Bear/Bull Market

Highlights The best recession indicators are not flashing red, but volatility is rising as the end of the cycle approaches; U.S. fiscal policy is surprising to the upside, as we expected; The next recession will usher in an inflationary political paradigm shift, with wealth transferred from Baby Boomers to Millennials; Expect a new U.K. election ahead of March 2019, but do not expect a second referendum unless popular opinion swings decisively against Brexit; Stay short U.S. 10-year Treasuries versus German bunds; short Fed Funds Dec 2018 futures; and initiate a short GBP/USD trade. Feature February has been tough for global markets, with the S&P 500 falling by 5.9% since the beginning of the month. Several clients have pointed out that the market may be sniffing out a recession and that the "buy the dip" strategy is therefore no longer applicable. It is true that markets and recessions go together (Chart 1), but it is not clear from the data that the equity market alone predicts recessions correctly. Chart 1Bear Markets & Recessions: Unclear Which One Leads The Other BCA's House View is that a recession is likely at the end of 2019.1 This view is in no small part based on our political analysis.2 President Trump ran on a populist electoral platform and populist policymakers globally have a successful track record of delivering higher nominal GDP growth than their non-populist counterparts (Chart 2). We assume that the Powell Fed will respond to such higher growth and inflation prospects no differently from the Yellen Fed and that it will restrict monetary policy to an extent that will usher in a mild recession by the end of next year. Chart 2Populists Deliver (Nominal) GDP Growth Of course, predicting recessions is extraordinarily difficult. Being six months early or late would still be an achievement, but the implications for the equity market would likely be considerably different. If our "late 2019" call is actually an "early 2019" recession, then equity markets may indeed be at or near their cyclical peaks. A "buy on dips" strategy may work for the next quarter or so, but superior returns over the course of the year may be achieved with a bearish strategy. To help guide clients through the uncertainty, our colleague Doug Peta, chief strategist of BCA's Global ETF Strategy, has recently updated BCA's methodology for identifying the inflection points that usher in a recession.3 In our 70-year history as an investment research house, we have picked up two definitive truths: valuation and technical indicators cannot call a recession. So what can? We encourage clients to pick up a copy of Doug's analysis.4 The report highlights the three BCA Research recession indicators: the orientation of the yield curve, the year-over-year change in the leading economic indicator (LEI),5 and the monetary policy backdrop. Charts 3, 4, and 5 show how successful the three indicators are in calling recessions. In our 50-year sample period, the yield curve has successfully called all seven recessions with just one false positive. However, it tends to be overly eager, preceding the onset of a recession by an average of nearly twelve months. When we combine the yield curve indicator with the LEI, the false positives go away. Chart 3The Yield Curve Has Called Seven Of The Last Eight Recessions... Chart 4... And So Has The Leading Economic Indicator To confirm the recession signal and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA's equilibrium fed funds rate model has calculated an estimate of the equilibrium policy rate, every recession has occurred when the fed funds rate exceeded our estimate of equilibrium. In other words, recessions only occur when monetary policy settings are restrictive. Today, none of the indicators are even close to pointing to a recession, with the LEI at a cyclical peak. However, the yield curve and monetary policy are directionally moving towards the end of the cycle. Taken together, they suggest that the only controversy about our late 2019 recession call is that it is so early. So why the market volatility? Because wage growth in the U.S. has begun to pick up in earnest (Chart 6), revealing that BCA's concerns about inflation may at last be coming true. Investors, after more than a year of rationalizing weak inflation by means of dubious concepts (Amazon, AI, robots, etc.), may be reassessing their forecasts in real time, causing market turbulence. Chart 5Tight Policy Is A Necessary,##br## If Not Sufficient, Recession Ingredient Chart 6Wages Picking##br## Up In Earnest There is of course a political explanation as well. Our colleague Peter Berezin correctly called the end of the 35-year bond bull market on July 5, 2016.6 The timing of the call - mere days after the U.K. EU membership referendum - was not a coincidence. As Peter mused at the time, "the post-Brexit shock running through policy circles leads to a further easing in fiscal and monetary policy." He was not speaking about the U.K. alone, but in global terms. Indeed, the populists have begun to deliver. Ever since President Trump's election, we have cautioned clients not to doubt the White House's populist credentials.7 After a surge in bond bearishness immediately following the election, investors lost faith in the populist narrative due to the failure of Congress to pass any significant legislation, as if Congress has ever been a nimble institution under previous presidents. But investors are beginning to realize that their collective political analysis was extremely wrong. Not only have profligate tax cuts been passed, as we controversially expected throughout 2017, but Congress is now on the brink of a monumental two-year appropriations bill that will add nearly 1% of GDP worth of fiscal thrust in 2018 higher than what the IMF expected for the U.S. (Chart 7). In addition, Congress has set in motion the process to re-authorize the use of "earmarks" - i.e. legislative tags that direct funding to special interests in representatives' home districts (Chart 8).8 Chart 72018 Fiscal Thrust Was Unexpected Chart 8Here Comes Pork! By our back-of-the-envelope accounting, Congress is about to authorize just shy of $400bn in extra spending over the next two years.9 If earmarks are allowed back into the legislative process, we could see up to another $50bn in spending. An infrastructure deal, which now also looks likely given that the Democrats have realized that their "resistance"/ "outrage" strategy does not work against the Trump White House, could add significantly to that total. We are already positioned for these political developments through two fixed-income recommendations. We are short U.S. 10-year Treasuries vs. German Bunds, a recommendation that has returned 27.7 bps since September 2017. In addition, we are short the Fed Funds December 2018 futures, a recommendation that has returned 43.17 bps since the same initiation date. In addition, we went long the U.S. dollar index (DXY) on January 31, right before the stock market correction and precisely when the greenback appeared to bottom. Should investors prepare for runaway inflation this cycle? Is it time to load up on gold? We do not think so. The fiscal impulse from the two-year budget deal will become negative in 2020. The capex incentives from the tax cut plan are also front-loaded. The paradigm-shifting impact on inflation will require a policy paradigm shift. And we expect such a shift only after the next recession. To put it bluntly, U.S. voters elected a TV game show host due to angst at a time when unemployment stood at 4.6% (the rate on November 2016). Who will they elect with unemployment rising to 6% in the aftermath of the next recession, or God forbid if that next recession is worse than we think it will be? Policymakers are unlikely to sit around and wait for an answer to that question. Extraordinary measures will be taken to prevent the median voter from lashing out against the system when the next recession hits. Inflation, which is a redistributive mechanism, will be employed to transfer wealth from savers (mainly well-to-do retirees) to consumers (their children). In large part, this will be a generational wealth transfer between Baby Boomers (or at least those with some savings) and their Millennial children. Given that Millennials have become the largest voting bloc in the U.S. as of the 2016 election, this will be a populist policy with firm backing in the electorate. The next recession will therefore usher in the inflationary era of the next decade, regardless of how painful the actual recession is. In the meantime, we recommend that clients with a 9-to-12 month horizon continue to "buy on dips," given that a recession is not on the horizon. However, with the U.S. 10-year yield approaching 3%, China moderately slowing down (with considerable risk to the downside), and the U.S. dollar slide arrested, we think that the outperformance of EM equities is over. Brexit: We Can't Work It Out10 The EU agreed on January 29 to its negotiation guidelines for the temporary transition period after the U.K. officially leaves the bloc in March 2019.11 The British press predictably balked at the conditions - the term "vassal state" has been liberally bandied about - which in our view included absolutely nothing out of the expected. The EU conditions for the transition period are not the fundamental problem. Rather, the problem is that the "Vote Leave" campaign was never honest with its promises. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister in Prime Minister Theresa May's cabinet, famously quipped after the referendum that "there will continue to be free trade and access to the single market."12 The problem with that promise, however, was that it was predicated on using London's "superior negotiating position" vis-à-vis the EU in order to force the Europeans to redefine what membership in the Common Market means. As we pointed out in our net assessment ahead of the Brexit referendum, the problem with exiting the EU but remaining in the Common Market is that the issue of sovereignty is not resolved (Diagram 1).13 As such, Johnson and other Brexit supporters argued that they could change the relationship by forcing the EU to change how the Common Market works. Diagram 1Common Market Membership Is Illogical Except for one problem: the U.K.'s negotiating position is not, never was, nor ever will be, superior. Anyone with a rudimentary understanding of how trade works can understand this. For example, the U.K. is a significant market for Germany, at 6% of German exports (right in line with the 6% of total EU exports that go to the U.K.). However, the EU is a far greater destination for British exports, with 47% of all exports going to the bloc.14 As we expected, the EU has surprised the conventional wisdom by remaining united in the face of negotiations. And as we also predicted, the Tories are now completely divided.15 PM May will attempt to hammer out an internal deal on how to approach the transition deal. But her political capital is so drained by the disastrous early election results that there is practically no way that she can produce a set of negotiating guidelines that will not be pilloried in the press. As such, we expect a new election to take place in the U.K. ahead of March 2019, perhaps sooner. We do not see how May's negotiating position will satisfy all wings of the Conservative Party. In addition, we see no scenario by which the ultimate exit deal with the EU gets enough votes in Westminster. Investors betting on that election replacing a second Brexit referendum would be wrong. A Jeremy Corbyn-led, Labour government will only turn against Brexit once the polls definitively turn against it. This has not yet happened, as the gap between supporters and opponents of Brexit in the polls, while widening in favor of opponents, remains within a margin of error (Chart 9). As such, Corbyn would scrap the Tory-led negotiations with the EU and ask Brussels for even more time - and thus more market uncertainty! - in order to produce a Labour-led Brexit deal.16 In order for the probability of Brexit to definitively decline, the polls have to show that "Bregret" or "Bremorse" is setting in. Without a move in the polls, U.K. politicians will continue to pursue Brexit, no matter how flawed their tactics may be. Policymakers are ultimately not the price makers but the price takers. On the issue of Brexit, the U.K. median voter is only slightly miffed regarding the outcome. Current polls suggest that Labour could win the next election, albeit needing to rule with a coalition (Chart 10). This would prolong the uncertainty facing the economy. Not only is Corbyn the most left-leaning politician in a major European economy since François Mitterand, but also his coalition would likely include the Scottish National Party and potentially the Liberal Democrats. Keeping all their priorities aligned could be even more difficult than the balancing act PM May is performing between soft-Brexiters, hard-Brexiters, and the Democratic Unionist Party. Chart 9Bremorse: Rising, But Not Definitive Chart 10Anti-Brexit Forces On The Rise Meanwhile, on the economic front, the situation is not much better. Our colleague Rob Robis, BCA's chief bond strategist, recently penned a critical assessment of the U.K. economy.17 As Rob pointed out, the OECD leading economic indicator is decelerating steadily and pointing to a real GDP growth rate below 2% in 2018 (Chart 11). The biggest factors that will weigh on growth will be a sluggish consumer and softer capex. Household consumer growth has been slowing since early 2017, driven by diminishing consumer confidence (Chart 12, top panel). High realized inflation, which has sapped the purchasing power of U.K. workers who have not seen matching increases in wages, is weighing on confidence (third panel). Consumers were able to maintain a decent pace of spending during a period of stagnant real income growth by drawing on savings, but that looks to be tapped out now with the saving rate down to a 19-year low of 5.5% (bottom panel). Chart 11U.K. Growth Set To Slow Chart 12The U.K. Consumer Looks Tapped Out Making matters worse, U.K. consumers are not seeing much of a wealth effect from the housing market. The January 2018 readings of the year-over-year growth rate of U.K. house prices from the Halifax and Nationwide indexes came in at 1.9% and 3.1% respectively (Chart 13). In addition, the net balance of national house price expectations from the Royal Institution of Chartered Surveyors (RICS) has steadily declined since mid-2016 and now sits just above zero (i.e. equal number of respondents expecting higher prices and falling prices). The same indicator for London was a staggering -47% in January 2018. Apparently, foreigners are no longer interested in a Brexit discount. Our global bond team goes on to point out that political uncertainty is also weighing on U.K. business investment spending. Capital expenditure growth slowed to 4.3% year-over-year in nominal terms in Q3 2017 and is even lower in real terms (Chart 14). Chart 13No Wealth Effect ##br## From Housing Chart 14Brexit Gloom Trumps ##br##Export Boom For U.K. Companies Putting all of this together, neither our global bond team nor our foreign exchange team expect the Bank of England to raise interest rates, despite the market pricing in 36 bps of rate hikes over the next twelve months. As Chart 15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating. Thus, the pass-through from a lower exchange rate is beginning to dissipate.18 In the long-term, we understand why investors are itching to bet on Brexit never happening. But to get from here to there, the market will have to riot. And that means more downside to U.K. assets. Chart 15U.K. Inflation:##br## Less Pass-Through From The Pound Chart 16GBP:##br## Stuck In A Rut Bottom Line: BCA's FX strategist, Mathieu Savary, has pointed out that the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart 16). As our FX and bond teams show in their respective research, the economics currently at play make it unlikely that the pound will be able to punch above the ceiling of this range. Our political assessment adds to this view. In fact, we expect that the coming political uncertainty, including an early election prior to March 2019, is likely to take the pound back to the floor of its trading range. As such, we are recommending that clients short cable, GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," June 16, 2017, available at gis.bcaresearch.com. 2 Please see BCA Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, and "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bcaresearch.com. 3 Please see BCA Special Report, "Timing The Next Equity Bear Market," dated January 24, 2014, and "Timing Equity Bear Markets," dated April 6, 2011, available at bcaresearch.com. 4 Please see BCA Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com. 5 The ten components of leading economic index for the U.S. include: 1. Average weekly hours, manufacturing; 2. Average weekly initial claims for unemployment insurance; 3. Manufacturers' new orders, consumer goods and materials; 4. ISM® Index of New Orders; 5. Manufacturers' new orders, nondefense capital goods excluding aircraft orders; 6. Building permits, new private housing units; 7. Stock prices, 500 common stocks; 8. Leading Credit Index TM; 9. Interest rate spread, 10-year Treasury bonds less federal funds; and 10. Index of consumer expectations. Source: The Conference Board. 6 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 9 We are referring to the Senate deal struck last week to authorize additional military spending ($80bn in FY2018 and $85bn in FY2019) and discretionary spending ($63bn in FY2018 and $68bn in FY2019), as well as to provide disaster relief in the amount of $45bn for both fiscal years. 10 Life is very short, and there's no time ... For fussing and fighting, my friend ... 11 Please see European Council, "Brexit: Council (Article 50) adopts negotiating directives on the transition period," dated January 29, 2018, available at consilium.europa.eu. 12 Please see "UK will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 13 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 14 This is not a coincidence. The whole point of the EU is that it is the world's richest consumer market. As such, it has massive negotiating leverage with all trade partners. As a side note, this throws into doubt the logic that the U.K. can get better trade deals by leaving the bloc. The first test of that premise will be its negotiations with the EU itself. 15 Please see BCA Special Report, "Break Glass To Brexit: A Fact Sheet," dated June 17, 2016, available at bca.bcaresearch.com. 16 Investors should remember that Westminster voted decisively 319 to 23 to reject the Liberal Democrats' amendment seeking a referendum on the final Brexit agreement. Only nine Labour MPs voted in favor of the amendment after Jeremy Corbyn instructed his party to abstain. 17 Please see BCA Global Fixed Income Strategy Weekly Report, "A Melt-Up In Equities AND Bond Yields?" dated January 23, 2018, available at gfis.bcaresearch.com. 18 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com.

Highlights The spike in volatility last week led to a sharp correction in equities. However, the bull market in equities is not over yet. The Fed's response to the selloff will be critical. Policymakers will closely monitor financial conditions. The most overvalued assets are at greatest risk during a selloff. Feature Financial markets did not give new Fed Chair Jay Powell a warm welcome last week. Volatility spiked, and risk assets fell sharply. Nonetheless, BCA's view is that strong economic growth and stout earnings growth will keep the bull market intact. The selloff is reminiscent of the 7% drop in the S&P 500 in May of 2006.1 Back in the spring of 2006, then Chairman Ben Bernanke had just taken the helm at the Federal Reserve. Global growth was strong, the U.S. dollar was selling off and global share prices were surging and overbought. From May through June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish, allowing U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM assets. The February 2018 may not play out exactly like May 2006. That said, there are enough similarities to draw parallels. Global growth is robust and inflationary pressures are accumulating. Bond yields are rising, and the greenback is selling off. A new Fed Chairman just took over the reins, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. The Fed's response to the tighter financial conditions will be crucial. The May 2006 selloff turned out to be just a correction in a bull market that lasted another 18 months. Still, investors today are also concerned about what to sell first as the end of the expansion draws closer. A Shake Up BCA strategists believe that the market turmoil since last week reflects a technical correction from overbought and over complacent levels, but the cyclical bull run is not yet over.2 Nonetheless, investors should note that the bull market is entering its late stages. The low inflation and low volatility era is ending as the U.S. economy begins to face late-cycle, supply-side constraints, especially in the labor market. Therefore, the equity advance will be associated with higher volatility than in the past few years. Chart 1 shows that the VIX soared by roughly four times more on February 5 than expected, based on the decline in equity prices. This suggests that the spike in volatility caused the stock market plunge, rather than the other way around. The relatively muted reaction in the past few days of other risk gauges, such as junk bonds, EM stocks, and gold prices, is consistent with this thesis. Chart 1Last Monday's VIX Spike Was Abnormally Large Importantly, the implosion of volatility funds is unlikely to reverberate across the global financial system in the same way as it did during the 2007-2009 financial crisis. The mortgage crisis a decade ago was so toxic that the losses were concentrated in the books of highly leveraged financial institutions. However, that does not appear to be the current case with volatility funds. The cyclical underpinnings for the bull market in equities is intact. The odds of a recession remain low (Chart 2). Corporate earnings continue to come in above expectations, aided by a wave of share buybacks linked to the U.S. Tax Cut and Jobs Act (Chart 3). Global economic growth remains upbeat as well. Chart 2Odds Of A Recession##BR##Remain Low Chart 3Buybacks, Surging Capex##BR##Raising The Bar For 2018 EPS Growth Chart 4U.S. Equities And Vol##BR##Climbed Through The 1990s This does not mean that everything will be smooth sailing. Last week's selloff marked an inflection point in the low-volatility world that has prevailed in the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Volatility will stay elevated relative to what investors have come to anticipate. As the experience of the 1990s shows, stocks can still climb when volatility trends higher (Chart 4), but this is going to make for a more challenging investment environment. Bottom Line: Rising volatility does not mean the end of the bull market or the economic expansion. Bear markets outside of recessions are rare, and our view remains that the odds of a recession this year or next remain low. Moreover, the additional dose of fiscal stimulus passed by Congress late last week may extend the expansion into 2020. Stay overweight stocks versus bonds.3 The Policy Response The Fed's reaction to this new regime will be critical. The 7.2% drop in equities last week occurred on Jay Powell's first as Chairman of the Fed. Chart 5 shows that it is not unusual for the equity markets to be in turmoil in the early months of a new Fed Chair's tenure. BCA expects that Powell and his FOMC colleagues will adopt Janet Yellen's gradual approach to raising rates this year. Nonetheless, the January readings on average hourly earnings suggest that supply-side constraints are beginning to bite. The runway for low inflation and easy monetary policy may not be as long as some had hoped. Just like Yellen, Jay Powell will seek a consensus among his colleagues. The composition of the FOMC will probably shift in a more hawkish direction, but the evolution will be slow. In the meantime, the recommendations of career Fed staff will represent an important and often underappreciated source of continuity. Last week, several Fed speakers reinforced that the central bank will continue to monitor incoming economic and financial data, and react accordingly. The stock market rout has led to some tightening in financial conditions, but FCIs in the U.S. remain more expansionary than they were six months ago (Chart 6). As a result, U.S. economic growth is poised to accelerate even more in the first half of the year (Chart 7). This will push the unemployment rate further below NAIRU and ultimately force up wage and price inflation. Chart 5New Fed Chairs##BR##And The Equity Market Chart 6Decline In Equity Market##BR##Tightened Financial Conditions However, at 2.1% on February 8, the 10-year TIPS breakeven yield was still below the 2.4 to 2.5% range where markets need to worry about the Fed falling behind the curve (Chart 8). A shift above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would signal that the FOMC will have to boost the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We will likely take some money off the table if core inflation rises, even if it is still below 2%, when the TIPS breakeven reaches 2.4%. Chart 7Lagged Effect Of Easier##BR##Monetary Conditions Will Boost Growth Chart 8Breaking Down##BR##The Rise In Yields A sustained move above 3% on the nominal 10-year Treasury yield will require a more durable increase in inflation. Ultimately, we think core inflation will move4 above 2%, forcing the Fed to lift interest rates into restrictive territory. However, this probably will be a story for 2019 rather than 2018. Stocks tend to peak about six months before the start of a recession (Table 1). If the next recession occurs in late 2019, as we forecast, the equity bull market could last a while longer. The additional fiscal impulse from the spending bill passed by Congress last week may extend the expansion into early 2020. A modest overweight on global risk assets is warranted for now, but investors should consider reducing their risk exposure later this year. Table 1Too Soon To Get Out Bottom Line: The Fed and the market are now in agreement on rate hikes in 2018. BCA's U.S. Bond Strategists' stance is that the 2/10 curve will flatten from here, as the upside in long maturity yields will be limited once the TIPS breakeven inflation rates reach our target fair value range of 2.4-2.5%. Nonetheless, at that point, the nominal 10-year yield5 is likely to be between 3.0 and 3.25%. Stay underweight duration for now. Where Do We Go From Here? Clients have asked our view on the appropriate order in which to reduce risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the most over-valued ones are at greatest risk, and thus profits should be taken here first. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time span? We include multiple measures because there is no widely accepted approach. More than one time period was used in some cases to capture regime changes. Table 2 provides our best approximation for nine asset classes. The approaches range from sophisticated methods6 developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (i.e. oil), to simple deviations from a time trend (i.e. real raw industrial commodity prices and gold). Table 2Valuation Levels For Major Asset Classes We averaged the valuation readings where there were multiple estimates for a single asset class. The results are shown in Chart 9. Chart 9Valuation Levels For Major Asset Classes By far, U.S. equities stand out as the most expensive at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads follow at 0.7, tracked closely by U.S. Treasuries (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are very expensive in absolute terms based on the fact that government bonds are pricey. Oil is sitting very close to fair value, despite the rapid price run up in the past couple of months. This makes oil exposure doubly attractive because the fundamentals point to higher prices when the underlying asset is not expensive. Historical analysis around equity market zeniths provides an alternative approach to the sequencing question. Table 3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table 3Asset Class Leads & Lags Vs. Peak In S&P 500 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, tech stocks or small-cap versus large-cap relative returns. Sometimes they reached their zenith before the S&P 500, and sometimes after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyze due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time was long and variable. The U.S. corporate bond market offers the most consistent lead/lag relationship. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio before we scale back on equities. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over as expected to the EM economies. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of China's economy in the coming months. Oil is a different story. OPEC 2.0 will likely cut back on supply in the face of an economic downturn, which will help keep prices elevated.7 Therefore, we may not trim energy exposure this year. In terms of equities, our recommended portfolio is still overweight cyclicals for now. Our themes of a synchronized global capex boom, rising bond yield, and firm oil price means we will stay overweight in the industrials, energy and financial sectors. Utilities and homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. Our U.S. Equity Strategists have already started a gradual shift away from cyclicals toward defensives. This transition will continue in the coming months as we reduce risk. We will also shift small caps to neutral on earnings disappointments and elevated debt levels.8 Bottom Line: The economic expansion is not over, but investors are already wondering what to sell first as the next peak in equities nears. Market participants should look to trim credit exposure before scaling back on equities, and BCAs' U.S. Equity Strategy service is already scaling back on cyclicals and reduced small caps to neutral from overweight last month. At under $60/ barrel WTI, oil is 5% below our Commodity & Energy Strategy's target of $63/bbl. Moreover, global inventories will continue to draw on the back of OPEC supply restraint as shale production growth alone will not satisfy stronger global demand driven by stronger global economic growth. If prices hit the low $70 range, supply restraint and demand growth will ebb, capping incremental upside. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Insight "Buy The Dip," published February 8, 2018. Available at uses.bcaresearch.com. 2 Please see BCA Research's Global Investment Strategy Special Report "The Return Of Vol," published February 6, 2018. Available at gis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Watching Five Risks," published January 24, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 6 Please see BCA Research's The Bank Credit Analyst Monthly Report, published January 25, 2018. Available at bca.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Vs. The Fed," published February 8, 2018. Available at ces.bcaresearch.com. 8 Please see BCA Research's U.S. Equity Strategy Weekly Report "Too Good To Be True?," published January 22, 2018. Available at uses.bcaresearch.com.

Highlights The end of the low volatility regime could mark a leadership change in global equities away from EM to DM. The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows RMB appreciation to head off major protectionist threats from the U.S. This could delay the U.S. dollar rally and support EM risk assets. The EM and commodities equity rallies might be facing formidable technical resistances. These equity segments have to break out these technical resistances decisively to confirm the sustainability of the bull market. Feature Global stocks have corrected, and volatility measures have surged. The low volatility regime appears to have come to a decisive end. Even though in the short run volatility measures could well decline after their steep surge of the past week, the cyclical outlook points to higher volatility relative to last year. Financial markets are likely to be re-priced to adjust to the end of this low-volatility period. This entails more stress, and an additional selloff in risk assets. Periods of low volatility historically sow the seeds of their own reversal. Investors tend to embrace high-risk strategies amid low volatility, and take on more leverage. As a result, market excesses and froth arise, increasing the market's vulnerability in the event of a reversal. The latest period of low volatility lasted for more than a year, and no doubt facilitated the build-up of froth and excesses in global financial markets. Chart I-1 illustrates that the aggregate volatility measure of various financial markets was at its lows of the past 12 years before surging in recent days. Chart I-1Rising Volatility Coincides With A U.S. Dollar Rally What does rising volatility mean for emerging market (EM) relative performance vis a vis developed markets (DM)? It is primarily contingent on the U.S. dollar. If the U.S. dollar rebounds along with the rise in volatility, as it has done in the past (Chart I-1), EM equities will commence underperforming DM bourses. If the U.S. dollar fails to rebound and drifts lower, EM stocks are likely to outperform DM equities. With respect to exchange rates, we believe one of the major driving forces for currencies is the relative growth trajectory. The latter can be approximated by relative equity market performance in local currency terms. Chart I-2 shows that U.S. share prices - of both large and small caps - have been outperforming their global counterparts in local currency terms. Persisting periods of outperformance of U.S. stocks versus their global peers eventually, albeit sometimes with a considerable time lag, instigates a stronger trade-weighted U.S. dollar. U.S. large-cap share prices are making new highs versus their global peers in local currency terms. This entails that the selloff in the broad trade-weighted dollar is at a very late stage. The dollar rebound is a missing trigger for EM relative equity outperformance to reverse. A Risk To Our View: The U.S. Dollar One risk to our negative stance on EM risk assets and our recommendation of underweighting EM versus DM is the continuation of the U.S. dollar selloff. The greenback has been trading very poorly despite jitters in global equity markets. The recent surge in the RMB versus the U.S. dollar may be indicative that the Chinese authorities are tolerating RMB appreciation to defuse a threat of major protectionist measures from the U.S. (Chart I-3). If the RMB continues to appreciate versus the greenback, Asian and other EM currencies will stay well supported, and EM outperformance will persist. Chart I-2U.S. Relative Equity Outperformance ##br##Warrants A Stronger Dollar Chart I-3Will Beijing Tolerate A Stronger RMB? We suspect that Chinese policymakers are reluctantly allowing the RMB to appreciate. Indeed, Chinese policymakers have been both vocal and public about their understanding of Japan's experience with deleveraging, and specifically the mistake made by Japanese policymakers of allowing the yen to appreciate in the early 1990s. As most know, deflationary forces stemming from the combined effects of deleveraging and currency appreciation set off a formidable deflationary adjustment in Japan in the 1990s. Given Japan's experience, our conjecture is that Chinese policymakers would rather opt for a stable-to-mildly weaker currency. This has been one of the cornerstones of our bullish bias on the U.S. dollar versus emerging Asian currencies. If China allows the RMB to appreciate further versus the U.S. dollar, a potential U.S. dollar rally versus EM currencies will be delayed. In turn, this will likely allow EM equity, currency and credit markets to outperform their DM peers. That said, a strong currency will add to the ongoing policy tightening in China. The cumulative impact of this policy tightening combined with currency appreciation will weigh on China's growth later this year. As such, our fundamental thesis on China-slowdown is still valid in the medium term. However, political interference in the currency markets could delay EM risk assets' response to it. Bottom Line: The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows further RMB appreciation to head off potentially major protectionist threats from the U.S. May 2006 Redux? The current riot in global stocks resembles the May 2006 correction to a certain extent. Back in the spring of 2006, then Federal Reserve Chairman Ben Bernanke had just taken the helm at the Fed. Global growth was strong, the U.S. dollar was selling off, and global share prices were surging and overbought. Chart I-4May 2006 And Now: EM Stocks, ##br##U.S. Bond Prices And U.S. Dollar In May-June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish and would allow U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM. It seems that February 2018 may play out like May 2006. It will not be exactly the same, but there are enough similarities to draw parallels: Global growth is robust, inflationary pressures are accumulating. DM bond yields are rising and the greenback is selling off. The new Fed Chairman, Jerome Powell, just took over the reins at the Fed, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. Chart I-4 illustrates the similarities between financial market dynamics in 2005-2006 and now. If we take 2006 as a guide, we can infer that the selloff is not yet over. In a matter of only five weeks EM share prices plunged by 25% in U.S. dollar terms, and the S&P 500 dropped by 7%. From a big-picture perspective, the May 2006 selloff was a sharp correction in a bull market that lasted for another year or so. Importantly, the 25% plunge in EM share prices that took place in 2006 occurred despite EM corporate profit growth expanding at a double-digit rate in 2006-'07. All that said, the 2006 selloff marked an important regime shift in the global economic landscape - the rate of U.S. growth peaked in the second quarter 2006, and began to decelerate. We believe that the current equity market riot will likely mark a bottom in U.S. inflation and the beginning of a slowdown in China. The U.S. Bond Market Selloff Is Not Over... Yet The selloff in the U.S./DM bond markets has not yet run its course: The U.S. inflation model - constructed by our colleagues in the Foreign Exchange Strategy service and based on U.S. capacity utilization and broad money supply - is pointing to higher inflation in the months ahead (Chart I-5). U.S. bond yields will likely move higher as forthcoming inflation prints validate our expectations for higher U.S. inflation. Fiscal stimulus amid robust growth and a tight labor market in the U.S. as well as record-high optimism among consumers and businesses have created fertile ground for rising inflation. The weak dollar of the past 12 months will also manifest in rising inflationary pressures. The U.S. bond term premium is still extremely low. Yet, budding uncertainty over inflation and the gradual end of QE programs in DM, will likely cause the U.S. bond term premium to rise from current depressed levels. Finally, simple DM bond markets technicals are still pointing to higher yields ahead (Chart I-6). Chart I-5U.S. Core Inflation Set To Rise Chart I-6U.S. Bond Yields: The Path ##br##Of Least Resistance Is Up Overall, the path of least resistance for DM bond yields is up. This will make EM local currency bond yields less attractive versus DM and especially versus U.S. Treasurys. Yield differentials between EM and the U.S. are already at a 10-year low (Chart I-7). Low risk premiums on EM local bonds and rising global financial market volatility suggest that flows to EM fixed income markets will slow over the course of this year. That said, near-term risks still remain due to the massive inflows that previously went into EM funds, and might not have been deployed yet. China's Tightening And Pending Slowdown It is not unusual for an equity market riot to begin with inflation and high-interest-rate fears and then culminate with a growth scare - with a rebound in between. 