Valuations

Highlights There are a number of market signals and indicators that are denoting opening cracks in the reflation trade in general and EM risk assets in particular. EM/China narrow money (M1) growth points to relapse in their growth and profits in the second half this year. In this vein, we recommend reinstating a short EM stocks / long 30-year U.S. Treasurys trade. The South African rand has considerable downside and local bond yields will rise further. Stay short ZAR versus the U.S. dollar and MXN. Downgrade this bourse from neutral to underweight. Stay long MXN on crosses versus ZAR and BRL. Continue overweighting Mexican local currency bonds and sovereign credit within their respective EM universes. Feature Chart I-1EM Narrow Money Growth ##br##Signals Trouble Ahead EM Narrow Money Growth Signals Trouble Ahead EM Narrow Money Growth Signals Trouble Ahead Emerging market (EM) assets have been the beneficiary of large inflows this year and have delivered solid gains in the first quarter, causing our defensive strategy to miss the mark. In retrospect, it was a mistake not to chase the market higher last year. At the current juncture, however, with investor sentiment on risk assets very bullish, valuations rather expensive or at least not cheap1 and investor expectations for global growth elevated, the question is whether being contrarian or chasing momentum is the best strategy. Weighing the pros and cons, our view is that investors who now adopt a contrarian stance will be rewarded greatly in the next six to nine months. In this vein, we recommend reinstating a short EM stocks / long 30-year U.S. Treasurys trade. Review Of Market Indicators Following is a review of some specific EM market indicators: EM narrow money (M1) impulse - change in M1 growth - points to a potential major top in EM share prices (Chart I-1, top panel). In fact, M1 growth leads EM EPS growth by nine months and heralds a reversal in the months ahead (Chart I-1, bottom panel). We use equity market cap-weighted M1 growth to ensure that the country weights in the M1 aggregate are identical to those in the EM equity benchmark. The M1 impulse has rolled over decisively, not only in China as shown in Chart I-9 on page 6 but also in Taiwan, heralding a major top in the latter's stock market (Chart I-2). The Taiwanese bourse is heavy in technology stocks that have been on fire in the past year. We continue to hold the view that tech stocks will do better than commodity plays or banks. In short, we continue to recommend overweighting tech stocks within the EM universe. However, if tech stocks roll over as per Chart I-2, the EM equity universe will be at major risk. Global mining stocks have lately been struggling while EM share prices have been well bid (Chart I-3). Historically, these two correlate strongly. In this context, the latest rift between the two is unsustainable. Our bet is that EM stocks will converge to the downside with global mining stocks. Chart I-2Taiwan: Narrow Money ##br##Points To Top In Share Prices Taiwan: Narrow Money Points To Top In Share Prices Taiwan: Narrow Money Points To Top In Share Prices Chart I-3A Rift Between Global ##br##Mining And EM Stocks A Rift Between Global Mining And EM Stocks A Rift Between Global Mining And EM Stocks We are well aware that technology and internet stocks now account for 25% of the EM MSCI benchmark, thereby reducing the importance of commodities prices to EM. However, technology stocks are much overbought and could be at risk of a selloff too, as per Chart I-2 on page 2. On a more general level, we expect that if commodities prices relapse EM risk assets will sell off as well. Consistently, commodities currencies seem to be topping out, which also raises a red flag for EM stocks (Chart I-4). Various commodities prices trading in China are also exhibiting weakness, likely signaling a reversal in the mainland's growth revival (Chart I-5). Finally, all of these factors are occurring at a time when investor sentiment toward U.S. stocks is elevated relative to their sentiment on U.S. Treasurys, and the U.S. equity-to-bonds relative risk index is also at a level that has historically heralded stocks underperforming Treasurys (Chart I-6). Chart I-4An Unsustainable Gap An Unsustainable Gap An Unsustainable Gap Chart I-5Commodities Prices In China Commodities Prices In China Commodities Prices In China Chart I-6U.S. Stocks-To-Bonds: ##br##Relative Sentiment And Risk Profile U.S. Stocks-To-Bonds: Relative Sentiment And Risk Profile U.S. Stocks-To-Bonds: Relative Sentiment And Risk Profile Bottom Line: While global economic surveys and data still allude to firm growth conditions, there are a number of market signals and indicators that are denoting opening cracks in the reflation trade in general and EM risk assets in particular. It is important to note that this is the view of BCA's Emerging Markets Strategy team, which differs from BCA's house view. EM/China Growth Outlook Global and EM manufacturing PMIs are elevated and they will roll over in the months ahead. Yet, a top in economic and business surveys at high levels does not always warrant turning bearish. Our negative stance on EM/China growth stems from our fundamental assessment that these economies have not yet gone through deleveraging, i.e., credit excesses of the boom years have not been worked out. This is the reason why we believe the EM/China growth rebound of the last 12 months is unsustainable and sets the stage for another major downleg. There are preliminary indications that the one-off boost from last year's fiscal and credit push in China is waning. In particular, the number and value of newly started capital spending projects have relapsed dramatically (Chart I-7). This is consistent with our view that the 2016 fiscal push that boosted Chinese growth is passing. Meanwhile, private sector investment expenditures remain weak (Chart I-7, bottom panel). A renewed slump in capital spending will have negative ramifications for mainland imports of commodities. With the monetary authorities tightening liquidity and interest rates rising (Chart I-8), odds are that credit and money growth will decelerate, thwarting the recent amelioration in economic growth. Chart I-7China: 2016 Fiscal Stimulus Is Waning China: 2016 Fiscal Stimulus Is Waning China: 2016 Fiscal Stimulus Is Waning Chart I-8Beware Of Rising Rates In China Beware Of Rising Rates In China Beware Of Rising Rates In China We continue to emphasize that even marginal policy tightening amid lingering credit and property bubbles could have a disproportionately dampening impact on growth. Notably, China's narrow money (M1) impulse - the change in M1 growth rate - reliably leads industrial profits. It is now indicating a relapse in industrial profit growth in the months ahead (Chart I-9). There are also some early clues that global trade volumes may soon weaken, as evidenced by the recent drop in China's container shipment freight index (Chart I-10, top panel). Chart I-9China: Industrial Profits And Narrow Money China: Industrial Profits And Narrow Money China: Industrial Profits And Narrow Money Chart I-10Global Trade Volumes To Roll Over Global Trade Volumes To Roll Over Global Trade Volumes To Roll Over This is further corroborated by the most recent survey of 5000 industrial enterprises in China, which portends a top in overseas new orders (Chart I-10, bottom panel). Finally, Taiwan's M1 impulse leads the country's export volume growth, and currently alludes to potential deceleration in export shipments (Chart I-11). We are not suggesting that U.S. or euro area growth is at major risk. On the contrary, our sense is that the main risk to EM and global stocks from the U.S. and the euro area is higher bond yields in these regions in the near term. Importantly, the recent strength in EM trade has largely been due to Chinese imports, not the U.S. or Europe, as evidenced in Chart I-12. Korea's shipments to U.S. and Europe are rather weak, while sales to China have been very robust. In a nutshell, 27% of Korean exports go to China, while only 13% go to the U.S. and 12% to the EU. Chart I-11Taiwan: Narrow Money And Export Volumes Taiwan: Narrow Money And Export Volumes Taiwan: Narrow Money And Export Volumes Chart I-12Korea's Exports By Regions Korea's Exports By Regions Korea's Exports By Regions Furthermore, combined exports to the U.S. and Europe make up 35% of China's total exports and 7% of its GDP. In turn, China's capital spending amounts to 40-45% of GDP. Hence, investment expenditures are much more important for China than exports to the U.S. and Europe combined. In the meantime, the largest export destination for Asian and South American countries is China rather than the U.S. or Europe. Therefore, as China's growth slumps, its imports from Asian/EM as well as commodities prices will decline. Bottom Line: Risks to EM/China growth are to the downside, regardless of growth conditions in the advanced economies. Reinstate Short EM Stocks / Long 30-Year Treasurys Trade We took a 24% profits on this trade on July 13, 2016 and now believe the risk-reward is conducive to re-establish this position. Back in July2 we argued that EM stocks might be supported in the near term while DM bond yields would rise, justifying booking profits on this trade. Looking forward, the basis for reinstating this trade is as follows: Fundamentally, both market indicators as well as the rising odds of a relapse in EM/China growth per our discussion above support this trade. The relative total return on this position is facing a formidable technical support, and we believe it will hold (Chart I-13). The difference between the EM equity dividend yield and the 30-year Treasury yield is one standard deviation from its time-trend (Chart I-14). At similar levels in the past, this indicator heralded significant EM share price underperformance versus U.S. bonds. Chart I-13Reinstate Short EM Stocks-Long ##br##30-year U.S. Treasurys Reinstate Short EM Stocks-Long 30-year U.S. Treasurys Reinstate Short EM Stocks-Long 30-year U.S. Treasurys Chart I-14Relative Value Favors ##br##U.S. Bonds Versus EM Equities Relative Value Favors U.S. Bonds Versus EM Equities Relative Value Favors U.S. Bonds Versus EM Equities Chart I-6 on page 4 reveals that sentiment on stocks versus bonds is bullish. From a contrarian perspective, this invites a bet on stocks underperforming bonds in the months ahead. This trade will pan out regardless of whether a potential selloff in EM share prices is accompanied by rising or falling U.S. bond yields. Even if U.S. bond yields rise (bond prices decline), EM stocks will likely drop more than U.S. Treasury prices. Our base case remains that there is likely more upside in U.S. bond yields in the near term, but this trade is poised to deliver solid gains so long as EM share prices drop. That said, we believe that U.S. bond yields will likely be at current levels or lower by the end of this year when EM/China growth slowdown unleash new deflationary forces in the global economy. Bottom Line: Reinstate a short EM stocks / long 30-year Treasurys trade with a six-nine month time horizon. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM Equity Valuations Revisited", dated March 29, 2017, link available on page 18. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View", dated July 13, 2016, link available on page 18. South Africa: Back To Reality Political risks have not risen in South Africa with the dismissal of Finance Minister Pravin Gordhan. They had never declined in the first place. The markets have, however, ignored them in the past 12 months. Investors have failed to recognize the fundamental problem underpinning the disarray in the ruling African National Congress (ANC): growing public discontent with persistently high unemployment and income inequality. Despite a growing body of evidence that political stability has been declining for a decade, strong foreign portfolio flows have papered over the reality on the ground and allowed domestic markets to continue "whistling in the dark." Investors even cheered the poor performance of the ANC in municipal elections in August 2016, despite the fact that by far the biggest winners of the election were the left-wing Economic Freedom Fighters (EFF), not the centrist Democratic Alliance. This confirms BCA's Geopolitical Strategy's forecast that the main risk to President Jacob Zuma's rule is from his left flank, led by the upstart EFF of Julius Malema, and by the Youth and Women's Leagues of his own ANC.3 As such, it was absolutely nonsensical to expect Zuma to pivot towards pro-market reforms. Unsurprisingly, he has not. But could the Gordhan firing set the stage for an internal ANC dust-up that gives birth to a pro-reform, centrist party? This is the hopeful narrative in the press today. We doubt it. First, if the ANC splits along left-right lines, it is not clear that the reformers would end up in the majority. Therefore, the hope of the investment community that Deputy President Cyril Ramaphosa takes charge and enacts painful reforms is grossly misplaced. Second, Zuma may no longer be popular, but his populist policies are. While both the Communist Party (a partner of the Tripartite Alliance with the ANC) and the EFF now officially oppose his rule, they do not support pro-market reforms. Third, ethnic tensions are rising, particularly between the Zulu and other groups. These boiled over in social unrest last summer in Pretoria when the ruling ANC nominated a Zulu as the candidate for mayor of the Tshwane municipality (which includes the capital city). As such, we see the market's reaction as a belated acceptance of the reality in South Africa, which is that the country's consensus on market reforms is weakening, not strengthening. It is not clear to us that a change at the top of the ANC, or even a vote of non-confidence in Zuma, would significantly change the country's trajectory. In addition, the political tensions are growing at a time when budget revenue growth is dwindling and the fiscal deficit is widening (Chart II-1). To placate investor anxiety over the long-term fiscal outlook, the government should ideally cut its spending. However, it is impossible to do so when there are escalating backlashes from populist parties and from within the ruling Tripartite Alliance. Odds are that the current and future governments will resort to more populist and unorthodox policies. That will jeopardize the public debt outlook and erode the currency's value. Needless to say, the nation's fundamentals are extremely poor -- outright decline in productivity being one of the major causes (Chart II-2). Chart II-1South Africa: Fiscal Stress Is Building Up South Africa: Fiscal Stress Is Building Up South Africa: Fiscal Stress Is Building Up Chart II-2Underlying Cause Of Economic Malaise Underlying Cause Of Economic Malaise Underlying Cause Of Economic Malaise We believe the rand has made a major top and local currency bond yields reached a major low (Chart II-3). We continue to recommend shorting the ZAR versus both the U.S. dollar and Mexican peso. Traders, who are not short, should consider initiating these trades at current levels. Investors who hold local bonds should reduce their exposure. Dedicated EM equity investors should downgrade this bourse from neutral to underweight (Chart II-4). Chart II-3South Africa: Short ##br##The Rand And Sell Bonds South Africa: Short The Rand And Sell Bonds South Africa: Short The Rand And Sell Bonds Chart II-4Downgrade South African ##br##Equities To Underweight Downgrade South African Equities To Underweight Downgrade South African Equities To Underweight Finally, EM credit investors should continue underweighting the nation's sovereign credit within the EM universe and relative value trades should stay with buy South African CDS / sell Russian CDS protection. 3 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 2, 2015, and Strategic Outlook, "Strategic Outlook 206: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. Mexico: Stay Long MXN On Crosses And Overweight Fixed-Income Mexico's central bank could still hike interest rates by another 50 basis points or so because inflation is above the target and the recent raise in minimum wage could keep inflation/wage expectations elevated (Chart III-1). Even if further rate hikes do not materialize, the cumulative monetary tightening will depress domestic demand but support the peso, especially versus other EM currencies. We continue recommending long positions in MXN versus ZAR and BRL. Higher borrowing costs will squeeze consumer and investment spending in Mexico. Notably, household expenditures have so far remained very robust. We suspect consumers have brought forward their future demand due to expectations of higher consumer prices. In short, consumer spending will tank as there is very little pent-up demand remaining and higher borrowing costs will start biting very soon (Chart III-2). Chart III-1Inflation Expectations To Stay Elevated For Now Inflation Expectations To Stay Elevated For Now Inflation Expectations To Stay Elevated For Now Chart III-2Mexico: Domestic Demand To Buckle Mexico: Domestic Demand To Buckle Mexico: Domestic Demand To Buckle As household spending and investment expenditure relapse and exports to the U.S. revive, Mexico's current account will improve considerably. In the meantime, Brazil's current account deficit will widen as the economy recovers. Chart III-3 illustrates that the relative current account dynamics are turning in favor of the peso versus the real. The economic recovery that will eventually happen in Brazil this year will come too late and be too weak to stabilize the nation's public debt. We remain concerned about Brazil's public debt dynamics. In contrast, we are not concerned about Mexico's fiscal situation. Mexican policymakers have been very orthodox and we do not expect that to change much. In regard to valuation, the peso is cheap versus the U.S. dollar and is extremely cheap against the BRL and ZAR (Chart III-4). Chart III-3Mexico Versus Brazil: ##br##Current Account And Exchange Rate Mexico Versus Brazil: Current Account And Exchange Rate Mexico Versus Brazil: Current Account And Exchange Rate Chart III-4Mexican Peso Is Cheap Mexican Peso Is Cheap Mexican Peso Is Cheap Finally, investors have flocked from Mexico to Brazil last year amid the deteriorating political outlook in Mexico and stabilization in Brazilian politics. We believe such a positioning swing is overdone and our bet is that Mexico will be getting more investor flows this year compared with Brazil. Investment Conclusions Chart III-5Mexican local Bonds Offer Value Mexican local Bonds Offer Value Mexican local Bonds Offer Value Maintain long positions in MXN versus BRL and ZAR. The outlook for the latter is discussed in a section above. We are reluctant to initiate a long MXN/short U.S. dollar trade because we are negative on the outlook for EM exchange rates. It is not impossible but it will be hard for the peso to appreciate against the U.S. dollar if most EM currencies depreciate and oil prices drop, as we expect. Fixed-income investors should continue overweighting Mexican local currency and sovereign credit within their respective EM benchmarks. Mexico's fixed-income assets offer good value (Chart III-5). Relative value traders should consider the following trade: sell Mexican CDS / buy Indonesia CDS protection. Finally, dedicated EM equity portfolios should maintain a neutral allocation to Mexican stocks. The currency will outperform but share prices in local currency terms will underperform their EM peers. The Mexican bourse is tilted toward consumer stocks that are expensive and at risk of a major downturn in household spending as discussed above. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Research Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Dusting Off The BCA Bond Model: As central bankers moving away from the hyper-easy monetary policies of the post-crisis era, reverting back to more traditional bond investing tools, like our BCA Bond Model - which focuses on cyclical economic pressures, valuation and momentum - can be useful. GFIS Composite Bond Indicators: After adding a new element to our classic Bond Model, carry, we come up with a new measure to assess government bond markets - the GFIS Composite Bond Indicators. Current Signals: Our new indicators point to Australia, Canada and the U.K. as looking more attractive on a relative basis than Germany or France. Feature For global fixed income investors, four key questions matter most in selecting which government bond markets to prioritize at the country level: Where each country stands in its economic cycle? Which bonds offer the best value? Which bonds exhibit the strongest price momentum? Which bonds benefit from the best carry? To answer those questions, BCA has built specific macro indicators over the years. The ones related to the cycle, value and momentum form the building blocks of the BCA Bond Model. We have not spent as much time discussing these indicators in recent years. This is because the performance of bond markets has been dominated by extraordinarily easy monetary policies (quantitative easing, negative interest rates) in the major economies since the Great Recession. As more central banks start to question the need for maintaining those crisis-era policy settings, however, the utility of referring back to our classic bond indicators is growing. In this Special Report, we re-examine our bond indicators, explain briefly how they were built, evaluate quantitatively if they still provide a consistent signal and elaborate on the best way to utilize them. To enhance the existing model, we add a "carry" component to it, which is a vital part of bond investing. Since the cyclical, value, momentum and carry indicators often give different asset allocation signals at any given point in time, we propose a way to aggregate the information into one single indicator for each country, i.e. the BCA Global Fixed Income Strategy (GFIS) Bond Composite Indicators. We then test these indicators to see if they help bond portfolio managers outperform. The report concludes by comparing the latest message from the GFIS Bond Composite Indicators versus our current recommended portfolio positioning. Specifically, we explain why we are choosing to deviate from our indicators and assess how we could shift our tilts in the future. Evaluating The BCA Cyclical Bond Indicators The most important aspect of bond investing is to understand where each country stands in its current economic cycle. As a way to quickly assess this, we developed our Cyclical Bond Indicators many years ago. Tailored for each country, the Indicators are composed of economic data such as: the unemployment rate private sector credit growth the slope of the government bond yield curve commodity prices denominated in local currency terms realized inflation rates Since economies do not always exhibit the same sensitivity to common macro drivers, we created country-specific Cyclical Bond Indicators that each use a different set of variables. After transforming the data, using de-trending and standardizing techniques, the variables are aggregated to form a single indicator for each country.1 Although Developed Market (DM) countries typically appear to be in the same phase of their economic cycle simultaneously, there are always some slight differences between them. These are crucial to identify and can make a huge difference in the government bond asset allocation process. First and foremost, knowing where a country is in its business cycle should impact expected returns on fixed income. Theoretically, bonds should underperform as the economic cycle becomes more advanced and outperform as the economic cycle deteriorates. Statistical Observations To verify that last statement, we separated the cycle for each country in our DM bond universe into seven distinct phases for the economic cycle: Euphoria End of upturn Upturn Downturn End of downturn Crisis Mega Crisis The phases of the cycle are defined by how much the Cyclical Bond Indicator diverges from its mean, which is always zero since the Indicators are standardized (i.e. removing the mean and dividing by the standard deviation). Chart 1 illustrates how our four core countries (U.S., Germany, Japan, U.K.) have gone through those cycles since 1967. At the positive end of the spectrum, the Euphoria state represents instances where economic variables have been especially upbeat (i.e. the Cyclical Bond Indicator is more than two standard deviations above the mean). At the negative end, the Crisis and Mega Crisis periods are when the Cyclical Bond Indicator is more than two and three standard deviations below the mean, respectively. Chart 1The BCA Cyclical Bond Indicators For The 'Core Four' Markets The BCA Cyclical Bond Indicators For The 'Core Four' Markets The BCA Cyclical Bond Indicators For The 'Core Four' Markets To evaluate the usefulness of the Cyclical Bond Indicator as an investment tool, we have calculated the average monthly return during each phase of the cycle for the major DM countries with a one-month lag (i.e. the March 2017 returns are based on the signals given by the February 2017 readings of the Indicators - this is done throughout the rest of this report when testing other bond indicators). The results are shown in Table 1. Table 1Bond Market Performance, Seen Through Our Cyclical Bond Indicator Revisiting The BCA Bond Model Revisiting The BCA Bond Model As expected, the average monthly performance tends to increase as an economy enters a downturn. Conversely, as an economic upturn gathers momentum, the performance of the bond market tends to decline.2 In Table 1, we highlighted the current phase for each country. Australia and U.K. are the only countries in Downturn territory right now; compared to their peers, those two countries would have the largest expected return3 of this group. On the other hand, the U.S. economy might be at the End of Upturn phase, when Treasuries should be expected to post the worst return, if history is any guide. In Table 2, we broke out the monthly results into 10-year periods to test the consistency of the indicator performance over time. Unsurprisingly, the End of Upturn phase has been quite detrimental for the DM bond markets during all eras, while the End of Downturn episodes have been good for bond investors in every decade. Table 2Bond Market Returns During ##br##The Various Stages Of Our Cyclical Bond Indicator Are Consistent Across Time Revisiting The BCA Bond Model Revisiting The BCA Bond Model Chart 2The Gains From Bond Investing##br## According To The Economic Cycle Revisiting The BCA Bond Model Revisiting The BCA Bond Model Finally, we looked into the usefulness of the Cyclical Bond Indicators in helping construct simple bond portfolios by using them as a ranking tool using the steps described in Box 1. The big picture takeaway is this: the countries with the three highest ranking Cyclical Bond Indicators (i.e. those with the slowest economic growth) outperform by roughly +6 basis points (bps) per month, on average. Similarly, the countries with the lowest-ranked cyclical indicators would underperform by -6bps, on average (Chart 2). Box 1 Ranking Bond Returns Using The BCA Cyclical Bond Indicators We calculated the average monthly excess return by buckets using the following steps: We ranked the ten countries in our bond universe by the level of their Cyclical Bond Indicators, from lowest (ranked #1) to highest (ranked #10). We then calculated the monthly currency-hedged excess return of each country versus the average of all the countries in our DM bond universe We then aggregated all the monthly results to have an average excess return for all ten of our ranking buckets We then separated them further into three buckets (the top three, middle four and bottom three ranks) and averaged the monthly excess returns for those groupings. Comments There is nothing particularly out of the ordinary with those findings - the countries with the weakest economies have the best performing government bond markets. However, the results of these statistical exercises confirm that the BCA Cyclical Bond Indicators are reliable and can confidently be used to support our qualitative analysis for each country. Importantly, following those indicators brings a dose of discipline to our bond allocation framework. For example, if our initial qualitative macro analysis diverges markedly from what the Cyclical Bond Indicator is telling us, this would represent a red flag that prompts us to question our initial conclusions. We will highlight situations like this later in this report. Evaluating The BCA Bond Value Indicators To assess the richness or cheapness of DM government bonds, BCA developed a Bond Value Indicator for each country. It is composed of several measures that have a fundamental macroeconomic relationship to bond yields, such as: Central bank policy rate expectations Trend inflation The deviation of the exchange rate from Purchasing Power Parity (PPP) The 10-year U.S. Treasury yield (as a proxy for the global bond yield) The variables are transformed using regressions, then combined to form a single measure of how far bond yields are from a theoretical fair value. Similar to other components of the BCA Bond Model, the power of these country indicators arises when comparing them amongst each other. Bond markets with yields below fair value should outperform those with yields above fair value. Just like all other asset classes, valuation is a poor tactical timing tool for fixed income. Our Bond Value Indicator is more useful in the long term; value can remain cheap/expensive for an extended period of time. For example, Germany has been the most, or second-most, expensive bond market in our bond universe since June 2013. Due to this shortcoming, the Bond Value Indicator will be given a smaller weighting in our composite indicator laid out later in this report. Statistical Observations To test this indicator, we looked at the hedged excess monthly returns generated using the same ranking procedure laid out in Box 1. The results show that investors can expect to earn about +12bps per month in excess hedged return from countries with the three cheapest valuations according to the Bond Value Indicators, and can expect to lose -6bps/month in countries that are ranked most expensive (Chart 3). Moreover, betting on countries with the cheapest ranked valuations skews favorably the odds of outperforming, from about 46% to 53% (Chart 4). Chart 3The Gains From Bond Investing ##br##According To Value Revisiting The BCA Bond Model Revisiting The BCA Bond Model Chart 4Favor The Cheaper Bond Markets Revisiting The BCA Bond Model Revisiting The BCA Bond Model Comments Currently, the U.S. bond market offers the best value (Chart 5). This contrasts unfavorably with our recommended underweight exposure to U.S. Treasuries. Nonetheless, we remain comfortable with this exposure since the U.S. economy is currently in the strongest economic cycle, and its bond market is technically less oversold than its peers (see the next section). Chart 5Bunds Look Rich, Treasuries Look A Bit Cheap Bunds Look Rich, Treasuries Look A Bit Cheap Bunds Look Rich, Treasuries Look A Bit Cheap Also, note that German and Japanese yields look quite expensive, although this is no surprise given the extremely easy monetary policy settings (negative rates, central bank asset purchases) in place from the European Central Bank (ECB) and Bank of Japan (BoJ). As we have discussed in recent Weekly Reports, we see far greater risks for the ECB moving to a less accommodative monetary bias in the months ahead than the BoJ, and we shifted our country allocations to reflect that view (moving to overweight Japan and cutting Germany to neutral).4 In other words, Japanese bonds will likely stay expensive for longer, unlike German debt. As we mentioned earlier, the value component warrants lesser importance in our tactical and strategic bond allocation framework since it is more long term in nature. In a nutshell, value is something good to have on your side when the macro backdrop shifts, but is not absolutely crucial to generate returns on a month-to-month basis. Evaluating The BCA Bond Momentum Indicator So far, the BCA Bond Cyclical Indicator informed us where the macroeconomic forces were the strongest and the BCA Bond Value Indicator helped us find bargains. This is all great, but bond investors could still underperform if their timing is off. The BCA Bond Momentum Indicator helps in finding the appropriate short-term timing. It has been built simply by looking at how far bond yields are relative to their primary medium-term trend. In theory, bond markets where yields are too stretched to the upside (oversold) should outperform versus countries where yields are too stretched to the downside (overbought). Statistical Observations Using the same ranking methodology explained in Box 1, investors can expect to earn roughly +11bps/month in excess return versus DM peers where conditions are the most oversold and should expect to lose -6bps/month from bond markets with the most overbought conditions (Chart 6). Comments While we do consider technical analysis as part of the tactical component in our bond allocation framework, we put less emphasis on it relative to other more fundamental factors that sustainably drive bond returns over time. Nonetheless, our ranked findings show that choosing markets based on price/yield momentum does generate fairly reliable outperformance. What About Carry? As seen so far, our traditional bond indicators encompass typical variables that would be expected to influence bond returns. Our framework would be incomplete, however, without incorporating the notion of "carry" - the investment return generated by the interest income on bonds. Having instruments that earn too little carry can be very harmful to the returns of a bond portfolio over prolonged periods. A simple observation of the long-term performance of higher-yielding credit markets (i.e. corporate debt or Emerging Market sovereigns) proves that point (Chart 7), especially in the current era where investors continue to stretch for yield given puny risk-free interest rates in so many countries. Chart 6The Gains From Bond Investing ##br##According To Momentum Revisiting The BCA Bond Model Revisiting The BCA Bond Model Chart 7Carry Plays A Huge Role ##br##For Long-Run Bond Returns Carry Plays A Huge Role For Long-Run Bond Returns Carry Plays A Huge Role For Long-Run Bond Returns Of course, most of the major carry gaps between DM sovereign bond yields disappear after currency hedging. However, even on a hedged basis, the carry differentials remain important. Currently, Italian debt carries the highest hedged yield in our DM bond universe, at 3.95%, versus 1.54% for Japan. The 241bp differential between the two is significant, especially in the current global low yield environment. However, some of that additional yield is compensation for the greater riskiness of Italian debt, given the many structural problems in that country (high debt levels, low productivity, political instability, fragile banks). In other words, a better way to evaluate carry is on a risk-adjusted basis. In Chart 8, we show the hedged 10-year government bond yields of the ten DM countries shown throughout this report, both in absolute terms (top panel) and adjusted for volatility (bottom panel). Note that Italy's ranking moves down two notches after accounting for the greater return volatility of Italian debt, while Spain offers the most attractive yield on a risk-adjusted basis. At the other end of the spectrum, Australia and Canada have less attractive yields relative to their volatilities than Japan - home of the 0% bond yield. Of course, as the old investment saying goes, "you can't eat risk-adjusted returns." As a general rule, bond markets with higher yields should be expected to outperform markets with lower yields over time. Statistical Observations An historical analysis of our DM universe using the methodology laid out in Box 1 confirms that observation. The bond markets with better ranked carry have a tendency to generate positive excess returns (on a currency-hedged basis) and, on average, produce more winning months than losing ones (Chart 9). This is true even though the higher-yielding markets are often those with higher inflation, or greater government debt levels, or more active central banks that create interest rate volatility. Chart 8Peripheral European Carry##br## Is Still The Most Attractive Revisiting The BCA Bond Model Revisiting The BCA Bond Model Chart 9The Gains From Bond Investing##br## According To Carry Revisiting The BCA Bond Model Revisiting The BCA Bond Model Comments Currently, the carry factor would favor overweighting Italy, Spain and France, while underweighting Japan, Australia and the U.K. Those relative rankings still generally hold up even after adjusting for volatility. Pulling It All Together: Introducing The GFIS Bond Composite Indicators Now that we have outlined the four elements of our proposed composite bond indicator, the question becomes: how do we aggregate those pieces? The components of our original BCA Bond Model rarely give the same message simultaneously, even after adding a new factor (carry) to the mix. Moreover, as discussed above, some elements (Cyclical and Carry) are more important than others (Value and Momentum) in delivering consistent outperformance of bond returns. Hence, to build a new composite indicator, we need to make a judgment call as to which component should be given more weight. Cyclical (50%). Here at BCA, we spend a fair amount of time trying to deeply understand economic cycles, which are a major driver of financial markets. Bonds are no exception, with changes in growth and inflation expectations forming the fundamental building blocks of yields. As such, we allocate a substantial 50% weight to the cyclical component of our GFIS Bond Composite Indicators. Value (15%). Value moves much more slowly than the other indicators and yields often diverge from fair value for long periods of time. As such, we are giving a smaller weighting of 15% to the value piece of the GFIS Bond Composite Indicators that we are designing to provide a timely signal for country allocation. Momentum (15%). Although technical analysis should be a meaningful part of any investment process, markets can often trend for extended periods before any consolidation, or even reversal, takes place. To reflect that, our momentum indicator will also carry only a 15% weighting in our composite indicator, the same as the weight given to value. Carry (20%). Carry should play an important part in a bond allocation framework. To use a sporting analogy - favoring higher-yielding bonds means starting the game with the score already in your favor. For that reason, we will give carry a 20% weight in our overall bond indicators. After combining our individual bond indicator rankings (from 1 to 10) using the weightings described above, we come up with an overall score for each country which becomes the GFIS Composite Bond Indicator (Table 3). Ranking the countries according to their respective scores gives a new indication as to which bond markets we might want to overweight or underweight. Table 3Combining The BCA Bond Indicators Revisiting The BCA Bond Model Revisiting The BCA Bond Model Statistical Observations Chart 10Our Composite Bond Indicator ##br##Adds Value At The Extremes Our Composite Bond Indicator Adds Value At The Extremes Our Composite Bond Indicator Adds Value At The Extremes To test the investment performance of our new GFIS Composite Bond Indicators, we created an equally-weighted index using the monthly hedged returns of the ten countries in our DM bond universe. We then created two portfolios: One composed of the countries with the three best composite scores; The other composed of the countries with the three worst composite scores. In both cases, those sample portfolios out-/under-performed the equally-weighted index as expected, proving that value can be extracted by following the recommendations of the GFIS Composite Indicators (Chart 10). Comments This automatic/quantitative ranking of the countries is designed as a guideline only. The goal here is to quickly find what could be the most appealing bond markets on a relative basis. Judgment on whether to apply the findings should and will always take precedence when we make our investment recommendations. Also note, in attributing weightings across the components, we have not used any optimization techniques to find the perfect balance. We simply relied on our judgment for a simple reason: optimization gives the best fit according to a set of historical market volatilities and correlations. During periods when volatilities change, or correlations become less stable, the historically-optimal weightings may produce sub-optimal investment results. We prefer to use a constant set of weights across our individual indicators, derived from our own investment intuition and preferences. What Could Be Our Next Portfolio Tweaks? We compare the latest rankings from our GFIS Composite Bond Indicators to our current fixed income country allocations in Table 4. Deviations between the two can provide some ideas for possible changes to our recommendations. Table 4The GFIS Composite Bond Indicator##br## Vs. Our Current Recommendations Revisiting The BCA Bond Model Revisiting The BCA Bond Model From this table, two observations arise: The three countries that rank the highest, Australia, Canada and U.K. are at neutral in our recommended portfolio (Chart 11). Should we move them to overweight? Among the three countries that rank the worst, we are still only at neutral Germany and France (Chart 12). Should we move to an underweight stance given the signal from our new Composite Bond Indicator? On the first point, we have turned decidedly less negative on Australia and U.K. bonds of late.5 In the next few months, if more signs of cyclical deterioration emerge, we will be tempted to align ourselves with our composite indicators and overweight those markets. Although as we discussed in a recent Special Report, another set of our in-house indicators, the Central Bank Monitors, are pointing to pressures to tighten monetary policy in Australia, Canada and the U.K., perhaps providing some justification for only being neutral on those markets.6 On the second point, we recently downgraded core Europe to neutral from overweight, given our growing concern that the ECB will be forced to announce a tapering of its asset purchases, likely starting in early 2018.7 We anticipate that our next move will be to a full-blown underweight position on both Germany and France, although we prefer to wait until after the upcoming French elections before making that shift. Given our view that the populist Marine Le Pen will not win the presidency, we expect to be cutting Germany before France, as there is still a wide political uncertainty premium built into French-German bond spreads.8 Chart 11Bond Upgrade Candidates Bond Upgrade Candidates Bond Upgrade Candidates Chart 12Bond Downgrade Candidates Bond Downgrade Candidates Bond Downgrade Candidates Going forward, we will continue to monitor our GFIS's Composite Bond Indicators to supplement/confirm our macro analyses and to discover some potential portfolio moves/trades. Additionally, we will look to further test and refine the Composite Bond Indicators by looking at different weighting schemes among the component indicators, how the correlations between the components shift over time (and if there is any information from those changes), and other considerations. Now that we've "dusted off" our classic bond indicators, there is plenty of additional research that can be done to build on the initial results shown in this report. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 We have built the Cyclical Bond Indicators using data going back to 1967 for most DM countries, allowing for a robust historical analysis across the different bond markets. 2 Since global bonds have experienced a powerful secular bull market over the past 35 years, the majority of monthly returns in the history of the Cyclical Bond Indicator have been positive. As such, shorting bonds in absolute terms has seldom proved to be a value-added proposition. The only exceptions are when the macro landscape has entered the Euphoria state, which has been quite rare. 3 In local currency terms 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Staying Behind The Curve, For Now", dated March 21, 2017, available at gfis.bcaresearch.com 5 Please see BCA Global Fixed Income Strategy Weekly Reports, "Will The Hawks Walk The Talk?", dated March 7, 2017 (on the U.K.), and "It's Real Growth, Not Fake News", dated February 21, 2017 (on Australia), both available at gfis.bcaresearch.com 6 Please see BCA Global Fixed Income Strategy Special Report, "BCA Central Bank Monitor Chartbook", dated March 28, 2017, available at gfis.bcaresearch.com 7 Please see BCA Global Fixed Income Strategy Weekly Report, "March Madness", dated March 14, 2017, available at gfis.bcaresearch.com 8 Please see BCA Global Fixed Income Strategy Special Report "Our Views On French Government Bonds", dated February 7, 2017, available at gfis.bcaresearch.com

Highlights Chart 1Is Inflation Heating Up? Is Inflation Heating Up? Is Inflation Heating Up? In past reports we have argued that as long as inflation (and inflation expectations) are below the Fed's target, then the "reflation trade" will remain in vogue. In other words, with inflation still too low, the Fed has an incentive to back away from its hawkish rhetoric whenever risk assets sell off and financial conditions tighten. But with inflation heating up - the last two monthly increases in core PCE are close to the highest seen in this recovery (Chart 1) - will the Fed become less responsive? Not yet! Year-over-year core PCE is still only 1.75% (the Fed's target is 2%) and the cost of inflation protection embedded in long-dated TIPS remains too low (panel 2). In fact, the uptrend in TIPS breakevens lost some of its momentum last month alongside wider credit spreads and the S&P 500's first monthly decline since October. In this environment, we are inclined to add credit risk as spreads widen and believe a "buy the dips" strategy will work until inflation pressures are more pronounced. On a 6-12 month horizon we continue to recommend: below-benchmark duration, overweight spread product, curve steepeners and TIPS breakeven wideners. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 15 basis points in March. The index option-adjusted spread widened 3 bps on the month and, at 118 bps, it remains well below its historical average (134 bps). While supportive monetary policy will ensure excess returns consistent with carry, investors should not bank on further spread compression as spreads have already discounted a substantial improvement in leverage (Chart 2). In fact, leverage showed a marked increase in Q4 2016 even though spreads moved tighter. The measure of gross leverage (total debt divided by EBITD) shown in Chart 2 increased in the fourth quarter even though total debt grew at an annualized rate of only 0.3%. However, EBITD actually contracted at an annualized rate of 7% in Q4 causing leverage to rise. The quarterly decline in EBITD looks anomalous, and the year-over-year trend is improving (panel 4). In fact, we would not be surprised to see leverage stabilize this year as profits rebound.1 But similarly, we also expect that the recent plunge in debt growth will reverse. Historically, it has been very rare for leverage to fall unless prompted by a recession. We will take up this issue in more detail in next week's report. Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3), and we remain overweight. This week we also downgrade the Retailers and Packaging sectors, which have become expensive, and upgrade Cable & Satellite, which appears cheap. Table 3A Reflation Window Still Open Reflation Window Still Open Table 3B Reflation Window Still Open Reflation Window Still Open High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 25 basis points in March. The index option-adjusted spread widened 20 bps on the month and, at 383 bps, it is currently 136 bps below its historical average. Given the favorable policy back-drop described on page 1, we view the recent widening in junk spreads (Chart 3) as an opportunity to increase exposure to the sector. In fact, in a recent report2 we tested a strategy of "buying dips" in the junk bond market in different inflationary regimes. The strategy involved buying the High-Yield index whenever spreads widened by 20 bps or more in a month and then holding that position for 3 months. We defined the different inflationary regimes based on the St. Louis Fed's Price Pressures Measure (PPM).3 We found that our "buy the dips" strategy yielded positive excess returns 65% of the time in a very low inflation regime (PPM < 15%), 59% of the time in a low inflation regime (15% < PPM < 30%), 44% of the time in a moderate inflation regime (30% < PPM < 50%) and only 25% of the time in a high inflation regime (50% < PPM < 70%). Currently, the reading from the PPM is 13%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in March. The conventional 30-year MBS yield rose 6 bps on the month, driven entirely by a 6 bps increase in the rate component. The compensation for prepayment risk (option cost) declined by 6 bps, but this was exactly offset by a 6 bps widening in the option-adjusted spread. As a result, the zero-volatility spread was flat on the month. The option-adjusted spread represents expected excess returns to MBS assuming that prepayments fall in line with expectations. On this basis, MBS look more attractive than they have for some time (Chart 4). However, net MBS issuance also surged in Q4 2016 (panel 4) and should remain robust this year despite higher mortgage rates.4 Interest rates have not been a deterrent to mortgage demand since the financial crisis. The limiting factors have been a lack of household savings and restrictive bank lending standards. Both of these headwinds continue to gradually fade. The option-adjusted spread still appears too low relative to issuance. Nominal MBS spreads are linked to rate volatility (bottom panel), and volatility should increase as the fed funds rate moves further off its zero-bound.5 The wind-down of the Fed's MBS portfolio - which we expect will begin in 2018 - should also pressure implied volatility higher as the private sector is forced to absorb the increased supply, some of which will be convexity-hedged. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 22 basis points in March. The high-beta Sovereign and Foreign Agency sectors outperformed by 71 bps and 41 bps, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors outperformed by 9 bps and 15 bps, respectively. Local Authorities underperformed the Treasury benchmark by 17 bps. The performance of Sovereigns has been stellar this year, as the sector has benefited from a 3% depreciation in the trade-weighted dollar (Chart 5). However, the downtrend in the dollar looks more like a temporary reversal than an end to the bull market. With U.S. growth on a strong footing, there is still scope for global interest rate differentials to move in favor of the dollar. Potential fiscal policy measures - such as lower tax rates and a border-adjusted corporate tax - would also lead to a stronger dollar, if enacted. As such, we do not believe the current outperformance of Sovereigns can be sustained. We continue to recommend overweight allocations to Foreign Agencies and Local Authorities, alongside underweight allocations to the rest of the Government-Related index. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 24 basis points in March (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio declined 2% on the month and remains firmly anchored below its post-crisis average. This year's decline in M/T yield ratios has been concentrated at the short-end of the curve (Chart 6), and long maturities now offer a significant valuation advantage. This week we recommend favoring the long-end of the Aaa Muni curve (10-year maturities and beyond) versus the short-end (maturities up to 5 years). Overall, M/T yield ratios appear fairly valued on a tactical basis. While fund inflows have ebbed in recent weeks (panel 4), this has occurred alongside a plunge in gross issuance (bottom panel). The more concerning near-term risk for Munis is that yield ratios have already discounted a substantial improvement in state & local government net borrowing (panel 3). However, we expect net borrowing to decline during the next couple of quarters on the back of rising tax revenues. State & local government tax receipts decelerated throughout most of 2015 and 2016 alongside falling personal income growth and disappointing retail sales. However, both income growth and retail sales have moved higher in recent months, and this should soon translate into accelerating tax receipts and lower net borrowing. Longer term, significant risks remain for the Muni market.6 Chief among them is that state & local government budgets now finally look healthy enough to increase investment spending. Not to mention the significant uncertainty surrounding the potential for lower federal tax rates and plans to invest in infrastructure. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve underwent a small parallel shift upward in March, roughly split between a bear-steepening leading up to the FOMC meeting on March 15 and a bull-flattening from the meeting until the end of the month. Overall, the 2/10 Treasury slope flattened 1 basis point on the month and the 5/30 slope ended the month 1 bp steeper. Our recommended position long the 5-year bullet and short the 2/10 barbell - designed to profit from a steeper yield curve - returned +3 bps in March and is up 7 bps since inception on December 20. In addition, we also entered a short January 2018 fed funds futures trade on March 21.7 The performance of this trade has so far been flat. In a recent report,7 we identified the main cyclical drivers of the slope of the yield curve as: The fed funds rate (higher fed funds rate = flatter curve) Inflation expectations (higher inflation expectations = steeper curve) Interest rate volatility (higher volatility = steeper curve) Unit labor costs (higher unit labor costs = flatter curve) We concluded that even though the Fed is in the process of lifting the funds rate, the yield curve likely has room to steepen as long-maturity TIPS breakevens recover to levels more consistent with the Fed's inflation target (Chart 7). In addition, interest rate volatility has likely bottomed for the cycle and the uptrend in unit labor costs could level-off if productivity growth continues to rebound. The recent decline in bullish sentiment toward the dollar has also not yet been matched by a steeper 5/30 slope (bottom panel). TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 6 basis points in March. The 10-year TIPS breakeven rate declined 5 bps on the month and, at 1.97%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. While the catalyst for the recent softening in TIPS outperformance seems to be the hawkish re-rating of Fed rate hike expectations, the uptrend in TIPS breakevens was probably due for a pause in any case. Breakevens had become stretched relative to our TIPS Financial Model - based on the dollar, oil prices and the stock-to-bond total return ratio. However, measures of pipeline inflation pressure - such as the ISM prices paid survey (Chart 8) - still point toward wider breakevens and, as was noted on the front page of this report, recent core inflation prints have been quite strong. All in all, growth appears strong enough that core inflation should continue its gradual uptrend and, more importantly, the Fed will be keen to accommodate an increase in both realized core inflation and TIPS breakevens, which remain below target. This means that in the absence of a material growth slowdown, long-maturity TIPS breakevens should continue to trend higher until they reach the 2.4% to 2.5% range that historically has been consistent with the Fed's inflation target. In a baseline scenario where the unemployment rate is 4.7% at the end of the year and the dollar remains flat, our Phillips curve model8 predicts that year-over-year core PCE inflation will be 2.02% at the end of this year. ABS: Maximum Overweight Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +22 bps. Aaa-rated issues outperformed the Treasury benchmark by 16 bps on the month, and non-Aaa issues outperformed by 26 bps. The index option-adjusted spread for Aaa-rated ABS tightened 5 bps on the month. At 48 bps, the spread remains well below its average pre-crisis level (Chart 9). Banks are now tightening lending standards on both auto loans and credit cards. While we do not expect this recent development to have much of an impact on consumer spending, it is usually an indication that there is growing concern about ABS collateral credit quality. As such, this week we scale back our recommended allocation to ABS from maximum overweight (5 out of 5) to overweight (4 out of 5). While credit card charge-offs remain well below pre-crisis levels, net losses on auto loans have started to trend higher (bottom panel). We continue to favor Aaa-rated credit cards over Aaa-rated auto loans, despite the modest spread advantage in autos (panel 3). Further, the spread advantage in Aaa consumer ABS relative to other high-quality spread product is becoming less compelling. Aaa ABS now only provide a 12 bps option-adjusted spread cushion relative to conventional 30-year Agency MBS and offer a slightly lower spread than Agency CMBS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency commercial mortgage-backed securities underperformed the duration-equivalent Treasury index by 10 basis points in March, dragging year-to-date excess returns down to +16 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 4 bps on the month, but remains below its average pre-crisis level. Commercial real estate prices are still growing strongly, and prices in both major and non-major markets have re-gained their pre-crisis peaks (Chart 10). However, lending standards are tightening and, more recently, loan demand has rolled over (panel 4). This suggests that credit risk is starting to increase in commercial real estate, as do CMBS delinquencies which have put in a bottom (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in March, bringing year-to-date excess returns up to +16 bps. The index option-adjusted spread for Agency CMBS tightened 2 bps on the month, and currently sits at 53 bps. The option-adjusted spread on Agency CMBS looks attractive compared to other high-quality spread product: Agency MBS = 36 bps, Aaa consumer ABS = 48 bps, Agency bonds = 18 bps and Supranationals = 22 bps. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.54% (Chart 11). Our 3-factor version of the model, which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.28%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we are inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.35%. 1 For further detail on the medium-term profit outlook please see The Bank Credit Analyst, February 207, dated January 26, 2017, available at bca.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 8, 2017, available at usbs.bcaresearch.com 3 A composite of 104 economic indicators designed to capture the probability of PCE inflation exceeding 2.5% during the subsequent 12 months. https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure 4 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.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 Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Recommended Allocation Quarterly - April 2017 Quarterly - April 2017 The sweet spot of non-inflationary accelerating growth is likely to continue. European politics will fade as a risk, and Trump should still be able to get tax cuts through. We continue to be positive on risk assets on a one-year horizon, though returns are unlikely to be as good as in the past 12 months and there is a risk of the next recession arriving in 2019. Our portfolio tilts are generally pro-risk and pro-cyclical. We are overweight equities versus fixed income. We move overweight euro area equities, which should benefit from inexpensive valuations, higher beta and a falling political risk premium. Within fixed income, we prefer credit over government bonds, and raise high-yield debt to overweight on improved valuations. We expect the dollar to appreciate further, which makes us cautious on emerging market assets and industrial commodities. Feature Overview No Reasons To Turn Cautious Markets have paused for breath following the reflation trade that began a year ago and that was given an extra boost by the election of Donald Trump in November. Since the turn of the year, the dollar, U.S. 10-year Treasury yields, credit spreads and (to a degree) equities have all eased back a little (Chart 1). We don't think the risk-on rally is over, but the going will undoubtedly get tougher from here. The momentum of global growth cannot continue to rise at the same pace, with the Global PMI already at its highest level since 2011 (Chart 2). Global equities, therefore, are unlikely to return the 16% over the next 12 months, that they have over the past 12. Chart 1A Pause For Breath A Pause For Breath A Pause For Breath Chart 2Growth Momentum Must Slow From Here Growth Momentum Must Slow From Here Growth Momentum Must Slow From Here Nonetheless, we see nothing that is likely to stop risk assets continuing to outperform over the one-year horizon: Growth is likely to rise further. While the initial pick-up was in "soft" data such as consumer sentiment and business confidence, signs are emerging that "hard" data such as household spending and production are now also improving (Chart 3). Models developed by our colleagues on The Bank Credit Analyst indicate that real GDP growth in the U.S. this year will come in above 3% and in the euro area above 2% (Chart 4),1 compared to consensus forecasts of 2.2% and 1.6% respectively. Chart 3Hard Data Also Not Picking Up Hard Data Also Not Picking Up Hard Data Also Not Picking Up Chart 4GDP Growth Could Beat Consensus GDP Growth Could Beat Consensus GDP Growth Could Beat Consensus For now, this growth is unlikely to prove inflationary. In the U.S. the diffusion index for PCE inflation shows more prices in the basket falling than rising; in the eurozone, the rise to 2% in headline inflation in January was temporary, mainly because of higher oil prices, and core inflation remains at only 0.7%. The U.S. output gap will close soon, but the eurozone's is still deeply negative (Chart 5). We see the Fed raising rates twice more this year, in line with its dots, though it may have to accelerate the pace next year if the Trump administration succeeds in passing fiscal stimulus. The ECB, however, is unlikely to raise rates until 2019 and will taper asset purchases only slowly.2 Misplaced worries that it will tighten more quickly than this have recently dragged on European equities and strengthened the euro. We think the market is wrong to price out the probability of a tax cut in the U.S. just because of the Trump administration's failure to reform healthcare. Our Geopolitical strategists argue that Republicans in Congress (even the Freedom Caucus) are united behind the idea of cutting taxes, even if these are not funded by tax reforms or spending cuts (they can be justified on the grounds of "dynamic scoring").3 We see a cut in corporate and personal taxes passing before year-end to take effect in 2018. And Trump has not abandoned the idea of infrastructure spending. The market no longer expects any of this: the prices of stocks that would most benefit from lower corporate taxes or from government spending have reverted to their pre-election levels. European political risk is likely to wane. The market continues to worry about the possibility of Marine Le Pen winning the French Presidential election, as shown in the spread of OATs over Bunds (which has widened to 60-80 bp from 20 bp last summer). We think this very unlikely: polls show her consistently at least 20 points behind Emmanuel Macron in the second round of voting (Chart 6). While Italian politics remain a risk, the parliamentary election there is unlikely to take place until March 2018. Brexit is a threat to the U.K., but should have minimal impact on the eurozone. We retain, therefore, our pro-cyclical and pro-risk tilts on a 12-month time horizon. We have even added a little more beta to our recommended portfolio by raising high-yield bonds to overweight (since their valuations now look more attractive after a recent sell-off) and by going overweight eurozone stocks (paid for by notching down our double-overweight in U.S. stocks). The eurozone has consistently been a higher beta (Chart 7), more cyclical equity market than the U.S. and, once the political risks (at least temporarily) subside, should be able to outperform for a while. Chart 5Eurozone Output Gap Still Very Negative Eurozone Output Gap Still Very Negative Eurozone Output Gap Still Very Negative Chart 6Can Le Pen Really Win From Here? Can Le Pen Really Win From Here? Can Le Pen Really Win From Here? Chart 7Eurozone Is A High Beta Stock Market Eurozone Is A High Beta Stock Market Eurozone Is A High Beta Stock Market But we warn that the good times may not last for long. Tax cuts in the U.S. would add stimulus to an economy already at full capacity. The Fed might have to raise rates sharply next year (although the timing might depend on how President Trump tries to affect monetary policy, for example whom he appoints as Fed chair to replace Janet Yellen next February). U.S. recessions have typically come two or three years after the output gap turns positive (Chart 5). As Martin Barnes, BCA's chief economist, recently wrote,4 that may point to next recession arriving as soon as 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Chart 8Expensive, But Not At An Extreme Expensive, But Not At An Extreme Expensive, But Not At An Extreme Aren't You Worried About U.S. Equity Valuations? Valuation is a poor timing tool in the short term but, when it reaches extremes, it has historically added value. The valuation metrics we watch show that U.S. equities are expensive, but not at the extreme levels that have historically warranted an outright sell or underweight. First, according to MSCI, U.S. equities are currently trading at 24.4 times 12-month trailing earnings, and 25.7 times 10-year cyclically-adjusted earnings; both measures are about one standard deviation from their 10-year averages. Second, U.S. equities are trading at a premium to global equities, but the premium to the developed markets is in line with the 10-year average (Chart 8, panel 1), while the premium to emerging markets is about 1.5 standard deviations from the 10-year average (panel 2). Third, equities are cheap compared to fixed income: the earnings yield is still higher than the yields on both 10-year government bonds and investment grade corporate bonds, and the yield gaps are currently only slightly lower (more expensive) than their respective 10-year averages (panels 3 and 4). In the long run, the 10-year cyclically-adjusted PE (CAPE) has had relatively good forecasting power for 10 year forward returns. Currently, the regression indicates 143% (9.3% annualized) total returns over the next 10 years. This could be on the optimistic side given that we are no longer in an environment of declining bond yields and margins are elevated compared to the 1990s. That said, we have cut our U.S. equity overweight by half, partly due to valuation concerns. Is EM Debt Attractive? Chart 9Avoid EM Debt Avoid EM Debt Avoid EM Debt Emerging market debt has continued its run from last year, with sovereign and local currency debt providing YTD returns of 3% and 2% respectively. Over long periods, EM debt has displayed the ability to provide substantial returns while also providing robust diversification benefits to a 50/50 DM equity/bond portfolio, even more so than EM equities.5 However, over the cyclical horizon, we remain bearish on EM debt both in absolute terms and relative to global equities. EM fixed income markets have been able to defy deteriorating fundamentals for some time, but this is unsustainable. After years of leveraging, credit excesses will need to be unwound. Decelerating credit growth will be enough to dampen economic growth and damage emerging markets' ability to service their debt. Risks in EM sovereign debt markets are high. Historical returns have shown negative skewness and fat tails, suggesting high vulnerability to large downswings. This is particularly concerning given that yields are one standard deviation lower than their long-term average (Chart 9). While EM local currency debt is more fairly priced and has a more favorable risk/return profile than its sovereign debt counterpart, local currency debt returns are even more heavily influenced by their currencies. Above-trend growth in the U.S. leading to additional rate hikes, as well as rising U.S. bond yields and softer commodity prices will add further downward pressure to EM currencies. For EM dedicated investors, we suggest overweight positions in low beta/defensive markets. Regions that are less susceptible to currency weakness with high yields and low foreign funding requirements include Russia, India and Indonesia. How Will The Fed Shrink Its Balance Sheet, And Does It Matter? After the Fed's third rate hike, attention is turning to when it will begin to reduce its balance sheet. This has grown to $4.5 trillion, up from $900 billion before the Global Financial Crisis. Assets currently include $2.5 trillion of Treasury securities and $1.8 trillion of mortgage-related securities. Since asset purchases ended in October 2014, the Fed has rolled over maturing bonds to maintain the size of the balance sheet. The FOMC statement last December committed to maintaining this policy "until normalization of the level of the federal funds rate is well under way". The market takes this to mean 1-1.5%, a level likely to be reached by year-end. The view of BCA's fixed income team6 is that the Fed will start by ceasing reinvestment of Agency bonds and mortgage-backed securities (MBS) in 2018, at the same time reducing excess bank reserves on the liability side of the balance sheet (Chart 10). This will worry markets to a degree and the Fed will need to be careful how it communicates the policy: for example what size it thinks its balance sheet should ultimately be. It may also need to skip a rate hike or two in the first months of the shrinkage. The MBS market is likely to suffer from the increased supply. But the only historical precedent - the BoJ's unwinding of its 2000-3 QE - is reassuring: this had no discernible effect on rates or the yen (Chart 11). Chart 10Fed Will Cut MBSs First Fed Will Cut MBSs First Fed Will Cut MBSs First Chart 11Nobody Noticed The BoJ Taper Nobody Noticed The BoJ Taper Nobody Noticed The BoJ Taper When Will ECB Taper? Chart 12Recovery Not Permanent Recovery Not Permanent Recovery Not Permanent Euro area growth is recovering and headline inflation has hit the ECB's 2% target (Chart 12). Investors are wondering how rapidly the ECB will taper its asset purchases and when it will raise rates. Our view is that the ECB will move only slowly. The pickup in inflation is mostly driven by the base effect and by the rise in energy prices. The failure of core inflation, which remains below 1%, to pick up appreciably suggests that underlying price pressures are weak. The current program has the ECB purchasing EUR 60 Bn of assets each month until December 2017. Markets have recently become more hawkish with regards to the likely path of policy: currently futures are pricing in the first hike only 19 months away versus an expectations in January of 44 months. We expect the ECB to remain more dovish than that, given weak underlying inflation, political uncertainty, and banking system troubles. We think the ECB will announce around September this year a taper of its asset purchases in 2018. However, it is not clear whether it will cut them to, say EUR 30 Bn a month, or whether it will reduce the amount steadily each month or quarter. But we don't see an interest rate hike soon, since the euro area economy is not expected to reach full employment until 2019. Ewald Novotny, president of the Austrian central bank, spooked markets by suggesting a hike before complete withdrawal of asset purchases but, in our view, that would will send a confusing signal to investors. Nowotny has long been hawkish and we think his view is untypical of ECB council members. If our analysis is correct, ECB policy should be positive for euro area equities and bearish for the euro over the next 12 months. Will REIT Underperformance Continue? Chart 13Underweight REITs Underweight REITs Underweight REITs Relative REIT performance has continued its downtrend, underperforming the broad index by 5% YTD. While valuations have become more attractive and rental income is still robust, we expect the decline to continue given unsupportive macro factors. We previously argued that real estate is in a sweet spot, where economic growth was sufficient to generate sustainable tenant demand without triggering a new supply cycle.7 This is no longer the case. Office completions increased substantially over the past quarter and apartment completions remain in an uptrend. As we expect growth to remain robust in the U.S., the likelihood is that these two trends remain in place. REIT relative performance peaked at the beginning of August, shortly after long-term interest rates bottomed. REITs have historically outperformed when yields are falling and inflation is low (Chart 13). However, long-term rates should continue to rise over the cyclical horizon, primarily due to higher inflation expectations. Additionally, REITs typically benefit from increasing central bank asset purchases, as increased liquidity and lower interest rates boost real estate values. With the Fed clearly in tightening mode and the strong likelihood of ECB tapering next year, slowing asset purchases will be a considerable headwind to REIT performance. Within REITs, we maintain our sector tilts. Continue to favor Industrials, which will benefit in a rising USD environment and provide considerable income. Maintain underweight position in Apartments, due to rising completions and a low absorption ratio. Additionally, we continue to favor trophy over non-trophy markets given more stable rent growth as well as geopolitical risks in Europe and potential Washington disappointments. Global Economy Overview: The global economy has continued to recover from its intra-cycle slowdown in late 2015 and early 2016. Economic surprise indexes have everywhere surprised significantly on the upside since mid-2016 (Chart 14, panel 1). Although "hard" data (consumption, production etc.) have lagged "soft" data (consumer sentiment, business confidence), the former also have begun to recover recently. Although there are few negative indicators, it will get harder to beat expectations. U.S.: Lead indicators continue to improve, with the manufacturing ISM at 57.7 and new orders at 65.1. Sentiment quickly turned bullish after the presidential election, and hard data has now started to follow, with personal consumption expenditure rising 4.7% year on year and capital goods orders (+2.7% YoY in February) growing for the first time since 2014. With steady wage growth, continuing employment improvements, and a likely pick-up in capex, we expect 2017 GDP growth to beat the current consensus expectations of 2.2%. For now inflation remains quiescent, with core PCE inflation stuck at around 1.8%, below the Fed's 2% target. Euro Area: Leading indicators, such as PMIs, have rebounded in Europe too (Chart 15), suggesting that the consensus 2017 GDP forecast of 1.6% is achievable. Inflation has picked up, with the headline CPI 2.0% for the Eurozone in January, but core inflation remains low at 0.7% and headline fell back to 1.5% in February. However, the recent slowdown in bank loan growth (new credit creation is 36% below the level six months ago) suggests that continuing weakness in the banking sector is likely to keep growth sluggish. Chart 14How Long Can Growth Continue To Surprise? How Long Can Growth Continue To Surprise? How Long Can Growth Continue To Surprise? Chart 15A Synchronized Global Growth Rebound A Synchronized Global Growth Rebound A Synchronized Global Growth Rebound Japan is a tale of two segments. International-oriented data have recovered, with IP up 3.7% (Chart 15, panel 2) and exports +5.4% year on year. But domestic demand remains weak: wages are rising only 0.5% YoY (despite a tight labor market), which is holding back household spending (-1.2% YoY in January). Core inflation has shown the first signs of picking up, but remains very low at 0.1% YoY. Emerging Markets: The effects of China's reflationary policies from early 2016 continue to boost activity (Chart 15, panel 3). But the excess liquidity they triggered worries the authorities, who have clamped down on real estate purchases and capital outflows, slowed fiscal spending, and tightened monetary policy. China will prioritize stability until the Party Congress in the fall, but the impact of reflation on commodity prices and on other emerging markets will fade. Interest rates: The Fed is likely to hike twice more this year in line with its "dot plot", unless inflation surprises significantly to the upside. This, plus an acceleration of nominal GDP growth to 4.5-5%, should push the 10-year bond yield above 3% by year end. The ECB will not be as hawkish as the market expects (futures markets indicate a rate hike by end-2018), since Mario Draghi expects headline inflation to fall back once the oil price stabilizes and is concerned about political risk especially in Italy. Consequently, rates are unlikely to rise as quickly as in the U.S. The Bank of Japan will keep its 0% yield target for 10-year JGB for the foreseeable future. Global Equities Global equities continued to make impressive gains in Q1 2017, after a strong 2016. The price appreciation since the low in February 2016 has been driven by both multiple expansion and earnings growth, roughly in equal proportion, as shown in Chart 16, panel 1. Chart 16Earnings Improving But Valuation Stretched Earnings Improving But Valuation Stretched Earnings Improving But Valuation Stretched Equity valuation is expensive by historical standards but, as an asset class, equities are still attractively valued compared to bonds (see the "What Our Clients Are Asking" section on page 6). In this "TINA" (There Is No Alternative) world, we remain overweight equities versus bonds. Within equities, we maintain our call of favoring DM equities versus EM equities despite of the 6% EM outperformance in Q1, which was supported by attractive valuations. About half of that outperformance came from the appreciation of EM currencies versus the USD. Our house view is that the USD will strengthen further versus the EM currencies. Within EM, we have been more positive on China and remain so on a 6-9 month horizon. The only adjustment we make now is to upgrade euro area equities to overweight by reducing half of our large overweight in the U.S. so that now we are equally overweight the U.S. and euro area (see details on the next page). In terms of global sector positioning, we maintain a pro-cyclical tilt. Our largest overweight in Healthcare panned out very well in Q1 but the overweight in Energy did not, due to the drop in oil prices. Our Energy strategists believe this was caused by one-off technical factors on the supply side, and argue that the oil price will soon revert to $55 a barrel. Euro Area Equities: A Cheaper Alternative To The U.S. Political risks related to elections in some eurozone countries are receding. The ECB is likely to maintain its easy monetary policies, while the Fed is on track to normalize interest rates in the U.S. We have had a large overweight of 6 percentage points (ppts) on U.S. equities while being neutral on the euro area. We upgrade the eurozone to overweight by 3 ppts, so that we are now equally overweight the U.S. and the euro area. The following are the reasons: First, the relative performance of total returns between eurozone and the U.S. equities is at its lowest since 1987. Since April 2015, when the most recent brief period of eurozone outperformance ended, eurozone equities have underperformed the U.S. by over 16% in common currency terms (Chart 17, panel 1), while the euro lost only about 4% versus the USD over the same period. Second, eurozone equities are trading at a 22% discount to the U.S., compared to the five-year average discount of 17% (panel 3). Third, eurozone equities have lower margins than the U.S., but the profit margin in the eurozone has been improving (panel 2). Lastly, the PMIs in the euro area have been improving (panel 4) and this improvement is faster than the global aggregate PMI (panel 5), which implies - based on the close correlation between PMIs and earnings growth - that profitability in the eurozone should improve at a faster pace than the global average. Sector Allocation: We have had a relatively pro-cyclical tilt in our global sector positioning, overweight three cyclical sectors (Energy, Industrials and Info Tech) plus Healthcare, while underweight three defensive sectors (Consumer Staples, Telecoms and Utilities) as well as Consumer Discretionary. We have been neutral on Financials and Materials. After very strong performance in 2016, cyclical sectors underperformed in Q1 2017 (Chart 18, panel 1). The underperformance of cyclicals versus defensives can be largely attributed to the polar-opposite performance of Energy and Healthcare (Chart 19). Going forward, we maintain our current sector positioning for the following reasons: Chart 17Earnings Growth At Lower Valuation Earnings Growth At Lower Valuation Earnings Growth At Lower Valuation Chart 18Maintain The Cyclical Tilt Maintain The Cyclical Tilt Maintain The Cyclical Tilt Chart 19Global Sector Performance Quarterly - April 2017 Quarterly - April 2017 First, Energy was the only sector which fell in Q1, largely due to the decline in oil prices. BCA's Energy and Commodity Strategy attributes the oil price weakness to inventory buildup related to the production rush before the OPEC agreement to cut production, and therefore expects the WTI oil price to return to the $50-55 range. Energy stocks should benefit once oil prices turn back up. Chart 20Relative Factor Performance Relative Factor Performance Relative Factor Performance Second, the relative profitability between cyclicals and defensives is underpinned by global economic conditions, as represented by the global PMI. The PMI is on track to recover further, which bodes well for the profit outlook for cyclicals versus defensives. Third, our pro-cyclical tilt in sector positioning is hedged by an overweight in Healthcare (a defensive sector) and underweight in Consumer Discretionary (a cyclical). Smart Beta Update: No Style Bet Q1 2017 saw some significant performance reversals in the five most enduring factors: quality, minimum volatility, momentum, value, and size (Chart 20, panels 2-6). Quality and Momentum performed the best, outperforming the global benchmark by over 200 bps in Q1. The star performer in 2016, the Value factor, performed the worst, underperforming by 190 bps. According to the findings in our Special Report,8 recent factor performance seems to be pricing in a "Goldilocks" environment in which growth is rising and inflation falling. We have shown that it is very difficult to time the shift in factor performance cycles and so have advocated an equal weight in the five factors (Chart 20, panel 1) for long-term investors. We reiterate this view. Government Bonds Maintain slight underweight duration. Our 2-factor model made up of global PMI and U.S. dollar sentiment indicates the current fair value of the 10-year Treasury yield is 2.4% (Chart 21). While this suggests bonds are currently correctly priced, we still expect that long-term yields will rise over a cyclical horizon. The long end should grind higher given improving growth, rising equity prices and renewed "animal spirits." Additionally, large net short positions have been unwound, allowing for another leg higher in yields. Overweight TIPS vs. Treasuries. Diffusion indexes for both PCE and CPI inflation shifted into negative territory, suggesting realized inflation will soften in the near term. Nevertheless, with headline and core CPI readings of 2.7% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 22). This trend should continue as a result of cost-push inflation driven by faster wage growth. Very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Euro area growth is stable, but expectations of a rate hike from the ECB are premature (Chart 23). While the central bank opened the door slightly to a less-accommodative policy stance, it is unlikely that the ECB will hike until full employment is reached. Our expectation is for a tapering of asset purchases to occur in 2018. Once tapering is complete, rate hikes will follow by approximately 6-12 months. The implication is upward pressure on European bond yields and wider spreads for peripheral government debt. Chart 2110-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model Chart 22Inflation Has Bottomed Inflation Has Bottomed Inflation Has Bottomed Chart 23Will the ECB Hike Soon? Will the ECB Hike Soon? Will the ECB Hike Soon? Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 24). Over the last quarter, the indicator worsened, as profit margins, return-on-capital and liquidity declined. However, leverage did improve slightly. The trend toward weaker corporate health has been firmly established over the past 12 quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. The U.S. is in a self-reinforcing, low-inflation recovery. Economic growth should accelerate throughout 2017, with strong consumer spending, rising capex intentions, and still accommodative monetary policy. The potential sell-off from rate hikes this year should be fairly mild given that the market is already close to pricing in three. Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. Expect low but positive excess returns (Chart 25). Shift to overweight in high-yield debt. Our default model is showing improvement due to elevated interest coverage, a robust PMI reading, declining job cut announcements, softening lending standards and a rising sales/inventory ratio. The recent backup in yields has made junk bond valuations more attractive. The default adjusted spread, calculated by subtracting an ex-ante estimate of default losses from the average spread, is now approximately 220bps (Chart 26). Chart 24Balance Sheets Deteriorating Balance Sheets Deteriorating Balance Sheets Deteriorating Chart 25A Supportive Backdrop A Supportive Backdrop A Supportive Backdrop Chart 26High Yield: Valuations Becoming More Attractive High Yield: Valuations Becoming More Attractive High Yield: Valuations Becoming More Attractive Commodities Chart 27Upside To Resource Prices Limited Upside To Resource Prices Limited Upside To Resource Prices Limited Secular Perspective: Bearish A slowdown in Chinese activity, led by its transition to a services economy, coupled with unfavorable global demographics, will continue to constrain demand for commodities. This slack in demand coupled with excess capacity will continue to limit the upside in resource prices and prolong the commodities bear market which began in 2012 (Chart 27). Cyclical Perspective: Neutral Energy markets have moved from excess supply to excess demand, and so we remain positive on oil. But, with the impact of Chinese fiscal stimulus waning, excess supply in the metals market will persist, putting downward pressure on prices. Our divergent outlook for energy vs metals gives us an overall neutral view for commodities over the cyclical horizon. Energy: With a synchronized upturn in global growth and inflation, both OECD and non-OECD demand will remain strong. Following Saudi Arabia's production cuts, we expect the OPEC agreement to be honored by all members, including Russia. With strengthening demand and falling production, storage should draw through the year. We expect the oil-USD divergence to persist as improving fundamentals override the stronger dollar. Base Metals: With Chinese government spending slowing from 24% growth year on year in January 2016 to only 4%, the country's fiscal impulse has ended. Tightening in Chinese liquidity conditions have led to higher borrowing rates for the real estate sector, which is dampening its demand for materials. At the same time, inventories for key metals such as copper and steel have risen. We expect metals prices to correct over the coming months. Precious Metals: Gold has rallied 10% from last December, and another 4% following the Fed's March rate hike. These were responses to the dovish nature of the hike and continuing political risk. We expect the Fed to turn more hawkish in coming weeks, sending the dollar and real yields higher, thereby holding back the gold price from rising much further. Currencies Chart 28Return Of The Dollar Return Of The Dollar Return Of The Dollar USD: The last Fed meeting resulted in a dovish hike, as evidenced by the subsequent fall in the dollar. However, as the U.S. economy nears full employment, we expect a more hawkish tone from FOMC members in the coming weeks which will push the dollar up (Chart 28). The Fed continues to be data dependent, and sees the recent synchronized global upturn as an opportunity to deliver hikes in line with market expectations. Euro: As the economy stabilizes, as evidenced by rising headline inflation, stronger retail sales and improving PMI numbers, the ECB has opened the window for reducing monetary accommodation. However, since the economy is expected to reach full employment only in 2019, we expect rates to be kept low even after the tapering of ECB asset purchases starts next year. This will add further downward pressure on the euro. Yen: The Bank of Japan will continue its highly accommodative monetary policy, centered on its 0% yield target for 10-year government bonds, because Japanese growth and inflation is lagging the global upturn. Japan is benefitting from global growth, as seen in the improvement in its manufacturing PMI, but domestic demand remains weak as consumer confidence and retail sales stagnate. Continued downward pressure on relative interest rates will drive the only reliable source of inflation: a weaker yen. EM: A more hawkish Fed and rising bond yields will tighten global liquidity conditions, making it difficult for emerging nations that run current account deficits. The rising threat of protectionism could affect EM exports and create a new wave of deflationary pressure, forcing central banks to engineer currency devaluation. The fact that commodity prices have risen, yet EM currencies have remained weak, is a clear indications that EM fundamentals are weak. Alternatives Overweight private equity / underweight hedge funds. Leading indicators suggest that global growth continues to improve. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a boost to returns. Additionally, surveys suggest that managers are planning on increasing their allocation percentage toward private equity over the rest of the year. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 29). Overweight direct real estate / underweight commodity futures. Demand for commercial real estate (CRE) assets remains robust but the increase in completions is worrying. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 30). Overweight farmland & timberland / underweight structured products. The potential for trade wars, geopolitical risk in Europe and concerns over an equity market correction have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, the end of the 35-year bull market in bonds presents a substantial headwind. Structured products also tend to outperform during recessions, which is not our base case (Chart 31). Chart 29PE: Tied To Real Growth PE: Tied To Real Growth PE: Tied To Real Growth Chart 30Commodities: A Secular Bear Market Commodities: A Secular Bear Market Commodities: A Secular Bear Market Chart 31Structured Products Outperform In Recessions Structured Products Outperform In Recessions Structured Products Outperform In Recessions Risks To Our View Our pro-cyclical pro-risk tilts are based on the premise that global growth will remain strong over the next 12 months. We do not see many risks to this view: leading indicators suggest that consumption and capex are likely to continue to rebound. The one major indicator that suggests downside risk is loan growth. In the U.S., loans to firms have slowed to 5.4% from over 10% last summer, and in the euro area the meager pickup in corporate loan growth seems to have faltered (Chart 32). There may be some special factors: oil companies that borrowed in early 2016 when in difficulty no longer need to tap credit lines, and U.S. companies may be holding back to see details of tax cuts. But loan growth needs to be watched closely. More granularly, our country and sector preferences - in particular, our cautious views on Emerging Markets and industrial commodities - are based partly on the expectation that the U.S. dollar will appreciate further. If the global expansion remains highly synchronized (Chart 33) this might instigate all G7 central banks to tighten, allowing the Fed to raise rates without appreciating the dollar. However, we expect continuing divergences in growth and monetary policy to push the dollar up further. Finally, some indicators suggest that investors have become too positive on the outlook for stocks (Chart 34). Sentiment has in the past not been a reliable indicator of stock market peaks, but excess euphoria could trigger a short-term correction. Chart 32Why Is Bank Loan Growth Slowing? Why Is Bank Loan Growth Slowing? Why Is Bank Loan Growth Slowing? Chart 33Could Synchronized Growth Push Down USD? Could Synchronized Growth Push Down USD? Could Synchronized Growth Push Down USD? Chart 34Are Investors Too Euphoric? Are Investors Too Euphoric? Are Investors Too Euphoric? 1 Please see The Bank Credit Analyst, March 2017, page 33, available at bca.bcaresearch.com 2 Please see What Our Clients Are Asking: When Will The ECB Taper? on page 9 of this report for a full explanation of why we think this. 3 Please see Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was", dated March 8, 2017, available at gps.bcaresearch.com 4 Please see BCA Special Report titled "Beware The 2019 Trump Recession", dated March 7, 2017, available at bca.bcaresearch.com 5 Please see Global Asset Allocation Strategy Special Report, "EM Asset Allocation: Is There Any Reason To Own Stocks?," dated November 27, 2012, available at gaa.bcaresearch.com. 6 Please see Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet," dated February 28, 2017, available at gfis.bcaresearch.com. 7 Please see Global Asset Allocation Strategy Special Report, "REITs Vs. Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights Portfolio Strategy A window has opened up for utilities outperformance. Upgrade to overweight on a short-term (1-3 month) view. Leading indicators of beverage sales have improved, heralding an upgrading in depressed expectations. Stay overweight. The pullback in consumer finance stocks appears to be contagion from the overall financial sector selloff than a reflection of deteriorating industry-specific fundamentals. Buy on weakness. Recent Changes S&P Utilities - Boost to overweight from neutral on a tactical basis. Table 1 Great Expectations? Great Expectations? Feature Our view remains that stocks are in a consolidation phase, waiting for economic/profit confirmation that earnings will grow into the latest valuation expansion. Thin equity market risk premia can be justified if the economy has embarked on an extended and strong non-inflationary growth path that will spawn robust corporate profitability. Chart 1A Second Half Squeeze? A Second Half Squeeze? A Second Half Squeeze? On this note, the third mini-economic up-cycle since the Great Recession has been underway since last year. The first two bursts of economic strength fizzled quickly, eventually requiring a new dose of stimulus to reinvigorate growth. The current up-cycle may have more legs given that the rest of the world is now participating and the U.S. economy at full employment, but it would be dangerous to become complacent. The stock-to-bond ratio has crested on a growth rate basis, and its mean reversion properties suggest that key macro gauges such as the ISM index may cool as the year progresses (Chart 1). Odds of growth-propelling fiscal stimulus, that equities have already bought and paid for, may now fade following Congress' failure to move on health care reform. Total bank credit growth is decelerating on a broad basis. Chart 1 shows that of the 8 major bank loan categories, only 1 has a positive credit impulse (the annual change in the 52-week rate of change), the other 7 are negative, i.e. it isn't simply C&I loan weakness driving the credit deceleration. Traditionally, credit and economic growth move together, so the current gap warrants close attention. Meanwhile, the reflationary impulse over the past 18 months from China is set to fade as the authorities tap the brakes, particularly in the housing market, which may throw a wrench into new construction. Chinese property prices have been especially correlated with global economic up-cycles. Real estate inflation downturns have been important global economic signals (Chart 1). Consequently, the second half of the year may 'feel' slower from a growth perspective and challenge the reflation hypothesis. Some trepidation about the durability/breadth of the economic expansion is becoming evident in internal market behavior. Our Intermediate Equity Indicator (IEI) has continued to weaken as breadth and participation thin (Chart 2). If the IEI drops below zero, the odds of a meaningful pullback will rise substantially. Keep in mind there is a lot of air between the S&P 500 index and its 40-week moving average. The number of S&P 500 groups with a positive 52-week rate of change has pulled back to post-Great Recession lows (Chart 2). Last week we showed a composite of relative industry and sector performance that also heralded a choppy period ahead for the broad averages. All of these factors suggest that a tactical consolidation needs time to play out, especially with first quarter reporting season fast approaching and optimism in the outlook bursting at the seams. While trading sentiment is not overly stretched, the truest measure of sentiment is asset valuations and expectations. On this front, our Global Economic Sentiment Index, which contrasts equity and government bond valuations in the major economies, has reached the 'extreme optimism' zone (Chart 3, middle panel). Such a reading does not automatically foretell of an imminent major equity peak, but reinforces that there is little margin for disappointment. Chart 2Deteriorating Internals Deteriorating Internals Deteriorating Internals Chart 3Early Signs Of Overconfidence? Early Signs Of Overconfidence? Early Signs Of Overconfidence? In addition, the trend in analyst earnings expectations is also consistent with an overriding theme of exuberance. Cyclical earnings estimates have tentatively peaked after a steep upgrade over the last few quarters, and are now sitting below 5-year growth expectations, suggesting overwhelming confidence in the longevity of the expansion. The last three times that cyclical (12-month) profit growth estimates diverged negatively from lofty long-term estimates was in 2000, 2007 and 2015 (Chart 3). Each episode coincided with ebullient global economic sentiment, and heralded market turbulence, with varying lags. The point is that when financial conditions tighten enough to undermine the cyclical growth outlook but fail to dent conviction in the long-term outlook, it is a signal of overconfidence. The good news is that financial conditions have remained historically easy and should only tighten gradually, such that the risk of a policy-induced slowdown is not acute. In sum, we expect the tactical consolidation phase to persist, especially if economic momentum cools. Exuberant expectations argue for a digestion phase, which should continue to broadly support defensive over cyclical sector positioning, a stance that has paid off nicely since late last year. We may look to selectively increase cyclical and financial sector exposure in the coming weeks if the U.S. dollar remains tame and inflation expectations perk back up, but for now, we are making a tactical addition to the defensive side of the ledger. Utilities Are Powering Up We booked sizable gains in the S&P utilities index and downgraded to neutral last summer, because of our view that bond yields were bottoming on the back of economic stabilization. Since then, relative performance collapsed by 20%, but it has recently started showing some signs of life. Is it time to re-enter this overweight position on a tactical basis? The short answer is yes. There are five reasons to buy utilities at the current juncture with a tactical (1-3 month) time horizon. A possible cooling in economic momentum will redirect capital into the sector. Last week we highlighted that the economically-sensitive transportation index may be heralding mean reversion in key activity gauges, such as the ISM manufacturing index (Chart 4). If the run of positive economic surprises reverses, utilities stocks should receive a sizeable relative performance boost. Transport stock underperformance typically means utility stock outperformance (Chart 4, bottom panel). A cycle-on-cycle analysis of relative utilities performance and the ISM manufacturing survey reveals that is pays to overweight utilities when the latter hits the current level. This has occurred seven times since the early 1990s, and the S&P utilities sector outperformed in the subsequent 3 and 6 months by an average of 3 and 5%, respectively. Only one period generated negative returns (Table 2). Chart 4Utilities Win When Transports Lose Utilities Win When Transports Lose Utilities Win When Transports Lose Table 2Contrary Alert: Buy Utilities Great Expectations? Great Expectations? Market-based inflation expectations have crested, aided by the dip in oil prices. Relative share prices have been inversely correlated with inflation expectations, owing to the link to long-dated Treasury yields. Importantly, the University of Michigan's survey inflation expectations, both short and long term, have been drifting lower signaling that the recent backup in CPI headline inflation will likely prove transitory (inflation expectations shown inverted, Chart 5). The flattening yield curve is also sending a tactical buy signal for utilities stocks (shown inverted, Chart 5). Natural gas prices are strengthening. Nat gas prices are the marginal price setter for non-regulated utilities, and the recent price spike has boosted utilities pricing power. Sell-side analysts have taken notice, aggressively ratcheting EPS numbers higher. Nevertheless, the relative EPS growth bar still remains low, signaling that a relative profit outperformance period looms (Chart 6). Chart 5External Support As... External Support As... External Support As... Chart 6... Earnings Recover ... Earnings Recover ... Earnings Recover One risk to our tactically bullish utilities view is stagnant electricity generation growth. However, if overall output growth recedes in the next quarter or two, then the non-cyclical power demand profile will shine through, offsetting low utility utilization rates in absolute terms. Bottom Line: There is scope for a playable relative performance rally in the coming one-to-three months. Boost the niche S&P utilities sector to overweight. Soft Drinks Are About To Pop Indiscriminate selling of all consumer staples immediately after the Trump victory restored value in a number of defensive consumer groups. They have stealthily outperformed for most of this year. Chart 7 shows a number of valuation yardsticks. Soft drink stocks are yielding more than both 10-year Treasurys and the broad market. Similarly, the relative P/S and P/E ratios have dipped comfortably below their respective historical means. From a technical standpoint, relative share price momentum has been pushed to a bearish extreme (Chart 7). Against this valuation and technical backdrop, any whiff of operating traction should trigger a playable outperformance phase. Industry pricing power has rebounded smartly, exiting the deflation zone (Chart 8). This firming in selling prices appears to be demand driven. Growth in relative consumer outlays on food and non-alcoholic beverages has improved. Actual industry sales growth has returned to positive territory and beverage output growth is outpacing other non-durable goods industries (Chart 8). While export trends have been a sore spot for beverage companies, the tide should soon turn. The greenback has depreciated versus emerging market (EM) currencies since mid-December, permitting EM central banks to ease monetary policy. That heralds a recovery in consumer goods exports and a reversal of negative translation FX effects (Chart 9, middle panel). Chart 7Cheap And Washed Out Cheap And Washed Out Cheap And Washed Out Chart 8Inflection Point Inflection Point Inflection Point Chart 9Export Drag Should Reverse Export Drag Should Reverse Export Drag Should Reverse The improvement in top-line leading indicators is particularly noteworthy given that cost inflation remains muted. Food input prices are contracting and ethylene prices, a primary packaging ingredient, are also deflating. With headcount under control (Chart 9, bottom panel), there is scope for margin expansion at a time when overall profit margins face a steady squeeze from rising wage inflation. This brightening backdrop, especially in relative terms, has not yet been embraced by the analyst community. Not only are earnings slated to trail the broad market by 7% in the coming year, but 5-year relative EPS growth has plummeted to all-time lows. Such pessimism is unwarranted. All of this implies that while recent beverage shipment growth has been soft, a recovery is likely as the year progresses. That will set the stage for a series of positive surprises, supporting share price outperformance. Bottom Line: The compellingly valued S&P soft drinks index has troughed and has a very attractive reward/risk profile. Were we not already overweight, we would lift exposure to above benchmark today. The ticker symbols for the stocks in the S&P soft drinks index are: BLBG: S5SOFD-KO, PEP, MNST, DPS. Consumer Finance: Cast Aside, But For No Good Reason Like all financials, consumer finance stocks have underperformed the broad market in recent weeks. High intra-financial sector correlations are understandable early in a corrective phase, especially given the magnitude of the initial post-election rally. However, as time passes, correlations should recede because significant discrepancies exist among industry profit drivers. For instance, any meaningful broad market correction could undermine capital markets activity via reduced appetite for new equity issues, less M&A activity and smaller trading fees, taking a bite out of investment banking profits. Elsewhere, banks have been riding hopes for higher net interest margins and an easing regulatory burden. However, without any corresponding improvement in credit growth they are now giving back those gains because bond yields have stalled, the yield curve has narrowed and expectations for deregulation are being watered down to a dilution of terms These factors justify the pullback in both banks and capital markets stocks, even if temporary. On the flipside, the consumer finance group has also been dragged down, even though leading indicators of profitability have continued to improve. As shown in past research, the credit card interest rate spread has low sensitivity to shifts in the yield curve. As such, receivables growth matters more to profits than the slope of the yield curve. Whether consumers embark on debt-financed consumption is heavily dependent on job security, debt-servicing costs, and household wealth. When consumer comfort rises, the personal savings rate tends to decline, indicating a greater propensity to spend. Household net worth has set a new all time high on the back of buoyant financial markets and recovery in house prices (Chart 10). Debt service payments remain historically depressed as a share of disposable income, underscoring that the means to re-leverage exist (Chart 10). Typically credit card charge-offs stay muted until well after debt servicing requirements hit a much higher level, either through reduced incomes or higher interest rates, or a combination of the two. At