks reasonably bright. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 4). Consumer confidence is also soaring. If history is any guide, this will translate into stronger consumption growth in the months ahead (Chart 5). Chart 3Recovery Predates President Trump Recovery Predates President Trump Recovery Predates President Trump Chart 4Global Growth Backdrop Remains Solid Global Growth Backdrop Remains Solid Global Growth Backdrop Remains Solid Chart 5Rising Consumer Confidence Will Provide A Boost To Consumption Rising Consumer Confidence Will Provide A Boost To Consumption Rising Consumer Confidence Will Provide A Boost To Consumption The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 6 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will stay sturdy for the remainder of 2017. Stronger global growth should continue to power an acceleration in corporate earnings over the remainder of the year. Global EPS is expected to expand by 12.5% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 7 shows that the global earnings revisions ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Chart 6Easing Financial Conditions Will Support Activity In 2017 Easing Financial Conditions Will Support Activity In 2017 Easing Financial Conditions Will Support Activity In 2017 Chart 7Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Gridlock In Washington? As far as developments in Washington are concerned, it is certainly true that the failure to repeal and replace the Affordable Care Act has cast doubt on the ability of Congress to implement other parts of President Trump's agenda. Despite reassurances from Trump that a new health care bill will pass, we doubt that the GOP can cobble together any legislation that jointly satisfies the hardline views of the Freedom Caucus and the more moderate views of the Republicans in the Senate. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for Trump and the Republican Party. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). According to the Congressional Budget Office, the proposed legislation would have caused 24 million fewer Americans to have health insurance in 2026 compared with the status quo. The bill would have also reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. Now, that would have warranted lower bond yields and a weaker dollar. Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet Granted, the political fireworks over the past month serve as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy This is not to say that the "Trump Trade" won't fizzle out. It will. But that will be a story for 2018 rather than this year. This is because the disappointment for investors will stem not from the failure to cut taxes, but from the underwhelming effect that tax cuts end up having on the economy. The highly profitable companies that will benefit the most from lower corporate taxes are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the tax cuts will simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 8From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 8). In his Special Report on U.S. fiscal policy, my colleague Martin Barnes argues that "it is a FALLACY to describe overall non-defense discretionary spending as massively bloated and out-of-control."2 As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and major fiscal stimulus but end up getting neither. Investment Conclusions Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors should stay overweight global equities and high-yield credit at the expense of government bonds and cash. We prefer European and Japanese equities over the U.S., currency-hedged (See Appendix). As we discussed in detail last week, global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months. By historic standards, it will probably be a mild one. However, with memories of the Great Recession still fresh in most people's minds and President Trump up for re-election in 2020, the response could be dramatic. This will set the stage for a period of stagflation in the 2020s. Chart 9 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 9Market Outlook For Major Asset Classes The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com 2 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies And Fantasies," dated April 5, 2017, available at bca.bcaresearch.com. Appendix Tactical Global Asset Allocation Monthly Update We announced last week that we are making major upgrades to our Tactical Asset Allocation Model. In the meantime, we will send you a concise update of our recommendations every month based on a combination of BCA's proprietary indicators as well as our own seasoned judgement (Appendix Table 1). Appendix Table 2Global Asset Allocation Recommendations (Percent) The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet In a Special Report published last year, we laid out the quantitative factors that have historically predicted stock market returns. Appendix Chart 1 updates the output of that model for the U.S. It currently shows a slightly above-average return profile for the S&P 500 over the next three months. Appendix Chart 1S&P 500: Above Average Returns Over The Next 3 Months The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet Applying this model to the rest of the world yields a somewhat more positive picture for Europe and Japan, given more favorable valuations and easier monetary conditions in those regions. The technical picture has also improved in Europe and Japan. This is especially true with respect to price momentum: After a long period of underperformance, euro area equities have outpaced the U.S. by 11.5% in local-currency terms since last summer’s lows. Japanese stocks have suffered over the past few months, but are still up 12.5% against the U.S. over the same period (Appendix Chart 2). Turning to government bonds, the extreme bearish sentiment and positioning that prevailed in February and early March has been largely reversed, suggesting that the most recent rally in bonds could run out of steam (Appendix Chart 3). Looking ahead, yields are likely to rise anew on the back of strong economic growth and rising inflation. Thus, an underweight allocation to government bonds is warranted, particularly in the U.S. Appendix Chart 2Relative Performance Of Euro Area ##br##And Japanese Equities Troughed Last Summer Relative Performance Of Euro Area And Japanese Equities Troughed Last Summer Relative Performance Of Euro Area And Japanese Equities Troughed Last Summer Appendix Chart 3Rally In Bonds Could Soon Peter Out Rally In Bonds Could Soon Peter Out Rally In Bonds Could Soon Peter Out Clients should consult our Q2 Strategy Outlook for a more detailed discussion of the global investment outlook. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights There are a number of market signals and indicators that are denoting opening cracks in the reflation trade in general and EM risk assets in particular. EM/China narrow money (M1) growth points to relapse in their growth and profits in the second half this year. In this vein, we recommend reinstating a short EM stocks / long 30-year U.S. Treasurys trade. The South African rand has considerable downside and local bond yields will rise further. Stay short ZAR versus the U.S. dollar and MXN. Downgrade this bourse from neutral to underweight. Stay long MXN on crosses versus ZAR and BRL. Continue overweighting Mexican local currency bonds and sovereign credit within their respective EM universes. Feature Chart I-1EM Narrow Money Growth ##br##Signals Trouble Ahead EM Narrow Money Growth Signals Trouble Ahead EM Narrow Money Growth Signals Trouble Ahead Emerging market (EM) assets have been the beneficiary of large inflows this year and have delivered solid gains in the first quarter, causing our defensive strategy to miss the mark. In retrospect, it was a mistake not to chase the market higher last year. At the current juncture, however, with investor sentiment on risk assets very bullish, valuations rather expensive or at least not cheap1 and investor expectations for global growth elevated, the question is whether being contrarian or chasing momentum is the best strategy. Weighing the pros and cons, our view is that investors who now adopt a contrarian stance will be rewarded greatly in the next six to nine months. In this vein, we recommend reinstating a short EM stocks / long 30-year U.S. Treasurys trade. Review Of Market Indicators Following is a review of some specific EM market indicators: EM narrow money (M1) impulse - change in M1 growth - points to a potential major top in EM share prices (Chart I-1, top panel). In fact, M1 growth leads EM EPS growth by nine months and heralds a reversal in the months ahead (Chart I-1, bottom panel). We use equity market cap-weighted M1 growth to ensure that the country weights in the M1 aggregate are identical to those in the EM equity benchmark. The M1 impulse has rolled over decisively, not only in China as shown in Chart I-9 on page 6 but also in Taiwan, heralding a major top in the latter's stock market (Chart I-2). The Taiwanese bourse is heavy in technology stocks that have been on fire in the past year. We continue to hold the view that tech stocks will do better than commodity plays or banks. In short, we continue to recommend overweighting tech stocks within the EM universe. However, if tech stocks roll over as per Chart I-2, the EM equity universe will be at major risk. Global mining stocks have lately been struggling while EM share prices have been well bid (Chart I-3). Historically, these two correlate strongly. In this context, the latest rift between the two is unsustainable. Our bet is that EM stocks will converge to the downside with global mining stocks. Chart I-2Taiwan: Narrow Money ##br##Points To Top In Share Prices Taiwan: Narrow Money Points To Top In Share Prices Taiwan: Narrow Money Points To Top In Share Prices Chart I-3A Rift Between Global ##br##Mining And EM Stocks A Rift Between Global Mining And EM Stocks A Rift Between Global Mining And EM Stocks We are well aware that technology and internet stocks now account for 25% of the EM MSCI benchmark, thereby reducing the importance of commodities prices to EM. However, technology stocks are much overbought and could be at risk of a selloff too, as per Chart I-2 on page 2. On a more general level, we expect that if commodities prices relapse EM risk assets will sell off as well. Consistently, commodities currencies seem to be topping out, which also raises a red flag for EM stocks (Chart I-4). Various commodities prices trading in China are also exhibiting weakness, likely signaling a reversal in the mainland's growth revival (Chart I-5). Finally, all of these factors are occurring at a time when investor sentiment toward U.S. stocks is elevated relative to their sentiment on U.S. Treasurys, and the U.S. equity-to-bonds relative risk index is also at a level that has historically heralded stocks underperforming Treasurys (Chart I-6). Chart I-4An Unsustainable Gap An Unsustainable Gap An Unsustainable Gap Chart I-5Commodities Prices In China Commodities Prices In China Commodities Prices In China Chart I-6U.S. Stocks-To-Bonds: ##br##Relative Sentiment And Risk Profile U.S. Stocks-To-Bonds: Relative Sentiment And Risk Profile U.S. Stocks-To-Bonds: Relative Sentiment And Risk Profile Bottom Line: While global economic surveys and data still allude to firm growth conditions, there are a number of market signals and indicators that are denoting opening cracks in the reflation trade in general and EM risk assets in particular. It is important to note that this is the view of BCA's Emerging Markets Strategy team, which differs from BCA's house view. EM/China Growth Outlook Global and EM manufacturing PMIs are elevated and they will roll over in the months ahead. Yet, a top in economic and business surveys at high levels does not always warrant turning bearish. Our negative stance on EM/China growth stems from our fundamental assessment that these economies have not yet gone through deleveraging, i.e., credit excesses of the boom years have not been worked out. This is the reason why we believe the EM/China growth rebound of the last 12 months is unsustainable and sets the stage for another major downleg. There are preliminary indications that the one-off boost from last year's fiscal and credit push in China is waning. In particular, the number and value of newly started capital spending projects have relapsed dramatically (Chart I-7). This is consistent with our view that the 2016 fiscal push that boosted Chinese growth is passing. Meanwhile, private sector investment expenditures remain weak (Chart I-7, bottom panel). A renewed slump in capital spending will have negative ramifications for mainland imports of commodities. With the monetary authorities tightening liquidity and interest rates rising (Chart I-8), odds are that credit and money growth will decelerate, thwarting the recent amelioration in economic growth. Chart I-7China: 2016 Fiscal Stimulus Is Waning China: 2016 Fiscal Stimulus Is Waning China: 2016 Fiscal Stimulus Is Waning Chart I-8Beware Of Rising Rates In China Beware Of Rising Rates In China Beware Of Rising Rates In China We continue to emphasize that even marginal policy tightening amid lingering credit and property bubbles could have a disproportionately dampening impact on growth. Notably, China's narrow money (M1) impulse - the change in M1 growth rate - reliably leads industrial profits. It is now indicating a relapse in industrial profit growth in the months ahead (Chart I-9). There are also some early clues that global trade volumes may soon weaken, as evidenced by the recent drop in China's container shipment freight index (Chart I-10, top panel). Chart I-9China: Industrial Profits And Narrow Money China: Industrial Profits And Narrow Money China: Industrial Profits And Narrow Money Chart I-10Global Trade Volumes To Roll Over Global Trade Volumes To Roll Over Global Trade Volumes To Roll Over This is further corroborated by the most recent survey of 5000 industrial enterprises in China, which portends a top in overseas new orders (Chart I-10, bottom panel). Finally, Taiwan's M1 impulse leads the country's export volume growth, and currently alludes to potential deceleration in export shipments (Chart I-11). We are not suggesting that U.S. or euro area growth is at major risk. On the contrary, our sense is that the main risk to EM and global stocks from the U.S. and the euro area is higher bond yields in these regions in the near term. Importantly, the recent strength in EM trade has largely been due to Chinese imports, not the U.S. or Europe, as evidenced in Chart I-12. Korea's shipments to U.S. and Europe are rather weak, while sales to China have been very robust. In a nutshell, 27% of Korean exports go to China, while only 13% go to the U.S. and 12% to the EU. Chart I-11Taiwan: Narrow Money And Export Volumes Taiwan: Narrow Money And Export Volumes Taiwan: Narrow Money And Export Volumes Chart I-12Korea's Exports By Regions Korea's Exports By Regions Korea's Exports By Regions Furthermore, combined exports to the U.S. and Europe make up 35% of China's total exports and 7% of its GDP. In turn, China's capital spending amounts to 40-45% of GDP. Hence, investment expenditures are much more important for China than exports to the U.S. and Europe combined. In the meantime, the largest export destination for Asian and South American countries is China rather than the U.S. or Europe. Therefore, as China's growth slumps, its imports from Asian/EM as well as commodities prices will decline. Bottom Line: Risks to EM/China growth are to the downside, regardless of growth conditions in the advanced economies. Reinstate Short EM Stocks / Long 30-Year Treasurys Trade We took a 24% profits on this trade on July 13, 2016 and now believe the risk-reward is conducive to re-establish this position. Back in July2 we argued that EM stocks might be supported in the near term while DM bond yields would rise, justifying booking profits on this trade. Looking forward, the basis for reinstating this trade is as follows: Fundamentally, both market indicators as well as the rising odds of a relapse in EM/China growth per our discussion above support this trade. The relative total return on this position is facing a formidable technical support, and we believe it will hold (Chart I-13). The difference between the EM equity dividend yield and the 30-year Treasury yield is one standard deviation from its time-trend (Chart I-14). At similar levels in the past, this indicator heralded significant EM share price underperformance versus U.S. bonds. Chart I-13Reinstate Short EM Stocks-Long ##br##30-year U.S. Treasurys Reinstate Short EM Stocks-Long 30-year U.S. Treasurys Reinstate Short EM Stocks-Long 30-year U.S. Treasurys Chart I-14Relative Value Favors ##br##U.S. Bonds Versus EM Equities Relative Value Favors U.S. Bonds Versus EM Equities Relative Value Favors U.S. Bonds Versus EM Equities Chart I-6 on page 4 reveals that sentiment on stocks versus bonds is bullish. From a contrarian perspective, this invites a bet on stocks underperforming bonds in the months ahead. This trade will pan out regardless of whether a potential selloff in EM share prices is accompanied by rising or falling U.S. bond yields. Even if U.S. bond yields rise (bond prices decline), EM stocks will likely drop more than U.S. Treasury prices. Our base case remains that there is likely more upside in U.S. bond yields in the near term, but this trade is poised to deliver solid gains so long as EM share prices drop. That said, we believe that U.S. bond yields will likely be at current levels or lower by the end of this year when EM/China growth slowdown unleash new deflationary forces in the global economy. Bottom Line: Reinstate a short EM stocks / long 30-year Treasurys trade with a six-nine month time horizon. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM Equity Valuations Revisited", dated March 29, 2017, link available on page 18. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View", dated July 13, 2016, link available on page 18. South Africa: Back To Reality Political risks have not risen in South Africa with the dismissal of Finance Minister Pravin Gordhan. They had never declined in the first place. The markets have, however, ignored them in the past 12 months. Investors have failed to recognize the fundamental problem underpinning the disarray in the ruling African National Congress (ANC): growing public discontent with persistently high unemployment and income inequality. Despite a growing body of evidence that political stability has been declining for a decade, strong foreign portfolio flows have papered over the reality on the ground and allowed domestic markets to continue "whistling in the dark." Investors even cheered the poor performance of the ANC in municipal elections in August 2016, despite the fact that by far the biggest winners of the election were the left-wing Economic Freedom Fighters (EFF), not the centrist Democratic Alliance. This confirms BCA's Geopolitical Strategy's forecast that the main risk to President Jacob Zuma's rule is from his left flank, led by the upstart EFF of Julius Malema, and by the Youth and Women's Leagues of his own ANC.3 As such, it was absolutely nonsensical to expect Zuma to pivot towards pro-market reforms. Unsurprisingly, he has not. But could the Gordhan firing set the stage for an internal ANC dust-up that gives birth to a pro-reform, centrist party? This is the hopeful narrative in the press today. We doubt it. First, if the ANC splits along left-right lines, it is not clear that the reformers would end up in the majority. Therefore, the hope of the investment community that Deputy President Cyril Ramaphosa takes charge and enacts painful reforms is grossly misplaced. Second, Zuma may no longer be popular, but his populist policies are. While both the Communist Party (a partner of the Tripartite Alliance with the ANC) and the EFF now officially oppose his rule, they do not support pro-market reforms. Third, ethnic tensions are rising, particularly between the Zulu and other groups. These boiled over in social unrest last summer in Pretoria when the ruling ANC nominated a Zulu as the candidate for mayor of the Tshwane municipality (which includes the capital city). As such, we see the market's reaction as a belated acceptance of the reality in South Africa, which is that the country's consensus on market reforms is weakening, not strengthening. It is not clear to us that a change at the top of the ANC, or even a vote of non-confidence in Zuma, would significantly change the country's trajectory. In addition, the political tensions are growing at a time when budget revenue growth is dwindling and the fiscal deficit is widening (Chart II-1). To placate investor anxiety over the long-term fiscal outlook, the government should ideally cut its spending. However, it is impossible to do so when there are escalating backlashes from populist parties and from within the ruling Tripartite Alliance. Odds are that the current and future governments will resort to more populist and unorthodox policies. That will jeopardize the public debt outlook and erode the currency's value. Needless to say, the nation's fundamentals are extremely poor -- outright decline in productivity being one of the major causes (Chart II-2). Chart II-1South Africa: Fiscal Stress Is Building Up South Africa: Fiscal Stress Is Building Up South Africa: Fiscal Stress Is Building Up Chart II-2Underlying Cause Of Economic Malaise Underlying Cause Of Economic Malaise Underlying Cause Of Economic Malaise We believe the rand has made a major top and local currency bond yields reached a major low (Chart II-3). We continue to recommend shorting the ZAR versus both the U.S. dollar and Mexican peso. Traders, who are not short, should consider initiating these trades at current levels. Investors who hold local bonds should reduce their exposure. Dedicated EM equity investors should downgrade this bourse from neutral to underweight (Chart II-4). Chart II-3South Africa: Short ##br##The Rand And Sell Bonds South Africa: Short The Rand And Sell Bonds South Africa: Short The Rand And Sell Bonds Chart II-4Downgrade South African ##br##Equities To Underweight Downgrade South African Equities To Underweight Downgrade South African Equities To Underweight Finally, EM credit investors should continue underweighting the nation's sovereign credit within the EM universe and relative value trades should stay with buy South African CDS / sell Russian CDS protection. 