Market Returns

Highlights The European economy has outperformed that of the U.S. recently, prompting investors to bring forward their estimates of the first ECB rate hike. To make this judgement, one really needs to be positive on EM economies in general, and China in particular. This sphere is the source of the growth delta between Europe and the U.S. The recent tightening in Chinese monetary conditions points to risks for European growth bulls. In fact, we would expect emerging markets growth to begin disappointing in the coming months, which will limit the capacity of the ECB to hike by 2019. Cyclically, stay short the euro and commodity currencies. While cyclical headwinds against the yen are plentiful, the tightening in Chinese monetary conditions could provide a further temporary fillip for the JPY. Feature Chart I-1The Reason Behind The Euro's Resilience The Reason Behind The Euro's Resilience The Reason Behind The Euro's Resilience 2016 witnessed an astounding phenomenon: Euro area growth outperformed that of the U.S. This performance is even more impressive as Europe's trend GDP growth is around one percentage point lower than that of the U.S. As investors internalized this development, their perception of the ECB changed: from the first hike being expected 59 months in the future in July 2016, the ECB is now expected to hike in 2019 (Chart I-1). Obviously, with this kind of a move, the euro was able to remain resilient, even as 2-year real rates differentials moved in favor of the USD. Are markets correct to extrapolate the recent European economic strength into the future, or is there more at play? We believe that in fact, Europe's growth outperformance has mostly reflected something else: EM and Chinese resilience. This means that if our Emerging Market Strategy team is correct and EM economic conditions begin to soften anew, the days of economic outperformance in Europe are marked. Other FX crosses will feel the blow. Betting On Faster European Rate Hikes = Betting On A Further EM Rally Core inflation in Europe remains muted and in fact, slowed substantially last month (Chart I-2). Meanwhile, U.S. core CPI and PCE inflation are still clocking in at 2.2% and 1.8%, respectively, and remain perky when compared to the euro area. Going forward, for the path of the ECB policy to be upgraded relative to the Fed, thus, prompting a durable rally in the euro, economic slack in Europe needs to continue to dissipate faster than in the U.S. The recent economic data still points toward future growth improvement in Europe and in the global manufacturing cycle. Not only have euro area PMIs been very strong, Sweden's have also shot to the moon (Chart I-3). The small, open nature of Sweden's economy suggests that some real improvement is brewing behind the scenes. Hence, it would suggest that this European inflation underperformance should soon pass. Chart I-2No Domestic Inflationary Pressures No Domestic Inflationary Pressures No Domestic Inflationary Pressures Chart I-3European Growth Indicators Are On Fire European Growth Indicators Are On Fire European Growth Indicators Are On Fire However, this misses one key point: the source of the economic outperformance of Europe. It is true that Europe continues to create a fair amount of jobs as the unemployment rate has fallen to 9.5%, but the U.S. too is generating healthy job gains, averaging 210,000 jobs over the past nine months. Labor market dynamics are unlikely to be the source of the European economic outperformance, especially as European wages continue to underperform U.S. ones (Chart I-4). Instead, it would seem that some of the positive growth delta that has lifted European economic activity above U.S. activity comes from outside Europe. Indeed, euro area PMIs and industrial production have outperformed that of the U.S. on the back of improving monetary conditions in China. As Chart I-5 illustrates, since 2008, easing Chinese MCI has led to stronger European PMI and IP. Even more interesting is the relationship exhibited in Chart I-6. The difference in economic activity between Europe and the U.S. is even more tightly correlated with the gap between Chinese M2 and Chinese M1. When M2 underperforms M1, the growth rate of time deposits slows. This is akin to saying that the marginal propensity to save in China is slowing. This boosts European economic activity. Meanwhile, when M2 outperforms M1, Chinese time deposits accelerate relative to checking deposits, Chinese savings intentions grow, and the European economy underperforms. Chart I-4U.S. Domestic Demand##br## Is Better Supported U.S. Domestic Demand Is Better Supported U.S. Domestic Demand Is Better Supported Chart I-5Euro/U.S. Growth Differentials ##br##And Chinese Liquidity (I) Euro/U.S. Growth Differentials And Chinese Liquidity (I) Euro/U.S. Growth Differentials And Chinese Liquidity (I) Chart I-6Euro/U.S. Growth Differentials ##br##And Chinese Liquidity (II) Euro/U.S. Growth Differentials And Chinese Liquidity (II) Euro/U.S. Growth Differentials And Chinese Liquidity (II) The dynamics between Europe's relative performance vis-à-vis the Chinese MCI and vis-à-vis time deposits are congruent. It highlights that China's economy does respond to tightening monetary conditions by raising its savings, which subtracts from domestic economic activity. These increased savings tend to be deflationary (as demand falls relative to supply), and also tend to limit the growth rate of imports. This is a shock for countries exporting to China. Here lies the key link explaining why Europe is more sensitive to Chinese dynamics: Europe trades more with China and EM than the U.S. does. The euro area's growth is therefore more sensitive to EM economic conditions than the U.S., a proposition supported by the IMF's work, which shows that a 1% growth shock in EM economies affect European growth by nearly 40 basis points, versus affecting U.S. growth by around 10 basis points (Chart I-7). So what does this mean going forward? We continue to be worried by dynamics in Chinese monetary conditions, even if the timing of their repercussion on economic activity is uncertain. Chinese monetary conditions have already begun to tighten, suggesting savings should rise and that growth in the industrial sector should deteriorate. Buttressing this tightening, nominal rates in China keep rising with the 7-day interbank repo rate in a clear uptrend (Chart I-8, top panel). Chart I-7Europe Is More Sensitive To EM ECB: All About China? ECB: All About China? Chart I-8Higher Chinese Rates Have Consequences Higher Chinese Rates Have Consequences Higher Chinese Rates Have Consequences This rise in interest rates could have a material impact on Chinese credit growth. As the bottom panel of Chart I-8 illustrates, bond issuance by small and medium banks has already fallen substantially. In this cycle, this variable has been a reliable leading indicator of the Chinese credit impulse. This makes sense: much of the recent Chinese credit growth has happened in the "shadow banking system", outside of the traditional channels. Research by the Kansas City Fed has shown that securitized credit tends to be very sensitive to short-term rates, thus, this slowing in bond issuance by small Chinese lenders is very likely to genuinely affect broader credit growth.1 Moreover, the risk of a vicious circle emerging is real. At the peak of the hard lending fears in China, real rates were at 10.5%, mostly reflecting deep producer prices deflation of 6%. This meant that for many highly indebted borrowers, debt servicing was a herculean effort that cut funding available for investments and economically accretive activities. As Chart I-9 shows, tightening Chinese monetary conditions have led to slowing PPI inflation. As the current tightening in China's MCI progresses, Chinese PPI inflation is likely to weaken, putting upward pressure on real rates and further hurting monetary conditions. These dynamics are dangerous, even if a repeat of the 2015 hecatomb is unlikely. Preventing as negative an outcome as occurred in 2015 are a few key factors: some of the excess capacity in the steel and material sector has been removed; the authorities have now better control of the capital account; and while PPI has downside, it is unlikely to plunge as deeply as it did in 2015 - oil prices are now better anchored, as consequential amounts of oil supply have been cut globally. This means that deep commodity deflation like in 2015 is unlikely to repeat itself and annihilate PPI inflation in China in the process (Chart I-10). Chart I-9Chinese PPI Will Roll Over Soon Chinese PPI Will Roll Over Soon Chinese PPI Will Roll Over Soon Chart I-10Commodity Prices: Friend And Foe Commodity Prices: Friend And Foe Commodity Prices: Friend And Foe Thus, as the Chinese monetary tightening progresses without spiraling out of control, it is likely that the window of opportunity for the ECB to increase interest rates will dissipate. When this reality dawns on the markets, we would expect the bear market in the euro to resume. Additionally, the global inflation surprise index has spiked massively. Historically, a surge in positive inflation surprises tends to prompt global tightening cycles (Chart I-11). In other words, because inflation surprises have been so strong, it is likely that global liquidity conditions tighten exactly as Chinese monetary and fiscal conditions do. In addition, the fiscal thrust in other EM economies deteriorate.2 This represents a potential headwind for growth in the EM space, which could temporarily limit the upswing in global inflation. These dynamics also reinforce the risks highlighted by Arthur Budaghyan, BCA's head of EM research, that EM spreads have little downside from here and may in fact be selling off in the coming quarters. As Chart I-12 shows, this would also imply that the ECB's perceived months-to-hike metric has more upside from here than potential downside. This is a cyclical handicap for the euro. Chart I-11Global Tightening On Its Way? Global Tightening On Its Way? Global Tightening On Its Way? Chart I-12EM Spreads, ECB Month-To-Hike: Same Battle EM Spreads, ECB Month-To-Hike: Same Battle EM Spreads, ECB Month-To-Hike: Same Battle These forces may also have implications for EUR/JPY. In the long-term, the yen is likely to be the main victim of the dollar strength as the Bank of Japan is currently the G7 central bank with the strongest dovish bias. But the short-term dynamics resulting from the tightening in Chinese monetary conditions could nonetheless prompt a fall in EUR/JPY over the next six months. To begin with, since 2014, the spread between German and Japanese inflation expectations has been linked to Chinese monetary conditions (Chart I-13). German 5-year / 5-year forward inflation expectations are already melting. An underperformance relative to Japan would suggest that the perception by investors of the increasing proximity of an ECB rate hike is likely to be disappointed. Chart I-13China Tightens, Germany Feels It More China Tightens, Germany Feels It More China Tightens, Germany Feels It More Moreover, the yen continues to display stronger "funding currency" attributes than the euro. Japan has a positive net international investment position of 170% of GDP versus -8% for the euro area. This suggests that the potential for repatriations when global market turbulence emerges is greater in Japan than in the euro area. Additionally, the market currently expects the ECB to begin hiking one year before the Bank of Japan. This would also mean that there is more room in the European fixed-income markets to further push away the first rate hike than there is in Japanese markets in the event of an EM deflationary shock. Does the reasoning described above have any implications for the dollar? On a 12-to-18-months basis, these dynamics support being more bullish the USD than the euro. The U.S. economy is less exposed to EM growth than that of Europe. This implies that on over such a horizon, the Fed will be less constrained than the ECB by EM economies, especially as the domestic side of the ledger is more promising in the U.S. Additionally, our Geopolitical Strategy team continues to argues that tax cuts are far from dead in the U.S., and that some significant fiscal stimulus will emerge over the course of the next 12 months in the U.S. In Europe, while no fiscal drag is tabulated, the potential for a similarly-sized fiscal boost is more limited. These same dynamics are also unambiguously bearish commodity and EM currencies versus the USD as commodity currencies are a direct play on EM activity (Chart I-14). The Australian dollar is the most poorly placed currency in the G10. It is 11% overvalued on our productivity-adjusted metrics and investors are now very long the AUD. Most crucially, Australian's terms of trade are especially vulnerable to a slowdown in the Chinese sectors most exposed to the tightening in Chinese monetary conditions (Chart I-15). These risks are further compounded by the fact that China has accumulated large inventories of some of the natural resources most important for the Australian terms of trade. Chart I-14Problems In EM Equals Problems ##br##For Commodity Currencies Problems In EM Equals Problems For Commodity Currencies Problems In EM Equals Problems For Commodity Currencies Chart I-15AUD Is Most Exposed To ##br##The Chinese Tightening AUD Is Most Exposed To The Chinese Tightening AUD Is Most Exposed To The Chinese Tightening Tactically, the picture is more nuanced. Since 2015, the euro has benefited from some risk-off attributes, managing to rise against the USD when market sell-offs are at their most acute point. Again, while EUR does not display these "funding currency" attributes as strongly as the yen, it nonetheless does more so than the USD. Also, April is traditionally a month of seasonal weakness for the greenback. A homegrown shock could also give the euro a further fillip: the French election. Le Pen's probability of winning is low but not 0%. In a report co-published nine weeks ago, we and our Geopolitical Strategy team argued that a Le Pen victory was very unlikely.3 Hence, we expect that her bookies' odds of winning, which stands between 20% and 30%, will dissipate to 0% after the second round of the election, supporting the euro independently of relative monetary dynamics. Practically, in the short run, the euro could remain well bid until this summer. We prefer to express our positive tactical stance on the euro against the AUD instead of the USD. We are also more tactically positive on the yen than any other currency and thus hold short USD/JPY and short NZD/JPY positions. Cyclically, we are looking for either a market correction to unfold or a clear upswing in U.S. wages before moving outright short EUR and JPY against the USD. Our tactical and cyclical views on commodity currencies are lined up: we are shorting them. Bottom Line: The source of the delta in European growth seems to be emanating out of EM and China in particular. This means that if one wants to bet on the ECB being able to increase rates sooner than what is currently priced in - a key precondition to bet on a cyclical rebound in the euro - one needs to remain bullish EM. Currently, our Emerging Markets Strategy sister publication remains negative on the medium-term outlook for EM, this represents a big problem for cyclical euro bulls. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Tobias Adrian and Hyun Shong Shin, "Financial Intermediaries, Financial Stability and Monetary Policy," Federal Reserve Bank of New York, Staff Report No. 346, September 2008. 2 Please see Foreign Exchange Strategy Weekly Report, "Et Tu, Janet?" dated March 3, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy and Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017, available at fes.bcaresearch.com and gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The March FOMC minutes reveal that members discussed the possibility of a normalization of the bank's balance sheet in the near future, through phasing out or ceasing reinvestments of both Treasuries and mortgage-backed securities. This is quite a hawkish comment, as the Fed acknowledges a strengthening economy: ADP employment change recorded a 263,000 new jobs, above the 187,000 consensus; Initial jobless claims decreased to 234,000; ISM Manufacturing PMI came in at 57.2; ISM Prices Paid was at 70.5. Despite this data, some members also stated that stock prices were "quite high", which prompted weakness in the S&P, Treasury yields, and the dollar, as markets revised their growth outlook. Although this is most likely a misinterpretation, as the data quite accurately depicts the economy's fundamentals, the dollar will likely display a neutral bias this month due to seasonality effects. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro is likely to see some temporary strength on the back of improving economic conditions: Producer prices picked up to 4.5%, beating the 4.4% consensus; Retail sales remain strong at 1.8%; German manufacturing PMI remained unchanged at 58.3, while composite increased to 57.1. Nevertheless, PMIs were weak for many of the smaller, peripheral economies, which will cause downside for the euro in the longer-term. Adding confirmation to Praet's comments last week, Vitas Vasiliauskas, governor of Bank of Lithuania, stated that "the recovery of inflation is still fragile" and that they will first "have to end purchases and only then we can discuss other actions", further corroborating a weaker euro in the longer-term. In other news, the CNB seems to be softening its peg with the EUR as the bank progressively reverts to conducting an independent monetary policy. EUR/CZK depreciated more than 1.5%. Report Links: Healthcare Or Not, Risks Remain - March 24, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent Japanese data has been mixed: The unemployment rate outperformed expectations, falling down to 2.8%. However, household spending contracted further, falling by 3.8%, underperforming expectations. Furthermore, the Nikkei manufacturing PMI, also underperformed expectations, falling to 52.4 This deterioration in Japanese economic data is most likely a byproduct of the appreciation that the yen this year. Indeed, inflationary pressures and economic activity in Japan have been closely linked to the yen. This relationship will embolden the BoJ to keep its aggressive monetary stance in place, as the rate-setting committee understands that a weakening yen is a key lever to kick star Japan's tepid economy. Thus, while we are bullish on the yen on a 3-month horizon, we remain yen bears on a cyclical basis. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data in the U.K. has been disappointing as of late: GDP grew at 1.9% in Q4, against expectations of 2% growth. Construction and manufacturing PMI also underperformed, coming in at 52.2 and 54.2 respectively. Both measures also decreased from the previous month. Amid disappointing data, one bright spot for the pound was the massive reduction in their current account deficit. At 12 Billion pounds, the British current account deficit now stands at the lowest level since 2013. This is positive for the U.K. economy, as it provides a buffer against any slowdown in financial inflows that could materialize from the separation with the European Union. Thus, we continue to be bullish on the pound, particularly against the euro, as we believe that Brexit-related fears are overstated. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The latest dwelling figures indicate the fastest increase since May 2010, with Sydney and Melbourne witnessing 19% and 17% increases, respectively. They are up 8.3% nationally. What really highlights risks for Australia is that interest-only loans account for 40% of the country's housing finance, which prompted the APRA to put forward a limitation to interest-only lending to 30% of new mortgages, as a part of numerous other restrictive macro-prudential measures put in place to curb euphoria. Low rates, while sustaining robust housing activity in the past years, have been a primary factor in this exuberance. Worryingly, these low rates have not been enough to support wages, leading to increasing debt-to-income ratios. The RBA will find it hard to lift rates in the face of high household debt and the large share of interest-only loans, limiting the AUD's upside. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Although the NZD has been slightly weak this week against the U.S. dollar, it has appreciated against the Aussie. This might have something to do with the recent uptick in dairy prices, stopping a correction in prices that started in late 2016. Furthermore, the weakness in this cross seems to be sending an ominous signal, as AUD/NZD tends to lead relative activity dynamics between the manufacturing and non-manufacturing sectors in China. There is a reason behind this relationship, as the staple commodities of Australia and New Zealand (iron and dairy prices) cater to the industrial sector and the consumer sector, respectively. We believe that the outperformance by the Chinese industrial sector might be on its last legs, thus AUD/NZD is an attractive short. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 As highlighted numerously, the Canadian economy is haunted by the same underlying risk as the Australian economy. With the average price for a detached home in Toronto now at CAD 1.2 million, risks are coming into sharper focus. News media now highlights that the housing market is in a shortage, with multiple buyers in competition to purchase a single home, with buyers even skipping home inspections. In better news, the RBC Manufacturing PMI read at 55.5 in March, more than a 3-year high, with its output, new orders and employment components also at multi-year highs. Furthermore, the Business Outlook Survey highlights business intentions to expand and hire continue to be buoyant, which should augur well for the economy in the near future. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has rebounded after coming close to hitting the SNB implied floor of 1.065 on Tuesday. It seems that this strategy is paying off for the SNB, as recent data shows an improving Swiss economy: Real retail sales outperformed expectations, as they exited contractionary territory. They are now growing at 0.6%. SVME PMI also outperformed, coming in at 58.6. This measure now stands at its highest level since 2011. Moreover Swiss headline inflation month-on-month grow came in above expectations at 0.6%, while the annual inflation rate came in at 0.2%. This batch of strong data will certainly reassure the SNB that its intervention in the currency market is helping kick start the Swiss economy. However, for the time being the peg will remain as the economy is not yet strong enough to handle a change in this policy. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK appreciated by almost 1.5%, even on the face of a nearly 5% rally in oil. This is not an isolated case: since the beginning of the year USD/NOK has become much less sensitive to oil and more sensitive to the changes in the dollar. The poor state of the Norwegian economy explains this phenomenon as core and headline inflation continue to plummet and the credit impulse still stands in negative territory. One could point to unemployment as a bright spot, as it now stands at 2.9%. However this reduction in unemployment is accompanied by a contraction in employment, which suggests that people are just leaving the labor market. These factors will continue to solidify the Norges Bank's dovish bias, causing NOK to underperform terms-of-trade dynamics. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 As momentum retreats from oversold levels, the krona is displaying some strength on the back of buoyant economic data: Manufacturing PMI hit 65.2 for March; Industrial production in February increased at a 4.1% annual pace; New orders were up 12% in February. This data augurs well for Sweden's export sector, the economy's most key area. The Riksbank's Business Survey highlights these developments, with their proprietary economic activity indicators pointing to good growth. An interesting development in pricing pressures is that negotiated prices are no longer being reduced as often as before, which is "regarded as an incipient sign of demand, which in turn creates expectations of future price rises". The effects of rising commodity prices and a weaker krona are also now kicking in. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights WTI and Brent forward curves remain more or less backwardated beginning in 2018. On its face, this indicates hedgers and speculators are trading and positioning as if the OPEC - non-OPEC production deal negotiated by the Kingdom of Saudi Arabia (KSA) and Russia in late 2016 will succeed in drawing inventories, leaving the market in a physical deficit this year. Over the short-term, this induced supply shock benefits producers generally. Longer term, KSA and Russia will have to continue to manage supplies if they are to exert any influence on oil prices. This is a three-level game, which now involves U.S. shale-oil producers as a permanent feature of the market. It will be difficult to manage. But the stakes are sufficiently high for KSA and Russia that we believe it has to be played. Energy: Overweight. We closed the first quarter on an up note, with our trade recommendations still open and closed in 2017Q1 up 420.75% on average. Base Metals: Neutral. Striking miners at Freeport McMoRan's Cerro Verde facility in Peru are back on the job, as are workers at BHP's Escondido mine in Chile. Export licensing difficulties at Freeport's Grasberg facility in Indonesia are close to being resolved.1 Precious Metals: Neutral. Our long volatility play in gold is down -32.8%, which, from a macro perspective, indicates markets are not fearful of a Fed-related surprise over the next couple of months. Ags/Softs: Underweight. U.S. farmers' corn planting intentions came in 1mm acres less than expected at 90mm; beans came in at 89.5mm acres, or 1.4mm over expectations; and wheat was up 100k acres at 46.1mm. Stocks remain high, and we remain bearish. Feature KSA, Russia and their allies - OPEC 2.0 - are trying to regain control of oil fundamentals produced by one of the most unlikely combinations of events ever seen in the history of the oil market. This week, we review how we arrived at the market conditions we now confront, and consider a possible strategy evolving out of the production-cutting Agreement (the "Agreement" for short) that may allow them to do so. Current markets conditions were spawned by a surge in EM oil demand in the early part of the 21st century, which met an almost perfectly inelastic supply curve. This took prices from $55/bbl in 2005 to more than $140/bbl by the end of 2008H1 (Chart of the Week). Along the way, some 5mm b/d of DM oil demand had to be destroyed by higher prices to make room for the EM growth depicted in Chart 2, which is taken from an analysis by Hamilton (2009).2 Chart of the WeekEM Consumption Surge, Flat Production ##br##Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC Chart 2High Prices Were Required##br## To Balance Markets Pre-GFC The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? These high prices combined with the post-Global Financial Crisis (GFC) low-interest rate regime into a perfect storm, which allowed the supply side to evolve the shale technology in the U.S. Steadily rising light-tight-oil (LTO) production has profoundly altered the market, forcing OPEC and non-OPEC petro-states to devise a strategy to contain this surge. Whether they can do so is yet to be determined. In this article we consider one strategy that might allow OPEC 2.0 to regain some control over pricing and the rate of growth in shale production, but it is highly dependent on them maintaining production discipline and finding a way to coordinate their production. First, though, a quick review. How Did We Get Here? The GFC dragged all markets lower, leaving oil prices just above $40/bbl by the end of 2008. In the wake of the GFC, central banks led by the Fed pursued massively accommodative monetary policies, which took interest rates to the zero lower bound. OPEC, led by KSA, drastically cut supplies to remove a huge unintended inventory accumulation that developed as demand collapsed (Chart 3). While DM oil demand remained depressed in the wake of the GFC, EM governments, led by China, massively stimulated their economies, which lifted global oil consumption more than 4% by 2010 (Chart 4). Chart 3OPEC Cut Production To Defend Prices, ##br##Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 Chart 4EM Lifted Global Demand Post-GFC EM Lifted Global Demand Post-GFC EM Lifted Global Demand Post-GFC Growth in global supplies post-GFC, meanwhile, was more measured. OPEC total liquids production from 2009 to 2014 averaged just below 0.05% growth yoy. Part of this meager growth in OPEC production no doubt was explained by lower production from the Cartel resulting from civil war in Libya and nuclear-related sanctions against Iran, which reduced overall output. It also is possible the fall-out from the GFC and the euro-area crisis of 2009 - 2011 kept OPEC producers from committing to higher production as well. Be that as it may, EM demand growth, along with OPEC's lower output, allowed prices to again trade