the moment, both are working in favor of credit quality, not against it. In fact, house prices have reaccelerated sharply in the past few months, which heralds share price outperformance (Chart 11, top panel). Moreover, the steady increase in housing starts bodes well for additional gains in outlays on durable goods, a positive omen for consumer credit demand. Chart 10Credit Quality Remains Strong Credit Quality Remains Strong Credit Quality Remains Strong Chart 11Bullish Leading Indicators Bullish Leading Indicators Bullish Leading Indicators The latter is already growing at a solid clip, in contrast with other lending categories such as C&I loan growth (Chart 11), which is weak and dragging down total bank credit. The surge in consumer income expectations points to an expanded appetite for debt (Chart 11). Consequently, the sell-off in the S&P consumer finance index should be treated as indiscriminate contagion from the rest of the financials sector rather than a reflection of deteriorating fundamentals. Recent value creation represents a buying opportunity. Bottom Line: Stick with a high-conviction overweight in the S&P consumer finance index. The ticker symbols for the stocks in the S&P consumer index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The locomotive of the U.S. economy, the consumer, remains supported by powerful tailwinds. The Fed will be able to tighten monetary policy relative to other central banks by a higher degree than the market appreciates. The dollar will rise further. Use this dip to buy more dollars. Being tactically long the yen is a hedge against growth disappointments. Set a stop-sell for AUD/NZD. Feature In June of last year, we wrote a piece titled "What Could Go Right?" arguing key changes in the global economy may have justified a more pro-risk stance for investors.1 The core of the argument was that markets were pricing in a lot of negatives, as the annual return of the global stock-to-bond ratio was deeply negative and could only fall further if a recession were to emerge. Moreover, as commodity prices were improving, we foresaw a waning of deflationary forces that had engulfed the world. This easing deflation would cause real rates to fall and economic activity in EM to rebound. Chart I-1Global Asset Prices: From Gloom To Glee Global Asset Prices: From Gloom To Glee Global Asset Prices: From Gloom To Glee Over the subsequent nine months, this scenario moved from the world of theories to being the reality for the global economy. Today, the annual return of the global stock-to-bond ratio is now the mirror image of last June (Chart I-1). Thus, for the stock-to-bond ratio to move higher, we need to explore where growth may come from. Moreover, we need to consider whether this growth is likely to help the dollar or help other currencies. The U.S. Is In Charge The U.S. economy continues to show the most promise. It is true that some signs do point to a weak Q1. Much noise has been made about the decline in commercial and industrial loans. We are more sanguine. To begin with, the Conference Board includes C&I loans in its list of lagging indicators, not leading ones. Additionally, C&I loans lag banks' lending standards, and, in fact, the weakness in this subsection of credit aggregates is the natural consequence of the 2015-2016 tightening in lending standards. Their recent easing points toward a rebound in C&I loans, as do core durable goods new orders (Chart I-2). What is more concerning is the slowdown in credit to households (Chart I-3). The U.S. economy is driven by household dynamics and the Conference Board does include consumer credit in its list of leading indicators. Moreover, the amount of MBS and ABS on primary dealers' balance sheets remains in a downtrend. This is worrisome because it suggests that the slowing accumulation of consumer debt on banks' balance sheet is genuine, and not a reflection of securitization (Chart I-4). Chart I-2C&I Loans##br## Will Pick Up C&I Loans Will Pick Up C&I Loans Will Pick Up Chart I-3However, Household Credit ##br##Dynamics Are A Worry However, Household Credit Dynamics Are A Worry However, Household Credit Dynamics Are A Worry Chart I-4Securitization Unlikely ##br##To Be The Culprit Securitization Unlikely To Be The Culprit Securitization Unlikely To Be The Culprit However, there are causes to minimize these concerns. Mainly, the drivers of household income and spending are still healthy. First, U.S. financial conditions remain easy, a phenomenon that tends to boost GDP growth in the following quarters, suggesting that national income will remain strong. Second, the outlook for employment in the U.S. remains robust. As Chart I-5 illustrates, the employment components of the ISM and the Philly Fed surveys both point to a pick-up in job creation. This further supports the notion that nominal household income will strengthen Third, our real disposable income indicator, based on various components of the NFIB survey, is showing that households should enjoy strong income growth in the coming months (Chart I-6). Moreover, despite the failure of the AHCA, Marko Papic, the head of BCA's Geopolitical Strategy service argues that it will be much easier for the GOP to implement tax cuts, especially geared toward the middle class, than it was to repudiate the much-maligned Obamacare.2 This could further help household disposable income. Chart I-5Job Growth Will Rebound Job Growth Will Rebound Job Growth Will Rebound Chart I-6Household Income: Highway Star Household Income: Highway Star Household Income: Highway Star Fourth, household liquid assets represent 270% of disposable income, the highest level in decades. Moreover, household debt-servicing costs are still near multi-generational lows, suggesting that households are in the best financial shape they have been in decades. And fifth, household confidence has surged to its highest levels since 2000, reflecting both the large increase in net worth created by surging asset values as well as the very low level of unemployment in the U.S. (Chart I-7). Thus, the decline in the savings rate from 6.2% in 2015 to 5.5% at present could deepen further, adding more impetus to transform income gains into consumption gains. At the worst, this development suggests that the household savings rate will not rise much. These factors all imply that household consumption will remain robust and may in fact accelerate in the coming quarters. Consequently, that capex too has upside. We have highlighted how capex intentions have risen substantially, and this has historically been a powerful leading indicator of capex itself.3 However, the financial press is replete with commentators reminding us that the positive global economic surprises have mostly been a reflection of "soft data" and that "hard data" has not followed through. Not only do we philosophically disagree with this statement - historically soft data does indeed lead hard data - but as Chart I-8 illustrates, core capital goods orders have risen quite sharply, mimicking the developments in retail sales. A combination of strong retail sales and strong orders tend to portend to a rise in capex. Chart I-7Happy Shiny People Happy Shiny People Happy Shiny People Chart I-8Capex Will Rebound Capex Will Rebound Capex Will Rebound These developments raise the likelihood that U.S. growth will power the global economy and that the Fed will be in a good position to make good on its intent to increase interest rates two more times this year. In fact, there is even a growing probability that the Fed will add another tool to its tightening arsenal: letting MBS run off, resulting in a contraction of its balance sheet. The combined tightening of two more hikes and a shrinking balance sheet will be much greater than any tightening emanating from an ECB taper. As we argued last week: Europe's inflation and wage backdrop remains icy cold, limiting how far the ECB can tighten monetary policy.4 While an environment of globally rising rates is normally negative for the yen, with the BoJ displaying and even easier bias than in the past, any increase in rates in the U.S. is likely to supercharge weaknesses in the yen, as the BoJ will put a lead on JGB yields and force them to remain subdued.5 As a result of these views, we remain very committed dollar bulls on a 12-18 months basis and recommend using the current dip in the dollar as a buying opportunity, especially on a trade-weighted basis. Bottom Line: While consumer loan growth has slowed - which could result in a poor Q1 U.S. growth number - the outlook for U.S. household income and consumption remains promising. This will also feed through to higher investment growth, clearing the Fed's path toward higher rates. This dip in the dollar should be used as an occasion to buy the greenback. But Why Still Long The Yen Tactically? This position has two purposes. First, we have been worried about dynamics in China that could cause a correction in EM markets.6 More recently, the decline in Chinese house-price appreciation has deepened, representing an ominous sign for the iron ore market (Chart I-9). Poor metal prices tend to represent a negative terms of trade shock and therefore an economic handicap for many large EM nations. Moreover, back in June, the improvement in Taiwanese IP was one of the factors that prompted us to highlight a potential improvement in the global economy. So was the uptrend in our boom/bust indicator. Today, not only is the boom/bust indicator losing steam, but Taiwanese IP has sharply rolled over (Chart I-10). While this is not a reason to worry about our bullish view on the U.S. economy, this could suggest that the global manufacturing upswing has seen its heyday, a development that is likely to weigh more heavily on EM economies than on the U.S. Any EM stress is likely to boost the yen's appeal, temporarily countering the BoJ's aggressive stance. Chart I-9Problems For Iron Ore Problems For Iron Ore Problems For Iron Ore Chart I-10Two Clouds For Global Growth Two Clouds For Global Growth Two Clouds For Global Growth Second, we do not want to be dogmatic on our U.S. growth view. As the top panel of Chart I-11 illustrates, increases in 2-year Treasury yields have tended to lead to decreases in U.S. inflation expectations. While we would argue that the U.S. economy is on a stronger footing to withstand higher rates than at any point since 2010, a policy mistake is not out of the scope of probabilities. If rising rates is indeed a policy mistake, a large risk-off event would be a very likely outcome, one that boosts the yen. Finally, as the middle and bottom panels of Chart I-11 shows, a fall in U.S. inflation expectations would also extract its toll on EM and cyclical plays, further reinforcing any disappointment out of China, and further adding shine to the yen. Our original target on USD/JPY was 110, we are moving it to 108. At this point, we will become sellers of the yen, unless we see signs that the global economy is entering a more dangerous path than originally anticipated. Additionally, investors looking to express a bearish view on EM may want to go short MXN/JPY (Chart I-12). The peso has massively rallied and is now at a crucial technical spot against the JPY. Moreover, while being short USD/JPY may be a dangerous move - after all, we are playing what amounts in our view to a countertrend bounce in the yen - if EM are at risk, these risks could be exacerbated by the tightening in financial conditions created by a higher dollar. Mexico, with its high external debt, representing nearly 70% of GDP, is particularly exposed to this problem. Also, MXN, with its high liquidity for an EM currency, is often a vehicle for investors to play EM weaknesses. Thus, shorting MXN/JPY could be a great hedge for investors with long EM exposures. Chart I-11Are We Out Of The Woods Yet? Are We Out Of The Woods Yet? Are We Out Of The Woods Yet? Chart I-12A Gauge And A Play A Gauge And A Play A Gauge And A Play Bottom Line: Being tactically long the yen in a portfolio offers two advantages. First, it is a direct play on any disappointment of investors in the EM space, and, second, it is also a hedge against the risks to our strong U.S. growth view. AUD/NZD: Not A Bargain It is often argued that AUD/NZD is a bargain as it trade 6% below its purchasing power parity rate. This may be a valid reason to buy this cross, but only for investors with extremely long investment horizons, as PPP deviations can take seven years to correct. In fact, following the recent rebound in AUD/NZD, we would be inclined to short this pair once again. On the international front, AUD/USD seems to be driven by the dynamic in Chinese nominal GDP growth. We doubt Chinese nominal GDP growth will accelerate much beyond Q1. As Chart I-13 illustrates, AUD/USD seems to have moved ahead of Chinese GDP, putting this currency at risk. We also can also interpret AUD/NZD as a vehicle to play the growth rebalancing in China. The AUD (iron ore, other metals, and coal) is a bet on industrial and investment growth while the NZD (dairy, meat, and wool) is a wager on the Chinese households. As China moves away from an investment-led growth model toward a more consumption-led growth model, AUD/NZD should underperform. A simple fair value model for this cross designed to capture these dynamics as well as the USD dynamics indicates that AUD/NZD is 8% overvalued (Chart I-14). Chart I-13AUD Prices In Chinese Optimism AUD Prices In Chinese Optimism AUD Prices In Chinese Optimism Chart I-14AUD/NZD Is Expensive AUD/NZD Is Expensive AUD/NZD Is Expensive Moreover, still with an eye firmly planted on China, AUD/NZD has tended to perform poorly when Chinese monetary conditions tighten. The recent upward move in the Chinese 7-day repo rate could be a harbinger of bad things to come for this cross. Relative domestic factors also temper any bullishness on AUD/NZD. Kiwi house prices are outperforming Aussie prices and New Zealand inflation is catching up to that of Australia's. Moreover, the RBA has been paying more attention to the poor state of the Australian labor market, while that of New Zealand remains very strong. These dynamics suggest that kiwi rates could rise relative to that of Australia (Chart I-15). More technically, investors are massively long the AUD relative to the NZD (Chart I-16). This usually is a good signal to bet against this pair. Chart I-15Domestic Conditions Favor##br## Higher NZ Rates Vs. Australia Domestic Conditions Favor Higher NZ Rates Vs. Australia Domestic Conditions Favor Higher NZ Rates Vs. Australia Chart I-16Speculators ##br##Are Bullish Speculators Are Bullish Speculators Are Bullish Bottom Line: Shorting AUD/NZD at current levels makes sense. Not only is it a way to take advantage of the desire by Chinese authorities to rebalance growth away from the Chinese industrial sector, the Kiwi economy is outperforming that of Australia, and too much negativity has been priced in for the RBNZ relative to the RBA. Finally investors are overly long the AUD relative to the NZD. Set up a stop-sell of AUD/NZD at 1.1100, with a target of 1.000 and a stop at 1.1330. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "What Could Go Right?", dated June 24, 2016 available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Five Questions On Europe", dated March 22, 2017 available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Outlook: 2017's Greatest Hits", dated December 16, 2016 available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "JPY: Climbing To The Springboard Before The Dive", dated February 24, 2017 available at fes.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The DXY displayed resilience this week: the third estimate for U.S. GDP in 2016Q4 outperformed expectations at 2.1%, after being revised up from 1.9%; consumer confidence increased to 125.6, the highest level since 2000; yet Initial jobless claims ticked in at 258,000, underperforming expectations of 248,000 but beating previous figures of 261,000. Another factor lifting the dollar were recent comments by Secretary of Transportation, Elaine Chao, who stated that Trump's $1 trillion infrastructure plan will be unveiled later this year. This could be considerably positive for U.S. economic growth as it will cover a large part of the economy: "transportation infrastructure, energy, water and potentially broadband and veterans hospitals as well." Although specifics were not disclosed, such stimulus in the face of tightening labor market could fan inflation. Under the assumption of a proactive Fed, this could translate into a strong dollar. Report Links: USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Last week's hawkish comments by ECB board member Ewald Nowotny drove the euro higher, while recent comments by Peter Praet confirmed that "a very substantial degree of monetary accommodation is still needed", which pushed the euro down. Promoting the euro's downside were Italian industrial sales and orders, which contracted at a monthly pace of 3.5% and 2.9% respectively, although annual rates remain positive. Article 50's invocation was another factor which contributed to volatility. How Brexit negotiations evolve will dictate movements in EUR/GBP for the foreseeable future. President Tusk's demeanor was also quite negative in his speech, focusing on minimizing "the costs for EU citizens, businesses and Member States". In other news, Portugal's Finance Minister Mario Centeno hinted at a possible upgrade to the growth forecast to around 2% from 1.5% as exports grew by 19% in January. As exports continue to be a key driver of growth for this country, this suggests a weaker euro is still needed to support growth in the periphery. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data has been mixed for Japan: Corporate services prices rose by 0.8% year-over-year, outperforming expectations. However, retail trade yearly growth deteriorated to 0.1% from 1% the previous month, underperforming expectations. Furthermore, manufacturing PMI fell to 52.6 from 53.3 the previous month. We are changing our tactical target for USD/JPY from 110 to 108. The decline in Chinese property prices as well as slowing inflation expectations in the U.S. might create a risk off environment that will affect carry currencies and will benefit the safe havens like the yen. On a cyclical basis, we remain yen bears, as recent sluggishness will only embolden BoJ policy makers to maintain their radical monetary stance. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 It's official: Theresa May has triggered Article 50. The pound reacted relatively positive to the event as both parties in the negotiations chose to start with the carrot rather than the stick: In her letter to the EU Theresa May stated that she hoped to enjoy a "deep and special" relationship with the European Union once Brexit is finalized. On the other side of the channel, Donald Tusk also pledged to work "closely" with their counterparts in London, and that he hoped that the U.K. will stay a close partner after Brexit. These developments are encouraging, as it shows that cooler heads might prevail at the end of the day. This rosier outlook in an environment where expectations for the Britain are still too pessimistic makes the pound a very attractive buy, particularly against the euro, despite the potential for short-term volatility as the stick will ineluctably come out. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 In an attempt to curb housing market euphoria, all four major banks - ANZ, CBA, NAB and Westpac - increased lending rates on investor and interest-only mortgages this month. Fitch Ratings reports that the tightening was done "ahead of probable regulatory tightening", as hinted frequently by the RBA. Rising wholesale funding costs due to tighter U.S. policy is also a motivating factor behind this. For the time being, the housing market risk will continue to be restricted through macroprudential policies rather than actual tightening by the central bank. Eventually risks related to record-high household debt will limit the capacity of the RBA to increase rates. On the brighter side, banks are well positioned with strong capital buffers and pre-impairment to profitability, with Fitch rating them 'Stable'. This means that risks may not lie with the banking sector, but that the consumer sector will be the key drag on growth. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 In the current environment, although we like to continue to be short the NZD against the yen, we are also shorting AUD/NZD once again. Beyond its uncorrelated nature, there are many reasons why this is an attractive cross to short: AUD/NZD tends to perform poorly when Chinese monetary conditions tighten. Therefore, the spike in Chinese repo rates could weigh on this cross. Furthermore, investors are very long the AUD relative to the NZD. This gives us confidence that this cross might be in overbought territory and that the 5.5% rally in AUD/NZD over the last 2 months may be exhausting itself. Finally, as we have mentioned before, domestic factors still favor the NZD, as kiwi house prices are rising at a faster pace than Aussie ones, which should put pressure on rate differentials. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD is displaying some strength on the back of stronger oil prices, outweighing the pressure from a stronger USD. As mentioned last week, the trend for USD/CAD is still negative in the short term, as corroborated by a negative MACD trend. The greenback's seasonal behavior is also generally negative in April, which could buoy the CAD in the next month. Nevertheless, at the Bank of Canada's meeting in two weeks, Poloz is likely to continue displaying a dovish rhetoric, limiting the CAD's resilience. Similar to Australia, risks lie with the consumer sector, which is burdened by a huge debt load. This gives another reason for Poloz to stay off hikes for the time being and concentrate instead on promoting the implementation of macroprudential policies to regulate lending standards and mitigate housing market risks. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF now hovers around 1.07, clearing the implied floor by the Swiss National Bank. Recent data have been positive: The Zew survey for economic expectations reached 29.6, up from 19.4 in February. It is now at the highest level in 3 years. The KOF leading indicator came at 107.6, above expectations. Although it does seem that the Swiss economy is still improving, the SNB will stay resolute in its intervention for the time being. Indeed, this was the message of SNB Governing Board Member Andrea Maechler, who asserted that there was no limit on their expansion of FX reserves, and that the Swiss franc was "strongly overvalued". We will continue to observe how the Swiss economy develops. However, for the time being the SNB is likely to keep its floor in place. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has been relatively flat this week, even in the face of a rally in oil prices. This has been in part due to a phenomenon that should continue in the next months: an appreciation of the U.S. dollar against EM and commodity currencies. Furthermore, domestic factors should continue to weigh on the krone, as employment continues to contract and inflation is receding due to the stabilization of the krone. Indeed, Governor Olsen signaled that the Norges bank will likely leave rates unchanged for "a good while" due to these developments. Furthermore, oil could be at risk as well, as the market is starting to doubt the Russian commitment to its deal with OPEC. This, coupled with a slowdown in EM, could prompt a down leg in oil, hurting the NOK in the process. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data came out strong: Retail sales annual growth remains unchanged at 2.7%; The producer price index grew at 7.5%; Consumer confidence for March was at 102.6, down from the previous 104.3. Interesting technical developments for the krona are pointing to further weakness. USD/SEK has rebounded from oversold levels and the MACD line is beginning to overtake the signal line. More importantly, the Coppock curve is rebounding, signifying a bullish trend. EUR/SEK is showing similar signs with the MACD pointing up and the Coppock curve rebounding. Interestingly, Swedish inflation expectations have substantially decreased this week which might give the Riksbank cover to remain dovish. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Economic Outlook: The global economy is in a reflationary window that will stay open until mid-2018. Growth will then slow, culminating in a recession in 2019. While the recession is likely to be mild, the policy response will be dramatic. This will set the stage for a period of stagflation beginning in the early 2020s. Overall Strategy: Investors should overweight equities and high-yield credit during the next 12 months, while underweighting safe-haven government bonds and cash. However, be prepared to scale back risk next spring. Fixed Income: For now, stay underweight U.S. Treasurys within a global fixed-income portfolio; remain neutral on the euro area and the U.K.; and overweight Japan. Bonds will rally in the second half of 2018 as growth begins to slow, but then begin a protracted bear market. Equities: Favor higher-beta developed markets such as Europe and Japan relative to the U.S. in local-currency terms over the next 12 months. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is close to a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks in the middle of next year. Feature Reflation, Recession, And Then Stagflation The investment outlook over the next five years can be best described as a three-act play: First Act: "Reflation" (The present until mid-2018) Second Act: "Recession" (2019) Third Act: "Stagflation" (2021 onwards) Investors who remain a few steps ahead of the herd will prosper. All others will struggle to stay afloat. Let us lift the curtain and begin the play. Act 1: Reflation Reflation Continues If there is one chart that best encapsulates the reflation theme, Chart 1 is it. It shows the sum of the Citibank global economic and inflation surprise indices. The combined series currently stands at the highest level in the 14-year history of the survey. Consistent with the surprise indices, Goldman's global Current Activity Indicator (CAI) has risen to the strongest level in three years. The 3-month average for developed markets stands at a 6-year high (Chart 2). Chart 1The Reflation Trade In One Chart The Reflation Trade In One Chart The Reflation Trade In One Chart Chart 2Current Activity Indicators Have Perked Up Current Activity Indicators Have Perked Up Current Activity Indicators Have Perked Up What accounts for the acceleration in economic growth that began in earnest in mid-2016? A number of factors stand out: The drag on global growth from the plunge in commodity sector investment finally ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7% off the level of U.S. real GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 3). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus. The era of fiscal austerity ended. Chart 4 shows that the fiscal thrust in developed economies turned positive in 2016 for the first time since 2010. Financial conditions eased in most economies, delivering an impulse to growth that is still being felt. In the U.S., for example, junk bond yields dropped from a peak of 10.2% in February 2016 to 6.3% at present (Chart 5). A surging stock market and rising home prices also helped buoy consumer and business sentiment. Chart 3Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Chart 4The End Of Fiscal Austerity? Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 5Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Fine For Now... Looking out, global growth should stay reasonably firm over the next 12 months. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 6). The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 7 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will remain sturdy for the remainder of 2017. Chart 6Global Growth Will Stay Strong In The Near Term Global Growth Will Stay Strong In The Near Term Global Growth Will Stay Strong In The Near Term Chart 7Easing Financial Conditions Will Support Activity Easing Financial Conditions Will Support Activity Easing Financial Conditions Will Support Activity ... But Storm Clouds Are Forming Home prices cannot rise faster than rents or incomes indefinitely; nor can equity prices rise faster than earnings. Corporate spreads also cannot keep falling. As the equity and housing markets cool, and borrowing costs start climbing on the back of higher government bond yields, the tailwind from easier financial conditions will dissipate. When that happens - most likely, sometime next year - GDP growth will slow. In and of itself, somewhat weaker growth would not be much of a problem. After all, the economy is currently expanding at an above-trend pace and the Fed wants to tighten financial conditions to some extent - it would not be raising rates if it didn't! The problem is that trend growth is much lower now than in the past - only 1.8% according to the Fed's Summary of Economic Projections. Living in a world of slow trend growth could prove to be challenging. The U.S. corporate sector has been feasting on credit for the past four years (Chart 8). Household balance sheets are still in reasonably good shape, but even here, there are areas of concern. Student debt is going through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 9). Together, these two categories account for over two-thirds of non-housing related consumer liabilities. Chart 8U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit Chart 9U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem The risk is that defaults will rise if GDP growth falls below 2%, a pace that has often been described as "stall speed." This could set in motion a vicious cycle where slower growth causes firms to pare back debt, leading to even slower growth and greater pressure on corporate balance sheets - in other words, a recipe for recession. Act 2: Recession Redefining "Tight Money" "Expansions do not die of old age," Rudi Dornbusch once remarked, "They are killed by the Fed." On the face of it, this may not seem like much of a concern. If the Fed raises rates in line with the median "dot" in the Summary of Economic Projections, the funds rate will only be about 2.5% by mid-2019 (Chart 10). That may not sound like much, but keep in mind that the so-called neutral rate - the rate consistent with full employment and stable inflation - may be a lot lower now than in the past. Also keep in mind that it can take up to 18 months before the impact of tighter financial conditions take their full effect on the economy. Thus, by the time the Fed has realized that it has tightened monetary policy by too much, it may be too late. As we have argued in the past, a variety of forces have pushed down the neutral rate over time.1 For example, the amount of investment that firms need to undertake in a slow-growing economy has fallen by nearly 2% of GDP since the late-1990s (Chart 11). And getting firms to take on even this meager amount of investment may require a lower interest rate since modern production techniques rely more on human capital than physical capital. Chart 10Will The Fed's 'Gradual' Rate Hikes End Up Being Too Much? Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 11Less Investment Required Less Investment Required Less Investment Required Rising inequality has also reduced aggregate demand by shifting income towards households with high marginal propensities to save (Chart 12). This has forced central banks to lower interest rates in order to prop up spending. From this perspective, it is not too surprising that income inequality and debt levels have been positively correlated over time (Chart 13). Chart 12Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Chart 13U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP Then there is the issue of the dollar. The broad real trade-weighted dollar has appreciated by 19% since mid-2014 (Chart 14). According to the New York Fed's trade model, this has reduced the level of real GDP by nearly 2% relative to what it would have otherwise been. Standard "Taylor Rule" equations suggest that interest rates would need to fall by around 1%-to-2% in order to offset a loss of demand of this magnitude. This means that if the economy could withstand interest rates of 4% when the dollar was cheap, it can only withstand interest rates of 2%-to-3% today. And even that may be too high. Consider the message from Chart 15. It shows that real rates have been trending lower since 1980. The real funds rate averaged only 1% during the 2001-2007 business cycle, a period when demand was being buoyed by a massive, debt-fueled housing bubble; fiscal stimulus in the form of the two Bush tax cuts and the wars in Iraq and Afghanistan; a weakening dollar; and by a very benign global backdrop where emerging markets were recovering and Europe was doing well. Chart 14The Dollar Is In The Midst Of Its Third Great Bull Market The Dollar Is In The Midst Of Its Third Great Bull Market The Dollar Is In The Midst Of Its Third Great Bull Market Chart 15The Neutral Rate Has Fallen The Neutral Rate Has Fallen The Neutral Rate Has Fallen Today, the external backdrop is fragile, the dollar has been strengthening rather than weakening, and households have become more frugal (Chart 16). And while President Trump has promised plenty of fiscal largess, the reality may turn out to be a lot more sobering than the rhetoric. Chart 16Return To Thrift Return To Thrift Return To Thrift End Of The Trump Trade? Not Yet The failure to replace the Affordable Care Act has cast doubt in the eyes of many observers about the ability of Congress to pass other parts of Trump's agenda. As a consequence, the "Trump Trade" has gone into reverse over the past few weeks, pushing down the dollar and Treasury yields in the process. We agree that the "Trump Trade" will eventually fizzle out. However, this is likely to be more of a story for 2018 than this year. If anything, last week's fiasco may turn out to be a blessing in disguise for the Republicans. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play The GOP's proposed legislation would have reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. That would have warranted lower bond yields and a weaker dollar. The failure to pass an Obamacare replacement serves as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy Where the disappointment will appear is not during the legislative process, but afterwards. The highly profitable companies that will benefit the most from corporate tax cuts are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the corporate tax cuts may simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 17From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Chart 18Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 17). As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and lavish fiscal stimulus only to get neither. Euro Area: A 12-Month Window For Growth The outlook for the euro area over the next 12 months is reasonably bright, but just as in the U.S., the picture could darken later next year. Euro area private sector credit growth reached 2.5% earlier this year. This may not sound like a lot, but that is the fastest pace of growth since July 2009. A further acceleration is probable over the coming months, given rising business confidence, firm loan demand, and declining nonperforming loans. Conceptually, it is the change in credit growth that drives GDP growth. Thus, as credit growth levels off next year, the euro area's credit impulse will fall back towards zero, setting the stage for a period of slower GDP growth (Chart 18). In contrast to the U.S., the ECB is likely to resist the urge to raise the repo rate before growth slows. That's the good news. The bad news is that the market could price in some tightening in monetary policy anyway, leading to a "bund tantrum" later this year. As in the past, the ECB will be able to defuse the situation. Unfortunately, what Draghi cannot do much about is the low level of the neutral rate in the euro area. If the neutral rate is low in the U.S., it is probably even lower in the euro area, reflecting the region's worse demographics and higher debt burdens. The anti-growth features of the common currency - namely, the inability to devalue one's currency in response to an adverse economic shock, as well as the austerity bias that comes from not having a central bank that can act as a lender of last resort to solvent but illiquid governments - also imply a lower neutral rate. Chart 19Anti-Euro Sentiment Is High In Italy Anti-Euro Sentiment Is High In Italy Anti-Euro Sentiment Is High In Italy Indeed, it is entirely possible that the neutral rate is negative in the euro area, even in nominal terms. If that's the case, the ECB will find it difficult to keep inflation from falling once the economy begins to slow late next year. The U.K.: And Now The Hard Part The U.K. fared better than most pundits expected in the aftermath of the Brexit vote. Nevertheless, it would be a mistake to assume that the Brexit vote has not cast a pall over the economy. The pound has depreciated by 11% against the euro and 16% against the dollar since that fateful day, while gilt yields have fallen across the board. Had it not been for this easing in financial conditions, the economic outcome would have been far worse. As the tailwind from the pound's devaluation begins to recede next year, the U.K. economy could suffer. Slower growth in continental Europe and the rest of the world could also exacerbate matters. The severity of the slowdown will hinge on the outcome of Brexit negotiations. On the one hand, the EU has an interest in taking a hardline stance to discourage separatist forces elsewhere, particularly in Italy where pro-euro sentiment is tumbling (Chart 19). On the other hand, the EU still needs the U.K. as both a trade partner and a geopolitical ally. Investors may therefore be surprised by the relatively muted negotiations that transpire over the coming months. In fact, news reports indicate that Brussels has already offered the U.K. a three year transitional deal that will give London plenty of time to conclude a free trade agreement with the EU. In addition, the EU has dangled the carrot of revocability, suggesting that the U.K. would be welcomed back with open arms if enough British voters were to change their minds. Whatever the path, our geopolitical service believes that political risk actually bottomed with the January 17 Theresa May speech.2 If that turns out to be the case, the pound is unlikely to weaken much from current levels. China And EM: The Calm Before The Storm? The Chinese economy should continue to perform well over the coming months. The Purchasing Manager Index for manufacturing remains in expansionary territory and BCA's China Leading Economic Indicator is in a clear uptrend (Charts 20 and 21). Chart 20Bright Spots In The Chinese Economy Bright Spots In The Chinese Economy Bright Spots In The Chinese Economy Chart 21Improving LEI Points To Further Growth Acceleration Improving LEI Points To Further Growth Acceleration Improving LEI Points To Further Growth Acceleration Moreover, there has been a dramatic increase in the sales of construction equipment such as heavy trucks and excavators, with growth rates matching levels last seen during the boom years before the global financial crisis. Historically, construction machinery sales have been tightly correlated with real estate development (Chart 22). Reflecting this reflationary trend, the producer price index rose by nearly 8% year-over-year in February, a 14-point swing from the decline of 6% experienced in late-2015. Historically, rising producer prices have resulted in higher corporate profits and increased capital expenditures, especially among private enterprises (Chart 23). Chart 22An Upturn In Housing Construction? An Upturn In Housing Construction? An Upturn In Housing Construction? Chart 23Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits The key question is how long the good news will last. As in the rest of the world, our guess is that the Chinese economy will slow late next year, setting the stage for a major growth disappointment in 2019. Weaker growth abroad will be partly to blame, but domestic factors will also play a role. The Chinese housing market has been on a tear. The authorities are increasingly worried about a property bubble and have begun to tighten the screws on the sector. The full effect of these measures should become apparent sometime next year. Fiscal policy is also likely to be tightened at the margin. The IMF estimates that China benefited from a positive fiscal thrust of 2.2% of GDP between 2014 and 2016. The fiscal thrust is likely to be close to zero in 2017 and turn negative to the tune of nearly 1% of GDP in 2018 and 2019. The growth outlook for other emerging markets is likely to mirror China's. The IMF expects real GDP in emerging and developing economies to rise by 5.1% in Q4 of 2017 relative to the same quarter a year earlier, up from 4.2% in 2016 (Table 2). The biggest acceleration is expected to occur in Brazil, where the economy is projected to grow by 1.4% in 2017 after having contracted by 1.9% in 2016. Russia and India should also see better growth numbers. Table 2World Economic Outlook: Global Growth Projections Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play We do not see any major reason to challenge these numbers for this year, but think the IMF's projections will turn out to be too rosy for 2018, and especially, 2019. As BCA's Emerging Market Strategy service has documented, the lack of structural reforms in EMs over the past few years has depressed productivity growth. High debt levels also cloud the picture. Chart 24 shows that debt levels have continued to grow as a share of GDP in most emerging markets. In EMs such as China, where banks benefit from a fiscal backstop, the likelihood of a financial crisis is low. In others such as Brazil, where government finances are in precarious shape, the chances of another major crisis remains uncomfortable high. Japan: The End Of Deflation? If there is one thing investors are certain about it is that deflationary forces in Japan are here to stay. Despite a modest increase in inflation expectations since July 2016, CPI swaps are still pricing in inflation of only 0.6% over the next two decades, nowhere close to the Bank of Japan's 2% target. But could the market be wrong? We think so. Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 25). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. Over the past quarter century, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at only 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 26). Chart 24What EM Deleveraging? What EM Deleveraging? What EM Deleveraging? Chart 25Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Chart 26Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seems to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous cycle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Unfortunately, external events could conspire to sabotage Japan's escape from deflation. If the global economy slows in late-2018 - leading to a recession in 2019 - Japan will be hard hit, given the highly cyclical nature of its economy. And this could cause Japanese policymakers to throw the proverbial kitchen sink at the problem, including doing something that they have so far resisted: introducing a "helicopter money" financed fiscal stimulus program. Against the backdrop of weak potential GDP growth and a shrinking reservoir of domestic savings, the government may get a lot more inflation than it bargained for. Act 3: Stagflation Who Remembers The 70s Anymore? By historical standards, the 2019 recession will be a mild one for most countries, especially in the developed world. This is simply because the excesses that preceded the subprime crisis in 2007 and, to a lesser extent the tech bust in 2000, are likely to be less severe going into the next global downturn than they were back then. The policy response may turn out to be anything but mild, however. Memories of the Great Recession are still very much vivid in most peoples' minds. No one wants to live through that again. In contrast, memories of the inflationary 1970s are fading. A recent NBER paper documented that age plays a big role in determining whether central bankers turn out to be dovish or hawkish.3 Those who experienced stagflation in the 1970s as adults are much more likely to express a hawkish bias than those who were still in their diapers back then. The implication is the future generation of central bankers is likely to see the world through more dovish eyes than their predecessors. Even if one takes the generational mix out of the equation, there are good reasons to aim for higher inflation in today's environment. For one thing, debt is high. The simplest way to reduce real debt burdens is by letting inflation accelerate. In addition, the zero bound is less likely to be a problem if inflation were higher. After all, if inflation were running at 1% going into a recession, real rates would not be able to fall much below -1%. But if inflation were running at 3%, real rates could fall to as low as -3%. The Politics Of Inflation Political developments will also facilitate the transition to higher inflation. In the U.S., the presidential election campaign will start coming into focus in 2019. If the economy enters a recession then, Donald Trump will go ballistic. The infrastructure program that Republicans in Congress are downplaying now will be greatly expanded. Gold-plated hotels and casinos will be built across the country. Of course, several years could pass between when an infrastructure bill is passed and when most new projects break ground. By that time, the economy will already be recovering. This will help fuel inflation. As the economy turns down in 2019, the Fed will also be forced to play ball. The market's current obsession over whether President Trump wants a "dove" or a "hawk" as Fed chair misses the point. He wants neither. He wants someone who will do what they are told. This means that the next Fed chair will likely be a "really smart" business executive with little-to-no-experience in central banking and even less interest in maintaining the Federal Reserve's institutional independence. The empirical evidence strongly suggests that inflation tends to be higher in countries that lack independent central banks (Chart 27). This may be the fate of the U.S. Chart 27Inflation Higher In Countries Lacking Independent Central Banks Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Europe's Populists: Down But Not Out Whether something similar happens in Europe will also depend on political developments. For the next 18 months at least, the populists will be held at bay (Chart 28). Le Pen currently trails Macron by 24 percentage points in a head-to-head contest. It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. In Germany, support for the europhile Social Democratic Party is soaring, as is support for the common currency itself. For the time being, euro area risk assets will be able to climb the proverbial political "wall of worry." However, if the European economy turns down in 2019, all this may change. Chart 29 shows the strong correlation between unemployment rates in various French départements and support for Marine Le Pen's National Front. Should French unemployment rise, her support will rise as well. The same goes for other European countries. Chart 28France And Germany: Populists Held At Bay For Now France And Germany: Populists Held At Bay For Now France And Germany: Populists Held At Bay For Now Chart 29Higher Unemployment Would Benefit Le Pen Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Meanwhile, there is a high probability that the migrant crisis will intensify at some point over the next few years. Several large states neighboring Europe are barely holding together - Egypt being a prime example - and could erupt at any time. Furthermore, demographic trends in Africa portend that the supply of migrants will only increase. In 2005, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2015 revision, the UN doubled its estimate to 4 billion. And even that may be too conservative because it assumes that the average number of births per woman falls from 5.1 to 2.2 over this period (Chart 30). Chart 30Population Pressures In Africa Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play The existing European political order is not well equipped to deal with large-scale migration, as the hapless reaction to the Syrian refugee crisis demonstrates. This implies that an increasing share of the public may seek out a "new order" that is more attuned to their preferences. European history is fraught with regime shifts, and we may see yet another one in the 2020s. The eventual success of anti-establishment politicians on both sides of the Atlantic suggests that open border immigration policies and free trade - the two central features of globalization - will come under attack. Consequently, an inherently deflationary force, globalization, will give way to an inherently inflationary one: populism. The Productivity Curse Just as the "flation" part of stagflation will become more noticeable as the global economy emerges from the 2019 recession, so will the "stag." Chart 31 shows that productivity growth has fallen across almost all countries and regions. There is little compelling evidence that measurement error explains the productivity slowdown.4 Cyclical factors have played some role. Weak investment spending has curtailed the growth in the capital stock. This means that today's workers have not benefited from the same improvement in the quality and quantity of capital as they did in previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. Most prominently, the gains from the IT revolution have leveled off. Recent innovations have focused more on consumers than on businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. Human capital accumulation has also decelerated, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart 32). Educational achievement, as measured by standardized test scores in mathematics, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart 33).5 Given that test scores are extremely low in most countries with rapidly growing populations, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart 31Productivity Growth Has Slowed In Most Major Economies Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 32The Contribution To Growth From Rising Human Capital Is Falling Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 33Math Skills Around The World Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Productivity And Inflation The slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on (Chart 34). Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Chart 34A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation.6 One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a decade during which productivity growth slowed and inflation accelerated. Financial Markets Overall Strategy Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors with a 12-month horizon should stay overweight global equities and high-yield credit at the expense of government bonds and cash. Global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months, followed by a gradual recovery that sees the restoration of full employment in most countries by 2021. At that point, inflation will take off, rising to over 4% by the middle of the decade. The 2020s will be remembered as a decade of intense pain for bond investors. In relative terms, equities will fare better than bonds, but in absolute terms they will struggle to generate a positive real return. As in the 1970s, gold will be the standout winner. Chart 35 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 35Market Outlook For Major Asset Classes Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Equities Cyclically Favor The Euro Area And Japan Over The U.S. Stronger global growth is powering an acceleration in corporate earnings. Global EPS is expected to expand by 12% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 36 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. We prefer euro area and Japanese stocks relative to U.S. equities over a 12-month horizon. We would only buy Japanese stocks on a currency-hedged basis, as the prospect of a weaker yen is the main reason for being overweight Japan. In contrast, we would still buy euro area equities on a U.S. dollar basis, even though our central forecast is for the euro to weaken against the dollar over the next 12 months. Our cyclically bullish view on euro area equities reflects several considerations. For starters, they are cheap. Euro area stocks currently trade at a Shiller PE ratio of only 17, compared with 29 for the U.S. (Chart 37). Some of this valuation gap can be explained by different sector weights across the two regions. However, even if one controls for this factor, as well as the fact that euro area stocks have historically traded at a discount to the U.S., the euro area still comes out as being roughly one standard deviation cheap compared with the U.S. (Chart 38). Chart 36Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Chart 37Euro Area Stocks Are A Bargain... Euro Area Stocks Are A Bargain... Euro Area Stocks Are A Bargain... Chart 38...No Matter How You Look At It ...No Matter How You Look At It ...No Matter How You Look At It European Banks Are In A Cyclical Sweet Spot Of course, if euro area banks flounder over the next 12 months as they have for much of the past decade, none of this will matter. However, we think that the region's banks have finally turned the corner. The ECB is slowly unwinding its emergency measures and core European bond yields have risen since last summer. This has led to a steeper yield curve, helping to flatter net interest margins. Chart 39 shows that the relative performance of European banks is almost perfectly correlated with the level of German bund yields. Our European Corporate Health Monitor remains in improving territory, in contrast to the U.S., where it has been deteriorating since 2013 (Chart 40). Profit margins in Europe have room to expand, whereas in the U.S. they have already maxed out. The capital positions of European banks have also improved greatly since the euro crisis. Not all banks are out of the woods, but with nonperforming loans trending lower, the need for costly equity dilution has dissipated (Chart 41). Meanwhile, euro area credit growth is accelerating and loan demand continues to expand. Chart 39Performance Of European Banks And Bond Yields: A Good Fit Performance Of European Banks And Bond Yields: A Good Fit Performance Of European Banks And Bond Yields: A Good Fit Chart 40Corporations Healthier In The Euro Area Corporations Healthier In The Euro Area Corporations Healthier In The Euro Area Chart 41Cyclical Background Positive For Bank Stocks Cyclical Background Positive For Bank Stocks Cyclical Background Positive For Bank Stocks Beyond a 12-month horizon, the outlook for euro area banks and the broader stock market look less enticing. The region will suffer along with the rest of the world in 2019. The eventual triumph of populist governments could even lead to the dissolution of the common currency. This means that euro area stocks should be rented, not owned. The same goes for U.K. equities. EM: Uphill Climb Emerging market equities tend to perform well when global growth is strong. Thus, it would not be surprising if EM equities continue to march higher over the next 12 months. However, the structural problems plaguing emerging markets that we discussed earlier in this report will continue to cast a pall over the sector. Our EM strategists favor China, Taiwan, Korea, India, Thailand, Poland, Hungary, the Czech Republic, and Russia. They are neutral on Singapore, the Philippines, Hong Kong, Chile, Mexico, Colombia, and South Africa; and are underweight Indonesia, Malaysia, Brazil, Peru, and Turkey. Fixed Income Global Bond Yields To Rise Further We put out a note on July 5th entitled "The End Of The 35-Year Bond Bull Market" recommending that clients go structurally underweight safe-haven government bonds.7 As luck would have it, we penned this report on the very same day that the 10-year Treasury yield hit a record closing low of 1.37%. We continue to think that asset allocators should maintain an underweight position in global bonds over the next 12 months. In relative terms, we favor Japan over the U.S. and have a neutral recommendation on the euro area and the U.K. Chart 42The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months Underweight The U.S. For Now We expect the U.S. 10-year Treasury yield to rise to around 3.2% over the next 12 months. The Fed is likely to raise rates by a further 100 basis points over this period, about 50 bps more than the 12-month discounter is currently pricing in (Chart 42). In addition, the Fed will announce later this year or in early 2018 that it will allow the assets on its balance sheet to run off as they mature. This could push up the term premium, giving long Treasury yields a further boost. Thus, for now, investors should underweight Treasurys on a currency-hedged basis within a fixed-income portfolio. The cyclical peak for both Treasury yields and the dollar should occur in mid-2018. Slowing growth in the second half of that year and a recession in 2019 will push the 10-year Treasury yield back towards 2%. After that, bond yields will grind higher again, with the pace accelerating in the early 2020s as the stagflationary forces described above gather steam. Neutral On Europe, Overweight Japan Yields in the euro area will follow the general contours of the U.S., but with several important qualifications. The ECB is likely to roll back some of its emergency measures over the next 12 months, including suspending the Targeted Longer-Term Refinancing Operations, or TLTROs. It could also raise the deposit rate slightly, which is currently stuck in negative territory. However, in contrast to the Fed, the ECB is unlikely to hike its key policy rate, the repo rate. And while the ECB will "taper" asset purchases, it will not take any steps to shrink the size of its balance sheet. As such, fixed-income investors should maintain a benchmark allocation to euro area bonds. Chart 43A Bit More Juice Left A Bit More Juice Left A Bit More Juice Left A benchmark weighting to gilts is also warranted. With the Brexit negotiations hanging in the air, it is doubtful that the Bank of England would want to hike rates anytime soon. On the flipside, rising inflation - though largely a function of a weak currency - will make it difficult for the BoE to increase asset purchases or take other steps to ease monetary policy. We would recommend a currency-hedged overweight position in JGBs. The Bank of Japan is committed to keeping the 10-year yield pinned to zero. Given that neither actual inflation nor inflation expectations are anywhere close to that level, it is highly unlikely that the BoJ will jettison its yield-targeting regime anytime soon. With government bond yields elsewhere likely to grind higher, this makes JGBs the winner by default. High-Yield Credit: Still A Bit Of Juice Left The fact that the world's most attractive government bond market by our rankings - Japan - is offering a yield of zero speaks volumes. As long as global growth stays strong and corporate default risk remains subdued, investors will maintain their love affair with high-yield credit. Thus, while credit spreads have fallen dramatically, they could still fall further (Chart 43). Only when corporate stress begins to boil over in late 2018 will things change. Nevertheless, investors will continue to face headwinds from rising risk-free yields in most economies even in the near term. This implies that the return from junk bonds in absolute terms will fall short of what is delivered by equities over the next 12 months. Currencies And Commodities Chart 44Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Will Support The Greenback We expect the real trade-weighted dollar to appreciate by about 10% over the next 12 months. Historically, changes in real interest rate differentials have been the dominant driver of currency movements in developed economies. The past few years have been no different. Chart 44 shows that the ascent of the trade-weighted dollar since mid-2014 has been almost perfectly matched by an increase in U.S. real rates relative to those abroad. Interest rate differentials between the U.S. and its trading partners are likely to widen further through to the middle of 2018 as the Fed raises rates more quickly than current market expectations imply, while other central banks continue to stand pat. Accordingly, we would fade the recent dollar weakness. As we discussed in "The Fed's Unhike," the March FOMC statement was not as dovish as it might have appeared at first glance.8 Given that monetary conditions eased in the aftermath of the Fed meeting - exactly the opposite of what the Fed was trying to achieve - it is likely that the FOMC's rhetoric will turn more hawkish in the coming weeks. The Yen Has The Most Downside, The Pound The Least Among the major dollar crosses, we see the most downside for the yen over the next 12 months. The Bank of Japan will continue to keep JGB yields anchored at zero. As yields elsewhere rise, investors will shift their money out of Japan, causing the yen to weaken. Only once the global economy begins to teeter into recession late next year will the yen - traditionally, a "risk off" currency - begin to rebound. The euro will also weaken against the dollar over the next 12 months, although not as much as the yen. The ECB's "months to hike" has plummeted from nearly 60 last summer to 26 today (Chart 45). That seems too extreme. Core inflation in the euro area is well below U.S. levels, even if one adjusts for measurement differences between the two regions (Chart 46). The neutral rate is also lower in the euro area, as discussed previously. This sharply limits the ability of the ECB to raise rates. Chart 45Market's Hawkish View Of The ECB Is Too Extreme Market's Hawkish View Of The ECB Is Too Extreme Market's Hawkish View Of The ECB Is Too Extreme Chart 46Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Unlike most currencies, sterling should be able to hold its ground against the dollar over the next 12 months. The pound is very cheap by most metrics (Chart 47). The prospect of contentious negotiations over Brexit with the EU is already in the price. What may not be in the price is the possibility that the U.K. will move quickly to reach a deal with the EU. If such a deal fails to live up to the promises made by the Brexit campaign - a near certainty in our view - a new referendum may need to be scheduled. A new vote could yield a much different result than the first one. If the market begins to sniff out such an outcome, the pound could strengthen well before the dust settles. EM And Commodity Currencies The RMB will weaken modestly against the dollar over the coming year. As we have discussed in the past, China's high saving rate will keep the pressure on the government to try to export excess production abroad by running a large current account surplus. This requires a weak currency.9 Nevertheless, a major devaluation of the RMB is not in the cards. Much of the capital flight that China has experienced recently has been driven by an unwinding of the hot money flows that entered the country over the preceding years. Despite all the talk about a credit bubble, Chinese external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 48). At this point, most of the hot money has fled the country. This suggests that the pace of capital outflows will subside. Chart 47Pound: Cheap By All Accounts Pound: Cheap By All Accounts Pound: Cheap By All Accounts Chart 48Hot Money In, Hot Money Out Hot Money In, Hot Money Out Hot Money In, Hot Money Out A somewhat weaker RMB could dampen demand for base and bulk metals. A slowdown in Chinese construction activity next year could also put added pressure on metals prices. Our EM strategists are especially bearish on the South African rand, Brazilian real, Colombian peso, Turkish lira, Malaysian ringgit, and Indonesian rupiah. Crude should outperform metals over the next 12 months. This will benefit the Canadian dollar and other oil-sensitive currencies. However, Canada's housing bubble is getting out of hand and could boil over if domestic borrowing costs climb in line with rising long-term global bond yields. A sagging property sector will limit the ability of the Bank of Canada to raise short-term rates. On balance, we see modest downside for the CAD/USD over the coming year. The Aussie dollar will suffer even more, given the country's own housing excesses and its export sector's high sensitivity to metal prices. Finally, a few words on the most of ancient of all currencies: gold. We do not expect bullion to fare well over the next 12 months. A stronger dollar and rising bond yields are both bad news for the yellow metal. However, once central banks start slashing rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?" dated January 25, 2017, and Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 3 Ulrike Malmendier, Stefan Nagel, and Zhen Yan, "The Making Of Hawks And Doves: Inflation Experiences On The FOMC," NBER Working Paper No. 23228 (March 2017). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education And Growth In The 21st Century," dated February 24, 2011, available at bca.bcaresearch.com. 6 Note to economists: We can think of this relationship within the context of the Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. In the standard setup where the saving rate is fixed, slower population and productivity growth will always result in a lower equilibrium real interest rate. However, consider a more realistic setup where: 1) the saving rate rises initially as the population ages, but then begins to decline as a larger share of the workforce enters retirement; and 2) habit persistence affects consumer spending, so that households react to slower real wage growth by saving less rather than cutting back on consumption. In that sort of environment, the neutral rate could initially fall, but then begin to rise. If the central bank reacts slowly to changes in the neutral rate, or monetary policy is otherwise constrained by the zero bound on interest rates and/or political considerations, the initial effect of slower trend GDP growth will be deflationary while the longer-term outcome will be inflationary. 7 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "The Fed's Unhike," dated March 16, 2017, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Renewed deflationary pressures indicate that the Hong Kong dollar may have once again become expensive. The currency peg will stay and domestic prices will adjust as a release valve. Developing deflationary pressures and slowing rent growth may reinforce one other. Rising risk free interest rate calls for higher rental yield, which can only be achieved via lower home prices. Remain short HK government bonds relative to US Treasurys; Remain short HK property investors relative to benchmark. More evidence that China's profit cycle is in an upturn. Feature The election of Hong Kong's Chief Executive this past weekend garnered little coverage among the global mainstream media. Carrie Lam easily beat her competitors, purportedly with blessings from Beijing. However, she will face an uphill battle to reunite the citizens of Hong Kong, who have become increasingly divided in recent years. As a regional financial hub heavily exposed to global forces, local politics barely matter for Hong Kong's economy and financial markets. Nonetheless, the significance of politics has clearly been on an upward trajectory in recent years, which could impact investors' long-term risk perceptions for a market that has historically been largely viewed as an "apolitical" Laissez Faire system. On the economic front, also largely ignored has been Hong Kong's inflation statistics released early last week, which showed that headline consumer price inflation dropped by 0.1% in February, the first negative reading since August 2009. While one single data point certainly does not denote a trend, odds are high that deflationary forces are re-emerging in Hong Kong, with important implications for asset prices, particularly for the currency and local real estate market. Budding Deflation... Chart 1Deflation Is Coming Back Deflation Is Coming Back Deflation Is Coming Back The negative February CPI reading was largely attributed to some poverty relief factors, declining vegetable prices and the base effect due to the Chinese New Year holiday. However, headline CPI has been decelerating since the peak of 2011 (Chart 1). Indeed, after briefly dipping below zero at the height of the global financial crisis and then roaring back in the aftermath on improving growth, consumer prices in Hong Kong have been in a prolonged period of disinflation. In fact, February's negative CPI figure is just a continuation of a well-established trend rather than an anomaly caused by one-off factors. Moreover, falling inflation and developing deflation is rather broad-based. It is true that the nosedive in fresh food prices has clearly played a role in dragging down headline CPI. However, price inflation has been trending lower in almost all major components of the consumption basket such as housing, eating out and other miscellaneous services (Chart 1, bottom panel). Meanwhile, consumer durable goods inflation has been stuck in negative territory for more than 10 years. Interestingly, amid strengthening global growth momentum, most major economies have been experiencing bouts of reflation, particularly in sectors associated with commodities prices - intensifying disinflationary/deflationary pressures in Hong Kong are a notable exception. It means that inflation dynamics in Hong Kong are likely rooted in unique domestic factors. ...Indicates An Expensive Hong Kong Dollar In our view, a key factor behind Hong Kong's budding deflationary pressure is the exchange rate. As the Hong Kong dollar is pegged to the U.S. dollar, the relative shift in price levels between Hong Kong and the rest of the world cannot be adjusted through a change in the nominal exchange rate. Therefore, the adjustment must be achieved in real terms through price changes. Chart 2 shows that prior to 1983 when the currency board system was established, Hong Kong inflation largely followed that in the U.S., while the exchange rate fluctuated against the dollar. Since the 1983 currency peg, Hong Kong inflation has been swinging around the U.S. level, with the economy alternating between inflationary booms and deflationary busts. A new factor that has also become increasingly important in Hong Kong's inflation dynamics is China's price levels, which also relates to the exchange rate. Chart 3 shows Hong Kong headline inflation has outpaced Chinese inflation since 2013, and the RMB's depreciation against the Hong Kong dollar in recent years has put further downward pressure on local Hong Kong price levels. Chart 2Exchange Rate And Inflation Tango Exchange Rate And Inflation Tango Exchange Rate And Inflation Tango Chart 3Hong Kong Inflation: The China Factor Hong Kong Inflation: The China Factor Hong Kong Inflation: The China Factor In short, renewed deflationary pressures indicate that the Hong Kong dollar may have once again become expensive, and therefore domestic price levels have begun to adjust as the release valve. It remains to be seen how long the adjustment process will last. From investors' point of view, a few observations are in order: There is little risk that the Hong Kong dollar peg will break, unless it is a voluntary policy choice by the authorities. Hong Kong's solid banking sector is not prone to financial crises, and its massive fiscal and foreign exchange reserves give the government plenty of fire powder to defend the exchange rate in the event of a speculative attack, let alone the mighty official reserves held in mainland China (Chart 4). We remain convinced that Hong Kong's ultra-low interest rates compared with the U.S. are unjustified and unsustainable (Chart 5). Hong Kong 10-year government bond yields are still 84 basis points lower than their U.S. counterparts, which probably reflects upward pressure on the Hong Kong dollar to appreciate against the U.S. dollar, partially driven by Chinese capital outflows. In this vein, budding deflationary pressures in Hong Kong further diminish the odds of an upward move of the HKD against the U.S. dollar. Remain short Hong Kong government bonds against U.S. Treasurys with comparable durations. Historically Hong Kong's flexible and largely Laissez Faire system has been able to stomach drastic swings in domestic price levels induced by the currency peg. The rising grassroots anti-establishment movement in recent years suggests the side effects of the Hong Kong system may have become increasingly unpopular. It will be interesting to see if any deflationary growth downturn in Hong Kong triggers a populist backlash that leads to a change in Hong Kong's exchange rate scheme. Chart 4Ample Resources To Defend HKD Peg Ample Resources To Defend HKD Peg Ample Resources To Defend HKD Peg Chart 5HK Rates Should Move Higher HK Rates Should Move Higher HK Rates Should Move Higher Real Estate: Sky's The Limit? Another key reason behind Hong Kong's falling CPI inflation is rent, which has also turned sharply lower in recent months (Chart 1, bottom panel). This is in stark contrast to home prices, which have continued to rally strongly. After a temporary pullback last year, Hong Kong real estate prices have roared back to new record highs. Looking forward, the outlook for Hong Kong's real estate sector looks decisively bearish. First, Hong Kong's real estate market has become increasingly detached from economic fundamentals. Home prices have dramatically outpaced household income, in greater proportion than the previous housing bubble peak in the late 1990s (Chart 6). Therefore, it is not surprising that both transactions and construction activity have declined substantially to near-record lows. Thinning transaction activity suggests that ordinary local households may have been priced out, underscoring frothy market conditions. The saving grace is that the dramatic increase in prices has not led to euphoria in housing demand and transactions, which should limit financial sector risk should home prices decline. Second, developing deflationary pressures and slowing rent growth may reinforce one other, potentially creating a downward spiral. Meanwhile, risk-free interest rates, driven by Federal Reserve policy, will likely edge higher. This is an especially poor combination for Hong Kong real estate investors. Historically, higher risk-free yields should lead to higher rental yields (Chart 7). With falling rents, the only way for rental yields to go up is via lower prices. Chart 6Housing Market: Soaring Prices, Falling Volume Housing Market: Soaring Prices, Falling Volume Housing Market: Soaring Prices, Falling Volume Chart 7Rental Yield Will Be Pushed Higher Rental Yield Will Be Pushed Higher Rental Yield Will Be Pushed Higher From a big-picture vantage point, Hong Kong deflation and Fed tightening will lead to much higher real interest rates in Hong Kong, which amounts to significant tightening in monetary conditions. This will create further headwinds for both the Hong Kong domestic economy and property prices. The bottom line is that the risk in Hong Kong home prices is tilted to the downside. The market may have been boosted by an influx of capital from the mainland, which may sustain the bubble for a while longer. However, investors should not chase the market. Chart 8The Widening Valuation Gap The Widening Valuation Gap The Widening Valuation Gap Budding deflationary pressures also bode poorly for profits and equity prices. However, Hong Kong stocks are more heavily exposed to China and the global cycle than local business conditions, and therefore should not be impacted materially. Moreover, Hong Kong stock multiples historically have tracked their U.S. counterparts closely - the valuation gap has widened sharply since 2013 (Chart 8). This should further limit the downside in Hong Kong stocks. Meanwhile, we expect property owners such as REITs to underperform the broader market. A Word On Chinese Profits The latest numbers show Chinese industrial profits jumped by over 30% in the first two months of the year compared with a year ago, a sharp acceleration from recent months, as predicted by our model (Chart 9). The strong profit recovery has important implications. For equity earnings, the upturn in the profit cycle is also confirmed by bottom-up analysts. Net earnings revisions have been lifted, which has historically led to acceleration in forward earnings growth (Chart 10). Remain positive on Chinese H shares. From a macro perspective, rising earnings should lead to stronger investment, especially in the manufacturing and mining sectors. This should further boost domestic demand and prolong the ongoing mini cycle upturn. The profit recovery also helps alleviate financial stress in the banking system, as it will reduce the pace of accumulation of non-performing loans (NPL). Importantly, profits are rising particularly strongly in some of the hardest hit sectors in previous years, such as steelmakers and coal miners, which were precisely where the increase in NPLs were the most rampant. We will follow up on this issue in upcoming reports. Chart 9China's Profit Cycle Upturn China's Profit Cycle Upturn China's Profit Cycle Upturn Chart 10Chinese Equity Earnings Will Accelerate Chinese Equity Earnings Will Accelerate Chinese Equity Earnings Will Accelerate Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights EM equity valuations are neutral. Relative to the U.S., EM share prices do offer some value, but this primarily reflects elevated valuations within the S&P 500. According to the cyclically-adjusted P/E ratio, EM stocks are cheap for investors with a long-term time horizon - longer than two to three years. Corporate profits are much more important than equity valuations in driving share prices in the next 12 months. Our outlook for EM EPS is downbeat for the next 12 months. Maintain a defensive posture and an underweight allocation in EM stocks versus DM. A new trade: go long Russian energy stocks / short global energy ones. Feature Chart I-1EM P/E Ratio And EPS EM P/E Ratio And EPS EM P/E Ratio And EPS There is ongoing debate in the investment community concerning whether emerging markets (EM) equities are or are not cheap, in both absolute terms and relative to developed markets (DM). In this week's report we review various equity valuation indicators and reiterate that EM stocks are neither cheap nor expensive in absolute terms. For example, the average of trailing and forward P/E ratios is slightly above its historical mean (Chart I-1, top panel). Relative to the U.S., EM share prices do offer value, but this reflects elevated valuations within the S&P 500. Despite this, we recommend underweighting EM vs U.S./DM because the cyclical growth dynamics is much better in DM than EM. EM stocks are cheap if one assumes a strong earnings recovery (Chart I-1, bottom panel). If earnings per share (EPS) begin contracting anew, as we expect, then the current rally will be reversed sooner than later. Overall, we continue to recommend a defensive posture for absolute-return investors and maintaining an underweight allocation in EM stocks versus DM for asset allocators. Valuation Perspectives Below we consider several valuation ratios: The equal-sector weighted trailing P/E ratio is 17.7 for EM (Chart I-2). Table I-1 displays equal-sector weighted P/E ratio, price-to-book value ratio and dividend yields for major equity markets globally. This is an apples-to-apples comparison, as it assigns equal weights to each of the 10 MSCI sectors - i.e., it removes sector biases. Chart I-2Equal-Sector Weighted Trailing P/E Ratio Equal-Sector Weighted Trailing P/E Ratio Equal-Sector Weighted Trailing P/E Ratio Table I-1Equal-Sector Weighted Valuation Ratios Across EM And DM EM Equity Valuations Revisited EM Equity Valuations Revisited Hence, on a comparable basis, EM equities are only slightly cheaper than DM stocks as is evident in Table I-1. Besides, the composite valuation indicator based on equal-sector weighted trailing and forward P/E, price-to-book value, price-to-cash earnings ratios and dividend yield indicate that EM stocks are fairly valued (Chart I-3). The cyclically-adjusted P/E (CAPE) ratio. The CAPE ratio is a structural valuation measure, i.e. it matters in the long run. Importantly, it assumes that real (inflation-adjusted) EPS will revert to its historical mean or trend. In short, the CAPE ratio tells us what the P/E ratio would be if EPS were to revert to its historical trend. Chart I-4 illustrates the EM CAPE ratio. If EM EPS in inflation-adjusted U.S. dollar terms reaches its historical time trend, one can safely assume that EM stocks are cheap and currently worth buying. In a nutshell, the current CAPE ratio of 15 assumes that EM EPS should rise by about 30% in nominal U.S. dollar terms over an investor's time horizon. Chart I-3EM Equities Valuations Are Neutral bca.ems_wr_2017_03_29_s1_c3 bca.ems_wr_2017_03_29_s1_c3 Chart I-4EM CAPE Ratio EM CAPE Ratio EM CAPE Ratio Given that our time horizon is 12 months, the assumption that EM EPS will surge by about 30% in U.S. dollar terms is in our view ambitious. Therefore, we posit that EM share prices do not offer compelling value at all in the next 12 months. If one's investment horizon were two-to-three years or longer, the assumption that EPS will rise by 30% or more in U.S. dollar terms is much more plausible. In this sense we would concur that EM share prices offer decent value from a longer-term perspective. Our methodology of calculating the CAPE ratio for EM varies from the well-known Robert Shiller's CAPE ratio for the U.S.1 However, even when applying our CAPE methodology to U.S. equities, the resulting ratio is not very different from Shiller's CAPE (Chart I-5). Trimmed-mean equity valuation ratios. Chart 6 illustrates 20% trimmed-mean trailing and forward P/E, price-to-book value, price-to-cash earnings ratios and dividend yields for the EM equity universe. A 20% trimmed-mean ratio excludes the top 10% and bottom 10% of industry groups, and then calculates the average. All calculations are based on 50 EM industry group data available from MSCI. Why look at trimmed-mean valuation ratios? Because by removing the top and bottom 10% of industry groups, this measure excludes outliers and provides a better perspective on valuation. A few observations are in order: First, according to the trimmed-mean valuation ratios, EM equities are not cheap. The trimmed-mean ratios are close to their historical mean (Chart I-6). Second, the trimmed-mean ratios are well above their market cap ones. This indicates that there are a few industry groups with large market caps that pull EM multiples lower. In other words, market-cap weighted multiples are skewed to the downside by a few large industry groups. There are reasons why some sectors and countries have low or high equity multiples. It makes sense to exclude them. Finally, the composite valuation indicator based on trimmed-mean trailing and forward P/Es, PBV and price-to-cash earnings ratios and dividend yield demonstrates that EM equity valuations are neutral (Chart I-7). Chart I-5U.S. CAPE Ratios U.S. CAPE Ratios U.S. CAPE Ratios Chart I-6EM Stocks Are Close to Fair Value EM Stocks Are Close to Fair Value EM Stocks Are Close to Fair Value Chart I-7EM Equities Have Neutral Value bca.ems_wr_2017_03_29_s1_c7 bca.ems_wr_2017_03_29_s1_c7 Bottom Line: EM equities by and large command a neutral valuation. According to the CAPE ratio, EM equities are cheap for investors with a long-term time horizon, say two-to-three years or longer. Profits Hold The Key Valuations are not a good timing tool. For low equity valuations to be realized, i.e., to produce solid price gains, corporate profits should grow. The reverse is also true: for an overvalued market to decline, company earnings should contract, or at least disappoint. When valuations are neutral - as they currently are for the EM equity benchmark - a recovery in EPS should entail higher share prices, while EPS shrinkage should lead to a selloff. EM EPS will continue to recover in the next three to six months, given the rally in commodities prices in 2016, amelioration in China's business cycle and the technology sector boom in Asia. However, this moderate and short-lived EPS recovery is already priced in. For the market to rally further, EPS will need to expand beyond the next three to six months. Remarkably, there has been little improvement in EM ex-China domestic demand. Besides, the risk to bank loan growth remains to the downside both in China and EM ex-China. Slower loan growth and the need to recognize and provision for potentially large NPLs will pressure banks' profits in many EM countries. Finally, we expect oil and industrial metals prices to decline considerably over the course of this year. If and as this view plays out, energy and materials stocks will fall. Energy and materials share prices correlate not with their past or current profits but rather with underlying commodities prices. One area where we remain bullish is the technology sector. Even though tech share prices are overbought and could correct in absolute terms in the months ahead, they will continue to outperform the benchmark. Bottom Line: Corporate profits are much more important in driving share prices in the next 12 months than equity valuations. Our outlook for EM EPS is downbeat for the next 12 months or so, even though EPS will continue to recover in the next three to six months. Timing Reversal: Watch Credit Quality Spreads Chart I-8Credit Quality Spreads: ##br##A Correction Or Reversal? Credit Quality Spreads: A Correction Or Reversal? Credit Quality Spreads: A Correction Or Reversal? Following are some of the indicators we are monitoring to gauge a reversal in EM share prices. EM corporate spreads have widened a notch relative to EM sovereign spreads (Chart I-8, top panel). Similarly, Chinese off-shore corporate spreads have widened versus Chinese sovereign spreads (Chart I-8, middle panel). Credit quality spreads - the gap between B- and BAA-grade corporate bonds - have widened slightly in the U.S. (Chart I-8, bottom panel). These moves are still very small, and do not constitute a definite sign of a major trend reversal. Nevertheless, such widening in credit quality spreads is an important development. If they persist, they will certainly sound the alarm for the reflation trade. Interestingly, this is the first time a simultaneous widening in credit quality spreads has occurred since the risk assets rally began in early 2016. Bottom Line: Major equity market selloffs will occur when lower quality credit begins to persistently underperform better quality credit. There have been budding signs of quality spread widening that are worth being monitored. Identifying Relative Value Within the EM equity universe, valuation ratios differ greatly. For example, banks trade at a trailing P/E of 9.7, while consumer staple stocks trade at 24.8. Table I-2 portrays the trailing P/E ratio and its historical mean as well as 12-month forward EPS growth and the forward P/E ratio for each sector - as well as average of trailing and forward P/E ratios. Table I-3 shows the same valuation measures but for EM countries. Table I-2Stock Valuation Snapshot: EM Sectors EM Equity Valuations Revisited EM Equity Valuations Revisited Table I-3Equity Valuation Snapshot: EM Countries EM Equity Valuations Revisited EM Equity Valuations Revisited It is difficult to draw any definitive conclusions from these tables. On a general level, a simplistic approach to investing based on trailing and forward P/E ratios would not have produced great outcomes in EM in recent years. When analyzing EM stock valuations, we prefer to use the trailing rather than forward P/E ratio because historically, EM forward EPS have had a very poor record forecasting actual EPS. One of our favorite ways to identify relative value is to compare the PBV ratio and return on equity (RoE) across countries/sectors. Chart I-9 plots RoE on the X-axis and the PBV ratio on the Y axis. Countries and sectors located in the bottom right corner (at the low end of the shaded area) have a low PBV ratio compared to their RoE. In contrast, in the north-west side of the distribution (at the upper end of the shaded zone), these have an elevated PBV ratio, taking into account their RoE. Chart I-9Searching For Relative Value EM Equity Valuations Revisited EM Equity Valuations Revisited Among countries, Korea, Russia, Hungary, the Czech Republic and China appear cheap, while Mexico, Brazil, South Africa, Colombia, Malaysia and Poland are on the expensive side. Chart I-10EMS's Recommended ##br##Equity Portfolio Performance EMS's Recommended Equity Portfolio Performance EMS's Recommended Equity Portfolio Performance Concerning equity sectors, utilities and financials/banks are cheap, yet consumer staples and consumer discretionary, health care, telecom and materials appear expensive in relative terms. Our recommended country equity allocation is based on a qualitative assessment of many variables including but not limited to valuation. Chart I-10 displays the performance of our fully invested EM Equity Portfolio Model versus the EM benchmark. Our overweights presently include: Korea, Taiwan, India, China, Thailand, Russia and central Europe. Our underweights are Brazil, Turkey, Indonesia, Malaysia and Peru. We are neutral on Mexico, Chile, Colombia, South Africa and the Philippines. The lists of our country allocation and other equity investment recommendations are presented each week at the end of our reports. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Bet On Russia's Non-Compliance With OPEC Odds of Russia's compliance with the OPEC agreement to cut oil output by 300k b/d in the next two months are low. This poses downside risk to oil prices. Russia has so far done only 120k b/d cuts. Hence, in the next two months it should reduce its output by 180k b/d which amounts to 1.6% of the nation's oil output. One way to bet on Russia's non-compliance, regardless the direction of oil prices, is to go long Russian energy stocks / short global energy ones (Chart II-1). There are a number of political, economic and financial motives why Russia might care less about lower oil prices than Saudi Arabia in the next 12-18 months or so. As a result, Russia might not cut as much as it is expected by the OPEC agreement. Russia is able to increase oil production due to a cheaper ruble and technology advances. BCA's Energy Sector Strategy team has been highlighting that there have been concerted efforts by Russia's largest producers to employ horizontal drilling and multi-zone hydraulic fracturing in Western Siberia.2 These have stemmed declines from those aging fields and allowed production to rise (Chart II-2). Chart II-1Long Russia Energy / ##br##Short Global Energy Stocks Long Russia Energy / Short Global Energy Stocks Long Russia Energy / Short Global Energy Stocks Chart II-2Russian Oil ##br##Production Will Increase Russian Oil Production Will Increase Russian Oil Production Will Increase Russia will not shy away from being opportunistic and increase its market share when it can ramp up oil production. A rising global oil market share will allow Russian companies to outperform their global peers regardless the direction of oil prices. There are major cyclical divergences between Russian and Saudi economies. Russia's economy is gradually picking up while there is less certainty about Saudi's growth recovery. The reason is that Russia has allowed the ruble to depreciate and act as a shock absorber. Meanwhile, Sa­­­­udis have stuck to the currency peg. ­­­Oil prices are down by 27% from their top in rubles and 55% in Saudi riyals (Chart II-3). This has reflated Russia's fiscal revenues and the economy, while Saudi Arabia is still struggling with the consequences of low ­oil prices. On the fiscal front, Russia went through a notable fiscal squeeze and its budget deficit is projected to be 3.2% of GDP in 2017 (Chart II-4). In contrast, the Saudi Arabian fiscal deficit in 2016 reached an outstanding 17% of GDP, accounting for the drawdown in reserves by our estimates.3 Chart II-3Ruble's Depreciation ##br##In 2014-15 Made a Difference Ruble's Depreciation In 2014-15 Made a Difference Ruble's Depreciation In 2014-15 Made a Difference Chart II-4Fiscal Deficit: Small In ##br##Russia & Large In Saudi Fiscal Deficit: Small In Russia & Large In Saudi Fiscal Deficit: Small In Russia & Large In Saudi More importantly, Russia's federal budget for 2017 was constructed on the oil price assumption of $40/bbl. The 2017 Saudi budget assumes oil price of $50/bbl.4 Therefore, Russia would not mind if oil prices drop toward or slightly below $40 in the second half of this year. Therefore, Saudis care much more about sustaining oil prices at a higher level than Russians do. Finally, Rosneft has already conducted its IPO while Aramco's IPO has not taken place yet. As such, the need for higher oil prices is much greater in Saudi Arabia - to justify a higher value of their oil giant - than in Russia. Bottom Line: Odds are considerable that Russia will not comply with the OPEC deal and this could cause oil prices to selloff more. Regardless of direction of oil prices, we expect the Russian energy sector to outperform their global peers due to Russia's rising market share in the global oil market. Go long Russian energy stocks / short global ones. Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 For more detailed discussion on our methodology of CAPE, please refer to January 20, 2016 Emerging Markets Strategy Special Report titled "EM Equity Valuations: A CAPE Model", available at ems. bcaresearch.com 2 Please refer to the Energy Sector Strategy Weekly Report titled, "Russian Oil Production: Surpassing Expectation", dated December 14, 2016, available at nrg.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Special Report titled, "Saudi Arabia: Short-Term Gain, Long-Term Pain", dated February 1, 2017, available at ems.bcaresearch.com 4 https://mof.gov.sa/en/budget2017/Documents/The_National_Budget.pdf Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy Internal dynamics warn that a broad market consolidation phase has begun. The jump in growth vs. value stocks has provided an opportunity to shift to a neutral style bias. Transports have sold off sharply, but downside risks have not yet been fully expunged, especially for the airline group. Recent Changes Growth Vs. Value - Shift to a neutral stance. Table 1Sector Performance Returns (%) Heading For A Choppier Market Heading For A Choppier Market Feature The perceived dovish Fed shift and doubts about the achievability of Trump's policy goals are causing equity market consternation. To the extent that the run up in stocks has largely reflected an improvement in sentiment and other 'soft' economic data, the lack of follow through in 'hard' data has created a validation void. While a weaker U.S. dollar, lower oil prices and less hawkish Fed imply easier monetary conditions, which are ultimately positive for growth, profits and the stock market, a digestion phase still looms. Financials, and banks in particular, had been market leaders, driven up by hopes for a meaningful upward shift in the yield curve and unleashing of animal spirits. But these assumptions are being challenged and there is limited fundamental support. Indeed, bank lending growth remains non-existent and there is no tailwind from improving credit quality. Our view remains that banks carry the most downside risk of all financial groups (please see the March 6 Weekly Report for more details). Regional banks are now down on a year-to-date relative performance basis (Chart 1). In fact, our newly constructed gauge of the equity market's internal dynamics suggests that additional tactical broad market turbulence lies ahead. A composite of relative bank stock, relative transport, small/large cap and industrials/utilities share prices has been a good coincident to leading market indicator in recent years (Chart 2). While no indicator is infallible, the message is that overall market risk is elevated and a choppy period lies ahead, reinforcing our defensive vs. cyclical bias. Nevertheless, it will be important to put any corrective action into a longer-term context. Over the years, we have kept an eye on several qualitative 'unconventional indicators' that have helped time major market turning points. They are meant to augment rather than replace fundamental factors. Chart 1Market Leaders Are Stumbling Market Leaders Are Stumbling Market Leaders Are Stumbling Chart 2A Yellow Flag From Internal Dynamics A Yellow Flag From Internal Dynamics A Yellow Flag From Internal Dynamics Below we highlight five critical variables to gauge whether a correction will devolve into a sustained sell-off. Each of the indicators measures either; profits; business confidence; investor confidence; and/or reflects how liquidity conditions are impacting market dynamics. Investor confidence can be measured through margin debt. While extremely elevated (Chart 3), there is no concrete sign that access to funds is being undermined by the modest backup in interest rates. When the cost of borrowing becomes too onerous, it will manifest in reduced margin debt and forced selling, which will be a serious threat to stocks given that leverage is challenging levels experienced at prior peaks, as a share of nominal income. M&A activity is losing momentum (Chart 4). A peak in merger activity typically coincides with a rising cost of capital. If corporate sector capital availability becomes a pressing issue, then M&A activity will decline further, signaling that the corporate sector is facing growth headwinds. Economic signals are mostly positive. Durable goods orders have tentatively perked back up (Chart 5), reinforcing that profits and confidence have improved after a soft patch. Temporary employment continues to rise (Chart 5). When temp workers shrink, it is often an early warning sign that companies are entering retrenchment mode, given the ease and low cost of reducing this source of labor costs. If temporary employment falls at the same time as share prices, that would be a red flag. The relative performance of consumer discretionary to consumer staples can provide a read on purchasing power and/or the marginal propensity to spend. This share price ratio does not suggest any consumption concerns exist (Chart 4, bottom panel). If consumer staples begin to outperform, then it would warn of a more daunting economic outlook. Chart 3Borrowing Costs Are Not Yet Restrictive Borrowing Costs Are Not Yet Restrictive Borrowing Costs Are Not Yet Restrictive Chart 4M&A Is Starting To Labor M&A Is Starting To Labor M&A Is Starting To Labor Chart 5Economic Signals Are Decent Economic Signals Are Decent Economic Signals Are Decent In all, these indicators suggest that any pullback will be corrective rather than a trend change. If the profit cycle continues to improve and the Fed has no inflationary need to become restrictive, then any broad market correction could provide an opportunity to selectively add cyclical exposure to portfolios in the coming weeks. In the meantime, we are revisiting our growth vs. value view and providing an update on transports. Growth Vs. Value: Shifting To Neutral Our last style bias update in the December 19 Weekly Report concluded that we would likely recommend moving to a neutral stance over the coming weeks/months from our current growth vs. value (G/V) stance, but expected to do after growth stocks had staged a comeback. That recovery is now well underway and so we are revisiting the outlook. Growth indexes have outperformed value since the depths of the Great Recession. The preference for growth reflected central bank interest rate suppression, which boosted the multiple investors were willing to pay for perceived growth at a time when growth was scarce. In addition, the composition of the growth index is much longer duration than that of the value space. The surge in long-term earnings growth expectations suggests that investors have increased conviction in the durability of the expansion, which has aided the G/V recovery (Chart 6). That monetary experiment has recently begun to pay off, as global economic growth has finally demonstrated evidence of self-reinforcing traction, led by developed countries. As a result, most central banks are well past the point of maximum thrust, which would mean the loss, albeit not a reversal, of the primary support for the secular advance in growth vs. value indexes. Keep in mind that growth benchmarks have a massive technology sector weight, at just over 1/3 of the total index capitalization. Value indices carry only a 7% weight. As shown in previous research, the technology sector underperforms when economic growth is fast enough to create inflationary pressure and therefore, the interest rate structure. Furthermore, value benchmarks have more than 25% of their weight in the financials sector vs. less than 5% for growth indexes. The upshot is that a meaningful interest rate increase would pad the profits of financials-rich value indices while having little to no impact on growth benchmarks by virtue of their tech-dependence. It is no surprise that the G/V ratio trends with technology/financials relative sector performance (Chart 7). The latter has clearly peaked, with an assist from the renormalization in Fed policy. Chart 6Time To Shift Time To Shift Time To Shift Chart 7Two Key Sector Influences Two Key Sector Influences Two Key Sector Influences These sector discrepancies mean that a critical question for the style decision is what is the path for government bond yields? The U.S. economy is exhibiting signs of self-reinforcing behavior. The small business sector's hiring plans have surged, and the ISM employment index remains solid (Chart 8). Chart 8Economy No Longer Favors Growth Economy No Longer Favors Growth Economy No Longer Favors Growth Chart 9A Mixed Bag A Mixed Bag A Mixed Bag While at least a modest employment slowdown is probable given that the corporate sector is feeling the profit margin pinch from higher wage costs, these gauges do not suggest a major crunch is imminent. The personal savings rate is drifting lower, supporting consumption growth (Chart 8). Value indexes have a higher economic beta than growth benchmarks, owing to their exposure to shorter duration sectors. The gap between growth and value operating margins tends to close when the economy enjoys a meaningful acceleration (Chart 8). Chart 10Volatility Is A Style Driver Volatility Is A Style Driver Volatility Is A Style Driver Other markers of global economic growth are more mixed. The global manufacturing PMI survey is very strong, but oil and other commodity prices have started to diverge negatively (Chart 9). That may soon change if the U.S. dollar has crested, which would provide a much needed fillip to emerging markets and remove a source of deflationary pressure. Real global bond yields are grinding higher, suggesting that in all, economic prospects have improved, and alleviating a major constraint on value stocks. Against this backdrop, it is timely to shift to a neutral style preference after the sharp rebound in the G/V ratio since late last year. Why not a full shift into value indexes? Developing countries are conspicuously lagging developed countries, which caps the outlook for commodities and their beneficiaries. EM capital spending is still very weak in real terms. Deep cyclical sectors are much more heavily-weighted in value benchmarks. A global recovery that has a greater thrust from consumption than investment, at least at the outset, argues against expecting value stocks to outperform. Moreover, the fallout from potentially protectionist U.S. trade policies remains unknown, which could restrain economic growth momentum and unleash volatility in the equity markets. The latter has been incredibly muted in recent months. In fact, BCA's VIX model, which incorporates corporate sector health and interest rate expectations, is heralding a higher VIX. Clearly, elevated volatility has supported the G/V ratio over meaningful periods of time (Chart 10). Bottom Line: Shift to a neutral style bias. A full shift to a value preference would require BCA to forecast a much weaker U.S. dollar and/or demand-driven inflationary pressure. Transports: Stuck In Neutral The S&P transports index peaked in mid-December versus the broad market, the first major sub-group to fizzle after the post-election sugar high (Chart 11). The recent setback has been broad-based. We had been overweight both the rails and air freight & logistics industry sub-groups, but booked gains in both prior to their respective pullbacks. Is it time to get back in? Transportation equities are ultra-sensitive to swings in global economic growth. Chart 12 shows that the relative share price ratio is an excellent leading indicator of both the ISM manufacturing survey and Citi's economic surprise index. The message is that at least a mild mean reversion in both of these indexes looms in the coming months, i.e. beware of some form of economic cooling. Chart 11Transports Have Cracked... Transports Have Cracked... Transports Have Cracked... Chart 12... Signaling Economic Cooling Ahead ... Signaling Economic Cooling Ahead ... Signaling Economic Cooling Ahead Against this backdrop, we are revisiting our last remaining underweight, the S&P airlines index. While rails and air freight & logistics stocks are directly linked to global trade, the same does not hold true for the S&P airlines index. Business and consumer travel budgets are the key drivers of industry demand. A revival in animal spirits and a healthy U.S. consumer could be clear positives for air travel. Moreover, the recent pullback in fuel costs should cushion profit margins for unhedged airline operators (Chart 13). Finally, renowned investor Warren Buffett has recently become a major shareholder in the U.S. airline industry, raising its profile. While betting against Buffett is always fraught with risk, our cautious take on the airline industry boils down to our view that excess capacity will continue to hold back profitability. If the overall transport index is accurately signaling that some loss of economic momentum looms, then a rapid expansion in business and travel spending may not be quick to materialize. A pricing war has already gripped the industry, as airlines are scrambling to fill up planes. Revenue-per-available-seat-mile and U.S. CPI airfare are contracting (Chart 14), reflecting a fight for market share. That is a serious impediment to profit margins. Chart 13Airlines Are Losing Altitude... Airlines Are Losing Altitude... Airlines Are Losing Altitude... Chart 14... As Price Wars Persist ... As Price Wars Persist ... As Price Wars Persist The headwinds extend beyond the U.S. Chart 15 shows that global airfare deflation also bodes ill for top line industry growth. The lags from previous U.S. dollar strength could compound this source of drag. Absent a decisive recovery in total travel spending, there does not appear to be any catalysts to reverse deflationary conditions. Carriers are still allocating an historically high portion of cash flow to capital spending. While upgrading aging fleets to become more fuel-efficient in an era of low interest rates is a long-term positive, the payback period may be extended. Revenue has failed to keep up with the increase in capital expenditures (Chart 16, bottom panel), suggesting that capacity growth continues to outpace industry demand, a recipe for ongoing pricing pressure. Chart 15Deflation Is Global Deflation Is Global Deflation Is Global Chart 16Too Much Capacity Too Much Capacity Too Much Capacity This difficult backdrop has begun to infect analyst earnings estimates. Net earnings revisions have nosedived. Relative performance momentum is tightly lined with the trend in earnings estimates (Chart 16). The message is that the breakdown in cyclical momentum has further to run. Indeed, the 52-week rate of change rarely troughs until it reaches much lower levels, warning of additional downside relative performance risks. Bottom Line: The S&P transports group is heralding a period of economic cooling, but the airline sub-component has not yet fully discounted such an outcome. Stay underweight. The ticker symbols for the stocks in the S&P airlines index are: UAL, AAL, DAL, LUV & ALK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.