Market Returns

Highlights Rate Volatility: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Treasury Yields: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. MBS: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Feature Low interest rate volatility has been a constant feature of the investing landscape during the past few years. In fact, you need to go back to the 1970s to find another period when interest rate volatility was consistently at or below its current level (Chart 1). Not surprisingly, the implied volatility priced into Treasury options is also as low as it has been during the past 30 years, with the exception of the period just prior to the financial crisis in 2007 (Chart 2). Chart 1Yield Volatility: Lowest Since The 70s Chart 2Implied And Realized Yield Volatility Move Together This begs the question of whether the current low-vol environment can be sustained, or whether overly complacent investors are in for a shock. At the very least, we believe that rate volatility has already passed its cyclical trough and will start to move up this year. Investors should prepare themselves for higher volatility. In this week's report we examine the key macro drivers of interest rate volatility and discuss the implications of rising vol for both Treasury yields, and crucially, mortgage-backed securities. Macro Uncertainty & Rate Volatility Chart 3Macro Drivers Of Rate Volatility In a Special Report published in 2014,1 we posited that the long-term trends in volatility across all asset classes are largely driven by common macroeconomic factors. Specifically, investor uncertainty regarding the outlook for economic growth and monetary policy. A 2004 paper by Alexander David and Pietro Veronesi2 provides some theoretical justification for this view, as the authors observed that investors tend to overreact to new information when macro uncertainty is high, and underreact when uncertainty is low. To test the linkage between interest rate volatility and macro uncertainty we consider three measures of uncertainty. The first two measures, shown alongside the MOVE index of implied Treasury volatility in Chart 3, are measures of GDP growth and T-bill rate forecast dispersion. We measure dispersion - the disagreement among forecasters - by looking at individual forecasts of GDP growth and T-bill rates and calculating the difference between the 75th and 25th percentiles. The series shown in Chart 3 are equal-weighted averages of the forecast dispersion calculated for five different time horizons, ranging from the current quarter to four quarters ahead. As can be seen in the top two panels of Chart 3, implied interest rate volatility is higher when the disagreement among forecasters is greater, consistent with our thesis. The third measure of uncertainty we consider is the Global Economic Policy Uncertainty Index created by Baker, Bloom and Davis.3 This index tracks uncertainty about the macro environment by counting the number of mentions of certain key words in major global newspapers. Elevated readings from this index have also coincided with high rate volatility in the past (Chart 3, bottom panel). GDP Growth Forecast Dispersion Chart 4Forecast Dispersion & Corporate Lending Disagreement among GDP growth forecasts reached an all-time low in the fourth quarter of 2016, but has since recovered to slightly more typical levels. Historically, we have found that C&I lending standards and corporate sector balance sheet health correlate most closely with GDP growth forecast dispersion (Chart 4) and both measures suggest that forecast dispersion is biased upward. T-Bill Rate Forecast Dispersion T-bill rate forecast dispersion was abnormally low between 2011 and 2014 for two reasons. The first reason is quite simply the zero-lower-bound on interest rates. A short rate bounded at zero necessarily trimmed the distribution of possible T-bill rate forecasts, since forecasters logically assumed that further interest rate cuts were not possible. This impact will gradually dissipate the further the fed funds rate moves off zero. Chart 5Fed Says March Meeting Is Live The second reason for extremely low T-bill rate forecast dispersion was the Fed's forward guidance. During this timeframe the Fed was actively trying to convince the public that interest rates would remain low. The most obvious example being the "Evans Rule", where the Fed promised not to lift interest rates at least until the unemployment rate had fallen below a specific threshold. This activist forward guidance limited the range of conceivable T-bill rate forecasts and crushed interest rate volatility. Nowadays, the Fed is engaged in a different sort of forward guidance, trying to convince markets that every FOMC meeting is live and that rate hikes could occur at any moment. Essentially, the Fed is trying to inject volatility into the rates market. Just a few weeks ago, when asked about the low probability markets are assigning to a March rate hike (Chart 5), San Francisco Fed President John Williams replied flatly: "I don't agree. All our meetings are live." Global Economic Policy Uncertainty We have written a lot about the policy uncertainty index in recent reports,4 focusing specifically on how it has diverged from its historical relationships with many asset prices. At the very least, we expect that sustained elevated policy uncertainty will place upward pressure on asset price volatility at the margin. Bottom Line: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Rate Volatility & Treasury Yields Long-dated nominal Treasury yields can be decomposed in a few different ways. In recent reports we have focused on the decomposition of the nominal 10-year Treasury yield into its real and inflation components. By identifying different macro drivers for each component we concluded that nominal Treasury yields will increase this year, driven by a rising inflation component and relatively stable real yields.5 Alternatively, we can think of the nominal 10-year Treasury yield as consisting of an expectations component equal to the market's expected path of short rates over the next ten years, and a term premium that reflects all of the other market imbalances and uncertainties associated with taking duration risk. This second approach is complicated by the fact that it requires a model of ex-ante interest rate expectations and every commonly used model is fraught with its own unique difficulties.6 Setting that aside, if we use the Kim & Wright (2005)7 estimate of the 10-year term premium we observe an expectations component that generally tracks the fed funds rate and a term premium component that is correlated with implied Treasury volatility (Chart 6), although the latter correlation is less than perfect. This decomposition also suggests that nominal Treasury yields should rise. The Fed is much more likely to hike rates than cut them and we have concluded that rate volatility is likely to trend higher from current depressed levels. However, the relationship between rate volatility and the term premium is complicated. The main reason for the complicated relationship between interest rate volatility and the term premium is the fact that elevated interest rate volatility also tends to be correlated with high equity volatility (Chart 7). So while higher rate volatility puts upward pressure on the term premium, the associated increase in equity volatility tends to raise investor risk aversion and increase the perceived value of bonds as a hedge against equity positions. This mitigates some (or often all) of the impact of rising rate volatility on the term premium. Chart 6Which Way For The ##br##Term Premium? Chart 7MOVE & VIX Have Opposing##br## Impacts On Bond Yields Bottom Line: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. Rate Volatility & MBS The relationship between rate volatility and MBS is much more straightforward than for Treasury yields. We observe a tight correlation between nominal MBS spreads and the MOVE implied volatility index (Chart 8). Chart 8 suggests that, even in the near-term, MBS spreads are too low for current levels of rate vol. The relationship between MBS spreads and rate volatility is easily explained. The defining characteristic of a negatively convex asset, such as MBS, is that its duration is positively correlated with the level of interest rates (Chart 9). This correlation leads to increased losses when yields rise and lower gains when yields fall. It's not surprising that negatively convex assets perform best in low volatility environments. Chart 8MBS Spreads Are Linked To Vol Chart 9MBS Duration Moves With Yields We maintain an underweight allocation to MBS given that spreads are already low and that the volatility environment is poised to become less favorable. Further, if the Fed continues along its planned normalization path it is likely to cease the reinvestment of its MBS portfolio at some point in 2018. There are two reasons why this poses a risk for MBS. The first reason is that the unwinding of the Fed's MBS portfolio is likely to place upward pressure on implied volatility. While private investors often hedge their MBS positions by purchasing volatility, the Fed has no incentive to do so. It follows that by removing a large stock of MBS from private hands the Fed has also removed a large source of demand for volatility. When this supply is re-introduced into the market, demand for volatility is likely to increase. The second reason relates more directly to the supply and demand balance for MBS. In years when net MBS issuance (adjusted for Fed purchases) has been negative, excess MBS returns have tended to be positive (Chart 10). Further, while negative net MBS issuance (adjusted for Fed purchases) has been the norm since Fed asset purchases began in 2009 (Chart 11), this state of affairs will change once the Fed starts to unwind its MBS portfolio. Chart 10Annual MBS Excess Returns ##br## Vs. Net Supply Since 1989 Chart 11Net Issuance Will Turn##br## Positive In 2018 During the past three years the Fed has been buying between $20bn and $40bn MBS per month, just to keep its balance sheet stable. Net new MBS issuance will not be strong enough to overcome this hurdle in 2017, but net MBS issuance (adjusted for Fed purchases) will swing quickly into positive territory in 2018 if the Fed decides to let its MBS portfolio run down. Bottom Line: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "Volatility, Uncertainty And Government Bond Yields", dated May 13, 2014, available at usbs.bcaresearch.com 2 "Inflation and earnings uncertainty and volatility forecasts", Alexander David and Pietro Veronesi, Manuscript, Graduate School of Business, University of Chicago (2004). 3 Please see www.policyuncertainty.com for further details. 4 Please see Theme # 4 in U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Bond Volatility - The Unwelcome Guest That Will Not Leave", dated June 16, 2015, available at usbs.bcaresearch.com 7 Don H. Kim and Jonathan H. Wright, "An Arbitrage-Free Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates", FEDS 2005-33. https://www.federalreserve.gov/econresdata/feds/2005/index.htm Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The USD bull case is now well known by the market, but this is not strong enough a hurdle to end the dollar's run. The behavior of positioning, the U.S. basic balance of payments, interest rate expectations, and relative central bank balance sheets suggest we are entering the overshoot phase of the rally. Volatility will increase and differentiation on the dollar's pairs is becoming more important. Reflation plays are especially in danger, and the euro could be handicapped by political risk. The yen remains the preferred mean to play the ongoing dollar correction. Feature The dollar bull market has been echoing the path traced in the 1990s (Chart I-1). The key question for investors now is whether the dollar can continue to follow this road map or is the bull market over. The dollar bullish arguments are now well known by market participants, increasing the risk that purchases of the dollar might exhaust themselves. We review the indicators that worry us most and conclude that the dollar bull market could run further. However, as the dollar is now moving into overshoot territory, we expect that the volatility of the rally will only grow. Also, divergences in the dollar on its pairs are becoming more likely. We remain short USD/JPY, and explore the risks to the euro's near-term outlook. Signs Of An Overshoot? Sentiment The first factor that worries us about the future of the USD bull market is the near universality of the positive disposition of investors toward the dollar. However, two observations are in order. First, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-2). Second, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. Either way, the dollar can continue to climb despite this handicap. Chart I-1Will History Repeat Itself? Chart I-2In The 1990s, The Consensus Was Right This reflects the fact that currency markets can often fall victim to something called the "band-wagon" effect, where a strong trend attracts more funds and perpetuates itself. Chart I-3America Is Great Again, ##br##At Least According To Investors We think this is caused by two factors. Valuation signals in the currency market have a poor track record at making money on a less than 2-year basis. This means that such signals need to be extremely strong before investors act on them. The dollar being 10% overvalued does not fit this description, instead a 20% to 25% overvaluation would hit that mark. Also, a strong upward move in a currency attracts funds to that economy. This creates liquidity in that nation's banking sector, alleviating some of the economic pain created by a rising currency or the tighter monetary policy that often caused the currency in question to rise in the first place. Today, the U.S. economy fits this bill, as private investors are rapaciously grabbing U.S. assets (Chart I-3). The Basic Balance Of Payments We have been struggling with how to interpret a strong basic balance of payment position. On the one hand, an elevated basic balance suggests that there is buying out there supporting a nation's currency. On the other hand, a strong basic balance position, especially if not caused by a current account surplus, suggests that market participants have already implemented their purchases of that nation's currency's and assets. These investors thus need further positive shocks to buy even more of that currency in order to lift its exchange rate ever higher. Today, the basic balance of payments in the U.S. is at a record high of 3.8% of GDP, begging the question of how it can climb higher from here (Chart I-4). However, as the same chart reveals, each of the previous dollar bull markets ended a few years after the U.S. basic balance of payments had peaked. Thus, we currently continue to expect the dollar to strengthen even if the U.S. basic balance position were to deteriorate. Additionally, the euro area basic balance is very depressed today at -3.4% of GDP, despite a current account surplus of 3% of GDP. However, in 1999, the region's basic balance bottomed at -5.6% of GDP, and it took until 2002 before the euro could durably rally, at which point the euro area basic balance had move back near 0% of GDP. Therefore, we would need to see a marked improvement in the euro area's basic balance in order to buy and hold the euro on a 12-to-18 months basis. Interest Rate Expectations Investors have rarely been as convinced as they are today that the Fed will increase interest rates over the coming months. This implies that the room for disappointment is large. However, as Chart I-5 illustrates, this is still not a reason to begin betting on an end to the dollar cyclical bull market. An overshoot in the dollar is marked by a fall in expectations of interest rate hikes as the strong dollar hurts the economy, preventing the Fed from hiking as much as anticipated. Moreover, except in 1994, a decreasing prevalence of rising rate expectations has lead dollar bear markets by more than a year. This suggests that there is room for the dollar to strengthen even if markets downgrade their U.S. rates expectations. Chart I-4The Basic Balance##br## Is A Small Hurdle Chart I-5In An Over Shoot, The Dollar Can Rally ##br##Even If Investors Doubt The Fed Even when looked comparatively, the broad consensus of investors regarding the continuation of monetary divergences between the Fed and the ECB is not yet a hurdle for the dollar to continue beating the euro on a 12-18 months basis. Not only is EUR/USD currently trading in line with relative expectations, previous euro rallies have been preceded by a big upgrade of the expected path of policy in Europe relative to the U.S. We currently expect the ECB to go out of its way to telegraph that even if asset purchases get curtailed in the second half of 2017, this will in no way foretell an imminent increase in