above $100/bbl by 2011 and stay there till mid-2014 (Chart 5). The years-long combination of near-zero interest rates and high oil prices allowed U.S. shale-oil production to advance in leaps and bounds, such that by 2014, yoy light-tight oil (LTO) production from the shales was growing at more than 1mm b/d (Chart 6). Chart 5EM Surge, OPEC Production Moderation##br## Keep Prices Above $100/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 Chart 6High Prices, Low Interest Rates Propel Shale ##br##Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 Now What? OPEC underestimated the magnitude of the shale-oil revolution, as did most observers. However, KSA, the leader of the Cartel, was pre-occupied with geopolitical considerations, chiefly its ongoing proxy wars throughout the Middle East with Iran and its allies. High prices allowed it to build its reserves and fund these proxy wars. This ended when Iran and western powers began negotiating an end to sanctions, which, if successful, would once again allow Iran to access foreign capital and technology to develop its economy.3 As the negotiations to remove sanctions on Iran progressed, KSA led OPEC into a market-share war at the end of 2014, presumably to take back customers lost to shale, particularly in the U.S. We do not believe OPEC's primary aim in declaring a market-share war was to crush U.S. shale output. Indeed, we have consistently maintained the market-share war was more an extension of KSA's and Iran's proxy wars throughout the Middle East, and that KSA was using the pump-at-will strategy to limit revenues that would flow to Iran in the post-sanctions environment. The secondary target of the market-share war was U.S. shale production, but, even then we maintained shale-oil production was needed to keep prices from revisiting $140/bbl-plus levels.4 The market-share war tanked prices, as OPEC increased the quantity of oil it would supply at lower prices. In particular, Saudi Arabia surged production from November 2014, into the collapse of oil prices. Over time, the market-share strategy destroyed high-cost supply worldwide. U.S. shale production fell ~ 15% from a high of ~ 5.3mm b/d in March 2015 in the four largest LTO basins to a low of ~ 4.5mm b/d, by our reckoning, in 2017Q1. At the same time, non-Gulf OPEC production fell dramatically as well, close to 8% in 2016 yoy to an average of 7.7mm b/d. Gulf Arab producers in OPEC and Russia, however, saw production increase 6.5% and 2% yoy, respectively, to close to 25mm b/d and 11.2mm b/d in 2016. In the aftermath of the price collapse, U.S. shale producers retreated to their "core" producing properties - those areas with the lowest-cost, most accessible shale reserves - and dramatically improved their productivity (Chart 7). A collapse in services costs allowed LTO producers to maintain core operations and continue to advance shale-oil technology. At the end of the day, this made the global supply curve more elastic, in that LTO production now allowed higher demand to be met by smaller price increases than had been the case in the lead-up to the GFC. The increased elasticity of supply from U.S. shales, and the increased quantity supply by OPEC is depicted in Chart 8, which picks up from Hamilton's (2009) analysis shown in Chart 2. Chart 7U.S. Shale Productivity Surged ##br##During OPEC's Market-Share War U.S Shale Productivity Surged During OPEC's Market-Share War U.S Shale Productivity Surged During OPEC's Market-Share War Chart 8Global Oil Supply##br## Transformed By 2014H1 The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? OPEC's Market-Share War Failed We contend the KSA - Russia production Agreement negotiated at the end of last year represents an abandonment of OPEC's market-share strategy. If, as recent research suggests, this strategy was an attempt to "squeeze" higher-cost shale production from the market by increasing OPEC crude supplies, it was a failure: The market-share strategy imperiled the finances of OPEC and non-OPEC states heavily dependent on oil revenues to sustain themselves, and left U.S. shale production more resilient than it was prior to the market-share war being declared.5 The surge in shale supplies and in OPEC's quantity supplied to the market during its market-share war, coupled with slower growth following the dramatic increase in EM demand in 2010 - 2012, led to unintended inventory accumulation worldwide, which has kept global storage at record levels. This is the central issue being addressed by the OPEC - non-OPEC production Agreement to remove up to 1.8mm b/d of production from the market. In effect, the KSA - Russia deal is inducing a supply shock to shift the global supply curve back to the left, after it was pushed down and to the right from 2014H2 to 2015H2, as depicted in Chart 9. In and of itself, this should lift and stabilize prices by the end of this year. We expect this induced supply shock will begin to force more visible inventories - e.g., in the U.S. and OECD generally - to draw rapidly. We continue to expect OECD stocks to reach 5-year average levels by year-end 2017, and for prices to reach $60/bbl by year end (Chart 10). We do not believe an extension in OPEC 2.0's production Agreement is needed to achieve this. Chart 9KSA - Russia Deal Is An Induced Supply Shock##br## Intended To Shift The Curve Back To The Left The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Chart 10Oil Stocks Will Fall To 5-Year ##br##Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 It goes without saying, the parties to OPEC 2.0's production-management deal must maintain production discipline for this strategy to be able to evolve to the next level, where they attempt to restore a measure of price inelasticity to the global supply curve. If they are successful, then they will be able to exercise a degree of control over prices using spare capacity, storage and forward guidance to achieve and defend specific targets. If not, the market will do the hard work of destroying high-cost supply with lower prices. The End Game For KSA - Russia For the KSA - Russia Agreement to affect U.S. shale output over the medium to longer term, they have to coordinate production in a way that keeps WTI prices from rising to the point where shale-oil producers are able to step outside their "core" production areas. We believe over the short term, this price is between $55/bbl and $60/bbl. Our colleague Matt Conlan, of the BCA Energy Sector Strategy, has illustrated that the "true" breakeven for shale producers is much closer to $50/bbl, than the $30/bbl figure oft cited in the media.6 However, above $60/bbl, more costly reserves can be developed and still produce acceptable returns for LTO drillers. Therefore, if prices can be kept below $60/bbl, and the induced supply shock engineered by KSA and Russia causes oil inventories to draw as we expect this year, we believe the resulting backwardation in WTI will limit the rate at which rigs return to the field. In our modeling, we find shale rig counts to be sensitive to the shape of the forward curve for WTI. A backwardated curve translates into fewer rigs returning to the field than a flat or contango curve. In one model we estimated, we found a 10% backwardation from mid-2017 to end-2018 resulted in a rig count that was close to 18% below the rig count that could be expected from a relatively flat forward curve. The only way we see for KSA and Russia to affect the shape of the WTI forward curve over the short term - to end 2018 - is to use their own spare capacity and storage to keep the front of the curve below $60/bbl, and to provide forward guidance that they are able to adjust supply markets over the short- to medium-term in a manner that keeps the forward curve backwardated. This will require short-term production coordination among the states comprising OPEC 2.0, so that refinery demand is met out of current production plus inventories, and that unforeseen outages are remedied quickly. This is a short-term fix. It likely can be implemented this year and carried into next year. However, beyond that, it is difficult to see how KSA and Russia, and their respective allies, will coordinate production, storage operations and forward guidance having never attempted such an effort in the past. However, we are reasonably sure members of OPEC 2.0 are discussing how to implement such coordination. Keeping the front of the curve at a price that dissuades shale producers from expanding beyond their "core" production also will limit the amount of investment that can be made in non-Gulf OPEC production, which already is in decline, and other higher-cost conventional production like deep water.7 This, coupled with the $1-trillion-plus cuts to global capex for projects that would have been producing between 2015 - 2020 resulting from the 2015 - 16 price collapse could produce a supply deficit by 2019 that only can be remedied by significantly higher prices that not only encourage new higher-cost production but destroys demand in the meantime while that production is being developed. Bottom Line: We expect the KSA - Russia Agreement to produce a physical deficit this year that draws OECD oil inventories down by ~ 300mm barrels by year end. We also expect to see deeper coordination among the petro-states that are party to this Agreement - OPEC 2.0 - this year and next, which will keep the WTI forward curve backwardated into 2018. While we expect WTI prices to average $55/bbl to 2020 - and to trade between $45 and $65/bbl most of the time - our level of conviction in that forecast is low beyond 2018. It is not clear OPEC 2.0 can endure beyond the short term (into 2018). We will be watching the response of U.S. shale producers to increasing demand, and increasing decline-curve losses outside the U.S. shales, the Gulf OPEC producers and Russia, where we expect production declines to accelerate. As we have noted often in the past, the loss of more than $1 trillion of capex will place an enormous burden on U.S. shales, Gulf Arab producers in OPEC and Russia. If any one of these cannot deliver higher volumes when called upon, prices could move sharply above $65/bbl after 2018 going forward. Likewise, we will be watching to see if OPEC 2.0 is capable of setting and meeting production and inventory goals. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Please see "Workers to end strike at Peru's top copper mine Cerro Verde," published March 30, 2017, by miningweekly.com. 2 Please see "Causes and Consequences of the Oil Shock of 2007-08," by James D. Hamilton, in the Brookings Papers on Economic Activity, Spring 2009, particularly pp. 228 - 234. 3 Please see "P5+1 and Iran agree on nuclear negotiation framework in Vienna," published February 20, 2014, by cnn.com. The sanctions were lifted in early 2016; see "Iran nuclear deal: Five effects of lifting sanctions," published January 18, 2016, by bbc.com. 4 For an in-depth analysis of OPEC's market-share war, please see the Special Report entitled "End Of An Era For Oil And The Middle East," published jointly by BCA Research's Commodity & Energy Strategy and Geopolitical Strategy groups on April 9, 2015, available at ces.bcaresearch.com. 5 Please see "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash," published September 8, 2016, and our "2017 Commodity Outlook: Energy," published December 8, 2016, in which we discuss the toll lower oil prices were taking on oil-dependent states including KSA and Russia. See also "The Dynamics of the Revenue Maximization - Market Share Trade-Off: Saudi Arabia's Oil Policy in the 2014 - 2015 Price Fall," by Bassam Fattouh, Rahmatallah Poudineh and Anupama Sen, published by The Oxford Institute For Energy Studies in October 2015, and "An analysis of OPEC's strategic actions, US shale growth and the 2014 oil price crash," by Alberto Behar and Robert A. Ritz, published by the IMF July 2016. Both papers consider OPEC's market-share war vis-à-vis U.S. shale-oil production, the strategy of squeezing shale producers from the market by increasing supply and lowering prices, and the likelihood for success. 6 Please see BCA Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017, available at nrg.bcaresearch.com. 7 Please see "The Other Guys In The Oil Market" in this week's Energy Sector Strategy, which takes an in-depth look at the stagnant-to-declining production in conventional oil-producing provinces outside the U.S. onshore, Middle East OPEC and Russia, available at nrg.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Summary of Trades Closed In 2016