3 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 2, 2015, and Strategic Outlook, "Strategic Outlook 206: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. Mexico: Stay Long MXN On Crosses And Overweight Fixed-Income Mexico's central bank could still hike interest rates by another 50 basis points or so because inflation is above the target and the recent raise in minimum wage could keep inflation/wage expectations elevated (Chart III-1). Even if further rate hikes do not materialize, the cumulative monetary tightening will depress domestic demand but support the peso, especially versus other EM currencies. We continue recommending long positions in MXN versus ZAR and BRL. Higher borrowing costs will squeeze consumer and investment spending in Mexico. Notably, household expenditures have so far remained very robust. We suspect consumers have brought forward their future demand due to expectations of higher consumer prices. In short, consumer spending will tank as there is very little pent-up demand remaining and higher borrowing costs will start biting very soon (Chart III-2). Chart III-1Inflation Expectations To Stay Elevated For Now Inflation Expectations To Stay Elevated For Now Inflation Expectations To Stay Elevated For Now Chart III-2Mexico: Domestic Demand To Buckle Mexico: Domestic Demand To Buckle Mexico: Domestic Demand To Buckle As household spending and investment expenditure relapse and exports to the U.S. revive, Mexico's current account will improve considerably. In the meantime, Brazil's current account deficit will widen as the economy recovers. Chart III-3 illustrates that the relative current account dynamics are turning in favor of the peso versus the real. The economic recovery that will eventually happen in Brazil this year will come too late and be too weak to stabilize the nation's public debt. We remain concerned about Brazil's public debt dynamics. In contrast, we are not concerned about Mexico's fiscal situation. Mexican policymakers have been very orthodox and we do not expect that to change much. In regard to valuation, the peso is cheap versus the U.S. dollar and is extremely cheap against the BRL and ZAR (Chart III-4). Chart III-3Mexico Versus Brazil: ##br##Current Account And Exchange Rate Mexico Versus Brazil: Current Account And Exchange Rate Mexico Versus Brazil: Current Account And Exchange Rate Chart III-4Mexican Peso Is Cheap Mexican Peso Is Cheap Mexican Peso Is Cheap Finally, investors have flocked from Mexico to Brazil last year amid the deteriorating political outlook in Mexico and stabilization in Brazilian politics. We believe such a positioning swing is overdone and our bet is that Mexico will be getting more investor flows this year compared with Brazil. Investment Conclusions Chart III-5Mexican local Bonds Offer Value Mexican local Bonds Offer Value Mexican local Bonds Offer Value Maintain long positions in MXN versus BRL and ZAR. The outlook for the latter is discussed in a section above. We are reluctant to initiate a long MXN/short U.S. dollar trade because we are negative on the outlook for EM exchange rates. It is not impossible but it will be hard for the peso to appreciate against the U.S. dollar if most EM currencies depreciate and oil prices drop, as we expect. Fixed-income investors should continue overweighting Mexican local currency and sovereign credit within their respective EM benchmarks. Mexico's fixed-income assets offer good value (Chart III-5). Relative value traders should consider the following trade: sell Mexican CDS / buy Indonesia CDS protection. Finally, dedicated EM equity portfolios should maintain a neutral allocation to Mexican stocks. The currency will outperform but share prices in local currency terms will underperform their EM peers. The Mexican bourse is tilted toward consumer stocks that are expensive and at risk of a major downturn in household spending as discussed above. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Research Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Dusting Off The BCA Bond Model: As central bankers moving away from the hyper-easy monetary policies of the post-crisis era, reverting back to more traditional bond investing tools, like our BCA Bond Model - which focuses on cyclical economic pressures, valuation and momentum - can be useful. GFIS Composite Bond Indicators: After adding a new element to our classic Bond Model, carry, we come up with a new measure to assess government bond markets - the GFIS Composite Bond Indicators. Current Signals: Our new indicators point to Australia, Canada and the U.K. as looking more attractive on a relative basis than Germany or France. Feature For global fixed income investors, four key questions matter most in selecting which government bond markets to prioritize at the country level: Where each country stands in its economic cycle? Which bonds offer the best value? Which bonds exhibit the strongest price momentum? Which bonds benefit from the best carry? To answer those questions, BCA has built specific macro indicators over the years. The ones related to the cycle, value and momentum form the building blocks of the BCA Bond Model. We have not spent as much time discussing these indicators in recent years. This is because the performance of bond markets has been dominated by extraordinarily easy monetary policies (quantitative easing, negative interest rates) in the major economies since the Great Recession. As more central banks start to question the need for maintaining those crisis-era policy settings, however, the utility of referring back to our classic bond indicators is growing. In this Special Report, we re-examine our bond indicators, explain briefly how they were built, evaluate quantitatively if they still provide a consistent signal and elaborate on the best way to utilize them. To enhance the existing model, we add a "carry" component to it, which is a vital part of bond investing. Since the cyclical, value, momentum and carry indicators often give different asset allocation signals at any given point in time, we propose a way to aggregate the information into one single indicator for each country, i.e. the BCA Global Fixed Income Strategy (GFIS) Bond Composite Indicators. We then test these indicators to see if they help bond portfolio managers outperform. The report concludes by comparing the latest message from the GFIS Bond Composite Indicators versus our current recommended portfolio positioning. Specifically, we explain why we are choosing to deviate from our indicators and assess how we could shift our tilts in the future. Evaluating The BCA Cyclical Bond Indicators The most important aspect of bond investing is to understand where each country stands in its current economic cycle. As a way to quickly assess this, we developed our Cyclical Bond Indicators many years ago. Tailored for each country, the Indicators are composed of economic data such as: the unemployment rate private sector credit growth the slope of the government bond yield curve commodity prices denominated in local currency terms realized inflation rates Since economies do not always exhibit the same sensitivity to common macro drivers, we created country-specific Cyclical Bond Indicators that each use a different set of variables. After transforming the data, using de-trending and standardizing techniques, the variables are aggregated to form a single indicator for each country.1 Although Developed Market (DM) countries typically appear to be in the same phase of their economic cycle simultaneously, there are always some slight differences between them. These are crucial to identify and can make a huge difference in the government bond asset allocation process. First and foremost, knowing where a country is in its business cycle should impact expected returns on fixed income. Theoretically, bonds should underperform as the economic cycle becomes more advanced and outperform as the economic cycle deteriorates. Statistical Observations To verify that last statement, we separated the cycle for each country in our DM bond universe into seven distinct phases for the economic cycle: Euphoria End of upturn Upturn Downturn End of downturn Crisis Mega Crisis The phases of the cycle are defined by how much the Cyclical Bond Indicator diverges from its mean, which is always zero since the Indicators are standardized (i.e. removing the mean and dividing by the standard deviation). Chart 1 illustrates how our four core countries (U.S., Germany, Japan, U.K.) have gone through those cycles since 1967. At the positive end of the spectrum, the Euphoria state represents instances where economic variables have been especially upbeat (i.e. the Cyclical Bond Indicator is more than two standard deviations above the mean). At the negative end, the Crisis and Mega Crisis periods are when the Cyclical Bond Indicator is more than two and three standard deviations below the mean, respectively. Chart 1The BCA Cyclical Bond Indicators For The 'Core Four' Markets The BCA Cyclical Bond Indicators For The 'Core Four' Markets The BCA Cyclical Bond Indicators For The 'Core Four' Markets To evaluate the usefulness of the Cyclical Bond Indicator as an investment tool, we have calculated the average monthly return during each phase of the cycle for the major DM countries with a one-month lag (i.e. the March 2017 returns are based on the signals given by the February 2017 readings of the Indicators - this is done throughout the rest of this report when testing other bond indicators). The results are shown in Table 1. Table 1Bond Market Performance, Seen Through Our Cyclical Bond Indicator Revisiting The BCA Bond Model Revisiting The BCA Bond Model As expected, the average monthly performance tends to increase as an economy enters a downturn. Conversely, as an economic upturn gathers momentum, the performance of the bond market tends to decline.2 In Table 1, we highlighted the current phase for each country. Australia and U.K. are the only countries in Downturn territory right now; compared to their peers, those two countries would have the largest expected return3 of this group. On the other hand, the U.S. economy might be at the End of Upturn phase, when Treasuries should be expected to post the worst return, if history is any guide. In Table 2, we broke out the monthly results into 10-year periods to test the consistency of the indicator performance over time. Unsurprisingly, the End of Upturn phase has been quite detrimental for the DM bond markets during all eras, while the End of Downturn episodes have been good for bond investors in every decade. Table 2Bond Market Returns During ##br##The Various Stages Of Our Cyclical Bond Indicator Are Consistent Across Time Revisiting The BCA Bond Model Revisiting The BCA Bond Model Chart 2The Gains From Bond Investing##br## According To The Economic Cycle Revisiting The BCA Bond Model Revisiting The BCA Bond Model Finally, we looked into the usefulness of the Cyclical Bond Indicators in helping construct simple bond portfolios by using them as a ranking tool using the steps described in Box 1. The big picture takeaway is this: the countries with the three highest ranking Cyclical Bond Indicators (i.e. those with the slowest economic growth) outperform by roughly +6 basis points (bps) per month, on average. Similarly, the countries with the lowest-ranked cyclical indicators would underperform by -6bps, on average (Chart 2). Box 1 Ranking Bond Returns Using The BCA Cyclical Bond Indicators We calculated the average monthly excess return by buckets using the following steps: We ranked the ten countries in our bond universe by the level of their Cyclical Bond Indicators, from lowest (ranked #1) to highest (ranked #10). We then calculated the monthly currency-hedged excess return of each country versus the average of all the countries in our DM bond universe We then aggregated all the monthly results to have an average excess return for all ten of our ranking buckets We then separated them further into three buckets (the top three, middle four and bottom three ranks) and averaged the monthly excess returns for those groupings. Comments There is nothing particularly out of the ordinary with those findings - the countries with the weakest economies have the best performing government bond markets. However, the results of these statistical exercises confirm that the BCA Cyclical Bond Indicators are reliable and can confidently be used to support our qualitative analysis for each country. Importantly, following those indicators brings a dose of discipline to our bond allocation framework. For example, if our initial qualitative macro analysis diverges markedly from what the Cyclical Bond Indicator is telling us, this would represent a red flag that prompts us to question our initial conclusions. We will highlight situations like this later in this report. Evaluating The BCA Bond Value Indicators To assess the richness or cheapness of DM government bonds, BCA developed a Bond Value Indicator for each country. It is composed of several measures that have a fundamental macroeconomic relationship to bond yields, such as: Central bank policy rate expectations Trend inflation The deviation of the exchange rate from Purchasing Power Parity (PPP) The 10-year U.S. Treasury yield (as a proxy for the global bond yield) The variables are transformed using regressions, then combined to form a single measure of how far bond yields are from a theoretical fair value. Similar to other components of the BCA Bond Model, the power of these country indicators arises when comparing them amongst each other. Bond markets with yields below fair value should outperform those with yields above fair value. Just like all other asset classes, valuation is a poor tactical timing tool for fixed income. Our Bond Value Indicator is more useful in the long term; value can remain cheap/expensive for an extended period of time. For example, Germany has been the most, or second-most, expensive bond market in our bond universe since June 2013. Due to this shortcoming, the Bond Value Indicator will be given a smaller weighting in our composite indicator laid out later in this report. Statistical Observations To test this indicator, we looked at the hedged excess monthly returns generated using the same ranking procedure laid out in Box 1. The results show that investors can expect to earn about +12bps per month in excess hedged return from countries with the three cheapest valuations according to the Bond Value Indicators, and can expect to lose -6bps/month in countries that are ranked most expensive (Chart 3). Moreover, betting on countries with the cheapest ranked valuations skews favorably the odds of outperforming, from about 46% to 53% (Chart 4). Chart 3The Gains From Bond Investing ##br##According To Value Revisiting The BCA Bond Model Revisiting The BCA Bond Model Chart 4Favor The Cheaper Bond Markets Revisiting The BCA Bond Model Revisiting The BCA Bond Model Comments Currently, the U.S. bond market offers the best value (Chart 5). This contrasts unfavorably with our recommended underweight exposure to U.S. Treasuries. Nonetheless, we remain comfortable with this exposure since the U.S. economy is currently in the strongest economic cycle, and its bond market is technically less oversold than its peers (see the next section). Chart 5Bunds Look Rich, Treasuries Look A Bit Cheap Bunds Look Rich, Treasuries Look A Bit Cheap Bunds Look Rich, Treasuries Look A Bit Cheap Also, note that German and Japanese yields look quite expensive, although this is no surprise given the extremely easy monetary policy settings (negative rates, central bank asset purchases) in place from the European Central Bank (ECB) and Bank of Japan (BoJ). As we have discussed in recent Weekly Reports, we see far greater risks for the ECB moving to a less accommodative monetary bias in the months ahead than the BoJ, and we shifted our country allocations to reflect that view (moving to overweight Japan and cutting Germany to neutral).4 In other words, Japanese bonds will likely stay expensive for longer, unlike German debt. As we mentioned earlier, the value component warrants lesser importance in our tactical and strategic bond allocation framework since it is more long term in nature. In a nutshell, value is something good to have on your side when the macro backdrop shifts, but is not absolutely crucial to generate returns on a month-to-month basis. Evaluating The BCA Bond Momentum Indicator So far, the BCA Bond Cyclical Indicator informed us where the macroeconomic forces were the strongest and the BCA Bond Value Indicator helped us find bargains. This is all great, but bond investors could still underperform if their timing is off. The BCA Bond Momentum Indicator helps in finding the appropriate short-term timing. It has been built simply by looking at how far bond yields are relative to their primary medium-term trend. In theory, bond markets where yields are too stretched to the upside (oversold) should outperform versus countries where yields are too stretched to the downside (overbought). Statistical Observations Using the same ranking methodology explained in Box 1, investors can expect to earn roughly +11bps/month in excess return versus DM peers where conditions are the most oversold and should expect to lose -6bps/month from bond markets with the most overbought conditions (Chart 6). Comments While we do consider technical analysis as part of the tactical component in our bond allocation framework, we put less emphasis on it relative to other more fundamental factors that sustainably drive bond returns over time. Nonetheless, our ranked findings show that choosing markets based on price/yield momentum does generate fairly reliable outperformance. What About Carry? As seen so far, our traditional bond indicators encompass typical variables that would be expected to influence bond returns. Our framework would be incomplete, however, without incorporating the notion of "carry" - the investment return generated by the interest income on bonds. Having instruments that earn too little carry can be very harmful to the returns of a bond portfolio over prolonged periods. A simple observation of the long-term performance of higher-yielding credit markets (i.e. corporate debt or Emerging Market sovereigns) proves that point (Chart 7), especially in the current era where investors continue to stretch for yield given puny risk-free interest rates in so many countries. Chart 6The Gains From Bond Investing ##br##According To Momentum Revisiting The BCA Bond Model Revisiting The BCA Bond Model Chart 7Carry Plays A Huge Role ##br##For Long-Run Bond Returns Carry Plays A Huge Role For Long-Run Bond Returns Carry Plays A Huge Role For Long-Run Bond Returns Of course, most of the major carry gaps between DM sovereign bond yields disappear after currency hedging. However, even on a hedged basis, the carry differentials remain important. Currently, Italian debt carries the highest hedged yield in our DM bond universe, at 3.95%, versus 1.54% for Japan. The 241bp differential between the two is significant, especially in the current global low yield environment. However, some of that additional yield is compensation for the greater riskiness of Italian debt, given the many structural problems in that country (high debt levels, low productivity, political instability, fragile banks). In other words, a better way to evaluate carry is on a risk-adjusted basis. In Chart 8, we show the hedged 10-year government bond yields of the ten DM countries shown throughout this report, both in absolute terms (top panel) and adjusted for volatility (bottom panel). Note that Italy's ranking moves down two notches after accounting for the greater return volatility of Italian debt, while Spain offers the most attractive yield on a risk-adjusted basis. At the other end of the spectrum, Australia and Canada have less attractive yields relative to their volatilities than Japan - home of the 0% bond yield. Of course, as the old investment saying goes, "you can't eat risk-adjusted returns." As a general rule, bond markets with higher yields should be expected to outperform markets with lower yields over time. Statistical Observations An historical analysis of our DM universe using the methodology laid out in Box 1 confirms that observation. The bond markets with better ranked carry have a tendency to generate positive excess returns (on a currency-hedged basis) and, on average, produce more winning months than losing ones (Chart 9). This is true even though the higher-yielding markets are often those with higher inflation, or greater government debt levels, or more active central banks that create interest rate volatility. Chart 8Peripheral European Carry##br## Is Still The Most Attractive Revisiting The BCA Bond Model Revisiting The BCA Bond Model Chart 9The Gains From Bond Investing##br## According To Carry Revisiting The BCA Bond Model Revisiting The BCA Bond Model Comments Currently, the carry factor would favor overweighting Italy, Spain and France, while underweighting Japan, Australia and the U.K. Those relative rankings still generally hold up even after adjusting for volatility. Pulling It All Together: Introducing The GFIS Bond Composite Indicators Now that we have outlined the four elements of our proposed composite bond indicator, the question becomes: how