Market Returns

Highlights Risk assets have rallied smartly, yet key indicators like the relative performance of Swedish stocks or the price of kiwi equities are not corroborating these moves. With the Fed now very likely to increase rates in March, the broad-trade-weighted dollar could be about to resume its rally. This would prompt a correction in metals, and EM as well as commodity currencies. We think the tactical correction in the broad-trade-weighted dollar is over, and the cyclical dollar rally can resume. EUR and JPY will not suffer as much as the commodity currencies, go long EUR/AUD, short NZD/JPY. Feature In the Roman calendar, the Ides of March corresponds to the 15th of that month. Consigning that date to posterity in the year 44 BCE, Julius Caesar was assassinated on the floor of the senate in Rome, with his adoptive son Brutus, being among the conspirators. This event prompted yet another round of civil war in the republic, and ultimately a regime shift: the end of the Roman Republic and the Beginning of Imperial Rome under Augustus in 27 BCE. Fast forward 2061 years to the present. March 15th will be the day when the FOMC meeting ends. Will the period around the Ides of March represent a regime shift once again - albeit on a much different scale - where risk assets finally correct? Can the dollar resume its ascent? We believe the answer to both questions is yes. Unusual Market Moves Strange market dynamics have piqued our interest. In recent weeks, DM stock prices, and bond yields have been moving up (Chart I-1). This is consistent with investors pricing in an improving growth outlook and a Fed moving toward a tighter policy. On the other hand, EM stocks, metals, and gold in particular have also been moving up (Chart I-2). This move is more disturbing as it tends to imply an easing in monetary conditions, especially the strength in gold, even if it may have ended yesterday. This strange performance could be explained if the dollar was weakening or inflation expectations were moving up. However, the dollar has been strengthening in recent days and inflation expectations have been flat. Additionally, the U.S. yield curve has flattened, suggesting that the adjustment in the Fed's expected rate path is beginning to have marginally negative implications for future growth (Chart I-3). Chart I-1More Growth, More Hikes Chart I-2More Reflation As Well Chart I-3No Sign Of A Fed Behind The Curve So based on current information, how are these market moves likely to resolve themselves? Let's look at indicators. In the past, we have followed the common-currency performance of Swedish relative to U.S. equities as a gauge for the global growth outlook, and particularly non-U.S. growth relative to U.S. growth. This reflects the fact that U.S. stocks tend to be defensive, while Swedish stocks are very pro-cyclical. This dynamic is accentuated by the nature of the Swedish economy. Sweden is a small open nation that trades heavily with EM. While its biggest trading partner is the euro area, where it tends to export many intermediate goods and machinery, which are then re-exported as finished products to the EM space. Currently, Swedish equities continue to underperform U.S. ones. What is most striking is that this underperformance has happened despite a strong performance in EM stocks and metals, a very rare divergence (Chart I-4). Another worrying signal comes from New Zealand stocks in USD terms. New Zealand is another small open economy with deep trade links to the EM space. It is therefore very sensitive to global growth dynamics. While Kiwi equities did flag the rebound in EM growth and global manufacturing activity that happened in 2016, since late January, they have stopped participating in the rally in global risk assets despite a booming New Zealand economy. They have even begun swooning in recent weeks (Chart I-5). Chart I-4A Strange Divergence Chart I-5Are Kiwi Stocks Telling Us Something? Finally, two other reliable indicators of global growth are also not corroborating any further improvement in global growth from here: Small caps are underperforming large caps and oil is underperforming gold (Chart I-6). Obviously the next question becomes: are all these indicators likely to converge back toward EM equities, the AUD and the BRLs of the world or are the risk assets mentioned above likely to be the ones experiencing a downward adjustment? Here economics should give us a clue. For one, the 2016 rally in EM and risk assets can be explained by the large improvement in economic conditions. G10 and EM surprise indexes have moved up vertically in recent months (Chart I-7). However, this move might reflect the past not the future. Chart I-6Some Growth Indicators Are##br## Not Doing Well Anymore Chart I-7Too Much Of##br## A Good Thing? China has been a key reason explaining why EM assets and economic activity have been so positive. However, the large dose of fiscal stimulus that has supported that economy has dissipated (Chart I-8). Based on the IMF's October Fiscal Monitor, the fiscal thrust in China was 1.7% of potential GDP in 2015 (heavily loaded to the second half of that year), and 0.3% in 2016. It is moving to 0% in 2017. This means that as the lagged effects of the late 2015 fiscal surge dissipate, a key reflationary wind behind the global economy will disappear. The Keqiang index is mirroring these dynamics. After flirting with cyclical highs, and therefore highlighting a sharp improvement in the Chinese industrial sector, it has begun to roll over (Chart I-9). More weakness is likely in the cards. Fiscal dynamics have followed a similar pattern on a global level. The overall EM fiscal thrust was at its strongest in 2015, at 0.6% of EM potential GDP, fell to 0.1% in 2016, and is expected to hit -0.2% in 2017. In the DM, the pattern is slightly different. The high point of fiscal stimulus was 2016, when the fiscal impulse hit 0.4% of potential GDP. However, this measure is moving back to -0.1% in 2017. Chart I-8Losing A Source ##br##Of Reflation Chart I-9Chinese Industrial Activity ##br##May Be Rolling Over Additionally, the monetary environment is not as stimulative as it once was. Bond yields have risen in the whole DM space, with Treasury yields now more than 110bps higher than in July, Bund yields having moved from -0.18% to 0.31%, and JGB yields having adjusted 37bp higher to 0.07%. High-frequency loan data out of the U.S. already shows some strains caused by this rise in borrowing costs (Chart I-10). This combination points toward a deceleration in the growth impulse, especially in the goods sector. As such, we do expect the EM and G10 surprise indexes to roll over in coming weeks. Even if this phenomenon may prove temporary, the market is not priced for this event. Highlighting this vulnerability is the high level of complacency we have already flagged last week, which suggests that global investors are positioned for a continuation of the improvement in the growth outlook (Chart I-11). So high seems the conviction that growth will continue to accelerate that it is outweighing the move toward a tighter Fed going forward. Finally, the implied correlation in the S&P 500 has fallen to post 2010-lows. This could incentivize investors to take on more leveraged bets on portfolios of stocks. A low correlation results into higher diversification benefits and therefore, a lower portfolio volatility (Chart I-12). A rise in correlation would cause volatility to rise and thus a mini-deleveraging and de-risking cycle to take hold amongst investors. Chart I-10Response To Higher Yields Chart I-11Lots Of Complacency Globally Chart I-12Correlation-Induced Derisking On Its Way? Bottom Line: DM stocks are up, yields are up, the dollar is firming, yet EM equities, metals and gold especially have risen as well, and the U.S. yield curve is flattening while inflation expectations have recently been stable. We expect risk assets to end up buckling. Some reliable indicators of the trend in risk assets are pointing south, global investors are expecting further growth improvement in the coming months while global growth may in fact temporarily decelerate, and finally, if the low level of implied correlation in stocks normalizes, a correction may be catalyzed. What About The Fed Because Lael Brainard has been such a reliable dove on the FOMC, when she says that a hike is coming soon, we must listen. The fact that the market has come to price in an 83% probability of a Fed hike in March will only give the FOMC more comfort in increasing interest rate when it meets in two weeks (Chart I-13). While we have been expecting the Fed to move in line with its Summary of Economic Projection's interest rate forecast, and thus increase three times this year, we are surprised by the fast change of tune in recent days. Nonetheless, we are acknowledging this reality. Is this publication moving toward expecting four rate hikes in 2017? Not yet. We want to see how the market handles the coming hike going forward. A correction in risk assets, commodities, and EM is likely to force the Fed to pause again before resuming its hiking path. We are clearly expecting such a development. The broad dollar is likely to be caught in a bullish cross current. However, differentiation between the minors vis-à-vis the EUR and JPY might be essential for investors. Chart I-14 shows that recently, the broad-trade-weighted dollar has not kept pace with the increase in interest rate expectations for the U.S. With our capitulation index for this measure of the dollar moving closer to "oversold" territory, the weeks leading up to the Fed meeting could witness a stronger broad trade-weighted dollar. We are therefore removing our tactical short bias and moving in line with our cyclical bullish dollar stance. Chart I-13The Fed Tends To Telegraph ##br##Its Intention To Hike Chart I-14The Dollar Should ##br##Catch Up We believe that in this process, the dollar will be strongest against EM and commodity currencies. To begin with, the USD is trading near 19, 18, and 17 months lows against the BRL, ZAR, and RUB respectively. As recently as Wednesday, the AUD was also trading near the top of its distribution of the past two years (Chart I-15). Moreover, EM and commodity currencies are heavily geared to global growth. As such, the combination of a tightening Fed, rising bond yields, and a potential roll-over in global economic surprises may weigh especially heavily on them. On the other hand, in 2015 and 2016, the dollar has tended to be softer against the EUR and the JPY in periods of market turbulence. Thus, the call on EM and commodity currencies seems much cleaner than on these two currencies. In this regard, two crosses have caught our eye. One is EUR/AUD. Not only is it at the bottom end of a trading range established since June 2013, it has only traded lower at the apex of the euro area crisis between 2011 and the first half of 2013 (Chart I-16). The recent rollover in French / German bund spreads is potentially a good signal to buy this cross. The picture for JPY is now muddied. While higher interest rates should hurt the JPY, a period of risk-asset selloff should support the JPY. To play the cross-current described above, we are opening a short NZD/JPY position, a cross historically levered to rising volatility (Chart I-17). Chart I-15AUD Is Elevated Chart I-16To Fall From Here, EUR/AUD Needs A Euro Crisis Chart I-17Short NZD/JPY: A Risk-Off Play Bottom Line: The Fed moving forward its planned rate hike to March could be the ultimate catalyst to prompt a correction in risk assets, especially the segment of the market most levered to EM and growth conditions: EM and commodity currencies. We are removing our tactical USD stance and we are moving in line with our bullish cyclical stance. We are also buying EUR/AUD and shorting NZD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar USD Technicals 1 USD Technicals 2 Recent data paints a healthy picture for the U.S. economy: Fourth quarter annualized GDP came in unchanged from the previous quarter at 1.9%; PCE Price Index increased at a 1.9% annual pace, near the Fed's target; Core PCE remained steady at 1.7% annually and increased to 0.3% monthly, indicative of a robust economy; ISM Manufacturing PMI went up to 57.7. The market is now pricing in an 83% probability of a rate hike. Further enhancing growth prospects were Trump's remarks at his Joint Address to Congress, where he stated that there will be a "big, big cut" in corporate tax, and that he will seek to gain approval for a $1 trillion infrastructure plan. Hawkish comments from the previous FOMC meeting strengthened the dollar in February; Trump's comments may be an additional tailwind to the dollar's upside this month. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 The Euro EUR Technicals 1 EUR Technicals 2 Fundamentally, the euro area economy remains resilient: Services sentiment, business climate, and industrial confidence all picked up in February, outperforming expectations; Germany recorded a decrease in unemployed persons of 14,000; German CPI picked up to a 2.2% annual pace, also beating expectations Nevertheless, EUR/USD is unlikely to see any substantive upside in the coming months. With the Dutch elections in around 2 weeks, considerable volatility could rise up, something which has not been priced in. The Euro Stoxx 50 Volatility Index is showing a low reading of 16.55, just above the all-time low of 12. The ECB will meet next week and is likely to display a dovish bias due to potential political turmoil. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 The Yen JPY Technicals 1 JPY Technicals 2 On a cyclical basis we are still bearish on the yen, as the BoJ will continue to pursue radical measures to pull Japan out of its liquidity trap. Recent data seems to indicate that these measures have been somewhat successful: Retail trade YoY growth outperformed expectations coming in at 1%. Housing starts YoY growth also outperformed, coming in at 12.8%. On a tactical basis the picture is more nuanced. While it is very possible that the coming rate hike could lift rate expectations in the U.S., lifting USD/JPY, there is a risks that the hike might trigger a sell-off in risks assets, which could be very positive for the yen. For this reason we are shorting NZD/JPY, as this cross is very vulnerable to an increase in volatility. Report Links: JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 British Pound GBP Technicals 1 GBP Technicals 2 The past week has not been kind to the pound, with GBP depreciating by about 2% against both the Euro and the U.S. Dollar. This was in part due to the prospect of a Scottish Independence referendum. On the economic side, data for the U.K. continue to be mixed: House prices annual growth outperformed expectations coming in at 4.5% M4 broad money annual growth continues to climb higher and it is now at 7%. On the other hand manufacturing PMI, although still high, underperformed expectations, coming in at 54.6. Although the cyclical dollar bull market should continue to weigh on cable, we are more bullish on the pound, particularly against the euro, as expectations for the U.K. economy continue to be too pessimistic, while the dark cloud of this year's election cycle looms on the euro. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar AUD Technicals 1 AUD Technicals 2 AUD lost 1.3% of its value Thursday morning amid disappointing trade data. It seems that the market largely ignored stronger data this week: GDP grew at a 2.4% annual rate Q42016 and both NBS and Ciaxin Chinese Manufacturing PMI beat expectations. Exports, however, contracted at a 3% pace and the surplus missed expectations by 66%, most likely due to the AUD's strength this year, even alongside higher commodity prices. This is also particularly worrying seeing that exports failed to pick up despite a previously strong Chinese PMI reading. Now, alongside a Keqiang Index that is topping out, the future for Australian exports could be limited. Additionally, this outlook is further supported by investment diverting to the non-resource sector. It is difficult to see whether the RBA will respond to this export slump, as the contractionary Q32016 GDP data was largely overlooked and dismissed. Nevertheless, we stand by our bearish outlook on AUD. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 New Zealand Dollar NZD Technicals 1 NZD Technicals 2 The RBNZ continues to assert its neutral bias. On Wednesday, RBNZ Governor Graeme Wheeler stated that "there is an equal probability that the next OCR adjustment could be up or down". This caused the kiwi to come close to reaching 0.71, its lowest point since mid-January. We continue to believe that the RBNZ stance is not hawkish enough, as powerful inflationary forces continue to brew in New Zealand. That being said, it is very likely that the RBNZ will continue with its neutral tone up until the middle of the year, when we start to have a clearer picture about the outcome in European elections. Therefore, given that the Fed is likely to hike in March, diverging monetary policies should continue to weigh on NZD/USD until then. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Canadian Dollar CAD Technicals 1 CAD Technicals 2 The BoC left their overnight rate target unchanged at 0.5% despite a high CPI reading of 2.1% in January. A further surprise was a particularly dovish tone, highlighting that higher energy prices will have a temporary effect on inflation, and indicating "material excess capacity in the economy". Additional weaknesses were highlighted with regards to competitiveness challenges for the export sector and subdued wage growth accompanied by contracting hours worked. Trade developments are an additional headwind for the Canadian economy that the bank is monitoring and will continue to do so until the outlook clarifies. CAD has lost more than 2% of its value against the USD in 3 days due also to a stronger dollar based on Fed rate hike expectations and Trump's potential infrastructure spending and tax cuts. It is unlikely that CAD will see any strength in the near future as the Bank has set forth a rather cautious tone. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc CHF Technicals 1 CHF Technicals 2 Recent data has been mixed, which indicates that although economic activity in Switzerland is improving, it still is very tepid: The KOF leading indicator outperform expectations coming in at 107.2 Retail sales outperformed expectations. However they are still contracting by 1.4% GDP annual growth was 0.6%, falling significantly from last quarter reading of 1.4% The SNB is currently in a tight spot, as improvements are very marginal and it is evident that the economy is still plagued by strong deflationary forces. Meanwhile EUR/CHF is under 1.065 and has been unable to climb above this level this month, as the SNB continues to fight risk off flows coming into the franc due to the risks of the European election cycle. As these risks increase, the floor in this cross will continue to get tested. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone NOK Technicals 1 NOK Technicals 2 Risks continue to point for further upside in USD/NOK. Oil is unlikely to rally much further from current levels, even if the OPEC agreement continues. Thus the movements in USD/NOK should be dominated by monetary divergences between the United States and Norway. These are likely to continue to favor the dollar, as the Fed should continue its hawkish tone. Meanwhile the Norges Bank is likely to stay dovish, as their economy has been to be very weak. GDP growth is negative, the output gap is over -2% of GDP and employment and real wages continue to contract. Meanwhile, the high inflation that Norway experiences last year is likely to continue its slowdown, as the effects of the currency depreciation should start to dissipate. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona SEK Technicals 1 SEK Technicals 2 In past reports, we have argued that the Swedish economy is robust and inflation is picking up. This has been corroborated by strong consumer and business confidence, and high resource utilization and inflation expectations. Recent data has supported this view: Retail sales picked up 2.2% annually; Producer price index was up 8.2% from last year in January; Annual GDP growth came in at 2.3% at the end of last year. Growth and inflation have been supported by expansionary monetary policy. With the Riksbank stating that "there is still a greater possibility that the rate will be cut than... raised in the near future", these conditions are unlikely to falter. Nevertheless, it is important to note that it is this cautionary stance by the Bank that is the reason for the SEK's recent weakness, not fundamentals. It is now the probable case that any upside in the SEK will be noted and limited by the Riksbank, capping the upside on the krona. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights In this week's report, we update the "Three Controversial Calls"1 we made at BCA's New York Investment Conference held on September 26-27th, 2016. Call #1: "Trump Wins, And The Dollar Rallies." We still see 5% more upside for the greenback. Call #2: "Japan Overcomes Deflation." Inflation expectations have moved higher over the past five months, while the yen has weakened. This trend will persist. Call #3: "Global Banks Finally Outperform." Bank shares have beaten their global benchmark by 14% since we made this prediction. European financials have finally turned the corner. Feature Call #1: "Trump Wins, And The Dollar Rallies" Chart 1From Unrealistic To Even More Unrealistic We never bought into the notion that a Trump victory would cause investors to flee the dollar. On the contrary, we argued that most of Trump's policies were bond bearish/dollar bullish. In particular, we reasoned that Trump's attempts to browbeat companies into moving production back home would help reduce the U.S. trade deficit, boosting aggregate demand in the process. Efforts to curb illegal immigration would also push up the wages of low-skilled workers. Meanwhile, fiscal stimulus would fire up the labor market at a time when it was already approaching full employment. Fiscal Deficit On Upward Path With nearly four months having passed since the election, what have we learned? First, and foremost, a big increase in the budget deficit still looks likely. As Trump's address to the joint session of Congress on Tuesday night underscored, the president has plenty of specific areas in mind where he would like to increase spending (more money for defense, infrastructure, etc.) and a long list of taxes he would like to cut (corporate and personal income taxes, estate taxes, a new childcare tax credit,2 etc.). We do not take seriously Trump's pledge to pay for increased military spending by cutting annual nondefense discretionary spending by $54 billion relative to the existing CBO baseline. Chart 1 shows that under current budgetary rules, nondefense discretionary spending is set to decline from 3.3% of GDP in 2016 - already close to a historic low - to only 2.7% of GDP in 2026. Cutting that portion of the budget above and beyond what has already been legislated is unrealistic. There simply aren't enough programs like the National Endowment for the Arts that Republicans can take to the woodshed without facing a severe political backlash (Chart 2). As long as big ticket entitlement programs such as Social Security and Medicare remain unscathed - which Treasury Secretary Steven Mnuchin confirmed would be the case earlier this week - overall government spending will rise, not fall. Chart 2Nondefense Discretionary Spending: Where The Money Goes Trump And Trade The one category where Trump would be more than happy to see taxes go up is on imports. The constraint here is political. A unilateral move to legislate large-scale import duties would be in gross violation of WTO rules and could spark a global trade war. Many of Trump's Republican colleagues, as well as a fair number of Democrats, also favor free trade and would resist such an effort. One solution that Trump vaguely alluded to in his speech is to raise duties on imports within the context of a broader tax reform bill. A border adjustment tax, for example, would bring in $1.2 trillion in revenues over ten years.3 As we argued in a Special Report earlier this year, the introduction of a BAT would be highly dollar bullish.4 Pulling Back The Welcome Mat? On immigration, Trump has sent mixed messages. On the one hand, he continues to insist that he will build "the wall" and has maintained his hardline stance on refugee policy. On the other hand, he has backed off his campaign promise to reverse Obama's executive order protecting the so-called "dreamers." This order allows immigrants who came to the U.S. illegally as children to remain in the country indefinitely, provided they do not commit a serious criminal offence. During his speech, Trump signaled a willingness to shift the U.S. immigration system towards one based on merit, similar to what countries such as Canada and Australia already have. This is an excellent idea, but it raises the question of what will happen to the 11 million illegal aliens currently residing in the country, the vast majority of whom are poorly educated. It is important to remember that U.S. immigration laws are already very strict. Trump has given the U.S. Immigration and Customs Enforcement agency (ICE) greater leeway in enforcing these laws, while also pledging to hire 5,000 more border agents and 10,000 additional ICE officers. As such, a "status quo immigration policy" under Trump could prove to be much more restrictive than the one under Obama even if no new legislation is passed. A key implication is that labor shortages in areas such as construction and hospitality services may intensify. Solid U.S. Growth Outlook Favors A Stronger Dollar Meanwhile, the U.S. growth picture remains reasonably bright (Chart 3). This may not be obvious from current Q1 tracking estimates, which are pointing to real GDP growth of below 2%. However, the weak Q1 numbers are mainly due to an unexpectedly large jump in imports and a sharp decline in inventory accumulation. According to the Atlanta Fed's model, taken together these two factors have shaved a full percentage point off growth. Real private final demand is still rising at nearly 3% (Chart 4). If U.S. growth stays solid as we expect, the Fed will raise rates three or four times this year, starting in March. This is slightly more than the market is currently pricing in, which should be enough to ensure that the trade-weighted dollar strengthens by another 5% or so over the remainder of the year (Chart 5). We see the greatest upside for the dollar versus EM currencies, and as we discuss next, against the yen. Chart 3U.S. Economic Data Are Upbeat Chart 4Trade And Inventories Detract From ##br##A Bright Q1 Growth Picture Chart 5Real Rate Differentials Are ##br##Driving UpThe Dollar Call #2: "Japan Overcomes Deflation" Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 6). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. For most of the past 25 years, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 7). Chart 6Japan: Easing Deflationary Forces Chart 7Japan: Low Household Saving Rate ##br##And A Tightening Labor Market Chart 8Investors Still Not Entirely ##br##Convinced Japan Is Eradicating Deflation Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seem to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous circle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Stay Short The Yen Consistent with this narrative, market-based inflation expectations have risen over the past five months. But with inflation swaps still pricing in inflation of only 0.6% over the next 20 years, there is plenty of scope for real rates to fall further (Chart 8). This implies that investors should maintain a structurally short position in the yen. A weaker yen will help boost Japanese stocks, at least in local-currency terms. As a relative play, investors should consider overweighting Japanese exporters versus domestically-exposed sectors. Multinational manufacturers stand to gain the most, as they will benefit from increased overseas sales, while the highly automated, capital-intensive nature of their operations will limit the burden of rising real wages. Call #3: "Global Banks Finally Outperform" Global bank shares have risen by 25% since we made this call, outperforming the MSCI All Country World Index by 14% (Chart 9). The thesis that we outlined five months ago still remains intact (Charts 10 and 11): Chart 9Global Bank Shares Have Bounced Chart 10Factors Supporting Bank Stocks Chart 11Global Banks Are Still Fairly Cheap Improving business and consumer confidence should continue to support credit demand. Stronger economic growth will reduce nonperforming loans. Capital ratios have improved significantly, reducing the risk of further equity dilution. Yield curves have steepened since last summer, which should flatter net interest margins. Despite the run-up in share prices over the past five months, valuations remain attractive. Looking across regions, European banks stand out as being particularly attractive over a cyclical horizon of about 12 months. BCA's European Corporate Health Monitor continues to improve, foreshadowing further progress in mending loan books (Chart 12). The ECB's lending survey indicates that a majority of banks are seeing stronger loan demand (Chart 13). This suggests that credit growth is not about to stall anytime soon. Meanwhile, euro area banks are trading at a miserly 0.8-times book value, which gives valuations plenty of upside. Chart 12Euro Area: Improving Corporate Health Chart 13Euro Area: Banks See Rising Loan Demand Political Risks Chart 14This Will Not Get Le Pen Into The Elysee Palace The risk is that European political developments sabotage this thesis. Our view here is "near-term sanguine, long-term cautious." We continue to think that populism is in a long-term secular bull market. However, unlike in the case of Brexit or Trump, populist leaders in continental Europe will have to wait until the next economic downturn (probably in two or three years) before they seize power. To that extent, the prevailing - though admittedly rather myopic - consensus view is correct: Marine Le Pen will not become president this year. Keep in mind that the National Front underperformed during regional elections in December 2015, just weeks after the terrorist attacks in Paris. Despite a recent uptick in the polls, support for Le Pen is actually lower now than it was back then (Chart 14). As long as the French economy continues to show signs of tentative improvement, the establishment parties will succeed in keeping Le Pen out of power. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 2 Despite the populist sounding nature of this proposal, the Tax Policy Center estimates that 70% of the childcare credits will go to households earning $100,000 and up. See Lily L. Batchelder, Elaine Maag, Chye-Ching Huang, and Emily Horton, "Who Benefits from President Trump's Child Care Proposals?" Tax Policy Center (February 27, 2017) for details. 3 James R. Nunns, Leonard E. Burman, Jeffrey Rohaly, Joseph Rosenberg, and Benjamin R. Page, "An Analysis of the House GOP Tax Plan," Tax Policy Center (September 16, 2016). 4 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Crude-oil fundamentals stand out among commodities because of the active efforts by critical producers to rein in supply since the end of last year. This can be seen in even-higher compliance with the production accord - a supply shock in many ways - negotiated by the Kingdom of Saudi Arabia (KSA) and Russia: Last month, Reuters estimated 94% compliance on the 1.2mm b/d in cuts pledged by OPEC states. We expect compliance to remain high, which will strengthen the divergence between oil prices and the USD, as markets look toward the upcoming summer driving season in the Northern Hemisphere. Active supply management and robust demand growth wrought by lower prices could continue to overwhelm a strong USD's influence on oil prices, if this Agreement becomes a durable modus operandi for KSA and Russia going forward. We give a high probability to this outcome, even as the Fed leans into its interest-rate normalization. Energy: Overweight. This past Thursday, we closed our long WTI Dec/17 vs. short Dec/18 backwardation spread at +$0.96/bbl (Dec/17 over); it was initiated February 9 at -$0.11/bbl (Dec/17 under), resulting in a 972.7% gain. We also closed our Dec/19 short WTI vs. long Brent spread, elected February 6 at +$0.07/bbl (WTI over) at -$1.17/bbl (WTI under), for a gain of 1,771.4%. Base Metals: Neutral. Any demand uptick for base metals' coming from U.S. fiscal stimulus will not hit markets until 2H18 at the earliest. We remain neutral. Precious Metals: Neutral. Based on last week's analysis, we are tactically long a Jun/17 gold put spread (long the $1200/oz put vs. short the $1150/oz puts) and call spread (long the $1275/oz call vs. short the $1325/oz calls) at a net debit of $21/oz. Ags/Softs: Underweight. The USDA expects continued demand from China to keep soybeans relatively well bid versus corn and wheat in the 2017/18 crop year. Total planted area for these crops is expected to be the lowest since 2011, keeping ending stocks flat to lower. Feature Prior to the end of the 1990s, crude-oil prices were, to use one of the most popular catch-phrases in finance, mean-reverting: The price of crude oil imported to the U.S. averaged just over $19/bbl from Mar/83, when WTI futures began trading, to 1999 (Chart of the Week). This meant WTI traded at ~ $20/bbl on average over that period. Prices were volatile, but pretty much returned to $20ish/bbl, which allowed traders to take a view on how soon prices would revert to their mean. Whenever prices were too far removed from that level, markets expected producers - OPEC mostly - to adjust output to meet current and expected demand conditions. Since roughly 2000 - maybe a little earlier - oil prices have followed a random walk.1 During this time, oil prices have been negatively correlated with the broad trade-weighted index (TWI) for the USD. One striking characteristic of oil prices and the USD TWI during this time is both followed random walks, which "like the walk of a drunken sailor, wanders indefinitely far, listing with the wind," to borrow Paul Samuelson's well-turned metaphor (Chart 2).2 Chart of the WeekOil's Past As Prelude: ##br##A Return To Mean Reversion? Chart 2Oil Prices And The USD Followed ##br##A Common Long-term Trend Until 1Q16 We believe this was caused by OPEC's decision to become a price-taker at the end of the 1990s - shortly after Dec/98 or thereabouts - after years of unsuccessfully trying to manage oil prices via production adjustments. After the price of oil imports in the U.S. dropped below $10/bbl (nominal), it appears the Cartel took the decision to respond to prices set by market forces (supply, demand, inventories and exchange rates), and to abandon its price-management efforts. The long-term correlation between oil and the USD was due to the fact that while oil prices and the USD followed random walks, they followed a common long-term trend as they wandered indefinitely about. This held up to the end of 1Q16, when a massive sell-off in risky-asset markets globally took oil prices below $30/bbl (Chart 3).3 This came on the heels of a price collapse brought about by OPEC's Nov/14 decision to launch a market-share war. By no means did this high correlation mean oil and the USD were always moving in lock step. The collapse in oil prices at the end of the last century led to a production-cutting agreement among OPEC states, Norway and Mexico, which lifted U.S. import prices from less than $10/bbl at the end of 1998 to $30/bbl by Nov/00. Likewise, export disruptions in Venezuela in 2002 - 2003 and, to a lesser extent, hurricane losses in the U.S. Gulf in 2005 sharply curtailed supply and lifted oil prices above what could have been expected given the USD's level at the time, as the Chart of the Week shows.4 End Of Oil's Random Walk? The price collapse of 1Q16 marked the bottom of the price move begun a few months prior to the Nov/14 market-share war declaration. The subsequent divergence between oil prices and the USD since then has been remarkable (Chart 4). The market-share strategy, which essentially allowed Cartel members to produce full-out and grab as much market share as possible, was engineered by KSA, and, we believe, initially was directed at undermining Iran's efforts to restore oil production lost to nuclear-related sanctions. From time to time, it also appeared OPEC was trying to retard the continued growth of shale-oil production in the U.S., which, by 2014, was increasing at an annual rate of more than 1mm b/d, enough to replace the entire output of Libya. Chart 3Close-up Of USD vs. ##br##Brent Divergence Chart 4The Divergence Between ##br##Oil Prices And The USD Is Remarkable This strategy was a complete failure. The price collapse that ensued brought KSA and Russia - both highly dependent on oil revenues - to the brink of financial ruin, compelling them to find a way to work together.5 After several false starts in 2016, they succeeded late in the year with a negotiated production cut. OPEC pledged to reduce output by as much as 1.2mm b/d, and non-OPEC producers agreed to cut output by close to 600k b/d, half of which is expected to come from Russia. Recent tallies by Reuters indicate 94% of the cuts from OPEC states that signed on to the deal have actually been realized.6 Should KSA and Russia find a way to coordinate their and their allies' production in a way that maintains the backwardation we expect later this year - the result of production cuts (Chart 5), and robust demand growth (Chart 6) - we could see oil prices become mean-reverting once again. Chart 5If KSA And Russia Can ##br##Coordinate Production ... Chart 6... And Demand Continues To Grow, ##br##The Oil-Price Backwardation Could Persist This likely requires the forward curves for WTI and Brent to remain backwardated, so as to moderate the growth in shale production, and for prices to remain between $55/bbl and $65/bbl, so as not to set off another shale boom. Gulf sources have indicated KSA prefers prices this year of ~ $60/bbl, which, we believe would allow it to keep some control over the rate at which shale production revives.7 Chart 7Supply Destruction And Robust Growth ##br##Rallied Oil Despite A Strong USD Investment Implications We are not calling for a return to mean-reversion in oil prices just yet. We are, however, highlighting the possibility for such a sea-change in the market if all the supply-side pieces fall into place - i.e., KSA, Russia and their respective allies find a way to work together to moderate U.S. shale-oil production. That said, we will be watching closely to see whether the KSA - Russia Agreement becomes a durable modus operandi in the oil market, particularly as regards the management of inventories and production in the market generally. If these states are able to keep prices ~ $60/bbl, and gain some control over the forward curve's slope - i.e., literally manage their production for backwardation - then there is a chance oil prices could once again become mean-reverting. In a mean-reverting world with backwardated oil prices, commodity-index exposure is favored, since investors would, once again, earn positive roll yields as the indices are rebalanced monthly in the underlying futures markets. Bottom Line: The persistent negative correlation between oil prices and the USD broke down following the global asset sell-off in 1Q16. Since then, the combination of supply destruction and robust demand growth has allowed oil prices to rally despite a strong USD (Chart 7). If KSA and Russia can continue to cooperate in their production-management deal - i.e., find a way to manage production so that prices remain closer to $60/bbl than not - and Brent and WTI forward curves backwardate, markets could once again become mean-reverting. In such a world, commodity-index exposures are favored - particularly those heavy on crude-oil and refined-products price exposure - for their positive roll yield. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Technically, oil prices have been I(1) variables (integrated of order 1) since about 2000, meaning they are mean-reverting in first differences (e.g., today's price minus yesterday's price). Please see Geman, Helyette (2007), "Mean Reversion Versus Random Walk in Oil and Natural Gas Prices," pp. 219 - 228, in Advances in Mathematical Finance. Haidar, Imad and Rodney C. Wolff (2011) obtained similar results, reporting crude prices were mean-reverting from Jan/86 - Jan/98, then random-walking since then; please see pp. 3 - 4 of "Forecasting Crude Oil Price (revisited)," presented at the 30th USAEE/IAEE North American Conference in Washington, D.C., during October 2011. Our own research corroborates these results - we find WTI and Brent were mean-reverting from Mar/83, when WTI futures started trading, to Mar/98; and were random-walking I(1) variables after that. 2 Please see Samuelson, Paul A. (1965), "Proof That Properly Anticipated Prices Fluctuate Randomly," in Industrial Management Review, 6:2. 3 This is to say, these variables were cointegrated, and could be expressed in a linear combination using an error-correction model. 4 Our colleague, Mathieu Savary, who runs BCA Research's Foreign Exchange Strategy, addressed these oil-USD divergences in "Party Like It's 1999," published November 25, 2016. It is available at fes.bcareseach.com. 5 We discuss this at length in the feature article of Commodity & Energy Strategy published September 8, 2016, entitled "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash." Both states were burning through cash reserves, and were trying tap foreign markets for additional funds by selling interests in their most valuable holdings - via the IPO of, and via the sale of just under 20% of Rosneft held by the Russian government. Russia placed its Rosneft shares late last year with Glencore and Qatar's sovereign wealth fund, while KSA is expected to IPO Aramco in late 2018. 6 Please see "OPEC compliance with oil curbs rises to 94 percent in February: Reuters survey," published by the news service online February 28, 2017. 7 Please see "Exclusive: Saudi Arabia wants oil prices to rise to around $60 in 2017 - sources," published by Reuters online February 28, 2016. Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of February 28, 2017. The model has maintained its large overweight in the U.S. Within the non-U.S. level 2 model, Spain and Italy weights have been increased at the expense of Japan and Switzerland. Japan and U.K. remain the two largest underweight countries. (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, both the level 1 and level 2 models outperformed their respective benchmarks in February, resulting in a 39 bps outperformance of the aggregate model vs. the MSCI World. Since inception, the GAA model has outperformed its benchmark by 30 bps. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of February 28, 2017. The momentum component has shifted Consumer Discretionary from overweight to underweight. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Associate Editor patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

How Long Is The Sweet Spot? Table 1Recommended Allocation The sweet spot on a baseball bat, scientists find,1 is the small area about two inches (5 cm) long, some six inches from the tip. The sweet spot for global risk assets may not be much bigger. The 22% rise in global equities since February last year has been driven by a "goldilocks" combination of recovering economic activity, quiescent inflation, and still-accommodative monetary policy. But, after such a strong rally, markets must walk a fine line - no slowdown in growth and no surprising tightening of monetary conditions - for prices to rise further. Our analysis suggests that they can, but the risk of a correction is rising. A lot of the better news of the past year has already been priced in. The price-to-sales ratio for U.S. stocks is close to an all-time high, and even the plain-vanilla 12-month forward PE ratio has reached 17.5x, the highest since 2002 (Chart 1). Volatility has fallen to a low level, with the VIX not rising above 12 over the past month, and the S&P500 index going 98 days without a one-day decline of 1% or more, the longest such period since 1995 (Chart 2). To a degree, this is justified by the recent strong pick-up in global growth. Sentiment indicators have accelerated since the election of President Trump, and even hard data is now showing the first signs of recovery (Chart 3) with, for example, U.S. retail sales rising 5.6% year-on-year in January, and core durable goods orders starting to follow the rise in companies' capex intentions (Chart 4). Similar positive economic surprises are visible in Europe, Japan, China and elsewhere. The problem is that further upside surprises are likely to be limited. Regional Fed NowCast surveys for Q1 real GDP growth are already at 2.5-3.1%. Consensus forecasts for S&P500 earnings growth in 2017 look about right at 10.5% but, with a stronger dollar and rising wages, are unlikely to be beaten. Chart 1Historically High Valuations Chart 2Time For A Pull-Back? Chart 3Hard Data Starting To Recover Too Chart 4Orders To Follow Capex Intentions Headline inflation has picked up (to 2.5% in the U.S. and 1.9% in the Eurozone), mainly because of higher oil prices, but core inflation remains sufficiently under control that central banks don't need to slam on the brakes. The rise in unit labor costs in the U.S. suggests that core PCE inflation will gradually move up to 2% during the year (Chart 5). The latest FOMC minutes revealed that members want a further rate hike "fairly soon", and BCA expects the Fed to raise three times this year (to which the futures market ascribes only a 36% probability). But Fed policy remains very accommodative (Chart 6), the European Central Bank is unlikely to end its asset purchases soon on account of political and banking system concerns, and the Bank of Japan remains committed to its 0% yield target for 10-year government bonds until inflation is well above 2%. Absent a powerful fiscal stimulus in the U.S. or a move by the "hard money" advocates in the Trump administration to change the Fed's modus operandi, we think its unlikely that a tightening of monetary policy will drag down asset prices. Chart 5Labor Costs Putting Pressure On Prices Chart 6Fed Policy Still Accomodative Risks certainly abound. The Trump administration could start a trade war with China. Its proposals for corporate and personal tax cuts could disappoint both in terms of their details and the timing of Congress's passing them. European politics remain a concern, with the probability of Marine Le Pen becoming French President increasing recently (though it remains small). But risk markets tend to rise on a wall of worry. Investor sentiment is not particularly bullish at the moment, with the bull/bear ratio among individual investors barely above 1 (Chart 7) and flows into equity funds in recent months not reversing the outflows of last year (Chart 8). Chart 7Retail Investors Not So Bullish Chart 8Equity Flows Are Still Tepid After a year of a strong cyclical risk-on rally, progress from now on will get tougher. A short-term change of direction is quite possible (and has already happened in some assets, with the yen moving back to 112 and the 10-year Treasury yield to 2.3%). But we expect economic growth to remain robust this year - with U.S. real GDP growth likely to come in close to 3% on the back of surprises in capex - which will push the 10-year Treasury yield above 3% by year-end. In this environment, we continue to favor equities over bonds, and maintain our pro-risk tilt in equity sectors, credit and alternative