Valuations

Highlights Portfolio Strategy A stable China, a depreciating U.S. dollar, rising commodity prices and sustained synchronized global growth signal that the industrials complex, especially the most cyclical part, remains on a solid footing. Deteriorating profit prospects warn that investors should refrain from paying a premium valuation for industrial machinery; take profits and move to the sidelines. Recent Changes S&P Industrial Machinery - Book profits of 4% and downgrade to neutral today. S&P Construction Machinery & Heavy Truck - Stop triggered last week, remove from the high-conviction list for a 10% gain. Small Caps / Large Caps - Downgrade alert in a recent Insight. Table 1 Corporate Pricing Power Update Corporate Pricing Power Update Feature The S&P 500 smashed through the 2,800 mark last week, as corporate profits continued to deliver, the U.S. dollar took a dive and global economic data releases held their own. Stars could not be more aligned for a euphoric blow off phase, with equity bourses the world over already registering annual-like returns in but a few short weeks. While stocks have more room to run, especially versus bonds, on a cyclical time frame, tactically the likelihood of a short-term healthy pullback is increasing. Last week we identified five indicators we are closely monitoring that are signaling an overstretched market.1 This week we update our Complacency-Anxiety Indicator that also catapulted to all-time highs and breached the one standard deviation above the historical mean mark (Chart 1). This confirms that a Q1 setback remains likely, and our strategy since December 18 has been to monetize gains in tactical trades and institute stops to the high flyers in our high-conviction call list. Were a 5-10% correction to materialize, we would "buy the dip" as we do not foresee a recession in the coming 9-12 months. While consumer price inflation is nowhere to be found, corporate selling prices are climbing at a brisk pace. The U.S. dollar debasement and related commodity reflex rebound, especially in oil prices, are the culprits, and the latter will likely assist even the CPI basket and morph into an inflationary impulse as we posited in late-November (please see the bottom two panels of Chart 1B). Already, inflation expectations are headed higher. Chart 2 updates our corporate sector pricing power proxy and our diffusion index. It also updates the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report. The middle panel of Chart 2 shows the Atlanta Fed Wage Growth Tracker and that measure of wage inflation has converged down to the AHE reading, suffering a 100bps drop in the past year. Chart 1Complacency Reigns Complacency Reigns Complacency Reigns Chart 2Margin Expansion Phase Is Intact Margin Expansion Phase Is Intact Margin Expansion Phase Is Intact Corporate pricing power is upbeat at a time when wages are decelerating. Taken together, our margin proxy indicator suggests that the ongoing profit margin expansion phase has more upside (bottom panel, Chart 2). Table 2 shows our updated industry group pricing power gauges, which we calculate from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter-term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power Corporate Pricing Power Update Corporate Pricing Power Update 78% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. Importantly, inflation rates have increased since our late-September update. The outright deflating sectors dropped by two to 13 since our last update. Encouragingly, only 7 industries are experiencing a downtrend in selling price inflation, or 5 fewer than our most recent report. Impressively, deep cyclicals/commodity-related industries dominate the top ranks, occupying 8 out of the top 10 slots (top panel, Chart 3). A softening greenback and rising global end demand explain the commodity complex's sustained ability to increase prices. In contrast, tech, telecom and consumer discretionary sectors populate the bottom ranks of Table 2. Netting it out, accelerating corporate sector pricing power will continue to bolster top line growth in 2018. Tack on high operating leverage kicking into higher gear at this stage of the cycle and still muted wage inflation and profit margins and EPS growth will remain upbeat. With regard to cyclicals versus defensives, diverging pricing power (Chart 3) and wage growth trends (Chart 4) suggest that cyclicals continue to have the upper hand compared with defensives (Chart 5). Chart 3Deep Cyclicals... Deep Cyclicals... Deep Cyclicals... Chart 4...Have The Upper Hand... ...Have The Upper Hand... ...Have The Upper Hand... Chart 5...Vs. Defensives ...Vs. Defensives ...Vs. Defensives This week we update our view on a deep cyclical sector and modestly tweak our intra-sector positioning. Industrials And China We lifted the S&P industrials sector to an above benchmark allocation in early October via boosting the S&P construction machinery & heavy truck sub index to overweight.2 Synchronized global growth, a capex upcycle, firming capital goods final demand, and the U.S. dollar's fall coupled with the commodity price rebound all pointed to a bright outlook for U.S. capital goods producers. Currently, all these forces remain in play and continue to bolster industrials stocks' profit prospects. However, the emerging market (EM)/Chinese economic backdrop deserves closer scrutiny. Why? Because the most cyclical parts of the industrials complex are levered to the EM in general and China in particular. These high operating leverage businesses also drive relative profit and stock performance, signaling that China's economic growth might or ails determine the overall fortunes of U.S. capital goods producers. While Chinese economic data are currently a mixed bag and we take them with a big grain of salt, global high-frequency financial market data are emitting an unambiguously positive signal. First, BCA's FX strategist, Mathieu Savary, brought to our attention that the extremely economic-sensitive Canadian TSX Venture Exchange Index is in a V-shaped recovery.3 Highly speculative basic resources issues dominate this Index and help explain the tight positive correlation with Chinese output (top panel, Chart 6). Second, the ultimate economic-sensitive indicator, Dr. Copper, is also in a violent upswing, heralding that China will be, at least, stable in 2018 (middle panel, Chart 6). Third, high-beta Australian materials stocks have been in an upward trajectory since the early 2016 trough both versus the MSCI All-Country World Index and the broad Australian market, sniffing out improving Chinese-related commodity demand (bottom panel, Chart 6). Similarly, upbeat non-Chinese economic data suggest that China's economic prospects are far from faltering. Australia's close economic ties with China signal that taking a pulse of the Australian economic juggernaut reveals the state of China's economic affairs. Down Under employment growth has been brisk of late, with annual job creation running at a 3.3% clip, a rate last hit in the mid-2000s when China's economy was roaring and the commodity super-cycle was in full swing (second panel, Chart 7). Australian CEO confidence as well as consumer confidence are pushing decade highs, and the manufacturing PMI survey recently shot to a 16 year high (third panel, Chart 7). Chart 6China Is##BR##Alright China Is Alright China Is Alright Chart 7Australian Indicators Confirm:##BR## China Is Stable Australian Indicators Confirm: China Is Stable Australian Indicators Confirm: China Is Stable All of this suggests that China will likely remain stable in 2018, barring a policy mistake a la the August 11, 2015 currency devaluation. The upshot is that industrials EPS and equities have more room to run. On that front, both our Cyclical Macro Indicator and our profit growth model corroborate that the path of least resistance for relative share prices is higher (Chart 8). U.S. dollar debasing is synonymous with capital goods producers' top line growth acceleration, as a large part of total revenues are sourced from abroad. The near 20 percentage point fall in the trade-weighted U.S. dollar since 2015 suggests that more global market share gains are in store for U.S. industrials (Chart 9). Global growth is also joined at the hip with the greenback's depreciation. Synchronized global growth along with our derivative coordinated global capex growth 2018 theme, will likely serve as catalysts for a sustained breakout in relative share prices (Chart 10). Chart 8EPS Model And CMI Flash Green EPS Model And CMI Flash Green EPS Model And CMI Flash Green Chart 9Industrials Love A Cheap Greenback Industrials Love A Cheap Greenback Industrials Love A Cheap Greenback Chart 10Levered To Global Growth Levered To Global Growth Levered To Global Growth Adding it up, a stable China is music to the ears of industrials executives. Tack on a depreciating U.S. dollar, rising commodity prices and sustained synchronized global growth and the most cyclical parts of the industrials complex will continue to lead the pack. Bottom Line: Stay overweight the S&P industrials index, but selectivity is warranted. Take Profits In Industrial Machinery We outlined above that the most cyclical parts of the S&P industrials index with high foreign sales content would benefit disproportionately from our stable-to-mildly sanguine EM/China view. While the broad machinery index fits the bill, the industrial machinery sub index less so, and we recommend monetizing gains of 4% since inception and moving to the sidelines. Chart 11 shows the relative performance of the two key drivers of the S&P machinery index: industrial machinery and construction machinery & heavy truck sub-indexes. While these indexes moved hand-in-hand since the mid-1990s, early this decade this tight positive correlation fell apart. One key determinant of the relative move of these indexes is the U.S. dollar. The greenback troughed in 2011 and since then the more "defensive", less globally-exposed S&P industrials machinery index left their brethren in the dust (bottom panel, Chart 11). Now that the U.S. dollar has peaked, the catch up phase in the S&P construction machinery & heavy truck index that is already underway will likely gain momentum (top panel, Chart 11). Beyond the depreciating currency, at the margin, softening S&P industrial machinery operating metrics argue for pruning exposure in this index. Both the Empire and Philly Fed new orders surveys have petered out, suggesting that industry new order growth will likely continue to lose steam (middle panel, Chart 12). In fact, a weak industrial machinery new orders-to-inventories ratio is also warning that sell-side analysts' relative profits forecasts are too optimistic (bottom panel, Chart 12). Chart 11Catch Up Phase Catch Up Phase Catch Up Phase Chart 12Waning End-Demand Waning End-Demand Waning End-Demand Drilling deeper into industry operating metrics is revealing. While shipments have held their own and moved mostly sideways similar to new orders, inventory accumulation is worrying. Industry inventories have risen by over 30% during the past three years (Chart 13). Simultaneously, industrial machinery backlogs have drifted steadily lower. Given the supply build up, any hiccup in demand, even a minor one, could prove very deflationary and heavily weigh on industry profitability. With regard to valuations, Chart 14 shows that both on a relative trailing price-to-sales and relative forward price-to-earnings ratio basis, the index is trading one standard deviation above the historical mean. The moderating industry demand backdrop suggests that relative valuations are expensive. Chart 13Inventory Liquidation Risk Inventory Liquidation Risk Inventory Liquidation Risk Chart 14Why Pay A Premium? Why Pay A Premium? Why Pay A Premium? Adding it all up, deteriorating profit prospects warn that investors should refrain from paying a premium valuation for the S&P industrial machinery index. Bottom Line: Book profits of 4% in the S&P industrial machinery index and downgrade to a benchmark allocation. We also recommend redeploying profits from our downgrade in the S&P industrial machinery index to their more cyclical machinery siblings the S&P construction machinery & heavy truck index, thus sustaining the overall overweight exposure in the broad S&P industrials sector. Housekeeping Last week we instituted a risk management tool for our 2018 high-conviction list: setting a stop once a call has cleared the 10% return mark.4 This past week, the S&P construction machinery & heavy truck index hit the trailing stop at the 10% mark, and thus we are booking gains and removing this index from the high-conviction list. While our confidence is not as high as in late-November given the parabolic move in this index and rising chance of a tactical overall equity market pullback, from a cyclical perspective we continue to recommend a core overweight in this industrials sector powerhouse. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Earnings Take Center Stage," dated October 2, 2017, available at uses.bcaresearch.com. 3 Please see BCA Foreign Exchange Strategy Weekly Report, "Health Care Or Not, Risks Remain," dated March 24, 2017, available at fes.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, recent market action is beginning to resemble a classic late cycle blow-off phase. The fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. The S&P 500 could return 14% or more this year. Unfortunately, the consensus now shares our upbeat view for 2018. Valuation is stretched and many indicators suggest that investors have become downright giddy. This month we compare valuation across the major asset classes. U.S. equities are the most overvalued, followed by gold, raw industrials and EM assets. Oil is still close to fair value. Long-term investors should already be scaling back on risk assets. Investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but a risk management approach means that they should not try to squeeze out the last few percentage points of return. In terms of the sequencing of the exit from risk, the most consistent lead/lag relationship relative to previous tops in the equity market is provided by U.S. corporate bonds. For this reason, we are likely to take profits on corporates before equities. EM assets are already at underweight. We still see a window for the U.S. dollar to appreciate, although by only about 5%. A lot of good news is discounted in the euro, peripheral core inflation is slowing and ECB policymakers are getting nervous. Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. The economy and inflation should justify four Fed rate hikes in 2018 no matter the makeup. The bond bear phase will continue. Feature Chart I-1Investors Are Giddy Investors Are Giddy Investors Are Giddy U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, though, recent market action is beginning to resemble the classic late cycle blow-off phase. Such blow-offs can be highly profitable, but also make it more difficult to properly time the market top. Our base case is that the fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. Unfortunately, the consensus now shares our upbeat view for 2018 and many indicators suggest that investors have become downright giddy (Chart I-1). These indicators include investor sentiment, our speculation index, and the bull-to-bear ratio. Net S&P earnings revisions and the U.S. economic surprise index are also extremely elevated, while equity and bond implied volatility are near all-time lows. From a contrarian perspective, these observations suggest that a lot of good news is discounted and that the market is vulnerable to even slight disappointments. It is also a bad sign that our Revealed Preference Indicator moved off of its bullish equity signal in January (see Section III for more details). Meanwhile, central banks are beginning to take away the punchbowl as global economic slack dissipates. This is all late-cycle stuff. Equity valuation does not help investors time the peak in markets, but it does tell us something about downside risk and medium-term expected returns. The Shiller P/E ratio has surged above 30 (Chart I-2). Chart I-3 highlights that, historically, average total returns were negligible over the subsequent 10-year period when the Shiller P/E was in the 30-40 range. Granted, the Shiller P/E will likely fall mechanically later this year as the collapse of earnings in 2008 begins to drop out of the 10-year EPS calculation. Nonetheless, even the BCA Composite Valuation indicator, which includes some metrics that account for extremely low bond yields, surpassed +1 standard deviations in January (our threshold for overvaluation; Chart I-2, bottom panel). An overvaluation signal means that investors should be biased to take profits early. Chart I-2BCA Valuation Indicator Surpasses One Sigma BCA Valuation Indicator Surpasses One Sigma BCA Valuation Indicator Surpasses One Sigma Chart I-3Expected Returns Given Starting Point Shiller P/E February 2018 February 2018 As we highlighted in our 2018 Outlook Report, long-term investors should already be scaling back on risk assets. We recommend that investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but we need to be vigilant in terms of scouring for signals to take profits. A risk management approach means that investors should not try to get the last few percentage points of return before the peak. U.S. Earnings And Repatriation Before we turn to the timing and sequence of our exit from risk assets, we will first update our thoughts on the earnings cycle. Fourth quarter U.S. earnings season is still in its early innings, but the banking sector has set an upbeat tone. S&P 500 profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS growth estimates have been aggressively ratcheted higher (from 12% growth to 16%) in a mere three weeks on the back of Congress' cut to the corporate tax rate.1 U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Our short-term profit model remains extremely upbeat (Chart I-4). The positive profit outlook for the first half of the year is broadly based across sectors as well, according to the recently updated EPS forecast models from BCA's U.S. Equity Sector Strategy service.2 The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. Studies of the 2004 repatriation legislation show that most of the funds "brought home" were paid out to shareholders, mostly in the form of buybacks. A NBER report estimated that for every dollar repatriated, 92 cents was subsequently paid out to shareholders in one form or another. The surge in buybacks occurred in 2005, according to the U.S. Flow of Funds accounts and a proxy using EPS growth less total dollar earnings growth for the S&P 500 (Chart I-5). The contribution to EPS growth from buybacks rose to more than 3 percentage points at the peak in 2005. Chart I-4Profit Growth Still Accelerating Profit Growth Still Accelerating Profit Growth Still Accelerating Chart I-5U.S. Buybacks To Lift EPS U.S. Buybacks To Lift EPS U.S. Buybacks To Lift EPS We expect that most of the repatriated funds will again flow through to shareholders, rather than be used to pay down debt or spent on capital goods. Cash has not been a constraint to capital spending in recent years outside of perhaps the small business sector, which has much less to gain from the tax holiday. A revival in animal spirits and capital spending is underway, but this has more to do with the overall tax package and global growth than the ability of U.S. companies to repatriate overseas earnings. Estimates of how much the repatriation could boost EPS vary widely. Most of it will occur in the Tech and Health Care sectors. Buybacks appear to have lifted EPS growth by roughly one percentage point over the past year. We would not be surprised to see this accelerate by 1-2 percentage points, although the timing could be delayed by a year if the 2004 tax holiday provides the correct timeline. This is certainly positive for the equity market, but much of the impact could already be discounted in prices. Organic earnings growth, and the economic and policy outlook will be the main drivers of equity market returns over the next year. We expect some profit margin contraction later this year, but our 5% EPS growth forecast is beginning to look too conservative. This is especially the case because it does not include the corporate tax cuts. The amount by which the tax cuts will boost earnings on an after-tax basis is difficult to estimate, but we are using 5% as a conservative estimate. Adding 2% for buybacks and 2% for dividends, the S&P 500 could provide an attractive 14% total return this year (assuming no multiple expansion). Timing The Exit Chart I-6Timing The Exit (I) Timing The Exit (I) Timing The Exit (I) That said, we noted in last month's Report and in BCA's 2018 Outlook that this will be a transition year. We expect a recession in the U.S. sometime in 2019 as the Fed lifts rates into restrictive territory. Equities and other risk assets will sniff out the recession about six months in advance, which means that investors should be preparing to take profits sometime during the next 12 months. Last month we discussed some of the indicators we will watch to help us time the exit. The 2/10 Treasury yield curve has been a reliable recession indicator in the past. However, the lead time on the peak in stocks was quite extended at times (Chart I-6). A shift in the 10-year TIPS breakeven rate above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We are likely to take some money off the table if core inflation is rising, even if it is still below 2%, at the time that the TIPS breakeven reaches 2.4%. We will also be watching seven indicators that we have found to be useful in heralding market tops, which are summarized in our Scorecard Indicator (Chart I-7). At the moment, four out of the seven indicators are positive (Chart I-8): State of the Business Cycle: As early signals that the economy is softening, watch for the ISM new orders minus inventories indicator to slip below zero, or the 3-month growth rate of unemployment claims to rise above zero. Monetary and Financial Conditions: Using interest rates to judge the stance of monetary policy has been complicated by central banks' use of their balance sheet as a policy tool. Thus, it is better to use two of our proprietary indicators: the BCA Monetary Indicator (MI) and the Financial Conditions Indictor. The S&P 500 index has historically rallied strongly when the MI is above its long-term average. Similarly, equities tend to perform well when the FCI is above its 250-day moving average. The MI is sending a negative signal because interest rates have increased and credit growth has slowed. However, the broader FCI remains well in 'bullish' territory. Price Momentum: We simply use the S&P 500 relative to its 200-day moving average to measure momentum. Currently, the index is well above that level, providing a bullish signal for the Scorecard. Sentiment: Our research shows that stock returns have tended to be highest following periods when sentiment is bearish but improving. In contrast, returns have tended to be lowest following periods when sentiment is bullish but deteriorating. The Scorecard includes the BCA Speculation Indicator to capture sentiment, but virtually all measures of sentiment are very high. The next major move has to be down by definition. Thus, sentiment is assigned a negative value in the Scorecard. Value: As discussed above, value is poor based on the Shiller P/E and the BCA Composite Valuation indicator. Valuation may not help with timing, but we include it in our Scorecard because an overvalued signal means investors should err on the side of getting out early. Chart I-7Equity ScoreCard: Watch For A Dip Below 3 Equity ScoreCard: Watch For A Dip Below 3 Equity ScoreCard: Watch For A Dip Below 3 Chart I-8Timing The Exit (II) Timing The Exit (II) Timing The Exit (II) We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in subsequent months. A drop below three this year would signal the time to de-risk. Table I-1Exit Checklist February 2018 February 2018 To our Checklist we add the U.S. Leading Economic index, which has a good track record of calling recessions. However, we will use the LEI excluding the equity market, since we are using it as an indicator for the stock market. It is bullish at the moment. Our Global LEI is also flashing green. Table I-1 provides a summary checklist for trimming equity exposure. At the moment, 2 out of 9 indicators are bearish. Cross Asset Valuation Comparison Clients have asked our view on the appropriate order in which to scale out of risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the ones that are most overvalued are at greatest risk, and thus profits should be taken the earliest. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time period? Since there is no widely accepted approach, we include multiple measures. More than one time period was used in some cases to capture regime changes. Table I-2 provides out 'best guestimate' for nine asset classes. The approaches range from sophisticated methods developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (oil), to simple deviations from a time trend (real raw industrial commodity prices and gold). Table I-2Valuation Levels For Major Asset Classes February 2018 February 2018 We averaged the valuation readings in cases where there are multiple estimates for a single asset class. The results are shown in Chart I-9. Chart I-9Valuation Levels For Major Asset Classes February 2018 February 2018 U.S. equities stand out as the most expensive by far, at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads come next at 0.7, followed closely by U.S. Treasurys (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are quite expensive in absolute terms based on the fact that government bonds are expensive. Oil is sitting very close to fair value, despite the rapid price run up over the past couple of months. This makes oil exposure doubly attractive at the moment because the fundamentals point to higher prices at a time when the underlying asset is not expensive. Sequencing Around Past S&P 500 Peaks Historical analysis around equity market peaks provides an alternative approach to the sequencing question. Table I-3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table I-3Asset Class Leads & Lags Vs. Peak In S&P 500 February 2018 February 2018 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, Tech stocks, or small-cap versus large-cap relative returns. Sometimes they peaked before the S&P 500, and sometime after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyse due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time is long and variable. The most consistent lead/lag relationship is given by the U.S. corporate bond market. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio in advance of scaling back on equities. But the 'return of vol' that we expect to occur later this year will take a toll on carry trades more generally. We are already underweight EM equities and bonds. This EM recommendation has not gone in our favor, but it would make little sense to upgrade them now given our positive views on volatility and the dollar. An unwinding of carry trades will also hit the high-yielding currencies outside of the EM space, such as the Kiwi and Aussie dollar. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over to the EM economies as we expect. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of the Chinese economy in the coming months. Oil is a different story. OPEC 2.0 is likely to cut back on supply in the face of an economic downturn, helping to keep prices elevated. We therefore may not trim energy exposure this year. As for equity sectors, our recommended portfolio is still overweight cyclicals for now. Our synchronized global capex boom, rising bond yield, and firm oil price themes keep us overweight the Industrials, Energy and Financial sectors. Utilities and Homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. That said, our sector specialists are already beginning a gradual shift away from cyclicals toward defensives for risk management purposes. This transition will continue in the coming months as we de-risk. We are also shifting small caps to neutral on earnings disappointments and elevated debt levels. The Dollar Pain Trade Market shifts since our last publication have largely gone in our favor; stocks have surged, corporate bonds spreads have tightened, oil prices have spiked, bonds have sold off and cyclical stocks have outperformed defensives. One area that has gone against us is the U.S. dollar. Relative interest rate expectations have moved in favor of the dollar as we expected at both the short- and long-ends of the curve. Nonetheless, the dollar has not tracked its historical relationship versus both the yen and euro. The Greenback did not even get a short-term boost from the passage of the tax plan and holiday on overseas earnings. Perhaps this is because the lion's share of "overseas" earnings are already held in U.S. dollars. Reportedly, a large fraction is even held in U.S. banks on U.S. territory. Currency conversion is thus not a major bullish factor for the U.S. dollar. The recent bout of dollar weakness began around the time of the release of the ECB Minutes in January which were interpreted as hawkish because they appeared to be preparing markets for changes in monetary policy. The European debt crisis and economic recession were the reasons for the ECB's asset purchases and negative interest rate policy. Neither of these conditions are in place now. The ECB is meeting as we go to press, and we expect some small adjustments in the Statement that remove references to the need for "crisis" level accommodations. Subsequent steps will be to prepare markets for a complete end to QE, perhaps in September, and then for rates hikes likely in 2019. The key point is that European monetary policy has moved beyond 'peak stimulus' and the normalization process will continue. Perhaps this is partly to blame for euro strength although, as mentioned above, interest rate differentials have moved in favor of the dollar. Does this mean that the dollar has peaked and has entered a cyclical bear phase that will persist over the next 6-12 months? The answer is 'no', although we are less bullish than in the past. We believe there is still a window for the dollar to appreciate against the euro and in broader trade-weighted terms by about 5%. First, a lot of euro-bullish news has been discounted (Chart I-10). Positive economic surprises heavily outstripped that in the U.S. last year, but that phase is now over. The euro appears expensive based on interest rate differentials, and euro sentiment is close to a bullish extreme. This all suggests that market positioning has become a negative factor for the currency. Chart I-10Euro: A Lot Of Bullish News Is Discounted EURO: A Lot Of Bullish News Is Discounted EURO: A Lot Of Bullish News Is Discounted Second, the chorus of complaints against the euro's strength is growing among European central bankers, including Ewald Nowotny, the rather hawkish Austrian central banker. Policymakers' concerns may partly reflect the fact that peripheral inflation excluding food and energy has already weakened to 0.6% from a high of 1.3% in April last year (Chart I-10, fourth panel). Third, U.S. consumer price and wage inflation have yet to pick up meaningfully. The dollar should receive a lift if core U.S. inflation clearly moves toward the Fed's 2% target, as we expect. The FOMC would suddenly appear to have fallen behind the curve and U.S. rate expectations would ratchet higher. Chart I-10, bottom panel, highlights that the euro will weaken if U.S. core inflation rises versus that in the Eurozone. The implication is that the Euro's appreciation has progressed too far and is due for a pullback. As for the yen, the currency surged in January when the Bank of Japan (BoJ) announced a reduction in long-dated JGB purchases. This simply acknowledged what has already occurred. It was always going to be impossible to target both the quantity of bond purchases and the level of 10-year yield simultaneously. Keeping yields near the target required less purchases than they thought. The market interpreted the BoJ's move as a possible prelude to lifting the 10-year yield target. It is perhaps not surprising that the market took the news this way. The economy is performing extremely well; our model that incorporates high-frequency economic data suggests that real GDP growth will move above 3% in the coming quarters. The Japanese economy is benefiting from the end of a fiscal drag and from a rebound in EM growth. Nonetheless, following January's BoJ policy meeting, Kuroda poured cold water on speculation that the BoJ may soon end or adjust the YCC. Recent speeches by BoJ officials reinforce the view that the MPC wants to see an overshoot of actual inflation that will lower real interest rates and thereby reinforce the strong economic activity that is driving higher inflation. Only then will officials be convinced that their job is done. Given that inflation excluding food and energy only stands at 0.3%, the BoJ is still a long way from the overshoot it desires. On the positive side, Japan's large current account surplus and yen undervaluation provide underlying support for the currency. Balancing the offsetting positive and negative forces, our foreign exchange strategists have shifted to neutral on the yen. The Euro remains underweight while the dollar is overweight. Similar to our dollar view, we still see a window for U.S. Treasurys to underperform the global hedged fixed-income benchmark as world bond yields shift higher this year. European government bonds will also sell off, but should outperform Treasurys. JGBs will provide the best refuge for bondholders during the global bond bear phase, since the BoJ will prevent a rise in yields inside of the 10-year maturity. Our global bond strategists upgraded U.K. gilts to overweight in January. Momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. FOMC Transition Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. An abrupt shift in policy is unlikely. There was some support at the December 2017 FOMC meeting to study the use of nominal GDP or price level targeting as a policy framework, but this has been an ongoing debate that will likely continue for years to come. The Fed will remain committed to its current monetary policy framework once Powell takes over. Table I-4 provides a summary of who will be on the FOMC next year, including their policy bias. Chart I-11 compares the recent FOMC makeup with the coming Powell FOMC (voting members only). The hawk/dove ratio will not change much under Powell, unless Trump stacks the vacant spots with hawks. Table I-4Composition Of The FOMC February 2018 February 2018 Chart I-11Composition Of Voting FOMC Members 2017 Vs. 2018 February 2018 February 2018 In any event, history shows that the FOMC strives to avoid major shifts in policy around changeovers in the Fed Chair. In previous transitions, the previous path for rates was maintained by an average of 13 months. Moreover, Powell has shown that he is not one to rock the boat during his time on the FOMC. It will be the evolution of the economy and inflation, not the composition of the FOMC, that will have the biggest impact on markets at the end of the day. Recent speeches reveal that policymakers across the hawk/dove spectrum are moving modesty toward the hawkish side because growth has accelerated at a time when unemployment is already considered to be below full-employment by many policymakers. The melt-up in equity indexes in January did little to calm worries about financial excesses either. The Fed is struggling to understand the strength of the structural factors that could be holding down inflation. This month's Special Report, beginning on page 21, focusses on the impact of robot automation. While advances on this front are impressive, we conclude that it is difficult to find evidence that robots are more deflationary than previous technological breakthroughs. Thus, increased robot usage should not prevent inflation from rising as the labor market continues to tighten. The macro backdrop will likely justify the FOMC hiking at least as fast as the dots currently forecast. The risks are skewed to the upside. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. This is inconsistent with real GDP growth well in excess of its supply-side potential. The unemployment rate is more likely to reach a 49-year low of 3.5% by the end of this year. As highlighted in last month's Report, a key risk to the bull market in risk assets is the end of the 'low vol/low rate' world. The selloff in the bond market in January may mark the start of this process. Conclusions We covered a lot of ground in this month's Overview of the markets, so we will keep the conclusions brief and focused on the risks. Our key point is that the fundamentals remain positive for risk assets, but that a lot of good news is discounted and it appears that we have entered a classic blow-off phase. This will be a transition year to a recession in the U.S. in 2019. Given that valuation for most risk assets is quite stretched, and given that the monetary taps are starting to close, investors must plan for the exit and keep an eye on our timing checklist. The main risk to our pro-cyclical portfolio is a rise in U.S. inflation and the Fed's response, which we believe will end the sweet spot for risk assets. Apart from this, our geopolitical strategists point to several other items that could upset the applecart this year:3 1. Trade China has cooperated with the U.S. in trying to tame North Korea. Nonetheless, President Trump is committed to an "America First" trade policy and he may need to show some muscle against China ahead of the midterm elections in November in order to rally his base. It is politically embarrassing to the Administration that China racked up its largest trade surplus ever with the U.S. in Trump's first year in office. A key question is whether the President goes after China via a series of administrative rulings - such as the recently announced tariffs on solar panels and white goods - or whether he applies an across-the-board tariff and/or fine. The latter would have larger negative macroeconomic implications. 2. Iran On January 12, President Trump threatened not to waive sanctions against Iran the next time they come due (May 12), unless some new demands are met. Pressure from the U.S. President comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by threatening to close the Straits of Hormuz or by boarding foreign vessels in international waters. The domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. For the time being, however, we expect only a minor geopolitical risk premium to seep into the energy markets, supporting our bullish House View on oil prices. 3. China Last month's Special Report highlighted that significant structural reforms are on the way in China, now that President Xi has amassed significant political support for his reform agenda. The reforms should be growth-positive in the long term, but could be a net negative for growth in the near term depending on how deftly the authorities handle the monetary and fiscal policy dials. The risk is that the authorities make a policy mistake by staying too tight, as occurred in 2015. We are monitoring a number of indicators that should warn if a policy mistake is unfolding. On this front, January brought some worrying economic data. The latest figures for both nominal imports and money growth slowed. Given that M2 and M3 are components of BCA's Li Keqiang Leading Indicator, and that nominal imports directly impact China's contribution to global growth, this raises the question of whether December's economic data suggest that China is slowing at a more aggressive pace than we expect. For now, our answer is no. First, China's trade numbers are highly volatile; nominal import growth remains elevated after smoothing the data. Second, China's export growth remains buoyant, consistent with a solid December PMI reading. The bottom line is that we are sticking with our view that China will experience a benign deceleration in terms of its impact on DM risk assets, but we will continue to monitor the situation closely. Mark McClellan Senior Vice President The Bank Credit Analyst January 25, 2018 Next Report: February 22, 2018 1 According to Thomson Reuters/IBES. 2 Please see U.S. Equity Sector Strategy Special Report "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com 3 For more information, please see BCA Geopolitical Strategy Weekly Report "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. Also see "Watching Five Risks," dated January 24, 2018. II. The Impact Of Robots On Inflation Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. Technological advance in the past has not prevented improving living standards or led to ever rising joblessness over the decades, but pessimists argue that recent advances are different. The issue is important for financial markets. If structural factors such as automation are holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. We see no compelling evidence that the displacement effect of emerging technologies is any stronger than in the past. Robot usage has had a modest positive impact on overall productivity. Despite this contribution, overall productivity growth has been dismal over the past decade. If automation is increasing 'exponentially' and displacing workers on a broad scale as some claim, one would expect to see accelerating productivity growth, robust capital spending and more violent shifts in occupational shares. Exactly the opposite has occurred. Periods of strong growth in automation have historically been associated with robust, not lackluster, wage gains, contrary to the consensus view. The Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. This and other evidence suggest that it is difficult to make the case that robots will make it tougher for central banks to reach their inflation goals than did previous technological breakthroughs. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. Recent breakthroughs in technology are awe-inspiring and unsettling. These advances are viewed with great trepidation by many because of the potential to replace humans in the production process. Hype over robots is particularly shrill. Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. In the first in our series of Special Reports focusing on the structural factors that might be preventing central banks from reaching their inflation targets, we demonstrated that the impact of Amazon is overstated in the press. We estimated that E-commerce is depressing inflation in the U.S. by a mere 0.1 to 0.2 percentage points. This Special Report tackles the impact of automation. We are optimistic that robot technology and artificial intelligence will significantly boost future productivity, and thus reduce costs. But, is there any evidence at the macro level that robot usage has been more deflationary than technological breakthroughs in the past and is, thus, a major driver of the low inflation rates we observe today across the major countries? The question matters, especially for the outlook for central bank policy and the bond market. If structural factors are indeed holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. However, if low inflation simply reflects long lags between wages and the tightening labor market, then inflation may suddenly lurch to life as it has at the end of past cycles. The bond market is not priced for that scenario. Are Robots Different? A Special Report from BCA's Technology Sector Strategy service suggested that the "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity and the microchip.1 GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time. The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks," and this encompasses a broad range of machines: From the Jacquard Loom, which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. Our Technology Sector report made the case that there is nothing particularly sinister about robots. They are just another chapter in a long history of automation. Nor is the displacement of workers unprecedented. The industrial revolution was about replacing human craft labor with capital (machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing and maintaining the machinery. Agriculture offers a good example. This sector involved over 50% of the U.S. labor force until the late 1800s. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," contributed to a massive rise in output-per-man hour. The number of hours worked to produce a bushel of wheat fell by almost 98% from the mid-1800s to 1955. This put a lot of farm hands out of work, but these laborers were absorbed over time in other growing areas of the economy. It is the same story for all other historical technological breakthroughs. Change is stressful for those directly affected, but rising productivity ultimately lifts average living standards. Robots will be no different. As we discuss below, however, the increasing use of robots and AI may have a deeper and longer-lasting impact on inequality. Strong Tailwinds Chart II-1Robots Are Getting Cheaper Robots Are Getting Cheaper Robots Are Getting Cheaper Factory robots have improved immensely due to cheaper and more capable control and vision systems. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Most importantly, robots are already able to do more than just routine tasks, thus enabling them to replace or aid humans in higher-skilled processes. Robot prices are also falling fast, especially after quality-adjusting the data (Chart II-1). Units are becoming easier to install, program and operate. These trends will help to reduce the barriers-to-entry for the large, untapped, market of small and medium sized enterprises. Robots also offer the ability to do low-volume "customized" production and still keep unit costs low. In the future, self-learning robots will be able to optimize their own performance by analyzing the production of other robots around the world. Robot usage is growing quickly according to data collected by the International Federation of Robotics (IFR) that covers 23 countries. Industrial robot sales worldwide increased to almost 300,000 units in 2016, up 16% from the year before (Chart II-2). The stock of industrial robots globally has grown at an annual average pace of 10% since 2010, reaching slightly more than 1.8 million units in 2016.2 Robot usage is far from evenly distributed across industries. The automotive industry is the major consumer of industrial robots, holding 45% of the total stock in 2016 (Chart II-3). The computer & electronics industry is a distant second at 17%. Metals, chemicals and electrical/electronic appliances comprise the bulk of the remaining stock. Chart II-2Global Robot Usage Global Robot Usage Global Robot Usage Chart II-3Global Robot Usage By Industry (2016) February 2018 February 2018 As far as countries go, Japan has traditionally been the largest market for robots in the world. However, sales have been in a long-term downtrend and the stock of robots has recently been surpassed by China, which has ramped up robot purchases in recent years (Chart II-4). Robot density, which is the stock of robots per 10 thousand employed in manufacturing, makes it easier to compare robot usage across countries (Chart II-5, panel 2). By this measure, China is not a heavy user of robots compared to other countries. South Korea stands at the top, well above the second-place finishers (Germany and Japan). Large automobile sectors in these three countries explain their high relative robot densities. Chart II-4Stock Of Robots By Country (I) Stock Of Robots By Country (I) Stock Of Robots By Country (I) Chart II-5Stock Of Robots By Country (II) (2016) February 2018 February 2018 While the growth rate of robot usage is impressive, it is from a very low base (outside of the automotive industry). The average number of robots per 10,000 employees is only 74 for the 23 countries in the IFR database. Robot use is tiny compared to total man hours worked. Chart II-6U.S. Investment In Robots U.S. Investment in Robots U.S. Investment in Robots In the U.S., spending on robots is only about 5% of total business spending on equipment and software (Chart II-6). To put this into perspective, U.S. spending on information, communication and technology (ICT) equipment represented 35-40% of total capital equipment spending during the tech boom in the 1990s and early 2000s.3 The bottom line is that there is a lot of hype in the press, but robots are not yet widely used across countries or industries. It will be many years before business spending on robots approaches the scale of the 1990s/2000s IT boom. A Deflationary Impact? As noted above, we view robotics as another chapter in a long history of technological advancements. Pessimists suggest that the latest advances are different because they are inherently more threatening to the overall job market and wage share of total income. If the pessimists are right, what are the theoretical channels though which this would have a greater disinflationary effect relative to previous GPT technologies? Faster Productivity Gains: Enhanced productivity drives down unit labor costs, which may be passed along to other industries (as cheaper inputs) and to the end consumer. More Human Displacement: The jobs created in other areas may be insufficient to replace the jobs displaced by robots, leading to lower aggregate income and spending. The loss of income for labor will simply go to the owners of capital, but the point is that the labor share of income might decline. Deflationary pressures could build as aggregate demand falls short of supply. Even in industries that are slow to automate, just the threat of being replaced by robots may curtail wage demands. Inequality: Some have argued that rising inequality is partly because the spoils of new technologies over the past 20 years have largely gone to the owners of capital. This shift may have undermined aggregate demand because upper income households tend to have a high saving rate, thereby depressing overall aggregate demand and inflationary pressures. The human displacement effect, described above, would exacerbate the inequality effect by transferring income from labor to the owners of capital. 1. Productivity It is difficult to see the benefits of robots on productivity at the economy-wide level. Productivity growth has been abysmal across the major developed countries since the Great Recession, but the productivity slowdown was evident long before Lehman collapsed (Chart II-7). The productivity slowdown continued even as automation using robots accelerated after 2010. Chart II-7Productivity Collapsed Despite Automation Productivity Collapsed Despite Automation Productivity Collapsed Despite Automation Some analysts argue that lackluster productivity is simply a statistical mirage because of the difficulties in measuring output in today's economy. We will not get into the details of the mismeasurement debate here. We encourage interested clients to read a Special Report by the BCA Global Investment Strategy service entitled "Weak Productivity Growth: Don't Blame The Statisticians." 4 Our colleague Peter Berezin makes the case that the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, radio, indoor plumbing and air conditioning. He argues that the real reason that productivity growth has slowed is that educational attainment has decelerated and businesses have plucked many of the low-hanging fruit made possible by the IT revolution. Cyclical factors stemming from the Great Recession and financial crisis are also to blame, as capital spending has been slow to recover in most of the advanced economies. Some other factors that help to explain the decline in aggregate productivity are provided in Appendix II-1. Nonetheless, the poor aggregate productivity performance does not mean that there are no benefits to using robots. The benefits are evident at the industrial level, where measurement issues are presumably less vexing for statisticians (i.e., it is easier to measure the output of the auto industry, for example, than for the economy as a whole). Chart II-8 plots the level of robot density in 2016 with average annual productivity growth since 2004 for 10 U.S. manufacturing industries (robot density is presented in deciles). A loose positive relationship is apparent. Chart II-8U.S.: Productivity Vs. Robot Density February 2018 February 2018 Academic studies estimate that robots have contributed importantly to economy-wide productivity growth. The Centre for Economic and Business Research (CEBR) estimated that labor productivity growth rises by 0.07 to 0.08 percentage points for every 1% rise in the rate of robot density.5 This implies that robots accounted for roughly 10% of the productivity growth experienced since the early 1990s in the major economies. Another study of 14 industries across 17 countries by the Centre for Economic Performance (CEP) found that robots boosted annual productivity growth by 0.36 percentage points over the 1993-2007 period.6 This is impressive because, if this estimate holds true for the U.S., robots' contribution to the 2½% average annual U.S. total productivity growth over the period was 14%. To put the importance of robotics into historical context, its contribution to productivity so far is roughly on par with that of the steam engine (Chart II-9). It falls well short of the 0.6 percentage point annual productivity contribution from the IT revolution. The implication is that, while the overall productivity performance has been dismal since 2007, it would have been even worse in the absence of robots. What does this mean for inflation? According to the "cost push" model of the inflation process, an increase in productivity of 0.36% that is not accompanied by associated wage gains would reduce unit labor costs (ULC) by the same amount. This should trim inflation if the cost savings are passed on to the end consumer, although by less than 0.36% because robots can only depress variable costs, not fixed costs. There indeed appears to be a slight negative relationship between robot density and unit labor costs at the industrial level in the U.S., although the relationship is loose at best (Chart II-10). Chart II-9GPT Contribution To Productivity February 2018 February 2018 Chart II-10U.S.: Unit Labor Costs Vs. Robot Density February 2018 February 2018 In theory, divergences in productivity across industries should only generate shifts in relative prices, and "cost push" inflation dynamics should only operate in the short term. Most economists believe that inflation is a purely monetary phenomenon in the long run, which means that central banks should be able to offset positive productivity shocks by lowering interest rates enough that aggregate demand keeps up with supply. Indeed, the Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. Also, note that inflation is currently low across the major advanced economies, irrespective of the level of robot intensity (Chart II-11). From this perspective, it is hard to see that robots should take much of the credit for today's low inflation backdrop. Chart II-11Inflation Vs. Robot Density February 2018 February 2018 2. Human Displacement A key question is whether robots and humans are perfect substitutes. If new technologies introduced in the past were perfect substitutes, then it would have led to massive underemployment and all of the income in the economy would eventually have migrated to the owners of capital. The fact that average real household incomes have risen over time, and that there has been no secular upward trend in unemployment rates over the centuries, means that new technologies were at least partly complementary with labor (i.e., the jobs lost as a direct result of productivity gains were more than replaced in other areas of the economy over time). Rather than replacing workers, in many cases tech made humans more productive in their jobs. Rising productivity lifted income and thereby led to the creation of new jobs in other areas. The capital that workers bring to the production process - the skills, know-how and special talents - became more valuable as interaction with technology increased. Like today, there were concerns in the 1950s and 1960s that computerization would displace many types of jobs and lead to widespread idleness and falling household income. With hindsight, there was little to worry about. Some argue that this time is different. Futurists frequently assert that the pace of innovation is not just accelerating, it is accelerating 'exponentially'. Robots can now, or will soon be able to, replace humans in tasks that require cognitive skills. This means that they will be far less complementary to humans than in the past. The displacement effect could thus be much larger, especially given the impressive advances in artificial intelligence. However, Box II-1 discusses why the threat to workers posed by AI is also heavily overblown in the media. The CEP multi-country study cited above did not find a large displacement effect; robot usage did not affect the overall number of hours worked in the 23 countries studied (although it found distributional effects - see below). In other words, rather than suppressing overall labor input, robot usage has led to more output, higher productivity, more jobs and stronger wage and income growth. A report by the Economic Policy Institute (EPI)7 takes a broader look at automation, using productivity growth and capital spending as proxies. Automation is what occurs as the implementation of new technologies is incorporated along with new capital equipment or software to replace human labor in the workplace. If automation is increasing 'exponentially' and displacing workers on a broad scale, one would expect to see accelerating productivity growth, robust capital spending, and more violent shifts in occupational shares. Exactly the opposite has occurred. Indeed, the report demonstrates that occupational employment shifts were far slower in the 2000-2015 period than in any decade in the 1900s (Chart II-12). Box II-1 The Threat From AI Is Overblown Media coverage of AI/Deep Learning has established a consensus view that we believe is well off the mark. A recent Special Report from BCA's Technology Sector Strategy service dispels the myths surrounding AI.8 We believe the consensus, in conjunction with warnings from a variety of sources, is leading to predictions, policy discussions, and even career choices based on a flawed premise. It is worth noting that the most vocal proponents of AI as a threat to jobs and even humanity are not AI experts. At the root of this consensus is the false view that emerging AI technology is anything like true intelligence. Modern AI is not remotely comparable in function to a biological brain. Scientists have a limited understanding of how brains work, and it is unlikely that a poorly understood system can be modeled on a computer. The misconception of intelligence is amplified by headlines claiming an AI "taught itself" a particular task. No AI has ever "taught itself" anything: All AI results have come about after careful programming by often PhD-level experts, who then supplied the system with vast amounts of high quality data to train it. Often these systems have been iterated a number of times and we only hear of successes, not the failures. The need for careful preparation of the AI system and the requirement for high quality data limits the applicability of AI to specific classes of problems where the application justifies the investment in development and where sufficient high-quality data exists. There may be numerous such applications but doubtless many more where AI would not be suitable. Similarly, an AI system is highly adapted to a single problem, or type of problem, and becomes less useful when its application set is expanded. In other words, unlike a human whose abilities improve as they learn more things, an AI's performance on a particular task declines as it does more things. There is a popular misconception that increased computing power will somehow lead to ever improving AI. It is the algorithm which determines the outcome, not the computer performance: Increased computing power leads to faster results, not different results. Advanced computers might lead to more advanced algorithms, but it is pointless to speculate where that may lead: A spreadsheet from 2001 may work faster today but it still gives the same answer. In any event, it is worth noting that a tool ceases to be a tool when it starts having an opinion: there is little reason to develop a machine capable of cognition even if that were possible. Chart II-12U.S. Job Rotation Has Slowed February 2018 February 2018 The EPI report also notes that these indicators of automation increased rapidly in the late 1990s and early 2000s, a period that saw solid wage growth for American workers. These indicators weakened in the two periods of stagnant wage growth: from 1973 to 1995 and from 2002 to the present. Thus, there is no historical correlation between increases in automation and wage stagnation. Rather than automation, the report argues that it was China's entry into the global trading system that was largely responsible for the hollowing out of the U.S. manufacturing sector. We have also made this argument in previous research. The fact that the major advanced economies are all at, or close to, full employment supports the view that automation has not been an overwhelming headwind for job creation. Chart II-13 demonstrates that there has been no relationship between the change in robot density and the loss of manufacturing jobs since 1993. Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. Interestingly, despite a worsening labor shortage, robot density among Japanese firms is falling. Moreover, the Japanese data show that the industries that have a high robot usage tend to be more, not less, generous with wages than the robot laggard industries. Please see Appendix II-2 for more details. Chart II-13Global Manufacturing Jobs Vs. Robot Density February 2018 February 2018 The bottom line is that it does not appear that labor displacement related to automation has been responsible in any meaningful way for the lackluster average real income growth in the advanced economies since 2007. 3. Inequality That said, there is evidence suggesting that robots are having important distributional effects. The CEP study found that robot use has reduced hours for low-skilled and (to a lesser extent) middle-skilled workers relative to the highly skilled. This finding makes sense conceptually. Technological change can exacerbate inequality by either increasing the relative demand for skilled over unskilled workers (so-called "skill-biased" technological change), or by inducing companies to substitute machinery and other forms of physical capital for workers (so-called "capital-biased" technological change). The former affects the distribution of labor income, while the latter affects the share of income in GDP that labor receives. A Special Report appearing in this publication in 2014 focused on the relationship between technology and inequality.9 The report highlighted that much of the recent technological change has been skill-biased, which heavily favors workers with the talent and education to perform cognitively-demanding tasks, even as it reduces demand for workers with only rudimentary skills. Moreover, technological innovations and globalization increasingly allow the most talented individuals to market their skills to a much larger audience, thus bidding up their wages. The evidence suggests that faster productivity growth leads to higher average real wages and improved living standards, at least over reasonably long horizons. Nonetheless, technological change can, and in the future almost certainly will, increase income inequality. The poor will gain, but not as much as the rich. The fact that higher-income households tend to maintain a higher savings rate than low-income households means that the shift in the distribution of income toward the higher-income households will continue to modestly weigh on aggregate demand. Can the distribution effect be large enough to have a meaningful depressing impact on inflation? We believe that it has played some role in the lackluster recovery since the Great Recession, with the result that an extended period of underemployment has delivered a persistent deflationary impulse in the major developed economies. However, as discussed above, stimulative monetary policy has managed to overcome the impact of inequality and other headwinds on aggregate demand, and has returned the major countries roughly to full employment. Indeed, this year will be the first since 2007 that the G20 economies as a group will be operating slightly above a full employment level. Inflation should respond to excess demand conditions, irrespective of any ongoing demand headwind stemming from inequality. Conclusions Technological change has led to rising living standards over the decades. It did not lead to widespread joblessness and did not prevent central banks from meeting their inflation targets over time. The pessimists argue that this time is different because robots/AI have a much larger displacement effect. Perhaps it will be 20 years before we will know the answer. But our main point is that we have found no evidence that recent advances in robotics and AI, while very impressive, will be any different in their macro impact. There is little evidence that the modern economy is less capable in replacing the jobs lost to automation, although the nature of new technologies may be affecting the distribution of income more than in the past. Real incomes for the middle- and lower-income classes have been stagnant for some time, but this is partly due to productivity growth that is too low, not too high. Moreover, it is not at all clear that positive productivity shocks are disinflationary beyond the near term. The link between robot usage and unit labor costs over the past couple of decades is loose at best at the industry level, and is non-existent when looking across the major countries. The Fed was able to roughly meet its 2% inflation target in the 1990s and the first half of the 2000s, despite IT's impressive contribution to productivity growth during that period. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. The global output gap will shift into positive territory this year for the first time since the Great Recession. Any resulting rise in inflation will come as a shock since the bond market has discounted continued low inflation for as far as the eye can see. We expect bond yields and implied volatility to rise this year, which may undermine risk assets in the second half. Mark McClellan Senior Vice President The Bank Credit Analyst Brian Piccioni Vice President Technology Sector Strategy Appendix II-1 Why Is Productivity So Low? A recent study by the OECD10 reveals that, while frontier firms are charging ahead, there is a widening gap between these firms and the laggards. The study analyzed firm-level data on labor productivity and total factor productivity for 24 countries. "Frontier" firms are defined to be those with productivity in the top 5%. These firms are 3-4 times as productive as the remaining 95%. The authors argue that the underlying cause of this yawning gap is that the diffusion rate of new technologies from the frontier firms to the laggards has slowed within industries. This could be due to rising barriers to entry, which has reduced contestability in markets. Curtailing the creative-destruction process means that there is less pressure to innovate. Barriers to entry may have increased because "...the importance of tacit knowledge as a source of competitive advantage for frontier firms may have risen if increasingly complex technologies were to increase the amount and sophistication of complementary investments required for technological adoption." 11 The bottom line is that aggregate productivity is low because the robust productivity gains for the tech-savvy frontier companies are offset by the long tail of firms that have been slow to adopt the latest technology. Indeed, business spending has been especially weak in this expansion. Chart II-14 highlights that the slowdown in U.S. productivity growth has mirrored that of the capital stock. Chart II-14U.S. Capex Shortfall Partly To Blame For Poor Productivity U.S. Capex Shortfall Partly To Blame For Poor Productivity U.S. Capex Shortfall Partly To Blame For Poor Productivity Appendix II-2 Japan - The Leading Edge Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. The popular press is full of stories of how robots are taking over. If the stories are to be believed, robots are the answer to the country's shrinking workforce. Robots now serve as helpers for the elderly, priests for weddings and funerals, concierges for hotels and even sexual partners (don't ask). Prime Minister Abe's government has launched a 5-year push to deepen the use of intelligent machines in manufacturing, supply chains, construction and health care. Indeed, Japan was the leader in robotics use for decades. Nonetheless, despite all the hype, Japan's stock of industrial robots has actually been eroding since the late 1990s (Chart II-4). Numerous surveys show that firms plan to use robots more in the future because of the difficulty in hiring humans. And there is huge potential: 90% of Japanese firms are small- and medium-sized (SME) and most are not currently using robots. Yet, there has been no wave of robot purchases as of 2016. One problem is the cost; most sophisticated robots are simply too expensive for SMEs to consider. This suggests that one cannot blame robots for Japan's lack of wage growth. The labor shortage has become so acute that there are examples of companies that have turned down sales due to insufficient manpower. Possible reasons why these companies do not offer higher wages to entice workers are beyond the scope of this report. But the fact that the stock of robots has been in decline since the late 1990s does not support the view that Japanese firms are using automation on a broad scale to avoid handing out pay hikes. Indeed, Chart II-15 highlights that wage deflation has been the greatest in industries that use almost no robots. Highly automated industries, such as Transportation Equipment and Electronics, have been among the most generous. This supports the view that the productivity afforded by increased robot usage encourages firms to pay their workers more. Looking ahead, it seems implausible that robots can replace all the retiring Japanese workers in the years to come. The workforce will shrink at an annual average pace of 0.33% between 2020 and 2030, according to the Japan Institute for Labour Policy and Training. Productivity growth would have to rise by the same amount to fully offset the dwindling number of workers. But that would require a surge in robot density of 4.1, assuming that each rise in robot density of one adds 0.08% to the level of productivity (Chart II-16). The level of robot sales would have to jump by a whopping 2½ times in the first year and continue to rise at the same pace each year thereafter to make this happen. Of course, the productivity afforded by new robots may accelerate in the coming years, but the point is that robot usage would likely have to rise astronomically to offset the impact of the shrinking population. Chart II-15Japan: Earnings Vs. Robot Density February 2018 February 2018 Chart II-16Japan: Where Is The Flood Of Robots? Japan: Where Is The Flood OF Robots? Japan: Where Is The Flood OF Robots? The implication is that, as long as the Japanese economy continues to grow above roughly 1%, the labor market will continue to tighten and wage rates will eventually begin to rise. 1 Please see Technology Sector Strategy Special Report "The Coming Robotics Revolution," dated May 16, 2017, available at tech.bcaresearch.com 2 Note that this includes only robots used in manufacturing industry, and thus excludes robots used in the service sector and households. However, robot usage in services is quite limited and those used in households do not add to GDP. 3 Note that ICT investment and capital stock data includes robots. 4 Please see BCA Global Investment Strategy Special Report "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 5 Centre for Economic and Business Research (January 2017): "The Impact of Automation." A Report for Redwood. In this report, robot density is defined to be the number of robots per million hours worked. 6 Graetz, G., and Michaels, G. (2015): "Robots At Work." CEP Discussion Paper No 1335. 7 Mishel, L., and Bivens, J. (2017): "The Zombie Robot Argument Lurches On," Economic Policy Institute. 8 Please see BCA Technology Sector Strategy Special Report "Bad Information - Why Misreporting Deep Learning Advances Is A Problem," dated January 9, 2018, available at tech.bcaresearch.com 9 Please see The Bank Credit Analyst, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June 2014, available at bca.bcaresearch.com 10 OECD Productivity Working Papers, No. 05 (2016): "The Best Versus the Rest: The Global Productivity Slowdown, Divergence Across Firms and the Role of Public Policy." 11 Please refer to page 27. III. Indicators And Reference Charts As we highlight in the Overview section, the earnings backdrop for the U.S. equity market remains very upbeat, as highlighted by the rise in the net earnings revisions and net earnings surprises indexes. Bottom-up analysts will likely continue to boost after-tax earnings estimates for the year as they adjust to the U.S. tax cut news. Our main concern is that a lot of good news is now discounted. Our Technical Indicator remains bullish, but our composite valuation indicator surpassed one sigma in January, which is our threshold of overvaluation. From these levels of overvaluation, the medium-term outlook for equity total returns is negligible. Our speculation index is at all-time highs and implied volatility is low, underscoring that investors are extremely bullish. From a contrary perspective, this is a warning sign for the equity market. Our Monetary Indicator has also moved further into 'bearish' territory for equities, although overall financial conditions remain positive for growth. It is also disconcerting that our Revealed Preference Indicator (RPI) shifted to a 'sell' signal for stocks, following five straight months on a 'buy' signal. This occurred because investors may be buying based on speculation rather than on a firm belief in the staying power of the underlying fundamentals. For now, though, our Willingness-to-Pay indicator for the U.S. rose sharply in January, highlighting that investor equity inflows are very strong and are favoring U.S. equities relative to Japan and the Eurozone. This is perhaps not surprising given the U.S. tax cuts just passed by Congress. The RPI indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Our U.S. bond technical indicator shows that Treasurys are close to oversold territory, suggesting that we may be in store for a consolidation period following January's surge in yields. Treasurys are slightly cheap on our valuation metric, although not by enough to justify closing short duration positions. The U.S. dollar is oversold and due for a bounce. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights One of the biggest mistakes in finance is to equate risk with volatility. The correct measure of risk is the negative skew in payoff distributions. If 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. This would be the point at which to scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Feature It is the crucial question that all investors should ask at all times. What is the relative risk of the two major asset classes - bonds and equities - and are their relative return prospects commensurate with the relative risk? Chart of the WeekBelow A 2% Yield, 10-Year Bonds Are Riskier Than Equities Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? But first, there is an even more fundamental question: what do we mean by risk? Conventional wisdom says that the risk of an investment is captured by its volatility. Indeed, through instruments such as the VIX futures and currency volatility options, volatility has become a multi-trillion dollar asset-class in its own right. Therefore, volatility must measure the risk of an investment, right? Wrong. The Biggest Mistake In Finance As a measure of risk, volatility is clearly wrong. Volatility regards price gains in exactly the same way as it regards price losses. But investors don't mind gains, they only mind losses! Consider an investment whose price moves alternately sideways and sharply higher. The maths would say that the returns have high volatility, implying that the investment is very risky. In truth though, the investment is highly desirable and 'risk-free' - because its price never declines. At our recent New York conference, Nobel Laureate Daniel Kahneman warned that one of the biggest mistakes in finance is to equate risk with volatility. After decades of empirical and theoretical studies - which culminated in the 2002 Nobel Prize for Economics - Kahneman proved that investors are not concerned about the symmetrical fluctuations in investment returns. Instead, they are concerned about the asymmetry - or skew - in payoff distributions. Kahneman explained the underlying psychology. "People are limited in their ability to comprehend and evaluate extreme probabilities, so highly unlikely events are overweighted." If the payoff distribution is symmetric, the overweighting of unlikely events in the loss tail and the gain tail exactly cancels out. But if the distribution is asymmetric, the longer tail determines the perceived attractiveness of the payoff. Where the longer tail is on the gain side, the distribution is said to have positive skew (Figure I-1). The classic example is a lottery. When people play the lottery, their loss is limited to the ticket price, but their gain could be tens of millions. People perceive the positive skew as attractive because they overweight the minuscule probability of becoming a millionaire. As a result, they overpay for the lottery ticket versus its expected value. Where the longer tail is on the loss side, the distribution is said to have negative skew (Figure I-2). This is like a lottery in reverse. The gain size is relatively limited, but the loss could be very large. People perceive the negative skew as unattractive because they overweight the probability of a large loss. As a result, they demand overpayment to take it on. Figure I-1People Like Positive Skew Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? Figure I-2People Dislike Negative Skew Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? For investments with negative skew, this overpayment takes the form of an excess return demanded from the market - a 'risk premium' - versus investments with less negative skew. Are Bonds A Greater Risk Than Equities? We are now in a position to tackle the question in the title. To determine whether bonds are riskier than equities or vice-versa, we must compare the skews of their return profiles.1 The important point is that for a bond, the skew of its return profile changes with its yield. At yields above 2.5%, 10-year bond returns show no skew. Worst losses broadly equal best gains. However, when yields drop below 2%, returns start to exhibit negative skew (Chart I-2). And at yields below 1%, the negative skew becomes extreme. Chart I-2Bond Risk Increases At ##br##Low Bond Yields Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? Chart I-3Equity Risk Does Not Increase At##br## Low Bond Yields Are Bonds A Greater Risk Than Equities? Are Bonds A Greater Risk Than Equities? The reason is obvious. Central banks accept that there is a 'lower bound' for policy interest rates - perhaps slightly negative - below which there would be an exodus of bank deposits. The limit also marks the lower bound for bond yields. Close to this lower bound for yields, bond mathematics necessarily creates a negatively skewed return profile. Simply put, prices have little upside, but they have a lot of downside! Chart I-4A 40Bps Rise In Yields Would Make Global ##br##Bonds Riskier Than Equities A 40Bps Rise In Yields Would Make Global Bonds Riskier Than Equities A 40Bps Rise In Yields Would Make Global Bonds Riskier Than Equities Turning to equities, the empirical evidence shows that equity returns always exhibit negative skew. Worst losses are typically around 1.5 times the size of best gains (Chart I-3). But the negative skew of equity returns is largely independent of the bond yield. The upshot is that there is a crossover bond yield below which the negative skew on 10-year bonds exceeds that on equities. This crossover bond yield is around 2%. In negative skew terms, we can say that at a 10-year bond yield below 2%, 10-year bonds are riskier than equities. And at a yield above 2%, equities are riskier than 10-year bonds (Chart of the Week). So in negative skew terms, 10-year bonds are riskier investments than equities in Europe and in Japan. But equities are riskier investments than 10-year bonds in the United States. Still, given that developed financial markets tend to move en masse, the relationship that is most significant is the aggregate one. At a global level, 10-year bond yields are 40bps below the crossover yield at which equities become riskier than bonds (Chart I-4). QE Distorted The Relative Valuation Of Equities Versus Bonds Which segues us neatly to today's ECB monetary policy meeting. Many people, worried about the end of QE, point out that the $10 trillion of bonds that the 'big four'2 central banks have bought is not far short of the size of the euro area economy. However, in the context of a global fixed income market of $220 trillion,3 $10 trillion of buying is small change. For the $220 trillion global bond and bank loan complex, the much more significant driver of yields has been the expected path of policy interest rates. As ECB Chief Economist Peter Praet put it, serial QE has been nothing more than "a signalling channel which reinforces the credibility of forward guidance on (ultra-low) policy rates." Chart I-5A Promise To Keep The Policy Rate Ultra-Low ##br##Pulls Down Bond Yields A Promise To Keep The Policy Rate Ultra-Low Pulls Down Bond Yields A Promise To Keep The Policy Rate Ultra-Low Pulls Down Bond Yields Central bankers know that QE depressed bond yields by signalling an extended period of ultra-low interest rates (Chart I-5). They also know that if the prospective return on bonds drops, so must the prospective return on competing investments such as equities. Thereby, the absolute valuations of bonds and equities both rise. However, one largely overlooked impact of QE - even by central bankers - has been the effect on the relative valuation of equities versus bonds. To repeat, when 10-year bond yields drop below 2%, their return distribution becomes more negatively skewed than that for equities. But if bonds become riskier investments, the 'risk premium' (excess return) on equities must disappear. Meaning equity valuations and prices get a second boost, compressing the prospective 10-year equity return to become 'bond-like'. Is this the case? Unlike for 10-year bonds, we do not know the 10-year prospective return from equities with certainty. However, we can get a good estimate from today's starting valuation. But which valuation metric to use? We are cautious of using profit based metrics as these will be flattered by the advanced position in the business cycle as well as the structural uptrend in profit margins. Instead, at an aggregate level, world equity market capitalisation to world GDP has been an excellent predictor of the prospective 10-year return on world equities. Today, this valuation metric is at the same level as in 2000 and 2007, and implies a prospective return of less than 2% a year (Chart I-6). Chart I-6World 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 World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return Nevertheless, while the global 10-year bond yield stays below 2%, this is a sustainable valuation for equities. Effectively, equities and bonds are offering broadly similar negative skews, and therefore should offer broadly similar prospective returns. However, if 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. Though not there yet, this would be the point when we would scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 One simple way to quantify this skew is to find an extended period of time in which the price ended where it started, and then to calculate the period's worst 3-month loss as a multiple of the best 3-month gain. We define skew = -ln(worst 3-month loss / best 3-month gain) using log returns for 3-month loss and 3-month gain. 2 The Federal Reserve, ECB, Bank of Japan and Bank of England. 3 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017. Fractal Trading Model* This week's trade is to position for an underperformance of the Japanese energy sector (led by JXTG Holdings And Inpex) versus the overall Japanese market. This is a longer trade than normal with a maximum duration of 26 weeks. Set a profit-target at 8% with a symmetrical stop-loss. 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-7 Short Japan Oil & Gas Short Japan Oil & Gas 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 EM stocks are about one standard deviation above their fair value, according to several valuation indicators. Provided EM equities are neither extremely overvalued nor undervalued, the key to their performance over the next 12 months will be corporate profits. Having missed this rally, we are reluctant to chase it at current levels amid the prevailing investor euphoria and overbought conditions. Compared with DM equities, EMs are not cheap - relative valuations are neutral. Meanwhile, the corporate profit outlook is better in DM than EM. As a result, we are reiterating our underweight stance on EM stocks versus DM bourses. Feature This week we delve into overall emerging markets (EM) stock valuations. Next month we will publish another report outlining a valuation ranking among individual EM bourses and equity sectors. After the significant share price run up, the question for investors is whether EM equities are still cheap or have become overvalued. Our composite valuation indicator based on trimmed-mean multiples suggests that EM equity valuations are one standard deviation above their fair value (Chart I-1). The message is the same when using the medians of various multiples for 50 sub-sectors (Chart I-2). Chart I-1EM Equity Valuations: ##br##Trimmed-Mean Multiples bca.ems_sr_2018_01_24_s1_c1 bca.ems_sr_2018_01_24_s1_c1 Chart I-2EM Equity Valuations: ##br##Medians Of Multiples bca.ems_sr_2018_01_24_s1_c2 bca.ems_sr_2018_01_24_s1_c2 These two composite valuation indicators are the averages of the trailing P/E, forward P/E, price-to-cash earnings,1 price-to-book value (PBV) and price-to-dividend ratios. The 20%-trimmed mean excludes the top 10% and bottom 10% of sub-sectors - i.e., it removes outliers and then calculates an equal-weighted average. Finally, the composite valuation indicator using equal-weights (not market-cap weights) for all 11 sectors also corroborates that the overall EM universe is somewhat overvalued (Chart I-3). Interestingly, based on Chart I-1 and I-2, EM stocks did not become cheap at their 2016 bottom - they were only fairly valued in early 2016. The individual components of the composite median valuation indicator - based on medians of 50 EM sub-sectors - are presented in Chart I-4. The top three panels reveal that the trailing P/E, forward P/E and price-to-cash earnings ratios are all well above their historical mean, and close to their previous peaks. The components that keep the composite indicator from being extremely overvalued are the PBV and price-to-dividend ratios. These two variables are close to their historical means (Chart I-4, bottom two panels). Chart I-3EM Equity Valuation: ##br##Equal-Weighted Sector Multiples bca.ems_sr_2018_01_24_s1_c3 bca.ems_sr_2018_01_24_s1_c3 Chart I-4Components of Median ##br##Valuation Composite Components of Median Valuation Composite Components of Median Valuation Composite As to qualitative assessment of EM valuations, our sense is that EM equity segments that have good fundamentals are currently overvalued, while those that feature low multiples are "cheap" for a reason. Bottom Line: According to valuation indicators based on various multiples, EM stocks are moderately overvalued. Relative Valuations To DM Relative to DM, EM equity valuations are neutral. Both relative composite valuation indicators computed using 20% trimmed-mean and the median are at the middle of their historical range (Chart I-5). This signifies there is presently no valuation gap between EM and DM stocks. All these measures are determined using the MSCI indexes, and utilize comparable data for both DM and EM across all companies, industry groups and sectors. Using equal weighted-sector multiples, the EM versus DM relative composite valuation indicator also upholds that relative equity valuations are neutral (Chart I-6). This measure uses equal weights for all sectors in both the EM and DM stock indexes. Hence, this composite removes sector weight differences among various equity indexes. EM equity valuations are also on par with the U.S. stock market, based on 20% trimmed-mean, median or equal sector-weighted multiples (Chart I-7). Chart I-5EM Versus DM: Relative Trimmed-Mean##br## And Median Multiples bca.ems_sr_2018_01_24_s1_c5 bca.ems_sr_2018_01_24_s1_c5 Chart I-6EM Versus DM: Relative Equal-Weighted ##br##Sector Multiples bca.ems_sr_2018_01_24_s1_c6 bca.ems_sr_2018_01_24_s1_c6 Chart I-7EM Versus U.S.: Trimmed-Mean, Median And ##br##Equal-Weighted Sector Multiples bca.ems_sr_2018_01_24_s1_c7 bca.ems_sr_2018_01_24_s1_c7 The takeaway from these relative valuation composites is that EM stocks are neither cheap nor expensive compared with U.S. or other DM equities. This is contrary to the widely held view among many investors and commentators that EM stocks are cheap versus DM in general, and the U.S. in particular. Additionally, in absolute terms, EM, DM and U.S. equities are all - about one standard deviation - expensive, according to these valuation yardsticks. Bottom Line: After removing outlier sub-sectors with the lowest and highest multiples and using equal weights for all sectors in the equity benchmarks, EM valuations appear comparable to those in the DM universe and the U.S. The CAPE Ratio: A Structural Valuation Perspective Our cyclically-adjusted P/E (CAPE) ratio for the EM equity universe currently stands at its fair value (Chart I-8). Due to the lack of historical data for EM, we were unable to use Robert Shiller's methodology for constructing the CAPE ratio for developing markets. The Shiller method uses a 10-year moving average of EPS to calculate the cyclically adjusted EPS. However, in the case of EM aggregate EPS, data go back only to 1986. If we were to calculate a 10-year moving average, we would lose 10 years of data, and the valuation indicator would only start in 1994. This is too short a time frame for a structural valuation indicator. Instead, we used the following methodology to construct the CAPE ratio: We deflated EM EPS and EM equity prices (both in U.S. dollar terms) by U.S. consumer price inflation (CPI) to get both EM EPS and EM share prices in real (inflation-adjusted) U.S. dollar terms. Then we regressed EM EPS in real U.S. dollar terms against a time trend. The resulting trend line represents the cyclically adjusted EPS in real U.S. dollar terms (Chart I-8, bottom panel). Finally, we divided EM stock prices in real U.S. dollar terms by the EM EPS trend line. The outcome is the EM CAPE ratio (Chart I-8, top panel). To be sure that our methodology produced a reasonable outcome, we computed a CAPE ratio using our methodology for the U.S. stock market and compared it with the Shiller CAPE ratio. Chart I-9 demonstrates that our methodology generated a CAPE ratio quite similar to Shiller's CAPE ratio from 1935 to the present. Consequently, we are comfortable that the results generated by our methodology are robust and sensible. When we calculate the EM versus U.S. relative CAPE ratio, the outcome is that EM appears cheap versus the U.S. stock market (Chart I-10). The degree of relative undervaluation is meaningful: one standard deviation. Chart I-8EM CAPE Ratio Is At Fair Value EM CAPE Ratio Is At Fair Value EM CAPE Ratio Is At Fair Value Chart I-9U.S. CAPE Ratio: EMS Vs. Shiller U.S. CAPE Ratio: EMS Vs. Shiller U.S. CAPE Ratio: EMS Vs. Shiller Chart I-10Relative CAPE Ratio: EM Versus U.S. Relative CAPE Ratio: EM Versus U.S. Relative CAPE Ratio: EM Versus U.S. The idea behind the CAPE model is to remove cyclicality of corporate profits when computing the P/E ratio. Our CAPE model gauges stock valuations under the assumption of EPS converging to their trend line. The latter is the cyclically adjusted EPS in real U.S. dollar terms. The slope of the time trend - the historical annual compound growth rate of EPS in inflation-adjusted U.S. dollar terms - is 2.8% for EM and 2% for the U.S. Please note that we determined the earnings time trend using the historical range of 1983-present for EM and 1935-present for the U.S. Hence, these CAPE models assume that EM EPS will grow 0.8% (2.8% - 2%) percentage points faster than U.S. corporate EPS in the inflation-adjusted U.S. dollar terms, as they have done historically. Under this assumption, EM stocks are materially cheaper than the U.S. market. Finally, the CAPE ratio is a structural valuation model, i.e., it works in the long term. Only investors with a time horizon greater than 3-5 years should use CAPE in their investment decisions. Bottom Line: According to our CAPE models, EM equities are fairly valued in absolute terms, but they are meaningfully cheaper than U.S. stocks. What About Interest Rates And Profits The above valuation measures did not incorporate one important variable: interest rates. The current high equity valuations in both DM and EM would in some way be justified if both global bond yields and EM local interest rates held at current low levels. Our bias is that U.S. bond yields will break out, dragging up other DM bond yields. DM government bond prices seem to be teetering on the edge of a technical breakdown (Chart I-11). The current robust growth in the U.S. and euro area justifies upward revisions to their interest rate expectations. In turn, higher U.S. bond yields will put a floor under the U.S. dollar. We anticipate that most of the potential U.S. dollar rally will occur versus EM and commodities currencies, and less so against the euro and other European currencies. Chart I-12 demonstrates that since January 2017, EM currencies have defied the rise in U.S. inflation-linked bond (TIPS) yields. We expect the negative correlation between EM currencies and U.S. TIPS yields - which existed from 2013 to 2017 - to re-establish itself. Chart I-11DM Bond Prices Are On Edge Of Breakdown DM Bond Prices Are On Edge Of Breakdown DM Bond Prices Are On Edge Of Breakdown Chart I-12EM Currencies And U.S. Real Yields EM Currencies And U.S. Real Yields EM Currencies And U.S. Real Yields This will likely occur as the recently approved tax cuts buoy the U.S. economy. Meanwhile, in China, regulatory tightening on banking and shadow banking as well as liquidity tightening will weigh on mainland growth. A shift in relative China-U.S. growth dynamics in favor of the U.S. will likely lead to a setback in the value of EM exchange rates. In turn, EM currency depreciation will produce higher local bond yields in a number of high-yielding developing markets (Chart I-13). Overall, the odds favor rising DM bond yields in the coming months. This, along with a slowdown in China, will trigger a selloff in EM currencies. The latter will produce widening EM credit (sovereign and corporate) spreads and lead to higher EM domestic bond yields. Altogether, this warrants a de-rating of EM versus DM equity multiples. On corporate profits, visible growth deceleration in China heralds a notable relapse in commodities prices and EM EPS growth. Our EM EPS model - based on narrow money (M1) growth - continues to flash red on the EM corporate profit outlook (Chart I-14). Chart I-13EM Currencies And Local Bond Yields EM Currencies And Local Bond Yields EM Currencies And Local Bond Yields Chart I-14EM EPS Is At Risk EM EPS Is At Risk EM EPS Is At Risk Investment Conclusions Chart I-15Bottom-Up Analysts Are ##br##Record Bullish On EM EPS Bottom-Up Analysts Are Record Bullish On EM EPS Bottom-Up Analysts Are Record Bullish On EM EPS Equity valuations matter most when valuations are at an extreme - two standard deviations overvalued or undervalued. This is presently not the case for EM stocks. Provided EM equities are neither extremely overvalued nor undervalued, the key to their performance over the next 12 months will be corporate profits. We expect EM corporate growth to downshift due to a slowdown in China and a setback in commodities prices. EM is more leveraged to China than to the U.S. or Europe. Hence, robust growth in DM is not inconsistent with our negative view on EM currencies and stocks. In the meantime, EM share prices continue to exhibit strong momentum. It is difficult to time a reversal amid such intense capital inflows. Nevertheless, from a big-picture perspective, such a stampede and the ensuing melt-up in stock prices typically precedes a major top. Having missed this rally, we are reluctant to chase it at current levels amid the prevailing investor euphoria (Chart I-15) and overbought conditions. Compared with DM equities, EMs are not cheap - relative valuations are neutral. Hence, there is no valuation justification to favor EM versus DM. Meanwhile, the corporate profit outlook is better in DM than in EM. As a result, we are reiterating our underweight stance on EM versus DM stocks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 MSCI defines cash earnings as earnings per share including depreciation and amortization as reported by the company. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy Relative sector index composition, the macro backdrop, relative operating metrics along with compelling valuations and washed out technicals suggest that a value over growth style bias is warranted. Rising interest rates and a flattening yield curve, coupled with increasing relative indebtedness and lack of relative profit growth signal that the time is right to shift the capitalization bias to a neutral setting. Recent Changes Shift the style bias and favor value over growth today. Book profits in the small over large cap size bias of 2% since the mid-August 2016 inception. Table 1 Too Good To Be True? Too Good To Be True? Feature Equities catapulted to new all-time highs last week as earnings season got underway. Upbeat bank reports set the tone, and SPX profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS estimates have been aggressively ratcheted higher, on the back of the tax bill passage, rising from 12% to 16% in a mere three weeks, according to Thomson Reuters/IBES. Our SPX EPS growth model agrees that, cyclically, profits will continue to drift higher and a low-to-mid double-digit growth rate is likely for 2018, as we posited last week.1 While the synchronized and disinflationary global growth narrative continues to dominate, we are a bit uneasy. The eerie calm overtaking the markets, and headlines like this recent one from Bloomberg "The Stock Market Never Goes Down" give us cause for concern. As a reminder, the SPX is up 1000 points since the 1800 level registered in early-2016. Put differently, the SPX has been rising by roughly 25% per annum for the past two years. Such a breakneck pace is unsustainable. Our sense is that from a tactical perspective, equities are currently extremely stretched and warrant some caution. Therefore, this week we identify five key signposts we are closely monitoring that are sending clear warning signals (for a more comprehensive list please see the tactical section of our August 7th White Paper).2 First, our reflation gauge (RG) has taken a turn for the worse (Chart 1). At the margin, higher oil prices and interest rates may begin to bite. Historically, our RG has been an excellent leading indicator of both sentiment that has vaulted to multi-decade highs and CITI's economic surprise index. Our global reflation gauge emits a similar signal (not shown). Mean reversion is looming. Second, speculation runs rampant. Our Equity Speculation Index (ESI) is close to two standard deviations above the historical mean. Since the early-1960s, the ESI has only been higher during the dotcom bubble (Chart 2). While the ESI can rise further, it is at least waving a yellow flag. Investor sentiment has also gone parabolic with the bull/bear ratio reaching a level last seen right before the 1987 crash (third panel, Chart 2). Chart 1Yellow Flag Yellow Flag Yellow Flag Chart 2Extended Extended Extended Third, financial conditions are as good as they get. The St. Louis Fed Financial Stress Index recently hit an all-time low level. Similarly, Goldman Sachs' and the Chicago Fed's National Financial Conditions indexes are also near uncharted territory. This should be cause for some trepidation (Chart 3). Fourth, extended EPS breadth, all time highs in net earnings revisions, stretched median valuations and overbought technical conditions are near levels that have marked previous temporary broad market pullbacks (Chart 4). Finally, gold is behaving strangely. While the U.S. dollar's selloff explains part of the recent jump in the shiny metal, we think bullion may be sniffing out some trouble as it remains a true safe haven asset. Either real rates have to come down or gold has to reverse course; such a steep divergence is unsustainable (gold shown inverted, top panel, Chart 5). Chart 3As Good As It Gets As Good As It Gets As Good As It Gets Chart 4Peak Euphoria? Peak Euphoria? Peak Euphoria? Chart 5What's Gold Sniffing Out? What's Gold Sniffing Out? What's Gold Sniffing Out? Since December 18th our strategy has been to book gains in tactical trades and to refrain from altering our cyclical over defensive portfolio positioning bent,3 as we do not foresee a recession in the coming 9-12 months.4 We continue to pursue this strategy and were a 5-10% selloff to materialize, we would "buy the dip". In addition, this week we introduce/apply a risk management measure to our recently revealed high-conviction 2018 calls.5 Almost all of our calls are in the black outperforming the broad market on average by 640bps (Chart 6). While we are not compelled to change our views just yet, our confidence is not as high as two months ago, especially in the two calls that are registering double-digit relative returns. Thus, we suggest that clients institute a tight stop in these trades (please see the "Stop" column in the "Top High-Conviction Calls For 2018" table on page 15). Going forward, we will introduce such risk management trailing stops once a call clears the 10% relative return mark. This week we shift both our style and size biases. Chart 6Time To Set Stops Too Good To Be True? Too Good To Be True? Buy Value At The Expense Of Growth There is a once in a decade opportunity to prefer value over growth (V/G) stocks, and we recommend shifting our style bias in favor of value stocks. Typically, the V/G ratio moves in multi-year up and down cycles, and at the current juncture it is a screaming buy, if history at least rhymes. Chart 7 shows that relative share prices are not only near previous troughs, but also 1.5 standard deviations below the six-decade time trend. Chart 7Compelling Entry Point Compelling Entry Point Compelling Entry Point In fact we already have a flavor of this style preference in one of our market-neutral pair trades, long financials / short tech (for additional details on this trade please refer to our "Disentangling Pricing Power" early-summer report). Table 2 depicts why this is so: financials stocks dominate value indexes, while IT comprises 40% of growth indexes. Sector composition also suggests that a long energy / short health care trade would mimic this V/G preference, as energy stocks offer a lot of value, whereas health care stocks sit prominently in growth indexes (Table 2 & Chart 8). While we do not have this pair trade on per se, as a reminder we are overweight the energy sector and underweight health care stocks; we are also overweight financials and underweight tech (please see page 14 for a complete picture of our current sector recommendations). Table 2Sector Composition Too Good To Be True? Too Good To Be True? With regard to macro variables, these sector preferences would equate to a positive interest rate and oil price correlation. Indeed, the 10-year Treasury yield moves in lockstep with the V/G ratio and similarly oil prices are joined at the hip with relative performance (Chart 9). Chart 8Value/Growth Replicas Value/Growth Replicas Value/Growth Replicas Chart 9Rising Oil And Rates = Buy Value / Sell Growth Rising Oil And Rates = Buy Value / Sell Growth Rising Oil And Rates = Buy Value / Sell Growth One of BCA's themes for 2018 is higher interest rates, with our bond strategists still expecting an inflation-driven rise in the 10-year Treasury yield near 3%. Similarly, BCA' commodity strategists remain constructive on oil prices. Taken together, these BCA views warrant a value over growth preference. Importantly, since the depths of the GFC, value has underwhelmed growth by a wide margin. Likely, this growth over value preference reflected central bank interest rate suppression, which boosted the multiple investors were willing to pay for perceived growth at a time when growth was scarce. Now that the Fed has lifted rates five times since December 2015 and is on track to do so three more times this year, value should take the reins (Chart 10). Moreover, the Fed is unwinding its balance sheet and that tightening in monetary conditions, at the margin, favors value over growth (Chart 11). Chart 10Avoid Growth Stocks During Fed Tightening Cycles... Avoid Growth Stocks During Fed Tightening Cycles... Avoid Growth Stocks During Fed Tightening Cycles... Chart 11...And During Quantitative Tightening ...And During Quantitative Tightening ...And During Quantitative Tightening On the currency front, the V/G ratio has had a tight positive correlation with the EUR/USD foreign exchange rate (Chart 12). Once again sector composition has been underpinning this relationship. However, sector composition is constantly shifting. Currently, a larger percentage of growth stocks have international sales (especially tech) compared with more domestically-oriented value stocks. Thus, the depreciating U.S. dollar is a risk to our value over growth preference On the operating metric front, value stocks have the upper hand versus their growth siblings. Our relative composite pricing power gauge has swung by eight percentage points from trough-to-peak and heralds a deflation exit for relative top line growth (middle panel, Chart 13). Chart 12Depreciating U.S. Dollar Is ##br##Typically A Boon To The V/G Ratio Depreciating U.S. Dollar Is A Boon To The V/G Ratio Depreciating U.S. Dollar Is A Boon To The V/G Ratio Chart 13Relative Pricing Power ##br##Favors Value Over Growth Relative Pricing Power Favors Value Over Growth Relative Pricing Power Favors Value Over Growth Sell-side analysts have taken notice and have been aggressively bumping their net earnings revisions in favor of value versus growth indexes. As mentioned earlier, rising oil price inflation and better credit pricing power are a boon to V/G profit prospects (bottom panel, Chart 13). Valuations and technicals also suggest that investors should overweight value at the expense of growth. Our relative Valuation Indicator (VI) has recently sunk to a level last hit in the early-2000s, approaching one standard deviation below the historical mean. Similarly, the V/G ratio is oversold and our relative Technical Indicator (TI) has fallen to a level that has marked previous bull market phases (Chart 14). Finally, over the past thirty years V/G price moves have been a mirror image of both junk bond yields and vol. In other words, a value over growth preference has been synonymous with a "risk on" backdrop (junk yield and the VIX shown inverted, Chart 15). However, these close correlations appear to have broken down since the Great Recession as the Fed's unconventional monetary policies functioned well in keeping a lid on vol and suppressing bond yields across the fixed income spectrum. Chart 14Value Vs Growth Stocks Are Cheap And Oversold Value Vs Growth Stocks Are Cheap And Oversold Value Vs Growth Stocks Are Cheap And Oversold Chart 15Bet On Convergence Bet On Convergence Bet On Convergence As the Fed winds down its balance sheet there are good odds that volatility will make a comeback and interest rates will also shoot higher. The upshot is that these inverse correlations get reestablished in the coming quarters via a rise in the V/G ratio, an increase in vol and a selloff in the junk corporate bond market (Chart 15). Adding it up, relative sector composition, the macro backdrop, relative operating metrics along with a compelling VI reading and our washed out TI suggest that a value over growth style bias is warranted. Bottom Line: Boost value stock exposure at the expense of growth equities. The V/G ratio offers an excellent entry point with limited downside risk. Book Profits In Small Caps Vs. Large Caps And Move To The Sidelines In August 2016, we recommended a small over large cap (S/L) bias, predating the Trump election victory, on the back of five key drivers: non-inflationary growth would persist allowing central banks to stay incredibly accommodative, emerging market tail risks had eased taming equity market vol, small/large sector composition differentials, relative EPS fundamentals and restored relative valuations. Given that most of these factors have moved in favor of small versus large caps and some are starting to shift against the S/L ratio, does it still pay to have a small cap size bias? The short answer is no, and we now recommend investors book profits and move to the sidelines. While the euphoric tailwind surrounding the new administration and its promise to slash red tape and taxes tripped us up and we failed to monetize 10%+ gains, better late than never. First, from a big picture perspective, the near two decade S/L outperformance phase is running on fumes and it has likely put in a secular top in late-2016 (Chart 16). Similar to the style bias, this ratio also tends to move in long cycles. We are clearly in extended territory hovering at one standard deviation above the historical time trend. Chart 16Major Top? Major Top? Major Top? Second, interest rates bear close attention. Rising interest rates on the back of an inflationary impulse is BCA's view for the coming year and, coupled with the yield curve narrowing, are a harbinger of small cap trouble. Chart 17 shows the tight positive correlation between the S/L ratio and the yield curve, and the current message is to avoid small caps. Small caps are mostly domestically exposed and are ultra-sensitive to interest rate moves as small and medium businesses rely more heavily on their bankers for credit, rather than debt markets. When the yield curve flattens late in the cycle it is typically because the Fed is aggressively tightening monetary policy. While such a monetary backdrop is neither conducive to small nor to large firms, small caps suffer more, at the margin. Third, we are perplexed by the lack of profit growth in the small cap complex. It has now been over a year since Trump came into power and small cap EPS underperformance has been extremely prominent (top panel, Chart 18). The 12-month forward profit growth delta has also widened considerably over the past year to the detriment of small caps (middle panel, Chart 18). While the U.S. dollar's sizable depreciation explains part of the profit divergence, i.e. as the currency falls foreign sales exposed large caps enjoy a significant translation gain, relative indebtedness is also likely playing a key role. The bottom panel of Chart 19 shows the net debt-to-EBITDA ratio for the small cap and large cap indexes. The relative ratio has gone parabolic and is making all-time highs. Rising small cap indebtedness, at a time when cash flow growth is anemic, suggests that the S&P 600 is increasingly vulnerable. Not only are interest payments eating into income, but also refinancing risk is a threat in an era of rising interest rates. Under such a backdrop, small cap stocks should not trade at a valuation premium (bottom panel, Chart 18). Chart 17Yield Curve Blues Yield Curve Blues Yield Curve Blues Chart 18Small Cap Profit Trouble Small Cap Profit Trouble Small Cap Profit Trouble Chart 19Mind The Small Cap Indebtedness Mind The Small Cap Indebtedness Mind The Small Cap Indebtedness Bottom Line: The time is ripe to take profits of 2% and move to the sidelines in the capitalization bias. Were our indicators to further deteriorate, we would not hesitate to fully reverse course and prefer large to small caps. Stay tuned. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "White Paper: U.S. Equity Market Indicators (Part I)," dated August 7, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth and stay neutral small over large caps.

Highlights The euro is in a cyclical bull market. It is supported by attractive valuations, improving balance of payments dynamics, declining political risk, potential shifts in reserves preferences, and a re-rating of the European terminal rate. This positive cyclical backdrop hides a more treacherous short-term outlook. EUR/USD is vulnerable because ECB members are increasingly worried, the European periphery is displaying early strains, European inflation will slow versus the U.S., global industrial activity may experience a mini down cycle, and sentiment measures are massively stretched. Short EUR/JPY for now, and use any move in EUR/USD to 1.15 or lower to buy this pair. Feature The euro has undergone a major paradigm shift over the course of the past 16 months. In December 2016, the euro was trading near parity, and expectations were uniform that it would fall well below that threshold. The narrative was simple: Europe was turning Japanese, with inflation forever moribund; also, Europe was succumbing to the siren call of nationalism and populism, which meant the euro was bound to break up within the next five years. Meanwhile, the U.S. was on the rebound. Core consumer price inflation was above 2.2%, and U.S. President Donald Trump was set to massively stimulate the American economy, giving a free hand for the Federal Reserve to hike to its heart's content. Today, the picture could not be more different. Investors expect the European Central Bank's first hike to materialize in the summer of 2019, European growth is stellar, and European inflation is not low enough to warrant emergency-level policy rates. As a result, not only is EUR/USD trading above 1.20, but consensus forecasts increasingly see the euro trading into the 1.25 to 1.30 zone by year end. Is EUR/USD at 1.22 a buying or a selling opportunity? Short-term risks are currently elevated for the euro, but a move toward 1.15 would represent a buying opportunity, as the cyclical bear market in the euro is over. The Long-Term Bull Case A crucial long-term positive factor for the euro is that it is cheap. EUR/USD currently trades at a 10% discount to its purchasing-power-parity equilibrium, even after a nearly 17% rally since its December 2016 low. Encapsulating this concept, the real effective exchange rate for the euro remains well below equilibrium (Chart I-1). Additionally, our fundamental long-term fair value model pegs the euro as being almost 1-sigma undervalued. The euro area's balance of payment is also very favorable. It is well known among the investment community that the euro area sports a surplus of 3.5% of GDP, but significant changes are also materializing in the capital account. Portfolios outflows out of the euro area have begun to decrease, as equity inflows are rising and bond outflows are becoming smaller. Moreover, the euro area basic balance is moving into positive territory, which historically has been a precursor to sustainable euro rallies (Chart I-2). The supply of euro for international markets is therefore decreasing. Additionally, the euro area's net international investment position (NIIP), which was as low as -17% of GDP in 2014, will likely move into positive territory toward the end of the year. The NIIP has historically been a strong driver of long-term exchange rate moves.1 Chart I-1The Euro Is Still Cheap The Euro Is Still Cheap The Euro Is Still Cheap Chart I-2The European Balance Of Payments Has Improved The European Balance Of Payments Has Improved The European Balance Of Payments Has Improved Politics too have been moving in the right direction. Euro skepticism is not taking hold in the euro area: Last year's French election was a vivid demonstration that "more Europe" is not electoral poison. Even the Italian elections this coming March may not land much of a blow to the European project: The Five Star Movement is rapidly softening its anti-euro rhetoric, and support for centrist parties is strengthening (Chart I-3). Moreover, a German move toward a grand coalition means Angela Merkel's CDU is very likely to be governing along with a pro-euro SPD, whose campaign theme was "MEGA": Make Europe Great Again. Already, Germany is lending a listening ear to some of Macron's integrationist proposals, and fiscal stimulus could well be in the pipeline. Long-term reserves diversification is also in the euro's favor. A headline last week suggested that China would unload some of its vast holdings of Treasurys. This leak was soon condemned as "Fake News" by China's State Administration of Foreign Exchange. However, while the news clearly lacked substance, the reality remains that despite the euro area and the U.S. being similarly sized economies, the euro only represents 20% of allocated global reserves, compared to 65% for the greenback. The greater depth and liquidity of U.S. bond markets contributes to this discrepancy, but the ECB's bond buying, by creating a scarcity of euro denominated securities, has exacerbated the disparity. This latter handicap for the euro will end sometime next fall, and if Europe's integrates further, European bond markets will increasingly become alternatives to U.S. ones. A rebalancing of reserves would principally help the euro by hurting the U.S. dollar: It will become more tenuous for the U.S. to achieve a positive international income balance while sporting a NIIP of -40% of GDP if official international demand for dollars falls (Chart I-4). Chart I-3Italian Centrists Are Gaining Ground Italian Centrists Are Gaining Ground Italian Centrists Are Gaining Ground Chart I-4The USD Needs Its Reserve Status The USD Needs Its Reserve Status The USD Needs Its Reserve Status Finally, the terminal rates differential between the U.S. and the euro area remains well above its long-term average of 110 basis points. Thus, there is scope for a normalization of European terminal rates relative to the U.S. on a long-term basis (Chart I-5). However, an average is only a number. What forces could cause the terminal rate spread between the euro area and the U.S. to normalize over the coming years? European policy is currently very loose when compared to the U.S., which will enable the ECB to play catchup over the coming years. To make this judgment, we look at broad money supply in excess of money demand. Because money demand is an unobserved variable, we have to estimate it. Economic theory argues it should be a positive function of economic activity, wealth and uncertainty. Therefore, to get a sense of what money demand may be, we regress the real broad money aggregates of various countries on uncertainty indices and real wealth.2 The difference between real broad money supply numbers and these estimates represent excess money supply. If a country's excess money is being generated today, it ends up stimulating future economic activity and inflation. This increase in expected nominal growth should contribute to lifting expected interest rates at the long end of the yield curve - i.e. expected terminal rates. As Chart I-6 shows, the stock of excess money supply in the U.S. has stopped growing since 2015. However, it is currently exploding in the euro area as European commercial banks are regaining their health and lending again. The money supply dynamics in Europe signal that the easy policy of the ECB is finally bearing fruit. And as the bottom panel of Chart I-6 illustrates, when European excess money supply increases relative to the U.S., as is currently the case, EUR/USD experiences cyclical rallies.3 This counterinituitive result exists because previous ECB easing is bearing fruits, European asset returns are rising, and economic activity is increasing. As a result, the European terminal rate now has more scope to rise vis-à-vis the U.S. The steepening of the German yield curve relative to the Treasury curve only confirms this message (Chart I-7). Chart I-5The U.S. Terminal Rate Has Room To Fall##br## Against That Of Europe The U.S. Terminal Rate Has Room To Fall Against That Of Europe The U.S. Terminal Rate Has Room To Fall Against That Of Europe Chart I-6European Excess##br## Money Is Surging European Excess Money Is Surging European Excess Money Is Surging Chart I-7Listen To Yield ##br##Curves Listen To Yield Curves Listen To Yield Curves The five forces described above imply that the euro's move from 1.03 to 1.21 was the first salvo in what is likely to be a long cyclical bull market that could end up driving the euro above 1.40 over many years. However, these factors provide little insight regarding the euro's path over the next three to six months. Bottom Line: The euro is likely to have embarked on a cyclical bull market at the beginning of 2017. Five factors support this judgment: The euro is cheap, the European balance-of-payment backdrop is favorable, political winds in the euro area remain favorable to further European integration, global foreign exchange reserves are very underweight the euro, and the spread between U.S. and euro area expected terminal rates remains well above its long-term average, and has scope to narrow. Murkier Short-Term Outlook While the long-term outlook is very favorable for the euro, the shorter-term outlook is much more clouded. First, the chorus of complaints against the euro's strength is growing among European central bankers. In recent days, not only have Vitor Constâncio and Francois Villeroy voiced concerns over the euro's recent strength, but so has Ewald Nowotny, the rather hawkish Austrian central banker. Additionally, Bundesbank President Jens Weidmann stated that the market should not anticipate a rate hike before the summer of 2019, suggesting he would not want to see a more aggressive rate pricing than what is currently at play (Chart I-8). Second, the less competitive and more fragile European periphery is already showing early signs that the sharp appreciation in the euro is causing some pain. Peripheral equities have begun to underperform the stocks of core euro area nations, and are also sharply underperforming U.S. equities. This phenomenon tends to be associated with a weakening euro. Moreover, peripheral inflation excluding food and energy has already weakened to 1.3% from a high of 2% in February last year, the consequence of a tightening in financial conditions (Chart I-9). Chart I-8ECB Doesn't Want This To Change ECB Doesn't Want This To Change ECB Doesn't Want This To Change Chart I-9Peripheral Core Inflation In Free Fall Peripheral Core Inflation In Free Fall Peripheral Core Inflation In Free Fall Third, the economic environment points to underperformance of aggregate European inflation relative to the U.S. A fall in the gap between euro area and U.S. inflation tends to be associated with short-term gyrations in EUR/USD (Chart I-10). This is because a fall in relative inflation against the euro area causes investors to temporarily tweak the perceived path of future policy differentials. Over the course of 2018, U.S. inflation is set to increase. A simple model based on U.S. capacity utilization and the velocity of money shows that U.S. core CPI could hit 2.1% (Chart I-11). While this model has done a good job picking the turning points in U.S. core inflation, it has consistently overestimated inflation since 2013. Correcting for this bias, the model still forecasts a significant pick-up in inflation to 1.8% (Chart I-11, bottom panel). Chart I-10Higher European Inflation Equals Higher Euro Higher European Inflation Equals Higher Euro Higher European Inflation Equals Higher Euro Chart I-11A U.S. Inflation Pick Up Is Coming A U.S. Inflation Pick Up Is Coming A U.S. Inflation Pick Up Is Coming The same cannot be said for euro area inflation. Not only is the European periphery already feeling the pain caused by the euro's strength, but also we have entered the window of time where the previous tightening in euro area financial conditions vis-à-vis the U.S. puts a brake on euro area relative inflation.4 Moreover, the diffusion index of the components of the euro area core CPI index has been below 50% for four months in a row now. Historically, this has been associated with a fall in core CPI. Fourth, over the past year or so, EUR/USD has traded in line with risk assets. The euro area has benefited from EM growth improvement, which has lifted all corners of the global economy levered to the global industrial cycle. As a result, as investors become increasingly bullish on industrial metals, EM assets or momentum plays, so they have of the euro.5 However, clouds are slowly forming over the global economy, at the very least pointing to a mini-cycle downturn. For one, Chinese producer prices have rolled over, and Chinese import growth has significantly underperformed expectations in recent months, slowing to a 5% pace from a 20% pace as recently as September 2017. Essentially, industrial activity has slowed in response to a tightening in Chinese monetary conditions. This slowdown is already beginning to impact various corners of the globe: Korean and Taiwanese export growth continues to decelerate; BCA's Global LEIs Diffusion Index is well below the 50% mark, which normally precedes slowdowns in the global LEI itself; Our boom/bust and global growth indicators have slowed further - two precursors to global industrial production decelerations. Our global economic and financial A/D line, which tallies 100 pro-cyclical variables, has also rolled over sharply, another early warning sign for the global economy (Chart I-12). Finally, as we highlighted in December, EM/JPY carry trades, a canary for the global economy, have lost momentum - a signal that has normally preceded a slowdown in global industrial activity.6 All these signals only confirm the "Yellow Flags" we highlighted last October.7 In an environment where complacency is rampant and assets levered to growth are priced for perfection, this is worrisome. The euro's recent elevated correlation to such risk assets, along with the fact that the gap between European and U.S. core inflation is itself led by Chinese PPI, suggests that the euro is tactically vulnerable. Fifth, from a technical perspective speculators have never been this long the euro, which represents a significant danger as the euro is trading at a sharp premium to its short-term interest rate driver (Chart I-13). Moreover, risk-reversals for EUR/USD point to heightened susceptibility of a selloff if the bad omen on global growth and European inflation come to fruition (Chart I-14). Chart I-12Rising Risks For Global Growth Rising Risks For Global Growth Rising Risks For Global Growth Chart I-13The Euro Is Vulnerable The Euro Is Vulnerable The Euro Is Vulnerable Chart I-14Risk Reversals Point To Euro Downside Risk Reversals Point To Euro Downside Risk Reversals Point To Euro Downside This short-term picture suggests that the probability of a move in EUR/USD toward 1.15 is growing over the course of the next three to six months. Bottom Line: While the cyclical picture for the euro is bright, the short-term snapshot is much more dangerous. Not only are an increasing number of ECB officials weighing in on the impact of the euro's recent rally, but the European periphery is showing growing signs that the euro rally has indeed taken a bite. Additionally, European inflation is set to underperform U.S. inflation, and the global economic cycle could enter a short burst of disappointment. Finally, investors are not positioned for such developments, increasing the likelihood of a downward move in the euro. What To Do? Caught between a cyclically propitious backdrop and a tactically dangerous environment, EUR/USD presents a riddle for FX investors right now. The odds of a euro correction over the next three to six months are substantially greater than 50%. But as we highlighted last week, instead of taking a direct bet on EUR/USD, we recommend investors short EUR/JPY. Shorting EUR/JPY is an even cleaner way to take advantage of the cloudy weather building over the global economy.8 Moreover, in recent years, EUR/JPY has fallen when the 52-week rate-of-change of momentum trades began to weaken (Chart I-15). This highly mean-reverting indicator is currently in the 96th percentile of its distribution for the past 25 years, suggesting an imminent rollover. Additionally, EUR/JPY tends to perform well when the LIBOR-OIS spread widens. Today, the three-month FRA-OIS spread has been widening, even as the end-of-year dollar funding shortage has passed (Chart I-16). These kinds of dynamics point to a potential drying out in global liquidity, a phenomenon which historically hurts risk assets, especially when they are as frothy as they are now. This should once again hurt EUR/JPY. Chart I-15EUR/JPY And Momentum Stocks EUR/JPY And Momentum Stocks EUR/JPY And Momentum Stocks Chart I-16Funding Stresses Point To A Fall In EUR/JPY Funding Stresses Point To A Fall In EUR/JPY Funding Stresses Point To A Fall In EUR/JPY Thus, shorting EUR/JPY is our highest conviction trade for the next six months or so. If, as we foresee, EUR/USD weakens during the first half of 2018, we will look to buy this pair. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets" dated February 26, 2016 available at fes.bcaresearch.com 2 We do not include real GDP in the models because since wealth is affected by GDP, they are two co-integrated variables, which creates strong multi-collinearity in the regressions. Of the two variables, real wealth was the stronger explanatory variable. 3 While the focus of this report is on the euro, the relationship between relative excess money supply and currency performances works across many exchange rates. We will develop this theme over the coming weeks. 4 Please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets" dated February 26, 2016 available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "Euro: Risk On Or Risk Off" dated November 17, 2017 available at fes.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, "A Cold Snap Doesn't Make A Winter" dated January 5, 2018 available at fes.bcaresearch.com 7 Please see Foreign Exchange Strategy Weekly Report, "The Best Of Possible Worlds?" dated October 6, 2017 available at fes.bcaresearch.com 8 Please see Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Data out of the U.S. was strong this week: Industrial production increased by 0.9% on a monthly pace; Capacity utilization increased to 77.9% from 77.2%; Continuing jobless claims increased to 1.952 million from 1.876 million, beating expectations of 1.9 million; Initial jobless claims however decreased to 220K from 261K, beating expectations of 250K. We continue to expect the Fed to hike more than is priced by the market. A tightening labor market will eventually feed inflationary pressures, causing upward pressure on the dollar. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was decent: German CPI came in unchanged and at expectations, at 1.6%; European headline and core CPI also remained unchanged and at consensus, coming in at 1.4% and 1.1% respectively. However, the euro seems to be losing momentum his week. Comments by ECB board members such as Ewald Nowotny, Vitor Constâncio, and Francois Villeroy, all pointed to issues with the euro's sharp rise, and how they "don't reflect changes in fundamentals". Additionally, relapsing inflation data in the peripheries shows that the strength in the euro is beginning to cause strains and may even negatively affect the ECB's mandate. Report Links: The Unstoppable Euro - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Domestic corporate goods year on year inflation underperformed expectations, coming in at 3.1%. It also decreased substantially from November. Moreover, the Eco Watchers Survey for current conditions underperformed expectations, coming in at 53.9. It also decreased from the November reading. However, machinery orders yearly growth outperformed expectations substantially, coming in at 4.1%. USD/JPY is relatively flat from last week. Overall we expect upside to the yen to be limited against the U.S. dollar, given that bond yields are set to go up in the U.S. That being said, the yen has upside against the euro, as financial conditions have eased significantly in Japan relatively to the euro area. This should cause rate expectations in Japan to improve relative to those of Europe's, pushing EUR/JPY lower. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: The DCLG House Price Index yearly growth outperformed expectations, coming in at 5.1%. However, core consumer price inflation underperformed expectations, coming in at 2.5%. It also decreased from the 2.7% reading of November. Moreover, headline inflation came in line with expectations at 3%. This also marks the first decrease in inflation in the U.K. since July 2017. Lifted by the USD's weakness, cable has now reached the pre-Brexit low 1.38 hit in February 2016. However, GBP has been experiencing a downtrend versus the euro since last September Overall, we continue to be skeptical of the ability of the BoE to raise interest rates meaningfully. Thus, we would fade any further rally from GBP/USD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was strong this week: Home loans grew at a 2.1% annual pace in November, higher than the expected -0.2%; Employment grew by 34.7K, beating expectations of 9K. The part-time component increased by 19.5K, while the full-time component grew by 15.1K; The participation rate increased to 65.7% from 65.5%; Unemployment rate increased to 5.5% from 5.4%. Foreign exchange traders lifted the AUD further this week. While the headline employment data remains stellar, the heavy concentration part-time job creation means that overall labor utilization measures is staying low. This will cap wage and inflationary pressures, especially as the AUD is once again expensive, further exacerbating deflationary pressures. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been negative: The month-on-month growth of food prices declined from -0.4% to -0.8%. Moreover, Electronic Card retail sales yearly growth slowed from 4.3% to 3.3%. Finally the ANZ Commodity Price Index year on year growth declined from -0.9% to -2.2%. The New Zealand Dollar has surges by almost 3% year to data against the U.S. dollar. This has been largely due to the depreciation of the greenback itself, as global growth continues to beat forecast. On a short term basis we are positive on the NZD relative to the AUD, as Chinese tightening should weigh more on Australia than New Zealand. However, the new populist government in New Zealand worsens the outlook of the kiwi on a long term basis. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Movements in the petrocurrency were muted following the 'dovish hike' by the Bank of Canada. Numerous factors were highlighted to justify the rate hike to 1.25%, such as: strong employment growth; higher wages; robust consumption; and exceptional GDP growth in 2017. While the Bank's Business Outlook Survey suggests the labor market is tightening due to labor shortages, the BoC underplayed this factor, pointing to much more muted overall labor utilization metrics. The BoC also noted the expected decline in the contribution of housing and consumption to growth this year due to higher mortgage and borrowing rates. While the economy is firing on all fronts, the spread between the West Canada Select and West Texas Intermediate oil prices continues to widen due to a lack of pipeline capacity to ship the oil out of Canada. According to the Bank, these bottlenecks should be temporary, which means that the CAD could catch up to oil later. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 On Tuesday, Thomas Jordan, the president of the SNB once again reiterated that the franc is still "highly valued", and thus interest rates need to stay low so as to prevent the franc from appreciating. Moreover, he emphasized that while expansionary monetary policy was necessary, it was important to not wait too long to normalize rates. Overall, we believe that the SNB will want to see sustained inflation at relatively high levels to justify an exit from their radical monetary policy. In the meantime the Swiss Central bank will stay accommodative, and thus, EUR/CHF is likely to have limited downside. If the mini down cycle takes hold of the global economy, this would temporarily weigh on EUR/CHF. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The krone continued to appreciate this week, and is now UP 3.3% year-to-date. The krone has been helped mostly by the surge in oil prices and by the fall in the dollar. Overall, we are bullish on this cross against the CAD, as there are 60 basis points of hiked priced in the Canadian curve, even after this week's hike. In the meantime, there are only 21 basis points in the Norwegian curve. We believe this spread is too high, and thus, that the krone should appreciate against the Canadian dollar. Moreover, further downside in EUR/NOK is limited, given that near 70 dollars, there is not much room for oil prices to go up. Thus, we are closing our EUR/NOK trade with a 3.40% gain but keep our long NOK/SEK call in place. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 In a recent speech in Uppsala, Sweden, Deputy Governor Henry Ohlsson reminded the audience of his view from the December meeting that it would have reasonable to hike rates in "early 2018". He pointed to Sweden's robust economic performance, highlighting population growth, migration into cities, and higher real wages. Inflation has also been on target since mid-2017. This assessment is in line with our view of the economy, however Governor Ingves consistently supported a strong dovish tone which undermined our view. Now that the ECB has begun tapering, the consensus within the Riksbank seems to also be shifting. Falling house prices need to be monitored closely, especially when one keeps in mind Governor Ingves dovish inclinations. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights We are upgrading our allocation to Indian stocks from neutral to overweight within EM equity portfolios. India's public banks are much further along in their necessary adjustment process, and the credit cycle downturn is much more advanced relative to China's. To capitalize on this theme, we recommend going long Indian banks and shorting Chinese bank stocks. India's public bank recapitalization program will allow them to slowly augment credit origination, assisting the economic recovery. Feature Chart I-1Favor Indian Banks Versus Chinese Ones Favor Indian Banks Versus Chinese Ones Favor Indian Banks Versus Chinese Ones Our report this week highlights the results from stress tests we conducted on Indian and Chinese public banks, and also compares their respective equity valuations. Based on our findings, we are initiating a new relative equity trade: long Indian / short Chinese bank stocks (Chart I-1). The health of the banking system, the credit cycle outlook as well as the performance of bank share prices hold the key to relative performance of any bourse in the EM universe. Provided our positive bias toward Indian banks relative to their EM peers on all the above parameters, we are upgrading our allocation to India from neutral to overweight within EM equity portfolios. Indian Versus Chinese Public Banks From 2003 to 2012, India went through a large credit binge and capital misallocation cycle in its industrial and infrastructure sectors. During this period, banks' loans to companies and bank assets rose from 12% to 23% and 63% to 85% of GDP, respectively (Chart I-2A). By comparison, Chinese (ex-policy) commercial banks' claims on companies and their total assets have surged from 85% to 110% and from under 180% to 230% of GDP, respectively, since 2009 (Chart I-2B). In both countries, the banking sector remains dominated by public banks that hold more than 50% of banking system assets. Chart I-2ACredit Boom In Perspective: India Credit Boom In Perspective: India Credit Boom In Perspective: India Chart I-2BCredit Boom In Perspective: China Credit Boom In Perspective: China Credit Boom In Perspective: China Today, Indian public banks - who were the main lenders to industrial companies during the corporate credit binge in the 2003-12 period - have been experiencing mushrooming bad loans. Total public banks' NPLs and distressed asset ratios have reached 13.5% and 2.7% of total loans, respectively (Chart I-3). By contrast, for all Chinese banks, the current NPL ratio is at a mere 1.7%, while the distressed loan ratio stands at only 3.6% of total loans. Chart I-3NPL Ratios In Perspective: India & China NPL Ratios In Perspective: India & China NPL Ratios In Perspective: India & China Further, under pressure from the central bank, Indian public banks have been raising provisioning levels for bad assets very aggressively. On the flip side, Chinese regulators have been following tolerant policies toward their own commercial banks. As such, the provisions-to-loans ratio at all public banks now stands at 3% in China, compared with 5.6% in India. In addition, Chinese banks have bought a lot of corporate bonds that are not provisioned for at all. Does this higher NPL ratio in India relative to China mean that credit allocation is much worse in India? Not quite. The thesis that Indian public banks are more poorly managed than Chinese public banks is not accurate. These banks are managed by public sector executives who often allocate credit to support government growth policies. This is why it is reasonable to assume that the quality of credit allocation among Chinese and Indian public banks is probably similar. As such, we presume that Chinese banks' current NPL ratio is severely understated, and has the potential to rise to levels currently being reported by Indian public banks. The basis is that the Chinese credit boom has dramatically exceeded that of India (see Chart I-2A and I-2B on page 2). Typically, the resulting NPL ratio is proportional to the magnitude of the preceding credit frenzy. Finally, India's central government announced a major recapitalization plan in October 2017 to assist the country's public banks in cleaning up their balance sheets and to also support them in expanding credit. It is likely, therefore, that these banks are now approaching the final stages of their balance sheet repair and deleveraging process. Bottom Line: India's public banks are much further along in their necessary adjustment, and their credit cycle downturn is also much more advanced relative to Chinese banks. The latter have been postponing the inevitable balance sheet clean-up process. To capitalize on this theme, we recommend going long Indian banks and shorting Chinese bank stocks. Banking Stress Test For India And China We have conducted stress tests for India's top seven and China's top five listed public banks. We used the following assumptions for the three scenarios we considered: Non-performing risk-weighted assets (NPA) ratios to rise to 14% (pessimistic), 12% (baseline) and 10% (optimistic scenario) of risk-weighted assets for both Indian and Chinese public banks. Risk-weighted assets adjust banks' various types of assets based on their degree of riskiness. In that way, the risk-weighted asset values are comparable between the two banking systems. We assume a 30% recovery rate in all three NPA scenarios for both countries. The recovery rate on Chinese banks' NPAs in the 2001-2005 period was 20% amid a booming economy. The assumed recovery rate of 30% is therefore not low. The outcome of the stress tests is as follows: In the baseline scenario of 12% NPA, the losses post recovery and provisions would amount to 1.3 trillion rupees in India (0.9% of GDP) and RMB 3.4 trillion in China (4.2% of GDP). This would translate into a 33% equity impairment for India's seven public banks, and 48% for China's five public banks (Table I-1 and I-2, column 7). Table I-1Stress Test For Top 7 Indian Public Banks Long Indian / Short Chinese Banks Long Indian / Short Chinese Banks Table I-2Stress Test For Top 5 Chinese Public Banks Long Indian / Short Chinese Banks Long Indian / Short Chinese Banks From a valuation standpoint, the post-impairment price-to-book value (PBV) ratio would jump to 1.44 and 1.62 for Indian- and Chinese-listed public banks, respectively. Assuming a fair PBV ratio of 1.3 - which is the average PBV ratio for all EM banks since 2011 - Indian public banks are 11% overvalued and Chinese ones are about 25% overvalued. In other words, if one were to calculate the true PBV ratio of these banks after a comprehensive "clean-up" has been done, then Indian public bank stocks would be cheaper than Chinese ones. It is important to note that the above valuation exercise does not take into consideration banks' future profits. As such, we account for their recurring profits in the following manner: Table I-3 calculates the ratio of NPA losses to banks' recurring net profits before provisioning. Losses are the amount to be written-off post provisioning and recovery. In the baseline scenario of a 12% of NPA, this ratio is 2.5 for India and 3.4 for China. In other words, it will take 2.5 and 3.4 years of net profits before provisions close the "black hole" of NPA losses (post provisions and recovery) in India and China, respectively. Hence, on this measure as well, India's listed public banks appear more appealing than those in China. Table I-3Profit Coverage Of Loan Losses Long Indian / Short Chinese Banks Long Indian / Short Chinese Banks There is a caveat regarding Chinese banks' stress and their post-impairment book value. Our analysis is performed based on risk-weighted assets, and does not include off-balance-sheet assets. Therefore, any losses from off-balance-sheet assets will make losses for Chinese public banks greater than our analysis captures. Further, the Chinese financial authorities are currently tightening regulations, which will likely curtail banks' off-balance-sheet activities and by extension their profitability. These risks are not present in India, where banks have less off-balance-sheet assets. Bottom Line: Public bank stocks are currently overvalued by about 11% and 25% in absolute terms in both India and China, respectively. This favors Indian bank share prices outperforming their Chinese peers. The fact that the "clean-up" has not yet begun in China reinforces this trade. Banks' Recapitalization In India Saddled with NPLs, Indian public banks have not been willing to lend in recent years. Chart I-4 demonstrates that their loan growth has stalled. Credit to large industrial companies has in particular suffered (Chart I-4, bottom panel), as most of this type of credit is typically extended by public banks. Chart I-4India: Public Bank Loan Growth Has Slumped India: Public Bank Loan Growth Has Slumped India: Public Bank Loan Growth Has Slumped Consequently, India's capital expenditures have languished in recent years, weighing not only on cyclical growth but also depressing long-term productivity and potential growth. In October, the Indian government announced an estimated 2.11 trillion rupees public bank recapitalization program that will be implemented over the next two years. The program is for all public banks, while the above stress test was performed for only the top seven listed public banks. The latter account for around 60% of all public banks' assets, so we assume they will get around 60% of the stated recapitalization amount. The recapitalization program is designed as follows: The central government plans to inject 180 billion rupees of equity capital into all public banks via budgetary allocations. The public banks will in turn raise 580 billion rupees from the market. The remaining 1,350 billion rupees will come from government-issued Bank Recapitalization Bonds. The government will issue bonds to banks and then use the funds to buy more shares from public banks. It is important to note that in the stress test above and for the calculation of post-impairment PBV ratios, we assume the government will not subsidize existing shareholders when it injects money into public banks. This means the government will provide equity capital to public banks at post-impairment equity value - i.e., at a fair market price. It will be difficult for the Indian government to bail out its public banks without making current shareholders bear losses. If the government bails out public banks' private and foreign shareholders, the opposition parties will use the bank recapitalization program against Prime Minister Narendra Modi's government in the general elections scheduled to be held in 2019. Many investors and commentators assume that India's bank recapitalization program is automatically bullish for bank share prices. While it is positive for banks' ability to lend and drive growth in the medium and long term, the program is not necessarily bullish for share prices, particularly at their current high levels. The same is true for potential recapitalization programs in China. Overall, odds are that current shareholders of public banks will likely shoulder meaningful losses in India and possibly in China as well. How well off will capitalized public banks in India be after implementation of the recapitalization program? In the case of the seven Indian public banks we performed the stress test on, Table I-4 estimates that post-impairment and recovery, the total equity capital-to-risk-weighted assets ratio will be 8% in our baseline scenario. This is lower than the regulatory minimum of 9%. Table I-4Capital Ratios For India's Top 7 Public Banks Long Indian / Short Chinese Banks Long Indian / Short Chinese Banks The recapitalization will bring this equity capital adequacy ratio to 11.3%, which exceeds the regulatory minimum of 9%. Hence, after the program is completed, Indian public banks will likely become well capitalized and will be able to resume their lending and expand their assets. This in turn will facilitate the economic recovery. Bottom Line: The Indian government's recapitalization program is sufficient to raise public banks' capital adequacy ratio above the regulatory minimum. This will allow public banks to resume their lending. India's Cyclical Growth Outlook India's cyclical outlook will be one of muted recovery. Yet it is superior to other EMs, where we expect meaningful deceleration due to a potential slowdown in China and a rollover in commodities prices. Public banks' recap program will be slow in India - to be conducted over the next two years - and banks' ability to boost lending will improve only gradually. Meanwhile, private banks have and will probably continue to concentrate their lending efforts on consumers rather than on industrial companies and infrastructure. In the next 12-18 months, a slow improvement in public banks' ability to originate credit will allow only moderate improvement in capital spending growth. The latter is required to resolve bottlenecks and unleash the nation's productivity potential. Several indicators of capital spending are lukewarm (Chart I-5, top panel). However, new capex project announcements and the number of investment proposals have been dropping (Chart I-5, middle panel). Surprisingly, companies' foreign external borrowing is still contracting, despite booming capital inflows into EM (Chart I-5, bottom panel). On the consumer side, the outlook remains bright. Motorcycle sales have recovered sharply and commercial vehicle sales are beginning to pick up (Chart I-6). Chart I-5India's Capital Spending Is Sluggish India's Capital Spending Is Sluggish India's Capital Spending Is Sluggish Chart I-6Indian Consumer Health Is Strong Indian Consumer Health Is Strong Indian Consumer Health Is Strong Consumer/personal loans are accelerating from an already strong growth rate, largely thanks to the aggressiveness of private sector banks (Chart I-6, bottom panel). In turn, the employment outlook is finally beginning to show signs of improvement (Chart I-7). The manufacturing PMI has also risen substantially, and is currently in expansion territory (Chart I-8). Likewise, the service sector PMI has bounced above 50. Chart I-7India's Employment Is Turning The Corner India's Employment Is Turning The Corner India's Employment Is Turning The Corner Chart I-8India: PMIs Are Positive India: PMIs Are Positive India: PMIs Are Positive Finally, India is less exposed to China's growth and a retracement in commodities prices than many other emerging economies. This makes us upbeat on India's cyclical economic dynamics and relative equity and currency performance versus other EMs. Bottom Line: India's cyclical outlook is better than that of many other EMs. Structural Tailwinds And Impediments India holds huge promise for investors as it is a much-underinvested economy, and potential return on capital is considerably higher in those countries than in relatively overinvested ones. In addition, its population and labor force growth are among the highest in mainstream developing countries. On the other hand, for such potential to be realized, the country needs to be able to boost its productivity. On this count, the outlook is less positive. India's share of global goods and services exports has declined substantially since 2011 (Chart I-9). This should not be surprising, given weak investment spending has led to stagnation in trade competitiveness. Chart I-10 reveals that based on the UNCTAD1 dataset, India has been losing market share in both low- and high-skilled labor sectors export markets worldwide. Chart I-9India's Share In Global Trade India's Share In Global Trade India's Share In Global Trade Chart I-10India Has Been Losing Export Market Share India Has Been Losing Export Market Share India Has Been Losing Export Market Share While certain reforms such as the introduction of a sales tax will have a positive impact on the economy, other much-needed changes, such as land and labor market reforms, have so far remained unattainable. Moreover, the agriculture sector still faces material challenges. Without these vital reforms, it will be difficult to boost efficiency and productivity and build global competitiveness. Finally, in terms of education enrollment, India lags other EMs, especially China, in tertiary education (Chart I-11). This makes it even more difficult to boost productivity and growth potential. Bottom Line: India has great secular potential, but the structural advance has stalled since 2011. The jury is still out on whether it can implement additional reforms to realize this potential. Investment Conclusions India's banking sector outlook is brighter, and the deleveraging cycle is much more advanced, compared with many other EMs in general and China in particular. Therefore, we recommend a new relative equity trade: long Indian banks / short Chinese banks. Investors could buy Indian public banks or all banks with the understanding that private banks are typically in better shape than their state-owned peers, but are also much more expensive. We will be tracking this trade's performance using the Bankex index for India and the MSCI bank index for China. The Bankex index has a larger share of market cap of public banks than the MSCI India bank index. Within China, we are maintaining our short small and medium / long large banks position initiated on October 26th 2016. We are also recommending EM equity investors upgrade the Indian bourse from neutral to overweight. We shifted Indian stocks from overweight to neutral on August 23rd 2017, but the risk-reward has improved since then (Chart I-12). Chart I-11India's Education Improvement Is Lagging India's Education Improvement Has Stalled India's Education Improvement Has Stalled Chart I-12Upgrade Indian Bourse Within EM Universe Upgrade Indian Bourse Within EM Universe Upgrade Indian Bourse Within EM Universe Our primary concerns with EM stocks are a China slowdown, a rollover in commodities prices and a rebound in the U.S. dollar. Associated strains in countries with large foreign debt levels or wide current account deficits as well as lack of credit deleveraging and bank recapitalization will define EM financial markets' performance in the next 12-18 months. On all of these counts, India scores better than many EMs, justifying this equity upgrade. The absolute outlook for Indian stocks, however, is not inspiring. This equity market is rather expensive and overbought in absolute terms. If EM risk assets experience a setback in 2018, as we expect, Indian equities will also relapse in absolute terms. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com   1 United Nations Conference on Trade and Development.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Equities have melted up in recent weeks, celebrating the tax bill passage, synchronized upswing in global economic data, still quiescent inflation and near vanishing tail risk. On July 10th when we penned the "SPX 3,000?" report, the S&P 500 was close to 2400.1 Over the past six months stocks have been in an uninterrupted upleg, moving to within 10% of our SPX 3,000 target. Table 1 White Paper: Introducing Our U.S. Equity Sector Earnings Models White Paper: Introducing Our U.S. Equity Sector Earnings Models Stocks have run "too far too fast" for our liking and there are increasing odds of a healthy pullback, especially now that no pundits are talking of a correction. In addition, were the selloff in the bond markets to accelerate in a short time frame, at some point it will cause equity market consternation. But, bonds still remain extremely overvalued versus stocks (Chart 1). Late last year, we began to modestly de-risk the portfolio via booking impressive gains in tactical market-neutral trades, as our upbeat cyclical view remains intact.2 Our cyclical strategy is to "buy the dip", as we do not foresee a recession in the coming 9-12 months. Importantly, profits will dictate the S&P 500's direction and the cyclical path of least resistance is higher still. Our SPX profit model continues to forecast healthy EPS growth in 2018 (Chart 2) and as we posited in the last report of 2017, earnings will do the heavy lifting at the current juncture with the forward P/E multiple likely moving laterally (Chart 3). Chart 1Simple Bond Valuation Metric Says:##br## Bonds Are Overvalued Vs. Stocks Simple Bond Valuation Metric Says: Bonds Are Overvalued Vs. Stocks Simple Bond Valuation Metric Says: Bonds Are Overvalued Vs. Stocks Chart 2All ##br##Clear All Clear All Clear Chart 3EPS Will Do The##br## Heavy Lifting In 2018 EPS Will Do The Heavy Lifting In 2018 EPS Will Do The Heavy Lifting In 2018 A simple decomposition shows that equity returns could reasonably reach a low-to-mid double digit level this year. Our assumptions are the following: nominal GDP can grow near 5% (3% real plus 2% inflation) and thus we estimate organic EPS growth that typically mimics GDP at this stage of the cycle of ~5%, ~2% dividend yield, ~2% buyback yield, ~5% tax related boost to EPS and no multiple expansion. The above assumptions are based on four key drivers: energy and financials will command a larger slice of the earnings pie,3 synchronized global capex upcycle will boost EPS,4 delayed positive translation effects from the U.S. dollar will lift profits5 and easy fiscal policy will also act as a tonic to EPS.6 On this note, this White Paper officially introduces the U.S. Equity Strategy earnings models for the eleven GICS1 equity sectors. We have identified key macro earnings drivers for each sector and incorporated them into individual sector models. The objective is to forecast the direction of earnings growth. Beyond introducing our EPS models, the purpose of this White Paper is to also compare and contrast the cyclical readings of our equity sector models with sell-side analysts' profit growth (Charts 4 & 5) and margin expectations and help clients position portfolios for the rest of 2018. The earnings models carry the most weight in determining our sector positioning, with our macro overlay and our valuation and technical indicators rounding out our methodology. Currently, our earnings models are consistent with maintaining a mostly cyclically biased portfolio structure (top panel, Chart 6), and thus participating in the broad market's overshoot. Chart 4What EPS Are Priced In... What EPS Are Priced In... What EPS Are Priced In... Chart 5...Per Sector For 2018 ...Per Sector For 2018 ...Per Sector For 2018 Chart 6Continue To Prefer Cyclicals Over Defensives Continue To Prefer Cyclicals Over Defensives Continue To Prefer Cyclicals Over Defensives Encouragingly, an equal weight of the 10 GICS1 sector model outputs (we are excluding real estate due to lack of history), accurately forecasts the S&P 500's profit growth (bottom panel, Chart 6), and currently also confirms the broad market's upbeat four factor macro EPS model (Chart 2). Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Financials (Overweight) Our financials earnings growth model comprises bank credit growth, the U.S. dollar index and net earnings revisions. The U.S. credit impulse is gaining traction, indicating that the market has digested the almost doubling in long-term rates over the past 18 months. Bankers are willing extenders of C&I credit and, with the economy humming north of 3% in real GDP terms, the outlook for loan growth is excellent. Loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities are all welcome news for financials profitability. Tack on BCA's higher interest rate view in 2018 and net interest margins will also get a bump, further adding to the sector's EPS euphoria. Credit quality is the third key profit driver for bank profitability and pristine credit quality is a harbinger of increased profits. The unemployment rate is plumbing generational lows and suggests that non-performing loans as a percentage of total loans will remain on a downward trajectory. Our profit model is expanding at twice the current profit growth rate (second panel, Chart 7) and 10 percentage points above the Street's 12-month forward estimates (top panel, Chart 5). In fact, the latter have gone vertical of late playing catch up to our model's estimates. The S&P financials sector remains a core portfolio overweight and we reiterate our high-conviction overweight status in the heavyweight S&P banks index. Chart 7Financials (Overweight) Financials (Overweight) Financials (Overweight) Energy (Overweight) The three drivers behind the S&P energy sector EPS growth model are oil-related currencies, the U.S. oil & gas rig count and WTI crude oil prices. A depreciating greenback, whittling down OECD oil stocks and rising global oil demand are all boosting energy profitability. OPEC 2.0 cutbacks have not only helped stabilize oil markets, but also paved the way for a breakout in oil prices above the $62.50/bbl stiff resistance level. Sustained OPEC output restraint will counterbalance U.S. shale oil production increases and coupled with rising global demand likely continue to underpin oil prices. Our synchronized global capex upcycle theme included the basic resources following a multi-year drubbing in outlays. Energy capex cannot contract at double digit rates indefinitely. Already a V-shaped capex momentum recovery is in store, as 2018 capital spending budgets are on track to at least match 2017. Our EPS growth model (second panel, Chart 8) matches sell-side analyst optimism (third panel, Chart 5). Keep in mind that only recently did the energy space become profit positive, making a solid recovery from an extremely low base. Margins are only now renormalizing above the zero line and breakneck pace EPS growth should continue in 2018. Following a negative 2017 return, the S&P energy sector is the best performing sector year-to-date, and we reiterate the high-conviction overweight stance. Chart 8Energy (Overweight) Energy (Overweight) Energy (Overweight) Industrials (Overweight) Our S&P industrials EPS model comprises the ISM manufacturing survey, raw industrials commodity prices and interest rates. It has an excellent track record in forecasting industrials EPS momentum, and sports one of the highest explanatory powers amongst all sector EPS models. While industrials EPS growth has been bouncing off the zero line for the better part of the past five years, our profit model has spoken: forecast EPS are in a V-shaped recovery since the end of the recent manufacturing recession (second panel, Chart 9). Commodity prices are recovering and increasing final demand, coupled with a soft U.S. dollar suggest that more gains are in store. Tack on the global virtuous capex upcycle, and the stars are aligned for this deep cyclical sector to break out of its multi-year trading range funk on the back of a surge in profits. China is a wild card, but signs of stability are enough to sustain the upward trajectory in the commodity-levered complex, including industrials stocks. Our industrials sector EPS model suggests that industrials profits will easily surpass the low (and below the overall market) analysts' EPS growth hurdle (third panel, Chart 4). The late-cyclical S&P industrials sector remains an overweight. Chart 9Industrials (Overweight) Industrials (Overweight) Industrials (Overweight) Consumer Staples (Overweight) The S&P consumer staples EPS growth model key drivers are: food exports, non-discretionary retail sales and analysts' net earnings revision ratio. Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (middle panel, Chart 10). Our model is expanding at a near double digit rate, and is in line with 12-month forward EPS growth estimates (second panel, Chart 4). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put out positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. This small hedge will serve our portfolio well if we do indeed get a healthy Q1/2018 pullback, as we expect. Chart 10Consumer Staples (Overweight) Consumer Staples (Overweight) Consumer Staples (Overweight) Consumer Discretionary (Neutral - Downgrade Alert) Measures of consumer confidence, consumer discretionary exports and the net earnings revisions ratio comprise BCA's global consumer discretionary EPS growth model, which has an excellent track record in forecasting the path of consumer discretionary profits. Consumer confidence is rolling over, albeit from a nose-bleed level, signaling that, at the margin, discretionary consumer outlays will remain tame. Worrisomely, rising interest rates coupled with a breakout in crude oil prices are net negatives for consumer spending. Our consumer drag indicator captures these consumer headwinds and warns that the sector is not out of the woods yet (bottom panel, Chart 11). The Fed is on track to raise rate three more times in 2018 and continue to mop up liquidity via renormalizing its balance sheet. This dual tightening backdrop bodes ill for early cyclical discretionary stocks as we highlighted in the September 25th Weekly Report. Our consumer discretionary EPS growth model is making an effort to bounce, signaling that contracting earnings will likely reverse course and come out of their recent funk (second panel). But, analysts are overly optimistic penciling in a near double-digit profit growth backdrop for the consumer discretionary sector (fourth panel, Chart 5). Netting it all out, the anemic message from our profit model along with the ongoing Fed tightening cycle and spiking energy prices warrant a downgrade alert. Stay tuned. Chart 11Consumer Discretionary (Neutral-Downgrade Alert) Consumer Discretionary (Neutral-Downgrade Alert) Consumer Discretionary (Neutral-Downgrade Alert) Telecom Services (Neutral) Telecom pricing power and capital expenditures expectations comprise our S&P telecom services EPS growth model. Telecom capital expenditures have bounced off the zero line and are growing at 4% per annum while sector sales growth has been nil. This capital-intensive industry must continually invest to stay relevant. A push by telecom carriers into TV offerings as part of a quad-play (internet, wireline, wireless and TV) has rekindled an M&A boom, and capex is slated to increase. However, margins will suffer if increased investment fails to translate into new sales (bottom panel, Chart 12). Steeply contracting pricing power is a bad omen both for top and bottom line growth prospects (fourth panel). Hopefully, industry consolidation will lead to a better pricing backdrop, but the jury is still out. Our EPS model has sunk into the contraction zone (second panel). Analysts are a little bit more sanguine, penciling in low single-digit profit growth (bottom panel, Chart 4). Industry deflation is not alone as a headwind as the bond market selloff is weighing on the high dividend yielding telecom services stocks. Despite all the bearish news, near all-time lows in relative valuation and washed out technicals are keeping us on the sidelines. Chart 12Telecom Services (Neutral) Telecom Services (Neutral) Telecom Services (Neutral) Materials (Neutral) Materials EPS growth is a far cry from the near 100% year-over-year mark hit during the commodity super-cycle the mid-2000s and the reflex rebound following the Great Recession (second panel, Chart 13). Our S&P materials EPS model inputs include the U.S. currency, metals commodity prices and a measure of borrowing costs. The model has been steadily decelerating recently, and moving in the opposite direction compared with sell-side analysts' optimistic estimates (bottom panel, Chart 5). Consequently, there is scope for downward revisions. Materials stocks are reflationary beneficiaries and also high fixed cost high operating leverage deep cyclicals that benefit most during the later stages of the business cycle when a virtuous capex/EPS upcycle takes root. A number of both developed and developing central banks have recently embarked on tightening monetary policy following in the Fed's footsteps. Global liquidity is on the verge of getting mopped up as even the ECB and the BoJ have started to hint that they would remove some of their ultra-accommodative and unconventional policy measures. These opposing forces keep us at bay and we continue to recommend a benchmark allocation in the S&P materials index. Chart 13Materials (Neutral) Materials (Neutral) Materials (Neutral) Real Estate (Neutral) Commercial real estate loan demand, a labor market measure and the EUR/USD comprise our S&P real estate profit growth model (second panel, Chart 14). The 10-year Treasury yield and real estate relative performance have been nearly perfectly inversely correlated since the GFC as REITs sport a hefty dividend yield and thus are considered a fixed income proxy. BCA's higher interest rate 2018 theme suggests that more downside looms for this rate-sensitive sector. Similarly, a firming EUR/USD reflecting the nearly 100% domestic exposure of the sector weighs on real estate relative performance. Our EPS model has recently sunk into the contraction zone and is in sync with sell-side analysts' negative profit growth figures for calendar 2018 (second panel, Chart 5). While all this signals that an underweight stance is appropriate, we would rather stay on the sidelines for three reasons: First, sector pricing power (mostly rents) has not eroded yet, despite the surge in multi-family housing construction. Second, most of the bad news is likely already discounted in sinking valuations and extremely oversold technicals. Finally, we would rather concentrate our interest rate related underweight in the pure play fixed income proxy, the utilities sector (please see page 15). Stick with a benchmark allocation in the S&P real estate index. Chart 14Real Estate (Neutral) Real Estate (Neutral) Real Estate (Neutral) Health Care (Underweight) Our S&P health care EPS growth model consists of health care pricing power, labor costs and a measure of health care outlays. Health care demand is fairly inelastic, signaling that health care spending prospects remain upbeat, especially given the aging population. However, the industry's up-to-recently structurally robust pricing power backdrop is under intense scrutiny. Medical commodity cost inflation is melting and drug pricing power has nearly halved since early 2016. Democrats and Republicans alike, despise the pharmaceutical/biotech industry's pricing tactics and drug price containment is on nearly every legislator's agenda. Add on the generic drug inroads, and Big Pharma/biotech resilient profits appear vulnerable, weighing heavily on the sector's relative performance. From a secular perspective, there is scope for health care sector profit gains. Developing countries are only just starting to institute social "safety nets" that the developed world already has in place. Our profit model is decelerating (second panel, Chart 15) and forecasting single digit EPS growth, in line with the Street's 12-month forward profit estimates (fourth panel, Chart 4). The S&P health care sector is a core underweight portfolio holding and we reiterate the high-conviction underweight status in the heavy weight S&P pharma sub index. Chart 15Health Care (Underweight) Health Care (Underweight) Health Care (Underweight) Utilities (Underweight) Utilities pricing power, the yield curve and analysts' net earnings revisions are the key inputs in our S&P utilities EPS growth model (second panel, Chart 16). While natgas prices, the industry's marginal price setter, have been stuck in a trading range between $2.6 and $3.4/mmbtu over the past 18 months, they are currently contracting and weighing heavily on industry pricing power. The U.S. economy is firing on all cylinders (bottom panel, Chart 16) and a selloff in the 10-year Treasury market near 3% is BCA's base-case scenario for 2018. Under such a backdrop, fixed income proxied defensive equities lose their luster, and thus utilities stocks will likely remain under intense downward pressure, Our S&P utilities EPS growth model is expanding at a mid-single digit growth rate, broadly in line with sell-side analysts' forecasts (fifth panel, Chart 4) and roughly 700bps below the broad market. The S&P utilities sector is a high-conviction underweight. Chart 16Utilities (Underweight) Utilities (Underweight) Utilities (Underweight) Technology (Underweight - Upgrade Alert) Our three-factor global technology EPS growth model includes capex intentions, the trade-weighted U.S. dollar and sell-side analysts' net earnings revision ratio. While the tech sector is still largely considered a deep cyclical, we view it as more defensive. The majority of large capitalization tech companies are mature, cash rich, cash flow generating, dividend paying and high margin. Tech firms thrive in a deflationary backdrop as business models have been built to withstand the inherently disinflationary "creative destruction" process. BCA's interest rate view calls for an inflationary driven sell off in bonds for 2018, suggesting that investors avoid high-flying tech stocks. Weakness in basic resources explains most of the delta in cyclical capital outlays. Encouragingly, technology's share of the U.S. capex pie is making inroads rising to roughly 10% (bottom panel, Chart 17). Tech investment has been so abysmal for so long that it is hard to get any worse. In fact, it has started to improve both on an absolute and relative basis, as pent-up tech demand is being unleashed. Our synchronized global capex upcycle theme is gaining traction and the tech sector will continue to make gains at the expense of resource-related spending. Our global tech EPS model is forecasting modest double-digit growth in the coming quarters (second panel, Chart 17), largely aligned with sell-side analysts' profit growth expectations (fifth panel, Chart 5). On balance, we are putting the S&P tech sector on upgrade alert reflecting the capex tailwind offsetting the rising interest rate backdrop, and reiterate our capex-related high-conviction overweight in the S&P software sub-index. Chart 17Technology (Underweight-Upgrade Alert) Technology (Underweight-Upgrade Alert) Technology (Underweight-Upgrade Alert) 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And "Nothing Else Matters"," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Dissecting Profit Composition," dated July 24, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Dollar The Great Reflator," dated September 18, 2017, available at uses.bcaresearch.com. 6 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.

Highlights Chart 1Bond Bear On Pause? Bond Bear On Pause? Bond Bear On Pause? The start of a new year often brings optimism and nowhere is this more evident than in economic projections. In three of the past four years (2017 being the exception) Bloomberg consensus GDP growth expectations ended the year lower than where they began. A related pattern played itself out in the Treasury market. At the turn of each of the past four years the average yield on the Bloomberg Barclays Treasury Index increased in December only to fall back in January. In two of those instances the January decline exceeded the December increase. Should we expect a similar January bond rally this year? Our favorite short-term indicators are not sending a strong signal (Chart 1). Net speculative futures positions weakly suggest that the 10-year yield will be lower in three months, but our auto regressive model suggests the Economic Surprise Index will still be in positive territory at the end of the month. In a recent report we showed that yields tend to rise in months where the Surprise Index is above zero.1 Perhaps most importantly, our 2-factor Treasury model shows that yields are significantly lower than is suggested by global economic fundamentals. Maintain below-benchmark duration. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 49 basis points in December and by 335 bps in 2017. At 94 bps, the average index spread is 28 bps tighter than at the beginning of 2017 and investment grade corporate spreads are extremely expensive compared to history (Chart 2). After adjusting for changes in the average duration of the index over time, we calculate that A-rated corporate spreads have only been tighter 5% of the time since 1989 (panel 2), and Baa-rated spreads have only been tighter 7% of the time (panel 3). Essentially, at this stage of the credit cycle we should expect excess returns no greater than carry. As for the credit cycle itself, we noted in our last report that with corporate balance sheets deteriorating, low inflation and still-accommodative monetary policy are the sole supports for corporate spreads.2 We expect spreads will start to widen later this year once inflation rises and policy becomes more restrictive. With excess returns likely to be lower in 2018 than in 2017, we should also expect a lower marginal return from increasing the riskiness within credit portfolios.3 For investors looking to scale back on credit risk, our model shows that Financials and Technology are the most attractive low-risk sectors. Energy, Basic Industry and Communications are all attractive high-risk sectors (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* January Effect January Effect Table 3BCorporate Sector Risk Vs. Reward* January Effect January Effect High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 23 basis points in December and by 602 bps in 2017. The average index option-adjusted spread tightened 1 bp on the month and 66 bps in 2017. Though spreads appear somewhat more attractive than for investment grade corporates, there is still not much room for spread compression in high-yield. In fact, we calculate that if the high-yield index spread tightens another 117 bps, junk bonds will be the most expensive they have been since 1995. In an optimistic scenario where the index spread tightens 100 bps, bringing it close to all-time expensive levels, then we would expect junk excess returns to be in the range of 600 bps (annualized). Given trends in corporate leverage, another 100 bps of spread tightening should be viewed as unlikely. More realistically, we expect excess returns in the range of 200 bps to 500 bps (annualized) between now and the end of the credit cycle (Chart 3). Given our forecast for default losses, flat spreads translate to a 12-month excess return of 213 bps. An additional warning sign for junk spreads is that the slope of the 2/10 Treasury curve is hovering around 50 bps. We showed in a recent report that when the 2/10 slope is between 0 bps and 50 bps, junk bonds underperform Treasuries in 48% of months, and average monthly excess returns (though still positive) are much lower than when the curve is steeper.4 MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 16 basis points in December and by 51 bps in 2017. The conventional 30-year zero-volatility MBS spread narrowed 2 bps in December, the combination of a flat option-adjusted spread (OAS) and a 2 bps decline in the compensation for prepayment risk (option cost). The Z-spread widened 2 bps in 2017, as an 8 bps OAS widening was offset by a decline of 6 bps in the compensation for prepayment risk. The substantial OAS widening in early 2017 was almost certainly caused by investors pricing-in the eventual run-off of the securities on the Fed's balance sheet. Now that run-off has begun we see no obvious catalyst for further OAS widening in the months ahead. Turning to the compensation for prepayment risk, with Treasury yields biased higher as the Fed continues to lift rates, we see little risk of a material increase in refinancing activity. This will ensure that overall MBS spreads stay capped near historically low levels (Chart 4). All in all, with MBS OAS looking more attractive relative to Aaa-rated credit than at any time since 2015 (panel 3), we think this is an opportune time for investors looking to de-risk their portfolios to shift some of their spread product allocation away from corporate bonds and into MBS. We already upgraded our recommended allocation to MBS from underweight to neutral in October, and will likely further increase exposure as we advance toward the end of the credit cycle. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 5 basis points in December, but outperformed by 216 bps in 2017. Sovereign bonds underperformed the Treasury benchmark by 36 bps in December, Foreign Agencies and Domestic Agencies underperformed by 8 bps and 1 bp, respectively. Local Authorities outperformed the benchmark by 17 bps, and Supranationals underperformed by 1 bp. Sovereign bonds were the best performers within the Government-Related index in 2017, delivering excess returns of 538 bps relative to duration-matched U.S. Treasuries. This outperformance was concentrated early in the year and was driven by the sharp depreciation of the U.S. dollar (Chart 5). With the market still priced for a relatively modest 63 bps of Fed rate hikes during the next 12 months, further sharp dollar depreciation appears unlikely. We recommend an underweight allocation to Sovereign debt. We remain overweight Local Authority and Foreign Agency bonds, sectors that delivered excess returns of 420 bps and 248 bps, respectively in 2017. Despite the outperformance, both of these sectors still offer attractive spreads after adjusting for credit rating and duration. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 15 bps and 17 bps of option-adjusted spread, respectively. We much prefer Agency-backed MBS and CMBS which are also relatively low risk and offer option-adjusted spreads of 28 bps and 42 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 99 bps in December and by 332 bps in 2017 (before adjusting for the tax advantage). The average Aaa Municipal / Treasury (M/T) yield ratio fell 5% in December, and is 12% below where it began 2017 (Chart 6). The recent decline follows a sharp increase that was driven by fluctuating supply trends related to the passage of U.S. tax legislation. The final tax bill ends the practice of advance refunding municipal bonds. As a result, December set a new high of $55.6 billion for municipal issuance as issuers rushed to get their advance refunding deals to market before the bill was passed (panel 3). Now that the bill has passed, visible supply has evaporated and the average M/T yield ratio has fallen back to one standard deviation below its post-crisis mean. The absence of advance refunding will bias municipal bond issuance lower in 2018, thus removing one potential risk for yield ratios. The M/T yield ratio for short maturity debt has risen considerably relative to the yield ratio for long maturity debt in recent months (panel 2), and the risk/reward trade-off now appears more balanced. We close our recommendation to favor long maturities versus short maturities on the Aaa Muni curve. The third quarter update of our Muni Health Monitor showed a slight improvement (panel 5), but still no clear reversal of trend. Although health remains supportive for now - and consistent with municipal upgrades outpacing downgrades - with yield ratios close to their lows we maintain an underweight allocation to Municipal bonds.  Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in December. The 2/10 Treasury slope flattened 13 bps on the month, and the 5/30 Treasury slope flattened 15 bps. The evolution of the Treasury curve in 2018 will come down to a trade-off between how quickly inflation rises versus how quickly the Fed lifts rates. For example, in a recent report we showed that the 10-year Treasury yield will likely settle into a range between 2.80% and 3.25% by the time that core PCE inflation reaches the Fed's 2% target.5 That same report shows that if that adjustment occurs relatively quickly, and the Fed has only lifted rates once or twice between now and then, then the 2/10 Treasury slope is much more likely to steepen than to flatten. Conversely, if the Fed lifts rates three or four more times between now and the time that inflation returns to target, then the curve is more likely to flatten. For our part, we think it is wise to maintain a position long the 5-year bullet and short a duration-neutral 2/10 barbell. Such a position profits from a steeper curve, and our model shows that the butterfly spread is currently priced for significant curve flattening (Chart 7). According to our model, the 2/5/10 butterfly spread is discounting 27 bps of 2/10 flattening during the next six months.6 In other words, if the 2/10 slope steepens or flattens by less than 27 bps, then our recommended position will profit. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 41 basis points in December, but underperformed by 43 bps in 2017. The 10-year TIPS breakeven inflation rate went on a wild ride last year. It started 2017 at 1.95% and, driven by strong inflation prints and continued post-election euphoria, reached as high as 2.09% in January. The breakeven dropped to a low of 1.66% in June, as inflation started to disappoint in the second quarter, but has rebounded during the past couple of months and just recently broke back above 2%. The 10-year TIPS breakeven rate is currently 2.02%, above where it began 2017. According to our TIPS Financial Model, the recent widening in breakevens is in line with the message from other related financial market instruments (Chart 8). Specifically, oil prices, the trade-weighted dollar and the stock-to-bond total return ratio. Further, measures of pipeline inflation pressure continue to signal an increase in inflationary pressures (panels 3 and 4), and the trimmed mean PCE shows that the realized inflation data are forming a tentative bottom (bottom panel). The annualized 6-month rate of change in the trimmed mean PCE ticked up to 1.68% in November, higher than the 12-month rate of change (1.67%). The 1-month rate of change is higher still at 2.19%, annualized. We continue to see signs that inflation will start to rebound in the coming months, and this will cause long-maturity TIPS breakeven inflation rates to reach a range between 2.4% and 2.5% by the time that inflation returns to the Fed's target. Remain overweight TIPS versus nominal Treasury securities. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities performed in line with the duration-equivalent Treasury index in December and outperformed by 92 basis points in 2017. In 2017, Aaa-rated ABS outperformed the Treasury benchmark by 79 bps and non-Aaa ABS outperformed by 217 bps. The index option-adjusted spread for Aaa-rated ABS widened 1 bp in December, but tightened 21 bps in 2017. It now sits at 31 bps, only 4 bps above its all-time low (Chart 9). At 31 bps, Aaa-rated ABS now offer only a 3 bps spread advantage over Agency-backed MBS, and offer 11 bps less spread than Agency-backed CMBS. With consumer lending standards tightening and delinquency rates rising, we view no more than a neutral allocation to ABS as appropriate. On lending standards, the Fed's October Senior Loan Officer's Survey showed a continued tightening in lending standards on both credit cards and auto loans (panel 4), and also that demand for credit card and auto loans was essentially unchanged from the prior quarter. It also included a set of special questions regarding the reasons for changes in the supply and demand for consumer credit. Banks cited a less favorable or more uncertain economic outlook, a deterioration in existing loan quality and a general reduced risk tolerance as reasons for tightening the supply of credit. The hard data confirm that banks are seeing a deterioration in the quality of their consumer loan books (bottom panel). Although delinquencies remain depressed compared to history, with ABS spreads near all-time tights, rising delinquencies and tightening lending standards make for a poor risk/reward trade-off in the sector. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in December and by 201 bps in 2017. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps in December and 13 bps in 2017. At its current level of 64 bps, the index spread is about one standard deviation below its pre-crisis mean, and only 13 bps above its all-time low reached in 2004 (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we continue to view the risk/reward trade-off in non-Agency CMBS as unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 21 basis points in December and by 133 bps in 2017. The index option-adjusted spread for Agency CMBS tightened 3 bps in December and 13 bps in 2017. At its current level of 42 bps, the sector offers greater option-adjusted compensation than a position in Agency-backed MBS (28 bps) and Aaa-rated consumer ABS (31 bps). Such an attractive spread pick-up in a sector that benefits from Agency backing is surely worth grabbing.   Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.94% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.92%. PMIs across the world continue to surge. December PMI data show increases in the four largest economic blocs (U.S., Eurozone, China, Japan), and more broadly show that 86% of the 36 countries with available data currently have PMIs above the 50 boom/bust line. Meanwhile, bullish sentiment toward the U.S. dollar continues to trend lower in response to strong growth in the rest of the world (bottom panel). This is also a bearish development for U.S. bonds. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.48%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com 6 For further details on the model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)