European rates. Meanwhile, the Fed is in a firm position to increase rates as U.S. slack has dissipated (Chart I-6). Moreover, the proposed fiscal stimulus of the Trump administration should create inflationary pressures in this environment, solidifying the Fed's resolve to hike rates further. Chart I-6The Fed Pass Toward Higher Rates In Being Cleared Balance Sheet Positions One indicator concerns us more than the others at this point in time. As we wrote two weeks ago, one factor that has propelled the dollar higher has been its relative scarcity. The limited supply of dollar in the offshore markets - courtesy of the meltdown in the prime money-market funds industry and the heavier regulatory burden on banks - has caused cross-currency basis swap spreads to widen, pushing the greenback higher.1 Chart I-7Balance Sheet Dynamics And##br## The Scarcity Of Dollars Currently, the cross-currency basis swap spreads are hovering near record lows. However, as Chart I-7 illustrates, the surplus of euros created by the ECB's balance-sheet expansion as the Fed stopped its own purchases had a role to play in this phenomenon. While we expect the ECB to stand pat on the interest rate front for the foreseeable future, a further tapering of asset purchases in the second half of 2017 and beyond is very likely. This could limit the widening in cross-currency basis swap spreads that has been so helpful to the dollar, especially if the Fed elects not to curtail the size of its balance sheet. Net Net Many indicators suggest that the potential for dollar buying may be on the verge of exhausting itself. However, when looked closer, while these factors are a cause for concern, they still do not preclude an overshoot in the dollar. In fact, if anything, they suggest that the dollar is only now beginning its overshoot phase, a leg of the bull market that historically begins to inflict deeper pain on the U.S. economy as the dollar gets ever more dissociated from its fundamentals. So What? While the above indicators do not yet point to an end of the bull market, they in no way suggest that the dollar cannot suffer episodic corrections. We believe we are in the midst of such an event. Can the correction last further? Yes. To begin with, while the heavy net long positioning in the dollar does not represent much of a cyclical hurdle to beat, it does still constitute an important tactical risk. Our models corroborate this view. DXY is only currently fairly valued based on our intermediate-term timing model. Historically, tactical corrections fully play out once this model is in cheap territory (Chart I-8). Moreover, our capitulation index paints a similar story. This indicator has corrected some of its overbought excesses but remains above levels suggestive of an oversold environment. To the contrary, the fact that this index is still below its 13-week moving average points to additional selling pressures on the USD (Chart I-9). Chart I-8The Dollar Tactical Correction Is Not Over Chart I-9Confirming The Dollar Tactical Downside However, other factors suggest that the dollar could strengthen on certain pairs. The outlook seems especially grim for the reflation plays like the commodity currencies. Our reflation gauge, based on the prices of lumber, industrial metals, and platinum, has moved upward exactly as the U.S. dollar has rallied, a short-lived phenomenon that happened in 2001, 2002, and 2009. In all these cases, the Fed was easing policy and U.S. rates were softening relative to the rest of the world (Chart I-10). We doubt this phenomenon can continue much longer, especially as the Fed is currently tightening policy and U.S. rates are rising relative to the rest of the world. Moreover, Chinese fiscal stimulus was crucial in supporting this divergence in both 2009 and 2016. However, Chinese government spending went from growing at a 25% annual rate in November 2015, to a near 0% rate now. Moreover, the PBoC has already increased rates twice on its medium-term facilities and has also stopped injecting liquidity in the interbank market despite recent upward pressures on the SHIBOR. This tightening could prove problematic for natural resources like coking coal, iron ore, or copper, commodities highly levered to the Chinese real estate market and of which China recently accumulated large inventories (Chart I-11). Chart I-10An Unusual Move Chart I-11Elevated Chinese Metal Inventories Additionally, on the back of the longest expansion in the global credit impulse in a decade, G10 economic surprises have become very perky. However, it will be difficult to beat expectations going forward. Not only have investors ratcheted up their global growth expectations, the recent increase in global interest rates limits the capacity of the credit impulse to grow further. In fact, the recent tightening in U.S. banks credit standards for consumer loans, the fall in the quit rates in the U.S. labor market, and the underperformance of junk bonds relative to Treasurys since late January only re-inforce this message. Sagging global growth, even if temporary, is always a problem for commodities and commodity currencies. The euro faces its own risk: France. Last week, along with our colleagues from BCA's Geopolitical Strategy service, we wrote that the chance of a Le Pen electoral victory is still extremely low and we would buy the euro on any sell-off caused by a rising euro-area breakup risk premium.2 Yet, we are not oblivious to the risk that before the second round of the election is over on May 7th, investors can continue to place bets that Marine will win and that France will exit the euro area. The recent widening of the OAT/Bund spread reflects these exact dynamics as François Fillon's hardship and Macron's love life have taken center stage. So real has been the perception of this risk that spreads on Italian and Spanish bonds have followed suit (Chart I-12). While we are inclined to lean against this move, it is a risk that investors may want to bet on or hedge against. At the current juncture, the euro is fully pricing in these developments, and no mispricing is evident. However, as our model based on real rates differentials, commodity prices, and intra-European spreads shows, if France spreads were to widen further, EUR/USD could suffer (Chart I-13). In fact, if French spreads retest their 2011 levels, the euro could fall toward parity. Chart I-12Le Pen Is Causing A Repricing ##br##Of The Euro Area's Breakup Chance Chart I-13The Euro Will Suffer If French ##br##Bonds Underperform Further Investors wanting to speculate on the French election but wanting to avoid taking on some USD exposure can do so by shorting EUR/SEK, a very profitable strategy when the euro crisis was raging (Chart I-14) or could short EUR/GBP, as interest rates expectations have begun to move against the common currency and in favor of the pound (Chart I-15). While EUR/CHF tends to weaken during times of euro-duress, it is currently trading close to the unofficial SNB floor and we worry that growing intervention by the Swiss central bank will limit any downside on this pair. The currency that is likely to benefit the most against the dollar remains the yen. Not only are investors still very short the yen, but based on our intermediate-term timing model, the yen remains very attractive (Chart I-16). Moreover, the recent large improvement In the Japanese inventory-to-shipment ratio only highlights that the Japanese economy has gathered momentum, decreasing the likelihood of an enlargement of the current set of ultra-stimulative measures from the BoJ. Chart I-14Short EUR/SEK: A Hedge Against Le Pen Chart I-15Downside Risk For EUR/GBP Chart I-16Yen: Biggest Winner If USD Corrects Additionally, any risk-off event caused by a correction of the reflation trade would benefit the yen. Falling commodity prices will hurt Japanese inflation expectations and lift real rate differentials in favor of the yen. A correction in the reflation trade would also put downward pressure on global bond yields, which means that due to the low yield-beta of JGBs, Japanese nominal interest rates spread would further contribute to a narrowing of real interest rate differentials in favor of the JPY. Finally, if investors begin to bet even more aggressively on a breakup of the euro area fueled by the perceived prospects of a Le Pen electoral victory, the vicious wave of risk aversion unleashed around the globe by such an event would likely support the yen beyond our expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please refer to the Foreign Exchange Strategy Weekly Report, "Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism", dated January 27, 207, available at fes.bcaresearch.com 2 Please refer to the Foreign Exchange/ Geopolitical Strategy Special Report, "The French Revolution", dated February 3, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 As we highlighted in previous reports, DXY's losses extended no further than the 99-100 support range, and the index has rebounded since then. A key external driver of the USD is EUR, whose roll-over has coincided with the DXY's rebound. In the coming months, EUR/USD could display downside risk as markets price in election jitters. This could be bullish for the greenback. The budget plan is in discussion. Due in around a month, the tentative plan comprises tax cuts and defense spending mostly. While this is still speculative, this plan may be bullish for the dollar. Until then, it is likely that the DXY will follow in its seasonal trend and be largely unchanged with little upside this month. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Two main factors are weighing on the euro this week. Firstly, Draghi continues to retain his dovish stance. He stated that there is still "significant degree of labour market slack", which is limiting wage growth, a key contributor to underlying inflation. Secondly, and more substantial, are politically-induced anxieties in the run up to the European elections. In particular, French elections have increased risk premia, forcing the 10-year OAT-Bund spread to reach early-2014 highs. Greek 2-year yields have also spiked above 10%. Volatility is likely to be elevated in the lead up to the French election and possibly through Italian elections. The longer-term outlook will remain dictated by the development of the ECB's monetary policy stance. Report Links: The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Then yen continues to rally, with USD/JPY already down by almost 5% this year. Uncertainty surrounding the European elections should help continue this trend, given that the yen should benefit from safe haven flows. Nevertheless, the outlook for the yen remains bearish on a cyclical basis, as the measures that the BoJ has taken, such as anchoring 10-year rates near 0, and switching to de facto price level targeting will eventually lower Japanese real rates vis-à-vis the rest of the world. The BoJ has taken these measures to kick start an economy plagued by deflation. Early returns from this policy are mixed: Machinery Orders grew by 6.7% YoY, outperforming expectations. However both housing starts growth and Nikkei Manufacturing PMI fell below expectations, coming at 3.9% and 52.7 respectively. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Wednesday, the U.K. House of Commons finally gave their approval to a bill authorizing the government to start exits talks with the European Union. The House of Lords will be the next hurdle that Brexit hopefuls will have to overcome. Although cable suffered from some volatility following the decision it has remained relatively unaffected. We continue to think that the pound has further upside, particularly against the euro, as the negative consequences of Brexit on the British economy are already well priced into cable. Furthermore, increasing uncertainty regarding the French elections should also be bearish for EUR/GBP. If the fear of a Le Pen presidency starts to increase, Brexit will become an afterthought as exiting the European Union takes on a completely different meaning if the integrity of the EU starts being put into question. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA held rates at 1.5% this week on the basis of upbeat business and consumer confidence, and above-trend growth in advanced economies. This decision helped the AUD, as investors repriced dovish bets and interpreted a change in stance. While above-trend growth is possible, Chinese demand is particularly important for Australia. Last week, the PBoC silently tightened their 7-, 14-, and 28-day reverse repo rates by 10 bps each to help alleviate looming risks in the real estate market and general financial stability. This may signal an end to an easing cycle, which may limit demand growth going forward. Australia has its own financial worries. Household debt is at its highest ever, at 186% of disposable income, which would be catastrophic if rates are raised. Lowe also highlighted concerns about a strong AUD and its impact on Australia's economic transition. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The RBNZ decided to keep interest rates unchanged at 1.75% in their monetary policy meeting this Wednesday. Additionally, as expected, Governor Graeme Wheeler stated that the RBNZ had shifted from having a dovish bias to a having neutral one. Nevertheless, the kiwi has depreciated sharply since the announcement, not only because Governor Wheeler highlighted that the currency "remains higher than is sustainable for balanced growth" but also because the RBNZ showed a cautious approach by stating that "premature tightening of policy could undermine growth and forestall the anticipated gradual increase in inflation". However, we believe that the RBNZ will turn more hawkish, as inflationary forces in the economy will eventually put upward pressure on rates. This will lift the NZD, particularly against the AUD. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Uncertainty has come up as a key issue in the Bank of Canada's headlights, as Poloz remains nervous about the future of U.S.-Canada relations. CAD has recently displayed some strength despite this uncertainty. It has appreciated against USD, AUD and NZD. This is likely due to a brightening perception of the Canadian economy with the Ivey PMI recording a reading above 50 for January, at 52.3, above the previous 49.3. Additionally, housing starts beat expectations, dampening housing market concerns. Exports have been strong, which has also fed into this appreciation. A rapidly appreciating currency would exacerbate trade concerns further and adversely affect the Canadian economy. Therefore, it is likely that the BoC remains tilted to the dovish side, which will generate downside for the CAD through rate differentials. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has reached its lowest level since August 2015. At around 1.065, this cross is hovering in the lower range of the implied floor set by the SNB. Increased uncertainty caused by the upcoming European elections cycle will continue to test this floor, as the increased odds of an Eurosceptic government in France will not only decrease the value of the euro but will also put upward pressure on the franc, given its safe haven status. Nevertheless, the SNB will do everything in its power to weaken its currency as the Swiss economy continues to be plagued by deflationary forces: After showing glimpses of a recovery last month Real retail sales contracted by 3.5% YoY, falling well short of expectations. The SVMI Purchasing Manager's Index also came below expectations coming in at 54.6. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has rebounded after reaching 8.20, its lowest level since Trump got elected. Interestingly, the NOK has not been as correlated with oil prices since the start of 2017 as it has been in the past. This is a trend worth monitoring. The inflation picture remains complex, although core and headline inflation have deaccelerated slightly as of late, inflation expectations are at their highest level of the last 9 years. Additionally house prices are growing at nearly 20%, a pace not seen since before the 2008 crisis. The Norges Bank is now facing a tough dilemma between risking an inflation overshoot if they keep their dovish bias or raising rates in an economy where growth for employment, real retail sales and nominal GDP is still in negative territory. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK continues to duplicate the dollar's movements, rolling over slightly from the 7% appreciation it saw over a month and a half. A more accurate measure of the SEK's value, EUR/SEK, paints a similar picture. These movements have been more or less in line with the Riksbank's desired developments, as it indicates a deceleration in the pace of recent appreciation. However, we believe that the rebound in EUR/SEK is not likely to run further. Political turbulence is being priced into the euro. After sustaining near oversold levels, the rebound could be nothing more than momentum exiting from oversold territories. Nevertheless, it is likely that EUR/SEK will correct in the coming months due to European elections. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Weekly swings in U.S. inventories notwithstanding, we believe global storage is on track to draw ~ 10% by early- to mid-3Q17, which will have achieved the goal of the OPEC - Russia production Agreement negotiated late last year. This will not require an extension of the pact beyond June, based on our modeling. Unexpectedly high compliance by OPEC producers to agreed cuts is being offset somewhat by increased production in those states exempted from the deal. Strong oil consumption on the back of a synchronized global uptick in GDP growth, which started to emerge late last year, provides the impetus for sustained storage draws. Markets are overestimating offshore production's resilience, particularly in the U.S. Gulf, where we see material declines beginning to set in next year. Backwardation likely persists in 2018, absent a U.S. policy-induced USD rally that crimps EM demand and spurs production ex U.S. Energy: Overweight. The return of contango in the WTI forward curve gives us the opportunity to reset our strategic front-to-back position (long Dec/17 vs. short Dec/18) at tonight's close. Our balances assessment supports our view backwardation will return in the deferred part of the curve. Our Dec/19 short WTI vs. long Brent spread buy stop was elected at $0.07/bbl. Base Metals: Neutral. We remain neutral base metals, but are keeping a close watch on copper. Unions working at BHP's Escondida mine, the world's largest, are set to strike today. Negotiations resumed this week, following BHP's request for government mediation. Precious Metals: Neutral. We continue to look to get long gold at $1,180/oz. Ags/Softs: Underweight. Grain fundamentals remain unsupportive for a rally. We remain underweight. Feature Chart of the WeekGlobal Oil Storage On Track For 10% Drop Global oil storage levels remain on track to hit the ~ 10% draw targeted in last year's OPEC - Russia production Agreement by early- to mid-3Q17, weekly gyrations in U.S. inventories notwithstanding. This means an extension of the agreement beyond its June expiry will not be required. Early reports suggest compliance with the deal is unexpectedly high by OPEC states that agreed to cut production by up to 1.2mm b/d - exceeding 80% by various accounts. However, OPEC states not required to cut - Libya, Nigeria, and Iran - have increased production and partially offset those declines, which took total reductions in OPEC output to ~ 840k b/d, based on a Bloomberg tally last week.1 This brought total Cartel compliance to ~ 60% of the agreed cuts, which, as we noted in our 2017 Commodity Outlook in December, would be sufficient to achieve the Agreement's goal of pulling inventories in the OECD down by ~ 10% by 3Q17.2 Non-OPEC producers also appear to be complying with the Agreement. Notable among them is Russia, which is ahead of its commitment with cuts of close to 120k b/d in January, due partly to extreme cold in Siberian fields. We expect cuts in Russia to average 200k b/d in 1Q17, going to 300k b/d in 2Q17. These cuts will allow demand to outstrip supply in 1H17 and into year-end. By early- to mid-3Q17, draws to OECD storage of 300mm bbl can be expected, without extending the OPEC - Russia production agreement (Chart of the Week). We expect to see these cuts show up in OECD inventory data this month and next and continue into the end of 2017. For non-OECD states, the draws will show up in JODI data beginning in March.3 The physical deficits - i.e., supply less than demand - will force storage to draw, backwardating the WTI forward curve later this year (Chart 2).4 If markets are not surprised by a policy-induced rally in the USD on the back of a U.S. border-adjustment tax (BAT), or a too-aggressive tightening by the Fed as it seeks to normalize monetary policy, we expect the drawdown in inventories to continue keeping markets backwardated. Even with production returning to pre-Agreement levels in 2H17 in states with the capacity to expand and reliably sustain production - Gulf Arab producers, Russia and U.S. shales - we expect storage to continue to draw through the year and into 2018 (Chart 3). Chart 2We Continue To Expect Backwardation Chart 3Storage Drawdown On Track In 4Q16 the impact of the higher Kuwaiti and UAE output is apparent, along with higher Russian production. This put more crude on the market, which found its way into storage late in 4Q16 and early 1Q17, reversing the trend in draws seen earlier in 2H16. This put the market back in a temporary surplus condition, with the result being more storage will have to be worked off in 1H17 than our earlier estimates indicated. But these draws will occur, following the implementation of the production accord. Extending The KSA - Russia Deal Beyond June Is Unnecessary In our estimates, OPEC crude production increases by ~ 850k b/d in 2H17 versus 1H17 levels. Despite this recovery, the storage drawdown continues. Our modeling assumes Gulf OPEC will account for slightly more than +1mm b/d growth, and non-Gulf OPEC will see production continue to fall by 170k b/d. Russia's total liquids production goes from 10.95mm b/d in 1H17 to 11.34mm b/d in 2H17. We estimate U.S. shale production grows at an average rate of ~ 300k b/d in 2H17, while total U.S. liquids production increases 720k b/d over the same interval. Setting aside the possibility of a policy-induced rally in the USD on the back of too-aggressive Fed tightening or a border-adjusted tax becoming the law of the land, both of which would depress demand and raise production ex U.S., we expect the crude-oil market to remain backwardated next year. The globally synchronized upturn in GDP will keep demand robust, with growth coming in close to even with this year's rate of ~ 1.50mm b/d. We have global liquids production and OPEC crude output growing less than 1.0% next year. We believe the market is overestimating the resilience of offshore production next year, particularly in the U.S. Gulf, based on the stout performance put in last year and expected for this year. Our colleague Matt Conlan notes in BCA's Energy Sector Strategy, U.S. production growth since October has almost exclusively been from the Gulf of Mexico's new projects. Output in the Gulf continues to increase due to the lagged effect of final investment decisions made during 2012 - 2014, when WTI prices were consistently trading above $100/bbl. GOM production will peak in 2017 then decline in 2018 due to lack of new investments made since 2014. Indeed, as "increasing decline rates overwhelm a shrinking inventory of new projects, GOM production should peak sometime in 2017 and then start decreasing. The EIA's estimate for another 200,000 b/d increase in GOM production in 2017 seems overly-optimistic."5 Once this becomes apparent to the market, we believe backwardation will reassert itself and persist into 2018. The backwardation of the forward curve structure will affect U.S. shale production economics in 2018. However, our base case is for U.S. shale-oil production in the "Big Four" basins - Permian, Eagle Ford, Bakken and Niobrara - to grow 700k b/d next year, given the current structure of the WTI forwards, which were taken higher along with the WTI price rally at the front of the curve. This triggered the revival of rig counts; however, we want to point out that different curve shapes at different price levels produce different expected rig-count responses.6 Chart 4Barring a Policy Shock Demand Will Remain Robust Global Demand Firing On All Cylinders Robust demand growth - ~ +1.50mm b/d in 2017 and 2018 in our modeling - provides the impetus for the continued draws in storage this year and next (Chart 4). We revised our demand estimates for 2015 - 16 in line with the IEA's just-revised assessment of global consumption published in its January 2017 Oil Market Report.7 The IEA brought 2016 oil demand growth up to 1.50mm b/d, in line with our earlier estimates, but significantly revised 2015 demand growth upward to 2.0mm b/d. The Agency expects higher prices to crimp demand this year, taking it to 1.30mm b/d; our estimate, however, is higher, largely on the back of the first global synchronized growth we've seen since the Global Financial Crisis, which will be supported by accommodative monetary conditions worldwide, all else equal.8 Investment Implications Our analysis suggests there will be no need to extend the OPEC - Russia production accord into 2H17. In addition, it reinforces our view markets will backwardate later this year and stay backwardated in 2018, provided we do not see a BAT-induced rally in the USD, or an overly aggressive Fed normalization trajectory. As we noted in previous research, a BAT would lift the value of the USD, which would lower demand ex U.S. and raise supply at the margin.9 We make the odds of a BAT becoming the law of the land in the U.S. this year 50:50, so this is a non-trivial risk. This would be unambiguously bearish for oil prices. While we do not expect oil to be included among the imported commodities subject to a BAT, we do, nonetheless, expect the imposition of a BAT to lift the USD by 10%. This, coupled with the 5% increase in the greenback we'd already penciled in due to the Fed's monetary-policy normalization, will lift the USD 15% if it goes through. Should this occur, we would be preparing for prices to again fall below $50/bbl and push back to the $40/bbl area, which would cause supply and capex to once again contract significantly. That said, we are reinstating our long front-to-back WTI recommendation (long Dec/17 WTI vs. short Dec/18 WTI), given our updated balances assessment. Our expectation for inventories to continue to draw after the OPEC - Russia production-cutting agreement expires in June supports this recommendation. In addition, if we do see a BAT in the U.S., we believe markets will take the deferred WTI curve significantly lower in expectation of reduced demand and higher marginal supplies that almost surely will ensue in 2018. While the Dec/17 contract also will trade lower, more damage to prices will occur in 2018 contracts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "OPEC Cuts Oil Output, But More Work Needed to Fulfill Deal," published by Bloomberg February 2, 2017. Iraq stands out among OPEC producers agreeing to cut, but apparently not following through as diligently as the rest of the Gulf Arab states; we are assuming production of 4.5mm b/d for 1H17, going to 4.6mm b/d in 2H17 for Iraq. 2 Please see BCA Research's Commodity & Energy Strategy "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 3 JODI refers to the Joint Organisations Data Initiative, a supranational producer-consumer oil-market data provider headquartered in Riyadh, Saudi Arabia. 4 "Backwardation" describes a forward price curve in which the price for a commodity for prompt delivery (e.g., tomorrow) exceeds the price of a commodity delivered in the future (e.g., next year). It is the opposite of a contango curve structure. 5 Please see issue of BCA Research's Energy Sector Strategy "Gulf Of Mexico Oil Production Likely To Peak In 2017," dated January 11, 2017, available nrg.bcaresearch.com. 6 In next week's report, we will present scenario analysis of shale-oil production as a function of WTI forward curve shape - i.e., the implications of backwardation for shale rig counts. This will update our assessments of price sensitivities to interest rates and USD movements. 7 Please see the IEA's Oil Market Report of 19 January 2017. 8 We discuss this in last week's Commodity & Energy Strategy feature article entitled "Gold Will Perform...," dated February 2, 2017, available at ces.bcaresearch.com. 9 Please see BCA Research's Commodity & Energy Strategy "Taking A BAT To Commodities," dated January 26, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Highlights Chart 1Strong Growth & An Easy Fed More than a month has passed since the Fed's latest rate hike and, at least so far, the economy is displaying no ill effects. While the economic data continue to surprise to the upside, Fed rate hike expectations have moderated since mid-December (Chart 1). The combination of accelerating growth and accommodative monetary policy sets the stage for further outperformance in spread product. This message was underscored by last Friday's employment report which showed robust payroll gains of +227k alongside a slight deceleration in wage growth. This is consistent with an environment where growth remains above trend but the recovery in inflation proceeds more gradually. Against this back-drop we favor overweight positions in spread product and TIPS relative to nominal Treasuries, while also positioning for a bear-steepening of the Treasury curve. While we would not rule out a near-term correction in risk assets, due to extended positioning and elevated policy uncertainty, we would view any correction as a buying opportunity given the supportive growth and monetary policy back-drop. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 5 basis points in January (Chart 2). The index option-adjusted spread tightened 2 bps on the month and, at 121 bps, it remains well below its historical average (134 bps). In a recent report1 we examined historical excess returns to corporate bonds given different levels of core PCE inflation. We found that excess returns are best when year-over-year core PCE is below 1.5%. This should not be surprising since an environment of low inflation is most likely to coincide with extremely accommodative monetary policy. When inflation is between 1.5% and 2% (year-over-year core PCE is currently 1.7%), average monthly excess returns are close to zero and a 90% confidence interval places them between -19 bps and +17 bps. Excess returns do not turn decisively negative until core PCE is above 2%. Given the Fed's desire to nurture a continued recovery in inflation, we expect corporate bond excess returns to be low, but positive. The Technology sector is relatively defensive and is close to neutrally valued according to our model (Table 3). In addition, our Geopolitical Strategy service has observed that many of the firms in this sector carry significant exposure to China, a risk as U.S. protectionism ramps up.2 We therefore downgrade our position in Technology from overweight to neutral, and upgrade our positions in Wirelines, Media & Entertainment and Other Utilities from underweight to neutral. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 124 basis points in January. The index option-adjusted spread tightened 21 bps on the month and, at 376 bps, it is currently 144 bps below its historical average. As we highlighted in our year-end Special Report,3 the uptrend in defaults is likely to reverse this year, mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Given the improving default outlook, last week we upgraded high-yield from underweight to neutral. Still-tight valuation is the reason we maintain a neutral allocation as opposed to overweight. Our estimate of the default-adjusted high-yield spread - the average spread of the junk index less our forecast of 12-month default losses - is currently 152 bps (Chart 3). This is close to one standard deviation below its long-run average. Historically, we have found that a default-adjusted spread between 150 bps and 200 bps is consistent with positive 12-month excess returns 65% of the time, but with an average 12-month excess return of -164 bps. With the spread in this range a 90% confidence interval places 12-month excess returns between -500 bps and +171 bps. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 24 basis points in January. The conventional 30-year MBS yield rose 5 bps in January, driven by a 7 bps widening of the option-adjusted spread. The rate component of the yield held flat, while the compensation for prepayment risk (option cost) declined by 2 bps. MBS spreads remain extremely tight, relative both to history and Aaa-rated credit. Historically, the option-adjusted spread is correlated with net MBS issuance and robust issuance will eventually lead this spread wider. At least so far, net MBS issuance shows no sign of slowing down. While refinancing applications declined alongside the recent spike in Treasury yields, purchase applications have remained resilient (Chart 4). The Fed ceasing the reinvestment of its MBS portfolio would also significantly add to MBS supply. As we explained in a recent report,4 we expect the Fed will not start to wind down its balance sheet until 2018. However, if growth is stronger than we expect there is a chance the process could begin near the end of this year. In that same report we also observed that nominal MBS spreads are very low relative to both the slope of the yield curve and implied rate volatility. This poses a risk to MBS in the near-term. Government-Related: Cut To Underweight Chart 5Government-Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 21 basis points in January. Sovereign bonds outperformed by 75 bps, while Foreign and Domestic Agency bonds outperformed by 6 bps and 14 bps, respectively. Local Authorities outperformed by 34 bps and Supranationals outperformed by 2 bps. This week we downgrade the government-related sector from overweight to underweight, although we recommend maintaining an overweight allocation to both the Foreign Agency and Local Authority sectors. Sovereigns are not attractive compared to corporate credit, according to our model, and will struggle to outperform if the dollar remains in a bull market, as we expect it will. A stronger dollar increases the cost of debt servicing from the perspective on non-U.S. issuers. Foreign Agencies and Local Authorities both appear attractive relative to corporate credit, after adjusting for differences in credit rating and duration. Foreign Agencies in particular will perform well if oil prices continue to trend higher. Supranationals offer very little spread, and are best thought of as a hedge in spread widening environments. Domestic Agency debt can also be thought of in this vein, but with the added risk that spreads start to widen if any progress is made toward GSE reform. While any concrete movement on GSE reform is still a long way off, the new administration has brought the topic back into the headlines and this has led to some increased volatility in Domestic Agency spreads in recent weeks (Chart 5). Municipal Bonds: Upgrade To Neutral Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 40 basis points in January (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio fell 2% in January and currently sits just below its post-crisis average. Even though net state & local government borrowing edged higher in Q4, issuance has rolled over in recent weeks and fund flows have sharply reversed course (Chart 6). As a result, our tactical yield ratio model - based on issuance, fund flows and ratings migration - shows that yield ratios are very close to fair value. Although the average M/T ratio still appears expensive if we include the global economic policy uncertainty index as an additional explanatory variable.5 While we remain cautious on the long-term prospects for state & local government health, we expect that improving trends in fund flows and issuance will support yield ratios for the next several months. Eventually we expect that increased state & local government investment will lead to higher issuance, but this will take some time to play out. In the meantime it will be crucial to monitor the federal government's progress on tax reform, particularly if there appears to be any appetite for removing municipal bonds' tax exempt status. Our sense is that the tax exemption will remain in place due to the administration's stated preference for increased infrastructure spending. But that outcome is highly uncertain. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview After a volatile end to last year, the Treasury curve was relatively unchanged in January. The 2/10 slope steepened by 1 basis point on the month and the 5/30 slope steepened by 2 bps. In previous reports we detailed how the combination of accelerating economic growth and still-accommodative Fed policy will cause the Treasury curve to bear-steepen this year. This steepening will be driven by a continued, but gradual, recovery in long-dated TIPS breakeven inflation back to pre-crisis levels (2.4% to 2.5%). Once inflation expectations return to pre-crisis levels, it is possible that the Fed will shift to a monetary policy that is focused more on tamping out inflation than supporting growth. At that point the curve will shift from a bear-steepening to a bear-flattening regime. However, as we posited in a recent report,6 it could take until the end of this year before TIPS breakevens return to pre-crisis levels and core inflation returns to the Fed's target. To position for a steeper Treasury curve, we recommend that investors favor the 5-year bullet versus a duration-equivalent 2/10 barbell. Not only will the bullet outperform the barbell as the curve steepens, but the 5-year bullet is currently very cheap relative to the 2/10 slope (Chart 7). This trade has so far returned +29 bps since initiation on December 20. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 58 basis points in January. The 10-year TIPS breakeven inflation rate increased 10 bps on the month and, at 2.05%, it remains well below its pre-crisis range of 2.4% to 2.5%. The Fed will be keen to allow TIPS breakevens to rise toward levels more consistent with its inflation target, and will quickly adopt a more dovish policy stance if breakevens fall. This "Fed put" is a key reason why we remain overweight TIPS relative to nominal Treasuries, although we expect the uptrend in breakevens will moderate during the next few months. As we detailed in a recent report,7 while accelerating wage growth will ensure that inflation remains in an uptrend, the impact from wages will be mitigated by deflating import prices. Diffusion indexes for both PCE and CPI have also rolled over recently, suggesting that inflation readings will soften during the next couple of months. The anchor from slowly rising inflation will prevent TIPS breakevens from increasing too quickly, and breakevens are also too high compared to the reading from our TIPS Financial model - based on the dollar, oil prices and the stock-to-bond total return ratio (Chart 8). At the moment, only pipeline measures of inflationary pressure such as the ISM prices paid index (panel 4) suggest that breakevens will move rapidly higher in the near term. Remain overweight TIPS but expect the uptrend in breakevens to moderate in the months ahead. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in January. Aaa-rated issues outperformed by 5 bps while non-Aaa issues outperformed by 17 bps. Credit card issues outperformed by 8 bps and auto loans outperformed by 5 bps. The index option-adjusted spread for Aaa-rated ABS tightened 3 bps on the month. At 51 bps, the spread remains well below its average pre-crisis level. As was noted in the Appendix to our year-end Special Report,8 consumer ABS provided better volatility-adjusted excess returns than all fixed income sectors except Baa-rated corporates and Caa-rated high-yield in 2016. With ABS spreads still elevated relative to other similarly risky fixed income sectors, we expect this risk-adjusted performance to continue. The spread on Aaa-rated credit card ABS tightened 4 bps in January, and now sits at 49 bps. Meanwhile, the spread on Aaa-rated auto loan ABS tightened 1 bp on the month, and now sits at 54 bps. In early November we recommended favoring Aaa-rated credit cards relative to Aaa-rated auto loans. Collateral credit quality between credit cards and auto loans is clearly diverging in favor of credit cards (Chart 9, bottom panel), and in early November, our measure of the volatility adjusted breakeven spread (days-to-breakeven) was displaying no discernible valuation advantage in autos. Since November, however, autos have started to look more attractive (Chart 9, panel 3). If auto loan spreads continue to widen relative to credit cards we may soon shift back into autos. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month, and is now close to one standard deviation below its pre-crisis mean (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 22 basis points in January. The index option-adjusted spread for Agency CMBS tightened 4 bps on the month, and currently sits at 51 bps. The spread offered from Agency CMBS is similar to what is offered by Aaa-rated consumer ABS (52 bps) and greater than what is offered by conventional 30-year MBS (30 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Global PMI Model The current reading from our 2-factor Global PMI model (which includes the global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.44% (Chart 11). Our 3-factor version of the model, which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.08%. The lower fair value is the result of a large spike in the uncertainty index in November that has yet to unwind (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. It is for this reason that we recently moved back to a below-benchmark duration stance.9 For further details on our Global PMI models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.44%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2016, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin", dated January 18, 2016, available at gps.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 5 For further details on the model please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes for 2017", dated December 20, 2016, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Another Update", dated January 31, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Portfolio Strategy Food price deflation bodes well for increased volumes, and by extension, packaging stocks. Upgrade to overweight. Prospects for intensifying market and economic volatility argue for reestablishing a portfolio hedge in gold shares. The tech sector underperforms when there is upward pressure on inflation, and the next twelve months is unlikely to prove an exception. Stay clear. Recent Changes S&P Containers & Packaging - Upgrade to overweight from neutral. Gold Mining Shares - Upgrade to overweight from neutral. Table 1 Feature Equity markets finally took a breather last week, as investors digested spotty earnings and began to discount the possible economic downside of U.S. isolationism. While profits should dictate the trend in stocks over the long haul, equity valuations have soared since the election, it is critical to consider the durability of this trend and other influences at this juncture. The recent string of positive economic surprises raises the risk that monetary conditions will tighten further, especially amidst rising inflation pressures and a tight labor market. As such, the broad market remains in a dangerous overshoot phase, predicated on hopes for a sustained non-inflationary global economic mini-boom. The risk is that these hopes are dashed by nationalistic policy blunders (i.e. protectionism and trade barriers) or a more muted and drawn out improvement in global economic growth than double-digit earnings growth forecasts would imply. There appears to be full buy-in to a durable bullish economic/profit outcome. We have constructed a 'Complacency-Anxiety' Indicator (CAI), using a number of variables that gauge investor positioning, sentiment and risk on/off biases (Chart 1). The CAI is at its highest level ever, signaling extreme confidence/conviction in the outlook for equities. While timing market peaks is difficult, because momentum can persist for longer than seems rational, the level of investor complacency is disturbingly high given that policy uncertainty is such a large economic threat. Global economic growth has never accelerated when global economic policy uncertainty has been this high (Chart 2, shown inverted). Chart 1Complacency Reigns Chart 2Uncertainty Is A Growth Impediment If rhetoric about anti-globalization measures turns into reality, that will deal a serious blow to burgeoning economic confidence before it translates into actual economic growth. Thus, the risk of sudden market downdrafts has risen to its highest level of this bull market. Chart 3 shows that positive economic surprises remain primarily sentiment/confidence driven, rather than from upside in hard economic data. To be sure, the stock market trades off of 'soft data' given its leading properties, but the size of the current gap is unusually large and reinforces that a big jump in 'hard data' surprises is already discounted. This gap represents a latent risk, as it did in the spring of 2011 just before the summertime equity market swoon. Chart 3A Big Gap Means Big Shoes To Fill Worryingly, the behavior of corporate insiders suggests that their confidence does not match their share price valuations. According to Barron's1, the insider sell/buy ratio has soared to an extremely bearish level for markets. For context, their gauge is close to 60; anything over 20 is deemed bearish while less than 12 falls into the bullish zone. Chart 4An Increasing Supply Of Stock The spike in secondary issuance corroborates insider selling (Chart 4). Insiders would not be unloading their shares if they felt earnings prospects would outperform what is discounted in current valuations. Even the pace of share buybacks has slowed considerably, to the point where the number of shares outstanding (excluding financials) has moved higher for the first time in 6 years (Chart 4). An increase in the supply of shares, from sources that have incentive to sell when the reward/risk tradeoff is unattractive, is a yellow flag. All of this argues for maintaining a capital preservation mindset rather than chasing market euphoria in the near run. Elevated complacency suggests that the consensus is focused solely on return rather than risk. It will be more constructive to put money to work when anxiety levels are higher than at present. This week we recommend adding a defensive materials sector gem, buying some portfolio insurance and we update our tech sector views. Packaging Stocks Are Gift Wrapped While our materials sector Cyclical Macro Indicator is hitting new lows, this is often a sign that the countercyclical S&P containers & packaging index deserves a second look. We have shown in past research that its strongest relative performance phases often occur when the overall materials sector is struggling. This group offers a more attractively valued alternative to play a transportation recovery than either rails or air freight, as discussed in last week's Report. From a macro perspective, deflation in global export prices should provide a strong tailwind. Why? Low prices spur volume growth. Global export volumes have begun to rebound, consistent with the increase in U.S. port traffic and intermodal (consumer) goods shipments (Chart 5). Any increase in global trade would bolster sentiment toward this high volume industry. Companies in this index are also highly exposed to the food and beverage business since the bulk of consumable non-durable goods products require packaging materials. As such, its fortunes rise and fall with swings in food prices. When food inflation is rising, consumers spend less in real terms, undermining the volume of food packaging demand. The opposite is also true. The current contraction in the food CPI has spawned a boom in food consumption, as measured by the surge in real (volumes) personal outlays on food & beverage products (Chart 6). This phenomenon is also true on a global basis, as food exports are booming (Chart 6, bottom panel), a remarkable development given U.S. dollar appreciation. Chart 5Stealth Play On Volume Growth Chart 6Booming Food Demand... Chart 7... Should Drive Up Multiples If food and beverage consumption stays robust, then the relative valuation expansion in packaging stocks will persist (food demand shown advanced, Chart 7). Increased demand for packaging products has become evident in the budding rebound in pricing power (Chart 8). The producer price index for containers has picked up nicely on a 6-month rate of change basis, albeit it is still low in annual growth terms. Nevertheless, any increase in pricing power would support profit margins if volume expansion persists, given the industry's disciplined productivity focus. Headcount remains in check, likely reflecting automation and investment, and is falling decisively relative to overall employment (Chart 8). The implication is that profit margins have a chance to outperform, particularly if energy prices stay range-bound (Chart 8). U.S. protectionism, and/or a continued rise in bond yields on the back of improving global economic momentum constitute relative performance risks to this position. Chart 9 shows that relative performance is mostly inversely correlated with global bond yields, given that it is a disinflationary winner. Chart 8Productivity Gains Chart 9A Risk Factor However, the global economy has already been through a phase of upside surprises. Moreover, now that China has moved to cool housing, investors should temper expectations for more stimulus to cause Chinese growth to accelerate. Conversely, economic disappointment could materialize before midyear if financial conditions tighten further. In sum, packaging stocks offer attractive exposure within an otherwise unattractive S&P materials sector. Bottom Line: Raise the S&P containers & packaging index to overweight. Gold: Back To Overweight As A Portfolio Hedge Gold mining shares look increasingly attractive, at least as a portfolio hedge. We took profits on our overweight position in the middle of last summer, just prior to the share price crunch, because tactical sentiment and positioning had gotten