assets. Equities: U.S. equities have outperformed Eurozone ones by 5% year-to-date, mainly because of worries about Europe's political risk and the fragility of its banking sector. Though we think the political risks are overstated (except perhaps in Italy), we continue to prefer the U.S. in common currency terms because of our expectations of further dollar appreciation and because the lower volatility of the U.S. helps reduce the beta of our recommended portfolio. Emerging markets have outperformed global equities by 3% YTD, mainly on the back of stronger commodities prices. But we remain underweight EM because of the risks from a stronger dollar and rising global rates, concerns about protectionism and debt refinancing, and because of the likelihood that China's rebound will run out of steam over the next 12 months (Chart 9). Fixed Income: Rates have pulled back recently: long-term institutional investors have begun to find attraction in the long end of the U.S. Treasury yield curve at 2-3%, though speculative investors remain short (Chart 10). With the Fed likely to raise rates three times this year, inflation expectations to pick up further, and nominal GDP growth in the U.S. to reach 4.5-5%, we expect the U.S. 10-year yield to rise above 3%. We therefore remain underweight duration and prefer inflation-linked over nominal bonds. In the improving economic environment, we continue to like credit, but find valuations more attractive for investment-grade bonds than for high-yield. Currencies: Dollar appreciation has been on hold since January but we think the long-term trend remains in place because of the probable direction of relative interest rates. Neither Japan nor the Eurozone is likely to move towards monetary tightening over the next 12 months. Even if the Trump administration were to want a weaker dollar, a few tweets would not be enough to offset monetary fundamentals. And, while it is true that sentiment towards the dollar is already bullish, this has historically not precluded further appreciation, for example in the late 1990s (Chart 11). Chart 9EM Equities Correlated With China PMIs Chart 10Divergent Views On U.S. Bonds Chart 11Optimism Need Not Stop USD's Rise Commodities: The oil price remains close to its equilibrium level at around $55 a barrel, with the OPEC agreement largely holding but being offset by a production increase from the U.S. shale drillers, whose rig count has doubled since last May. We are neutral on industrial commodities: Chinese demand resulting from last year's reflationary policy is likely to be offset by the stronger dollar. Gold remains a useful portfolio hedge in a world of elevated geopolitical worries and inflation tail-risk, but is also negatively correlated with the U.S. dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see, for example, "The Sweetspot of a Hollow Baseball or Softball Bat", by Daniel A. Russell, Pennsylvania State University, available at www.acs.psu.edu/drussell/bats/sweetspot.html Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights Portfolio Strategy The market has quietly adopted a less cyclical sectoral tone since yearend, a trend that could amplify over the coming months, even if overall appreciation persists. Defense stocks have grown into previously extended valuations, warranting ongoing above-benchmark exposure. The opposite is true for aerospace equities. Data processing shares are more likely to roll over than break out and we recommend paring positions to underweight. Recent Changes S&P Data Processing - Downgrade to underweight from overweight. Table 1 Feature The stock market has cheered the broad-based rebound in earnings and improvement in corporate sector pricing power (Chart 1). Unbridled optimism about growth friendly policy tilts including potential tax reform and select regulatory relief combined with an easing in financial conditions have encouraged investors to make large down payments against expected future profit gains. Indeed, extreme economic and earnings bullishness is evident in record setting price/sales (P/S) multiples: Chart 1 shows that on a median basis, the industry group (P/S) ratio is far above the 2000 peak, providing yet another metric in a long list of yardsticks signaling that greed is the overriding market emotion. Nosebleed valuation levels are cause for significant cyclical concern, but as discussed last week, momentum and a valuation-agnostic transition from fixed income to equities are the dominant tactical forces at the moment. Since it is difficult to reconcile valuations at odds with realistic expectations about future earnings growth, we remain focused on sub-surface positioning to indemnify against disappointment. Since late last year, the market has adopted a more defensive than cyclically-oriented tenor. Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models (Chart 2). Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal (Chart 2). Chart 1Future Growth Has Been Paid For Already Chart 2The Market Tone Is Changing Contrarians should take note. These nascent trend changes have developed even though economic data have generally surprised on the upside, which may be an indication that a more forceful response will occur once the string of upside surprises loses momentum. The global PMI has been very strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive vs. cyclical stocks (Chart 3). The contraction in U.S. bank lending growth may be heralding slippage in hard economic data (Chart 3), to the benefit of defensive vs. cyclical sectors. Keep in mind that the market is priced for non-inflationary growth nirvana, such that even modest economic disappointment could short circuit the buying binge. The yield curve has stopped widening and financial conditions are no longer easing (Chart 3), providing additional confirmation that the defensive vs. cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend. A trend change is also consistent with the relentless downgrading in emerging market vs. developed country GDP growth expectations (Chart 4). Chart 3Forward Looking Yellow Flags Chart 4No EM Confirmation For Cyclicals The lack of a durable and credible growth thrust in EM is confirmed by regional share price performance, as EM equities have significantly lagged their developed country counterparts (Chart 4). Now that China's fiscal stimulus impulse has rolled over amidst ongoing currency depreciation, EM lacks a catalyst for incremental growth outperformance vs. developed markets. Adding it up, evidence of a sub-surface trend change continues to materialize, even in the face of upward momentum in the broad market. We expect a mostly defensive along with select interest rate-sensitive exposure to provide optimal portfolio performance in the next 3-6 months. Defense Stocks Will Continue To Protect Portfolios... A Special Report sent to clients on October 31 outlined the long-term appeal of defense stocks, prior to the installment of a new, bellicose U.S. Administration. If anything, the latter threatens to exacerbate the decline in globalization that was already in progress (as discussed since 2014 by BCA's Geopolitical Strategy Service), potentially creating a leadership vacuum that will raise the specter of open military conflict. More nationalistic foreign policies in a number of countries, i.e. moving away from collaboration and cooperation and toward isolationism and self-sufficiency, is a recipe for increased geopolitical instability. China's challenge to the status quo is also likely to motivate a boost to defense spending globally. The recent World Economic Forum estimates of global military spending by 2030 cite both China and India planning to quadruple military outlays over this time frame (Table 2). The U.S. Administration is already pressuring other NATO members to boost defense spending after a long contraction (Chart 5), which should eventually spillover into rising defense contractor sales. Reportedly, only 5 out of 28 NATO members reached the targeted goal of spending 2% of GDP on defense. Ergo, there is room for an increase, especially in some larger countries with fiscal room to maneuver. More imminently, the conditions that have created the gap between aerospace and defense relative performance are growing even stronger (Chart 6). Table 2A New Arms Race Underway Chart 5Lots Of Upside Chart 6A Growing Gap While U.S. defense spending has been through a soft patch for the past several years, new orders for defense goods have been one of the strongest components of overall durable goods orders (Chart 6). The unfortunate reality is that the incentive to boost defense and security spending has never been higher. Terrorist activity continues to proliferate around the world (Chart 7), raising a sense of geopolitical uncertainty and mistrust. With defense new orders continuing to make new cyclical highs, factory output should run at levels flattering operating margins. Shipments of defense goods are outpacing inventories by a wide margin, which is consistent with solid pricing power. Even exports of military goods are booming (Chart 7), despite the strong U.S. dollar, reflecting a strong undercurrent of global demand. Domestic defense spending has room to expand. Real defense outlays are only just starting to recover (Chart 8). President Trump ran on a campaign to protect the U.S. from terrorism. That should make it comparatively easy to increase defense spending in the years to come. It is normal for defense stocks to retain momentum as defense spending growth accelerates (Chart 8, top panel). Increased staffing at the U.S. Department of Defense (DOD) implies that purse strings may already be loosening in anticipation of heightened activity. DOD employment growth often provides a good leading indication for real defensive spending trends (Chart 8, bottom panel). Thus, while share prices have been on a tear and valuations are not cheap, rapid earnings growth has pushed down forward multiples to manageable, below-market, levels (Chart 9, shown as an average of the companies in the BCA Defense Index). Chart 7Powerful Momentum... Chart 8... With Long-Term Durability Chart 9Growing Into Valuations Prospects for strong multiyear growth should support a move to a premium valuation as margins expand (Chart 9), similar to what occurred during past defense spending booms, as chronicled in our October 31 Special Report. ...But Aerospace Stocks Are Out Of Fuel In terms of aerospace equities, the outlook is more challenging. New orders have been sinking steadily, reflecting a downturn in the commercial aerospace cycle. While long lead times and lengthy delivery schedules offer some earnings protection, dwindling order backlogs will ultimately undermine confidence in the long-term outlook. Chart 10 shows that aerospace unfilled orders are contracting, an environment typically associated with share price underperformance, or at least elevated volatility. Shipments of aerospace goods are falling, a rare occurrence (Chart 10). The implication is that aerospace industrial production is also shrinking (Chart 10). With a heavily unionized labor force, it will be difficult to maintain profitability. Will increased global growth translate into a recovery in aerospace new orders? Doubtful. Aerospace cycles tend to be long and are not always correlated with the business cycle. Aerospace new order growth has little correlation with the global leading economic indicator. In fact, if anything, it is more countercyclical. Ominously, there are signs of excess capacity. Our global airline consumer price index, a composite of airline pricing power in a number of major countries, is in negative territory. A negative CPI reflects excess capacity, and warns of grim prospects for a recovery in new airplane orders (Chart 11). Chart 10Running On Empty Chart 11Too Much Capacity Against this backdrop, aerospace profits will become increasingly reliant on maintenance, repair and consumables activity. However, weak pricing power suggests that this source of revenue is soft (Chart 11). Aerospace valuations are close to a par with those of defense stocks. Divergent profit outlooks imply that the latter should expand while the former get squeezed. Bottom Line: We remain confident that the BCA defense index (LMT, GD, RTN, NOC, LLL) will continue to generate above market returns, whereas the BCA aerospace index (BA, UTX, HON, TXT) exhibits asymmetric downside risk. Data Processors Are Losing Their Allure After a consolidation phase that restored value to a more neutral level, we upgraded the S&P data processing index to overweight in late-September, because it fit into our consumption vs. capital spending theme, outperforms in disinflationary environments and would benefit from a recovery in industry sales growth. While several of those factors still exist, the share price ratio has been unable to gain traction and the window for outperformance may be closing. The economic backdrop is no longer conducive to capital inflows. Data processing companies enjoy hefty recurring revenue and high returns on equity, warranting persistent above market valuations (Chart 12). However, the flipside of predictability is lower operating leverage than many other industries and a pattern of underperformance during periods of rising inflation expectations. Indeed, cyclical share price momentum tends to take its cue, inversely, from inflation expectations (inflation expectations shown inverted, middle panel, Chart 12). Renewed traction in global economic growth, as evidenced by the upturn in the global leading economic indicator (GLEI, shown inverted, top panel, Chart 13), represents a headwind to capital inflows and relative multiple expansion. The improvement in business sentiment has also boosted our capital spending model, albeit we are doubtful as to whether increased animal spirits will translate into much of a capital spending cycle in a world of deficient final demand and soft free cash flow. Still, any rise in capital spending would put the services-based data processing group at a disadvantage, in relative terms. The downturn in the ISM services index compared with the ISM manufacturing index reinforces that the external environment has become more challenging (Chart 13). All of these factors could be overcome if operating trends were set to improve. Data processing revenue trends are tightly linked with consumer spending (Chart 14). The personal savings rate has room to fall, facilitating an increase in outlays, particularly now that the labor market has tightened. Rising job security has buoyed consumer confidence, which has historically augured well for data processing sales growth. Chart 12The Window Has Closed Chart 13Sell Signals Chart 14Margin Squeeze But top-line growth has been in a funk of late, even with firming pricing power (second panel, Chart 14). Companies have made a significant investment to boost marketing, as evidenced by the surge in SG&A, but so far, this has sapped margins more than stoked revenue. Importantly, Visa has recently provided a fee break to retailers, who are increasingly banding together to put pressure on the industry to lower fees. Amidst increased competition on the payments processing side, this trend is likely to be structural and put downward pressure on profit margins. Thus, we are reluctant to embrace the jump in the producer price index, as future readings could be much weaker. The implication is that operating performance will not overcome macro hurdles. Bottom Line: Reduce the S&P data processing index (V, MA, PYPL, ADP, FIS, FISV, PAYX, ADS, GPN, WU, TSS) from overweight to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Despite our tactical bullish stance, the cyclical outlook remains firmly negative for the yen, with a 12-month target for USD/JPY above 120. The BoJ is currently committed to an inflation overshoot, with this solid commitment, a strong economy will be able to lift inflation expectations, depress real interest rates, and hurt the yen. The key improvements pointing to higher inflation expectations are: Already positive inflation expectation dynamics, the closing of the output gap, the removal of the fiscal drag, the tightness in the labor market, and the end of the private-sector deleveraging. The tactical environment suggests that nimble traders with short investment horizons should stay short USD/JPY for now. Longer-term investors may want to add to short bets on the yen on further weaknesses. Feature We have espoused a cyclically bearish stance on the yen since September when the BoJ began targeting the price of money instead of the quantity of money, aiming for stable JGB yields around 0%.1 More recently, we have been buyers of the yen on a tactical basis. Here, we are reviewing whether this tactical call should morph into a cyclical bullish stance on the yen or whether the primary trend for the yen still points lower. Ultimately, we expect USD/JPY to punch through 120 on a 12 month basis. The Liquidity Trap Our framework to analyze the yen rests on one key assumption: Japan remains mired in liquidity trap dynamics. As we have pointed out before, the key symptom of this disease is evident in the Land of the Rising Sun: Loan demand has become irresponsive to changes in private sector borrowing costs (Chart I-1). In this environment, we can experience strange dynamics. As we argued in details a few months ago, when both in a liquidity trap and at the lower bound of interest rates, the demand for money is infinite, and interest rates are independent of the level of output in the economy.2 In other words, a decrease in exports, government spending, or investment, hurts demand without affecting nominal interest rates (Chart I-2, middle panel). However, in the long run, decreases in aggregate demand exert downward pressure on prices, and thus, lower inflation expectations today (Chart I-2, bottom panel). The opposite is true for a positive demand shock. Chart I-1The Symptom Of Disease Chart I-2The Thing That Should Not Be In this topsy-turvy world, a negative shock to growth, by decreasing inflation expectations, pushes up real interest rates, and thus the exchange rate. Meanwhile, a positive shock increases inflation expectations, pulling down real rates and the exchange rate as well. This is fundamental as USD/JPY continues to trade closely in line with real rate differentials between the U.S. and Japan (Chart I-3). Chart I-3USD/JPY: No Money Illusion Here This is even truer now that the Bank of Japan is both trying to keep 10-year JGB yields near 0%, and has promised to keep a very accommodative monetary policy in place until inflation has overshoot the price stability target of an average inflation rate of 2% over the whole business cycle. In other words, the BoJ's inflation target is near symmetrical and monetary policy will only harden once previous inflation undershoots below 2% have been compensated by an extended period of inflation overshoot. Also, we expect the BoJ to stay committed to this policy. Not only does Abenomics remain popular in Japan, but we expect Kuroda to be re-appointed to lead the BoJ. Moreover, the last two members of the policy committee not appointed by Abe will see their terms end in 2017. After this year, the BoJ committee will fully represents Abe's wishes. Under this framework, the key to expect the yen to fall is therefore not valuation, nor the current account outlook - two factors pointing to a higher yen - but whether or not the economy and inflation expectations can improve durably on a cyclical basis. In the next section, we explore the key positive economic developments underpinning our negative JPY stance. Bottom Line: As the BoJ is strongly committed to maintaining an extremely dovish stance until inflation overshoots by a wide-enough margin to compensate for previous undershoots, key economic improvements in Japan should lead to higher inflation expectations, falling Japanese real interest rates, and a much weaker yen. The Five Samurais We see five reasons to remain bearish the JPY: Inflation expectation dynamics, the closing output gap, the disappearance of the fiscal drag, the labor market tightness, and the end of the Japanese private sector's deleveraging. Factor 1: Inflation Expectations Are Already Unhinged Even before the BoJ aggressively targeted 0% JGB yields, Japanese inflation expectations were on an improving path. During the 2012 summer, markets began correctly anticipating the December electoral victory of Shinzo Abe, apprehending that his BoJ was about to massively ramp up quantitative easing. Japanese 5-year/5-year forward CPI swaps soon decoupled from the rest of the world and the U.S. (Chart I-4). Chart I-4The BoJ Policy Has Already Borne Fruit Chart I-5The Mechanics Of Price-Level Targeting So strong has the perceived commitment of the BoJ to higher inflation been that Japanese inflation expectations never tanked the way U.S. ones did after 2014. These dynamics contributed to keep Japanese real rates depressed relative to U.S. ones. Moreover a virtuous circle was created where lower real rates supercharged the USD/JPY's rally, lifting it by more than 60% from 77 in September 2012 to 125 in June 2015, and this further supported Japanese inflation expectations. In the summer of 2015, as EM and commodity prices began imploding on the growing expectation of a Chinese economic hard landing, Japanese inflation expectations did relapse, strengthening the yen rally. But again, unlike in the U.S., Japanese CPI swaps never fell to new lows, pointing to some improving dynamics for the domestic component of Japanese inflation expectation formations. Going forward, we expect Japanese inflation expectations to move further up. The price level targeting mechanism put in place by the BoJ last fall reinforces inflationary dynamics (Chart I-5). Any anticipated tightening in monetary policy in response to economic improvements has been pushed further away in the future, in a world where inflation may be higher locally and globally. Additionally, if global and local inflation rises, because nominal interest rates are pegged at low levels, the increase in inflation expectations puts additional downward pressure on real rates, further stimulating the domestic economy, further weakening the yen, and further boosting inflation expectations. The circuits for positive feedback loops are being laid in place. Factor 2: The Output Gap Based on the OECD's estimates, the Japanese output gap has now moved into positive territory for the first time since 2007-2008, the last episode where Japan experienced anything close to inflation (Chart I-6). Prior to then, the last time the Japanese output gap was as positive as it will be in 2017 was in 1993, among the last years when Japanese core inflation was still above 1%. While this reflects the global phenomenon of low productivity growth, the low level of supply expansion in Japan has been augmented by the 2% decline in the labor force since 1998. This means that the capacity constraints in the Japanese economy are easy to reach even if average real GDP growth has only been 0.8% since 2010. The cyclical improvements in the business cycle only point toward an increasingly positive output gap and rising inflationary pressures. To begin with, business confidence and PMIs are all very robust (Chart I-7). Chart I-6No More Slack In Japan Chart I-7Japanese Businessmen Feel Good The strength of the U.S. ISM index suggests that Japanese exports have more upside (Chart I-8) as well. Not only does a stronger Japanese trade balance contributes to a larger positive output gap, but also, strong export growth has often been the key precursor to higher capex in Japan (Chart I-8, bottom panel). Finally, the credit dynamics remain supportive. Bank loan growth has not slowed much, despite the large tightening in Japanese monetary conditions in 2016. With conditions now easing in the country, we expect the credit impulse, which has bottomed around the zero line, to re-accelerate going forward, supporting excess demand above potential GDP growth (Chart I-9). Together, all these factors suggest that the improvement in the Japanese shipments-to-inventory ratio witnessed since March 2016 will continue to lift Japanese inflation expectations higher (Chart I-10). Chart I-8Strong Japanese Exports ##br##Will Filter To Capex Chart I-9The Japanese Credit ##br##Impulse Will Rebound Chart I-10Upward Momentum In ##br##Japanese Inflation Expectations Factor 3: Fiscal Policy Another key factor that has hampered the Japanese economy since 2013 has been the large fiscal belt-tightening experience by the country. In the wake of the 2011 Tohoku earthquake, the government primary deficit blew up to 7.7% of potential GDP in 2011. It will hit 3.5% for 2017, but the IMF does not forecast much more narrowing of the government budget gap (Chart I-11). This signifies that the great brake that slowed the Japanese economy and prevented a rise in inflation is being lifted. In fact, we expect the Japanese government deficit to increase again. First, Abe's upper house electoral victory last summer was built on a campaign of larger government spending. Second, with an approval rating of 56% four years into his premiership, Abe remains a highly popular prime minister for a country plagued by 15 changes of government since 1990. This is a vote of confidence by the Japanese public toward his "Abenomics" program. Finally, military spending is likely to increase. As recently as 2005, Japan's and China's defense budgets were the same; today, China outspends Japan by four times (Chart I-12). In an increasingly unstable Asia-Pacific region, where China, Russia, and North Korea are all conducting more independent foreign policy agendas, Japan will be forced to fend for itself with more military spending, underscoring the relatively hawkish agenda of the Abe administration on this front. This will require more spending by Tokyo in this arena. Chart I-11Vanishing Japanese##br## Fiscal Drag Chart I-12The Geopolitical Imperative To Increase ##br##Japanese Government Spending Factor 4: The tightening Labor Market The Japanese labor market has now become very tight and key supply-side adjustments are behind us. The job-openings-to-applicants ratio stands at July 1991 levels, the last time when Japan was able to generate any durable wage growth. Additionally, the level of participation of women in the labor force is very elevated. The employment-to-population ratio for prime-age females stands at 74%, well above the 71.4% level of the U.S. today, and just as high as the U.S. in 2000, when that ratio was at its highest (Chart I-13). Additionally, despite a shrinking labor force and population, the total number of employed individuals stands at 65 million, the highest level since 1999 (Chart I-14). Hiring growth is also experiencing its most vigorous upswing in 20 years. Unsurprisingly, nominal wages have been growing since 2013, the longest upswing since 2004 to 2006, and wages are now at their highest level since 2009 (Chart I-14, middle panel). Chart I-13The Japanese Labor Market Is Very Tight (I) Chart I-14The Japanese Labor Market Is Very Tight (II) With the economy remaining robust, the output gap being closed, and the fiscal drag disappearing, this tightening in the labor-market should lead to additional wage gains in Japan. As the labor market slack dissipates further, we expect Japanese employment growth to slow and wages to accelerate their upward path. It is true that the Japanese labor market duality still constitutes a structural damper on Japanese wages, but for now, the very important positive cyclical factors noted above should overpower this long-term negative. Only with additional reform of the labor market will this duality dissipate structurally. Factor 5: End Of The Private Sector Deleveraging The last factor that has turned the corner in Japan is the evolution of the private sector's deleveraging. Non-financial private debt fell from 220% of GDP in 1994 to 160% of GDP today, after having stabilized since 2009 (Chart I-15). At these levels, the Japanese non-financial private debt to GDP is in line with the worldwide average of 157%, much below China's 210%, as well as below the levels recorded in Canada, Australia, New Zealand or Sweden. This development is key for many reasons. First, since 2011, Japanese households have in fact re-levered, with their debt load rising by 6.5% since their trough. This means that Japanese households are generating demand in excess of their earnings, and are therefore a source of inflation in the country. Second, the end of deleveraging has coincided with an end to the decline in Japanese land prices that has put downward pressure on all prices since 1991 (Chart I-16). Finally, the rising debt load of the Japanese government is no longer just a compensating mechanism for the deficiency in demand created by the private sector's sector deleveraging. In fact, like for households, government dissaving is now purely adding to the aggregate demand of Japan, and at the margin, is inflationary. Unsurprisingly, since 2012, periods of accelerating growth in the Japanese broad money supply have now been associated with periods of weakness in the yen (Chart I-17). This highlights the fact that money creation is now generating some increase in inflation expectations as the private sector is not furiously building its savings anymore and as the Kuroda BoJ is not leaning against inflationary developments. Chart I-15Private Sector Deleveraging Is Over Chart I-16Land Prices Are Not A Source Of Deflation Anymore Chart I-17Money Matters Putting It All Together In our view, in an environment where Japan is beginning to generate domestic inflationary pressures of its own, where the output gap is now positive, where the government is not putting a brake on growth anymore, where the labor market is at its tightest in decades, and where private sector deleveraging is not an handicap anymore, any improvement in global growth is likely to result in further increases in Japanese inflation expectations. Our sister service, Global Investment Strategy is long Japanese CPI swaps, a trade we agree with. In the context of FX, with the BoJ firmly on an easing path, rising Japanese inflation expectations will only depress Japanese real rates, exactly as the Fed becomes more aggressive. As a result, on a 12-18 months basis, the downside for the yen is very large. What About Trump? Chart I-8Japan FDI Profile President Trump wants to see a lower dollar to achieve his goal of creating manufacturing jobs in the U.S. Much ink has been spilled on the potential emergence of a Plaza 2.0 accord. We disagree. The U.S. has very little leverage to boost the value of the yen. The Bank of Japan's policy is designed to generate domestic inflationary pressures, the yen is only a casualty of this policy. In fact, with inflation expectations having been so low for so long, no country in the world can better justify having a very loose monetary policy setting than Japan. Also, the 97% surge in the yen that followed the Plaza accord of 1985 caused Japanese interest rates to stay too low relative to the state of the economy. As a result, a massive debt bubble ensued that lifted the economy further, but then prompted the bust which Japan still pays for. Today, the Japanese are unlikely to want to repeat the same mistake. While we do think that deleveraging has ended in Japan, a country with a falling population is unlikely to begin a new private-sector debt supercycle either. Finally, China continues to be an economy that saves too much. This means that China can either allocate these savings domestically through the debt market or export them internationally through its current account surplus. We expect Chinese authorities, who are already very worried by the high debt load in China to choose the second option for the next two years. As a result, BCA foresees further declines in the RMB over the next 12 to 18 months. In this environment, the Japanese would find it very difficult to remain competitive in the Chinese market if their currency rises as the RMB weakens.3 That being said, Trump will want some concessions out of the Japanese. Already, the February 10 meeting between the U.S. president and PM Abe is giving us a glimpse of things to come. Japanese non-tariff barriers on U.S. products are likely to decrease, potentially in the agricultural and automotive field especially. Additionally, Japan still runs a large current account surplus and therefore, a large capital account deficit. We expect Japanese FDIs in the U.S. to only grow going forward. The main beneficiary is likely to be the automotive sector as it would be the key mechanism for Japanese firms to avoid paying large tariffs / punitive taxes and still access the vital U.S. market (Chart I-18). Moreover, this fits well within Trump's agenda as it creates manufacturing jobs in the U.S. Call it a win-win situation if you will. Not Time To Close Short USD/JPY Yet Despite this very negative cyclical view on the yen, we remain committed to our tactical short USD/JPY position: For one, positioning on the yen remains too extreme (Chart I-19). Second, as argued by our European Investment Strategy service, we may be on the cusp of a mini down cycle in the credit impulse, suggesting a temporary deceleration in the G10.4 The recent collapse in quarterly credit growth in the U.S. points exactly in this direction (Chart I-20). Because U.S. 10-year bond yields are so tightly linked to global economic surprises, negative surprises could put temporary downward pressure on Treasury yields (Chart I-21). A move lower in yields would be very supportive of the yen, even if only for a few months. Chart I-19Speculators Are Still Too ##br##Short JPY Tactically Chart I-20Falling Short-Term Credit##br## Impulse In The U.S. Chart I-21Falling Surprises Can##br## Temporarily Help Bond Prices Third, the dollar correction is not over. Sentiment and positioning on the dollar represent tactical hurdles that need to be overcome before the greenback can resume its ascent. Also French OAT / German bunds spreads are at distressed levels, having only been higher at the height of the euro crisis in 2012, and not far off the levels experienced during the ERM crisis of the early 1990s (Chart I-22). This suggests that the risk of a Le Pen presidency is now well known. We agree that the impact of such an event would be enormous, but the 34.5% odds currently assigned to it on Oddschecker are too great, especially now that Bayrou - a centrist politician - is not entering the race and putting his support behind Macron. Finally, the dollar has followed a textbook wave pattern since October. A continuation of this pattern suggests that the DXY has downside toward 97-98 (Chart I-23). Chart I-22OAT / Bund Spreads Price In A Lot Of Negatives Chart I-23A Textbook Wave Pattern In The Dollar The ultimate factor in favor of the continuation of the yen correction is the higher degree of complacency that has settled globally. Our Global Complacency indicator, based on the G10 stock-to-bond ratio, commodity prices, and the VIX is at an extremely elevated level warning of a potential risk-off event globally. Any rollover in this very mean-reverting indicator would prompt a further weakness in USD/JPY as well as AUD/JPY, especially if the BoJ doesn't increase stimulus in the meantime (Chart I-24). Chart I-24AUnless The BoJ Eases Further, Too Much ##br##Complacency Equals Tactically Long JPY Chart I-24BUnless The BoJ Eases Further, Too Much ##br##Complacency Equals Tactically Long JPY Bottom Line: Tactical investors should continue shorting USD/JPY for the moment. More cyclical players can begin deploying capital to short the yen as the cyclical outlook for this currency remains dire, but better opportunity to sell this currency are likely to emerge over the coming months. A dollar-cost averaging strategy seems wise at this point. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see the Foreign Exchange Strategy Weekly Report, "How do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016, available at fes.bcaresearch.com 2 Please see the Foreign Exchange Strategy Weekly Report, "Down The Rabbit Hole", dated April 15, 2016, available at fes.bcaresearch.com 3 For a more detailed discussion on the RMB, please see the Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?", dated February 24, 2017, available at gis.bcaresearch.com 4 For a more detailed discussion of the mini-cycle, please see the European Investment Strategy Weekly Report, "Slowdown: How And When?", dated February 2, 2017, available at eis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. economy is giving a green light to the Fed to hike. Headline CPI is at 2.5% annually, and core CPI is at 2.3%; Retail sales beat expectations at 0.4% MoM; The core CPI measure is evidence that the U.S. economy is fundamentally strong and dynamic. Real GDP now stands 11% above its pre-recession peak, and it is approaching the Congressional Budget Office's estimate of potential output. The unemployment and output gap are also close to their long-term levels. With the economy closing in on its potential, it is only natural that FOMC participants "expressed the view that it might be appropriate to raise the federal funds rate again fairly soon" in the Minutes. Although a risk of disappointment from Trump's fiscal proposal is possible, the economy's momentum will continue. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro area remains robust, with this week's data showing a strong outperformance: German, French and overall euro area PMI increased and beat expectations across all measures, with the exception of France which only outperformed on the Composite measure; Euro area producer prices strengthened to a 2.4% annual pace; After seeing some downside from worries about a Le Pen victory, markets have calmed François Bayrou, a centrist, announced an alliance with presidential candidate Emmanual Macron, adding a resistance to the euro's downside. Substantial volatility can still be expected, however, as a Le Pen victory is not completely out of the realm of possibility, which means that the euro can see some weakness in the near term. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Positive signs continue to emerge in Japanese data: Industrial production yearly growth came in at 3.2% Nikkei Manufacturing PMI came in at 53.5, outperforming expectations Japan's Leading Economic Index came at 104.8, the highest level since 2015 These economic developments are good news for the BoJ, as it shows them that their price level targeting and yield curve control measures seem to be working. However the objective of these measures is not to achieve these marginal improvements in the economy. The objective is to catapult Japan out of the liquidity trap it is in, which means that these measures will likely stay in place for a while. Therefore, on a cyclical basis we remain short the yen, as we expect USD/JPY to reach 120 on a 12 to 18 month horizon. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data has painted a mixed picture for the U.K. Industrial and manufacturing production yearly growth came in at 4.3% and 4% respectively. Both measures blew past expectations. Also, in spite of the dramatic fall in the pound, Inflation seems to be relatively contained, as both core and headline numbers came in below expectation at 1.8% and 1.6% respectively. However not everything is good news. Yearly growth for retail sales and retail sales ex fuel underperformed expectations coming at 1.5% and 2.6%, respectively. Additionally, wage growth has been limited, as average weekly earnings yearly growth came below expectations at 2.6%. We continue to be bullish on the pound, particularly against the euro as any additional political risks caused by Brexit are now well known by participants, making the pound very cheap, especially if one takes into account real rate differentials. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has been the top performing currency against the USD out of the G10, having appreciated 7.11% since the beginning of the year. This rally is increasingly tenuous. Full-time employment has struggled to pick up, while part-time employment increased by 4%. This will hamper wage growth and consumption going forward. This is important as consumption is already 58% of the economy. Meanwhile, net exports have made a negative contribution to GDP growth for almost two years. In fact, Australian exports to China subtracted 1% of GDP growth last year, due to a decline in commodity prices. Going forward, a limited upside in commodity prices and an end to the Chinese easing cycle can exacerbate this decline. On a technical basis, AUD/USD has sustained momentum since the beginning of the year, with the RSI displaying overbought levels since mid-January. The cross is also approaching a key resistance level, pointing to growing risks ahead. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data for New Zealand has not been particularly positive and have weighed on the kiwi: Retail sales underperformed, growing by 0.8% QoQ against expectations of 1.1%. Business NZ PMI fell to 51.6 from last month's 54.5. Nevertheless, a closer look at the data paints a much brighter picture: the decline in NZ PMI seems to have been primarily due to bad weather conditions, which means that the strong fundamentals of the kiwi economy should show up in the data once seasonal factors start to dissipate. Therefore, we are bullish on the NZD versus the AUD, as the structural backdrop for these countries could not be further apart, yet the market is now pricing less than a 10 basis points difference from here until the end of the year. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian employment numbers came out seemingly strong, with a net change in employment of 48,300 and a decrease in the unemployment rate to 6.8%. However, these numbers mask numerous underlying inconsistencies. The decrease in unemployment was the result of a robust part-time employment growth of 5.6%, not the 0.3% growth in full-time employment. Wage growth remains subdued, with average hourly earnings of permanent workers currently increasing at a 1% annual pace, compared to 3.3% a year ago. Furthermore, hours worked have declined by 0.8%, exacerbating the weakness of full-time employment's contribution to activity. Retail sales underperformed expectations, contracting at a 0.5% monthly pace; the measure excluding Autos also contracted at a 0.3% pace. Increasing household debt and festering labor market complications are likely to weigh on consumer confidence. An uncertain outlook on trade developments is an additional handicap to future CAD strength. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 During the last couple of weeks, fear of a Eurosceptick government in Europe's second biggest economy, has lowered EUR/CHF below the implied floor that the SNB has had for the last couple of years. Indeed, last week, as La Pen surged on French presidential polls, this crossed reached 1.063, its lowest level since August 2015. This is bad news for Switzerland, as economic data continues to indicate that the country has not been able to shake off the shackles of deflation: Headline inflation outperformed expectations as it finally exited deflationary territory, coming in at 0%. Industrial production contracted by 3.3% on a year on year basis Given this deflationary backdrop, the SNB will continue to try to limit the downside for this cross. However, on the months leading to the French elections, the floor will continue to get tested. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Inflation seems to be abating in Norway as core and headline inflation numbers fell sharply from last month reading, coming in at 2.1% and 2.8% respectively. This is the result of various factors: First, the inflation caused by the collapse of the krone is starting to fade away. From 2014 to 2016, the krone collapsed along with oil prices. This selloff in the krone passed through inflation to the Norwegian economy via rising imported goods, with a lag. Today, roughly one year after the NOK bottomed, the effects of the currency on inflation is starting to dissipate. Furthermore, labor market dynamics in Norway are anything but inflationary as wage growth is contracting by 4% and although unemployment is low, the Norges Bank has pointed out that is in largely caused by a fall in the participation rate. Thus, given that high inflation is receding, the Norges Bank will keep its easing bias for the time being. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The February 2017 Monetary Policy Statement illustrated a clear dovish stance. Governors and economists at the Riksbank are paranoid about risks emanating from a strong currency and political developments. Tensions from a recently strong SEK have created worries about a potential slowdown in inflation. The Bank has therefore reiterated the possibility of an intervention if the Krona's appreciation is too rapid, making it a very real possibility. A questionable political outlook from the U.S. and the euro area has further hampered the Riksbank's optimism. The euro area is a particular risk since it represents a large source of Sweden's growth, and any damage to the monetary union will have a catastrophic effect on Sweden. Because of these reasons, the Riksbank explicitly stated that it is "still prepared to make monetary policy more expansionary if the upward trend in inflation were to be threatened and confidence in the inflation target weakened." Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Portfolio Strategy Add the S&P asset manager & custody banks index to the high-conviction overweight list. Prospects for higher interest rates bode well for a catch up phase with the rest of the financials sector. Initiate a long S&P consumer staples/short S&P technology pair trade, a truly out of consensus call. Housing-related equities are likely to gain ground as housing activity should stay resilient amidst rising borrowing costs. Recent Changes S&P Asset Managers & Custody Banks - Added to our high-conviction overweight list on February 16th. Long S&P Consumer Staples/Short S&P Technology - Initiate this pair trade today. Table 1Sector Performance Returns (%) Feature Momentum continues to drive the broad market trend. The drag from a reduction in global liquidity courtesy of depleting foreign exchange reserves continues to be overwhelmed by economic optimism. The latter is fueling a major rotation from bonds to stocks, which is the dominant market force. Valuations have taken a backseat, emblematic of blow-off phases. Two weeks ago we introduced our Complacency-Anxiety Indicator, which hit a new high. Another way to measure greed overwhelming fear is the relentless rise of the forward P/E over the VIX. The spread between these two measures can also gauge complacency. This Indicator has also soared to an all-time high (Chart 1). Chart 2 applies this methodology for the broad S&P sectors, using forward P/E and implied equity volatility, and then standardizes the result to remove biases from perennially low and high P/E sectors. A low reading suggests lower risk, and vice versa. Chart 1Buy At Your Own Risk Chart 2Sector Vulnerabilities And Opportunities At the moment, financials, telecom, utilities, REITs and health care have the lowest implicit vulnerability, while cyclical sectors carry the most risk. How long can this overshoot phase last? There are obviously no easy answers. However, from a purely technical perspective and in the absence of any major monetary, economic and/or geopolitical shocks, an examination of our Composite Technical Indicator (CTI) suggests some running room remains. Our CTI is driven primarily by momentum components. Overbought conditions are signaled once it hits one standard deviation above the mean. Currently, the TI remains slightly below this threshold (Chart 3). Even then, it can cross decisively into the danger zone before the S&P 500 eventually sells off in a meaningful fashion. Chart 3Overbought Conditions Can Persist Importantly, when the CTI swings quickly from deeply oversold to overbought levels, there can be a multi month lead before the broad market crests or suffers a sustained setback (Chart 3), and the bulk of those moves are associated with economic recessions and/or growth disappointments. The implication is that even though extended broad market valuations virtually guarantee paltry long-term returns and economic expectations are now sky-high, technical conditions suggest that momentum may continue to carry the day for a while longer. That does not mean investors should abandon a largely defensive portfolio structure, given that this is where the reward/risk tradeoff is most attractive and timing corrections is inherently difficult. Two weeks ago we recommended buying both gold and packaging stocks. As part of our ongoing rebalancing, this week we are further tweaking our portfolio. We recommend a pair trade to position for the inevitable sub-surface mean reversion heralded by our Indicators in the coming 3-6 months. Asset Managers: Shifting To High-Conviction Status The interest rate and market-sensitive S&P asset managers & custody banks index (AMCB) has lagged most other financials sub-indexes at a time when macro forces are lining up bullishly, particularly in view of the sector's attractive ranking on a forward P/E to volatility basis. While the capital markets and banks groups are seen as having higher torque to these positive forces, these three groups tend to move together. Lately, a divergence has opened, but a number of factors point to an imminent AMCB catch up phase (Chart 4), especially given that AMCB is not levered to overall credit growth, which has dried up. Fed Chair Yellen's testimony last week was interpreted to be slightly more on the hawkish side. That, coupled with the recent upside surprise in core inflation, raises the possibility of more 2017 tightening than currently discounted. That would provide further relief for custody banks, as ultra-low interest rates have been an anchor on this group's profitability as fees earned on funds held in trust have been minimal. The increase in short-term Treasury yields heralds a share price rally (Chart 5, top panel). Chart 4Catch Up Ahead Chart 5Time To Rally Moreover, the boost in economic expectations signals scope for an increase in fee generating activity, such as M&A, stock issuance and even stock lending. BCA's Global Economic Sentiment Index also indicates that the share price ratio has undershot (Chart 5). Most importantly, the asset preference shift from bonds to stocks reverses another major drag on profitability (Chart 5, third panel). Fixed income products carry lower margins than equity products, so as equity assets under management grow, profit margins should expand. If so, then we would anticipate a relative valuation re-rating, especially if the pace and scale of financial sector deregulation disappoints. The latter has been a key factor propelling capital markets and banks, and any disappointment could cause a capital rotation into the lagging AMCB index. Bottom Line: We are already overweight the S&P asset management & custody banks index, and added it to our high-conviction list in a daily Sector Insight on February 16th. New Pair Trade This week we are recommending what can be considered a highly contrarian pair trade: long the S&P consumer staples sector and short the S&P technology sector. It may be difficult to swallow executing such a non-consensus position while the broad market is going gangbusters. However, the objective message from our Indicators and increasing odds of a vicious, un-telegraphed correction, argue that the reward/risk trade-off is too attractive to ignore. As outlined in last week's Cyclical Indicator Update, the technology sector's relative earnings profile has deteriorated, because the corporate sector is not spending much yet and tech companies have suffered a serious loss of pricing power. Conversely, the consumer staples sector has a better chance of earnings outperformance, according to our model (Chart 6). Both sectors appear to have discounted the opposite outcome. Moreover, from a technical perspective, tech stocks are overbought and consumer staples are extremely oversold (Chart 6). Even a simple technical/momentum renormalization would imply a sharp jump in the share price ratio. Both sectors lose competitiveness when the U.S. dollar rise, but given that the technology sector's share of foreign sales (58%) is much higher than that of consumer staples (28%), the pain is disproportional. Importantly, consumer staples exports are accelerating, whereas tech exports are shrinking (Chart 7). Chart 6Contrasting Profiles Chart 7The Strong Dollar Is Worse For Tech Non-durable consumer goods are less sensitive to emerging market prospects, and thus when their currencies weaken, momentum in the consumer staples/tech share price ratio tends to accelerate (EM currencies shown inverted and advanced, bottom panel, Chart 7). Moreover, a strong U.S. dollar tends to reduce input costs for many consumer staples vendors, both through lower commodity prices and a reduced cost of imported goods sold. We have shown that tech stocks fare poorly toward the latter stages of a U.S. dollar bull market, when consumer staples start to shine. This dynamic reflects the economic fallout abroad from a strong U.S. dollar, particularly on developing economies, as well as the drag on U.S. corporate profits, and by extension, capital spending. While the U.S. dollar and stocks have risen in tandem in recent months, that cannot continue indefinitely, and when the correlation breaks down, the defensive consumer staples sector should outperform. In terms of economic dynamics, this share price ratio tends to accelerate when consumer spending outperforms capital spending. Consumer confidence is outpacing business confidence (Chart 8, top panel), signaling such an environment ahead. That sentiment mismatch has already translated into faster consumption than business investment on tech goods (Chart 8, second panel). Unless the gap between the return on and cost of capital reverses course and widens anew, then this trend is likely to persist. As a result, the surge in consumer staples vs. technology pricing power will continue, ultimately flattering the share price ratio through relative profit performance (Chart 8, bottom panel). The message is that consumer staples profits can have the upper hand over tech even when overall GDP growth is positive, provided the underlying driver is consumption rather than capital spending. From an external standpoint, it is notable that consumer staples have a better track record than tech stocks during inflationary periods. Chart 9 shows that the uptrend in long-term inflation expectations and increase in actual inflation both forecast a revival in this pair trade. Chart 8Unsustainable Divergences Chart 9Inflation Pressures? Buy This Ratio Rising inflation ultimately heralds tighter monetary policy, which is a precursor to elevated broad market volatility and a rise in the discount rate, to the detriment of long duration sectors. History shows that the high priced tech sector is more vulnerable than the safe haven staples sector in such an environment. In sum, the time is ripe for a contrary pair trade favoring consumer staples vs. technology. Notable risks to this trade are that the U.S. dollar weakens meaningfully and/or global capital spending re-accelerates decisively, relative to consumer spending. Bottom Line: We recommend a market neutral long consumer staples/short technology pair trade. The time horizon for this trade is 3-6 months. Will Housing Stocks Go Through The Roof? Housing-related stocks have delivered positive earnings surprises, but anxiety about rising mortgage rates challenges the outlook. While the latter is a risk, cheap valuations and consumers' underappreciated ability to absorb rising borrowing costs offset these concerns. Sensitivity analysis shows that even a 200 basis point (bps) spike in interest rates from current levels would fail to push housing affordability back to the long-term average (Chart 10). Moreover, mortgage payments as a percentage of incomes and effective borrowing costs would also remain below their respective historic means even with such a spike. Importantly, housing market fundamentals are improving. Lumber prices are on fire. Lumber has been the best performing commodity year-to-date. This is a real time indicator of housing demand (Chart 11). Similarly, railroad carloads of lumber are also firming, signaling that the price rise is demand-driven rather than a speculative bet in the trading pits. Sustained house price inflation, solid housing turnover and the acceleration in building permits reinforce that housing activity remains robust (Chart 11). Chart 10Higher Rates Are Not A Show Stopper Chart 11Lumber Strength Is Housing Bullish The credit tap to sustain strong activity is still open. According to the latest Fed Senior Bank Loan Officer Survey, banks are willing and able to extend residential mortgage credit (bottom panel, Chart 11). This contrasts with many other credit categories, where banks are tightening the screws and credit demand is faltering: C&I loans have shrunk over the past three months, as has total bank credit. First time home buyers are also reappearing and anecdotes of increased house flipping activity signal a vibrant market with unobstructed access to credit. All of this should continue to support earnings-led outperformance from both homebuilders and home improvement retailers (HIR). The bullish outlook for the S&P homebuilding index rests on four pillars. The latest National Association of Home Builders (NAHB) survey revealed that sales expectations remain over 20 points above the boom/bust line and just shy of recent cyclical highs (Chart 12). Homebuilders are clearly still seeing strong traffic. New home prices are still expanding at a healthy clip (Chart 12). Sales growth and new home price inflation are tightly linked. The mortgage application purchase index has picked up steam despite the mortgage rate increase, confirming that first time homebuyers are entering the market after a long hiatus as the financial motivation to buy vs. rent has improved. This optimism is causing an aggressive re-rating in earnings estimates from chronically bearish levels (Chart 12), a harbinger of further gains in relative share prices. The S&P HIR index also has a concrete foundation. Higher lumber prices flow straight to the bottom line, because HIR companies typically earn a set margin on lumber-related sales. Moreover, higher housing turnover is a boon for industry sales volumes (Chart 13). Historically, home sales momentum has been an excellent leading indicator of renovation activity. Chart 12Buy Homebuilders... Chart 13... And Building Supply Retailers Encouragingly, the NAHB remodeling survey is still in expansion territory, and tends to follow the trend in home sales, underscoring that home renovation activity is set to improve (Chart 13). Our HIR model encapsulates many of these key drivers, and has climbed anew (Chart 13). The message is that profits, and share prices, are on track to outperform. Adding it all up, the housing backdrop remains attractive, and even a steady increase in borrowing costs should not disrupt momentum. The time to become concerned will be if inflation becomes a serious risk, causing the Fed to get 'tight' and credit availability to dry up. The next few interest rate hikes won't move the monetary settings to that phase yet. Until then, we recommend erring on the bullish side. Bottom Line: We reiterate our high-conviction overweight in the S&P home improvement retail index (HD, LOW) and continue to recommend an above benchmark allocation in the S&P homebuilding index (PHM, DHI, LEN). Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Dear Client, In addition to our regular Weekly Report, we sent you a Special Report on Wednesday prepared by my colleague Marko Papic, BCA's chief geopolitical strategist, assessing the election landscape in Europe this year. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights Global growth has accelerated, corporate earnings are rebounding, and leading indicators suggest that these positive trends will persist over the remainder of the year. This supports our cyclically bullish view on global equities. Looking further out, the impulse to growth from the easing in financial conditions that began in early 2016 will fade, setting the stage for a slowdown in 2018. If growth does falter next year, easier fiscal policy could provide an offsetting tailwind. However, there continues to be a large gap between what politicians are promising and what they can realistically deliver. What is different this time is that spare capacity is much lower than it was during previous mid-cycle slowdowns. Thus, while global bond yields could eventually dip, they remain in a secular uptrend. Feature The Elusive Correction We have been arguing since last fall that stronger global growth will help fuel a variety of reflationary trades.1 This part of our view has panned out nicely. What has surprised us is just how relentlessly the market has traded that view. With the exception of a few small wobbles, the S&P 500 has basically marched higher since the morning following the U.S. presidential election. Reflecting this development, the VIX fell to near record low levels earlier this week (Chart 1). The market's failure to take a breather has sabotaged our efforts to have our cake and eat it too - to maintain an overweight stance on global equities, while also profiting from the occasional correction. In contrast to our last three tactical hedges - which generated a cumulative return of 42% - our latest hedge is now down 9%. That's a lot of red ink. Out of pure risk management considerations, we will close this trade if the loss breaches 10%. Nevertheless, most indicators continue to warn of a looming correction. In particular, our U.S. equity strategists' new "Complacency-Anxiety" index is at an all-time high, suggesting that stocks have entered a technical overshoot phase (Chart 2).2 Chart 1VIX Is Near Record Lows Chart 2Complacency Reigns Cyclical Picture Still Solid In contrast to the short-term outlook, the 12-month cyclical picture for risk assets still looks reasonably good. Measures of current activity are rebounding as animal spirits begin to kick in (Chart 3). Falling unemployment and stronger wage growth are causing households to open their wallets. Against the backdrop of decreasing spare capacity, firms are reacting to this by increasing investment spending. Capital goods orders in the G3 economies have jumped higher in recent months, and capex intention surveys are pointing to further upside (Chart 4). Chart 3Current Activity Indicators Are Rebounding Chart 4An Upswing In Capex Corporate earnings have also accelerated on the back of faster economic growth. Consensus estimates call for global EPS to expand by 12% in local-currency terms this year, with the S&P 500 registering 10.4% growth, the STOXX Europe 600 gaining 14.3%, Japan's TOPIX adding 12.5%, and MSCI EM leading the pack at 16%. Outside the U.S., year-to-date earnings revisions have generally been positive, particularly in Japan and EM (in the U.S., 2017 EPS estimates have ticked down a modest 0.8%). BCA's in-house earnings models are consistent with this optimistic profit picture (Chart 5). What accounts for this fortuitous turn of events? A number of reasons help explain why growth accelerated in the second half of 2016: The drag on global growth from the plunge in commodity sector investment ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7 percent off the level of U.S. GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 6). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus, helping to reflate the economy. Global growth benefited with a lag from the easing in financial conditions that began in earnest in early 2016. Government bond yields fell to record low levels in July. In addition, junk bond spreads collapsed, dropping from a peak of 7.9% in February to 4.3% by year-end (Chart 7). Higher equity prices, particularly in a number of beaten down emerging markets, also helped. Chart 5Broad-Based Acceleration In Corporate Earnings Chart 6Inventory Destocking Was A Drag On Growth Chart 7Corporate Borrowing Costs Have Fallen How Much Longer? Chart 8Improvement In Global ##br##Leading Economic Indicators The key question for investors is how long the good times will last. Right now, most leading indicators that we follow are signaling that the expansion will endure for the remainder of this year (Chart 8). As we look towards 2018, however, things get murkier. Conceptually, it is the change in financial conditions that matters for growth. While the ongoing rally in global equities and continued narrowing in credit spreads has contributed to some easing in financial conditions since the U.S. presidential election, this has been partly offset by higher government bond yields. A stronger dollar has also led to an incremental tightening in the U.S., as well as in some emerging markets with high levels of U.S. dollar-denominated debt. As such, it is likely that the positive "impulse" to economic growth from the easing in financial conditions that took place last year will begin to dissipate towards the end of this year. Fiscal Policy To The Rescue? If growth does slow next year, easier fiscal policy could provide an offsetting tailwind. The fiscal thrust for developed economies turned positive in 2016, the first year this happened since 2010 (Chart 9). However, it remains to be seen whether this trend will continue. There is little support among Republicans in Congress for a big infrastructure program. It once seemed possible that Chuck Schumer and his fellow Democrats could find common ground with President Trump on this issue, but that is looking less likely with each passing day, given the level of vitriol in Washington. Broad-based tax cuts are a certainty, but the risk is that they will be coupled with cuts to government spending. Empirically, the latter have a larger "multiplier effect" on GDP than the former. To complicate matters, the introduction of a border adjustment tax - something to which we assign 50% odds - could generate significant near-term dislocations for the global economy.3 Meanwhile, much of Trump's regulatory agenda is in limbo. A repeal of Dodd-Frank is off the table. Senate Republicans do not have the 60 votes needed to scrap it. The Volcker rule is here to stay. On the other side of the Atlantic, the European Commission has recommended a further loosening in fiscal policy this year, but member states themselves are actually targeting somewhat smaller fiscal deficits (Chart 10). As is often the case, budgetary overruns are likely, but with the Greek bailout program now back on the ropes, Germany and a number of other countries may begin to dial up the austerity rhetoric. Chart 9Will Fiscal Policy Continue To Ease? Chart 10European Commission Recommending Greater Fiscal Expansion Uncertainty over the slew of European elections slated for this year could also weigh on business sentiment. Marine Le Pen is likely to place first in the initial round of the French presidential election, but faces an uphill battle in the subsequent runoff. Nevertheless, betting markets are assigning a one-in-three chance of Le Pen becoming president - similar to the odds they were assigning to a Brexit "yes vote" and a Trump victory (Chart 11). Italy also remains a risk, as my colleague Marko Papic, BCA's chief geopolitical strategist, discussed in this week's Special Report.4 Anti-euro sentiment is now stronger there than in any other major European economy (Chart 12). Chinese fiscal policy has already tightened significantly, with the year-over-year rate of change in government spending falling from a high of 25% in November 2015 to zero at present (Chart 13). So far the Chinese economy has held up well, but there is a risk that this may change. Despite Trump's backpedaling on the "One China" question, we expect the Trump administration to declare China a currency manipulator later this year. This will pave the way for higher tariffs on a variety of Chinese goods, which could lead to retaliatory measures by China. Chart 11Brexit, Then Trump... Is Le Pen Next? Chart 12Italy: Anti-Euro Sentiment Is A Risk Chart 13China: Fiscal Stimulus Is Fading Investment Conclusions Chart 14Diminished Slack In The Global Economy Global growth continues to be strong, and is likely to stay that way for the remainder of this year. However, there is a heightened risk that the global economy will falter in 2018. We remain cyclically overweight global equities and underweight government bonds, but are not dogmatic about this view. As the discussion above suggests, plenty of things could derail the reflation trade. If evidence begins to mount that a slowdown is coming earlier than we think, we will turn more bearish on stocks. Given that equities are technically overbought at present, we would not fault anyone for taking some money off the table. If growth does slow in 2018, does this mean that bond yields will fall back towards last year's lows? We don't think so. For one thing, a major deflationary commodity bust of the sort we endured in 2014-15 is not in the cards. In addition, there is less slack in the global economy now than there was last year, or for that matter, anytime since early 2008 (Chart 14). As we discussed in our Q1 Strategy Outlook, potential GDP growth is likely to remain structurally depressed across much of the world, owing to slower productivity and labor force growth.5 Lower potential growth means that excess capacity could continue to be absorbed even if growth slows somewhat from its current well-above trend pace. In the U.S., this absorption of excess capacity is nearly complete, with most labor market indicators suggesting that the economy is approaching full employment (Chart 15). In this vein, we would heavily discount the decline in average hourly earnings in January's employment report. Chart 16 shows that this was mainly driven by an anomalous drop in compensation in the financial sector. Broader measures continue to point to brewing wage pressures (Chart 17). We expect the Fed to raise rates three times this year, one more hike than the market is now pricing in. If this happens, the dollar is likely to strengthen modestly over the remainder of the year. Chart 15U.S. Economy Approaching ##br##Full Employment Chart 16Financial Sector Dragging ##br##Down Hourly Earnings In The U.S. Chart 17U.S.: Broad Measures Pointing ##br##To Rising Wage Pressures Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. 2 Please see U.S. Equity Strategy Weekly Report, "Bridging The Gap," dated February 6, 2017, available at uses.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 5 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights We expect the high level of compliance with the OPEC - non-OPEC production agreement engineered by the Kingdom of Saudi Arabia (KSA) and Russia will endure, leading to significant reductions in global oil inventories this year and next. All else equal, this should backwardate WTI and Brent forward curves later this year. However, recent developments in the North American pipeline market - i.e., U.S. President Donald Trump's orders to revive development of the Keystone XL (KXL) and completion of the Dakota Access (DAPL) pipelines - could send as much as 1mm barrels/day (bbl/d) of crude south from Canada and the Bakken, which would boost inventories at Cushing and other Midwest storage facilities later in this decade. Depending on when these pipelines are completed - likely by 2020 in the case of KXL - the WTI forward curve could return to a sustained contango.1 The expanded flows of heavy crude via KXL, and light-tight oil south via the DAPL could undo a subtle benefit arising from the backwardation induced by the KSA - Russia production pact, which we uncovered in our modeling. Energy: Overweight. At Tuesday's close, our short Dec/19 WTI vs. long Dec/19 Brent spread elected last week at $.07/bbl (WTI over) was up 700%. Our long Dec/17 WTI vs. short Dec/18 WTI front-to-back spread, entered into at -$0.11/bbl on Feb 9/17, was up 263%. Base Metals: Neutral. BHP declared force majeure at its Escondida mine, which accounts for ~ 5% of global supply, after workers voted to strike. Union leaders agreed to another round of government-mediated talks with BHP management. Precious Metals: Neutral. Fed Chair Yellen's Senate Banking Committee testimony was more hawkish than expected, which rallied the USD and muted gold's overnight strength. We continue to look to get long gold at $1,180/oz. Ags/Softs: Underweight. The USDA revised grain and soybean supply/demand estimates last week, showing markets tightening slightly, with ending stocks for the 2016/17 crop year expected to be a touch lower. We remain bearish. Feature Chart of the WeekStorage Drawdowns Should Accelerate ##br##As U.S. Oil Imports Slow Regular readers of BCA's Commodity & Energy Strategy service will not be surprised by the very high compliance levels seen in the wake of the OPEC - non-OPEC production Agreement engineered by KSA and Russia late last year.2 Because the stakes are so high for KSA and Russia - and their respective oil-producing allies - we expect compliance to remain high into June, resulting in a drawdown of global oil storage, the stated goal of the deal. We believe the pact will result in both WTI and Brent forward curves returning to backwardation, as global storage levels fall some 300mm bbl (Chart of the Week). We are positioned for this outcome by being long Dec/17 WTI vs. short Dec/18 WTI. We are expecting to see the last of the Persian Gulf export surge to the U.S. this month, as the 45- to 50-day sailing time from the Gulf to the U.S. implies the last of these vessels will be arriving this week or next. This backwardation will, in all likelihood, restrain the rate at which U.S. shale-oil producers return rigs to the market next year. Chart 2Curve Shape Can Affect Rig Counts WTI Term Structure And Rig Counts: It's Complicated Recent modeling we've completed suggests curve shape can affect rig counts in the U.S. light-tight oil fields. When we regress U.S. rig count on the WTI forward curve, we find rig counts can be expected to increase when the forwards are in contango, and to decline when the market is backwardated. A flat forward curve can be expected to keep rig counts fairly constant (Chart 2).3 Obviously, the starting point for these outcomes is critical. We simulated rig counts by assuming Monday's closing prices for March through June WTI futures, then assumed different levels for July WTI futures as a starting point for estimating rig counts to end-2018. We used $50, $55 and $60/bbl in July as our starting point. All else equal, with the July/17 WTI at ~ $55/bbl and the forward curve backwardated by 10% 18 months out, we would expect to see average rig counts fall by 4.38 rigs/month in 2018, given the three-to-four month lag between rigs actually being deployed and the price signal being sent by the futures market. A contango term structure produces the opposite result. With the July/17 WTI at ~ $55/bbl and the forward curve in a contango of 10% 18 months out, we would expect to see rig counts increase by 4.57 rigs/month in 2018. There obviously is a price threshold from which the forward curve originates in this analysis, which we believe to be between $50 and $55/bbl. Below this level, we would expect shale producers to retreat back to their core production areas, and await a price signal to increase their rig counts. Above $60/bbl, backwardation and contango matters for rig counts over the next 2 to 2.5 years. A backwardated forward curve will, all else equal, incentivize a slightly lower level of rigs being deployed than a contango. For example, a 10% contango with a $60/bbl starting point results in 5.24 rigs/month being deployed, while 10% backwardation would lead us to expect 5.02 rigs/month being deployed. Sustaining Backwardation Will Be Difficult A sustained backwardation will be threatened later in this decade by the expansion of the North American pipeline grid, following U.S. President Trump's orders to revive the Keystone XL (KXL) pipeline's development and the completion the Dakota Access Pipeline (DAPL). The KXL and DAPL buildouts, if approved, will expand U.S. midcontinent crude deliveries by 1mm bbl/d, according to Genscape's tally.4 The KXL volumes would add close to 600k bbl/d to Canadian exports, and would flow directly into Cushing, OK. Another 400k bbl/d of light-tight oil from the Bakken LTO fields will flow to the midcontinent refining market via the DAPL. "Increased flows into Cushing due to the addition of Keystone XL could lead to a bottleneck of inventories at the hub, which would put downward pressure on crude prices," Genscape notes. Work on the KXL could start this year, and be completed before 2020. The DAPL is ~ 95% complete, and should be done in 6 months or less. Genscape believes the DAPL could be built and line fill could be in place in less than three months. Indeed, "drilling under Lake Oahe in southern North Dakota for Energy Transfer Partner's Bakken-to-Patoka, IL, Dakota Access (DAPL) crude pipeline began immediately upon receiving an easement from the U.S. Army Corps of Engineers on February 8, according to a company spokesman. It is expected to take 83 days for construction and linefill... ." We will monitor these pipeline buildouts closely, given the profound implications they have for U.S. midcontinent and Gulf Coast refiners, who could once again find themselves benefiting from a widening of the Brent vs. WTI differential, and Canadian E&Ps, who can be expected to increase production into this KXL buildout. The key market to watch as these pipelines are under construction will be the WCS vs. WTI spreads (Chart 3). As pipeline capacity opens up, exports of heavy crude from Canada will increase and the WCS - WTI differential will narrow, which will benefit Canadian E&Ps (Chart 4). A return of contango following the opening of these pipelines would benefit U.S. refiners, who can be expected to increase exports. Chart 3Expanding the N. American Pipeline Network##br## Will Widen WTI Differentials Chart 4Crude Differentials Will##br## Adjust To Pipeline Buildouts Bottom Line: The backwardation of the WTI and Brent forwards should accelerate as the last of the surge in exports from the Persian Gulf arrives in the U.S. President Trump's decision to expedite KXL and the completion of the DAPL in 6 months or less will have a profound impact on crude movements and storage levels in the U.S. later in the decade. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 President Trump's decision to revive KXL was endorsed by House and Senate leaders in the U.S. last month, which greatly raises the odds it will go ahead. In addition, the DAPL received an easement from the U.S. Army Corps of Engineers to complete construction. 2 Please see issue of BCA Research's Commodity & Energy Strategy Weekly Report "Raising The Odds Of A KSA-Russia Oil-Production Cut," dated November 3, 2016, available at ces.bcaresearch.com. 3 Our previous modeling indicates Granger causality goes from WTI prices to rig counts - i.e., E&P companies drilling decisions are driven by price levels and curve shape. We believe this relationship arises from the hedging behavior of shale-oil producers, many of whom hedge their forward revenues in the futures markets over a two-year interval. 4 Please see "Keystone XL, Dakota Access Could Cause Bottlenecks at U.S. Mid-Continent Storage Hubs, Shift Crude Prices," published on Genscape's blog February 14, 2017. Genscape is a near-real-time pipeline, storage and shipping monitoring service. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in