2018 may shape up to fit this pattern. Global equity markets seem to be immersed with inflation and policy tightening in the U.S. - and potentially in China. At some point, share prices could well stage a rebound but then relapse again as materially slower Chinese growth spills over to global trade.1 We have discussed our view on China and its spillover effect on EM in past reports, and will not reiterate our views and analysis here. We will only bring to clients' attention that manufacturing production volume in Asia has already been weakening for a couple of months (Chart I-8). Chart I-7EM Local Currency Bonds Over ##br##U.S. Treasurys: Yield Differential Chart I-8Asia's Manufacturing ##br##Production Growth Is Slowing Leadership changes in the equity markets occur amid selloffs. Hence, it is reasonable to expect a leadership shift within global equity market sectors and countries as well as currency markets. One major equity leadership shift could be that EM begins underperforming DM. A combination of rising U.S. inflation and bond yields and a slowdown in China are negative for EM financial markets, especially relative to DM ones. Reading Markets' Tea Leaves It remains to be seen how much further this selloff in global equities will last and whether this is the beginning of a major downtrend in EM risk assets. It is impossible to have perfect foresight. To help investors in their portfolio decisions, we combine our fundamental analysis with tools that assist us in forecasting business cycles as well as various chart patterns that may be indicative of the market's potential trajectory. The following charts illustrate that the EM and commodities equity rally may be facing formidable technical resistance. These equity markets have to break out decisively through these technical resistance lines to confirm the sustainability of the bull market. Global energy stocks have corrected after reaching their long-term moving average (Chart I-9, top panel). The latter served as a floor in the 2008 crash. It was a key technical level in the 2014-'15 bear market that did not hold up and was followed by a collapse in crude prices. Similarly, global steel stocks are exhibiting the same pattern (Chart I-9, bottom panel). Relative performance of emerging Asian share prices versus the global equity benchmark is also at a similar critical juncture (Chart I-10, top panel). Chart I-9Global Energy And Steel Stocks: ##br##A Technical Resistance Chart I-10Select EM Equity Markets ##br##Are Facing A Critical Test Finally, Brazilian share prices in U.S. dollar terms have also reached a crucial technical threshold (Chart I-10, bottom panel). Bottom Line: Share prices of a few equity sectors and markets that are imperative to the EM equity outlook are at important technical junctures. Failure to break above these technical resistance lines will corroborate our negative stance on EM/China growth and related financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We elaborated the relationship between China/EM and DM growth in November 29, 2017 Emerging Markets Strategy Weekly Report, the link is available on page 12. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The dollar seems to have entered a cyclical bear market, which suggests that EUR/USD is in a multi-year bull market. While the euro performs well in the late stages of the business cycle, it has moved ahead of long-term fundamentals. A correction is growing increasingly likely. The euro's rally has been a reflection of hope that the ECB will tighten policy in excess of the Fed's in the coming years. This leaves the euro vulnerable to short-term disappointments on both the inflation front and the global growth front. The trade-weighted pound has downside from current levels as the BoE will be handcuffed by a fall in inflation, courtesy of a diminishing pass-through. Feature Two weeks ago, we explored the confluence of forces facing the euro. We concluded that in all likelihood, the euro had embarked on a new cyclical bull market that could push EUR/USD well above 1.30 over the course of the coming few years. We also highlighted some tactical risks that were present for the euro.1 This week, we delve into how the cyclically positive outlook for the euro is interacting with the more cautious, short-term view, especially in the wake of the U.S. dollar's recent wave of weakness that has pushed the euro above 1.25. The probability of a correction has grown only further. This could represent a shorting opportunity for tactical players, as well as an occasion to deploy more funds into the euro for agents with a longer investment horizon. It's A Bull Market, But... The body of evidence is growing that the U.S. dollar has entered a bear market, which would support the view that the dollar's antithesis - the euro - has entered a bull market. To begin with, my colleague Harvinder Kalirai, who runs BCA's Daily Insights service, has noted that the dollar has been following an interesting pattern since the end of the Bretton Woods era: It tends to depreciate for roughly 10 years, and then rally for five to six years (Chart I-1). Admittedly, there is a small set of bull and bear markets here, but this begs the question: Was the 2011-2016 bull market the heyday for the dollar this decade? Chart I-1USD: Times Up? To answer this question, it helps to understand where we stand in the current business cycle. BCA believes that while a U.S. recession is not imminent, we are nonetheless entering the last two innings of this cycle. Interestingly, as Chart I-2 illustrates, the euro tends to appreciate during the last two years of U.S. economic upswings. This is because historically, European growth begins to outperform U.S. growth in the late stages of the economic cycle. This observation resonates with today's environment. Chart I-2The Euro Rallies Late In The Business Cycle There is a glaring exception to this phenomenon: the period from 1999 to 2000. However, we view this particular interval as rather exceptional. First, the euro had just entered into force, and was still untested. Second, the U.S. basic balance was in a large surplus as M&A waves and the tech bubble were sucking in capital from all over the world. Third, the U.S. was experiencing the apex of its peace dividend, resulting in fiscal surpluses that gave comfort to investors. Beyond the ebullience of U.S. tech stocks, the parallels with this era are limited. The tendency for the European economy to boom late into the cycle also has implications for monetary dynamics. We, as most commenters, have been puzzled by the euro's divorce from interest rate differentials, especially at the short end of the curve. Even indicators that historically have been extremely reliable such as the spread between the European and U.S. 1-year/1-year forward risk-free rate have lost their explanatory power. However, late into the cycle, the European economic boom tends to lift expectations of future European Central Bank policy tightening faster than these same expectations in the U.S. As a result, the European yield curve steepens in contrasts to that of the U.S. We built a simple three-factor model to capture these dynamics. These factors are: real 2-year yield differentials between the euro area and the U.S., to grab the effect of current policy; the euro area minus the U.S. 10/2-year yield curve slope, to incorporate changes in perception of how fast the ECB will hike in coming years compared to the Federal Reserve; and the price of copper relative to lumber, to capture how U.S. growth dynamics - as represented by the price of lumber - are evolving relative to the rest of the world, as represented by the price of copper. Chart I-3 shows the model's results. Over the long run, this model explains nearly 70% of EUR/USD's variations, and most importantly, the significance of the three factors is stable over various samples. Three points are worth noting: Chart I-3A 3-Factor Model To Explain The Euro First, the euro was very undervalued from 2015 to 2017. It was not as cheap as in 1985 or 2000, but the narrative behind the dollar's strength this cycle was the perception that the USD was the "cleanest dirty shirt." This is not the same optimism as what prevailed during former U.S. President Ronald Reagan's Imperial Cycle of the 1980s, or the New Economy boom / unipolar moment for the U.S. in the late 1990s. Second, the euro's fair value has stopped falling as global growth has caught up to the U.S., and as the European yield curve has steepened relative to the U.S. thanks to the reappraisal by investors of the future path of the ECB's terminal policy rate this cycle. Third, the euro is now trading at an 8% premium to its fair value. This last point raises the question of a euro correction. Are we seeing conditions fall into place for the euro to experience a pullback toward its fair value of roughly 1.15? A move to this level would bring the euro straight back into its 38-50% retracement levels, based on the low recorded in late 2016. Bottom Line: It appears as if the dollar has begun a cyclical bear market. As a corollary, this implies that the euro has begun a cyclical bull market that could last many years. The main reason relates to where we stand in the current business cycle: An ageing business cycle is associated with a stronger euro - a result of the euro area's economic outperformance toward the end of the cycle. Despite this positive, it would seem the euro has overshot fundamentals factors that try to capture these dynamics. ... The Correction Is Nigh Conditions are still too precarious to call for a correction in the euro, but some facts need to be kept in mind as they highlight growing short-term risk. Dollar Dynamics From a technical perspective, the dollar is much oversold. Last week we illustrated how our Capitulation Index was inching closer to a buy signal. The "buying" threshold was hit this week. Confirming this message, the Dollar's RSI and 13-week rate of change are also at levels consistent with a dollar rebound (Chart I-4). To be sure, many FX investors have become enthralled by the "twin deficit" narrative. Since 2011, when worries about a growing combined fiscal and current account deficit spike, this tends to represent dollar buying opportunities for the next three to six months (Chart I-5). Chart I-4Oversold Dollar Chart I-5Because The Narrative Is Scary Blood In The Street? When it comes to the twin deficit narrative, at this point it is a very nice-sounding story, but it still lacks substance. For one, while a growing U.S. economy tends to be associated with a growing current account deficit, the U.S. is increasingly morphing from an oil importer to an oil exporter. As Chart I-6 illustrates, net oil imports for the U.S. have collapsed from 13.5 million bbl/day in 2005 to 3.8 million today, as oil production recently hit a 47-year high. Matt Conlan, who runs BCA's Energy Sector Strategy service, anticipates that within the next two to three years the U.S could even become a net exporter of oil. Thus, the expansion of the current account deficit is not baked in the cake. The fiscal deficit may also not widen as much as many fears over the next year or two. As Chart I-7 illustrates, the gyrations in the U.S. 30-year swap spread have been linked to fluctuations in the velocity of money in the U.S. As banks faced the imposition of higher capital ratios, Dodd-Frank, rising supplementary leverage ratios, and so on, they decreased their participation in the swap market. As the supply of funds fell in that market, swap spreads collapsed, punishing the receivers of the 30-year swap rate. But recently, with the growing likelihood that the supplementary leverage ratio rules will be softened, banks are coming back to the market, and the swap spread is rising again. Banks are also easing their credit standards on most things from C&I loans to mortgages. This suggests credit growth could pick up further, lifting money velocity. Chart I-6A Support For The U.S. Current Account Chart I-7Money Velocity To Pick Up Why does this matter? Simply put, the rise in velocity portends to an acceleration in nominal GDP growth. Rising nominal expansion is historically associated with narrowing budget deficits. This cycle is a prime example. The main reason why the U.S. deficit fell from 8% of GDP to 3.5% of GDP this cycle is because activity recovered, which lifted government revenues and narrowed the deficit. To be clear, we do not want to sound overly sanguine. The chickens will come home to roost. If the budget deficit does not blow out as much as many fear over the next two years, it will catch up to these dire expectations once GDP growth slows. Euro Dynamics In a mirror image to the DXY, the euro's 13-week week rate of change and RSI oscillator are also flagging overbought conditions. But more interesting developments are happening that highlight the elevated correction risk for the euro. As Chart I-8 shows, the correlations between EUR/USD and the relative euro area/U.S. yield curve slope as well as the real interest rate gap tends to swing widely over time. Most interestingly, when the euro correlates closely with the relative yield curve slope and ignores real rate differentials, this tends to be followed by a reversal of the previously prevailing trend in the euro. This seems to tell us that when investors are more focused on the potential for an adjustment in relative policy between the euro area and the U.S. instead of current real rate differentials, they expose themselves to surprises - surprises that cause the trend to change. Today, the euro correlates massively with anticipated policy changes - not the current situation - highlighting the risk of a correction if anything dashes hopes of higher European rates in future. Chart I-8Euro: Future Versus Present In terms of potential culprits, inflation expectations rise to the top of the list. Since mid-2016, when euro area CPI swaps began to weaken relative to the U.S., this has typically been followed by a correction in EUR/USD (Chart I-9). Simply put, sagging relative inflation expectations prompt investors to question whether or not they should continue to anticipate a tightening by the ECB relative to the Fed in the years ahead. Additionally, EUR/USD has historically traded as a function of global export growth, reflecting the euro area's greater leverage to global trade than the U.S.'s. However, as Chart I-10 highlights, the euro has overshot the mark implied by global trade growth. Chart I-9Inflation Expectations Point To A Correction Chart I-10Euro Is Stronger Than Global Trade Warrants In of itself, this is a weak signal. After all, the decoupling can be solved by a rebound in global trade. However, the decline in manufacturing production evident across EM Asia suggests this will not be the case, as global trade is dominated by shipments of manufacturing goods (Chart I-11). If these waves were to affect Europe, it could spur a period where investors begin questioning the path for the ECB's policy rate. Some European indicators already highlight this risk. Sweden's economy is very sensitive to global trade growth, as exports represent nearly 50% of Sweden's economy. Moreover, Sweden exports a lot of intermediary goods to Europe. This place within the European supply chain suggests that if any weakness in global trade emerges, it is likely to be felt in Sweden before it is felt in the rest of Europe. Today, while European PMIs are still near record highs, Swedish Manufacturing PMI have been falling significantly after hitting 65 last year (Chart I-12, top panel). This suggests the first ripples of the manufacturing slowdown in Asia are hitting Europe's shores. Chart I-11A Headwind For Global Trade Chart I-12The Slowdown Will Come To Europe In the same vein, Switzerland is a large exporter of machinery and chemicals. Its exports are therefore also sensitive to the global manufacturing cycle. Swiss export orders have been nosediving in recent months, which has historically pointed to periods of vulnerability for EUR/USD (Chart I-12, bottom panel). Finally, as Chart I-13 shows, for the past year, rises in the FX market's implied volatility have been followed by periods of weaknesses in EUR/USD. This also suggests that at the very least, the euro will need to digest its recent strength for another while before rallying anew. At worst, a correction could emerge in the first quarter of 2018. Meanwhile, Chart I-14 illustrates that EUR/JPY could also suffer downside in the wake of a rise in currency implied volatility. We were stopped out of this trade for now, but it remains a high conviction all for the first half of 2018. Chart I-13Higher FX Vol: A Risk For EUR/USD... Chart I-14...And EUR/JPY Bottom Line: The time is nigh for a euro correction to begin. From the dollar's perspective, not only is it oversold, but stories of a 'twin deficit" tend to be associated with selling pressures hitting their paroxysm, at least on a three- to six-month basis. Meanwhile, the euro is not only overbought but is also trading in line with hopes for a rise in policy rates vis-à-vis the U.S. while ignoring the current situation in terms of real rate differentials - a situation that historically has only lasted so long without a reversal, even if temporary. Moreover, European inflation expectations are weakening and Asia's manufacturing cycle is slowing, heightening the risk that investors temporarily curtail their hopes for the ECB and move back to focusing on current real rate spreads. A Few Words On The Pound The Bank Of England is meeting next week. BoE Governor Mark Carney made some hawkish noise this week, highlighting that the impact of the Brexit shock is passing, and that the BoE can narrow its focus on inflation dynamics. This of course begs the question of what the outlook is for inflation dynamics. As Chart I-15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating as sharply as it did in 2016. Thus, the pass-through from a lower exchange rate is beginning to dissipate. Moreover, in terms of growth, Brexit risk may have receded, but the British economy continues to face important hurdles. For one, real consumption, which constitutes 63% of the British economy, could decelerate further (Chart I-16). Real disposable income growth is negative and household confidence is declining. Additionally, the savings rate has no downside left, especially as household credit growth is beginning to weaken. The weakness in house prices, especially in London, will not dissipate anytime soon, as the RICS survey is still displays poor showings. Chart I-15U.K.: Less Pass-Through Chart I-16The British Consumer Is Feeling The Pinch On the capex front, the picture is not much brighter. Strength in the global economy along with weakness in the pound have lifted export growth. However, corporate investments have failed to follow. In fact, private credit growth is flagging anew (Chart I-17). The market is currently pricing in 36 basis points of interest rate hikes in the U.K. for 2018, with the first one anticipated in September. Rob Robis, our Chief Global Fixed Income Strategist, does not believe the current economic situation will let the BoE actually follow this lead. Carney's recent emphasis on inflation may actually turn out to be a double-edged sword: If today's inflationary strength justifies higher rate, tomorrow's anticipated weakness will not. Thus, a potentially hawkish BoE next week will probably have to be faded, not heeded. In terms of currency markets, the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart I-18). The economics currently at play in the U.K. make it unlikely that it will be able to punch above this line yet, especially as the U.K.'s basic balance is once again dipping as FDI is drying out. Chart I-17Private Credit Growth Is Slowing Chart I-18GBP: Stuck In A Rut Bottom Line: British inflation is set to slow, and the economy remains on a weak footing. The BoE will find it difficult to tighten policy much this year. With the trade-weighted pound at the top end of its post-Brexit range, a correction is likely over the coming weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "The Unstoppable Euro?" dated January 19, 2018 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been decent: Initial jobless claims declined to 230,000, while continuing jobless claims increased to 1.953 million; ISM Manufacturing index beat expectations of 58.8, coming in at 59.1; ISM Prices paid also beat expectations at 72.7; However, the employment subcomponent decelerated sharply; Chicago PMI beat expectations of 64.1, coming in at 65.7; While the Fed stayed pat in this week's FOMC monetary policy meeting, there is a 99% probability currently being priced in that New Chairman Powell will begin his leadership with a hike. This is in line with our own expectations. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed this week: Consumer confidence, service sentiment, business climate and overall economic sentiment all failed to meet expectations; 2017 Q4 GDP grew at a 2.6% annual pace, implying that the euro area's growth in 2017 once again beat that of the U.S.; German headline inflation came in at 1.4%, less than the expected 1.6%; German unemployment rate decreased to 5.4%, beating expectations; Overall European inflation (headline and core) both outperformed consensus at 1.3% and 1% respectively. However, PMIs remain strong. The overall sentiment on the euro remains very bullish. We are likely seeing the beginning of a protracted cycle of appreciation in the euro as markets align the ascent of the currency with its growth prospects. However, the relationship against the greenback may be blurred as the Fed is hiking faster than the ECB. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Unstoppable Euro? - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The jobs/applicant ratio outperformed expectations, coming in at 1.59. This measure is now at 44 year-highs. Moreover, retail trade yearly growth outperformed expectations, coming in at 3.6%. It also increased from 2.1% the previous month. However, consumer confidence underperformed expectations, coming in at 44.7. Additionally, the unemployment rate also surprised negatively, coming in at 2.8%. It also increased from 2.7% the previous month. After falling precipitously last week, USD/JPY has been flat this week as Japanese policy makers increase purchases and talked down the yen. In the coming 3 months, we expect EUR/JPY to have significant downside, as financial conditions have tighten significantly in Europe relative to Japan. Moreover, rising volatility, particularly from such depressed levels will also weigh on this cross. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Net lending to individuals monthly growth outperformed expectations, coming in at 5.2 billion pounds. This measure also increased from last month's 4.9 billion pound reading. Moreover, nationwide house price yearly growth also surprised to the upside, coming in at 3.2%. This measure also increased from 2.6% last month. However, mortgage approvals underperformed expectations, coming in at 61 thousand. Finally, manufacturing PMI underperformed expectations, coming in at 55.3. GBP/USD has rallied by roughly 0.6% this week. Overall, we expect the ability of the BoE to hike more than once this year to be limited, given that the sharp appreciation that the pound has experienced in recent months should weigh on inflation. This means that cable is unlikely to have much upside from here on. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data this week surprised to the downside: NAB Business Confidence and Conditions came in lower than expected at 11 and 13 respectively; Headline CPI disappointed at 1.9% yoy, while the trimmed mean CPI also failed to perform as expected, coming in at 1.8%; Building permits contracted heavily in monthly terms at 20%, even contracting in yearly terms at a 5.5% rate; The RBA Commodity Index in SDR terms contracted by 0.6%, which was still better than the expected 8.9% contraction; These data support our view that substantial slack remains in the Australian economy. The RBA will need to consider the lackluster inflation figures at their next meeting, and are likely to maintain an easy policy setting this year. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: The trade balance outperformed expectations, coming in at -2.840 billion. It also increased from -3.480 billion the previous month. Moreover, exports for December came in at 5.5 billion, increasing from the November reading of 4.61 billion. NZD/USD appreciated by 1.2% this week. Overall the kiwi has upside against the Australian dollar, given that a negative fiscal impulse and decreased investment will likely weigh on Australia's economic outlook. Moreover the NZD would be less sensitive than the AUD to a potential slowdown in Chinese industrial activity caused by the PBoC tightening. These factors will likely weigh on AUD/NZD. That being said, if a Chinese slowdown does occur, NZD/JPY could have significant downside. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was decent: GDP grew at a 0.4% monthly rate, in line with expectations; Raw material prices, however, contracted by 0.9%; Markit Manufacturing PMI increased to 55.9 from 54.7, beating expectations of 54.8; The Canadian economy is still booming alongside a stellar labor market. Higher oil prices and higher wages will add to inflationary pressures this year, prompting the BoC to tighten in line with expectations. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance underperformed expectations, coming in at 2.6 billion. However it increased from the previous month reading. The KOF indicator also underperformed expectations, coming in at 106.9 However the SVME PMI outperformed expectations, coming in at 65.3 EUR/CHF has depreciated by about 0.75% this week, as risk-on assets have lost ground due to the perception that a correction in the markets might be overdue. Overall, while Swiss inflation is on the rise, it is not yet high enough to cause the SNB to abandon its current dovish tilt. Thus, unless global markets weaken meaningfully, downside to EUR/CHF will likely be limited. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth surprised to the downside, coming in at -1%. This measure also declined from 2.1% on the previous month. However, Norway's credit indicator outperformed expectations, coming in at 6.3%. USD/NOK has fallen by roughly 0.8% this week, as the fall in the dollar continues to weigh on this cross. Overall, we expect the krone to have upside against the Canadian dollar, as the market is pricing 3 rate hikes in the next 12 months for the BoC, while only pricing 27 basis points for the Norges Bank. While it is true, that the recovery is much more advanced in Canada than in Norway, given the surge in oil prices, the gap in rate expectations should narrow. This will weigh on CAD/NOK. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish Manufacturing PMI surprised to the downside, coming in at 57 compared to the expected 60. Manufacturing PMI in Sweden has been declining since April last year. However, inflation has been in line with the target thanks to higher energy prices and the weakness of the cheapness of the SEK. This year, the Riksbank also seems to be slowly moving away from its dovish stance. This has allowed the SEK to recoup some of its 2017 losses against the euro. We may see a stronger SEK this year as the Riksbank is likely to turn hawkish quicker than the ECB. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, I recorded a webcast with my colleague Caroline Miller earlier this week. Caroline and I discussed the recent tax legislation in the U.S. and other key investment topics. I hope you will find the time to listen in. I am also happy to announce that going forward, in addition to sending you my regular reports, I will be sharing my thoughts on the economy and markets through Twitter. Best regards, Peter Berezin, Chief Global Strategist Highlights Some profit taking is likely over the next few weeks as U.S. equities discount a more realistic assessment of how lower tax rates will affect corporate cash flows. The cyclical picture for the U.S. and the global economy remains bright, implying that any correction will be short-lived. History suggests that the 7th and 8th innings of business-cycle expansions are often the most profitable for equity investors. With another recession still at least a year away, it is too early to get bearish on stocks and other risk assets. Feature Tax Cuts Arrive Early We had expected the Republicans in Congress to deliver on their pledge to cut taxes, but thought that the legislative process would drag on for longer than it did. In the end, the Senate was able to pass a hastily negotiated bill, giving Donald Trump his first major political victory. The question is where things go from here. The Senate and House bills still need to be reconciled. We do not anticipate much drama in that regard, given the broad similarities between the two versions. The bigger issue is how the legislation will affect the economy and markets. The Joint Committee on Taxation (JCT) estimated in mid-November that the original Senate version of the bill would raise the level of real GDP by an average of 0.8% over the ten-year budget window.1 It is reasonable to assume that the final bill will boost GDP by a similar amount. The impact on growth is likely to be somewhat front-loaded, given that several provisions will either expire or be phased out after five years. We expect real GDP growth to be 0.2%-to-0.3% higher in 2018 and 2019 as a result of the legislation. This is not a particularly large effect, which explains why the bond market reaction has been fairly muted. The impact on corporate profits will be more pronounced, but even here, one should keep things in perspective. The final bill is likely to reduce corporate taxes by about $350 billion over the next ten years. The JCT's baseline assumes corporate tax receipts of $3.9 trillion over the next decade. Thus, the bill will probably reduce the effective corporate tax rate by a bit less than two percentage points, taking it down from 19% to 17%. This, in turn, implies an increase in after-tax corporate cash flows of about 2.5% (i.e., 83 divided by 81). The market ran up a lot more than that over the past few months. Thus, we would not be surprised to see some profit-taking over the coming weeks. Cyclical Picture Still Bright If such a stock market correction occurs, it would represent a buying opportunity. Historically, recessions and bear markets have gone hand in hand (Chart 1). Right now, none of our recession indicators are warning of an imminent downturn (Chart 2). Chart 1Recessions And Bear Markets Usually Overlap Chart 2ANo Imminent Risk Of A U.S. Recession Chart 2BNo Imminent Risk Of A U.S. Recession This reassuring conclusion is consistent with the signal from our forthcoming MacroQuant Model, which we will be discussing in greater detail in the months ahead. This ground-breaking model examines dozens of variables, including a number of BCA's proprietary indicators, in order to consistently and accurately project returns across the key asset classes, geographies, and time horizons. Currently, the model is flagging a somewhat elevated risk of a temporary pullback, but continues to give a highly bullish reading on the cyclical (6-to-12 month) outlook (Chart 3). Chart 3BCA's MacroQuant Model Still Likes Equities The model's auspicious assessment largely stems from the strength of recent economic data in the U.S. and around the world. Global growth estimates continue to grind higher (Chart 4). In the U.S., the new orders component of the ISM manufacturing index rose to 64 in November, while the inventory component sank to 47. We have found that the gap between the two is a powerful predictor of stock market returns (Chart 5). The current gap is in the 87th percentile of its historic range. By the same token, core durable goods orders, initial unemployment claims, capex intentions, consumer and business confidence, global PMIs, and most other leading indicators paint a fairly upbeat picture. Chart 4Global Growth Projections Are Trending Higher Chart 5ISM As A Predictor Of Market Returns The euro area and Japan also continue to grow at a robust pace (Chart 6). Somewhat worryingly, China has seen growth tick down a notch in recent months (Chart 7). However, the evidence so far suggests that growth has merely slowed from an above-trend pace back towards potential. Nominal GDP rose by 11.2% year-over-year in Q3 2017, up from 6.4% in Q4 2015. Producer price inflation has gone from as low as negative 5.9% in September 2015 to 6.9% at present. Core CPI inflation has also accelerated, rising to 2.3% in October (Chart 8). In this light, recent efforts by the authorities to expedite structural reforms are coming at an opportune time. Chart 6Positive Growth Momentum ##br##In The Euro Area And Japan Chart 7Growth Has Ticked Down##br## In China... Chart 8... But Merely From##br## An Above-Trend Pace Too Early To Bail Out Of Stocks Table 1Stocks And Recessions: Case-By-Case All good things must come to an end. As we discussed in our latest Strategy Outlook, the global economy is likely to fall into recession in late 2019.2 Markets will sniff out a recession before it happens, but in general, the lag time between when markets peak and when recessions begin does not tend to be very long. Table 1 shows that the lag has averaged seven months during the post-war era, with the past three recessions featuring an average gap of only four months. In fact, history suggests that the 7th and 8th innings of business-cycle expansions are often the most profitable for investors. The S&P 500 has delivered an average annualized real total return of 14.2% since 1950 in the 13-to-24 months prior to past U.S. recessions (Table 2). This exceeds the average return of 10.1% during business-cycle expansions. The S&P has returned 8% at an annualized pace in the 7-to-12 months prior to past recessions. While this is below the average return during past expansions, it is still well above the average return on bonds and cash during the corresponding periods. Moreover, the performance of stocks in the 7-to-12 month period preceding recessions has improved sharply over the past few business cycles. The S&P 500 generated an annualized real total return of 22.2%, 20%, and 13.6% in the 7-to-12 months prior to the beginning of the 1990-91, 2001, and 2007-09 recessions, respectively. Table 2How Have Stocks Performed Prior To Recessions? Stocks only begin to underperform in a meaningful way in the six months before the recession and continue to underperform in the initial phase of the downturn. Thus, even if one had known with complete certainty that a recession was coming, getting out of stocks more than six months in advance of the downturn would have been a mistake. Bottom line: With another recession still at least a year away, it is too early to get bearish on equities and other risk assets. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see "Macroeconomic Analysis Of The "Tax Cut And Jobs Act" As Ordered Reported By The Senate Committee On Finance On November 16, 2017," The Joint Committee On Taxation, U.S. Congress (November 30, 2017). 2 Please see Global Investment Strategy Outlook, "A Timeline For The Next Five Years," dated December 1, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Risk assets continue to rise despite a flattening yield curve. Individual investors are more sanguine than institutional investors as stocks make new highs. The S&P 500 is testing the top of a key channel. Will it break out or break down? Bond market sentiment, positioning and technicals today vs. 1994. Feature Risk-on returned to financial markets last week as the S&P 500 hit a new all-time high and oil prices reached a 2-year high. Credit spreads narrowed as well. This occurred despite growing investor angst regarding the flattening yield curve. At 58 basis points, the 2/10 yield curve is still in positive territory, but the recent flattening could be interpreted as heralding a Fed policy mistake. We, too, are concerned. The flattening curve is being driven by the Fed's determination to continue lifting short-term rates even in the face of subdued inflation readings. Our base case outlook sees inflation grinding higher in the coming months, leading to a temporarily steeper curve. Nonetheless, we will re-evaluate our asset allocation if the curve continues to flatten and core inflation remains stuck in a range. BCA expects U.S. stocks to outperform Treasuries in 2018. S&P 500 EPS growth and margins will hold up through mid-year, supported by an above-trend domestic economic expansion in 1H 2018, a dose of fiscal stimulus and accelerating economic activity outside the U.S. Still, many investors are concerned that sentiment and valuations are signaling that a pullback is nigh. Sanguine Sentiment Our technical and sentiment indicators are not flashing red as in previous bear markets, but neither are they giving an all-clear for U.S. equity investors. Sentiment levels are a bigger concern than technical indicators and investors should monitor both for signs of an equity sell-off. BCA's U.S. equity sentiment indicator is elevated, although not at an extreme (Chart 1). Remarkably, in contrast to previous market troughs, individual Investors (panel 2) are more sanguine than either financial advisors (panel 3) or traders (panel 4). Bullishness among traders is at a 10-year high. Typically, after a long bull run, institutions are more cautious about equities than the oft-maligned individual investor. Several other sentiment surveys illustrate the divergence in sentiment between institutions and individuals. As per the American Institute of Individual Investors, the percentage of small investors who are bearish (Chart 2, 35%, panel 2) is in the middle of a 30-year range while the percentage of bulls (29%, panel 3) is at the low end. Moreover, Chart 3 shows the gap in the expectation between households and professionals on future stock market returns (as tallied by the Yale School of Management's International Center for Finance) and on buying the dips (panel 4). That said, individuals and institutions are more aligned on the likelihood of a stock market crash in the next six months. None of the three sentiment indicators from the Yale survey are at an extreme. Chart 1Overall Sentiment Levels Elevated##BR##But Not At Extremes Chart 2Individuals Are Not##BR##Overly Bullish Active managers have reduced equity risk since the beginning of Q4 (Chart 4). At 61%, the average equity exposure of institutional investors surveyed by the NAAIM1 is at the lowest level since May 2016 and is nearly half the 102% exposure at the start of 2017. The March 2017 reading was the highest since 2007, just before the S&P 500 peak in October 2007. Chart 3Gap Between Individual##BR##And Institutional Investors Chart 4Active Managers Still##BR##Overweight Equities... Similarly to previous bear markets, BCA's equity speculation index moved into "high speculation" territory in early 2017 and remains so as the year ends and range bound on average at somewhat lower levels. Net speculative positions of S&P 500 stocks are in balance, however, and do not signal that market risk-taking is rampant (Chart 5). Moreover, the dispersion of equity volatility of new high and lows of the S&P500 is quite wide, ranging from over 20% to below 5%, over previous historical periods since 1994. Although volatility is not a leading indicator of future equity market returns, good or bad, the current low level of volatility, especially over the short-term, 6 months to 1-year, may be longer-lasting, having peaked from over 15% only since early 2016 and now closer to 5%. Longer-term volatility, for example, based on 2-, 3- and 4-years, still remains above 10%. It is not unusual for both short-term and long-term volatility to eventually converge, as seen in post-bear market phases, especially in the mid-2000s (Chart 6). Chart 5Speculation High, But Not At Extremes Chart 6Equity Vol Remains Low Warning Signs From Technicals? On balance, the technical indicators we monitor do not suggest that the market is stretched. Chart 7 shows that the S&P 500 is testing the top end of the 2009-2017 recovery trend channel. A failure to break out of the channel may result in some near-term consolidation for U.S. equities. However, a definitive break above 2616 would imply another upleg for stocks. The escalating advance/decline line is also in a bullish trend (Chart 7). The other technical indicators we monitor fall into two categories. Some are elevated, but not at extremes. Others are still in the middle of the range and are not a concern. The S&P 500 is 6% above its 200-day moving average, in the upper end of its post-2000 range, which is well below the recent highs set in 2009, 2011 and 2013. The S&P's distance from its 50-day MA is in a similar position (Chart 8, panels 1 and 2). BCA's composite technical measure is in the middle of the 2007-2017 range, and is not a concern (Chart 9, panel 5). Moreover, the percent of NYSE stocks above their 10- and 30-week highs are midway in their recent range. Furthermore, new highs minus new lows is at neutral lows (Chart 6, panel 2). Chart 7Breakout...Or Breakdown##BR##At Top Of Channel? Chart 8S&P Not Elevated Vs.##BR##Moving Averages Chart 9U.S. Stocks Not##BR##Overextended Bottom Line: Neither sentiment nor technical indicators are flashing red, although the fact that institutional managers are heavily overweight stocks is worrying. We continue to recommend stocks over bonds in the next 12 months, but acknowledge that risks to BCA's stance are climbing. Investors should be prudent with risk assets, paring back any maximum overweight positions and holding some safe-haven assets within diversified portfolios. BCA's U.S. Equity Strategy service maintains a positive technical stance on the energy sector2 and notes that technicals in the consumer discretionary sector look washed out.3 BCA downgraded consumer discretionary from overweight to neutral on September 25, 2017 despite the attractive technical backdrop of the sector. Is It 1994 - Again? BCA's U.S. Bond Strategy service puts fair value on the U.S. 10-year Treasury at 2.69%,4 and rates may climb as high as 3.0% in 2018 if inflation returns to the Fed's 2.0% target. Fundamentals (elevated inflation, above-trend U.S. growth, a more aggressive Fed) support our bond view. However, what does the technical picture in the bond market tell investors? Charts 10 and 11 show the sentiment and technical indicators for the bond market in 2017 and 1994. The duration positioning of portfolio managers in late 2017 matches the situation in 1994. At 100%, portfolio duration is the highest since March 21, 2017. This positioning implies that the market is vulnerable to a spike in rates, as it was in 1994 when the Fed's 75-basis point rate hike in February caught the market off guard. In October 1994, portfolio duration was 103%. While BCA views a Fed policy mistake as a risk to our bullish equity call in 2018, a 1994-style surprise from the Fed is unlikely. In 1994, the Fed's policy intentions were opaque, at best. Since then, the Fed has become increasingly transparent and frequently seeks a "buy-in" from the market before boosting rates. Chart 10Bond Market Positioning,##BR##Sentiment And Technicals In 1994.... Chart 11...And In##BR##2017 The 10-year Treasury yield is currently in an uptrend as it was in early 1994. Today, yields have climbed 80 bps off their post-Brexit lows in mid-2016. The 10-year yield troughed in October 1993 at 5.19%, and rose 60 bps before the Fed's shock rate hike in early 1994. However, in 1994 yields were only beginning to enter the second decade of what would become a 35-year fall in bond yields. BCA's view is that the 1.57% yield in June 2016 marked the end of that multi-year decline. The bond market in late 2017 is as oversold as the bond market was in early 1994, although it took different paths to get to the same juncture. According to BCA's Composite Bond Indicator, the bond market in late 1993 and early 1994 was working off a deeply overbought position. However, by early 1994, bonds were modestly oversold. BCA's bond measure was deeply oversold in late 2016 and early 2017, but shifted into overbought territory in the summer. Today, bonds are modestly oversold. Panel 4 of Charts 10 and 11 show that Fed rate hikes were not priced in at the end of 1993 and in early 1994; today, a few increases are priced in. Investors were net purchasers of bond funds in 1993 and 1994, which is the same as the current situation. In 1993, however, investors were shedding bond funds while individuals are now adding to their bond positions. Bottom Line: Several sentiment and technical indicators in the bond market echo the scenario in 1994. Nonetheless, 25 years of increased Fed transparency means it would be unlikely that the market will be surprised by the Fed's next rate increase. Still, with a new Fed Chair, a record number of vacancies on the Fed's Board and an unprecedented unwinding of its balance sheet, a policy misstep by the Fed would threaten BCA's position on the economy, equities and bonds in 2018. A bigger risk may be that the bond market is still priced for the low inflation environment to persist. Accordingly, if there is an upside surprise on inflation, bonds could be hit hard on a re-assessment of the Fed's rate path. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 National Association of Active Investment Managers. 2 Please see BCA Research's U.S. Equity Strategy Weekly Report "Invincible", published November 6, 2017. Available at uses.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Weekly Report "Resilient", published September 25, 2017. Available at uses.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "Into The Fire", published November 7, 2017. Available at usbs.bcaresearch.com.

Special Report

Highlights On Black Monday, October 19, 1987, equity bourses around the world plunged amid cascading bouts of selling, recording some of their largest single-day losses of the twentieth century. The plunge, exacerbated by derivatives transactions, and transmitted swiftly around the world, marked the first contemporary global financial crisis. BCA clients were well prepared. The Bank Credit Analyst steadily warned of increasing stock market vulnerabilities across all of 1987 even as it correctly predicted that the S&P 500 would most likely soar before eventually cracking. The Federal Reserve's immediate all-out effort to contain the damage ushered in a new central bank template for responding to quaking markets and helped give rise to the Greenspan put. While we do not fear a repeat of Black Monday, the U.S. equity market's long-term prospects are dramatically less appealing than they were in 1987. Investors should be prepared for an extended stretch of public market returns that pale beside the ones earned over the last 30-plus years. Feature 30 years ago today, Black Monday erupted around the world, reaching its nadir in New York, where relentless waves of selling drove the major indexes down 20%. The contagion had spread in a rapid relay from Hong Kong to Europe and then to New York, before fetching up in Auckland and other Asia-Pacific exchanges as Black Tuesday. The event was the centerpiece of what turned out to be sharp, albeit relatively brief, bear markets around the world (Charts 1 and 2). Confounding nearly every observer, however, the crash did not amount to much in a broader economic context and financial markets quickly regained their footing, with global equities vaulting to new highs in the '90s1 amidst speculative excesses that made the '80s' mania look demure. Chart 1Great Runs... Chart 2...And Sudden Stops Like all serious investors, BCA researchers are students of history. Black Monday was the first modern global financial crisis, and its 30th anniversary affords us the chance to study its run-up and aftermath for insights into future dives. It also gives us the chance to return to BCA's extensive archives and see how our forebears assessed conditions in real time. Their ex-ante analysis and forecasts were stellar, and reinforce the robustness of our approach. Their lagging ex-post performance highlights the need for investors to maintain a flexible mindset that can accommodate all possibilities. From Fear To Greed Black Monday marked the definitive end of a historically potent bull market (Table 1) that began, as the best ones do, in revulsion. Business Week's August 1979 cover story trumpeting the death of equities has become notorious, but the S&P 500 didn't bottom for three more years, during which it lost a quarter of its inflation-adjusted value. All told from the end of September 1968 to the end of July 1982, the S&P tumbled 62.5% in real terms (Chart 3). Inflation took a heavy toll on real growth over the 55 quarters of U.S. stocks' lost decade and a half (Chart 4, top panel), but the economy had expanded nonetheless, and stocks emerged from the ashes of the Volcker double-dip recession with a lot of ground to make up. Table 1A Bull With Speed And Stamina Chart 3A Lost Decade And A Half ... Chart 4...Despite Steady, If Unspectacular, Real Growth The ensuing five-year bull market (Chart 5, top panel) unfolded in two phases: the first, which burst out of the gate on a sudden repricing before taking a full year to catch its breath, had the support of earnings growth (Chart 5, middle panel) and re-rating; the second, which went on without pause for two and a half years, was all about re-rating (Chart 5, bottom panel). It finally ended in late August 1987, when skeptical investors could no longer stomach big gains derived entirely from multiple expansion, and stocks began to retreat in earnest in October, sliding 5% and 9% in the two weeks before Black Monday. Proximate triggers included sickly trade data, a competitive devaluation threat and proposed tax legislation that stood to make corporate takeovers a good deal more costly. The first two factors pushed the dollar down and yields up, as investors fretted that the Fed would be forced to raise rates (Chart 6), and the last pulled the plug on runaway speculation in takeover targets. Chart 5A Two-Act Bull Market Chart 6Be Careful What You Wish For The Echo Chamber, ... There is career safety in numbers, but portfolio danger. As the late Barton Biggs put it, there's no investment so good that it can't be destroyed by too much capital. Portfolio insurance may not have even been a good idea, as it didn't amount to anything more than a portfolio-sized stop-loss order, souped up with computer software and derivatives contracts. But by the fall of 1987, its widespread adoption had turned it into a very bad one. Portfolio insurance was developed in the late '70s by two finance professors who sought a method that would allow investors to participate in equity market gains while limiting their downside exposure. When stocks began to decline in the direction of a set downside limit, the portfolio insurance program would reduce net equity exposure via the sale of index futures. Once the market recovered and the program determined the coast was clear, it would unwind the futures positions. Although the technique had its flaws on a micro scale - futures trading wasn't costless, and there was considerable potential for whipsawing - it was doomed at the aggregate level because the index futures market wasn't deep enough to accommodate all the selling pressure that would be unleashed by a significant correction. ... Or, From Wall Street To LaSalle Street And Back Again There was more to Black Monday than portfolio insurance - the event was global, and the technique was not a factor on other bourses - but it helped to create a self-reinforcing spiral between the cash market in New York and the futures market in Chicago. Heavy selling of stocks in New York triggered heavy selling of index futures in Chicago, as insured portfolios sold futures to mitigate their direct cash exposures. The selling redounded back to New York as the futures buyers on the other side of the trade sold the underlying stocks to balance out their long futures positions2 and opportunistic investors seized the chance to front-run the mechanical portfolio insurers.3 The new sales pushed share prices even lower in New York, triggering more index futures selling in Chicago, and cinching the vicious circle. The View From Peel Street BCA, safely removed from the madding crowd in Montreal, foresaw something quite like the crash. The September 1986 and 1987 editions of our annual New York conferences bore the respective titles, "The Escalation in Debt and Disinflation: Prelude to Financial Mania and Crash?" and "Phase II in the Escalation of Debt, Disinflation and Market Mania: Prelude to Financial Crash?" Throughout all of 1987, the monthly Bank Credit Analyst warned of the U.S. equity market's increasing vulnerability and recommended that investors reduce exposure in a disciplined fashion ahead of the inevitable bust. The investment policy recommendation, issued in accord with prudent money management principles, differed from BCA's market forecast, which was for robust, potentially parabolic, gains before the bull market ended. BCA was not trying to have it both ways: it has long been a central tenet of our work that one's investment strategy can - and regularly should - be distinct from one's market forecast. We do not attempt to squeeze every last drop out of a bull or a bear market. Empirical evidence makes it abundantly clear that no one can consistently call tops or bottoms. In the words of turn-of-the-century trading legend Jesse Livermore: "One of the most helpful things that anybody can learn is to give up trying to catch the last eighth - or the first. These two are the most expensive eighths in the world.4" The opening paragraph of the March 1987 Bank Credit Analyst, published six months before the market peak, summarizes our ongoing advice: [I]nvestors who are overexposed should reduce positions to a level comfortable to ride out what will likely become a much more volatile phase of the secular bull market in stocks. ... At some point, it is likely that the U.S. stock market will experience a 1962-type correction - a sharp decline which comes out of the blue as a result of extreme overvaluation and excessive speculation. As then, it is unlikely to be associated with a credit crunch, as almost all post-war bear markets have been. ... At present, there is nothing in the data, either fundamental or technical, which suggests that such a shakeout is imminent. However, the key for investors in this bull market is to have positions which are sufficiently comfortable so that they can ride out sudden, dramatic corrections and participate in the long upward rise, which we feel has much further to go. (pp. 3-4) Eighteen months before the August 25th peak, the March 1986 Bank Credit Analyst's Section III was titled, "The Coming Financial Mania," and its strategy prescriptions were much more aggressive, even as it acknowledged the risks: Increasing volatility should be expected both because of the still lingering risks prevailing and the dramatic price movements in recent months. Hence, conservative investors should not overtrade. To fully capitalize on the ongoing revaluation of financial assets, it is important not to lose positions as a result of the necessary sharp corrections which will be experienced along the way. The stock and bond market potential over the next 2-3 years remains extraordinary. (p.11) The great dilemma for investors is, of course, how aggressively to play the game during the latter stages. The fascination, excitement and danger is the knowledge that vast fortunes are easily made right up to the end, but there is no reliable method to get out just before the crash. [...] Frequently the bubble goes on much longer and prices go far higher than anyone can imagine [...]. Yet, the vulnerabilities grow proportionately to the power of the manic phase. (p.26) Investment strategy in [a manic] environment must be based on the historically observed phenomenon that price appreciation generally accelerates to a climax or blowoff and that the hidden risks grow exponentially with price rises. Therefore, investors must constantly guard against the natural tendency to become increasingly greedy and careless in valuation standards as prices rise. (p.41) As good as BCA's near- and intermediate-term calls were in the run-up to the '87 crash, our longer-term calls were even better. We repeatedly argued that disinflation would be a secular trend, and that it would power secular bull markets in bonds and equities. Three decades on, with the Barclays Aggregate Index, the Barclays High Yield Index and the S&P 500 having produced real annualized total returns of 5%, 9.3% and 7.6%, respectively, the call has been vindicated (Table 2). As BCA foresaw, the harsh monetary medicine administered by the Volcker Fed to slay the inflation dragon has paid hefty market dividends. Table 2A Great Three Decades For Financial Assets The Trouble With The Austrians For all that BCA achieved ahead of Black Monday, and as correct as our long-term calls from the '80s turned out to be, it must be acknowledged that we missed the boat on getting back into equities after the crash. Part of the miss is understandable: one wouldn't expect the strategist with the most prescient call ahead of a downturn to be the first one to identity the beginning of the subsequent rally. The best investors are the ones with the supplest minds, however, and the BCA archives reveal a bias that may have gotten in the way of embracing more bullish near-term outcomes. To wit, one cannot read the 1988 and 1989 Bank Credit Analysts, and indeed, our original leaders' output, without detecting strong sympathies for the Austrian School of Economics (Box 1). BOX 1 An Austrian's Lonely Lot The Austrian School of Economics most saliently parts company with neoclassical economics in its adamant opposition to government intervention and its fraught relationship with credit. Instead of intervening to counter business cycles, Austrians would prefer to let busts run their course so as to cleanse the economy of the excesses embedded in booms. They occupy the Mellonian, purge-the-rottenness-out-of-the-system end of the continuum in opposition to the Debt Supercycle's unconditional forgiveness. Austrians regard banking and credit with some measure of suspicion, as Austrian Business Cycle Theory holds that artificially low interest rates are the raw material of destabilizing booms. Encouraged by central bankers seeking to steer an economy out of recession with a bare minimum of discomfort, borrowers take on debt to invest in projects that may not be able to pay their own way were it not for intervention. Once rates rise after policy accommodation fades, the economy slows and the extent of the malinvestment is revealed. The Debt Supercycle prescribes more of the hair of the dog to alleviate the suffering from malinvestment. The debt overhang is thereby never eliminated; it instead continues to silt up, requiring larger and larger interventions. Unchecked, the degree of intervention required to keep the plates spinning will eventually exceed capacity. This analysis is logically sound, but it so thoroughly contradicts the reigning orthodoxy that an investor who becomes emotionally invested in it is at risk of serially tilting at windmills. There is nothing wrong with the Austrian School per se. We rather like its outsider status, and actively seek heterodox inputs and perspectives so as to stay out of the ruts of the well-worn consensus path. Even its pessimistic bent has its uses; investors are surely exposed to enough cheerleading. Its prescriptions are so bracing, however, that a little goes a long way and real-world users should handle them with care. A popular pair of You Tube videos of actors portraying Keynes and Hayek issuing dueling raps about their respective ideologies (Keynes: I want to steer markets/Hayek: I want them set free!) provide an entertaining example of the Austrian-inspired investor's dilemma. Keynes, drink after drink in hand, is the exuberant life of the party, while the sallow Hayek stares into the bottom of his glass, unable to capture any other partygoers' attention. The simple conceit animating the video - Keynesianism is fun; Austrians are dour scolds - resonates deeply with elected officials. Voters love free drinks, but hate being told to eat their vegetables. The Austrian School, therefore, is a poor guide to the path that policy is likely to take. It also has the problematic effect of introducing an element of moral judgment into what should be a purely objective sphere. Investors should have a laser-like focus on what is most likely to happen and should strive to suppress extraneous notions about what should happen. The Debt Supercycle is a brilliantly incisive way of viewing the interaction between constituents' desires and officials' incentives, and has predicted the long-run direction of policy to a T. Only someone with a focus on money flows, informed by exposure to Austrian Business Cycle Theory, could have come up with it. In the hands of BCA editors in the late '80s, however, it seemed to feed a desire to see the American economy get its comeuppance. Setting aside that desire for punishment - and value judgments altogether - is the clearest way that we could have done better in the aftermath of the crash 30 years ago, when BCA essentially sat out the December '87 - July '90 equity bull market. We should strive to be dispassionate and unbiased observers of the economy and markets. After all, the process illustrated by the Debt Supercycle concept has surely helped put the wind at equities' back throughout the postwar era (Chart 7). Making sense of it without decrying it could help us to provide even better counsel. Chart 7Equity Investing Is An Optimists' Game Then And Now Does 2017 look like 1987? Is another crash lurking just around the corner? Our answers are "no," and "no." We think the resemblances between then and now are merely superficial. The good news is that the probability of a Black Monday-style crash is remote, and we think that even a run-of-the-mill bear market is not likely until our most reliable recession leading indicators, which are still dormant, begin to flash red.5 While that view may come as a short-term relief, 1987's long-term market outlook was vastly superior. While both today's bull market and the '82-'87 bull market began with forward earnings multiples at multi-year lows, the trough multiple in 1982 was in the low sixes, nearly two standard deviations below the mean (Chart 8). Even though it more than doubled by the August '87 peak, it only just reached what is now the mean level for the entire series. This bull market has seen the S&P 500's forward multiple rise to a full standard deviation above the mean. Valuation is not everything, of course. It is a lousy short-term indicator and only issues a reliable intermediate-term signal at extremes. Long-term returns correlate closely with the cyclically-adjusted P/E ("CAPE"), however, and it is currently at levels only previously reached ahead of the 1929 and 2000 peaks (Chart 9). The frothy CAPE portends a tepid long-run U.S. equity outlook. Chart 8Not A Lot Of Room To Grow Chart 9Not The Stuff Of Secular Rallies Both of the bull markets emerged from the ashes of nasty recessions (Chart 10), but the periods' primary economic threats were polar opposites, as were the policy settings adopted to counteract them. The Volcker Fed tightened monetary conditions to the point of pain in the early '80s, plunging the economy into a double-dip recession for the express purpose of eradicating the scourge of double-digit inflation (Chart 11). After the financial crisis, on the other hand, the clear and present danger was the potential for the credit bust to trigger a deflationary spiral. The Bernanke Fed pursued unprecedentedly accommodative policy in response. Chart 10Similarly Nasty Recessions ... Chart 11... But Opposite Inflation Backdrops The policy measures of the early '80s were an example of swapping near-term pain for long-term gain, and they set the stage for secular rallies in financial assets that continue to this day. Once inflation was removed from the equation, interest rates had to fall, and they did so for 35 years. The extraordinary accommodation in the wake of the crisis was an attempt to stave off hysteresis, which boils down to mitigating near-term pain as an insurance policy against long-term pain.6 It may well have worked, but there is no such thing as a free lunch, and the Fed's exertions have likely pulled forward much of the bond and stock markets' future returns. Black Monday And The Fed Put Before the October 20th open, the Fed issued the following statement: The Federal Reserve, consistent with its responsibilities as the Nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system. Although it was only 30 words long, the statement packed a punch. It signaled the Fed's willingness to fulfill its function as the lender of last resort and may also have prodded skittish banks into fulfilling their responsibilities as intermediaries. Behind the scenes, the Federal Reserve Banks of New York and Chicago were doing their utmost to keep the system functioning. New York Fed president Corrigan was twisting lenders' arms to keep credit flowing so the crash would not infect the banking system and the real economy.7 Meanwhile, the Chicago Fed wasn't letting the letter of the law keep it from "help[ing to] engineer a solution" when one of the biggest derivatives market participants "ran short of cash.8" The statement, and the vigorous offstage exertions, countered the Fed's determinedly low profile. These were the days, after all, when monetary policy actions were still regarded as something akin to state secrets. Wall Street firms employed "Fed watchers," who were charged with studying the tea leaves to determine if the Fed had adjusted policy. As late as January 1990, the Bank Credit Analyst could devote an entire Section III to the question, "Has the Federal Reserve Eased?" Some of Alan Greenspan's comments in his memoir may reflect after-the-fact boasting or burnishing, but Black Monday can be viewed as a policy watershed. After it, the Fed's conduct of monetary policy has become transparent to the point of oversharing. More meaningfully for investors, it marked the origin of the "Greenspan Put," the widespread notion among market participants that the Fed would do its best to ward off or mitigate financial market downdrafts. Are ETFs The New Portfolio Insurance? Responsibility for the crash cannot be precisely apportioned among factors, but all post-mortem analyses agree that portfolio insurance played a leading role. While it may well have proven harmless if pursued on a modest scale by a limited number of players, it morphed into a destabilizing force once a critical mass of investors embraced it. On Black Monday, it became a paradox of safety akin to the paradox of thrift: prudent and rational when practiced by one individual, but a metastasizing disaster when followed by a crowd. A reasonable roadmap for someone trying to spot parallels between then and now is to identify market products that may have become overly popular. Wall Street's tendency to wring every last drop out of financing innovations, coupled with investors' tendency to move in herds, can lead to excesses. The latest innovation to achieve wild popularity is the ETF. Is it possible that ETFs could exert the same destabilizing influence as portfolio insurance if investors' ardor for them suddenly cools? We think not. As our Global ETF Strategy service has argued, the claims about passive investing's dangers are overheated.9 The notion that index tracking is undermining price discovery disregards the power of incentives. Passive investing strikes us as the best cure for passive investing: if so many people are pursuing it that index-trackers begin to drown out active investors, the prospective returns to active investing will soar and money will rotate out of index-tracking strategies in sufficient quantity to correct the imbalance. Chatter about a passive bubble also fails to consider the source of fund flows into index-tracking ETFs. The oft-repeated statement, "so much money is flowing into ETFs that it's distorting prices across the board," does not hold up to scrutiny. Away from Japan and Switzerland, where QE purchases of ETFs are being funded with new yen and franc notes, ETFs are not being purchased with new investment capital that has materialized out of thin air. They are being purchased with existing investment capital that has merely been reallocated away from actively managed mutual funds (Chart 12). Chart 12Mirror Image Bubbles are always the result of speculative, excess-profit-seeking activity. Index-tracking ETFs are vehicles intended to deliver market returns. They are the opposite of a get-rich-quick scheme; they're the instrument investors turn to when they give up on quick riches. We do not worry that ETFs are the object of a bubble, or that they are in any way analogous to portfolio insurance in the fall of 1987. Investment Implications Black Monday was a one-off event that remained contained within the financial markets despite widespread fears that it would spread to constrict the broader financial system and the real economy. A lot has changed in 30 years, but the collision of algorithms, derivatives and global pressures squarely places it in our time. It is entirely possible that its elements could come together to create another massive single-day drop. A key difference between future single- or intra-day swoons, and the ones that have already occurred since the crisis, is that they will arrive while the Fed is tightening policy at the margin. The future swoons, then, may not be as likely to disappear quickly without leaving much of a mark. It may go too far to say that market infrastructure is vulnerable, but it would be too optimistic to assume that it has kept pace with the advances in rapid-fire trading and the increasing prevalence of algorithms. It may make sense for investors with less tolerance for risk to maintain an extra cash buffer to protect against swoons and to ensure that they have dry powder to exploit them when they materialize. We remain constructive on the global economy, however, and our house view recommends overweighting risk assets while maintaining below-benchmark duration within bond portfolios. We sympathize with investors who lament that nothing in the public markets is cheap, but synchronized global acceleration remains intact. None of our models are warning of imminent danger. We therefore remain fully invested but vigilant, seeking out signs that the long bull market may be running out of steam. After reviewing our shortcomings in the aftermath of Black Monday, however, we will seek with an open mind and will not attenuate our efforts by awaiting the rapture of a final reckoning, when the sheep and the goats will be separated according to their virtue. The whole point of policy makers' efforts to engineer a rising tide is to keep the goats, and the broader economy, from harm. Doug Peta, Senior Vice President Global ETF Strategy dougp@bcaresearch.com 1 Except in New Zealand, where Black Tuesday popped a bubble of such notable excess that the MSCI New Zealand Index today trades at less than two-thirds of its September 1987 high, and Japan, where the mania lasted until December 1989 and the MSCI Japan Index is still nearly 40% below its all-time high. 2 Index arbitrageurs would have followed the same pattern, but they were sidelined by delayed price quotes and the failure of the NYSE's automated order execution system, which kept them from accurately identifying and exploiting true arbitrage opportunities. 3 Portfolio insurance was no secret - it was estimated that $90 billion of assets were following the strategy - and its potential to amplify selling pressures in a vicious circle had been the subject of a widely followed Wall Street Journal column published a week before the crash. 4 Lefevre, Edwin. Reminiscences of a Stock Operator, John Wiley & Sons, Inc.: Hoboken (NJ), pp. 57-8. Until 1997, the prices of NYSE-listed stocks were quoted in eighth-of-a-dollar increments. 5 For details on the interaction between recessions and equity bear markets, please see the August 16, 2017 Global ETF Strategy Special Report, "A Guide to Spotting and Weathering Bear Markets," available at etf.bcaresearch.com. 6 Hysteresis is the process by which a negative cyclical phenomenon, if left unchecked, can evolve into a secular phenomenon. 7 Greenspan, Alan. The Age of Turbulence: Adventures in a New World, Penguin (New York): 2007, p.108. Greenspan disavowed knowledge of the details, but suggested that Corrigan, "the Fed's chief enforcer," "bit off a few earlobes" while encouraging bankers to keep in mind that, "'if you shut off credit to a customer just because you're a little nervous about him, but with no concrete reason, he's going to remember that'." 8 Greenspan, p. 110.

Highlights Looking into 2018, the major risk factors driving gold - inflation and inflation expectations; fiscal and monetary policy; and geopolitics - will, on balance, continue to favor gold as a strategic portfolio hedge. We expect gold will provide a good hedge against rising inflation. However, this will be partially mitigated by Fed rate hikes next year. On the back of tighter U.S. monetary policy, our macroeconomists expect a recession by 2H19, possibly earlier in 2019, which likely would be sniffed out by equity markets as early as 2H18. Our analysis indicates gold will provide a good hedge against this expected recession and the associated equity bear market.1 Lastly, geopolitical risks from (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration and (3) ongoing conflicts in the Middle East will support gold prices next year, given the metal's safe-haven properties. Energy: Overweight. At the end of 3Q17, our open energy recommendations were up 45%, led by our long Dec/17 WTI $50/bbl vs. $55/bbl Call spread. We closed out our long Brent recommendations in 3Q17 for an average gain of 116%. (Please see p. 13 for a summary of trades closed in 3Q17). Base Metals: Neutral. Our tactical short Dec/17 copper position ended 3Q17 up 6%. We are placing a trailing stop at $3.10/lb. Precious Metals: Neutral. Our long gold portfolio hedge ended 3Q17 up 4.3%. The balance of risks continues to favor this as a strategic position, which we discuss below. Ags/Softs: Neutral. We lifted our weighting on ags - particularly grains - to neutral last week. Our long corn/short wheat position is up 1.2%. Feature Chart of the WeekInflation And U.S. Financial Variables##BR##Explain Gold Prices Inflation and U.S. financial variables - particularly the USD broad trade-weighted index (TWIB), and real rates - are the main factors explaining the evolution of gold prices (Chart of the Week).2 Subdued inflation and low unemployment - a decoupling of the so-called Phillips Curve relationship that drives central-bank models of the macroeconomy - have dominated the macro landscape this year (Chart 2). We expect that current low inflation, positive growth, and low interest rates will remain in place for the next 12 months (Chart 3). Although economies such as the U.S. are growing above trend, inflation has remained weak due to a redistribution of demand through imports from countries with spare capacity, according to BCA's Global Investment Strategy.3 This is expected to continue in the near term to end-2018. However, we expect the USD to gradually strengthen, as the Fed cautiously normalizes policy rates, while other systemically important central banks remain accommodative relative to the U.S. central bank (Chart 4). Further falls in the unemployment rate will push the U.S. economy into the steep end of the Phillips Curve. Weak capex in the post-Global Financial Crisis (GFC) era means demand for labor will increase as low unemployment - and associated higher wages - encourage higher consumer spending. This will cause inflation to lift next year or early 2019. Chart 2A Decoupling Of The Phillips Curve Relationship? In such an environment, any U.S. tax cuts - which we still expect by the end of 1Q18 - will simply add fuel to the inflationary fire, and lift inflation expectations for next year and beyond. As BCA's Geopolitical Strategy team puts it, the tax cuts are a "form of modest stimulus ... (which), this far into the economic cycle, could have a significant effect."4 With unemployment at or below levels consistent with full employment in the U.S. and little slack of any sort, it would not take much in the way of fiscal stimulus to further pressure inflation. Chart 3No Pressure From Inflation Or U.S. Financial##BR##Variables...For Now Chart 4A Strengthening U.S. Dollar Will##BR##Keep The Pressure Off Gold Inflation vs. Fed Hikes In the face of the rising inflation we expect next year, gold's appeal will increase. As our previous research reveals, gold's correlation with inflation is strengthened during periods of low real rates, i.e., the difference between nominal rates and inflation. This is a perfect context for gold. However, gold's ability to hedge inflation risks to portfolios will be partially hampered by a more-hawkish Fed. As inflation finally takes off, the Fed will feel confident to hike rates more aggressively. More than anything, this will put a bid under the USD, as U.S. interest-rate differentials vs. other currencies rise in favor of the dollar. In addition, real rates will rise as the Fed gains confidence it can lift policy rates without doing serious harm to the U.S. economy, and follows thru with its normalization. Thus, the gold market will be facing two opposing forces: On the one hand, gold will be an attractive inflation hedge as inflationary pressures build up. On the other, as the Fed begins to tighten to respond to those inflationary pressures, gold will lose its appeal in the face of rising real rates and a strong dollar. Chart 5Fed Will Ease Pressure Off Gold##BR##If It Gets Ahead Of Inflation The timing of the Fed's rate hikes will be critical to the evolution of gold prices next year and beyond. We previously assumed that rate hikes will remain behind wage growth, which would be supportive of gold prices as inflation picks up. However, if the Fed begins hiking ahead of any realized uptick in inflation, this would create a stronger-than-expected headwind for gold (Chart 5). While we expect inflation to take off in 2H18, our House view calls for 2 to 3 hikes by then. This is a risk to our gold view. Longer term, Fed rate hikes could trigger a feedback loop that will make it difficult for the U.S. central bank policy to support low unemployment rates. As real rates rise, increased unemployment will lead households to spend less. Lower demand will force firms to reduce hiring. The accompanying slowing of U.S. growth will disseminate to the rest of the world, pushing the global economy into a shallow recession as early as 2H19. In all likelihood, this higher-inflation/higher-policy-rate period will be sniffed out by equity markets before the economy actually enters a recession, leading to a bear market. Somewhat counterintuitively, this will favor gold as a portfolio hedge, as we discuss below. Bottom Line: As U.S. unemployment continues falling, inflation will re-emerge, as predicted by the Philips Curve trade-off so important to central-bank policy. Gold then will face two opposing forces. Its inflation hedging properties will be partially hamstrung by rising real U.S. rates and a strengthening USD. Nevertheless, we will turn bullish gold towards the end of next year as signs of an equity bear market emerge. Gold Will Outperform In An Equity Bear Market Our modelling indicates gold is an exceptional safe-haven during downturns in equity markets.5 It is especially attractive in equity bear markets because its returns during such episodes are negatively correlated with the U.S. stock market. This relationship with equities does not hold in bull markets -- gold prices typically rise during such periods, but at a slower rate than equities (Table 1). Table 1Gold's Ability To Hedge U.S. Equities In a Special Report titled "Safe Havens: Where To Hide Next Time?" BCA's Global Asset Allocation Strategy team looked at the performance of nine safe-haven assets and found, on average, they are negatively correlated with equities in every bear market since 1972.6 Although the current equity bull market still has room to run, recessions and bear markets tend to coincide (Chart 6). If the economy goes into recession in 2H19, equities could peak as early as the end of next year.7 Chart 6Bear Markets Usually Precede Recessions Gold's role as a global portfolio hedge during bear markets would thus support the hypothesis that the metal could enter a bull market as soon as end-2018 when equity markets start pricing in a recession (Chart 7). Things could get interesting at this point, since a clear indication the economy is entering into a recession likely will cause "traumatized" central bankers to turn overly dovish. This would add support to the gold market longer term.8 Chart 7Gold Outperforms During Recessions##BR##And Geopolitical Crises Correlations between safe havens decline during bear markets, as our GAA strategists found when they compared correlations by dividing the assets into three "buckets": currencies, inflation hedges, and fixed-income instruments. In this analysis, our GAA team found that gold outperformed TIPS and Farmland in the inflation-hedge bucket.9 Bottom Line: Gold is an exceptional hedge against downturns in equity markets. The bear market preceding the late-2019 recession we expect will put a bid under gold. The eventual turn to the dovish side by central bankers will further support the metal. Gold Will Hedge Geopolitical Risks A confluence of elevated geopolitical risks next year will drive part of gold's performance. BCA's Geopolitical Strategy (GPS) group has highlighted the following three themes investors need to track going into next year: U.S.-China Tensions: Our geopolitical strategists believe that the Korean conflict is a derivative of a more important secular trend of U.S.-China tensions. They estimate the risk of total war on the Korean peninsula at less than 3% and believe that the market impact of North Korea's provocations has peaked in the late summer. Nevertheless, they warn against complacency, as the underlying tensions over Pyongyang's nuclear program remain unresolved and North Korea could break with its past patterns.10 If the North stages attacks against U.S. or Japanese assets, or international shipping or aircraft, for instance, it could cause a larger safe-haven rally than what we witnessed earlier this year. At the very least, geopolitically induced volatility may return as U.S. President Trump tries to convince the world that war is a real option - a critical condition for establishing a "credible threat" of war with which to influence North Korean behavior - and as the U.S. and China spar over other issues. Trump's protectionism: Trump's campaign promised significant trade-protectionism. While he has not yet acted on those promises, the risk is that he returns to them next year.11 These policies could impact the gold market by: a. Feeding fears that the United States is abandoning the global liberal order; b. Intensifying U.S. trade tensions and strategic distrust with China; c. Pressuring U.S. domestic inflation via higher import prices. This risk will become even more elevated if the Trump administration and Congress fail to pass any tax legislation this year. Our geopolitical strategists believe that such a failure, while not their baseline scenario, would drive Trump to focus on his foreign policy and trade agenda more intently, especially ahead of the midterm elections in November next year, which would increase safe-haven flows. 3. Mideast Troubles: While we are not alarmist about the Middle East, the risk of market-relevant conflicts will be higher over the coming 12 months than over the previous year, following the fall of ISIS. The latter gave reason for various regional powers to cooperate, while its absence will revive their grievances with each other. Kurdish assertiveness is a key consequence, highlighted by last month's Kurdish independence referendum.12 Iraqi forces have pushed ISIS out of major Iraqi cities and the slowdown in the fight against ISIS could push Iraqi forces to focus on regaining the province of Kirkuk. Kirkuk, which is home to major oil fields and reserves, has been under Kurdish control since 2014 when the Peshmerga forces there captured it from ISIS. As ISIS ceases to be a threat, Baghdad will try to regain control of these precious oil fields. The Kurdish conflict, as well as Trump's pressure tactics against Iran, will increase geopolitical risks in oil-producing (hence market-relevant) areas. Chart 82017 Risks Were Overstated In a recent study investigating how different "safe-havens" assets react to political and financial events, our GPS colleagues found that gold provides the best average returns following a major geopolitical event (Chart 7).13 Our House geopolitical view has maintained that political risks in 2017 were overstated. This was particularly the case in Europe, where much of the risk was exaggerated and merely the product of linear extrapolation from the outcomes of the U.K. referendum on EU membership and the U.S. presidential election. As such, we do not expect any European break-up risk to support gold prices next year. Although elevated Italian Euroscepticism is one lingering European risk that could impact gold markets, we see this as a long-term risk rather than a market catalyst arising from the Italian general election in May next year. Reflecting our view, the policy uncertainty index has fallen drastically in the last two months (Chart 8). Bottom Line: Elevated political risks in 2018 will further support the gold market. Most notable on our geopolitical strategists' minds are continued U.S.-China tensions (most notably over Korea), Trump's protectionist policies, and potential conflicts in the Middle East. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 2 Our results show 1% increase in U.S. YoY CPI, 5 year real rates, and USD TWI are associated with a 4% increase, 0.18% decline and a 0.21% decline in gold prices, respectively. The adjusted R2 is 0.88. 3 Please see the Global Investment Strategy Outlook "Fourth Quarter 2017: Goldilocks And The Recession Bear," dated October 4, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report "Is King Dollar Back," dated October 4, 2017, available at gps.bcaresearch.com. 5 We use the S&P 500 Total Return (TR) index as a proxy for U.S. equities. 6 Please see Global Asset Allocation Special Report "Safe Havens: Where To Hide Next Time?," dated April 21, 2017, available at gaa.bcaresearch.com. 7 Please see Global Asset Allocation Quarterly Portfolio Outlook, dated October 2, 2017, available at gaa.bcaresearch.com. 8 Please see the Global Investment Strategy Outlook "Fourth Quarter 2017: Goldilocks And The Recession Bear," dated October 4, 2017, available at gis.bcaresearch.com. 9 Please see Global Asset Allocation Special Report "Safe Havens: Where To Hide Next Time?," dated April 21, 2017, available at gaa.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 12 Armed conflict in the Middle East usually lead to a sharp rally in gold prices. Please see Table 1 from Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," dated August 16, 2017, available at gps.bcaresearch.com. 13 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Financial markets have slipped into a 'risk off' phase. The upbeat second quarter earnings season in the U.S., Japan and the Eurozone was overwhelmed by a number of negative events. Equity bear markets are usually associated with recessions. On that score, we do not see any warning signs of an economic downturn. However, geopolitical risks are rising at a time when valuation measures suggest that risk assets are vulnerable. We do not see the debt ceiling or the failure of movement on U.S. tax reform as posing large risks for financial markets. However, trade protectionism and, especially, North Korea are major wildcards. We don't believe the tensions in the Korean peninsula will end the cyclical bull market in global equities. Nonetheless, investors should expect to be tested numerous times over the next year to 18 months. BCA Strategists debated trimming equity exposure to neutral. However, the majority felt that, while there will be near-term volatility, the main equity indexes are likely to be higher on a 6-12 month horizon. Riding out the volatility is a better approach than trying to time the short-term ups and downs. That said, it appears prudent to be well shy of max overweight positions and to hold some safe haven assets within diversified portfolios. On a positive note, we have upgraded our EPS growth forecasts, except in the Eurozone where currency strength will be a significant drag in the near term. The Fed faced a similar low inflation/tight labor market environment in 1999. Policymakers acted pre-emptively and began to tighten before inflation turned up. This time, the FOMC will want to see at least a small increase in inflation just to be sure. Wages may be a lagging indicator for inflation in this cycle. Watch a handful of other indicators we identify that led inflection points in inflation in previous long economic expansions. This year's euro strength is unlikely to delay the next installment of ECB tapering, which we expect in early in 2018. Investors seem to be taking an "I'll believe it when I see it" attitude toward the U.S. inflation outlook, which has led to very lopsided rate expectations. Keep duration short. Feature Chart I-1Trump Popularity Headwind For Tax Reform A 'risk off' flavor swept over financial markets in August. The upbeat second quarter earnings season in the U.S., Japan and the Eurozone was overwhelmed by a number of negative events, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to North Korean tensions to the Texas flood and the terror attack in Spain. Trump's popularity rating is steadily declining, even now among Republican voters (Chart I-1). This has raised concerns that none of his business-friendly policies, tax cuts or initiatives to boost growth will be successfully enacted. It is even possible that the debt ceiling will be used as a bargaining chip among the various Republican factions. The political risks are multiplying at a time when the equity and corporate bond markets are pricey. Valuation measures do not help with timing, but they do inform on the potential downside risk if things head south. At the moment, we do not see any single risk as justifying a full retreat into safe havens and a cut in risk asset allocation to neutral or below. Nonetheless, there is certainly a case to be cautious and hold some traditional safe haven assets. Timing The Next Equity Bear Market It is rare to have an equity bear market without a recession in the U.S. There have been plenty of market setbacks that did not quite meet the 20% bear-market threshold, but were nonetheless painful even in the absence of recession (Black Monday, LTCM crisis, U.S. debt ceiling showdown and euro crises). Unfortunately, these corrections are very difficult to predict. At least with recessions, investors have a fighting chance in timing the exit from risk exposure. The slope of the yield curve and the Leading Economic Indicator (LEI) are classic recession indicators, and for good reason (Chart I-2). Over the past 50 years they have both successfully called all seven recessions with just one false positive. We can eliminate the false positive signals by combining the two indicators and follow a rule that both must be in the red to herald a recession.1 Chart I-2The Traditional Recession Indicators Have Worked Well It will be almost impossible for the yield curve to invert until the fed funds rate is significantly higher than it is today. Thus, it may be the case that a negative reading on the LEI, together with a flattening (but not yet inverted) yield curve, will be a powerful signal that a recession is on the way. Neither of these two indicators are warning of a recession. Global PMIs are hovering at a level that is consistent with robust growth. The erosion in the Global ZEW and the drop in the diffusion index of the Global LEI are worrying signs, but at the moment are consistent with a growth slowdown at worst (Chart I-3). Financial conditions remain growth-friendly and subdued inflation is allowing central banks to proceed cautiously when tightening (in the case of the Fed and Bank of Canada) or tapering (ECB). As highlighted in last month's Overview, the global economy has entered a synchronized upturn that should persist for the next year. The U.S. will be the first major economy to enter the next recession, but that should not occur until 2019 or 2020, barring any shocks in the near term. That said, risk asset prices have been bid up sharply and are therefore vulnerable to a correction. Below, we discuss five key risks to the equity bull market. (1) Is All Lost For U.S. Tax Cuts? Our recent client meetings highlight that investors are skeptical that any fiscal stimulus or tax cuts will see the light of day in the U.S. Tax cuts and infrastructure spending appear to have been priced out of the equity market, according to the index ratios shown in Chart I-4. We still expect a modest package to eventually be passed, although time is running out for this year. Tax reform is a major component of Trump's and congressional Republicans' agenda. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Chart I-3Some Worrying Signs On Growth Chart I-4Fiscal Stimulus Largely Priced Out One implication of Tropical Storm Harvey is that it might force Democrats and Republicans to cooperate on an infrastructure bill for rebuilding. Even a modest spending boost or tax reduction would be equity-market positive given that so little is currently discounted. The dollar should also receive a lift, especially given that the Fed might respond to any fiscally-driven growth impulse with higher interest rates. (2) Who Will Lead The Fed? There is a significant chance that either Yellen will refuse to stay on when her term expires next February or that Trump will appoint someone else anyway. In this case, we would expect the President to do everything he can to ensure that the Fed retains its dovish bias. This means that he is likely to favor a non-economist and a loyal adviser, like Gary Cohn, over any of the more traditional, and hawkish, Republican candidates. Cohn could not arrive at the Fed and change the course of monetary policy on day one. The FOMC votes on rate changes, but in reality decisions are formed by consensus (with one or two dissents). The only way Cohn could implement an abrupt change in policy is if the Administration stacks the Fed Governors with appointees that are prepared to "toe the line" (the Administration does not appoint Regional Fed Presidents). Stacking the Governorships would take time. Nonetheless, it is not clear why President Trump would take a heavy hand in monetary policy when the current FOMC has been very cautious in tightening policy. The bottom line is that we would not see Cohn's appointment to the Fed Chair as signaling a major shift in monetary policy one way or the other. (3) The Debt Ceiling A more immediate threat is the debt ceiling. Recent fights over Obamacare and tax reform have pit fiscally conservative Republicans against the moderates, and it is possible that the debt ceiling is used as a bargaining chip in this battle. While government shutdowns have occurred in the past, the debt ceiling has never been breached. At the end of the day, the debt ceiling will always be raised because no government could stand the popular pressure that would result from social security checks not being mailed out to seniors or a halt to other entitlement programs. Even the Freedom Caucus, the most fiscally conservative grouping in the House, is considerably divided on the issue. This augurs well for a clean bill to raise the debt ceiling as the Republican majority in the House is 22 and the Freedom Caucus has 31 members. Democrats will not stand in the way of passage in the Senate. The worst-case scenario for the market would be a two-week shutdown in the first half of October, just before the debt ceiling is hit. We would not expect a shutdown to have any lasting impact on the economy, although it could provide an excuse for the equity market to correct. That said, the risk of even a shutdown has been diminished by events in Houston. It would be very difficult and damaging politically to shut down the government during a humanitarian emergency. (4) Trade And Protectionism The removal of White House Chief Strategist Stephen Bannon signals a shift in power toward the Goldman clique within the Trump Administration. National Economic Council President Gary Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross are now firmly in charge of economic policy. The mainstream media has interpreted this shift within the Administration as reducing the risk of trade friction. We do not see it that way. President Trump still sounds hawkish on trade, particularly with respect to China. Our geopolitical experts point out that there are few constraints on the President to imposing trade sanctions on China or other countries. He could use such action to boost his popularity among his base heading into next year's midterm elections. On NAFTA, the Administration took a hard line as negotiations kicked off in August. This could be no more than a negotiating tactic. Our base case is that it will be some time before investors find out if negotiations are going off the rails. That said, the situation is volatile for both NAFTA and China, and we can't rule out a trade-related risk-off phase in financial markets over the next year. (5) North Korea North Korea's missile launch over Japan highlights that the tense situation is a long way from a resolution. The U.S. is unlikely to use military force to resolve the standoff. There are long-standing constraints to war, including the likelihood of a high death toll in Seoul. Moreover, China is unlikely to remain neutral in any conflict. However, the U.S. will attempt to establish a credible threat in order to contain Kim Jong-un. From an investor's perspective, it will be difficult to gauge whether the brinkmanship and military displays are simply posturing or evidence of real preparations for war.2 We don't believe the tensions in the Korean peninsula will end the cyclical bull market in global equities. Nonetheless, investors should expect to be tested numerous times over the next year to 18 months. Adding it all up, there is no shortage of things to keep investors awake at night. We would be de-risking our recommended portfolio were it not for the favorable earnings backdrop in the major advanced economies. Profit Outlook Update Chart I-5EPS Growth Outlook Second quarter earnings season came in even stronger than our upbeat models suggested in the U.S., Eurozone and Japan. This led to upward revisions to our EPS growth forecast, except in the Eurozone where currency strength will be a significant drag in the near term. The U.S. equity market enjoyed another quarter of margin expansion in Q2 2017 and the good news was broadly based. Earnings per share were higher versus Q2 2016 in all 11 sectors. Results were particularly strong in energy, technology and financials. Looking ahead, an update of our top-down model suggests the EPS growth will peak just under 20% late this year on a 4-quarter moving average basis, before falling to mid-single digits by the end of 2018 (Chart I-5). The peak is predicted to be a little higher than we previously forecast largely due to the feed-through of this year's pullback in the dollar. In Japan, a solid 70% of reporting firms beat estimates. Chart I-6 shows that Japan led all other major stock markets in positive earnings surprises in the second quarter. Manufacturing sectors, such as iron & steel, chemicals and machinery & electronics, were particularly impressive in the quarter, reflecting yen weakness and robust overseas demand. Japanese earnings are highly geared to the rebound in global industrial production. Moreover, Japan's nominal GDP growth accelerated in the second quarter and the latest PPI report suggested that corporate pricing power has improved. Twelve-month forward EPS estimates have risen to fresh all times highs, and have outperformed the U.S. in local currencies so far this year. Corporate governance reform - a key element of Abenomics - can take some credit for the good news on earnings. The share of companies with at least two independent directors rose from 18% in 2013 to 78% in 2016. The number of companies with performance-linked pay increased from 640 to 941, while the number that publish disclosure policies jumped from 679 to 1055. Analysts have been slow to factor in these positive developments. We expect trailing EPS growth to peak at about 25% in the first half of 2018 on a 4-quarter moving total basis, before edging lower by the end of the year. This is one reason why we like the Japanese market over the U.S. in local currency terms. Second quarter results in the Eurozone were solid, although not as impressive as in the U.S. and Japan. The 6% rise in the trade-weighted euro this year has resulted in a drop in the earnings revisions ratio into negative territory. Our previous forecast pointed to a continued rise in the 4-quarter moving average growth rate into the first half of 2018. However, we now expect the growth rate to dip by year end, before picking up somewhat next year. If the euro is flat from today's level, our model suggests that the drag on EPS growth will hover at 3-4 percentage points through the first half of next year as the negative impact feeds through (Chart I-7, bottom panel). Chart I-6Japan Led In Q2 Earning Surprises Chart I-7Currency Effects On Eurozone EPS Our top-down EPS model highlights that Eurozone earnings are quite sensitive to swings in the currency. In Chart I-7, we present alternative scenarios based on the euro weakening to EUR/USD 1.10 and strengthening to EUR/USD 1.30. For demonstration purposes we make the extreme assumption that the trade-weighted value of the euro rises and falls by the same amount in percentage terms. Profit growth decelerates by the end of 2017 in all three scenarios because of the lagged effect of currency swings. The projections begin to diverge only in 2018. EPS growth surges to around 20% by the end of next year in the euro-bear case, as the tailwind from the weakening currency combines with continuing robust economic growth. Conversely, trailing earnings growth hovers in the 5-8% range in the euro bull scenario, which is substantially less than we expect in the U.S. and Japan over the next year. EPS growth remains in positive territory because the assumed strength in European and global growth dominates the drag from the euro. The strong euro scenario would be negative for Eurozone equity relative performance versus global stocks in local currencies, although Europe might outperform on a common currency basis. The bottom line is that 12-month forward earnings estimates should remain in an uptrend in the three major economies. This means that, absent a negative political shock, the equity bull phase should resume in the coming months. Monetary policy is unlikely to spoil the party for risk assets, although the bond market is a source of risk because investors seem unprepared for even a modest rise in inflation. FOMC Has Seen This Before The Minutes from the July FOMC meeting highlighted that the key debate still centers on the relationship between labor market tightness and inflation, the timing of the next Fed rate hike and how policy should adjust to changing financial conditions. Chart I-8The FOMC Has Been Here Before The majority of policymakers are willing for now to believe that this year's soft inflation readings are driven largely by temporary 'one-off' factors. The hawks worry that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge of inflation. They also point to the risk that low bond yields are promoting excess risk taking in financial markets. Moreover, the recent easing in financial conditions is stimulative and should be counterbalanced by additional Fed tightening. The hawks are thus anxious to resume tightening, despite current inflation readings. Others are worried that inflation softness could reflect structural factors, such as restraints on pricing power from global developments and from innovations to business models spurred by advances in technology. In this month's Special Report beginning on page 18, we have a close look at the impact of "Amazonification" in holding down overall inflation. We do not find the evidence regarding e-commerce compelling, but the jury is still out on the impact of other technologies. If robots and new business strategies are indeed weighing on inflation, it would mean that the Phillips curve is very flat or that the full employment level of unemployment is lower than the Fed estimates (or both). Either way, the doves would like to see the whites-of-the-eyes of inflation before resuming rate hikes. The last time the Fed was perplexed by a low level of inflation despite a tight labor market was in the late 1990s (Chart I-8). The FOMC cut rates following the LTCM financial crisis in late 1998, and then held the fed funds rate unchanged at 4¾% until June 1999. Core inflation was roughly flat during the on-hold period at 1% to 1½%, even as the unemployment rate steadily declined and various measures pointed to growing labor shortages. The FOMC 's internal debate in the first half of 1999 sounded very familiar. The minutes from meetings at that time noted that some policymakers pointed to the widespread inability of firms to raise prices because of strong competitive pressures in domestic and global markets. Some argued that significant cost saving efforts and new technologies also contributed to the low inflation environment for both consumer prices and wages. One difference from today is that productivity growth was solid at that time. The FOMC decided to hike rates in June 1999 by a quarter point, despite the absence of any clear indication that inflation had turned up. Policymakers described the tightening as "a small preemptive move... (that) would provide a degree of insurance against worsening inflation later". The Fed went on to lift the fed funds rate to 6½% by May 2000. Interestingly, the unemployment rate in June 1999 was 4.3%, exactly the same as the current rate. There are undoubtedly important differences in today's macro backdrop. The Fed is also more fearful of making a policy mistake in the aftermath of the Great Recession and financial crisis. Nonetheless, the point is that the Fed has faced a similar low inflation/tight labor market environment before, but in the end patience ran out and policymakers acted pre-emptively. Inflation Warning Signs During Long-Expansions We have noted in previous research that inflation pressures are slower to emerge in 'slow burn' recoveries, such as the 1980s and 1990s. In Chart I-9, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth was a lagging indicator. Economic commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. This is not to say that we should totally disregard wage information. But it does mean that we must keep an eye on a wider set of data. Indicators that provided some leading information in the previous two long cycles are shown in Chart I-10. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart I-10 because it does not have enough history. At the moment, the headline PPI, ISM Prices Paid and BCA's pipeline inflation pressure index are all warning that inflation pressures are gradually building. However, this message is not confirmed by the St. Louis Fed's index and corporate selling prices. We are also watching the velocity of money, which has been a reasonably good leading indicator for U.S. inflation since 2000 (Chart I-11). Chart I-9In The 80s & 90s Wage Growth ##br##Gave No Early Warning On Inflation Chart I-10Leading Indicators Of Inflation ##br##In "Slow Burn" Recoveries Chart I-11Money Velocity And Inflation Our Fed view remains unchanged from last month; the FOMC will announce its balance sheet diet plan in September and the next rate hike will take place in December. Nonetheless, this forecast hangs on the assumption that core inflation edges higher in the coming months. Some indicators are pointing in that direction and recent dollar weakness will help. Wake Me When Inflation Picks Up Investors seem to be taking an "I'll believe it when I see it" attitude toward the U.S. inflation outlook. They also believe that persistent economic headwinds mean that monetary policy will need to stay highly accommodative for a very long time. Only one Fed rate hike is discounted between now and the end of 2018, and implied forward real short-term rates are negative until 2022. While we do not foresee surging inflation, the risks for market expectations appear quite lopsided. We expect one rate hike by year end, followed by at least another 50 basis points of tightening in 2018. The U.S. 10-year yield is also about almost 50 basis points below our short-term fair value estimate (Chart I-12). Moreover, over the medium- and long-term, reduced central bank bond purchases will impart gentle upward pressure on equilibrium bond yields. Twenty-eighteen will be the first time in four years in which the net supply of government bonds available to private investors will rise, taking the U.S., U.K., Eurozone and Japanese markets as a group. This year's euro strength is unlikely to delay the next installment of ECB tapering, which we expect in early in 2018. The currency appreciation will keep a lid on inflation in the near term. However, we see the euro's ascent as reflective of the booming economy, rather than a major headwind that will derail the growth story. Overall financial conditions have tightened this year, but only back to levels that persisted through 2016 (Chart I-13). Chart I-12U.S. 10-year Yield Is Below Fair Value Chart I-13Financial Conditions It will take clear signs that the economy is being negatively affected by currency strength for the ECB to back away from tapering. Indeed, the central bank has little choice because the bond buying program is approaching important technical limits. European corporate and peripheral bond spreads are likely to widen versus bunds as a result. The implication is that global yields have significant upside potential relative to forward rates, especially in the U.S. market. Duration should be kept short. JGBs are the only safe place to hide if global yields shift up because the Bank of Japan is a long way from abandoning its 10-year yield peg. Treasury yields should lead the way higher, which will finally place a bottom under the beleaguered dollar. Nonetheless, we are tactically at neutral on the greenback. Conclusions Chart I-14Gold Loves Geopolitical Crises In light of rising geopolitical risk, the BCA Strategists recently debated trimming equity exposure to neutral. Some argued that the risk/reward balance has deteriorated; the upside is limited by poor valuation, while there is significant downside potential if the North Korean situation deteriorates alarmingly. However, the majority felt that, while there will be near-term volatility, the main equity indexes are likely to be higher on a 6-12 month horizon. Riding out the volatility is a better approach than trying to time the short-term ups and downs. That said, it appears prudent to be well shy of max overweight positions and to hold some safe haven assets within diversified portfolios. BCA research has demonstrated that U.S. Treasurys, Swiss bonds and JGBs have been the best performers in times of crisis (Chart I-14).3 The same is true for the Swiss franc and the Japanese yen, such that the currency exposure should not be hedged in these cases. The dollar is more nuanced. It tends to perform well during financial crises, but not in geopolitical crises or recessions. Gold has tended to perform well in geopolitical events and recessions, although not in financial crises. We continue to prefer Japanese to U.S. stocks in local currency terms, given that EPS growth will likely peak in the U.S. first. Japanese stocks are also better valued. Europe is a tough call because this year's currency strength will weigh on earnings in the next quarter or two. However, the negative impact on earnings will reverse if the euro retraces as we expect. EM stocks have seen the strongest positive earnings revisions this year. We continue to worry about some of the structural headwinds facing emerging markets (high debt levels, poor governance, etc.). However, the cyclical picture remains more upbeat. Chinese H-shares remain our favorite EM market, trading at just 7.5 times 2017 earnings estimates. Our dollar and duration positions have been disappointing so far this year. Much hinges on U.S. inflation. Investors appear to have adopted the idea that structural headwinds to inflation will forever dominate the cyclical pressures. This means that the bond market is totally unprepared for any upside surprises on the inflation landscape. Admittedly, a rise in bond yields may not be imminent, but the risks appear to us to be predominantly to the upside. Lastly, crude oil inventories are shrinking as our commodity strategists predicted. They remain bullish, with a price target of USD60/bbl. Mark McClellan Senior Vice President The Bank Credit Analyst August 31, 2017 Next Report: September 28, 2017 1 Please see BCA Global ETF Strategy, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com 3 Please see BCA Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com II. Did Amazon Kill The Phillips Curve? A "culture of profound cost reduction" has gripped the business sector since the GFC according to one school of thought, permanently changing the relationship between labor market slack and wages or inflation. If true, it could mean that central banks are almost powerless to reach their inflation targets. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. In theory, positive supply shocks should not have more than a temporary impact on inflation if the price level is indeed a monetary phenomenon in the long term. But a series of positive supply shocks could make it appear for quite a while that low inflation is structural in nature. We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence at the macro level. The admittedly inadequate measures of online prices available today do not suggest that e-commerce sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points. Moreover, it does not appear that the disinflationary impact of competition in the retail sector has intensified over the years. Today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. However, the fact that retail margins are near secular highs outside of department stores argues against this thesis. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High profit margins for the overall corporate sector and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. Anecdotal evidence is all around us. The global economy is evolving and it seems that all of the major changes are deflationary. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. Central banks in the major advanced economies are having difficulty meeting their inflation targets, even in the U.S. where the labor market is tight by historical standards. Based on the depressed level of bond yields, it appears that the majority of investors believe that inflation headwinds will remain formidable for a long time. One school of thought is that low inflation reflects a lack of demand growth in the post-Great Financial Crisis (GFC) period. Another school points to the supply side of the economy. A recent report by Prudential Financial highlights "...obvious examples of ... new business models and new organizational structures, whereby higher-cost traditional methods of production, transportation, and distribution are displaced by more nontraditional cost-effective ways of conducting business."1 A "culture of profound cost reduction" has gripped the business sector since the GFC according to this school, permanently changing the relationship between labor market slack and wages or inflation (i.e., the Phillips Curve). Employees are less aggressive in their wage demands in a world where robots are threatening humans in a broadening array of industrial categories. Many feel lucky just to have a job. In a highly sensationalized article called "How The Internet Economy Killed Inflation," Forbes argued that "the internet has reduced many of the traditional barriers to entry that protect companies from competition and created a race to the bottom for prices in a number of categories." Forbes believes that new technologies are placing downward pressure on inflation by depressing wages, increasing productivity and encouraging competition. There are many factors that have the potential to weigh on prices, but analysts are mainly focusing on e-commerce, robotics, artificial intelligence, and the gig economy. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. The latter refers to the advent of new business models that cut out layers of middlemen between producers and consumers. Amazonification E-commerce has grown at a compound annual rate of more than 9% over the past 15 years, and now accounts for about 8½% of total U.S. retail sales (Chart II-1). Amazon has been leading the charge, accounting for 43% of all online sales in 2016 (Chart II-2). Amazon's business model not only cuts costs by eliminating middlemen and (until recently) avoiding expensive showrooms, but it also provides a platform for improved price discovery on an extremely broad array of goods. In 2013, Amazon carried 230 million items for sale in the United States, nearly 30 times the number sold by Walmart, one of the largest retailers in the world. Chart II-1E-Commerce: Steady Increase In Market Share Chart II-2Amazon Dominates With the use of a smartphone, consumers can check the price of an item on Amazon while shopping in a physical store. Studies show that it does not require a large price gap for shoppers to buy online rather than in-store. Amazon appears to be impacting other retailers' ability to pass though cost increases, leading to a rash of retail outlet closings. Sears alone announced the closure of 300 retail outlets this year. The devastation that Amazon inflicted on the book industry is well known. It is no wonder then, that Amazon's purchase of Whole Foods Market, a grocery chain, sent shivers down the spines of CEOs not only in the food industry, but in the broader retail industry as well. What would prevent Amazon from applying its model to furniture and appliances, electronics or drugstores? It seems that no retail space is safe. A Little Theory Before we turn to the evidence, let's review the macro theory related to positive supply shocks. The internet could be lowering prices by moving product markets toward the "perfect competition" model. The internet trims search costs, improves price transparency and reduces barriers to entry. The internet also allows for shorter supply chains, as layers of wholesalers and other intermediaries are removed and e-commerce companies allow more direct contact between consumers and producers. Fewer inventories and a smaller "brick and mortar" infrastructure take additional costs out of the system. Economic theory suggests that the result of this positive supply shock will be greater product market competition, increased productivity and reduced profitability. In the long run, workers should benefit from the productivity boost via real wage gains (even if nominal wage growth is lackluster). Workers may lower their reservation wage if they feel that increased competitive pressures or technology threaten their jobs. The internet is also likely to improve job matching between the unemployed and available vacancies, which should lead to a fall in the full-employment level of unemployment (NAIRU). Nonetheless, the internet should not have a permanent impact on inflation. The lower level of NAIRU and the direct effects of the internet on consumer prices discussed above allow inflation to fall below the central bank's target. The bank responds by lowering interest rates, stimulating demand and thereby driving unemployment down to the new lower level of NAIRU. Over time, inflation will drift back up toward target. In other words, a greater degree of the competition should boost the supply side of the economy and lower NAIRU, but it should not result in a permanently lower rate of inflation if inflation is indeed a monetary phenomenon and central banks strive to meet their targets. Still, one could imagine a series of supply shocks that are spread out over time, with each having a temporary negative impact on prices such that it appears for a while that inflation has been permanently depressed. This could be an accurate description of the current situation in the U.S. and some of the other major countries. We have sympathy for the view that the internet and new business models are increasing competition, cutting costs and thereby limiting price increases in some areas. But is there any hard evidence? Is the competitive effect that large, and is it any more intense than in the past? There are a number of reasons to be skeptical because most of the evidence does not support Forbes' claim that the internet has killed inflation. (1) E-commerce affects only a small part of the Consumer Price Index As mentioned above, online shopping for goods represents 8.5% of total retail sales in the U.S. E-commerce is concentrated in four kinds of businesses (Table II-1): Furniture & Home Furnishings (7% of total retail sales), Electronics & Appliances (20%), Health & Personal Care (15%), and Clothing (10%). Since goods make up 40% of the CPI, then 3.2% (8% times 40%) is a ballpark estimate for the size of goods e-commerce in the CPI. Table II-1E-Commerce Market Share Of Goods Sector (2015) Table II-2 shows the relative size of e-commerce in the service sector. The analysis is complicated by the fact that the data on services includes B-to-B sales in addition to B-to-C.2 However, e-commerce represents almost 4% of total sales for the service categories tracked by the BLS. Services make up 60% of the CPI, but the size drops to 26% if we exclude shelter (which is probably not affected by online shopping). Thus, e-commerce in the service sector likely affects 1% (3.9% times 26%) of the CPI. Table II-2E-Commerce Market Share Of Service Sector (2015) Adding goods and services, online shopping affects about 4.2% of the CPI index at most. The bottom line is that the relatively small size of e-commerce at the consumer level limits any estimate of the impact of online sales on the broad inflation rate. (2) Most of the deceleration in inflation since 2007 has been in areas unaffected by e-commerce Table II-3 compares the average contribution to annual average CPI inflation during 2000-2007 with that of 2007-2016. Average annual inflation fell from 2.9% in the seven years before the Great Recession to 1.8% after, for a total decline of just over 1 percentage point. The deceleration is almost fully explained by Energy, Food and Owners' Equivalent Rent. The bottom part of Table II-3 highlights that the sectors with the greatest exposure to e-commerce had a negligible impact on the inflation slowdown. Table II-3Comparison Of Pre- and Post-Lehman Inflation Rates (3) The cost advantages for online sellers are overstated Bain & Company, a U.S. consultancy, argues that e-commerce will not grow in importance indefinitely and come to dominate consumer spending.3 E-commerce sales are already slowing. Market share is following a classic S-shaped curve that, Bain estimates, will top out at under 30% by 2030. First, not everyone wants to buy everything online. Products that are well known to consumers and purchased on a regular basis are well suited to online shopping. But for many other products, consumers need to see and feel the product in person before making a purchase. Second, the cost savings of online selling versus traditional brick and mortar stores is not as great as many believe. Bain claims that many e-commerce businesses struggle to make a profit. The information technology, distribution centers, shipping, and returns processing required by e-commerce companies can cost as much as running physical stores in some cases. E-tailers often cannot ship directly from manufacturers to consumers; they need large and expensive fulfillment centers and a very generous returns policy. Moreover, online and offline sales models are becoming blurred. Retailers with physical stores are growing their e-commerce operations, while previously pure e-commerce plays are adding stores or negotiating space in other retailers' stores. Even Amazon now has storefronts. The shift toward an "multichannel" selling model underscores that there are benefits to traditional brick-and-mortar stores that will ensure that they will not completely disappear. (4) E-commerce is not the first revolution in the retail sector The retail sector has changed significantly over the decades and it is not clear that the disinflationary effect of the latest revolution, e-commerce, is any more intense than in the past. Economists at Goldman Sachs point out that the growth of Amazon's market share in recent years still lags that of Walmart and other "big box" stores in the 1990s (Chart II-3).4 This fact suggests that "Amazonification" may not be as disinflationary as the previous big-box revolution. (5) Weak productivity growth and high profit margins are inconsistent with a large supply-side benefit from e-commerce As discussed above, economic theory suggests that a positive supply shock that cuts costs and boosts competition should trim profit margins and lift productivity. The problem is that the margins and productivity have moved in the opposite direction that economic theory would suggest (Chart II-4). Chart II-3Amazon Vs. Walmart: ##br##Who's More Deflationary? Chart II-4Incompatible With A Supply Shock By definition, productivity rises when firms can produce the same output with fewer or cheaper inputs. However, it is well documented that productivity growth has been in a downtrend since the 1990s, and has been dismally low since the Great Recession. A Special Report from BCA's Global Investment Strategy5 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, in many industries it appears that productivity is over-estimated. If e-commerce is big enough to "move the dial" on overall inflation, it should be big enough to see in the aggregate productivity figures. Chart II-5Retail Margin Squeeze ##br##Only In Department Stores One would also expect to see a margin squeeze across industries if e-commerce is indeed generating a lot of deflationary competitive pressure. Despite dismally depressed productivity, however, corporate profit margins are at the high end of the historical range across most of the sectors of the S&P 500. This is the case even in the retailing sector outside of department stores (Chart II-5). These facts argue against the idea that the internet has moved the economy further toward a disinflationary "perfect competition" model. (6) Online price setting is characterized by frictions comparable to traditional retail We would expect to observe a low price dispersion across online vendors since the internet has apparently lowered the cost of monitoring competitors' prices and the cost of searching for the lowest price. We would also expect to see fairly synchronized price adjustments; if one vendor adjusts its price due to changing market conditions, then the rest should quickly follow to avoid suffering a massive loss of market share. However, a recent study of price-setting practices in the U.S. and U.K. found that this is not the case.6 The dataset covered a broad spectrum of consumer goods and sellers over a two-year period, comparing online with offline prices. The researchers found that market pricing "frictions" are surprisingly elevated in the online world. Price dispersion is high in absolute terms and on par with offline pricing. Academics for years have puzzled over high price rigidities and dispersion in retail stores in the context of an apparently stiff competitive environment, and it appears that online pricing is not much better. The study did not cover a long enough period to see if frictions were even worse in the past. Nonetheless, the evidence available suggests that the lower cost of monitoring prices afforded by the internet has not led to significant price convergence across sellers online or offline. Another study compared online and offline prices for multichannel retailers, using the massive database provided by the Billion Prices Project at MIT.7 The database covers prices across 10 countries. The study found that retailers charged the same price online as in-store in 72% of cases. The average discount was 4% for those cases in which there was a markdown online. If the observations with identical prices are included, the average online/offline price difference was just 1%. (7) Some measures of online prices have grown at about the same pace as the CPI index The U.S. Bureau of Labor Statistics does include online sales when constructing the Consumer Price Index. It even includes peer-to-peer sales by companies such as Airbnb and Uber. However, the BLS admits that its sample lags the popularity of such services by a few years. Moreover, while the BLS is trying to capture the rising proportion of sales done via e-commerce, "outlet bias" means that the CPI does not capture the price effect in cases where consumers are finding cheaper prices online. This is because the BLS weights the growth rate of online and offline prices, not the price levels. While there may be level differences, there is no reason to believe that the inflation rates for similar goods sold online and offline differ significantly. If the inflation rates are close, then the growing share of online sales will not affect overall inflation based on the BLS methodology. The BLS argues that any bias in the CPI due to outlet bias is mitigated to the extent that physical stores offer a higher level of service. Thus, price differences may not be that great after quality-adjustment. All this suggests that the actual consumer price inflation rate could be somewhat lower than the official rate. Nonetheless, it does not necessarily mean that inflation, properly measured, is being depressed by e-commerce to a meaningful extent. Indeed, Chart II-6 highlights that the U.S. component of the Billion Prices Index rose at a faster pace than the overall CPI between 2009 and 2014. The Online Price Index fell in absolute and relative terms from 2014 to mid-2016, but rose sharply toward the end of 2016. Applying our guesstimate of the weight of e-commerce in the CPI (3.2% for goods), online price inflation added to overall annual CPI inflation by about 0.3 percentage points in 2016 (bottom panel of Chart II-6). There is more deflation evident in the BLS' index of prices for Electronic Shopping and Mail Order Houses (Chart II-7). Online prices fell relative to the overall CPI for most of the time since the early 1990s, with the relative price decline accelerating since the GFC. However, our estimate of the contribution to overall annual CPI inflation is only about -0.15 percentage points in June 2017, and has never been more than -0.3 percentage points. This could be an underestimate because it does not include the impact of services, although the service e-commerce share of the CPI is very small. Chart II-6Online Price Index Chart II-7Electronic Shopping Price Index Another way to approach this question is to focus on the parts of the CPI that are most exposed to e-commerce. It is impossible to separate the effect of e-commerce on inflation from other drivers of productivity. Nonetheless, if online shopping is having a significant deflationary impact on overall inflation, we should see large and persistent negative contributions from these parts of the CPI. We combined the components of the CPI that most closely matched the sectors that have high e-commerce exposure according to the BLS' annual Retail Survey (Chart II-8). The sectors in our aggregate e-commerce price proxy include hotels/motels, taxicabs, books & magazines, clothing, computer hardware, drugs, health & beauty aids, electronics & appliances, alcoholic beverages, furniture & home furnishings, sporting goods, air transportation, travel arrangement and reservation services, educational services and other merchandise. The sectors are weighted based on their respective weights in the CPI. Our e-commerce price proxy has generally fallen relative to the overall CPI index since 2000. However, while the average contribution of these sectors to the overall annual CPI inflation rate has fallen in the post GFC period relative to the 2000-2007 period, the average difference is only 0.2 percentage points. The contribution has hovered around the zero mark for the past 2½ years. Surprisingly, price indexes have increased by more than the overall CPI since 2000 in some sectors where one would have expected to see significant relative price deflation, such as taxis, hotels, travel arrangement and even books. One could argue that significant measurement error must be a factor. How could the price of books have gone up faster than the CPI? Sectors displaying the most relative price declines are clothing, computers, electronics, furniture, sporting goods, air travel and other goods. We recalculated our e-commerce proxy using only these deflating sectors, but we boosted their weights such that the overall weight of the proxy in the CPI is kept the same as our full e-commerce proxy discussed above. In other words, this approach implicitly assumes that the excluded sectors (taxis, books, hotels and travel arrangement) actually deflated at the average pace of the sectors that remain in the index. Our adjusted e-commerce proxy suggests that online pricing reduced overall CPI inflation by about 0.1-to-0.2 percentage points in recent years (Chart II-9). This contribution is below the long-term average of the series, but the drag was even greater several times in the past. Chart II-8BCA E-Commerce Proxy Price Index Chart II-9BCA E-Commerce Adjusted Proxy Price Index Admittedly, data limitations mean that all of the above estimates of the impact of e-commerce are ballpark figures. Conclusions We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence. The available data are admittedly far from ideal for confirming or disproving the "Amazonification" thesis. Perhaps better measures of e-commerce pricing will emerge in the future. Nonetheless, the measures available today do not suggest that online sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points, and it does not appear that the disinflationary impact has intensified by much. One could argue that lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. Nonetheless, if this were the case, then we would expect to see significant margin compression in the retail sector. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High corporate profit margins and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Finally, today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. Rising online activity means that we need fewer shopping malls and big box outlets to support a given level of consumer spending. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. To the extent that central banks were slow to recognize that equilibrium rates had fallen to extremely low levels, then policy was behind the curve and this might have contributed to the current low inflation environment. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Robert F. DeLucia, "Economic Perspective: A Nontraditional Analysis Of Inflation," Prudential Capital Group (August 21, 2017). 2 Business to business, and business to consumer. 3 Aaron Cheris, Darrell Rigby and Suzanne Tager, "The Power Of Omnichannel Stores," Bain & Company Insights: Retail Holiday Newsletter 2016-2017 (December 19, 2016). 4 "US Daily: The Internet And Inflation: How Big Is The Amazon Effect?" Goldman Sachs Economic Research (August 2, 2017). 5 Please see Global Investment Strategy Weekly Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 6 Yuriy Gorodnichenko, Viacheslav Sheremirov, and Oleksandr Talavera, "Price Setting In Online Markets: Does IT Click?" Journal of the European Economic Association (July 2016). 7 Alberto Cavallo, "Are Online And Offline Prices Similar? Evidence From Large Multi-Channel Retailers," NBER Working Paper No. 22142 (March 2016). III. Indicators And Reference Charts Stocks struggled in August on the back of intensifying geopolitical risks, such that equity returns slipped versus bonds in the month. The earnings backdrop remains constructive for global stocks. In the U.S., 12-month forward EPS estimates continue to climb, in line with upbeat net revisions and earnings surprises. Nonetheless, the risk/reward balance has deteriorated due to escalating risks inside and outside of the U.S. Allocation to risk assets should still exceed benchmark, but should be shy of maximum settings. It is prudent to hold some of the traditional safe haven assets, including gold. Our new Revealed Preference Indicator (RPI) remained at 100% in August, sending a bullish message for equities. We introduced the RPI in the July report. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. WTP topped out in June and the same occurred in August for the Japan and the Eurozone indexes. While the indicators are still bullish, they highlight that flows into the equity markets in the major countries are beginning to moderate. These indicators would have to clearly turn lower to provide a bearish signal for stocks. The VIX increased last month, but remains depressed by historical standards. This implies that the equity market is vulnerable to bad news. However, investor sentiment is close to neutral and our speculation index has pulled back from previously elevated levels. These suggest that investors are not overly long at the moment. Our monetary indicator is only slightly negative, but the equity technical indicator is close to breaking below the 9-month moving average (a negative technical sign). Bond valuation continues to hover near fair value, according to our long-standing model that is based on a simple regression of the nominal 10-year yield on short-term real interest rates and a moving average of inflation. Another model, presented in the Overview section, estimates fair value based on dollar sentiment, a measure of policy uncertainty and the global PMI. This model suggests that the 10-year yield is almost 50 basis points on the expensive side. We think that Fed rate expectations are far too benign, suggesting that bond yields will rise. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China