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Homebuilding relative performance is pulling back from the top end of its trading range, and there are low odds that it can exit this lateral pattern for the foreseeable future. The introduction of U.S. tariffs on Canadian lumber imports will keep lumber prices elevated, adding to the cost of building a new home. While homebuilders could attempt to pass through these cost increases, they are already having to offer price concessions to move new product. New home prices are deflating, warning that total sales growth is likely to slip further. Thus, while total home sales activity remains robust and there is still plenty of runway for residential construction to increase as a share of GDP, we are doubtful that this will translate into homebuilding stock outperformance. We recommend taking profits and downgrading to neutral, focusing housing-related investments in the home improvement retail index, as discussed in the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5HOME-PHM, DHI, LEN. Downgrade Homebuilders Downgrade Homebuilders

Highlights Portfolio Strategy Any advance in Treasury yields should be gradual and more reflective of an improving global economy than it would be restrictive for equities. Book profits in homebuilders and downgrade to neutral. Rising lumber prices will do more harm than good. In contrast, home improvement retailers are in a sweet spot. We reiterate our high-conviction overweight stance. Recent Changes S&P Homebuilding - Downgrade to neutral. Table 1 Awaiting A Catalyst Awaiting A Catalyst Feature Equities marked time at the top end of their range last week. A catalyst may be required to sustain a breakout to new highs, as robust corporate profitability and forward guidance, coupled with tame monetary conditions, are battling against a spate of economic disappointments and soft commodity prices. Financial conditions remain sufficiently easy that economic growth should rebound in the back half of the year. The Fed is in no hurry to aggressively tighten monetary policy, owing to the lack of a serious inflation threat. If hard data begin to firm, then investors will gain confidence in the durability of the profit recovery, powering a further share price advance. While there may be some concern that stronger growth will simply embolden the Fed and push up Treasury yields, we doubt that the latter will become a roadblock just yet. Last week we highlighted that it typically takes a rise to at least one standard deviation above the mean in BCA's Treasury Bond Valuation Indicator to warn that the economy and stocks are at risk of a major downturn. That level would equate to 3.3% on the 10-year Treasury yield (Chart 1). Such large moves in Treasury yields do occur occasionally, (Nov/2010-Feb 2011, summer of 2013 and winter of 2016) and have sometimes preceded/caused economic slowdowns and/or financial accidents. The speed of the adjustment clearly plays a role, as short-term spikes are much harder to digest than gradual yield advances. Nominal GDP growth is comfortably above the 10-year Treasury yield, signaling that financial conditions will stay sufficiently easy for some time, barring a major bond selloff (second panel, Chart 2). Chart 1Yields Have Room To Rise##br## Before Becoming Restrictive Yields Have Room To Rise Before Becoming Restrictive Yields Have Room To Rise Before Becoming Restrictive Chart 2Sales Will Support##br## The Overshoot Sales Will Support The Overshoot Sales Will Support The Overshoot In other words, any advance in yields should be gradual and more reflective of a better global economy than restrictive, especially given the ongoing gentle softening in the U.S. dollar. The upshot is that the string of economic disappointments should begin to fade. In recent research, we have stressed the importance of a meaningful revival in corporate sector revenue growth in order to sustain sky-high valuations (top panel, Chart 2). Encouragingly, inflation expectations are recovering globally. A whiff of inflation is a positive omen for top line growth prospects. Inflation and economic growth expectations have firmed around the world. Chart 2 shows that euro area sales per share are on track to exit deflation after a multiyear slump, based on the message from the bond market. The same is true for emerging markets. If companies outside the U.S. finally enjoy renewed top-line growth, that would bode well for a continued recovery in U.S. business sales, especially if the U.S. dollar weakens. Chart 3 shows that both EM currencies and regional confidence surveys are heralding ongoing gains in U.S. profits sourced from overseas. Nevertheless, it is critical to keep the backdrop in a longer-term context. BCA's Equity Speculation Index (ESI) signals that the advance is at a very high risk stage (Chart 4). The ESI can stay in elevated territory for a prolonged period, as occurred in 2014/2015, before a correction unfolds. But, investors should maintain some non-cyclical exposure even if the market continues its advance in the short run. Chart 3Foreign-Sourced Profit Support Foreign-Sourced Profit Support Foreign-Sourced Profit Support Chart 4The Rally Is Very High Risk The Rally Is Very High Risk The Rally Is Very High Risk This week we are updating our overall view of the consumer discretionary sector and tweaking our housing-related equity positioning. Consumer Discretionary: On The Way To All-Time Highs Consumer discretionary stocks have been portfolio stalwarts in 2017 (outside of autos and select media), advancing by over 10% and besting the S&P 500 by about 400bps. The heavyweight media sub-group (ex-cable and satellite) has come under scrutiny recently, as fears that ad spending will endure a deep slump have resurfaced. However, most of our indicators suggest that ad spending, at least outside of autos, will not suffer a major downturn, given our upbeat outlook for consumption and profits. Cord-cutting is not a new phenomenon, and is already reflected in very washed out profit expectations, both on a cyclical and structural horizon (we will be covering media in more detail in an upcoming Report). Consequently, there are good odds that this impressive consumer discretionary showing will remain intact especially as last Friday's payrolls bounced smartly. Two key drivers have added fuel to this fiery performance: border adjustment tax fears have subsided and soft economic data have given the Fed enough breathing room to continue erring on the dovish side. Importantly, leading indicators of discretionary spending are heralding a solid recovery in consumer outlays. Interest rates remain near generationally low levels and oil price inflation has peaked. The economy is near full employment, signaling that wage inflation will quicken. According to BCA's Income Indicator1, consumer income growth is expected to reaccelerate imminently (bottom panel, Chart 5). While consumers have demonstrated a preference for saving vs. spending, several factors suggest that purse strings should soon loosen. Consumer confidence has soared, buoyed by income gains (third panel, Chart 5). Moreover, new highs in household net worth as a percent of disposable income signal that the upward pressure on the personal savings rate should diminish (second panel, Chart 5). The implication is that recent disappointing consumer spending data should prove transitory. While these factors could ultimately put upward pressure on interest rates, there may be a window where limited inflation pressures and weak credit growth permit only a gradual upshift in the Treasury curve. Regardless, there are other indicators pointing to additional outperformance. For instance, there is still a wide gap between forward earnings breadth and washed-out technical conditions. Roughly 75% of consumer discretionary sub-groups have rising 12-month forward profit estimates. This is sustainable as long as consumers have an incentive to spend. In contrast, the proportion of consumer discretionary sub-indexes with a positive 52-week rate of change and/or are trading above their 40-week moving average remains well below 50%. This divergence between fundamentals and technicals is an exploitable gap, which should narrow via a sustained rise in relative share prices (Chart 6). Chart 5Upbeat Consumption Outlook Upbeat Consumption Outlook Upbeat Consumption Outlook Chart 6Exploitable Gap Exploitable Gap Exploitable Gap Finally, consumer discretionary stocks are no longer expensive. On a relative forward P/E basis they trade below the historical mean and at a discount to the S&P 500. Consumer discretionary EV/EBITDA is also trailing the broad market, as well as its long-term average. If a recovery in consumer outlays pans out in the back half of the year, as we expect, then a re-rating phase is likely. However, not all sub-groups are created equal. This week we are tweaking our housing-related consumer discretionary exposure. Homebuilders' Pain... Homebuilding stocks have been moving sideways for the better part of the past four years in a narrow trading range. They are currently sitting near the top of this range. Is it time to book profits? The short answer is yes. The recent confirmation of U.S. tariffs on Canadian lumber imports represents a source of cost inflation that may embed a risk premium in share prices until a new trade deal can be worked out. Lumber prices have nearly doubled during the past sixteen months and remain the best performing commodity in 2017 (bottom panel, Chart 7). Lumber comprises anywhere between 10%-20% of the cost of a new home, underscoring that a 20% lumber tariff will add to the cost of building a new home, squeezing margins unless homebuilders can pass this cost on via increased house prices. However, we are skeptical that there is a lot of room for new house price increases given that it would make it more difficult to compete with existing house sales. While new homes have taken market share from existing homes since the residential housing market trough earlier in the decade (Chart 8), market share gains have come at the expense of profit margins. Homebuilders have been aggressively discounting properties in order to lure new buyers. Given the buildup in new home inventories, further market share gains are at risk, unless additional selling price concessions materialize. Chart 7Elevated Lumber Prices... Elevated Lumber Prices... Elevated Lumber Prices... Chart 8...Spell Trouble For Homebuilding Margins ...Spell Trouble For Homebuilding Margins ...Spell Trouble For Homebuilding Margins The implication is that builders would likely have to absorb any input cost inflation, to the detriment of margins. Indeed, homebuilder sales are already decelerating as a consequence of pricing pressure (second panel, Chart 7). A simple homebuilder profit margin proxy (comprising new house price inflation minus the residential construction wage bill) warns that operating margins will compress, irrespective of the path of lumber prices (bottom panel, Chart 8). Nevertheless, there are some positive offsets that prevent us from turning outright bearish on the niche S&P homebuilding index. These counterbalances are related to the stage of the housing recovery. Homebuilders' sales expectations have surged, nearing the previous cycle's peak, according to the NAHB survey (Chart 9). Similarly, overall housing market conditions are probing multi-year highs and buyer traffic has vaulted to the highest level since mid-2005. Homebuilders remain optimistic about new housing demand. Household formation is still running higher than housing starts, representing a bullish backdrop for future new home construction. Rising incomes and a firming job market also bode well for the prospects of residential real estate. In aggregate, house prices are still expanding according to the Case-Shiller indexes and there are pockets of frothiness in select markets. The thirty year fixed mortgage rate recently broke back below 4% (Chart 10) and banks are willing extenders of mortgage credit, allaying fears that the price of credit will undermine housing affordability. According to our updated estimates (not shown), even if mortgage rates spiked 200bps from current levels, neither affordability nor mortgage payments as a percent of median incomes would return to their respective long-term average. Chart 9Housing Market Remains Firm... Housing Market Remains Firm... Housing Market Remains Firm... Chart 10...Warranting A Neutral Stance ...Warranting A Neutral Stance ...Warranting A Neutral Stance Still, these positives are already reflected in expectations, as the sell side has aggressively upgraded homebuilding profit estimates. The net earnings revisions ratio has catapulted to a 12-year high (Chart 10). Given our more balanced outlook for homebuilding earnings, we are leaning against this exuberance. Bottom Line: Book profits of 3.4% in the S&P homebuilding index and downgrade to neutral. The ticker symbols for the stocks in this index are: DHI, LEN, PHM. ...Is Home Improvement Retailers' Gain While our confidence in further homebuilding outperformance has ebbed, the opposite is true for the S&P home improvement retail (HIR) index. We put the S&P HIR index on our high-conviction overweight list at the beginning of the year, and so far, so good. HIR stocks have outperformed the broad market and the S&P consumer discretionary sector year-to-date. There are good odds that more gains lie ahead. Industry retail sales are running at a mid-single digit rate, surpassing lackluster overall retail sales (second panel, Chart 11). Importantly, household appliance and furniture selling prices have surged, reinforcing that demand is robust and signaling that HIR same-store sales growth will likely accelerate in the busy spring selling season, and beyond (middle panel, Chart 11). Unlike homebuilders, home improvement retailers benefit from rising lumber prices. HIR companies typically earn a set margin on lumber-related sales. Thus, any absolute increase in lumber prices boosts top line growth, and profit margins (bottom panel, Chart 11). The industry's disciplined approach to store additions in the aftermath of the GFC has set the stage for ongoing selling price gains. Chart 12 shows that while house prices have overtaken the 2006 highs, increasing the incentive for homeowners to remodel and invest in this key asset, building and supply store construction activity has remained depressed. Easier mortgage lending standards should ensure that total home sales activity remains elevated, to the benefit of home prices, and provide the necessary financing needed for large projects (Chart 12). Tight labor markets, rising wages and surging consumer confidence are signaling that consumers have an appetite to re-lever and space to take on more debt (Chart 12). With store capex budgets under tight control, same-store sales and cash flow growth are bound to sustain their solid advance as renovation activity accelerates. All of this is best encapsulated by our HIR model. The model has recently soared, driven by the drop in fixed mortgage rates and surge in lumber prices, signaling that the path of least resistance is higher for relative share prices (top panel, Chart 11). Indeed, relative profits have already soared to fresh highs, also signaling the same for relative share prices (top panel, Chart 13). Oddly, analysts are overly pessimistic about the industry's sales and earnings growth prospects. In fact, top line growth estimates are trailing those of the broad market, and the 12-month forward relative profit growth hurdle is set very low at 2% (middle panel, Chart 13). Chart 11All Signals Flashing Green All Signals Flashing Green All Signals Flashing Green Chart 12Capacity Restraint Is Paying Dividends Capacity Restraint Is Paying Dividends Capacity Restraint Is Paying Dividends Chart 13Earnings Led Advance Earnings Led Advance Earnings Led Advance Given the positive message from leading indicators of remodeling activity we are far more optimistic, and expect both relative top and bottom line growth numbers to overwhelm. Bottom Line: The re-rating phase in the S&P home improvement retail index has room to run. We reiterate our high-conviction overweight stance. The ticker symbols for the stocks in this index are: HD, LOW. 1 Please see Foreign Exchange Strategy Weekly Report, "U.S. Households Remain In The Driver's Seat," dated March 31, 2017, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

U.S. vehicle sales have slowed markedly in recent months, disappointing more buoyant forecasts. While auto stocks reflect this weakness, there appears to be lingering optimism that auto parts makers will have a better fate: auto parts stocks have diverged positively from auto stocks. However, a similar divergence occurred in 2015, which ultimately culminated in a relapse in auto parts shares. While consumer surveys show strong vehicle buying intentions, their ability to finance these purchases is becoming more restricted. Deteriorating auto loan credit quality has forced banks to significantly tighten vehicle-related credit standards. Rising borrowing rates represent a major headwind to auto sales growth, warning that the rise in auto parts new orders is destined for a sharp reversal. Auto parts industrial production is already contracting at a steep rate, underscoring that it is only a matter of time before auto parts demand tumbles. We reiterate our underweight position. The ticker symbols for the stocks in this index are: BLBG: S5AUTC -DLPH, BWA, GT. Auto Sales Disappoint, Again Auto Sales Disappoint, Again

Highlights The global credit impulse is 4 months into a mini-downswing, and it is too soon to position for the next mini-upswing. The euro area economy will remain one of the better performers in a global growth pause. Underweight German bunds in a global bond portfolio. Stay long the euro, especially euro/yuan. Go long euro area Financials versus U.S. Financials, currency unhedged, as a first foray into a beaten-up sector. Feature First the good news: the ECB's latest bank lending data indicate that the euro area 6-month bank credit impulse is stabilizing after a modest but clear decline in recent months (Chart I-2). Now the bad news: the global bank credit impulse continues to weaken. The upshot is that the euro area economy - even with 1.5% growth - will remain one of the better performers in what is now a very clear global growth pause. Chart of the WeekThe Global Bond Yield Has Shown ##br##A Regular Wave Like Pattern The Global Bond Yield Has Shown A Regular Wave Like Pattern The Global Bond Yield Has Shown A Regular Wave Like Pattern Chart I-2The 6-Month Credit Impulse Has Stabilized In The ##br##Euro Area... But Not In The U.S. Or China The 6-Month Credit Impulse Has Stabilized In The Euro Area... But Not In The U.S. Or China The 6-Month Credit Impulse Has Stabilized In The Euro Area... But Not In The U.S. Or China How To Play The Euro Area's Economic Outperformance In a global growth pause, the best way to play euro area economic outperformance is through relative positions in the bond markets and through currencies. Specifically, underweight German bunds in a global bond portfolio but stay long the euro, especially euro/yuan. The implication for euro area equities is more ambiguous. The Eurostoxx50 has a very low exposure to Technology, which tends to perform defensively in a growth pause. Conversely, the Eurostoxx50 has a high exposure to Financials, whose relative performance reduces to a play on the bond yield (Chart I-3). Given that the global credit impulse is still weakening, it is premature to expect a sustained absolute rally in Financials anywhere. Therefore, the strong knee-jerk absolute rally in European banks after the French election first round is unlikely to last. That said, with the euro area economy likely to outperform in a global growth pause, and euro area Financials still near a 50-year relative low versus U.S. Financials, euro area bank equities can now outperform banks in other markets (Chart I-4). Chart I-3Global Bond Yield = ##br##Financials Vs. Market Global Bond Yield = Financials Vs. Market Global Bond Yield = Financials Vs. Market Chart I-4T-Bond/German Bond Spread Compression =##br## Euro Area Financials Outperform U.S. Financials T-Bond/German Bond Spread Compression = Euro Area Financials Outperform U.S. Financials T-Bond/German Bond Spread Compression = Euro Area Financials Outperform U.S. Financials As a first foray into a beaten-up sector, go long euro area Financials versus U.S. Financials, currency unhedged. (Caveat: all of this assumes that Emanuel Macron beats Marine Le Pen to the French Presidency on Sunday, as we expect.) Don't Rely On Year On Year Comparisons Nature provides many of our units of time. The earth's orbit around the sun gives us a year; the moon's orbit around the earth gives us a month; the earth's rotation on its axis gives us a day. But there is absolutely no reason why economic and financial cycles should follow nature's cycles. Yet most analysts persist at looking for patterns and cycles in economic and financial data using yearly, monthly, or daily rates of change. Unfortunately, by focusing on years, months and days, they risk completely missing some of the strongest patterns and cycles in the economy and markets. Think about a clock pendulum. If you look at it once a second, it will always seem to be in the same position, motionless. You will miss the cycle. Likewise, if an economy regularly accelerates for 6 months and then symmetrically decelerates for 6 months, the yearly rate of change will be a constant, giving the false appearance that nothing is happening. It will miss the cycle. It turns out that the global economy does indeed regularly accelerate and decelerate - and that each half-cycle averages about 8 months. The strongest evidence of this very clear oscillation comes from the remarkably regular wave like pattern in the global bond yield, illustrated in the Chart of the Week and Chart I-5 and Chart I-6. Chart I-5The Global Bond Yield Has Shown A ##br##Regular Wave Like Pattern... The Global Bond Yield Has Shown A Regular Wave Like Pattern... The Global Bond Yield Has Shown A Regular Wave Like Pattern... Chart I-6...Which Is Easier To See ##br##When Detrended ...Which Is Easier To See When Detrended ...Which Is Easier To See When Detrended Furthermore, the acceleration and deceleration of bank credit flows - as measured in the global credit impulse - also exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months. But crucially, a half-cycle length of less than a year means that a year on year analysis would miss this very clear oscillation. Hence, our analysis always uses the 6-month credit impulse (Chart I-7). Chart I-7The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Mini Half-Cycles Average Eight Months It is not a coincidence that the bond yield and bank credit impulse exhibit near identical half-cycle lengths. The bond yield and credit impulse cycles are inextricably embraced in a perpetual feedback loop. A higher bond yield will initiate a mini down cycle. All else being equal, the higher cost of credit will weigh on credit flows. This will slow economic growth, which will then show up in GDP (and other hard) data. The bond yield will respond by readjusting down. In turn, a lower bond yield will then initiate a mini up cycle. And so on... But each stage in the sequence comes with a delay. For a change in the cost of credit to register with households and firms and fully impact credit flows, it clearly takes time. The credit flows do not generate instantaneous economic activity either. Fully spending the credit flows also takes time. Once you accept these assumptions of internal regulating feedback combined with delays in economic response, the economy has to be a naturally-oscillating system whose half-cycle length depends on the delays in economic response. And the important point is that these delays have little connection with nature's cycles. For those who are mathematically inclined, Box I-1 shows the differential equations which define the economic mini-cycle and its half-cycle length. Box 1The Mathematics Of Mini-Cycles Why Europe's 1.5% Growth Will Look Stellar Why Europe's 1.5% Growth Will Look Stellar Still, some commentators counter that credit flows don't just depend on the cost of credit. They also depend on so-called "animal spirits" - optimism or pessimism about the future. These commentators point to sentiment and survey data which show that animal spirits have soared. Our response is yes, for credit flows, heightened animal spirits in isolation are indeed a tailwind. But any rise in the cost of credit is a headwind. It follows that the net impact on credit flows depends on the relative strengths of the tailwind from heightened animal spirits and the headwind from the higher cost of credit. It is the net effect on the 6-month credit impulse - rather than heightened animal spirits per se - that determines the cyclical direction of the economy. We would suggest that the tailwind from heightened animal spirits has been countered by an even stronger headwind - the sharpest proportional rise in borrowing costs for at least 70 years (Chart I-8). Chart I-8The Sharpest Proportional Rise In Borrowing Costs For At Least 70 Years! The Sharpest Proportional Rise In Borrowing Costs For At Least 70 Years! The Sharpest Proportional Rise In Borrowing Costs For At Least 70 Years! As anticipated in our 16th February report The Contrarian Case For Bonds, incoming GDP data from the world's largest economies - the U.S., U.K. and France - now confirm this. First quarter growth (at annualised rates) sharply decelerated to 0.7%, 1.2% and 1.0% respectively. And this is not just about so-called first quarter "residual seasonality" as 6-month growth rates have also lost momentum. The global credit impulse is 4 months into a mini-downswing; the global bond yield is 2 months into a mini-downswing. Previous half-cycles have averaged 8 months, with the shortest at around 5 months. Hence, we feel it is somewhat premature to position for the next mini-upswing. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* The rally in Portuguese sovereign bonds appears technically overextended. Go short Portuguese sovereign 10-year bonds versus Spanish sovereign 10-year bonds with a profit target and stop loss of 2.5% . For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 10-Year Bonds: Short Portugal / Long Spain 10-Year Bonds: Short Portugal / Long Spain * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

We are making room for the financials sector upgrade by trimming the health care sector to neutral. As discussed in recent weeks, a modest shift away from a defensive to a more balanced portfolio has been on our radar. At the beginning of the year we added the S&P health care equipment (HCE) index to our high-conviction overweight list for three main reasons: valuations had undershot owing to health care reform uncertainty, domestic sales were set to improve and leading indicators of foreign sourced revenue also painted a rosy picture. But some of these forces are losing their potency. The most troubling aspect has been a downturn in leading indicators of domestic demand growth. New health care facility construction has dropped sharply, warning that investment in medical equipment may soon follow suit (second panel). Consumer outlays at hospitals have nosedived on a growth rate basis. This suggests that the growth in patient visits has dried up, and may be a warning that medical equipment new order growth will also decelerate (third panel). Moreover, as outlined in recent Weekly Reports, the broad corporate sector has regained pricing power, but medical equipment suppliers have lagged (bottom panel). The implication is that our confidence in a further valuation re-rating has been dented. Take profits and downgrade to neutral, and please see yesterday's Weekly Report for more details. This brings our overall health care sector weighting to neutral. Take Profits In Health Care Equipment Take Profits In Health Care Equipment

The financials sector has given back roughly 50% of its post-election surge this year. The main culprits have been a calming in Fed interest rate hike expectations, a flattening yield curve and softening inflation expectations. Moribund credit creation has also created earnings uncertainty. Nevertheless, the corrective phase appears to be drawing to a close. The hiatus in the U.S. dollar bull market is a significant positive catalyst, if it arrests the decline in inflation expectations. The yield curve is making an effort to stabilize, suggesting that the risks of falling back close to the deflationary precipice are low. There are already signs of a positive reversal in euro area financials, which had led the U.S. financial sector on the way down after peaking late last year. The euro area has been in a deleveraging phase with acute deflationary risks, underscoring that the signal from share price stabilization in this region is worth noting. The key to a sustained recovery in sector profits is economic reacceleration. Corporate sector profits are healing as a consequence of the pickup in global final demand and the peak in the U.S. dollar, which should ensure that labor market slack does not imminently build. We recommend using this year's selloff to augment positions to overweight, via the bank index, as discussed in yesterday's Weekly Report. Upgrading Financials Upgrading Financials

Highlights Chart 1Rate Hikes Lagging Wage Growth Rate Hikes Lagging Wage Growth Rate Hikes Lagging Wage Growth Last Friday's GDP report showed that the U.S. economy grew a meagre 0.7% (annualized) in the first quarter of 2017, well below levels necessary to sustain an uptrend in inflation. However, our forward looking indicators still point to U.S. growth of around 2% during the next few quarters. It is likely that faulty seasonal adjustments suppressed Q1 GDP growth. Q1 growth has averaged -0.1% during the past 10 years, while Q2 growth has averaged more than 2%. Q2 growth has also exceeded Q1 growth in 8 of the last 10 years. For its part, the Bloomberg Barclays Treasury index has provided an average return of close to 1% during the past 10 Q1s and an average return of 0.4% during the past 10 Q2s. Treasury returns have been greater in the first quarter than in the second quarter in 6 out of the past 10 years. Investors would be wise to ignore Q1 GDP and stay focused on the uptrends in wage growth and inflation that are likely to persist (Chart 1). With the market priced for only 38 bps of rate hikes between now and the end of the year, there is scope for the Fed to send a hawkish surprise. Stay at below-benchmark duration and short January 2018 Fed Funds Futures. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 23 basis points in April. The index option-adjusted spread tightened 2 bps on the month and, at 116 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 a recent report,1 we noted that net leverage (defined as: total debt minus cash, as a percent of EBITD) is positively correlated with spreads, and also that it has never reversed its uptrend unless prompted by a recession. In other words, the corporate sector never voluntarily undertakes deleveraging, it only starts to pay down debt when forced by a severe economic contraction. We conclude that debt growth will likely continue to outpace profit growth (panel 4), even as profits rebound over the course of this year. If our anticipated timeline plays out, we will be looking to scale back on credit risk in 2018, when inflationary pressures are more pronounced and the Fed steps up the pace of tightening. Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3). Further, our commodity strategists expect OPEC production cuts will be extended through to the end of the year, and that $60/bbl remains a reasonable target for oil prices. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Time Of The Season Time Of The Season Table 3BCorporate Sector Risk Vs. Reward* Time Of The Season Time Of The Season High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 62 basis points in April. The index option-adjusted spread tightened 12 bps on the month and, at 371 bps, it is currently 27 bps above its 2017-low. Wider junk spreads in recent months appear to be largely related to flight-to-safety flows driven by elevated global political uncertainty. We find it notable that spreads tightened following the market-friendly result of the first round of the French election. While political uncertainty remains, we view current spreads as attractive on a 6-12 month horizon. In a recent report,2 we tested a strategy of "buying dips" in the junk bond market and found that it produced favorable results in a low-inflation environment. With the St. Louis Fed's Price Pressures Measure still suggesting only a 6% chance of PCE inflation above 2.5% during the next 12 months, we think this strategy will continue to work. Moody's recorded 21 defaults in Q1 (globally) down from 41 in the first quarter of 2016, with the improvement attributable to recovery in the commodity sectors. While commodity sectors still accounted for half of the defaults in Q1, Moody's predicts that the retail sector will soon assume the mantle of "most troubled sector." According to Moody's, nearly 14% of retail issuers are trading at distressed levels. Moody's still expects the U.S. speculative grade default rate to be 3% for the next 12 months, down from 4.7% for the prior 12 months. Based on this forecast we calculate the High-Yield default-adjusted spread to be 207 bps (Chart 3), a level consistent with positive excess returns on a 12-month horizon more than 70% of the time. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in April. The conventional 30-year MBS yield fell 10 bps on the month, driven by an 11 bps decline in the rate component. The compensation for prepayment risk (option cost) rose by 2 bps, but this was partially offset by a 1 bp tightening in the option-adjusted spread (OAS). Since the middle of last year the MBS OAS has widened alongside rising net issuance, but this has been offset by a falling option cost (Chart 4). This is exactly the price behavior we would expect to see in an environment where mortgage rates are moving higher and the market is starting to discount the Fed's eventual exit from the MBS market. Higher mortgage rates suppress refinancings, and this will ensure that the option cost component of spreads remains low. However, higher mortgage rates are also unlikely to halt the uptrend in net MBS issuance, since the main constraint on housing demand this cycle has been insufficient household savings, not un-affordable mortgage payments.3 This means that OAS still have room to widen alongside greater net issuance. The winding down of the Fed's mortgage portfolio - a process that is likely to begin later this year - will only add to the supply that the market needs to absorb. How will the opposing forces of low option cost and widening OAS net out? The option cost component of spreads is already close to its all-time low, while the OAS is still 16 bps below its pre-crisis mean. We think it is unlikely that a lower option cost can fully offset OAS widening. 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 2 basis points in April, bringing year-to-date excess returns up to 75 bps. The high-beta Sovereign and Foreign Agency sectors outperformed by 8 bps and 1 bp, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors outperformed by 7 bps each. Local Authorities underperformed the Treasury benchmark by 23 bps. Since the beginning of the year, excess returns from the Sovereign sector have been supported by a weakening U.S. dollar (Chart 5). Mexican debt, in particular, has benefited from a 10% appreciation of the peso relative to the U.S. dollar (panel 3). A stronger peso obviously makes Mexico's USD-denominated debt easier to service and has led to year-to-date excess returns of 402 bps for Mexican sovereign debt relative to U.S. Treasuries. Mexican debt accounts for 21% of the Sovereign index. Our Emerging Markets Strategy service thinks that Mexico's central bank could deliver another 50 bps of rate hikes, because inflation is above target, but also maintains that further rate hikes will soon start to squeeze consumer spending.4 Conversely, the Fed has scope to hike rates much further. Sovereigns no longer appear expensive on our model, relative to domestic U.S. corporate sectors. But we still expect them to underperform as the dollar resumes its bull market. Local authorities and Foreign Agencies still offer lucrative spreads on our model, and we remain overweight those spaces within an overall underweight allocation to the Government-Related index. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in April (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio was flat on the month, but has fallen 15% since peaking shortly after the U.S. election (Chart 6). The sparse details of the Trump administration's proposed tax reform plan, released last week, did not include any specific mention of the municipal bond tax exemption, but did call for the elimination of "targeted tax breaks" leaving some to wonder if the tax exemption is in play. It is too soon to tell whether repealing the tax exemption will be part of the final tax reform plan, although its repeal would be at odds with the President's stated desire to spur infrastructure spending. For this reason, we suspect the tax exemption will ultimately survive. Assuming the tax exemption survives, the proposed repeal of the Alternative Minimum Tax and of the state & local government income tax deduction should both increase demand for tax-exempt municipal bonds. However, this positive impact will be offset by lower tax rates. All in all, it is too soon to know how this will all shake out, but the considerable uncertainty makes us reluctant to take strong directional bets in the municipal bond market for now. Meanwhile, Muni mutual fund inflows have totaled more than $9 billion since the beginning of the year, while total issuance is at a 12-month low. Strong inflows and low supply likely explain why yield ratios are testing the low-end of their post-crisis trading range. 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 shifted lower in April, with the 2/10 slope flattening by 12 basis points and the 5/30 slope steepening by 6 bps. The 5-year Treasury yield declined 12 bps on the month, while the 10-year yield fell 11 bps. The 2-year yield actually ticked 1 bp higher. Significant outperformance in the 5-year part of the curve means that our recommendation to favor the 5-year bullet over a duration-matched 2/10 barbell has returned 27 bps since inception on December 20, 2016. This 5-year bullet over duration-matched 2/10 barbell trade is designed to profit from 2/10 curve steepening, which has not yet materialized. Instead, the trade has performed well because the 2/5/10 butterfly spread has moved much closer to our estimate of fair value (Chart 7). The 5-year bullet still looks moderately cheap on the curve, but no longer offers an exceptional valuation cushion. For our trade to outperform from here we will likely need to see some 2/10 curve steepening. We continue to hold the 5-year bullet over duration-matched 2/10 barbell trade, because we still expect the 2/10 slope to steepen. This steepening will be driven by wider long-maturity TIPS breakevens which should eventually catch up to leading pipeline inflation measures (see next page). In a recent report,5 we outlined the main drivers of the slope of the yield curve on a cyclical horizon and concluded that wider breakevens can cause the nominal curve to steepen even with the Fed in the midst of hiking rates. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 25 basis points in April. The 10-year TIPS breakeven rate declined 5 bps on the month and, at 1.92%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Our Financial Model of TIPS breakevens - which models the 10-year TIPS breakeven rate using the stock-to-bond total return ratio, the price of oil and the trade-weighted dollar - attributes the recent decline in breakevens to weakness in the stock-bond ratio and the fact that the 10-year breakeven rate was already quite elevated compared to fair value (Chart 8). Both core and trimmed mean PCE inflation dropped sharply in March, and are now running at 1.6% and 1.8% year-over-year, respectively (bottom panel). This decline is likely to reverse in the coming months. Crucially, pipeline inflation measures, such as the ISM prices paid index, are holding firm at high levels (panel 4). We remain overweight TIPS versus nominal Treasuries on the view that growth will be strong enough to keep measures of core inflation on a steady upward trajectory, eventually converging with the Fed's 2% inflation target. In that environment, TIPS breakevens should eventually return to their pre-crisis range. In last week's report,6 we considered the possibility that TIPS breakevens might not return to their pre-crisis trading range, even if measures of core inflation remain strong. The most likely reason relates to structural rigidities in the repo market that have made it more costly to arbitrage the difference between real and nominal rates. For now, we consider this simply a risk to our overweight view. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in April, bringing year-to-date excess returns up to +33 bps. Aaa-rated issuers outperformed the Treasury benchmark by 10 bps on the month, while non-Aaa issues outperformed by 13 bps. The index option-adjusted spread for Aaa-rated ABS tightened 1 bp on the month, and remains well below its average pre-crisis level. 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,7 it is usually an indication that there is growing concern about ABS collateral credit quality. This concern is echoed by the fact that net losses on auto loans are trending sharply higher (Chart 9). Credit card charge-offs remain subdued for now - and we continue to recommend that investors favor Aaa-rated credit cards over Aaa-rated auto loans - but even in the credit card space quality concerns are starting to mount. Capital One reported a 20% drop in earnings in Q1 versus the same quarter in 2016, and noted that it has been tightening underwriting standards against a back-drop of credit card loans growing faster than income. We remain overweight ABS for now, as the securities still offer attractive spreads compared to other high-quality spread product, but we are closely monitoring credit quality metrics for signs of rising stress. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in April, bringing year-to-date excess returns up to +19 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month, and is fast approaching its average pre-crisis level. Apartment and office building prices are growing strongly, but as in the corporate space, the retail sector is a major drag (Chart 10). Tighter lending standards and falling demand also suggest that credit stress is starting to mount, but while office and retail delinquencies are rising multi-family delinquencies remain low (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in April, bringing year-to-date excess returns up to +19 bps. The index option-adjusted spread for Agency CMBS widened 1 bp on the month, and currently sits at 54 bps. The option-adjusted spread on Agency CMBS looks attractive compared to other high-quality spread product: Agency MBS = 35 bps, Aaa consumer ABS = 46 bps, Agency bonds = 17 bps and Supranationals = 20 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 2.59% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.43%. 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. It should also be noted that the fair value readings from both the 2-factor and 3-factor models are calculated using FLASH PMI estimates for April. These estimates will be revised later today when the actual PMI data are released. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.32%. 1 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 4 Please see Emerging Markets Strategy Weekly Report, "A Time To Be Contrarian", dated April 5, 2017, available at ems.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 7 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 April 30, 2017. The model has increased its allocation to Spain at the expenses of Germany largely driven by changes in the value and technical indicators, 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) outperformed its benchmark by 99 basis points (bps) in April, largely a result from the overweight of the euro area versus the underweight in Japan, Canada and Australia. Level 1 model, the allocation between U.S. and non-U.S., underperformed by 13 bps in April due to the large overweight in the U.S. Overall, the aggregate GAA model outperformed its MSCI World benchmark by 15 bps in April and by 138 bps since going live. 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. 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) GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of April 30, 2017. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates The growth component has become more bullish on global growth. The model has now turned overweight on materials & consumer discretionary, and underweight on utilities & healthcare. For more 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 Geopolitical tensions eased last week, but there are still a few near term hurdles to clear. Domestic policy uncertainty remains. Investors still can't seem to reconcile the disconnect between weak "hard" data and solid "soft" data. A gradual Fed may be the right response to the recent run of mixed economic data. Housing and housing-related investments led the global economy into the last recession. Housing is still on the mend. The housing sector will contribute about 0.2 percentage points and 0.5 percentage points to real GDP growth in 2017 and 2018, respectively. Investors should look to housing-related assets as a source of potential outperformance over the coming 6-12 months. Feature U.S. equity prices neared record highs and Treasury yields bounced off of their late-March low last week as near term international and domestic political risk melted away in the minds of investors. We continue to expect U.S. equities to beat bonds this year. Oil prices continue to trade near $50/bbl, and the dollar held steady amid all the news-good and bad. Both have upside over the remainder of 2017. In today's report, we examine the following key issues for investors: Since the end of the Great Recession, geopolitical risks have ebbed and flowed, and 2017 has proven to be no different. Are political risks over, or just over for now? How does the recent run of mixed U.S. data influence the Fed, and what does this mean for risky asset prices? Housing and housing-related investments led the global economy into the last recession. Where do we stand now? Are Geopolitical Concerns Over? North Korea failed to test another nuke after a nerve rattling Easter Weekend. The leadup to the presidential election in South Korea on May 9 may have motivated a part (or most) of the uptick in belligerence that we are seeing from North Korea. All leading candidates are more likely to try diplomacy and economic engagement with North Korea than to maintain the past ten years of conservative efforts to strengthen military deterrence via stronger alliances with the U.S. and Japan. In the euro area, the good news is that the polls in the first round of the French election (April 23) were correct. The bad news is that there is still another election. Macron and Le Pen face off on this Sunday (May 7), and markets are betting that the polls will be correct again given Macron's 20 point lead over Le Pen. The June parliamentary elections in France should be a non-event for U.S. financial markets; we still see Italy - where most voters favor Eurosceptic parties - as the biggest risk on the geopolitical scene in the next year or so. In the U.K., the ruling Tories look to add to their majority in June's parliamentary election, which will provide British Prime Minister Theresa May with a stronger hand to negotiate with Europe and increases the odds of a less extreme Brexit outcome (Chart 1). Chart ICGeopolitical Risk Is Ebbing...For Now Geopolitical Risk Is Ebbing...For Now Geopolitical Risk Is Ebbing...For Now Chart 1BGeopolitical Risk Is Ebbing...For Now Geopolitical Risk Is Ebbing...For Now Geopolitical Risk Is Ebbing...For Now Chart 1AGeopolitical Risk Is Ebbing...For Now Geopolitical Risk Is Ebbing...For Now Geopolitical Risk Is Ebbing...For Now There was good news and bad news on the domestic policy front last week as well. The release of the long awaited Trump tax plan and the passage of a spending bill by Congress to avert a government shutdown (at least until later this week) helped to remove some domestic political uncertainty. The bad news is that the plan was more tax cut than tax reform. The one page plan lacked detail and still has to pass muster with the House GOP. The Trump Administration may have started a trade war with Canada (over lumber) and sent trial balloons about pulling out of NAFTA (despite walking back from this position soon after). Is this "negotiator" Trump or something worse? The bad news is that tax reform, trade wars, dynamic scoring, and yes, even Obamacare will be with us until late Summer/early Fall. The good news is that the border adjustment tax may not be. The takeaway for investors is that while geopolitical concerns have not disappeared, they have ebbed, and this will support the relative performance of U.S. equities over 10-year government bonds over the coming year. Italy (not North Korea, France, or Germany) remains the biggest geopolitical risk on the horizon, but the next election there isn't until early-2018. Domestically, Trump's pro-growth agenda is advancing at a pace that is slower than many investors would prefer, but it is advancing, which we believe will continue to support a pro-cyclical asset allocation stance. Bottom Line: Geopolitical concerns have not disappeared, but they have ebbed materially to the benefit of risky asset prices. Investors should stay overweight U.S. stocks vs 10-year government bonds within a multi-asset portfolio. Mixed Data Warrants A Gradual Fed Investors still can't seem to reconcile the disconnect between weak "hard" data and solid "soft" data. The recent uptick in initial claims and the soft Q1 GDP data are the most recent examples. Investors should recall that claims are inherently noisy; a rise in claims of more than 75,000 over a 6-month period is typically needed to signal a recession. Chart 2 makes it clear that the latest wiggles on claims are not sending a recessionary signal. Chart 2Claims Are Not Even Close To Sending A Recession Signal Claims Are Not Even Close To Sending A Recession Signal Claims Are Not Even Close To Sending A Recession Signal Friday's GDP report highlighted that growth in Q1 was soft again. As we noted in last week's report, GDP growth in Q1 averaged -0.1% over the last 10 years. Q2 growth has averaged more than 2%. Q1 growth has been below Q2 in 8 of the last 10 years. 2017 is shaping up to be a repeat performance. Defense spending - identified by the Cleveland Fed as a key culprit in the unwanted seasonal weakness in Q1 GDP - fell 4% in Q1, subtracting 0.2% from growth. Inventories were also singled out by the Cleveland Fed, and they shaved 0.9% off of GDP in Q1. We expect to see a snapback in all three components of growth (GDP, defense spending and inventories) in Q2. Business capital spending, and housing were bright spots in Q1 (Chart 3). Corporate earnings are the ultimate piece of hard data. Equity prices track earnings growth over the long term. With 288 members of the S&P 500 reporting, 77% have beaten expectations on the bottom line. Healthcare, financials and technology lead the way. Weakness was evident in defensives. More impressive is the 7.1% gain in revenues in Q1 so far (Table 1). But overall, corporations appear to have pricing power. The ECI accelerated in Q1 to +2.4% year-over-year from +2.2%, but remain relatively subdued. This implies that margins will hold up, which will continue to support our view that stocks will beat bonds this year. With no Fed Chair Yellen press conference, a new set of dot plots or a new economic forecast, markets will have to be content with just the FOMC statement this week. A speech by Fed Vice Chair Fischer will be closely watched for signals about the June FOMC meeting. The market has been too quick to price out rate hikes in 2017. Expectations for rate hikes in 2018 have all but disappeared (Chart 4). We expect this gap will close - in favor of the Fed for both 2017 and 2018. We expect Treasury yields and inflation to head higher this year, despite recent soft readings on March CPI. The March PCE deflator - also due this week-is key. Chart 3Markets Shouldn't Be Surprised By Weak##br## Q1 GDP, Or What Caused It The Good And The Bad The Good And The Bad Table 1S&P 500: ##br##Q1 2017 Results* The Good And The Bad The Good And The Bad Chart 4Still Plenty Of Disagreement Between Fed ##br##And Market; Both Expect Gradual Hikes Though Still Plenty Of Disagreement Between Fed And Market; Both Expect Gradual Hikes Though Still Plenty Of Disagreement Between Fed And Market; Both Expect Gradual Hikes Though Bottom Line: We continue to expect the hard data to catch up to the soft data in the coming months. Financial markets have overreacted to the weak data and have been too quick to price out Fed rate hikes this year and next. The Fed is taking a gradual approach to rate hikes for a reason; the data-hard or soft-doesn't warrant an aggressive Fed. But a gradual Fed and solid profit growth strongly favor an allocation towards stocks over bonds this year. Housing: Set To Keep A "Slow-Burn" Expansion Burning Housing is one sector of the economy that stands to look relatively good over the coming few years, with some important implications for housing-related asset performance. The monthly Bank Credit Analyst recently published some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment in the labor market, similar to what has occurred since the Great Recession. Chart 5 compares the current cycle (dotted lines) with the average of the 1980s and 1990s long expansions (solid lines). The cycles are all lined up with the beginning of the expansion, indicated by the first vertical line. These long "slow burn" recoveries also extended well beyond the point at which the economy first reached full employment (called late-cycle phases, shaded in Chart 5). Inflation pressures were slower to emerge in these types of recoveries, allowing the Fed to proceed cautiously when normalizing interest rates. Interestingly, earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. We are not making the case that returns will be anywhere near this level in the coming years. The starting point for valuation, for example, is much more extended than it was in previous long cycles. There are also plenty of possible sources of shocks that could end the expansion abruptly. Nonetheless, it is not going to die simply of old age. In the absence of any major shocks, this expansion may continue for a while yet. One reason is that there are no major areas of overspending that would make the economy highly vulnerable. This includes the housing sector, where investment has lagged previous slow-burn recoveries by a wide margin. A lagging housing market is not surprising given the bloated inventory of vacant homes that had to be absorbed in this cycle. The good news is that overhang appears to now be gone. The stock of unsold new and existing homes has returned to low levels by historical standards (inventories of new homes are in fact now rising, after plunging between 2006 and 2012; Chart 6). Chart 5The Current Cycle Is ##br##A "Slow Burn" Expansion The Current Cycle Is A "Slow Burn" Expansion The Current Cycle Is A "Slow Burn" Expansion Chart 6The Overhang From Housing##br## Inventories Is Gone The Overhang From Housing Inventories Is Gone The Overhang From Housing Inventories Is Gone Other positive factors include the following: Lending standards haven't eased much, but FICO scores have increased sharply, meaning that more renters now qualify for loans and thus might move from rental unit to a single family home (which generates more GDP per unit). This factor was highlighted in a recent Special Report on housing.1 Affordability is favorable, and the cost of owning is cheap relative to the cost of renting. The home-ownership rate has returned to its long-term average (Chart 6, bottom panel). If the pre-Lehman bubble in the homeownership rate has been unwound, it removes a headwind for construction activity because renting favors multi-family construction that produces less GDP per unit than single family homes. The supply of foreclosed homes onto the market has withered along with the foreclosure rate. This might not affect construction activity because it represents families simply swapping homes for other ones, but it supports home prices. Importantly, household formation is still recovering from a period in which young adults stayed with their parents for longer than normal for economic reasons. The tightening in the labor market and cyclical rebound in real disposable income growth is allowing millennials to finally move out, boosting the demand for new housing stock (Chart 7). Chart 8 presents a simple way of estimating the remaining pent-up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the remaining gap implies an extra 540,000 housing units. Chart 7Income Growth Is Helping Young Americans To Leave The Nest Income Growth Is Helping Young Americans To Leave The Nest Income Growth Is Helping Young Americans To Leave The Nest Chart 8A Catch-Up Housing Construction Will Occur If This Gap Closes A Catch-Up Housing Construction Will Occur If This Gap Closes A Catch-Up Housing Construction Will Occur If This Gap Closes The equilibrium number of housing starts that cover underlying population growth plus the units lost to scrappage is estimated to be about 1.4 million annually. If the household formation 'catch up' occurs over the next two years, adding another 250,000 units per year, total demand could be 1.6 to 1.7 million in each of the next two years. This compares to the just-released March housing starts level of 1.2 million. If starts rise smoothly from today's level to 1.7 million at the end of 2018, then the housing sector will contribute about 0.2 percentage points and 0.5 percentage point to real GDP growth in 2017 and 2018, respectively (Chart 9). Chart 9A Housing Catch-Up Will Boost GDP Growth A Housing Catch-Up Will Boost GDP Growth A Housing Catch-Up Will Boost GDP Growth For the economy, the implication is that this already-aged expansion phase could persist for a couple of more years as long as it is not hit by a negative shock and inflationary pressures remain quiescent, allowing the Fed to proceed slowly. Bottom Line: Housing starts remain well below the equilibrium level implied by underlying household formation, and a "catch up" phase could help keep the current "slow burn" expansion burning over the coming years. Favor Housing-Related Assets The above analysis also has some favorable implications for housing-related financial assets. We originally examined the implications of a rebound in home construction in 2012, during the early phase of the recovery in housing starts.2 Our approach was to test the historical excess return performance of several financial assets as a function of key housing market variables, and concluded that housing-related financial assets were set to outperform their respective benchmarks in a bullish housing scenario over the following year (and beyond). We have updated our original analysis in this report, with a few modifications. First, we examine the relationship between key housing market variables and excess returns of housing-related assets since the onset of the U.S. economic expansion in June 2009, given the structural change in the housing market that occurred following the Great Recession. Second, our analysis is based on a more focused set of housing market indicators, given the relatively poor predictive power of new home sales and the months' supply of homes following the crisis period on housing-related asset returns. Table 2 presents the list of housing-related assets that we examined,3 along with the key housing market variables used to forecast excess returns (and whether they were significant predictors in the post-crisis era). The table highlights that most of the variables do contain useful information, with the exception of the two noted above. The rightmost column presents the share of excess returns explained by a composite model of the factors noted as significant for each asset, which varies from a low of 13% to a high of 20%. Table 2Important Predictors Of Housing-Related Asset Excess Returns* (June 2009-December 2016) The Good And The Bad The Good And The Bad Charts 10 and 11 present a set of relatively conservative assumptions for the key housing market variables shown in Table 2, based on a rise in housing starts modestly above the scrappage rate that we noted in the previous section. We assume that house price appreciation and housing affordability moderate due to further rate hikes from the Fed, that the already-elevated homebuilders' confidence index stays flat, that refi applications remain low due to the uptrend in mortgage rates, and that purchase applications rise in lockstep with housing starts. Chart 10A Set Of Conservative Assumptions... A Set Of Conservative Assumptions... A Set Of Conservative Assumptions... Chart 11...For Key Housing Market Variables ...For Key Housing Market Variables ...For Key Housing Market Variables Finally, Table 3 illustrates the predicted excess returns over the coming 12-months of the housing-related assets that we examined, along with the annualized excess returns in 2016 and over the entire sample period for the purposes of comparison. It is important to note that excess returns of corporate bonds are presented relative to duration-matched government bonds, not a speculative- or investment-grade corporate bond aggregate. Table 3Excess Returns Of Housing-Related Assets* (%) The Good And The Bad The Good And The Bad The analysis presented above highlights several important conclusions for investors: The predictive power of key housing market variables has been smaller over the course of this economic expansion than in the past economic cycle (including the recession of 2008-2009), suggesting that housing market developments were more important during the downturn than they have been during the recovery. Still, housing market data is an important driver of excess returns for housing-related assets. All of the housing-related assets that we examined are expected to outperform their respective benchmarks over the coming year, even given the relatively conservative assumptions that we have made about the pace of gains in the housing market. For the three corporate bond assets shown in Tables 2 and 3, our model predicts outperformance even relative to their respective corporate bond benchmarks, albeit only marginally in the case of investment-grade banks. With the exception of S&P 500 homebuilders and banks, the model's predicted excess returns are lower over the coming year than they have been on an annualized basis since the onset of the recovery, highlighting that housing-related assets have front-run at least some of the expected normalization in the housing market over the coming few years. However, a full rise to our equilibrium estimate of 1.7 million starts over the coming two years could potentially lead to even larger outperformance than the model would predict. Charts 12 and 13 do not suggest that valuation will be an impediment to the outperformance of housing-related assets. Chart 12Valuation Won't Be An Impediment... Valuation Won't Be An Impediment… Valuation Won't Be An Impediment… Chart 13...For Housing Related Assets ...For Housing Related Assets ...For Housing Related Assets Bottom Line: Investors should look to housing-related assets as a source of potential outperformance over the coming 6-12 months. The historical relationship between key housing market variables and the excess returns of these assets implies the latter is set to outperform even given conservative assumptions about the former. 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 Jonathan LaBerge Vice President, Special Reports jonathanl@bcaresearch.com 1 Please see U.S. Investment Strategy Special Report "U.S. Housing: What Comes Next?", dated March 27, 2017, available at usis.bcaresearch.com 2 Please see U.S. Investment Strategy Weekly Report U-3 Or U-6?", dated February 13, 2012, available at usis.bcaresearch.com 3 Note that we have excluded fixed and floating rate home equity loan ABS from our list of housing-related assets owing to a lack of data, as well as investment-grade REITs because of a very low degree of return predictability from key indicators of the housing market

Highlights Portfolio Strategy Upgrade the financials sector to overweight. This year's consolidation phase is drawing to a close as inflation expectations stabilize. Lift the S&P banks index to overweight. Leading indicators of credit creation are signaling a reacceleration as the year progresses. Trim the S&P health care sector to neutral via profit-taking in medical equipment stocks. Recent Changes S&P Financials - Upgrade to overweight from neutral. S&P Banks Index - Upgrade to overweight from underweight. S&P Health Care - Downgrade to neutral. S&P Health Care Equipment - Downgrade to neutral. Table 1 Girding For A Breakout? Girding For A Breakout? Feature Chart 1Yields Are Not Yet Restrictive Yields Are Not Yet Restrictive Yields Are Not Yet Restrictive The S&P 500 is challenging the top end of its range. A playable breakout looks increasingly probable, albeit the exact timing is difficult. First quarter profit results have been strong, corporate guidance has been solid and monetary conditions are unlikely to become tight enough in the short run to dent renewed profit optimism. The latest string of economic disappointments is seen as providing the Fed with ample leeway, and investors are willing to overlook ongoing sluggishness because earnings are outperforming the economy via margin expansion. As discussed in detail in recent weeks, earnings growth is supported by a broad-based recovery in sales and pricing power. Top-line growth is critical to sustaining the overall equity market overshoot given sky-high valuations. Indeed, the appeal of equities stems from their attractiveness relative to other asset classes rather than in absolute terms. History shows that an asset preference shift can take time to play out, and push valuations higher than seems justified on fundamentals alone as long as recession is not an imminent risk. The Treasury market can provide clues as to when vulnerabilities will intensify. According to BCA's Treasury Bond Valuation Model, yields usually need to be at least one standard deviation above normal before stocks, and the economy, are at risk of a major downturn (Chart 1). At those turning points, inflation concerns are typically running hot, forcing the Fed to tighten enough to slow growth and undermine economic activity. This simple rule of thumb warned of the most recent stock market peaks, as well as equity slumps in the early-1990s, 1987, and the early-1980s, and supported bond vs. equity outperformance. Recently, the 10-year Treasury yield has returned to fair value, and the U.S. dollar has come off the boil. The implication is that there is no monetary roadblock to halt the upward momentum in equities at the moment. There is ample room for yields to rise before becoming restrictive, especially if the primary driver is the real component. In this light, we will continue with our program of transitioning to a more balanced equity portfolio from its previous defensive tilt. This week we downgrade a defensive sector to neutral and redeploy capital into the financials sector. Upgrade The Financials Sector... The financials sector has given back roughly 50% of its post-election surge this year. The main culprits have been a calming in Fed interest rate hike expectations, a flattening yield curve and softening inflation expectations. Moribund credit creation has also created earnings uncertainty (Chart 2). Nevertheless, the corrective phase appears to be drawing to a close, because financials sector profits are increasingly likely to surpass those of the overall corporate sector going forward. Traditionally, the financials sector benefited from a strong U.S. dollar. A strong dollar exerted downward pressure on interest rates, which spurred domestic economic strength, loan demand and a steepening yield curve. However, since the GFC, the opposite has been true. Zero interest rates and intense deflationary risks were exacerbated by U.S. dollar appreciation, as the corporate sector and commodities suffered. In other words, with the economy operating on a knife's edge between deflation and inflation, a strong currency weighed heavily on financial shares. Thus, the hiatus in the U.S. dollar bull market is a significant positive catalyst, if it arrests the decline in inflation expectations. The yield curve is making an effort to stabilize, suggesting that the risks of falling back close to the deflationary precipice are low. There are already signs of a positive reversal in euro area financials, which had led the U.S. financial sector on the way down after peaking late last year (Chart 2). The euro area has been in a deleveraging phase with acute deflationary risks, underscoring that the signal from share price stabilization in this region is worth noting. The key to a sustained recovery in sector profits is economic reacceleration. Corporate sector profits are healing as a consequence of the pickup in global final demand and the peak in the U.S. dollar, which should ensure that labor market slack does not imminently build. That is necessary to sustain credit quality and generate faster credit demand, and can be illustrated through the positive correlation between the output gap and relative share price performance (Chart 3), at least until the gap grows too large to generate inflationary pressures and by extension, tight monetary policy. Chart 2Earnings Uncertainty... Earnings Uncertainty... Earnings Uncertainty... Chart 3...But A Narrowing Output Gap... ...But A Narrowing Output Gap... ...But A Narrowing Output Gap... Leading economic indicators are consistent with erring on the side of optimism (Chart 4). Our proxy for the supply/demand balance for C&I loans confirms a positive bias for future loan growth (Chart 4). The upturn in the financial sector sales/employment ratio is encouraging (Chart 4). Productivity improvement has begun prior to a reacceleration in loan creation, suggesting that additional upside looms as balance sheets expand. Any unlocking of the regulatory shackles would be a bonus. Strength in our Financials Cyclical Macro Indicator confirms that profits should best those of the overall corporate sector. The financial sector is contributing more to overall GDP growth than it did even during the credit binge/housing bubble (Chart 5), despite the headwind of ultralow interest rates. Chart 4...And Leading Indicators ##br##Are Positive Offsets ...And Leading Indicators Are Positive Offsets ...And Leading Indicators Are Positive Offsets Chart 5Market Cap ##br##Gains Loom Market Cap Gains Loom Market Cap Gains Loom Even though financials represent an ever increasing share of the broad economy, the sector still garners less than its historic median market cap weight (Chart 5). The upshot is that if the economy stays resilient, the correction in relative share price performance should fully reverse, and we recommend further upgrading allocations to overweight via the heavyweight bank group. ...And Bank On Faster Growth Bank profit growth is supported by three main pillars: the quantity, price and quality of credit. All three are set to improve. While seven out of eight lending categories are experiencing a negative credit impulse, forward looking indicators are sending a more positive message. Business and consumer confidence have skyrocketed (Chart 6). If the revival in animal spirits lifts real economic activity later this year, capital demands could finally break out of their slump and reinvigorate moribund loan growth (Chart 6). Importantly, our U.S. Capital Spending Indicator (CSI) snapped back into positive territory. This primarily reflects both the firming in the ISM manufacturing survey and tightness in the labor market. Credit growth has not yet troughed, but should recover in the second half of the year based on our CSI's reading (Chart 6, top panel). Other leading indicators are heralding a pickup in credit demand. A steepening yield curve and the soaring ISM new orders index have an excellent track record in leading the Fed's Senior Loan Officer Survey for overall credit demand (Chart 6). Solid house price inflation and a tight labor market should ensure that consumer credit growth also firms (Chart 7), pointing to the potential for a broad-based bank balance sheet expansion. Overall household leverage has fallen back to 2003 levels and the household debt-service ratio is at multi-decade lows. Chart 6A Turning Point For Loans... A Turning Point For Loans… A Turning Point For Loans… Chart 7...As Demand Recovers …As Demand Recovers …As Demand Recovers Bank deposits are still growing, outpacing nominal GDP by 200bps, and the sector is extremely well capitalized. The loan-to-deposit ratio remains low by historical standards (Chart 8). Bank holdings of risk free securities comprise about 15% of the sector's assets, well above the historic average (Chart 8). The upshot is that there is plenty of firepower to crank up credit creation. True, a rundown in Treasury holdings would result in mark-to-market losses, but banks are well positioned to navigate through rising interest rates. According to the FDIC, net interest income as a share of total revenue has climbed steadily at commercial banks with assets greater than $1bn (Chart 9). Thus, if a better economy and rising inflation materialize in the back half of the year, then higher interest rates will boost profitability (Chart 9). Chart 8Banks Have Dry Powder Banks Have Dry Powder Banks Have Dry Powder Chart 9A Durable NIM Expansion A Durable NIM Expansion A Durable NIM Expansion Table 2 shows a sample of the four largest U.S. banks' earnings sensitivity to interest rate changes. Banks profit from overall rising interest rates in two ways: reinvesting at higher yields and assets repricing at a faster pace than deposits. Table 2Top Four Banks' Interest Rate Sensitivities Girding For A Breakout? Girding For A Breakout? Thus, a steepening yield curve would signal that bank profit estimates should experience a re-rating, provided the yield lift at the long end of the curve was gradual and did not choke off growth via a sudden spike (Chart 9). In terms of credit quality, non-performing loans and charge-offs are sinking from already low levels. It would take a significant deterioration in the labor market to warn that credit quality was about to become a profit drag (Chart 10). Chart 10Credit Quality Is Not An Issue, For Now Credit Quality Is Not An Issue, For Now Credit Quality Is Not An Issue, For Now Importantly, the reserve coverage ratio has climbed to near 100%, as non-current loans have fallen faster than banks have released reserves. Historically, credit quality improvement has been positively correlated with rising valuations (Chart 10). This message is corroborated by return on equity (ROE). Bank ROE has recouped most of the losses since the GFC on the back of recovering productivity gains. However, valuations do not yet reflect the ROE improvement. History shows that after a financial crisis, it can take a prolonged period of improved ROE before investors reward the sector with a valuation expansion, as occurred in the early-1990s (Chart 7, bottom panel). Bottom Line: Boost the S&P financials sector to overweight from neutral. Lift the S&P banks index to overweight. The ticker symbols for the stocks in the S&P banks index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Take Health Care Equipment Down A Notch We are making room for the financials sector upgrade by trimming the health care sector to neutral. As discussed in recent weeks, a modest shift away from a defensive to a more balanced portfolio has been on our radar and the surge in equities over the past week suggests that the consolidation phase is now ending in a bullish fashion, as expected. At the beginning of the year we added the S&P health care equipment (HCE) index to our high-conviction overweight list for three main reasons: valuations had undershot owing to health care reform uncertainty, domestic sales were set to improve and leading indicators of foreign sourced revenue also painted a rosy picture. What has changed? Relative share prices have undergone a V-shaped snapback, all of which can be attributed to a valuation expansion. A flurry of recent M&A activity has also buoyed relative valuations, as takeover premiums have been significant. Relative performance is now at a natural spot to expect a breather. On the operating front, a number of positive profit drivers are still intact. The industry's shipments-to-inventories ratio remains at multi-decade highs and the backlog of medical equipment orders is robust (top and bottom panels, Chart 11). HCE exports are primed to accelerate in the coming months likely irrespective of the U.S. dollar's move. In particular, Europe matters most to S&P HCE constituents, as roughly half of international sales originate in the old continent. Forward-looking indicators of European demand are upbeat, especially with the surge in German medical equipment orders (Chart 11). However, domestic sales indicators have downshifted. New health care facility construction has dropped sharply, warning that investment in medical equipment may soon follow suit (Chart 12, second panel). Consumables demand growth may also take a breather. Consumer outlays at hospitals have nosedived on a growth rate basis. This suggests that the growth in patient visits has dried up, and may be a warning that medical equipment new order growth will also decelerate (Chart 12). Moreover, as outlined in recent Weekly Reports, the broad corporate sector has regained pricing power, but medical equipment suppliers have lagged. Chart 12 shows that relative selling prices are contracting at an accelerating pace. This is significant, as deflation concerns could undermine revenues, and halt the valuation expansion. If domestic medical equipment demand cools, then it will sustain downward pressure on industry activity (Chart 13). Already, medical equipment industrial production (IP) has collapsed, in marked contrast with the expansion in overall IP. Chart 11Export Prospects Are Positive... Export Prospects Are Positive... Export Prospects Are Positive... Chart 12...But Domestic Blues... ...But Domestic Blues... ...But Domestic Blues... Chart 13...Will Weigh On Activity ...Will Weigh On Activity ...Will Weigh On Activity Worrisomely, the HCE new orders-to-inventories ratio has also lost steam, warning that a recovery in future production growth may not be imminent. The implication is that productivity gains are petering out, denting our confidence in a further valuation re-rating. Bottom Line: Downgrade the S&P health care equipment index and remove it from the high-conviction overweight list for an 9% gain. This also pushes the broad health care index to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HCEP: MDT, ABT, DHR, SYK, BDX, BSX, ISRG, BAX, ZBH, EW, BCR, IDXX, HOLX, VAR. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.