too stretched. Thereafter, the equity risk premium melted, dimming appetite for portfolio insurance (Chart 10). Moreover, bond yields rose in response to firming economic expectations, increasing the opportunity cost of holding an income-free asset like gold. However, in the absence of a global economic boom, which seems unlikely, and if trade barriers are erected and policy uncertainty continues to escalate, there is a limit to how high real rates can rise. Potential GDP growth remains low throughout the world, weighed down by excessive debt, weak productivity and deflationary demographics (Chart 11, second panel). Chart 10End Of Correction? Chart 11Structurally Bullish A revival in market volatility and an unwinding of previously frothy technical conditions have created an attractive re-entry point in gold shares. The yield curve stopped steepening when the Fed raised interest rates last month (Chart 12). The last playable rally began when the yield curve started to flatten, signaling doubts about the longevity of the business cycle. If the yield curve does not steepen anew, and interest rate expectations move laterally, then the U.S. dollar is less likely to be a barrier to gold price gains. Sentiment toward the yellow metal is no longer overheated, as evidenced by both surveys and investor behavior. Flows into gold ETFs have been trending lower in recent months, reversing last summer's buying frenzy (Chart 12). Speculative positions have also been unwound (Chart 12). Netting it out, the surge in U.S. policy uncertainty, prospects for economic disappointment relative to increasingly elevated expectations and any pause in the U.S. dollar rally support reestablishing overweight positions in gold mining stocks as a portfolio hedge, especially now that overbought conditions have been unwound (Chart 13). Chart 12No Longer Frothy Chart 13Time To Buy Hedges Bottom Line: Return to an overweight position in gold mining shares, using the GDX as a proxy. A Tec(h)tonic Shift Our Special Report published in early-December showed that the tech sector underperforms when inflation pressures accelerate. Companies in the S&P technology sector are typically mature and have shifted from reinvesting for growth to paying dividends and buying back stock. Thus, the rise in bond yields and headline inflation imply higher discount rates and by extension, lower valuations, all other things equal, for the long duration tech sector (Chart 14). Tech companies exist in a deflationary business model mindset. While relative pricing power had been in an uptrend since 2011, it has recently relapsed into the deflationary zone (Chart 15, middle panel). As shown in last Monday's Weekly Report, the tech sector is one of the few suffering from deteriorating pricing power. Chart 14Stiff Headwinds Chart 15Pricing Power Disadvantage Among the broad eleven sectors, tech stocks have the highest international sales exposure, so a higher dollar is also a net negative for exports, revenues and by extension profit growth, relative to the broad market. Industry sales growth is nil, significantly trailing the S&P 500's recent pick up in top line growth rate. History shows that tech relative performance is negatively correlated with the U.S. dollar in the latter stages of a currency bull market. While the temptation to position for an increase in capital spending via the tech sector is high, data do not show any demand improvement. Tech new order growth is decelerating. The tech new orders-to-inventories ratio is on the verge of contracting, and further weakness would herald downward pressure on forward earnings estimates (Chart 16). Net earnings revisions have swung violently downward recently. Any prolonged de-rating would warn of negative share price momentum given the tight correlation between the two (Chart 16). Meanwhile, the loss of tech sector competitiveness and a retreat from globalization via protectionism de-globalization pose serious headwinds to the industry's longer-term prospects. Return on equity is already ebbing, reflecting more intense profit margin pressure from the surge in wage growth and a lack of revenue gains. As a result, EBITDA growth has been non-existent (Chart 17). Chart 16Momentum Is Fading Chart 17Growth Remains Elusive Chart 18Profits Set To Underperform All of these factors are encapsulated in our S&P technology operating profit model, which has an excellent record in forecasting tech earnings. Chart 18 shows that tech profits are likely to contract as the year progresses, a far cry from what is expected for the broad market and the 450bps of profit outperformance embedded in analyst forecasts in the coming 12 months. Bottom Line: Reducing tech exposure on price strength is a prudent strategy. Stay underweight. 1 http://www.barrons.com/public/page/9_0210-instrans.html Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

The GAA DM Equity Country Allocation model is updated as of January 31, 2017. The model has shifted to an overweight position on Switzerland at the expense of a larger reduction in Sweden. Additionally, the model reduced its underweight position in Japan and France (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the non-U.S. model (Level 2) underperformed its benchmark by 90 bps in January, due to the underweight in Japan. The large overweight in the U.S. caused the Level 1 model to underperform by 14 bps. Overall, the GAA model underperformed its MSCI World benchmark by 36 bps in January. Since Inception, the GAA model underperformed its benchmark by 16 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) Chart 4Overall Model Performance GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of January 31, 2017. The momentum component has shifted Energy from overweight to underweight. It has also shifted Info Tech and Consumer Discretionary from underweight to overweight. 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. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights Duration: Rising political tensions in the U.S. will not offset the cyclical upward momentum in global growth, which is supported by accelerating corporate profits. Bond yields are unlikely to fall much in the near term, despite significant bearish investor duration positioning. Shift back to a below-benchmark overall portfolio duration stance and position for bear-steepening of yield curves. Country Allocation: Downgrade U.S. Treasuries to underweight (2 of 5) in global hedged bond portfolios. Corporates: A better global growth outlook should continue to support U.S. corporate debt markets, despite tight valuations and a strong U.S. dollar. Upgrade allocations to U.S. Investment Grade to above-benchmark (4 of 5) and U.S. High-Yield to neutral (3 of 5), at the expense of U.S. Treasuries. Favor the higher quality tiers (i.e. above Caa) in U.S. junk. Feature Optimism reigns supreme in the markets at the moment, particularly in the U.S. where bullish investors traded in their "Make America Great Again" hats for "Dow 20,000" ballcaps last week. The string of better-than-expected economic data across the world is continuing - a fact confirmed by the latest corporate profit releases showing that an earnings recovery was already underway before Donald Trump's election victory. We have been looking for a meaningful pullback in government bond yields, and a widening of credit spreads, before returning to a below-benchmark portfolio duration stance and raising corporate allocations. That opportunity may not come to pass as economic data remains solid and leading indicators are accelerating. With no major inflation hiccups likely in the near-term to force the major central banks to rapidly shift to a more hawkish stance, and with equity markets remaining supported by accelerating earnings growth, the current "sweet spot" for risk can continue. Return expectations must be tempered, though, as much of the recent growth improvements is already reflected in bond and equity valuations. Any sign that the optimism shown in confidence surveys is not translating into improving hard economic data could trigger an equity market correction and a risk-off move to lower government bond yields and wider credit spreads. Given our view that global growth will be faster than consensus expectations in 2017, however, we think that a pro-risk overshoot phase is more likely than a risk-off correction in the near term. Any upset in equity markets would represent a medium-term opportunity to increase credit risk and reduce duration. This week, we are adapting a more pro-growth, pro-risk stance in our recommended portfolio allocations this week, making the following changes: Reduce overall portfolio duration to below-benchmark Reduce U.S. Treasury exposure to below-benchmark (2 of 5) Upgrade U.S. Investment Grade corporate exposure to above-benchmark (4 of 5) Upgrade U.S. High-Yield corporate exposure to neutral (3 of 5), favoring B- & Ba-rated names Importantly, we are maintaining our current allocations to Euro Area corporates (above-benchmark) and Emerging Market sovereign and corporate debt (neutral for both), given that we see more potential for upside surprises in the U.S. economy relative to the rest of the world. Duration: Re-Establish A Cyclical Below-Benchmark Stance We moved to a neutral stance on our overall duration recommendation back on December 6th, which we viewed as a tactical profit-taking exercise on our previous successful bearish bond call dating back to last July.1 Our view at the time was that global bonds were still in a cyclical bear phase, led by rising inflation expectations and better economic growth prospects in the developed world (especially in the U.S.). Given the extreme bearish positioning in government bond markets, at a time of oversold momentum, our stated plan of attack was to look to move back to a below-benchmark stance after a meaningful pullback in yields. The likely trigger for that move was expected to be some disappointment on actual economic data, especially given the heightened growth expectations in the U.S. after Trump's electoral victory. Global economic data continues to trend in a positive direction, however, which is preventing any pullback in bond yields despite a deeply oversold market (Chart of the Week). The Citigroup Data Surprise index for the major developed economies is at the highest levels since early 2014. The Global ZEW indicator, one of our favorites, is at the highest level since mid-2015. The global leading economic indicator from the OECD is back to levels last seen in 2013, suggesting that the positive growth momentum can continue to put upward pressure on real bond yields. There are few signs of disappointment at the country level, with the Purchasing Managers Indices for all major developed markets, as well as for China, all pointing to expanding global activity (Chart 2). Chart of the WeekYields Supported By Faster Growth Chart 2A Broad Based Upturn It will be interesting to see if this uptrend can withstand the "bull in the China shop" approach of the new Trump administration with regards to U.S. trade policy. Already, in just the first week of his presidency, Trump has aggressively pushed to implement much of his protectionist campaign promises, like pulling out of the Trans-Pacific Partnership, pushing to renegotiate the North American Free Trade Agreement and threatening the imposition of tariffs or border taxes in an effort to reduce the U.S. trade deficit. Global confidence surveys will be critical to monitor in the next month or two for any sign that Trump uncertainty is having a detrimental effect on business optimism outside the U.S. Importantly, the starting point is strong, with both consumer and business confidence measures in Europe and China rising steadily, as are net earnings revisions for global equities (Chart 3). A combination of improving economic sentiment, confirmed by stronger corporate profits, may be enough for the global economy to withstand the shifting plate tectonics of U.S. economic policy. In the U.S. itself, the GDP report released last week showed that 2016 ended on a soft note, with annualized growth of only 1.9% in the 4th quarter. However, a sector-by-sector forecast for U.S. GDP presented last month by our colleagues at BCA U.S. Bond Strategy shows that there is upside risk for most major elements of the U.S. economy (Chart 4).2 Rising consumer confidence amid a tight labor market should help boost consumption, while the large drag from inventory destocking seen last year will not be repeated in 2017. Chart 3An Improving Corporate Profit Backdrop Chart 4Upside Risks For U.S. Growth The wild cards for U.S. growth will come from all the sectors most impacted by potential policies from the Trump administration: business investment, government spending and net exports. Trump has been going full steam ahead with his protectionist leanings in his initial days in office, but how much he can quickly implement remains to be seen. For now, the U.S. dollar is not rising rapidly enough to generate much of a drag on U.S. GDP growth, unlike the 2014/15 surge in the greenback (see the bottom panel of Chart 4). More importantly, the improving trend in U.S. corporate profit growth and post-election surge in business confidence should support faster growth in U.S. capital spending, which is already showing signs of perking up a bit (Chart 5). As we discussed in a Weekly Report earlier this month, the bigger upside surprise for the U.S. economy this year will come from capital spending, not government spending, as Trump will have a much easier time passing pro-growth corporate tax cuts than getting his infrastructure spending program green-lighted quickly through the U.S. Congress.3 U.S. growth will be much faster than the Fed's current forecast of 2.1%, which will embolden the Fed to deliver on additional rate hikes later this year. The Fed will likely want to see some sign of clarity on the fiscal policy outlook before contemplating the next rate hike, and we are not expecting a rapid acceleration of U.S. inflation in the next few months that would force to Fed to act more quickly. The next rate hike will come at the June FOMC meeting, with the Fed delivering at least the 50bps of rate hikes by year-end currently discounted in the market, and possibly the full 75bps of hikes shown in the latest FOMC projections if the economy delivers faster growth in 2017, as we expect. When looking at the other major bond yields in the "Big-4" developed markets, all elements of valuation have repriced higher (Chart 6): Chart 5U.S. Corporate Profits & Confidence Are Stronger, Capex Is Next Chart 6All Yield Components Are Rising Central bank policy rate expectations have shifted away from cuts in the Euro Area, Japan and the U.K., with a small hike from the Bank of England now discounted in the U.K. Overnight Index Swap (OIS) curve; Term premiums have risen from the mid-2016 lows, but remain negative in the countries where central banks are still actively engaging in asset purchase programs; Inflation expectations are well off the 2016 lows in all markets, but with higher levels in the U.K. and U.S. We see much higher upside risks for growth and inflation, and tighter monetary policy, in the U.S. and U.K. than the Euro Area or Japan. To reflect this in our model portfolio, we are downgrading our U.S. country allocation to below-benchmark (2 of 5) this week, while maintaining our underweight in the U.K. (also 2 of 5). We are keeping the Euro Area at above-benchmark (4 of 5) and Japan at benchmark (3 of 5). Government bond yield curves should see mild steepening pressure from rising inflation expectations before central banks are forced to turn more hawkish. We are focusing our decision to reduce overall portfolio duration more at the longer end of yield curves, especially in the U.S. and U.K. (Chart 7). A large headwind to any significant move higher in bond yields remains investor positioning, with only the "active client" portion of the JP Morgan duration survey showing a flip back to a net long duration stance in recent weeks (Chart 8). A full unwind of the large short positions in government bond markets is unlikely in the absence of much weaker economic data or a big correction in equity markets. The latter is impossible to time, but nothing that we are seeing in the forward-looking data is pointing to an imminent slowing of economic growth. Thus, we are choosing to shift back to our desired strategic below-benchmark duration stance this week. Chart 7Rising Inflation = Steeper Yield Curves Chart 8Large Short Positions Still An Issue Bottom Line: Rising political tensions in the U.S. will not offset the cyclical upward momentum in global growth and inflation. Bond yields are unlikely to fall much in the near term, despite significant bearish investor duration positioning. Shift back to a below-benchmark overall portfolio duration stance and position for bear-steepening of yield curves. Downgrade U.S. Treasuries to underweight (2 of 5) in global