Yield Curve

Dear Client, This is our final publication for the year. We will be back on January 5th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Prosperous New Year! Best regards, Peter Berezin, Chief Global Strategist Highlights Global bonds have sold off in recent days, but the spread between long-term and short-term Treasury yields remains well below where it was at the start of the year. A flatter Treasury yield curve suggests that the ongoing U.S. business-cycle expansion is getting long in the tooth. Nevertheless, three factors dilute the potentially bearish message from the curve. First, the yield curve has flattened largely because short-term rate expectations have risen thanks to better economic data. Second, both the 10-year/2-year and 10-year/3-month spreads are still above levels that have foreshadowed poor returns for risk assets in the past. This is particularly true for equities. Third, a structurally low term premium has distorted the signal from the yield curve. The U.S. yield curve is likely to steepen over the next six months, before flattening again in the lead-up to a recession in late-2019. We reveal the One Number that will kill bitcoin. Feature A Harbinger Of Recession? The U.S. yield curve has steepened in recent days, but is still much flatter than it was at the start of the year. The 10-year/3-month spread currently stands at 113 bps, down 84 bps year-to-date. The 10-year/2-year spread has fallen from 125 bps to 62 bps. Numerous academic studies have highlighted the importance of the yield curve as a leading indicator of recessions.1 In fact, every U.S. recession over the past 50 years has been preceded by an inverted yield curve (Chart 1). Chart 1An Inverted Yield Curve Has Often Been A Harbinger Of A Recession The converse has generally been true as well: Most inversions in the yield curve have coincided with a recession. The only two exceptions were in 1967 - when credit conditions tightened and industrial production decelerated, but the U.S. still managed to avoid succumbing to a recession - and in 1998, when the yield curve briefly inverted during the LTCM crisis. Considering that recessions and equity bear markets typically overlap (Chart 2), it is not surprising that investors have begun to fret about what a flatter yield curve may mean for their portfolios. Chart 2Recessions And Bear Markets Usually Overlap Don't Worry... Yet Chart 3U.S. Growth Expectations Revised Higher We would not be as dismissive of a flatter yield curve as Fed Chair Yellen was during her December press conference. Policymakers and investors alike have been too quick to downplay the signal from the yield curve in the past. In 2006, they blamed the "global savings glut" for dragging down long-term yields. In 2000, they argued that the federal government's budget surplus was reducing the supply of long-term bonds. In both cases, the bond market turned out to be seeing something more ominous than they were. That said, there are three reasons why we would discount some of the more bearish interpretations of what a flatter yield curve is telling us. First, the flattening of the yield curve has occurred mainly because of an increase in short-term rate expectations, rather than a decrease in long-term bond yields. The increase in rate expectations has been largely driven by stronger growth data. The economic surprise index has surged far into positive territory and analysts are now scrambling to revise up their 2018 and 2019 U.S. GDP growth projections (Chart 3). The Fed now sees growth of 2.5% in 2018 and an unemployment rate of 3.9% by the end of next year. Back in September, the Fed expected growth of 2.1% and an unemployment rate of 4.1%. Second, our research suggests that the slope of the yield curve only becomes worrisome for the economy when it falls to extremely low levels. This conclusion is reinforced by the New York Fed's Yield Curve Recession Model, which uses the difference between 10-year and 3-month Treasury rates to estimate the probability of a U.S. recession twelve months ahead.2 The model's current recession probability stands at a modest 11% (Chart 4). The last three recessions all began when the implied probability was over 25%. Chart 4NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low Third, the slope of the yield curve is weighed down by a structurally low term premium. The term premium measures the additional return investors can expect to receive by locking in their money in a 10-year Treasury note instead of rolling over a short-term Treasury bill for an entire decade. Historically, the term premium has been positive. Over the past few years, however, it has often been negative - meaning that investors have been willing to pay a premium to take on duration risk. Many commentators have attributed this peculiar state of affairs to central bank asset purchases, which they claim have artificially depressed long-term bond yields. There is some truth to this, but we think there is an even more important reason: Bonds today provide a good hedge against bad economic news. When fears of an economic slowdown mount, equities tend to sell off, while bond prices rise. This differs from the circumstances that existed in the 1970s and 1980s, when bad economic news usually meant higher inflation. To the extent that long-term bonds now serve as insurance policies against recessions, investors are more willing to accept the lower yields that they offer. Empirically, one can see this in the shift of the correlation between equity returns and bond yields. It was strongly negative up until the mid-1990s. Now it is strongly positive (Chart 5). A low term premium implies that the slope of the yield curve should be structurally flatter. That is exactly what we see today. Chart 6 shows that the 10-year/3-month spread would be well above its long-term average if the term premium were removed from the picture. This implies that investors have little to fear from the shape of today's yield curve, at least over the next six-to-twelve months. Chart 5Bond Prices Now Tend To Rise When Equity Prices Go Down Chart 6Stripping Out The Term Premium,##BR##The Yield Curve Is Not So Flat Rising Odds Of A Recession In Late-2019 Beyond then, things start to get dicey. The Fed's end-2018 unemployment rate projection of 3.9% is 0.7 percentage points below its long-term estimate of the unemployment rate. This means that at some point in the future, the Fed will need to lift interest rates above their "neutral" level in order to push the unemployment rate up to its equilibrium level. That's a risky gambit. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing (Chart 7). Modern economies are subject to feedback loops. Once economic conditions begin to deteriorate, households cut back on spending. This leads to less hiring and even less spending. Bad economic news begets worse news. Chart 7Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Implications For Equities And Credit A flatter Treasury yield curve suggests that the U.S. business cycle is entering the home stretch. Nevertheless, as we pointed out two weeks ago, the 7th-to-8th innings of business-cycle expansions are often the juiciest for equity investors (Table 1).3 Table 1Too Soon To Get Out Chart 8 shows that the term spread today is still at levels that have signaled positive equity returns in the past. In fact, today's term spread is close to levels that prevailed in the second half of the 1990s, a period that coincided with the greatest bull market in American history. This message is echoed by our forthcoming MacroQuant model, which continues to flag upside risks for stocks over the next 6-to-12 months (Chart 9). Chart 8Current Term Spread Is Still Pointing##BR##To Positive Equity Returns Chart 9MacroQuant Still Positive##BR##On The Stock Market Globally, we favor euro area and Japanese equities (in local-currency terms) in the developed market sphere due to our expectation that the euro and yen will depreciate somewhat next year. Both the euro area and Japan also have greater exposure to cyclical sectors. This fits with our bias towards owning cyclicals over defensive stocks. Today's term spread is a bit more worrying for corporate credit. As our bond strategists have noted, a flatter yield curve is consistent with lower, though still positive, monthly excess returns for high-yield bonds (Chart 10).4 Again, the second half of the 1990s provides a potentially useful template: Despite a sizzling stock market, high-yield spreads actually widened as corporations loaded up on debt (Chart 11). The deterioration in our Corporate Health Monitor over the past five years suggests that a similar dynamic may be afoot (Chart 12). Chart 10Junk Monthly Excess Returns##BR##And The Yield Curve Chart 11Second Half Of 1990s: When High-Yield Spreads##BR##Rose With Stock Prices Chart 12Corporate Health Has##BR##Been Deteriorating Yield Curve Should Steepen Over The Coming Months Of course, much depends on what happens to the yield curve going forward. We suspect that it will flatten again towards the end of next year. However, it is likely to steepen over the next six months. U.S. GDP growth will remain above trend next year, as wages start to rise more briskly and firms boost capital spending to meet rising demand for their products. Fiscal policy should also help. Tax cuts will lift growth by 0.2%-to-0.3% in 2018. Higher disaster relief efforts following the hurricanes and a pending agreement to raise caps on discretionary spending will also translate into increased federal government spending. Investors have largely overlooked this source of fiscal stimulus, but increased spending will contribute almost as much to growth next year as lower taxes. Unfortunately, all this additional growth, coming at a time when the output gap is all but closed, is likely to stoke inflationary pressures. Our Pipeline Inflation Pressure Index has risen sharply since early 2016, while the ISM prices paid index has shot up. The New York Fed's Underlying Inflation Gauge has accelerated to an 11-year high of 3% (Chart 13). Historically, rising inflation expectations have led to a steeper yield curve (Chart 14). The implication is that investors should favor inflation-linked securities over government bonds. Chart 13U.S. Inflation Pressure Are Building Chart 14Rising Inflation Expectations Lead To A Steeper Yield Curve The One Number That Will Kill Bitcoin In a normal world, most reasonable people would regard a flatter yield curve and continued weak inflation readings as evidence that fiat money was, if anything, doing too good a job as a store of value. However, nothing is normal or reasonable about bitcoin.5 Chart 15Governments Will Want Their Cut:##BR##U.S. Seigniorage Revenue No one knows when the bitcoin bubble will burst. Only a tiny fraction of the public owns the virtual currency. The value of all bitcoin in circulation represents 0.35% of global GDP. At its peak in 1996, the value of all pyramid scheme assets in Albania amounted to almost half of GDP. Never underestimate the lure of easy money. While we do not know where the price of bitcoin will be ten months from now, we do have a good guess of where it will be ten years from today. And that price is zero, or thereabouts. When the U.S. Treasury issues a $100 bill, it gains the ability to buy $100 of goods and services with it. The government's cost is whatever it pays to print the bill, which is next to nothing. This so-called "seigniorage revenue" is set to reach $100 billion this year (Chart 15). That is the number that will kill bitcoin. There is no way the U.S. government will forsake this revenue in order to make room for bitcoin and other cryptocurrencies. Not when there are entitlements to pay and gaping budget deficits to finance. A variety of other countries have a love-hate relationship with bitcoin, partly because of their "the enemy of my enemy is my friend" attitude towards the dollar. But that will change when they see their tax bases eroding as more commerce gets done in the anonymous world of cryptocurrencies. Bitcoin's days are numbered. The only question is who will be holding the bag when the party ends. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see Jonathan H. Wright, "The Yield Curve And Predicting Recessions," FEDs Working Paper No. 2006-7, May 3, 2006; Michael Owyang, "Is the Yield Curve Signaling a Recession?"Federal Reserve Bank Of St. Louis, March 24, 2016; and Arturo Estrella and Mishkin, Frederic S., "The Yield Curve as a Predictor of U.S. Recessions," Federal Reserve Bank Of New York, (2:7), June 1996. 2 Please see "The Yield Curve As A Leading Indicator: Probability of U.S. Recession Charts," Federal Reserve Bank Of New York. 3 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017. 4 Please see U.S. Bond Strategy, "Proactive, Reactive Or Right?" dated December 12, 2017. 5 Please see European Investment Strategy Weekly Report, "Bitcoins And Fractals," dated December 21, 2017; Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" dated December 12, 2017; Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Technology Sector Strategy Special Report, "Blockchain And Cryptocurrencies," dated May 5, 2017. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

This will be the last U.S. Bond Strategy report of the year. The next publication will be on January 9 with our Portfolio Allocation Summary for January 2018. Until then we extend our best wishes for a wonderful holiday and a Happy New Year. Highlights Duration: Rising core inflation will cause the nominal 10-year Treasury yield to increase, driven mostly by the inflation component. We target a range of 2.80% to 3.25% for the nominal 10-year Treasury yield by the time that core inflation is back close to the Fed's target, likely sometime in the middle of 2018. Yield Curve: The yield curve will steepen modestly during the next six months as inflation recovers and the Fed lifts rates only gradually. This mild steepening will transition to flattening once long-maturity TIPS breakeven inflation rates have recovered to pre-crisis levels. Credit Cycle: Our indicators suggest that we are moving into the late stages of the credit cycle, but for now we retain an overweight cyclical stance on corporate bonds. A shift to a more restrictive monetary policy, tightening C&I bank lending standards and/or a continued uptrend in gross corporate leverage are the main catalysts we will be monitoring to gauge the end of the cycle. Feature Chart 1Fed Sees Stronger Growth In 2018 As was widely anticipated, the Fed delivered the fifth rate hike of the cycle last week, bringing the target range for the fed funds rate up to 1.25% to 1.5%. What's more, neither the Summary of Economic Projections nor Janet Yellen's final post-meeting press conference gave much indication that the Fed is worried enough about inflation to deviate from its current pace of tightening. To wit, the Fed did not alter its median projections for inflation or the near-term pace of rate hikes. As in September, the Fed still expects core PCE inflation to rise from its current 1.45% to 1.9% by the end of 2018. It also still expects to lift rates three more times next year. However, the Fed did respond to recent strong growth and employment data by revising its projection for GDP growth higher and its projection for the unemployment rate lower (Chart 1). It also revised the post-meeting statement to indicate that it now believes the economy has reached full employment. In other words, the Fed believes there is no longer any slack in the labor market. This dichotomy between stronger growth and a tight labor market on the one hand and low inflation on the other gets to the heart of the first big challenge that incoming Fed Chairman Jay Powell will face next year. Specifically, how much faith should the Fed have in its framework for forecasting inflation? Chart 2 shows that Janet Yellen's Phillips Curve model of core inflation does not explain this year's decline.1 It also shows that inflation is close to 0.5% below fair value, almost the largest deviation since 1995 (Chart 2, panel 2). It is this deviation that prompted Chair Yellen to say the following at last week's press conference: [W]e've had an undershoot of inflation for a number of years. We absolutely recognize that. I think until this year [the] undershoot was understandable. In other words, until this year the Fed's model did a good job of explaining low inflation. But now that a large residual has opened up between inflation and the Fed's model, it is reasonable for both the market and the Fed to question whether the underlying relationship between inflation and economic growth has changed. The market has already rendered its verdict in the affirmative. The compensation for inflation priced into the 10-year Treasury yield is only 1.88%. Historically, a level between 2.4% and 2.5% suggests the market has