Valuations

Highlights Hong Kong property prices are frothy and will continue to face headwinds. Real estate currently offers a poor risk-return trade off from an investment perspective, and will likely lag other asset classes in the medium to long run. A replay of another spectacular housing bust is highly unlikely. Several critical differences between the current environment and that of 1997 prevent a meltdown. Favor Hong Kong property developers over property owners strategically. Aim to upgrade the property sector on further decline in prices. Feature Chart 1Hong Kong Property Prices Remain Red Hot Hong Kong Property Prices Remain Red Hot Hong Kong Property Prices Remain Red Hot This coming weekend marks the 20th anniversary of Hong Kong's handover from Great Britain to the People's Republic of China - as well as the onset of the spectacular bust of a massive housing bubble that saw home prices collapsing by 70%. Fast forward 20 years and Hong Kong home prices are once again standing at bubbly highs, with growing consensus that the market is on the verge of another major crash. Some analysts are predicting a 50% decline in the coming years, and officials are also issuing stern warnings. Financial Secretary Paul Chan Mo-po has cautioned that "the risk in the property market is very high." Norman Chan Tak-lam, chief executive of the Hong Kong Monetary Authority (HKMA) has also noted that market conditions today are reminiscent of those in 1997, and has warned there are risks that the property bubble might burst again. We have been equally concerned about Hong Kong housing for a while,1 and have been surprised by its remarkable resilience (Chart 1). After a temporary dip between mid-2015 and early 2016, Hong Kong home prices bounced right back and have been touching records again, even though the authorities have significantly tightened regulations to cool off demand. Stamp duties for home sales have been raised to 15% for local households, except for first-time homebuyers, or as high as 30% for foreign buyers - both of which are draconian measures that immediately squeezed out speculative buyers. The fact that Hong Kong home prices have been able to withstand the aggressive policy crackdown suggests that fundamentals are probably stronger than commonly perceived. We maintain the view that the Hong Kong real estate market will likely continue to face downward pressure, but prevailing concerns in the marketplace appear overdone. The surprise could be that any decline in home prices will likely be smaller than many anticipate. The Anatomy Of Two Property Bubbles Chart 2Monetary Conditions Set The Broad Trend##br## In Property Prices Monetary Conditions Set The Broad Trend In Property Prices Monetary Conditions Set The Broad Trend In Property Prices At the onset, current housing market conditions in Hong Kong share some disturbing similarities with the real estate bubble 20 years ago. From a macro perspective, our fundamental concern is the tightening in monetary conditions, which have historically always boded poorly for Hong Kong asset prices in general and real estate prices in particular (Chart 2). Hong Kong's currency board system copies U.S. monetary policy in totality, and the Federal Reserve's current tightening cycle has led to a notable tightening in Hong Kong monetary conditions, especially through exchange rate appreciation. Moreover, tightening in monetary conditions often leads peaks in asset prices by a long interval. In the 1997 episode, monetary conditions began to tighten in 1993, four years ahead of the ultimate housing bubble peak. This time around, our monetary conditions index for Hong Kong has rolled over since 2012, casting a shadow on home prices from a macro standpoint. Specific to the housing market, there are also plenty of warning signs that home prices are unsustainable at current levels. Home prices have quadrupled in the past 15 years, outpacing nominal GDP as well as household income by a wide margin. In fact, the gap between home prices and household income levels has become much wider than in 1997 (Chart 3). On the surface, housing affordability does not appear as dire as during the peak of the previous bubble. A closer look, however, reveals it is almost entirely due to increasing maturities of mortgage loans over the past two decades (Chart 4). Indeed, the average contractual life of new mortgages has increased from 200 months in the early 2000s to about 320 months currently, leading to a smaller monthly payment for mortgage borrowers but an additional 10 years to pay back all the debt. If mortgage terms were held constant, our calculation shows that housing affordability would be as bad as during the 1997 bubble peak, even considering today's exceedingly low interest rates (bottom panel, Chart 4). Rental yields of Hong Kong residential properties are standing at close to record lows, only marginally higher than government bond yields. In comparison, rental yields dropped below the risk-free rate in the 1990s, but were still much higher even at the peak of the housing bubble than today's level (Chart 5). It is true that interest rates may be structurally lower than in the past, but the Hong Kong housing market is priced for "perfection," leaving no room for negative interest rate surprises. Chart 3Home Prices Massively Outpaced Income Home Prices Massively Outpaced Income Home Prices Massively Outpaced Income Chart 4Housing Affordability: Worse Than Appears Housing Affordability: Worse Than Appears Housing Affordability: Worse Than Appears Chart 5Hong Kong Property Yields: Priced For Perfection Hong Kong Property Yields: Priced For Perfection Hong Kong Property Yields: Priced For Perfection Taken together, investors should remain cautious on the Hong Kong housing sector. It offers a poor risk-return trade off from an investment perspective, and will likely lag other asset classes in the medium to long run. However, there are also some critical differences between the current environment and that of 1997 that make a replay of another spectacular housing bust highly unlikely. Five Key Differences First, there is currently much less speculative activity in the Hong Kong housing market than two decades ago, thanks to regulators' punitive measures against non-first time homebuyers and home "flippers." Overall housing transactions currently are a fraction of the overheated levels in the early 1990s. So-called "confirmor transactions," deals in which properties are re-sold before the original transaction is completed, were as high as 10% of total sales in the run-up to the 1997 housing bubble peak, while today they are practically non-existent (Chart 6). This has made home prices much less vulnerable to a self-feeding downward spiral, when speculators rush to exit when market conditions shift. Second, banks' lending practices, especially for new mortgages, are significantly tighter now than it was in the 1990s. Prior to the 1997 bust, commercial lenders were required to maintain a loan-to-value (LTV) ratio for mortgage loans at a minimum of 70%. The LTV ratio was only cut to 60% in January 1997 when home prices were already excessively high, which in hindsight may well have sown the seeds for the market collapse. This time around, the HKMA has been tightening mortgage and lending standards going as far back as 2009, and the macro-prudential supervision on housing related activity has continued to increase in recent years. Overall, banks' mortgage LTV ratio is currently hovering at 50%, underscoring a massive buffer between banks' asset quality and home prices (Chart 7). Anecdotally, some developers have been offering mortgage loans with higher LTVs for newly built projects. However, new projects account for less than a quarter of total housing transactions, and therefore such practices, even if they were widespread, would not change the situation in a meaningful way. Overall, mortgage lending in Hong Kong is fairly conservative and closely monitored by regulators. In fact, even in the previous dramatic housing downturn, Hong Kong banks' mortgage delinquency ratio peaked out at 1.5%, an extremely low number by any standard. Tightened lending regulations have made the banking sector even less vulnerable to home price declines than 20 years ago. Chart 6Much Less Speculative Housing Demand ##br##Than 20 Years Ago Much Less Speculative Housing Demand Than 20 Years Ago Much Less Speculative Housing Demand Than 20 Years Ago Chart 7Banks Have Significantly Tightened##br## Mortgage Lending Standards Banks Have Significantly Tightened Mortgage Lending Standards Banks Have Significantly Tightened Mortgage Lending Standards Third, it is important to note that another critical reason for the housing crash home prices after 1997 was a dramatic increase in new housing supply. To ease the housing shortage and rampant upward pressure on prices, then-Chief Executive Tung Chee-hwa came to office in 1997 with a promise to build 85,000 units annually for the next 10 years - 35,000 by private developers and 50,000 by the public sector. Mr. Tung was not able to reach these targets, and the housing plan was quickly suspended as home prices collapsed, but his policy still led to a sharp increase in land supply and housing starts, which in turn led to rising housing completions in the following years at a time when demand had vanished - compounding downward pressure on prices (Chart 8). In recent years, even though the Hong Kong government has acknowledged the acute housing shortage, there has been no ambitious plan to increase housing supply. The government expects a total of 96,000 new housing units in the coming three to four years, barely higher than current levels and less than a third of the early 2000s. Without oversupply, any downside in home prices will prove self-limiting. Chart 8Housing Supply: This Time Is Different Housing Supply: This Time Is Different Housing Supply: This Time Is Different Chart 9No Longer Hong Konger's Hong Kong No Longer Hong Konger's Hong Kong No Longer Hong Konger's Hong Kong Fourth, a major difference between now and 20 years ago is the dramatic wealth creation among mainland households, which will offer critical support for the Hong Kong housing market if prices drop precipitously. Chart 9 shows total value of Hong Kong residential properties as a share of local GDP has already surpassed that during the 1997 housing bubble peak, according to our estimate, but as a share of Chinese GDP it is currently standing at a record low. The point is that Hong Kong property has become a store of wealth for rich mainland investors and households. The Hong Kong authorities have been working hard to squeeze out mainland demand for local properties with punitively high taxes - homes purchased by non-Hong Kong permanent residents, mostly mainland Chinese, currently account for less than 1% of total home sales, compared with about 6% in 2012 (Chart 10). These discriminative taxes against mainland buyers can be reversed, should Hong Kong home price drop beyond the Hong Kong authorities' comfort zone. We doubt the Hong Kong government would allow home prices to drop by more than 30% from current levels. Finally, currently Hong Kong property developers' stock prices have priced in a sharp decline in home prices, while the market in general is a lot more complacent than in the previous episode. A simple regression between Hong Kong developers' stocks and property prices suggests that developers' stock prices are about 30% below some intrinsic "fair value" - roughly in line with the developers' current price-to-book ratio (Chart 11, top panel). In 1997, Hong Kong developers' PB ratio was 1.7, roughly comparable to their global peers, despite the obvious froth in underlying property prices (Chart 11, middle and bottom panel). This time around, developers' PB ratio is currently 0.7, on par with the 2003 levels, when home prices had already crashed by 70%. Hong Kong property stocks are trading at over 50% discount to their DM and EM counterparts, based on PB ratios. Chart 10Mainland Chinese Buyers ##br## Have Been Pushed Out Hong Kong Housing Bubble: A Replay Of 1997? Hong Kong Housing Bubble: A Replay Of 1997? Chart 11Hong Kong Property Stocks: ##br##Priced In A Sharp Housing Downturn Hong Kong Property Stocks: Priced In A Sharp Housing Downturn Hong Kong Property Stocks: Priced In A Sharp Housing Downturn Looking forward, our base-case scenario is that Hong Kong developers' stocks will likely remain under downward pressure along with softening home prices. Stock markets are an emotional discounting mechanism, and the Hong Kong bourse has been notoriously volatile. Therefore, periods of undershoots cannot be ruled out. However, it is noteworthy that developers' stock prices may have priced in at least a 30% decline in home prices. Strategically, we still prefer property developers over property owners and aim to upgrade the property sector on further decline in prices. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "The Fed "Lift Off", Hong Kong And The RMB," dated August 12, 2015, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Our new Revealed Preference Indicator (RPI) is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. The RPI borrows from Paul Samuelson's "revealed preference" theory of consumer behavior to market behavior. It combines the idea of market momentum with valuation and the monetary policy backdrop. A trading rule for the stock/bond allocation based on the RPI outperforms traditional technical, monetary, and valuation indicators. It provides a powerful bullish signal if positive equity market momentum lines up with positive signals from policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. This model adds value on its own, but we feel that it is best used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. In 1938, economist Paul Samuelson published a paper entitled, "A Note on the Pure Theory of Consumer's Behavior," in which he outlined an alternative to the well-known economic principle, utility theory. He dubbed his work "revealed preference theory."1 His goal was to redefine utility - a measure of consumer satisfaction with a good or service - by observing behavior. He posited that when consumers reveal their preferences by buying one item rather than another, they reveal the way in which they maximize happiness or satisfaction. For instance, one can measure preferences via experiments in which a subject is given $200 and the choice between two brands of shoes at different prices. Repeating the exercise at different levels of income and relative prices generates "preference axioms." Samuelson's theory has many more layers of complexity, but this Special Report focuses on modelling investors' preferences through observed behavior. Borrowing from Samuelson's reasoning, we developed a methodology to identify investors' axioms of preference for equities and bonds at different levels of incomes and prices. Then we compared investors' real actions with those anticipated by our methodology. This allowed us to generalize our findings and analyze the effects on a portfolio of equities and bonds. The main finding of our statistical exercise is that asset allocators can profit from understanding how short-term moves are linked to the market's revealed preferences at different times during the economic cycle. We then use the results to construct an indicator and a trading rule that not only outperforms a buy-and-hold strategy by a wide margin, it outperforms other traditional trading rules as well. Building A Revealed Preference Model Our primary objective in constructing a revealed preference indicator (RPI) is to understand: (1) how market preferences shape the behavior of investors; and (2) how they ultimately affect future returns. To do so, we broke down our analysis into three key areas: Part I identifies market preferences for different levels of income and price in the economy. Part II defines a general investment strategy that utilizes historic preferences and short-term market movements as a market timing tool. Part III optimizes the RPI and compares its historical track record with a buy-and-hold asset allocation and trading rules based on other indicators. Part I - Developing The Framework The first step in building the RPI is to establish the proper control variables. We limited our basket of investable "goods" to U.S. equities and 10-year Treasurys. We also need a variable that is analogous to the income measure that Samuelson used in his study. For the choice facing investors who are deciding between buying two financial assets, we believe that a measure of market "liquidity" is more appropriate than income. By this we do not mean the ease by which financial assets can be bought and sold. Rather, it is "funding liquidity", or how easily it is to borrow to invest. BCA often uses the four phases of the Fed cycle, as interest rates fluctuate around the equilibrium level, as a measure of funding liquidity (Chart II-1):2 Chart II-1Fed Funds Rate As A Proxy For Income Fed Funds Rate As A Proxy For Income Fed Funds Rate As A Proxy For Income Phase I = Policy is accommodative but the fed funds rate is rising. Phase II = Policy is tight and the Fed is still tightening. Phase III = Policy is tight but the Fed is cutting rates. Phase IV = Policy is easy and the Fed is cutting rates. The rationale for using the fed funds-rate cycle as a proxy for income is that, when interest rates are below equilibrium, monetary conditions are accommodative. Leverage is easy to obtain because there is plenty of liquidity (income) to fund investments. When conditions are tight, funding liquidity is relatively scarce. To measure relative prices, we first divided the S&P 500 price index by its 12-month moving average and second, we took the inverse of the 10-year Treasury yield divided by 12-month moving average.3 We then used the ratio of these two deviations-from-trend to construct a relative price measure (Chart II-2). This ratio provides a single measure of how expensive stocks and bonds are, not only to each other, but to their own history as well. We then grouped the relative price data into four sets of percentiles, or buckets, shown in Table II-1. Stocks are expensive and bonds cheap at the top of the table, while the reverse is true at the bottom. Chart II-2Constructing A Single Price Measure For Equities And Bonds Constructing A Single Price Measure For Equities And Bonds Constructing A Single Price Measure For Equities And Bonds Table II-1Distribution Of Relative Price July 2017 July 2017 Table II-2A presents the average historical monthly percent change in stock prices for each combination of the four relative price and liquidity buckets over the entire dataset. In the fourth phase of the Fed cycle (when monetary conditions are easy and the Fed is still cutting interest rates), and when relative prices are in the first bucket (i.e. stocks are expensive), the average stock price increase during the month was slightly above 1% percent. Table II-2B provides the same breakdown for the average change in bond yields (shown in basis points, not returns). Tables II-2A and II-2B are recalculated at each point in time - meaning that we used an expanding sample to calculate the price buckets, and updated the results for the ensuing price or yield movements as new data are added. That way, we completely avoid the advantage of hindsight. To simplify our methodology, we coded the results to end up with the stock and bond returns for the 16 different combinations of Fed and relative price buckets. Table II-3 uses the results from Tables II-2A and II-2B in the last period of history as an example. The "Liquidity" and "Price" columns indicate the bucket (e.g. price in bucket 1 and liquidity in bucket 1). The "Stocks" and "Bonds" columns are coded as "1" if the asset appreciated during the month given the indicated liquidity/price bucket, and a "0" if it depreciated that month. Table II-2AEquity Market Reactions At Given Levels Of Price And Liquidity July 2017 July 2017 Table II-2BTreasury Market Reactions At Given Levels Of Price And Liquidity July 2017 July 2017 Chart II-3Revealing What Investors Prefer July 2017 July 2017 Part II - Habits Create Expectations It is important to keep in mind that the objective of our revealed preference model is not to use the revealed market preferences as forecasts but rather to examine what happens when investors decide to follow or ignore them. Our hypothesis in building this model is that, when investors go against their historical preferences, the result should be interpreted as short-term noise. It is only when preferences and (subsequent) short-term market moves are aligned that we should heed the signal and invest accordingly. Table II-3 can be thought of as the market's revealed preference. Again, keep in mind that we allowed revealed preferences to change over time by recalculating it under our stretching-sample approach. The following steps detail how we used investor preferences to create a trading rule that verifies our hypothesis empirically: Step 1 - Expected vs. Actual: The first step is to examine how actual equity prices and bond yields behaved relative to their expected trajectory. We created two variables - one for equities and one for bonds. If revealed preference last month (t-1) suggested that the asset's return should be positive in the subsequent month (t), and it indeed turned out to be positive in period t, then we coded month t as "1." If both the revealed preference and the actual outcome were negative, we coded it as "-1." If they did not match, the code is "0" (in other words, the market did not follow the typical historical revealed preference). Thus we have two time series, one for bonds and one for stocks, which are made up of 1s, -1s and zeros. Step 2 - Bullish, Bearish, and Neutral: We combined the coded series for stocks and bonds to encompass the nine possible outcomes in our model (i.e. both bonds and stocks can have a value in any month of 1, 0 or -1, providing 9 different combinations). Table II-4 presents the nine outcomes along with the asset allocation that would have maximized investor returns based on our historical analysis. For example, investors were paid to be overweight equities when equities and bonds have a code of "1" and "-1," respectively (top row in Table II-4). In other words, stocks tended to outperform bonds when revealed preferences from the month before predicted rising stock prices and rising bond yields, and these predictions were confirmed. Table II-4Understanding The Signals From Preferences July 2017 July 2017 If revealed preference is not confirmed for both bonds and stocks, then it is best for investors to stand aside with a benchmark allocation. Step 3 - "If It Don't Make Dollars, It Don't Make Sense": To test whether our theory would add strategic value, we computed a trading rule to see how well it performed against a benchmark portfolio of 50% equities and 50% Treasurys. The trading rule was computed as follows: when the revealed preference for equities is positive (at time t-1) and this signal is confirmed in t, then in t+1 we allocate 100% to the S&P 500 and 0% to Treasurys. When the revealed equity preference signal is correctly bearish, we removed all exposure to equities and allocated 100% to Treasurys. When the signal was neutral, we kept a benchmark allocation of 50% equities and 50% Treasurys. Chart II-3 shows that this trading rule outperforms the benchmark, confirming our initial hypothesis - one should fade the short-term movements when investors go against their preferences, and only follow the signals when those movements align with historical preferences. History shows that investors tend to underperform in terms of the stock/bond allocation when they deviate from their revealed preference. Chart II-3Correctly Gauging How Investors Behave Pays Off Correctly Gauging How Investors Behave Pays Off Correctly Gauging How Investors Behave Pays Off Part III - Validating The Results One drawback is that this trading rule would require frequent portfolio allocation changes every month, as shown in Chart II-4. As such, we constructed a smoothed version by imposing the rule that asset allocation is unchanged unless the model provides a new signal for two months in a row (Chart II-5).4 These restrictions not only dramatically reduced the frequency of the asset allocation adjustments, but it also augmented historical cumulative excess returns (Chart II-6). Chart II-4Revealed Preference Indicator Is Inherently Volatile Revealed Preference Indicator Is Inherently Volatile Revealed Preference Indicator Is Inherently Volatile Chart II-5Removing Some Of The Noise Removing Some Of The Noise Removing Some Of The Noise Any new indicator of course must be able to outperform a buy-and-hold strategy to be useful but it is also interesting to see how its performance ranks compared to a set of random portfolios. This way, we can identify if the indicator truly provides additional information. Random portfolios are generated using a monthly allocations of 100% or 0% to equities, with the remainder in Treasurys. Chart II-7 shows the performance of the smoothed indicator versus a set of 1,000 randomly generated portfolios. Chart II-6Once Smoothed, The RPI Truly Shines Once Smoothed, The RPI Truly Shines Once Smoothed, The RPI Truly Shines Chart II-7The RPI Adds A Significant Amount Of Information The RPI Adds A Significant Amount Of Information The RPI Adds A Significant Amount Of Information We compared the indicator's trading rule to simple moving averages or BCA's other indicators. We also wanted to ensure that the RPI adds value beyond investing based strictly on the four phases of the liquidity cycle or based on relative value alone. We therefore compared the track record of the RPI trading rule to rules that are based on: (1) the deviation of the S&P 500 from its 12-month moving trend; (2) BCA's monetary conditions indicator; (3) BCA's valuation indicator; (4) BCA's technical indicator; (5) the four phases of the Fed cycle; and (6) the relative price index. Charts II-8A and II-8B highlights that RPI indeed impressively dominates the other trading rules. The one exception is that, during the Great Recession, the model's performance fell to roughly match the performance of a S&P 500 technical trading rule. Chart II-8AThe RPI Outperforms The Sum Of Its Parts... July 2017 July 2017 Chart II-8B...As Well As Other Indicators July 2017 July 2017 Part IV - Conclusions The RPI is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. This model adds value on its own, but we feel that it will best be used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. The indicator's current reading for stocks versus bonds, at benchmark, is more conservative than our official recommendation. The benchmark reading reflects the fact that equities are overvalued and that investors have deviated from their preferences in their past two quarters. David Boucher Associate Vice President Quantitative Strategist 1 For more information, please see P. A. Samuelson, "A Note on the Pure Theory of Consumer's Behavior," Economica 5:17 (1938), pp. 61-71. 2 Please see U.S. Investment Strategy Special Report "Stocks And The Fed Funds Rate Cycle," dated December 23, 2013, available at usis.bcaresearch.com 3 We tested a few other measures, most notably the stock-to-bond total return ratio (measured by comparing each asset's total returns), but the chosen measures provided the best and most robust results. 4 We conducted a statistical exercise to validate and optimize the allocations in Table 4 to provide a smoother performance.

Dear Client, We hope that you will find value in this report, a product of collaboration between BCA’s Geopolitical Strategy and EM Equity Sector Strategy. My colleagues Oleg Babanov and Matt Gertken look for investment opportunities in the recent geopolitical changes on the Korean Peninsula. The election of President Moon Jae-in will be a boon for domestic consumer sentiment and relations with China. This will produce a tailwind for the consumer-oriented South Korean stocks, which have high exposure to the country’s trade with China. We deliver this report to you both for its investment value and as an example of BCA Research commitment to seek alpha in the intersection of economics, markets, and geopolitics. Kindest Regards, Marko Papic Senior Vice President Chief Geopolitical Strategist Overweight South Korea Consumer Staples We are recommending an overweight position in select South Korean consumer staples on a long-term (one year-plus) time horizon. A decline in geopolitical tensions between South Korea and China, and a potential improvement on the Korean peninsula, will provide tailwinds to the performance of Korean consumer staples, which have high exposure to China. We expect Chinese tourist numbers to Korea to recover gradually, and sales of South Korean products in mainland China to pick up over the rest of the year. Presidential elections in South Korea and a slowly improving economy are bolstering consumer sentiment and aiding a turnaround in retail sales in the country, with companies in the consumer space displaying better earnings momentum and trading at more attractive valuations than their EM peers (Table 1). Image Sector Backdrop We are turning cautiously positive on consumer staples in South Korea. We believe the following factors will trigger a turnaround in consumer sentiment and support share price performance of consumer-oriented South Korean stocks. Geopolitics Image The election of President Moon Jae-in by a wide margin, as well as a geopolitical shift toward more accommodative policy on China, will alleviate geopolitical risks and help consumer sentiment. Moon has already kicked off his administration's tenure with considerable political capital. For one, his administration represents a return to stable and legitimate government after over a year of turmoil surrounding the scandal, impeachment and removal of former President Park Geun-hye - a relief for South Korean voters. What's more, voter turnout was higher than usual, at 77%, and Moon's margin of victory over his closest contender was over 15%, the second-highest since South Korea became a full-fledged democracy in 1987 (Chart 1). There are also institutional factors playing to Moon's advantage. He was the leading contender for the presidency even without Park being removed from office - but if she had not been removed, he would have taken office in January 2018. Now, Moon has half a year longer in office than he otherwise would have had before he faces his first serious political hurdle in the April 2020 legislative elections. This half year could make a difference. Since Korean presidents serve a single, five-year term, they often become lame ducks in the second half of their term, and therefore move rapidly on policy in the first half while their political capital is high. The only significant domestic political constraint on Moon is the rival left-of-center party, the People's Party. It holds the kingmaker position in the legislature, with the ability to give a majority to either Moon's ruling Democratic Party or to the conservative opposition (Chart 2). However, the People's Party has serious weaknesses and has been compelled by its voting base to cooperate on much of Moon's platform of expanding social spending and thawing relations with North Korea and China. Moreover, the conservative opposition is discredited and fractured. Thus, Moon has limited political constraints. Given that his administration is competent - i.e. the clear populist elements are not joined with a lack of experience or pragmatism - the key question is what policies he will prioritize while his political capital is high. Image Chart 3THAAD Deployment Hurt ##br##Bilateral China-Korea Trade THAAD Deployment Hurt Bilateral China-Korea Trade THAAD Deployment Hurt Bilateral China-Korea Trade It is our view that China-exposed companies stand to benefit in the short term as China eases sanctions over the recently deployed U.S. THAAD missile defense system (Chart 3), and as better relations with China benefit the economy more broadly (Chart 4). However, if Moon prioritizes China and North Korea excessively, he risks squandering his political capital. Korea remains stuck in the middle of U.S.-China tensions that are growing on a secular basis. Tensions with the U.S. will rise as a result of Moon's orientation, and North Korean political risks will remain elevated over the medium and long term. Moon's attempts to engage with North Korea will collide with Trump's efforts to ratchet up pressure against it. Image Therefore, Moon is likely to find the most success in his domestic agenda of increasing government spending, hiring more public workers, raising wages and instilling worker protections, expanding the social safety net and subsidizing small- and medium-sized enterprises. These measures will boost both public and private consumption. We do not have particularly high hopes for Moon's ability to reform the so-called 'chaebol', a South Korean term denoting large, typically family-owned corporate conglomerates, but his attempt to do so will add a modicum of corporate governance and competitiveness improvements that markets will likely cheer. Macroeconomics With improvement in the geopolitical situation, stabilization in the local political system following the Park Geun-hye scandal and new elections has aided in a recovery in consumer sentiment (Chart 5). Meanwhile, a rebound in total employment numbers together with a decline in household debt is providing support to consumer spending (Charts 6A, 6B, 6C). Chart 5Consumer Confidence Is ##br##Back To A Five-Year High Consumer Confidence Is Back To A Five-Year High Consumer Confidence Is Back To A Five-Year High Chart 6ANumber Of Employed ##br##Higher Than In 2015... Number Of Employed Higher Than In 2015... Number Of Employed Higher Than In 2015... Chart 6B...While The Household Debt ##br##Burden Is Slowly Declining... ...While The Household Debt Burden Is Slowly Declining... ...While The Household Debt Burden Is Slowly Declining... Chart 6C...Aiding A Recovery##br## In Retail Sales ...Aiding A Recovery In Retail Sales ...Aiding A Recovery In Retail Sales Sector Specifics From a sector perspective, South Korean consumer staples remain highly competitive, outperforming their EM peers (Chart 7). At the same time, valuations are attractive for South Korean companies (Charts 8A & 8B). Chart 7South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... Chart 8ASouth Korean Companies Trading At Cheaper ##br##Valuations Since Mid-2016... South Korean Companies Trading At Cheaper Valuations Since Mid-2016 South Korean Companies Trading At Cheaper Valuations Since Mid-2016 Chart 8B...And At One Standard Deviation Below ##br##Their Seven-Year Average ...And At One Standard Deviation Below Their Seven-Year Average ...And At One Standard Deviation Below Their Seven-Year Average Furthermore, bottom-line expansion of South Korean companies remains strong, supported by solid margin trends (Charts 9A, 9B, 9C). Chart 9A...Earnings Growth In South Korea##br## Is Outperforming EM Peers ...Earnings Growth In South Korea Is Outperforming EM Peers ...Earnings Growth In South Korea Is Outperforming EM Peers Chart 9B...With Gross Margin Nearly Twice ##br## The EM Industry Average... ...With Gross Margin Nearly Twice The EM Industry Average... ...With Gross Margin Nearly Twice The EM Industry Average... Chart 9C...And EBTIDA Margin Is Steadily ##br## Above EM Peers ...And EBTIDA Margin Is Steadily Above EM Peers ...And EBTIDA Margin Is Steadily Above EM Peers We also like the fact that the net debt level for South Korean consumer staples companies is low to negative, while companies have managed to generate excess free cash flow. One undesirable implication, however, is notoriously low dividend yields, which are discouraging investors and raising corporate governance issues (Charts 10A, 10B, 10C). Taking into account the factors listed above, we have created a portfolio of six South Korean consumer staples stocks (Table 2). Chart 10ADebt Levels Have Fallen Significantly ##br## Over The Past Seven Years... Debt Levels Have Fallen Significantly Over The Past Seven Years... Debt Levels Have Fallen Significantly Over The Past Seven Years... Chart 10B...While Cash Generation ##br## Has Recovered... ...While Cash Generation Has Recovered... ...While Cash Generation Has Recovered... Chart 10C...But Dividend Yields ##br## Remain Disappointing Low ...But Dividend Yields Remain Disappointing Low ...But Dividend Yields Remain Disappointing Low Image The Overweight Basket Chart 11Performance Since June 2016: ##br## Amorepacific Corp Vs. MSCI EM Performance Since June 2016: Amorepacific Corp Vs. MSCI EM Performance Since June 2016: Amorepacific Corp Vs. MSCI EM Amorepacific Corp (090430 KS): A leading beauty and cosmetics producer in South Korea (Chart 11). Founded in the 1940s by Yun Dok-jeong as a company distributing camellia oil for hair treatment, the company was inherited by Yun's son and later grandson, who became the second-richest man in South Korea, controlling directly 10% of the company's free float. Today, Amorepacific is the world's 14th largest cosmetics company, with oversight of some 33 brands around the world such as Etude House, Sulwhasoo and others. In terms of revenue, the bulk is generated by beauty and cosmetic products (91%), where luxury cosmetics constitute 43%, followed by premium brands with 18%. Personal care products contribute 9% to total revenue. Geographically, 70% of revenues are generated in South Korea, and another 19% in China. Amorepacific reported weaker-than-expected first-quarter 2017 financial results on April 24. Revenue increased by 5.7% year over year, with falling Chinese tourist numbers weighing on local sales, and weaker sales in mainland China. At the same time, cost of sales went up by 10.6% year over year, which resulted in gross margin compression by 100 basis points. As a result of an operating cost increase of 8.4% year over year, mainly driven by SG&A expansion (increased labor costs and one-off bonus payments), operating profit fell 6.2% year over year. Operating margin finished at 20.2% compared to 22.8% same period last year, while EBTDA margin contracted to 17.8% from 19.5% last year. Weak operating performance and disproportionate expense growth led to the bottom line falling 15% year over year. Amorepacific is currently trading at a forward P/E of 30.0x, while the market is forecasting an EPS CAGR of 13% over the next three years. We believe the share price will continue to recover strongly, taking into account that easing tensions with China will restore demand and organic volume growth as well as strong momentum in overseas sales, supporting an earnings recovery. Chart 12Performance Since June 2016: ##br## E-Mart Vs. MSCI EM Performance Since June 2016: E-Mart Vs. MSCI EM Performance Since June 2016: E-Mart Vs. MSCI EM E-Mart (139480 KS): Number one hypermarket brand in South Korea (Chart 12). E-Mart was established in 1993 and has grown into the largest hypermarket and discount store chain in South Korea, operating over 148 branch locations locally and another 16 in China. In 2006 the company also acquired its largest competitor in the country - Wal-Mart Korea - strengthening its market share. Additionally, E-Mart runs speciality shops such as "Emart" discount stores, the "Emart Mall" online store, "Emart Traders," an everyday low-price store, as well as pet and sports/outdoor stores. In terms of revenue breakdown, the flagship E-Mart brand is responsible for 78% of total revenue, followed by the food distribution and supermarket segment with 7% each respectively. From a geographic perspective, 98% of revenue originates in South Korea and only 2% in China. E-Mart reported first-quarter 2017 financial results on May 11, missing estimates. Revenue growth was solid, up 7.4% year over year, helped by 1% same-store sales growth in the main hypermarket segment, while cost of sales increased by 6.5% year over year, which resulted in gross margin falling slightly by 20 basis points to 28.2%. Operating profit increased by 2.8% year over year, weighed on by a year-on-year jump in operating expenses of 11.1%. Operating margin stood at 4.1%, down from 4.3% in 2016, while EBITDA margin finished virtually flat at 6.7%. Thanks to better operating performance, the bottom line improved by 5% year over year. The main detraction to performance came from one-off store opening expenses and a negative calendar effect. E-Mart is currently trading at a forward P/E of 14.0x, while the market is forecasting an EPS CAGR of 9% over the next three years. A store restructuring program is currently underway, and management has done well in accelerating closures of non-performing stores, which has already led to cost savings and margin turnaround. We expect this process to continue. Together with strong performance of the discount and online segments, this should warrant a further re-rating of the share price. Chart 13Performance Since June 2016: ##br## GS Retail Vs. MSCI EM Performance Since June 2016: GS Retail Vs. MSCI EM Performance Since June 2016: GS Retail Vs. MSCI EM GS Retail (007070 KS): Number one convenience store chain in South Korea (Chart 13). GS Retail is part of the GS Group, a former part of LG Group and the sixth-largest conglomerate in South Korea, which controls just under 66% of the company. GS Retail was incorporated back in 1971 and today operates GS25 - the largest convenience store brand in South Korea - as well as other brands such as GS Supermarkets, Watsons - a health and beauty chain, and Parnas Hotel. The largest contributor to total revenue is the convenience store segment, with 77%, followed by the supermarket business with 20% and the hotel operation with 3%. Geographically, all the revenue originates in South Korea. GS Retail reported first-quarter 2017 financial results on May 11. Revenue displayed strong growth, up 12.5% year over year, driven by solid performance in the convenience store segment (+21% year over year), while cost of sales increased by 12.3% year over year, which brought gross margin up by 20 basis points to 18.4%. A 15% year-over-year increase in operating costs due to the ongoing consolidation of the Watsons business brought operating income down slightly by 1.5% year over year, suppressing operating margin by 20 basis points to 1.4%. EBITDA margin stood at 5.9% compared to 6.2% a year ago. Despite weak operating performance, the bottom line grew by 18.8%, helped by a non-operating gain and lower interest expenses. GS Retail is currently trading at a forward P/E of 19.6x, while the market is forecasting an EPS CAGR of 14% over the next three years. We expect the non-convenience store segments to contribute more to performance in the second part of the year. Furthermore, non-performing supermarket store closedowns together with seasonally strong second and third quarters, where the summer weather typically helps sales, should support stock performance. Chart 14Performance Since June 2016: ##br## H&H Vs. MSCI EM Performance Since June 2016: H&H Vs. MSCI EM Performance Since June 2016: H&H Vs. MSCI EM LG Household & Healthcare (051900 KS): Producer of the very first cosmetic products in Korea (Chart 14). LG H&H was incorporated in 1947 by Koo In-Hwoi, the founder of LG Corp., and had the initial name Lucky Chemical Industrial Corp. The company produced the first-ever Korean cosmetic product, "Lucky Cream," followed by "Lucky Toothpaste." From 1995 to 2001, LG H&H was part of LG Chem before being spun off. In addition to the cosmetics and household goods businesses, the company also acquired Coca Cola Beverage in 2007, turning itself into an exclusive bottler and distributor of Coca Cola products in South Korea. In terms of revenue breakdown, the cosmetics business contributes 53% to overall revenue, followed by personal products with 27% and the soft drink division with 20%. Geographically, 84% of revenue originates in South Korea, followed by China with 8% and Japan with 4%. LG H&H reported better-than-expected first-quarter 2017 financial results on April 28. Revenue expanded by 5.3% year over year, driven by strong sales in the luxury cosmetics and beverage segments, while cost of sales grew by 4% year over year, bringing gross margin 50 basis points higher to 60.9%. Furthermore, operating income displayed strong growth, up 11.3%, helped by good management of operating expenses (+4.5% year over year). As a result, operating margin improved by 90 basis points to 16.2% and EBITDA margin finished at 16.9%, up from 15.7% last year. The bottom line increased by 11.9% year over year, helped by strong operating performance. LG H&H is currently trading at a forward P/E of 24.1x, while the market is forecasting an EPS CAGR of 8% over the next three years. As with Amorepacific, the trigger to a re-rating in the share price of LG H&H is the improving geopolitical situation. We expect tourist numbers to South Korea to gradually increase, which will aid in both sales recovery and earnings revisions, while strong momentum in the luxury cosmetics segment will contribute to further margin expansion. Chart 15Performance Since June 2016: ##br## KT&G Vs. MSCI EM Performance Since June 2016: KT&G Vs. MSCI EM Performance Since June 2016: KT&G Vs. MSCI EM KT&G Corp (033780 KS): Korea Tobacco & Ginseng (Chart 15). Initially founded as a government monopoly with the name "Korea Tobacco & Ginseng," the company was later privatized and rebranded as the "Korea Tomorrow & Global Corporation." Today, the company is the largest tobacco company in South Korea, controlling the majority of the local market. The company also has extensive exposure to Eastern European countries. In addition to the tobacco business, KT&G also has a pharma arm, the Korea Ginseng Corp. The revenue stream is broken down into the cigarette business, which contributes 60% to overall revenue, followed by the ginseng-pharma segment, adding another 30%. KT&G reported in-line first-quarter 2017 financial results on April 27. Revenue increased by a solid 8% year over year, helped by strong ginseng sales, which expanded despite a market contraction and were also alleviated by market share gain and higher prices. Cost of sales, meantime, were up 12.7%, bringing gross margin down to 59.4% from 61.1% previously. Due to a strong increase in operating costs (+11.3% year over year), driven by higher SG&A expenses, operating income edged up only 0.6% year over year. Operating margin fell 45 basis points from last year, while EBITDA margin stood at 35.5%, or 80 basis points lower compared to the same period last year. The bottom line fell by 17.5% year over year, weighted on by higher foreign exchange losses. KT&G is currently trading at a forward P/E of 12.8x, while the market is forecasting an EPS CAGR of 6.5% over the next three years. Several factors have been weighing on the company's share price recently, including the introduction of warning messages on cigarette packages and the introduction of e-cigarettes in the domestic market - making the stock one of the cheapest among its global peers (~20% discount). We believe that worries regarding e-cigarette introduction and projections of the Japanese experience are overstated due to differences in law (e.g. prohibition of smoking indoors), as well as the age composition of the market. Furthermore, we expect a strong revival in overseas sales in the second part of the year, with less headwinds from foreign exchange swings and double-digit growth due to low base effects - as well as an offset to flat local market expansion via higher selling prices. Chart 16Performance Since June 2016: ##br## Nongshim Vs. MSCI EM Performance Since June 2016: Nongshim Vs. MSCI EM Performance Since June 2016: Nongshim Vs. MSCI EM Nongshim (004370 KS): Farmer's Heart (Chart 16). Nongshim, or Farmer's Heart, was founded in 1965 under the name Lotte Food Industrial Company, and later changed its name. The company first focused on ramyun (instant noodle) production, later expanding into snacks - it was the first to introduce the "Shrimp Cracker" as well as beverages. Today, Nongshim is the largest ramyun and snack company in South Korea, selling to over 100 countries, with production facilities in Korea, China and the U.S. From a revenue perspective, ramyun products contribute 67% to total revenue, followed by other food products with 17.5% and snacks with 15.6%. Geographically, most sales occur in South Korea, with 80%, followed by the U.S. with 10% and China with 8%. Nongshim reported slightly better-than-expected first-quarter 2017 financial results on May 15. Revenue declined slightly by 2.2% year over year due to a fall in domestic ramyun sales by 9%, while cost of sales actually declined by 5% year over year, which led to a gross margin improvement by 190 basis points to 33.7% (helped by price increases.) Operating income was virtually flat year over year, as operating costs increased by 4%. Operating margin stood at 5.85% compared to 5.70% in 2016, while EBITDA margin declined to 7.9% from 9.4% last year. Nongshim is currently trading at a forward P/E of 18.5x, while the market is forecasting an EPS CAGR of 5.6% over the next three years. We expect a reversal of weak sales in China (-5% year over year) due to an easing of the geopolitical situation. Furthermore, Nongshim has already begun to claw back market share, helped by new starts and forced price hikes among its competition, which will continue to help turn around margins and improve profitability. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of listed equities consisting of six overweight recommendations. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Amorepacific Corp (090430 KS); E-Mart (139480 KS); GS Retail (007070 KS); LG Household & Healthcare (051900 KS); KT&G Corp (033780 KS); Nongshim (004370 KS). ETFs: At the moment, there are no ETFs with significant consumer staples sector exposure for South Korea. Funds: At the moment, there are no funds with significant consumer staples sector exposure for South Korea. Please note this trade recommendation is long term (1Y+) and based on an overweight trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case We believe that one of the main risks is the geopolitical situation and further developments surrounding North Korea. Although the usual springtime tensions have passed, the underlying dynamic remains highly precarious. North Korea has not moderated its behavior despite President Moon's olive branch and U.S. President Trump continues to prioritize the issue and threaten bolder action. Any kind of escalation in tensions, whether they be driven by North Korea or the U.S., would negatively affect both Chinese interests and the new South Korean administration's attempts at engagement. Given that South Korea has not yet fully reversed the THAAD missile deployment, for instance, it is possible that China could maintain or intensify its informal sanctions on South Korea, such as travel and product bans, and that renewed tensions could depress overall consumer sentiment in South Korea. We are also cognizant that debt levels in the South Korean manufacturing sector as well mass layoffs in shipyards and a slowdown in exports could continue to create pressure on household disposable income levels and, in turn, spending. However, President Moon's efforts for a supplementary budget to support employment in the public sector, if approved, should alleviate some pain from layoffs. On a company level, we see increased price competition as one of the main risks to our investment case. Since many of the companies in the basket are market leaders, they will need to defend their market share aggressively in case of increased competition. Furthermore, for companies operating abroad, we see increased expansion costs as one of the risk factors for future performance. Finally, Chinese economic policy pose a risk to our view. The fiscal spending and credit impulse in China have rolled over, suggesting that demand will slow in the coming months. Moreover, the Communist Party’s ongoing “deleveraging campaign” – a crackdown on various risky financial practices and the shadow banking sector – raises the risks of a policy mistake. A slowdown in China would have negative repercussions for the South Korean companies most exposed to China and the broader Korean economy. Nevertheless, we think Chinese authorities are willing and able to meet their growth target this year. Oleg Babanov, Senior Editor obabanov@bcaresearch.co.uk Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.co.uk

Highlights Fed Policy Loop: Low inflation is preventing rate hike expectations from being revised higher, prolonging the current rally in spread product. We expect rate hike expectations to move up as inflation recovers, eventually leading to a correction in spread product. Such a correction will prove fleeting as long as inflation stays below target. High-Yield: High-yield valuation is consistent with its historical average, after accounting for expected default losses. Current valuation levels should translate into excess returns of just over 200 bps during the next 12 months. Aaa Spread Product: Non-agency CMBS offer the most spread pick-up of any Aaa-rated sector. However, we prefer to focus our Aaa-rated spread product allocation in Agency CMBS and credit card backed consumer ABS. Feature Chart 1The Fed Policy Loop In Action The Fed Policy Loop In Action The Fed Policy Loop In Action One of this publication's main themes during the past few years has been the Fed Policy Loop.1 In essence, the Loop describes the feedback mechanism between monetary policy and financial markets, a relationship that results from both investors' sensitivity to the Fed's policy stance and the Fed's reliance on financial conditions as a predictor of economic growth. In practice, the Loop works as follows: Easier Fed policy causes spread product to outperform Treasuries. Tighter credit spreads lead to easier financial conditions, which the Fed interprets as a sign that economic growth will accelerate. An improved economic outlook causes the Fed to step up the pace of tightening. Tighter Fed policy causes spread product to underperform Treasuries. Wider credit spreads lead to tighter financial conditions, which the Fed interprets as a sign that economic growth will moderate. A worse economic outlook causes the Fed to slow its expected pace of tightening. Rinse, repeat. Chart 2 Chart 2 provides a graphical description of the Loop, and its most recent iteration can be seen in Chart 1 above. Chart 1 shows that corporate bonds outperformed Treasuries leading up to the March rate hike, but then rate expectations rose too far. In mid-March the market was discounting a fed funds rate of 1.86% by the end of 2018. These overly stringent rate hike expectations caused corporate bonds to underperform, and this underperformance led rate hike expectations to be revised lower. The market now expects a fed funds rate of only 1.47% by the end of 2018, and these depressed rate expectations have fueled the rally in corporate bonds that started in mid-April. Normally at this stage of the Fed Policy Loop we would expect rate hike expectations to move higher until they eventually prompt a correction in corporate spreads. However, extremely disappointing core inflation prints during the past three months have caused the market to keep its rate hike expectations depressed. This has extended the most recent rally in spread product. This is why we have consistently pointed to core inflation and the cost of inflation protection embedded in long-maturity bond yields as the main factors to watch to determine how much life is left in the corporate bond trade. As long as inflation stays below target, the Fed absolutely needs it to rise. It will therefore be quick to respond to any tightening of financial conditions/widening of credit spreads. Table 1 shows average monthly excess returns for investment grade corporate bonds relative to duration-matched Treasuries. These returns are split into buckets based on the reading from the St. Louis Fed's Price Pressures Measure (PPM). The PPM is a composite of 104 economic indicators designed to measure the probability that inflation will exceed 2.5% during the next 12 months. As can be seen, average monthly excess returns are strongest when inflation pressures are low, but they gradually decline as inflation heats up and the Fed's reaction function becomes less supportive for markets. At present, the PPM gives a reading of only 4.8%. Table 1Investment Grade Corporate Bond Excess Returns* Under Different ##br## Ranges Of Price Pressures Measure** (January 1990 To Present) Risk Rally Extended Risk Rally Extended Similarly, Table 2 shows that it is difficult to get a long-lasting correction in an environment with low inflation pressures and a responsive Fed. This table shows the results of a "buy the dips" trading strategy where if the average junk spread widens by 20 basis points we buy the junk index versus duration-matched Treasuries and hold it for a period of 1, 2 or 3 months. Just as in Table 1, this strategy works well when inflation pressures are muted, but starts to fail as inflation ramps up. Table 2High-Yield Corporate Bond Returns* Achieved By Holding The Junk Index ##br## Following A 20 BPs Widening In High-Yield Corporate OAS** Under Different Ranges Of ##br## The St. Louis Fed Price Pressures Measure*** (February 1994 To Present) Risk Rally Extended Risk Rally Extended Beatings Will Continue Until Morale Improves So when will the Fed staunch the current rally? That depends on how quickly inflation rebounds,2 and also on how much emphasis Fed policymakers place on financial conditions versus the actual inflation data. At the moment, most indexes are sending the message that financial conditions are easier than average and that the Fed should continue to tighten (Chart 3). However, as was noted above, inflation gauges are sending the opposite signal (Chart 3, panel 2). For now, the Fed is downplaying low inflation as transitory. It decided to leave its median projected rate hike path unchanged at the June FOMC meeting. But the Fed's refusal to capitulate in the face of weaker inflation has caused the yield curve to flatten, the cost of inflation protection to plummet (Chart 3, bottom panel) and investors to grow increasingly concerned about a policy mistake (Chart 4). Chart 3Financial Conditions Are Supportive Financial Conditions Are Supportive Financial Conditions Are Supportive Chart 4Should The Fed Keep Tightening? Should The Fed Keep Tightening? Should The Fed Keep Tightening? This brings up an interesting flaw in the financial conditions approach to policymaking. Most indexes of financial conditions are at least partially driven by long-maturity Treasury yields (lower yields = easier financial conditions, and vice-versa). This makes some sense. Lower yields do in fact indicate that the financing back-drop is more supportive and tend to translate into higher growth in the future (Chart 5). Chart 5Financial Conditions Lead Economic Growth Financial Conditions Lead Economic Growth Financial Conditions Lead Economic Growth However, what if lower long-maturity Treasury yields are the result of excessively tight Fed policy? This would appear to be the case at the moment. Investors are revising their long-run inflation forecasts lower on the view that the Fed is not doing enough to allow prices to rise. In such a situation it would be incorrect to interpret lower Treasury yields as a signal that policy needs to tighten further. On the contrary, tighter policy would only exacerbate the downtrend in yields. For this reason we do not include the level of yields in the financial conditions component of our Fed Monitor (Chart 3, top panel). As a result, this financial conditions indicator is not as deep in "easing territory" as most other indicators. However, it is still above the zero line, suggesting that policy should be biased tighter at the margin. Bottom Line: Low inflation is preventing rate hike expectations from being revised higher, prolonging the current rally in spread product. We expect rate hike expectations to move up as inflation recovers, eventually leading to a correction in spread product. Such a correction will prove fleeting as long as inflation remains below the Fed's target. The key risk is that inflation stays low but the Fed continues to focus exclusively on "easy" readings from financial conditions indexes, and proceeds on its current tightening path. In that scenario cries of "policy mistake" will grow louder and spread product will sell off, converging with lower rate hike expectations. We view this scenario as a low-probability tail risk. Junk Valuation Update At 378 bps, the average spread on the Bloomberg Barclays High-Yield index is only 55 bps above its post-crisis low, but still more than 100 bps above the level where it tends to settle in the late stages of the economic cycle when the Fed is tightening policy (Chart 6, top panel). Higher debt levels than are typical for this stage of the cycle suggest that somewhat wider spreads are justified,3 but the idea that junk spreads are extremely tight compared to history does not hold up to scrutiny. Chart 6High-Yield Default-Adjusted Spread High-Yield Default-Adjusted Spread High-Yield Default-Adjusted Spread Our preferred measure of junk valuation, the default-adjusted high-yield spread, paints an even rosier picture. The second panel of Chart 6 shows an ex-post measure of the default-adjusted spread (the option-adjusted spread of the high-yield index less actual default losses over the subsequent 12 months). The most recent reading from this indicator is based on our forecast of default losses for the next 12 months, and is shown as a dashed line. The message from the default-adjusted spread is that, assuming our default loss forecast is correct, junk bonds currently offer compensation for default risk that is in line with the historical average. That level of compensation would be consistent with an excess return of just over 200 bps during the next 12 months (Chart 6, panel 3), and is contingent on the speculative grade default rate falling to 2.68%, in line with Moody's baseline forecast (Chart 6, bottom panel). We expect a decline in the default rate to materialize in the coming months as commodity sector defaults continue to work their way out of the data. Moody's did not record any commodity-related defaults in May, the first month this has occurred since January 2015. The risk going forward is that defaults start to emerge in the increasingly stressed retail sector. So far, Moody's has recorded two retail defaults this year. However, more are probably on the way. This will be especially true if inflationary pressures start to mount and the Fed tightens policy, giving banks less incentive to extend credit. We will be monitoring the situation in retail closely going forward. Bottom Line: High-yield valuation is consistent with its historical average, after accounting for expected default losses. Current valuation levels should translate into excess returns of just over 200 bps during the next 12 months. Aaa Roundup As can be inferred from the previous two sections, we are still reasonably comfortable taking credit risk in U.S. bond portfolios. However, this week we also look at the compensation offered by Aaa-rated spread product. For investors who desire some Aaa-rated allocation outside of the Treasury market, Chart 7 provides a snapshot of where the most additional spread is available. Chart 7 The first thing that jumps out is that Agency bonds offer very little spread compared to other Aaa-rated instruments. Agency residential mortgage-backed securities also offer relatively little compensation, unless one is willing to extend into premium coupons (4% and above). Agency CMBS, auto ABS and credit card ABS all offer more spread than Aaa-rated corporate bonds. Non-agency CMBS offer much more attractive spreads than the other Aaa sectors, but we see potential for capital losses in that segment, as is discussed below. Agency MBS Only agency MBS carrying coupons of 4% or above offer interesting compensation relative to other Aaa-rated sectors, and even there we see potential for spread widening in the coming months. Nominal MBS spreads are already very tight compared to history (Chart 8) and appear even tighter relative to trends in net issuance (Chart 8, panel 2). While refinancing activity will likely stay depressed (Chart 8, panel 3), we see potential for option-adjusted spreads to follow net issuance higher, even as the compensation for prepayment risk (option cost) remains low. A similar scenario played out in 2007 (Chart 8, bottom panel). The Fed's exit from the MBS market, which could occur as early as September, represents an additional upside risk for spreads. Chart 8MBS Spreads Biased Wider MBS Spreads Biased Wider MBS Spreads Biased Wider Chart 9Avoid Non-Agency CMBS Avoid Non-Agency CMBS Avoid Non-Agency CMBS CMBS As noted above, non-agency CMBS look very attractive compared to other Aaa-rated spread products. But we see potential for spread widening in this sector. Commercial real estate lending standards are tightening and property prices are decelerating, both should pressure non-agency CMBS spreads wider (Chart 9). Agency CMBS offer somewhat lower spreads than their non-agency counterparts. But this sector should be more insulated from spread widening. For one thing, Agency CMBS are mostly backed by multi-family loans. Multi-family property prices have been stronger than those in the retail or office segments (Chart 9, panel 3), and multi-family properties have also experienced much lower delinquencies (Chart 9, bottom panel). Consumer ABS Chart 10Credit Cards Greater Than Autos Credit Cards > Autos Credit Cards > Autos While Chart 7 shows that Aaa-rated auto ABS offer a slight spread advantage over Aaa-rated credit card ABS, we are inclined to view credit card ABS more favorably. Rising auto loan net loss rates pose a risk for auto ABS spreads, while credit card charge-offs remain historically low (Chart 10). Auto lending standards have also moved deep into "net tightening" territory, while credit card lending standards have dipped back into "net easing" territory. The small extra compensation available in auto ABS relative to credit card ABS does not seem to be worth the extra risk. Bottom Line: Non-agency CMBS offer the most spread pick-up of any Aaa-rated sector. However, we view the risk of a further widening in non-agency CMBS spreads as substantial. We prefer to focus our Aaa-rated spread product exposure in Agency CMBS and credit card backed consumer ABS. Both sectors offer reasonably attractive spreads, and should remain insulated from capital losses going forward. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 2 Our view is that core inflation will rebound fairly quickly. For further details please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 3 For further details please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Swap consumer staples into financials in our pair trade versus the tech sector. Relative profit fundamentals signal that this relative share price ratio will soon come alive. Global growth tailwinds argue for lifting the air freight & logistics index to high-conviction overweight status. Recent Changes S&P Financials/S&P Tech - Switch the long side of the S&P Consumer Staples/S&P Tech pair trade from S&P Consumer Staples to S&P Financials. S&P Consumer Staples - Remove from the high-conviction overweight list. S&P Air Freight & Logistics - Add to the high-conviction overweight list. Table 1Sector Performance Returns (%) Disentangling Pricing Power Disentangling Pricing Power Feature Equities broke out to new highs early last week, and there are good odds that a playable rally will unfold. Investors' jitters have recently focused on the bear market in oil prices and weak core CPI, which have joined forces to push down inflation expectations (Chart 1). However, we have a more bullish interpretation. Unlike in late-2015/early-2016, oil and stock prices have decoupled. True, energy stocks are plumbing multi-decade lows relative to the broad market, but the energy sector comprises less than 6% of the S&P 500's market cap. In fact, the two largest S&P 500 constituents have a greater weight than the 34 stocks in the S&P energy index combined. In other words, the energy sector's broad market influence has been severely diluted. We think it is unlikely that the positive correlation between oil and stock prices reasserts itself. Rather, our sense is that this is likely an energy/commodity-centered deflation that will not have a serious contagion on the rest of the corporate sector. High yield energy spreads continue to widen, but the overall junk spread is flirting with cyclical lows. This stands in marked contrast with the summer of 2014 and late-2015, the last time oil prices melted (second panel, Chart 1). Chart 2 shows that the nonfarm business sector and the GDP implicit price deflators, both of which are reliable corporate sector pricing power proxies, are positively deviating from core CPI. These deflators have historically been excellent leading indicators of inflation and signal that the recent poor inflation prints will likely prove transitory. Importantly, the U.S. is a large closed economy that benefits greatly from lower oil prices, via a boost to discretionary income. Lower energy costs are adding to an already stimulative backdrop owing to the decline in the U.S. dollar and Treasury yields. At the margin, the broad corporate sector also benefits from oil price deflation: energy is a non-trivial input cost. Our more optimistic overall economic and market outlook is also borne out by survey data: economists revised higher their U.S and global GDP growth expectations both for 2017 and 2018, according to Bloomberg estimates (bottom panel, Chart 1). Finally, real yields, the bond market's gauge for economic growth expectations, have climbed close to a 2-year high, and suggest that GDP growth will soon pick up steam (Chart 1). Our view remains that this is a goldilocks scenario for equities, as it may keep the Fed at bay for a while longer and sustain easy financial conditions. This thesis also assumes that the corporate sector will maintain its pricing power gains, and likely pull consumer prices out of their lull. On that front, we have updated our corporate pricing power proxy and while it has lost some steam of late, it continues to expand at a healthy clip (Chart 3). Chart 1Decoupled Decoupled Decoupled Chart 2Implicit Price Deflators Lead Core CPI Implicit Price Deflators Lead Core CPI Implicit Price Deflators Lead Core CPI Chart 3Corporate Pricing Power Is Fine Corporate Pricing Power Is Fine Corporate Pricing Power Is Fine Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power Disentangling Pricing Power Disentangling Pricing Power Our analysis concludes that still ¾ of the industries we cover are enjoying rising selling prices and 43% are also beating overall inflation rates. Admittedly, the inflation rates have come down since our April update, and there was a tick up in the number of deflating industries from 14 to 16, but that figure is still down from the 19 registered in January. Importantly, 27 out of 60 industries have clocked a rising pricing power trend down from 31 in April, but still up from 20 in January, 14 have a flat trend and 19 are falling. Encouragingly, corporate sector selling prices are still comfortably outpacing wage inflation, which suggests that the positive momentum in profit margins has staying power (Chart 3). One theme that stands out from our analysis is that commodity related industries have either falling or flat inflation trends, with the exception of aluminum and chemicals. We take this as confirmation that resources are at the epicenter of deflation/disinflation pressures. Similarly, the majority of tech sub-sectors are still fighting deflation and suffer from a flat or down trend in selling prices. Adding it all up, the recent mild slowdown in corporate sector selling prices is transitory, mostly commodity related and unlikely to infect the broad business sector. There are high odds that an earnings-led playable break out phase in the equity market will develop from here. This week we promote an industrials sub-sector to our high-conviction overweight list and swap a safe haven sector out, and also tweak our long/short pair trade. Pair Trade Tweak: Long Financials/Short Tech Over the past month, we have reduced the extent of our consumer staples overweight, downgrading soft drinks to underweight and hypermarkets to neutral. In contrast, in May we boosted the S&P financials index to overweight on the back of improving earnings fundamentals. As a result, swapping out consumer staples for financials in our existing pair trade versus the tech sector makes sense. This relative share price ratio is at a critical juncture and has dropped to its long term support level (top panel, Chart 4). Importantly, the relative market capitalization differential is at its widest gap since the tech bubble (Chart 5) and a renormalization is in order. Chart 4Long Term Support Should Hold Long Term Support Should Hold Long Term Support Should Hold Chart 5Unsustainable Gap Unsustainable Gap Unsustainable Gap The valuation case is equally compelling: financials are deeply undervalued and unloved compared with the tech sector (Chart 4), such that even a modest shift in sentiment would drive a large relative price swing. The macro outlook is rife with catalysts to trigger a renormalization. Our respective Cyclical Macro Indicators (CMI) signal that financials profits will best tech sector earnings in the coming quarters (top panel, Chart 6). Historically, relative performance has moved in lockstep with relative profitability. The message from our CMIs is that relative earnings will move decisively in favor of the financials sector, thereby producing positive price momentum (bottom panel, Chart 6). A simple relative demand indicator concurs with our CMIs message: bank loan growth should outpace tech capital expenditures in the back half of the year. The middle panel of Chart 6 shows our recently published bank loans and leases regression model compared with our U.S. Capex Indicator (a good proxy for tech spending) and the message is to expect a catchup phase in relative share prices. If our thesis proves accurate, then relative demand will soon show up in relative top line figures. On that front, our forward looking relative sales per share models argue that the budding recovery in relative revenue is sustainable (Chart 7). Relative pricing power dynamics provide another source of support, both in terms of sales and operating profit margins. Firming financials pricing power is the mirror image of chronically deflating tech selling prices (Chart 7). Keep in mind that overall mild price inflation is a boon for financials because it will keep monetary conditions from becoming overly tight, which would undermine credit quality and availability. Using the nonfarm business sector's implicit price deflator as a proxy for overall inflation, the (third panel, Chart 7) shows that relative share prices move in lockstep with overall corporate sector prices. In terms of economic undercurrents, if geopolitical risks remain muted and financial conditions reasonably accommodative, then a further boost in economic and investor sentiment is likely. History shows that the financials/tech share price ratio has benefited when risk premia recede. The same relationship is also evident in the positive correlation with our U.S. sentiment indicator and real 10-year bond yield (Chart 8), and inverse correlation with corporate bond spreads (not shown). Chart 6Heed The Relative##br## CMI Signal Heed The Relative CMI Signal Heed The Relative CMI Signal Chart 7Financials Have##br## The Upper Hand Financials Have The Upper Hand Financials Have The Upper Hand Chart 8Improving Economy = ##br##Go Long Financials/Short Tech Improving Economy = Go Long Financials/Short Tech Improving Economy = Go Long Financials/Short Tech Finally, recent positive bank sector news suggests that financials have the upper hand in this share price ratio. Banks passed the Fed's stringent stress test with flying colors and should become more shareholder friendly, i.e. boost dividend payouts and reinstate/augment share retirement. In addition, even a modest watering down of Dodd-Frank will also lift the appeal of banks and financials at the expense of tech stocks in the coming quarters. Adding it up, we recommend swapping consumer staples with financials in our pair trade versus the tech sector. Relative profit fundamentals suggest that this relative share price ratio will soon spring into action. Bottom Line: Switch consumer staples out and sub financials in the pair trade versus tech stocks. We are also removing the S&P consumer staples index from our high-conviction overweight list for a modest gain of 0.1% since the early-January inclusion. The latter move makes room for an upgrade to high-conviction of a transportation sub-group that has caught fire since our recent upgrade to overweight. Air Freight Stocks Achieve Liftoff! We raised the S&P air freight & logistics group to overweight two months ago, reflecting a lack of recognition in either valuations or earnings estimates that a global trade revival was unfolding and washed out technical conditions. Since then, this transportation sub-group has regained its footing, and firming profit fundamentals now embolden us to add air freight stocks to our high-conviction overweight list. The relative share price ratio has smartly bounced off its GFC lows. Similarly, our Technical Indicator found support at one standard deviation below the historical mean, a typical launch point for playable rallies. Importantly, deeply discounted valuations remain in place, both in terms of P/S and P/E ratios (Chart 9). We expect the rebound in global growth to help unlock excellent value in air freight equities. Global trade is reviving. The synchronized DM and EM economic recovery has buoyed the global manufacturing PMI, which continues to trend well above the boom/bust line. Both global export volumes and prices are expanding. Yet buoyant global trade expectations are still not reflected in tumbling relative sales expectations (Chart 10). Chart 9Unwarranted ##br##Grounding Unwarranted Grounding Unwarranted Grounding Chart 10Buoyant Trade Growth Is Neither Reflected##br## In Collapsing Sales Expectations... Buoyant Trade Growth Is Neither Reflected In Collapsing Sales Expectations... Buoyant Trade Growth Is Neither Reflected In Collapsing Sales Expectations... Chart 11 highlights two additional Indicators to gauge the stage of the global trade recovery. Korea and Taiwan are two small open economies: exports in both countries are accelerating. Meanwhile, our Global Trade Activity Indicator, comprising the economically-sensitive Baltic Dry Index and lumber prices, is also waving a green flag. The upshot is that a number of Indicators confirm that a durable pickup in trade is underway, which should ultimately translate into a recovery in relative earnings expectations (Chart 11). Domestically, business shipments-to-inventories ratios are expanding comfortably in all three major segments: manufacturing, wholesale and retail (bottom panel, Chart 10). Anecdotally, recent news that FedEx beat both top and bottom line estimates also reinforces a firm global activity backdrop. All of this serves as reliable evidence that the budding recovery in global (and domestic) growth has morphed into a sustainable advance. The implication is that air freight pricing power has ample room to grow. Wholesale price momentum has reached a 5-year high. If our thesis plays out, more pricing power gains are in store, which will boost profit margins given the industry's impressive labor cost restraint and high operating leverage (Chart 12). Chart 11...Nor In Depressed##br## Forward EPS ...Nor In Depressed Forward EPS ...Nor In Depressed Forward EPS Chart 12Margin Expansion##br##Phase Looms Margin Expansion Phase Looms Margin Expansion Phase Looms Finally while investors are digesting the Walmart in-store pick up option and Amazon's push for its own delivery service plans, the persistent ascent in online shopping suggests that the structural increase in rapid delivery services will remain intact. Investors should expect pricing power to gravitate toward the long-term trend (bottom panel, Chart 12). Tack on the recent corrective action in the commodity pits and this group also benefits from the fall in fuel costs. Taken together, profit margins should resume expanding. In sum, appealing relative valuations along with a durable synchronized global growth rebound argue for increasing conviction in our overweight position in this transportation sub-group. Bottom Line: Stay overweight the S&P air freight & logistics group (UPS, FDX, CHRW, EXPD), and bump it to the high-conviction overweight list. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Dear client, This week, we are sending you an abbreviated Weekly Report as we co-authored a Special Report on Wednesday with our sister Geopolitical Strategy service. In our Special Report, available on our website, we argue that Italy's flirtation with leaving the euro area is rooted in its positive experience with devaluations in the 1990s. However, we note that this time is different and devaluing the euro through exit will not be a panacea, as financial market linkages would cause a deep domestic recession that could be brought forward by the mere reality of a referendum on the topic. As such, we think that Italy is unlikely to leave the Euro Area, but that it will remain a drag on the Eurozone - one that will force the European Central Bank to stay a bit more dovish than warranted by conditions in the broader Euro Area. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature Chart I-1The Dollar At A Critical Spot The Dollar At A Critical Spot The Dollar At A Critical Spot Since the end of last week, the dollar has staged a small rebound. This rebound was of the utmost importance as it materialized at an important level. Had DXY punched below the 96 level, the dollar could have sold off toward 93 in a matter of weeks. However, if the dollar can remain above 96, the greenback is likely to have formed a trough for the remainder of 2017 as it will rest above an important congestion zone that has been in place since early 2015 (Chart I-1). What are the odds of the greenback moving back to 93? We think that right now the balance of probability is in favor of a continued rebound. A call on DXY is first and foremost a call on the euro, as EUR/USD represents 60% of this index. We'll thus focus on the dynamics in this pair. Currently, nominal short rate differentials remain in the dollar's favor. As Chart I-2 illustrates, interbank rate spreads between the Euro Area and the U.S. are broadly supportive of the USD. Additionally, in both the late 1990s and in 2005-06, this spread had been much more negative than at present. BCA still expects the spread to grow more negative as the Federal Reserve continues on its intended policy path, while we also believe it will take a few more years before the ECB can begin lifting rates.1 Real rate differentials paint a similar picture. The euro's strength in the second quarter has emerged in spite of a move in real rate spreads in favor of the USD. As Chart I-3 shows, this divergence has mostly reflected dynamics at the short end of the yield curve, but over the past month and a half the real interest rate difference at the 10-year maturity has also diverged from the EUR/USD's path. Chart I-2EUR/USD Short Rate Differentials ##br##Can Grow Deeper EUR/USD Short Rate Differentials Can Grow Deeper EUR/USD Short Rate Differentials Can Grow Deeper Chart I-3EUR/USD Has Dissociated##br## From A Key Driver EUR/USD Has Dissociated From A Key Driver EUR/USD Has Dissociated From A Key Driver Technically, the dollar is beginning to look attractive against the euro as well. Our positioning indicator - based on sentiment, net speculative positions, and the euro's advanced/decline line - shows that investors are already positioned the most euro bullish since 2012 (Chart I-4). Our intermediate-term technical indicator is also at highly overbought levels, highlighting the euro's limited upside potential. Most importantly though, these moves have happened as the Euro Area economic surprise index massively beat the U.S. one (Chart I-4, bottom panel). This means that Europe's economic outperformance has been driving the euro's strength, unlike in 2015 when the surge in the European surprise index relative to the U.S. was reflective of the euro's 2014 collapse. This paints a picture where much good European news has been priced into EUR/USD during the recent rally. At current levels, the mean-reverting nature of the relative surprise index suggests that European surprises are unlikely to continue to beat U.S. ones by such a margin going forward. This means that the already overbought euro is likely to lose a key support. Finally, as we highlighted two weeks ago, global analysts have already ratcheted up their year-end estimates for EUR/USD (Chart I-5). Not only are their forecasts at levels that have in recent years been indicative of a peak, but the speed and magnitude of their adjustments has also been exceptional. This corroborates that the positive momentum in the Eurozone vis-à-vis the U.S. has already been internalized by market participants. If anything, this favorable relative economic momentum must only grow going forward for the euro to rally further. However, European LEIs have already rolled over relative to the U.S. as the latter looks set to exit its soft patch in the coming months (Chart I-6). Chart I-4Good News Already ##br##In The Euro Good News Already In The Euro Good News Already In The Euro Chart I-5Investors Have Already##br## Bought The Euro Investors Have Already Bought The Euro Investors Have Already Bought The Euro Chart I-6The Economic Tailwinds For The ##br##Euro Are Beginning To Fade The Economic Tailwinds For The Euro Are Beginning To Fade The Economic Tailwinds For The Euro Are Beginning To Fade Bottom Line: DXY has rebounded at a crucial level. If it can stay above 96, this would suggest that its correction is over. We are willing to make this bet as the euro - the key component of the DXY - has dissociated from rate differentials on strong optimism toward the economic outlook for Europe - at the exact time that investors have become more incredulous of the Fed's intentions. Due to these dynamics, EUR/USD is now massively overbought and at risk of a further pullback. Cutting Loose Short USD/JPY Last week, we closed our short USD/JPY position at a 4.2% gain. We did so because we see an increasingly less-supportive environment for the yen. To begin with, the U.S. Treasury notes' fair-value model used by our U.S. Bond Strategy service highlights that U.S. bond yields are currently quite expensive, and could be set to rise anew (Chart I-7). Because JGBs possess a very low beta relative to U.S. yields, an environment where global rates rise tends to be associated with rate differentials moving in favor of USD/JPY, often prompting a rally in the latter. Also, the Bank of Japan is keenly aware that it will be very difficult to achieve its 2% inflation target. The yen's recent strength has exerted a significant tightening in Japanese financial conditions that will drag down inflation (Chart I-8). Hence, the BoJ will continue to be among the most dovish central banks in the world. Additionally, while Japanese industrial production has been strong, it looks set to soften in the coming months, which will give further reason to the BoJ to talk down the yen: Japanese industrial production is very much a function of financial conditions. We are entering a window where the recent tightening in Japanese financial conditions should begin to bite industrial production. The growth rate of the Japanese shipments-to-inventories ratio has rolled over, historically a precursor of a slowdown in industrial production (Chart I-9). Chart I-7T-Notes Are Expensive T-Notes Are Expensive T-Notes Are Expensive Chart I-8Japanese FCI Points To Lower Inflation Japanese FCI Points To Lower Inflation Japanese FCI Points To Lower Inflation Chart I-9Japanese IP Will Turn Japanese IP Will Turn Japanese IP Will Turn Finally, the annual growth rate of Japan's industrial production is heavily influenced by China's economic dynamics, as EM represents 43% of Japanese exports. Two months ago, the Keqiang index - a barometer of strength for the Chinese economy based on credit growth, railway freight volumes, and electricity production - hit its highest level since June 2010, levels only recorded in early 2007, early 2005, and early 2004. Even though we do not anticipate it to crater, we do expect its recent rollover to deepen further in response to the recent wave of policy tightening in China. This should result in some weakness for Japan's industrial production. In practice there is little additional actions the BoJ can implement to ease policy further. However, because investors are currently so negative on the prospects for further Fed rate increases, with only 40 basis points priced in over the next 24 months, a re-assurance by the BoJ that easy policy is here to stay could put upward pressure on USD/JPY. While we remain worried about EM assets, we think that shorting the AUD or the NZD against the yen represents better portfolio protection than shorting USD/JPY. Bottom Line: USD/JPY has a generous amount of upside from here. Investors are too pessimistic regarding the Fed's ability to increase rates over the next 24 months. Meanwhile, the recent tightening in Japanese financial conditions is a headache for the BoJ, as it points to weaker inflation and a slowdown in industrial production. Hence, we expect the BoJ will try to talk down the yen over the coming months. EUR/NOK At An Interesting Spot Chart I-10If Brent Doesn't Fall Below,##br## EUR/NOK Is A Short If Brent Doesn't Fall Below $40, EUR/NOK Is A Short If Brent Doesn't Fall Below $40, EUR/NOK Is A Short The price action in EUR/NOK caught our eye this week. EUR/NOK is at a critical level and has rallied as investor optimism toward the Euro Area economy continues to grow. Meanwhile, oil prices have collapsed to US$45/bbl. Since Norway is an economy heavily geared to oil-price gyrations, this bifurcation created an ideal combination to generate a EUR/NOK rally. However, by discounting these developments, EUR/NOK has now entered massively overbought territory. Additionally, as Chart I-10 illustrates, the cross has only traded at higher levels at the depth of the financial crisis in the first quarter of 2009 and the early days of 2016. In both instances, Brent was trading below US$40/bbl. A selling opportunity could soon emerge. Our Commodity And Energy Strategy service continues to expect a deepening of the adjustment in global oil inventories as the OPEC 2.0 deal remains in vigor and compliance stays in place.2 This means a move below US$40/bbl for Brent is very unlikely, and the upside in EUR/NOK is extremely limited. While in the coming weeks a move in Brent to between US$44/bbl and US$42/bbl could happen, we think this limited downside points to an attractive risk-reward ratio to shorting this cross. We are currently long CAD/NOK and short EUR/CAD, with the latter having greater potential downside than EUR/NOK. However, due to Canada's deep integration with the U.S. economy, the EUR/CAD trade is often affected by dynamics in the U.S. dollar. Shorting EUR/NOK is thus a cleaner play on oil and removes much of the risk associated with the greenback's fluctuations. Finally, yesterday, the Norges Bank policy release displayed less dovish tone than anticipated by the market. This kind of surprise would create an additional support to being short EUR/NOK. Bottom Line: EUR/NOK looks set to weaken. Over the past 10 years, it has only traded above current levels when Brent prices were below US$40/bbl. Based on our commodity team's analysis, such a move is very unlikely. Thus, any short-term weakness in oil prices should be used to sell EUR/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 6, 2017, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report titled "Time For "Whatever It Takes" In Oil?", dated June 2, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights While the yield curve is a critical indicator for developed economies, its significance in China should be put in proper perspective, as the country's market-based financial intermediation is much less important compared with the West. The inverted Chinese yield curve indicates tighter interbank liquidity in recent months, but the impact on the economy should be limited. The PBoC will at minimum pause its liquidity tightening campaign, which will provide a window for bonds to rally. Go long Chinese onshore corporate bonds. The near term impact of MSCI's A Share inclusion should be negligible for the broader market. Valuation indicators of the select 222 large-cap names are much more attractive compared with their domestic peers, which may well provide a catalyst for some catch-up rally. Feature Chart 1China's Inverted Yield Curve China's Inverted Yield Curve China's Inverted Yield Curve The Chinese authorities' tightening measures on the financial sector have significantly pushed up interest rates across the curve, particularly in the short end, leading to rapid yield-curve flattening. By some measures, long-dated interest rates are currently lower than short rates, generating an inverted yield curve (Chart 1). Some have viewed an inverted Chinese yield curve as a harbinger of an impending material growth slowdown. While the yield curve is undoubtedly a critical indicator for developed economies, its significance in China should be put in proper perspective. In short, bank loans still play a dominant role in financial intermediation, the interest rates on which are still largely determined by the policy lending rate. Therefore, a simple comparison of the Chinese yield curve to its counterparts in the West misreads the situation and is overly alarmist. Moreover, we suspect that the phase of maximum strength of policy tightening is over, at least in the near term. Therefore, Chinese interest rates are likely to fall in the coming three to six months. This week we recommend a long position in Chinese onshore corporate bonds. Why The Yield Curve Matters Less For China To be sure, the yield curve is among the most relevant and watched indicators in some developed economies. In the U.S., for example, an inverted yield curve, defined as U.S. 10-year Treasury yields resting below three-month Treasury yields, has historically been a reliable indicator in predicting economic recessions (Chart 2). Evidence from other developed economies such as Japan and Europe is less compelling, but a flat/inverted yield curve is still generally regarded as a market signal for growth problems. Chart 2U.S. Yield Curve Inversion Predicts Economic Recession U.S. Yield Curve Inversion Predicts Economic Recession U.S. Yield Curve Inversion Predicts Economic Recession The reasons for the linkage between yield curve inversion and economic recessions have been the subject of lengthy debates among academia, policymakers and investors. From a financial market perspective, it is generally accepted that an inverted yield curve occurs when the bond market anticipates a significant slowdown in growth and/or decline in inflation, which bids down long-term yields, while policymakers fail to respond in a timely manner, which holds short-term rates at elevated levels. Yield curve inversion is typically followed by aggressive monetary easing as central banks wake up to the economic reality predicted by the bond market. Economically, the costs of funding in most developed countries are tightly linked with interest rates in the bond markets. One of banks' key functions as financial intermediaries is to transform maturity - i.e. to "borrow short and lend long," and therefore interest rates of bank loans are tied to government bond yields at the longer end, while their costs of funding are linked to the shorter end. Therefore, an inverted yield curve typically compresses banks' interest margins, which tends to hinder credit origination and slow down business activity. For example, Chart 3 shows that U.S. mortgage interest rates historically have been tightly linked with 10-year Treasury yields, while interest rates of banks' deposit base and interbank rates for "wholesale" funding are both determined by short-term Treasury yields, which is in turn determined by the fed funds rate. In China, the yield curve plays a much smaller role than in the developed world, simply because the country's market-based financial intermediation is much less important. Traditionally both lending rates and deposit rates of commercial banks were rigidly set by the People's Bank of China, and there was little lending/borrowing activity outside the formal commercial banking system. The situation has been gradually changing in recent years as a result of financial reforms. Banks are given flexibility to set their own interest rates, and non-bank lending, or shadow banking activity that is more driven by market interest rates, has expanded. However, commercial banks still play a dominant role. Chart 3U.S. Bank Loan Rates Follow Treasury Yields Closely U.S. Bank Loan Rates Follow Treasury Yields Closely U.S. Bank Loan Rates Follow Treasury Yields Closely Chart 4China: Bank Loans Still Dominate China: Bank Loans Still Dominate China: Bank Loans Still Dominate Bank loans currently account for over 70% of China's total non-equity social financing, both in terms of flow and total outstanding stock (Chart 4). Commercial banks' average lending rate still closely tracks the PBoC policy benchmark. Banks' prime lending rate moves in lock step with PBoC interest rate adjustments, and average interest rates on new mortgages are also primarily determined by the policy rate (Chart 5). Banks' cost of funding is also primarily determined by retail deposit interest rates, which are in turn set by the PBoC. Retail deposits account for about 80% of total loanable funds for large banks, or 70% for smaller banks (Chart 6). Repo and interbank transactions, which are subject to the central bank's liquidity tightening, only account for 14% of smaller lenders' source of funds, or a mere 2% for large lenders. Chart 5Chinese Bank Loan Rates ##br##Still Track PBoC Benchmarks Chinese Bank Loan Rates Still Track PBoC Benchmarks Chinese Bank Loan Rates Still Track PBoC Benchmarks Chart 6Retail Deposits Are Still The Dominant Funding Source ##br##For Commercial Banks Retail Deposits Are Still The Dominant Funding Source For Commercial Banks Retail Deposits Are Still The Dominant Funding Source For Commercial Banks The important point is that market signals from China's juvenile and volatile financial markets should be taken with a healthy dose of skepticism, and a simple comparison with the West is often misleading. For example, a significant decline in stock prices in developed economies may well herald a growth recession in their respective economies. In China, however, domestic stock prices have routinely gone through massive boom and bust cycles without any tangible impact on the broader economy, as the equity markets play a marginal role for both the corporate sector in terms of raising capital and for households in managing their wealth. In recent years, China's financial sector reforms have been gradually introducing market forces in setting interest rates, but the process is far from advanced enough to have a meaningful and direct impact on the cost of funding for both the corporate sector and banks. Overall, the inverted Chinese yield curve indicates tighter interbank liquidity in recent months, but the impact on the economy should be limited. PBoC Tightening: Passing The Phase Of Maximum Strength Moreover, it is noteworthy that yield-curve flattening has been a global phenomenon rather than a China-specific development (Chart 7). What's different is that in other countries the flatter yield curve has been mostly due to falling yields of longer-dated bonds, while in China it has been entirely driven by a sharp increase in short-term yields due to the PBoC's liquidity tightening.1 Looking forward, the PBoC will maintain close scrutiny on the financial sector to keep financial excesses in check. However, we believe the phase of maximum strength of liquidity tightening is likely over, at least in the near term. There is no case for genuine monetary tightening, as inflation is extremely low and growth momentum is already softening. It is very unlikely that the PBoC will tighten monetary conditions further, amplifying deflationary pressures in the process.2 The PBoC's tightening measures have already significantly reduced the pace of leverage buildup and excesses in the financial system. Banks' exposure to non-bank financial institutions has tumbled, net issuance of commercial banks' negotiable certificates of deposits has turned negative of late, and overall off-balance-sheet lending by financial institutions, or shadow banking activity, has slowed sharply in recent months (Chart 8). In other words, the tightening campaign has achieved the intended consequences, diminishing the odds of further escalation. Chart 7Synchronized Yield Curve Flattening Synchronized Yield Curve Flattening Synchronized Yield Curve Flattening Chart 8Financial Excesses Are Being Reined In Financial Excesses Are Being Reined In Financial Excesses Are Being Reined In Global developments are also conducive for some loosening by the PBoC. Last week's rate hike by the Federal Reserve has further pushed down both U.S. interest rates and the dollar. The spread between Chinese 10-year government bond yields and U.S. Treasurys has widened sharply of late, which is helping stabilize the RMB (Chart 9). All of this has reduced pressure on the PBoC to follow the Fed with additional domestic tightening. Already, the PBoC has stepped in to ease liquidity pressure in the interbank system in recent weeks. After massive liquidity withdrawals early this year, the PBoC has been injecting liquidity into the interbank market through various open market operations in the past two months, according to our calculations - likely a key reason why interbank rates have stopped rising of late (Chart 10). Chart 9China - U.S. Interest Rate Spread Versus##br## Exchange Rate China - U.S. Interest Rate Spread Versus Exchange Rate China - U.S. Interest Rate Spread Versus Exchange Rate Chart 10The PBoC Is Stepping In ##br##To Ease Interbank Liquidity Pressure The PBoC Is Stepping In To Ease Interbank Liquidity Pressure The PBoC Is Stepping In To Ease Interbank Liquidity Pressure Chart 11Onshore Corporate Bonds ##br##Are Attractive Onshore Corporate Bonds Are Attractive Onshore Corporate Bonds Are Attractive Chinese corporate bonds will benefit the most, should the authorities stop further tightening (Chart 11). Onshore corporate spreads have widened sharply since late last year amid the PBoC crackdown, and are now substantially higher than in other countries. Chinese corporate spreads should recover without further escalation in liquidity tightening, and will also benefit from the ongoing profit recovery in the corporate sector. We expect both quality spreads and government bond yields to drop in the next three to six months, lifting corporate bond prices. Bottom Line: The PBoC will at minimum pause its liquidity tightening campaign, which will provide a window for bonds to rally. Go long Chinese onshore corporate bonds. A Word On The MSCI A-Share Inclusion MSCI Inc. announced this week its decision to include Chinese A shares in its widely followed emerging market and world equities indexes. The company will add 222 China A large-cap stocks to its EM benchmark at a 5% partial inclusion factor, which will account for about 0.73% of EM market cap. This marks a major milestone in China's capital market development and financial sector liberalization. Increasing participation of foreign institutional investors will also over the long run help improve China's corporate governance and regulatory practices - all of which are instrumental for improving the efficiency of domestic capital market as well as the efficiency of capital allocation. Table 1Valuation Of China A-Share Universe Chinese Financial Tightening: Passing The Phase Of Maximum Strength Chinese Financial Tightening: Passing The Phase Of Maximum Strength The near-term market impact, however, should be negligible. After all, the inclusion will take effect June next year. In addition, foreign investors already have access to these A share companies through the existing Stock Connect channels between Chinese domestic exchanges and Hong Kong. Moreover, potential capital inflows from global managed assets benchmarked to MSCI indexes in the initial step will be marginal. It is estimated that a total of US$18 billion, or RMB 125 billion, foreign capital may follow the MSCI decision into the A share market, a tiny fraction of A-shares' almost RMB 40 trillion market cap. That said, the valuation indicators of the select 222 large-cap names look attractive compared with their domestic peers, with median trailing P/E and P/B ratios at 23 and 2 times, substantially lower than other major domestic indexes (Table 1). MSCI inclusion may well provide a catalyst for some catch-up rally. We will follow up on this issue in the following weeks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports, "A Chinese Slowdown: How Much Downside?," dated June 8, 2017, and "Chinese Growth: Testing Time Ahead," dated April 6, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights For the time being, our cyclical stance is to underweight the globally-sensitive Energy, Materials and Banks sectors versus Healthcare - in both the equity and credit asset-class. Combined with our expectation of a weakening pound/euro, this necessarily means the following European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands and Sweden. Underweight: Italy, Spain, and Norway. We anticipate shifting to a more cyclical sector (and country) allocation by the late summer, especially on dips. Feature It is worth reminding readers that picking mainstream equity markets1 is overwhelmingly about the industry sectors and dominant stocks that you are buying, wittingly or unwittingly. Picking equity markets is seldom about the prospects of the underlying domestic economies or head-to-head valuations.2 Chart of the WeekGlobal Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) Global Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) Global Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) The usual top-down approach to picking stock markets ignores two dominant features of these markets. First, they have huge variations in their sector exposures. Second, large industry sector groups like Energy, Banks, Healthcare and Technology tend to move en masse under the influence of global or regional rather than domestic drivers. The combination of these two features means that for most stock markets, the sector (and dominant company) impact swamps the effect that comes from the domestic economy. Right now, by far the most important consideration for country pickers is the relative outlook for the globally-sensitive Energy and Banks sectors versus the more defensive Healthcare. As an example, consider the choice between Spain and Switzerland. Spain's IBEX is at the mercy of its huge weighting to Banks, dominated by Santander and BBVA; while Switzerland's SMI is at the mercy of its similarly dominant weighting in the Healthcare sector, via Novartis and Roche. Box I-1 - Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks (Chart 2). France (CAC) is underweight Banks and Basic Materials (Chart 3). Italy (MIB) is overweight Banks (Chart 4). Spain (IBEX) is overweight Banks (Chart 5). Netherlands (AEX) is overweight Technology, underweight Banks (Chart 6). Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy (Chart 7). And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound (Chart 8). Switzerland (SMI) is overweight Healthcare, underweight Energy (Chart 9). Sweden (OMX) is overweight Industrials (Chart 10). Denmark (OMX20) is overweight Healthcare and Industrials (Chart 11). Norway (OBX) is overweight Energy (Chart 12). The U.S. (S&P500) is overweight Technology, underweight Banks (Chart 13). It follows that if Banks underperform Healthcare, it is highly likely that Spain's IBEX will underperform Switzerland's SMI, irrespective of the performances of the Spanish and Swiss domestic economies. For long-term investors, the large skews in sector exposure also mean that a head-to-head comparison of country valuations can be very misleading. At first glance, Spain, trading on a forward price to earnings (PE) multiple of 15.5, appears 15% cheaper than Switzerland, trading on a multiple of over 18. But this head-to-head difference just reflects the impact of forward PEs of Banks at 11 and Healthcare at 18. The Bank sector's lower multiple does not necessarily make it better value than Healthcare. Unlike two developed economies - whose long-term growth prospects tend to be broadly similar - two industry sectors could end up experiencing very different structural growth outcomes. Which would justify very different multiples. Despite its low multiple, a structural underweight to Banks might nonetheless be a good strategy if the sector's structural growth outlook is poor. In such a case, the low multiple is potentially a value trap. Picking Stock Markets The Right Way To reiterate, the decision to overweight or underweight a mainstream equity index should not be based on your view of the country's underlying economy - unless, of course, the country is the potential source of a major tail-risk event. Instead, the decision should be based on your over-arching sector view, combined with the country's skews to specific dominant stocks and sectors (Box I-1). Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7, Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12 and Chart I-13 should leave readers in absolutely no doubt. A market's dominant sector skew is by far the most important determinant of its relative performance. Chart I-2Germany (DAX) Is Overweight Chemicals,##br## Underweight Banks Germany (DAX) Is Overweight Chemicals, Underweight Banks Germany (DAX) Is Overweight Chemicals, Underweight Banks Chart I-3France (CAC) Is Underweight Banks##br## And Basic Materials France (CAC) Is Underweight Banks And Basic Materials France (CAC) Is Underweight Banks And Basic Materials Chart I-4Italy (MIB) Is Overweight Banks Italy (MIB) Is Overweight Banks Italy (MIB) Is Overweight Banks Chart I-5Spain (IBEX) Is Overweight Banks Spain (IBEX) Is Overweight Banks Spain (IBEX) Is Overweight Banks Chart I-6Netherlands (AEX) Is Overweight Technology,##br## Underweight Banks Netherlands (AEX) Is Overweight Technology, Underweight Banks Netherlands (AEX) Is Overweight Technology, Underweight Banks Chart I-7Ireland (ISEQ) Is Overweight Airlines (Ryanair) ##br##Which Is, In Effect, Underweight Energy Ireland (ISEQ) Is Overweight Airlines (Ryanair) Which Is, In Effect, Underweight Energy Ireland (ISEQ) Is Overweight Airlines (Ryanair) Which Is, In Effect, Underweight Energy Chart I-8The U.K. (FTSE100) Is Effectively ##br##Underweight The Pound The U.K. (FTSE100) Is Effectively Underweight The Pound The U.K. (FTSE100) Is Effectively Underweight The Pound Chart I-9Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Switzerland (SMI) Is Overweight Healthcare, Underweight Energy Switzerland (SMI) Is Overweight Healthcare, Underweight Energy Chart I-10Sweden (OMX) Is ##br##Overweight Industrials Sweden (OMX) Is Overweight Industrials Sweden (OMX) Is Overweight Industrials Chart I-11Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Denmark (OMX20) Is Overweight Healthcare And Industrials Denmark (OMX20) Is Overweight Healthcare And Industrials Chart I-12Norway (OBX) Is ##br##Overweight Energy Norway (OBX) Is Overweight Energy Norway (OBX) Is Overweight Energy Chart I-13The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks The U.S. (S&P500) Is Overweight Technology, Underweight Banks The U.S. (S&P500) Is Overweight Technology, Underweight Banks Which brings us to the key consideration for country allocation right now: how to allocate to the sectors that feature most often in the skews: Energy and Banks versus Healthcare. For Energy relative performance, note the very strong recent connection with the global 6-month credit impulse. The downswing in the impulse - heralding a very clear growth pause - lines up with the setback in energy and resource prices and the underperformance of these globally-sensitive equity sectors (Chart of the Week and Chart I-14). Meanwhile, in the most recent mini-cycle, Banks' relative performance is tracking the bond yield almost tick for tick (Chart I-15). There are two reasons. For banks, lower bond yields presage both slimmer net interest margins and weaker economic growth. Chart I-14Commodity Price Inflation Is Just Tracking ##br##The Global 6-Month Credit Impulse Commodity Price Inflation Is Just Tracking The Global 6-Month Credit Impulse Commodity Price Inflation Is Just Tracking The Global 6-Month Credit Impulse Chart I-15Financials Are Just Tracking ##br##The Bond Yield Financials Are Just Tracking The Bond Yield Financials Are Just Tracking The Bond Yield So for both Energy and Banks relative performance the overriding question is: when will this mini-downswing end? To answer this question, we note that we are 4-5 months into the global mini-downswing, whose average duration tends to be around 8-9 months. On this basis, now is a little too early to switch to an aggressively pro-cyclical sector allocation. But we would look for potential opportunities by the late summer, especially on sharp dips. Hence, for the time being our cyclical stance is to underweight the globally-sensitive Energy (and Materials) and Banks versus Healthcare. Combined with our expectation of a weakening pound/euro, this necessarily means the following European country allocation: Overweight: France,3 Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands, and Sweden. Underweight: Italy, Spain, Netherlands and Norway. Clearly, if you have a different cyclical and over-arching sector view, you will arrive at a different country allocation. That's fine. The important point is that the stock and sector skew approach is the right way to pick between mainstream equity indexes. Financials Drive The European Credit Market Finally, an over-arching sector view is also highly relevant for the European corporate credit market. In the euro area, the credit market is heavily skewed towards bank and other financial sector bonds, which account for almost half of euro area corporate bonds by value. By comparison, the U.S. credit market is not so skewed to one dominant sector. Hence, the outlook for the European credit asset-class hinges on the prospects for one sector: Financials (Chart 16). With the European high yield credit spread already close to a 20-year low, we would again wait for a better opportunity before adding aggressively to the European credit asset-class. Chart I-16Mirror Image: European High Yield Credit Spread And Bank Equity Prices Mirror Image: European High Yield Credit Spread And Bank Equity Prices Mirror Image: European High Yield Credit Spread And Bank Equity Prices Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In the developed world. 2 Please also see the three European Investment Strategy Special Reports 'Picking 5 European Countries The Right Way' November 13, 2014, 'Picking Countries The Right Way: Part 2' March 26, 2015 and 'Picking Countries The Right Way: Part 3' November 12, 2015. 3 But expect a small near-term countertrend underperformance in the CAC40. See page 11. Fractal Trading Model* There are no new trades this week. Last week's trade, long nickel / short palladium has made an encouraging countertrend move at the classic limit of a trend. 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-17 Long Nickel / Short Palladium Long Nickel / Short Palladium 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 Portfolio Strategy The rally in the S&P restaurants index has run its course and a profit recovery is fully discounted. Lock in profits and downgrade to neutral. Intensified inter-industry competition, the onslaught of online retailers and a rebounding U.S. economy are stiff headwinds for hypermarket stocks. Sell positions down to neutral. Recent Changes S&P Restaurants - Downgrade to neutral, booking profits of 11%. S&P Hypermarkets - Downgrade to neutral. Table 1 Rotation Does Not Mean Correction Rotation Does Not Mean Correction Feature The S&P 500 remained resilient in the face of the fourth Fed interest rate hike and the drubbing in the tech sector. The latter is notable given that a select few stocks have contributed roughly one quarter of the overall market's gains this year, and signals that money is not leaving equities en masse, but is merely rotating into other sectors. This suggests that consolidation rather than correction is the main watchword. Our view remains that stocks are in a sweet spot: a lack of inflation pressures has kept long-term interest rates at bay, despite decent economic momentum and rising corporate profits. The latter have been driven by impressive corporate pricing power gains (see Chart 1 from last week's Weekly Report), creating an ideal equity market scenario whereby the business sector can grow profits without any corresponding consumer price inflation pressures. Investors are likely to extrapolate this goldilocks equity scenario for a while longer, given that our Reflation Gauge (RG), a combination of oil prices, Treasury yields and the U.S. dollar, has exploded to the highest level since 2010 and just shy of all-time highs. The RG leads both the U.S. economic surprise index and equity sentiment (Chart 1). If economic activity begins to reaccelerate, as we expect and irrespective of tax reform success, the window is open for additional equity market gains. Meanwhile, the mini sector rotation that commenced two weeks ago is a healthy development and may not be a precursor to a more vicious and widespread correction. In recent Weekly Reports, we have shown that our Equity Market Internal Dynamics Indicator was signaling that upward momentum in the broad market was well supported by the character of market participation (see Chart 2 from the May 15th Weekly Report). Chart 1Coiled Spring Coiled Spring Coiled Spring Chart 2Healthy Rotation Healthy Rotation Healthy Rotation Chart 2 shows that lately the small/large ratio has sprung back to life. Growth/value stalled near the previous all-time peak, and capital has flowed out of frothy tech stocks and into the cheaper and more economic-sensitive financials sector. Against a backdrop of a budding rebound in domestic economic data, this recent market rotation is likely to stay intact. That view is corroborated by the collapse in correlations among stocks and overall assets. The CBOE's implied correlation index has fallen to fresh cyclical lows, which suggests that investors have become increasingly discerning and that earnings fundamentals/valuations should become the primary drivers of stock market returns. Keep in mind that empirical evidence shows that receding stock correlations also underpin the broad equity market (top & bottom panels, Chart 2). All of these fluctuations signal that the broad equity market is more likely to build a base before it resumes its advance to new cyclical highs, rather than suffer an imminent and major correction. As such, we continue to slowly and deliberately recalibrate our portfolio away from its previously heavy bias toward defensives. This week we make two consumer-related shifts. Restaurants: Beware Of Heartburn One quarter ago we posited that the consolidation phase in the broad consumer discretionary sector restored value and created an attractive entry point. Washed out technicals and an upswing in industry earnings fundamentals supported our thesis (Chart 3). An upgrade in the S&P restaurants sub-index to overweight provided an attractive way to execute that thesis. This view has largely played out, as restaurant shares have bested the market by double digits since March 20th. Is there any more upside left to this impressive quarterly relative return? We doubt it. While we remain constructive on the overall consumer discretionary sector (Chart 4), we recommend crystalizing gains of 11% in the S&P restaurants index and downshifting to neutral. Chart 3Stay ##br##The Course... Stay The Course... Stay The Course... Chart 4...As Our Consumer Drag ##br## Indicator Is Flashing Green ...As Our Consumer Drag Indicator Is Flashing Green ...As Our Consumer Drag Indicator Is Flashing Green Q1 industry conference calls revealed that improved store traffic and better offerings boosted same-store sales, and relative share prices followed suit from a technically depressed level. That caused sell side analysts to modestly lift relative EPS forecasts, but a valuation re-rating still explains the bulk of the stock price surge (Chart 5). We are reluctant to pay a 40% premium to the broad market on a 12-month forward P/E basis. The National Restaurant Association's Restaurant Performance Index fell to the boom/bust 100 line and downside momentum has accelerated (second panel, Chart 5). Worrisomely, the Current Situation Index (not shown) of the same survey was in the contraction zone for "the sixth time in the last seven months". Similarly, the Expectations Index also decelerated, heralding an uncertain dining outlook. Indeed, demand for away from home dining is on the decline in absolute terms and compared with overall retail sales and consumption (middle panel, Chart 6). This suggests that the first quarter increase in store traffic may not be sustainable (top panel, Chart 6). The recent spike in restaurant construction expenditures will further dilute same-store sales growth opportunities (bottom panel, Chart 6). Chart 5Too Expensive Too Expensive Too Expensive Chart 6Do Not Overstay Your Welcome Do Not Overstay Your Welcome Do Not Overstay Your Welcome Leading indicators of profit margins have also eroded. An uptick in commodity input costs and 8% growth in the industry's wage bill, stand in marked contrast with anemic industry pricing power. Our restaurants profit margin gauge captures all of these forces and warns that a squeeze looms (Chart 7). Nevertheless, it is not all bad news. The improvement in consumer finances should counterbalance some of the casual dining industry's deficient demand hiccups. Rising household net worth makes consumers feel wealthier, and therefore increases their marginal propensity to spend. Importantly, the $15-$35K income cohort also expects a sizable boost to their take home pay, according to the latest Conference Board survey data (not shown). Importantly, the earnings headwind from foreign sales exposure has likely morphed into a profit tailwind. U.S. dollar softness is not only evident against G10 currencies, but also emerging market (EM) FX rates (Chart 8). In addition, healthy EM domestic demand is the mirror image of fickle U.S. final demand. EM central banks are easing monetary policy - whereas the Fed hiked for a fourth time this cycle last week - in order to rekindle EM consumer spending/growth. As a result, EM restaurant sales should improve (Chart 8). Chart 7Rising Input Costs ##br##Are Eating Into Margins Rising Input Costs Are Eating Into Margins Rising Input Costs Are Eating Into Margins Chart 8Export ##br## Relief Valve Export Relief Valve Export Relief Valve In sum, the playable rally in the S&P restaurants index has run its course and a profit recovery is fully priced in frothy valuations. The V-shaped rebound in share prices has outpaced fundamental improvements, and a consolidation/corrective phase is inevitable. Bottom Line: While we remain overweight the S&P consumer discretionary sector, we recommend booking profits of 11% in the S&P restaurants index (MCD, SBUX, YUM, DRI, CMG), and moving to a benchmark allocation. Time To Downgrade Hypermarkets While investors have shed anything retail related year-to-date (YTD), big box retailers have been a positive exception. In fact, the S&P hypermarkets index has been a stalwart performer YTD, outshining both the broad consumer staples universe and the overall market. Is this impressive run-up sustainable? The short answer is no. Three main headwinds suggest that some caution is warranted now that index outperformance has eliminated the previous valuation appeal: soft pricing power likely further aggravated by new German competitors expanding in/entering the U.S. market, the ongoing assault from online retailers and the improving U.S. economy, especially consumer spending. These factors imply that profit margins will remain under chronic pressure, but concerns could become more acute on a cyclical basis. Consumer goods import prices have surged in recent months (Chart 9), and the depreciating U.S. dollar is likely to sustain this uptrend. Cutthroat competition means that retailers will likely absorb these rising costs, to the detriment of profit margins. While food prices are making an effort to exit the deflation zone, ALDI and Lidl, two deep-pocketed German competitors are entering the U.S. retail scene, reportedly with massive expansion plans. Tesco, Sainsbury's and ASDA in the U.K., Carrefour in Europe and Woolworth's and Coles in Australia continue to feel the wrath of German retailers. Consequently, it would be dangerous to extrapolate the nascent improvement in retail food CPI. All of this is likely to sustain the profit margin squeeze (Chart 9). Further, the online retail onslaught will continue to escalate. The Amazon juggernaut appears unstoppable. The latest news that it will take over Whole Foods Market confirms that even grocery sales are now seriously on its radar screen. Chart 10 shows that non-store retail sales continue to grow at a much faster pace than traditional retailers. The greater the market share gains for online retailers, the larger the downward pressure on hypermarkets relative profitability (relative retail sales shown inverted, second panel, Chart 10). Chart 9Margin Pressures Margin Pressures Margin Pressures Chart 10Beware Online Retailers' Onslaught Beware Online Retailers' Onslaught Beware Online Retailers' Onslaught Under such a tough operating backdrop we are reluctant to pay a premium valuation for this safe haven sector. Worrisomely, soft revenue growth argues against a further a valuation re-rating (Chart 11). Finally, macro forces required to spur better revenue no longer exist. The U.S. economy has entered a self-reinforcing recovery. While personal consumption expenditures have underwhelmed of late, buoyant job certainty and a vibrant housing market are boosting consumer confidence. Before long, consumers should loosen their purse strings and indulge anew. Historically, a lively consumer spending backdrop has been inversely correlated with relative share prices (PCE is shown inverted, Chart 12). Similarly, Federal tax coffers have started to refill following a one year hiatus (bottom panel, Chart 12). The implication is that incomes and profits are expanding, boosting the incentive for consumers to "trade up" and shop at higher ticket stores. Nevertheless, some partial offsets exist. The lower income consumer is the industry's main clientele and low interest rates, low gasoline prices and soaring income confidence for this consumer cohort should cushion store traffic woes (third panel, Chart 13). Chart 11Derating ##br## Warning Derating Warning Derating Warning Chart 12Improving Economy = ##br## Bad Omen For Hypermarkets Improving Economy = Bad Omen For Hypermarkets Improving Economy = Bad Omen For Hypermarkets Chart 13Positive ##br##Offsets Positive Offsets Positive Offsets Meanwhile, the overall retail sales price deflator has tentatively troughed, albeit it continues to deflate. Given the high volume nature of the hypermarket industry, any small positive change in pricing power tends to have a meaningful impact on sales growth (second panel, Chart 13). Multi-year highs in overall income growth signals that on average consumers will have more disposable income. The bottom panel of Chart 13 shows that income growth has been a reliable indicator for hypermarket EPS. Adding it up, this is an opportune time to book modest profits and downgrade exposure in the S&P hypermarkets index to neutral. Intensified inter-industry competition, the onslaught of online retailers and a rebounding U.S. economy argue against extrapolating recent optimism far into the future. Bottom Line: Downgrade the S&P hypermarkets index to a benchmark allocation (WMT, COST). Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The Federal Reserve stuck to its guns, which lifted the U.S. dollar despite a disastrous CPI report. We agree with the Fed's assessment and expect U.S. inflation to pick up, clearing the way for higher interest rates and a stronger dollar. With three dissenters voting in favor of higher rates, the Bank of England meeting delivered a hawkish surprise. However, the inflation surge will continue to weigh on consumer spending, limiting the capacity of the BoE to increase rates. Stay short cable, but use any rally in EUR/GBP above 0.88 to short this cross. The Canadian economy is strong, and the CAD should perform well on its crosses. However, USD/CAD downside is limited. Go short EUR/SEK. Feature This week was replete with central bank meetings, most crucially the Federal Reserve and the Bank of England, which provided much-needed color on the near-term future direction of global monetary policy. While the BoE does face a serious rise in inflation, it is still focused on the risks to U.K. growth. In contrast, the Fed mostly ignored the disastrous inflation report released the morning before its policy announcement and kept its focus on the underlying strength in the U.S. economy. We believe both institutions are pursuing the appropriate strategy for their respective economies. The Fed: Straight Ahead Fed Chair Janet Yellen and her gang increased the fed funds rate by 25 basis points to 1-1.25% and pre-announced the parameters around the reduction in the Fed's balance sheet size. On the balance sheet front, the Fed removed any doubt that it will begin reducing its asset holdings this year. Additionally, the Fed provided its new set of forecasts for growth, inflation, unemployment, and interest rates. While it increased its growth forecast for 2017 to 2.2% from 2.1%, it curtailed its core PCE deflator forecast for 2017 by 0.3 percentage points to 1.6%. However, in line with its conviction that the soft patch in inflation is temporary, it kept its 2018 and 2019 core PCE forecasts at 2%. The Fed did also acknowledge that the equilibrium unemployment rate was lower than it believed in March, decreasing its long-term estimate by 0.1% to 4.6%. However, despite recognizing that NAIRU has fallen, the Fed still thinks the labor market is tight. It proceeded to curtail its unemployment rate forecasts by 0.2% in 2017 to 4.3%, and by 0.3% in 2018 and 2019 to 4.2%. Congruent with these forecasts, the Fed did not adjust its intended path for interest rates. It still expects to hike rates once more in 2017, and three more times in both 2018 and 2019. As a result of these policy changes and the intentions associated with the new set of forecasts, the dollar recouped its CPI report-induced decline, and gold suffered. Most interestingly, the market seems to believe that the Fed is entering the realm of policy mistakes as the 2-10-year yield curve flattened considerably, and inflation expectations plunged to their lowest levels since November 4, 2016 (Chart I-1). But is the Fed really making a mistake? We do not think so. Simply put, we agree with the Fed that underlying economic momentum in the U.S. is real, and that both wage growth and inflation will turn the corner this summer. To begin with, our composite capacity utilization gauge, based on both industrial capacity and labor market utilization, is now fully into "no slack" territory. Historically, this has given the Fed the green light to increase interest rates. There is no mystery behind this relationship: when this indicator is above the zero line, inflation pressures emerge and wage growth accelerates (Chart I-2). This time is unlikely to prove different. Chart I-1A Policy ##br##Mistake? A Policy Mistake? A Policy Mistake? Chart I-2Conditions In Place For Higher##br## Inflation And Rates Conditions In Place For Higher Inflation And Rates Conditions In Place For Higher Inflation And Rates Supporting this assessment, many indicators show that the recent slowdown in wage growth will prove a temporary phenomenon. First, the spread between the Conference Board's "jobs plentiful" and "jobs hard to get" series still points to accelerating average hourly earnings (Chart I-3). Second, the labor market is likely to remain healthy. True, the fastest pace of job creation is behind us, a key symptom that labor market slack is vanishing, but some of our favorite employment indicators - such as Janet Yellen's labor market condition index and the NFIB job openings and hiring plans subcomponents - have picked up again (Chart I-4). In an environment of little slack, this might not translate into impressive nonfarm payroll numbers, but most likely faster wage growth. Chart I-3Wages Will Pick Up Wages Will Pick Up Wages Will Pick Up Chart I-4Yes, The Labor Market Is Healthy Yes, The Labor Market Is Healthy Yes, The Labor Market Is Healthy Third, capex intentions are still perky. Historically, capex intentions have tightly correlated with wages, and even the recent softness in wages was forecast by these intentions. This is simply because capex tends to require labor. When corporate investment materializes as worries about the durability of final demand hits cyclical lows, this is generally an environment that requires bidding up the price of labor - i.e. wages. This is precisely the current economic backdrop (Chart I-5). While the slowdown in bank credit to enterprises has caused many commentators to worry about the outlook for capex, we do not share these concerns. For one, although businesses may not have been tapping bank loans in Q1, they have been aggressively borrowing in the bond market (Chart I-6, top panel). Moreover, credit standards are now easing anew, and small firms are reporting little difficulty in accessing credit (Chart I-6, bottom panel). Chart I-5Good Outlook For Growth And Wages Good Outlook For Growth And Wages Good Outlook For Growth And Wages Chart I-6I Need Credit; No Problem! I Need Credit; No Problem! I Need Credit; No Problem! With respect to consumption, weren't retail sales on the soft side as well? Here again, we need to step back. Real retail sales continue to grow at a healthy 4.2% annual pace; meanwhile, the so-called control group - which affects GDP computations - was flat in May, but the April number was revised to 0.6% month-on-month, suggesting real consumption will be robust in Q2. In fact, federal income tax withholdings, a good proxy for household income growth, is also accelerating, further supporting consumption (Chart I-7). Overall, we agree with the Fed that the economy is on its way to escaping from its recent soft patch and that wage growth will accelerate. Ryan Swift, who writes our sister U.S. Bond Strategy service, has also recently argued that the U.S. Philips curve remains alive and well, and that wages and inflation will thus pick up again.1 Our own work does highlight the potential for not just wage growth but core CPI to also perk up. U.S. real business sales have been very strong of late, which historically has been a good leading indicator of core inflation (Chart I-8, top panel). Labor market dynamics tell a similar story. Our unemployment diffusion index is also a good leader of core CPI, and after a soft patch is now pointing to firming underlying inflation (Chart I-8, bottom panel). Chart I-7Real Consumption Will Trudge Along Real Consumption Will Trudge Along Real Consumption Will Trudge Along Chart I-8Inflation Soft Patch Will End Inflation Soft Patch Will End Inflation Soft Patch Will End Therefore, we expect the recent negative inflation surprise in the U.S. to reverse. Moreover, inflation surprises in the U.S. are also likely to beat those of the euro area. To a very large extent, Europe's positive inflation surprise, especially relative to the U.S., reflected the 2014 collapse in the euro. The recent stability in the euro since March 2015 further reinforces that the boost to European relative monetary conditions is dissipating, and that European inflation surprise will not outpace the U.S. going forward (Chart I-9). Chart I-9U.S. Inflation Surprises ##br##Will Pick Up Versus Europe's U.S. Inflation Surprises Will Pick Up Versus Europe's U.S. Inflation Surprises Will Pick Up Versus Europe's Chart I-10Diverging Policy ##br##Expectations Diverging Policy Expectations Diverging Policy Expectations This is very important, as these relative inflation surprise dynamics have been the key factor underpinning divergent expectations behind ECB policy and the Fed's path. While investors have increasingly brought forward the ECB's first hike, they have aggressively curtailed the number of hikes expected in the U.S. over the next two years (Chart I-10). If, as we expect, relative inflation surprises do once again move in favor of the U.S., this gap will disappear, supporting the dollar in the process. Bottom Line: The Fed is right to stay the course. The economy continues to display momentum, and the inflation soft patch should soon dissipate. Moreover, U.S. economic surprises are bottoming. As such, we expect market expectations for inflation and interest rates to move back toward the Fed's forecast, lifting the U.S. dollar in the process. BoE Dissenters Grab The Headlines, But... The poor BoE is in an infinitely more tenuous situation than the Fed. Core inflation continues to pick up, but economic uncertainty is also on the rise. This dichotomy is most pronounced when it comes to wages. At 2.6%, core inflation is now outpacing wage growth, thus real income levels are contracting (Chart I-11). This is problematic because at 65% of GDP, the U.K. is an economy fundamentally driven by consumer spending. As Chart I-12 illustrates, when inflation picks up and puts downward pressure on real wages, consumption sags. Therein lies the BoE's conundrum. Chart I-11U.K.: Inflation Everywhere, But Not In Wages U.K.: Inflation Everywhere, But Not In Wages U.K.: Inflation Everywhere, But Not In Wages Chart I-12The BOE's Dilemma The BOE's Dilemma The BOE's Dilemma Despite the three dissenters who voted in favor of a hike this week, we expect the BoE to continue to favor not lifting rates, leaving its accommodation in place.2 Household inflation expectations remain well moored, but a further relapse in growth could prompt a widening of the output gap and produce entrenched deflationary expectations down the line - something BoE Governor Mark Carney and his colleagues want to avoid at all costs. Chart I-13U.K. FDI At Risk U.K. FDI At Risk U.K. FDI At Risk Some investors have been wondering out loud about the likelihood of a "soft Brexit" coming back on the agenda, arguing that it would support the pound. Remaining in the common market is, after all, an unmitigated positive for the U.K. But to be part of the common market, the U.K. also has to adopt the sacrosanct freedom of movement of people. We remain unconvinced that the British will budge on this point. Brexit was first and foremost a rejection of neo-liberal ideals that have been perceived as detrimental to the British middle class. And no point has been and continues to be more contentious than immigration. With the EU absolutely unwilling to dilute freedom of movement, access to the common market for the U.K. remains a distant dream. Moreover, with the British median voter switching to the left, a topic discussed in last Friday's Geopolitical Strategy Service Special Report on the election, British politics are likely to become less business friendly.3 Compounding this issue, U.K. industrial production is flat on an annual basis, bucking the global improvement seen last year and implying that the falling pound has not boosted competitiveness in the U.K. manufacturing sector. Together these forces suggest that the recent upsurge in FDI inflows into the U.K. could reverse in coming quarters (Chart I-13), a big problem for a country with a current account deficit of more than 4% of GDP and deeply negative real rates. Ultimately, the pound is cheap, trading at a one-sigma discount to its fair value. This means the market is well aware of the negatives that are weighing on sterling. Thus, the risks to GBP are well balanced. As a result, we expect GBP/USD to finish the year toward 1.2 because of our expectation of USD strength. EUR/GBP has limited upside, and rises above 0.88 should be used to build short positions. Bottom Line: The BoE decision was in line with expectations, but the market was nonetheless surprised by the fact that three MPC members dissented and voted for a rate hike. Sure, British inflation is on the rise, but this is hurting household real incomes, and thus consumption. These dynamics limit the upside risk to policy rates. We think that GBP could weaken against the USD; we would use moves above 0.88 to short EUR/GBP. The Bank Of Canada Volte Face Despite a 5% fall in oil prices this week, the CAD has appreciated 1.2% against the USD. Behind this impressive move has been Monday's speech by Senior Deputy Governor Carolyn Wilkins, in which she hinted that the Bank of Canada's next move will be a hike, coming sooner than investors have been anticipating. The BoC assessed that the negative impact of the fall in oil prices in 2014-'15 has passed, and that domestic strength in the Canadian economy has become self-sustaining. With the output gap expected to close in Q2 2018, the logical path for policy is tighter. Do the indicators warrant such a view? Yes: Canadian employment is quite strong, growing at a 1.8% annual pace. Unemployment too has fallen substantially. Capacity utilization is elevated in the manufacturing sector, thanks to a decade of low corporate investment. If our assessment of the U.S. capex cycle is correct, Canadian goods exports should pick up, adding to capacity and inflationary pressures in the country (Chart I-14). Our Canadian economic diffusion index - based on retail trade, manufacturing sales, building permits, and employment data in the 10 provinces - has sharply accelerated, pointing to a continued rise in GDP growth. Canadian LEIs and PMIs are all strong. Canadian house prices continue to forge ahead, growing at a 14% annual rate, which will additionally support Canadian consumption. This picture highlights that the BoC does have room to adjust its forward guidance, especially if the Fed stays on its desired path. Today, not only are investors the most short CAD since early 2007, but the loonie is cheap relative to real rate differentials (Chart I-15). As a result of these distortions, CAD could respond very positively to continued reaffirmation by the BoC that policy may become tighter. Chart I-14O Canada O Canada O Canada Chart I-15CAD At A Discount To Rates CAD At A Discount To Rates CAD At A Discount To Rates Practically, due to our broad bullish outlook on the USD, we find the most interesting way to play CAD strength is through its various crosses. Thus, we remain short EUR/CAD, short AUD/CAD, and long CAD/NOK. Bottom Line: The Canadian economy has escaped its funk. True, the long-term risks associated with the housing bubble will ultimately come home to roost. However, in the short term, the BoC is finding room to lift its forward guidance. As a result, CAD is likely to move higher on non-USD crosses. EUR/SEK Is A Short EUR/SEK should weaken in the coming quarters. To begin with, EUR/SEK is trading at a 7% premium against its PPP fair value. Additionally, the real trade-weighted SEK stands at a one-sigma discount to its long-term fundamental fair value, which further highlights the SEK's upside potential versus the euro, the main trading counterparty of Sweden (Chart I-16). Valuations are not enough to motivate a position. Economics need to join the ball. Today, the Swedish output gap is positive while that of Europe remains negative. Unsurprisingly, Swedish core inflation has overtaken that of the euro area (Chart I-17). Moreover, while we have argued at length why euro area core inflation is likely to disappoint going forward,4 pressure on Swedish resources is such that Swedish core inflation is likely to display additional upside (Chart I-18). Chart I-16SEK Is Cheap SEK Is Cheap SEK Is Cheap Chart I-17Swedish Core Inflation Is Outpacing Europe's Swedish Core Inflation Is Outpacing Europe's Swedish Core Inflation Is Outpacing Europe's Chart I-18Swedish Core Inflation Will Rise Further Swedish Core Inflation Will Rise Further Swedish Core Inflation Will Rise Further This means there will be attractive relative policy dynamics between the Riksbank and the ECB in the coming months. If the ECB has to tighten policy, the Riksbank has an even better case to be hawkish. If, however, the global economic environment prevents the ECB from tightening and forces it toward an easing bias, these global deflationary pressures should prove more muted in Sweden. Thus, we expect that Swedish policy will tighten relative to the ECB's, despite the economic and inflation environment. Chart I-19CPI Expectations Differential Will Push ##br##Policy Toward A Lower EUR/SEK CPI Expectations Differential Will Push Policy Toward A Lower EUR/SEK CPI Expectations Differential Will Push Policy Toward A Lower EUR/SEK Additionally, inflation expectations are pointing toward a lower EUR/SEK. The recent Swedish Prospera inflation survey showed that economic agents are expecting a pickup in inflation. As a result, market-based inflation expectations in Sweden have outperformed those in Germany, pointing to a lower EUR/SEK (Chart I-19). Essentially, this reflects potential changes in the relative direction of policy between the two currencies. The big risk to this view is that Stefan Ingves, the Riksbank governor, continues to be one of the most dovish policy makers in the world. However, his term ends on January 1, 2018, and unless he is renewed for another six years, his words and desires will increasingly lose their ability to affect markets. Bottom Line: The Swedish economy is increasingly moving closer to an inflationary environment. This cannot yet be said about the euro area. With inflation expectations sharply moving up in Sweden versus the euro zone, investors should begin betting against EUR/SEK. Housekeeping We are closing our short USD/JPY trade this week at a 4.2% profit. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report titled, "Low Inflation And Rising Debt", dated June 3, 2017, available at usbs.bcaresearch.com 2 Moreover, one of the dissenters was Kristin Forbes, who was attending her last meeting as a member of the MPC. 3 Please see Geopolitical Strategy Special Report titled, "U.K. Election: The Median Voter Has Spoken", dated June 9, 2017, available at gps.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Chairwoman Janet Yellen has halted the dollar selloff for now, with the DXY finally seeing some upside. Following the press conference, the greenback sits 1.2% above the lows seen prior to the Fed policy meeting. We share the view of the Fed and the expect markets to converge over time toward the Fed's forecasts. Additionally, Yellen confirmed that there is still one more hike on the table this year. We believe the market continues to underprice these factors, concentrating too much on what amounts to a temporary soft patch. As we have said in the past, these factors will continue to widen rate differentials between the U.S. and its G10 counterparts. Report Links: Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 Exploring Risks To Our DXY View - May 26, 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 EUR/USD dropped on the news of a weak trade balance figure of EUR 19.6 bn, below the expected EUR 27.2 bn. Generally, EUR/USD has remained reasonably static as euro weakness was muted by equal dollar weakness, but recent Fed hawkishness has broken this trend. Draghi's hawkishness is tepid at best and the Fed hiking rates this Wednesday, as well as Yellen reiterating that another hike will be seen later this year will continue to help U.S. policy anticipations relative to Europe. As a result, rate differentials are likely to widen, and the euro to soften. The little appreciation in the euro earlier this week, was a result the following positives: German ZEW Survey's Current Situation went up to 88, beating expectations of 85; Euro Area ZEW Survey's Current Situation also went up to 37.7 from 35.1. Report Links: Look Ahead, Not Back - June 9, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been negative: Domestic corporate goods prices grew by 2.1% YoY, against expectations of 2.2%. Machinery orders yearly growth came in at 2.7%, underperforming expectations by a wide margin. Industrial production yearly growth stayed flat at 5.7%. Ultimately, economic activity in Japan will largely depend on the currency. With the yen appreciating for most of 2017, it will be difficult for the Japanese economy to improve sustainably. At this point, we are closing our USD/JPY trade, as the correction in the U.S. dollar has run its course. Meanwhile, we remain bearish on NZD/JPY, as the rising dollar and the tightening in Chinese monetary conditions will deliver a formidable one-two punch to risk assets, and thus weigh on this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 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: Industrial Production contracted by 0.8% on a YoY basis, underperforming expectations. Manufacturing production yearly growth stayed flat, also underperforming. Meanwhile, both core and headline inflation came in above expectations, at 2.6% and 2.9% respectively. Yesterday the BoE came in more hawkish than expected, as Ian McCafferty and Michael Saunders joined Kristin Forbes voting and dissented in favor offor a hike. Meanwhile, in their monetary policy summary the BoE stated that inflation will stay above target for an "extended period". Following the report, EUR/GBP plunged by about 0.8%. We are now not positive on the pound, as core inflation is now outpacing wage growth, a development that should weigh on demand due to the decline in real income. This development could cause GBP/USD and EUR/GBP to reach 1.2 and 0.92 respectively to reach 1.2 by year end, but any move in EUR/GBP above 0.88 should be used to short this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 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 Data out of Australia was mixed this week: National Australia Bank's Business Confidence declined to 7 from 13; Westpac Consumer Confidence fell to -1.8% from -1.1%; However, the unemployment rate dropped to 5.5%, with full-time employment growing by 52,100, and part-time employment shrinking by 10,100. Most of the movement in the AUD was dominated by the employment data, seeing a broad-based increase versus other G10 currencies. While oil prices kept the CAD and NOK at bay, Chinese industrial production and retail sales increased at a 6.5% and 10.7% annual rate, respectively. Iron ore and copper, commodities important to Australia, however, saw little action, but coal saw a slight upside. The above dynamics resulted in the AUD outperforming other currencies versus the USD, and EUR/AUD weakened massively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 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 mixed: Electronic card retail sales grew by 5.2% year-on-year, increasing from 4.2% the month before. However, the current account deficit came in at 3.1% of GDP against expectations of 2.7%. Meanwhile, yearly GDP growth came in at 2.5%, underperforming expectations. The kiwi rallied this week as expectations of a dovish fed weighed on the dollar, although most of these gains vanished following the FOMC press conference. We continue to be positive on the NZD relative to the AUD, given that the kiwi economy is in much better footing than the Australian one. However, upside for NZD/USD is limited, as this cross has reached highly overbought levels. Furthermore, the tightening in Chinese monetary conditions will become a headwind for a sustainable rally in the NZD. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The downside in oil continues as EIA crude oil stocks decreased by 1.661 million barrels, less than the expected 2.739 million. AUD/CAD and NZD/CAD rallied on the news, while CAD/NOK levelled off. In the commodity space, we remain most positive on the Canadian economy. While oil prices are a hurdle, business and consumer confidence, as well as PMIs remain robust, and the BoC expects the output gap to close in Q2 2018. Our Commodity and Energy Strategy team continues to believe that OPEC cuts and increased oil demand will eventually curtail inventories. We therefore expect our short AUD/CAD trade to prove profitable as markets begin to digest these developments. While the CAD looks good on its crosses, the resumption of the dollar bull market will limit the USD/CAD's downside. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 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 Yesterday, in their monetary policy statement, the SNB reasserted its dovish bias, pledging to keep its extremely accommodative monetary policy in the years to come. Their inflation outlook changed little, upgrading the near term slightly while downgrading the longer term outlook. It is important to consider that when the SNB states that they expect that inflation will reach only 1.5% by the first quarter of 2020, they do so assuming the LIBOR rate stays at -0.75%. Meanwhile, they also signaled that they will stay active intervening in the currency market, with SNB president Thomas Jordan reiterating that the Franc “remains significantly overvalued”. We had previously stated that the implied floor put under EUR/CHF by the SNB could be removed by the end of this year. However, this scenario now seems unlikely, given the strong commitment by the SNB to remain accommodative. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 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 Following a sell-off for most of the beginning of the week, USD/NOK has rebounded sharply, following the FOMC interest rate decision. Furthermore, the disappointing draw in oil inventories also contributed to the surge in USD/NOK. We continue to be bearish on the NOK, given that inflation is still receding in Norway. Recent data supports this, with core inflation and producer prices falling from anewApril. Furthermore, any surge in the U.S. dollar will provide a tailwind to USD/NOK given that this cross is highly sensitive to the dollar. Another cross where we are positioned towe use to take advantage of gain from Norway's economic weakness difficulties is CAD/NOK. The Canadian economy is on ain much stronger footing than the Norwegian one, and the rally in the dollar has historically been a tailwind for this cross. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 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 Sweden's economy is developing as expected, with headline inflation reading at the expected level of 1.7%, with a 0.1% monthly increase. Although inflation decreased from the previous 1.9% reading, the Riksbank's Resource Utilization Indicator - historically, a reliable indicator for core inflation - continues to point up, indicating that core inflation will accelerate further. We are putting on a short EUR/SEK trade on the basis of long-term valuations being in the favor of the krona. With a closed output gap, Sweden's economy is more advanced in its business cycle than the euro area', which points to a further bifurcation in inflation rates between the two. These factors will also warrant a quicker removal of policy support from the Riksbank than the ECB. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades