Valuations

Highlights EM EPS has recovered, supporting the current rally. However, forward-looking indicators portend a reversal and potential renewed contraction in EM EPS. BCA's Emerging Markets Strategy team has a more pessimistic outlook than the BCA house view, which is upbeat on the prospects for China's capex growth and commodity prices. The ongoing liquidity tightening in China amid lingering credit excesses is bound to produce major negative growth surprises. The authorities will reverse the ongoing monetary tightening only if the pain on the ground becomes visible or the economic data deteriorates significantly. Financial markets will sell off considerably in advance. In Chile, take profits on the receiving 3-year swap rate trade; stay neutral on this bourse within an EM equity portfolio. Feature EM Profit Recovery: How Enduring? EM equities have not only advanced in absolute terms but have also outperformed developed market (DM) share prices considerably since early this year. This outperformance has been rationalized by a recovery in EM earnings per share (EPS). Indeed, EM EPS has revived briskly in recent months (Chart I-1A). Chart I-1AEM/China Profits Growth To Roll Over (I) EM/China Profits Growth To Roll Over (I) EM/China Profits Growth To Roll Over (I) Chart I-1BEM/China Profits Growth To Roll Over (II) EM/China Profits Growth To Roll Over (II) EM/China Profits Growth To Roll Over (II) For this rally to continue, EM EPS would need to continue to expand further. We do not expect this. On the contrary, our bet is that EM EPS growth will slow considerably later this year and most likely contract in early 2018. Our basis is that the growth (first derivative) and impulse (second derivative) of EM & Chinese narrow money (M1) has in the past led their respective profit cycle (Chart I-1A and Chart I-1B). If these relationships hold and EM EPS growth dwindles later this year, EM share prices should begin to sense it now, and start falling back very soon. Interestingly, EM EPS net revisions have failed to rise above the zero line despite the recent rebound in profits (Chart I-2, top panel). This is in contrast to DM EPS net revisions, which have surged well above zero (Chart I-2, middle panel). As a result, recent EM relative outperformance against their DM peers has occurred despite the drop in relative net EPS revisions (Chart I-2, bottom panel). This presages EM equity analysts are not revising upward their forward estimates for EM EPS, despite the ongoing rally in share prices. This is extremely puzzling (and rare) and may be a reflection of recent weakness in commodities prices - or the fact that expectations for EM EPS growth were already elevated. We do not place much emphasis on analysts' EPS revisions because the latter swing with stock prices - they have zero forecasting power for share prices. We highlight this fact simply to counter the common market narrative that EM corporate earnings growth expectations are improving, driving EM bourses higher. Bottom Line: EM EPS has recovered, supporting the current rally. However, forward-looking indicators portend a reversal and potential renewed contraction in EM EPS nine months ahead. Importantly, EM equity prices relative to DM shares are at a major technical juncture (Chart I-3). A decisive breakout would be a very bullish technical signal, whereas a failure to break out would be an important warning sign. We continue to bet on the latter. Chart I-2EPS Net Revisions: EM And DM EPS Net Revisions: EM And DM EPS Net Revisions: EM And DM Chart I-3Relative Equity Performance: EM Versus DM Relative Equity Performance: EM Versus DM Relative Equity Performance: EM Versus DM China's Credit Cycle And Commodities Redux Our overarching theme has been and remains that China is tightening liquidity amid a lingering credit bubble. This cannot end well for financial markets that are exposed China's growth. Here we revisit our rationale for a credit slowdown in China and its impact on EM. Chinese interest rates have risen dramatically since last November across the entire yield curve. The 3-month interbank rate and AA- on-shore corporate bond yields both have risen by about 200 basis points since November 1, 2016. Monetary policy works with a time lag, and higher interest rates warrant a slowdown in credit growth (Chart I-4). In turn, it takes only a deceleration in credit growth for the credit impulse - the second derivative of outstanding credit - to turn negative. The falling credit and fiscal impulse will consequently lead to a relapse in Chinese import volumes and EM EPS (Chart 5), in turn weighing on commodity prices and non-commodity producing countries like Korea and partially Taiwan. Mainland import volumes contracted mildly in the second half of 2015, as demonstrated in Chart I-5. De facto, from the perspective of the rest of the world, China was in mild recession in late 2015. Not surprisingly, global risk assets in general, and particularly those exposed to China, tumbled. Chart I-4China: Higher Rates Point To##br## Negative Credit Impulse China: Higher Rates Point To Negative Credit Impulse China: Higher Rates Point To Negative Credit Impulse Chart I-5China's Credit Impulse Heralds ##br##Slowdown In Its Imports China's Credit Impulse Heralds Slowdown In Its Imports China's Credit Impulse Heralds Slowdown In Its Imports We expect China import volumes to shrink again by the end of this year or early next. Some sort of replay of 2015 is a real possibility. The broad-based yet mild selloff in commodities since early this year (Chart I-6) amid weakness in the U.S. dollar exchange rate gives us confidence in our view. Chart I-6ABroad-Based Selloff In Commodities (I) Broad-Based Selloff In Commodities (I) Broad-Based Selloff In Commodities (I) Chart I-6BBroad-Based Selloff In Commodities (II) Broad-Based Selloff In Commodities (II) Broad-Based Selloff In Commodities (II) Our colleagues at BCA have attributed the selloff in commodities this year to deleveraging in China's shadow banking system, and to traders worldwide closing their long positions. They expect an improving commodities supply-demand balance to support prices going forward. It makes sense to us to explain the selloff in commodities as having been caused by deleveraging in China's shadow banking system. Yet to be consistent, we should also acknowledge that the rally in commodities last year was to a large extent driven by the same forces in reverse: non-commercial buyers (investors) buying commodities both in China and elsewhere. In short, this signifies there was little improvement in worldwide commodities demand last year. In 2016, rising commodities prices provided a significant boost to commodity-producing countries and underlying corporate profits - and ultimately EM risk assets. The drop in commodities prices this year, if sustained, should lead to the opposite dynamic: income/profits among commodities countries/companies will drop. As such, falling commodities prices amid diminishing investor demand for commodities is bearish for EM risk assets. Where we differ from the majority of our colleagues at BCA is that we expect Chinese credit growth to decelerate, thereby weighing on its capital spending and depressing demand for commodities (please refer to Chart I-5). We have written extensively1 on this topic and will not fully rehash our view that China's annual credit growth will decelerate from the current 12% to somewhere around 8% in the next 12-18 months. In short, China's corporate and household credit-to-GDP ratio cannot rise indefinitely from an already high level of 225% of GDP. Credit growth will likely downshift to a level of sustainable nominal GDP growth, which is probably around 8%. Our main disagreement with our colleagues on structural issues is as follows: we believe China's credit excesses are not a natural outcome of the nation's high savings rate but rather the outcome of a speculative credit boom driven by high-risk behavior among creditors and debtors.2 Tightening liquidity amid such speculative excesses creates a very bearish backdrop for risk assets exposed to China's credit cycle. The bullish camp on China has recently pointed to a strong recovery in mainland nominal GDP growth, which in their view suggests that double-digit credit growth in China is not excessive (Chart I-7). However, such a surge in nominal GDP growth has been due to the GDP deflator rising from zero in the fourth quarter of 2015 to 5% in the first quarter of this year. Importantly, the swings in the GDP deflator almost perfectly correlate with the fluctuation in commodities prices (Chart I-8). This proves how much China's economy is exposed to commodities cycles and how much of nominal GDP swings are stipulated by resource price swings. Chart I-7China: Credit And ##br##Nominal GDP Growth China: Credit And Nominal GDP Growth China: Credit And Nominal GDP Growth Chart I-8China's GDP Deflator Is Very Sensitive##br## To Commodities Prices China's GDP Deflator Is Very Sensitive To Commodities Prices China's GDP Deflator Is Very Sensitive To Commodities Prices As commodities prices decline, China's GDP deflator, producer prices and nominal GDP growth will all dwindle. Thereby, China's underlying steady state nominal GDP growth is probably around 8% at best (5.5-6% real growth), with inflation of 2-2.5% (assuming flat commodities prices). If this is indeed the case, corporate and household credit growth of 12% entails a further build-up of leverage and an escalating non-public credit-to-GDP ratio, which already stands at 225% of GDP: corporate debt is 180% and household debt is at 45% of GDP. Bank loans account for 70%, while shadow (non-bank) funding channels (corporate bonds, trust products, entrusted loans, and banker's acceptance) constitute 30% of outstanding non-public credit or 65% of GDP. Both are growing at an annual rate of 11-12.5% (Chart I-9). On the whole, the share of shadow banking is non-trivial and its current growth pace is unsustainable amid ongoing regulatory tightening and rising interest rates. Furthermore, banks are themselves exposed to shadow banking as their claims on non-depository financial institutions have risen exponentially from RMB 3 trillion to RMB 27 trillion over the past five years. In regard to non-standard credit assets,3 our estimates are that banks' off-balance-sheet exposure is RMB 10 trillion compared with RMB 18.3 trillion of their balance-sheet non-standard credit assets. The off-balance-sheet credit exposure to non-standard credit assets is much larger for medium and small banks than the largest five (Table I-1). We discussed these issues in greater detail in our June 15, 2016 Special Report titled "Chinese Banks' Ominous Shadow". Chart I-9Bank Loans And Non-Bank (Shadow) Credit Growth Bank Loans And Non-Bank (Shadow) Credit Growth Bank Loans And Non-Bank (Shadow) Credit Growth Chart I- With banks being forced by regulators to bring off-balance-sheet assets onto their balance sheets, their capital adequacy ratios will drop and their ability to sustain double-digit credit growth will be curtailed. Chart I-10Stay With Short Small / Long Large ##br##Banks Equity Trade Stay With Short Small / Long Large Banks Equity Trade Stay With Short Small / Long Large Banks Equity Trade The risks to medium and small banks is greater than to the large five banks. That is why we reiterate our recommendation from October 26, 2016 to short small banks versus large ones (Chart I-10). As a final note, we are often asked whether the government will provide a bail out if things deteriorate. Yes, we concur that policymakers will step in and backstop a financial system to preclude a systemic crisis. However, they are tightening now, and like the rest of us have little visibility. The authorities will meaningfully reverse the ongoing monetary tightening only if the pain on ground becomes visible or economic data deteriorate considerably. Financial markets will sell off materially in advance. Bottom Line: Investors should not be long China-plays, commodities and EM risk assets when mainland policy tightening is occurring amid lingering speculative credit excesses. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Strategy For Chilean Markets We recommended receiving 3-year swap rates on November 2, 2016 and this position has panned out with rates dropping by 30 basis points. We now recommend booking profits. The following has led us to conclude that the risk-reward profile of this position is no longer attractive: The improvement in narrow money (M1) growth points in a bottom in the economic activity indicator (Chart II-1). Mining production plunged amid the strikes in the world's largest copper producer Codelco (Chart II-2, top panel) and manufacturing production has also been contracting (Chart II-2, bottom panel). A period of improvement in mining and manufacturing output from a very low base is likely. Chart II-1Book Profits On Receiving ##br##3-Year Swap Rate Position Book Profits On Receiving 3-Year Swap Rate Position Book Profits On Receiving 3-Year Swap Rate Position Chart II-2Chile: Money And Economic##br## Activity Are Bottoming Out Chile: Money And Economic Activity Are Bottoming Out Chile: Money And Economic Activity Are Bottoming Out This will ameliorate overall business conditions and cause the central bank, at least for the time being, to halt the easing cycle. The pace of expansion in employment, wage growth, and consumer credit remains decent (Chart II-3). This will put a floor under household spending growth for now. Odds are that copper prices will decline meaningfully in the next nine months or so, which will cause the Chilean peso to depreciate. Although a depreciating currency will not to lead to materially higher interest rates in Chile, it will limit downside in local rate expectations. Finally, local 3-year swap rates and their spread over U.S. 3-year bond yields are extremely low from a historical perspective (Chart II-4). At this point, there is little value left in Chilean local rates. Chart II-3Chile's Mining And Manufacturing ##br##A Period Of Stabilization Ahead Chile's Mining And Manufacturing A Period Of Stabilization Ahead Chile's Mining And Manufacturing A Period Of Stabilization Ahead Chart II-4Chile: Consumer Spending##br## Is Holding Up Chile: Consumer Spending Is Holding Up Chile: Consumer Spending Is Holding Up Investment Conclusions Chart II-5Chilean Local Rates Spreads Over ##br##U.S. Treasurys: Not Much Value Left Chilean Local Rates Spreads Over U.S. Treasurys: Not Much Value Left Chilean Local Rates Spreads Over U.S. Treasurys: Not Much Value Left We do not expect the central bank to hike but the downside in local rates is limited for the time being. Take profits on the receiving 3-year swap rate trade. As to equities, the outlook for relative performance is balanced; we continue recommending a benchmark weight in Chile for dedicated EM equity portfolios. For absolute return investors, the risk-reward profile is not attractive because our profit margin proxy points to a relapse in corporate earnings (Chart II-5). Unit labor costs are rising faster than the core inflation rate, producing a profit margin squeeze (Chart II-5, bottom panel). Finally, we continue shorting the peso versus the U.S. dollar as a bet on lower copper prices. 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, Misconceptions About China's Credit Excesses", dated October 26, 2016 and "China's Money Creation Redux And The RMB", dated November 23, 2016, available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Reports titled, "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?", dated March 23, 2017, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, "Misconceptions About China's Credit Excesses", dated October 26, 2016 and "China's Money Creation Redux And The RMB", dated November 23, 2016, available at ems.bcaresearch.com 3 Non-standard credit assets are banks' claims on corporates that are not classified as loans. For more details please refer to the Emerging Markets Strategy Special Report titled, "Chinese Banks' Ominous Shadow", dated June 15, 2016, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy Downgrade communications equipment stocks to underweight. All three end-markets are weak and signal that profits will continue to surprise to the downside. Continue to avoid the electrical components & equipment index. Deficient demand warns that the profit down cycle is far from over. Recent Changes S&P Communications Equipment - Downgrade to underweight. Table 1Sector Performance Returns (%) Extended Time Horizons Extended Time Horizons Feature Equities broke out to new highs last week. The minutes from the latest FOMC meeting implied that it would take considerable economic strength for the Fed to tighten more than markets currently forecast. A reactive rather than proactive Fed raises the odds that the equity overshoot will persist, because it means monetary conditions will still support profits. A good part of this year's market advance has been concentrated in a small number of stocks, but that belies the breadth of the profit recovery. Net analyst earnings revisions have hit their highest level since the initial post-GFC surge. The number of S&P industry groups with rising earnings estimates has climbed above 80%, reflecting broad-based earnings upgrades. Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates (Chart 1). Evidence of a healthy earnings recovery is supported by our own Indicators. Of our ten sector pricing power gauges, seven are in positive territory. On a more granular basis, the majority of our 64 industry group pricing power proxies is also rising. This reflects increased global business activity and U.S. dollar depreciation. In terms of costs, six out of ten wage inflation proxies are decelerating, and more than 50% of our industry labor expense gauges are falling. As a result, seven out of ten of our broad sector profit margin proxies are in positive territory, i.e. pricing power is rising at a faster pace than wage inflation. Of the three in negative territory, two are easing in intensity, i.e. margin pressures are diminishing. These profit trends will support stocks, at least until they generate economic overheating and by extension, a more restrictive Fed. Thus, the good news for bulls is that financial conditions will remain sufficiently easy to sustain a durable profit recovery (see Chart 1 from last week's Report), so much so that investors are lengthening their time horizons. Evidence of the first synchronized global expansion in years and the ability of regional economies to bounce back from a headline risk, such as Brexit, have boosted conviction in the sustainability and strength of long-term earnings growth: analyst 5-year earnings growth forecasts are being steadily upgraded. History shows that as long as economic tail risk remains on the back burner, then valuations can camp out in overshoot territory, as occurred in the second half of the 1990s (Chart 2). To be sure, nosebleed valuation levels underscore that the rally is in a high risk phase and virtually guarantee paltry long-term returns. Still, timing pullbacks is notoriously difficult. We follow a checklist of five reliable indicators that should provide a helpful timing tool. Emerging market currencies have weakened prior to or coincident with U.S. stock market corrections (Chart 3). Exchange rate depreciation in these high beta economies is emblematic of growth disappointment, fears of capital flight and/or risk aversion. At the moment, our proxy of EM currencies is accelerating. Chart 1Buoyant Breadth Bodes Well Buoyant Breadth Bodes Well Buoyant Breadth Bodes Well Chart 2Long-Term Profit Conviction Is Driving Multiples Long-Term Profit Conviction Is Driving Multiples Long-Term Profit Conviction Is Driving Multiples Chart 34/5 Lights Flash Green 4/5 Lights Flash Green 4/5 Lights Flash Green Corporate bond spreads, both in the U.S. and emerging markets, have also widened coincident with, or in advance of, meaningful equity setbacks (Chart 3). So far, spreads remain tight in both regions, suggesting minimal concerns about debt servicing capabilities. In addition, bullish individual investor sentiment has also eclipsed the 60% zone in advance of the two largest post-GFC drawdowns. Individual investors are currently upbeat, but are not yet frothing bulls, according to the latest survey data (Chart 3). Of the five checklist items, the behavior of the yield curve is the most disconcerting. The curve has narrowed considerably in recent weeks, and is closing in on the pre-U.S. election lows as inflation expectations recede (Chart 3). If real long-term yields do not soon advance and confirm the profit/economic recovery narrative, then the odds of an imminent corrective phase will ratchet higher. In sum, the overshoot should remain intact for a while longer. But we continue to recommend a barbell portfolio rather than one with excessive beta, favoring select defensives and early cyclical sectors such as consumer discretionary and financials given the lack of economic confirmation from the bond market. This week we highlight two exceptions to the generally bullish profit backdrop, which reinforces that selectivity remains critical to portfolio construction. A Weak Signal From Communications Equipment: Downgrade To Underweight Communications equipment stocks have diverged negatively from the broad tech sector and have also trailed the broad market. Instead, this small corner of the tech industry moves with the ebb and flow of telecom carrier stocks - a key end-market, with a slight lag (top panel, Chart 4). The latest signal from telecom services stocks is bearish, and we recommend a downgrade to a below-benchmark allocation in the S&P communications equipment group. While the share price ratio has lost ground and valuations look compelling (Chart 4), the risks of further near-term losses and a longer-term value trap remain high. Technical conditions are still far from previously extreme washed out levels. In fact, the overbought conditions' unwind is recent and there is ample downside left before a full capitulation materializes (middle panel, Chart 4). Worryingly, all three key communications equipment end-markets point to additional weakness in the coming months. Telecom carrier outlays have hit a wall. Telecom providers are at each other's throats and a full blown price war has engulfed the industry. This is outright deflationary, and telecom services pricing power has contracted at a double-digit rate during the past three months (bottom panel, Chart 5). In the absence of revenue growth, telecom capex is unlikely to reaccelerate. U.S. telecom facilities construction and communications equipment new order growth move in lockstep (second panel, Chart 5). Both have collapsed on a short-term rate of change basis, warning that communications equipment demand is soggy. Tack on the quickest industry inventory accumulation since 2011 (third panel, Chart 5), a soft order backlog (not shown), and the industry sales growth outlook has darkened even further. Overall corporate outlays are also soft. While a capex upcycle looms and some capital will inevitably flow to the communication equipment industry (middle panel, Chart 6), anemic C&I loan growth (an excellent proxy for broad corporate health, not shown) is a yellow flag. Chart 4Value Trap Value Trap Value Trap Chart 5Weak Telecom Segment Capex... Weak Telecom Segment Capex... Weak Telecom Segment Capex... Chart 6...Aggravates The Sales Risk ...Aggravates The Sales Risk ...Aggravates The Sales Risk Moreover, enterprise spending has not been concentrated on communications equipment gear for years, as the industry has been unable to gain any share of total corporate investment. The implication is that any business sector uptick is unlikely to match the pressure stemming from the telecom services sector. The government segment represents another source of drag. True, a global move away from austerity is a plus, but delays/uncertainty with regard to U.S. fiscal policy is a sizeable offset. In fact, U.S. government spending as a percentage of output is in decline (not shown) and the Trump administration's strict budget control warns that the government's purse strings will remain tight for some time. Finally, export markets are unlikely to offset domestic cooling. While the cheapened U.S. dollar should boost U.S. communication equipment manufacturers' competitiveness, China's global networking ascendancy and Europe's recent V-shaped export recovery suggest that U.S. gear providers are losing market share (Chart 7). All of this paints a grim picture for communications equipment sales. As such, cyclically stretched operating margins are at risk (Chart 8). Industry productivity growth has crested, and is likely to recede because slowing new orders and rising inventories imply reduced output. The implication will be profit margin pressure and a return on equity squeeze (middle panel, Chart 8). While the industry constantly realigns headcount to the challenging operating environment, a sustainable profit turnaround requires a demand driven rebound. Chart 7U.S. Manufacturers Are Losing Market Share U.S. Manufacturers Are Losing Market Share U.S. Manufacturers Are Losing Market Share Chart 8Beware A Margin Squeeze Beware A Margin Squeeze Beware A Margin Squeeze Meanwhile, industry specific forces will also contribute to margin pressure. Five years ago, Cisco's CEO dismissed the nascent virtual networking threat. However, today, virtual networking is a deflationary reality. Such intense deflationary pressure is a clear profit negative and warns that relative EPS are headed south (Chart 8). Bottom Line: The S&P communications equipment index is breaking down. Trim exposure to below benchmark. The ticker symbols for this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV. Electrical Components & Equipment Are Out Of Power The niche S&P electrical components & equipment (ECE) industrials sub-index has marked time since our late-November downgrade to underweight. Our bearish thesis remains intact. Cyclical momentum has sputtered after the relative share price ratio failed to sustain its post-U.S. election euphoria. Valuations remain dear, with the forward P/E ratio trading at a 15% premium to the broad market (bottom panel, Chart 9). If profits continue to disappoint, as we expect, then a de-rating phase is inevitable. ECE companies garner roughly half of their sales from abroad. Thus, the U.S. dollar's fluctuations are inversely correlated with relative share prices. Delayed translation effects from the U.S. dollar's large run-up last year should continue to weigh on profits, and offset the European and emerging market economic recoveries. Worrisomely, there is a wide gap between relative performance and the greenback. If history rhymes, then a convergence phase is likely with the relative share price ratio deflating closer to the level predicted by the U.S. dollar (currency shown inverted, top panel, Chart 9). Domestically, news is equally grim. Investment spending on electrical equipment remains moribund: outlays are contracting in absolute terms and continue to trail overall investment. Historically, the industry's new orders-to-inventories ratio has been closely correlated with relative outlays and the current message is bleak (bottom panel, Chart 10). Chart 9No Reasons To Pay For Premium Valuations No Reasons To Pay For Premium Valuations No Reasons To Pay For Premium Valuations Chart 10No Reasons To Pay For Premium Valuations Productivity Loss Leads To Profit Loss Productivity Loss Leads To Profit Loss Importantly, the surge in ECE inventory growth and deceleration in backlog growth point to pricing power pressure in the coming months. Chart 11 shows that a rising wage bill and anemic pricing power have squeezed our industry margin proxy. In terms of industry productivity, gains have given way to losses, according to our gauge. This suggests that profits will continue to languish (middle panel, Chart 10). Tack on the slump in weekly hours worked, and there is cause to doubt recent sell side analyst optimism (bottom panel, Chart 11). A demand-driven increase in revenues/backlogs is needed to reverse the industry's profit fortunes. However, our relative EPS model is forecasting the opposite: profits will continue to underwhelm and trail the broad market into the back half of the year (Chart 12). Chart 11Lean Against Analysts' Exuberance Lean Against Analysts' Exuberance Lean Against Analysts' Exuberance Chart 12EPS Model Says Sell EPS Model Says Sell EPS Model Says Sell Against this backdrop, we remain reluctant to pay a premium valuation to own an industry with an uncertain, at best, earnings profile. Bottom Line: While we are neutral on the broad industrials sector, we continue to recommend underweight exposure in the S&P electrical components & equipment index. The ticker symbols for the stocks in this index are: BLBG: S5ELCO - EMR, ETN, ROK, AME, AYI. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The equity risk premium (ERP) is distorted: too low. The Eurostoxx600 uptrend is reaching a technical limit according to its 130-day (6-month) fractal dimension. The U.S.-Euro area bond yield spread is distorted: too high. The Spain-France bond yield spread is distorted: too high. The Italy-Germany bond yield spread is not distorted. Feature Central banks' massive interventions in markets have left many investors wondering: has the market's price discovery mechanism become dysfunctional - and if so, where most severely? It is a good question because clearly, the prices that are most distorted are also the ones most likely to dislocate, and generate lucrative opportunities. This week's report assesses the distortion in three important relative pricings: the Italy-Germany sovereign yield spread; the U.S.-euro area sovereign yield spread; and the prospective excess return from equities over bonds, otherwise known as the equity risk premium. The Italy-Germany Bond Yield Spread Is Not Distorted We often hear the claim that the ECB's bond purchase program has compressed periphery bond yields relative to core yields. But we find no evidence for such a distortion. For example, relative to the ECB's capital key1 and other guidelines for bond purchase volumes, there is a larger ongoing supply of Italian BTPs than German bunds.2 So from a technical perspective, the ECB's interventions should have depressed German bund yields more than Italian BTP yields, thereby expanding the spread. Chart Of The WeekLow Volatility: We've Been Here Before... And It Didn't Last Low Volatility: We've Been Here Before...And It Didn't Last Low Volatility: We've Been Here Before...And It Didn't Last In fact, the technical distortion seems quite small because the Italy-Germany yield spread can be fully justified by its two underlying fundamentals: relative competitiveness (Chart I-2) and euro breakup probability (Chart I-3). Chart I-2Euro Area Yield Spreads Depend On Relative Competitiveness ... Euro Area Yield Spreads Depend On Relative Competitiveness... Euro Area Yield Spreads Depend On Relative Competitiveness... Chart I-3... And The Probability Of Euro Break-Up ...And The Probability of Euro Break-Up ...And The Probability of Euro Break-Up The premium on Italian BTP yields exists as a compensation for the expected redenomination loss in the tail-event of euro breakup. Assuming this currency depreciation would neutralize Italy's current 25% under-competitiveness versus Germany, we can infer that the 125 bps yield premium on 5-year BTPs is pricing a 5% annual probability of euro breakup (because 125 bps = 25% loss times 5% probability). The probability should account for an Italian election that is due within the next year, and Italian public support for the euro hovering at an unconvincing majority of around 55%. In this context, the probability should be somewhat elevated, though not alarming. So a 5% annual probability of euro breakup through the next five years seems reasonable within its post-crisis 2%-20% range. On this basis, the Italian-Germany yield spread is not distorted (Chart I-4). Instead, the real anomaly is the Spain-France (5-year) yield spread which stands at 50 bps (Chart I-5). There is now no difference in competitiveness between Spain and France, so there should be no redenomination premium on Spanish Bonos over French OATs, irrespective of the probability of euro break up. Stay structurally overweight Spanish Bonos versus French OATs. Chart I-4The Italy-Germany Yield Spread At 150 Bps Is Fair The Italy-Germany Yield Spread At 150bps Is Fair The Italy-Germany Yield Spread At 150bps Is Fair Chart I-5The Spain-France Yield Spread At 50 Bps Is Too High The Spain-France Yield Spread At 50bps Is Too High The Spain-France Yield Spread At 50bps Is Too High The U.S.-Euro Area Bond Yield Spread Is Distorted: Too High If bond price discovery were based solely on economic fundamentals, the U.S.-euro area yield spread would not be at a multi-decade extreme today. Such an extreme spread exists because the difference between Fed and ECB policy is much more polarized than is justified by the economic fundamentals. In this sense, the relative pricing is distorted. Consider the hard data. The percentages of the working age population in employment are at the same respective pre-crisis highs in both economies; the difference in wage inflation is closing; and the gap between core inflation in the U.S. and euro area has narrowed very sharply to just 0.6%. Indeed, excluding the cost of shelter - which is not represented in the euro area CPI - core inflation in the U.S. is now lower than in the euro area. Agreed, Fed policy should be tighter than ECB policy. But the expected difference should not be at a multi-decade extreme. Given the self-proclaimed 'data-dependency' of both the Fed and the ECB, the polarization of monetary policy expectations (Chart I-6) has to converge to the rapidly narrowing gap in the hard economic data, one way or another (Chart I-7). Chart I-6The U.S.-Euro Area Yield ##br##Spread Is Too High ... The U.S.-Euro Area Yield Spread Is Too High... The U.S.-Euro Area Yield Spread Is Too High... Chart I-7... And Will Gravitate To The Narrowing ##br##Gap In The Economic Data ...And Will Gravitate To The Narrowing Gap In Economic Data ...And Will Gravitate To The Narrowing Gap In Economic Data I conclude that: the U.S.-euro area (and U.S.-Germany) yield spread can close much further; euro/dollar can rise structurally; and the market neutral equity pair-trade long euro area Financials/short U.S. Financials can continue to outperform. The caveat is that these positions are just one big correlated trade (Chart I-8 and Chart I-9). Chart I-8Expected Monetary Policy Difference ##br##Is Driving The U.S.-Germany Yield Spread ... Expected Monetary Policy Difference Is Driving The U.S.-Germany Yield Spread... Expected Monetary Policy Difference Is Driving The U.S.-Germany Yield Spread... Chart I-9... And Therefore The Relative ##br##Performance Of Financials ...And Therefore The Relative Performance Of Financials ...And Therefore The Relative Performance Of Financials The Equity Risk Premium Is Distorted: Too Low Equity market behaviour is starkly asymmetric; market ascents tend to be gentle and drawn out, while descents tend to be violent and abrupt. By contrast, bond market behaviour is more symmetric; both upward and downward moves can be gentle or violent. The upshot is that when the equity market is ascending, its observed volatility declines. And the longer and more established the ascent becomes, the lower the observed volatility goes, both in absolute terms and relative to bonds. Crucially, this is just an observation of the inherent behaviour of equities: a low observed volatility simply tells us that equity ascents are gentle and drawn out (Chart I-10); it does not tell us that equity risk has diminished. Chart I-10Low Volatility Just Tells Us That Equity Ascents Are Gentle And Drawn Out. ##br##It Does Not Tell Us That Equity Risk Has Diminished! Low Volatility Just Tells Us That Equity Ascents Are Gentle And Drawn Out. It Does Not Tell Us That Equity Risk Has Diminished! Low Volatility Just Tells Us That Equity Ascents Are Gentle And Drawn Out. It Does Not Tell Us That Equity Risk Has Diminished! Unfortunately, the decline in the observed volatility may create the illusion that equity risk has diminished. In response, investors might demand a smaller (or no) equity risk premium (ERP) - the excess prospective long-term return over bonds - because they have falsely concluded that the risk of a large intermediate loss is vanishing. In turn, the shrinking ERP and lower required return justifies an even higher price today, allowing the market to continue its gentle ascent. So observed volatility falls even further, and the process feeds on itself in a self-reinforcing spiral. Readers might recognise this as the setup of the Minsky hypothesis in which the illusion of systemic stability breeds systemic instability and an eventual tipping point - a so-called 'Minsky Moment'. The Minsky hypothesis is an explanation for the boom bust cycle in the economy. It proposes that a credit boom initially generates strong and steady growth with low observed volatility. But the associated hubris - "no more boom and bust" - eventually encourages reckless lending and thereby sows the seeds of its destruction. When the misallocated loans cannot be repaid, the inevitable nemesis arrives. Likewise, in the case of the equity market, today's low observed volatility is absolutely not a reason for hubris. Yet as demonstrated in Markets Suspended In Disbelief,3 the low observed volatility has seduced investors into accepting a wafer-thin ERP. Today's low observed volatility is at the lower end of a range that has existed for at least 50 years (Chart of the Week). We have been here many times before. In each case, the low observed volatility did not last. And when it rose, so too did the ERP. As supporting evidence, observe that the 130-day (6-month) fractal dimension of the Eurostoxx600 is suggesting that the current uptrend is reaching its technical limit (Chart I-11). As a reminder, when an investment's fractal dimension approaches its natural lower bound, it signals that excessive trend following and groupthink have reached a natural point of instability. At which point the established trend is likely to break down with or without an external catalyst. Chart I-11The Current Uptrend In The Eurostoxx600 ##br##Is Reaching Its Technical Limit The Current Uptrend In The Eurostoxx600 Is Reaching Its Technical Limit The Current Uptrend In The Eurostoxx600 Is Reaching Its Technical Limit Before making a large absolute commitment to the equity asset class on a 6-12 month or longer horizon, I would first like to see both of these trustworthy signals stop flashing red. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 The capital key refers to the proportion of the ECB's capital owned by each of the euro area member states, and it is broadly pro-rata to the member state's GDP. 2 German GDP is 2 times the size of Italian GDP, but the stock of German sovereign debt is only 1.1 times the size of Italian sovereign debt. 3 Published on April 13 2017 and available at eis.bcaresearch.com Fractal Trading Model* The 65-day fractal dimension of nickel versus tin is approaching a level which has previously signaled an imminent trend-reversal. Go long nickel/short tin as this week's trade. Chart I-12 Long Nickel/Short Tin Long Nickel/Short Tin 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. 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 - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Portfolio Strategy Upgrade packaged food stocks to overweight. Enough value creation has occurred to create an attractive entry point in this consumer goods sub-index. Our tactical overweight in the S&P utilities sector is beginning to bear fruit. Get ready to book profits. Resist the temptation to bottom fish in steel stocks. Tightening Chinese monetary and financial conditions along with domestic demand blues should weigh on steel profits. Recent Changes S&P Packaged Foods - Upgrade to overweight. S&P Utilities - Downgrade Alert. Table 1 Focus On Financial Conditions Focus On Financial Conditions Feature The market waffled last week, but quickly recovered. The upshot is that investors still appear content to look through the circus in Washington, focused instead on the positive reflationary dynamics supporting the corporate sector. Financial conditions have eased considerably ever since the Fed resumed its tightening campaign last December. Equity price gains, narrowing credit spreads and a weaker U.S. dollar have more than offset the negative impact of the back-up in bond yields. Cheap equity capital also remains easily accessible. While the labor market is tightening, BCA argues that the headline unemployment rate may understate slack given the large number of part-time workers that want to work full-time and prime-age workers that are still out of work. With core inflation surprising to the downside in recent months, there is no urgency for the Fed to slam the brakes. In other words, there is more than enough monetary fuel to sustain the equity overshoot. Easy financial conditions will allow investors to extrapolate the profit recovery (Chart 1), especially since it has been sales driven for the first time in years. It is notable that while consumer price inflation has softened, in aggregate, businesses are not feeling any renewed deflationary pressure. The depreciation in the U.S. dollar has been a critical support for U.S. businesses. Our corporate sector pricing power proxy continues to accelerate (Chart 1), arguing that revenue growth should persist. The combination of muted consumer price inflation yet positive corporate sector inflation is a stock market positive, all else equal. Digging beneath the surface, divergent sector inflation trends are increasingly evident. The commodity-linked energy and materials sectors have lost upward pricing power momentum (Chart 2), courtesy of the cooling in China. Technology sector selling prices are sinking deeper into deflationary territory, albeit the FANG juggernaut pays no attention to sector specific forces. Telecom services pricing power has also taken a header (Chart 2). On the plus side, other defensive sectors, including utilities, are still able to raise prices at a much greater rate than overall inflation. Even the pace of financial sector price hikes is at the top end of its long-term range (Chart 3). Chart 1Sustained Profit Expansion ##br##Requires Easy Financial Conditions Sustained Profit Expansion Requires Easy Financial Conditions Sustained Profit Expansion Requires Easy Financial Conditions Chart 2Some Softness In ##br##Cyclical Pricing Power... Some Softness In Cyclical Pricing Power... Some Softness In Cyclical Pricing Power... Chart 3...But Defensive Selling##br## Prices Are Resilient ...But Defensive Selling Prices Are Resilient ...But Defensive Selling Prices Are Resilient The upshot is that selectivity remains a critical portfolio input rather than simply tracking the broad S&P 500. These forces should allow the market to continue grinding higher into overshoot territory. The latter means that the market is increasingly vulnerable to minor external shocks. Ergo, we continue to recommend a selective weighting in some 'safe' areas, such as consumer staples, which are undervalued in relative terms and will buffet portfolios should volatility escalate further. This week we are taking advantage of the drubbing in food stocks to augment positions. Packaged Foods: Going Against The Grain After a surge to all-time relative performance highs in mid-2016, the S&P packaged foods index has deflated by roughly 20%. Two key reasons are behind the downdraft: the allure to hold stable cash flow companies has diminished since the November election, and weak industry-specific metrics - in particular pricing power and sales contraction amid private label competition. Despite these negatives, our sense is that enough value destruction has occurred to create an attractive entry point in this consumer goods sub-index. Relative valuations reflect most of these investor worries. The relative forward P/E ratio has de-rated to below the two-decade average, and our Valuation Indicator (VI) is near one standard deviation below the historical mean. In fact, every time the VI falls to such an undervalued extreme, relative performance stages a sizable comeback (Chart 4). Technical conditions are also washed out. Relative performance momentum has plunged to the lowest level in a decade, and likely fully reflects investor angst. Deeply oversold readings and undervaluation suggest that a full bearish capitulation has occurred, which is contrarily positive. Encouragingly, there is light at the end of the tunnel. Grain price deflation (shown inverted, third panel, Chart 4) suggests that industry input costs are well contained, and will underpin profit margins. It is normal for falling grain prices to coincide with upward revisions to analyst profit estimates (second panel, Chart 4). While industry sales are mired in deflation, there are high odds that top line growth will exit deflation by early 2018. Consumer outlays on food and beverages are brisk, and wholesale food manufacturing prices have recently reaccelerated. Chart 5 shows that industry revenues follow the trend in consumption and pricing power, underscoring that profitability is set to expand anew. True, private label competition and grocery store market share wars have put pressure on industry pricing power. But as long as food manufacturers can keep input costs under control, profit margins should remain wide. A simple industry profit margin gauge (PPI food manufacturing versus PPI crude food) gives us comfort that margins will remain resilient (bottom panel, Chart 5). Importantly, packaged food producers are well positioned to fight back against food retailers' demands for price concessions. Robust consumer outlays on food and beverages are corroborated by real retail sales at food stores, which are bucking the deceleration in overall retail sales (third panel, Chart 6). The hook up in food manufacturing hours worked confirms that industry activity is on the mend, which bodes well for productivity gains. Sell-side analysts have taken notice. Positive earnings revisions will continue to outstrip negative ones. Chart 4Buy Against The Grain Buy Against The Grain Buy Against The Grain Chart 5End Of The Revenue Lull... End Of The Revenue Lull... End Of The Revenue Lull... Chart 6...As Demand Recovers ...As Demand Recovers ...As Demand Recovers Finally, food and beverage exports have held onto recent double-digit growth gains despite the strong greenback. Now that the U.S. dollar is under some pressure, especially against the euro and emerging market currencies, foreign sales should provide a further relief valve should domestic pricing pressures persist for a little longer than we expect (second panel, Chart 6). In sum, while investors have rushed for the exits in the defensive S&P packaged foods index, a buying opportunity has emerged. Relative valuations have corrected to the lower end of their historic range and already reflect investor profitability worries. Our thesis is that a domestic demand-driven recovery has commenced and strict cost control, along with food commodity deflation, should sustain profit margins. Bottom Line: Start a buy program in the S&P packaged foods index, and boost exposure to overweight. The ticker symbols for the stocks in this index are: BLBG: S5PACK - MDLZ, SJM, KHC, CPB, MKC, CAG, TSN, MJN, GIS, HSY, HRL, K. Our Utilities Overweight Is Starting To Pay Off Our tactical overweight in the S&P utilities sector is beginning to bear fruit. Importantly, the five factors that drove this decision are starting to play out1, albeit in varying degrees of magnitude. Chart 7 shows that the U.S. economic soft patch has persisted. Hard data have not yet caught up to the surge in 'soft' data, such as sentiment and confidence surveys. The Citi Economic Surprise Index is inversely correlated with the relative share price ratio. Similarly, the ISM manufacturing index has crested. Our analysis shows that forward relative returns are strong after the ISM manufacturing survey hits extremely high levels, given that mean reversion ultimately occurs. The upshot is that utilities relative performance has more upside. The yield curve has also moved favorably for utilities stocks. The 10/2 Treasury curve has flattened since early January, as economic data continue to surprise to the downside, underscoring that the tactical utilities buy signal remains intact. The third reason to augment utilities exposure was the ebbing in inflation expectations. The latter continues unabated (Chart 7). Our recent Special Report highlighted that utilities suffer in times of inflation2. But the opposite is also true: utilities stocks outperform in times of disinflation/deflation. This reflects the stable rate of return regulated utilities enjoy, in addition to the increased appeal of dividend yields and cash flow during times of economic volatility and uncertainty. Finally, natural gas prices are firm. Utilities pricing power moves in lockstep with natural gas prices (middle panel, Chart 8). The latter are the marginal price setter for non-regulated utilities, and the recent price reacceleration could be a positive catalyst (bottom panel, Chart 8). Nevertheless, the utilities share price reaction has been more muted than we had expected, at least so far, perhaps reflecting the ongoing outperformance of stocks vs. bonds, and the weakness in electricity production growth (Chart 9). If the five factors begin to lose momentum, we will recommend booking profits in this tactical overweight position. Chart 7Prepare To Book Profits... Prepare To Book Profits... Prepare To Book Profits... Chart 8...When Utilities Turbocharge ...When Utilities Turbocharge ...When Utilities Turbocharge Chart 9Two Utilities Risks To Monitor Two Utilities Risks To Monitor Two Utilities Risks To Monitor Bottom Line: Stick with overweight exposure in the S&P utilities sector for now, but get ready to book profits in the coming weeks. Put utilities on downgrade alert. Rusting Steel Stocks Steel stocks have come full circle. Following the initial euphoria since the Trump election, the relative share price ratio is now roughly where it was in early November. There is more downside ahead. China is tapping the monetary brakes, attempting to contain the shadow banking system. However, it is difficult to target one segment of the economy through monetary policy. Tight policy is starting to backlash onto commodity prices, including steel and iron ore. A number of indicators suggest that China's internal dynamics will further undermine global steel share prices. The top panel of Chart 10 shows that the recent Chinese yield curve inversion is pointing toward more pain ahead for U.S. steel producers. Further, the Chinese credit impulse is waning. Historically, BCA's Chinese Credit Impulse Indicator (CII) has an excellent track record forecasting relative performance momentum. The latest grim CII reading warns that U.S. steel stocks have more downside (second panel, Chart 10). Slower Chinese credit creation will continue to weigh on infrastructure spending. Chinese capital expenditure and loan growth are joined at the hip. Feeble loan growth suggests that fewer projects will come to fruition (third panel, Chart 10). Sinking iron ore prices reflect this grim outlook. The implication is that overly optimistic relative profit estimates are vulnerable to disappointment (bottom panel, Chart 10). True, Chinese steel exports and domestic production have eased, which suggests that the risk of a steel inventory glut has receded. Nevertheless, U.S. steel imports have climbed anew, despite ongoing steel tariffs. As steel imports command a larger share of U.S. domestic production, price deflation is necessary to resolve this imbalance (Chart 11). This will cast a shadow on steel profit prospects. Steel industry troubles are not endemic to China. Worrisomely, U.S. steel demand dynamics remain unfavorable. Two key domestic end-markets are quickly losing steam. Commercial real estate and automobile excesses are starting to correct. Banks are reining in credit to both loan categories according to the Fed's latest Senior Loan Officer Survey (second panel, Chart 12). Simultaneously, within commercial real estate, construction and land development credit demand is also anemic. With regard to consumer loan categories, auto loan demand has registered the worst showing. Chart 10China Macro Weighs On Steel bca.uses_wr_2017_05_23_c10 bca.uses_wr_2017_05_23_c10 Chart 11Steel Deflation Looms Steel Deflation Looms Steel Deflation Looms Chart 12Weak Domestic End-Markets Provide No Relief Weak Domestic End-Markets Provide No Relief Weak Domestic End-Markets Provide No Relief Already, non-residential construction is flirting with contraction and light vehicle sales are sinking like a stone (third panel, Chart 12). As a result the steel industry's new orders-to-inventories ratio has come off the boil, exerting a gravitational pull on scrap steel prices (bottom panel, Chart 12). The implication is that steel price deflation will undermine industry profits. Adding it up, the U.S. steel industry's earnings hurdle is sky-high. Tightening Chinese monetary and financial conditions along with domestic demand blues signal that U.S. steel producers' profits will surprise to the downside. Bottom Line: Continue to avoid steel stocks. The ticker symbols for the stocks in the S&P 1500 steel index are: BLBG: S15STEL - TMST, ATI, CMC, X, AKS, CRS, HAYN, RS, ZEUS, WOR, SXC, STLD, NUE. 1 Please see BCA U.S. Equity Strategy Weekly Report, "Great Expectations?" dated April 3, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Equity Sector Winners And Losers When Inflation Climbs," dated December 5, 2016, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The structural theme of overweighting technology stocks within the overall equity benchmark, and relative to other cyclical sectors such as commodities and machinery stocks, remains intact. However, in absolute terms, EM tech/semi share prices have become overbought and have already priced in a lot of good news. They will likely sell off soon due to the potential slowdown in the pace of semiconductor demand. Continue overweighting EM tech stocks, Taiwanese and Korean bourses within EM equity portfolios. We also reiterate our long-standing long tech / short materials strategy. Feature EM technology stocks have surged to all-time highs (Chart I-1, top panel), contributing significantly to the ongoing EM rally. In fact, excluding tech stocks, EM share prices have not yet surpassed a major technical hurdle, as shown in the bottom panel of Chart I-1. BCA's Emerging Markets Strategy (EMS) team has been recommending that investors overweight tech stocks since June 8, 2010. In our report titled, How To Play EM Growth In The Coming Decade,1 we contended that the structural bull market in commodities was over, and that in the coming decade (2010-2019) the winners would be health care and technology (Chart I-2). We also identified a potential mania candidate - i.e., a segment that was poised for exponential price gains. We reasoned that the fusion between technology and health care - health care equipment stocks - could experience exponential price moves. This strategy has paid off exceptionally well. Consistently, within the EM equity benchmark, we have been overweighting Taiwanese and Korean tech stocks since 2007 and 2010, respectively (Chart I-3). Chart I-1EM Tech Stocks Have ##br##Surged To All Time Highs EM Tech Stocks Have Surged To All Time Highs EM Tech Stocks Have Surged To All Time Highs Chart I-2EMS Strategy Since 2010: ##br##Long Tech / Short Materials EMS Strategy Since 2010: Long Tech / Short Materials EMS Strategy Since 2010: Long Tech / Short Materials Chart I-3Taiwanese & Korean Tech ##br##Stocks Relative To Overall EM Taiwanese & Korean Tech Stocks Relative To Overall EM Taiwanese & Korean Tech Stocks Relative To Overall EM After such enormous gains, a relevant question is whether technology share prices will continue to rally in absolute terms, boosting the EM equity benchmark, or whether their absolute performance and/or relative performance will roll over. Chart I-4EM Tech Stocks Are Overbought EM Tech Stocks Are Overbought EM Tech Stocks Are Overbought Before we proceed in laying out our analysis, a caveat is in order: we can offer thematic long-term views on various sectors, but investors should realize the investment calls on many technology, internet and social media companies are driven by bottom-up - not macro - views. From a top-down perspective, we can offer little insight on whether EM internet and social media stocks such as Alibaba, Tencent and Baidu are cheap or expensive, whether their business models are or are not proficient, or what their profit outlooks might be. The reason is that these and other global internet/social media companies' revenues are not driven by business cycle dynamics and top-down analysis is less imperative in forecasting their performance. In this report we will shed some light on the business cycle in the global/Asian semiconductor industry. The latter is subject to both business cycle swings as well as sector-specific factors. Again, sector-unique factors for the semi industry are also beyond our top-down approach. The five largest constituents of the EM MSCI tech sector are Samsung (4.3% of EM MSCI market cap), Tencent (4.0%), Taiwan Semiconductor Manufacturing Company (3.5%), Alibaba (3.0%), and Baidu (1.0%). Chart I-4 shows their share prices. In short, they have become a large part of the EM benchmark and are also extremely overbought, increasing the risk of correction. Technology's Structural Bull Market Is Intact... Even though EM tech prices have skyrocketed in both absolute and relative terms, odds are that the structural bull market has further to run. There are no structural excesses in the technology sector that would warrant a bust for now. Even in China, credit/leverage excesses are concentrated in the old industries, not among the tech and new economy segments. Demand for tech products in general and semiconductors in particular is not very dependent on the credit cycle in EM. In both developed market (DM) and EM economies, spending on many tech gadgets is contingent on income gains rather than credit growth. Our bearish view on EM/China growth is primarily due to our expectations of a credit downturn that will affect spending that is financed by credit. Investment expenditures driven by credit are much more important for commodities and industrial goods than technology products. While the share prices of technology and new economy companies are overbought and may be expensive, global/EM economic demand growth will be skewed toward new industries and technologies rather than commodities. In brief, the outlook for global tech spending remains positive, both cyclically and structurally. Having outperformed all other sectors by a large margin, the EM technology sector presently accounts for 26% of the EM MSCI benchmark, while at its previous structural peak in 2000 its market share stood at 22% (Chart I-5, top panel). During the 1999-2000 tech bubble, the U.S. and DM tech sector’s share of market cap reached 34% and 24% of the U.S. MSCI and DM MSCI benchmark market caps, respectively (Chart I-5, middle and bottom panels). Despite being stretched, it is possible that the technology sector's market cap will rise further before another structural top transpires. Hence, we are not yet ready to call the top in the tech's share of the overall market cap either in EM or DM. From a very long-term perspective (since 1960), the relative performance of the U.S. technology sector against the S&P 500 has not yet reached two standard deviations above its time trend, as it did in the year 2000 during the tech bubble. Conversely, the same measure for energy, materials and machinery stocks is not yet depressed enough to warrant a mean reversion bet (Chart I-6). Chart I-5Tech Stocks Market Cap Share ##br##Of Overall Equity Benchmarks Tech Stocks Market Cap Share Of Overall Equity Benchmarks Tech Stocks Market Cap Share Of Overall Equity Benchmarks Chart I-6Relative Performance Of ##br##U.S. Sectors Vs. S&P 500 Relative Performance Of U.S. Sectors Vs. S&P 500 Relative Performance Of U.S. Sectors Vs. S&P 500 Finally, secular leadership rotations within global equities typically occur during market downturns. Chart I-7 shows that commodities stocks and tech leadership changed in 2001 and 2008. It is possible that new sectoral leadership will emerge in global equities during the next bear market/severe selloff. However, it is too early to bet on it now. The current character of equity markets - which favors technology over commodities - will persist. Bottom Line: The structural theme of overweighting technology stocks within the overall equity benchmark and relative to other cyclical sectors such as resources/commodities and machinery stocks remains intact. ...But The Semi Cycle Upswing Is Advanced The semiconductors industry is cyclical, and as such business cycle analysis is pertinent here. The rest of the technology sector, however, is not correlated with overall business cycles. Therefore, there is little value that macro analysis can deliver on the outlook for non-semi tech areas. This is why this section is focused on semiconductors rather than the overall tech sector. There is no basis as to why semiconductor/tech cycles should correlate with commodities cycles. However, when they do, the amplitude of global business cycle fluctuations rises. Indeed, Asian exports and global trade tumbled in 2015 and have subsequently improved over the past 12 months for the following reason: the 2015 downturn and the ensuing recovery in the semiconductor cycle overlapped with similar swings in commodities and Chinese capital goods demand (Chart I-8). This has increased the amplitude of the global business cycle's swings in the past two years. Chart I-7Secular Leadership ##br##Rotation: Tech Vs. Energy Secular Leadership Rotation: Tech Vs. Energy Secular Leadership Rotation: Tech Vs. Energy Chart I-8Chinese Capital Goods Imports & ##br##Global Semiconductor Cycle Chinese Capital Goods Imports & Global Semiconductor Cycle Chinese Capital Goods Imports & Global Semiconductor Cycle We remain bearish on Chinese capital spending in general and construction in particular. This entails weaker demand for commodities and industrial goods. Yet we are not bearish on Chinese demand for semiconductors and tech devices. The semiconductor cycle has experienced a mini boom in the past 12-18 months. Demand for electronic products in the U.S. has been exceptionally strong (Chart I-9, top panel). Moreover, European production and sale of overall high-tech products as well as computer and electronic products have been robust (Chart I-9, bottom panel). In China, retail sales of communication appliances have also been extremely healthy (Chart I-10, top panel). By extension, the mainland's production of electronics has also boomed (Chart I-10, bottom panel). Chart I-9DM Demand For Tech Is Strong... DM Demand For Tech Is Strong... DM Demand For Tech Is Strong... Chart I-10...And So Is China's ...And So Is China's ...And So Is China's One soft spot for semi demand, however, could emanate from the global auto sector. U.S. auto sales have begun to contract, and auto production will likely shrink as well (Chart I-11, top panel). In addition, the growth rate of auto sales in both China and Europe may have reached a peak (Chart I-11, middle and bottom panels). Annual vehicle sales have reached 25 million units in China, and 17 million vehicles in both the U.S. and euro area. Overall global auto production is set to decelerate and this will weigh on semiconductor demand given that autos consume a lot of electronics. In addition, there are several other indications that suggest a mini-slowdown will likely transpire in the global semiconductor sector later this year: Taiwan's narrow money (M1) growth impulse has historically been correlated with the tech-heavy TSE index and has led export cycles (Chart I-12). This money impulse currently heralds a major top and relapse in both share prices and exports. Chart I-11Global Auto Production Global Auto Production Global Auto Production Chart I-12Taiwanese M1 Money Impulse Is Signaling A ##br##Growth Slowdown And Risk To Stocks Taiwanese M1 Money Impulse Is Signaling A Risk To Stocks Taiwanese M1 Money Impulse Is Signaling A Risk To Stocks The semiconductor shipments-to-inventory ratio has peaked in Korea and Taiwan (Chart I-13). This indicates that the best of the semi upswing may be behind us. Consistently, both global semiconductor producers' and semiconductor equipment stocks' forward EPS net revisions have already surged, and are elevated. This implies that a lot of earnings optimism has been priced in. Historically, when forward earning net revisions have reached these levels, global semi share prices have rolled over or entered a consolidation period (Chart I-14). Chart I-13Korea's & Taiwan's Semi ##br##Cycle Is Topping Out Korea's & Taiwan's Semi Cycle Is Topping Out Korea's & Taiwan's Semi Cycle Is Topping Out Chart I-14Semiconductors' Forward EPS ##br##Revisions Are Elevated Semiconductors' Forward EPS Revisions Are Elevated Semiconductors' Forward EPS Revisions Are Elevated Bottom Line: We expect a moderation in semi demand, but not recession. Semi share prices may react negatively to slower demand growth as the former have become extremely overbought and have already priced in a lot of good news. Investment Conclusions Semiconductor stocks have become overbought and a marginal slowdown in demand might be enough to cause a shake-out. The same is true for the overall tech sector. That said, we continue to recommend that investors overweight EM tech stocks, Taiwanese and Korean bourses within the EM equity portfolios. We also reiterate our long-standing long tech / short materials strategy. Remarkably, the KOSPI and Taiwanese TSE indexes - highly leveraged to semiconductors - have rallied to their previous highs (Chart I-15). In the past, they failed to break above these levels and we expect them to struggle again. If these equity indexes pull back and tech stocks correct, the overall EM stock index will roll over too. The rest of EM equity universe has much poorer fundamentals than tech companies. Financials and commodities sectors make 25% and 7% of the EM MSCI benchmark's market cap, respectively. The former is at risk from credit slowdown in EM and the latter is at a risk from lower commodities prices (Chart I-16). Chart I-15KOSPI & TSE Have Reached ##br##Major Resistances KOSPI & TSE Have Reached Major Resistances KOSPI & TSE Have Reached Major Resistances Chart I-16Industrial Metals ##br##Prices To Head Lower bca.ems_wr_2017_05_17_s1_c16 bca.ems_wr_2017_05_17_s1_c16 On the whole, we believe the recent divergence of EM risk assets from commodities prices and the EM/China credit cycles does not represent a structural regime shift in EM fundamentals, it rather reflects complacency in the marketplace. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Ayman Kawtharani, Associate Editor aymank@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "How The Play Emerging Market Growth In The Coming Decade", dated June 8, 2010, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Fed: The Fed is likely to lift rates in June, which could roil markets if economic data do not improve between now and then. Municipal Bonds: Weak state & local government revenue growth reflects the fall-out from the mid-2014 commodity price collapse. Now that energy sector capex has recovered, state & local government revenues will soon follow. Economy & Inflation: Consumer confidence remains elevated, and this should lead to a snapback in consumer spending in the second quarter. Stronger growth and a tight labor market should also cause core inflation to soon resume its uptrend, driven by accelerating wage growth. Feature How stubborn are Fed policymakers? This is an important question for markets at the moment. The Fed has clearly articulated that its base case economic outlook will result in two more rate hikes before the end of 2017, and even traditionally dovish Chicago Fed President Charles Evans said he "could be fine with two more rate hikes this year."1 Meanwhile, broad indexes of financial conditions suggest that markets can absorb another rate increase (Chart 1). Everything appears to be set up for the FOMC to lift rates by another 25 basis points when it meets next month, and this remains our expectation. The only problem is that the flow of economic data has turned decisively negative (Chart 2). Most recently, core CPI disappointed expectations by increasing only 0.1% in April, causing the year-over-year growth rate to fall to 1.9%. It was only three months ago that core CPI was growing 2.3% year-over-year. True to form, President Evans also noted last week that "downside risks [to inflation] still predominate". Chart 1Green Light From Financial Conditions Green Light From Financial Conditions Green Light From Financial Conditions Chart 2Red Light From Data Surprises Red Light From Data Surprises Red Light From Data Surprises The risk from a market point of view is that the Fed holds true to its promise and lifts rates in June, despite the fact that recent data have disappointed and inflation remains well below target. In that scenario, it is possible that markets come to the conclusion that the Fed is running an overly tight policy, resulting in a bear-flattening of the yield curve and a near-term sell-off in spread product. Chart 3Stay Positioned For Higher Yields Stay Positioned For Higher Yields Stay Positioned For Higher Yields As we have highlighted numerous times in the context of our Fed Policy Loop,2 with inflation below target, the Fed will be quick to adopt a more dovish stance when faced with a sharp tightening of financial conditions. This will put a floor under risk assets. Further, as was discussed in last week's report,3 negative data surprises are not likely to persist for much longer. But until that turnaround occurs, there is a heightened risk of a near-term widening in credit spreads if the Fed sticks to its guns. Ultimately, the Fed will continue to support credit spreads, and we remain overweight spread product on a 6-12 month investment horizon. Our 6-12 month outlook for Treasury yields is also unchanged, even though recent yield movements reflect the "hawkish Fed" scenario described above. The nominal 10-year yield has risen in recent weeks, driven entirely by real yields that have moved higher alongside increasingly hawkish rate hike expectations (Chart 3). The compensation for inflation protection has actually declined, in reaction to disappointing inflation data and perceptions of a more hawkish Fed. Even in the event that financial conditions tighten and the Fed is forced to adopt a more dovish policy stance, we would expect the decline in real yields to be offset by an increase in the cost of inflation compensation, which still has considerable upside (see section titled "The Consumer Is Strong, But Where's The Inflation?" below). We therefore continue to recommend a below-benchmark duration stance. Finally, futures market positioning is now solidly net long, suggesting that yields are biased higher during the next three months (Chart 3, bottom panel). Bottom Line: Risk assets could sell off in the near-term if economic data do not turn around and the Fed proceeds with a June hike. However, Fed policy will ultimately encourage tighter credit spreads and a higher cost of inflation compensation on a 6-12 month horizon. Remain at below-benchmark duration and overweight spread product. Municipal Bonds: Not Just About Taxes The uncertain outlook for fiscal policy is the immediate concern in municipal bond markets. While we expect some sort of tax bill will make its way through Congress before the end of the year, as of now, we don't have much clarity on what that bill will include. Lower corporate and individual tax rates seem likely, and the administration has also expressed a desire to curb deductions. Unfortunately, for now that's about all we can say for certain. Lower tax rates would be negative from the perspective of municipal bond investors, but fewer deductions would increase demand for munis, assuming the municipal bond tax exemption is not scrapped altogether. We haven't even mentioned the potential replacement of Obamacare and a possible federal infrastructure bill! For now, the muni market seems content to shrug off this uncertainty. Muni / Treasury (M/T) yield ratios are approaching their post-crisis lows across the entire curve (Chart 4), though longer maturity yield ratios remain elevated compared to pre-crisis levels (Chart 5). We recently recommended that investors favor long over short maturities on the Aaa muni curve.4 Chart 4Yield Ratios At Post-Crisis Lows Yield Ratios At Post-Crisis Lows Yield Ratios At Post-Crisis Lows Chart 5More Value In Long Maturities More Value In Long Maturities More Value In Long Maturities As for tax reform, although nothing is known for certain, we do expect that the administration's desire for increased infrastructure investment will keep the muni tax exemption in place. We also anticipate lower corporate and individual tax rates. How much of an impact will lower tax rates have on M/T yield ratios? Even that is hard to pin down, although we note that historically there has only been a loose relationship between yield ratios and the top marginal income tax rate (Chart 6). Chart 6The Municipal Treasury Yield Ratio & Tax Rates The Municipal Treasury Yield Ratio & Tax Rates The Municipal Treasury Yield Ratio & Tax Rates Further, elevated yield ratios since the financial crisis are much more driven by concerns about credit quality than changes in tax policy. With the potential for municipal bankruptcy more present than ever in investors' minds, as long as the muni tax exemption is not repealed, we think that trends in state & local government balance sheet health will continue to drive yield ratios. On that latter point, there is growing reason for optimism. Revenue Growth Ready To Rebound Periods of rising state & local government net savings have historically coincided with tightening M/T yield ratios, and vice-versa. Net savings increases when revenue growth exceeds expenditure growth. However, expenditure growth has been outpacing revenue growth since early 2015 and net savings have declined as a result (Chart 7). Unsurprisingly, state & local governments have reduced their pace of hiring in an effort to protect budgets (Chart 7, panel 3). Ratings downgrades have also spiked, but the message from our Municipal Health Monitor is that they will soon subside (Chart 7, bottom panel).5 We concur, and in fact believe that state & local government revenue growth has reached an inflection point and is poised to head higher. Breaking out the different sources of state & local government revenue we see that the recent deceleration has been concentrated in income tax and sales tax revenues (Chart 8). Property tax growth has been steady, if unspectacular. Transfers from the federal government have also decelerated since early 2015, but have been flat recently. Transfer revenue is at risk of falling if the federal government is able to pass a healthcare bill that includes the block-granting of Medicaid payments. But there is still a long road ahead before any proposed healthcare bill becomes law, and a lot can change in the interim. Chart 7A Setback In State & Local Savings A Setback In State & Local Savings A Setback In State & Local Savings Chart 8State & Local Revenue By Source State & Local Revenue By Source State & Local Revenue By Source What seems clear at the moment is that personal income growth is heading higher and consumer spending is firm (please see the following section of this report, titled "The Consumer Is Strong, But Where's The Inflation?", for a discussion of the outlook for income and consumer spending growth). Both suggest that income and sales tax revenue growth have bottomed for the time being. Chart 9State & Local Revenue By State State & Local Revenue By State State & Local Revenue By State Using data from the Rockefeller Institute, we can also examine state & local government revenue by state. Then, if we split out the nine states that are most heavily dependent on the energy and mining sectors,6 we observe that commodity-dependent states have dragged overall state & local government revenue growth lower since commodity prices collapsed