hedged bond portfolios. Corporate Bonds: A Cyclical Upgrade In The U.S., Despite Tight Valuations Global corporate debt has enjoyed solid relative performance versus government bonds over the past several months, driven by the improvements in economic growth and earnings. Credit spreads have narrowed in response, for both Investment Grade and High-Yield. In the Euro Area, the U.K. and Japan, central bank asset purchases of corporate bonds have also helped to keep spreads tight and help support the overall positive backdrop for credit markets. High levels of corporate leverage remain an issue, especially in the U.S., but an improving profit backdrop and faster nominal GDP growth will help paper over problems associated with high company debt. In the U.S., the items in our "Corporate Checklist" are providing a generally positive signal (Chart 9): Our Corporate Health Monitor (CHM) is starting to signal a slight improvement in corporate credit metrics after several years of deterioration; Bank lending standards are no longer tightening, according to the Fed's Senior Loan Officer Survey, after a brief period of more stringent standards in 2015 & 2016; Bank equities are outperforming the overall market, which in the past has been a positive signal for credit availability and corporate debt performance; Monetary conditions are still only just neutral, even with the U.S. dollar at very expensive levels. The monetary backdrop could become a concern later on in the year if Fed rate hikes lead to another period of rapid U.S. dollar appreciation. Until then, the more positive backdrop for profits will continue to boost balance sheet health, resulting in reduced equilibrium risk premiums (i.e. spreads) on corporate bonds. Already, U.S. corporate debt has priced in the better news (Chart 10). In High-Yield, the massive rally in energy-related names after the recovery in oil prices last year (top panel) has driven the spread on the Energy sub-component of the Barclays Bloomberg benchmark index back to levels last seen when oil was at $100/bbl ... even though the price of oil is still in the low $50s! Meanwhile, junk spreads ex-energy now reflect the benign macro volatility environment, as proxied by the VIX index (middle panel). Chart 9A Better Fundamental Backdrop Chart 10Corporate Valuations Are Not Cheap... In Investment Grade, spreads have also tightened alongside falling volatility, although spreads are still somewhat higher than during the previous period when the VIX was this low back in 2014 (bottom panel), suggesting that spreads could compress even further if the macro backdrop stays benign. We have maintained a generally cautious stance on U.S. corporate credit for much of the past year, given the combination of poor corporate health, contracting profits and slowly tightening monetary conditions. Now that the backdrop has changed, the case for upgrading U.S. corporates versus U.S. Treasuries is more compelling. This is especially so given the improvement in global economic growth momentum, which usually correlates with periods of positive excess returns for both Investment Grade and High-Yield versus Treasuries (Chart 11). Given our more optimistic tone on global economic growth, led by the potential for upside surprises in the U.S., this week we are upgrading our recommended stance on U.S. Investment Grade corporates to above-benchmark (4 of 5) and U.S. High-Yield to at-benchmark (3 of 5). Within High-Yield, we are focusing our exposure on the high-to-middle quality tiers, as both B-rated and Ba-rated spreads look far more attractive than Caa-rated debt. That can be seen in Chart 12, which shows the option-adjusted spread (OAS) for the overall U.S. High-Yield index and the three main credit tier buckets, divided by the 12-month trailing volatility of excess returns for each grouping. These "vol-adjusted" spreads are at the long-run median level for B-rated and Ba-rated debt, while Caa-rated bonds (which are dominated by the now-expensive debt of energy-related companies) offers poor value relative to their volatility. Chart 11...But The Growth Outlook Remains Supportive Chart 12Avoid The Lower Credit Tiers In U.S. Junk Differentiating within the credit tiers is important, as the overall U.S. High-Yield spread is not particularly cheap once expected default losses are taken into account (Chart 13). If U.S. economic growth surprises to the upside, as we expect, then the default outlook will look better and High-Yield spreads will look more attractive. For this reason, we would look to shift to an above-benchmark stance on any risk-off correction in global equities or corporates. With the business cycle improving, buying any dips in U.S. corporate credit markets should pay off in 2017. One final point: we have had a long-standing recommendation to overweight Euro Area Investment Grade corporate debt versus U.S. equivalents. That view was based on the underlying support for Euro Area corporates from ECB purchases, coming at a time when Euro Area balance sheets were improving in absolute terms, and relative to the U.S., as shown by our Euro Area Corporate Health Monitor (Chart 14). However, with our U.S. CHM now showing some modest improvement, and with U.S. likely to show more upside growth surprises in 2017, we are not upgrading Euro Area debt from the current above-benchmark (4 of 5) ranking, even as we boost our U.S. corporate allocation. Chart 13Expect Carry-Like Returns, Given Tight Spreads Chart 14A Bullish Case For Both U.S. and Euro Area IG Bottom Line: A better global growth outlook should continue to support U.S. corporate debt markets, despite tight valuations and a strong U.S. dollar. Upgrade allocations to U.S. Investment Grade to above-benchmark (4 of 5) and U.S. High-Yield to neutral (3 of 5), at the expense of U.S. Treasuries. Favor the higher quality tiers (i.e. above Caa) in U.S. junk. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Vigilantes Take A Break For The Holidays", dated December 6, 2016, available at gfis.bcaresearch.com 2 Please see BCA U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "A "Post-Truth" Economic Upturn?", dated January 17, 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Table 1Recommended Allocation The Reflation Trade Continues It is wrong to think that the recent rally in risk assets is mainly due to the election of President Donald Trump. Yes, since November 8, U.S. equities have risen by 7% and global equities by 3%. But the rally began as long ago as February last year, and since then U.S. and global equities have risen by 25% and 20% respectively. A more useful narrative is that the U.S. went through a "mini-recession" in late 2015/early 2016 (as indicated by the manufacturing ISM and credit spreads, Chart 1). Since then, assets have moved as they typically do in the first year of a cyclical recovery: small caps, cyclicals and value stocks have outperformed, bond yields risen, and equity multiples expanded in anticipation of a recovery in earnings. Expectations of Trump's fiscal stimulus and deregulation merely gave that momentum an extra boost. Our view is that global economic growth is likely to continue to accelerate. With the U.S. now at full employment, wage growth should rise further (Chart 2). Trump's policies are igniting animal spirits among companies, whose capex intentions have jumped sharply (Chart 3). U.S. real GDP growth this year could be 2.5-3%, somewhat above the consensus forecast of 2.3%. Meanwhile, Europe is growing above trend, and China will continue for a while longer to see the effects from last year's massive monetary stimulus (Chart 4). Chart 1One Year On From A Mini Recession Chart 2Wage Growth Is Set To Accelerate Chart 3Comapanies' Animal Spirits On The Rise Chart 4China's Reflation Still Coming Through In the short term, a correction is possible: the rally looks technically over-extended, and investors have begun to notice that in addition to "good Trump" (tax cuts, deregulation and infrastructure spending), there is also a "bad Trump" (market unfriendly measures such as immigration control, confrontation with China, and arbitrary interference in companies' investment decisions). But, on a 12-month view, our expectations of accelerating growth and only a moderate rise in inflation imply that the "sweet spot" for risk assets will continue, and so we maintain the overweight on equities and underweight on bonds we instituted in late November. What could end the reflation trade? The main risks we see (and the reasons we don't think they are serious enough to derail the rally for now) are: Extreme moves by the new U.S. administration. The biggest risk is a confrontation with China over trade. Our view is that Trump will use the threat of recognizing Taiwan to force concessions out of China. A precedent is the way the U.S. handled its trade deficit with Japan in the 1980s (note that new U.S. Trade Representative Robert Lighthizer was deputy USTR at the time). China is unlikely to accept significant currency appreciation, understanding how this caused a bubble in Japan. But it might agree to voluntary export restrictions, to increasing investment in the U.S., opening the Chinese market more to foreign companies, and to stimulating domestic consumption, as Japan did in the 1980s (Chart 5). This may even chime with how Xi Jinping wants to reform the economy, though missteps by the U.S. could force him into a nationalistic position. Fiscal policy fails. The details of tax cuts are complex: alongside lowering the headline rate of corporate tax to 15% or 20%, for example, Republicans are discussing a border-adjustment tax, one-year depreciation, and an end of the tax offset for interest payments. Infrastructure spending won't happen quickly either, not least since it is disliked by Republican fiscal hawks (who are much less averse to tax cuts). BCA's geopolitical strategists, however, believe that Trump will able to get a program of personal and corporate tax cuts through Congress by August. Economic (and earnings) growth stumble. While corporate and consumer sentiment have picked up recently, hard data has not yet. U.S. 4Q GDP growth of only 1.9%, for example, was disappointing. Earnings growth will need to recover this year to justify elevated multiples. EPS growth for the S&P500 stocks in Q4 2016 looks to have been around 4% YoY according to FactSet. Stocks might fall if earnings do not come in somewhere close to the 12% that the bottom-up consensus forecasts for 2017. Inflation risks rise, triggering the Fed and the European Central Bank to rush to tighten monetary policy. Core U.S. PCE inflation, at 1.7% YoY, is not far below the Fed's 2% target and inflation could accelerate as fiscal policy stimulates an economy where slack has already disappeared. However, it is likely to take some time for inflation expectations to rise, and over the past few months core PCE inflation has, if anything, slowed (Chart 6). We expect the Fed to raise rates three times this year (compared to market expectations of twice) but not to move faster than that. German inflation, at 1.9% YoY, is starting to get uncomfortably high too, but the ECB will probably continue to set policy with more focus on the periphery, especially Italy. Chart 5When U.S. Pushed Japan In The 1980's Chart 6Inflation Has Been Slow To Pick Up Equities: We prefer U.S. equities over European ones in common currency terms. This is partly because we expect further U.S. dollar appreciation. But we also remained concerned about the structural weakness in the European banking system, and by the higher volatility of eurozone equities. Moreover, European earnings will not be boosted by currency depreciation as much as will Japanese earnings, since the euro has hardly weakened on a trade-weighted basis (Chart 7). We continue to like Japanese equities (with a currency hedge). The Bank of Japan remains committed to an overshoot of its 2% inflation target, which should weaken the yen and boost earnings. We are underweight Emerging Market equities: structural vulnerabilities remain, and the inverse correlation with the U.S. dollar is intact. Chart 7Euro Hasn't Weakened Much Fixed Income: For now, U.S. 10-year Treasury bonds are at around fair value. But we expect the yield to rise moderately further, as growth and inflation pick up, to about 3% by year-end. Yields on eurozone government bonds will also rise, but not by as much. This means that global sovereigns could produce a YoY negative return for the first time since 1994. In the U.S. we continue to prefer TIPS over nominal bonds: inflation expectations are still 30-40 bps below a normalized level (Chart 8). With risk assets likely to outperform, we recommend exposure to spread product, but find investment grade bonds more attractively valued than high-yield. Currencies: Short term, the dollar has probably overshot and could correct. But growth and interest rate differentials (Chart 9) suggest that the dollar will appreciate further until such time as Europe and Japan can contemplate raising rates. Additionally, if the proposal of a border-adjustment tax looks like becoming reality, the dollar could appreciate sharply: a BAT of 20% would theoretically be offset by a 25% rise in the dollar. The yen is likely to depreciate further (perhaps back to JPY125 against the dollar) as the Bank of Japan successfully maintains its target of a 0% 10-year government bond yield. The euro will fall by less, especially if the market begins to worry about ECB tapering in the face of rising inflation. Chart 8TIPS Have Further to Go Room To Rise Chart 9Interest Rate Differentials Suggest Stronger Dollar Commodities: The supply/demand picture for industrial metals looks roughly balanced for the year, with Chinese demand likely to remain robust, suppliers more disciplined, but the stronger dollar acting as a headwind. In the oil market, Saudi Arabia and Russia seem to be sticking to their commitment to cut supply, but U.S. shale oil producers are filling the gap, with the rig count up 23% in Q4 over the previous quarter. We continue to expect crude oil to average US$55 a barrel for the next two years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights Portfolio Strategy Pricing power has improved across a number of industries, with the exception of technology, a necessary development to sustain an overall profit recovery. The S&P railroads index has surged to the point where it will take massive upside earnings surprises to drive additional gains. Profit-taking is appropriate. Telecom services profit drivers have deteriorated significantly of late, and a full shift to underweight is recommended. Recent Changes S&P Railroads Index - Take profits of 22% and downgrade to neutral. S&P Telecom Services Index - Take profits of 6% and downgrade to underweight from overweight. Table 1 Feature Chart 1Pricing Power Is Profit Positive... Momentum remains the dominant market force. Fear of missing out is pulling sidelined cash into the market, supported by a decent earnings season to date and rising economic confidence. While consumer inflation expectations remain very low, market-derived inflation expectations have moved up markedly since the U.S. election (Chart 1), a surprising development given the surge in the U.S. dollar. Inflation expectations are back to levels that existed prior to the 2014 kickoff to the U.S. dollar rally. A shift away from deflation worries is supporting a re-pricing of stocks vs. bonds. That trend could continue until the U.S. economy begins to disappoint, potentially causing inflation expectations to retreat. Our pricing power update shows that while deflation remains prevalent, its intensity is fading. We have updated our industry group pricing power (Table 2), which compiles the relevant CPI, PPI, PCE or commodity-data for 60 S&P 500 industry groups. The table also compares those pricing power trends with overall inflation rates to help determine which areas are at a profit advantage or disadvantage. Based on our analysis, the number of groups suffering deflation in selling prices has shrunk to 19 from 23 in our update last September, and 32 last March. In all, 34 out of 60 groups are still unable to raise prices by more than 1%, but that is also an improvement from the 40 out of 60 industries that couldn't keep a 1% price hike pace last September. The bad news is that less than 1/3 have a rising selling price trend, even if the absolute level is negative, down from 50%, and another third has a flat trend. The implication is that upward momentum in pricing power may already be fading. Where is the pricing power improvement? Deep cyclical sectors such as energy and materials account for the lion's share, reflecting higher commodity prices. However, as discussed previously, 6-month growth rates have rolled over (Chart 2), signaling that the unwinding of the negative rate of change shock has run its course. The technology sector is also notable, as several groups are cutting selling prices at a faster clip. Table 2Industry Group Pricing Power Defensive sectors such as consumer staples, health care and utilities remain well represented in the positive category, while a reacceleration in consumer discretionary and financials sector selling price increases has boosted interest rate-sensitive sector pricing power (Chart 2). This would suggest that profit advantages continue to reside in these areas, rather than in cyclical sectors. That is confirmed by the uptrend in developed vs. developing market PMIs. This manufacturing gap would presumably widen further if the U.S. ever imposes import taxes. The latter would weaken developing country exports, thereby forcing currency devaluation and hurting capital inflows. Regardless, the PMI divergence reinforces that, in aggregate, cyclical sectors are not as fundamentally well supported as other sectors, and that a highly targeted and selective approach is still the right strategy (the PMI ratio is shown advanced, Chart 3). Even external factors warn against chasing lingering cyclical sector strength. Using the options market, the SKEW index provides a good read on perceived tail risk for the S&P 500. A rise toward 150 indicates significant worries about potential outlier returns. The SKEW has soared in recent weeks, which is often a harbinger of increased equity volatility and defensive vs. cyclical sector strength (Chart 4). Chart 2... But Is Not Broad-Based Chart 3Global PMIs Are Signaling Defense First... Chart 4... As Are Market-Based Indicators In sum, the broad market has a powerful head of steam and it could be dangerous to stand in its way, but the rally continues to exhibit signs of a late stage blow-off, vulnerable to sudden and sharp corrections. Maintain a healthy dose of non-cyclical exposure to protect against building and potentially sudden downside overall market risks, while being careful in terms of cyclical industry coverage. This week, we are taking advantage of exuberance in the rail space, and reversing our call on the telecom services sector in response to broad-based erosion in profit indicators. Rails Are Now Priced For Perfection For such a mundane and staid industry, railroad stocks have garnered considerable attention of late. Most recently, rumors that railroad maven Hunter Harrison will be installed at CSX to engineer yet another corporate turnaround have spurred a massive buying frenzy. We upgraded the S&P railroads index to overweight on August 1, 2016. Our analysis suggested that analysts and investors had made a full bearish capitulation, slashing long-term growth estimates to deeply negative territory and pushing valuations decisively into the undervalued zone. That pessimism overlooked efforts to cut costs and stabilize profit margins in the face of waning freight growth, setting the stage for a re-rating. While that thesis has worked out, we are concerned that the needle has now swung too far in the other direction, much like what occurred in the air freight industry. The latter had a steep run up only to disappoint newly buoyant expectations. We took air freight profits in late-November, as the soaring U.S. dollar was an anti-reflationary threat to the anticipated recovery in global trade that both investors and the industry had positioned for. Indeed, industry hiring has expanded rapidly (Chart 5). However, hours worked are contracting (Chart 5). Ergo, the hoped for increase global revenue ton miles has not materialized to the extent that was expected (Chart 5). Over-employment is a productivity and profit margin drag, and we were fortunate to take profits before the payback period. We can envision a similar scenario for railroads. There has no doubt been an improvement in freight activity, and there is more in the pipeline. The question is one of degree. Total rail shipment growth has climbed back into positive territory, and our rail shipment diffusion index, which measures the number of freight categories experiencing rising vs. falling growth, is near the 80% level (Chart 6). The key consumer-driven intermodal segment, which accounts for over half of total freight volumes, has finally begun to recover. Rising personal incomes should underpin credit availability and demand, and therefore, spending. The increase in business sales-to-inventories and growth in Los Angeles port traffic also augur well for intermodal shipments (Chart 6). One caveat is that autos represent a large portion of this segment, and pent-up demand has been fully realized at the same time that auto credit quality is beginning to crack. That could keep a lid on the magnitude of the intermodal shipment recovery. Coal volumes have also shown signs of life after a brutal contraction. Coal is a high margin product and another large freight category, and any sustained recovery would provide a meaningful profit boost. Rising natural gas prices typically bode well for coal volumes (Chart 7), via increasing the cost of competing fuels to burn for power generation. However, it is premature to celebrate, because the abnormally warm North American winter may mean that the rebound in electricity production is passed its peak. That would slow the burn rate and keep coal (and natural gas) supplies higher than otherwise would be the case. Chart 5Stay Grounded Chart 6Broad-Based Freight Recovery Chart 7Coal Is Critical History shows that pricing power and coal shipment growth are tightly linked. Selling prices have firmed in recent months, but are not at a level that heralds meaningful improvement in return on equity (Chart 8, third panel). True, rising oil prices typically lead to rail companies reinstituting fuel surcharges. But that is profit margin protective, not expansionary, as true pricing power gains come on the back of increased demand and the creation of bottlenecks. It is not clear that such a point has been reached. The Cass Freight Expenditures Index has been flat for several months, signaling that companies do not intend to raise transportation outlays. This series correlates positively with relative forward earnings estimates (Chart 8). That will make it difficult for rail freight to grow faster than GDP (Chart 9), a necessary development to drive earnings outperformance. Meanwhile, productivity gains may be slow to accrue if freight only grows modestly. Weekly train speeds have been stuck in neutral (Chart 8), and the industry may be in the early stages of a capital spending reacceleration. Rail employment growth has jumped in recent months, which is often a leading indicator of investment (Chart 9). If capital spending begins to take a larger share of sales in the coming quarters, then recent investor excitement may ease, leading to a prolonged consolidation phase. After all, valuations are stretched. Over the past two decades, whenever the relative forward P/E has crossed above a 10% premium, relative forward 12-month returns have averaged -4%, and been negative in 4 out of 5 cases. Overheated technical momentum also warns against extrapolating the latest price gains (Chart 10). Chart 8Earnings Will Only Improve Slowly... Chart 9... If Capital Spending Re-Accelerated Chart 10A Profit Recovery Is Discounted Bottom Line: Take profits of 22% and downgrade the S&P rails index (BLBG: S5RAIL - UNP, CSX, NSCX, KSU) to neutral, as the index appears to be setting up for a 'buy the rumor, sell the news' scenario. Stay neutral on the S&P air freight index (BLBG: S5AIRF - UPS, FDX, CHRW, EXPD). Telecom Services: Can You Hear Me Now? The niche S&P telecom services sector (comprising 3% of the S&P 500) has served our portfolio well, up 6% since inception. However, operating conditions have downshifted and we recommend lightening up a notch and reducing weightings to underweight. There are five factors driving this downgrade: the relative spending profile, sales outlook, margins pressure, interest rates and capital spending trends. First, telecom services personal consumption expenditures (PCE) have sunk anew after a brief attempt to stabilize last year. While consumer spending on telecom services has increasingly become a discretionary item, the improvement in consumer finances and vibrant labor market appear to be generating even more outlays on non-telecom goods and services (top panel, Chart 11). Second, this spending backdrop has undermined the sector sales outlook. Top line growth has retreated to nil, and BCA's telecom services sales-per-share model is signaling that a contraction phase looms (middle panel, Chart 11). Worrisomely, the latest producer price index release revealed that industry pricing power has taken a turn for the worse, which will sustain downward pressure on revenue growth. Third, profit margins are under stress. Selling prices are deflating at a time when the wage bill is still expanding at a mid-single digit rate. The implication is that margins, and thus earnings, are unlikely to improve much in the coming quarters (Chart 12). Chart 11Sales Prospects Have Dimmed Chart 12Ditto For Profit Fourth, telecom services is a high yielding sector and the recent sell-off in 10-year Treasurys (UST) is an unwelcome development. When competing investments rise in yield, the allure of telecom carriers diminishes, and vice versa. Chart 13 shows that relative performance momentum and the change in UST yields are inversely correlated, underscoring that as long as the bond market selloff persists relative share price pressures will remain intact. Finally, industry capital expenditures are reaccelerating, which is a short-term negative for profitability. This message is corroborated by the government's construction spending release, which shows a pickup in telecom facilities construction (bottom panel, Chart 13). Taken together with the deteriorating sales backdrop, higher capital spending would be negative for profit margins. While we would normally be reluctant to move an attractively valued sector all the way to underweight (Chart 14), the marked deterioration in these five drivers of relative profitability warrants such an extreme move, regardless of our reticence about the sustainability of the broad market's recent gains. Chart 13Higher Bond Yields Aren't Helping Chart 14Technical Breakdown Our Technical Indicator has crossed decisively into the sell zone, and the share price ratio has failed to break back above its 40-week moving average, providing technical confirmation of a breakdown (Chart 14). Bottom Line: Lock in profits of 6% in the S&P telecom services sector since the Nov 9th, 2015 inception and downgrade exposure all the way to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights The DXY correction has a bit more to run as G10 economic surprises are likely to roll over. EM-related plays like commodity currencies can rally for a few more months, but the outlook for 2017 is troublesome. China is at risk of a deceleration. Global liquidity is tightening. Protectionism is rising. Feature Dollar Correction: It Ain't Over 'til It's Over Can the dollar correction advance further, or is the dollar bull market about to resume? We prefer to position ourselves for additional dollar weakness in the coming months. Despite persistently high bond yields, the DXY is still softening. It is being dragged down by a euro supported by strong economic news such as this week's Belgian business confidence, our favorite bellwether for the euro area. The pound too continues to show some vigor, which is also a byproduct of economic data pointing toward better growth (Chart I-1). We expect the support for the greenback from higher Treasury yields to be temporary. Momentum in U.S. 10-year government bond yields is driven by G10 economic surprises (Chart I-2). Currently, economic surprises are flirting with the upper end of their distribution of the past 12 years. Chart I-1The British Economy Is Picking Up Chart I-2G10 Economic Surprises Drive Treasury Yields Accentuating the odds of a rollover in surprises are two factors: First, as bond yields and risk-asset prices attest, investors are revising their growth expectations upward, lifting the hurdle for data to surprise to the upside. Second, having expanded for 10 months, the global credit impulse has experienced its longest upswing in a decade. Yet, the increase in global borrowing costs, along with the widening in cross-currency basis swap spreads, points to tightening global liquidity conditions, a poison for the credit cycle (Chart I-3). As credit slows, the economy will deteriorate. Chart I-3The Credit Cycle Is Stretched This means that the key factor that has supported the stronger dollar in recent months - higher U.S. yields - will begin to dissipate, putting downward pressure on the USD. Finally, our dollar capitulation index, after hitting overbought conditions, is now falling. Moreover, it currently stands below its 13-week moving average, conditions under which the greenback has recorded an average 8.1% annualized weekly loss since 1994, and an average 5.3% annualized weekly loss since 2011 (Chart I-4). Chart I-4Negative Momentum For The Dollar We continue to play this correction by shorting USD/JPY. As we have pointed out before, USD/JPY remains a function of the level of global bond yields (Chart I-5). Additionally, a negative surprise in global growth is likely to hurt risk assets. To conclude with the favorable backdrop for the yen, the high degree of uncertainty created by the seemingly erratic policy changes of the new Trump administration suggests that equity implied volatility remains too low. After all, we do not know what changes will hit global tax regimes, what the Fed policy will look like, nor how protectionist Trump will really be. Imbedding a premium for these risks will require higher equity implied vols. A higher VIX tends to support the yen against the USD (Chart I-6). Chart I-5USD/JPY And G10 Bond Yields Chart I-6The Yen Likes Uncertainty Bottom Line: The correction in the dollar should continue, as bond yields still have downside on a one- to three-month basis. The yen remains the best-placed currency to take advantage of these dynamics, especially if risk assets experience a correction. Focus - Emerging Markets and Liquidity: A March To The Scaffold This week, we re-examine our bearish view on emerging markets, a key theme underpinning our bearish stance on commodity currencies. EM assets, and therefore commodity currencies, have outperformed our expectations, reflecting the percolation of previous positive economic surprises in EM relative to the U.S. (Chart I-7). EM and commodity currencies are priced for perfection, with the risk-reversals on EM currencies displaying elevated levels of optimism (Chart I-8). For EM and commodity currencies to rally further, EM economies need to continue to outperform durably. This requires the Chinese economy and the global liquidity backdrop to only improve further. Can this happen? Chart I-7Surprise Beat In EM Versus The U.S. Has ##br##Helped EM And Commodity Currencies Chart I-8EM And Commodity Currencies ##br##Priced For Perfection While the next month or two may continue to generate generous returns for EM-related plays, the rest of 2017 may not prove as kind. The China Syndrome Let's begin with China. The recent upsurge in metal prices has reflected an improvement in Chinese economic activity (Chart I-9). As we have pinpointed before, the Keqiang index is near cycle highs, and, Chinese railway freight volumes have been growing at their fastest pace since 2010. This situation is unlikely to continue much longer. The upsurge in Chinese commodity intake - metals in particular - has been fueled by a vigorous rebound in Chinese real estate construction. However, Chinese real estate price appreciation has hit dangerous levels, and the authorities are already leaning against it, with the PBoC increasing rates by 10 basis points this week. The roll-over in Chinese real estate activity should deepen Chart I-10), hurting commodity prices - particularly iron ore, steel and copper - and commodity currencies along the way. Chart I-9China's Rebound Explains ##br##The Metals Rally Chart I-10The Risk Of A China Real Estate ##br##Slowdown Is Growing Moreover, some of the upswing in Chinese economic activity was also related to large amounts of fiscal stimulus in that nation. In mid-2015, the Middle Kingdom was inching ever closer to a hard landing, prompting a panicked Beijing to boost fiscal support and to speed up the roll-out of US$1.2 trillion of infrastructure public-private partnerships. Today, this fiscal hand-out is fading (Chart I-11). This could once again cause industrial activity and investments to weaken as Chinese capacity utilization remains near recession troughs. The recent disappointing investment growth reading in the latest Chinese GDP release could be a harbinger of this reality. Finally, as we have highlighted last week, Chinese monetary conditions have massively improved as Chinese producer-price inflation rebounded, pushing down Chinese real rates in the process. However, with commodity price inflation set to slow - courtesy of a dissipating base effect and of last year's dollar rally - Chinese PPI should roll over, pulling up real rates and tightening monetary conditions (Chart I-12). A tightening in Chinese monetary conditions represents a big problem for EM as it portends a slowdown in economic activity (Chart I-13). This will ultimately lead to a big drag on DM commodity producers, as EM commodity intake decreases, pushing down the likes of the AUD, CAD, and NZD as their terms of trade suffer. Chart I-11Fading Chinese##br## Fiscal Stimulus Chart I-12Commodity Inflation Will Peak, ##br##So Will Chinese Inflation Chart I-13Tightening China Monetary Conditions##br## Will Hurt EM Economic Activity Bottom Line: In early 2016, global markets were not positioned for a rebound in Chinese economic activity. Yet, Chinese industrial activity improved, resulting in a rebound in EM assets, commodity prices, and commodity currencies. The crackdown on real estate activity, the removal of Chinese fiscal stimulus, and the expected tightening in Chinese monetary conditions should result in a reversal of these trends, hurting commodity producers and their currencies in the process. Global Liquidity In Retreat While China represents a problem for EM plays and commodity currencies, deteriorating global liquidity could prove an even stronger hurdle. Our tactical expectation of a lower dollar and lower rates may support EM plays temporarily, but the cyclical outlook remains grim. To begin with, EM economies are dependent on global liquidity as they run a current account deficit expected to hit US$140 billion in 2017, or US$400 billion if China is excluded. Moreover, they sport large external debts of US$4.8 trillion, excluding Taiwan and China. Especially worrisome are the large funding requirements of many EM countries, especially for Turkey, Malaysia, and Colombia. (Chart I-14). Chart I-14EM Debt Vulnerability Ranking Why is this a problem? Two reasons: Global Interest rates and the dollar. Global Interest rates, driven by higher Treasury yields, are rising as the U.S.'s economic slack vanishes, suggesting that the current tightening campaign by the Fed will be durable (Chart I-15). Higher U.S. rates lift the U.S. dollar against EM currencies, tightening EM liquidity conditions. But an unrelated shock is also putting exogenous upward pressure on the dollar. This force is the widening in LIBOR spreads (Chart I-16). This is the result of the regulation-related 90% melt down in the asset under management of U.S. prime money-market funds, an important source of global dollar liquidity. Moreover, U.S. banks, with their balance sheets under pressure by the binding constraints of Basel III, have not been able to fill the gap. Chart I-15The Fed has A Green Light To Hike Chart I-16Stresses In The Libor Market Remain The end result has been a widening of cross-currency basis swap spreads, which usually tends to boost the dollar (Chart I-17). This phenomenon increases the hedging costs to foreign investors of holding U.S. dollar assets. These investors become increasingly tolerant of purchasing U.S. assets unhedged, pushing up the value of the dollar in the process. This is best illustrated by the fact that net portfolio investments in the U.S. moved from a deficit of US$300 billion in Q1 2015 to a surplus of more than US$550 billion. Yet, hedges put in place, as approximated by the BIS's volume of OTC FX derivatives, have flat-lined since 2013 (Chart I-18). Chart I-17Widening Cross-Currency Basis Swap Spreads Equals A Higher Dollar Chart I-18Hedging Activity is Receding A rising dollar and LIBOR stresses are tightening global dollar liquidity, creating a big problem for EM. Wider-than-normal cross-currency basis swap spreads have been associated with declining global trade (Chart I-19). The stronger dollar plays a role, as it hurts the price of globally-traded good prices. Also, higher borrowing costs result in a mild disintermediation of global trade flows. As physical exports are 26% of EM GDP versus 13% for the U.S., this represents a huge drag on EM currencies, especially versus the USD. As a corollary, it is also a problem for the small open commodity producing DM economies like Australia, Canada, or New Zealand. Furthermore, the strength in the dollar associated with LIBOR shocks further hurts EM domestic economies by impeding EM credit growth (Chart I-20). The combined assault of a stronger dollar and higher rates increases the cost of EM foreign debt. Also, according to the BIS, between 2002 and 2014, 55% of EM commodity producers' debt issuance has been in USD.1 When the dollar rises, they see both their borrowing costs rise and the prices of the products they sell fall. Altogether, these forces preempt capex and credit accumulation in EM nations. Chart I-19Tightening Global Liquidity##br##Is Bad For Trade Chart I-20A Stronger Dollar Will Hamper##br## EM Credit Growth Bottom Line: The global liquidity backdrop is deteriorating. DM rates are rising cyclically, which is lifting the dollar. Moreover, a global dollar shortage is also supporting the greenback, further hurting EM liquidity conditions. Thus, we expect EM growth to deteriorate, hurting EM assets and commodity currencies. Protectionism The final issue affecting EM economies is the rise of protectionism, especially in the United States. EM - Asia and China in particular - have been the main beneficiaries of globalization (Chart I-21). Currently, they are in the line of sight of President Trump. Thus, we expect that any potential trade war between the U.S. and the rest of the world will focus on EM economies and China. Chart I-21EM And Asia Are In Trump's Line Of Sight EM are much more dependent on the U.S. than the other way around. As an example, China's exports to the U.S account for 3.5% of Chinese GDP, while U.S. exports to China account for less than 1% of U.S. GDP. EM economies have a lot more to lose from a trade war than the U.S. Because of this imbalance in relative trade-exposures, EM economies are at risk from the border-adjustment tax being discussed in the U.S. These taxes would be very deflationary for EM economies as they could force a downward adjustment in EM labor costs and further depress capex in these nations. To ease these adjustments, falling EM exchange rates would be required. Once again, commodity currencies would suffer from these developments. First, lower capex in EM hurts Australian, New Zealand, or Canadian terms of trade. Second, lower EM exchange rates means that that exports from the dollar bloc to EM would suffer. Finally, and most perversely, lower EM exchange rates will give EM commodity producers an advantage versus DM producers, in that a stronger U.S. dollar means their local-currency costs are falling. EM commodity producers would keep producing more than warranted, putting additional downward pressure on commodity prices and stealing market shares from the dollar bloc producers. This is not a pretty picture. Bottom Line: EM should bear the brunt of the pain of any rise in U.S. protectionism. The tight link between EM economies and DM commodity producers suggests that this pain should adversely affect the AUD, the CAD, and the NZD. Risks To Our View Chart I-22Chinese Tariffs Are Falling The biggest risk to our view is a redoubling of Chinese fiscal stimulus. The threat of U.S. tariffs and trade sanctions is obviously deflationary and negative for the Chinese economy. We know this, as do the relevant powers in Beijing. A tool to mitigate any of these negative repercussions on the Chinese economy might be for Beijing to press on the gas pedal once more. Additionally, as our colleague Yan Wang wrote in this week's China Investment Strategy, key members of the new U.S. administration have been on record saying that the threat of tariffs is not an end game, but rather a negotiating tool to extract concessions from U.S. trade partners, implying a potentially more pragmatic stance from the U.S. than current rhetoric suggests.2 Moreover, the Chinese side of the negotiation table is also more open minded than most observers fear. China has been cutting its own tariffs and could continue to do so (Chart I-22). Moreover, Premier Li Keqiang has made a new pledge to move faster toward opening and liberalizing Chinese markets for access by foreign companies. A deal may be less elusive than feared. Finally, regarding the global liquidity deterioration, the recent rebound in gold and silver prices may be a harbinger of improving liquidity conditions globally. We doubt that the economic situation will let this rally be durable, but it remains something to monitor. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Bruno Valentina, and Hyun Song Shin, "Global Dollar Credit And Carry Trades: A Firm-level Analysis", BIS, Working Papers, August 205. 2 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard", dated January 6, 2017, available at cis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed this week. The labor market saw both continuing and initial jobless claims rise above expectations. However, the economy is still near full employment and the Fed will not respond to this news. Furthermore, the Beige Book, released last week, also highlights that the U.S. economy remains resilient with employment and pricing activity particularly strong. This week the DXY broke through the key 100 level, as the market continues to reprice capricious assumptions of Trump's policies. Nevertheless, it has rebounded since then. The dollar is unlikely to see any real movement until the administration releases concrete information about its policies. For the time being, the Fed also seems to be on the sidelines in anticipation of more information. Report Links: U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Although the euro area has seen a brighter economic environment as of late, this week's data has been mixed: German and overall euro area services and composite PMI underperformed, while manufacturing PMI outperformed consensus. The IFO Business Climate and Expectations both underperformed consensus, while the Current Assessment remained in line with consensus. All measures still remain over 100. Finally, Belgian Business Confidence accelerated sharply. The ECB is unlikely to change its dovish stance. The euro will therefore see little upside. The recent uptrend in EUR/USD is due to dollar weakness, but the recent downtrend in EUR/GBP and EUR/SEK indicate that the market is not necessarily hopeful that the ECB will reach its inflation target anytime soon. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data indicates that last year's sharp depreciation of the yen is helping the Japanese economy: Exports increased by 5.4% YoY, crushing expectations of 1.2% growth. Nikkei Manufacturing PMI reached 52.8, also beating expectations. In November machinery orders grew by more than 10% YoY. The BoJ will be more resolute on its radical monetary measures, as recent data shows that their approach is working. This will prove very bearish for the yen on a cyclical basis, given that the cap in Japanese rates will cause the rate differential between the U.S. and Japan to widen. In the short term, USD/JPY will resume its correction. We estimate that USD/JPY will cease to be attractive as a short opportunity at around 110. Report Links: Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Tuesday, the Supreme Court upheld the decision of the High Court, requiring a parliamentary vote to authorize the exit of the U.K. from the European Union. This news is an added boon for cable, which has surged by almost 5% after bottoming at 1.20 about 10 days ago. As political risks start to dissipate, and the currency trades more on economic fundamentals, the pound should become a more attractive buy, particularly against the euro, given that the U.K. economy should outperform the market's dismal expectations. Recent data supports this view: Average earning growth outperformed expectations in November. GDP growth was 2.2% YoY in Q4, also outperforming expectations. Furthermore, short-term technicals point to a stronger pound. EUR/GBP has broken through its 100-day moving average, which indicates that momentum should continue to drive this cross downwards for the time being. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Two weeks ago, we argued that the rally in AUD lacks fundamental domestic causes. This week, the momentum of the recent AUD rally, caused by rising iron ore and copper prices, has seemingly paused. Exacerbating this change of pace is recent data which indicates a weak economic backdrop: the RBA trimmed mean CPI, and the more common CPI measure, underperformed consensus at both a quarterly and yearly pace. This could be due to depressed consumer sentiment, as the labor market remains mired in a slump, with the unemployment rate increasing to 5.8%, and total hours worked falling. Given recent data, it is likely that markets reprice growth prospects in Australia. U.S. trade policies could also potentially curtail global trade, painting a bearish picture for AUD. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The Kiwi has appreciated 4.4% since the start of 2017. Although this rally might eventually be limited against the U.S. dollar, the NZD will likely have more upside against its crosses, particularly the AUD. Indeed it seems that low inflation, one of the only sore spots for the RBNZ in an otherwise stellar kiwi economy, has turned the corner, surging to 1.3% on the latest reading Wednesday. More importantly, not only did inflation beat expectations but it also surpassed 1% for the first time since 2014. This is a significant development, given that persistently low inflation in New Zealand was keeping the dovish bias of the RBNZ. With this hurdle gone, and an economy that continues to be the best performing in the G10, this dovish bias should disappear, which will ultimately lift the NZD against its crosses. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Despite the dissipating oil slump, potential risks may weigh on Canada's future. These risks are likely to emanate from an international sphere. Key concerns revolve around U.S. policies: recent statements have increased yields and tightened financial conditions, but global trade worries are not fully priced in. Recent news indicates that Trump has no ill-intentions aimed at Canada, however, protectionist policies could hurt global trade, indirectly curtailing Canadian exports. A U.S. corporate tax cut can also deviate investment from Canada to the U.S. The recent appreciation in the CAD against major currencies can also hurt Canadian competitiveness going forward. As oil is likely to remain relatively stable in the near future, we may again see a disassociation of CAD with oil, and a continued tight relationship with interest rate spreads. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Yesterday, EUR/CHF fell below the crucial 1.07 level. As we have recommended many times, any time that this cross falls below this threshold, it becomes an excellent buying opportunity. The SNB has not been shy to intervene in the currency markets, and they have been very clear that they will not tolerate any currency strength past a certain threshold as it could add additional deflationary pressures to an economy that has not had a positive inflation rate since 2014. We have identified a level of 1.07 for EUR/CHF as this threshold. Moreover given that the euro is the currency of reference for interventions, the behavior of USD/CHF should roughly mirror the behavior of the dollar against the Euro. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Norwegian Krone has rallied along other commodity currencies so far this year, in spite of the meek performance of oil over this timeframe. This surge might prove unsustainable in the short term, as USD/NOK is very close to oversold territory. In the long term, the outlook for the NOK is more positive, particularly against other commodity currencies. Rising oil prices resulting from the OPEC cuts should supercharge the already high inflationary pressures in the Norwegian economy. This factor will eventually push the Norges Bank off its dovish bias, and the NOK higher in the process. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy seems to be finally benefitting from last year's weaker krona; PPI numbers came in at 2.1% MoM, and 6.5% YoY, higher than previous numbers. This will feed into CPI in the near future. Additionally, 1-year, 2-year, as well as the important 5-year Prospera Inflation Expectations have all picked up, with the 5-year at 2%, in line with the Riksbank's target. The bank is aware of the krona's recent strength against major currencies, and realizes that it is important that the appreciation slows. In the short term, the SEK could continue to rally on the back of the dollar's correction and the Swedish economic outperformance vis-à-vis the euro area. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades