Spain

Highlights Contagion risk from Italy to its European peers presents a buying opportunity; Italian policymakers are constrained by the bond market and avoiding brinkmanship; In a game of chicken between Berlin and Rome, Chancellor Angela Merkel is behind the wheel of a 2.5-ton SUV; Italy's ultimate constraint is its bifurcated economic system - staying in the EU helps manage this problem; Underweight Italian bonds in a global portfolio and short Italian bonds versus their Spanish equivalents. Feature Chart 1Is Contagion Warranted? Is Contagion Warranted? Is Contagion Warranted? On May 31, Italy formed the second overtly populist government in the Euro Area. The first was the short-lived SYRIZA government in Greece, which lasted from January to September 2015. Under the leadership of Prime Minister Alexis Tsipras and his colorful finance minister Yanis Varoufakis, Athens took Greece to the brink of Euro Area exit in the summer of 2015. Ultimately, Greek politicians blinked, folded, and re-ran the January election in September, transforming SYRIZA from an overtly euroskeptic party to a europhile party in just eight months. Investors are concerned that "this time will be different." We disagree. To use a poker analogy, Italian policymakers are better positioned to "bluff" their European counterparts as their chip stack is larger. But they are still holding a bad hand, and other players at the table still hold big stacks. The recent turbulence in Italian bond markets has spilled over into other Mediterranean countries (Chart 1). This contagion is unwarranted, as there has been much improvement across the region over the past few years, both politically and economically. As for Italy itself, it is positive that populists have come to power today, for several reasons. First, it will force them to actually run the country, a sobering process that often tempers anti-establishment zeal, as it did in Greece. Second, they will run the country at a time when popular support for the Euro Area and EU remains strong enough to deter an overt attempt to exit those institutions. Third, Italy remains massively constrained by material forces outside of their control, which will force compromises in negotiations with Brussels and fellow EU member states. There Will Be No Contagion From Italy Markets overreacted to the political risks emanating from Italy in recent weeks. Fundamentally, Italy's peripheral peers have emerged stronger from the Euro Area crisis. Since the onset of the Euro Area crisis, Greece, Portugal, Ireland, and Spain - the hardest-hit economies in 2010 - have seen their unit labor costs contract by an average of 8.7%. Over the same period, the rest of the Euro Area inflated its labor cost structure by around 10.9% (Chart 2). Italy remains saddled with a rigid, under-educated, and rather unproductive workforce that has seen no adjustment in labor costs.1 Meanwhile, its Mediterranean peers have practically closed their once-enormous unit labor-cost gap with Germany. Furthermore, all southern European countries now run primary surpluses, reducing the need for external funding (Chart 3). It is fair that the market should apply a fiscal premium to Italy, given the new government's plans to blow out the budget deficit. But no such fiscal plan is in the works in the rest of the Mediterranean. The cyclically-adjusted primary balance - for Italy, Spain, Portugal, and Greece - has gone from a deficit of 4.4% during the height of the debt crisis, to a surplus of 1.4% today. One can argue about whether such fiscal austerity was really necessary. The advantage, however, is that the improvement in structural budget balances has diminished the need for additional austerity measures and could also provide greater fiscal space during the next recession. Finally, household balance sheets have been on the mend for some time. Consumer debt levels as a percentage of disposable income in Spain, Portugal, and Ireland - the epicenter of the original Euro Area debt crisis - have now dipped below U.S. levels. In the case of Italy, importantly, the household sector was never over-indebted to begin with (Chart 4). Chart 2Italy Has Had No Labor-Cost Adjustment Italy Has Had No Labor-Cost Adjustment Italy Has Had No Labor-Cost Adjustment Chart 3Mediterranean Austerity Is Over Mediterranean Austerity Is Over Mediterranean Austerity Is Over Chart 4No Household Credit Bubble In Italy No Household Credit Bubble In Italy No Household Credit Bubble In Italy On the political front, Italians are clearly more euroskeptic than their Euro Area peers (Chart 5). Although only 30% of Italians oppose the common currency, in line with Greece, this is still considerably higher than in Spain and Portugal (Chart 6). Italians also feel less "European" than the Spanish or the Portuguese - i.e., they identify more exclusively with their unique nationality. Again this is in line with Greek sentiment (Chart 7). Italians were not always this way: in the early 1990s, they felt the most European. Chart 5Italy Lags In Support For The Euro... Italy Lags In Support For The Euro... Italy Lags In Support For The Euro... Chart 6...But Only 30% Of Italians Want Out ...But Only 30% Of Italians Want Out ...But Only 30% Of Italians Want Out Chart 7Italians Are Feeling More Italian Italians Are Feeling More Italian Italians Are Feeling More Italian In Portugal and Spain, parties across the political spectrum have responded to improving political and economic fundamentals. In Spain, the mildly euroskeptic Podemos is polling below its June 2016 election result. Its leadership has also abandoned any ambiguity on its support of the common currency, although it still campaigned in 2016 on restructuring Spain's foreign debt. The leading party in the Spanish polls is the centrist Ciudadanos (Chart 8), led by 38-year old Albert Rivera. Much like French President Emmanuel Macron, Rivera has a background in finance - he worked as a legal counsel at La Caixa - and presents a centrist vision for Europe, favoring more integration. The rise of Ciudadanos is important as Spain could have new elections soon. Conservative Prime Minister Mariano Rajoy resigned following a vote of no-confidence engineered by the Spanish Socialist Party (PSOE) leader Pedro Sánchez. However, PSOE only holds 84 seats of the 350-seat parliament. As such, it is unclear how the Socialist minority government will govern, particularly with the budget vote coming in early fall. But investors should welcome, not fear, early elections in Spain. With Ciudadanos set to join a governing coalition, it is clear that Spain's commitments to the Rajoy structural reforms will remain in place while no discussions of Spanish exit from European institutions is on any investment-relevant horizon. In Portugal, the minority government of Prime Minister António Costa has overseen a brisk economic recovery. Costa's center-left Socialist Party has received support in parliament from the far-left, euroskeptic Left Bloc, plus the Communists and Greens. Despite the involvement of the Left Bloc, the minority government has not initiated any euroskeptic policy. The latest polling suggests that Costa could win a majority in 2019. An election has to be held by October of that year, thus potentially strengthening the pro-European credentials of the Portuguese government (Chart 9). Finally, in Greece, the once overtly euroskeptic SYRIZA is polling well below their 2015 levels of support. Ardently europhile and centrist New Democracy (ND) is set to win the next election - which must be held by October 2019 - if polling remains stable (Chart 10). The fascist and euroskeptic Golden Dawn remains a feature of Greek politics, but has a support rate under 10%, as it has over the past decade. In fact, the rising player in Greek politics is the centrist and europhile Movement for Change, an alliance that includes the vestiges of the center-left PASOK, which polls around 10%. Chart 8There Is No Populism In Spain... There Is No Populism In Spain... There Is No Populism In Spain... Chart 9...Or Portugal... ...Or Portugal... ...Or Portugal... Chart 10...And Surprisingly None In Greece ...And Surprisingly None In Greece ...And Surprisingly None In Greece Bottom Line: Italy stands alone in the Mediterranean as a laggard on both economic and political fundamentals. Contagion risk from Italy to the rest of its European peers should be faded by investors. It represents a buying opportunity every time it manifests itself. What Car Is Italy Driving In This Game Of Chicken? The new ruling coalition in Rome has a democratic mandate for a confrontation with Brussels over fiscal spending. The coalition consists of the Five Star Movement (M5S) and the League (Lega), formerly known as the "Northern League." In his inaugural speech to the Italian Parliament, Prime Minister Guiseppe Conte emphasized that the mandate of the new coalition includes "reducing the public debt ... by increasing our wealth, not with austerity."2 So, the gloves are off! Not really. Almost immediately, Conte pointed out that "we are optimistic about the outcome of these discussions and confident of our negotiating power, because we are facing a situation in which Italy's interests... coincide with the general interests of Europe, with the aim of preventing its possible decline. Europe is our home." PM Conte subsequently focused in his speech on increasing social welfare payments to the poor, conditional on vocational training and job reintegration. Talk of a "flat tax" was replaced with an eponymous concept that is anything but a "flat tax."3 And there was no mention of overturning unpopular pension reforms, but merely "intervening in favor of retirees who do not have sufficient income to live in dignity."4 We may be reading too much into one speech. However, the time for brinkmanship is at the beginning of a government's mandate. And Conte's opening salvo suggests that the M5S-Lega coalition has already punted on three of its most populist promises: wholesale change to retirement reforms, a flat tax of 15%, and universal basic income. The back-of-the-envelope cost of these three proposals is €100bn, which would easily blow out Italy's budget deficit by 5% of GDP, putting the total at 7%. There was also no mention of issuing government IOUs that would create a sort of "parallel currency" in the country. Conte's relatively tame speech represents one of three concessions that Rome has made before it even engaged Brussels in brinkmanship. The two others were to replace the original economy minister designate - euroskeptic Paulo Savona - and to form a government in the first place. The latter is particularly telling. Polls have shown that the two populist parties would have an even stronger hand if they waited until the fall to re-run the election (Chart 11). In particular, Lega has seen its support rise by 9% since the election. It is politically illogical to form a governing coalition with less political capital when a new election would strengthen the hand of both populist parties. So why the concessions? Because Italian policymakers are not interested in brinkmanship. The populist campaign rhetoric and hints of euroskepticism were an act. And perhaps the act would have continued, but the bond market reaction was so quick and jarring (Chart 12) - including the largest day-to-day selloff since 1993 (Chart 13) - that it has disciplined Italy's policymakers almost immediately. Chart 11Lega Gave Up A Lot By Forming A Coalition Lega Gave Up A Lot By Forming A Coalition Lega Gave Up A Lot By Forming A Coalition Chart 12Bond Vigilantes Are... Bond Vigilantes Are... Bond Vigilantes Are... Chart 13...A Massive Constraint On Rome ...A Massive Constraint On Rome ...A Massive Constraint On Rome This is instructive for investors. In 2015, Greece decided to play the game of brinkmanship with Europe and ultimately lost. Our high-conviction view at the time was that Athens would back off from brinkmanship because it was massively constrained.5 Not only would an exit from the Euro Area mean a government default and the redenomination of all household saving into "monopoly money," but the level of euroskepticism in Greece was not high enough to support such a high-risk strategy. At the time, we pointed out that most investors - and practically all pundits - were wrong when they argued that brinkmanship between Greece and Brussels was "unpredictable." This conventional view was supported by an incorrect reading of game theory, particularly the "game of chicken." Game theory teaches us that a game of chicken is the most dangerous game because it can create an equilibrium in which all rational actors have an incentive to stick to their guns - to "keep driving" in the parlance of the game - despite the risks.6 In Diagram 1, we can see that continuing to drive carries the most risks, but it also carries the most reward, provided that your opponent swerves. Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. When this does not happen, the bottom-right quadrant emerges, one of chaos and deeply negative payouts for everyone involved in the crash. The problem with this analysis is that - as with most game theory - its parsimony belies deep complexity that often varies due to a number of factors. The first such factor is replayability. The decisions of Italian policymakers will be informed by the outcomes of the 2015 Greek episode, which did not go well for Athens. Another factor that obviously varies the payout matrix is the relative strength of each player; or, to stick with the analogy, the type of vehicle driven by each actor. Greece and its Euro Area peers were not driving the same car. The classic game of chicken only produces the payouts from Diagram 1 if all participants are driving the same vehicle. However, if Angela Merkel is behind the wheel of a Mercedes-Benz G-Class SUV, while Greek PM Alexis Tsipras is riding a tricycle, then the payouts are going to be much different in the case of a crash. In that case, the payouts should approximate something closer to Diagram 2. Diagram 1Regular Game Of Chicken Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? Diagram 2Greece Versus Euro Area In 2015 Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? So the crucial question for investors is what vehicle are Italian policymakers driving? We do not doubt that it is an actual car, unlike Tsipras's tricycle. But it is more likely to be a finely-crafted Italian sportscar, adept at hugging the twists and turns of Rome's policy, rather than an SUV capable of colliding with Merkel's ominous truck. Why doesn't Rome have more capability than Greece? Because of time horizons. An Italian exit from the Euro Area would undoubtedly shake the foundations of the common currency and the European integrationist project. But Rome actually has to exit in order to shake those foundations. As we have learned with Brexit, such an "exit" scenario could take months, if not years. In the process of trying to exit, the Italian banking system would become insolvent, turning household savings and retirements into linguini. This would occur immediately and would exert economic, financial, and - most importantly - political pressure on Italian policymakers instantaneously. Our colleague Dhaval Joshi, BCA's Chief European Strategist, has argued that a 4% Italian bond yield is the "line in the sand" regarding the survival of Italy's banks.7 As Dhaval points out, investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). Based on this rule, the largest Italian banks now have €165 billion of equity capital against €130 billion of net NPLs, implying excess capital of €35 billion (Chart 14). Although the net NPL figure has improved much from the peak in 2015, it remains large. It follows that there would be fresh doubts about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of just a tenth from the recent peak. Dhaval estimates that this equates to the 10-year BTP yield breaching and remaining above 4% (Chart 15). Chart 14Italian Banks' Equity Capital ##br##Exceeds Net NPLs By Euro 35 Bn Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn Chart 15Italian Banks' Solvency Would Be In ##br##Question If The 10-Year BTP Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% Additionally, while Italian support for the common currency is relatively low, there is still a majority of around 60% that support the euro. This is similar to the level of support for the euro in Greece in 2015. We would suspect that the support for the currency would rise - and that populist parties would decline in popularity - if Italian policymakers set off a bond market riot that caused the insolvency of Italian banks. Does this mean that the bond market is a permanent constraint on Italian exit from the Euro Area? No. At some point in the future, after a deep recession that raises unemployment levels substantively, popular support for the common currency could tank precipitously. But we are far from that point. In fact, Italy has enjoyed a relatively robust recovery over the past 18 months. As such, any economic crisis today will be blamed on the populist policymakers themselves, yet another reason for them to moderate and seek the path of calm negotiations with the EU. Bottom Line: With regards to any potential "game of chicken" negotiations with the rest of Europe, Italian policymakers are not riding a tricycle like their Greek counterparts were in 2015. Italians are behind the wheel of a finely-crafted, titanium-chassis, Italian roadster. Unfortunately, Chancellor Angela Merkel is still in a Mercedes SUV that weighs 2.5 tons. This is a high-conviction view based on the actions of Italian policymakers over the past month. Despite an improvement in polling, populists have backed off from calling for a new election (which would have been perfectly logical) and that would have been advantageous to them and have abandoned some of the most controversial - and expensive - platforms of their coalition agreement. Unlike their peers in Greece, Italian populists have proven to have little stomach for actual confrontation. The Ultimate Constraint: Risorgimento In a report published back in 2016, we argued that Italy's original sin was its unification in 1861.8 Risorgimento brought together the North and South in a political and economic union that made little sense. The North had developed a market economy during the Middle Ages (and gave the West its Renaissance!), while the South had remained under feudalism well into the early twentieth century. Given the limited resources, governance, and technology of the mid-nineteenth century, the scope, ambition, and yes, folly of uniting Italy were probably several orders of magnitude greater than the effort to forge a common currency union in Europe in the twenty-first century. To this day, Italy remains an economically bifurcated country. Map 1 shows that the four wealthiest and most-productive regions of Europe, outside of capital cities, are the German Rhineland, Bavaria, the Netherlands, and Northern Italy. Meanwhile, the Italian South - or Mezzogiorno - is as undeveloped as Greece and Eastern Europe. Map 1Core Europe Extends Well Into Northern Italy Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? The units of analysis in Map 1 are the so-called EU "nomenclature of territorial units for statistics" (NUTS).9 These regions matter because Brussels uses them to determine how much "structural funding" - essentially development aid - each country receives from the EU. The EU "regional and cohesion" funding - totaling €351.8 billion for the 2014-2020 budget period - is not distributed based on the aggregate wealth of each country, since that would favor the new entrants into the union. The EU's discerning eye when it comes to distributing development funds is not accidental. It is a product of decades of lobbying by Italy (and Spain) to prevent a shift of structural funding to Eastern European member states. From Rome's perspective, the real European development project is not in Poland or Greece, but in the Mezzogiorno. Chart 16Italy Shares The Burden Of The Mezzogiorno With The EU Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? To this day, Italy and Spain receive the second and third largest amount of EU development aid (Chart 16). Despite contributing, in gross terms, 13% to the EU's total revenues, Italy's net contribution per person is smaller than those of the Netherlands, Sweden, Denmark, Finland, and Austria (Chart 17). Given that Italy is a wealthy EU state, its net budget contribution of approximately €3 billion, 0.2% of GDP, essentially means that it gets the benefits of EU membership for free. Chart 17Italy Gets To Join The Club For Free Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? And EU membership comes with many benefits. Membership in the Euro Area - combined with sharing the same "lender of last resort" with Germany, the European Central Bank - allows Italy to finance its budget deficits at low interest rates and to issue government debt in the world's second largest reserve currency (Chart 18). These financial benefits are even greater than the rebate it gets from Europe. Access to cheap financing allows Italy to carry the costs of Mezzogiorno on its own. Chart 18The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today It is somewhat ironic that Lega is today preaching populism and euroskepticism. In the early 1990s, its main target of angst was not the EU and Brussels, but Italy's South and profligate Rome, which funneled the North's taxes to the South. This early iteration of the party was quite pro-EU, as it saw Italy's North as genuinely European and worthy of membership in EU institutions. Some of its politicians and voters hoped that Northern Italy could meld into the EU, leaving the Mezzogiorno to fend for itself. Hence there is no deep, ideological euroskepticism in Lega's DNA. The party's evolution also illustrates how opportunistic and pragmatic Italian policymakers can be. The reality is that if Italy were to act on its threat of "exit," it would undoubtedly become far worse off economically. Not only would Northern Italy have to support the Mezzogiorno alone, but any structural reforms that could lift productivity and education in the South would become far less likely as anti-establishment forces took hold. Bottom Line: Our high-conviction view is now the same as it was in 2016. Italy is "bluffing." Leaving the EU or the Euro Area makes no sense given its economic bifurcation, which is the result of Risorgimento. Both policymakers and voters understand this. The real intention in the game of chicken between Brussels and Rome is to see an easing of austerity. We expect that Italian policymakers will ultimately succeed in getting leniency from Brussels on allowing deficit-widening fiscal stimulus, but the stimulus will be much smaller than their original plans that spooked the bond market laid out. To European and Italian politicians, Italy's economic bifurcation is well understood. Jean-Claude Juncker, the President of the European Commission, specifically referred to it when he said, "Italians have to take care of the poor regions of Italy." He was later forced to apologize for his comments, with leaders of M5S and Lega faking outrage. But given that the ideological roots of Lega are precisely in the same intellectual vein as Juncker's comments, investors should understand that politicians in Rome are well aware of their fundamental constraints. Juncker's comments were a dog whistle to Rome. The actual message was: we know you are bluffing. Investment Implications Our analysis suggests that the path of least resistance for the M5S-Lega coalition is to negotiate some austerity relief from the EU Commission, but to definitively pivot away from talk of "exit" from European institutions. PM Conte has reaffirmed that exiting the euro is off the table and that it was never on the table to begin with. The new economy minister, Giovanni Tria, followed this up with a comment that "the position of this government is clear and unanimous... there are no discussions taking place about any proposal to leave the euro." Meanwhile, Lega leader and new Italian interior minister Matteo Salvini has focused his early efforts and commentary on the party's promise to check illegal immigration to Italy. This will be a policy upon which Lega will test its populist credentials, not a fight with Brussels. Is the worst of the crisis therefore "over"? Is it time to buy Italian assets? Not yet. Both Italian bonds and equities rallied throughout 2017. Italian equities, for example, have a higher Shiller P/E ratio than both Spanish and Portuguese stocks (Chart 19). As such, a sell-off was long overdue. Chart 19Why Did Italian Equities Rally So Much? Why Did Italian Equities Rally So Much? Why Did Italian Equities Rally So Much? Chart 20Italy's Binary Future Italy's Binary Future Italy's Binary Future Furthermore, we do not expect Rome's negotiations with Brussels to proceed smoothly. It is very likely that the bond market will have to continue to play the role of disciplinarian. The government debt-to-GDP ratio could quickly become unsustainable if the current primary budget balance is thrown into a deficit (Chart 20). According to the IMF and BCA Research calculations, Italian long-term debt dynamics are stable even with real interest rates rising to 2% - from just 0.5% today - and real GDP growth remaining at a muted 1%. But this stability requires the country to continue to run a primary budget surplus of around 2% of GDP (Chart 21). Conversely, running a persistent primary deficit of 2% would result in an explosive increase in Italy's debt dynamics. Even if that stimulus produces real GDP growth of 3%, the "bond vigilantes" could protest the surge in debt and drive real interest rates to 3.5% or higher. As such, the country's fiscal space will ultimately be determined by the bond market. Rome can afford to lower its primary budget surplus, but only so far as the bond market does not riot. Our colleague Dhaval Joshi believes that the math behind an Italian fiscal stimulus would make sense if it provides enough of a sustainable boost to economic growth without blowing out the budget deficit.10 We suspect that the bond market will eventually agree, but only if Brussels and Berlin bless the ultimate fiscal package as well. While investors wait to see the outcome of Rome-Brussels budget talks, which will likely last well into Q4, we prefer to play Mediterranean politics by shorting Italian government bonds versus their Spanish equivalents. BCA's Global Fixed Income Strategy initiated such a trade on December 16, 2016, which has produced a total return of 5.8%. The original logic for the trade was based on an assessment that Italy's medium-term growth potential, sovereign-debt fundamentals, and political stability were all much worse than those of Spain (Chart 22). These differences were not reflected in relative bond prices. Chart 21Three Factors Will Influence Italy's Debt Trajectory Three Factors Will Influence Italy's Debt Trajectory Three Factors Will Influence Italy's Debt Trajectory Chart 22Spain Trumps Italy On All Fronts Spain Trumps Italy On All Fronts Spain Trumps Italy On All Fronts Ongoing political turmoil in Italy has justified sticking with the trade. Looking ahead, there is potential for additional spread widening between Italy and Spain in the coming months. Spain is enjoying better economic growth; the deficit outlook will invariably worsen for Italy with the new coalition government; and Spanish support for the euro and establishment policymakers remains far higher and more buoyant than in Italy. All these factors justify a wider risk premium for Italian debt over Spanish bonds (Chart 23). Chart 23Stay Short 5-Year Italy Vs. 5-Year Spain Stay Short 5-Year Italy Vs. 5-Year Spain Stay Short 5-Year Italy Vs. 5-Year Spain Chart 24Stay Underweight Italian Debt Stay Underweight Italian Debt Stay Underweight Italian Debt One final critical point - the timing of any budget related uncertainty could not be worse for Italy. Economic growth is slowing and leading indicators say that this trend will continue, which suggests that Italian government bonds should continue to underperform global peers (Chart 24). Our Global Fixed Income Strategy team has argued that government debt in the European "periphery" should be treated more like corporate credit rather than sovereign debt.11 Faster economic growth leads to fewer worries about debt sustainability and increased risk-taking behavior by investors, both of which lead to reduced credit risk premiums and eventually, stronger growth. In other words, think of Italian BTPs as a BBB-rated corporate bond rather than a "risk-free" Euro Area government bond. So as long as the Italian economy continues to lose momentum, an underweight stance on Italian government bonds is justified. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 2 Please see Repubblica, "Il discorso di Conte in Senato, la versione integrale," dated June 6, 2018, available at repubblica.it. 3 Conte's exact quote was "the objective is the 'flat tax,' that is a tax reform characterized by the introduction of rates that are fixed, with a system of deductions that can guarantee that the tax code remains progressive." This is our own translation from Italian and therefore we may be missing something. However, a "flat tax" that has a number of different rates and that remains progressive is, by definition, not a flat tax. 4 In fact, the speech could be read with an eye towards some genuine supply-side reforms, particularly in bringing the country's youth into the labor force, improving governance, reforming the judiciary, cracking down on corruption and privileges of the political class, and generally de-bureaucratizing Italy. If successful, these would all be welcome reforms. 5 Please see BCA Geopolitical Strategy Monthly Report, "After Greece," July 8, 2015, available at gps.bcaresearch.com. 6 The game derives its name from a test of manhood by which two drivers drive towards each other on a collision course, preferably behind the wheel of a 1950s American muscle car. Whoever swerves loses. Whoever keeps driving, wins and gets the girl. 7 Please see BCA European Investment Strategy Weekly Report, "Italy's 'Line In The Sand,'" dated May 31, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 9 The acronym stands for Nomenclature des Unités Statistiques. 10 Please see BCA European Investment Strategy Special Report, "Italy Vs. Brussel: Who's Right?" dated May 24, 2018, available at eis.bcaresearch.com. 11 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?" dated May 22, 2018, available at gfis.bcaresearch.com.

Highlights In this Weekly Report, we review all of the individual trades in our Tactical Overlay portfolio. These are positions that are intended to complement our strategic Model Bond Portfolio, typically with shorter holding periods, and sometimes in smaller or less liquid markets that are outside our usual core bond coverage (like Swedish government bonds or euro area CPI swaps). This report includes a summary of the rationale for each position, as well as a decision on whether to retain the position, close it or switch it into a new trade that has more profit potential for the same theme underlying the original trade (Table 1). Table 1Global Fixed Income Strategy Tactical Overlay Trades Hold, Close Or Switch: Reviewing Our Tactical Overlay Trades Hold, Close Or Switch: Reviewing Our Tactical Overlay Trades Feature U.S. Long 5-year U.S. Treasury bullet vs. 2-year/10-year duration-matched barbell (CLOSE AND SWITCH TO NEW TRADE) Long U.S. TIPS vs. nominal U.S. Treasuries (HOLD) Short 10-year U.S. Treasuries vs. 10-year German Bunds (HOLD) Chart 1UST Curve Trading More Off The Funds##BR##Rate Than Inflation Expectations UST Curve Trading More Off The Funds Rate Than Inflation Expectations UST Curve Trading More Off The Funds Rate Than Inflation Expectations We have three U.S.-focused tactical trades that are all expressions of our core views on U.S. inflation expectations and future Fed monetary policy moves. We first recommended a U.S. butterfly trade, going long the 5-year U.S. Treasury bullet and short a duration-matched 2-year/10-year Treasury barbell (Chart 1), back on December 20th, 2016. We have kept the recommendation during periodic reviews of our tactical trades since then. This is a position that was expected to benefit from a bearish steepening of the U.S. Treasury curve as the market priced in higher longer-term inflation expectations. The trade has not performed according to our expectations, however, generating a loss of -0.40% since inception.1 There was a positive correlation between the slope of the Treasury curve, the butterfly spread and TIPS breakevens shortly after trade inception. However, the Treasury curve flattened through 2017 as the Fed continued to hike rates, even as realized inflation fell (2nd panel), pushing the real fed funds towards neutral levels as measured by estimates like r* (3rd panel). This has left the 2/5/10 Treasury butterfly cheap on our valuation model (bottom panel), Looking ahead, the case for a renewed bear-steepening of the U.S. Treasury curve, and widening of the 2/5/10 butterfly spread, rests on the Fed accommodating the current rise in U.S. inflation by being cautious with future rate hikes. Recent comments from Fed officials suggest that policymakers are in no hurry to rapidly raise rates in order to cool off an "overheating" U.S. economy. Yet at the same time, U.S. inflation continues to rise and the economy is in good shape, so the Fed can't take a pause on rate hikes. This will likely leave the Treasury curve range bound, with the potential for some periods of bear-steepening as inflation expectations rise. Our conviction on this Treasury butterfly spread trade has fallen of late. Yet with our model suggesting that the belly of the curve is somewhat cheap to the wings, and given our view that U.S. inflation expectations have not reached a cyclical peak, we are reluctant to completely exit this position. Instead, we are opting to switch out of the 2/5/10 U.S. Treasury butterfly into another butterfly that our colleagues at BCA U.S. Bond Strategy have identified as cheap within their newly-expanded curve modeling framework - the 1/7/20 butterfly (long the 7-year bullet vs. short a duration-matched 1/20 barbell).2 That butterfly offers better carry than the 2/5/10 butterfly (Chart 2), and is nearly one standard deviation cheap to estimated fair value. Another of our U.S.-focused tactical trades has been to directly play for rising U.S. inflation expectations by going long TIPS versus nominal U.S. Treasuries. This is a long-held trade (initiated on August 23rd, 2016) which has performed very well, delivering a return of 4.13%.3 We continue to see the potential for TIPS breakevens to widen back to levels consistent with the market believing that inflation can sustainably return to the Fed's 2% target on the PCE deflator, which is equivalent to 2.4-2.5% on CPI-based 10-year TIPS inflation expectations. Given the persistent strong correlation between oil prices and breakevens, and with the BCA Commodity & Energy Strategy team continuing to forecast Brent oil prices jumping above $80/bbl over the next year (Chart 3), there is still solid underlying support for wider breakevens. This is especially true given the uptrend in overall global inflation (middle panel), and the likelihood that core U.S. inflation can also continue to rise alongside an expanding U.S. economy (bottom panel). We are sticking with our long TIPS position vs. nominal Treasuries. Chart 2Switch The UST Butterfly##BR##Trade From 2/5/10 to 1/7/20 Switch The UST Butterfly Trade From 2/5/10 to 1/7/20 Switch The UST Butterfly Trade From 2/5/10 to 1/7/20 Chart 3Stay Long U.S. TIPS##BR##Vs. Nominal Treasuries Stay Long U.S. TIPS vs. Nominal Treasuries Stay Long U.S. TIPS vs. Nominal Treasuries Our final U.S.-focused tactical trade is actually a cross-market trade where we are short 10-year U.S. Treasuries versus 10-year German Bunds. We initiated that trade on August 8th, 2017 when the Treasury-Bund spread was at 179bps. With the spread now at 252bps, the trade has delivered a solid total return of 4.23%. This was driven primarily by the rapid move higher in Treasury yields in response to faster U.S. growth (Chart 4), more rapid U.S. inflation and Fed rate hikes versus a stand-pat European Central Bank (ECB).4 From a medium-term perspective, those three fundamental drivers of the Treasury-Bund spread continue to point to U.S. bond underperformance (Chart 5). From this perspective, the peak in the spread will not be reached until U.S. economic growth and inflation peak and the Fed signals an end to its current tightening cycle. None of those outcomes is on the horizon, and we continue to target an eventual cyclical top in the 10-year Treasury yield in the 3.25-3.5% range as inflation expectations move higher. Yet the Treasury-Bund spread has reached an overvalued extreme according to our "fair value" model (Chart 6). In other words, the markets have moved to more than fully discount the cyclical differences between the U.S. and euro area - a trend that surely reflects the huge short positioning in the U.S. Treasury market. Yet it is also important to note that the fair value spread continues to steadily climb higher. In our model, the spread is primarily a function of differences in central bank policy rates between the Fed and ECB, relative unemployment rates and relative headline inflation rates. All three of those factors continue to move in a direction favorable to a wider Treasury-Bund spread, and the gap is only growing wider with both growth and inflation in the euro zone losing momentum. Chart 4Stay Long 10yr UST##BR##Vs. 10yr German Bund Stay Long 10yr UST vs 10yr German Bund Stay Long 10yr UST vs 10yr German Bund Chart 5UST-Bund Spread Widening##BR##Due To Relative Fundamentals... UST-Bund Spread Widening Due To Relative Fundamentals... UST-Bund Spread Widening Due To Relative Fundamentals... Chart 6...But The Spread##BR##Has Overshot A Bit ...But The Spread Has Overshot A Bit ...But The Spread Has Overshot A Bit The spread is currently being pushed to even wider extremes by the current turmoil in Italy, which is pushing money out of Italian BTPs into safer assets like Bunds. The situation remains fluid and new elections are likely in Italy later this year, thus it is unlikely that any more to restore investor confidence in Italy is on the immediate horizon. This will keep Bund yields depressed versus Treasuries, even as the ECB continues to signal that it will fully taper its asset purchases by year-end (rate hikes remain a long way off in Europe, however). We continue to recommend staying short Treasuries versus Bunds, and would view any tightening of the spread back towards our model estimate of fair value as an opportunity to enter the position or add to an existing position. Euro Area Long 10-year euro area CPI swaps (HOLD, BUT ADD A STOP AT 1.5%) Short 5-year Italy government bonds vs. 5-year Spain government bonds (HOLD) Chart 7Stay Long 10-Year Euro Area CPI Swaps Stay Long 10-Year Euro Area CPI Swaps Stay Long 10-Year Euro Area CPI Swaps We have two tactical trades that are purely within the euro area: positioning for higher inflation expectations through a long position in 10-year euro CPI swaps, and playing relative credit quality within the Peripheral countries by shorting 5-year Italian bonds versus a long position in 5-year Spanish debt. The long 10-year CPI swaps trade, which was initiated on December 20th, 2016, has generated a total return of +0.45% over the life of the trade so far (Chart 7).5 The rationale for the recommendation, and our conviction behind it, has evolved over that time. We first recommended the trade when the ECB was aggressively easing monetary policy and there was clear positive momentum in euro area economic growth that was driving down unemployment. At a time when oil prices were steadily climbing and the euro was very weak, the case for seeing some improvement in inflation expectations in the euro area was a strong one. Inflation expectations stayed resilient in 2017, however, despite the unexpected strength of the euro. Continued gains in oil prices and above-trend economic growth that rapidly absorbed spare capacity in the euro area more than offset any downward pressure on inflation from a stronger currency. Looking ahead, the combination of renewed weakness in the euro and firm oil prices should allow headline inflation in the euro area to drift higher from current levels in the next 3-6 months (2nd panel). However, the euro area economy has lost the positive momentum seen last year with steady declines in cyclical data like manufacturing PMIs, industrial production and exports (3rd panel). Admittedly, that deceleration has come from a high level and leading indicators are not yet pointing to a prolonged period of below-potential growth that could raise unemployment and reduce domestic inflation pressures. Yet with core inflation still struggling to climb beyond the 1% level (bottom panel), any worsening of euro area economic momentum could lead to inflation expectations stalling out well before getting close to the ECB's 2% target level. Thus, we continue to recommend this long 10-year CPI swaps position, but we are adding a new stop-out level at 1.5% to protect against downside risks if the euro area growth outlook darkens. On our other euro area tactical trade, we have been recommending shorting Italian government bonds versus Spanish equivalents. We initiated that trade on December 16th, 2016 and it has produced a total return of +0.57% over the life of the trade. The original logic for the trade was based on an assessment that Italy's medium-term growth potential, sovereign debt fundamentals and political stability were all much worse than that of Spain (Chart 8), yet Italian bond yields were still trading at too low a spread to Spanish debt. The cyclical improvement in the Italian economy in 2017 helped pushed Italian yields even closer to Spanish yields, yet we stuck with the trade given the looming political risk from the Italian parliamentary elections. The recent political turmoil in Italy has justified our persistence with this trade, with the 5-year Italy-Spain spread widening out by 46 bps over just the past two weeks. With the situation remaining highly fluid as the Italian coalition partners (the 5-Star Movement and the League) struggle to form a new government, Italian assets will continue to trade with a substantial risk premium to Spain and other European bond markets. Yet with the Italian economy now also showing signs of losing cyclical momentum, the case for continued Italian bond underperformance is a strong one, and we moved to a strategic underweight stance on Italian debt last week.6 Looking ahead, we see the potential for additional spread widening between Italy and Spain in the coming months. Spain is enjoying better economic growth, the deficit outlook is worsening for Italy with the new coalition government proposing a stimulus that could widen the budget deficit by as much as 6% of GDP, and Spanish support for the euro currency is far higher than it is in Italy. All those factors justify a wider risk premium for Italian debt over Spanish bonds (Chart 9). Chart 8Spain Trumps Italy On All Fronts Spain Trumps Italy On All Fronts Spain Trumps Italy On All Fronts Chart 9Stay Short 5-Year Italy Versus 5-Year Spain Stay Short 5-Year Italy Versus 5-Year Spain Stay Short 5-Year Italy Versus 5-Year Spain Our view on Italian debt, both from a tactical and strategic viewpoint, is bearish. We are maintaining our tactical trade, and we also advise selling into any rallies in Italy rather than buying the dips. U.K. Long 5-year Gilt bullet vs. duration-matched 2-year/10-year Gilt barbell (HOLD) We entered into a U.K. Gilt butterfly trade, long the 5-year bullet versus the duration-matched 2-year/10-year barbell, back on March 27th, 2018.7 The logic of the trade was a simple one. We simply did not believe that the Bank of England (BoE) would follow through on its hawkish commentary by hiking rates as much as was discounted in the Gilt curve. Our view came to fruition as the BoE held rates steady at the May monetary policy meeting, which resulted in a bullish steepening at the front end of the Gilt curve. Our butterfly trade has returned +0.25% since inception, and we see more to come in the coming months.8 The U.K. economy has lost considerable momentum, with no growth shown in Q1 (real GDP only expanded +0.1%). The OECD leading economic indicator for the U.K. is at the weakest level in five years, and now consumer confidence is rolling over as rising oil costs are offsetting the pickup in wages (Chart 10). Overall headline inflation has peaked, however, after the big currency-fueled surge in 2016 and 2017 (bottom panel). With both growth and inflation slowing, and with the lingering uncertainty of the Brexit negotiations weighing on business confidence and investment, the BoE will have a tough time hiking rates even one more time this year. There are still 34bps of rate hikes priced into the U.K. Overnight Index Swap (OIS) curve, which leaves room for 2-year Gilts to decline as the BoE stays on hold for longer (Chart 11). This will cause the front-end of the Gilt curve to steepen. Meanwhile, longer-term Gilt yields will have a difficult time falling given the deceleration of global central bank asset purchase programs that is slowly raising depressed term premia on government bonds (3rd panel). Another factor that will help keep the Gilt curve steeper, all else equal, is the path of the inflation expectations curve. Shorter-dated expectations are likely to fall faster as growth slows and headline inflation continues to drift lower (bottom panel). Chart 10Fading Momentum For##BR##U.K. Growth & Inflation Fading Momentum For U.K. Growth & Inflation Fading Momentum For U.K. Growth & Inflation Chart 11Stay Long The 5yr U.K. Gilt Bullet##BR##Vs. The 2/10 Gilt Barbell Stay Long The 5yr U.K. Gilt Bullet vs The 2/10 Gilt Barbell Stay Long The 5yr U.K. Gilt Bullet vs The 2/10 Gilt Barbell Although some narrowing of the butterfly spread is already priced in the forwards (top panel), we see that outperformance of the 5-year happening faster, and by a greater amount, than the forwards. Stay long the belly of the Gilt curve versus the wings. Canada Long 10-year Canada inflation-linked government bonds vs. nominal Canada government bonds (HOLD) We recommended entering a long Canada 10-year breakeven inflation trade on January 9th, 2018.9 Since then, the 10-year breakeven inflation rate rose by 6bps along with the rise in oil prices denominated in Canadian dollars (Chart 12). This has helped our tactical trade deliver a return of +0.64% since inception.10 More fundamentally, the breakeven has risen as strong Canadian growth has helped close the output gap and push realized Canadian inflation back to the middle of the Bank of Canada (BoC)'s 1-3% target band. The rapid rate of real GDP growth has decelerated a bit after approaching 4% last year, and the OECD leading economic indicator for Canada may be peaking at a high level (Chart 13). Growth in consumer spending is also look a bit toppy, with bigger downside risks evident in the sharp declines in the growth of retail sales and house prices (3rd panel). Both were affected by a harsher-than-usual Canadian winter, but the cooling of the overheated Canadian housing market (especially in Toronto) is a welcome development for financial stability. Chart 12Stay Long Canadian##BR##Inflation Breakevens Stay Long Canadian Inflation Breakevens Stay Long Canadian Inflation Breakevens Chart 13Canadian Inflation At BoC Target,##BR##But Has Growth Peaked? Canadian Inflation At BoC Target, But Has Growth Peaked? Canadian Inflation At BoC Target, But Has Growth Peaked? On balance, however, the current state of Canadian economic data shows an economy that is slowing a bit from a very overheated pace, but is still likely to grow above potential with no spare capacity available. Both headline and core inflation will remain under upward pressure against this backdrop, at a time when the BoC's policy rate is still well below neutral. We continue to recommend staying long Canadian inflation-linked government bonds over nominal equivalents with a near-term target of 2% on the 10-year breakeven inflation rate. We will re-evaluate the position with regards to Canadian growth and inflation trends once that target is reached. Australia Long December 2018 Australian Bank Bill futures (SELL AND SWITCH TO NEW TRADE). We entered into a long December 2018 Australian Bank Bill futures trade on October 17, 2017 as a focused way to express the view that the Reserve Bank of Australia (RBA) would stay on hold for longer than markets expect. The trade has worked out nicely, generating a profit of +0.25%. The potential for further upside is fairly low at these levels so we are now closing the trade. However, our view remains that the RBA will not be able to hike as early as markets are pricing. As such, we are opening a new position - long October 2019 Australia Bank Bill futures. Markets expect the first rate hike will occur in nine months' time. The October 2019 Australia Bank Bill futures are currently pricing in a massive 180bps of rate hikes over the next sixteen months. That will not happen. The RBA will not be able to hike this much given the lack of inflation pressures and a wide output gap. Our Australia Central Bank Monitor, which measures cyclical growth and inflation pressures, has pulled back to the zero line, confirming that there is no current need to tighten policy (Chart 14). Real GDP growth slowed to 2.4% in Q4 2017, from 2.9% the previous quarter. Weakness in the OECD leading economic indicator and Citigroup economic surprise index for Australia suggest that the Q1 reading will also disappoint. Consumer spending will be dampened by weak wage growth, softening consumer sentiment and the recent decline in house prices in multiple major cities. As a result of easing house prices, the growth rate of household net wealth was considerably lower in 2017 relative to the previous four years. Additionally, credit growth has been slowing, even before the recent news of the bank scandals that will force banks to be more stringent with lending practices. Most importantly, however, inflation remains below the RBA's target and there is a lack of inflationary pressures. The inflation component of our Central Bank Monitor has collapsed and is now well below the zero line. Both headline and core inflation readings are stable but remain persistently below 2%. Tradeable goods prices have declined for nine consecutive months despite the currency weakness seen in the Australian dollar over the past twelve months. The IMF is not projecting Australia to have a closed output gap until 2020, and that is with the optimistic expectation that Australia achieves 3% growth. Labor markets have plenty of slack as evidenced by rising unemployment rate, nonexistent wage growth and elevated level of underemployment. The RBA estimates that the current unemployment rate is still approximately 0.5% above full employment. Against this backdrop, it is unlikely that inflation will sustainably rise enough to force the RBA's hand, leaving scope for interest rate expectations to decline (Chart 15). Chart 14The RBA Will##BR##Stay Dovish The RBA Will Stay Dovish The RBA Will Stay Dovish Chart 15Switch Long Australia Bank Bill Futures##BR##Trade From Dec/18 Contract To Oct/19 Contract Switch Long Australia Bank Bill Futures Trade From Dec/18 Contract To Oct/19 Contract Switch Long Australia Bank Bill Futures Trade From Dec/18 Contract To Oct/19 Contract New Zealand Long 5-year New Zealand government bonds vs. 5-year U.S. Treasuries, currency-hedged into U.S. dollars (HOLD) Long 5-year New Zealand government bonds vs. 5-year German government bonds, with no currency hedge (HOLD) One of our more successful tactical trades has been in New Zealand (NZ) government bonds. We entered long positions in 5-year NZ debt versus 5-year U.S. Treasuries and 5-year German Bunds on May 30th, 2017, but we reviewed, and decided to maintain, those positions in a recent Weekly Report.11 The NZ-US spread trade has returned 4.67% since inception, hedged into U.S. dollars (Chart 16).12 The NZ-Germany trade, however, was a very rare instance where we recommended a cross-country spread trade on a currency UN-hedged basis, based on the negative view on the euro that we had last year. With the euro rising sharply against the New Zealand dollar, the unhedged return on that trade has been -2.87% (a return that, if hedged back into the euro denomination of the German bonds, would have generated a return of +3.56%). Looking ahead, we see continued scope for NZ bond outperformance, although the return potential is far less than it was when we first put on the trade. NZ economic growth is in the process of peaking, with export growth already rolling over (Chart 17, top panel). Net immigration inflows, which have been a major support for the NZ housing market and overall consumer spending over the past five years, have already begun to slow with the Reserve Bank of New Zealand (RBNZ) projecting bigger declines in the next couple of years (2nd panel). Both headline and core CPI inflation took a surprising downward turn in Q1 of this year, and both are well below the midpoint of the RBNZ target band (3rd panel). Chart 16Stay Long NZ 5yr Bonds##BR##Vs. The U.S. & Germany... Stay Long NZ 5yr Bonds Vs The U.S. & Germany... Stay Long NZ 5yr Bonds Vs The U.S. & Germany... Chart 17...With NZ Growth &##BR##Inflation Losing Momentum ...With NZ Growth & Inflation Losing Momentum ...With NZ Growth & Inflation Losing Momentum With both growth and inflation slowing, the RBNZ can remain dovish on monetary policy. An additional factor is the NZ government has recently changed the mandate of the RBNZ to include both inflation targeting and "maximizing employment" in a similar fashion to the Federal Reserve. With inflation posing no threat, the RBNZ can focus on its employment mandate by maintaining highly accommodative policy settings. With the NZ OIS curve still discounting one full 25bp RBNZ hike over the next year (bottom panel), there is scope for NZ bonds to outperform as that hike will not happen. This will allow NZ bond spreads to tighten, or at least outperform versus the forwards where some modest widening is currently priced. We are sticking with both spread trades, but we are choosing to leave the NZ-Germany trade currency unhedged given the renewed weakness in the euro (the unhedged return has already improved by over two full percentage points since the euro peaked earlier this year). We will monitor levels of the NZD/EUR currency cross rate to determine when to potentially hedge the currency exposure of our trade back into euros. Sweden Long Sweden 10-year government bond vs. 2-year government bond Short 2-year Sweden government bond vs. 2-year German government bond We recently entered two Sweden tactical bond trades on May 8, 2018, going long the Swedish 10-year vs. the 2-year and shorting the Swedish 2-year vs. the German 2-year (Chart 18).13 We expect that strong growth momentum, rising inflation and a tight labor market will force the Riksbank to raise rates earlier, and by more, than markets expect. Since inception for these "young" trades, each has returned -1bp.14 Sweden's economy made a solid recovery in 2017, with year-over-year real GDP growth reaching 3.3% in Q4. Going forward, export growth will remain supported by strong global activity, low unit labor costs, and a weak krona. Our own Swedish export growth model is already signaling a pickup over the rest of 2018. Consumption has been resilient and should continue to be supported by steadily recovering wages. Capital spending has been robust and industrial confidence remains in an uptrend. Additionally, leading indicators are still signaling positive growth momentum. The Riksbank's preferred measure of inflation, CPIF, slowed to 1.9% in April after briefly touching the central bank's target last month (Chart 19). In our view, this is a minor pullback rather than the start of a sustained reversal. Our core inflation model projects a gradual increase in the coming months, driven by above-trend growth that has soaked up all spare capacity. Labor markets have tightened considerably, and the unemployment rate is now more than one percentage point below the OECD's estimate of the full-employment NAIRU. During the last period when unemployment was this far below NAIRU, wage growth surged to over 4%. Chart 18Stay In A Sweden 2/10 Curve Flattener##BR##& Short 2yr Swedish Bonds Vs Germany Stay In A Sweden 2/10 Curve Flattener & Short 2yr Swedish Bonds Vs Germany Stay In A Sweden 2/10 Curve Flattener & Short 2yr Swedish Bonds Vs Germany Chart 19The Riksbank Will Not Ignore##BR##The Coming Inflation Overshoot The Riksbank Will Not Ignore The Coming Inflation Overshoot The Riksbank Will Not Ignore The Coming Inflation Overshoot For the curve flattener trade, our expectation is that the Riksbank will shift to a more hawkish tone in the coming months, leading markets to reprice the shape of the Swedish yield curve, as too few rate hikes are discounted in the short-end. With their mandates met, the Riksbank will be forced to act more aggressively. Importantly, there is no flattening currently priced into the Swedish bond forward curve, thus there is no negative carry associated with putting on a flattener now. In the relative value trade, we shorted the Swedish 2-year relative to the German 2-year. Growth in Sweden is likely to outpace that of the euro area once again in 2018. Swedish inflation is almost at the Riksbank target while euro area inflation continues to undershoot the ECB benchmark. The ECB is signaling that it is in no hurry to begin raising interest rates, therefore policy rate differentials will drive the 2-year Sweden-Germany spread wider over the next 12-18 months, with no spread move currently priced into the forwards. South Korea Short Korea 10-Year Government Bonds Vs. Long 2-Year Korea Government Bonds (CLOSE) We first introduced this trade on May 30th, 2017, after the election of Moon Jae-In as the South Korean president.15 The new government made major campaign promises to greatly expand fiscal spending on social welfare, public sector job creation, and increased aid to North Korea. With the central government's budget balance set to worsen significantly, we expected longer-term Korean bond yields to begin to price in faster growth and rising future debt levels, resulting in a bearish steepening of the yield curve (Chart 20). Since the new president was elected, however, the Korean economy worsened - even as much of the global economy was enjoying a cyclical upturn - with the trend likely to continue (Chart 21). The OECD leading economic indicator for Korea is weakening, while the annual growth in industrial production now sits at -4.2% - the worst level since the 2009 recession. Capital spending and exports are also slowing rapidly. Chart 20Close The 2yr/10y Korean##BR##Government Bond Curve Steepener Close The 2yr/10y Korean Government Bond Curve Steepener Close The 2yr/10y Korean Government Bond Curve Steepener Chart 21Korean Curve Stable,##BR##Despite Slower Growth & Fiscal Stimulus Korean Curve Stable, Despite Slower Growth & Fiscal Stimulus Korean Curve Stable, Despite Slower Growth & Fiscal Stimulus Due to the slowdown in the economy, Korean firms' capacity utilization is now at the worst level since the middle of 2009. Although businesses were already suffering from downward pressure on revenues, the Moon administration dramatically increased the minimum wage last year, directly leading to a rise in bankruptcies for small and medium size firms (the bankruptcy rate rose from 1.9% in the first half of 2017 to 2.5% in the latter half). Looking ahead, the Moon government will continue to increase spending on welfare and financial aid for North Korea, especially if the domestic economy continues to struggle. We still believe that the rise in deficits and debt will eventually lead the market to price in some increase in the fiscal risk premium and a steeper Korean yield curve. Yet with the Bank of Korea (BoK) having already surprised the markets last November with a rate hike, and with Korean inflation now ticking higher alongside a stable won, we fear that any renewed steepening of the Korean curve awaits a shift to a more dovish BoK that is not yet on the horizon. For now, given the competing forces on the Korean yield curve, we are choosing to close our 2/10 Korea curve steepener at a loss of -0.63%.16 We will continue to monitor the Korean situation to look for opportunities to re-enter the trade at a later date. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Returns are calculated using Bloomberg pricing of the total return of a 2/5/10 butterfly. 2 Please see BCA U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15th 2018, available at usbs.bcaresearch.com. 3 Return is taken directly from Bloomberg Barclays index data on the duration-adjusted excess return of the entire TIPS index versus the entire Treasury index. 4 This return is calculated using Bloomberg data on actual U.S. and German bonds, and is shown on a currency-hedged basis into U.S. dollars - the currency denomination of the bond we are short in this spread trade. 5 Returns are calculated using Bloomberg Barclays inflation swap index data for a euro area CPI swap with a rolling 10-year maturity. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?", dated May 22nd 2018, available at gfis.bcaresearch.com. 7 Please see BCA Global Fixed Income Strategy Weekly Report, "Nervous Complacency", dated March 27th, 2018, available at gfis.bcaresearch.com. 8 Returns are calculated using Bloomberg data on actual Gilts, rather than bond index data. 9 Please see BCA Global Fixed Income Strategy Weekly Report, "Let The Good Times Roll", dated January 9th 2018, available at gfis.bcaresearch.com. 10 This return is measured as the total return of the Canadian inflation-linked bond index less that of the nominal Canadian government bond index from the Bloomberg Barclays family of bond indices. 11 Please see BCA Global Fixed Income Strategy Weekly Report, "Serenity Now", dated May 15th 2018, available at gfis.bcaresearch.com. 12 Returns are calculated using Bloomberg data on actual New Zealand government bonds, with our own adjustments for the impact on returns from currency hedging. 13 Please see BCA Global Fixed Income Strategy Special Report, "Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore", dated May 8th 2018, available at gfis.bcaresearch.com. 14 Returns are calculated using Bloomberg data for actual individual Swedish government bonds, rather than bond index data. Both legs of the trade are duration-matched. 15 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30th 2017, available at gfis.bcaresearch.com. 16 Returns are calculated using Bloomberg data for actual individual Korean government bonds, rather than bond index data. Both legs of the trade are duration-matched and funding costs are included. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Hold, Close Or Switch: Reviewing Our Tactical Overlay Trades Hold, Close Or Switch: Reviewing Our Tactical Overlay Trades Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The global economic mini-cycle is set to weaken while the euro is set to grind higher. Upgrade Telecoms to overweight. Also overweight Healthcare and Airlines. Underweight Banks, Basic Materials and Energy. Overweight France, Ireland, U.K., Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. The Eurostoxx50 will struggle to outperform the S&P500. Feature We are strong believers in Investment Reductionism, a philosophy synthesized from the Pareto Principle and Occam's Razor.1 Investment reductionism offers a liberating thesis - the incessant barrage of investment research, newsfeeds and ten thousand word commentaries is largely superfluous to the investment process. What seems like a complexity of investment choice usually reduces to getting a few over-arching decisions right. Chart of the WeekIn Quadrant 4, Overweight Domestic Defensives And Underweight International Cyclicals The Four Quadrants Of Cyclical Investing The Four Quadrants Of Cyclical Investing For equity sector and country allocation, two over-arching decisions dominate: Whether the global economic mini-cycle is set to strengthen or weaken (Chart I-2). Whether the domestic currency is set to strengthen or weaken. Chart I-2The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The four permutations of these two decisions create the four quadrants of cyclical investing (Chart of the Week). Right now, European investors find themselves in quadrant four: the global economic mini-cycle is set to weaken while the euro is set to grind higher. This favours an overweight stance to defensives, especially domestic-focused defensives. Therefore today, we are upgrading Telecoms to overweight. We also recommend an underweight stance to the most cyclical sectors, especially international-focused cyclicals such as Basic Materials and Energy. Country allocation then just drops out of this sector allocation. The Global Economic Mini-Cycle Is Set To Weaken We can predict the changes of the seasons and the tides of the sea with utmost precision. How? Not because we have an ingenious leading indicator for the seasons and tides, but because we recognise that these phenomena follow perfectly regular cycles. Regular cycles create predictability. Significantly, global bank credit flows also exhibit remarkably regular cycles with half-cycle lengths averaging around eight months. Recognizing these mini-cycles is immensely powerful because, just as for the seasons and the tides, it creates predictability. Furthermore, if most investors are unaware of these cycles, the next turn will not be discounted in today's price - providing a compelling investment opportunity for those who do recognise the predictability. The empirical evidence for credit mini-cycles is irrefutable. The theoretical foundation is also rock solid, based on an economic model called the Cobweb Theory.2 This states that in any market where supply lags demand, both the quantity supplied and the price must oscillate. Given that credit supply clearly lags credit demand, the quantity of credit supplied and its price (the bond yield) must experience mini-cycles (Chart I-3). And as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same regular oscillations. Today, the global 6-month credit impulse is turning from mini-upswing to mini-downswing, with all three subcomponents - the euro area, the U.S. and China - now in decline (Chart I-4). This is exactly in line with prediction. Mini half-cycles average eight months, and the latest mini-upswing started eight months ago. Chart I-3The Global Economic Mini-Cycle##br## Is Set To Weaken The Global Economic Mini-Cycle Is Set To Weaken The Global Economic Mini-Cycle Is Set To Weaken Chart I-4All Three Subcomponents Of The Global 6-Month ##br##Credit Impulse Are Now Declining All Three Subcomponents Of The Global 6-Month Credit Impulse Are Now Declining All Three Subcomponents Of The Global 6-Month Credit Impulse Are Now Declining More importantly, as we enter a mini-downswing, we can also predict that global growth is likely to experience at least a modest deceleration through the coming two to three quarters. The Euro Is Set To Grind Higher, Except Versus The Yen Chart I-5Lost In Translation Lost In Translation Lost In Translation Nowadays, mainstream stock markets tend to be eclectic collections of multinational companies which happen to be quoted on bourses in Frankfurt, Paris, New York, and so on. For example, BASF is not really a German chemical company, it is a global chemical company headquartered in Germany. For operational hedging, multinational companies like BASF will intentionally diversify their sales and profits across multiple major currencies, say euros and dollars. But of course, the primary stock market quotation will be in the currency of its home bourse, euros. Therefore, when the euro strengthens, the company's multi-currency profits, translated back into a stronger euro, will necessarily weaken (Chart I-5). Clearly, more domestic-focused companies like telecoms will not experience such a strong currency-translation headwind. We expect the main euro crosses to continue strengthening over the next 8 months, with the exception being the cross versus the Japanese yen. Our central thesis is that the payoff profile for a foreign exchange rate just tracks the bond yield spread. This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive asymmetry called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, long-term expectations for the ECB policy rate possess an asymmetry: they cannot go significantly lower, but they could go significantly higher. Exactly the same applies to long-term expectations for the BoJ policy rate. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they could go either way, lower or higher. This stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. Which Sectors And Countries To Own And Which To Avoid? Pulling together the preceding two sections, the global economic mini-cycle is set to weaken while the euro is set to grind higher. This puts Europe in quadrant four of our four quadrant framework for cyclical investing. Unsurprisingly, the relative performance of the most cyclical sectors - Banks, Basic Materials and Energy - very closely tracks the regular mini-cycles in the global 6-month credit impulse. In a mini-downswing these cyclical sectors always underperform (Chart I-6, Chart I-7 and Chart I-8). Accordingly, underweight these three sectors on a two to three quarter horizon. Chart I-6In A Mini-Downswing, ##br##Banks Always Underperform In A Mini-Downswing, Banks Always Underperform In A Mini-Downswing, Banks Always Underperform Chart I-7In A Mini-Downswing,##br## Basic Materials Always Underperform In A Mini-Downswing, Basic Materials Always Underperform In A Mini-Downswing, Basic Materials Always Underperform Chart I-8In A Mini-Downswing,##br## Energy Always Underperforms In A Mini-Downswing, Energy Always Underperform In A Mini-Downswing, Energy Always Underperform Conversely, overweight the relatively defensive Healthcare sector. Also overweight the Airlines sector. Airlines' performance is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost. Furthermore, as aviation fuel is priced in dollars, it also insulates European Airlines against a strengthening euro. Today, we are also upgrading the Telecoms sector to overweight given its relative non-cyclicality (Chart I-9), its domestic-focus, and the excessively negative groupthink towards it (Chart I-10). Chart I-9In A Mini-Downswing, ##br##Telecoms Always Outperform In A Mini-Downswing, Telecoms Always Outperform In A Mini-Downswing, Telecoms Always Outperform Chart I-10Telecoms Are Due ##br##A Trend Reversal Telecoms Are Due A Trend Reversal Telecoms Are Due A Trend Reversal In summary: Overweight: Healthcare, Telecoms, and Airlines Underweight: Banks, Basic Materials and Energy Then to arrive at a country allocation, just combine the cyclical view on the major sectors with the country sector skews in Box 1. The result is the following unchanged European equity market allocation. Overweight: France, Ireland, U.K., Switzerland and Denmark Neutral: Germany and Netherlands Underweight: Italy, Spain, Sweden and Norway Lastly, what is the prognosis for the Eurostoxx50 relative to the S&P500? Essentially, this reduces to a battle between the multinational cyclicals - especially banks - that dominate euro area bourses and the multinational technology giants that dominate the U.S. stock market. With the global economic mini-cycle set to weaken and the euro set to grind higher, the Eurostoxx50 will struggle to outperform the S&P500. Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Pareto Principle, often known as the 80-20 rule, says that 80% of effects come from just 20% of causes. Occam's Razor says that when there are many competing explanations for the same effect, the simplest explanation is usually the best. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11, 2018 and available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to short the Helsinki OMX versus the Eurostoxx600. Apply a profit target of 3% with a symmetrical stop-loss. In other trades, we are pleased to report that short Japanese Energy versus the market achieved its 8% profit target at which it was closed. This leaves four open positions. 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 11 Helsinki OMX Vs. Eurostoxx 600 Helsinki OMX Vs. Eurostoxx 600 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. * 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 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

Highlights The German 10-year bund yield rising to 1%, or the U.S. 10-year T-bond yield rising to 3% would be a trigger to downgrade equities and upgrade bonds... ...especially as the blue sky expectations for global growth in H1 2018 will turn out to be overly-optimistic. On a 6-9 month horizon, upgrade Airlines to overweight. Downgrade Banks to underweight. Upgrade Germany (DAX) to neutral. Downgrade Italy (MIB) and Spain (IBEX) to underweight. Feature Where has the equity market cycle gone? Since 2012, the stock market's 6-month returns have generated an unprecedented consistency, with only a brief breakdown - at the end of 2015 - into negative territory (Chart of the Wesk and Chart I-2). Chart of the WeekSince 2012, The Equity Market ##br##Cycle Has Disappeared Since 2012, The Equity Market Cycle Has Disappeared Since 2012, The Equity Market Cycle Has Disappeared Chart I-2Much Less Cyclicality In Equities ##br##Than In Commodities Much Less Cyclicality In Equities Than In Commodities Much Less Cyclicality In Equities Than In Commodities The disappearance of the equity market cycle brings to mind the concept of the "Great Moderation", a term coined in 2002 to describe the big drop in business cycle volatility during the 1990s. In 2004, Ben Bernanke suggested that "improvements in monetary policy, though certainly not the only factor, probably were an important source of the Great Moderation." Today's Great Moderation 2.0 refers to the equity market cycle - or rather, its disappearance. And in finding a reason for the Great Moderation 2.0, Bernanke's attribution to monetary policy might be right on the money. Stick With TINA, Or Flirt With TIA? For many years, ultra-accommodative monetary policy has provided a consistent and substantial uplift to world stock market valuations. Since 2012, our preferred measure of equity market valuation - world stock market capitalisation to GDP - has almost doubled. This inexorable and relatively trouble-free rise has even spawned its own acronym: TINA - There Is No Alternative (to owning equities.) However, the uplift to stock market valuations has happened in a less obvious way than you might realise. Based on the excellent predictive power of stock market capitalisation to GDP, the prospective 10-year annualised return from world equities has collapsed from 9% in 2012 to 1.5% now (Chart I-3). Over the same period, the global 10-year bond yield has compressed from 3% to 1.5%. Hence, the collapse in prospective equity returns is not due to the decline in bond yields per se. It has happened mostly because the excess return offered by equities over bonds - the so-called 'equity risk premium' has compressed from 6% to zero (Chart I-4). Chart I-3World Equity Market Cap To GDP Implies##br## A Feeble Prospective 10-Year Return World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return Chart I-4Prospective Equity Returns ##br##Have Become 'Bond Like' Prospective Equity Returns, Have Become "Bond Like" Prospective Equity Returns, Have Become "Bond Like" Ultra-accommodative monetary policy has caused the disappearance of the equity risk premium. The simple reason is that at low bond yields, the risk of owning bonds becomes similar to the risk of owning equities. Chart I-5Below A 2% Yield, 10-Year Bonds Have ##br##More Negative Skew Than Equities Beware The Great Moderation 2.0 Beware The Great Moderation 2.0 When bond yields approach their lower bound, bond prices have little upside but they have a lot of downside. This ratio of an investment's potential losses relative to its potential gains is the risk that most frightens investors,1 and is known as negative skew. At yields below 2%, bond returns become as negatively skewed as equity returns, or even more negatively skewed than equities (Chart I-5). As the risk of bonds increases to become 'equity-like', the prospective return from equities must compress to become 'bond-like'. Which is to say, equity valuations become substantially richer. All well and good - so long as the global 10-year bond yield stays low. Above a 2% yield, the negative skew on bond returns disappears, and equities once again require an excess prospective return over bonds. More colloquially, investors would dump TINA and start flirting with TIA (There Is an Alternative). In essence, a big threat to the Great Moderation 2.0 comes the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1%, or the U.S. 10-year T-bond yield rising to 3%. Any moves towards these thresholds would be a trigger to downgrade equities and upgrade bonds - especially as we now explain why the blue sky expectations for global growth in H1 2018 will turn out to be overly-optimistic. The Equity Sector Cycle Is Alive And Well For the stock market in aggregate, the cycle has been moribund. But for equity sector relative performance, the cycle is very much alive and well. In The Cobweb Theory And Market Cycles 2 we showed and explained the existence of mini-cycles in economic and financial variables. To summarise, a lag between the demand for credit and its supply necessarily creates mini-cycles in both the price of credit (the bond yield) and the quantity of credit (the global credit impulse). Thereby it also creates mini-cycles in GDP growth. The useful point is that these cycles are very regular with half-cycles averaging 6-8 months. Which makes their turning points and phases predictable. Given that the global credit impulse cycle has been in a mini-upswing phase since last May, it is highly likely to turn into a mini-downswing phase through the first half of 2018. The latest data point, showing a tick down, seems to corroborate such a turning point. From an equity sector perspective, Banks versus Healthcare has closely tracked the phases of the credit impulse mini-cycle (Chart I-6). In all five of the last five mini-downswings, Banks have underperformed Healthcare, and we would expect no difference in the next mini-downswing. Hence, on a 6-9 month horizon, downgrade Banks to underweight. Unsurprisingly, exactly the same pattern applies to Basic Materials (and Energy) versus Healthcare (Chart I-7). Hence, on a 6-9 month horizon, stay underweight Basic Materials and Energy versus Healthcare. Also unsurprisingly, the performance of European Airlines is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost (Chart I-8). As an aside, this also somewhat insulates the European Airlines against a strengthening euro, given that this variable cost is priced in dollars. Hence, on a 6-9 month horizon, upgrade European Airlines to overweight. Chart I-6Banks Vs. Healthcare Tracks The ##br##Credit Impulse Mini-Cycle Banks Vs. Healthcare Tracks The Credit Impulse Mini-Cycle Banks Vs. Healthcare Tracks The Credit Impulse Mini-Cycle Chart I-7Materials Vs. Healthcare Tracks The##br## Credit Impulse Mini-Cycle Materials Vs. Healthcare Tracks The Credit Impulse Mini-Cycle Materials Vs. Healthcare Tracks The Credit Impulse Mini-Cycle Chart I-8European Airlines Relative Performance Is A##br## Mirror-Image of The Oil Price Cycle European Airlines Relative Performance Is A Mirror-Image of The Oil Price Cycle European Airlines Relative Performance Is A Mirror-Image of The Oil Price Cycle Country Allocation Just Drops Out Of Sector Allocation Our core philosophy of investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. For example, the defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks. So unsurprisingly, MIB and IBEX relative performance reduces to: will banks outperform the market? (Chart I-9 and Chart I-10). Chart I-9Italy = Long Banks Italy = Long Banks Italy = Long Banks Chart I-10Spain = Long Banks Spain = Long Banks Spain = Long Banks Therefore, the key consideration for European equity country allocation is always: how to allocate to the vital few equity sectors that feature most often in the skews: Banks, Healthcare, Energy and Materials. To reiterate, our 6-9 month recommendation is to underweight Banks, Materials And Energy versus Healthcare, and to overweight Airlines versus the market. Then to arrive at a country allocation, combine the cyclical view on the vital few sectors with the country sector skews shown in Box I-1. Even if you disagree with our sector views, the sector-based approach is the right way to pick European equity markets. If you agree with our sector views, the result is the following updated European equity market allocation: Box I-1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands. Underweight: Italy, Spain, Sweden and Norway. In terms of change, it means upgrading Germany (DAX) to neutral and downgrading Italy (MIB) and Spain (IBEX) to underweight. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report "Are Bonds A Greater Risk Than Equities", January 28, 2018 available at eis.bcaresearch.com. 2 Please see the European Investment Strategy Weekly Report "The Cobweb Theory And Market Cycles", January 11, 2018 available at eis.bcaresearch.com. Fractal Trading Model* There is a lot of optimism already priced into the South African rand, making it vulnerable to a countertrend reversal. Therefore, this week's recommended trade is to go long USD/ZAR with a profit-target of 6% and a symmetrical stop-loss. In other trades, short S&P500/long Eurostoxx50 hit its stop-loss, while short Japanese energy and short palladium moved comfortably into profit. 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-11 USD/ZAR USD/ZAR 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. * 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 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

Highlights Overweighting Eurostoxx50 versus S&P500 is just a sector play - you must believe that banks are going to outperform technology. It is categorically not a relative economic growth or relative valuation play. The best expression of euro area economic outperformance - as we believe is likely - is not through mainstream equity indexes. It is through the euro. Could Spain in 2014-17 be Italy in 2018-21? If so, the cleanest play is through Italian bonds: long Italian BTPs versus French OATs. Play the lottery for free: when the price gap between the second and first month VIX future is greater than that between the first month and VIX spot - as it is now - it signals a potentially free lottery ticket. Feature Don't Play The Euro Area Economy Through The Stock Market The fallacy of division is a logical fallacy. It occurs when somebody falsely infers that what is true for the whole is also true for the parts that make up the whole. For example, somebody might see that their computer screen appears purple, and infer that the pixels that make up the screen are also purple. In fact, pixels are never purple. They are either red or blue. The fallacy of division is that the property of the whole - purpleness - does not translate to the property of the parts - redness or blueness. Chart of the WeekEuro Area Vs. U.S. Equities Is Just A Sector Play: Banks Vs. Technology Euro Area Vs. U.S. Equities Is Just A Sector Play: Banks Vs. Technology Euro Area Vs. U.S. Equities Is Just A Sector Play: Banks Vs. Technology The fallacy of division also affects investors. Since global equities are a play on the global economy, some investors infer that major equity indexes such as the Eurostoxx50 are relative plays on their regional economies. In fact, this is a fallacy of division: the property of the equity market as a global aggregate does not translate to the relative property of an equity market as a regional or national part. Through the past three years, the euro area economy has comfortably outperformed the U.S. economy1 (Chart I-2). Yet the Eurostoxx50 has substantially underperformed the S&P500 (Chart I-3). Why? Because the Eurostoxx50 has a major 14% weighting to banks and a minor 7% weighting to technology. The S&P500 is the mirror image; a minor 7% weighting to banks and a major 24% weighting to technology. Chart I-2The Euro Area Economy ##br##Has Outperformed... The Euro Area Economy Has Outperformed... The Euro Area Economy Has Outperformed... Chart I-3...But The Eurostoxx50 ##br##Has Underperformed ...But The Eurostoxx50 Has Underperformed ...But The Eurostoxx50 Has Underperformed Hence, for the Eurostoxx50 the distinguishing property is 'bank'; for the S&P500 it is 'technology'. And as banks have underperformed technology, the Eurostoxx50 has underperformed the S&P500. This large difference in sector exposure also means that a head-to-head comparison of equity market valuation is misleading. The euro area, trading on a forward price to earnings (PE) multiple of 15, appears considerably cheaper than the U.S., trading on a forward PE of 19. But this head-to-head difference just reflects the forward PEs of banks at 11 and technology at 19. As banks will likely generate less long-term growth than technology, banks are rightfully cheaper than technology and the Eurostoxx50 is rightfully cheaper than the S&P500. Some people suggest sector-adjusting stock market valuations to allow for the sector biases. The problem is that this suggestion cannot avoid the inescapable end-result. The bank-heavy Eurostoxx50 versus the tech-heavy S&P500 relative performance will still depend on banks versus technology (Chart of the Week). Remarkably, this overarching driver is captured in just the three largest euro area banks versus the three largest U.S. tech stocks. This means that relative performance simply reduces to whether Banco Santander, BNP Paribas and ING outperform Apple, Microsoft and Google,2 or vice-versa (Chart I-4). Chart I-4Eurostoxx50 Vs. S&P500 Reduces To: Santander, BNP & ING Vs. Apple, Microsoft & Google Eurostoxx50 Vs. S&P500 Reduces To: Santander, BNP & ING Vs. Apple, Microsoft & Google Eurostoxx50 Vs. S&P500 Reduces To: Santander, BNP & ING Vs. Apple, Microsoft & Google Everything else is largely irrelevant. Hence, the counterintuitive conclusion is that overweight Eurostoxx50 versus S&P500 is actually a sector play. You must hold the view that banks are going to outperform technology. At the moment, we are agnostic on this view. The best expression of euro area economic outperformance - as we believe is likely - is not through mainstream equity indexes. It is through bond yield spread compression and through exchange rates. Our preferred expression is structurally long EUR/USD. Could Spain In 2014-17 Be Italy In 2018-21? In 2013, Spain seemed to be on its knees. The economy had slumped by almost 10%, unemployment stood at 27%, and the stock of bank loans which were non-performing exceeded 13%. Doomsayers abounded. Standard and Poor's downgraded Spain's sovereign credit rating to BBB-, one notch above junk, and esteemed Wall Street strategists predicted the unemployment rate would remain above 25% for the rest of the decade. But the esteemed strategists were completely wrong. Through 2014-17, Spanish real GDP per head has grown by almost 15% (Chart I-5) - making it one of the top performing developed economies; unemployment has plunged by 10% (Chart I-6); and non-performing loans have declined sharply. What suddenly transformed Spain from zero to hero? The answer is that Spain recapitalised its banks. Chart I-5Through 2014-17 Spanish Real GDP ##br##Per Head Is Up Almost 15%... Through 2014-17 Spanish Real GDP Per Head Is Up Almost 15%... Through 2014-17 Spanish Real GDP Per Head Is Up Almost 15%... Chart I-6...And Unemployment##br## Is Down 10% ...And Unemployment Is Down 10% ...And Unemployment Is Down 10% After a financial crisis, the golden rule of recovery is to repair the banking system as soon as possible. In the aftermath of housing-related banking crises in 2008, the U.S. and U.K. quickly recapitalised their damaged banking systems; Ireland followed a couple of years later; Spain waited until 2013. But in each case, the economies rebounded very strongly as soon as the banks' aggressive deleveraging ended. Which brings us to Italy. Many people claim that Italy's long-standing economic underperformance is due to deep-seated structural problems. We do not dispute that such problems exist, but they cannot be the main cause of the economic underperformance. After all, through 1999-2007, Italian real GDP per head performed more or less in line with the U.S., Canada and France (Chart I-7), even without a private sector credit boom which the other economies had. Italy's underperformance really started after the 2008 financial crisis. And the most plausible explanation is that its dysfunctional banking system has been left broken for so long. Italy has procrastinated because its government is more indebted than other sovereigns and its banking problems have not caused an outright crisis - yet. But now policymakers in Rome, Brussels and Frankfurt realise that a hamstrung economy carries risks of a populist backlash against the European project. Finally, Italian banks' equity capital is rising, their solvency is improving and the share of non-performing loans appears to have peaked at the same level as in Spain in 2013 (Chart I-8). Chart I-7Through 1999-2007 Italy Performed In##br## Line With Other Major Economies Through 1999-2007 Italy Performed In Line With Other Major Economies Through 1999-2007 Italy Performed In Line With Other Major Economies Chart I-8Spanish NPLs Peaked In 2013, ##br##Italian NPLs Are Peaking Now Spanish NPLs Peaked In 2013, Italian NPLs Are Peaking Now Spanish NPLs Peaked In 2013, Italian NPLs Are Peaking Now So could Spain in 2014-17 be Italy in 2018-21? Once again, doomsayers abound and the counterintuitive thought could pay off. The cleanest way to play this is through Italian bonds: long Italian BTPs versus French OATs. Play The Lottery For Free As everybody knows, playing the lottery is not a good investment strategy. Most of the time your Lotto ticket brings zero reward, though occasionally you do win a prize. In fact, the U.K. National Lottery has said that the expected win per £1 played averages £0.47. Meaning the long-term return on this strategy is -53%. In the financial markets, the equivalent of a Lotto ticket is to buy volatility. In practice, this means buying a future on a volatility index such as the VIX. The problem is that the VIX futures curve usually slopes upwards. So if the curve doesn't change, a future bought above the spot price loses value when it expires at the spot price (Chart I-9). The upshot is that most of the time, the future 'rolls down the curve', and you lose money, though occasionally when volatility spikes you win. But counterintuitively, sometimes you can play the lottery for free. Look at the VIX futures curve: when the price gap between the second and first month is greater than that between the first month and spot - as it is now (Chart I-10) - it signals a potentially free lottery ticket. Chart I-9VIX Futures "Roll Down The Curve" VIX Futures "Roll Down The Curve" VIX Futures "Roll Down The Curve" Chart I-10Spotting A Free Lottery Ticket Spotting A Free Lottery Ticket Spotting A Free Lottery Ticket Under these circumstances, the strategy is to go long the first month future and short the second month future. If the futures curve stays broadly as it is - and both futures contracts roll down the curve - the loss on the first month long position will be made up by the gain on the second month short position. Effectively, the combined position becomes costless. Yet this potentially costless position is still playing the lottery. Because if volatility does spike, the volatility futures curve tends to invert sharply (go into backwardation). Hence, the gain on the first month long position substantially outweighs the loss on the second month short position. Now might be a good time to play the lottery for free. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 On a real GDP per capita basis. 2 Listed as Alphabet. Fractal Trading Model* Silver's 65-day fractal dimension is at a level which has previously indicated four tradeable trend reversals. Go long silver with a profit target / stop-loss of 4.5% In other trades, we are pleased to report that short basic materials versus market and short copper / long tin both hit their respective profit targets. This leaves us with six open positions. 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-11 Long Silver Long Silver 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. * 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 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

Highlights The current mini-upswing in the global mini-cycle started in May and is likely to end around January. On a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. The contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Feature Key to the medium-term behaviour of markets is the existence of what we call 'mini-cycles' in global activity. The evolution of these perpetual mini-cycles explains much of what has happened, what is happening, and what will happen, to financial markets both in Europe and more broadly. Chart of the WeekExpect A Trend-Reversal In The Metals Market Expect A Trend-Reversal In The Metals Market Expect A Trend-Reversal In The Metals Market Mini-cycles are not a hypothesis. They are an indisputable empirical fact. Just look at the global bond yield (Chart I-2), metal price inflation (Chart I-3), global inflation (Chart I-4), and the bank credit impulse (Chart I-5 and Chart I-6). The regular mini-cycles shout out at you! Furthermore, given that these clearly observed mini-cycles show the same half-cycle length of about 8 months, Investment Reductionism strongly suggests that there is a common over-arching driver. Chart I-2The Global Bond Yield Exhibits Mini-Cycles The Global Bond Yield Exhibits Mini-Cycles The Global Bond Yield Exhibits Mini-Cycles Chart I-3Metal Price Inflation Exhibits Mini-Cycles Metal Price Inflation Exhibits Mini-Cycles Metal Price Inflation Exhibits Mini-Cycles Chart I-4Inflation Exhibits Mini-Cycles Inflation Exhibits Mini-Cycles Inflation Exhibits Mini-Cycles Chart I-5The Global Credit Impulse Exhibits Mini-Cycles The Global Credit Impulse Exhibits Mini-Cycles The Global Credit Impulse Exhibits Mini-Cycles Chart I-6Individual Credit Impulses Exhibit Mini-Cycles Individual Credit Impulses Exhibit Mini-Cycles Individual Credit Impulses Exhibit Mini-Cycles Explaining Mini-Cycles Previously,1 we explained that the distinct mini-cycles are interconnected parts of the same never-ending feedback loop. A lower bond yield accelerates bank credit flows... which boosts economic growth... which pushes up commodity inflation and overall inflation... causing the bond market to raise the bond yield, at which point the cycle reverses. And then the alternate cycles repeat ad perpetuam (see Box I-1). Box I-1The Mathematics Of Mini-Cycles How To Profit From Mini-Cycles How To Profit From Mini-Cycles One common question we get is: why focus on bank credit analysis and not on bond-intermediated credit analysis too? The simple answer is that bank credit expands the broad money supply whereas bond-intermediated credit usually does not. When a bank issues a new loan, fractional reserve banking allows it to create money 'out of thin air'. In contrast, when a company or government issues a new bond, no new money is created, unless the primary issue is financed by the central bank - which is generally forbidden. Usually, when a bond is issued, existing money just moves from one account - that of the bond buyer - to another account - that of the bond issuer. This means that bond-intermediated credit cannot increase demand by creating new money, but only by increasing the velocity of existing money. Whereas bank credit can increase demand by increasing both the amount of money and its velocity. Therefore, changes in bank credit are the much bigger driver of the mini-cycle in economic activity. If a bank issues 100 euros of credit today, then we know that this new money will be spent in the coming days and weeks - because nobody borrows money just to sit on it. If, in the previous period, the bank had issued 90 euros which was spent, it means that economic activity in the coming period will grow by 10 euros. But if the bank had previously issued 110 euros, it means that economic activity in the coming period will contract by 10 euros. In this way, the cycles in credit and activity are interconnected. Mini-upswings in the credit impulse mini-cycle tend to signal mini-upswings in commodity inflation (Chart I-7), overall inflation and bond yields. So if we can identify turning points in the credit impulse then we can correctly position the cyclical stance of our investment strategy. Chart I-7The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The problem is that the bank credit data is slow to come out. For example, although we are in the middle of November, the last bank credit data for the euro area refers to September. This means that if the mini-cycle is turning now, we might not find out until January. Nevertheless, we can still use the mini-cycle framework. We know that the current mini-upswing started in May and that mini-upswings have an average length of 8 months. Hence, we can infer that the mini-upswing is likely to end around January. That said, upswing lengths do have some degree of variation: the current upswing might be longer or shorter than the average. How to avoid being too early or too late? Combining Mini-Cycles With Fractal Analysis To optimise our proprietary mini-cycle framework, we propose combining it with our proprietary fractal analysis framework. As regular readers know, fractal analysis measures whether herding in a specific investment has become excessive, signalling the end of its price trend. The combined mini-cycle and fractal framework works best if we use a 130-day herding indicator (fractal dimension), as it broadly aligns with the mini half-cycle length. Excessive herding signals that an investment's trend is approaching exhaustion because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when the market is split between different herds - say, short-term momentum traders and long-term value investors. This is because the herds disagree with each other. If the price fluctuates up, the momentum trader wants to buy while the value investor wants to sell; and vice-versa. So the herds trade with each other with plentiful liquidity. But liquidity starts to evaporate when too many value investors join the momentum herd. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders add fuel to the trend. The tipping point comes when all the value investors have joined the momentum herd. If a value investor then suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated, and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. Earlier this year, our combined frameworks signalled that the aggressive rise in bond yields was likely to reverse (Chart I-8). Therefore, on February 2 we correctly advised: "Lean against the rise in bond yields and bank equities." Chart I-8Excessive Herding In Bonds Always Signals A Trend Reversal Excessive Herding In Bonds Always Signals A Trend Reversal Excessive Herding In Bonds Always Signals A Trend Reversal Today, we see the same dynamic in parts of the commodity rally - and specifically the move in the LME Index (Chart of the Week). Hence, on a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. Could Italy Be A Good Surprise? Returning to the concept of the bank credit cycle, the evolution of longer-term impulses also explains the contrasting recent fortunes of Spain and Italy. In 2013, Spain recapitalized its banking system and ring-fenced bad assets within a 'bad bank'. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. As Spanish banks' aggressive deleveraging ended, the bank credit impulse rebounded very sharply and has remained positive for several years. This undoubtedly explains why Spanish real GDP has grown by 13% since mid-2013 (Chart I-9). In contrast, Italy's banking system remained dysfunctional - which meant that its own credit impulse stayed much more muted and barely positive over the past four years (Chart I-10). But now, the Italian banking system is slowly recuperating. Italian banks' equity capital is rising, their solvency is improving, and the share of non-performing loans has fallen sharply this year. Chart I-9Spain's Peak Credit Impulse##br## Is Probably Behind It Spain"s Peak Credit Impulse Is Probably Behind It Spain"s Peak Credit Impulse Is Probably Behind It Chart I-10Italy's Peak Credit Impulse##br## Is Likely Ahead Of It Italy"s Peak Credit Impulse Is Likely Ahead Of It Italy"s Peak Credit Impulse Is Likely Ahead Of It So the contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report 'Credit Slumps While Animal Spirits Soar. Why?' March 30, 2017 available at eis.bcaresearch.com Fractal Trading Model* There are no new trades this week, leaving us with six open positions. 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-11 Short Nikkei225/Long Eurostoxx50 Short Nikkei225/Long Eurostoxx50 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. * 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 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

Highlights This week, we are reviewing all our current active trades in our Tactical Overlay. As a reminder, these positions (Table 1) are meant to complement our strategic GFIS Model Fixed Income Portfolio, typically with shorter holding periods and occasionally in smaller or less liquid markets outside our usual core bond market coverage (i.e. U.S. TIPS or Swedish interest rate swaps). This report includes a short summary of the rationale behind each position, as well as a decision on whether to continue holding the trade, close it out or switch to a new position that may more efficiently express our view. The trades are grouped together by the country/region that is most relevant for the performance of each trade. Table 1GFIS Tactical Overlay Trades Updating Our Tactical Overlay Trades Updating Our Tactical Overlay Trades Feature U.S. Short July 2018 Fed Funds futures (HOLD). Long 5-year U.S. Treasury (UST) bullet vs. 2-year/10-year duration-matched UST barbell (HOLD). Long U.S. TIPS vs. nominal USTs (HOLD). Short 10-year USTs vs. 10-year German Bunds (HOLD). The tactical trades that we have been recommending within U.S. markets all have a common theme - positioning for an expected rebound in U.S. inflation that will push up U.S. bond yields. We are maintaining all of them. The drift lower in realized inflation rates since the spring has been a surprise given the backdrop of above-potential growth, low unemployment and a weakening U.S. dollar. On the back of this, markets have priced out several of the Fed rates hikes that had been expected over the next year, leaving U.S. Treasury yields at overly-depressed levels. Back on July 11th, we initiated a recommendation to short the July 2018 fed funds futures contract (Chart 1). This was a position that would turn a profit if the market moved to once again discount multiple Fed rate hikes by mid-2018. The trade has a modest profit of 9bps, but with scope for additional gains if the market moves to discount 2-3 hikes by the middle of next year. Our base case scenario is that the Fed will lift rates again this December, and deliver additional increases next year amid healthy growth and with inflation likely to grind higher towards the Fed's 2% target. With the market discounting 46bps of rate hikes over the next year, there is scope for additional profits in our fed funds futures trade. Another tactical position that we've been recommending is a butterfly trade within the U.S. Treasury (UST) curve, long a 5-year UST bullet versus a duration-matched 2-year/10-year UST barbell. This is a position that would benefit from a bearish steepening of the UST curve as the market priced in higher longer-term inflation expectations (Chart 2). We have held that trade for a much longer period than a typical tactical trade, going back nearly a full year to December 20th, 2016. Yet while the UST curve has flattened since that date, our trade has delivered a return of +18bps. This outperformance can be attributed to the undervalued level of the 5-year bullet at the initiation of the trade. Chart 1Stay Short July 2018##BR##Fed Funds Futures Stay Short July 2018 Fed Funds Futures Stay Short July 2018 Fed Funds Futures Chart 2Stay Long The 5yr UST Bullet Vs.##BR##The 2yr/10yr UST Barbell Stay Long The 5yr UST Bullet Vs The 2yr/10yr UST Barbell Stay Long The 5yr UST Bullet Vs The 2yr/10yr UST Barbell While that valuation cushion no longer exists (bottom panel), longer-term TIPS breakevens are back to the levels seen last December (middle panel), thanks in no small part to much higher energy prices (top panel). This leaves the UST curve at risk of a bearish re-steepening on the back of rising inflation expectations. Add in a U.S. dollar that is -2.5% weaker from year-ago levels (Chart 3, middle panel), and a solid U.S. economic expansion that should eventually translate into rising core inflation momentum (bottom panel), and the case for a steeper UST curve over the next 3-6 months is a strong one. The above logic also supports our trade recommendation to go long U.S. TIPS vs. nominal USTs, which is up +248bps since inception on August 23, 2016. We have been holding this trade for much longer than our usual tactical recommendations, but we will not look to take profits until we see the 10-year breakeven (now at 186bps) return back to levels consistent with the Fed's 2% PCE inflation target (i.e. headline U.S. CPI inflation back to 2.5%). One final tactical trade that will benefit from higher UST yields is our recommendation to position for a wider spread between 10-year USTs and 10-year German Bunds. This trade was initiated on August 9th of this year, and has delivered a profit of +9bps. Yet the UST-Bund spread still looks too low relative to shorter-term interest rate differentials that favor the U.S. (Chart 4, top panel). With U.S. data starting to surprise more on the upside than Euro Area data (middle panel), and with UST positioning still quite long (bottom panel), there is potential for additional near-term UST-Bund spread widening. The upcoming decision by the European Central Bank (ECB) on potential tapering of its asset purchases next year represents a potential risk for the long Bund leg of our recommended trade. Any hawkish surprises on that front would be a likely catalyst for us to close out this position. Chart 3Stay Long U.S. TIPS Vs. Nominal USTs Stay Long U.S. TIPS Vs. Nominal USTs Stay Long U.S. TIPS Vs. Nominal USTs Chart 4Stay Short 10yr USTs Vs. German Bunds Stay Short 10yr USTs vs German Bunds Stay Short 10yr USTs vs German Bunds Euro Area Long 10yr Euro Area CPI swaps (HOLD). Long 5-year Spain vs. 5-year Italy in government bonds (HOLD). We have two recommended tactical trades that are specifically focused on developments in the Euro Area. We are maintaining both of them. As a way to position for an eventual pickup in European inflation, we entered a long position in 10-year Euro Area CPI swaps back on December 20th, 2016. That trade is now estimated to have a profit of +29bps, as market-based inflation expectations have drifted higher in the Euro Area. The simple reason for that increase is that realized inflation has moved higher on the back of rising energy costs, as there is a very robust correlation between the annual growth rate of oil prices (denominated in euros) and headline Euro Area inflation (Chart 5). More importantly, the booming Euro Area economy, which has eaten up much of the spare capacity in the Europe, has boosted wage growth and core inflation to levels seen prior to the disinflation shock from the 2014/15 collapse in oil prices (bottom panel). With no signs of any imminent slowing of Euro Area growth that could raise unemployment and slow underlying inflation pressures, the trend for inflation expectations in Europe is still upward. The current 10-year Euro Area CPI swap at 1.5% is still well beneath the ECB's inflation target of "just below" 2% on headline CPI, so there is room for inflation expectations to continue drifting higher. ECB tapering of asset purchases is not an immediate threat to this trade, as the central bank is still likely to keep buying bonds next year (at a slower pace), while holding off on any interest rate increases until late 2019. In other words, the ECB will not be looking to act to slow economic growth to bring down Euro Area inflation anytime soon. Our other tactical trade recommendation in Europe is a relative value spread trade, long 5-year Spanish government debt versus 5-year Italian bonds. This trade was initiated on December 13th, 2016 and currently has only a modest gain of +9bps, although the profits were much larger earlier this year. Italian bonds have been outperforming on the back of improving Italian economic growth (Chart 6, top panel) and, recently, a generalized sell-off in Spanish financial assets on the back of the political uncertainty in Catalonia. Chart 5Stay Long 10yr##BR##Euro Area CPI Swaps Stay Long 10yr Euro Area CPI Swaps Stay Long 10yr Euro Area CPI Swaps Chart 6Stay Long 5yr Spanish Government Bonds Vs.##BR##5-Year Italian Debt Stay Long 5yr Spanish Government Bonds Vs 5-Year Italian Debt Stay Long 5yr Spanish Government Bonds Vs 5-Year Italian Debt Our colleagues at BCA Geopolitical Strategy have been downplaying the threat to Spanish political stability from the Catalonian independence movement, given that the polling data shows only 35% for outright independence from Spain. At the same time, the poll numbers in Italy for the upcoming parliamentary elections are much closer, with parties favoring less integration with Europe holding a slight lead over more "establishment" parties (bottom two panels). With the bulk of the cyclical convergence between Italian and Spanish growth now largely completed, and with a greater potential for future political instability in Italy compared to Spain, we expect that Spain-Italy spreads will tighten further back to the lows seen at the beginning of 2017 (-64bps on the 5-year spread). That is a level we are targeting on our current tactical trade recommendation. Canada Short 10-year Canadian government bonds vs. 10-year USTs (TAKE PROFITS). Long Canada/U.K. 2-year/10-year government bond yield curve box, positioning for a relatively flatter Canadian curve (TAKE PROFITS). Short 5-year Canada government bond versus a duration-matched 2-year/10-year barbell (TAKE PROFITS). We have three different Canadian fixed income trades in our Tactical Overlay, all of which were biased towards tighter monetary policy in Canada: a Canada-U.S. bond spread widener, a yield curve box trade versus the U.K. and a curve flattener expressed as a barbell trade (Chart 7) All three positions are in the money, but we now recommend taking profits. We had initiated these recommendations in a very timely fashion earlier in the year at a time when the Bank of Canada (BoC) was sending a relative dovish message. In our view, the Canadian economy was building significant upward momentum that would eventually force the central bank to shift its policy bias. This would especially be true with the Fed also in a tightening cycle, given the typical tendency for the BoC to follow the Fed's policy actions. Several members of the BoC monetary policy committee began to sing a more hawkish tune over the summer, particularly after the release of the Q2 BoC Business Outlook Survey. That robust report, which was confirmed by a 2nd quarter GDP growth rate of nearly 4% (Chart 8), led the BoC to deliver not one by two unexpected interest rate hikes in July and September. Markets reacted accordingly, driving Canadian bond yields higher and flattening the yield curve. Chart 7Take Profits On Bearish Canadian Bond Trades Take Profits On Bearish Canadian Bond Trades Take Profits On Bearish Canadian Bond Trades Chart 8Canadian Growth Set To Cool Off A Bit Canadian Growth Set To Cool Off A Bit Canadian Growth Set To Cool Off A Bit Now, we see the market pricing as having gone a bit too far, too quickly. The Q3 Business Outlook Survey, released yesterday, was still positive but with readings softer than the booming Q2 report. Meanwhile, the commentary from the BoC has become more balanced, with BoC Governor (and BCA alumnus) Stephen Poloz describing the central bank as being more "data dependent" after the recent rate hikes. Markets are now pricing in another 72bps of rate hikes over the next year, even with our own BoC Monitor off the peak (Chart 9). Chart 9Our BoC Monitor Is Peaking Our BoC Monitor Is Peaking Our BoC Monitor Is Peaking From a tactical perspective, the repricing of the BoC that we expected earlier this year is now largely complete. Thus, we are taking profits on all three Canadian trades: Canada-U.S. spread trade: initiated on January 17th, profit of +43bps. Canada/U.K. box trade: initiated on May 16th, profit of +67bps. Canada 2yr/5yr/10yr butterfly trade: initiated on December 6th, 2016, profit of +95bps. From a strategic perspective, we still see a case where the BoC can deliver additional rate hikes and keep upward pressure on Canadian bond yields. The output gap in Canada is now closed, according to BoC estimates, and additional strength in the economy now has a greater chance in translating to higher inflation. Strong global growth, especially in the U.S., will also support Canadian export growth and feed into rising capital spending. While the rate hikes have help boost the value of the Canadian dollar (CAD), the exchange rate (on a trade-weighted basis) also largely reflects a rising value of energy prices and is, therefore, should provide an additional boost to growth via stronger terms-of-trade (bottom panel). In other words, the rising CAD will not prevent additional BoC rate hikes if oil prices remain strong. Thus, we are maintaining our underweight recommendation on Canadian government bonds in our strategic model bond portfolio, even as we take profits on our bearish Canadian tactical trades. Australia Long a 2-year/10-year Australia government bond curve flattener (SELL AND SWITCH TO NEW TRADE). On July 25th of this year, we entered into a 2-year/10-year curve flattener trade for Australia. Though employment was improving and house prices were booming in Australia, the wide output gap, high level of consumer indebtedness and lack of real wage growth was keeping the Reserve Bank of Australia (RBA) inactive. In our view, nothing has changed since then; the RBA remains in a very difficult position. While the yield curve flattened substantially following the initiation of our trade, the global rise in long-term yields since mid-September lifted Australian longer-maturity yields, and the yield curve with it (Chart 10). Now, Australian long-term yields are not reflecting domestic fundamentals but are instead driven by improving global growth. As such, we are closing the trade and initiating a new position - long Dec 2018 Australian Bank Bill futures - as a more focused way to express the view that the RBA will stay on hold for longer than markets expect. Markets are currently pricing in 30bps of RBA rate hikes over the next twelve months. We believe this will be unlikely, for several reasons. Macroprudential measures on the Australian housing market will continue to dampen credit growth. Core inflation is slowly rising but still far below the central bank's target. Additionally, there is plenty of slack in the labor market despite the spike in employment growth. This is evidenced in anemic real wage growth, stubbornly high underemployment rate, low hours worked and high percentage of part-time to full-time workers (Chart 11). Chart 10Close Australian Government##BR##Bond 2yr/10yr Flattener Close Australian Government Bond 2yr/10yr Flattener Close Australian Government Bond 2yr/10yr Flattener Chart 11RBA Unlikely To Deliver##BR##Discounted Rate Hikes RBA Unlikely To Deliver Discounted Rate Hikes RBA Unlikely To Deliver Discounted Rate Hikes The biggest risk to our new trade would if signs of a tighter Australian labor market started to feed through into faster wage growth, which would likely coincide with faster underlying price inflation and a more hawkish turn by the RBA. New Zealand Long 5-year NZ government bonds vs. 5-year USTs (currency hedged). Long 5-year NZ government bonds vs. 5-year Germany (currency unhedged). Chart 12Stay Long 5yr NZ Government Bonds##BR##Vs. U.S, & Germany Stay Long 5yr NZ Government Bonds Vs U.S, & Germany Stay Long 5yr NZ Government Bonds Vs U.S, & Germany We entered two New Zealand (NZ) tactical bond trades on May 30th, going long 5-year government bonds vs. U.S. and Germany (Chart 12). We expected NZ spreads to tighten faster than the forwards based on our more hawkish views on the Fed and, to a lesser extent, the ECB relative to the more dovish view on the Reserve Bank of New Zealand (RBNZ). The outright bond spreads have tightened and, on a currency-hedged basis, both trades are in the money. Our dovish view on the RBNZ came from the central bank's own forecasts, which called for slowing headline inflation on the back of softer "tradeables" inflation and a sharp cooling of domestic "non-tradeables" inflation through a slowing housing market (Chart 13, bottom two panels). Our own RBNZ Monitor has been calling for the need for higher interest rates in NZ, mostly from the strength in the labor market. Yet we have been ignoring that signal, as has the market which has priced out one full expected RBNZ rate hike since the beginning of the year. With business confidence rolling over, and with the trade-weighted NZ dollar still staying at stubbornly strong levels, the case for the RBNZ to deliver even a single rate hike is not a strong one - especially given the soft inflation forecasts of the central bank. Thus, we are sticking with our tactical spread trades for NZ versus the U.S. and Germany. We are maintaining the currency hedge on the U.S. version of the trade, as we typically do for the vast majority of our cross-country spread trade recommendations. Occasionally, however, we will make an active decision to do a spread trade UN-hedged if we felt very strongly about a currency move. We did that for our NZ-Germany spread trade and this has cost us in the performance of the trade, which is down -3.4%. This is because of a surprisingly large decline in the New Zealand dollar (NZD) versus the euro since the inception of our trade. Yet a review of the technical indicators on the NZD/EUR currency cross shows that the currency pair is now very stretched versus its medium-term trend (the 40-week moving average), with price momentum also at some of the most negative levels of the past decade (Chart 14). These measures suggest that the worst of the downturn in the currency is likely over. The relative positioning on the two individual currencies is now neutral, as long positions on the NZD have been reduced (bottom panel). Chart 13RBNZ Dovishness Is Justified RBNZ Dovishness Is Justified RBNZ Dovishness Is Justified Chart 14Keep NZ/Germany Position Currency Unhedged Keep NZ/Germany Position Currency Unhedged Keep NZ/Germany Position Currency Unhedged Given these technical indicators, and from these current levels, we see greater upside potential for NZD/EUR in the months ahead. This leads us to maintain our unhedged currency position on the NZ-Germany spread trade so as not to realize the current mark-to-market losses on the trade. Sweden Pay 18-month Sweden Overnight Index Swap (OIS) rate (TAKE PROFITS). We entered into a bearish Swedish rates position back on November 22nd, 2016, paying Sweden 18-month Overnight Index swap rates (Chart 15). At the time, we expected the Riksbank to begin hiking interest rates earlier than what was priced in the markets IF inflation reached the central bank target faster due to a weaker Swedish krona. We also believed that the economy would continue to expand at a robust pace when the economy had no spare capacity, creating additional upside inflation surprises. According to the Riksbank's latest Monetary Policy Statement (MPS), the central bank will likely keep the repo rate at -0.5% until mid-2018, while continuing its asset purchase program until the end of this year - even with an overheating economy. This is because realized inflation has remained below the Riksbank target for a long period of time and, although current inflation is above target, it was not necessary to immediately tighten conditions. More likely, the Riskbank is worried about the potential for the krona to appreciate - especially versus the euro - if rate hikes are delivered. It will only be a matter of time before the central bank is forced to tighten policy with the economy likely to strengthen further, led by solid domestic demand, strong productivity growth, and improving exports. Consumption is also expected to increase as households have scope to cut back their high level of savings. Combining the Riksbank's easing policy with the current strength of the economy and the tightness of the labor market, inflation is very likely to return to the 2% target in the next year or two (Chart 16). Chart 15Close Sweden OIS Trade Close Sweden OIS Trade Close Sweden OIS Trade Chart 16Riksbank More Worried About SEK Than Inflation Riksbank More Worried About SEK Than Inflation Riksbank More Worried About SEK Than Inflation However, if the Riskbank remains too concerned about the currency versus the euro, as we suspect, then this will prevent any shift to a more hawkish stance before any change from the ECB. That is unlikely to happen over the next year, at least, even if the ECB slows the pace of asset purchases as we expect. Thus, we are closing out our Sweden 18-month Overnight Index Swap position at a small profit of 12bps. We have already kept this trade for longer than the typical investment horizon for one of our tactical overlay trades. We will investigate the potential for more profitable trade opportunities in the Swedish fixed income markets in a future report. Korea Long a 2-year/10-year Korean government bond yield curve steepener (HOLD). We recommended entering into a 2-year/10-year steepening trade in the Korean government bond yield curve on May 30th, 2017. Since then, the yield curve has flattened by 7bps, which was mainly caused by an unexpected rise in the 2-year yield, rather than a decline in 10-year yield (Chart 17). Korea is currently enjoying a solid business cycle upturn. Leading economic indicators are rising, the year-over-year growth in exports has risen to a 7-year high and previously sluggish private consumption has also rebounded recently. The Bank of Korea (BoK) is of the view that the recovery will continue and consumer price inflation will stabilize at the target level over the medium-term. This recovery should cause the 2/10 curve to steepen as longer-term inflation expectations rise. Based on South Korean President Moon's aggressive fiscal plans to increase welfare spending and create jobs in the public sector, at a time when the economy is good shape, we still believe that long-end of the curve (10-year) will rise. In addition, as shown in Chart 18, the 26-week rolling beta of changes in the 10-year UST yield and Korean 10-year bond is very high, nearly 1. Given our bearish view on USTs, this implies Korean yields can follow suit. On the other hand, the correlation between the 2-year UST yield and equivalent maturity Korean yields is much lower (4th panel), as Korean rate expectations have not been following those of the U.S. higher - even with a stronger Korean economy. Most likely, this is due to investors downplaying the potential for the BoK to match Fed rate hikes tick-for-tick given the heightened tensions between the U.S. and North Korea. Chart 17Stay In Korea 2yr/10yr##BR##Government Bond Steepener Stay In Korea 2yr/10yr Government Bond Steepener Stay In Korea 2yr/10yr Government Bond Steepener Chart 18Long-Term Korean##BR##Yields Are Too Low Long-Term Korean Yields Are Too Low Long-Term Korean Yields Are Too Low We still believe the Korean curve can steepen as longer-term yields rise, although we will be monitoring the behavior of shorter-dated Korean yield as the situation between D.C. and Pyongyang evolves. If investors begin to demand a higher risk premium on Korean assets, particularly the Korean won, then 2-year Korean yields may rise much faster and our curve trade may not go our way. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Updating Our Tactical Overlay Trades Updating Our Tactical Overlay Trades Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Tipping points tend to occur when too many long-term value investors are uncharacteristically behaving like short-term momentum traders. Long IBEX35 versus Eurostoxx50 constitutes a good tactical trade. The underperformance of Spanish equities appears excessively pessimistic. Euro/dollar is technically extended by about 4 cents. The near term event risk is the ECB meeting on October 26, when a taper of asset purchases which extends well beyond 12 months might be regarded as dovish. But in the medium term, euro/dollar will head well north of 1.30. Underweight Basic Materials equities relative to the market as a tactical trade. Feature Spain: Red Herring Or Red Flag? Long Spanish equities is an excellent tactical trade provided that the imbroglio in Catalonia turns out to be a red herring. The IBEX35 index is at a classic tipping point of excessive short-term (negative) groupthink and herding (Chart of the Week). Chart Of The WeekThe Underperformance Of Spanish Equities Seems Excessive The Underperformance Of Spanish Equities Seems Excessive The Underperformance Of Spanish Equities Seems Excessive But is the imbroglio in Catalonia a red herring? Most likely, yes. As my colleague Marko Papic, BCA Chief Geopolitical Strategist points out, any unilateral declaration of independence from Catalonia would be vacuous if it lacked international legitimacy, or the ability to enforce it with arms. German sociologist Max Weber famously defined a nation's sovereignty as a "monopoly over the use of legitimate force." Unlike the Basque separatists, Catalan separatists have never resorted to force. A descent into violence remains unlikely because the Catalan independence movement is mainly a bourgeois, middle and upper class intellectual vision. The majority of Catalonia's working class are neither Catalan, nor support independence. Any unilateral declaration of independence would also lack political credibility because the opponents of independence largely boycotted the recent referendum to avoid giving it legitimacy. The vote for independence comprised only 37% of the electorate, meaning that popular support for independence remains questionable. The real (and unspoken) reason for the independence referendum was that it was the only glue holding together the Junts Pel Si (Together For Yes) four party coalition forming Catalonia's regional government. Without this glue, the two nationalist parties from opposite sides of the ideological spectrum would not be in bed with each other. And it is unclear whether this unholy alliance can stay entwined. To sum up, Catalan independence is an intellectual vision which at the moment lacks political and implementation credibility. For the imbroglio to become a full-blown crisis, the Catalan government, or militant groups, or the Spanish government would have to escalate tensions with the use of force. We do not expect this to happen. So the underperformance of Spanish equities appears excessively pessimistic, and long IBEX35 versus Eurostoxx50 constitutes a good 3-month trade (Chart I-2 and Chart I-3). Chart I-2The IBEX 35 And Euro Stoxx 50 Have Parted Company The IBEX35 And Euro Stoxx 50 Have Parted Company The IBEX35 And Euro Stoxx 50 Have Parted Company Chart I-3The IBEX 35 Has Catch-Up Potential The IBEX35 Has Catch-Up Potential The IBEX35 Has Catch-Up Potential Identifying Tipping Points Of Price Trends Let's take this opportunity to review how we identify such tipping points of excessive groupthink and herding. Tipping points tend to occur when too many long-term value investors are uncharacteristically behaving like short-term momentum traders. Instead of dispassionately investing on the basis of value, long-term investors get sucked into chasing a price trend, and thereby amplify it. These price trends reach exhaustion when there are no more value investors left to suck in, and at the margin, someone wants to get out. The following analysis describes the tipping point of a price uptrend, but exactly the same analysis applies in reverse to the tipping point of a price downtrend. When a financial asset price starts to rise, the momentum trader's natural inclination is to chase the price rise, and buy. Conversely, the long-term value investor's natural inclination, ordinarily, is to lean against the price rise, and sell. The two investors interpret the same information in polar opposite ways because they have very different time horizons. Importantly, their different interpretations of the same information - stemming from their different time horizons - allow the momentum trader and the value investor to trade with one another in very large volume at the current price. This is what creates a healthy market with plentiful liquidity. Now consider what happens when a long-term value investor flips out of character and acts like a momentum trader. With the numerical balance shifting to the momentum traders, the price has to move up to balance buy and sell orders. As more and more value investors defect to momentum trading, the price uptrend gathers steam. This uptrend is exhausted when the long-term value investors have all joined the trend. Regular readers know that we identify these tipping points by comparing the behaviour of investors with 'short-term' 1-day horizons and investors with 'long-term' 65-day horizons. For any financial asset, a near term price reversal is likely to occur when its 65-day fractal dimension hits a lower limit of 1.25 (Chart I-4), which we have found to be the 'universal constant of finance'.1 Chart I-4When The Valuation Framework Changes, It Is More Difficult To Assess Tipping Points When The Valuation Framework Changes, It Is More Difficult To Assess Tipping Points When The Valuation Framework Changes, It Is More Difficult To Assess Tipping Points At this remarkably consistent limit, the long-term investor reverts back to character, realises the stock is now overvalued and wants to sell. The trouble is that everybody has already joined the trend. To sell, there needs to be a buyer. But who will buy at the current price? Usually, the answer is nobody. The marginal buyer will be a new category of investor: an 'ultra-long term' value investor - let's say, with a 130-day horizon - who stayed true to character and refused to join the uptrend. As this investor knows that the stock is overvalued at the current price, he will only provide liquidity at the 'correct' lower price. So this is the tipping point at which the price trend reverses. Occasionally, there is another possibility. The ultra-long term value investor could also join the trend at the current price. This might happen when the valuation framework for an investment is especially uncertain, leaving long-term value investors extremely disoriented and unable to assess the 'correct' price. An important conclusion is that when the valuation framework for an investment is undergoing a major change, it is much more difficult to assess the tipping point of a price trend. Which brings us to the euro. Is The Euro Overbought? Through the second half of 2014 and early 2015, the euro was in a major downtrend as the ECB first signalled and then implemented its QE program. On several occasions, the 65-day downtrend seemed technically exhausted but after only minor reversals, the downtrend continued (see Chart I-4 again). Even after the 130-day downtrend seemed exhausted at the start of 2015, it persisted into the spring (Chart I-5). The reason was that as the ECB moved into the uncharted territory of QE, ZIRP and NIRP, the valuation framework for the euro also moved into uncharted territory. Without a reliable valuation anchor, longer and longer term investors jumped on the euro bear bandwagon. Chart I-5The Euro Is Overbought, But The Reversal Might Be Minor The Euro Is Overbought, But The Reversal Might Be Minor The Euro Is Overbought, But The Reversal Might Be Minor Today, we face the mirror-image situation. The euro has been in a major uptrend for most of 2017 as the ECB has signalled a recalibration of its extraordinary monetary easing. But though the 65-day uptrend seemed exhausted in the early summer, the uptrend continued as longer term investors joined the trend. Just as in 2014-15, the question today is: at a major turning point in ECB policy, what is the most reliable valuation anchor? For us, the best explanatory model for euro/dollar is the expected difference in ECB versus Fed policy rates 5 years ahead. As this differential compressed from -230 bps to -160 bps, euro/dollar rallied in perfect lockstep from 1.03 to 1.15. However, the subsequent rally has deviated from the expected policy rate differential, suggesting that the euro's uptrend is indeed overdone by about 4 cents. But in the medium term, the much bigger question is: what will happen to the expected policy rate differential? As we explained in Positioning For A Sea-Change2 the differential must eventually compress to around -40 bps, because this is the mid-point of a very well established multi-decade cycle (Chart I-6 and Chart I-7). In which case, euro/dollar must eventually head well north of 1.30 (Chart I-8). Chart I-6The Euro Area - U.S. Average ##br##Interest Rate Differntial = -40 bps... The Euro Area - U.S. Average Interest Rate Differntial = -40bps... The Euro Area - U.S. Average Interest Rate Differntial = -40bps... Chart I-7...Because The Euro Area-U.S. ##br##Inflation Differential = -40 bps ...Because The Euro Area-U.S. Inflation Differential = -40bps ...Because The Euro Area-U.S. Inflation Differential = -40bps Chart I-8An Expected Interest Differential ##br##Of -40 bps Means EUR/USD Goes North Of 1.30 An Expected Interest Differential Of -40 bps Means EUR/USD Goes North Of 1.30 An Expected Interest Differential Of -40 bps Means EUR/USD Goes North Of 1.30 To be clear, north of 1.30 is the medium term direction of travel, and the journey will not be a straight line. The near term event risk is the ECB meeting on October 26, when the central bank will very likely announce a recalibration of its monetary policy. A taper of asset purchases which extends well beyond 12 months might be regarded as dovish, as it would delay the timing of policy rate normalisation. In which case, euro/dollar could retest 1.15. Finally, and very briefly, Chart I-9 shows the major equity sector most at risk of a price trend reversal is Basic Materials. Although global growth seems healthy and synchronized, materials equities seem to have run much too far ahead, especially relative to other cyclical equity sectors. We recommend tactically underweighting Basic Materials relative to the market. Chart I-9Tactically Underweight Basic Materials Tactically Underweight Basic Materials Tactically Underweight Basic Materials Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report, "The Universal Constant Of Finance," September 25 2014, available at eis.bcaresearch.com. 2 Published on September 7 2017 and available at eis.bcaresearch.com. Fractal Trading Model* As decribed in the main body of this report, this week’s new trade recommendation is to go long Spain’s IBEX35 versus the Eurostoxx50 with a profit target/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-10 Long Canadian 10-Year Government Bond Long Canadian 10-Year Government Bond * 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 Fractal Trading Model 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. 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 - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Dear Client, This week, in addition to this regular Geopolitical Strategy Weekly Report, we decided to send you a collaborative report we penned with BCA's Energy Sector Strategy. My colleague Matt Conlan runs the service, which blends BCA's macroeconomic framework with his bottom-up expertise in the energy sector. Matt's service is one of the few that our firm publishes with specific company recommendations. In the report titled "King Salman Goes To Moscow, Bolsters OPEC 2.0," Matt argues that the emerging détente between Russia and Saudi Arabia will strengthen OPEC 2.0 and provide a structural tailwind for BCA's bullish view on energy. I highly recommend that you check out the research Matt and his team produce at nrg.bcaresearch.com. All the very best, Marko Papic Senior Vice President, Geopolitical Strategy Highlights Easier fiscal policy and tighter monetary policy is bullish for U.S. equities; The Dec. 12 Alabama Senate race could be a game changer in U.S. politics; Trump's anti-immigration policies could boost inflation; Our Catalan view is bearing out. Go long Spain's IBEX 35 / short Eurostoxx 50. Separately, book profits on our China volatility trade and our long China big bank trade. Feature "Buy In May And Enjoy Your Day!" has been our mantra throughout the summer. Despite the doom and gloom in the media surrounding the Mueller investigation, North Korea, Trump's legislative agenda, the French elections, Brexit, and so on, the S&P 500 is up 16% and global equities are up 10.8%. Our April 23 Weekly Report bearing the same cheery title focused on three overstated risks:1 European politics - massively overstated; U.S. politics - all noise, no signal; Brexit - irrelevant for global investors. We have also cautioned investors throughout the year to worry, but not to obsess, about North Korea. Yes, it is a risk.2 Yes, it will continue to buoy safe haven assets on occasion.3 But it is extremely unlikely to produce total war and therefore has lost some market relevance as assets have adjusted to the higher geopolitical volatility on the Korean Peninsula under the Trump regime.4 We are not reiterating these calls just to pat ourselves on the back. Rather, our point is to emphasize that there is nothing supernatural about the ongoing bull market. It has not "ignored" geopolitical risks. Rather, geopolitical risks on hand have not developed in a market-relevant way. The bottom line here is that geopolitics is not voodoo. It is not an "error term," a disturbance in an elegant model that can go awry at any moment because "one cannot forecast politics." Investors can systematically analyze geopolitics just as they do the economy or the markets. When geopolitical risks are overstated, as they have been since the beginning of the year, recognizing the mispricing can generate significant alpha. Going forward, however, geopolitics will likely play a headwind for the market. We are particularly concerned with three dynamics: The upcoming party congress in China may signal a shift towards more growth-stalling reforms, as we have been writing all year. The Trump administration could make a hard turn towards a more populist agenda, particularly on trade, if it fails to enact any legislative successes this year. A plethora of political risks in emerging markets (EM) - with the usual suspects of Brazil, South Africa, and Turkey on top of our list - could re-surface in 2018 if China is not firing on all cylinders. We will be focusing on these three risks to markets until the end of 2017 and beyond. This week, however, we focus on upcoming tax legislation in the U.S. First, a reason to be optimistic ("easier fiscal policy, tighter monetary policy" is a winning policy combination). Then, a reason to be pessimistic (Alabama). Finally, a few words about inflation from a political perspective and a quick word on Catalonia. Easy Fiscal, Tighter Monetary Policy Mix - What Does It Mean? If our base case view on tax legislation is correct, U.S. equities should gain double-digit returns from current levels. Our colleague Anastasios Avgeriou, Chief Strategist of BCA's U.S. Equity Strategy, believes that the passage of stimulative tax legislation would serve as a catalyst to further fuel the blow-off phase in equities. In his latest Weekly Report, Anastasios presents empirical evidence suggesting that easy fiscal policy outweighs the drag from Fed interest rate tightening.5 Filtering the post-World War Two era for periods of easing fiscal and tightening monetary policies during economic expansions is revealing. Anastasios defines easy fiscal policy as periods with a positive fiscal thrust and tight monetary policy as a rising fed funds rate. Fiscal thrust is the year-over-year change in the cyclically-adjusted fiscal balance as a percentage of potential GDP (shown inverted on the bottom panel of Chart 1). While such a policy mix is a rare occurrence, it has happened seven times since the mid-1950s (shaded areas, Chart 1).6 All iterations resulted in positive returns, with the SPX rising on average by over 16%. Table 1 details all seven periods that have an average duration of 16 months. For sectoral implications of such an "easier fiscal, tighter monetary" policy mix, we encourage our clients to peruse the work of BCA's U.S. Equity Strategy. On the other hand, the demand for fiscal stimulus usually rises during times of high volatility, unlike today (Chart 2). Investors have become acutely aware of the political difficulties of stimulating the economy late in the economic cycle. We now turn to some emerging risks to our sanguine view on tax policy. Chart 1Easy Fiscal + Tight Money##br## = Buy SPX Easy Fiscal + Tight Money = Buy SPX Easy Fiscal + Tight Money = Buy SPX Table 1SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Why So Serious? Why So Serious? Chart 2Fiscal Stimulus Usually##br## Comes With High Volatility Fiscal Stimulus Usually Comes With High Volatility Fiscal Stimulus Usually Comes With High Volatility Bottom Line: If our base case view holds, and Republicans pass mildly stimulative tax legislation, the blow-off phase in equities should continue. "Alabama, You Got The Weight On Your Shoulders" The market continues to doubt that the Trump administration can pass significant tax legislation over the next six-to-nine months. The gap in the probabilities assigned to such an outcome by the market and ourselves has narrowed over the past two weeks, generating alpha on several of our "Trump Reflation" trades (Chart 3). But skepticism abounds. Chart 3Signs Of Life For 'Trump Reflation' Trades Signs Of Life For 'Trump Reflation' Trades Signs Of Life For 'Trump Reflation' Trades We have spent the entire year pushing against the skepticism, but there is now an actual reason to worry. The December 12 Alabama Senate special election - being held to elect a replacement for former Senator Jeff Sessions, now the U.S. Attorney General - has become a premier league event. Former Alabama Chief Justice Roy Moore won the Republican primary against a candidate backed by the Republican establishment and President Trump. The reason the Alabama special election is of global significance is because the Republicans are already down to essentially 50 votes in the Senate. The rhetorical war between President Donald Trump and Senator Bob Corker (R - Tennessee) has reached epic proportions, with the latter insinuating via twitter that the president was an adult baby. Corker has announced his retirement from the Senate, which increases the probability that he will go out by refusing to support the president's agenda across all fronts.7 This now makes two GOP senators that want nothing to do with President Trump's agenda. John McCain (R - Arizona) has harbored ill will since the presidential campaign and has twice played the spoiler in the effort to repeal Obamacare. Further complicating matters is the role of former White House Chief Strategist Steve Bannon, who strongly backed Moore when nobody in the Republican establishment would. If Moore should remain loyal to Bannon beyond the election, it would mean that Trump's former campaign strategist would become the kingmaker on tax legislation. Bannon's departure from the White House was cheered by the markets, as it signaled victory for the "Goldman Sachs clique" and the trio of generals managing President Trump's foreign policy over Bannon's populist "Breitbart clique." We do not think that Bannon is opposed to stimulative tax policy. Yes, he has branded his ideology "economic nationalism," but his media empire, Breitbart, has so far stayed away from attacking the Republican tax plan. Instead, Bannon and Moore could hold out on supporting tax policy until they see movement on other pillars of the populist agenda, namely on immigration policy. As such, Moore's Alabama victory would complicate the horse-trading surrounding tax legislation, and elevate Bannon's standing on Capitol Hill, but it would not be a death knell for stimulus. The actual death knell for tax reform would be if Moore actually lost the December 12 Alabama special election. Moore's views are generally considered to be staunchly conservative, even for Alabama, and therefore a shock defeat cannot be ignored.8 Polls are limited, but most show Moore leading the Democratic candidate Doug Jones by only 5%-8%. This in a state where Republican Senate candidates have defeated their Democrat counterparts by an astounding average of 36% in the last decade! If Jones were to win, Republicans would be down to 51 Senators. Given the staunch opposition to Trump by Corker and McCain, this would effectively end the tax legislation push. Not all is negative for the tax push in Washington. The U.S. House of Representatives has passed a budget resolution that includes steep spending cuts as well as reconciliation instructions for tax legislation. This now sets in motion the reconciliation process by which Republicans can pass tax legislation with merely 51 votes in the Senate. Of the 18 GOP representatives who voted against the budget resolution, only three were from the 31-member Freedom Caucus, which is rhetorically committed to fiscal conservativism. This is very bullish for tax cuts as it means that the Freedom Caucus is toeing the line of its Chair Mark Meadows (R - North Carolina) who has been hinting since the spring that he would have no problem with budget-busting tax cuts. The majority of Republicans who voted against the budget resolution were from highly-taxed "Blue States," suggesting that the real point of contention for Republicans in the House was the proposal to end the state and local tax deduction. Treasury Secretary Steven Mnuchin has already signaled that the White House is willing to compromise on this particular revenue offset. Bottom Line: The December 12 Alabama special election now has global market relevance. A defeat for GOP candidate Roy Moore would be a massive game changer. It would reduce the Republican majority in the Senate to 51 votes, putting in danger President Trump's tax agenda given the staunch opposition from Senators Corker and McCain. What Can Politics Do To Inflation? The greatest surprise to the markets this year has been lackluster inflation data in the U.S. Both headline and core data have been disappointing (Chart 4). This is particularly puzzling as the U.S. has closed its output gap and unemployment has fallen below the low reached in 2007 (Chart 5). Chart 4U.S. Inflation Has Disappointed... U.S. Inflation Has Disappointed... U.S. Inflation Has Disappointed... Chart 5...Which Is Puzzling At Full Employment ...Which Is Puzzling At Full Employment ...Which Is Puzzling At Full Employment One possible explanation is that the U.S. has been importing deflation from abroad. The U.S. imports around 12.5% of GDP worth of goods and 2.8% of GDP worth of services (Chart 6). However, the import price deflator has been growing at 2.7% so far this year and yet inflation has been nonexistent (Chart 6, bottom panel). Export prices have grown by 5% in 2017, from the lows of -15% amidst the commodity bust in 2015 (Chart 7). Chart 6The U.S. Is Not Importing Deflation The U.S. Is Not Importing Deflation The U.S. Is Not Importing Deflation Chart 7Global Export Prices Are Rising Global Export Prices Are Rising Global Export Prices Are Rising Another explanation is that structural changes in the labor market - globalization and the fall in the unionization rate - have eroded the bargaining power of workers (Chart 8). When combined with the shock of the 2008 Great Recession, workers may simply be happy to have a job and are therefore delaying asking of a raise or switching to a higher-paying, but higher-risk, job. As a result, the economy may have closed its output gap, but with no inflationary effects coming from the low unemployment figures. Chart 8Globalization Suppressed U.S. Wages Globalization Suppressed U.S. Wages Globalization Suppressed U.S. Wages Further restricting wage gains may be the high number of migrants - legal or illegal (Chart 9). The foreign born population in the U.S. is at an all-time high of 43.2 million, although unauthorized migration has come down from around 12 million prior to the GFC to 11.3 million in 2016. The conventional wisdom is that most immigrants are uneducated, competing with blue collar laborers and suppressing wages at the lower income levels. However, this is a stereotype stuck in the 1980s. Today's migrants are as educated as Americans: 29.7% have a Bachelor's degree or higher, compared with just over 30% Americans in general (Chart 10). Chart 9Immigration Helps Explain Weak Wage Growth Why So Serious? Why So Serious? Chart 10Immigrants Not Stealing Low-Skill Jobs Why So Serious? Why So Serious? The point is that immigration has evolved along with the U.S. economy. With 78% of the U.S. economy based in services, the modern migrant has had to keep up with the educational requirements of the American job market. The Trump administration could be a game-changer for the skilled, legal immigration into the U.S. First, President Trump ordered a full review of the high-skilled, H-1B immigration visa in April. Second, President Trump asked Congress in August to curb legal migration by sharply curtailing family reunification while keeping immigration based on job skills roughly the same. Third, anti-immigrant rhetoric - as well as restrictions to family reunification down the line - could influence highly-skilled migrants to choose job opportunities in countries like Australia, Canada, and New Zealand, instead of in the U.S. Bottom Line: Investors often think of fiscal policy as the main vehicle through which politicians can influence inflation. However, the U.S. economy has been enjoying, since the 1980s, the combined effect of rapidly expanding immigration and a parallel increase in the educational attainment of incoming migrants. In a way, the influx of skilled migrants has been an important supply side reform for the U.S. economy. The Trump administration could influence immigration either directly, through policies to curb it, or indirectly, through creating a general atmosphere that redirects some of the flows to other developed economies. Spain: Fade Catalan Risks As we have expected since 2014, the prospects for Catalan independence remain slim.9 As we go to press, Catalan President Carles Puigdemont has backed away from his earlier hints toward a unilateral declaration of independence. Instead, he has succumbed to domestic and international pressure and told the regional parliament that he has "suspended" any declaration in order to begin negotiations with Madrid. Puigdemont's decision to suspend something that has not happened is not only illogical but also ineffectual. The Catalan pro-independence government is trying to force Madrid to be the "bad guy" and refuse negotiations; Spain has refused any discussion of independence. But slight narrative shifts and "gotcha" politics will not work in this case. While Puigdemont is playing checkers with Spanish Prime Minister Mariano Rajoy, the rest of Europe is playing chess. International recognition of Catalan independence is not forthcoming. And without it, Catalonia will not become independent. As we have extensively written, we strongly believe that investors should fade secessionism risk in Spain. First, the independence process in Catalonia falls far short of the democratic ideals established in similar referendums in the developed world, particularly in Scotland (2014), Montenegro (2006), and Quebec (1980 and 1995) (Table 2). The pro-independence government has been unable to significantly boost turnout figures from 2014, no doubt due to interference by the federal authorities. However, even if the pro-independence Catalans were to receive mediation from the EU, the outcome would likely be to strengthen Madrid's hand. For example, when the EU negotiated the 2006 divorce between Serbia and Montenegro, it required a supermajority of 55% in order to recognize the result of the Montenegro independence referendum. As an integrationist project, the EU has an anti-secession bias. Table 2Catalan Independence Demand Exaggerated By Low Voter Turnout Why So Serious? Why So Serious? Second, the French government has come out forcefully against Catalan independence, as we suspected it would. This is particularly important for Catalonia as it is nestled between Spain and France.10 It is quite likely that, were Catalans somehow to enforce their independence, both European powers would close their borders to Catalan travel and trade. In addition, French European Affairs Minister Nathalie Louiseau has repeated Madrid's assertion that by choosing independence Catalonia would automatically be kicked out of the EU. Third, Madrid is unlikely to make another mistake as the disastrous attempt to disrupt the independence referendum. Images of civilians being dragged through the streets of an advanced European economy while attempting to vote - even if the referendum was constitutionally illegal - shocked the world. Spanish officials have already offered rather tepid apologies for the police action, suggesting that a re-run of the heavy-handed actions is not to be expected. For investors who disagree with us, we suggest an empirical way to test our thesis. Chart 11 shows that only 34.7% of Catalans support independence. These are not pro-Madrid polls. They are the product of the Centre d'Estudis d'Opinió, which is affiliated with the Catalan (currently staunchly pro-independence) government and has been conducting polls on the issue of independence since 2005. Even if the level of support for independence is off in this data, the direction gives us valuable insight into the support for secession. The data clearly suggests that (A) the majority of Catalans have never supported independence and that (B) support for independence peaked in 2013, at the height of Spain's economic crisis, and has been in steady decline since then. That said, Chart 11 also shows that the other 57.5% of Catalans are not necessarily "pro-Spain." In fact, 30.5% support Catalonia remaining in its current form of an autonomous region, with considerable sovereignty devolved to the province. Another 21.7% favor a federal state, which would be a step in the direction of even greater sovereignty. Investors should watch the polls to see whether voters who previously favored federal or autonomous status have begun to shift towards independence, especially in light of the crackdown against the referendum by Madrid. Centre d'Estudis d'Opinió normally releases its third series of polls in October, which would mean that investors will have an update from the official polling agency soon. That said, we are willing to put our geopolitical views on the line. An unwarranted selloff in Spanish equities on the back of increased Catalonia-related geopolitical risk has created an opportunity for a market neutral trade: long Spanish IBEX 35/short Eurostoxx 50. This is a market neutral way to express our view that Catalonia does not pose a grand geopolitical risk as it will remain an integral part of Spain and thus the EU. Importantly, adding a hedge to this pair trade would also make sense for certain investors. Chart 12 shows that EUR/USD and relative Spanish equity performance are joined at the hip. Currently an uncharacteristically wide gap has opened. Thus, putting on this equity pair trade and simultaneously going short EUR/USD on the expectation of a convergence, should generate alpha, as the geopolitical dust settles. Chart 11The Silent Majority Fears Independence The Silent Majority Fears Independence The Silent Majority Fears Independence Chart 12Expect A Convergence Expect A Convergence Expect A Convergence Bottom Line: Fade geopolitical risks in Spain. For those with risk appetite, buy Spanish equities at any sign of geopolitical risk premium. Housekeeping With the Communist Party convening for the nineteenth National Party Congress over the next week, we think the time is opportune to book profits on two trades: our long China ETF volatility index, for a gain of 17.72%, and our long Chinese Big Five state-owned banks versus small and medium-sized banks, for a gain of 11.63%. We will revisit these trades in an upcoming report. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 6 Omitted from the sample are brief periods in the early-1960s, early-1970s, and twice in the early-1980s as they were very close to the end of recessions. 7 We suspect that Senator Corker is planning a centrist challenge to President Trump in the 2020 GOP presidential primaries. 8 "Staunchly conservative" does not do justice to Moore's ideological orientation. He was removed from his position as Chief Justice of the Alabama Supreme Court twice for failing to follow federal law. In both cases, Moore chose to inform his actions as the Chief Justice through Biblical scripture, rather than the U.S. Constitution. 9 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 10 Yes, we are aware that Catalonia also borders Andorra. However, given that French President Emmanuel Macro is the co-prince of Andorra, and that Andorra is a microstate, this fact is largely irrelevant and would in no way aid Catalan independence. However, you have now learned that the French President is automatically a co-prince of another country. And that there is such a thing as a "co-prince." Therefore, this footnote has not been a complete waste of your time.

Highlights Expect Spain's strong growth to fade somewhat as its credit impulse appears to have peaked. The Catalan independence debate is an inconvenience but not a long term tail-risk. Expect Italy's growth to pick up as the Italian banking system is repaired. Brave investors could go long Italian bonds versus Spanish bonds now. More cautious investors might wait until after the Italian election in the first half of next year. France's CAC40 is our preferred mainstream euro area equity market right now. Feature Recent history teaches us that to leave the European Union is inconvenient, but to leave the euro is disastrous. To leave the EU means redefining laws, institutions and trading relationships, but to leave the euro means redenominating the entire banking system's assets and liabilities into different currencies - leading to bank runs and chaotic insolvencies. For this reason, even tiny Greece chose to suffer an extended depression rather than to leave the euro. Chart of the WeekSpain Fixed Its Banks In 2013, Italy Is Fixing Its Banks Now Spain Fixed Its Banks In 2013, Italy Is Fixing Its Banks Now Spain Fixed Its Banks In 2013, Italy Is Fixing Its Banks Now Leaving The EU Is Inconvenient, Leaving The Euro Is Disastrous To leave the EU, there is a broadly defined process but the process is inconvenient and protracted, as the United Kingdom is now discovering. The U.K. will technically leave the EU on March 31 2019, but Prime Minister May has proposed a further transition period of "around two years." Therefore the U.K. will remain in the European single market and customs union - and fully subject to EU laws and regulations - until at least 2021, five years after the U.K. voted to leave the EU. This protraction of the exit process creates a tasty irony. Not long after the U.K. fully leaves in 2021, the Leave vote's 1.25 million majority will have disappeared - counting those who voted in 2016 who are still alive. This is because out of the 0.625 million deaths in the U.K. in each of the coming years, there is a very heavy skew to Leave's much older voters1 (Chart I-2). As the U.K is not in the euro there is no secondary issue of whether to leave the single currency. But this does raise an interesting hypothetical question. If a euro area country - or region like Catalonia - inconveniently left or was ejected from the EU, does it follow that it must also crash out of the euro? No. Several non-EU countries already use the euro. There are the European microstates of Andorra, Monaco, San Marino and Vatican City. More significantly, Montenegro and Kosovo have adopted the euro as their de facto currency. To be clear, we do not expect Catalonia to secede. Polls consistently show a significant majority in Catalonia do not want full independence (Chart I-3). The unionists mostly boycotted the independence referendum because Madrid deemed it illegal. Given the low turnout, the 89% vote for independence equalled just 37% of eligible voters. Chart I-2The Vote For Brexit Was ##br##Driven By Older Voters The Spain/Italy Conundrum The Spain/Italy Conundrum Chart I-3A Significant Minority In Catalonia##br## Do Not Want Full Independence A Significant Minority In Catalonia Do Not Want Full Independence A Significant Minority In Catalonia Do Not Want Full Independence But even if Catalonia did become independent, this hypothetical eventuality would not involve a catastrophic exit from the euro. Catalonia, in its economic interest, would want to keep the euro, and the EU would let it. The Spain/Italy Conundrum The much bigger threat would be if a major euro area country felt that the single currency was not in its economic interest, and decided to jettison the euro. In this regard, the problem - at first sight - appears to be Italy. Through the 19 years of the euro, Italy's real GDP per head has grown by just 6%, substantially less than any other major economy. If the single currency is to blame for the significant underperformance of its third largest economy with 60 million people, then the euro's long-term viability has to be in question. But it is hard to blame the euro per se for Italy's painful underperformance. For the first half of the euro's life, 1999-2007, Italian real GDP per head performed more or less in line with the United States, Canada and France (Chart I-4) - even without a substantial tailwind from a credit-fuelled boom which the other economies had. Then, in the post-2007 years, there was little to distinguish the economic performances of Italy and Spain until 2013 (Chart I-5). At which point, Spain took off, with real GDP per head subsequently expanding by 15%. Whereas Italy struggled to grow. The conundrum is: what explains this stark recent difference between Spain and Italy? Chart I-4Through 1999-2007, Italy Grew In Line ##br##With Other Major Economies Through 1999-2007, Italy Grew In Line With Other Major Economies Through 1999-2007, Italy Grew In Line With Other Major Economies Chart I-5Post-Crisis, There Was Little To Distinguish##br## Italy and Spain Until 2013 Post-Crisis, There Was Little To Distinguish Italy and Spain Until 2013 Post-Crisis, There Was Little To Distinguish Italy and Spain Until 2013 The start of Italy's underperformance in 2008 and the start of Spain's strong recovery in 2013 provide the solution to the conundrum. Following the global financial crisis in 2008, Italy has still to repair its banking system. Whereas Spain fixed its banks in 2013. Significantly, Spain ring-fenced bad assets within a bad bank while recapitalising good banks. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. Therefore in 2013, Spanish banks' aggressive deleveraging ended. The result was that Spain's credit impulse - which measures the change in bank credit flows - rebounded very sharply and has remained positive for four years. This explains Spain's remarkably strong recovery (Chart I-6). In contrast, Italy's still dysfunctional banking system means that its own credit impulse has been much more muted and barely positive over the past four years (Chart I-7). Begging the question: why has Italy been so slow to fix its dysfunctional banking system? One reason is that Italy's banking malaise has built up stealthily, generating frequent financial tremors but without an outright crisis. In contrast, the credit booms in the U.S., U.K., Ireland and Spain did eventually cause housing busts and full-blown banking crises, requiring urgent policymaker response. A second reason is that the Italian government is more highly indebted than other governments, making it more difficult to raise public funds to fix the banking system. The good news is that the Italian government, the EU and the ECB are now on the same page and finally progressing to repair the banking system. Italian banks' equity capital is rising (Chart I-8), their solvency is improving, and the share of non-performing loans has fallen sharply this year (Chart of the Week). Chart I-6Spain's Credit Impulse Rebounded Sharply Spain"s Credit Impulse Rebounded Sharply Spain"s Credit Impulse Rebounded Sharply Chart I-7Italy's Credit Impulse Has Been More Muted Italy"s Credit Impulse Has Been More Muted Italy"s Credit Impulse Has Been More Muted Chart I-8Italian Banks Are Raising Equity Capital Italian Banks Are Raising Equity Capital Italian Banks Are Raising Equity Capital Moreover, the recent smooth winding down of the failing Banca Popolare di Vicenza and Veneto Bank showed that the EU's new rules for resolving failing banks is working. Admittedly, the rules mean that institutional investors could still suffer losses. But a pragmatic solution will permit public funds to protect 'widows and orphans' retail investors. Some Investment Thoughts As the Italian banking system is repaired, there will be a pickup in Italy's growth just as there was in Spain. However, the strong tailwind to Spain's growth that started in 2013 is now fading given that Spain's credit impulse has peaked. This suggests that the yield spread between Italian BTPs and Spanish Bonos - which measures the extra risk premium in Italy - is at a cyclical peak from which it is likely to compress (Chart I-9). Brave investors could go long Italian bonds versus Spanish bonds now. More cautious investors might wait until after the Italian election in the first half of next year. On the face of it, a fading risk of euro breakup should also boost euro area equity relative performance. The trouble is that the relative performance of the broad Eurostoxx50 index is entirely at the mercy of its major sector skews - specifically, a huge underweighting to Technology and an overweighting to Banks (Chart I-10). The way around this dilemma - to like euro area equities but to dislike the overall sector skew - is to steer towards mainstream indexes which have less of a distorting skew. On this basis, the mainstream euro area equity market we would pick right now is France's CAC40 (Chart I-11). Chart I-9The Yield Spread Between Italian And ##br##Spanish Bonds Is At A Cyclical Peak The Yield Spread Between Italian And Spanish Bonds Is At A Cyclical Peak The Yield Spread Between Italian And Spanish Bonds Is At A Cyclical Peak Chart I-10Eurostoxx50 Relative Performance Is ##br##At The Mercy Of Its Sector Skews Eurostoxx50 Relative Performance Is At The Mercy Of Its Sector Skews Eurostoxx50 Relative Performance Is At The Mercy Of Its Sector Skews Chart I-11Prefer the CAC40 To##br## The Eurostoxx50 Prefer the CAC40 To The Eurostoxx50 Prefer the CAC40 To The Eurostoxx50 Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 In the U.K. around 625,000 people die every year and the vast majority of these are aged over 65. But in this older age cohort, 64% voted Leave (source: YouGov). So we can infer that of the 625,000 deaths, about 400,000 voted Leave and 225,000 voted Remain, eroding the Leave majority who are still alive by 175,000 every year. Fractal Trading Model This week, we note that the Canadian 10-year government bond is oversold and due a trend reversal. We prefer to express this as a new relative trade: long Canadian 10-year bond / short 10-year German bund with a profit target / stop-loss of 1% and double position size. In other trades, long USD/CAD hit its 2.5% profit target - the second success in this specific trade in the last three months. We now have three open positions. 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-12 Long Canadian 10-Year Government Bond Long Canadian 10-Year Government Bond 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. * 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 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