do we aggregate those pieces? The components of our original BCA Bond Model rarely give the same message simultaneously, even after adding a new factor (carry) to the mix. Moreover, as discussed above, some elements (Cyclical and Carry) are more important than others (Value and Momentum) in delivering consistent outperformance of bond returns. Hence, to build a new composite indicator, we need to make a judgment call as to which component should be given more weight. Cyclical (50%). Here at BCA, we spend a fair amount of time trying to deeply understand economic cycles, which are a major driver of financial markets. Bonds are no exception, with changes in growth and inflation expectations forming the fundamental building blocks of yields. As such, we allocate a substantial 50% weight to the cyclical component of our GFIS Bond Composite Indicators. Value (15%). Value moves much more slowly than the other indicators and yields often diverge from fair value for long periods of time. As such, we are giving a smaller weighting of 15% to the value piece of the GFIS Bond Composite Indicators that we are designing to provide a timely signal for country allocation. Momentum (15%). Although technical analysis should be a meaningful part of any investment process, markets can often trend for extended periods before any consolidation, or even reversal, takes place. To reflect that, our momentum indicator will also carry only a 15% weighting in our composite indicator, the same as the weight given to value. Carry (20%). Carry should play an important part in a bond allocation framework. To use a sporting analogy - favoring higher-yielding bonds means starting the game with the score already in your favor. For that reason, we will give carry a 20% weight in our overall bond indicators. After combining our individual bond indicator rankings (from 1 to 10) using the weightings described above, we come up with an overall score for each country which becomes the GFIS Composite Bond Indicator (Table 3). Ranking the countries according to their respective scores gives a new indication as to which bond markets we might want to overweight or underweight. Table 3Combining The BCA Bond Indicators Revisiting The BCA Bond Model Revisiting The BCA Bond Model Statistical Observations Chart 10Our Composite Bond Indicator ##br##Adds Value At The Extremes Our Composite Bond Indicator Adds Value At The Extremes Our Composite Bond Indicator Adds Value At The Extremes To test the investment performance of our new GFIS Composite Bond Indicators, we created an equally-weighted index using the monthly hedged returns of the ten countries in our DM bond universe. We then created two portfolios: One composed of the countries with the three best composite scores; The other composed of the countries with the three worst composite scores. In both cases, those sample portfolios out-/under-performed the equally-weighted index as expected, proving that value can be extracted by following the recommendations of the GFIS Composite Indicators (Chart 10). Comments This automatic/quantitative ranking of the countries is designed as a guideline only. The goal here is to quickly find what could be the most appealing bond markets on a relative basis. Judgment on whether to apply the findings should and will always take precedence when we make our investment recommendations. Also note, in attributing weightings across the components, we have not used any optimization techniques to find the perfect balance. We simply relied on our judgment for a simple reason: optimization gives the best fit according to a set of historical market volatilities and correlations. During periods when volatilities change, or correlations become less stable, the historically-optimal weightings may produce sub-optimal investment results. We prefer to use a constant set of weights across our individual indicators, derived from our own investment intuition and preferences. What Could Be Our Next Portfolio Tweaks? We compare the latest rankings from our GFIS Composite Bond Indicators to our current fixed income country allocations in Table 4. Deviations between the two can provide some ideas for possible changes to our recommendations. Table 4The GFIS Composite Bond Indicator##br## Vs. Our Current Recommendations Revisiting The BCA Bond Model Revisiting The BCA Bond Model From this table, two observations arise: The three countries that rank the highest, Australia, Canada and U.K. are at neutral in our recommended portfolio (Chart 11). Should we move them to overweight? Among the three countries that rank the worst, we are still only at neutral Germany and France (Chart 12). Should we move to an underweight stance given the signal from our new Composite Bond Indicator? On the first point, we have turned decidedly less negative on Australia and U.K. bonds of late.5 In the next few months, if more signs of cyclical deterioration emerge, we will be tempted to align ourselves with our composite indicators and overweight those markets. Although as we discussed in a recent Special Report, another set of our in-house indicators, the Central Bank Monitors, are pointing to pressures to tighten monetary policy in Australia, Canada and the U.K., perhaps providing some justification for only being neutral on those markets.6 On the second point, we recently downgraded core Europe to neutral from overweight, given our growing concern that the ECB will be forced to announce a tapering of its asset purchases, likely starting in early 2018.7 We anticipate that our next move will be to a full-blown underweight position on both Germany and France, although we prefer to wait until after the upcoming French elections before making that shift. Given our view that the populist Marine Le Pen will not win the presidency, we expect to be cutting Germany before France, as there is still a wide political uncertainty premium built into French-German bond spreads.8 Chart 11Bond Upgrade Candidates Bond Upgrade Candidates Bond Upgrade Candidates Chart 12Bond Downgrade Candidates Bond Downgrade Candidates Bond Downgrade Candidates Going forward, we will continue to monitor our GFIS's Composite Bond Indicators to supplement/confirm our macro analyses and to discover some potential portfolio moves/trades. Additionally, we will look to further test and refine the Composite Bond Indicators by looking at different weighting schemes among the component indicators, how the correlations between the components shift over time (and if there is any information from those changes), and other considerations. Now that we've "dusted off" our classic bond indicators, there is plenty of additional research that can be done to build on the initial results shown in this report. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 We have built the Cyclical Bond Indicators using data going back to 1967 for most DM countries, allowing for a robust historical analysis across the different bond markets. 2 Since global bonds have experienced a powerful secular bull market over the past 35 years, the majority of monthly returns in the history of the Cyclical Bond Indicator have been positive. As such, shorting bonds in absolute terms has seldom proved to be a value-added proposition. The only exceptions are when the macro landscape has entered the Euphoria state, which has been quite rare. 3 In local currency terms 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Staying Behind The Curve, For Now", dated March 21, 2017, available at gfis.bcaresearch.com 5 Please see BCA Global Fixed Income Strategy Weekly Reports, "Will The Hawks Walk The Talk?", dated March 7, 2017 (on the U.K.), and "It's Real Growth, Not Fake News", dated February 21, 2017 (on Australia), both available at gfis.bcaresearch.com 6 Please see BCA Global Fixed Income Strategy Special Report, "BCA Central Bank Monitor Chartbook", dated March 28, 2017, available at gfis.bcaresearch.com 7 Please see BCA Global Fixed Income Strategy Weekly Report, "March Madness", dated March 14, 2017, available at gfis.bcaresearch.com 8 Please see BCA Global Fixed Income Strategy Special Report "Our Views On French Government Bonds", dated February 7, 2017, available at gfis.bcaresearch.com

Highlights Chart 1Is Inflation Heating Up? Is Inflation Heating Up? Is Inflation Heating Up? In past reports we have argued that as long as inflation (and inflation expectations) are below the Fed's target, then the "reflation trade" will remain in vogue. In other words, with inflation still too low, the Fed has an incentive to back away from its hawkish rhetoric whenever risk assets sell off and financial conditions tighten. But with inflation heating up - the last two monthly increases in core PCE are close to the highest seen in this recovery (Chart 1) - will the Fed become less responsive? Not yet! Year-over-year core PCE is still only 1.75% (the Fed's target is 2%) and the cost of inflation protection embedded in long-dated TIPS remains too low (panel 2). In fact, the uptrend in TIPS breakevens lost some of its momentum last month alongside wider credit spreads and the S&P 500's first monthly decline since October. In this environment, we are inclined to add credit risk as spreads widen and believe a "buy the dips" strategy will work until inflation pressures are more pronounced. On a 6-12 month horizon we continue to recommend: below-benchmark duration, overweight spread product, curve steepeners and TIPS breakeven wideners. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 15 basis points in March. The index option-adjusted spread widened 3 bps on the month and, at 118 bps, it remains well below its historical average (134 bps). While supportive monetary policy will ensure excess returns consistent with carry, investors should not bank on further spread compression as spreads have already discounted a substantial improvement in leverage (Chart 2). In fact, leverage showed a marked increase in Q4 2016 even though spreads moved tighter. The measure of gross leverage (total debt divided by EBITD) shown in Chart 2 increased in the fourth quarter even though total debt grew at an annualized rate of only 0.3%. However, EBITD actually contracted at an annualized rate of 7% in Q4 causing leverage to rise. The quarterly decline in EBITD looks anomalous, and the year-over-year trend is improving (panel 4). In fact, we would not be surprised to see leverage stabilize this year as profits rebound.1 But similarly, we also expect that the recent plunge in debt growth will reverse. Historically, it has been very rare for leverage to fall unless prompted by a recession. We will take up this issue in more detail in next week's report. Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3), and we remain overweight. This week we also downgrade the Retailers and Packaging sectors, which have become expensive, and upgrade Cable & Satellite, which appears cheap. Table 3A Reflation Window Still Open Reflation Window Still Open Table 3B Reflation Window Still Open Reflation Window Still Open High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 25 basis points in March. The index option-adjusted spread widened 20 bps on the month and, at 383 bps, it is currently 136 bps below its historical average. Given the favorable policy back-drop described on page 1, we view the recent widening in junk spreads (Chart 3) as an opportunity to increase exposure to the sector. In fact, in a recent report2 we tested a strategy of "buying dips" in the junk bond market in different inflationary regimes. The strategy involved buying the High-Yield index whenever spreads widened by 20 bps or more in a month and then holding that position for 3 months. We defined the different inflationary regimes based on the St. Louis Fed's Price Pressures Measure (PPM).3 We found that our "buy the dips" strategy yielded positive excess returns 65% of the time in a very low inflation regime (PPM < 15%), 59% of the time in a low inflation regime (15% < PPM < 30%), 44% of the time in a moderate inflation regime (30% < PPM < 50%) and only 25% of the time in a high inflation regime (50% < PPM < 70%). Currently, the reading from the PPM is 13%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in March. The conventional 30-year MBS yield rose 6 bps on the month, driven entirely by a 6 bps increase in the rate component. The compensation for prepayment risk (option cost) declined by 6 bps, but this was exactly offset by a 6 bps widening in the option-adjusted spread. As a result, the zero-volatility spread was flat on the month. The option-adjusted spread represents expected excess returns to MBS assuming that prepayments fall in line with expectations. On this basis, MBS look more attractive than they have for some time (Chart 4). However, net MBS issuance also surged in Q4 2016 (panel 4) and should remain robust this year despite higher mortgage rates.4 Interest rates have not been a deterrent to mortgage demand since the financial crisis. The limiting factors have been a lack of household savings and restrictive bank lending standards. Both of these headwinds continue to gradually fade. The option-adjusted spread still appears too low relative to issuance. Nominal MBS spreads are linked to rate volatility (bottom panel), and volatility should increase as the fed funds rate moves further off its zero-bound.5 The wind-down of the Fed's MBS portfolio - which we expect will begin in 2018 - should also pressure implied volatility higher as the private sector is forced to absorb the increased supply, some of which will be convexity-hedged. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 22 basis points in March. The high-beta Sovereign and Foreign Agency sectors outperformed by 71 bps and 41 bps, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors outperformed by 9 bps and 15 bps, respectively. Local Authorities underperformed the Treasury benchmark by 17 bps. The performance of Sovereigns has been stellar this year, as the sector has benefited from a 3% depreciation in the trade-weighted dollar (Chart 5). However, the downtrend in the dollar looks more like a temporary reversal than an end to the bull market. With U.S. growth on a strong footing, there is still scope for global interest rate differentials to move in favor of the dollar. Potential fiscal policy measures - such as lower tax rates and a border-adjusted corporate tax - would also lead to a stronger dollar, if enacted. As such, we do not believe the current outperformance of Sovereigns can be sustained. We continue to recommend overweight allocations to Foreign Agencies and Local Authorities, alongside underweight allocations to the rest of the Government-Related index. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 24 basis points in March (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio declined 2% on the month and remains firmly anchored below its post-crisis average. This year's decline in M/T yield ratios has been concentrated at the short-end of the curve (Chart 6), and long maturities now offer a significant valuation advantage. This week we recommend favoring the long-end of the Aaa Muni curve (10-year maturities and beyond) versus the short-end (maturities up to 5 years). Overall, M/T yield ratios appear fairly valued on a tactical basis. While fund inflows have ebbed in recent weeks (panel 4), this has occurred alongside a plunge in gross issuance (bottom panel). The more concerning near-term risk for Munis is that yield ratios have already discounted a substantial improvement in state & local government net borrowing (panel 3). However, we expect net borrowing to decline during the next couple of quarters on the back of rising tax revenues. State & local government tax receipts decelerated throughout most of 2015 and 2016 alongside falling personal income growth and disappointing retail sales. However, both income growth and retail sales have moved higher in recent months, and this should soon translate into accelerating tax receipts and lower net borrowing. Longer term, significant risks remain for the Muni market.6 Chief among them is that state & local government budgets now finally look healthy enough to increase investment spending. Not to mention the significant uncertainty surrounding the potential for lower federal tax rates and plans to invest in infrastructure. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve underwent a small parallel shift upward in March, roughly split between a bear-steepening leading up to the FOMC meeting on March 15 and a bull-flattening from the meeting until the end of the month. Overall, the 2/10 Treasury slope flattened 1 basis point on the month and the 5/30 slope ended the month 1 bp steeper. Our recommended position long the 5-year bullet and short the 2/10 barbell - designed to profit from a steeper yield curve - returned +3 bps in March and is up 7 bps since inception on December 20. In addition, we also entered a short January 2018 fed funds futures trade on March 21.7 The performance of this trade has so far been flat. In a recent report,7 we identified the main cyclical drivers of the slope of the yield curve as: The fed funds rate (higher fed funds rate = flatter curve) Inflation expectations (higher inflation expectations = steeper curve) Interest rate volatility (higher volatility = steeper curve) Unit labor costs (higher unit labor costs = flatter curve) We concluded that even though the Fed is in the process of lifting the funds rate, the yield curve likely has room to steepen as long-maturity TIPS breakevens recover to levels more consistent with the Fed's inflation target (Chart 7). In addition, interest rate volatility has likely bottomed for the cycle and the uptrend in unit labor costs could level-off if productivity growth continues to rebound. The recent decline in bullish sentiment toward the dollar has also not yet been matched by a steeper 5/30 slope (bottom panel). TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 6 basis points in March. The 10-year TIPS breakeven rate declined 5 bps on the month and, at 1.97%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. While the catalyst for the recent softening in TIPS outperformance seems to be the hawkish re-rating of Fed rate hike expectations, the uptrend in TIPS breakevens was probably due for a pause in any case. Breakevens had become stretched relative to our TIPS Financial Model - based on the dollar, oil prices and the stock-to-bond total return ratio. However, measures of pipeline inflation pressure - such as the ISM prices paid survey (Chart 8) - still point toward wider breakevens and, as was noted on the front page of this report, recent core inflation prints have been quite strong. All in all, growth appears strong enough that core inflation should continue its gradual uptrend and, more importantly, the Fed will be keen to accommodate an increase in both realized core inflation and TIPS breakevens, which remain below target. This means that in the absence of a material growth slowdown, long-maturity TIPS breakevens should continue to trend higher until they reach the 2.4% to 2.5% range that historically has been consistent with the Fed's inflation target. In a baseline scenario where the unemployment rate is 4.7% at the end of the year and the dollar remains flat, our Phillips curve model8 predicts that year-over-year core PCE inflation will be 2.02% at the end of this year. ABS: Maximum Overweight Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +22 bps. Aaa-rated issues outperformed the Treasury benchmark by 16 bps on the month, and non-Aaa issues outperformed by 26 bps. The index option-adjusted spread for Aaa-rated ABS tightened 5 bps on the month. At 48 bps, the spread remains well below its average pre-crisis level (Chart 9). Banks are now tightening lending standards on both auto loans and credit cards. While we do not expect this recent development to have much of an impact on consumer spending, it is usually an indication that there is growing concern about ABS collateral credit quality. As such, this week we scale back our recommended allocation to ABS from maximum overweight (5 out of 5) to overweight (4 out of 5). While credit card charge-offs remain well below pre-crisis levels, net losses on auto loans have started to trend higher (bottom panel). We continue to favor Aaa-rated credit cards over Aaa-rated auto loans, despite the modest spread advantage in autos (panel 3). Further, the spread advantage in Aaa consumer ABS relative to other high-quality spread product is becoming less compelling. Aaa ABS now only provide a 12 bps option-adjusted spread cushion relative to conventional 30-year Agency MBS and offer a slightly lower spread than Agency CMBS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency commercial mortgage-backed securities underperformed the duration-equivalent Treasury index by 10 basis points in March, dragging year-to-date excess returns down to +16 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 4 bps on the month, but remains below its average pre-crisis level. Commercial real estate prices are still growing strongly, and prices in both major and non-major markets have re-gained their pre-crisis peaks (Chart 10). However, lending standards are tightening and, more recently, loan demand has rolled over (panel 4). This suggests that credit risk is starting to increase in commercial real estate, as do CMBS delinquencies which have put in a bottom (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in March, bringing year-to-date excess returns up to +16 bps. The index option-adjusted spread for Agency CMBS tightened 2 bps on the month, and currently sits at 53 bps. The option-adjusted spread on Agency CMBS looks attractive compared to other high-quality spread product: Agency MBS = 36 bps, Aaa consumer ABS = 48 bps, Agency bonds = 18 bps and Supranationals = 22 bps. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.54% (Chart 11). Our 3-factor version of the model, which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.28%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we are inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.35%. 1 For further detail on the medium-term profit outlook please see The Bank Credit Analyst, February 207, dated January 26, 2017, available at bca.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 8, 2017, available at usbs.bcaresearch.com 3 A composite of 104 economic indicators designed to capture the probability of PCE inflation exceeding 2.5% during the subsequent 12 months. https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure 4 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Recommended Allocation Quarterly - April 2017 Quarterly - April 2017 The sweet spot of non-inflationary accelerating growth is likely to continue. European politics will fade as a risk, and Trump should still be able to get tax cuts through. We continue to be positive on risk assets on a one-year horizon, though returns are unlikely to be as good as in the past 12 months and there is a risk of the next recession arriving in 2019. Our portfolio tilts are generally pro-risk and pro-cyclical. We are overweight equities versus fixed income. We move overweight euro area equities, which should benefit from inexpensive valuations, higher beta and a falling political risk premium. Within fixed income, we prefer credit over government bonds, and raise high-yield debt to overweight on improved valuations. We expect the dollar to appreciate further, which makes us cautious on emerging market assets and industrial commodities. Feature Overview No Reasons To Turn Cautious Markets have paused for breath following the reflation trade that began a year ago and that was given an extra boost by the election of Donald Trump in November. Since the turn of the year, the dollar, U.S. 10-year Treasury yields, credit spreads and (to a degree) equities have all eased back a little (Chart 1). We don't think the risk-on rally is over, but the going will undoubtedly get tougher from here. The momentum of global growth cannot continue to rise at the same pace, with the Global PMI already at its highest level since 2011 (Chart 2). Global equities, therefore, are unlikely to return the 16% over the next 12 months, that they have over the past 12. Chart 1A Pause For Breath A Pause For Breath A Pause For Breath Chart 2Growth Momentum Must Slow From Here Growth Momentum Must Slow From Here Growth Momentum Must Slow From Here Nonetheless, we see nothing that is likely to stop risk assets continuing to outperform over the one-year horizon: Growth is likely to rise further. While the initial pick-up was in "soft" data such as consumer sentiment and business confidence, signs are emerging that "hard" data such as household spending and production are now also improving (Chart 3). Models developed by our colleagues on The Bank Credit Analyst indicate that real GDP growth in the U.S. this year will come in above 3% and in the euro area above 2% (Chart 4),1 compared to consensus forecasts of 2.2% and 1.6% respectively. Chart 3Hard Data Also Not Picking Up Hard Data Also Not Picking Up Hard Data Also Not Picking Up Chart 4GDP Growth Could Beat Consensus GDP Growth Could Beat Consensus GDP Growth Could Beat Consensus For now, this growth is unlikely to prove inflationary. In the U.S. the diffusion index for PCE inflation shows more prices in the basket falling than rising; in the eurozone, the rise to 2% in headline inflation in January was temporary, mainly because of higher oil prices, and core inflation remains at only 0.7%. The U.S. output gap will close soon, but the eurozone's is still deeply negative (Chart 5). We see the Fed raising rates twice more this year, in line with its dots, though it may have to accelerate the pace next year if the Trump administration succeeds in passing fiscal stimulus. The ECB, however, is unlikely to raise rates until 2019 and will taper asset purchases only slowly.2 Misplaced worries that it will tighten more quickly than this have recently dragged on European equities and strengthened the euro. We think the market is wrong to price out the probability of a tax cut in the U.S. just because of the Trump administration's failure to reform healthcare. Our Geopolitical strategists argue that Republicans in Congress (even the Freedom Caucus) are united behind the idea of cutting taxes, even if these are not funded by tax reforms or spending cuts (they can be justified on the grounds of "dynamic scoring").3 We see a cut in corporate and personal taxes passing before year-end to take effect in 2018. And Trump has not abandoned the idea of infrastructure spending. The market no longer expects any of this: the prices of stocks that would most benefit from lower corporate taxes or from government spending have reverted to their pre-election levels. European political risk is likely to wane. The market continues to worry about the possibility of Marine Le Pen winning the French Presidential election, as shown in the spread of OATs over Bunds (which has widened to 60-80 bp from 20 bp last summer). We think this very unlikely: polls show her consistently at least 20 points behind Emmanuel Macron in the second round of voting (Chart 6). While Italian politics remain a risk, the parliamentary election there is unlikely to take place until March 2018. Brexit is a threat to the U.K., but should have minimal impact on the eurozone. We retain, therefore, our pro-cyclical and pro-risk tilts on a 12-month time horizon. We have even added a little more beta to our recommended portfolio by raising high-yield bonds to overweight (since their valuations now look more attractive after a recent sell-off) and by going overweight eurozone stocks (paid for by notching down our double-overweight in U.S. stocks). The eurozone has consistently been a higher beta (Chart 7), more cyclical equity market than the U.S. and, once the political risks (at least temporarily) subside, should be able to outperform for a while. Chart 5Eurozone Output Gap Still Very Negative Eurozone Output Gap Still Very Negative Eurozone Output Gap Still Very Negative Chart 6Can Le Pen Really Win From Here? Can Le Pen Really Win From Here? Can Le Pen Really Win From Here? Chart 7Eurozone Is A High Beta Stock Market Eurozone Is A High Beta Stock Market Eurozone Is A High Beta Stock Market But we warn that the good times may not last for long. Tax cuts in the U.S. would add stimulus to an economy already at full capacity. The Fed might have to raise rates sharply next year (although the timing might depend on how President Trump tries to affect monetary policy, for example whom he appoints as Fed chair to replace Janet Yellen next February). U.S. recessions have typically come two or three years after the output gap turns positive (Chart 5). As Martin Barnes, BCA's chief economist, recently wrote,4 that may point to next recession arriving as soon as 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Chart 8Expensive, But Not At An Extreme Expensive, But Not At An Extreme Expensive, But Not At An Extreme Aren't You Worried About U.S. Equity Valuations? Valuation is a poor timing tool in the short term but, when it reaches extremes, it has historically added value. The valuation metrics we watch show that U.S. equities are expensive, but not at the extreme levels that have historically warranted an outright sell or underweight. First, according to MSCI, U.S. equities are currently trading at 24.4 times 12-month trailing earnings, and 25.7 times 10-year cyclically-adjusted earnings; both measures are about one standard deviation from their 10-year averages. Second, U.S. equities are trading at a premium to global equities, but the premium to the developed markets is in line with the 10-year average (Chart 8, panel 1), while the premium to emerging markets is about 1.5 standard deviations from the 10-year average (panel 2). Third, equities are cheap compared to fixed income: the earnings yield is still higher than the yields on both 10-year government bonds and investment grade corporate bonds, and the yield gaps are currently only slightly lower (more expensive) than their respective 10-year averages (panels 3 and 4). In the long run, the 10-year cyclically-adjusted PE (CAPE) has had relatively good forecasting power for 10 year forward returns. Currently, the regression indicates 143% (9.3% annualized) total returns over the next 10 years. This could be on the optimistic side given that we are no longer in an environment of declining bond yields and margins are elevated compared to the 1990s. That said, we have cut our U.S. equity overweight by half, partly due to valuation concerns. Is EM Debt Attractive? Chart 9Avoid EM Debt Avoid EM Debt Avoid EM Debt Emerging market debt has continued its run from last year, with sovereign and local currency debt providing YTD returns of 3% and 2% respectively. Over long periods, EM debt has displayed the ability to provide substantial returns while also providing robust diversification benefits to a 50/50 DM equity/bond portfolio, even more so than EM equities.5 However, over the cyclical horizon, we remain bearish on EM debt both in absolute terms and relative to global equities. EM fixed income markets have been able to defy deteriorating fundamentals for some time, but this is unsustainable. After years of leveraging, credit excesses will need to be unwound. Decelerating credit growth will be enough to dampen economic growth and damage emerging markets' ability to service their debt. Risks in EM sovereign debt markets are high. Historical returns have shown negative skewness and fat tails, suggesting high vulnerability to large downswings. This is particularly concerning given that yields are one standard deviation lower than their long-term average (Chart 9). While EM local currency debt is more fairly priced and has a more favorable risk/return profile than its sovereign debt counterpart, local currency debt returns are even more heavily influenced by their currencies. Above-trend growth in the U.S. leading to additional rate hikes, as well as rising U.S. bond yields and softer commodity prices will add further downward pressure to EM currencies. For EM dedicated investors, we suggest overweight positions in low beta/defensive markets. Regions that are less susceptible to currency weakness with high yields and low foreign funding requirements include Russia, India and Indonesia. How Will The Fed Shrink Its Balance Sheet, And Does It Matter? After the Fed's third rate hike, attention is turning to when it will begin to reduce its balance sheet. This has grown to $4.5 trillion, up from $900 billion before the Global Financial Crisis. Assets currently include $2.5 trillion of Treasury securities and $1.8 trillion of mortgage-related securities. Since asset purchases ended in October 2014, the Fed has rolled over maturing bonds to maintain the size of the balance sheet. The FOMC statement last December committed to maintaining this policy "until normalization of the level of the federal funds rate is well under way". The market takes this to mean 1-1.5%, a level likely to be reached by year-end. The view of BCA's fixed income team6 is that the Fed will start by ceasing reinvestment of Agency bonds and mortgage-backed securities (MBS) in 2018, at the same time reducing excess bank reserves on the liability side of the balance sheet (Chart 10). This will worry markets to a degree and the Fed will need to be careful how it communicates the policy: for example what size it thinks its balance sheet should ultimately be. It may also need to skip a rate hike or two in the first months of the shrinkage. The MBS market is likely to suffer from the increased supply. But the only historical precedent - the BoJ's unwinding of its 2000-3 QE - is reassuring: this had no discernible effect on rates or the yen (Chart 11). Chart 10Fed Will Cut MBSs First Fed Will Cut MBSs First Fed Will Cut MBSs First Chart 11Nobody Noticed The BoJ Taper Nobody Noticed The BoJ Taper Nobody Noticed The BoJ Taper When Will ECB Taper? Chart 12Recovery Not Permanent Recovery Not Permanent Recovery Not Permanent Euro area growth is recovering and headline inflation has hit the ECB's 2% target (Chart 12). Investors are wondering how rapidly the ECB will taper its asset purchases and when it will raise rates. Our view is that the ECB will move only slowly. The pickup in inflation is mostly driven by the base effect and by the rise in energy prices. The failure of core inflation, which remains below 1%, to pick up appreciably suggests that underlying price pressures are weak. The current program has the ECB purchasing EUR 60 Bn of assets each month until December 2017. Markets have recently become more hawkish with regards to the likely path of policy: currently futures are pricing in the first hike only 19 months away versus an expectations in January of 44 months. We expect the ECB to remain more dovish than that, given weak underlying inflation, political uncertainty, and banking system troubles. We think the ECB will announce around September this year a taper of its asset purchases in 2018. However, it is not clear whether it will cut them to, say EUR 30 Bn a month, or whether it will reduce the amount steadily each month or quarter. But we don't see an interest rate hike soon, since the euro area economy is not expected to reach full employment until 2019. Ewald Novotny, president of the Austrian central bank, spooked markets by suggesting a hike before complete withdrawal of asset purchases but, in our view, that would will send a confusing signal to investors. Nowotny has long been hawkish and we think his view is untypical of ECB council members. If our analysis is correct, ECB policy should be positive for euro area equities and bearish for the euro over the next 12 months. Will REIT Underperformance Continue? Chart 13Underweight REITs Underweight REITs Underweight REITs Relative REIT performance has continued its downtrend, underperforming the broad index by 5% YTD. While valuations have become more attractive and rental income is still robust, we expect the decline to continue given unsupportive macro factors. We previously argued that real estate is in a sweet spot, where economic growth was sufficient to generate sustainable tenant demand without triggering a new supply cycle.7 This is no longer the case. Office completions increased substantially over the past quarter and apartment completions remain in an uptrend. As we expect growth to remain robust in the U.S., the likelihood is that these two trends remain in place. REIT relative performance peaked at the beginning of August, shortly after long-term interest rates bottomed. REITs have historically outperformed when yields are falling and inflation is low (Chart 13). However, long-term rates should continue to rise over the cyclical horizon, primarily due to higher inflation expectations. Additionally, REITs typically benefit from increasing central bank asset purchases, as increased liquidity and lower interest rates boost real estate values. With the Fed clearly in tightening mode and the strong likelihood of ECB tapering next year, slowing asset purchases will be a considerable headwind to REIT performance. Within REITs, we maintain our sector tilts. Continue to favor Industrials, which will benefit in a rising USD environment and provide considerable income. Maintain underweight position in Apartments, due to rising completions and a low absorption ratio. Additionally, we continue to favor trophy over non-trophy markets given more stable rent growth as well as geopolitical risks in Europe and potential Washington disappointments. Global Economy Overview: The global economy has continued to recover from its intra-cycle slowdown in late 2015 and early 2016. Economic surprise indexes have everywhere surprised significantly on the upside since mid-2016 (Chart 14, panel 1). Although "hard" data (consumption, production etc.) have lagged "soft" data (consumer sentiment, business confidence), the former also have begun to recover recently. Although there are few negative indicators, it will get harder to beat expectations. U.S.: Lead indicators continue to improve, with the manufacturing ISM at 57.7 and new orders at 65.1. Sentiment quickly turned bullish after the presidential election, and hard data has now started to follow, with personal consumption expenditure rising 4.7% year on year and capital goods orders (+2.7% YoY in February) growing for the first time since 2014. With steady wage growth, continuing employment improvements, and a likely pick-up in capex, we expect 2017 GDP growth to beat the current consensus expectations of 2.2%. For now inflation remains quiescent, with core PCE inflation stuck at around 1.8%, below the Fed's 2% target. Euro Area: Leading indicators, such as PMIs, have rebounded in Europe too (Chart 15), suggesting that the consensus 2017 GDP forecast of 1.6% is achievable. Inflation has picked up, with the headline CPI 2.0% for the Eurozone in January, but core inflation remains low at 0.7% and headline fell back to 1.5% in February. However, the recent slowdown in bank loan growth (new credit creation is 36% below the level six months ago) suggests that continuing weakness in the banking sector is likely to keep growth sluggish. Chart 14How Long Can Growth Continue To Surprise? How Long Can Growth Continue To Surprise? How Long Can Growth Continue To Surprise? Chart 15A Synchronized Global Growth Rebound A Synchronized Global Growth Rebound A Synchronized Global Growth Rebound Japan is a tale of two segments. International-oriented data have recovered, with IP up 3.7% (Chart 15, panel 2) and exports +5.4% year on year. But domestic demand remains weak: wages are rising only 0.5% YoY (despite a tight labor market), which is holding back household spending (-1.2% YoY in January). Core inflation has shown the first signs of picking up, but remains very low at 0.1% YoY. Emerging Markets: The effects of China's reflationary policies from early 2016 continue to boost activity (Chart 15, panel 3). But the excess liquidity they triggered worries the authorities, who have clamped down on real estate purchases and capital outflows, slowed fiscal spending, and tightened monetary policy. China will prioritize stability until the Party Congress in the fall, but the impact of reflation on commodity prices and on other emerging markets will fade. Interest rates: The Fed is likely to hike twice more this year in line with its "dot plot", unless inflation surprises significantly to the upside. This, plus an acceleration of nominal GDP growth to 4.5-5%, should push the 10-year bond yield above 3% by year end. The ECB will not be as hawkish as the market expects (futures markets indicate a rate hike by end-2018), since Mario Draghi expects headline inflation to fall back once the oil price stabilizes and is concerned about political risk especially in Italy. Consequently, rates are unlikely to rise as quickly as in the U.S. The Bank of Japan will keep its 0% yield target for 10-year JGB for the foreseeable future. Global Equities Global equities continued to make impressive gains in Q1 2017, after a strong 2016. The price appreciation since the low in February 2016 has been driven by both multiple expansion and earnings growth, roughly in equal proportion, as shown in Chart 16, panel 1. Chart 16Earnings Improving But Valuation Stretched Earnings Improving But Valuation Stretched Earnings Improving But Valuation Stretched Equity valuation is expensive by historical standards but, as an asset class, equities are still attractively valued compared to bonds (see the "What Our Clients Are Asking" section on page 6). In this "TINA" (There Is No Alternative) world, we remain overweight equities versus bonds. Within equities, we maintain our call of favoring DM equities versus EM equities despite of the 6% EM outperformance in Q1, which was supported by attractive valuations. About half of that outperformance came from the appreciation of EM currencies versus the USD. Our house view is that the USD will strengthen further versus the EM currencies. Within EM, we have been more positive on China and remain so on a 6-9 month horizon. The only adjustment we make now is to upgrade euro area equities to overweight by reducing half of our large overweight in the U.S. so that now we are equally overweight the U.S. and euro area (see details on the next page). In terms of global sector positioning, we maintain a pro-cyclical tilt. Our largest overweight in Healthcare panned out very well in Q1 but the overweight in Energy did not, due to the drop in oil prices. Our Energy strategists believe this was caused by one-off technical factors on the supply side, and argue that the oil price will soon revert to $55 a barrel. Euro Area Equities: A Cheaper Alternative To The U.S. Political risks related to elections in some eurozone countries are receding. The ECB is likely to maintain its easy monetary policies, while the Fed is on track to normalize interest rates in the U.S. We have had a large overweight of 6 percentage points (ppts) on U.S. equities while being neutral on the euro area. We upgrade the eurozone to overweight by 3 ppts, so that we are now equally overweight the U.S. and the euro area. The following are the reasons: First, the relative performance of total returns between eurozone and the U.S. equities is at its lowest since 1987. Since April 2015, when the most recent brief period of eurozone outperformance ended, eurozone equities have underperformed the U.S. by over 16% in common currency terms (Chart 17, panel 1), while the euro lost only about 4% versus the USD over the same period. Second, eurozone equities are trading at a 22% discount to the U.S., compared to the five-year average discount of 17% (panel 3). Third, eurozone equities have lower margins than the U.S., but the profit margin in the eurozone has been improving (panel 2). Lastly, the PMIs in the euro area have been improving (panel 4) and this improvement is faster than the global aggregate PMI (panel 5), which implies - based on the close correlation between PMIs and earnings growth - that profitability in the eurozone should improve at a faster pace than the global average. Sector Allocation: We have had a relatively pro-cyclical tilt in our global sector positioning, overweight three cyclical sectors (Energy, Industrials and Info Tech) plus Healthcare, while underweight three defensive sectors (Consumer Staples, Telecoms and Utilities) as well as Consumer Discretionary. We have been neutral on Financials and Materials. After very strong performance in 2016, cyclical sectors underperformed in Q1 2017 (Chart 18, panel 1). The underperformance of cyclicals versus defensives can be largely attributed to the polar-opposite performance of Energy and Healthcare (Chart 19). Going forward, we maintain our current sector positioning for the following reasons: Chart 17Earnings Growth At Lower Valuation Earnings Growth At Lower Valuation Earnings Growth At Lower Valuation Chart 18Maintain The Cyclical Tilt Maintain The Cyclical Tilt Maintain The Cyclical Tilt Chart 19Global Sector Performance Quarterly - April 2017 Quarterly - April 2017 First, Energy was the only sector which fell in Q1, largely due to the decline in oil prices. BCA's Energy and Commodity Strategy attributes the oil price weakness to inventory buildup related to the production rush before the OPEC agreement to cut production, and therefore expects the WTI oil price to return to the $50-55 range. Energy stocks should benefit once oil prices turn back up. Chart 20Relative Factor Performance Relative Factor Performance Relative Factor Performance Second, the relative profitability between cyclicals and defensives is underpinned by global economic conditions, as represented by the global PMI. The PMI is on track to recover further, which bodes well for the profit outlook for cyclicals versus defensives. Third, our pro-cyclical tilt in sector positioning is hedged by an overweight in Healthcare (a defensive sector) and underweight in Consumer Discretionary (a cyclical). Smart Beta Update: No Style Bet Q1 2017 saw some significant performance reversals in the five most enduring factors: quality, minimum volatility, momentum, value, and size (Chart 20, panels 2-6). Quality and Momentum performed the best, outperforming the global benchmark by over 200 bps in Q1. The star performer in 2016, the Value factor, performed the worst, underperforming by 190 bps. According to the findings in our Special Report,8 recent factor performance seems to be pricing in a "Goldilocks" environment in which growth is rising and inflation falling. We have shown that it is very difficult to time the shift in factor performance cycles and so have advocated an equal weight in the five factors (Chart 20, panel 1) for long-term investors. We reiterate this view. Government Bonds Maintain slight underweight duration. Our 2-factor model made up of global PMI and U.S. dollar sentiment indicates the current fair value of the 10-year Treasury yield is 2.4% (Chart 21). While this suggests bonds are currently correctly priced, we still expect that long-term yields will rise over a cyclical horizon. The long end should grind higher given improving growth, rising equity prices and renewed "animal spirits." Additionally, large net short positions have been unwound, allowing for another leg higher in yields. Overweight TIPS vs. Treasuries. Diffusion indexes for both PCE and CPI inflation shifted into negative territory, suggesting realized inflation will soften in the near term. Nevertheless, with headline and core CPI readings of 2.7% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 22). This trend should continue as a result of cost-push inflation driven by faster wage growth. Very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Euro area growth is stable, but expectations of a rate hike from the ECB are premature (Chart 23). While the central bank opened the door slightly to a less-accommodative policy stance, it is unlikely that the ECB will hike until full employment is reached. Our expectation is for a tapering of asset purchases to occur in 2018. Once tapering is complete, rate hikes will follow by approximately 6-12 months. The implication is upward pressure on European bond yields and wider spreads for peripheral government debt. Chart 2110-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model Chart 22Inflation Has Bottomed Inflation Has Bottomed Inflation Has Bottomed Chart 23Will the ECB Hike Soon? Will the ECB Hike Soon? Will the ECB Hike Soon? Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 24). Over the last quarter, the indicator worsened, as profit margins, return-on-capital and liquidity declined. However, leverage did improve slightly. The trend toward weaker corporate health has been firmly established over the past 12 quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. The U.S. is in a self-reinforcing, low-inflation recovery. Economic growth should accelerate throughout 2017, with strong consumer spending, rising capex intentions, and still accommodative monetary policy. The potential sell-off from rate hikes this year should be fairly mild given that the market is already close to pricing in three. Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. Expect low but positive excess returns (Chart 25). Shift to overweight in high-yield debt. Our default model is showing improvement due to elevated interest coverage, a robust PMI reading, declining job cut announcements, softening lending standards and a rising sales/inventory ratio. The recent backup in yields has made junk bond valuations more attractive. The default adjusted spread, calculated by subtracting an ex-ante estimate of default losses from the average spread, is now approximately 220bps (Chart 26). Chart 24Balance Sheets Deteriorating Balance Sheets Deteriorating Balance Sheets Deteriorating Chart 25A Supportive Backdrop A Supportive Backdrop A Supportive Backdrop Chart 26High Yield: Valuations Becoming More Attractive High Yield: Valuations Becoming More Attractive High Yield: Valuations Becoming More Attractive Commodities Chart 27Upside To Resource Prices Limited Upside To Resource Prices Limited Upside To Resource Prices Limited Secular Perspective: Bearish A slowdown in Chinese activity, led by its transition to a services economy, coupled with unfavorable global demographics, will continue to constrain demand for commodities. This slack in demand coupled with excess capacity will continue to limit the upside in resource prices and prolong the commodities bear market which began in 2012 (Chart 27). Cyclical Perspective: Neutral Energy markets have moved from excess supply to excess demand, and so we remain positive on oil. But, with the impact of Chinese fiscal stimulus waning, excess supply in the metals market will persist, putting downward pressure on prices. Our divergent outlook for energy vs metals gives us an overall neutral view for commodities over the cyclical horizon. Energy: With a synchronized upturn in global growth and inflation, both OECD and non-OECD demand will remain strong. Following Saudi Arabia's production cuts, we expect the OPEC agreement to be honored by all members, including Russia. With strengthening demand and falling production, storage should draw through the year. We expect the oil-USD divergence to persist as improving fundamentals override the stronger dollar. Base Metals: With Chinese government spending slowing from 24% growth year on year in January 2016 to only 4%, the country's fiscal impulse has ended. Tightening in Chinese liquidity conditions have led to higher borrowing rates for the real estate sector, which is dampening its demand for materials. At the same time, inventories for key metals such as copper and steel have risen. We expect metals prices to correct over the coming months. Precious Metals: Gold has rallied 10% from last December, and another 4% following the Fed's March rate hike. These were responses to the dovish nature of the hike and continuing political risk. We expect the Fed to turn more hawkish in coming weeks, sending the dollar and real yields higher, thereby holding back the gold price from rising much further. Currencies Chart 28Return Of The Dollar Return Of The Dollar Return Of The Dollar USD: The last Fed meeting resulted in a dovish hike, as evidenced by the subsequent fall in the dollar. However, as the U.S. economy nears full employment, we expect a more hawkish tone from FOMC members in the coming weeks which will push the dollar up (Chart 28). The Fed continues to be data dependent, and sees the recent synchronized global upturn as an opportunity to deliver hikes in line with market expectations. Euro: As the economy stabilizes, as evidenced by rising headline inflation, stronger retail sales and improving PMI numbers, the ECB has opened the window for reducing monetary accommodation. However, since the economy is expected to reach full employment only in 2019, we expect rates to be kept low even after the tapering of ECB asset purchases starts next year. This will add further downward pressure on the euro. Yen: The Bank of Japan will continue its highly accommodative monetary policy, centered on its 0% yield target for 10-year government bonds, because Japanese growth and inflation is lagging the global upturn. Japan is benefitting from global growth, as seen in the improvement in its manufacturing PMI, but domestic demand remains weak as consumer confidence and retail sales stagnate. Continued downward pressure on relative interest rates will drive the only reliable source of inflation: a weaker yen. EM: A more hawkish Fed and rising bond yields will tighten global liquidity conditions, making it difficult for emerging nations that run current account deficits. The rising threat of protectionism could affect EM exports and create a new wave of deflationary pressure, forcing central banks to engineer currency devaluation. The fact that commodity prices have risen, yet EM currencies have remained weak, is a clear indications that EM fundamentals are weak. Alternatives Overweight private equity / underweight hedge funds. Leading indicators suggest that global growth continues to improve. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a boost to returns. Additionally, surveys suggest that managers are planning on increasing their allocation percentage toward private equity over the rest of the year. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 29). Overweight direct real estate / underweight commodity futures. Demand for commercial real estate (CRE) assets remains robust but the increase in completions is worrying. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 30). Overweight farmland & timberland / underweight structured products. The potential for trade wars, geopolitical risk in Europe and concerns over an equity market correction have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, the end of the 35-year bull market in bonds presents a substantial headwind. Structured products also tend to outperform during recessions, which is not our base case (Chart 31). Chart 29PE: Tied To Real Growth PE: Tied To Real Growth PE: Tied To Real Growth Chart 30Commodities: A Secular Bear Market Commodities: A Secular Bear Market Commodities: A Secular Bear Market Chart 31Structured Products Outperform In Recessions Structured Products Outperform In Recessions Structured Products Outperform In Recessions Risks To Our View Our pro-cyclical pro-risk tilts are based on the premise that global growth will remain strong over the next 12 months. We do not see many risks to this view: leading indicators suggest that consumption and capex are likely to continue to rebound. The one major indicator that suggests downside risk is loan growth. In the U.S., loans to firms have slowed to 5.4% from over 10% last summer, and in the euro area the meager pickup in corporate loan growth seems to have faltered (Chart 32). There may be some special factors: oil companies that borrowed in early 2016 when in difficulty no longer need to tap credit lines, and U.S. companies may be holding back to see details of tax cuts. But loan growth needs to be watched closely. More granularly, our country and sector preferences - in particular, our cautious views on Emerging Markets and industrial commodities - are based partly on the expectation that the U.S. dollar will appreciate further. If the global expansion remains highly synchronized (Chart 33) this might instigate all G7 central banks to tighten, allowing the Fed to raise rates without appreciating the dollar. However, we expect continuing divergences in growth and monetary policy to push the dollar up further. Finally, some indicators suggest that investors have become too positive on the outlook for stocks (Chart 34). Sentiment has in the past not been a reliable indicator of stock market peaks, but excess euphoria could trigger a short-term correction. Chart 32Why Is Bank Loan Growth Slowing? Why Is Bank Loan Growth Slowing? Why Is Bank Loan Growth Slowing? Chart 33Could Synchronized Growth Push Down USD? Could Synchronized Growth Push Down USD? Could Synchronized Growth Push Down USD? Chart 34Are Investors Too Euphoric? Are Investors Too Euphoric? Are Investors Too Euphoric? 1 Please see The Bank Credit Analyst, March 2017, page 33, available at bca.bcaresearch.com 2 Please see What Our Clients Are Asking: When Will The ECB Taper? on page 9 of this report for a full explanation of why we think this. 3 Please see Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was", dated March 8, 2017, available at gps.bcaresearch.com 4 Please see BCA Special Report titled "Beware The 2019 Trump Recession", dated March 7, 2017, available at bca.bcaresearch.com 5 Please see Global Asset Allocation Strategy Special Report, "EM Asset Allocation: Is There Any Reason To Own Stocks?," dated November 27, 2012, available at gaa.bcaresearch.com. 6 Please see Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet," dated February 28, 2017, available at gfis.bcaresearch.com. 7 Please see Global Asset Allocation Strategy Special Report, "REITs Vs. Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights Economic Outlook: The global economy is in a reflationary window that will stay open until mid-2018. Growth will then slow, culminating in a recession in 2019. While the recession is likely to be mild, the policy response will be dramatic. This will set the stage for a period of stagflation beginning in the early 2020s. Overall Strategy: Investors should overweight equities and high-yield credit during the next 12 months, while underweighting safe-haven government bonds and cash. However, be prepared to scale back risk next spring. Fixed Income: For now, stay underweight U.S. Treasurys within a global fixed-income portfolio; remain neutral on the euro area and the U.K.; and overweight Japan. Bonds will rally in the second half of 2018 as growth begins to slow, but then begin a protracted bear market. Equities: Favor higher-beta developed markets such as Europe and Japan relative to the U.S. in local-currency terms over the next 12 months. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is close to a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks in the middle of next year. Feature Reflation, Recession, And Then Stagflation The investment outlook over the next five years can be best described as a three-act play: First Act: "Reflation" (The present until mid-2018) Second Act: "Recession" (2019) Third Act: "Stagflation" (2021 onwards) Investors who remain a few steps ahead of the herd will prosper. All others will struggle to stay afloat. Let us lift the curtain and begin the play. Act 1: Reflation Reflation Continues If there is one chart that best encapsulates the reflation theme, Chart 1 is it. It shows the sum of the Citibank global economic and inflation surprise indices. The combined series currently stands at the highest level in the 14-year history of the survey. Consistent with the surprise indices, Goldman's global Current Activity Indicator (CAI) has risen to the strongest level in three years. The 3-month average for developed markets stands at a 6-year high (Chart 2). Chart 1The Reflation Trade In One Chart The Reflation Trade In One Chart The Reflation Trade In One Chart Chart 2Current Activity Indicators Have Perked Up Current Activity Indicators Have Perked Up Current Activity Indicators Have Perked Up What accounts for the acceleration in economic growth that began in earnest in mid-2016? A number of factors stand out: The drag on global growth from the plunge in commodity sector investment finally ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7% off the level of U.S. real GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 3). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus. The era of fiscal austerity ended. Chart 4 shows that the fiscal thrust in developed economies turned positive in 2016 for the first time since 2010. Financial conditions eased in most economies, delivering an impulse to growth that is still being felt. In the U.S., for example, junk bond yields dropped from a peak of 10.2% in February 2016 to 6.3% at present (Chart 5). A surging stock market and rising home prices also helped buoy consumer and business sentiment. Chart 3Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Chart 4The End Of Fiscal Austerity? Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 5Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Fine For Now... Looking out, global growth should stay reasonably firm over the next 12 months. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 6). The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 7 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will remain sturdy for the remainder of 2017. Chart 6Global Growth Will Stay Strong In The Near Term Global Growth Will Stay Strong In The Near Term Global Growth Will Stay Strong In The Near Term Chart 7Easing Financial Conditions Will Support Activity Easing Financial Conditions Will Support Activity Easing Financial Conditions Will Support Activity ... But Storm Clouds Are Forming Home prices cannot rise faster than rents or incomes indefinitely; nor can equity prices rise faster than earnings. Corporate spreads also cannot keep falling. As the equity and housing markets cool, and borrowing costs start climbing on the back of higher government bond yields, the tailwind from easier financial conditions will dissipate. When that happens - most likely, sometime next year - GDP growth will slow. In and of itself, somewhat weaker growth would not be much of a problem. After all, the economy is currently expanding at an above-trend pace and the Fed wants to tighten financial conditions to some extent - it would not be raising rates if it didn't! The problem is that trend growth is much lower now than in the past - only 1.8% according to the Fed's Summary of Economic Projections. Living in a world of slow trend growth could prove to be challenging. The U.S. corporate sector has been feasting on credit for the past four years (Chart 8). Household balance sheets are still in reasonably good shape, but even here, there are areas of concern. Student debt is going through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 9). Together, these two categories account for over two-thirds of non-housing related consumer liabilities. Chart 8U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit Chart 9U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem The risk is that defaults will rise if GDP growth falls below 2%, a pace that has often been described as "stall speed." This could set in motion a vicious cycle where slower growth causes firms to pare back debt, leading to even slower growth and greater pressure on corporate balance sheets - in other words, a recipe for recession. Act 2: Recession Redefining "Tight Money" "Expansions do not die of old age," Rudi Dornbusch once remarked, "They are killed by the Fed." On the face of it, this may not seem like much of a concern. If the Fed raises rates in line with the median "dot" in the Summary of Economic Projections, the funds rate will only be about 2.5% by mid-2019 (Chart 10). That may not sound like much, but keep in mind that the so-called neutral rate - the rate consistent with full employment and stable inflation - may be a lot lower now than in the past. Also keep in mind that it can take up to 18 months before the impact of tighter financial conditions take their full effect on the economy. Thus, by the time the Fed has realized that it has tightened monetary policy by too much, it may be too late. As we have argued in the past, a variety of forces have pushed down the neutral rate over time.1 For example, the amount of investment that firms need to undertake in a slow-growing economy has fallen by nearly 2% of GDP since the late-1990s (Chart 11). And getting firms to take on even this meager amount of investment may require a lower interest rate since modern production techniques rely more on human capital than physical capital. Chart 10Will The Fed's 'Gradual' Rate Hikes End Up Being Too Much? Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 11Less Investment Required Less Investment Required Less Investment Required Rising inequality has also reduced aggregate demand by shifting income towards households with high marginal propensities to save (Chart 12). This has forced central banks to lower interest rates in order to prop up spending. From this perspective, it is not too surprising that income inequality and debt levels have been positively correlated over time (Chart 13). Chart 12Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Chart 13U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP Then there is the issue of the dollar. The broad real trade-weighted dollar has appreciated by 19% since mid-2014 (Chart 14). According to the New York Fed's trade model, this has reduced the level of real GDP by nearly 2% relative to what it would have otherwise been. Standard "Taylor Rule" equations suggest that interest rates would need to fall by around 1%-to-2% in order to offset a loss of demand of this magnitude. This means that if the economy could withstand interest rates of 4% when the dollar was cheap, it can only withstand interest rates of 2%-to-3% today. And even that may be too high. Consider the message from Chart 15. It shows that real rates have been trending lower since 1980. The real funds rate averaged only 1% during the 2001-2007 business cycle, a period when demand was being buoyed by a massive, debt-fueled housing bubble; fiscal stimulus in the form of the two Bush tax cuts and the wars in Iraq and Afghanistan; a weakening dollar; and by a very benign global backdrop where emerging markets were recovering and Europe was doing well. Chart 14The Dollar Is In The Midst Of Its Third Great Bull Market The Dollar Is In The Midst Of Its Third Great Bull Market The Dollar Is In The Midst Of Its Third Great Bull Market Chart 15The Neutral Rate Has Fallen The Neutral Rate Has Fallen The Neutral Rate Has Fallen Today, the external backdrop is fragile, the dollar has been strengthening rather than weakening, and households have become more frugal (Chart 16). And while President Trump has promised plenty of fiscal largess, the reality may turn out to be a lot more sobering than the rhetoric. Chart 16Return To Thrift Return To Thrift Return To Thrift End Of The Trump Trade? Not Yet The failure to replace the Affordable Care Act has cast doubt in the eyes of many observers about the ability of Congress to pass other parts of Trump's agenda. As a consequence, the "Trump Trade" has gone into reverse over the past few weeks, pushing down the dollar and Treasury yields in the process. We agree that the "Trump Trade" will eventually fizzle out. However, this is likely to be more of a story for 2018 than this year. If anything, last week's fiasco may turn out to be a blessing in disguise for the Republicans. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play The GOP's proposed legislation would have reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. That would have warranted lower bond yields and a weaker dollar. The failure to pass an Obamacare replacement serves as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy Where the disappointment will appear is not during the legislative process, but afterwards. The highly profitable companies that will benefit the most from corporate tax cuts are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the corporate tax cuts may simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 17From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Chart 18Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 17). As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and lavish fiscal stimulus only to get neither. Euro Area: A 12-Month Window For Growth The outlook for the euro area over the next 12 months is reasonably bright, but just as in the U.S., the picture could darken later next year. Euro area private sector credit growth reached 2.5% earlier this year. This may not sound like a lot, but that is the fastest pace of growth since July 2009. A further acceleration is probable over the coming months, given rising business confidence, firm loan demand, and declining nonperforming loans. Conceptually, it is the change in credit growth that drives GDP growth. Thus, as credit growth levels off next year, the euro area's credit impulse will fall back towards zero, setting the stage for a period of slower GDP growth (Chart 18). In contrast to the U.S., the ECB is likely to resist the urge to raise the repo rate before growth slows. That's the good news. The bad news is that the market could price in some tightening in monetary policy anyway, leading to a "bund tantrum" later this year. As in the past, the ECB will be able to defuse the situation. Unfortunately, what Draghi cannot do much about is the low level of the neutral rate in the euro area. If the neutral rate is low in the U.S., it is probably even lower in the euro area, reflecting the region's worse demographics and higher debt burdens. The anti-growth features of the common currency - namely, the inability to devalue one's currency in response to an adverse economic shock, as well as the austerity bias that comes from not having a central bank that can act as a lender of last resort to solvent but illiquid governments - also imply a lower neutral rate. Chart 19Anti-Euro Sentiment Is High In Italy Anti-Euro Sentiment Is High In Italy Anti-Euro Sentiment Is High In Italy Indeed, it is entirely possible that the neutral rate is negative in the euro area, even in nominal terms. If that's the case, the ECB will find it difficult to keep inflation from falling once the economy begins to slow late next year. The U.K.: And Now The Hard Part The U.K. fared better than most pundits expected in the aftermath of the Brexit vote. Nevertheless, it would be a mistake to assume that the Brexit vote has not cast a pall over the economy. The pound has depreciated by 11% against the euro and 16% against the dollar since that fateful day, while gilt yields have fallen across the board. Had it not been for this easing in financial conditions, the economic outcome would have been far worse. As the tailwind from the pound's devaluation begins to recede next year, the U.K. economy could suffer. Slower growth in continental Europe and the rest of the world could also exacerbate matters. The severity of the slowdown will hinge on the outcome of Brexit negotiations. On the one hand, the EU has an interest in taking a hardline stance to discourage separatist forces elsewhere, particularly in Italy where pro-euro sentiment is tumbling (Chart 19). On the other hand, the EU still needs the U.K. as both a trade partner and a geopolitical ally. Investors may therefore be surprised by the relatively muted negotiations that transpire over the coming months. In fact, news reports indicate that Brussels has already offered the U.K. a three year transitional deal that will give London plenty of time to conclude a free trade agreement with the EU. In addition, the EU has dangled the carrot of revocability, suggesting that the U.K. would be welcomed back with open arms if enough British voters were to change their minds. Whatever the path, our geopolitical service believes that political risk actually bottomed with the January 17 Theresa May speech.2 If that turns out to be the case, the pound is unlikely to weaken much from current levels. China And EM: The Calm Before The Storm? The Chinese economy should continue to perform well over the coming months. The Purchasing Manager Index for manufacturing remains in expansionary territory and BCA's China Leading Economic Indicator is in a clear uptrend (Charts 20 and 21). Chart 20Bright Spots In The Chinese Economy Bright Spots In The Chinese Economy Bright Spots In The Chinese Economy Chart 21Improving LEI Points To Further Growth Acceleration Improving LEI Points To Further Growth Acceleration Improving LEI Points To Further Growth Acceleration Moreover, there has been a dramatic increase in the sales of construction equipment such as heavy trucks and excavators, with growth rates matching levels last seen during the boom years before the global financial crisis. Historically, construction machinery sales have been tightly correlated with real estate development (Chart 22). Reflecting this reflationary trend, the producer price index rose by nearly 8% year-over-year in February, a 14-point swing from the decline of 6% experienced in late-2015. Historically, rising producer prices have resulted in higher corporate profits and increased capital expenditures, especially among private enterprises (Chart 23). Chart 22An Upturn In Housing Construction? An Upturn In Housing Construction? An Upturn In Housing Construction? Chart 23Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits The key question is how long the good news will last. As in the rest of the world, our guess is that the Chinese economy will slow late next year, setting the stage for a major growth disappointment in 2019. Weaker growth abroad will be partly to blame, but domestic factors will also play a role. The Chinese housing market has been on a tear. The authorities are increasingly worried about a property bubble and have begun to tighten the screws on the sector. The full effect of these measures should become apparent sometime next year. Fiscal policy is also likely to be tightened at the margin. The IMF estimates that China benefited from a positive fiscal thrust of 2.2% of GDP between 2014 and 2016. The fiscal thrust is likely to be close to zero in 2017 and turn negative to the tune of nearly 1% of GDP in 2018 and 2019. The growth outlook for other emerging markets is likely to mirror China's. The IMF expects real GDP in emerging and developing economies to rise by 5.1% in Q4 of 2017 relative to the same quarter a year earlier, up from 4.2% in 2016 (Table 2). The biggest acceleration is expected to occur in Brazil, where the economy is projected to grow by 1.4% in 2017 after having contracted by 1.9% in 2016. Russia and India should also see better growth numbers. Table 2World Economic Outlook: Global Growth Projections Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play We do not see any major reason to challenge these numbers for this year, but think the IMF's projections will turn out to be too rosy for 2018, and especially, 2019. As BCA's Emerging Market Strategy service has documented, the lack of structural reforms in EMs over the past few years has depressed productivity growth. High debt levels also cloud the picture. Chart 24 shows that debt levels have continued to grow as a share of GDP in most emerging markets. In EMs such as China, where banks benefit from a fiscal backstop, the likelihood of a financial crisis is low. In others such as Brazil, where government finances are in precarious shape, the chances of another major crisis remains uncomfortable high. Japan: The End Of Deflation? If there is one thing investors are certain about it is that deflationary forces in Japan are here to stay. Despite a modest increase in inflation expectations since July 2016, CPI swaps are still pricing in inflation of only 0.6% over the next two decades, nowhere close to the Bank of Japan's 2% target. But could the market be wrong? We think so. Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 25). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. Over the past quarter century, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at only 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 26). Chart 24What EM Deleveraging? What EM Deleveraging? What EM Deleveraging? Chart 25Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Chart 26Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seems to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous cycle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Unfortunately, external events could conspire to sabotage Japan's escape from deflation. If the global economy slows in late-2018 - leading to a recession in 2019 - Japan will be hard hit, given the highly cyclical nature of its economy. And this could cause Japanese policymakers to throw the proverbial kitchen sink at the problem, including doing something that they have so far resisted: introducing a "helicopter money" financed fiscal stimulus program. Against the backdrop of weak potential GDP growth and a shrinking reservoir of domestic savings, the government may get a lot more inflation than it bargained for. Act 3: Stagflation Who Remembers The 70s Anymore? By historical standards, the 2019 recession will be a mild one for most countries, especially in the developed world. This is simply because the excesses that preceded the subprime crisis in 2007 and, to a lesser extent the tech bust in 2000, are likely to be less severe going into the next global downturn than they were back then. The policy response may turn out to be anything but mild, however. Memories of the Great Recession are still very much vivid in most peoples' minds. No one wants to live through that again. In contrast, memories of the inflationary 1970s are fading. A recent NBER paper documented that age plays a big role in determining whether central bankers turn out to be dovish or hawkish.3 Those who experienced stagflation in the 1970s as adults are much more likely to express a hawkish bias than those who were still in their diapers back then. The implication is the future generation of central bankers is likely to see the world through more dovish eyes than their predecessors. Even if one takes the generational mix out of the equation, there are good reasons to aim for higher inflation in today's environment. For one thing, debt is high. The simplest way to reduce real debt burdens is by letting inflation accelerate. In addition, the zero bound is less likely to be a problem if inflation were higher. After all, if inflation were running at 1% going into a recession, real rates would not be able to fall much below -1%. But if inflation were running at 3%, real rates could fall to as low as -3%. The Politics Of Inflation Political developments will also facilitate the transition to higher inflation. In the U.S., the presidential election campaign will start coming into focus in 2019. If the economy enters a recession then, Donald Trump will go ballistic. The infrastructure program that Republicans in Congress are downplaying now will be greatly expanded. Gold-plated hotels and casinos will be built across the country. Of course, several years could pass between when an infrastructure bill is passed and when most new projects break ground. By that time, the economy will already be recovering. This will help fuel inflation. As the economy turns down in 2019, the Fed will also be forced to play ball. The market's current obsession over whether President Trump wants a "dove" or a "hawk" as Fed chair misses the point. He wants neither. He wants someone who will do what they are told. This means that the next Fed chair will likely be a "really smart" business executive with little-to-no-experience in central banking and even less interest in maintaining the Federal Reserve's institutional independence. The empirical evidence strongly suggests that inflation tends to be higher in countries that lack independent central banks (Chart 27). This may be the fate of the U.S. Chart 27Inflation Higher In Countries Lacking Independent Central Banks Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Europe's Populists: Down But Not Out Whether something similar happens in Europe will also depend on political developments. For the next 18 months at least, the populists will be held at bay (Chart 28). Le Pen currently trails Macron by 24 percentage points in a head-to-head contest. It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. In Germany, support for the europhile Social Democratic Party is soaring, as is support for the common currency itself. For the time being, euro area risk assets will be able to climb the proverbial political "wall of worry." However, if the European economy turns down in 2019, all this may change. Chart 29 shows the strong correlation between unemployment rates in various French départements and support for Marine Le Pen's National Front. Should French unemployment rise, her support will rise as well. The same goes for other European countries. Chart 28France And Germany: Populists Held At Bay For Now France And Germany: Populists Held At Bay For Now France And Germany: Populists Held At Bay For Now Chart 29Higher Unemployment Would Benefit Le Pen Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Meanwhile, there is a high probability that the migrant crisis will intensify at some point over the next few years. Several large states neighboring Europe are barely holding together - Egypt being a prime example - and could erupt at any time. Furthermore, demographic trends in Africa portend that the supply of migrants will only increase. In 2005, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2015 revision, the UN doubled its estimate to 4 billion. And even that may be too conservative because it assumes that the average number of births per woman falls from 5.1 to 2.2 over this period (Chart 30). Chart 30Population Pressures In Africa Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play The existing European political order is not well equipped to deal with large-scale migration, as the hapless reaction to the Syrian refugee crisis demonstrates. This implies that an increasing share of the public may seek out a "new order" that is more attuned to their preferences. European history is fraught with regime shifts, and we may see yet another one in the 2020s. The eventual success of anti-establishment politicians on both sides of the Atlantic suggests that open border immigration policies and free trade - the two central features of globalization - will come under attack. Consequently, an inherently deflationary force, globalization, will give way to an inherently inflationary one: populism. The Productivity Curse Just as the "flation" part of stagflation will become more noticeable as the global economy emerges from the 2019 recession, so will the "stag." Chart 31 shows that productivity growth has fallen across almost all countries and regions. There is little compelling evidence that measurement error explains the productivity slowdown.4 Cyclical factors have played some role. Weak investment spending has curtailed the growth in the capital stock. This means that today's workers have not benefited from the same improvement in the quality and quantity of capital as they did in previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. Most prominently, the gains from the IT revolution have leveled off. Recent innovations have focused more on consumers than on businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. Human capital accumulation has also decelerated, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart 32). Educational achievement, as measured by standardized test scores in mathematics, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart 33).5 Given that test scores are extremely low in most countries with rapidly growing populations, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart 31Productivity Growth Has Slowed In Most Major Economies Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 32The Contribution To Growth From Rising Human Capital Is Falling Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 33Math Skills Around The World Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Productivity And Inflation The slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on (Chart 34). Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Chart 34A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation.6 One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a decade during which productivity growth slowed and inflation accelerated. Financial Markets Overall Strategy Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors with a 12-month horizon should stay overweight global equities and high-yield credit at the expense of government bonds and cash. Global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months, followed by a gradual recovery that sees the restoration of full employment in most countries by 2021. At that point, inflation will take off, rising to over 4% by the middle of the decade. The 2020s will be remembered as a decade of intense pain for bond investors. In relative terms, equities will fare better than bonds, but in absolute terms they will struggle to generate a positive real return. As in the 1970s, gold will be the standout winner. Chart 35 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 35Market Outlook For Major Asset Classes Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Equities Cyclically Favor The Euro Area And Japan Over The U.S. Stronger global growth is powering an acceleration in corporate earnings. Global EPS is expected to expand by 12% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 36 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. We prefer euro area and Japanese stocks relative to U.S. equities over a 12-month horizon. We would only buy Japanese stocks on a currency-hedged basis, as the prospect of a weaker yen is the main reason for being overweight Japan. In contrast, we would still buy euro area equities on a U.S. dollar basis, even though our central forecast is for the euro to weaken against the dollar over the next 12 months. Our cyclically bullish view on euro area equities reflects several considerations. For starters, they are cheap. Euro area stocks currently trade at a Shiller PE ratio of only 17, compared with 29 for the U.S. (Chart 37). Some of this valuation gap can be explained by different sector weights across the two regions. However, even if one controls for this factor, as well as the fact that euro area stocks have historically traded at a discount to the U.S., the euro area still comes out as being roughly one standard deviation cheap compared with the U.S. (Chart 38). Chart 36Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Chart 37Euro Area Stocks Are A Bargain... Euro Area Stocks Are A Bargain... Euro Area Stocks Are A Bargain... Chart 38...No Matter How You Look At It ...No Matter How You Look At It ...No Matter How You Look At It European Banks Are In A Cyclical Sweet Spot Of course, if euro area banks flounder over the next 12 months as they have for much of the past decade, none of this will matter. However, we think that the region's banks have finally turned the corner. The ECB is slowly unwinding its emergency measures and core European bond yields have risen since last summer. This has led to a steeper yield curve, helping to flatter net interest margins. Chart 39 shows that the relative performance of European banks is almost perfectly correlated with the level of German bund yields. Our European Corporate Health Monitor remains in improving territory, in contrast to the U.S., where it has been deteriorating since 2013 (Chart 40). Profit margins in Europe have room to expand, whereas in the U.S. they have already maxed out. The capital positions of European banks have also improved greatly since the euro crisis. Not all banks are out of the woods, but with nonperforming loans trending lower, the need for costly equity dilution has dissipated (Chart 41). Meanwhile, euro area credit growth is accelerating and loan demand continues to expand. Chart 39Performance Of European Banks And Bond Yields: A Good Fit Performance Of European Banks And Bond Yields: A Good Fit Performance Of European Banks And Bond Yields: A Good Fit Chart 40Corporations Healthier In The Euro Area Corporations Healthier In The Euro Area Corporations Healthier In The Euro Area Chart 41Cyclical Background Positive For Bank Stocks Cyclical Background Positive For Bank Stocks Cyclical Background Positive For Bank Stocks Beyond a 12-month horizon, the outlook for euro area banks and the broader stock market look less enticing. The region will suffer along with the rest of the world in 2019. The eventual triumph of populist governments could even lead to the dissolution of the common currency. This means that euro area stocks should be rented, not owned. The same goes for U.K. equities. EM: Uphill Climb Emerging market equities tend to perform well when global growth is strong. Thus, it would not be surprising if EM equities continue to march higher over the next 12 months. However, the structural problems plaguing emerging markets that we discussed earlier in this report will continue to cast a pall over the sector. Our EM strategists favor China, Taiwan, Korea, India, Thailand, Poland, Hungary, the Czech Republic, and Russia. They are neutral on Singapore, the Philippines, Hong Kong, Chile, Mexico, Colombia, and South Africa; and are underweight Indonesia, Malaysia, Brazil, Peru, and Turkey. Fixed Income Global Bond Yields To Rise Further We put out a note on July 5th entitled "The End Of The 35-Year Bond Bull Market" recommending that clients go structurally underweight safe-haven government bonds.7 As luck would have it, we penned this report on the very same day that the 10-year Treasury yield hit a record closing low of 1.37%. We continue to think that asset allocators should maintain an underweight position in global bonds over the next 12 months. In relative terms, we favor Japan over the U.S. and have a neutral recommendation on the euro area and the U.K. Chart 42The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months Underweight The U.S. For Now We expect the U.S. 10-year Treasury yield to rise to around 3.2% over the next 12 months. The Fed is likely to raise rates by a further 100 basis points over this period, about 50 bps more than the 12-month discounter is currently pricing in (Chart 42). In addition, the Fed will announce later this year or in early 2018 that it will allow the assets on its balance sheet to run off as they mature. This could push up the term premium, giving long Treasury yields a further boost. Thus, for now, investors should underweight Treasurys on a currency-hedged basis within a fixed-income portfolio. The cyclical peak for both Treasury yields and the dollar should occur in mid-2018. Slowing growth in the second half of that year and a recession in 2019 will push the 10-year Treasury yield back towards 2%. After that, bond yields will grind higher again, with the pace accelerating in the early 2020s as the stagflationary forces described above gather steam. Neutral On Europe, Overweight Japan Yields in the euro area will follow the general contours of the U.S., but with several important qualifications. The ECB is likely to roll back some of its emergency measures over the next 12 months, including suspending the Targeted Longer-Term Refinancing Operations, or TLTROs. It could also raise the deposit rate slightly, which is currently stuck in negative territory. However, in contrast to the Fed, the ECB is unlikely to hike its key policy rate, the repo rate. And while the ECB will "taper" asset purchases, it will not take any steps to shrink the size of its balance sheet. As such, fixed-income investors should maintain a benchmark allocation to euro area bonds. Chart 43A Bit More Juice Left A Bit More Juice Left A Bit More Juice Left A benchmark weighting to gilts is also warranted. With the Brexit negotiations hanging in the air, it is doubtful that the Bank of England would want to hike rates anytime soon. On the flipside, rising inflation - though largely a function of a weak currency - will make it difficult for the BoE to increase asset purchases or take other steps to ease monetary policy. We would recommend a currency-hedged overweight position in JGBs. The Bank of Japan is committed to keeping the 10-year yield pinned to zero. Given that neither actual inflation nor inflation expectations are anywhere close to that level, it is highly unlikely that the BoJ will jettison its yield-targeting regime anytime soon. With government bond yields elsewhere likely to grind higher, this makes JGBs the winner by default. High-Yield Credit: Still A Bit Of Juice Left The fact that the world's most attractive government bond market by our rankings - Japan - is offering a yield of zero speaks volumes. As long as global growth stays strong and corporate default risk remains subdued, investors will maintain their love affair with high-yield credit. Thus, while credit spreads have fallen dramatically, they could still fall further (Chart 43). Only when corporate stress begins to boil over in late 2018 will things change. Nevertheless, investors will continue to face headwinds from rising risk-free yields in most economies even in the near term. This implies that the return from junk bonds in absolute terms will fall short of what is delivered by equities over the next 12 months. Currencies And Commodities Chart 44Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Will Support The Greenback We expect the real trade-weighted dollar to appreciate by about 10% over the next 12 months. Historically, changes in real interest rate differentials have been the dominant driver of currency movements in developed economies. The past few years have been no different. Chart 44 shows that the ascent of the trade-weighted dollar since mid-2014 has been almost perfectly matched by an increase in U.S. real rates relative to those abroad. Interest rate differentials between the U.S. and its trading partners are likely to widen further through to the middle of 2018 as the Fed raises rates more quickly than current market expectations imply, while other central banks continue to stand pat. Accordingly, we would fade the recent dollar weakness. As we discussed in "The Fed's Unhike," the March FOMC statement was not as dovish as it might have appeared at first glance.8 Given that monetary conditions eased in the aftermath of the Fed meeting - exactly the opposite of what the Fed was trying to achieve - it is likely that the FOMC's rhetoric will turn more hawkish in the coming weeks. The Yen Has The Most Downside, The Pound The Least Among the major dollar crosses, we see the most downside for the yen over the next 12 months. The Bank of Japan will continue to keep JGB yields anchored at zero. As yields elsewhere rise, investors will shift their money out of Japan, causing the yen to weaken. Only once the global economy begins to teeter into recession late next year will the yen - traditionally, a "risk off" currency - begin to rebound. The euro will also weaken against the dollar over the next 12 months, although not as much as the yen. The ECB's "months to hike" has plummeted from nearly 60 last summer to 26 today (Chart 45). That seems too extreme. Core inflation in the euro area is well below U.S. levels, even if one adjusts for measurement differences between the two regions (Chart 46). The neutral rate is also lower in the euro area, as discussed previously. This sharply limits the ability of the ECB to raise rates. Chart 45Market's Hawkish View Of The ECB Is Too Extreme Market's Hawkish View Of The ECB Is Too Extreme Market's Hawkish View Of The ECB Is Too Extreme Chart 46Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Unlike most currencies, sterling should be able to hold its ground against the dollar over the next 12 months. The pound is very cheap by most metrics (Chart 47). The prospect of contentious negotiations over Brexit with the EU is already in the price. What may not be in the price is the possibility that the U.K. will move quickly to reach a deal with the EU. If such a deal fails to live up to the promises made by the Brexit campaign - a near certainty in our view - a new referendum may need to be scheduled. A new vote could yield a much different result than the first one. If the market begins to sniff out such an outcome, the pound could strengthen well before the dust settles. EM And Commodity Currencies The RMB will weaken modestly against the dollar over the coming year. As we have discussed in the past, China's high saving rate will keep the pressure on the government to try to export excess production abroad by running a large current account surplus. This requires a weak currency.9 Nevertheless, a major devaluation of the RMB is not in the cards. Much of the capital flight that China has experienced recently has been driven by an unwinding of the hot money flows that entered the country over the preceding years. Despite all the talk about a credit bubble, Chinese external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 48). At this point, most of the hot money has fled the country. This suggests that the pace of capital outflows will subside. Chart 47Pound: Cheap By All Accounts Pound: Cheap By All Accounts Pound: Cheap By All Accounts Chart 48Hot Money In, Hot Money Out Hot Money In, Hot Money Out Hot Money In, Hot Money Out A somewhat weaker RMB could dampen demand for base and bulk metals. A slowdown in Chinese construction activity next year could also put added pressure on metals prices. Our EM strategists are especially bearish on the South African rand, Brazilian real, Colombian peso, Turkish lira, Malaysian ringgit, and Indonesian rupiah. Crude should outperform metals over the next 12 months. This will benefit the Canadian dollar and other oil-sensitive currencies. However, Canada's housing bubble is getting out of hand and could boil over if domestic borrowing costs climb in line with rising long-term global bond yields. A sagging property sector will limit the ability of the Bank of Canada to raise short-term rates. On balance, we see modest downside for the CAD/USD over the coming year. The Aussie dollar will suffer even more, given the country's own housing excesses and its export sector's high sensitivity to metal prices. Finally, a few words on the most of ancient of all currencies: gold. We do not expect bullion to fare well over the next 12 months. A stronger dollar and rising bond yields are both bad news for the yellow metal. However, once central banks start slashing rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?" dated January 25, 2017, and Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 3 Ulrike Malmendier, Stefan Nagel, and Zhen Yan, "The Making Of Hawks And Doves: Inflation Experiences On The FOMC," NBER Working Paper No. 23228 (March 2017). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education And Growth In The 21st Century," dated February 24, 2011, available at bca.bcaresearch.com. 6 Note to economists: We can think of this relationship within the context of the Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. In the standard setup where the saving rate is fixed, slower population and productivity growth will always result in a lower equilibrium real interest rate. However, consider a more realistic setup where: 1) the saving rate rises initially as the population ages, but then begins to decline as a larger share of the workforce enters retirement; and 2) habit persistence affects consumer spending, so that households react to slower real wage growth by saving less rather than cutting back on consumption. In that sort of environment, the neutral rate could initially fall, but then begin to rise. If the central bank reacts slowly to changes in the neutral rate, or monetary policy is otherwise constrained by the zero bound on interest rates and/or political considerations, the initial effect of slower trend GDP growth will be deflationary while the longer-term outcome will be inflationary. 7 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "The Fed's Unhike," dated March 16, 2017, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Spread Product: Any near-term correction in risk assets is likely to be fleeting. Investors should take the opportunity to increase credit exposure and maintain overweight spread product allocations on a 6-12 month horizon. Duration: Our 2-factor Global PMI model pegs fair value for the 10-year Treasury yield at 2.54%. Economy: U.S. economic growth will remain solidly above-trend this year, helped along by renewed strength in both residential and non-residential investment. Above-trend growth will ensure that inflation remains in its current gradual uptrend. Feature Chart 1Back Above 400 bps Back Above 400 bps Back Above 400 bps The reflation trade has come under question during the past couple of weeks. The S&P 500 is 1.7% off its recent high, the VIX has bounced and the average spread on the Bloomberg Barclays High-Yield index is back above 400 basis points (Chart 1). After such a move, it is reasonable to ask if the economic landscape has changed enough to warrant a reversal of our current overweight spread product allocation. We think not, and we advise investors to buy the dips, adding credit risk to their portfolios from more attractive levels. This week we examine why risk assets are vulnerable to a near-term correction, but also why these corrections are likely to be short lived. On a 6-12 month investment horizon we continue to recommend a pro-risk portfolio characterized by: below-benchmark duration, overweight spread product, curve steepeners and TIPS breakeven wideners. Three Catalysts For A Near-Term Sell Off... Three main factors suggest that risk assets might continue to correct in the near-term. The first is that Fed rate hike expectations might be increasing too quickly. Chart 2 shows the fed funds rate that is priced into the overnight index swap curve for the end of this year. The lower dashed horizontal line is the level consistent with one more rate hike between now and the end of the year. The higher dashed horizontal line is the level consistent with two more rate hikes between now and the end of the year. We see that risk assets were able to handle the shift in rate expectations up to the lower dashed line with no trouble. The yield curve steepened and the cost of inflation compensation rose (Chart 2, bottom panel). But now, as rate expectations approach the higher dashed line, the reflation trade is starting to fray. The yield curve has started to flatten and TIPS breakevens are rolling over. A second reason why risk assets might sell-off in the near-term is the still elevated level of economic policy uncertainty (Chart 3, top panel). Last Friday, markets hung on every word related to the likelihood of a new healthcare bill being passed. Now that the bill has failed, attention will turn quickly to tax reform. It is very likely that risk assets will suffer if it appears as though tax reform will be delayed or scrapped altogether. Importantly, it is the opinion of our Geopolitical Strategy service that tax reform will be passed before the end of the year.1 Chart 2How Much Hawkishness Can Markets Take? How Much Hawkishness Can Markets Take? How Much Hawkishness Can Markets Take? Chart 3Correction Catalysts? Correction Catalysts? Correction Catalysts? A third reason why risk assets are vulnerable to a near-term correction is that investors have bought into the reflation trade, and sentiment is extremely bullish (Chart 3, bottom panel). Surveys of investors conducted by Yale University show that 99% of investors expect the Dow to increase during the coming year, while simultaneously only 47% of investors characterize the stock market as "not too high" relative to its fundamental value. The divergence in itself suggests that the equity rally is built on a shaky foundation. It seems likely that either confidence needs to wane or valuations need to correct for the rally to be prolonged. ...But The Fed Cycle Trumps Them All In previous reports2 we outlined the four phases of the Fed Cycle (see Box), and observed that in all likelihood we are currently in Phase I. Box: The Four Phases Of The Fed Cycle Chart 4Stylized Fed Cycle Keep Buying Dips Keep Buying Dips The four phases of the Fed Cycle are illustrated in Chart 4 and defined as follows: Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium (or neutral) level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. In Phase I, the Fed has begun to remove monetary accommodation but still needs inflation to rise back to target. In other words, if risk assets sell off and financial conditions start to tighten the Fed will adopt a more dovish policy stance to ensure that the recovery persists and inflation continues to trend higher. We note that core PCE inflation is running at 1.74% year-over-year, still below the Fed's 2% target. Further, the St. Louis Fed Price Pressures Measure3 is signaling only a 19% chance that PCE inflation will exceed 2.5% during the next twelve months, and market-based measures of inflation compensation are well below levels that are consistent with the Fed's inflation target (Chart 5). Chart 5Fed Still Needs Higher Inflation Fed Still Needs Higher Inflation Fed Still Needs Higher Inflation In this environment, if risk assets sell off because of overly aggressive rate hike expectations, fiscal policy disappointments or over-extended sentiment, the Fed will quickly adopt a more dovish policy stance, lending support to the reflation trade. Of course, if any of the catalysts for the market correction also cause a severe contraction in economic growth, then the reflation trade would face a more lasting setback. However, none of the three reasons for a market correction listed above seem likely to have significant pass-through effects on the economy. Even if fiscal stimulus turns out to be much less than was previously anticipated, there appears to be sufficient momentum in economic growth to maintain inflation on its upward trajectory (see section titled "Above-Trend Growth: Aided By Housing & Capex" below). It follows from this analysis of the Fed Cycle that a strategy of "buying the dips" should work whenever we are in an environment where the Fed needs inflation to move higher. It is only when inflation is more firmly anchored around the Fed's target that the Fed will be less willing to support markets, making a "buy the dips" strategy less effective. To test this theory, we devised a trading rule for high-yield bonds where we buy the High-Yield index whenever spreads widen by 20 bps or more during a month. We then hold that position for a period ranging from 1 to 3 months and calculate excess returns relative to duration-matched Treasuries during that period. Our goal is to see if the effectiveness of this "buy the dips" strategy differs depending on the stage of the Fed Cycle. For this test we define the stages of the Fed Cycle using the aforementioned St. Louis Fed Price Pressures Measure, which we split into four ranges: 0% to 15%: An environment of very limited inflation pressure most consistent with Phase IV of the Fed Cycle. 15% to 30%: Still muted inflation pressures. Roughly consistent with Phase I of the Fed Cycle. 30% to 50%: Rising inflation pressures, but still less than a 50% chance that PCE will exceed 2.5% in the coming 12 months. This likely coincides with some Phase I periods and some Phase II periods of the Fed Cycle. 50% to 70%: Strong inflation pressures, and a good chance of inflation overshooting the Fed's target. Most likely coincides with Phase II or Phase III of the Fed Cycle. We indeed find that a "buy the dips" strategy is more effective when inflation pressures are lower (Table 1). A strategy of buying the junk index after spreads widen by at least 20 bps and holding it for three months produces positive excess returns 65% of the time when the St. Louis Fed Price Pressures Measure is between 0% and 15%. This same strategy works 59% of the time when the Price Pressures Measure is between 15% and 30%, 44% of the time when the Measure is between 30% and 50% and only 25% of the time when the Measure is between 50% and 70%. Table 1High-Yield Corporate Bond Returns* Achieved By Holding The Junk Index Following ##br##A 20 BPs Widening In High-Yield Corporate OAS** Under Different Ranges##br## Of The St. Louis Fed Price Pressure Measure*** (February 1994 To Present) Keep Buying Dips Keep Buying Dips With the Price Pressures Measure at only 19% currently, we advise investors to increase exposure to spread product on any near-term correction. Bottom Line: Any near-term correction in risk assets is likely to be fleeting. Investors should take the opportunity to increase credit exposure and maintain overweight spread product allocations on a 6-12 month horizon. Above-Trend Growth: Aided By Housing & Capex For the analysis of the Fed cycle performed above to be applicable, we must have confidence in the view that GDP will continue to grow at an above-trend pace. That is, growth must at least be strong enough to remove slack from the labor market and cause inflation to trend gradually higher. This has mostly been the case since measures of core inflation bottomed in early 2015 and we see no evidence at the moment to suggest it is about to change. In fact, measures of global growth most relevant for Treasury yields have hooked up strongly in recent months, and our model now suggests that fair value for the 10-year U.S. Treasury yield is 2.54% (Chart 6). At the time of publication the 10-year yield was 2.40%. The fair value reading from our model moved higher during the past month even though PMIs in both the U.S. and Japan ticked down. This negative move was offset by an acceleration in Eurozone PMI and a decline in bullish sentiment toward the dollar (Chart 6, bottom two panels). Less bullish dollar sentiment is a signal that the global recovery is becoming more synchronized which means that U.S. Treasury yields must rise more quickly for a given level of global growth.4 Returning to the U.S. growth outlook specifically, a recent BCA Special Report 5 showed that cyclical spending as a percent of overall GDP is an excellent leading indicator of economic downturns (Chart 7). Cyclical spending has been relatively firm as a percent of GDP during the past couple of years, and would have been stronger if not for stagnant residential investment (Chart 7, panel 3) and contracting non-residential investment in equipment & software (Chart 7, bottom panel). However, leading indicators suggest that both of these factors should shift from being sources of disappointment to sources of strength in the coming months. Chart 610-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model Chart 7Cyclical Spending Is Firm... Cyclical Spending Is Firm... Cyclical Spending Is Firm... Chart 8 shows the year-over-year change in each of the three cyclical components of GDP as a percent of overall growth alongside a reliable leading indicator. Consumer confidence suggests that consumer spending on durables will remain firm (Chart 8, panel 1). Our composite indicator of New Orders surveys also points to a rebound in nonresidential investment on equipment & software (Chart 8, panel 2). In prior reports we observed that nonresidential investment was held back by the 2014 oil price shock and should recover now that oil prices have found a floor.6 Also, any potential benefit from a more favorable tax and regulatory environment under the new federal government would only increase the upside for capex. Residential investment as a percent of GDP also rolled over last year, but homebuilder confidence has been trending sharply higher during the past few months (Chart 8, bottom panel). Home construction will be strong this year, despite the recent increase in mortgage rates. As was recently observed by our U.S. Investment Strategy service,7 the constraint on housing demand since the financial crisis has not come from un-affordable monthly mortgage payments. In fact, we calculate that even if mortgage rates rise by another 200 bps from current levels, the mortgage payment as a percent of income for the median household would still be below its long-run average (Chart 9). Chart 8...And Likely To Increase ...And Likely To Increase ...And Likely To Increase Chart 9Higher Rates Won't Kill Housing Higher Rates Won't Kill Housing Higher Rates Won't Kill Housing Rather, the constraint on housing demand has come from insufficient savings on the part of potential first time homebuyers relative to required down payments. This constraint can only subside as household savings increase and mortgage lending standards ease, two trends that are ongoing. Finally, housing supply is approaching historically low levels relative to demand (Chart 9, bottom panel) even including the "shadow inventory" from foreclosed properties which has now mostly vanished in any case. With supply at such depressed levels and demand likely to remain firm, it is no wonder that homebuilders are feeling more confident. Bottom Line: U.S. economic growth will remain solidly above-trend this year, helped along by renewed strength in both residential and non-residential investment. Above-trend growth will ensure that inflation remains in its current gradual uptrend. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was", dated March 8, 2017, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 3 A composite of 104 economic indicators designed to capture the probability of PCE inflation exceeding 2.5% during the subsequent 12 month period. https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure 4 A more detailed explanation of the inverse relationship between dollar sentiment and Treasury yields can be found in the U.S. Bond Strategy Weekly Report, "Dollar Watching: Another Update", dated January 31, 2017, available at usbs.bcaresearch.com 5 Please see BCA Special Report, "Beware The 2019 Trump Recession", dated March 7, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Investment Strategy Special Report, "U.S. Housing: What Comes Next?", dated March 27, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The years since the 2008 Global Financial Crisis have been dominated by the major central banks emptying their toolkits to fight off deflationary pressures and sustain even modest nominal growth rates. Extraordinary policy measues like quantitative easing, negative interest rates and "forward guidance" were all intended to be signals to expect nothing but stimulative monetary policy, even if there were brief pickups in growth or realized inflation rates. This helped suppress both bond yields and volatility, forcing investors to take on more risk to generate acceptable returns in fixed income markets. Now, however, there are signs that the world economy may finally be becoming a bit more "normal" after the years of malaise. While growth can hardly be described as booming, there are a growing number of countries that appear to have passed the worst phase of the excess capacity/deflation pressures that dominated the post-crisis era. This is creating more two-way risk with regards to central bank decisions than we have seen for some time. In this Special Report, we update one of our favorite tools to assess the potential for monetary policy changes, the BCA Central Bank Monitors. We present them in a chartbook format with a focus on the relationship to government bond yields. Feature An Overview Of The BCA Central Bank Monitors The BCA Central Bank Monitors are composite indicators that are designed to measure the cyclical growth and inflation pressures that can influence future central bank policy decisions. We created Monitors for the major developed economies: the U.S., Euro Area, Japan, the U.K., Australia, Canada and New Zealand. The list of data series used to construct the Monitors is not the same for each country, but the components generally measure the same things (i.e. manufacturing cycles, domestic demand pressures, commodity prices, labor market conditions, exchange rates, etc) Right now, the Monitors are rising in a coordinated fashion for the first time since 2011 (Chart 1 on Page 1). What is different in 2017 is that there is much less spare capacity in the developed economies than there was six years ago. For central bankers who still adhere to the Phillips curve tradeoff of unemployment versus inflation, tight labor markets alongside highly accommodative policy settings pose a problem. In the rest of this report, we show the individual Central Bank Monitors, along with measures of spare capacity and inflation for each country. We also show the correlations between the Monitors and changes in government bond yields, both before and after the 2008 Crisis. Correlations have shifted in the post-crisis era, but there are still some reliable relationships that can provide signals for bond investors. The broad conclusions: Japanese Government Bonds (JGBs) are the ideal country overweight in a world where all other developed economy central banks are witnessing rising cyclical pressures, while bonds in the U.K., Australia and New Zealand are likely to struggle as central banks in those regions become increasingly hawkish (Chart 2). Chart 1More Central Banks Are Under Pressure To Tighten More Central Banks Are Under Pressure To Tighten More Central Banks Are Under Pressure To Tighten Chart 2Tightening Pressures (Ex-Japan) ##br##Can Push Bond Yields Higher Tightening Pressures (ex-Japan) Can Push Bond Yields Higher Tightening Pressures (ex-Japan) Can Push Bond Yields Higher The Fed Monitor Is Pointing To Additional U.S. Rate Hikes Our Fed Monitor has just recently pushed above the zero line, indicating the need for the Fed to tighten policy (Chart 3A). The Fed already began raising the funds rate back in late 2015, but this was the beginning of normalizing the crisis-era policy settings rather than a move to offset improving U.S. cyclical conditions. The latter is now indeed happening, and it is perhaps no surprise that the Fed has just delivered 50bps of rate hikes in a span of three months. Chart 3AU.S.: Fed Monitor U.S.: Fed Monitor U.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. No Spare Capacity In The U.S. No Spare Capacity In The U.S. Chart 3CThe Fed Monitor Is Most Correlated To ##br##Shorter Maturity U.S. Treasuries The Fed Monitor Is Most Correlated To Shorter Maturity U.S. Treasuries The Fed Monitor Is Most Correlated To Shorter Maturity U.S. Treasuries We still see the Fed pursuing a relatively gradual process of raising rates further in 2017, but in line with the current FOMC projections of another 50bps of tightening before year-end. Measures like the output gap and the unemployment gap (unemployment relative to the level consistent with stable inflation) show no spare capacity in the U.S. economy (Chart 3B). At the same time, core inflation continues to only grind higher and inflation expectations are also drifting up towards the Fed's 2% target. This can hardly be qualified as an "overheating" economy that needs a sharp tightening of monetary conditions, particularly with the still-expensive U.S. dollar not providing any stimulus. The correlations between our Fed Monitor and the year-over-year changes in U.S. Treasury yields (Chart 3C) have been extremely low since the 2008 Crisis - unsurprising with the Fed keeping the funds rate near zero for most of that period while also buying large amounts of Treasuries. While the correlations appear to be shifting on the margin, we still see the Treasury curve steepening first (via rising inflation expectations), then flattening later (through tighter monetary conditions). BoE Monitor Calling For Tighter U.K. Policy Our Bank of England (BoE) Monitor is at very elevated levels (Chart 4A), driven by a combination of improving production data and high inflation. There is much more bubbling beneath the surface, however. The more domestically-focused components of the Monitor are losing some upward momentum, while the inflation elements are also starting to top out as the big post-Brexit depreciation of the Pound is losing momentum. Chart 4AU.K.: BoE Monitor U.K.: BoE Monitor U.K.: BoE Monitor Chart 4BTight Capacity In The U.K. Tight Capacity In The U.K. Tight Capacity In The U.K. Chart 4CGilts Are At Risk From A More Hawkish Turn From The BoE Gilts Are At Risk From A More Hawkish Turn From The BoE Gilts Are At Risk From A More Hawkish Turn From The BoE This is creating a dilemma for the BoE - respond to high U.K. inflation with tighter monetary policy, or focus on the slowdown in domestic demand and do nothing? The BoE signaled in February that the biggest concern for policy was a slump in consumer spending led by lower real income growth on the back of rising inflation. Yet at the March policy meeting, one BoE member even voted to raise rates and others raised concerns about the elevated level of U.K inflation. With even policymakers unsure about their next move, the marginal swings in U.K. growth should have an even greater impact on Gilt yields. The U.K. economy is running around full capacity and both headline and core inflation are rising (Chart 4B). Somewhat surprisingly, the correlations between changes in Gilt yields and our BoE Monitor have actually increased since the 2008 Crisis (Chart 4C). This raises a potential risk for the Gilt market if the BoE decides that the U.K. economy is not slowing as much as it is expecting. For now, we continue to recommend a neutral stance on Gilts until there is greater clarity on the state of the economy. ECB Monitor Reflects A Less Deflationary Backdrop In Europe Our European Central Bank (ECB) Monitor has recently crept above the zero line for the first time in three years (Chart 5A). This is driven mostly by the current uptrend in headline inflation in the Euro Area, but also by the steady improvement in economic growth. Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BExcess Capacity in Europe Dwindling Fast Excess Capacity in Europe Dwindling Fast Excess Capacity in Europe Dwindling Fast Chart 5CStable Correlations Between The ECB Monitor & The Front End Of The Yield Curve Stable Correlations Between The ECB Monitor & The Front End Of The Yield Curve Stable Correlations Between The ECB Monitor & The Front End Of The Yield Curve The Euro Area is the one economy presented in this report where no indicator (either the output gap or unemployment gap) is pointing to a lack of spare capacity (Chart 5B). All of the rise in headline Euro Area inflation can be attributable to base effects related to last year's rise in oil prices and decline in the euro. The latest ECB projections call for core inflation to return to just under 2% in 2019, suggesting that there is no hurry to begin tightening monetary policy. Yet the ECB remains in an asset purchase program which is set to expire at the end of this year, so a policy decision must be made in the next 3-6 months. We expect the ECB to begin tapering its bond buying in the first quarter of 2018, with interest rate hikes to follow after the tapering has been completed. The ECB could raise rates before tapering to try and minimize the impact on Peripheral sovereign and corporate bond yields (it is buying both), although that would likely create a greater degree of tightening than the ECB would like before full employment is reached. Given the strong correlations between our ECB Monitor and much of the Euro Area yield curve (Chart 5C), however, we anticipate moving soon to an underweight stance on Euro Area bonds after our recent downgrade to neutral. BoJ Monitor: Nothing To See Here Our BoJ Monitor has been in the "easier policy required" zone for most of the past 25 years, barring a brief blip above the zero line that heralded the rate hikes in 2006/07 (Chart 6A). Inadequate growth and excess capacity remain the biggest problem with Japan's economy, preventing any meaningful upturn in inflation beyond that caused by higher commodity prices or a weaker yen. Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BTight Labor Market, But Still No Inflation Tight Labor Market, But Still No Inflation Tight Labor Market, But Still No Inflation Chart 6CLonger-Maturity JGB Yields Have No Correlation To The BoJ Monitor Longer-Maturity JGB Yields Have No Correlation To The BoJ Monitor Longer-Maturity JGB Yields Have No Correlation To The BoJ Monitor Even with Japan operating at full employment, with an unemployment rate at 3%, there has barely been any acceleration in wages or core inflation (Chart 6B). The only way out of this for Japan is to keep monetary policy settings as easy as possible to ensure that there is enough growth to eat away at the remaining spare capacity in the Japanese economy. That means keeping both policy rates and the yen as low as possible, and hoping that this will cause enough of a rise in inflation expectations to lower real interest rates and boost domestic demand. As an added "kicker", the BoJ is even anchoring the long end of the Japan yield curve by targeting a 0% yield level on 10-year government debt - a policy that we do not expect to change anytime soon. We see Japan as a low-beta "safe haven" government bond market in an environment where other central banks are seeing some tightening pressures and Japanese bonds have virtually no correlation to the BoJ Monitor (Chart 6C). We continue to recommend an overweight stance on Japan within an overall defensively positioned government bond portfolio with below-benchmark duration exposure. BoC Monitor: No Big Need To Tighten In Canada Our Bank of Canada (BoC) Monitor has recently moved into positive territory (Chart 7A) , primarily due to some improvement in growth and higher commodity prices. Given the close linkages between the U.S. and Canadian economies, we include some U.S. growth variables in our BoC Monitor and these are also helping boost the indicator. However, there are no signs that the Canadian economy is overheating - unless you are trying to buy a home in Toronto - with both the output gap and unemployment gap not yet in positive territory (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BStill Not Much Inflation In Canada Still Not Much Inflation In Canada Still Not Much Inflation In Canada Chart 7CThe BoC Monitor Is Highly Correlated To Shorter-Maturity Canadian Bonds The BoC Monitor Is Highly Correlated To Shorter-Maturity Canadian Bonds The BoC Monitor Is Highly Correlated To Shorter-Maturity Canadian Bonds The BoC is maintaining a dovish bias at the moment. Some of that has to do with the uncertainty over the U.S. economic outlook, especially with regards to the fiscal and trade policies of the Trump administration. While a boost to U.S. growth via a fiscal easing could help support Canadian exports to the U.S., any move to renegotiate trade agreements involving the two countries could end up hurting the Canadian economy. Add to that the concerns over the bubbly valuations of Canadian real estate that could be pricked by even modest rate increases, and the BoC will likely not want to contemplate any early tightening of monetary policy. The higher correlations between our BoC Monitor and the front end of the Canadian yield curve (Chart 7C) suggest that a bear flattener would be the appropriate trade if and when the BoC does contemplate a rate hike. For now, however, we see that as a low-probability event and we are maintaining a neutral stance on Canadian bonds until there is greater clarity on U.S. growth and Trump's policy agenda. RBA Monitor: Higher Because Of Growth, Not Inflation Our Reserve Bank of Australia (RBA) Monitor has surged into the "tighter policy required" territory in recent months (Chart 8A), driven by higher commodity prices and stronger Asian export demand. Survey-based measures of inflation expectations are also part of the Monitor, and those have also been rising despite a lack of realized inflation in Australia (Chart 8B). The low inflation readings have been causing a bit of a problem for the RBA, given the tight labor market and that boost to Aussie demand from better Asian growth. This is especially true given the surprisingly soft readings on employment growth, consumer confidence and spending, all occurring against a persistent deceleration in core inflation. The RBA was focusing on the inflation story last year when it delivered some surprise rate cuts, and we still suspect that a lack of inflation pressure will keep the RBA on hold for at least the next few months. We are currently at a neutral stance on Australian government bonds, given these conflicting forces of better export growth but weakening domestic demand. The lack of an inflation threat could make Australia an outperformer in a world of rising bond yields. Given the surge in our RBA Monitor, however, we see some risk in looking at Aussie bonds as a potential safe haven market given upward pressures on yields in the U.S. and Europe. The correlations between Australian yields and the RBA Monitor are extremely high (Chart 8C), and have actually gone up in the post-crisis era. Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BNo Inflation Pressures On The RBA No Inflation Pressures On The RBA No Inflation Pressures On The RBA Chart 8CAussie Bonds Across The Curve Are Highly Correlated To The RBA Monitor Aussie Bonds Across The Curve Are Highly Correlated To The RBA Monitor Aussie Bonds Across The Curve Are Highly Correlated To The RBA Monitor RBNZ Monitor: A Strong Case For A Rate Hike Our Reserve Bank of New Zealand (RBNZ) Monitor is strongly in positive territory (Chart 9A), led by the components focused on commodity prices and global growth. However, there is a fairly solid structural case for an RBNZ rate hike, given the lack of any spare capacity in New Zealand and inflation on the rise (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BFull Employment & Rising Inflation In NZ Full Employment & Rising Inflation In NZ Full Employment & Rising Inflation In NZ Chart 9ANZ Bonds Are Vulnerable To Current Cyclical Pressures NZ Bonds Are Vulnerable To Current Cyclical Pressures NZ Bonds Are Vulnerable To Current Cyclical Pressures The RBNZ has been maintaining a dovish bias of late, although it has chosen to sight more "international" risks related to geopolitics, rather than domestic economic conditions. Perhaps this is nothing more than a fear of a potential shock outcome in the upcoming French elections, although it could also be worries that tensions between the Trump White House and China (or, worse yet, North Korea) could trigger a hit to demand for New Zealand exports to Asia. In the end, we think the RBNZ will be forced to a hike off the current record low interest rates as the next policy move. While we do not include New Zealand government bonds as part of our model fixed income portfolio, we do currently have a bearish rates trade on in our list of Tactical Overlay Trades, choosing to pay 12-month NZD OIS rates. We will maintain that recommendation, but we may look to add some bearish New Zealand bond trades, as well, given the strong correlation between our RBNZ Monitor and bond yields (Chart 9C). Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com