in mid-2014 (Chart 9). Further, we see that revenue growth in commodity-dependent states is heavily influenced by nonresidential investment in the energy and mining sectors (Chart 9, bottom panel). Now that commodity prices have recovered from the 2014 bust and energy sector investment is coming back on line, we would expect state & local revenue growth to follow with a lag. Investment Implications Although we expect state & local government revenue growth to accelerate from here, yield ratios already reflect quite a lot of good news. Also, heightened policy uncertainty means there is an increased risk that yield ratios will widen sharply in the coming months. For now, we recommend only a neutral allocation to Municipal bonds within U.S. fixed income portfolios. However, an interesting opportunity could lie in focusing municipal bond exposure on those aforementioned commodity-dependent states, where revenues are likely to grow more quickly as energy capex rebounds, and whose bonds might still trade at a discount because of lower current revenues. Looking at Charts 10 & 11, we notice that the General Obligation (GO) bonds of energy-dependent Texas offer a yield advantage of 15 bps versus the overall Aaa muni curve at the 10-year maturity point. This is close to the same yield advantage offered by Massachusetts GO bonds, even though Massachusetts is rated Aa1 and Texas carries a Aaa rating. Other Aaa-rated states (Virginia, Georgia, Maryland, North Carolina, South Carolina and Tennessee) trade at much lower yields. Not only that, but Texas has also seen the strongest population growth during the past 12 months of all the states in our sample (Chart 11), and employment growth in Texas should continue to rebound alongside rising oil prices (Chart 12). Our Commodity & Energy Strategy service maintains a $60/bbl year-end oil price target.7 Chart 10Grab The Premium In Texas GOs Part I Will The Fed Stick To Its Guns? Will The Fed Stick To Its Guns? Chart 11Grab The Premium In Texas GOs Part II Will The Fed Stick To Its Guns? Will The Fed Stick To Its Guns? Chart 12Texas Bouncing Back Texas Bouncing Back Texas Bouncing Back Bottom Line: Weak state & local government revenue growth reflects the fall-out from the mid-2014 commodity price collapse. Now that energy sector capex has recovered, state & local government revenues will soon follow. Commodity-dependent states should benefit disproportionately. Texas GOs in particular look attractive on a risk/reward basis. The Consumer Is Strong, But Where's The Inflation? Consumer Spending Chart 13Consumer Spending Looks Solid Consumer Spending Looks Solid Consumer Spending Looks Solid The post-election surge in consumer confidence does not look as though it's about to reverse. At least not according to the University of Michigan Consumer Sentiment Survey, which was released last week. The expectations component of that survey, which closely tracks real consumer spending (Chart 13), rose from 87 in April to 88.1 in May, suggesting that weak first quarter consumer spending will prove to be nothing more than a blip. We like to think about consumer spending as a combination of income growth and the savings rate. On income growth, survey measures are also pointing to an imminent acceleration (Chart 13, panel 2). Meanwhile, the savings rate will likely remain elevated compared to pre-crisis levels, but is unlikely to move meaningfully higher from here. In our February 21 report,8 we noted that while tightening bank lending standards correlated with a higher savings rate prior to the financial crisis, that relationship has since completely broken down (Chart 13, panel 3). Since the housing bust, the supply of credit is no longer the chief constraint on consumer borrowing. Households are now much more concerned with maintaining the health of their own balance sheets. For this reason, we do not view the recent tightening of consumer lending standards as a meaningful impediment to consumer spending. Similarly, we do not think the recent decline in demand for consumer credit (according to the Fed's Senior Loan Officer Survey) will soon translate into much weaker consumer spending. In prior cycles, we see that loan demand tended to fall several years prior to the next recession, while the savings rate did not spike until the recession actually hit (Chart 13, bottom panel). Inflation & TIPS As was mentioned above, the Consumer Price Index for April was also released last week. Not only was the core CPI print disappointing, but the decline was broad based across the four major components of core CPI: shelter, core goods, core services excluding shelter, and medical care (Chart 14). The tick lower in shelter inflation is not surprising, and in fact should continue now that rental vacancies have put in a bottom. We would also expect core goods inflation to stay low, given that the U.S. dollar remains in a bull market. More worrisome is the large drop in core services inflation excluding shelter (Chart 14, panel 3). This component of core inflation correlates most closely with wage growth, and we would expect this component to drive core inflation higher as the labor market tightens and wage growth accelerates. It is worth noting that while wage growth has also weakened during the past few months, leading wage growth indicators are still trending up (Chart 15). Pipeline measures of inflationary pressures, such as the core Producer Price Index and the Supplier Deliveries and Prices Paid components of the ISM Manufacturing index, are the other bright spots in the inflation outlook (Chart 16). While the 10-year TIPS breakeven rate has fallen all the way to 1.85% from its post-election high of 2.08%, these pipeline measures suggest the decline will prove fleeting. Chart 14Core CPI By Major Component Core CPI By Major Component Core CPI By Major Component Chart 15Wage Growth Will Recover Wage Growth Will Recover Wage Growth Will Recover Chart 16Pipeline Measures Still Positive Pipeline Measures Still Positive Pipeline Measures Still Positive We continue to expect that the 10-year TIPS breakeven inflation rate will reach 2.4% to 2.5% by the time that core PCE inflation returns to the Fed's 2% target, sometime near the end of this year. Bottom Line: Consumer confidence remains elevated, and this should lead to a snapback in consumer spending in the second quarter. Stronger growth and a tight labor market should also cause core inflation to soon resume its uptrend, driven by accelerating wage growth. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.bloomberg.com/news/articles/2017-05-12/evans-says-risks-to-fed-inflation-outlook-still-on-the-downside 2 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "Past Peak Pessimism", dated May 9, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Reflation Window Still Open", dated April 4, 2017, available at usbs.bcaresearch.com 5 For further details on our Municipal Health Monitor, please see: U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 6 These states are: Alaska, Louisiana, Montana, New Mexico, North Dakota, Oklahoma, Texas, West Virginia and Wyoming. 7 Please see Commodity & Energy Strategy Weekly Report, "Oil: Be Long, Or Be Wrong", dated May 11, 2017, available at ces.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Upgrade capital markets stocks to overweight and put them on the high-conviction list. Capital formation is poised to accelerate in the second half of the year. Our Indicators suggest that demand for media services will continue to improve. Stay overweight both the movies and entertainment and cable and satellite indexes. Recent Changes S&P Investment Banking & Brokerage - Upgrade to overweight and add to the high-conviction overweight list. S&P Consumer Finance - Remove from the high-conviction overweight list. Table 1Sector Performance Returns (%) Falling Correlations Falling Correlations Feature The S&P 500 continues to churn near its highs. Following a robust earnings season, the onus is now on the economy to provide confidence that the corporate profit recovery will prove durable, thereby justifying thinning equity risk premia. While slumping commodity prices suggest that global end-demand has downshifted a notch, the former boost real purchasing power and provide a reflationary support for stocks, particularly since resource-dependent sectors do not have a market leadership role. In fact, financial conditions remain sufficiently accommodative to expect a growth reacceleration in the back half of the year. It is notable that the recent selloff in the Treasury market has been driven by the real component, while inflation expectations have moved sideways. As a result, there is little pressure on the Fed to normalize at a faster pace than currently discounted in the forward curve. Thus, we expect the window for additional equity price appreciation to remain open this summer, unless growth reaccelerates sufficiently to stir inflation fears. Nevertheless, selectivity will become even more critical. Cross asset correlations have collapsed. Diminishing global macro tail risks have reduced the dominance of the beta-oriented "risk on/risk off" trade as a source of return. Empirical evidence suggests that asset correlations and the broad equity market are inversely correlated. This message is corroborated by falling correlations between regional stock market returns. Receding equity index correlations have been associated with positive S&P 500 returns (middle panel, Chart 1). This inverse correlation is also mirrored in the CBOE's implied correlation index, which tracks the correlation of the S&P 500 stocks with one another: tumbling correlations imply solid overall equity returns (top panel, Chart 1). These relationships are intuitive. Diminished macro tail risks bring earnings fundamentals to the forefront as the key driver of returns, and reward differentiation and discrimination in sector/region/asset class selection. While an eerie calm has dominated markets of late, as our Asset Class Volatility Indicator has collapsed to a multi-decade low (bottom panel, Chart 1), a more bullish explanation is that all-time highs in equities are synonymous with all-time lows in the VIX. This can be viewed as a contrary warning sign, but history shows that the VIX can stay depressed for a prolonged period. Our Equity Market Internal Dynamics Indicator (EMIDI), first introduced in late-March, has tentatively troughed, suggesting that sub-surface dynamics are becoming more supportive of the broad market (Chart 2). The EMIDI, which comprises relative bank, relative transport, small/large and industrials/utilities share prices, has been coincident to the leading market indicator, especially since the GFC. Chart 1Tumbling Correlations = Rising Stock Returns Tumbling Correlations = Rising Stock Returns Tumbling Correlations = Rising Stock Returns Chart 2Sub-Surface Dynamics Have Turned The Corner Sub-Surface Dynamics Have Turned The Corner Sub-Surface Dynamics Have Turned The Corner In that light, this week we are further augmenting our cyclical portfolio exposure by lifting another interest rate-sensitive group to overweight and are also updating the early cyclical media index and its major components. Capital Markets Stocks Have Rally Potential Two weeks ago, we recommended using this year's financial sector underperformance to boost allocations to overweight. This week we are further augmenting our exposure by upgrading the S&P investment banks & brokerage index to above benchmark. While the equity bull market is in the later innings, our view is that the overshoot will be extended for a while longer as a consequence of the overall sales and profit recovery and low probability that monetary conditions will tighten meaningfully in the near run. If this plays out, there is an opportunity for capital markets stocks to recover from their recent consolidation. This sub-index thrives when investor risk appetites are healthy and the business sector is moving from retrenchment to expansion mode, and vice versa. The outlook for increased capital formation has improved considerably. The corporate sector financing gap is beginning to widen anew (Chart 3), reflecting the surge in business and consumer confidence since the pro-business U.S. Administration took power. The widening financing gap is particularly notable because it is occurring alongside improving profit growth. In other words, the wider financing gap reflects accelerating capex demand, not weak corporate cash flows. This is confirmed by BCA's Capital Spending Indicator, which signals an increase in business investment ahead. Consequently, corporate sector demand for external capital should accelerate. The latter is the lifeblood of capital markets profitability. The nascent recovery in total bank credit growth after a period of malaise reinforces that working capital requirements are on the upswing (Chart 3).1 As businesses shift from maintenance capital spending to a more expansionist mindset, and companies reach further for growth to justify high stock valuations, capital markets activity could accelerate in the second half of the year. After all, investor confidence is high. Corporate bond spreads have tightened and corporate bond issuance is soaring. The Equity Risk Premium is steadily narrowing (shown inverted, second panel, Chart 4), reducing the cost of equity capital. New stock issuance is following on the heels of corporate bond issuance. Stocks are outperforming bonds by a comfortable margin and total mutual fund assets have grown sharply (Chart 3). The upshot is that access to corporate sector capital should stay healthy. As flows into equities advance, it will fuel a reacceleration in M&A activity (Chart 5). Chart 3Capital Markets Activity Is... Capital Markets Activity Is... Capital Markets Activity Is... Chart 4...Firing On All Cylinders ...Firing On All Cylinders ...Firing On All Cylinders Chart 5ROE On The Upswing ROE On The Upswing ROE On The Upswing Capital markets return on equity (ROE) is highly levered to business and investor risk appetite. Fees earned on M&A activity heavily influence overall profitability. As such, it is normal for ROE to expand when M&A activity picks up, and shrink when financial conditions tighten and takeovers dry up. Currently, M&A transactions represent an historically elevated share of GDP, but that is not a barrier to an increased rate of takeover activity. Companies are no longer using their balance sheets to repurchase their own shares en masse. Instead, there is an incentive to pursue business combinations as the global economy reaccelerates, underscoring that capital allocation should shift in favor of capital markets firms. Indeed, Chart 5 shows that ROE also follows the trend in our global leading economic indicator, and the current message is bullish. Even capital markets companies themselves confirm that their pipelines are full. Hiring activity remains robust. Pro-cyclical firm headcount rises quickly alongside revenue opportunities, and is just as quick to shrink when the outlook darkens. Ergo, we interpret headcount growth as a net positive. While trading activity is always a wildcard, and could be a source of weakness if bond market, and generalized asset class, volatility stays muted, the upbeat outlook for fee generation from increased capital formation provides us with confidence to use share price weakness as an opportunity to build a bigger position. Bottom Line: Lift the S&P investment banking & brokerage index to overweight, adding to our recent decision to upgrade the overall financials sector to above-benchmark. The ticker symbols for the stocks in this index are BLBG: S5INBK - GS, MS, SCHW, RJF, ETFC. Media Stocks: Temporary Pressure Media stocks have come under pressure recently, giving back all of this year's relative gains. Investor worries have centered around two thorny issues: cord-cutting and ad spending. Cord-cutting is not new, but weak overall Q1 TV subscriber numbers have refocused investors' attention on the secular challenges ahead. In addition, a number of companies noted softening ad spending on Q1 conference calls. According to media executives, this slowdown is not isolated to the automotive segment. Is it time to pull the plug or is a worst case scenario already priced into the group? We side with the latter. In aggregate, demand for media services is brisk. Consumer outlays on media have soared to a two decade high, hitting a double digit annual growth rate. S&P media sales are tightly correlated with media spending (second panel, Chart 6). Despite coming off the boil recently after hitting unusually high growth rates, media pricing power also remains in expansionary territory. Importantly, buoyant demand is boosting industry productivity gains. The third panel of Chart 6 shows that our media productivity proxy has reaccelerated. Meanwhile, an improving economic backdrop also bodes well for media earnings prospects. The ISM services new orders sub component has been an excellent leading indicator of relative profit growth expectations and the current message is positive (middle panel, Chart 7). If the overall economy bounces smartly from the weak Q1 print, as we expect, then an earnings-led recovery should sustain the valuation re-rating phase (bottom panel, Chart 7). Chart 6Buoyant Media Demand Buoyant Media Demand Buoyant Media Demand Chart 7Valuation Re-Rating Looms Valuation Re-Rating Looms Valuation Re-Rating Looms Our Ad Spending Indictor (ASI) incorporates all of these key media profit drivers, including consumption and overall corporate profits. The ASI has recently hooked up, signaling that earnings estimates should continue to rise (bottom panel, Chart 8). Nevertheless, sub-media group returns have been bifurcated, with the S&P movies and entertainment index exerting downward pressure on the overall sector of late. Relative performance has mostly treaded water since our upgrade last summer, but hit a soft patch after recent quarterly results. Before rushing to make a bearish judgment, it is notable that the relative forward P/E remains close to an undervalued extreme, signaling that it will be increasingly difficult to disappoint. Historically cheap valuations exist despite depressed expectations, which should serve to artificially inflate valuations: both top and bottom line are expected to lag the broad market, representing a very low hurdle (Chart 9). Chart 8Rosier EPS Prospects Lie Ahead Rosier EPS Prospects Lie Ahead Rosier EPS Prospects Lie Ahead Chart 9Unloved And Undervalued Unloved And Undervalued Unloved And Undervalued Beyond the positive consumer spending backdrop (Chart 10), we are inclined to stick with overweight positions in this sub-component for four major reasons. First, merger and acquisition activity should reduce capacity, and by extension, support pricing power, especially if the AT&T/Time Warner deal clears the regulatory hurdle. There is scope for additional M&A that could further reduce shares outstanding (Chart 11). Chart 10Improving Demand... Improving Demand... Improving Demand... Chart 11...And M&A Activity Are An EPS Tonic ...And M&A Activity Are An EPS Tonic ...And M&A Activity Are An EPS Tonic Second, content providers are adapting to the competitive threat. New online-only offerings and slimmer/nimbler packages should stem the drag from the likes of Netflix and other streaming services. Consumer spending on electronics continues to surge, suggesting that content providers have ample opportunity to fill increasing demand. Third, there is no substitute for live TV. News and live sports are two sticky offerings that will continue to be cash cows for the industry and drive select subscriber growth. Fourth, media giants have stepped up focus on other segments with higher growth potential, such as studios and franchises highlighting increasingly diversified revenue streams. Moreover, CEOs have been aligning cost structures to the new realities of cord-cutting, exercising strict cost control. Companies have also been careful with capex allocation decisions. All of this suggests that any shakeout in this media subgroup is a good entry point for building new positions with a compelling valuation starting point. Unlike the S&P movies and entertainment index, the S&P cable and satellite group has been relentlessly grinding higher, underpinning the broad media index. The multiyear share price advance has been cash flow driven. As a consequence, cable stocks still trade at a 25% discount to the broad market on a price/cash flow basis and the relative multiple is hovering near the historical mean (third panel, Chart 12). Cable and satellite sales growth has surged to healthy low double-digit growth rates after a one year lull. Encouragingly, soaring pricing power signals that recent revenue momentum is sustainable (second panel, Chart 12). As mentioned above, consumer outlays on cable services have had a V-shaped recovery, underscoring that the latest upleg in selling prices is demand driven (bottom panel, Chart 12). It is remarkable that the industry has consistently raised selling prices at a faster pace than overall inflation for decades (Chart 13). This impressive track record reflects cable operators' ability to continually evolve offerings and provide attractive content, even in the face of cord-cutting. Chart 12Cash Flow Driven Outperformance Cash Flow Driven Outperformance Cash Flow Driven Outperformance Chart 13The Cable Signal Is As Strong As Ever The Cable Signal Is As Strong As Ever The Cable Signal Is As Strong As Ever Meanwhile, content inflation rates have remained within the range of the past few years, underscoring that threats to robust profit margins are limited (bottom panel, Chart 13). More recently, news that Comcast and Charter will come together and cooperate on a wireless offering adds another layer of defense in effectively combating cord-cutting. How? By increasing the bundle offering beyond cable and internet services, cable providers are positioned to attract new clients by offering a one stop shop triple-play solution. A move into wireless service offerings would also assist in retaining existing customers. In sum, most of our indicators suggest that the demand outlook for media services continues to improve. Our Ad Spending Indicator is climbing, underscoring that fears of a deep and widespread slump are overblown. Bottom Line: The media index remains an overweight and we continue to recommend an above benchmark exposure both in the S&P movies and entertainment and S&P cable and satellite sub-groups. The ticker symbols for the stocks in these two indexes are BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB and BLBG: S5CBST - CMCSA, CHTR, DISH, respectively. 1 Please see BCA U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds," dated April 11, 2017, available at usbs.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Shorting the RMB against the dollar is no longer a one-way bet. Investors should look to reduce bearish positions on the RMB going forward. The RMB is no longer overvalued. Therefore, any further decline will push the RMB deeper into undershoot territory, which is ultimately subject to mean reversion. The recent focus on China's low and falling reserve-to-M2 ratio largely reflects lopsided expectations on continued capital outflows and further RMB declines. The PBoC should have no difficulties maintaining control over the exchange rate with the country's massive current account surplus, low foreign currency debt and pervasive capital account control measures. Feature With widespread consensus among investors and market-watchers for the RMB to continue depreciating against the U.S. dollar, a key question is whether the seemingly unloved RMB could once again become appreciated. Indeed, the widely shared consensus a mere three years ago - that the RMB had nowhere to go but up - has now become a highly controversial rhetorical question. The current prevailing view is that the RMB is under intense downward pressure against the dollar, and the People's Bank of China (PBoC) is fighting an uphill battle in maintaining exchange rate stability. Some have gone even further, relating the RMB's ongoing weakness to "money printing" and "credit largess." According to these pundits, the country's mighty official foreign reserves pale in comparison to domestic capital flight, and the end game will have to be a substantial currency depreciation before a new equilibrium is re-established. Chart 1The RMB's Rollercoaster Ride The RMB's Rollercoaster Ride The RMB's Rollercoaster Ride In June 2013, amid the comfortable consensus that the RMB would perpetually rise against the dollar and the RMB "carry trade" was running amok, we published a Special Report titled "Is The RMB Still Undervalued?"1 We argued at the time that "the large valuation buffer for the RMB has mostly been eliminated," and that "there is a strengthening case for the RMB to fall against the greenback." Fast forward four years, the CNY/USD peaked in January 2014 and has since depreciated by about 15% (Chart 1). As the consensus on the RMB has now completely swung to the other extreme, it is time for a new reality check and some provocative rethinking. What Has Changed? With the benefits of hindsight, it is easy to spot what went wrong for the RMB as well as for the Chinese economy. In our 2013 Special Report, we concluded that "the dollar appears to be bottoming out from its structural bear market" and that "the Chinese central bank should guide the RMB lower versus the greenback in order to maintain a relatively stable exchange rate against a currency basket." In reality, the sharp dollar rally of 2014-'15 pushed up the trade-weighted RMB by another 10% and led to draconian tightening in China's monetary conditions - a major policy mistake that caused relentless deflationary pressure and growth woes. By the same token, the depreciation of the RMB since early 2016 has turned out to be a key reflationary force that has helped stabilize the Chinese economy. As far as the RMB is concerned, there have been a few important changes in the macro environment. Chart 2The Dollar: A Long Term Perspective The Dollar: A Long Term Perspective The Dollar: A Long Term Perspective First, the dollar's multi-year bull market has pushed the greenback up by 25% since 2014. The U.S. economy is currently a bright spot in the world, and the Federal Reserve appears to be the most determined to tighten among the major monetary authorities - two factors that are likely to maintain dollar bullishness. However, it is important to note that the sharp rally has already pushed the dollar close to two sigma above its long-term trend (Chart 2). The dollar may remain well bid in the near term, but another major up leg similar to the one in 2014-'15 is highly unlikely. Second, the valuation froth in the RMB accumulated in previous years has been squeezed out (Chart 3). The trade-weighted RMB has fallen back to its long-term trend line after a two-sigma overshoot. Its spot rate against the dollar has now dropped below our PPP model fair value estimate. In real effective terms, the RMB has also quickly swung back from overvalued territory. The increase in Chinese producer prices since September 2016 also suggests the RMB may have become cheap again. Third, the massive RMB "carry trade" has been largely unwound. Before 2014, the RMB's one-way ascendance attracted speculative "hot money" inflows to China in anticipation of both higher yields and further currency upside. Chinese companies also sharply ramped up borrowing in foreign currencies, mostly U.S. dollars, for lower rates and potential exchange rate gains. Both trends abruptly reversed as the RMB began to fall, with hot money fleeing and domestic borrowers rushing to pay back foreign currency obligations. Chart 4 shows the abnormal surge of the RMB "carry trade" before 2014 has essentially vanished. Chart 3The RMB Is No Longer Overvalued The RMB Is No Longer Overvalued The RMB Is No Longer Overvalued Chart 4The Unwinding Of The RMB "Carry Trade" The Unwinding Of The RMB "Carry Trade" The Unwinding Of The RMB "Carry Trade" Finally, the reflationary benefit of a weaker exchange rate on the Chinese economy has been proven since 2016, which in of itself rules out the possibility of an endless RMB decline. As the largest manufacturer and exporter in the world, a weaker RMB is good news for the Chinese industrial sector's pricing power, profit margins and overall business activity - unless broad protectionist backlash blocks the positive feedback loop.2 The bearish argument on the RMB fixating on Chinese credit, even if true, ignores the reflationary impact on a major part of the Chinese economy, which in turn puts a floor under its exchange rate. What's Intact? Meanwhile, some factors that were widely viewed in previous years as supportive for an ever-rising RMB have remained largely intact. China still runs by far the largest trade surplus in the world, amounting to an annualized US$ 500 billion. Chinese foreign reserves, although having fallen by US$ 1 trillion since their all-time peak, still accounts for almost 30% of the global total (Chart 5). In comparison, China's official hoarding of foreign assets accounted for about 15% of the world in 2005, when the RMB was de-pegged from the greenback and began a decade-long ascent. In addition, Chinese exporters have continued to gain global market share, currently accounting for about 14% of world exports, more than double 2005 levels. Meanwhile, it is fairly likely that China's recent export numbers have been under-reported, as exporters have hidden part of their overseas proceeds offshore in anticipation of further RMB declines. Overall, there is no evidence that the value of the RMB has hindered Chinese exporters' competitiveness. From a long-term perspective, a country's productivity growth relative to the rest of the world fundamentally determines its relative competitiveness in global trade, which in turn is the ultimate driving force behind its exchange rate (Chart 6). On all these fronts, China still compares favorably to other major countries. Chart 5China's Foreign Official ##br##Reserves Remain Massive China's Foreign Official Reserves Remain Massive China's Foreign Official Reserves Remain Massive Chart 6Relative Productivity Determines ##br##Export Sector Competitiveness Relative Productivity Determines Export Sector Competitiveness Relative Productivity Determines Export Sector Competitiveness Are China's Foreign Reserves Enough? Chart 7 shows that the ebbs and flows of China's foreign exchange reserves are tightly linked with the USD/CNY "risk reversal" indicator, defined as the implied volatility for call options minus the implied volatility for put options on the cross rate. Chinese foreign reserves have increased for three consecutive months, a sign of slower capital outflows and easing concerns surrounding the RMB. It remains to be seen whether this is a permanent shift or a temporary pause. A more important question is whether China's foreign reserves are large enough for the PBoC to maintain control over its exchange rate. Chart 7The RMB Risk Aversion And Capital Flows The RMB Risk Aversion And Capital Flows The RMB Risk Aversion And Capital Flows Central banks' precautionary holdings of foreign reserves are mainly to reduce the likelihood of balance-of-payments pressures. From this perspective, for a country running chronic and massive trade surpluses with minimal foreign currency debt, China should not hold large foreign reserves at all. This is also why its massive foreign reserve holdings were long regarded as wasteful before 2014 by both market participants and Chinese policymakers - and since 2014 as the RMB has weakened the exact opposite: as not enough. Based on traditional yardsticks for reserve adequacy such as coverage ratios for imports or short-term foreign currency debt, China's reserves are far more than adequate. The more recent focus has been on additional metrics proposed by the IMF, particularly the ratio of reserves relative to a country's broad money supply (M2). This ratio captures potential residents' capital flight through the liquidation of their highly liquid domestic assets, which reflects potential drains on the balance of payments. Chart 8 shows a sharp decline in China's reserves-to-M2 ratio in recent years. However, this does not mean that Chinese foreign reserves are insufficient for the following reasons. Historically China's reserve-to-M2 ratio has had no direct correlation with the broad RMB trend. China's reserve-to-M2 ratio peaked at 28% in 2008, long before the RMB peaked. At 13% currently, the ratio is comparable to 2005 when the RMB began to rise against the dollar. Globally speaking, there is no empirical evidence that a higher reserve-to-M2 ratio helps alleviate downward pressure on a country's exchange rate. Other major emerging countries such as Brazil, Russia and India have much higher reserve-to-M2 ratios than China, but their currencies have suffered brutal declines in recent years (Chart 9). In contrast, Japan's reserve-to-M2 ratio is comparable to China, but the Bank of Japan has been trying desperately to weaken the yen. Germany's ratio is even lower. Finally, China's pervasive capital account control measures and its largely state-controlled financial institutions are powerful tools to hinder capital outflows, and can be adjusted to accommodate changes in the marketplace. This further diminishes the usefulness of this ratio. Chart 8China's Reserves-To-M2 Ratio Has Been Falling... China's Reserves-To-M2 Ratio Has Been Falling... China's Reserves-To-M2 Ratio Has Been Falling... Chart 9...But Does It Matter? ...But Does It Matter? ...But Does It Matter? Overall, the recent focus on China's low and falling reserve-to-M2 ratio largely reflects lopsided expectations on continued capital outflows and further RMB declines. This has all but ignored the prospect for capital inflows. True, Chinese households and companies will likely continue to diversify into foreign assets. However, there is an equally compelling case that foreign demand for RMB-denominated assets will also increase going forward. For example, Chinese local bond yields, both sovereign and credit, are substantially higher than other major economies. Meanwhile, foreign ownership in Chinese bonds is practically non-existent compared with other bourses (Chart 10). It is almost a sure bet that foreign demand for RMB bonds will increase significantly, especially if market expectations on the RMB stabilize. Given how dramatic market expectations on the RMB have shifted in the past several years, this could come much sooner than many expect. Chart 10The Case For Increasing Foreign Demand##br## For RMB Bonds The Case For Increasing Foreign Demand For RMB Bonds The Case For Increasing Foreign Demand For RMB Bonds Investment Conclusions We are not making the case for an immediate resumption of a rising RMB. In the near term, the USD/CNY cross rate will continue to be dominated by the broad dollar trend, the upside of which may not yet be exhausted. However, the prevailing bearish consensus means that shorting the RMB against the dollar has become a very crowded trade. Meanwhile, our valuation models suggest the RMB is currently no longer overvalued. Therefore, any further decline will push the RMB deeper into undershoot territory, which is ultimately subject to mean reversion. Overall, we caution against being overly negative at the moment, and investors should begin to reduce bearish bets on the RMB going forward. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Is The RMB Still Undervalued?," dated June 12, 2013, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Reflecting On The Trump-Xi Summit," dated April 13, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights ECB policy is set to become less dovish relative to other central banks. Stay long the euro; stay underweight German bunds within a global bond portfolio; and overweight euro area Financials within a global Financials portfolio. Female labour participation is surging. The state of the euro area labour market is not nearly as bad as many pessimists would have you believe. Play the mega-trend of rising female labour participation with a structural overweight in the Personal Products sector. Allowing for euro break-up risk, European equities are fairly valued - rather than cheap - versus U.S. equities. Prefer to gain exposure via a 50:50 combination of Germany (DAX) and Sweden (OMX). Feature "Domestic sources of risk to euro area growth have diminished while global, geo-global sources of risk have increased." - Mario Draghi The Cleanest Dirty Shirt Since the end of 2014, an unspectacular 1.9% growth rate1 has been enough to make the euro area the world's top-performing major economy - bettering the U.S., U.K. and Japan (Chart I-2). Chart of the WeekThe Percentage Of The French Population In Employment Is At An All-Time High The Percentage Of The French Population In Employment Is At An All-Time High The Percentage Of The French Population In Employment Is At An All-Time High Chart I-2The Euro Area Is The Top-Performing Economy The Euro Area Is The Top-Performing Economy The Euro Area Is The Top-Performing Economy The euro area economy has achieved this outperformance with exceptionally low volatility. For eight consecutive quarters, growth2 has remained within a very tight 1.2-2.2% band, less than half of the equivalent volatility in the U.S., U.K. and Japan. And growth is now "solid and broad", meaning that it includes all countries. The ECB's dispersion index of value-added growth in different countries stands at a historical minimum. We expect the euro area to remain the cleanest dirty shirt. As Draghi points out, the ECB is less worried about domestic risks and more worried about global risks. Specifically: "Markets are in the course of reassessment of U.S. fiscal policy" - Trumponomics will not be nearly as stimulative as first thought. "How the U.K. economy does post-Brexit has a channel of economic consequences for the euro area." "Possible negative surprises in some emerging market economies" - notably China. If any of the global risks do flare up, the ECB will sit pat, but other central banks will have to become more dovish relative to current expectations. If the risks do not flare up, the ECB will start to reduce its own extreme dovishness - at least with words, if not actions. Either way, ECB policy is set to become less dovish relative to other central banks. And the investment implications are: stay long the euro; stay underweight German bunds within a global bond portfolio; and overweight euro area Financials within a global Financials portfolio. Female Labour Participation Is Surging Chart I-3Rising Participation Boosts Employment Rising Participation Boosts Employment Rising Participation Boosts Employment As Emanuel Macron prepares to become the twenty fifth President of the French Republic, he can take heart from a statistic which may surprise you: The percentage of the French population in employment has never been this high. (Chart of the Week). How can this be when the French unemployment rate is still hovering around 10%? The answer is: as millions of formerly inactive French citizens have entered the labour market, it has lifted the percentage of the population with jobs to an all-time high (Chart I-3). But the flip side of rising participation is that it has kept the unemployment rate elevated - because some citizens who were formerly 'uncounted inactive' are now 'counted unemployed'. Remember that to count as unemployed, a person has to be in the labour market available for work. Some argue that French citizens have simply flooded into the labour market to claim generous and long-lasting unemployment benefits. This argument might hold during downturns, but it cannot explain the 25-year uptrend which also includes economic booms. Unpalatable as it might be to the pessimists, we are left with a more optimistic explanation. France has raised activity levels in the working age population with policies that encourage much greater female participation in the labour market. The important lesson is that when labour participation is rising or falling, we must interpret the headline unemployment rate with extreme care.3 If a country's unemployment rate is high because labour participation has increased - as in France - the labour market is not quite as bad as the high unemployment rate might suggest.4 Conversely, if a country's unemployment rate is low because labour participation has decreased - as in the U.S. (Chart I-4) - the labour market is not quite as good as the low unemployment rate might suggest. Counted unemployment has just been replaced with uncounted inactivity. We propose that the percentage of the working age population in employment is the truer measure of labour utilisation. With surging female participation boosting employment in France and most other European countries (Chart I-5), the state of the euro area labour market is not nearly as bad as many pessimists would have you believe. Chart I-4Participation Down In The U.S.,##br## But Up In Europe... Participation Down In The U.S., But Up In Europe... Participation Down In The U.S., But Up In Europe... Chart I-5...Led By ##br##Women ...Led By Women ...Led By Women Play the mega-trend of rising female labour participation with a structural overweight in the Personal Products sector. Political Risk Is Correctly Priced Many people saw the Brexit and Trump victories as the leading edge of a wave of economic nationalism. However, subsequent election results in the Netherlands, Austria, Finland, Bulgaria and now France have seen economic nationalists consistently underperforming their expectations. In hindsight, the Brexit and Trump victories were idiosyncratic. Both the Remain and Clinton campaigns were lacking in personality or a strong emotional message, and this proved to be their undoing. Nowadays, many voters care about personalities more than policies; emotional appeal matters more than rational appeal. Behavioural psychologist and Nobel Laureate Daniel Kahneman calls the emotional way of thinking "System 1", and the colder rational way of thinking "System 2". Crucially, in a tight contest, both the Brexit and Trump campaigns resonated with the emotional System 1 with passionate pleas such as "Take Back Control" and "Make America Great Again". By contrast, the Remain and Clinton campaigns tried to appeal mainly to the rational System 2. But as Kahneman explains, when rational System 2 competes with emotional System 1, emotional System 1 almost always wins. Chart I-6Euro Break-Up Probability = 5% A Year Euro Break-Up Probability = 5% A Year Euro Break-Up Probability = 5% A Year In more recent elections, candidates and parties opposing the nationalists - including Emanuel Macron - have used a good balance of System 1 and System 2 arguments, thereby helping to prevent shock outcomes. This is also likely to be case in the two round French legislative elections on June 11 and 18 which we do not expect to impact financial markets significantly. Does this mean that political risk is over in Europe? No. Until the euro area turns into a permanent and irreversible political union, there has to be a probability of euro break-up. To value euro area assets, investors must ask: what is this break-up probability? The sovereign bond market says it is 5% a year (Chart I-6). This shows up in a discount on German bund yields, because after a euro break-up a new deutschmark would rise; and a symmetrical premium on Italian BTP yields, because a new lira would fall. For the aggregate euro area bond, the risk largely cancels out because intra-euro currency redenomination would be zero sum. But European equities must trade at a discount for this tail-event. At the peak of the euro debt crisis in 2011, the Eurostoxx600 underperformed the S&P500 by 25% in one year. In an outright break-up, the underperformance would almost certainly be worse, let's conservatively say 30-40%. So assuming the tail-event probability is 5% a year, European equities must compensate with a valuation discount which allows a 1.5-2.0%5 excess annual return over U.S. equities. Today, the valuation discount on European equities relative to U.S. equities implies an excess annual return of 1.8%.6 This makes European equities cheap versus U.S. equities only if the annual probability of euro break-up is less than 5%. Our assessment is that a 5% annual risk is about right. Therefore, European equities are fairly valued - rather than cheap - versus U.S. equities. But to avoid the undesirable sector skews in the Eurostoxx600, a much better way to gain long-term exposure to European equities is via a 50:50 combination of Germany (DAX) and Sweden (OMX) (Chart I-7). Chart I-7Prefer A DAX/OMX Combo To The Eurostoxx50 Or Eurstoxx600 Prefer A DAX/OMX Combo To The Eurostoxx50 Or Eurstoxx600 Prefer A DAX/OMX Combo To The Eurostoxx50 Or Eurstoxx600 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 At an annualized rate. 2 At an annualized rate. 3 Geek's note: the unemployment rate can be expressed as: 100*(participation rate - employment to population rate) / (participation rate). Hence, all else being equal, a rising participation rate will raise the unemployment rate and a falling participation rate will depress the unemployment rate. 4 This lesson applies equally to any studies of labour market slack such as this one: https://www.ecb.europa.eu/pub/pdf/other/ebbox201703_03.en.pdf that do not take into account the dynamics of participation rates. 5 5% multiplied by 30-40% equals 1.5-2.0% 6 Through the next ten years. Please see the European Investment Strategy Weekly Report titled "Markets Suspended In Disbelief" dated April 13, 2017 available at eis.bcaresearch.com Fractal Trading Model The rally in the CAC40 after the French election is technically extended. The recommended technical trade is to short the CAC40 versus the Eurostoxx600. 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-8 Short CAC40 / Long EUROSTOXX600 Short CAC40 / Long EUROSTOXX600 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