faith in the Fed's 2% inflation target. Further, the yield curve has been flattening dramatically. The 2/10 Treasury slope is down to 51 bps, and the fed funds/10-year slope is down to 94 bps. In other words, the bond market is discounting that the Fed can only deliver another 3-4 rate hikes before the economy starts to struggle, at which point inflation will still be below target. The recent revisions to the Fed's own economic projections also suggest that the perceived relationship between economic growth and inflation has weakened. The Fed revised its projection for GDP growth higher and its projection for the unemployment rate lower, but left its projections for inflation and the fed funds rate unchanged. This can only mean that the Fed views the relationship between economic growth and inflation as having weakened since September. So how much longer can the Powell Fed tighten policy without inflation actually trending higher? This is the single biggest question for bond markets and we detailed the three possible answers in last week's report.2 The most likely scenario is that the Fed's Phillips Curve model starts to work again next year. Core inflation trends higher and this eases the flattening pressure on the yield curve allowing the Fed to continue tightening. In support of this outcome, pipeline inflation measures have hooked up in recent weeks, suggesting that core inflation is about to bottom (Chart 3). Chart 2The Fed's Inflation Model Chart 3Pipeline Inflation Measures However, in the scenario where inflation does not move higher, the next most likely outcome is that risk assets sell off in the next couple months. This would lead to a tightening of financial conditions and would cause the Fed to react by adopting a more dovish policy stance. We showed in last week's report that risk off episodes in junk spreads become more frequent once the 2/10 Treasury slope breaks below 50 bps. It is also possible that the Fed proactively adopts a more dovish policy stance without having its hand forced by tighter financial conditions, but this now seems like the least likely outcome. Implications For Treasury Yields In the most likely scenario where core inflation trends higher during the next six months, Treasury yields will rise driven mostly by the inflation component (Chart 4). A return to the range of 2.4% to 2.5% on the 10-year TIPS breakeven inflation rate would put between 52 bps and 62 bps of upward pressure on the nominal 10-year Treasury yield. This means that even if the real 10-year yield remains flat we should see the nominal 10-year yield in a range between 2.87% and 2.97% by the time that core inflation gets back to the Fed's target. But even a flat real 10-year yield seems like a fairly conservative assumption. We can think of the real 10-year yield as being driven by three main factors: (i) the fed funds rate itself, (ii) expectations for future changes in the fed funds rate and (iii) a term premium. In Chart 5 we show that a simple model based on these three factors does a good job explaining the fluctuations in the real 10-year Treasury yield.3 Chart 4Market Not Priced For Rising Inflation Chart 5A Simple Model Of The Real 10-Year Treasury Yield The model works better prior to the Great Recession because we deliberately chose pre-crisis coefficients for our three independent variables. Chart 6 shows the coefficients for the three variables estimated over rolling 5-year intervals, and the dashed horizontal lines show the coefficients we chose for our model. It is clear from Chart 6 that the zero-lower bound caused the estimated coefficient on the fed funds rate to decrease and the estimated coefficient on the 12-month discounter to increase. We expect both will converge slowly back toward pre-crisis levels now that the fed funds rate is well off the zero bound. Chart 6Controlling For The Zero Lower Bound The key conclusion from this modeling exercise is that, even with fairly conservative assumptions, it is difficult to craft a reasonable scenario where the real 10-year Treasury yield declines during the next 12 months. The forecast in Chart 5 assumes that the Fed lifts rates three times next year - consistent with its median projections - but also that rate hike expectations fall so that by the end of 2018 the market only expects one further rate hike during the next 12 months. Finally, we assume that implied interest rate volatility stays flat at historically low levels. Even in that relatively benign scenario our model suggests that the real 10-year Treasury yield would drift higher during the next 12 months. This leads us to project a range of 2.80% to 3.25% for the nominal 10-year Treasury yield by the time that core inflation moves back close to the Fed's 2% target. Implications For The Yield Curve The slope of the yield curve during the next 6-12 months will depend both on how quickly core inflation rises and how quickly the Fed tightens policy. Table 1 shows different scenarios for the fed funds rate, the 2-year/fed funds slope - which can be thought of as the expected number of rate hikes during the next two years - and the 10-year Treasury yield. For example, if core inflation rises back close to the Fed's target by next June and the Fed has only delivered one or two more rate hikes during that time period, then it is very likely that the yield curve will have steepened, at least modestly. If the Fed gets three or four hikes off before inflation gets back to target, then it is much more likely that the yield curve will have flattened. We think a modest curve steepening is the most likely outcome for the next six months. This is premised on the view that core inflation will start to trend higher in the coming months, and will approach the Fed's target by the middle of next year. During that timeframe the Fed will only deliver one or two rate hikes, consistent with its median projection for three hikes in 2018. Once core inflation is back closer to target and the compensation for inflation priced into long-dated Treasury yields is back to its pre-crisis 2.4% to 2.5% range, then aggressive curve flattening becomes much more likely. Table 1Scenarios For The Number Of Fed Rate Hikes By The Time That Inflation Returns To Target Bottom Line: The Fed is playing a dangerous game by continuing to signal a gradual pace of rate hikes in the face of inflation data that have not kept pace with its projections. Ultimately we think the Fed's models will be proven correct during the next six months and core inflation will resume its gradual cyclical uptrend. Rising core inflation will cause the nominal 10-year Treasury yield to increase, driven mostly by the inflation component. We target a range of 2.80% to 3.25% for the nominal 10-year Treasury yield by the time that core inflation is back close to the Fed's target, likely sometime in the middle of 2018. The yield curve will steepen modestly during the next six months as inflation recovers and the Fed lifts rates only gradually. This mild steepening will transition to flattening once long-maturity TIPS breakeven inflation rates have recovered to pre-crisis levels. Credit Cycle Update: Favorable For Now, But Will Turn In 2018 The U.S. Financial Accounts (formerly Flow of Funds) were released this month. This gives us the opportunity to update our Corporate Health Monitor (CHM), as well as our other indicators of non-financial corporate sector leverage. Recall that historically three conditions must be met before the credit cycle turns and a sustained period of corporate spread widening kicks in. They are: Corporate balance sheet health must be deteriorating Monetary policy must be restrictive Bank lending standards must be tightening Chart 7 provides a snapshot of the current state of affairs for these three criteria. Chart 7Credit Cycle Indicators Chart 8Corporate Health Monitor Corporate Balance Sheet Health The CHM is our number one indicator of non-financial corporate sector balance sheet health (Chart 7, panel 2). It has been signaling "deteriorating health" since 2015, but ticked down in the third quarter and has been moving slowly back toward "improving health" territory since the beginning of the year. It is worth mentioning that in order to get a leading signal from our CHM we use de-trended versions of the Monitor's underlying components. The six financial ratios that we combine to calculate the CHM are shown in their not de-trended forms in Chart 8. We also show a not de-trended version of the overall Monitor in the second panel of Chart 7. Notice that while the traditional (de-trended) CHM has been signaling "deteriorating corporate health" since 2015, the not de-trended version remains in "improving health" territory. Box: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole. These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets The unusual length of the current recovery has caused the not de-trended and de-trended versions of the CHM to diverge by much more than in prior cycles. While this almost certainly means that the negative signal from our traditional (de-trended) Monitor came too early this cycle, we should also expect the negative signal from the not de-trended version of our model to arrive too late. So while the truth lies somewhere in between the de-trended and not de-trended versions, we are fairly confident in saying that the condition of "deteriorating corporate health" has already been met for this cycle. Restrictive Monetary Policy Panels 3 and 4 of Chart 7 show two different indicators for the stance of monetary policy. The first is the real effective fed funds rate relative to the Laubach-Williams (2003) estimate of its equilibrium level. According to this measure, monetary policy moved into restrictive territory following last week's rate hike. However, a much simpler indicator for the stance of monetary policy is the slope of the yield curve. While the slope of the yield curve is not flashing red just yet, it has been rapidly flattening and is approaching levels that signaled a restrictive stance of monetary policy in prior cycles. In last week's report we showed that monthly excess returns to high-yield bonds have averaged only 12 bps when the slope of the 2/10 Treasury curve is between 0 bps and 50 bps, and that monthly excess returns have been negative 48% of the time in those periods.4 Tightening Bank Lending Standards The Federal Reserve's most recent Senior Loan Officer Survey showed that banks continue to modestly ease standards on commercial & industrial (C&I) loans (Chart 7, bottom panel). We traditionally view this third condition as more of a confirming indicator of the turn in the credit cycle. That is, tighter bank lending standards are typically preceded by deteriorating corporate health and restrictive monetary policy. An Additional Measure Of Corporate Sector Leverage In addition to the components of our CHM, we also track a measure of gross leverage for the non-financial corporate sector, calculated as total debt divided by EBITD (Chart 9). Historically, the trend in corporate bond spreads has followed the trend in gross leverage, or at the very least, deviations in direction between spreads and leverage have tended not to last very long. Chart 9Rising Gross Leverage Is A Risk For Spreads Our measure of gross leverage ticked higher in Q3, EBITD grew at an annualized rate of 4.1% but this was not enough to offset the 5.4% annualized increase in corporate debt. Overall, gross leverage has been roughly flat this year even though corporate spreads have tightened. Going forward, our leading indicators are still consistent with mid-single digit profit growth. If that view pans out then the pace of debt accumulation will need to fall in order for leverage to decline. We will be watching this measure of leverage closely during the next couple of quarters, if leverage continues to increase then we will be quicker to call the end of the credit cycle. Bottom Line: Our indicators suggest that we are moving into the late stages of the credit cycle, but for now we retain an overweight cyclical stance on corporate bonds. A shift to a more restrictive monetary policy, tightening C&I bank lending standards and/or a continued uptrend in gross corporate leverage are the main catalysts we will be monitoring to gauge the end of the cycle. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 The Phillips Curve model of inflation shown in Chart 2 is re-created from Janet Yellen's September 2015 speech: https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 3 We use our 12-month fed funds discounter to measure rate hike expectations and the MOVE implied volatility index as a proxy for the term premium. 4 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights BCA expects the 2/10 curve to steepen in 1H in 2018, then flatten in 2H. U.S. equities, the stock-to-bond ratio and oil thrive when the curve is flat. Small caps struggle. Record household net worth matters more for household saving than for consumption. Feature Wrangling over the GOP's tax plan and the Federal Open Market Committee's final meeting of 2017 provided the backdrop for financial markets last week. The dollar was the big loser, as investors doubted the ability of the Republican leadership in Congress to find the votes needed to pass the bill. BCA's view remains that Congress will pass a tax cut package by the end of Q1 2018. Even though inflation missed the Fed's forecast in 2017 (Chart 1), the FOMC left its inflation and interest projections unchanged for the next two years given its outlook for stronger growth and lower unemployment. Inflation will reach the 2% target by the end of 2019. As a consequence, the Fed expects to lift interest rates three more times in 2018 and another two times in 2019 (Chart 2). Chart 1Persistent Inflation Shortfall Chart 2The FOMC's Latest Forecasts The economy is now expected to grow 2.5% in 2018, up from the Fed's previous forecast of 2.1%. Growth is seen remaining above the 1.8% trend rate for three years. The Fed nudged its forecasts for the unemployment rate down by 0.2% for the next three years, based on the higher growth projections. The jobless rate is now expected to dip to 3.9% in 2018 and 2019, before ticking up to 4.0% in 2020. If anything, these forecasts look too conservative. Importantly, the Fed left its estimate for long-run unemployment unchanged at 4.6%. Therefore, the labor market is expected to tighten further beyond full employment. Consequently, wage gains should accelerate and allow inflation to return to the Fed's 2% target in 2019. We don't have any major disagreements with the Fed's interest rate forecasts for 2018, but inflation must turn higher. The Fed has raised rates five times over the last two years, but CPI inflation has made no progress toward the 2% objective. However, the New York Fed's Underlying Inflation Gauge continues to move steadily higher (Chart 1, panel 1). Nevertheless, the real Fed funds moved closer to its neutral level and the yield curve has continued to flatten (panel 3). Bottom Line: BCA expects the yield curve to steepen in the first half of 2018, driven either by rising inflation or a more dovish Fed. However, a flat curve is not the death knoll for risk assets. The yield curve will not invert until inflation has recovered to the Fed's target. This means that a period of modest curve steepening is likely, driven either by rising inflation or a more dovish Fed. Powell Versus The Market BCA's view is that the current paths of inflation and the yield curve are unsustainable. If the Fed continues to hike rates, but inflation fails to rise, then the yield curve will invert in the coming months. The inversion would signal that bond investors anticipate a recession and the Fed has not achieved its inflation target. Such an obvious policy error will not be permitted to occur, which leaves three possible outcomes for Fed policy and the Treasury curve during the next six months.1 1) The Fed Is Right In this scenario, inflation would rebound in the coming months, pushing up the compensation for inflation protection embedded in long-dated bond yields. This would cause an increase in long-maturity nominal yields and probably impart a steepening bias to the yield curve, depending on how quickly the Fed lifts rates. BCA's Outlook for 2018 makes a case why inflation will likely bottom in the coming months. Therefore, we view the "Fed is Right" scenario as the most probable outcome.2 2) The Fed Is Proactive In another scenario, the Fed recognizes there is a risk of tightening the yield curve into inversion - and the economy into recession - if inflation stays low. Therefore, the Fed may proactively adopt a more dovish policy stance to prevent the yield curve from inverting. The yield curve would also steepen, but this time it would be a bull-steepener where short-maturity yields fall more than long-maturity yields. This outcome would be the least likely of our three scenarios. The Fed will cling to its forecast that inflation will climb, given that economic growth is accelerating. If inflation fails to respond, then risky assets will eventually sell-off. 3) The Fed Is Reactive The Fed has a strong track record of reacting to tighter financial conditions and risk-off periods in equities and credit markets. If the yield curve continues to flatten, then we will soon see credit spreads widen and equities sell-off. At that stage, the Fed would almost certainly respond by signaling a slower pace of rate hikes. This would steepen the curve and ease pressures on risky assets. We view this development as more likely than the one where the Fed is proactive. Trouble With The Curve BCA's U.S. Bond Strategy team expects that the 2/10 yield curve will languish between 0 and 50 bps in 2018. The curve will steepen from 53 bps in mid-December 2017 through mid-year 2018, and then flatten into year-end. Which asset classes would benefit if BCA's curve call is accurate? Charts 3 through 7 show how several key financial markets have performed in previous yield curve environments. Chart 3A shows that the S&P 500 performs best when the curve is flat (between 0 and 50 bps), with average annualized returns of 22% and median annualized returns of 21%. Moreover, S&P 500 returns are negative less than 5% of the time when the curve is flat, but are negative 25% of the time when the curve is very steep (+100 to +150 bps) (Chart 3B). In general, Chart 3A demonstrates that returns diminish as the curve climbs. Chart 3AS&P 500 Total Return & Yield Curve##BR##(1988- Present) Chart 3BPercent Of Months With Negative##BR##S&P 500 Returns (1988- Present) A flat slope of the 2/10 curve is also the sweet spot for the stock-to-bond ratio (Chart 4A). Treasuries outperform stocks only in 5% of months when the 2/10 Treasury curve is flat (Chart 4B). As with stocks, the performance of the stock-to-bond ratio deteriorates as the curve steepens. The stock-to-bond ratio declines more than a third of the time when the curve is very steep. A 2/10 slope of +100 to +150 bps is the worst backdrop for the stock-to-bond ratio. Stocks underperform bonds 40% of the time in this situation. Chart 4AStock-To-Bond Total Return & Yield Curve##BR##(1988 - Present) Chart 4BPercent Of Months With Negative##BR##Stock-To-Bond Total Return (1988 - Present) However, a flat curve is a poor setting for small-cap excess performance (Chart 5A). Small caps underperform large caps nearly 80% of the time when the curve is flat (Chart 5B). The average underperformance is 600 bps. Moreover, a flat curve is the most unhealthy climate for small-cap excess returns, even poorer than when the curve inverts. A precipitous curve is the best environment for small caps, with small caps outperforming large by 400 bps on average. Small caps beat large caps 60% of the time when the curve is between 100 and 150 bps. Chart 5AS&P Small/Large TOTAL Return & Yield Curve##BR##(1988- Present) Chart 5BPercent Of Months With Negative##BR##S&P Small/Large Total Return (1988- Present) Our U.S. Bond Strategy colleagues note that the flatter the curve, the higher the risk of a sell-off in high-yields relative to Treasuries.3 Junk bonds underperform Treasuries 48% of the time when the curve is flat, which we expect in 2018 (not shown). The implication for investors is that the first half of 2018 will be the best period for junk bond returns. Investment-grade corporates have a similar return profile relative to the curve. Oil performs best when the 2/10 curve is inverted (Chart 6A). However, WTI oil returns an annualized 10-15% when the curve is between 0 and 100 bps. Plus, oil is higher 75% of the time when the curve is between 50 and 100 bps, which is the environment we expect in the first half of next year (Chart 6B). Chart 6AWTI Crude Oil Price Return & Yield Curve##BR##(1988- Present) Chart 6BPercent Of Months With Negative##BR##WTI Crude Oil Price Return (1988- Present) Forward earnings per share perform well with a flat curve, but earnings growth is optimal when the curve is inverted. The steeper the curve, the bigger the headwind for EPS. Since 1988, earnings growth has been positive when the curve inverts and is positive 95% of the time when the curve is flat. Chart 7 provides the historical context for a flat yield curve (0 to 50 bps) in terms of the performance of stocks, Treasury bonds, the stock-to-bond ratio, small caps and oil. The Appendix (see page 13) also includes three other charts that provide a perspective on asset class performance when the curve is moderately steep (50 to 100 bps), steep (100 to 150bps) and above 150 bps. Chart 7Stocks, Treasuries, Small Caps And Oil When The Curve Is Flat Bottom Line: BCA expects that the yield curve will first steepen in 2018, then become flatter, ultimately spending most of the year between 0 and 50 bps. A flat curve is the ideal environment for the S&P 500 and the stock-to-bond ratio. However, small cap stocks struggle when the curve is flat; BCA's view is that small caps will outperform large caps in 2018. A flat yield curve raises the risk of a sell-off in high yield, but provides a favorable grounding for oil, which is in line with BCA's fundamental view. BCA expects EPS growth will be positive next year; earnings growth is higher 75% of the time when the curve is flat. Household Net Worth Loses Influence Chart 8The Consumer Is In Good Shape U.S. consumer health has improved markedly since early this year, driving BCA's Consumer Health Indicator into positive territory (Chart 8). These elevated readings should bolster household consumption well into 2018. The improvement supports BCA's view of a stronger U.S. economy alongside a global synchronized recovery, at least over the next 12 months. Real consumer spending is underpinned by advances in real disposable income stemming from increasingly healthy labor market. Moreover, household net worth has continued to soar to an all-time high in 2017Q3 as equity markets remain frothy and house prices stable. However, net worth's direct influence on overall household consumption is not as significant as before the Great Recession. During the housing bubble in the early 2000s, U.S. households leveraged their spending through extensive mortgage refinancing and mortgage equity withdrawal. Real estate was the principal holding on most households' balance sheets. However, as the Great Recession unfolded, household net worth suffered with a collapse in both house prices and equity markets. By 2009, U.S. households were tapped out and grossly over-indebted. Deleveraging is now over, U.S. households have re-fortified their balance sheets and consumer spending is back in line with income growth. In the long term, inflation-adjusted disposable income is more highly correlated with inflation-adjusted consumer spending growth than real household net worth (Chart 9). Positive momentum should continue to support further real consumer spending over the next few quarters, given that unemployment is at a 17-year low and consumer confidence is at a 17-year high, and also given elevated consumers' expectations of real income gains over the next year or two. Chart 9Consumer Spending More Correlated With Income Than Net Worth Household net worth matters more for household saving than for consumption. Chart 10 shows the inverse relationship between net worth and the saving rate. Empirical research has demonstrated the risk that the structural decline (since the mid-1990s) in personal savings has on consumer spending and the overall economy. An often cited conclusion drawn by the investment community is that a lower savings rate raises the risk of consumer retrenchment.4 Chart 10Low Savings Rate, Record High Household Net Worth And Rising Income Expectations Even though the personal savings rate can be considered a contrarian measure for consumer spending, like many measures from the BEA national accounts (NIPA), it is subject to regular revisions. Over the long-term, according to the BEA, the level of the savings rate is often revised upwards but the trend over the last 45 years remains unchanged. There was a downtrend path to revisions in the mid-2000s housing bubble, but there has been a subtle uptrend since 2008 (Chart 11). Even so, in the long run, BCA views the low personal savings rate as a potential headwind for consumer spending as it cannot sustainably remain at its recovery low of 3.2%. However, rising income expectations and a sturdy labor market are offsets to depressed savings and will ensure that the economic expansion remains sustainable and, therefore, less vulnerable to volatile saving patterns. Does record high net worth alter the risks to the FOMC's goals of price stability and sustainable economic growth? In a recent research paper, the Federal Reserve of St-Louis looked at the most exuberant peaks in the ratio of household net worth to income in 1999 and 2006, which occurred before collapses in asset prices and recessions. Although caution is prescribed as household net worth keeps making new highs, the report noted that the composition of households' balance sheet is less alarming today than prior peaks, as equities and real estate relative to household income or total assets are more reasonable. Debt levels are also much more tame today than in 2006. With more immune balance sheets, households may be less vulnerable to unexpected shocks in the future (Chart 12).5 BCA's view is that financial vulnerabilities from the household sector are well contained. Outside of subprime auto loans, household borrowing is increasing modestly at an annual pace of 3.6%, in stark contrast with a 12.9% rate in the early-to-mid 2000s. Broad measures of household solvency, such as the household debt-to-income ratio, is within the range of the past few years and back to pre-recession levels. Furthermore, liquidity buffers (liquid assets to liabilities) are almost as high as the levels that preceded the equity market boom/bust in 1999-2000 (Chart 13). Chart 11Savings Rate Level Often Revised Upwards Chart 12Household Sector Balance Sheet Composition Chart 13Household Sector Buffers Are Solid BCA expects the Fed to remain vigilant about financial stability.6 Policymakers will take comfort that household liquidity and solvency ratios have improved dramatically in the past nine years, aided by the cumulative gains in housing and financial assets. Bottom Line: The outlook for the U.S. consumer is bright as incomes continue to improve amid tight labor market conditions. However, record household net worth is more relevant today for savings than for consumption. The Fed should remain committed to gradual rate hikes, but the central bank's quandary will be to determine the optimal pace to foster maximum employment and price stability. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?," published on December 12, 2017. Available at usbs.bcaresearch.com. 2 Please see BCA Research's "2018 Outlook Policy And The Markets: On A Collision Course ," published December 2017. Available at bca.bcaresearch.com. 3 Please see BCA Research's U.S. Bond Strategy Weekly Report "Proactive, Reactive Or Right?," published on December 12, 2017. Available at usbs.bcaresearch.com. 4 "Should The Decline In The Personal Savings Rate Be A Cause For Concern?", Alan C. Garner, The Federal Reserve Bank of Kansas City, 2006Q2; and "The Decline in the U.S. Personal Savings Rate: Is It Real and Is It A Puzzle?", Massimo Guidolin and Elizabeth A. La Jeunesse, The Federal Reserve Bank of St-Louis, November/December 2007. 5 "Household Wealth Is At A Post-WW II High: Should We Celebrate or Worry?", William R. Emmons and Lowell R. Ricketts, Federal Reserve Bank of St-Louis, In the Balance, Perspectives on Household Balance Sheets, May 2017. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Powell's In Power," published on November 6, 2017. Available at usis.bcaresearch.com. Appendix Chart 14U.S. Financial Markets When The 2/10 Curve Is Between 50 And 100 Bps Chart 15U.S. Financial Markets When The 2/10 Curve Is Between 100 And 150 Bps Chart 16U.S. Financial Markets When The 2/10 Curve Is Steeper Than 150 Bps

Highlights Yield Curve & Fed: The yield curve will not invert until inflation has first recovered to the Fed's target. This means that a period of curve steepening is likely, driven either by rising inflation or a more dovish Fed. Corporate Sectors: Expect less extra compensation from increasing the riskiness of corporate bond portfolios in 2018. The Energy, Communications, Basic Industry, Financial and Technology sectors offer the best risk-adjusted value. Economy & Inflation: All signs are that economic growth has accelerated in recent months. Decelerating consumer credit growth and rising consumer delinquency rates do not yet pose a risk to future spending. Feature Long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. [...] The broadly anticipated behavior of world bond markets remains a conundrum. - Alan Greenspan, February 20051 By the end of the week the Fed will have raised interest rates by 125 basis points since December 2015, yet the 10-year Treasury yield has risen only 7 bps (Chart 1). But unlike in 2005, there is no bond conundrum. On the contrary, the reason for low long-maturity Treasury yields is easily understood. Chart 1What Conundrum? Quite simply, the Federal Reserve has been lifting interest rates in-line with its projections for rising inflation, but markets are trading off the fact that this inflation has yet to materialize. The compensation for inflation protection embedded in 10-year yields is only 1.88%. Historically, when core inflation is close to the Fed's 2% target, compensation for inflation protection has traded in a range between 2.4% and 2.5%. Essentially, Fed rate hikes have lifted short-maturity yields but low inflation is keeping long-maturity yields depressed. The result is that the 2/10 Treasury slope has flattened all the way down to 58 bps from 128 bps in December 2015 (Chart 1, bottom panel). What should be clear is that the current paths of inflation and the yield curve are unsustainable. If the Fed continues to hike rates but inflation fails to rise, then the yield curve will invert in the coming months - a signal that bond investors anticipate a recession - and the Fed will have not achieved its inflation target. Such an obvious policy error will not be permitted to occur, which leaves us with three possible outcomes for Fed policy and the Treasury curve during the next six months. 1) The Fed Is Right In this scenario inflation starts to rebound in the coming months, pushing the compensation for inflation protection embedded in long-dated bond yields higher (Chart 2). This would certainly cause long-maturity nominal yields to increase and would probably impart a steepening bias to the yield curve, depending on how quickly the Fed lifts rates.2 BCA's Outlook for 2018 makes the case for why inflation is likely to bottom in the coming months, and we view the "Fed is Right" scenario as the most likely outcome.3 Chart 2Fed Expects Higher Inflation 2) The Fed Is Proactive In this scenario the Fed recognizes there is a risk of tightening the yield curve into inversion - and the economy into recession - if inflation stays low. It therefore proactively adopts a more dovish policy stance to prevent the yield curve from inverting. The likely first step would be signaling a slower pace of rate hikes in this week's Summary of Economic Projections. The yield curve would also steepen in this scenario, but this time a bull-steepening where short-maturity yields fall more than long-maturity yields. At least one FOMC member already seems worried enough to take this sort of action. St. Louis Fed President James Bullard said two weeks ago that: "Given below-target U.S. inflation, it is unnecessary to push normalization to such an extent that the yield curve inverts".4 But other policymakers are less concerned. Cleveland Fed President Loretta Mester downplayed the flat yield curve in a recent interview.5 We view this outcome as the least likely of our three scenarios. With economic growth accelerating (see Economy & Inflation section below), the Fed will likely cling to its forecast that inflation will move higher. If inflation fails to respond, then risky assets will eventually sell off. This brings us to the final scenario. 3) The Fed Is Reactive The Fed does not have a strong track record of proactively responding to low inflation readings, but it does have a strong track record of reacting to tighter financial conditions and risk off periods in equities and credit markets. What's more, if the yield curve continues to flatten, then we are very likely to see credit spreads widen and equities sell off quite soon. At that point the Fed would almost certainly respond by signaling a slower pace of rate hikes. That would steepen the curve and ease the pressure on risky assets. We view this third scenario as more likely than the one where the Fed is proactive. In fact, we observe that the yield curve is already flat enough that the chances of a sell-off in High-Yield corporate bonds relative to Treasuries are high. Using monthly data going back to 1988, we see that a flatter 2/10 Treasury slope is consistent with lower monthly excess returns from High-Yield (Chart 3). We also see that a flatter yield curve is consistent with more frequent risk-off periods (Chart 4). Chart 3Junk Monthly Excess Returns & ##br##Yield Curve (1988-Present) Chart 4% Of Months With Negative High-Yield ##br##Excess Returns (1988- Present) This makes sense intuitively. An inverted yield curve is a well-known recession indicator. This means that when the yield curve is very flat investors are obviously nervous that any new piece of bad news could tip the curve into inversion and signal an end to the economic recovery. In other words, a risk-off episode in junk bonds, like the one witnessed in early November, would be less likely to occur if the yield curve were steeper.6 We would recommend buying the dips on any near-term correction in junk bonds, because the Fed would then be forced to get more dovish and support the credit markets. But unless inflation returns and steepens the Treasury curve from current levels, the risk of just such an episode is high. Corporate Sector Year-In-Review With 2017 nearly in the books, this week we take a quick look back at the performance of the 10 main investment grade corporate bond sectors during the year. Chart 5 shows the excess return for each sector relative to its duration-times-spread (DTS) from the beginning of the year. DTS is a common measure of risk for corporate bonds, and can be thought of much like an equity's beta. When the overall corporate bond market is rallying, then high-DTS sectors tend to perform better. Conversely, when corporate bonds underperform Treasuries, then high-DTS sectors tend to lose more than the low-DTS alternatives. As can be seen in Chart 5, given that 2017 was a risk-on year, high-DTS sectors tended to outperform low-DTS sectors with a few exceptions. The Basic Industry sector and Financials performed much better than their DTS alone would have predicted, while the Communications sector performed much worse than its DTS would have predicted. Looking ahead into 2018, we make the following observations: Excess returns for investment grade corporate bonds are likely to be lower in 2018 than in 2017.7 In turn, this means that the Credit Risk Premium - the extra return earned for taking an additional unit of DTS risk - will also be lower. We calculated the Credit Risk Premium for each year since 2000 by performing a regression of annual excess returns for each of the 10 major sectors versus their beginning-of-year DTS. The beta from that regression represents the additional return earned that year from taking an extra unit of DTS risk. Chart 6 shows that this Credit Risk Premium is an increasing function of excess returns for the overall corporate sector. Logically, if the year ahead is likely to deliver lower excess returns for the overall index, then we should also expect less additional return from increasing the DTS risk of our corporate bond portfolios. Chart 52017 Corporate Sectors ##br##Excess Returns* Vs DTS** Chart 6Excess Returns* Vs ##br##Credit Risk Premium Second, we use our corporate sector model - a model that adjusts each sector's spread by its average credit rating and duration - to identify sectors that have the potential to outperform their DTS in the coming months. This model is updated each month in our Portfolio Allocation Summary.8 The most recent update shows that the high-DTS Energy, Basic Industry and Communications sectors are all attractively valued. The most attractive low-DTS sectors are Financials and Technology (Chart 7). Chart 7Risk-Adjusted Value In Corporate Sectors* Bottom Line: Expect less extra compensation from increasing the riskiness of corporate bond portfolios in 2018. The Energy, Communications, Basic Industry, Financial and Technology sectors offer the best risk-adjusted value. Economy & Inflation Does Consumer Credit Growth Put The Recovery At Risk? Last week's employment report showed a sharp increase in aggregate hours worked and suggests that U.S. economic growth has indeed shifted into a higher gear. We use a combination of year-over-year growth in aggregate hours worked and average quarterly productivity growth since 2012 to get a rough tracking estimate for U.S. real GDP growth. After last Friday's report this proxy is up to a healthy 3.1% (Chart 8). Last Friday's Consumer Sentiment data also suggest that consumer spending, the largest component of U.S. GDP, will stay firm in the coming months (Chart 9). While consumer credit growth has started to slow (Chart 9, panel 2) and consumer delinquencies are starting to rise (Chart 9, bottom panel), we are not yet inclined to view those trends as risks to the economic recovery. Chart 8Growth Tracking Well Above Trend Chart 9Credit Growth Falling & Delinquencies Rising First, notice that prior to the onset of recession, consumer spending growth tends to decline while consumer credit growth accelerates. It is only well after the recession begins that consumer credit growth follows spending growth lower. This chain of events is highly logical. In the late stages of the recovery households first start to see their incomes decline and then turn to credit to support their spending needs. Eventually, banks make consumer credit less available and consumer credit growth also decelerates, but we are already well into the recession by then. Chart 10Bank Lending Standards In fact, judging by the patterns observed in the lead up to the last two recessions, the warning sign for the economic recovery would be if consumer credit growth is rising while consumer spending growth is falling. So far this pattern has not been observed. Potentially more troubling is the increase in the consumer credit delinquency rate. Delinquencies do tend to rise prior to the onset of recession, although at the moment delinquencies are rising off an extremely low base. It is possible that after having kept lending standards very stringent for several years after the Great Recession, an uptick in delinquencies off historically low levels simply reflects a return to "business-as-usual" for banks. In fact, the Federal Reserve's Senior Loan Officer Survey showed a large tightening of consumer lending standards during the crisis, but then a moderate easing from 2010 until quite recently (Chart 10). Further, the most recent Senior Loan Officer Survey showed an increase in banks' willingness to extend consumer installment loans. Historically, this has been associated with falling consumer delinquency rates (Chart 10, bottom panel). Bottom Line: All signs are that economic growth has accelerated in recent months. Decelerating consumer credit growth and rising consumer delinquency rates do not yet pose a risk to future spending. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm 2 For a look at what different combinations of Fed rate hikes and long-maturity yields mean for the slope of the yield curve please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 3 Please see BCA Special Report, "Outlook 2018: Policy And The Markets: On A Collision Course", dated November 20, 2017, available at www.bcaresearch.com 4 https://www.stlouisfed.org/from-the-president/speeches-and-presentations/2017/assessing-yield-curve 5 https://www.bloomberg.com/news/articles/2017-12-01/fed-s-mester-shrugs-off-flattening-yield-curve-in-call-for-hikes 6 Please see U.S. Bond Strategy Special Report, "Junk Bond Jitters", dated November 21, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 8 For the most recent update please see U.S. Bond Strategy Portfolio Allocation Summary, "A Higher Gear", dated December 5, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 12017 Bond Returns Treasuries sold off for the third consecutive month in November (Chart 1), and with Congress about to deliver tax cuts and core inflation showing signs of bottoming, the bond bear market is poised to shift into a higher gear. At the moment, the biggest upside risk for bonds is that the Fed continues its hawkish posturing but inflation refuses to comply. That combination would put downward pressure on TIPS breakeven inflation rates and cause the yield curve to flatten further. A flat yield curve increases the odds of a risk-off episode in equities and credit spreads, with a consequent flight into the safety of Treasuries. We do not think the Fed will get it wrong and expect TIPS breakevens to widen alongside rising inflation, easing the flattening pressure on the yield curve. Investors should maintain a below-benchmark duration stance and an overweight allocation to spread product on a 6-12 month investment horizon.   Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 3 basis points in November, dragging year-to-date excess returns down to 285 bps. The average index option-adjusted spread widened 2 bps on the month and now sits at 97 bps. Spreads gapped wider early in the month but then reversed course, ending November not far from where they began. In other words, investment grade corporate bonds remain extremely expensive. We calculate that Baa-rated spreads can only tighten another 39 bps before reaching the most expensive levels since 1989. This represents 3 months of historical average spread tightening. Corporate bonds are essentially a carry trade at this stage of the cycle, but should continue to deliver positive excess returns to Treasuries until inflation pressures mount and the credit cycle comes to an end. We expect the credit cycle will end sometime in 2018.1 Last week's profit data showed that our measure of EBITD increased at an annualized rate of 4% in Q3 (Chart 2), solidly above zero but significantly slower than the 12% registered in Q2. If corporate debt grows by more than 4% in the third quarter, our measure of gross leverage will tick higher (panel 4). As we have shown in prior reports, this would bring the end of the credit cycle closer.2 Quarterly corporate debt growth has averaged just under 6% (annualized) since 2012, so higher leverage in Q3 is likely (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 2 basis points in November, dragging year-to-date excess returns down to 578 bps. The index option-adjusted spread widened 6 bps on the month, and currently sits at 349 bps. Excess returns were negative in November for only the fourth month since spreads peaked in February 2016. In a recent Special Report we argued that last month's sell-off would prove fleeting, but also cautioned that excess returns are likely to be low between now and the end of the credit cycle.3 The report flagged five reasons why investors might be nervous about their high-yield allocations. The two most important being that spreads are very tight and the yield curve is very flat. Tight spreads imply that investors should not expect much in the way of further capital gains, insofar as much further spread tightening would lead to historically expensive valuations. In a baseline scenario where spreads remain flat, we forecast excess returns to junk of 246 bps (annualized) (Chart 3). An inverted yield curve signals that investors believe the Fed will be forced to cut rates in the future. This makes it an excellent indicator for the end of the credit cycle. When the yield curve is very flat investors are more inclined to view any negative development as a signal that the cycle is about to turn. This leads to more frequent sell-offs. A period of curve steepening led by higher inflation would mitigate the risk. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in November, bringing year-to-date excess returns up to 35 bps. The conventional 30-year zero-volatility MBS spread was flat on the month, as a 2 bps widening in the option-adjusted spread (OAS) was offset by a 2 bps decline in the compensation for prepayment risk (option cost). Agency MBS OAS continue to look reasonably attractive, especially relative to Aaa-rated credit. And with the pace of run-off from the Fed's balance sheet already well telegraphed, there is no obvious catalyst for further OAS widening. In addition, mortgage refinancings are unlikely to spike any time soon. This will ensure that nominal MBS spreads remain capped at a low level (Chart 4). If bond yields rise during the next 6-12 months, as we expect, then higher mortgage rates will be a drag on refinancings. However, as we showed in a recent report, even if rates move lower, the coupon and age distribution of outstanding mortgages has made refi activity much less sensitive to rates than in the past.4 All in all, with OAS more attractive than they have been for several years, Agency MBS are an alluring alternative for investors looking to scale back exposure to corporate bonds. We anticipate shifting some of our recommended spread product allocation out of corporate bonds and into MBS once we are closer to the end of the credit cycle, likely sometime in 2018. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 28 basis points in November, bringing year-to-date excess returns up to 221 bps. Foreign Agencies and Local Authorities outperformed the Treasury benchmark by 39 bps and 34 bps, respectively. Meanwhile, Sovereign bonds delivered a stellar 93 bps of outperformance. Domestic Agency bonds outperformed by 4 bps, while Supranationals underperformed by 1 bp. We continue to hold a negative view of USD-denominated Sovereign debt. Not only is valuation unattractive compared to similarly-rated U.S. corporate bonds (Chart 5), but historically, periods of sovereign bond outperformance have coincided with falling U.S. rate hike expectations.5 Our Global Fixed Income Strategy team flagged similar concerns in a recent Special Report on the merits of USD-denominated EM debt (both corporate and sovereign).6 The recent moderation in Chinese money and credit growth also heightens the risk of near-term Sovereign underperformance.7 We remain overweight Local Authorities and Foreign Agencies. Year-to-date, those sectors have delivered 256 bps and 402 bps of excess return, respectively, and continue to offer attractive spreads after adjusting for credit rating, duration and spread volatility. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 19 basis points in November (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio moved sharply higher in November, with short maturities bearing the brunt of the sell-off. But even after November's weakness, the average M/T yield ratio remains below its average post-crisis level, and long maturities continue to offer a significant yield advantage over short maturities. Both the Senate and House have already passed their own versions of a tax bill, which now just need to be reconciled before new tax legislation is signed into law. Judging from the two versions of the bill, the following will likely occur: The Muni tax exemption will be maintained, the top marginal tax rate will remain close to its current level, the corporate tax rate will be reduced substantially, the state & local income tax deduction will be at least partially eliminated, the tax exemption for private activity bonds might be removed, and advance refunding of municipal bonds will be outlawed or severely restricted. Last month's poor Muni performance was driven by a surge in supply (Chart 6), almost certainly issuers trying to get their advance refundings done before the passage of the final bill. Given that the other provisions in the bill should not have a major impact on yield ratios (any negative impact from lower corporate tax rates should be mitigated by stronger household demand stemming from the removal of the state & local tax deduction), this back-up in yield ratios could present a tactical buying opportunity in Munis once the bill is passed. Stay tuned.   Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in November, as investors significantly bid up the expected pace of Fed rate hikes but did not correspondingly increase their long-dated inflation expectations. The sharp upward adjustment in rate hike expectations means that investors are now positioned for 69 bps of rate hikes during the next 12 months (Chart 7). Similarly, the July 2018 fed funds futures contract is now priced for 52 bps of rate hikes between now and next July. Even if the Fed lifts rates in line with its dots, we would only see 75 bps of rate hikes between now and next July. Since there are strong odds that the Fed will proceed more gradually, this week we close our short July 2018 fed funds futures position for an un-levered profit of 21 bps. In a Special Report published last week, we presented several scenarios for the slope of the 2/10 yield curve based on different combinations of Fed rate hikes and future rate hike expectations.8 We also noted that the positive correlation between long-maturity TIPS breakeven inflation rates and the slope of the nominal 2/10 yield curve has remained intact this cycle. We conclude that the 2/10 slope will steepen modestly in the first half of 2018, before transitioning to flattening once TIPS breakevens level-off at a higher level. With the 2/5/10 butterfly spread now discounting some mild curve flattening (panel 4), investors should remain long the 5-year bullet versus the duration-matched 2/10 barbell.   TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 15 basis points in November, bringing year-to-date excess returns up to -84 bps. The 10-year TIPS breakeven inflation rate fell 2 bps on the month and, at 1.86%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. As was detailed in last week's Special Report, one of our key views for 2018 is that core inflation will resume its gradual cyclical uptrend, causing long-maturity TIPS breakeven inflation rates to return to their pre-crisis trading range between 2.4% and 2.5%.9 A wide range of indicators, such as our own Pipeline Inflation Indicator and the New York Fed's Underlying Inflation Gauge, already suggest that TIPS breakevens are biased wider (Chart 8). Even more encouragingly, both year-over-year core CPI and core PCE inflation have printed higher in each of the last two months. But even if inflation remains stubbornly low, we think any downside in long-maturity breakevens will prove fleeting. We are quickly approaching an inflection point where if inflation does not rise, the Fed will have to adopt a more dovish policy stance. A sufficiently dovish policy response would limit any downside in breakevens. According to our model, the 10-year TIPS breakeven inflation rate is currently trading in-line with other financial market variables - oil, the trade-weighted dollar and the stock-to-bond total return ratio (panel 2). ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in November, bringing year-to-date excess returns up to 92 bps. Aaa-rated ABS outperformed the Treasury benchmark by 10 bps and non-Aaa ABS outperformed by 30 bps. The index option-adjusted spread (OAS) for Aaa-rated ABS tightened 3 bps on the month and, at 31 bps, it remains well below its average pre-crisis trading range. The value proposition in Aaa-rated ABS is not what it once was. At 31 bps, the average index OAS is only 1 bp greater than the average OAS for a conventional 30-year Agency MBS. Agency CMBS are even more attractive, offering an index OAS of 44 bps. Further, the credit cycle is slowly turning against consumer debt. Delinquency rates are rising, albeit off a very low base, but this has caused banks to start tightening lending standards on consumer credit (Chart 9). Tight bank lending standards typically coincide with wider spreads. Importantly, while lending standards are tightening they are not yet very restrictive in absolute terms. In response to a special question from the July 2017 Fed Senior Loan Officer's Survey, banks reported (on net) that lending standards are tighter than the midpoint since 2005 for subprime auto and credit card loans, but are still easier than the midpoint since 2005 for credit card and auto loans to prime borrowers. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 1 basis point in November, dragging year-to-date excess returns down to 180 bps. The index option-adjusted spread (OAS) for non-agency Aaa-rated CMBS widened 3 bps in November, but is still about one standard deviation below its pre-crisis average (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we continue to view the risk/reward trade-off in non-Agency CMBS as quite unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 15 basis points in November, bringing year-to-date excess returns up to 112 bps. The index OAS for Agency CMBS tightened 2 bps on the month but, at 44 bps, the sector continues to offer an attractive spread pick-up relative to other low-risk spread product. The Aaa-rated consumer ABS OAS is only 31 bps, and the OAS on conventional 30-year Agency MBS is a mere 30 bps. Such an attractive spread pick-up in a sector that benefits from Agency backing is surely worth grabbing. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.81% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.79%. The Global Manufacturing PMI edged higher once more in November, up to 54 from 53.5 in October. It is now at its highest level since March 2011. Meanwhile, sentiment toward the dollar remains significantly less bullish than it was in 2015 and 2016 (bottom panel). A higher PMI reading and less bullish dollar sentiment both lead to a higher fair value in our model. At the country level, both the Eurozone and Japanese PMIs ticked higher in November. The Eurozone PMI broke above 60 for the first time since April 2000. The U.S. and Chinese PMIs both moved modestly lower. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.39%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Junk Bond Jitters", dated November 21, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Yet Another Update", dated October 10, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 6 Please see Global Fixed Income Strategy Special Report, "Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios", dated October 31, 2017, available at gfis.bcaresearch.com 7 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 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)

Watching The Warning Signals Recommended Allocation Two of the three indicators we have focused on all year as reliable signals of recession (and, therefore, of the timing for reducing exposure to risk assets) have wobbled in the past month. But, for now, we are not too concerned about this, and continue to argue that the current bull market has maybe another year to run, until a possible 2019 recession starts to get priced in. Global growth indicators are showing no signs of slowdown, with the Global Manufacturing PMI at 53.5, and 26 of the 29 markets for which Markit runs its survey returning a PMI above 50 - close to the highest percentage on record (Chart 1). However, the flattening yield curve in the U.S. has raised concerns: the gap between the yield on two-year and 10-year Treasuries has fallen to less than 60 bps (Chart 2). But a flattening yield curve is not unusual when the Fed is tightening policy, and historically the curve has needed to invert before it became a recession signal. Also of concern was a jump in early November in high-yield spreads, which have also been a good lead indicator for recession (Chart 3). The rise was caused by poor earnings from lowly-rated telecoms companies, which triggered a sell-off in junk bond ETFs. But the rise in spreads remains insignificant, and has mostly reversed since. Chart 1Global Growth Looks Fine... Chart 2But Should We Worry About The Yield Curve... Chart 3...And Rising Credit Spreads? BCA's macro view, as laid out in detail in our recent 2018 Outlook,1 is that the strong growth that has been a positive for risk assets this year will slowly become a negative next year as it is increasingly accompanied by rising inflation. Two-thirds of countries globally now have unemployment below the NAIRU (Chart 4). In the U.S., employment has reached a level at which the Philips Curve has historically been "kinky", associated with an acceleration in wage growth (Chart 5). Upside surprises in inflation will mean that the Fed will hike three or four times next year (compared to the market's expectation of only 1½ hikes), 10-year bond yields will rise to above 3%, and the dollar will appreciate. Chart 4Unemployment Is Below Nairu In Most Places Chart 5The 'Kinky' U.S. Philips Curve What are the implications of this scenario for portfolio construction? We continue to recommend an overweight on risk assets on the 12-month time horizon, as we would expect equities to outperform bonds until Fed policy tightens above the neutral level (which is still about five rate hikes away, as long as core PCE inflation picks up to 2%, as we expect - Chart 6). However, the risks to this scenario are rising. The Fed could stubbornly push ahead with rate hikes even if inflation remains subdued. Chinese growth could slow if the authorities misjudge the timing of structural reforms. Our geopolitical strategists argue that, while investors overestimated political risks at the start of 2017, now they are underestimating the risks (North Korea, NAFTA renegotiation, China trade issues, Italian elections).2 With valuations stretched, small shocks could trigger a disproportionate negative market reaction. More risk-averse investors, therefore, might choose to reduce exposure now, at the risk of leaving some money on the table. Equities: If global equities have further upside, as we believe, higher beta markets such as the euro zone (average beta to global equities over the past 20 years: 1.2) and Japan (beta: 0.9) are likely to continue to outperform. Both have central banks that remain accommodative, our models suggest further upside for earnings growth into next year (Chart 7), and valuations are less stretched than in the U.S. While EM equities are also high beta, we think they are likely to lag next year: higher U.S. interest rates, a stronger U.S. dollar, potential slowdown in China, and sluggish domestic demand in most major emerging economies all represent significant headwinds. Chart 6How Long Until Rates Above Neutral? Chart 7Euro and Japan Earnings Have Upside Fixed Income: A combination of higher inflation and a more aggressive Fed is not a positive environment for government bonds. We expect the yield curve to steepen over the next six months, as the market prices in higher inflation and fiscal deficits (after the U.S. tax cut), but to resume flattening mid next year, as the Fed pushes ahead with rates hikes, and worries about the risk of a policy error emerge. For now, we remain underweight duration, and prefer inflation-linked over nominal bonds. For spread product, while valuations are stretched, we see some attractiveness. As long as the global expansion continues, U.S. investment grade bonds should see a carry pickup over Treasuries of around 100 bps, and high-yield bonds one of around 250 bps (adjusting for likely defaults) - even if we don't assume further spread contraction. In a world of continuing low rates, that remains alluring. Currencies will continue to be driven by relative monetary policy. While we see the Fed tightening more than the market expects, the ECB will not raise rates until late 2019, since underlying inflationary pressures in the euro zone are much weaker. This is largely in line with what the futures market is pricing in. Interest rate differentials (and an unwind of the current large speculative long-euro positions) should cause some weakness of the euro versus the dollar. We expect the Bank of Japan to stick to its 0% target for 10-year JGBs, which means that the yen will also weaken, to below 120 to the dollar, if U.S. interest rates rise in line with our forecasts (Chart 8). Emerging market currencies have already fallen by 1.3% since early September as U.S. rates rose, and amid signs of economic weakness in some emerging economies. We expect this to continue. Chart 8Yen Is Driven By U.S. Rates Chart 9China Is What Matter For Metals Commodities: Our energy strategists recently raised their target for Brent and WTI crude to an average over the next two years of $65 and $63 respectively, with risk of upside surprises in the event of geopolitical disruptions (Venezuela, Kurdistan etc.). They see the OPEC agreement being extended possibly to December 2018, and argue that backwardation of the oil curve (futures prices lower than spot) and rising extraction costs will delay the response of shale oil producers to the higher price. The outlook for industrial commodities depends, as always, on China, which now comprises greater demand for base metals than the rest of the world put together (Chart 9). The risk of a slowdown in Chinese infrastructure spending next year makes us wary on metals such as iron ore, and markets such as Australia and Brazil. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "2018 Outlook - Policy And The Markets On A Collision Course," dated 20 November 2017, available at bca.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "From Overstated To Understated Risks," dated 22 November 2017, available at gps.bcaresearch.com GAA Asset Allocation

Special Report

Highlights Higher Treasury Yields: As core inflation returns to the Fed's target in 2018 the 10-year TIPS breakeven inflation rate will rise by at least 50 basis points and the nominal 10-year Treasury yield will move above 2.80%. This is substantially higher than the 1-year forward rate of 2.49%. Maintain a below-benchmark portfolio duration stance. TIPS Over Nominal Treasuries: TIPS will outperform nominal Treasury securities in 2018 as long-maturity TIPS breakeven inflation rates widen alongside rising core inflation. The passage of tax cuts in the first half of next year would speed up the adjustment in breakevens. Curve Steepeners, Then Flatteners: The slope of the yield curve is positively correlated with TIPS breakeven inflation rates. Look for mild curve steepening in the first half of 2018 as breakevens widen, transitioning to flattening once breakevens level-off around mid-year. The Cyclical Sweet Spot Comes To An End: The cyclical sweet spot of solid growth and low inflation that has been driving the outperformance of spread product will come to an end in 2018. The catalyst will be higher inflation. We will start paring exposure to spread product once long-maturity TIPS breakeven inflation rates approach our target range of 2.4% to 2.5%, probably in the middle of next year. A Year Of Low Returns: Spreads are not that far from all-time expensive levels, meaning there is limited room for spread compression at this late stage of the credit cycle. Excess returns from spread product will be very similar to carry in 2018 - at least until inflation rises and it is time to prepare for a sustained period of spread widening. Feature BCA's Outlook for 2018 was published last week.1 That report laid out the macroeconomic themes that will impact markets during the next year. In this week's report we expand on those themes and discuss what they mean for U.S. fixed income markets specifically. We identify five key implications. Implication 1: Higher Yields One important theme for 2018 will be the resumption of the cyclical uptrend in inflation. As was stated in the Outlook: The historical evidence still suggests that once the labor market becomes tight, inflation eventually does accelerate. A broad range of data indicates that the U.S. labor market is indeed tight and the Atlanta Fed's wage tracker is in an uptrend, albeit modestly. Two other factors consistent with an end to disinflation are the lagged effects of dollar weakness and a firming in oil prices. Non-oil import prices have now moved decisively out of deflationary territory while oil prices in 2017 have averaged more than 20% above year-ago levels. Rising inflation mustn't necessarily translate into higher yields, but the Treasury market is not currently priced for the possibility that core inflation will ever re-gain the Fed's 2% target. Chart 1 shows the nominal 10-year Treasury yield split into its two main components: Chart 110-Year Treasury Yield Components The compensation for future inflation - proxied by the 10-year TIPS breakeven inflation rate. The real 10-year Treasury yield - proxied by the 10-year TIPS yield. As has been stated repeatedly in this publication, in an environment where realized inflation is well-anchored around the Fed's 2% target the 10-year TIPS breakeven inflation rate has historically traded in a range between 2.4% and 2.5% (Chart 1, top panel). The 10-year TIPS breakeven inflation rate currently sits at 1.84%. This means that by the time core inflation returns to the Fed's 2% target, a feat we think will be achieved in 2018, the 10-year TIPS breakeven inflation rate will impart 56 to 66 basis points of upside to the nominal 10-year Treasury yield. It is possible that any increase in the compensation for inflation protection could be offset by falling real yields. However, it is highly unlikely that the 10-year real yield would decline while the Fed is hiking rates, unless there is a sharp downward adjustment in our 12-month Fed Funds Discounter2 (Chart 1, panel 2). On that front, the market is currently priced for between two and three rate hikes during the next 12 months. This expectation could be revised even higher in the near-term as inflation recovers, but that faster pace of rate hikes is unlikely to be sustained for any significant period of time. All in all, the discounter appears not that far from its fair value, meaning that the 10-year real yield should impart some modest additional upside to the 10-year nominal yield on a 6-12 month horizon. To summarize, if core inflation returns to the Fed's target in 2018, then the nominal 10-year Treasury yield will move into a range between 2.90% and 3.00% (Chart 1, bottom panel), conservatively assuming no additional upside or downside from real yields. This is substantially above the 1-year forward rate of 2.49%, and we therefore advocate a below-benchmark portfolio duration stance. The Importance Of Synchronized Growth It was also observed in the Outlook that, according to the IMF, the median output gap for 20 advanced economies will shift from -0.1% in 2017 to +0.3% in 2018. If these forecasts pan out, then 2018 will also be the first year since the recession that more than 50% of those 20 economies have output gaps in positive territory. Meanwhile, the IMF estimates that the U.S. output gap has been essentially closed since 2015 (Chart 2). In other words, the U.S. has been leading the global economic recovery for the past few years but this is now starting to change. The rest of world is quickly catching up and the global economic recovery is now much more synchronized. This is critically important for U.S. bond yields because it lessens the impact of foreign inflows. For example, when U.S. growth was far outpacing growth in the rest of the world in 2014 and 2015, any increase in U.S. Treasury yields also widened the spread between U.S. yields and yields in the rest of the world. The wider gap encouraged foreign inflows to the U.S. bond market and limited how high U.S. yields could rise. Now, with the global economic recovery more synchronized, U.S. yields will have to increase by much more to have the same impact on the spread between U.S. yields and yields in the rest of the world. In our view this is an extremely bond-bearish development that often goes under-appreciated. Our 2-factor Treasury model attempts to quantify the impact of synchronized global growth on the U.S. 10-year Treasury yield (Chart 3). The model uses Global Manufacturing PMI as its proxy for global growth, and bullish sentiment toward the U.S. dollar as a proxy for the synchronization of the global recovery - a less synchronized recovery should lead to increased bullishness toward the dollar and vice-versa. The model's current reading pegs fair value for the 10-year Treasury yield at 2.69%. Chart 2Rest of World Playing Catch-Up Chart 32-Factor Treasury Model Bottom Line: As core inflation returns to the Fed's target in 2018 the 10-year TIPS breakeven inflation rate will rise by at least 50 basis points and the nominal 10-year Treasury yield will move above 2.80%. This is substantially higher than the 1-year forward rate of 2.49%. Maintain a below-benchmark portfolio duration stance. Implication 2: TIPS Over Nominal Treasuries It should be obvious that if the forecasts in the prior section pan out then TIPS will substantially outperform nominal Treasury securities as breakeven inflation rates widen in 2018. In our opinion the low level of long-maturity TIPS breakeven inflation rates represents the greatest source of medium-term value in U.S. bond markets. Chart 4Breakevens Biased Wider In addition, a wide range of indicators, such as our own Pipeline Inflation Indicator and the New York Fed's Underlying Inflation Gauge, already suggest that breakevens are biased wider (Chart 4). With the Fed engaged in a rate hike cycle, evidence of price pressures in the realized inflation data will be required before breakevens see significant upside. Our base case forecast is that the 10-year TIPS breakeven rate will reach our target range of 2.4% to 2.5% around the same time that core PCE inflation reaches 2%, probably in the middle of next year. However, there is one political risk that could speed up that adjustment. Namely, if Congress manages to pass tax cuts in the first half of 2018. From the Outlook: The U.S. tax system is desperately in need of reform [...]. However, the economy does not need stimulus from net tax giveaways given that it is operating close to potential. That would simply boost demand relative to supply, create overheating, and give the Fed more reason to get aggressive. The Republican's initial tax plan has some good elements of reform such as cutting back the personal mortgage interest deduction, eliminating some other deductions and making it less attractive for companies to shift operations overseas. However, many of these proposals are unlikely to survive the lobbying efforts of special interest groups. The net result probably will be tax giveaways without much actual reform. [...] There inevitably will be contentious negotiations in Congress but we assume that the Republicans will eventually come together to pass some tax cuts by early next year. Fiscal stimulus from tax cuts at this late stage of the cycle would be very inflationary, and judging by the sharp increase in TIPS breakevens that followed President Trump's election last November, the market has already figured this out. The passage of a tax bill early next year would no doubt speed up the return of long-maturity TIPS breakevens to our target range. Bottom Line: TIPS will outperform nominal Treasury securities in 2018 as long-maturity TIPS breakeven inflation rates widen alongside rising core inflation. The passage of tax cuts in the first half of next year would speed up the adjustment in breakevens. Implication 3: Curve Steepeners, Then Flatteners Another recommendation that follows from rising inflation is that the yield curve will steepen as long-maturity TIPS breakeven inflation rates rise. We have previously observed that changes in the slope of the 2/10 Treasury curve are positively correlated with changes in the 5-year/5-year forward TIPS breakeven inflation rate. Crucially, this positive correlation remains intact even when the Fed is hiking rates.3 In the current rate hike cycle (which started in December 2015) we observe that monthly changes in the 2/10 nominal Treasury slope have been positively correlated with monthly changes in the 5-year/5-year forward TIPS breakeven rate in 22 out of 24 months (Chart 5). It stands to reason that we should expect the yield curve to steepen as TIPS breakevens rise. Chart 52/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year/5-Year Forward ##br##(December 2015 - Present) However, we caution that curve steepening is probably only a story for the first half of 2018. Steepening will transition to flattening once long-dated TIPS breakevens reach our 2.4% to 2.5% target range, and in the meantime, there is a limit to how steep the yield curve can get. Let's assume that the Fed's median projection of a 3% terminal fed funds rate is reasonably accurate. It follows that the 10-year Treasury yield is unlikely to rise much above 3% before the end of the recovery. We can also calculate what the 2-year Treasury yield will be under different scenarios for the fed funds rate and the 2-year/fed funds slope. The latter can be thought of as simply the number of rate hikes the market expects during the subsequent two years. With these assumptions we can craft scenarios for where the 2/10 Treasury slope will be under different conditions, and these scenarios are presented in Table 1. The shaded cells in Table 1 are the scenarios that cause the 2/10 Treasury slope to steepen from its current level of 59 bps. Table 1Scenarios For The Number Of Fed Rate Hikes By ##br##The Time That Inflation Returns To Target For example, by the time that inflation recovers to the Fed's 2% target, the nominal 10-year Treasury yield will most likely be in a range between 2.8% and 3.25%. If the Fed only delivers two rate hikes between now and then it is very likely that the yield curve will steepen. This is shown in the section of Table 1 labelled "2 Rate Hikes". However, if the Fed lifts rates four times between now and the time that inflation returns to target, then it is much more likely that the 2/10 curve will flatten. These scenarios are shown in the top three rows of Table 1. The message is that the order of events matters. In our base case scenario, inflation starts to recover early next year and long-dated TIPS breakeven inflation rates reach our 2.4% to 2.5% target by mid-2018. At that point it is quite likely that the Fed will have only hiked rates a couple of times and the curve will have steepened. More rapid rate hikes, however, would severely limit the amount of potential steepening. We continue to advocate positioning for 2/10 steepening via a long position in the 5-year bullet versus a short position in the duration-matched 2/10 barbell. At present, the 2/5/10 butterfly spread is priced for 4 bps of 2/10 curve flattening during the next six months, so even mild curve steepening will lead to outperformance during that timeframe.4 We will shift from curve steepeners to flatteners once TIPS breakevens return to our target range. Bottom Line: The slope of the yield curve is positively correlated with TIPS breakeven inflation rates. Look for mild curve steepening in the first half of 2018 as breakevens recover, transitioning to flattening once breakevens re-normalize around mid-year. Implication 4: The Cyclical Sweet Spot Comes To An End From the Outlook: The perfect environment for markets has been moderate economic growth, low inflation and easy money. [...] We are assuming that growth is strong enough to encourage central banks to keep moving away from hyper-easy policies, setting up for a collision with markets. If growth slows enough that recession fears spike, then that also would be bad for risk assets. Sustaining the bull market requires a goldilocks growth outcome of not too hot and not too cold. Chart 6The "Fed Put" Is Still In Place This publication has named that goldilocks environment the "cyclical sweet spot" for risk assets. Essentially, as long as inflation is below the Fed's target, the Fed must respond to any economic weakness (or tightening of financial conditions) by adopting a more accommodative policy stance. The market knows that this "Fed put" is in place and that makes it very difficult to get a meaningful sell-off. In fact, the last major sell-off in corporate credit (in 2014/15) only occurred because the market assumed that the Fed would not deviate from its projected rate hike path even though commodity prices were plunging, causing defaults in certain exposed industry groups. Notice in Chart 6 that our 24-month Fed Funds Discounter stayed flat as spreads widened. Spreads only tightened in early 2016 after the Fed capitulated. So under what conditions will the "Fed put" disappear? Logically, if inflation were much higher the Fed would be less inclined to support markets at any sign of trouble. This is the reason that, while we remain overweight spread product versus Treasuries for now, we expect the cyclical sweet spot for spreads will come to an end next year. Long-maturity TIPS breakeven inflation rates approaching our target range of 2.4% to 2.5% will be the first signal that it is time to pare exposure. The importance of supportive monetary policy for spread product performance is also evident when looking at our three favorite credit cycle indicators (Chart 7). Historically, three conditions must be met before a sustained period of spread widening can occur. Chart 7Credit Cycle Indicators Our Corporate Health Monitor must be in "deteriorating health" territory (Chart 7, panel 2). Fed policy must be restrictive. This can be proxied by an inverted yield curve, or a real fed funds rate above its estimated equilibrium level (Chart 7, panels 3 & 4). Bank Commerical & Industrial lending standards must be in "net tightening" territory (Chart 7, bottom panel). For the time being only corporate health is sending a negative signal, but once inflation recovers we will be at increasing risk of monetary conditions turning restrictive. Tighter lending standards tend to follow restrictive monetary policy with a short lag. Bottom Line: The cyclical sweet spot of solid growth and low inflation that has been driving the outperformance of spread product will come to an end in 2018. The catalyst will be higher inflation. We will start paring exposure to spread product once long-maturity TIPS breakeven inflation rates approach our target range of 2.4% to 2.5%, probably in the middle of next year. Implication 5: A Year Of Low Returns From the Outlook: Our estimates indicate that a balanced portfolio will deliver average returns of only 3.3% a year over the coming decade, or 1.3% after inflation. That is down from the 4% and 1.9% nominal and real annual returns that we estimated a year ago, reflecting the current more adverse starting point for valuations. Heading into 2018 almost all U.S. spread product sectors are indeed faced with a more adverse starting point for valuations. Chart 8 compares today's option-adjusted spread (OAS) with the OAS at the end of 2016 for seven major spread products. With the exception of MBS, all sectors currently have lower spreads than at they did at the beginning of 2017. Chart 8Less Value In Spread Product Starting valuation is only one component of excess returns. Capital gains/losses from the change in spreads is the other. However, the deeper we move into the credit cycle the less room there is for further spread compression. In fact, we have previously calculated that the average spread for the investment grade Corporate bond index can only tighten another 35 bps before it reaches all-time expensive levels. This represents only 3 months of historical average spread tightening. The same calculation for the High-Yield index shows that the spread can only tighten another 145 bps, representing 4 months of average tightening.5 In other words, there is not much potential for spread compression at this late stage of the credit cycle and excess returns will be very similar to carry in 2018 - at least until inflation rises and it is time to prepare for a sustained period of spread widening. Chart 9 shows annualized 2017 year-to-date excess returns for each sector alongside projected excess returns for 2018 under two scenarios. The "flat spread" scenario assumes that spreads stay flat at current levels, while the "optimistic" scenario assumes that spreads tighten to all-time expensive valuation levels. Chart 92018 Excess Return Projections For investment grade corporate bonds even this extremely optimistic scenario would only provide excess returns of 363 bps, just 121 bps above this year's likely returns. For High-Yield, the optimistic scenario would provide excess returns of 637 bps, a mere 148 bps above this year's likely returns. For consumer ABS and domestic Agency bonds, the projections from our optimistic scenario do not even surpass this year's likely excess returns. Bottom Line: Spreads are not that far from all-time expensive levels, meaning there is limited room for spread compression at this late stage of the credit cycle. Excess returns from spread product will be very similar to carry in 2018 - at least until inflation rises and it is time to prepare for a sustained period of spread widening. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Outlook 2018, "Policy And The Markets: On A Collision Course", dated November 20, 2017, available at bca.bcaresearch.com 2 Our 12-month Fed Funds Discounter measures the number of rate hikes priced into the overnight index swap curve for the next 12 months. 3 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 For further details on our yield curve models and how we calculate the amount of steepening/flattening priced into the butterfly spread please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 These numbers refer to the spread tightening necessary to reach all-time lows on the 12-month breakeven spread for each index. We calculate the 12-month breakeven spread as OAS divided by duration. Fixed Income Sector Performance

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

Highlights The recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Credit spreads would need to widen significantly more to signal that a recession is imminent. What asset classes would benefit if the curve steepens and oil prices rise? Risk assets tend to do better the year before a tax cut than they do the year after. Feature BCA's view is that global growth is on solid footing. EPS growth in the U.S. is in the process of peaking, but will be relatively robust through the end of 2018. If our view is correct, U.S. stocks will outperform bonds in the next 12 months. Nonetheless, last week investors took profits in oil, the dollar, high-yield bonds and U.S. equities as the 2/10 Treasury curve flattened to just 65 bps, the lowest reading in 10 years (Chart 1). The risk aversion occurred amid concern about global growth, waning prospects for the GOP tax cut, and higher odds of a Fed policy mistake. Moreover, financial conditions tightened last week. Chart 1BCA Expects The Curve To Steepen In The Next 12 Months Even so, the recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Junk bonds have sold off in recent weeks, along with EM credit and currencies. In general, credit trends lead the stock market. Moreover, a recent Bank of America Merrill Lynch Survey found that a record share of fund managers are overweight risk assets. Any delay in passage of the tax plan could be the trigger for a correction. BCA's U.S. Equity strategists' views on financial and energy sectors run counter to the recent market action.1 Our position is that financials will benefit from a steeper yield curve and that a drawdown in inventories and robust global oil demand will allow oil prices to rise and energy shares to outperform the S&P 500. Later in this report, we will examine how other risk assets perform as the yield curve steepens and oil prices climb. We also investigate the efficacy of using the high-yield bond market to time equity market pullbacks and recessions. In addition, with investors concerned about the GOP tax bill, we evaluate the performance of U.S. financial market assets, commodities and earnings before and after stimulative fiscal policy is enacted. Slack Is Disappearing The health of the U.S. economy in Q4 is not a concern. Data released last week was solid on October's retail sales, small business optimism and industrial production. Moreover, the November readings on the Empire State and Philadelphia Fed's manufacturing indices support BCA's view that the output gap is narrowing. However, some of the bright readings on the economy in October may reflect a snap back from Hurricanes Harvey and Irma. The November 17 readings on Q4 real GDP from both the Atlanta Fed's GDP Now (+3.4%) and the New York Fed's Nowcast (+3.8%) show the economy is running hot. Inflation-adjusted GDP growth of 3.0% or more in Q4 indicates year-over-year GDP growth is well above the Fed's view of both potential GDP growth (1.8%) and its estimate for 2017 (2.4%). Above-potential economic expansion will ultimately lead to higher inflation, given the ever tightening labor market. Despite tightening in the past week, financial conditions have eased in the past year. The implication is that GDP growth in the U.S. is set to accelerate in the coming quarters (Chart 2). The October CPI data provide the Fed with enough reason to bump up rates again next month. The annual core inflation rate ticked up to 1.8% from 1.7%. However, it is still below the roughly 2.4% pace that would be consistent with the core PCE deflator reaching the Fed's 2% target. While inflation is still below-target, there were two encouraging signs in the report. First, BCA's CPI diffusion index nudged back above the zero line. Secondly, core services (ex-shelter and medical care) are showing signs of accelerating. This sub-component of core CPI is the most correlated with wages (Chart 3, panel 4). Fed officials will get one additional reading each on CPI (December 13), the PCE deflator (November 30), and wage inflation (December 8), before the end of the December 12-13 FOMC meeting. Chart 2Easier Financial Conditions Will Boost U.S. Growth Chart 3October CPI Provides Cover For The Fed Bond Market Message The recent widening of credit spreads is not a signal that a recession is imminent. Chart 4 shows that peaks in key credit market metrics are lagging indicators of recession. While the recent spread widening is worrisome on its own, spreads would need to widen significantly more to signal that a recession is imminent. BAA quality spreads, the prepayment and liquidity risk spread (AAA corporate bond yield less 10-year Treasury) and the default risk spread (BAA minus AAA quality spread) are at or close to multi-decade lows.2 BCA does not believe that the spike in all these metrics in late 2015 was a signal that the economy was in or just exiting recession. Rather, the spread widening was related to the collapse in oil prices between mid-2014 and early 2016. BCA's Commodity & Energy Strategy service forecasts oil prices to rise as high as $70 per barrel in 2018.3 Chart 4Spreads Would Need To Widen Significantly More To Signal A Recession That said, these spreads tend to trough just prior to the onset of a recession. In longer expansions in the '60s, '80s, and '90s, bottoms in spreads occurred in mid-cycle. Credit spreads bottomed at the onset of recessions in the early 1960s, late 1960s, mid-1970s and early 1980s. The BAA quality spread and the prepayment and liquidity risk spreads bottomed six months before the onset of the 2007-2009 recession. However, the default risk spread formed a bottom in late 2004, three years before the end of a cycle (Chart 4). Spreads on lower-rated high-yield debt provide slightly earlier signals than those listed above. In the mid-1990s, spreads on BB- and CCC-rated U.S. corporate debt troughed in late 1998 as Russia defaulted, oil prices collapsed and LTCM failed. The signal came more than two years before the onset of the 2001 recession. In the mid-2000s, these spreads formed a bottom in late 2004/early 2005, three years before the 2007-2009 recession. The CCC- and BB-rated OAS spreads in this cycle initially bottomed in mid-2014 as oil price peaked. BB-rated spreads are below their mid-2014 trough, but spreads on CCC-rated debt are not (Chart 5). Chart 5HY Credit Still Outperforming Treasuries Investors question if the widening of spreads is a signal for other markets, especially the equity market. BCA finds that signals from the credit markets for equity markets are short-lived. Table 1 shows that the 13-week change in high-yield OAS is coincident to changes in S&P 500 prices. Often, stocks have already changed direction before any significant sell-off in the high-yield market. Rising spreads of more than 100 basis points tend to last for an average of 16 weeks and are accompanied by a 6% drop in the S&P 500. The only episode when a peak in spreads was not associated with a drop in equity prices occurred in 2001, as the S&P 500 rebounded in the wake of the 9/11 terrorist attacks. Table 1Stock Market Warning? Rising default rates are a necessary pre-condition for a prolonged interval of escalating spreads. Chart 6 shows the peaks in high-yield OAS spreads, along with the S&P, the VIX and Moody's trailing and forward default rates. In seven of the eight periods, spread widening occurred alongside a rising default rate. The only exception was in 2002 when spreads widened despite a fall in the default rate as accounting scandals rocked corporate America. Today, the default rate is low and falling. BCA's U.S. Bond Strategy team expects the default rate to move modestly lower in the next 12 months.4 Chart 6Spread Widening, Recessions, S&P 500 And Vol Bottom Line: The recent widening in credit spreads is one of the factors driving our cautious tactical stance on the U.S. equity market. Despite our near-term concern, BCA favors investment-grade credit and high-yield bonds over Treasuries in the next 12 months. Rising Oil And A Steeper Yield Curve BCA expects that oil prices will move 25% higher to $70/bbl in the next 12 months and that the yield curve will steepen. Above potential economic growth, tightening labor markets and rising inflation expectations will push up the long end of the Treasury curve, while the Fed lags the inflation upturn, leading initially to a steeper curve. What other asset classes would benefit if BCA's call is accurate? Chart 7 and Chart 8 show periods when oil prices rise and the yield curve steepens along with the performance of several key financial markets. Since 1970, there were five periods when oil prices moved higher and seven when the curve steepened. There are several years when both occurred at the same time, and many of these intervals also overlapped with recessions. Chart 7Lessons From Periods Of Rising Oil Prices Chart 8Lessons From Periods Of A Steepening Yield Curve The stock-to-bond ratio climbs when oil prices are rising, including the most recent episode. The S&P 500 outperformed the 10-year Treasury between 2009 and 2014 alongside oil prices, in the second half of the 1998-2008 run up in prices, and in the mid-1980s. However, during the rally in oil in the mid-to-late 1970s, stocks and bonds performed similarly. Both investment-grade and high-yield bonds outpace Treasuries as oil prices escalate. Investment-grade corporates outperformed in each of the five periods. Junk bonds struggled in the late 1980s as oil prices rose and then cruised in the 1990s, but trailed Treasuries in the first half of the 1998-2008 oil boom, finally catching up late in the cycle. The peak in both investment-grade and high-yield's performance versus Treasuries came in June 2007, providing a 12-month advance warning that oil prices had peaked for the cycle. Credit outpaced Treasuries in both oil rallies since the end of the 2007-2009 recession. Small cap performance during oil price rallies is mixed. Small caps beat large caps in the late 1970s, but underperformed in the mid-1980s. Small caps trounced large caps in the first half of the 1998-2008 energy price rally; large caps ran up and then back down again as the tech bubble swelled and then burst. Small caps only kept pace with large as energy prices soared between 2005 and 2008. Small caps eked out modest gains versus large between 2009 and 2014, and since 2016. Today, the energy sector's weight in the small cap sector is 3%, but it has ranged from 2% (2015) to 13% (2008) since 2001. Gold performs well as energy prices increase, aided in part by a weaker dollar. Gold climbed and the dollar fell during all five periods of expanding oil prices. There were several phases (mid-to-late 1980s, early 2000s and earlier this year) when the dollar mounted along with oil prices. Gold moved sideways at times as oil rose, but ultimately gold trended higher. BCA's stock-to-bond ratio generally moves lower as the curve steepens. Nonetheless, there are a few distinct but brief stages (late 1970s, mid 2000s, and 2009-10) when stocks beat bonds. There is not much difference between the performance of either investment-grade or high-yield credit in each of the six periods of curve steepening, but several shifts in a few of these cycles that overlapped with recessions are notable. Credit underperformed Treasuries in the early 1990s, early 2000s and mid-2000s as the economy entered recession, but then outperformed as the recession ended and the curve continued to steepen. Small cap performance as the curve steepens is mixed. As with credit, small caps underperform large on the way into recession as the curve steepens, but outperform after the recession ends. Recessions were not a significant factor in the performance pattern for gold and the dollar during curve steepening. Gold climbed in four of the seven periods of curve steepening, but changed little in the late 1980s/early 1990s episode. Gold declined sharply along with inflation and inflationary expectations in the early 1980s. The dollar moved significantly higher in just one of the seven periods (early 1980s) and was mixed-to-lower in the others. Bottom Line: BCA's bullish stance on the energy and financials sectors in the next 12 months is driven by our view that oil prices will continue to rally and that the Treasury yield curve will steepen as U.S. economic growth accelerates and inflation moved back to the Fed's 2% target. Stocks typically beat bonds as oil prices rally, but stocks generally underperform as the curve steepens. Gold advances under either scenario, while the dollar moves lower when the curve steepens and oil prices rise. The performance of credit and small caps in these episodes is sensitive to the business cycle. Hooray For Tax Cuts? BCA's Geopolitical Strategy team expects the GOP to pass a tax cut bill by the end of Q1 2018.5 Furthermore, the bill should provide a small but positive boost for the U.S. economy, and be neutral for EPS in the 10-year lifetime of the cuts. Chart 9 and Table 2 show that there have been seven periods since 1970 when the OECD's measure of "fiscal thrust"6 climbed. On average, stocks underperform bonds, although both are higher on average. Investment-grade corporate debt beats Treasuries, but high-yield underperforms as fiscal stimulus swells. Small caps (relative to large), gold, oil and the dollar, all are winners. Chart 9Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Treasuries are the most consistent performers when fiscal policy boosts the economy, advancing in each of the seven episodes. Small caps beat large and the S&P 500 rises in five of the seven periods. The process to propose, debate, and enact significant fiscal stimulus can be a long one, and in many cases, investors deduce that a fiscal boost is on the way well before it is passed into law. Accordingly, risk assets tend to outperform a year before a tax plan is passed. On average, stocks beat bonds, small caps do better than large caps, and both gold and oil accelerate a year before fiscal thrust starts to intensify. Corporate and high-yield bonds keep pace with Treasuries during these episodes. The S&P 500 jumps nearly 10% a year prior to an increase in fiscal thrust, while the total return on Treasuries rises by 5% and the dollar is flat (Table 3). Table 2 and 3Impact Of Fiscal Policy On Markets, The Dollar And Earnings The most consistent performers as fiscal thrust is priced in are small caps over large, oil prices, the S&P 500 and the 10-year Treasury. Each of these asset classes strengthens in five of the seven periods mentioned above. Chart 10 shows the Trump trades in the past year. The performance matches the historical experience a year before the economy receives a boost from tax and spending legislation. The tax proposal before Congress provides fiscal stimulus via tax cuts, but does not provide any economic lift from an increase in government spending. Therefore, it may be more useful to review asset class performance after personal income tax rates are lowered. The GOP plan also proposes corporate tax cuts, but the historical evidence is scant; corporate tax rates have been lowered only three times in the past 45 years. There is no clear pattern of performance for U.S. financial assets and commodities in the wake of a reduction in the top marginal personal tax rate. Chart 11 shows the performance of the primary U.S. dollar asset classes and financial markets since 1970. Stocks outperformed bonds in the year after the top marginal tax rate fell in only one of the four periods (mid-1980s). The track record for corporate bonds is also mixed at best. Investment-grade either matches or beats the performance of Treasuries in each of the four periods. High-yield outperformed in the mid-1980s, but subsequently underperformed in the wake of the early 2000s tax cut. Gold was the most consistent winner, climbing in three of the four intervals. The dollar was higher in two of the three periods since moving off the gold standard in the early 1970s. There is no consistent pattern for small caps after a decrease in personal tax rates. Chart 10Market Remains Skeptical That Tax Package Will Pass Chart 11Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Bottom Line: BCA's stance is that by the end of Q1 2018 the GOP will pass a tax cut that will provide a small lift to the economy. History shows that investing in risk assets in the year before fiscal thrust passes would provide the best returns. That said, the GOP plan only has tax cuts, and the performance of risk assets is mixed in the year following reduced personal tax rates, at best. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Later Cycle Dynamics", dated October 23, 2017. Available at uses.bcarearch.com. 2 "One component of the Baa-Treasury spread is the prepayment premium (Aaa-Treasury) to investors for the risk that if interest rates fall in the future, borrowers might retire old debt with new debt at lower rates. Another component of the Baa-Treasury spread is a liquidity premium (Aaa-Treasury) that compensates investors for the fact that private instruments are less desirable to hold relative to U.S. Treasuries when financial markets are turbulent and investors are very risk averse. The Baa-Treasury spread also contains a default risk premium (Baa-Aaa) to compensate lenders for the risk that borrowers may not repay, reflecting the amount of default risk posed and the price of risk."; Source: "What Credit Market Indicators Tells US", John V. Duca, Federal Reserve Bank of Dallas, October 1999 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary, "Into The Fire," November 7, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism," November 8, 2017. Available at gps.bcaresearch.com. 6 The change in general government cyclically-adjusted balance as percent of potential GDP, Source: OECD.

Highlights Question 1: Why is U.S. inflation still so low? Question 2: How important is the upcoming change in Fed leadership? Question 3: What are the implications of the U.S. tax cuts? Question 4: What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? Question 5: Are markets underestimating the potential impact from slower growth of central bank balance sheets? Question 6: How much longer can this powerful rally in Emerging Markets continue? Question 7: What are other investors worried about? Feature I have just returned from an extended two-week trip visiting clients in the Asia-Pacific region. The meetings were all very well attended, with even many non-dedicated fixed income investors turning up to ask tough questions about global bond markets. My impression was that given the powerful returns earned in virtually all risk assets this year (equities, credit, Emerging Markets), our clients are growing more concerned about the potential risks from tighter global monetary policy and rising interest rates than they have been for some time. Oddly enough, this is despite not fearing either a serious rise in inflation or a major growth slowdown next year. If such a thing as "nervous complacency" can exist, it seemed widely evident in most of my meetings. This week, I am taking a more personal tone than in a typical Global Fixed Income Strategy Weekly Report to summarize the key client questions from ten days of meetings, spread across six cities in five countries on two continents. Why is U.S. inflation still so low? Chart 1Tightest Global Labor Market##BR##Since The Mid-2000s Almost all of the meetings began with a discussion of the current situation in the U.S., particularly the lack of inflation. The current BCA view that U.S. inflation will accelerate in 2018 was met with some skepticism, particularly when framed in the context of the uncertain unemployment/inflation trade-off. In one meeting, outright laughter actually broke out when the term "Phillips Curve" was mentioned! Clearly, the burden of proof is on the inflation data itself. On that note, I presented several of the best BCA charts from recent months that show how the backdrop is ripe for a turnaround in global inflation. Clients were impressed when shown that nearly ¾ of the countries in the OECD had unemployment rates below the full-employment NAIRU, a level not seen since the period of strong coordinated global growth and rising inflation in the mid-2000s (Chart 1). Yet when I then presented a chart showing the actual inflation/unemployment data in the U.S. over the past 20 years, with a clear "kinked" Phillips Curve and the latest data point well on the steeper portion of that curve (Chart 2), the majority of clients were less convinced. The most cited reason was that the U.S. inflation data simply did not accelerate in 2017 when it was supposed to given the steady fall in unemployment over the preceding few years. Perhaps most surprising was that, rather than believe that the NAIRU rate may simply be lower now than in past business cycles, so many people that I met were willing to discard the entire Phillips Curve concept as a useful framework to forecast inflation. When presented with charts showing non-Phillips Curve reasons to expect higher inflation, however, there was far less skepticism. Perhaps the most compelling chart showed the typical 18-month lag between U.S. economic growth and the "momentum" of U.S. inflation (Chart 3). Upon seeing this, clients were more convinced that inflation would pick up next year in response to the current U.S. growth upturn. Chart 2U.S. Economy Has Moved Into##BR##The "Steep" Part Of The Phillips Curve Chart 3Inflation Typically Follows Economic Growth With A Long Lag I was also able to break down some of the skepticism on the U.S. inflation outlook even more after discussing the bullish oil forecast from our colleagues at Commodity & Energy Strategy. Admittedly, their view that the benchmark Brent oil price will average $65/bbl in 2018 sounds far less dramatic given that the current spot price has risen to nearly that level in the aftermath of the recent political turmoil in Saudi Arabia. Yet clients did appreciate that our bullish oil call was driven more by a view of improving global oil demand and continued production discipline by oil producers (especially for the so-called "OPEC 2.0" nations of Russia and Saudi Arabia). When shown our chart describing how oil prices persistently in the mid-$60s next would put some upward pressure on the inflation expectations component of global bond yields (Chart 4), there was virtually no disagreement from any clients that I met. There was a bit more pushback on the view that, if the BCA forecast of higher U.S. inflation and rising oil prices in 2018 comes to fruition, there is room for a substantial rise in U.S. Treasury yields from current levels. When presented a chart showing that market-based inflation expectations (both using TIPS breakevens and CPI swaps) could rise by 50-60bps just to get back to levels consistent with the Fed's inflation target (Chart 5), most clients politely nodded and basically said "show me the actual inflation first." Although there was widespread agreement with our view that it would take that kind of move in inflation expectations to prompt the Fed to fully deliver on the 100bps of rate hikes it is currently projecting to occur over the next year. Chart 4A Boost To Inflation Expectations##BR##From Higher Oil In 2018 Chart 5The Normalization Of U.S. Inflation##BR##Expectations Will Continue How important is the upcoming change in Fed leadership? The vast majority of clients that I met asked about the BCA view on the nomination of Jerome Powell as the new Fed Chair, replacing Janet Yellen. My impression was that there was not a lot of concern over the potential for serious alterations to the future path of U.S. monetary policy under new leadership. Yet it was still potentially a big enough change to ask questions about it. Most clients agreed with the BCA view that a Fed Chair Powell will not act much differently than Yellen. His voting history has aligned with hers and, by his own admission, he is a very data dependent central banker given that he is not a formally-trained economist. Only by knowing the ins and outs of the data has he been able to debate successfully with the Ph.D economists on the FOMC. Powell will likely be a data-driven Fed Chair that would not look to hike rates without higher inflation (and vice versa). Chart 6A Communications Problem##BR##For Jerome Powell? One point that I raised in all the meetings was that the Fed's communication strategy on future rate increases is the more worrisome issue for financial markets at the moment. The U.S. money market curve is still priced for only 50bps of rate increases over the next year, while the Fed "dots" are signaling 100bps of hikes. We think the Fed will deliver on its projections, which is one of the reasons we are recommending a below-benchmark duration stance in the U.S. (the upside in inflation expectations is the other reason). More importantly, the Fed's so-called "terminal rate" projection is at 2.75%, while our proxy for the market pricing of that rate - the 5-year U.S. Overnight Index Swap rate, 5-years forward - is hovering just above 2% (Chart 6). The persistent disagreement between the market and the Fed over the appropriate level of the terminal rate will become a problem later in 2018 if the Fed does indeed raise the funds rate to over 2% and continues to signal that more rate hikes will come to get the funds rate up to "neutral" (the terminal rate). If the Fed is not able to change the market's mind about the appropriate neutral level of the funds rate, then a move to the Fed's estimated terminal rate of 2.75% would push U.S. monetary policy into what will would be perceived a restrictive stance. This would have implications for the shape of the U.S. Treasury curve (a lot flatter) and for future growth expectations (a lot slower) heading into 2019. My impression from my meetings was that this possibility - that the Fed could engineer what would look to the markets like a policy mistake simply by sticking to its forecasts - was not at the forefront of clients' thinking at the moment. Yet there was no disagreement with the logic of how that could play out. The new Fed leadership under Jerome Powell may have its hands full clearly explaining their policy decisions in 2018, which could create some turbulence in global financial markets later in the year. What are the implications of the U.S. tax cuts? The details of the tax plans from the U.S. House of Representatives and the U.S. Senate were a very hot topic in all of my client meetings. Considering all the ideas being proposed, from cuts in corporate tax rates to changes in the tax treatment of debt interest costs to removing the disincentive to repatriate profits earned abroad, it is no surprise that both equity and fixed income clients had a lot of questions on future U.S. tax policy. It is difficult right now to judge the net impact of the tax changes, as not all of the proposals in the two Congressional tax plans will likely be implemented. There will be plenty of horse trading between the Republicans and Democrats (and between the Republicans themselves) before the final tax deal is done. Yet there was a lot of concern among clients in my meetings over the likelihood that the tax cuts will be implemented at all. After seeing President Trump lose the battle on health care reform earlier this year, many clients were worried that a repeat could happen for the Trump tax cut agenda. This would have negative implications for U.S. equity markets, the U.S. dollar and future Fed policy moves. I explained the views from our colleagues at Geopolitical Strategy, who strongly believe that a tax cut will eventually pass (likely in early 2018) given the need for Congressional Republicans to have something positive to present to voters heading into the 2018 U.S. midterm elections. The tax cuts will have a moderate stimulative effect on the U.S. economy that the markets were not yet fully discounting. I also presented the chart from Global Fixed Income Strategy showing that wider U.S. budget deficits usually coincide with a steeper U.S. Treasury curve, almost always because the U.S. economy is slowing down, prompting looser fiscal policy and also Fed rate cuts (Chart 7). This time is different, however, since the Trump tax cuts will be stimulating an economy currently at full employment (middle panel). This has the potential to trigger more inflation through faster economic growth and even tighter labor markets which could prompt the Fed to move more aggressively on interest rate increases next year and eventually flatten the UST curve (bottom panel). Chart 7A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve The idea of a "steeper, then flatter" Treasury yield curve in response to U.S. fiscal policy stimulus generated a lot of discussion in my meetings. Some even noted that the recent flattening of the curve was a sign that the markets were discounting a lower probability of a tax deal being reached in D.C. I described the flat curve as a consequence of inflation expectations remaining too low, as the Treasury curve was much flatter than implied by the low level of the real fed funds rate, which is one of the most reliable relationships in the bond markets (higher real rates = a flatter curve, and vice versa). My conclusion from these meetings (and from the current market pricing) is that clients are a bit skeptical that a tax deal will be reached. This suggests there is room for bond yields to rise, and the Treasury curve to bear-steepen, if our political strategists are right and the tax cuts will happen. What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? While most of the questions in my meetings focused on the U.S. outlook, several clients asked about the next move from the European Central Bank (ECB). This was both from a fixed income perspective and, perhaps even more importantly, with an eye on the future direction of the euro versus the U.S. dollar. I made the straightforward argument that with Euro Area economic growth showing strong momentum that is unlikely to slow much in 2018, and with headline Euro Area inflation likely to surprise to the upside based on our bullish oil call (Chart 8), the ECB would likely be forced to signal a tapering of its asset purchase program to zero by the end of next year. The oil view was especially important, as the ECB is expecting a slowing of headline Euro Area inflation to 1% in early 2018 based on the base effects from comparisons to the rise in oil prices seen in early 2017. If our house view on oil prices plays out, then there is potential for inflation to catch the ECB by surprise in 2018. The key will be how core inflation plays out as oil prices rise further. Core Euro Area inflation has dipped lower in recent months, even as wage growth has accelerated (bottom panel). Given tightening Euro Area labor markets, and robust domestic demand, the recent dip in core inflation is likely to bottom out sometime in the first few months of 2018. But until that happens, there is more potential for higher U.S. bond yields through faster increases in inflation expectations and Fed rate hikes (Chart 9). This will support a higher U.S. dollar versus the euro through wider interest rate differentials (bottom panel). Chart 8ECB Will Fully Taper##BR##By The End Of 2018 Chart 9UST-Bund Spread Will Widen Next Year,##BR##Supporting The USD Clients were generally in agreement with that view on relative interest rates, but the views on the direction of EUR/USD were far more mixed. My impression is that if the Fed delivers the rate hikes that we expect in 2018, EUR/USD has room to move lower as investors were not prepared for this. Are markets underestimating the potential impact from slower growth of central bank balance sheets? I received many questions on the potential impact of central banks either shrinking balance sheets (the Fed) or slowing their expansion (the ECB and Bank of Japan). The chart showing how the growth in central bank money printing since 2015 (when the ECB began buying bonds) has correlated strongly with the bull markets in virtually all global risk assets garnered a lot of attention (Chart 10). This was especially true when I showed the chart that converted the level of the major central bank balance sheets to a growth rate and plotted that versus the returns on global equities and credit markets (Chart 11). The implication - expect lower returns on global equity markets, and MUCH lower returns from corporate bond markets next year. Chart 10CB Liquidity Has Supported Risk Assets... Chart 11...But That Tailwind Will Fade Next Year On this point, there was almost no disagreement from clients. There is widespread awareness that this era of puny interest rates, spurred on by central banks buying up huge quantities of government bonds and other financial assets, was forcing investors to take on far more risk in their portfolios to achieve acceptable returns. The key is when this will all turn around. Clients were generally in agreement with my view that the final leg of this liquidity-driven global bull market in risk assets will best be played through equity markets over corporate credit. These stable, earnings-driven rallies seen in global equity markets have not yet reached a "blowoff" phase that would suggest a larger correction is imminent. Perhaps it will take a final asset allocation decision to move more money out of bonds into equities to trigger that final run-up in equity prices before tighter monetary policies and slower growth expectations begin to damage returns later in 2018 into 2019. How much longer can this powerful rally in Emerging Markets continue? This is a topic that generated a healthy amount of debate in my meetings, particularly given the bearish views on Emerging Market (EM) assets from my colleagues at Emerging Markets Strategy. Here again, clients were generally looking at EM as a way to achieve acceptable returns in their portfolios while also participating in the global economic upturn through growth-sensitive assets. The previous chart showing the impact of diminished central bank liquidity on EM credit markets got some clients a bit nervous about the outlook for EM markets. What also spooked them were the charts from our EM strategists showing accelerating Chinese inflation (Chart 12) and slowing Chinese money growth. There is obviously a connection between the two, as China's policymakers are being forced to tighten monetary policy, and clamp down on excess credit creation, in response to accelerating inflation and very high debt levels. The chart showing how our "China M3 Impulse" had turned negative this year and was pointing to slower growth in industrial metals prices and China capital goods imports (Chart 13) was particularly unnerving for even the most bullish of EM clients. Chart 12This Is Why China Is Tightening Monetary Policy Chart 13Prepare For Slower Chinese Growth In 2018 My impression is that the clients I met were fully loaded up on EM assets but were comfortable holding those positions based on expectations of solid Chinese economic growth and continued inflows into EM assets from yield-starved global investors. If BCA's view that Chinese growth will slow next year comes to fruition, combined with rising U.S. interest rates and a stronger U.S. dollar as the Fed tightens more than currently discounted by the markets, then there is potential for outflows from EM markets to accelerate, to the detriment of EM returns. What are other investors worried about? This is a question that comes up a lot at BCA meetings, as clients are always curious as to what we are hearing from other investors. Perhaps this can be chalked up to a version of "confirmation bias", where investors like to hear that their own views are shared by others in the markets. In my meetings over the past two weeks, however, I got the sense that clients are heavily exposed to risk assets, which have performed beyond their expectations, and are growing more worried about how things can go wrong. Like an end to the current low volatility regime, for example. Given the BCA views on the likelihood of global inflation increasing next year, triggering a more hawkish response from policymakers, I noted that I did not believe that clients were prepared for that outcome. This suggests that the beginning of the end of the current low volatility regime, which is seen across all asset classes (Chart 14), will occur through a pickup in bond volatility. This will take place from a rise in inflation expectations first, and a rise in policy rate expectations later. My advice to clients was that if realized bond volatility picks up, this is the signal to reduce exposure to credit and equity markets. We anticipate making such a recommendation sometime during 2018. Chart 14The Low Market Volatility Backdrop Will End When Bond Volatility Rises Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@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