Highlights Dear Client, In this analysis, my colleague Bob Ryan of the BCA Commodity & Energy Strategy argues that there is more upside to oil prices. First, Russia and OPEC will continue to coordinate their production for at least the rest of the year. Second, oil prices are too low to incentivize high cost, non-Gulf OPEC production, such as deep-water production. Third, the world lost roughly $1-trillion-plus of capex due to the oil-price collapse. Bob collaborates frequently with the Geopolitical Strategy team. As we controversially argued in February 2016, Saudi-Iranian tensions have peaked and created the geopolitical conditions for a renewal of OPEC production coordination. With oil prices plumbing decade lows in 2015-2016, both countries have set regional differences aside for the sake of domestic stability. I hope that you will enjoy Bob's note as much as I did. Many clients with whom I have met in person already know the view well, as it forms the core of Geopolitical Strategy's view on the Middle East. For those of you who are not subscribed to BCA's Commodity & Energy Strategy, and BCA's Energy Sector Strategy, I would recommend that you reach out to your account manager for a trial of both services. Kindest Regards, Marko Papic, Senior Vice President Geopolitical Strategy Feature KSA, Russia and their allies - OPEC 2.0 - are trying to regain control of oil fundamentals produced by one of the most unlikely combinations of events ever seen in the history of the oil market. This week, we review how we arrived at the market conditions we now confront, and consider a possible strategy evolving out of the production-cutting Agreement (the "Agreement" for short) that may allow them to do so. Current markets conditions were spawned by a surge in EM oil demand in the early part of the 21st century, which met an almost perfectly inelastic supply curve. This took prices from $55/bbl in 2005 to more than $140/bbl by the end of 2008H1 (Chart Of The Week). Along the way, some 5mm b/d of DM oil demand had to be destroyed by higher prices to make room for the EM growth depicted in Chart 2, which is taken from an analysis by Hamilton (2009).1 Chart Of The WeekEM Consumption Surge, Flat Production##br## Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC Chart 2High Prices Were Required ##br##To Balance Markets Pre-GFC The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? These high prices combined with the post-Global Financial Crisis (GFC) low-interest rate regime into a perfect storm, which allowed the supply side to evolve the shale technology in the U.S. Steadily rising light-tight-oil (LTO) production has profoundly altered the market, forcing OPEC and non-OPEC petro-states to devise a strategy to contain this surge. Whether they can do so is yet to be determined. In this article we consider one strategy that might allow OPEC 2.0 to regain some control over pricing and the rate of growth in shale production, but it is highly dependent on them maintaining production discipline and finding a way to coordinate their production. First, though, a quick review. How Did We Get Here? The GFC dragged all markets lower, leaving oil prices just above $40/bbl by the end of 2008. In the wake of the GFC, central banks led by the Fed pursued massively accommodative monetary policies, which took interest rates to the zero lower bound. OPEC, led by KSA, drastically cut supplies to remove a huge unintended inventory accumulation that developed as demand collapsed (Chart 3). While DM oil demand remained depressed in the wake of the GFC, EM governments, led by China, massively stimulated their economies, which lifted global oil consumption more than 4% by 2010 (Chart 4). Chart 3OPEC Cut Production To Defend Prices,##br## Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 Chart 4EM Lifted Global##br## Demand Post-GFC EM Lifted Global Demand Post-GFC EM Lifted Global Demand Post-GFC Growth in global supplies post-GFC, meanwhile, was more measured. OPEC total liquids production from 2009 to 2014 averaged just below 0.05% growth yoy. Part of this meager growth in OPEC production no doubt was explained by lower production from the Cartel resulting from civil war in Libya and nuclear-related sanctions against Iran, which reduced overall output. It also is possible the fall-out from the GFC and the euro-area crisis of 2009 - 2011 kept OPEC producers from committing to higher production as well. Be that as it may, EM demand growth, along with OPEC's lower output, allowed prices to again trade above $100/bbl by 2011 and stay there till mid-2014 (Chart 5). The years-long combination of near-zero interest rates and high oil prices allowed U.S. shale-oil production to advance in leaps and bounds, such that by 2014, yoy light-tight oil (LTO) production from the shales was growing at more than 1mm b/d (Chart 6). Chart 5EM Surge, OPEC Production Moderation##br## Keep Prices Above 0/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 Chart 6High Prices, Low Interest Rates Propel Shale##br## Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 Now What? OPEC underestimated the magnitude of the shale-oil revolution, as did most observers. However, KSA, the leader of the Cartel, was pre-occupied with geopolitical considerations, chiefly its ongoing proxy wars throughout the Middle East with Iran and its allies. High prices allowed it to build its reserves and fund these proxy wars. This ended when Iran and western powers began negotiating an end to sanctions, which, if successful, would once again allow Iran to access foreign capital and technology to develop its economy.2 As the negotiations to remove sanctions on Iran progressed, KSA led OPEC into a market-share war at the end of 2014, presumably to take back customers lost to shale, particularly in the U.S. We do not believe OPEC's primary aim in declaring a market-share war was to crush U.S. shale output. Indeed, we have consistently maintained the market-share war was more an extension of KSA's and Iran's proxy wars throughout the Middle East, and that KSA was using the pump-at-will strategy to limit revenues that would flow to Iran in the post-sanctions environment. The secondary target of the market-share war was U.S. shale production, but, even then we maintained shale-oil production was needed to keep prices from revisiting $140/bbl-plus levels.3 The market-share war tanked prices, as OPEC increased the quantity of oil it would supply at lower prices. In particular, Saudi Arabia surged production from November 2014, into the collapse of oil prices. Over time, the market-share strategy destroyed high-cost supply worldwide. U.S. shale production fell ~ 15% from a high of ~ 5.3mm b/d in March 2015 in the four largest LTO basins to a low of ~ 4.5mm b/d, by our reckoning, in 2017Q1. At the same time, non-Gulf OPEC production fell dramatically as well, close to 8% in 2016 yoy to an average of 7.7mm b/d. Gulf Arab producers in OPEC and Russia, however, saw production increase 6.5% and 2% yoy, respectively, to close to 25mm b/d and 11.2mm b/d in 2016. In the aftermath of the price collapse, U.S. shale producers retreated to their "core" producing properties - those areas with the lowest-cost, most accessible shale reserves - and dramatically improved their productivity (Chart 7). A collapse in services costs allowed LTO producers to maintain core operations and continue to advance shale-oil technology. At the end of the day, this made the global supply curve more elastic, in that LTO production now allowed higher demand to be met by smaller price increases than had been the case in the lead-up to the GFC. The increased elasticity of supply from U.S. shales, and the increased quantity supply by OPEC is depicted in Chart 8, which picks up from Hamilton's (2009) analysis shown in Chart 2. Chart 7U.S. Shale Productivity Surged##br## During OPEC"s Market-Share War U.S. Shale Productivity Surged During OPEC"s Market-Share War U.S. Shale Productivity Surged During OPEC"s Market-Share War Chart 8Global Oil Supply ##br##Transformed By 2014H1 The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? OPEC's Market-Share War Failed We contend the KSA - Russia production Agreement negotiated at the end of last year represents an abandonment of OPEC's market-share strategy. If, as recent research suggests, this strategy was an attempt to "squeeze" higher-cost shale production from the market by increasing OPEC crude supplies, it was a failure: The market-share strategy imperiled the finances of OPEC and non-OPEC states heavily dependent on oil revenues to sustain themselves, and left U.S. shale production more resilient than it was prior to the market-share war being declared.4 The surge in shale supplies and in OPEC's quantity supplied to the market during its market-share war, coupled with slower growth following the dramatic increase in EM demand in 2010 - 2012, led to unintended inventory accumulation worldwide, which has kept global storage at record levels. This is the central issue being addressed by the OPEC - non-OPEC production Agreement to remove up to 1.8mm b/d of production from the market. In effect, the KSA - Russia deal is inducing a supply shock to shift the global supply curve back to the left, after it was pushed down and to the right from 2014H2 to 2015H2, as depicted in Chart 9. In and of itself, this should lift and stabilize prices by the end of this year. We expect this induced supply shock will begin to force more visible inventories - e.g., in the U.S. and OECD generally - to draw rapidly. We continue to expect OECD stocks to reach 5-year average levels by year-end 2017, and for prices to reach $60/bbl by year end (Chart 10). We do not believe an extension in OPEC 2.0's production Agreement is needed to achieve this. Chart 9KSA - Russia Deal Is An Induced Supply Shock ##br##Intended To Shift The Curve Back To The Left The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Chart 10Oil Stocks Will Fall To 5-Year##br## Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 It goes without saying, the parties to OPEC 2.0's production-management deal must maintain production discipline for this strategy to be able to evolve to the next level, where they attempt to restore a measure of price inelasticity to the global supply curve. If they are successful, then they will be able to exercise a degree of control over prices using spare capacity, storage and forward guidance to achieve and defend specific targets. If not, the market will do the hard work of destroying high-cost supply with lower prices. The End Game For KSA - Russia For the KSA - Russia Agreement to affect U.S. shale output over the medium to longer term, they have to coordinate production in a way that keeps WTI prices from rising to the point where shale-oil producers are able to step outside their "core" production areas. We believe over the short term, this price is between $55/bbl and $60/bbl. Our colleague Matt Conlan, of the BCA Energy Sector Strategy, has illustrated that the "true" breakeven for shale producers is much closer to $50/bbl, than the $30/bbl figure oft cited in the media.5 However, above $60/bbl, more costly reserves can be developed and still produce acceptable returns for LTO drillers. Therefore, if prices can be kept below $60/bbl, and the induced supply shock engineered by KSA and Russia causes oil inventories to draw as we expect this year, we believe the resulting backwardation in WTI will limit the rate at which rigs return to the field. In our modeling, we find shale rig counts to be sensitive to the shape of the forward curve for WTI. A backwardated curve translates into fewer rigs returning to the field than a flat or contango curve. In one model we estimated, we found a 10% backwardation from mid-2017 to end-2018 resulted in a rig count that was close to 18% below the rig count that could be expected from a relatively flat forward curve. The only way we see for KSA and Russia to affect the shape of the WTI forward curve over the short term - to end 2018 - is to use their own spare capacity and storage to keep the front of the curve below $60/bbl, and to provide forward guidance that they are able to adjust supply markets over the short- to medium-term in a manner that keeps the forward curve backwardated. This will require short-term production coordination among the states comprising OPEC 2.0, so that refinery demand is met out of current production plus inventories, and that unforeseen outages are remedied quickly. This is a short-term fix. It likely can be implemented this year and carried into next year. However, beyond that, it is difficult to see how KSA and Russia, and their respective allies, will coordinate production, storage operations and forward guidance having never attempted such an effort in the past. However, we are reasonably sure members of OPEC 2.0 are discussing how to implement such coordination. Keeping the front of the curve at a price that dissuades shale producers from expanding beyond their "core" production also will limit the amount of investment that can be made in non-Gulf OPEC production, which already is in decline, and other higher-cost conventional production like deep water.6 This, coupled with the $1-trillion-plus cuts to global capex for projects that would have been producing between 2015 - 2020 resulting from the 2015 - 16 price collapse could produce a supply deficit by 2019 that only can be remedied by significantly higher prices that not only encourage new higher-cost production but destroys demand in the meantime while that production is being developed. Bottom Line: We expect the KSA - Russia Agreement to produce a physical deficit this year that draws OECD oil inventories down by ~ 300mm barrels by year end. We also expect to see deeper coordination among the petro-states that are party to this Agreement - OPEC 2.0 - this year and next, which will keep the WTI forward curve backwardated into 2018. While we expect WTI prices to average $55/bbl to 2020 - and to trade between $45 and $65/bbl most of the time - our level of conviction in that forecast is low beyond 2018. It is not clear OPEC 2.0 can endure beyond the short term (into 2018). We will be watching the response of U.S. shale producers to increasing demand, and increasing decline-curve losses outside the U.S. shales, the Gulf OPEC producers and Russia, where we expect production declines to accelerate. As we have noted often in the past, the loss of more than $1 trillion of capex will place an enormous burden on U.S. shales, Gulf Arab producers in OPEC and Russia. If any one of these cannot deliver higher volumes when called upon, prices could move sharply above $65/bbl after 2018 going forward. Likewise, we will be watching to see if OPEC 2.0 is capable of setting and meeting production and inventory goals. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Please see "Causes and Consequences of the Oil Shock of 2007-08," by James D. Hamilton, in the Brookings Papers on Economic Activity, Spring 2009, particularly pp. 228 - 234. 2 Please see "P5+1 and Iran agree on nuclear negotiation framework in Vienna," published February 20, 2014, by cnn.com. The sanctions were lifted in early 2016; see "Iran nuclear deal: Five effects of lifting sanctions," published January 18, 2016, by bbc.com. 3 For an in-depth analysis of OPEC's market-share war, please see the Special Report entitled "End Of An Era For Oil And The Middle East," published jointly by BCA Research's Commodity & Energy Strategy and Geopolitical Strategy groups on April 9, 2015, available at ces.bcaresearch.com. 4 Please see "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash," published September 8, 2016, and our "2017 Commodity Outlook: Energy," published December 8, 2016, in which we discuss the toll lower oil prices were taking on oil-dependent states including KSA and Russia. See also "The Dynamics of the Revenue Maximization - Market Share Trade-Off: Saudi Arabia's Oil Policy in the 2014 - 2015 Price Fall," by Bassam Fattouh, Rahmatallah Poudineh and Anupama Sen, published by The Oxford Institute For Energy Studies in October 2015, and "An analysis of OPEC's strategic actions, US shale growth and the 2014 oil price crash," by Alberto Behar and Robert A. Ritz, published by the IMF July 2016. Both papers consider OPEC's market-share war vis-à-vis U.S. shale-oil production, the strategy of squeezing shale producers from the market by increasing supply and lowering prices, and the likelihood for success. 5 Please see BCA Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017, available at nrg.bcaresearch.com. 6 Please see "The Other Guys In The Oil Market" in this week's Energy Sector Strategy, which takes an in-depth look at the stagnant-to-declining production in conventional oil-producing provinces outside the U.S. onshore, Middle East OPEC and Russia, available at nrg.bcaresearch.com.

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 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)

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of March 31, 2017. The model has not made significant changes compared to previous month as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, Level 2 model ( the allocation among the 11 non-U.S. DM countries) sharply outperformed its benchmark by 338 basis points (bps) in March, largely a result from the overweight of Spain and Italy versus underweight in Japan and Canada. Level 1 model, the allocation between U.S. and non-U.S., underperformed by 27 bps in March due to the large overweight in the U.S. Overall, the aggregate GAA model outperformed its MSCI World benchmark by 71 bps in March and by 117 bps since going live. Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model". http://gaa.bcaresearch.com/articles/view_report/18850. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of March 31, 2017. Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates Chart 4Overall Model Performance Overall Model Performance Overall Model Performance The momentum component has shifted Materials from overweight to underweight and Consumer Discretionary from underweight to overweight. The growth component has become less optimistic on global growth given the weakness in metals prices. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Associate Editor patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights With the labor market near full employment and the economy growing modestly, the U.S. economy is not in dire need of a "shot in the arm" from fiscal stimulus. Stocks may dip temporarily out of disappointment, but the economy will be fine even if Congress fails to boost infrastructure spending and/or cut taxes. Our view is that the market will adjust up expectations toward the Fed's view for 2018. The timing of this convergence will depend critically on the path of realized inflation and inflation expectations. If the 5-year, 5-year forward TIPS breakeven rate rises above a level that is consistent with the Fed's 2% inflation target. That would signal that investors fear the Fed is falling behind the inflation curve. Our view remains that U.S. equities will continue to outperform U.S. Treasury bond market in 2017, although that view is as much about the poor prospective returns in the bond market as it is about our bullish view on stocks. Much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years. Feature With the labor market near full employment and the economy growing modestly, the U.S. economy is not in dire need of a "shot in the arm" from fiscal stimulus (Chart 1). The situation is very different from the early 1980s, early 2000s and during the aftermath of the collapse of Lehman Brothers in the fall of 2008. In early 2009, when the Congress and President Obama passed the $787 billion American Recovery and Reinvestment Act (ARRA), the economy was in the midst of the Great Recession and was still reeling from the collapse of Lehman Brothers and the freezing up of credit markets. Chart 1Trump Inheriting Best Economy For A New President In Decades Trump Inheriting Best Economy For A New President In Decades Trump Inheriting Best Economy For A New President In Decades Similarly, the economy was still struggling from the aftermath of the bursting of the technology, telecom and media bubble in 2000, when President Bush and an all-Republican Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001. When President Reagan and a split Congress passed the Economic Recovery Tax Act (ERTA) in August 1981, the economy had entered the second recession in as many years. While the economic expansion since the end of the Great Recession has been sluggish, and has not benefited all Americans the same way, the U.S. economy today is in much better shape than any of the three periods listed above. Monetary policy remains stimulative, financial conditions are easy and none of our forward-looking indicators warn of an economic downturn. Longer term, many of the policy proposals rattling around the Trump Administration may help to boost productivity and, ultimately, growth over the coming years. These include: simplifying the tax code; reducing regulation; and enacting legislation to enhance the nation's infrastructure. In the short term, however, some of those proposals may create uncertainty and thereby spark an economic soft patch (for example, the "border adjustment tax" or repealing Obama Care without immediately replacing it). Nonetheless, our main point is that the U.S. economy doesn't need a shot in the arm from fiscal policy to "rescue it" as was the case in decades past. The bottom line is that stocks may dip temporarily out of disappointment, but the economy will be fine even if Congress fails to boost infrastructure spending and/or cut taxes. Resetting The Stage The odds of a recession this year remain low, as there are few excesses in the system that typically lead to economic downturns. Just because the economic expansion that began in mid-2009 will turn eight years old later this quarter, that doesn't mean that a recession is imminent. We will continue to carefully monitor the economy for signs that excesses are building. But for now, our view remains that modest economic growth will continue, even without a boost from fiscal stimulus. The market has long questioned the pace of Fed rate hikes contained in the FOMC's 'dot plot'. Expectations for 2017 have converged on two more quarter-point hikes this year (Chart 2). It's a different story for 2018 and 2019, where the Fed sees 3 more hikes in 2018 and 4 more in 2019, but the market is pricing in just 2 and 1. Our view is that the market will adjust up expectations toward the Fed's view for 2018. The timing of this convergence will depend critically on the path of realized inflation and inflation expectations. A Tale Of Two Halves Headline inflation is likely to remain elevated and above the Fed's 2% target in 1H 2017, before fading modestly in the second half of the year as we pass the anniversary of the low in oil prices. That may cause markets to temporarily roll back the outlook for Fed tightening in 2018. Nonetheless, a continuing upward march in wage growth will keep pressure on core PCE inflation. The FOMC will likely 'look through' any softening in the headline rate that is simply due to oil prices. Notably, service sector inflation, which accounts for 2/3 of CPI, has been accelerating for 7 years and is above 3% (Chart 3). Chart 2Connected In 2017 And Disconnected After Connected In 2017 And Disconnected After Connected In 2017 And Disconnected After Chart 3Service Inflation Accelerating Service Inflation Accelerating Service Inflation Accelerating Rising short-term interest rates should not be a major headwind for the equity market to the extent that it is reflective of robust growth rather than surging inflation. Inflation expectations are only creeping higher at the moment according to market-based measures (Chart 4). Risk assets could run into trouble if the 5-year, 5-year forward TIPS breakeven rate rises above a level that is consistent with the Fed's 2% inflation target, at 2.4-2.5%. That would signal that investors fear the Fed is falling behind the inflation curve and will have to crank up the pace of tightening. The so-called 'Trump trades' are under pressure following the failure to reform Obamacare, at a time when U.S. equity valuations are stretched and some measures of equity sentiment are elevated. Nonetheless, we do not believe it is time to become defensive, scale back on risk assets, upgrade bonds and short the dollar. A lack of progress on a meaningful tax package and infrastructure plan may well end up being the catalyst for the first U.S. equity market correction of more than 5% in the Trump era. Nonetheless, the lack of excesses in the economy, general agreement between the Fed and the market on the path of rates for this year and rising, but still modest, inflation are likely to make any pullback in U.S. stocks a buying opportunity for investors. In fact, one could argue that fiscal stimulus at this point in the cycle would truncate the expansion because the Fed would have to respond more aggressively if the stimulus boosted inflation pressures. Fed Chair Yellen has made this point in recent public appearances. The failure to pass a tax reform package might undermine the long-term productivity story, but it could actually extend the length of this expansion and the equity bull market by delaying aggressive Fed rate hikes. Our view remains that U.S. equities will continue to outperform the U.S. Treasury bond market in 2017, although that view is as much about the poor prospective returns in the bond market as it is about our bullish view on stocks (Chart 5). Chart 4Inflation Expectations##br## Well Contained Inflation Expectations Well Contained Inflation Expectations Well Contained Chart 5Equities Continue To ##br##Outperform Bonds This Year Equities Continue To Outperform Bonds This Year Equities Continue To Outperform Bonds This Year The remainder of this week's publication focuses on the forces behind the continuing drop in risk asset correlations, and the implications for a mean-reversion in the equity risk premium. Correlation, ERP And Hurdle Rates Elevated financial market correlations have been a hallmark of this expansion, making life difficult for traders and for investors searching for diversification (Chart 6). Correlations have been higher than normal across assets, across regions and within asset classes. However, the situation has changed dramatically over the past 6 months. A drop in asset correlations is important for diversification reasons and because it provides a better backdrop for those seeking alpha. But the reasons behind the decline in correlations may have broader financial and economic implications. One can only speculate on the underlying cause of the surge in asset correlations in the first place. Our theory has been that the large global output gap lingered because of the sub-par recovery that followed the most damaging macroeconomic shock since the Great Depression. The growth headwinds were formidable and many felt that the sustainability of the recovery hinged solely on the success or failure of radical monetary policy. Either policy would "work", the output gap will gradually close, the deflation threat would be extinguished and risk assets would perform well, or it would fail, and risk assets would be dragged down as the economy fell back into recession. Thus, risk assets fluctuated along with violent swings in investor sentiment in what appeared to be a binary economic environment. In the March 2017 Quarterly Review, the Bank for International Settlements described it this way: "In a global environment devoid of growth but plentiful in liquidity, central bank decisions appear to draw investors into common, successive phases of buying or selling risk." In previous research, we developed a model that helps to explain the historical movements in correlations. We chose to focus on the correlation of individual stocks within the S&P 500 (Chart 7). The two explanatory variables are: (1) the equity risk premium (ERP; the difference between the S&P 500 forward earnings yield and the 10-year Treasury yield); and (2) rolling 1-year realized downside volatility.1 The logic behind the model is that a higher ERP causes investors to revalue cash flows from all firms, which in turn, causes structural shifts in the correlation among stocks. Conversely, a lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. Chart 6Market Correlations Are Shifting Market Correlations Are Shifting Market Correlations Are Shifting Chart 7Market Correlation And The ERP bca.usis_wr_2017_04_03_c7 bca.usis_wr_2017_04_03_c7 A rise in the ERP could occur for different reasons, but the most obvious include an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Volatility is included to explain the cyclical variation of correlations, but we use only below-average returns in the calculation because we are more concerned about the risk of equity market declines. It makes sense that perceptions of downside "tail risk" should affect investors' appetite for risk. The model almost completely explains the trend in stock price correlations over the past decade, highlighting the importance of the ERP in driving the structural change in correlations (Chart 8). But why was the ERP so elevated after 2007? The preceding moderation in risk premia in the 1990s was likely due to a decline in macroeconomic volatility, a phenomenon that began in the early 1980s and has since been dubbed "The Great Moderation". A waning in the volatility of global inflation and growth contributed to a decline in the volatility of interest rates, which are used to discount future cash flows. This also reduced the perceived riskiness of investing in securities that are leveraged to economic growth, thus causing investors to trim their required excess returns to equities. Unfortunately, the Great Moderation contributed to complacency and bubbles in tech stocks and, later, housing.2 The bursting of the U.S. housing bubble brought the Great Moderation to a crushing end, ushering in an era of rolling financial crises and monetary extremism. Our measure of downside volatility soon returned to normal levels after the recession-driven spike. However, the ERP continued to fluctuate at a higher average level, which helps to explain the strong correlation among risk asset prices in the years since the recession. The ERP And Capital Spending An elevated equity risk premium is consistent with the view that investors demanded a more generous premium to take risk in a post-Lehman world. This may also help to explain the disappointing rate of capital spending growth in the major countries in recent years. Firms demanded a fat "hurdle rate" when evaluating new investment projects. Sir John Cunliffe, a member of the Bank of England Monetary Policy Committee, recently cited survey evidence related to the dismal U.K. capital spending record since the recession.3 The main culprits were bank lending issues, the high cost of capital and elevated hurdle rates. Eighty percent of publically-owned firms in the survey agreed that financial market pressure for short-term returns to shareholders had been an obstacle to investment. This short-termism makes sense if investors feared that the recovery could turn to bust at any moment. The survey highlighted that market pressure, together with macro uncertainty among CEOs, kept the hurdle rate applied to new investment projects at close to 12%, despite the major drop in market interest rates. In other words, the gap between the required rate-of-return on new projects and the risk-free rate or corporate borrowing rates surged (Chart 9). Chart 8Modeling The Stock Price ##br##Correlation Within The S&P 500 Modeling The Stock Price Correlation Within The S&P 500 Modeling The Stock Price Correlation Within The S&P 500 Chart 9Capex Hurdle Rates ##br##Never Came Down Capex Hurdle Rates Never Came Down Capex Hurdle Rates Never Came Down J.P. Morgan concluded that hurdle rates have also been sticky at around 12% in the U.S.4 This study blamed uncertainty over the cash-flow outlook (macro risk) and the fact that CEOs believed that low borrowing rates are temporary. It is rational for a firm to hold cash and buy back stock if perceptions of downside tail risk remain lofty. The bottom line is that uncertainty and higher risk aversion related to macro volatility kept the ERP elevated, curtailing animal spirits and lifting correlation among risk asset prices. Chart 10Forward Multiple Scenarios bca.usis_wr_2017_04_03_c10 bca.usis_wr_2017_04_03_c10 The good news is that the situation appears to have changed since the U.S. election. Measures of market correlation have dropped sharply across asset classes, within asset classes and across regions. Animal spirits also appear to be reviving given the jump in consumer and business confidence in the major countries. We are not making the case that all risks have dissipated. The military situation in North Korea and upcoming European elections are just two on a long list. Our point is that, absent further negative shocks, perceptions of downside tail risk and a binary economic future should wane further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can now focus more on long-term revenue generation rather than on guaranteeing their existence. Does The ERP Have More Downside? It is difficult to determine the equilibrium equity risk premium, but back-of-the-envelope estimates can provide a ballpark figure. Let us assume that the ERP is not going back into negative territory, as was the case from 1980-2000. A more reasonable assumption is that the ERP instead converges with the level that prevailed during the last equity bull market, from 2003 to 2007 (about +200 basis points). The ERP is currently 3.2, which is equal to the forward earnings yield of 5.6 minus the 10-year yield of 2.4% (Chart 10). The ERP would need to fall by 120 basis points to get back to the 2% average yield of 2003-2007. This convergence can occur through some combination of a lower earnings yield or a higher bond yield. If the 10-year Treasury yield is assumed to peak in this cycle at about 3%, then this leaves room for the earnings yield to fall by 60 basis points. This would boost the earnings multiple from 17.8 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We lean to the latter scenario for bonds, although it will take some time for the bond bear phase to play out. In the meantime, an equity overshoot is possible. The bottom line is that much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years, although that will be much better than the (likely negative) returns in the bond market. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Downside volatility is calculated in a fashion similar to standard deviation, except only using below-average returns. 2 Of course, the Great Moderation was not the only factor that contributed to the financial market bubbles. 3 Are Firms Underinvesting - And If So Why? Speech by Sir Jon Cunliffe, Deputy Governor Financial Stability and Member of the Monetary Policy Committee. Greater Birmingham Chamber of Commerce. February 8, 2017. 4 It's Time to Reassess Your Hurdle Rates. J.P. Morgan, November 2016.

Highlights Portfolio Strategy A window has opened up for utilities outperformance. Upgrade to overweight on a short-term (1-3 month) view. Leading indicators of beverage sales have improved, heralding an upgrading in depressed expectations. Stay overweight. The pullback in consumer finance stocks appears to be contagion from the overall financial sector selloff than a reflection of deteriorating industry-specific fundamentals. Buy on weakness. Recent Changes S&P Utilities - Boost to overweight from neutral on a tactical basis. Table 1 Great Expectations? Great Expectations? Feature Our view remains that stocks are in a consolidation phase, waiting for economic/profit confirmation that earnings will grow into the latest valuation expansion. Thin equity market risk premia can be justified if the economy has embarked on an extended and strong non-inflationary growth path that will spawn robust corporate profitability. Chart 1A Second Half Squeeze? A Second Half Squeeze? A Second Half Squeeze? On this note, the third mini-economic up-cycle since the Great Recession has been underway since last year. The first two bursts of economic strength fizzled quickly, eventually requiring a new dose of stimulus to reinvigorate growth. The current up-cycle may have more legs given that the rest of the world is now participating and the U.S. economy at full employment, but it would be dangerous to become complacent. The stock-to-bond ratio has crested on a growth rate basis, and its mean reversion properties suggest that key macro gauges such as the ISM index may cool as the year progresses (Chart 1). Odds of growth-propelling fiscal stimulus, that equities have already bought and paid for, may now fade following Congress' failure to move on health care reform. Total bank credit growth is decelerating on a broad basis. Chart 1 shows that of the 8 major bank loan categories, only 1 has a positive credit impulse (the annual change in the 52-week rate of change), the other 7 are negative, i.e. it isn't simply C&I loan weakness driving the credit deceleration. Traditionally, credit and economic growth move together, so the current gap warrants close attention. Meanwhile, the reflationary impulse over the past 18 months from China is set to fade as the authorities tap the brakes, particularly in the housing market, which may throw a wrench into new construction. Chinese property prices have been especially correlated with global economic up-cycles. Real estate inflation downturns have been important global economic signals (Chart 1). Consequently, the second half of the year may 'feel' slower from a growth perspective and challenge the reflation hypothesis. Some trepidation about the durability/breadth of the economic expansion is becoming evident in internal market behavior. Our Intermediate Equity Indicator (IEI) has continued to weaken as breadth and participation thin (Chart 2). If the IEI drops below zero, the odds of a meaningful pullback will rise substantially. Keep in mind there is a lot of air between the S&P 500 index and its 40-week moving average. The number of S&P 500 groups with a positive 52-week rate of change has pulled back to post-Great Recession lows (Chart 2). Last week we showed a composite of relative industry and sector performance that also heralded a choppy period ahead for the broad averages. All of these factors suggest that a tactical consolidation needs time to play out, especially with first quarter reporting season fast approaching and optimism in the outlook bursting at the seams. While trading sentiment is not overly stretched, the truest measure of sentiment is asset valuations and expectations. On this front, our Global Economic Sentiment Index, which contrasts equity and government bond valuations in the major economies, has reached the 'extreme optimism' zone (Chart 3, middle panel). Such a reading does not automatically foretell of an imminent major equity peak, but reinforces that there is little margin for disappointment. Chart 2Deteriorating Internals Deteriorating Internals Deteriorating Internals Chart 3Early Signs Of Overconfidence? Early Signs Of Overconfidence? Early Signs Of Overconfidence? In addition, the trend in analyst earnings expectations is also consistent with an overriding theme of exuberance. Cyclical earnings estimates have tentatively peaked after a steep upgrade over the last few quarters, and are now sitting below 5-year growth expectations, suggesting overwhelming confidence in the longevity of the expansion. The last three times that cyclical (12-month) profit growth estimates diverged negatively from lofty long-term estimates was in 2000, 2007 and 2015 (Chart 3). Each episode coincided with ebullient global economic sentiment, and heralded market turbulence, with varying lags. The point is that when financial conditions tighten enough to undermine the cyclical growth outlook but fail to dent conviction in the long-term outlook, it is a signal of overconfidence. The good news is that financial conditions have remained historically easy and should only tighten gradually, such that the risk of a policy-induced slowdown is not acute. In sum, we expect the tactical consolidation phase to persist, especially if economic momentum cools. Exuberant expectations argue for a digestion phase, which should continue to broadly support defensive over cyclical sector positioning, a stance that has paid off nicely since late last year. We may look to selectively increase cyclical and financial sector exposure in the coming weeks if the U.S. dollar remains tame and inflation expectations perk back up, but for now, we are making a tactical addition to the defensive side of the ledger. Utilities Are Powering Up We booked sizable gains in the S&P utilities index and downgraded to neutral last summer, because of our view that bond yields were bottoming on the back of economic stabilization. Since then, relative performance collapsed by 20%, but it has recently started showing some signs of life. Is it time to re-enter this overweight position on a tactical basis? The short answer is yes. There are five reasons to buy utilities at the current juncture with a tactical (1-3 month) time horizon. A possible cooling in economic momentum will redirect capital into the sector. Last week we highlighted that the economically-sensitive transportation index may be heralding mean reversion in key activity gauges, such as the ISM manufacturing index (Chart 4). If the run of positive economic surprises reverses, utilities stocks should receive a sizeable relative performance boost. Transport stock underperformance typically means utility stock outperformance (Chart 4, bottom panel). A cycle-on-cycle analysis of relative utilities performance and the ISM manufacturing survey reveals that is pays to overweight utilities when the latter hits the current level. This has occurred seven times since the early 1990s, and the S&P utilities sector outperformed in the subsequent 3 and 6 months by an average of 3 and 5%, respectively. Only one period generated negative returns (Table 2). Chart 4Utilities Win When Transports Lose Utilities Win When Transports Lose Utilities Win When Transports Lose Table 2Contrary Alert: Buy Utilities Great Expectations? Great Expectations? Market-based inflation expectations have crested, aided by the dip in oil prices. Relative share prices have been inversely correlated with inflation expectations, owing to the link to long-dated Treasury yields. Importantly, the University of Michigan's survey inflation expectations, both short and long term, have been drifting lower signaling that the recent backup in CPI headline inflation will likely prove transitory (inflation expectations shown inverted, Chart 5). The flattening yield curve is also sending a tactical buy signal for utilities stocks (shown inverted, Chart 5). Natural gas prices are strengthening. Nat gas prices are the marginal price setter for non-regulated utilities, and the recent price spike has boosted utilities pricing power. Sell-side analysts have taken notice, aggressively ratcheting EPS numbers higher. Nevertheless, the relative EPS growth bar still remains low, signaling that a relative profit outperformance period looms (Chart 6). Chart 5External Support As... External Support As... External Support As... Chart 6... Earnings Recover ... Earnings Recover ... Earnings Recover One risk to our tactically bullish utilities view is stagnant electricity generation growth. However, if overall output growth recedes in the next quarter or two, then the non-cyclical power demand profile will shine through, offsetting low utility utilization rates in absolute terms. Bottom Line: There is scope for a playable relative performance rally in the coming one-to-three months. Boost the niche S&P utilities sector to overweight. Soft Drinks Are About To Pop Indiscriminate selling of all consumer staples immediately after the Trump victory restored value in a number of defensive consumer groups. They have stealthily outperformed for most of this year. Chart 7 shows a number of valuation yardsticks. Soft drink stocks are yielding more than both 10-year Treasurys and the broad market. Similarly, the relative P/S and P/E ratios have dipped comfortably below their respective historical means. From a technical standpoint, relative share price momentum has been pushed to a bearish extreme (Chart 7). Against this valuation and technical backdrop, any whiff of operating traction should trigger a playable outperformance phase. Industry pricing power has rebounded smartly, exiting the deflation zone (Chart 8). This firming in selling prices appears to be demand driven. Growth in relative consumer outlays on food and non-alcoholic beverages has improved. Actual industry sales growth has returned to positive territory and beverage output growth is outpacing other non-durable goods industries (Chart 8). While export trends have been a sore spot for beverage companies, the tide should soon turn. The greenback has depreciated versus emerging market (EM) currencies since mid-December, permitting EM central banks to ease monetary policy. That heralds a recovery in consumer goods exports and a reversal of negative translation FX effects (Chart 9, middle panel). Chart 7Cheap And Washed Out Cheap And Washed Out Cheap And Washed Out Chart 8Inflection Point Inflection Point Inflection Point Chart 9Export Drag Should Reverse Export Drag Should Reverse Export Drag Should Reverse The improvement in top-line leading indicators is particularly noteworthy given that cost inflation remains muted. Food input prices are contracting and ethylene prices, a primary packaging ingredient, are also deflating. With headcount under control (Chart 9, bottom panel), there is scope for margin expansion at a time when overall profit margins face a steady squeeze from rising wage inflation. This brightening backdrop, especially in relative terms, has not yet been embraced by the analyst community. Not only are earnings slated to trail the broad market by 7% in the coming year, but 5-year relative EPS growth has plummeted to all-time lows. Such pessimism is unwarranted. All of this implies that while recent beverage shipment growth has been soft, a recovery is likely as the year progresses. That will set the stage for a series of positive surprises, supporting share price outperformance. Bottom Line: The compellingly valued S&P soft drinks index has troughed and has a very attractive reward/risk profile. Were we not already overweight, we would lift exposure to above benchmark today. The ticker symbols for the stocks in the S&P soft drinks index are: BLBG: S5SOFD-KO, PEP, MNST, DPS. Consumer Finance: Cast Aside, But For No Good Reason Like all financials, consumer finance stocks have underperformed the broad market in recent weeks. High intra-financial sector correlations are understandable early in a corrective phase, especially given the magnitude of the initial post-election rally. However, as time passes, correlations should recede because significant discrepancies exist among industry profit drivers. For instance, any meaningful broad market correction could undermine capital markets activity via reduced appetite for new equity issues, less M&A activity and smaller trading fees, taking a bite out of investment banking profits. Elsewhere, banks have been riding hopes for higher net interest margins and an easing regulatory burden. However, without any corresponding improvement in credit growth they are now giving back those gains because bond yields have stalled, the yield curve has narrowed and expectations for deregulation are being watered down to a dilution of terms These factors justify the pullback in both banks and capital markets stocks, even if temporary. On the flipside, the consumer finance group has also been dragged down, even though leading indicators of profitability have continued to improve. As shown in past research, the credit card interest rate spread has low sensitivity to shifts in the yield curve. As such, receivables growth matters more to profits than the slope of the yield curve. Whether consumers embark on debt-financed consumption is heavily dependent on job security, debt-servicing costs, and household wealth. When consumer comfort rises, the personal savings rate tends to decline, indicating a greater propensity to spend. Household net worth has set a new all time high on the back of buoyant financial markets and recovery in house prices (Chart 10). Debt service payments remain historically depressed as a share of disposable income, underscoring that the means to re-leverage exist (Chart 10). Typically credit card charge-offs stay muted until well after debt servicing requirements hit a much higher level, either through reduced incomes or higher interest rates, or a combination of the two. At the moment, both are working in favor of credit quality, not against it. In fact, house prices have reaccelerated sharply in the past few months, which heralds share price outperformance (Chart 11, top panel). Moreover, the steady increase in housing starts bodes well for additional gains in outlays on durable goods, a positive omen for consumer credit demand. Chart 10Credit Quality Remains Strong Credit Quality Remains Strong Credit Quality Remains Strong Chart 11Bullish Leading Indicators Bullish Leading Indicators Bullish Leading Indicators The latter is already growing at a solid clip, in contrast with other lending categories such as C&I loan growth (Chart 11), which is weak and dragging down total bank credit. The surge in consumer income expectations points to an expanded appetite for debt (Chart 11). Consequently, the sell-off in the S&P consumer finance index should be treated as indiscriminate contagion from the rest of the financials sector rather than a reflection of deteriorating fundamentals. Recent value creation represents a buying opportunity. Bottom Line: Stick with a high-conviction overweight in the S&P consumer finance index. The ticker symbols for the stocks in the S&P consumer index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The locomotive of the U.S. economy, the consumer, remains supported by powerful tailwinds. The Fed will be able to tighten monetary policy relative to other central banks by a higher degree than the market appreciates. The dollar will rise further. Use this dip to buy more dollars. Being tactically long the yen is a hedge against growth disappointments. Set a stop-sell for AUD/NZD. Feature In June of last year, we wrote a piece titled "What Could Go Right?" arguing key changes in the global economy may have justified a more pro-risk stance for investors.1 The core of the argument was that markets were pricing in a lot of negatives, as the annual return of the global stock-to-bond ratio was deeply negative and could only fall further if a recession were to emerge. Moreover, as commodity prices were improving, we foresaw a waning of deflationary forces that had engulfed the world. This easing deflation would cause real rates to fall and economic activity in EM to rebound. Chart I-1Global Asset Prices: From Gloom To Glee Global Asset Prices: From Gloom To Glee Global Asset Prices: From Gloom To Glee Over the subsequent nine months, this scenario moved from the world of theories to being the reality for the global economy. Today, the annual return of the global stock-to-bond ratio is now the mirror image of last June (Chart I-1). Thus, for the stock-to-bond ratio to move higher, we need to explore where growth may come from. Moreover, we need to consider whether this growth is likely to help the dollar or help other currencies. The U.S. Is In Charge The U.S. economy continues to show the most promise. It is true that some signs do point to a weak Q1. Much noise has been made about the decline in commercial and industrial loans. We are more sanguine. To begin with, the Conference Board includes C&I loans in its list of lagging indicators, not leading ones. Additionally, C&I loans lag banks' lending standards, and, in fact, the weakness in this subsection of credit aggregates is the natural consequence of the 2015-2016 tightening in lending standards. Their recent easing points toward a rebound in C&I loans, as do core durable goods new orders (Chart I-2). What is more concerning is the slowdown in credit to households (Chart I-3). The U.S. economy is driven by household dynamics and the Conference Board does include consumer credit in its list of leading indicators. Moreover, the amount of MBS and ABS on primary dealers' balance sheets remains in a downtrend. This is worrisome because it suggests that the slowing accumulation of consumer debt on banks' balance sheet is genuine, and not a reflection of securitization (Chart I-4). Chart I-2C&I Loans##br## Will Pick Up C&I Loans Will Pick Up C&I Loans Will Pick Up Chart I-3However, Household Credit ##br##Dynamics Are A Worry However, Household Credit Dynamics Are A Worry However, Household Credit Dynamics Are A Worry Chart I-4Securitization Unlikely ##br##To Be The Culprit Securitization Unlikely To Be The Culprit Securitization Unlikely To Be The Culprit However, there are causes to minimize these concerns. Mainly, the drivers of household income and spending are still healthy. First, U.S. financial conditions remain easy, a phenomenon that tends to boost GDP growth in the following quarters, suggesting that national income will remain strong. Second, the outlook for employment in the U.S. remains robust. As Chart I-5 illustrates, the employment components of the ISM and the Philly Fed surveys both point to a pick-up in job creation. This further supports the notion that nominal household income will strengthen Third, our real disposable income indicator, based on various components of the NFIB survey, is showing that households should enjoy strong income growth in the coming months (Chart I-6). Moreover, despite the failure of the AHCA, Marko Papic, the head of BCA's Geopolitical Strategy service argues that it will be much easier for the GOP to implement tax cuts, especially geared toward the middle class, than it was to repudiate the much-maligned Obamacare.2 This could further help household disposable income. Chart I-5Job Growth Will Rebound Job Growth Will Rebound Job Growth Will Rebound Chart I-6Household Income: Highway Star Household Income: Highway Star Household Income: Highway Star Fourth, household liquid assets represent 270% of disposable income, the highest level in decades. Moreover, household debt-servicing costs are still near multi-generational lows, suggesting that households are in the best financial shape they have been in decades. And fifth, household confidence has surged to its highest levels since 2000, reflecting both the large increase in net worth created by surging asset values as well as the very low level of unemployment in the U.S. (Chart I-7). Thus, the decline in the savings rate from 6.2% in 2015 to 5.5% at present could deepen further, adding more impetus to transform income gains into consumption gains. At the worst, this development suggests that the household savings rate will not rise much. These factors all imply that household consumption will remain robust and may in fact accelerate in the coming quarters. Consequently, that capex too has upside. We have highlighted how capex intentions have risen substantially, and this has historically been a powerful leading indicator of capex itself.3 However, the financial press is replete with commentators reminding us that the positive global economic surprises have mostly been a reflection of "soft data" and that "hard data" has not followed through. Not only do we philosophically disagree with this statement - historically soft data does indeed lead hard data - but as Chart I-8 illustrates, core capital goods orders have risen quite sharply, mimicking the developments in retail sales. A combination of strong retail sales and strong orders tend to portend to a rise in capex. Chart I-7Happy Shiny People Happy Shiny People Happy Shiny People Chart I-8Capex Will Rebound Capex Will Rebound Capex Will Rebound These developments raise the likelihood that U.S. growth will power the global economy and that the Fed will be in a good position to make good on its intent to increase interest rates two more times this year. In fact, there is even a growing probability that the Fed will add another tool to its tightening arsenal: letting MBS run off, resulting in a contraction of its balance sheet. The combined tightening of two more hikes and a shrinking balance sheet will be much greater than any tightening emanating from an ECB taper. As we argued last week: Europe's inflation and wage backdrop remains icy cold, limiting how far the ECB can tighten monetary policy.4 While an environment of globally rising rates is normally negative for the yen, with the BoJ displaying and even easier bias than in the past, any increase in rates in the U.S. is likely to supercharge weaknesses in the yen, as the BoJ will put a lead on JGB yields and force them to remain subdued.5 As a result of these views, we remain very committed dollar bulls on a 12-18 months basis and recommend using the current dip in the dollar as a buying opportunity, especially on a trade-weighted basis. Bottom Line: While consumer loan growth has slowed - which could result in a poor Q1 U.S. growth number - the outlook for U.S. household income and consumption remains promising. This will also feed through to higher investment growth, clearing the Fed's path toward higher rates. This dip in the dollar should be used as an occasion to buy the greenback. But Why Still Long The Yen Tactically? This position has two purposes. First, we have been worried about dynamics in China that could cause a correction in EM markets.6 More recently, the decline in Chinese house-price appreciation has deepened, representing an ominous sign for the iron ore market (Chart I-9). Poor metal prices tend to represent a negative terms of trade shock and therefore an economic handicap for many large EM nations. Moreover, back in June, the improvement in Taiwanese IP was one of the factors that prompted us to highlight a potential improvement in the global economy. So was the uptrend in our boom/bust indicator. Today, not only is the boom/bust indicator losing steam, but Taiwanese IP has sharply rolled over (Chart I-10). While this is not a reason to worry about our bullish view on the U.S. economy, this could suggest that the global manufacturing upswing has seen its heyday, a development that is likely to weigh more heavily on EM economies than on the U.S. Any EM stress is likely to boost the yen's appeal, temporarily countering the BoJ's aggressive stance. Chart I-9Problems For Iron Ore Problems For Iron Ore Problems For Iron Ore Chart I-10Two Clouds For Global Growth Two Clouds For Global Growth Two Clouds For Global Growth Second, we do not want to be dogmatic on our U.S. growth view. As the top panel of Chart I-11 illustrates, increases in 2-year Treasury yields have tended to lead to decreases in U.S. inflation expectations. While we would argue that the U.S. economy is on a stronger footing to withstand higher rates than at any point since 2010, a policy mistake is not out of the scope of probabilities. If rising rates is indeed a policy mistake, a large risk-off event would be a very likely outcome, one that boosts the yen. Finally, as the middle and bottom panels of Chart I-11 shows, a fall in U.S. inflation expectations would also extract its toll on EM and cyclical plays, further reinforcing any disappointment out of China, and further adding shine to the yen. Our original target on USD/JPY was 110, we are moving it to 108. At this point, we will become sellers of the yen, unless we see signs that the global economy is entering a more dangerous path than originally anticipated. Additionally, investors looking to express a bearish view on EM may want to go short MXN/JPY (Chart I-12). The peso has massively rallied and is now at a crucial technical spot against the JPY. Moreover, while being short USD/JPY may be a dangerous move - after all, we are playing what amounts in our view to a countertrend bounce in the yen - if EM are at risk, these risks could be exacerbated by the tightening in financial conditions created by a higher dollar. Mexico, with its high external debt, representing nearly 70% of GDP, is particularly exposed to this problem. Also, MXN, with its high liquidity for an EM currency, is often a vehicle for investors to play EM weaknesses. Thus, shorting MXN/JPY could be a great hedge for investors with long EM exposures. Chart I-11Are We Out Of The Woods Yet? Are We Out Of The Woods Yet? Are We Out Of The Woods Yet? Chart I-12A Gauge And A Play A Gauge And A Play A Gauge And A Play Bottom Line: Being tactically long the yen in a portfolio offers two advantages. First, it is a direct play on any disappointment of investors in the EM space, and, second, it is also a hedge against the risks to our strong U.S. growth view. AUD/NZD: Not A Bargain It is often argued that AUD/NZD is a bargain as it trade 6% below its purchasing power parity rate. This may be a valid reason to buy this cross, but only for investors with extremely long investment horizons, as PPP deviations can take seven years to correct. In fact, following the recent rebound in AUD/NZD, we would be inclined to short this pair once again. On the international front, AUD/USD seems to be driven by the dynamic in Chinese nominal GDP growth. We doubt Chinese nominal GDP growth will accelerate much beyond Q1. As Chart I-13 illustrates, AUD/USD seems to have moved ahead of Chinese GDP, putting this currency at risk. We also can also interpret AUD/NZD as a vehicle to play the growth rebalancing in China. The AUD (iron ore, other metals, and coal) is a bet on industrial and investment growth while the NZD (dairy, meat, and wool) is a wager on the Chinese households. As China moves away from an investment-led growth model toward a more consumption-led growth model, AUD/NZD should underperform. A simple fair value model for this cross designed to capture these dynamics as well as the USD dynamics indicates that AUD/NZD is 8% overvalued (Chart I-14). Chart I-13AUD Prices In Chinese Optimism AUD Prices In Chinese Optimism AUD Prices In Chinese Optimism Chart I-14AUD/NZD Is Expensive AUD/NZD Is Expensive AUD/NZD Is Expensive Moreover, still with an eye firmly planted on China, AUD/NZD has tended to perform poorly when Chinese monetary conditions tighten. The recent upward move in the Chinese 7-day repo rate could be a harbinger of bad things to come for this cross. Relative domestic factors also temper any bullishness on AUD/NZD. Kiwi house prices are outperforming Aussie prices and New Zealand inflation is catching up to that of Australia's. Moreover, the RBA has been paying more attention to the poor state of the Australian labor market, while that of New Zealand remains very strong. These dynamics suggest that kiwi rates could rise relative to that of Australia (Chart I-15). More technically, investors are massively long the AUD relative to the NZD (Chart I-16). This usually is a good signal to bet against this pair. Chart I-15Domestic Conditions Favor##br## Higher NZ Rates Vs. Australia Domestic Conditions Favor Higher NZ Rates Vs. Australia Domestic Conditions Favor Higher NZ Rates Vs. Australia Chart I-16Speculators ##br##Are Bullish Speculators Are Bullish Speculators Are Bullish Bottom Line: Shorting AUD/NZD at current levels makes sense. Not only is it a way to take advantage of the desire by Chinese authorities to rebalance growth away from the Chinese industrial sector, the Kiwi economy is outperforming that of Australia, and too much negativity has been priced in for the RBNZ relative to the RBA. Finally investors are overly long the AUD relative to the NZD. Set up a stop-sell of AUD/NZD at 1.1100, with a target of 1.000 and a stop at 1.1330. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "What Could Go Right?", dated June 24, 2016 available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Five Questions On Europe", dated March 22, 2017 available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Outlook: 2017's Greatest Hits", dated December 16, 2016 available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "JPY: Climbing To The Springboard Before The Dive", dated February 24, 2017 available at fes.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The DXY displayed resilience this week: the third estimate for U.S. GDP in 2016Q4 outperformed expectations at 2.1%, after being revised up from 1.9%; consumer confidence increased to 125.6, the highest level since 2000; yet Initial jobless claims ticked in at 258,000, underperforming expectations of 248,000 but beating previous figures of 261,000. Another factor lifting the dollar were recent comments by Secretary of Transportation, Elaine Chao, who stated that Trump's $1 trillion infrastructure plan will be unveiled later this year. This could be considerably positive for U.S. economic growth as it will cover a large part of the economy: "transportation infrastructure, energy, water and potentially broadband and veterans hospitals as well." Although specifics were not disclosed, such stimulus in the face of tightening labor market could fan inflation. Under the assumption of a proactive Fed, this could translate into a strong dollar. Report Links: USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Last week's hawkish comments by ECB board member Ewald Nowotny drove the euro higher, while recent comments by Peter Praet confirmed that "a very substantial degree of monetary accommodation is still needed", which pushed the euro down. Promoting the euro's downside were Italian industrial sales and orders, which contracted at a monthly pace of 3.5% and 2.9% respectively, although annual rates remain positive. Article 50's invocation was another factor which contributed to volatility. How Brexit negotiations evolve will dictate movements in EUR/GBP for the foreseeable future. President Tusk's demeanor was also quite negative in his speech, focusing on minimizing "the costs for EU citizens, businesses and Member States". In other news, Portugal's Finance Minister Mario Centeno hinted at a possible upgrade to the growth forecast to around 2% from 1.5% as exports grew by 19% in January. As exports continue to be a key driver of growth for this country, this suggests a weaker euro is still needed to support growth in the periphery. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data has been mixed for Japan: Corporate services prices rose by 0.8% year-over-year, outperforming expectations. However, retail trade yearly growth deteriorated to 0.1% from 1% the previous month, underperforming expectations. Furthermore, manufacturing PMI fell to 52.6 from 53.3 the previous month. We are changing our tactical target for USD/JPY from 110 to 108. The decline in Chinese property prices as well as slowing inflation expectations in the U.S. might create a risk off environment that will affect carry currencies and will benefit the safe havens like the yen. On a cyclical basis, we remain yen bears, as recent sluggishness will only embolden BoJ policy makers to maintain their radical monetary stance. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 It's official: Theresa May has triggered Article 50. The pound reacted relatively positive to the event as both parties in the negotiations chose to start with the carrot rather than the stick: In her letter to the EU Theresa May stated that she hoped to enjoy a "deep and special" relationship with the European Union once Brexit is finalized. On the other side of the channel, Donald Tusk also pledged to work "closely" with their counterparts in London, and that he hoped that the U.K. will stay a close partner after Brexit. These developments are encouraging, as it shows that cooler heads might prevail at the end of the day. This rosier outlook in an environment where expectations for the Britain are still too pessimistic makes the pound a very attractive buy, particularly against the euro, despite the potential for short-term volatility as the stick will ineluctably come out. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 In an attempt to curb housing market euphoria, all four major banks - ANZ, CBA, NAB and Westpac - increased lending rates on investor and interest-only mortgages this month. Fitch Ratings reports that the tightening was done "ahead of probable regulatory tightening", as hinted frequently by the RBA. Rising wholesale funding costs due to tighter U.S. policy is also a motivating factor behind this. For the time being, the housing market risk will continue to be restricted through macroprudential policies rather than actual tightening by the central bank. Eventually risks related to record-high household debt will limit the capacity of the RBA to increase rates. On the brighter side, banks are well positioned with strong capital buffers and pre-impairment to profitability, with Fitch rating them 'Stable'. This means that risks may not lie with the banking sector, but that the consumer sector will be the key drag on growth. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 In the current environment, although we like to continue to be short the NZD against the yen, we are also shorting AUD/NZD once again. Beyond its uncorrelated nature, there are many reasons why this is an attractive cross to short: AUD/NZD tends to perform poorly when Chinese monetary conditions tighten. Therefore, the spike in Chinese repo rates could weigh on this cross. Furthermore, investors are very long the AUD relative to the NZD. This gives us confidence that this cross might be in overbought territory and that the 5.5% rally in AUD/NZD over the last 2 months may be exhausting itself. Finally, as we have mentioned before, domestic factors still favor the NZD, as kiwi house prices are rising at a faster pace than Aussie ones, which should put pressure on rate differentials. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD is displaying some strength on the back of stronger oil prices, outweighing the pressure from a stronger USD. As mentioned last week, the trend for USD/CAD is still negative in the short term, as corroborated by a negative MACD trend. The greenback's seasonal behavior is also generally negative in April, which could buoy the CAD in the next month. Nevertheless, at the Bank of Canada's meeting in two weeks, Poloz is likely to continue displaying a dovish rhetoric, limiting the CAD's resilience. Similar to Australia, risks lie with the consumer sector, which is burdened by a huge debt load. This gives another reason for Poloz to stay off hikes for the time being and concentrate instead on promoting the implementation of macroprudential policies to regulate lending standards and mitigate housing market risks. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF now hovers around 1.07, clearing the implied floor by the Swiss National Bank. Recent data have been positive: The Zew survey for economic expectations reached 29.6, up from 19.4 in February. It is now at the highest level in 3 years. The KOF leading indicator came at 107.6, above expectations. Although it does seem that the Swiss economy is still improving, the SNB will stay resolute in its intervention for the time being. Indeed, this was the message of SNB Governing Board Member Andrea Maechler, who asserted that there was no limit on their expansion of FX reserves, and that the Swiss franc was "strongly overvalued". We will continue to observe how the Swiss economy develops. However, for the time being the SNB is likely to keep its floor in place. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has been relatively flat this week, even in the face of a rally in oil prices. This has been in part due to a phenomenon that should continue in the next months: an appreciation of the U.S. dollar against EM and commodity currencies. Furthermore, domestic factors should continue to weigh on the krone, as employment continues to contract and inflation is receding due to the stabilization of the krone. Indeed, Governor Olsen signaled that the Norges bank will likely leave rates unchanged for "a good while" due to these developments. Furthermore, oil could be at risk as well, as the market is starting to doubt the Russian commitment to its deal with OPEC. This, coupled with a slowdown in EM, could prompt a down leg in oil, hurting the NOK in the process. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data came out strong: Retail sales annual growth remains unchanged at 2.7%; The producer price index grew at 7.5%; Consumer confidence for March was at 102.6, down from the previous 104.3. Interesting technical developments for the krona are pointing to further weakness. USD/SEK has rebounded from oversold levels and the MACD line is beginning to overtake the signal line. More importantly, the Coppock curve is rebounding, signifying a bullish trend. EUR/SEK is showing similar signs with the MACD pointing up and the Coppock curve rebounding. Interestingly, Swedish inflation expectations have substantially decreased this week which might give the Riksbank cover to remain dovish. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades