Developed Countries

The key theme that has been driving our investment thesis in U.S. Equity Strategy in the past quarter has been accelerating global industrial production and trade, with a corresponding rotation out of defensive and into cyclical stocks. We have been adjusting our portfolio accordingly and it now has a deep cyclical bent with leverage to a burgeoning capex cycle. Industrial conglomerates capitalize on most of these themes: they are globally-oriented and capex-driven, and leading indicators of final demand suggest that earnings should accelerate in the near-term (second panel). However, the index has underperformed the broad market, dragged down by heavyweight GE (third panel) and its specific headwinds, most notably fears of a looming dividend cut. Further, the index's highest exposure sectors (namely aerospace, health care equipment, energy equipment & services and utilities) are mostly weighted negatively in our overall sector view. Adding it up, the negatives offset the positives and, in the context of fair valuations (bottom panel), we expect the S&P industrial conglomerates index to perform in line with the overall market. We are initiating coverage with a neutral rating; please see yesterday's Special Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP.

Highlights Risk assets are responding well to better data and rising rates. Q3 EPS results beating lowered expectations, but growth earnings will peak soon. The conditions are in place for robust capital spending. Financial assets are adhering to the post-Hurricane playbook, with a few notable exceptions. Feature Chart 1Risk Assets Higher Despite Higher Rates Risk assets rose last week for the 6th week in a row (Chart 1). A solid start to Q3 earnings season, more legislative progress on the GOP's tax plan and a narrowing of President Trump's choice for Fed Chair (Jerome Powell, John Taylor and incumbent Janet Yellen) all added to the positive backdrop. The 4 bps rise in the 10 year Treasury yield last week (and 37 bps since early September) was not an impediment to higher equity and oil prices, and gains for small caps and high yield bonds. The positive reaction likely reflected the fact that yields rose more because of increased growth expectations than higher inflation expectations. Despite the impact of Hurricanes Harvey and Irma, Q3 GDP posted an impressive 3% gain. The composition of the Q3 readings suggests an even stronger report in Q4 (Chart 2). At 2.3%, the year-over-year change in real GDP is close to the Fed's 2017 forecast (2.4%) and above the long run forecast (1.8%). The implication for investors is that because U.S. economic growth is faster than its long-term potential, the labor market is tightening and inflation is poised to move higher. Accordingly, market odds for a Fed hike in December are near 90% and participants expect 51 bps more hikes in the next 12 months (Chart 1, panel 3). BCA's view is that U.S. economic growth is set to accelerate in the coming quarters aided by a post hurricane rebound in housing. The Fed will raise rates in December and three more times next year as inflation returns to 2% and perhaps beyond. Corporate profit growth will peak in the next few quarters, but remain supportive of higher stock prices for now. The rise in the Economic Surprise Index will continue for another few months, and provide another lift for risk assets. A surge in capital spending adds to the upbeat tone. Chart 2GDP Growth Remains Below Average, But Above Fed's Long Run Target Capital Spending Blasts Off Business capital spending is on the upswing. The robust readings in September on core durable goods orders (7.8% year-over-year) and shipments reported last week were paybacks for the Hurricane-weakened August report. Nonetheless, the impressive soundings on the three -month change in both orders and shipments were not distorted by the storms. Moreover, the durable goods report was one of the latest in a series of data points brightening capex's outlook (Chart 3). Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM readings and soaring sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters. CEO confidence soared to a 13-year high in Q1 according to the latest Duke University/CFO Magazine Business Outlook, but retreated modestly in Q2 and Q3 (Chart 4). Surveys by the Conference Board and Business Roundtable show a similar pattern. Notably, readings on all three surveys have climbed since Trump's election in November 2016, but then retreated as his pro-business agenda stalled. The drop in sentiment reflects the lack of legislative progress in Washington (Chart 5). The dip in CEO sentiment in Q2 and Q3 is in sharp contrast with the easing of policy concerns in the Beige Book. Chart 3Bright Outlook For Capital Spending Chart 4Capital Spending Plans Upbeat Chart 5Managements Remain Upbeat The upbeat numbers in the regional Federal Reserve Banks' surveys of capital spending intentions further support rising capex spending in the next few quarters. The average readings from the New York, Philadelphia and Richmond Feds' capex survey plans are close to cycle highs, despite a modest pullback in the summer months. Moreover, the regional Feds' capex spending plans diffusion index hit an eight-year high in October (Chart 5, panel 3). Bottom Line: Stay overweight stocks versus bonds, and underweight duration. Rising capex will drive up GDP, employment and EPS in the coming quarters. Q3 Earnings Beating Lowered Expectations The Q3 earnings reporting season is off to a strong start, with both EPS and sales growth well ahead of consensus expectations as we forecast in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Just under 55% of companies have reported results so far, with 74% beating consensus EPS projections just above the long-term average of 55%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the LT average of 69%. The surprise factor for Q3 stands at 5% for EPS and 2% for sales. These compare favorably with the average EPS (4.2%) and sales (1.2%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, initial results imply that Q2 will be another quarter of margin expansion. Average earnings growth (Q3 2017 versus Q3 2016) is solid at 7% with revenue growth at 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in eight of the 11 sectors. The 7.3% year-over-year drop in the financial sector is linked to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up 4.7% from a year ago. EPS results are particularly stout in energy (164%), technology (18%) and healthcare (7%). Those sectors likewise experienced significant sales gains (16%, 9% and 5% respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 6). Trump's name was mentioned just once in the Q3 earnings calls held through October 27, matching Q2's reporting period. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The peak in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Chart 6Managements Focused On##BR##The Message Out Of DC In contrast, the words "tax" and "reform" have appeared 39 times thus far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2, when there was skepticism that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.1 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 7). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 figure. That said, the divergence can be explained by the impact of the hurricanes on the financial sector's earnings in 2017 and probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from 2018's clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.2 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 toward a level commensurate with 3 ½-4% nominal GDP growth (Chart 8). Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any positive effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, although this would also bring forward Fed rate hikes. The entire Treasury curve has readjusted to reflect this view. Chart 7Stability In '17 & '18 EPS Estimates,##BR##But '19 Likely To Move Lower Chart 8Strong EPS Growth Ahead,##BR##Will Start To Slow Soon 10-Year Treasury Update BCA's view is that the 10-year Treasury yield will head higher in the coming months. However, is the move from 2.03% in early September to 2.43% last week sustainable? BCA's fair value model for the 10-year Treasury yield (based on Global PMI and dollar sentiment) places fair value at 2.65% (Chart 9, panel 1). Moreover, BCA's three-factor version of the model (that includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.63% (Chart 9, panel 3). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. Chart 9Treasury Fair Value Models BCA's U.S. Bond Strategy service will publish updated fair models after the November 1 release of October's global PMI data. The latest readings on Citi's Economic Surprise index also support BCA's stance on rates. How Long Can The Economic Surprise Index Stay Positive? The Citi Economic Surprise Index crossed into positive territory on October 2nd, remaining above zero for 20 business days, and risk assets are responding (Chart 10). Since 2010, once the Index turns positive, it continues to rise for 46 days. The implication for investors is that the economic data will continue to be remarkable for another two months. Table 2 shows that risk assets outperform as the economic surprise index rises from zero toward its zenith. Risk assets have also outperformed since the June bottom in economic surprises, matching the historical performance.3 Oil (+17%), small caps and investment grade corporates are all standouts and the gains may not be over. The track record of risk assets as the Economic Surprise Index climbs suggests that additional increases are in prospect for risk assets. On average, equities (relative to treasuries) and oil are the best performers during these intervals. Chart 10May Still Be Room To Run On Economic Surprise Table 2Risk Assets Perform Well As Economic Surprise Rises Post-Hurricane Macro Backdrop The strength of the Citi Economic Surprise Index following the hurricanes duplicates the historical trend and supports the rise in risk assets. The Index moves higher for the first month post-storm, and then remains above zero for an additional three weeks (Chart 11, panel 4). This bolsters BCA's stance that the direction of the Index will continue to lift risk assets in the next few months. Financial assets are also adhering to the post-Hurricane playbook,4 with a few notable exceptions (Chart 12). The stock-to-bond ratio moved higher and the VIX has declined since Hurricane Harvey, matching the typical post-storm performance. However, the 10-year Treasury yield, the S&P 500 and the Fed funds rate, all have bucked historical trends. The S&P 500 rose by 5.6% since late August; stocks typically drift lower in the first few months after a major storm. In addition, the 10-year Treasury yield climbed but it usually moves down in the two months following a hurricane. Post- storm, the Fed typically continues to do whatever it was doing prior to the storm. Accordingly, we expect the Fed to hike rates at its December meeting. Chart 11Major Hurricane Impact##BR##On Activity Data Chart 12Major Hurricane Impact On##BR##Financial Markets And The Fed The economic, inflation and sentiment data are also mixed. Housing data frequently lags in the wake of a storm, but both new and existing home sales moved up in the month after Harvey and Irma; housing starts declined in recent months which is counter to the historical pattern (Chart 13). Both IP and employment plunged after the storms, however, these indicators tend to rise after major weather. Initial claims for unemployment insurance were typically volatile in the six weeks since Harvey hit Texas, but have resumed their downtrend. Average hourly earnings in inflation climbed after Harvey and Irma, while consumer confidence dipped, matching history. However, the bump in gasoline prices since late August runs counter to historical precedent. Gasoline prices tend to decline after major storms (Chart 14). Chart 13Major Hurricane Impact##BR##On Housing Data Chart 14Major Hurricane Impact On##BR##Sentiment And Inflation Data Investment Conclusions: The macro backdrop remains bullish for risk assets, especially since synchronized growth has reduced fears of secular stagnation. Bond yields will rise, but won't be a headwind for stocks yet.5 Rising bond yields because of growth, without rising inflation, are bullish for risk assets, but this will change as inflation reaches 2% and inflation expectations start to rise. At that point, the Fed will be behind the curve. This will lead to faster Fed rate hikes, historically a headwind for equities. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 2 Please see BCA's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration," April 17, 2017. Available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From The Storm," September 5, 2017. Available at usis.bcaresearch.com. 5 Please see BCA's U.S. Investment Strategy Weekly Report, "Still In The Sweet Spot" June 19, 2017. Available at usis.bcaresearch.com.

Special Report

A capex revival is underway, powered by exceptionally strong business and consumer sentiment, the breadth of which covers virtually all developed economies. This global capex upcycle should underpin top-line growth and margin expansion for the industrial conglomerates index, whose product and geographic diversification ensures exposure to the global upswing. However, the index has underperformed the broad market, dragged down by heavyweight GE and its specific headwinds. Further, the index's highest exposure sectors (namely aerospace, health care equipment, energy equipment & services and utilities) are mostly weighted negatively in our overall sector view. Adding it up, the negatives offset the positives and, in the context of fair valuations, we expect the S&P industrial conglomerates index to perform in line with the overall market. We are initiating coverage with a neutral rating. The key theme that has been driving our investment thesis in U.S. Equity Strategy in the past quarter has been accelerating global industrial production and trade, with a corresponding rotation out of defensive and into cyclical stocks. We have been adjusting our portfolio accordingly and it now has a deep cyclical bent with leverage to a burgeoning capex cycle. Enticing Macro Outlook Industrial conglomerates capitalize on most of these themes: they are globally-oriented and capex-driven, and leading indicators of final demand suggest that earnings should accelerate in the near-term. Capex Upcycle On the domestic front, regional Fed surveys of domestic capex intentions and the ISM manufacturing survey are hitting modern highs; both have been excellent indicators of a capex upcycle and the signal is unambiguously positive (Chart 1). Our Capex Indicator also corroborates this message. Durable goods orders have already surged and inventories have reverted to a more normal level, coming out of the late-2015/early-2016 manufacturing recession (Chart 2). This implies increasingly resilient pricing power from a demand-driven capital goods upcycle. Further, the capital goods cycle has significant room to run as new orders remain well below the 2013-2014 levels. Chart 1Exceptionally Strong Sentiment... Chart 2...Is Already Reflected In A Capex Upcycle Chart 3Capital Goods Demand Is Globally Synchronous The global picture echoes the domestic, with the global manufacturing PMI surging to a six-year high. The global strength is remarkably broad: all 46 of the economies tracked by the OECD are expected to see gains in 2017, a first since the GFC, and the BCA global leading economic indicator is signaling all-clear (Chart 3). U.S. Dollar Reflation The greenback's slide in 2017 should further boost global demand for domestic exports. In fact, given the diversity of industries served by the industrial conglomerates and the relatively high proportion of foreign sales (Table 1), the U.S. dollar is the single largest driver of both sales and earnings (Chart 4). Due to the lagged impact on results from the currency, industrial conglomerates margins should benefit from translation gains in the next two quarters, regardless of where the U.S. dollar moves. Table 1Conglomerates More Global Than Industrial Peers Chart 4U.S. Dollar Drives Conglomerate Profits But GE Weighs On The Index With the enormously supportive demand environment in mind, one could safely assume that the globally integrated niche industrial conglomerates index has been a strong performer in 2017. That would be true were it not for index heavyweight (and laggard) General Electric. Excluding GE from this index, industrial conglomerates have outperformed the S&P 500 by 20% since the start of the year (Chart 5). However, GE represents 40% of the index (Chart 5) and its current transformation continues to weigh heavily on its share price and, hence, the index at large. The new CEO, who took over earlier this month, has stated that "everything is on the table" as part of a $20 billion target for divestitures over the coming two years. The current fear among investors is that GE will need to reduce its dividend to preserve enough liquidity to continue growing despite the fairly synchronous storm in its end-markets. In March, 2009, GE's share price reached its modern nadir, a level not seen since the recession of the early 1990's, a week following its dividend cut announcement. While hardly analogous to GE today (recall that a cash crisis at GE Capital threatened to bankrupt the entire firm), the risk of a dividend cut will keep GE's share price suppressed, and likely hold the overall index hostage. Payout ratios in the industrial conglomerates index reflect GE's cash flow woes and have now surpassed the pre-dividend cut level during the GFC (Chart 6). This largely reflects cash contraction, combined with an unwillingness to even halt dividend growth. Regardless, GE investors clearly anticipate the new CEO will reduce the dividend, having pushed the yield to its highest level since the last dividend cut (Chart 6). Chart 5GE Still Dominates The Index Chart 6A Dividend Cut Looks To Be In The Cards Soft End-Markets Backdrop From the mid-1990's until 2007, the narrative of the S&P industrial conglomerates index was the rise and fall of GE Capital, as evidenced by the index' price. In 2015, the now largely complete sale of the majority of GE Capital was announced, realigning the company as an industrial manufacturer. Accordingly, analyzing the key end-market industries that the S&P industrial conglomerates cater to is in order: aerospace, healthcare, oil & gas and utilities. Chart 7Aerospace Profits Look Set To Fall Chart 8Health Care Equipment Pricing Collapsing Aerospace (Underweight recommendation) - We downgraded the BCA aerospace index to underweight at the end of 2015, corresponding fairly closely to the peak of the aerospace orders cycle (Chart 7). Since then, orders have fallen by half reflecting a downturn in the commercial aerospace cycle. While shipments have been falling, the decline has been much less precipitous as manufacturers have been running down backlogs. Historically, maintenance has buffered aerospace profits, repair and consumables activity, though weak current pricing power suggests that this may prove less sustainable than in previous cycles. Both GE & HON share extensive exposure to aerospace demand as it represented 23% and 38% of 2016 revenues, respectively. Health Care Equipment (Neutral recommendation) - We reduced our recommendation to neutral earlier this year as weaker demand no longer supported the thesis of an earnings-led outperformance. Since then the industry's outlook has not improved as demand has downshifted and pricing has cooled substantially; orders and production both crested last year and pricing power has contracted relative to overall since December 2016 (Chart 8). This bodes ill for medical equipment margins. Health care equipment represented 16% and 18% of GE & MMM 2016 revenues, respectively. Energy Equipment & Services (Overweight recommendation) - Energy Equipment & Services is our only overweight recommended sector relevant to the industrial conglomerates analysis. We upgraded in late 2016 (and doubled down on June 2) based on three key factors: troughing rig counts, cresting global oil inventories and falling production growth. Two of these factors have come to fruition: the global rig count bottomed in 2015, and has staged its best recovery since 2009 (Chart 9) and the growth in total OECD oil stocks is moderating rapidly with recent large storage draws. The key missing ingredient has been pricing power, which should eventually turn up if rig counts prove resilient. Energy equipment & services represented 11% of GE's 2016 revenues. Utilities (Underweight recommendation) - As previously noted, a key macro theme in U.S. Equity Strategy is accelerating global industrial production and trade. Utilities tend to move in the opposite direction of that theme given their safe haven status (top panel, Chart 10). Combined with falling domestic electricity production and capacity utilization, and rising turbine & generator inventories, the industry's outlook is bleak (middle & bottom panels, Chart 10). GE's Power segment is one of the world's largest gas and steam turbine manufacturers and delivered 24% of 2016 revenues. Investment Recommendation A roaring, globally synchronous capital goods upcycle should mostly keep sales and profits buoyant in this industrials subsector. However, high concentration in one stock, which is experiencing a greater than normal amount of flux, adds significant specific risk. Further, we are less optimistic about the key industries served by the industrial conglomerates than we are for the economy at large, implying more opportunity for outperformance from other, more focused, S&P industrials peers. If valuations were particularly compelling they could provide a cushion to any profit mishap, but this is not the case. Our Valuation Indicator is in the neutral zone and, while our Technical Indicator is in oversold territory, it has shown an ability to remain at these levels for prolonged periods (Chart 11). Chart 9Energy Services Is A Bright Spot Chart 10Utilities Are In A Deep Cyclical Decline Chart 11Valuations Are Not Compelling Bottom Line: Netting it out, we think the S&P industrial conglomerates index should perform broadly in line with the overall market. Accordingly, we are initiating coverage with a neutral rating. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com

Underweight This summer, we downgraded the S&P soft drinks index to underweight based on a collapse in beverage shipments and its high correlation with relative performance. That decline has since accelerated but even lower volumes have not been enough to reverse the industry's price deflation (second panel). Index heavyweights KO & PEP recently reported declining Q3 revenues and profits, confirming the message that demand is shrinking and earnings will continue to suffer. Valuations too have come down, reflecting the industry's woes (third panel). However, they sport a 21% premium to the S&P 500 despite much worse growth prospects (bottom panel). Given these industry dynamics, we think the valuation slide has further to go; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFD - PEP, KO, DPS, MNST.

Feature This week we are sending you a shorter-than-usual market update, as we are also publishing a Special Report exploring the outlook for USD cross-currency basis swap spreads. This report argues that USD basis swap spreads should widen over the next 12 months. Being a phenomenon associated with higher FX vols, this should hurt carry trades, including EM and dollar bloc currencies. It will also potentially create additional support for the USD. Also, next week, we will provide a deeper analysis of the fallout from the New Zealand government's dynamics. ECB Tapers? European Central Bank President Mario Draghi refused to call it "tapering," but he nonetheless announced that the ECB will be cutting back its asset purchases to EUR30 billion per month until at least September 2018. However, because the ECB will continue to proceed with re-investment of the stock of assets it holds, the monthly total presence of the ECB in European bond markets will stay above EUR 30 billion. Moreover, the ECB is keeping the door open to leaving its purchases in place beyond September 2019, if inflation does not keep track with the central bank's forecasts, and thus referred to the adjustment as being open-ended. Ultimately, the ECB does think that the recent rebound in inflation has been and remains a function of maintaining a very accommodative monetary setting. We think this option to keep the asset purchases in place beyond September 2018 is just this: an option. However, we do believe that yesterday's change in policy means the ECB will not increase interest rates until well into 2019. We also anticipate U.S. core inflation to begin outperforming euro area core inflation as U.S. financial conditions have eased significantly relative to the euro area - a key factor to redistribute inflationary pressures among these two economies (Chart I-1). As a result, because we anticipate that the Federal Reserve will increase the fed funds rate by more than the 67 basis points currently expected over the next two years, there could be some downside risk in EUR/USD. This downside risk is already highlighted by the large gap that has recently emerged between the 1-year/1-year forward risk-free rate spread between Europe and the U.S. versus the euro itself (Chart I-2). Chart I-1U.S. Inflation Set To Outperform Euro Area Prices Chart I-2Forward Interest Rates Point To A Lower Euro Moreover, the elevated long positioning right now further highlights the downside risk present in the euro (Chart I-3), probably explaining the European currency's rather violent reaction to what was a well-anticipated policy move. This means that EUR/USD could end 2017 in the 1.15 neighborhood, and fall further in 2018. Chart I-3Positioning Risk In EUR/USD Bottom Line: The ECB delivered exactly what was anticipated, yet the euro sold off. The ECB is unlikely to increase interest rates until well into 2019, suggesting the first anticipated rate hike in Europe is fairly priced. Thus, in order to justify any downside in the euro, one needs to be more positive on the Fed than what is currently priced into the U.S. interest rate curve. We fall into this camp. Moreover, positioning remains too long the euro. We expect EUR/USD to fall toward 1.15 by year end, and display more downside in 2018. Bank Of Canada The Bank of Canada (BoC) surprised the market this week by expressing a reversing of its recent pronounced hawkish bias, instead expressing a much more cautious tone. Where a closed output gap was once driving the need for tighter policy, residual labor market slack now warrants a more restrained approach to tightening. What has changed? NAFTA. The most recent and tenuous NAFTA negotiation round raised the specter of an end to the North American FTA. While NAFTA is still not dead, the rising probability that Canada-U.S. trade falls backs under the umbrella of the previous CUSFTA or even maybe something worse is causing a headache for Canadian policymakers. Some 20% of Canadian GDP is made up of products destined to be exported to the U.S., and this large chunk of GDP could be under some risk. Additionally, as the BoC highlighted, future investment decisions by firms in Canada may become investments in the U.S. to bypass regulatory uncertainty. Ultimately, if the Canada / U.S. trade relationship falls back under the CUSFTA umbrella, the impact on Canadian growth will be limited. Nonetheless, we think the BoC is correct to play its hand carefully, especially as the Canadian housing market is cooling. Moreover, a recent IPSOS survey revealed that around 40% of Canadian households would face financial difficulties if rates moved up significantly, which may justify a slower pace of hiking. With all this uncertainty looming, it is logical for the BoC to take its time before tightening policy anew. But in the end, we do anticipate the Canadian central bank to increase rates around two times next year, which is in line with the market's assessment: Canada's output gap is closing, and inflation is moving in the right direction. Thus, the outlook for the CAD is likely to be dominated by the outlook for oil. Robert Ryan, who runs BCA's Commodity And Energy Strategy service, expects WTI to move toward US$63/bbl next year, with upside risk to his forecast.1 This could help the CAD. However, the CAD does not seem particularly cheap against the USD when Canada's poor productivity performance is taken into account (Chart I-4), and speculators are now quite long the CAD (Chart I-5). As a result, our preferred medium to express positive views on the CAD is to be short AUD/CAD, where a valuation advantage is still present for the loonie (Chart I-6). Moreover, the AUD is more likely to suffer from China moving away from its investment-led growth model, while the CAD is less exposed to this risk. Chart I-4The CAD Is Not That Cheap Chart I-5Speculators Are Very Long The CAD Chart I-6Short AUD/CAD Bottom Line: The BoC is rightfully concerned that a breakdown of NAFTA would negatively affect the Canadian economy. While a return to CUSFTA would minimize any impact, the current high degree of uncertainty warrants that the BoC takes a more cautious stance. Ultimately, the BoC will increase rates next year, potentially two times. We continue to prefer to short AUD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, titled "Upside Risks Dominate BCA's Oil Price Forecast", dated October 26, 2017, available at ces.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been strong: Manufacturing PMI came out at 54.5, stronger than expected; Services PMI came out at 55.9, also stronger than expected; Durable goods orders increased by 2.2%; New home sales increased by 18.9% monthly, the highest growth rate in 25 years; Initial jobless claims declined and beat expectations. Crucially, the DXY is above its 100-day moving average and has broken the reverse head-and-shoulders neckline, with momentum in the greenback's favor. The ECB's tapering weakened the euro by 1.4%. Further weakness in commodity currencies also allowed the dollar to gain momentum. We expect this momentum to continue as inflation in the U.S. re-emerges over the next six to twelve months. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB's decision was largely in line with market consensus, but the euro nonetheless fell significantly. The ECB will halve its rate of purchases to EUR 30 bn a month starting next year until at least September 2018. However, President Mario Draghi stated that this could be extended beyond September, or even increased, if conditions warrant it. Draghi noted that "domestic price pressures are still muted overall and the economic outlook and the path of inflation remain conditional on continued support from monetary policy", also stating that rates would remain low for an extended period of time, and possibly even "past the horizon of the net asset purchases". Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The Leading Economic Index increased from 105.2 to 107.2 in the month of August. Nikkei Manufacturing PMI surprised to the downside, coming in at 52.5, declining from 52.9 the month before. However, corporate service prices year-on-year growth came in at 0.9%, against expectations of 0.8%. Following the overwhelming victory of Prime Minister Shinzo Abe, the USD/JPY traded above 114, before stabilizing just below later in the week. Now that Abe has won the election, he is freer to implement loose fiscal policy in order to increase his chances to amend the pacifist Japanese constitution. This, accompanied by 10-year JGB rates anchored around zero, and a Federal Reserve that is likely to hike more than expected, should push USD/JPY higher. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in Britain has been mixed: Gross Domestic product yearly and quarterly growth surprised to the upside, coming in at 1.5% and 0.4% respectively. Moreover, public sector net borrowing was also lower than expected coming in at 5.236 billion pounds for the month of September. However, BBA mortgage approvals came below expectations, coming in at 41.584 thousand, which is lower than the month before. The pound has gone up following the positive GDP reading. As of now the market considers there is a 91% probability that the Bank of England hikes rates in November. However any hikes beyond that would require a significant improvement in economic activity. Thus, we would tend to fade any strength in GBP/USD, as the Fed is more likely to hike rates than the BoE on a sustainable basis. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD declined on weak consumer price numbers. The trimmed mean CPI remained steady at 1.8% annually, below the expected 2% rate, and weakened to 0.4% quarterly, down from 0.5%. The largest yearly decline was in communication (services or equipment) of 1.4%, although declines in food prices and clothing were also substantial at 0.9%. This is largely in line with our view that the consumer sector is handicapped with poor wage growth. We believe inflation is unlikely to move much higher; this will keep the RBA at bay. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: Imports surprised to the upside, coming in at 4.92 billion dollars. This figure also increased form last month's reading. However exports underperformed expectations, coming in at 3.78 billion dollars for the month of September. Finally the trade balance, also underperformed expectations, coming in at -1.143 billion dollars. After the election of new Prime Minister Jacinda Ardern the kiwi has plunged, and now has a negative return year-to-date. The government is trying to implement three measures which significantly affect the value of the kiwi: a dual central bank mandate, restrictions on immigration, and a stop to foreign real estate purchases. All these measures lower the terminal rate for the RBNZ. With this being said, we are still shorting AUD/NZD given that commodity dynamics will dominate the movements of this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 CAD had an eventful week as the Bank of Canada came out with a monetary policy decision. The decision was in line with the consensus, but the statement was not. The Bank was particularly concerned "about political developments and fiscal and trade policies, notably the renegotiation of the North American Free Trade Agreement". Additionally, it was also noted that "because of high debt levels, household spending is likely more sensitive to interest rates than in the past". The Bank also made a U-turn in its view of the labor market, stating that "wage and other data indicate that there is still slack in the labor market". These unexpected remarks dropped the CAD's value by 1% against USD. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Franc continues to depreciate against the Euro, even as EUR/USD has gone down more than 2.5% since peaking early in December. Meanwhile, as the franc has depreciated, economic variables have improved. The KOF Industry Survey Business Climate indicator is now positive for the first time since 2011. Meanwhile, core inflation has reached 2011 highs as well. Additionally multiple components of PMI are at their highest level in the past 6 years. All of these factors bode well for the Swiss economy, and prove that the SNB's ultra-loose monetary policy and currency intervention is working. That being said, we would like to see more strength from key economic variables to consider shorting EUR/CHF, given that the recovery is still too fragile for the SNB to change policy. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Norges Bank left their key policy rate unchanged at 0.5% yesterday. The central bank highlighted that capacity utilization was below normal levels and that inflation was expected to be below 2.5% in the coming years. Furthermore, the comittee highlighted that although the labor market appears to be improving, inflation has been lower than expected, while the krone is also weaker than projected. The bank has reassured our view that even in the face of strong oil prices, slack is still too big in the Norwegian economy for the Norges Bank to start raising rates. Furthermore, a hawkish fed will further put upward pressure on USD/NOK. Than being said, EUR/NOK should depreciate, given that this cross is much more sensitive to oil than it is to rate differentials. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has depreciated considerably in recent weeks owing to somewhat weaker inflation figures. It has weakened particularly against the EUR, as markets are expecting the Riksbank to follow the ECB in its rate path. This was confirmed by a particularly dovish tone from the recent monetary policy statement which exacerbated this decline, with the board expecting to maintain the current monetary policy until mid-2018, and even discussed a possible extension of asset purchase programs beyond December. The Board has "also taken a decision to extend the mandate that facilitates a quick intervention in the foreign exchange market". Finally, they lowered their inflation forecasts for both 2017 and 2018. Stefan Ingves is firmly in control. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. Feature Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. The rather arcane topic of cross-currency basis swap spreads has periodically surfaced in the news in the past few years. The widening in cross-currency basis swap spreads has been highlighted as one of the key factors explaining why covered interest rate parity relationships (the link between the price of FX forward, spot prices and interest rate differentials) have not held as closely after the Great Financial Crisis (GFC) as before. The widening of cross-currency basis swap spreads has also been highlighted as a factor behind the strength in the U.S. dollar in 2014 and 2015. Similarly, the recent narrowing in the cross-currency basis swap spread has been highlighted as a factor behind the weakness in the USD this year. This week we delve a little deeper into what cross-currency basis swap spread measures, and what some of its major determinants are. We ultimately expect the USD cross-currency basis swap spread to widen again, which should contribute to a stronger dollar and increased global FX volatility. What Is A Cross-Currency Basis Swap? To examine what drives cross-currency basis swap spreads, one first needs to understand what these instruments are. Let's begin with a regular FX swap. An FX swap in EUR/USD is a contract through which two counterparties agree to exchange EURs for USDs today, with a reversal of that exchange at the maturity of the contract - a reversal set at a predetermined exchange rate simply equal to the forward value of the EUR/USD. So, if counterparty A lends X million EURs to counterparty B, the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. The transaction does not end there. Simultaneously, the FX swap forces B to give back the X million EURs to counterparty A at maturity, while counterparty A gives back X million EUR times the EUR/USD forward rate in U.S. dollars to counterparty B. This forward rate is the rate prevalent when the contract was agreed upon. The transactions are illustrated in the top panel of Chart 1. Chart 1FX Swaps Vs. Cross Currency Basis Swaps The problem with regular FX swaps is that they offer little liquidity at extended maturities. If market players want to hedge long-term liabilities and assets, they tend to do so using a cross-currency basis swap, where much more liquidity is available at long maturities. Chart 2A Bigger Funding Gap = ##br##A Wider Basis Swap Spread A EUR/USD cross currency basis swap begins in the same way as a regular FX swap: counterparty A lends X million EURs to counterparty B, and the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. However, this is where the similarities end. A cross-currency basis swap has exchanges of cash flows through its term. Counterparty B, which provided USDs to counterparty A, receives 3-month USD Libor, while counterparty A, which provided EURs to counterparty B, received 3-month EUR Libor + a (alpha being the cross-currency basis swap spread). At the maturity of the contract, counterparty A and B both receive their regular intermediary cash flows, and also re-exchange their respective principal - but this time at the same spot rate as the one that existed at the entry of the contract (Chart 1, bottom panel). In both regular FX and cross-currency basis swaps, counterparties have removed their FX risks, except that in the latter, the interest differentials have been paid during the life of the contract instead of being factored through the forward premium/discount. This is fine and dandy, but it leaves a unexplained. The cross currency basis swap spread (a), is a direct function of the relative supply and demand for each currency. If investors demand a lot of EUR in the swap market relative to its supply, a will be positive. If they demand more USDs, a will be negative. A good example of this dynamic is the funding gap of banks. Let's take the Japanese example. Japanese banks have a surplus of domestic deposits (thanks to the massive savings of the Japanese corporate sector) relative to their yen lending. As a result, they have large dollar lending operations. To hedge their dollar assets, Japanese banks borrow USD in large quantities in the cross-currency swap market. This tends to result in a negative swap spread in the yen (Chart 2). This is particularly true if both the banking sector and the other actors in the economy (institutional investors and non-financial firms) also borrow dollars in the swap market to hedge dollar assets, which is the case in Japan (Chart 3). Chart 3Japanese Investors Are Accumulating Assets Abroad Additionally, if there are perceived solvency risks in the European banking sector, this should further weigh on the cross-currency basis swap spread, pushing it deeper into negative territory, as the viability of the main EUR counterparties becomes at risk. The same dance is true for any currency pair. Chart 4The Structural Gap In The Basis Swap Spread##br## Reflects Regulation The other factor that affects USD cross-currency basis swap spreads is the supply of U.S. dollars, especially the room on large banks' balance sheets to service these markets. The cross-currency basis swap spread could be close to zero if large arbitrageurs take offsetting positions to arbitrage the spread away, doing so until the spread disappears. However, with the imposition of Basel III and Dodd-Franks, banks have been constrained in their capacity to do this. Indeed, increased leverage ratio requirements (now banks need to post more capital behind repo transactions as well as collateralized lending and other derivatives) mean that arbitraging cross-currency basis swap spreads and deviations from covered interest rate parity has become much more expensive. Furthermore, the increase in Tier 1 capital ratios associated with these regulations has forced banks to de-lever; however, engaging in arbitrage activities still requires plenty of leverage (Chart 4). Economic Factors Driving The Spread The factors that we look at essentially relate to the supply of USD available for lending in offshore markets, as well as determinants of relative counterparty risks between the U.S. and the rest of the world. Factors Arguing For Narrower Cross-Currency Basis Swap Spreads Global Banks Health The price-to-book ratio of global banks outside the U.S. has been largely correlated with USD cross-currency swap spreads. When global banks get de-rated, spreads widen, and it becomes more expensive to hedge USD positions in the swap market (Chart 5). This is because as investors perceive the solvency of global banks deteriorating, they impose a penalty as the Herstatt risk increases. Additionally, solvency problems can force banks to scramble to access USD funding, prompting deeper spreads. Chart 5Banks Perceived Health Determines ##br##Basis Swap Spreads BCA is positive on global financials and sees continued improvement in European NPLs. This means that solvency risk concerns are likely to remain on the backburner for now, pointing to narrower basis swap spreads. Supplementary Leverage Ratio Changes In June, the U.S. Treasury announced a relaxation of some of its rules on supplementary leverage ratios, lowering the amount of capital required to support activity in the repo market behind initial margins for centrally cleared derivatives, and behind holdings of Treasurys. This means that commercial banks in the U.S. can have bigger balance sheets and more room to engage in arbitrage activity, implying a greater supply of dollars in the USD cross-currency basis swap market. In response to last June's proposal, basis swap spreads narrowed by 11 basis points. BCA believes these changes will continue to support dollar liquidity, and will further help in narrowing cross-currency basis swap spreads. Prime Money-Market Funds Debacle Is Over Chart 6More Expensive Bank Funding Equals ##br##Wider Basis Swap Spreads In October 2016, regulatory changes were implemented that allowed prime money market funds to have fluctuating net asset values. Obviously, this meant that prime money-market funds would be not-so-prime anymore. As a result, to remain the ultra-safe vehicles that they once were, prime money-market funds de-risked. As a result, they cut their exposure to risky activities in anticipation of these changes. In practice, a key source of short-term funding for banks evaporated from the market, putting upward pressure on bank financing costs. As the LIBOR-OIS spread increased, so did basis-swap spreads (Chart 6): as it became more expensive for banks to finance themselves, they had to curtail the supply of USDs provided to the swap market, an activity normally requiring intense demand on banks' balance sheets. This adjustment is now over, suggesting limited potential widening in USD basis swap spreads. Factors Arguing For Wider Cross-Currency Basis Swap Spreads 1. U.S. Loan Growth When U.S. banks increase their loan formation activity, USD cross-currency basis swap spreads widen (Chart 7). As banks increase their extension of credit through loans, they decrease the amount of securities they hold on their balance sheets (Chart 8). This means there is less supply of liquidity available for balance sheet activities, particularly providing dollar funding in the offshore market. In the Basel III / Dodd-Frank world, less-liquid bank balance sheets are synonymous with wider USD basis-swap spreads. As we argued last week, increasing U.S. capex, easing lending standards for firms and rising household income levels should result in increasing loan growth in the U.S. which will result in lower abundance of liquid assets and a widening basis swap spreads.1 Chart 7More Bank Loans Lead To Wider Swap Spreads Chart 8More Debt Equals Less Securities In Bank Credit 2. U.S. Inflation There is a fairly close relationship between U.S. inflation and the USD basis swap spread, where a higher core CPI tends to lead to a wider spread (Chart 9). The fall in U.S. inflation this year likely contributed to the narrowing in basis swap spreads. Our take on this is that as inflation falls, it gives an incentive for banks to hold low-yielding liquidity on their balance sheets as real returns on cash improve. This fuels a gigantic carry trade through the basis-swap market. We expect inflation to pick up meaningfully by mid-2018, which should widen cross-currency basis swap spreads.2 3. Central Bank Balance Sheets When the Federal Reserve increases the size of its balance sheet relative to other balance sheets, this tends to lead to a narrowing of the USD basis swap spread as the global supply of dollars relative to other currencies increases. The opposite is also true. This relationship did not work after late 2016 (Chart 10). However, during that episode, as the change in prime money-market funds caused a dislocation in banks' funding, commercial banks exhibited cautious behavior and increased their reserves with the Fed. As Chart 11 illustrates, there is a tight relationship between the change in commercial banks' reserves held at the Fed and cross-currency basis swap spreads. Going forward, as the Fed lets it balance sheet run off, we expect to see a decrease in commercial banks' excess reserves. This could contribute to upward movement in the basis swap spread. Chart 9When U.S. Inflation Increases, ##br##Swap Spreads Widen Chart 10Smaller Fed Balance Sheet Leads To##br## Wider Basis Swap Spreads Chart 11Fed Runoff Could##br## Widen Basis Swap Spreads 4. U.S. Repatriations The most revealing relationship unearthed in our study was that when U.S. entities repatriate funds at home, this tends to put strong widening pressure on the USD cross-currency basis swap spread (Chart 12). U.S. businesses hold large cash piles abroad - by some estimates more than US$2.5 trillion. However, most of these funds are held in highly liquid, high-quality U.S.-dollar assets offshore. These assets are perfect collaterals for various transactions in the interbank market. The funds held abroad by U.S. firms are a source of supply for U.S. dollars in the offshore markets. When U.S. entities bring assets back home, the widening in the basis swap spread essentially reflects a decline in the supply of USD in offshore markets, and vice versa when Americans export capital abroad. Chart 12U.s. Repatriations Support Wider Basis Swap Spreads BCA's base case is that tax cuts are likely to hit the U.S. economy in 2018, even if the growing feud between Trump and the establishment Republican party members is a growing risk. BCA still views a tax repatriation as a higher-likelihood event, as it is the easiest way for the U.S. government to bring funds into its coffers. The 2004 tax repatriation under former President George W. Bush did result in substantial fund repatriation in the U.S. This time will not be different. We expect any such tax repatriation to cause a potentially large deficit of supply in the USD offshore markets, which could create a strong widening basis on the cross-currency basis swap spread in favor of the dollar. Bottom Line: Three factors argue for USD cross-currency basis swap spreads to stay at current levels, or even narrow further. These factors are the health of global banks, the easing in U.S. supplementary leverage ratios and the end of the adjustment of U.S. bank funding to new regulations affecting prime money-market funds. On the other hand four factors points to wider USD cross-currency basis swap spreads: BCA's positive outlook for U.S. credit growth; BCA's positive outlook on U.S. inflation; the run-off of the Fed's balance sheet; and the potential for U.S. entities repatriating funds from abroad. Potential Direction And Investment Implications We anticipate USD cross-currency basis swap spreads to widen over the coming 12 months. We think the easing in the Supplementary Leverage Ratios rules by the U.S. Treasury is the most important factor pointing to narrower USD cross-currency basis swap spreads. However, Basel III rules and most of Dodd-Frank are still in place, which suggest there remains large constraints on the balance-sheet activities of global banks, which will limit the potential for a narrowing of the USD basis swap spread as U.S. banks will remain constrained in their ability to supply U.S. dollars in the offshore market. On the other hand many factors support wider USD cross-currency basis swap spreads, most important of which is the potential for more credit growth. This is in our view a very strong force as it requires banks to ration the use of their balance sheets, limiting their activity in the offshore market. Moreover, we do foresee a high probability of tax repatriation, which would put strong widening pressure on the swap spreads. In terms of implications, wider USD basis swap spreads tend to be associated with rising FX vols (Chart 13). As we highlighted in a Special Report last year, higher FX vols are poison for carry trades.3 As such, we think that widening swap spreads could spur a period of trouble for traditional carry currencies. This means EM and dollar-block currencies are likely to suffer in this environment. Chart 13Wider Basis Swap Spreads Equals Higher Vol Additionally, in China, Xi Jinping is consolidating power and has taken control of the Politburo. This implies he now has more room to implement reforms. Removal of growth targets after 2020, removal of growth as a criterion for grading local officials, a focus on balanced growth, and a focus on combatting pollution all suggest that Chinese growth is unlikely to follow the same debt-fueled, capex-led model.4 This will weigh on Chinese imports of raw materials, and hurt export volumes and prices for many EM countries and commodities producers. This means these policies represent a headwind for many carry currencies. Moreover, historically, wider USD funding costs have been associated with a stronger dollar, as it makes it more expensive to hedge dollar assets. Thus, in an environment where U.S. interest rates are rising relative to the rest of the world - making U.S. assets attractive - wider basis swap spreads are an additional factor that could lift the dollar. Bottom Line: We anticipate the USD cross-currency basis swap spread to widen over the next 12 months. This will be associated with higher FX vols, which hurt carry trades, EM currencies and dollar-block currencies. Chinese reforms will reinforce these risks. Additionally, wider basis swap spreads will create support for the USD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "All About Credit", dated October 20, 2017, available at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, and "Is The Dollar Expensive?", dated October 13, 2017. 3 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016. 4 Please see Geopolitical Strategy Weekly Report, titled "Xi Jinping: Chairman Of Everything", dated October 25, 2017 and Special Report, titled "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017.

Bank Credit Analyst

Highlights The macro environment remains positive for risk assets. Nonetheless, the shadow of the '87 stock market crash is a reminder that major market corrections can occur even when the earnings and economic growth backdrop is upbeat. Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of easier financial conditions and the likelihood of some fiscal stimulus next year. Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should overweight Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments). High-yield relative value is decent after accounting for the favorable default outlook. It is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late cycle phase. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. The risk of disappointment is therefore elevated. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons and provide dry powder to boost exposure after the correction. Feature The October anniversary of the '87 stock market crash was a reminder to investors that major market corrections can arrive out of the blue. With hindsight, there were some warning signs evident before the crash. Nonetheless, the speed and viciousness of the correction caught the vast majority of investors by surprise, in large part because the economy was performing well (outside of some yawning imbalances such as the U.S. current account deficit). Many worried that the 20% drop in the S&P 500 would trigger a recession, but the economy did not skip a beat and it was not long before the equity market recouped the losses. We view the '87 crash as a correction rather than a bear market. BCA's definition of a bear market is a combination of magnitude (at least a 15% decline) and duration (lasting at least for six months). Bear markets are usually associated with economic recessions. Corrections tend to be short-lived because they are not associated with an economic downturn. None of our forward-looking indicators suggest that a recession is in the cards in the near term for any of the major economies. Even the risk of a financial accident or economic pothole in China has diminished in our view. As discussed below, the global economy is firing on almost all cylinders. Chart I-1Valuation Today Is Very Stretched Vs. 1987 Nonetheless, there are some parallels today with the mid-1980s. A Special Report sent to all BCA clients in October provides a retrospective on the '87 crash.1 One concern is that the proliferation of financial computer algorithms and derivatives is a parallel to the popularity of portfolio insurance in the 1980s, which was blamed for turbocharging the selling pressure when the market downturn gathered pace in October. My colleague Doug Peta downplays the risks inherent in the ETF market in the Special Report, but argues that automatic selling will again reinforce the fall in prices once it starts. It is also worrying that equity valuation is much more stretched than was the case in the summer of 1987 based on the cyclically-adjusted P/E ratio (CAPE, Chart I-1). The CAPE is currently at levels only previously reached ahead of the 1929 and 2000 peaks. In contrast, the CAPE was close to its long-term average in 1987. Quantitative easing and extremely low interest rates have pulled forward much of the bond and stock markets' future returns. It has also contributed to today's extremely low readings on implied volatility. The fact that the Fed is slowly taking away the punchbowl and that the ECB is dialing back its asset purchase program only add to the risk of a sharp correction. The Good News For now though, investors are focusing on the improving global growth backdrop and the still-solid earnings picture. While the S&P 500 again made new highs in October, it was the Nikkei that stole the show among the major countries. Impressively, the surge in the Japanese stock market was not on the back of a significantly weaker yen. As we highlighted last month, risk assets are being supported by the three legged stool of robust earnings growth, low volatility and yield levels in government bonds, and the view that inflation will remain quiescent for the foreseeable future. The fact that the global growth impulse is broadly-based is icing on the cake because it reduces lingering fears of secular stagnation. Even emerging economies have joined the growth party, while a weak U.S. dollar has tempered fears of a financial accident in this space. Our forward-looking growth indicators are upbeat (Chart I-2). Our demand indicators in the major economies remain quite bullish, especially for capital spending (not shown). Animal spirits are beginning to stir. Moreover, financial conditions remain growth-friendly, especially in the U.S., and subdued inflation is allowing central banks to proceed cautiously for those that are tightening or tapering. The global PMI broke to a new high in October, and the economic surprise index for the major economies has surged in recent months. Our global LEI remains in a strong uptrend and its diffusion index shifted back into positive territory, having experiencing a worrisome dip into negative territory earlier this year. We expect the global growth upturn will persist for at least the next year. The U.S. will be the first major economy to enter the next recession, although this should not occur until 2019. It is thus too early to expect the equity market to begin to anticipate the associated downturn in profit growth. Earnings: Japan A Star Performer It is still early days in the Q3 earnings season, but the mini cyclical rebound from the 2015/16 profit recession in the major economies is still playing out. The bright spots at the global level outside of energy are industrials, materials, technology and consumer staples (Chart I-3). All four are benefitting from strengthening top line growth and rising operating margins. Chart I-2Upbeat Global Economic Indicators Chart I-3Global Earnings By Sector The U.S. is further advanced in the mini-cycle and EPS growth is near its peak on a 4-quarter moving total basis. The expected topping out in profit growth is more a reflection of challenging year-on-year comparisons than a deterioration in the underlying fundamentals. The hurricanes will take a bite out of third quarter earnings, but this effect will be temporary. Moreover, oil prices are turbocharging earnings in the energy patch and we expect this to continue. Our commodity strategists recently lifted their 2018 target price for both Brent and WTI to $65/bbl and $63/bbl, respectively. The global uptick in GDP growth, along with continued production discipline from OPEC 2.0 are the principal drivers of our revised outlook. We expect the fortuitous combination of fundamentals to accelerate the drawdown in oil inventories globally, which also will be supportive for prices. While U.S. financials stocks have cheered the prospects that Congress may pass a tax bill sometime in early 2018, sell-side analysts have been brutally downgrading financial sector EPS estimates. This has dealt a blow to net earnings revisions in the sector. Expected hurricane-related losses are probably the main culprit, especially in the insurance sector. Nonetheless, our equity sector strategists argue that such indiscriminate downgrades are unwarranted, and we would lean against such pessimism.2 Recent profit results corroborate our positive sector bias, although we are still early in the earnings season. European profits will suffer to some extent in the third quarter due to the lagged effects of previous euro strength. The same will be true in the fourth quarter, although we expect this headwind to diminish early in 2018. That leaves Japan as the star profit performer among the majors in the near term. The recent surge in foreign flows into the Japanese market suggests that global investors are beginning to embrace the upbeat EPS story. Abe's election win in October means that the current monetary stance will remain in place. The ruling LDP's shift away from austerity (e.g. abandoning the primary balance target) may also be lifting growth expectations. A Return To The Great Moderation? Chart I-4Market Correlation And The ERP A lot of the good news is already discounted in equity prices. The depressed level of the VIX and the drop in risk asset correlations this year signal significant complacency. Large institutional investors are reportedly selling volatility and thus dampening vol across asset classes. But there is surely more to it. It appears that investors believe we have returned to the pre-Lehman period between 1995 and 2006 when the Great Moderation in macro volatility contributed to low correlations among stocks within the equity market (Chart I-4). The idea is that low perceived macroeconomic volatility during that period had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. Of course, the Great Recession and financial market crisis brought the Great Moderation to a crashing end. Correlations rocketed up and investors demanded a higher equity risk premium to hold stocks. Today, dispersion in the outlooks for growth and interest rates have fallen back to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart I-5). Some of this can be justified by fundamentals. The onset of a broadly-based global expansion phase has likely calmed lingering fears that the global economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has moderated as well (bottom panel). Historically, implied volatility tended to fall during previous periods when global industrial production was strong and global earnings were rising across a broad swath of countries (Chart I-6). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to fall as earnings fundamentals become more important performance drivers and sector differentiation generates alpha, as the broad market enters the last stage of the bull market. Similarly, the VIX can fluctuate at low levels for an extended period when global growth is broadly based. Chart I-5A Less Uncertain Macro Outlook? Chart I-6Broad-Based Growth Lower Implied Volatility Still, current levels of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table I-1 shows the drop in the S&P 500 index during non-recession periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during the nine episodes, with a range of -3.6 to -18.1%. Table I-1Episodes When VIX Spiked The Equity Risk Premium Chart I-7Still Some Value In High-Yield On a positive note, the equity risk premium (ERP) is not overly depressed. There are many ways to define the ERP, but we present it as the 12-month forward earnings yield minus the 10-year Treasury yield in Chart I-4. It has fallen from about 760 basis points in 2011 to 310 basis points today. We do not believe that the ERP can return to the extremely low levels of 1990-2000. At best, the ERP may converge with the level that prevailed during the last equity bull market, from 2003-2007 (about 200 basis points). The current forward earnings yield is 550 basis points and the 10-year Treasury yield is 2.4%. The ERP would need to fall by 110 basis points to get back to the 2% equilibrium. This convergence can occur through some combination of a lower earnings yield or higher bond yield. If the 10-year yield is assumed to peak in this cycle at about 3% (our base case), then this leaves room for the earnings yield to fall by 50 basis points. This would boost the forward earnings multiple from 18 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We are not betting on any further multiple expansion but the point is that stocks at least have some padding in the event that bond yields adjust higher in a gradual way. It is the same story for speculative-grade bonds, which are not as expensive as they seem on the surface. The average index OAS is currently 326 bps, only about 100 bps above its all-time low. However, junk value appears much more attractive once the low default rate is taken into account. Chart I-7 presents the ex-post default-adjusted spreads, along with our forecast based on unchanged spreads and our projection for net default losses over the next year. The spread padding offered by the high-yield sector is actually reasonably good by historical standards, assuming there is no recession over the next year. We are not banking on much spread tightening from here, which means that high-yield is largely a carry trade now. Nonetheless, given a forecast for the default and recovery rate, we expect U.S. high-yield excess returns to be in the range of 2% and 5% (annualized) over the next 6-12 months. The bottom line is that the positive growth backdrop does not rule out a correction in risk assets, especially given rich valuations. But at least the profit, default and growth figures will remain a tailwind in the near term. The main risk is a breakout in inflation, which financial markets are not priced for. Inflation And Hidden Slack The September CPI report did little to buttress the FOMC's view that this year's inflation pullback is temporary. The report disappointed expectations again with core CPI rising only 0.13% month-over-month. For context, an environment where inflation is well anchored around the Fed's target would be consistent with core CPI prints of 0.2% every month, roughly 2.4% annualized. The inflation debate continues to rage inside and outside the Fed as to whether the previous relationship between inflation and growth have permanently changed, whether low inflation simply reflects long lags, or whether it will require tighter labor markets in this business cycle to fuel wage and price pressures. We back the latter two of these three explanations but, admittedly, predicting exactly when inflation will pick up is extremely difficult and we must keep an open mind. A Special Report in the October IMF World Economic Outlook sheds some light on this vexing issue.3 Their work suggests that the deceleration in wage growth in the post-Lehman period in the OECD countries can largely be explained by traditional macro factors: weak productivity growth, lower inflation expectations and labor market slack. The disappointing productivity figures alone account for two-thirds of the drop in wage growth. However, a key point of the research is that the headline unemployment figures are not as good a measure of labor market slack as they once were. This is because declining unemployment rates partly reflect workers that have been forced into part-time jobs, referred to as involuntary part-time employment (IPT). The rise in IPT employment could be associated with automation, the growing importance of the service sector, and a diminished and more uncertain growth outlook that is keeping firms cautious. The IMF's statistical analysis suggests that the number of involuntary part-time workers as a share of total employment (IPT ratio) is an important measure of slack that adds information when explaining the decline in wage growth. Historically, each one percentage point rise in the IPT ratio trimmed wage growth by 0.3 percentage points. Chart I-8 and Chart I-9 compare the unemployment rate gap (unemployment rate less the full-employment estimate) with the deviation in the IPT ratio from its 2007 level. The fact that the IPT ratio has had an upward trend since 2000 in many countries makes it difficult to identify a level that is consistent with full employment. Nonetheless, the change in this ratio since 2007 provides a sense of how much "hidden slack" the Great Recession generated due to forced part-time employment. Chart I-8Measures Of Labor Market Slack (I) Chart I-9Measures Of Labor Market Slack (II) For the OECD as a whole, labor market slack has been fully absorbed based on the unemployment gap. However, the IPT ratio was still elevated at the end of 2016 (latest data available), helping to explain why wage growth has remained so depressed across most countries. The IPT ratio is still above its 2007 level in three-quarters of the OECD countries. Of course, there is dispersion across countries. Japan has no labor market slack by either measure. In the U.S., the unemployment gap has fallen into negative territory, but only about half of the post-2007 rise in the IPT ratio has been unwound. For the Eurozone, the U.K. and Canada, the unemployment gap is close to zero (or well into negative territory in the U.K.). Nonetheless, little of the under-employment problem in these economies has been absorbed based on the IPT ratio. Our discussion in last month's report highlighted the importance of the global output gap in driving inflation in individual countries. Consistent with this, the IMF finds that there have been important spillover effects related to labor market slack, especially since 2007. This means that wage growth can be held down even in countries where slack has disappeared because of the existence of a surplus of available labor in their trading partners. Phillips Curve Is Not Dead That said, we still believe that the U.S. is at a point in the cycle when inflationary pressures should begin to build, even in the face of persisting labor market slack at the global level. Chart I-10 shows the ECI and the Atlanta Fed wage tracker, which are the best measures of wages because they are less affected by composition effects. Both have moved higher along with measures of labor market tightness. Wage and consumer price inflation have ebbed this year, but when we step back and look at it over a longer timeframe, the Phillips curve still appears to be broadly operating. Moreover, inflation is a lagging indicator. Table I-2 splits the post-war U.S. business cycles into short, medium, and long buckets based on the length of the expansion phase. It presents the number of months from when full employment was reached to the turning point for consumer price inflation in each expansion. There was a wide variation in this lag in the short- and medium-length expansions, but the lags were short on average. Chart I-10Phillips Curve Still (Weakly) Operating Table I-2Inflation Reacts With A Lag It is a different story for long expansions, where the lag averaged more than two years. We have pointed out in the past that it takes longer for inflation pressures to reveal themselves when the economy approaches full employment gradually, in contrast to shorter expansions when momentum is so strong the demand crashes into supply constraints. The fact that U.S. unemployment rate has only been below the estimate of full employment for eight months in this expansion suggests that perhaps we and the Fed are just being too impatient in waiting for the inflection point. Turning to Europe, the IPT ratio confirms the ECB's view that there is an abundance of under-employment, despite the relatively low unemployment rate. This suggests that the Eurozone remains behind the U.S. in the economic cycle. As expected, the ECB announced a tapering in its asset purchase program to take place next year. While policymakers are backing away from QE in the face of healthy growth and a shrinking pool of bonds to purchase, they will continue to emphasize that rate hikes are a long way off in order to avoid a surge in the euro and an associated tightening in financial conditions. U.S./Eurozone bond yield spreads are still quite wide by historical standards and thus it is popular to bet on spread narrowing and a stronger euro/weaker dollar. However, some narrowing in short-term rate spreads is already discounted based on the OIS forward curve (Chart I-11). The real 5-year, 5-year forward OIS spread - the market's expectation of how much higher U.S. real 5-year rates will be in five years' time relative to the euro area - stands at about 70 basis points. This spread is not wide by historical standards, and thus has room to widen again if market expectations for the fed funds rate moves up toward the Fed's 'dot plot' over the next 6-12 months. While market pricing for the ECB policy rate path appears about right in our view, market expectations for rate hikes in the U.S. are too complacent. This implies that long-term spreads could widen in favor of the U.S. dollar over the coming months, especially if U.S. growth accelerates while euro area growth cools off a bit. The fact the U.S. economic surprise index has turned positive is early evidence that this process may have already begun. Moreover, the starting point is that the dollar has been weaker than interest rate differentials warrant, such that there is some room for the dollar to 'catch up', even if interest rate differentials do not move (Chart I-12). We see EUR/USD falling to 1.15 by the end of the year. Chart I-11Room For U.S./Eurozone Spreads To Widen... Chart I-12...Giving The Dollar A Lift A New Fed Chair? Our forecast for yield spreads and currencies is not overly affected by the choice of Fed Chair for next year. President Trump's meeting with academic John Taylor reportedly went well, but we think the President will prefer someone with a less hawkish bent. Keeping Chair Yellen is an option, but she has strong views on financial sector regulation that Trump does not like. The prevailing wisdom is that Jerome Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. In any event, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. As discussed above, uncertainty is elevated, but our base case sees inflation rising enough in the coming months for the Fed to maintain their 'dot plot' forecast. The market and the Fed are correct to 'look through' the near-term growth hit from the hurricanes, to the rebound that always follows the destruction. The U.S. housing sector is a little more worrying because some softness was evident even before the hurricanes hit. Since the early 1960s, a crest in housing led the broader economic downturn by an average of seven quarters. Nonetheless, we continue to expect that the housing soft patch does not represent a peak for this cycle. Residential investment should provide fuel to the economy for at least the next two years as pent up demand is worked off, related to depressed household formation since the 2008 financial crisis. Affordability will still be favorable even if mortgage rates were to rise by another 100 basis points (Chart I-13). Robust sentiment in the homebuilder sector in October confirms that the hurricane setback in housing starts is temporary. China And Base Metals Turning to China, economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at double-digit rates, albeit down from recent peak levels (Chart I-14). Various price indexes also reveal a fairly broadly-based inflation pickup to levels that will unnerve the authorities. Growth will likely slow in 2018 as policymakers continue to pare back stimulus. We do not foresee a substantial growth dip next year, but it could be hard on base metals prices. Chart I-13Housing Affordability Outlook Housing ##br##Affordability Under Various Rate Assumptions Chart I-14China: Healthy ##br##Growth Indicators Policy shifts discussed in Chinese President Xi's speech in October to the Party Congress are also negative for metals prices in the medium term. The speech provided a broad outline of goals to be followed by concrete policy initiatives at the National People's Congress (NPC) in March 2018. He emphasized that policy will tackle inequality, high debt levels, overcapacity and pollution. Globalization will also remain a priority of the government. The supply side reforms required to meet these goals will be positive in the long run, but negative for growth in the short run. Restructuring industry, deleveraging the financial sector and fighting smog will all have growth ramifications. The government could use fiscal stimulus to offset the short-term hit to growth. However, while overall growth may not slow much, the shift away from an investment-heavy, deeply polluting growth model, will undermine the demand for base metals. Our commodity strategists also highlight the supply backdrop for most base metals is not supportive of an extended rally in prices. The implication is that investors who are long base metals should treat it as a trade rather than a strategic position. Despite our expectation that policy will continue to tighten, we believe that investors should overweight Chinese stocks relative to other EM markets. Investment Conclusions: Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of the easing in U.S. financial conditions that has taken place this year and the likelihood of some fiscal stimulus next year. The U.S. Congress has drawn closer to approving a budget resolution for fiscal 2018 that would pave the way for tax legislation to reach President Donald Trump's desk by the end of the first quarter of next year. Surveys show that investors have all but given up on the prospect of tax cuts, which means that it will be a positive surprise if it finally arrives (as we expect). Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should favor Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments) in the major developed fixed-income markets. Our base-case outlook implies that it is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late-cycle phase. Calm macro readings and still-easy monetary policy have generated signs of froth. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Upside inflation surprises would destabilize the three-legged stool supporting risk assets, especially at a time when the Fed is shrinking its balance sheet. Black Monday is a reminder that major market pullbacks can occur even when the economic outlook is bright. Thus, investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons, and to ensure that they have dry powder to exploit them when they materialize. Mark McClellan Senior Vice President The Bank Credit Analyst October 26, 2017 Next Report: November 20, 2017 1 Please see BCA Special Report, "Black Monday, Thirty Years On: Revisiting The First Modern Global Financial Crisis," October 19, 2017, available at bca.bcaresearch.com 2 Please see BCA U.S. Equity Strategy Weekly Report, "Banks Hold The Key," October 24, 2017, available at uses.bcaresearch.com 3 Recent Wage Dynamics In Advanced Economies: Drivers And Implications. Chapter 2, IMF World Economic Outlook. October 2017. II. Three Demographic Megatrends Dear Client, This month's Special Report is written by my colleague, Peter Berezin, Chief Global Strategist. Peter highlights three key demographic trends that will shape financial markets in the coming decades. His non-consensus conclusions include the idea that demographic trends will be negative for both bonds and equities over the long haul, in part because the trends are inflationary. Moreover, continuing social fragmentation will not be good for business. Mark McClellan Megatrend #1: Population Aging. Aging has been deflationary over the past few decades, but will become inflationary over the coming years. Megatrend #2: Global Migration. International migration has the potential to lift millions out of poverty while boosting global productivity. However, if left unmanaged, it poses serious risks to economic stability. Megatrend #3: Social Fragmentation. Rising inequality, cultural self-segregation, and political polarization are imperilling democracy and threatening free-market institutions. On balance, these trends are likely to be negative for both bonds and equities over the long haul. In today's increasingly short-term oriented world, it is easy to lose track of megatrends that are slowly shifting the ground under investors' feet. In this report, we tackle three key social/demographic trends. Chart II-1Our Aging World Megatrend #1: Population Aging Fertility rates have fallen below replacement levels across much of the planet. This has resulted in aging populations and slower labor force growth (Chart II-1). In the standard neoclassical growth model, a decline in labor force growth pushes down the real neutral rate of interest, r*. This happens because slower labor force growth causes the capital stock to increase relative to the number of workers, resulting in a lower rate of return on capital.1 The problem with this model is that it treats the saving rate as fixed.2 In reality, the saving rate is likely to adjust to changes in the age composition of the workforce. Initially, as the median age of the population rises, aggregate savings will increase as more people move into their peak saving years (ages 30 to 50). This will put even further downward pressure on the neutral rate of interest. Eventually, however, savings will fall as these very same people enter retirement. This, in turn, will lead to a higher neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in r*, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up, leading to higher long-term nominal bond yields. Contrary to popular belief, spending actually increases later in life once health care costs are included in the tally (Chart II-2). And despite all the happy talk about how people will work much longer in the future, the unfortunate fact is that the percentage of American 65 year-olds who are unable to lead active lives because of health care problems has risen from 8.8% to 12.5% over the past 10 years (Chart II-3). Cognitive skills among 65 year-olds have also declined over this period. We are approaching the inflection point where demographic trends will morph from being deflationary to being inflationary. Globally, the ratio of workers-to-consumers - the so-called "support ratio" - has peaked after a forty-year ascent (Chart II-4). As the support ratio declines, global savings will fall. To say that global saving rates will decline is the same as saying that there will be more spending for every dollar of income. Since global income must sum to global GDP, this implies that global spending will rise relative to production. That is likely to be inflationary. Chart II-2Savings Over The Life Cycle Chart II-3Climbing Those Stairs Is ##br##Getting More And More Difficult Chart II-4The Ratio Of Workers To ##br##Consumers Has Peaked The projected evolution of support ratios varies across countries. The most dramatic change will happen in China. China's support ratio peaked a few years ago and will fall sharply during the coming decade. Nearly one billion Chinese workers entered the global labor force during the 1980s and 1990s as the country opened up to the rest of the world. According to the UN, China will lose over 400 million workers over the remainder of the century (Chart II-5). If the addition of millions of Chinese workers to the global labor force was deflationary in the past, their withdrawal will be inflationary in the future. The fabled "Chinese savings glut" will eventually dry up. Chart II-5China On Course To Lose More ##br##Than 400 Million Workers Rising female labor force participation rates have blunted the effect of population aging in Europe and Japan. This has allowed the share of the population that is employed to increase over the past few decades. However, as female participation stabilizes and more people enter retirement, both regions will also see a rapid decline in saving rates. This could lead to a deterioration in their current account balances, with potential negative implications for the yen and the euro. Population aging is generally bad news for equities. The slower expansion in the labor force will reduce the trend GDP growth. This will curb revenue growth, and by extension, earnings growth. To make matter worse, to the extent that lower savings rates lead to higher real interest rates, population aging could reduce the price-earnings multiple at which stocks trade. This could be further exacerbated by the need for households to run down their wealth as they age, which presumably would include the sale of equities. Megatrend #2: Global Migration Economist Michael Clemens once characterized the free movement of people across national boundaries as a "trillion-dollar bill" just waiting to be picked up from the sidewalk.3 Millions of workers toil away in poor countries where corruption is rife and opportunities for gainful employment are limited. Global productivity levels would rise if they could move to rich countries where they could better utilize their talents. Academic studies suggest that less restrictive immigration policies would do much more to raise global output than freer trade policies. In fact, several studies have concluded that the removal of all barriers to labor mobility would more than double global GDP (Table II-1). The problem is that many migrants today are poorly skilled. While they can produce more in rich countries than they can back home, they still tend to be less productive than the average native-born worker. This can be especially detrimental to less-skilled workers in rich countries who have to face greater competition - and ultimately, lower wages - for their labor. Chart II-6 shows that the share of U.S. income accruing to the top one percent of households has closely tracked the foreign-born share of the population. Table II-1Economic Benefits Of Open Borders Chart II-6Immigration Versus Income Distribution Low-skilled migration can also place significant strains on social safety nets. These concerns are especially pronounced in Europe. The employment rate among immigrants in a number of European countries is substantially lower than for the native-born population (Chart II-7). For example, in Sweden, the employment rate for immigrant men is about 10 percentage points lower than for native-born men. For women, the gap is 17 points. The OECD reckons that a typical 21-year old immigrant to Europe will contribute €87,000 less to public coffers in the form of lower taxes and higher welfare benefits than a non-immigrant of the same age (Chart II-8). Chart II-7Low Levels Of Immigrant Labor Participation In Parts Of Europe Chart II-8Immigration Is Straining Generous ##br##European Welfare States All of this would matter little if the children of today's immigrants converged towards the national average in terms of income and educational attainment, as has usually occurred with past immigration waves. However, the evidence that this is happening is mixed. While there is a huge amount of variation within specific immigrant communities, on average, some groups have fared better than others. The children of Asian immigrants to the U.S. have tended to excel in school, whereas college completion rates among third-generation-and-higher, self-identified Hispanics are still only half that of native-born non-Hispanic whites (Chart II-9). Across the OECD, second generation immigrant children tend to lag behind non-immigrant students, often by substantial margins (Chart II-10). Chart II-9Hispanic Educational Attainment Lags Behind Chart II-10Worries About Immigrant Assimilation Immigration policies that place emphasis on attracting skilled migrants would mitigate these concerns. While such policies have been adopted in a number of countries, they have often been opposed by right-leaning business groups that benefit from cheap and abundant labor and left-leaning political parties that want the votes that immigrants and their descendants provide. Humanitarian concerns also make it difficult to curtail migration, especially when it is coming from war-torn regions. Chart II-11The Projected Expansion ##br##In Sub-Saharan Population Europe's migration crisis has ebbed in recent months but could flare up at any time. In 2004, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2017 revision, the UN doubled its projection to 4 billion. Nigeria's population is expected to rise to nearly 800 million by 2100; Congo's will soar to 370 million; Ethiopia's will hit 250 million (Chart II-11). And even that may be too conservative because the UN assumes that the average number of births per woman in sub-Saharan Africa will fall from 5.1 to 2.2 over this period. For investors, the possibility that migration flows could become disorderly raises significant risks. For one, low-skill migration could also cause fiscal balances to deteriorate, leading to higher interest rates. Moreover, as we discuss in greater detail below, it could propel more populist parties into power. This is a particularly significant worry for Europe, where populist parties have often pursued business-sceptic, anti-EU agendas. Megatrend #3: Social Fragmentation In his book "Bowling Alone," Harvard sociologist Robert Putnam documented the breakdown of social capital across America, famously exemplified by the decline in bowling leagues.4 There is no single explanation for why communal ties appear to be fraying. Those on the left cite rising income and wealth inequality. Those on the right blame the welfare state and government policies that prioritize multiculturalism over assimilation. Conservative commentators also argue that today's cultural elites are no longer interested in instilling the rest of society with middle-class values. As a result, behaviours that were once only associated with the underclass have gone mainstream.5 Technological trends are exacerbating social fragmentation. Instead of bringing people together, the internet has allowed like-minded people to self-segregate into echo chambers where members of the community simply reinforce what others already believe. It is thus no surprise that political polarization has grown by leaps and bounds (Chart II-12). When people can no longer see eye to eye, established institutions lose legitimacy. Chart II-13 shows that trust in the media has collapsed, especially among right-leaning voters. Perhaps most worrying, support for democracy itself has dwindled around the world (Chart II-14). Chart II-12U.S. Political Polarization: Growing Apart Chart II-13The Erosion Of Trust In Media It would be naïve to think that the public's rejection of the political establishment will not be mirrored in a loss of support for the business establishment. The Democrats "Better Deal" moves the party to the left on many economic issues. Nearly three-quarters of Democratic voters believe that corporations make "too much profit," up from about 60% in the 1990s (Chart II-15). Chart II-14Who Needs Democracy When You Have Tinder? Chart II-15People Versus Companies The share of Republican voters who think corporations are undertaxed has stayed stable in the low-40s, but this may not last much longer. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to lean liberal on social issues and conservative on economic ones - the exact opposite of a typical Trump voter. If Trump voters abandon corporate America, this will leave the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. The fact that social fragmentation is on the rise casts doubt on much of the boilerplate, feel-good commentary written about the "sharing economy." For starters, the term is absurd. Uber drivers are not sharing their vehicles. They are using them to make money. Both passengers and drivers can see one another's ratings before they meet. This reduces the need for trust. As trust falls, crime rises. The U.S. homicide rate surged by 20% between 2014 and 2016 according to a recent FBI report.6 In Chicago, the murder rate jumped by 86%. In Baltimore, it spiked by 52%. Chart II-16 shows that violent crime in Baltimore has remained elevated ever since riots gripped the city in April 2015. The number of homicides in New York, whose residents tend to support more liberal policing standards for cities other than their own, has remained flat, but that is unlikely to stay the case if crime is rising elsewhere. The multi-century decline in European homicide rates also appears to have ended (Table II-2). Much has been written about how millennials are flocking to cities to enjoy the benefits of urban life. But this trend emerged during a period when urban crime rates were falling. If that era has ended, urban real estate prices could suffer tremendously. It is perhaps not surprising that the increase in crime rates starting in the 1960s was mirrored in rising inflation (Chart II-17). If governments cannot even maintain law and order, how can they be trusted to do what it takes to preserve the value of fiat money? The implication is that greater social instability in the future is likely to lead to lower bond prices and a higher equity risk premium. Chart II-16Do You Still Want To Move Downtown? Table II-2Crime Rates Are Creeping Higher In Europe Chart II-17Homicides And Inflation Peter Berezin Chief Global Strategist Global Investment Strategy 2 Another problem with the neoclassical model is that it assumes perfectly flexible wages and prices. This ensures that the economy is always at full employment. Thus, if the saving rate rises, investment is assumed to increase to fully fill the void left by the decline in consumption. In the real world, the opposite tends to happen: When households reduce consumption, firms invest less, not more, in new capacity. One of the advantages of the traditional Keynesian framework is that it captures this reality. And interestingly, it also predicts that aging will be deflationary at first, but will eventually become inflationary. Initially, slower population growth reduces the need for firm to expand capacity, causing investment demand to fall. Aggregate savings also rises, as more people move into their peak saving years. Globally, savings must equal investment. If desired investment falls and desired savings rises, real rates will increase. At the margin, higher real rates will discourage investment and encourage saving, thus ensuring that the global savings-investment identity is satisfied. As savings ultimately begins to decline as more people retire, the equilibrium real rate of interest will rise again. 3 Michael A. Clemens, "Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?" Journal of Economic Perspectives Vol. 25, no.3, pp. 83-106 (Summer 2011). 4 Robert D. Putnam, "Bowling Alone: The Collapse And Revival Of American Community," Simon and Schuster, 2001. 5 Charles Murray has been a leading proponent of this argument. Please see "Coming Apart: The State Of White America, 1960-2010," Three Rivers Press, 2013. 6 Federal Bureau of Investigation, "Crime In The United States 2016" (Accessed October 25, 2017). III. Indicators And Reference Charts Global equity markets partied in October on solid earnings and economic growth figures, and the rising chances of a tax cut in the U.S. among other bullish developments. The Nikkei has been particularly strong in local currency terms following the re-election of Abe. Our equity indicators remain upbeat on the whole, although the rally is looking stretched by some measures. The BCA monetary indicator is hovering at a benign level. Implied equity volatility is very low, investor sentiment is frothy and our Speculation Indicator is elevated. These suggest that a lot of good news is already discounted. Our valuation indicator is also closing in on the threshold of overvaluation at one standard deviation. Our technical indicator is rolling over, although it needs to fall below the zero line to send a 'sell' signal. On a constructive note, the solid rise in earnings-per-share is likely to continue in the near term, based on positive earnings surprises and the net revisions ratio. Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in September for the third consecutive month. We introduced the RPI in the July report. It combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and European WTPs rose in October after a brief sideways move in previous months, suggesting that equity flows have turned more constructive. But the Japanese WTP is outshining the others. Given that the Japanese WTP is rising from a low level, it suggests that there is more 'dry powder' available to purchase Japanese stocks, especially relative to the U.S. market. We favor Japanese stocks relative to the other two markets in local currency terms, as highlighted in the Overview section. Oversold conditions for the U.S. dollar have now been absorbed based on our technical indicator, but there is plenty of upside for the currency before technical headwinds begin to bite. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys has moved above the zero line, but has not reached oversold territory. Bond valuation is close to fair value based on our long-standing valuation model. These factors suggest that yields have more upside potential before meeting resistance. Other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still about 20 basis points on the expensive side. Stay below benchmark in duration. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market ##br##And Earnings: Relative Performance Chart III-8Global Stock Market ##br##And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Overweight We have recently been highlighting the burgeoning capex upcycle as the key investment theme driving our sector rotation into cyclical stocks over defensives. The investment bank & brokers index in particular thrives when the business sector is moving to expansion mode. Capital formation moves in lockstep with business confidence as firms look to expand balance sheets to meet future capital needs; sentiment has been soaring since the November election and so too have secondary equity issues (second panel). This should mean that relative earnings gains for investment banks should follow sky-high capex expectations, if history repeats (third panel). Stay overweight the S&P investment banks & brokers index. The ticker symbols for the stocks in this index are: BLBG: S5INBK - ETFC, SCHW, GS, RJF, MS.

Highlights Depressed bond yields do justify exponentially higher equity valuations provided bond yields stay well below 3%. But when bond yields are at ultra-low levels, the much higher equity valuations necessarily mean that both bond and equity markets go on to generate feeble 10-year returns. The mainstream investments that could produce impressive 10-year returns are now most likely to come from the currency and real estate asset classes. The glaring pricing anomaly right now is the interest rate expected in the euro area relative to that in the U.S. five years out. The record high spread between euro area and U.S. long-term interest rates is nothing more than a QE 'timing distortion'. Chart Of The WeekEuro Area Employment To Population Is Now At An All-Time High Feature As the ECB prepares to 'recalibrate' its bond purchases, the 9-year global QE story is approaching its denouement. This makes now the perfect moment to put this big story into its full context. The $10 trillion of bonds that the 'big four'1 central banks have bought is not far short of the size of the euro area economy (Chart I-2). Hence, it would be natural to believe that this massive buying in itself is behind the structural rally across the whole global fixed income complex. However, this belief would be wrong. The global bond market exceeds $100 trillion. Long-term bank loans amount to another $100 trillion. In the context of this $217 trillion2 global fixed income market, $10 trillion of QE is small change. For the $217 trillion global bond and bank loan complex, the much more significant driver of yields is the expected path of short-term interest rates. The important thing about QE is not the $10 trillion of central bank purchases per se, but what these purchases have signalled for the path of interest rate policy.3 QE Is The Action That Speaks Louder Than Words We will let ECB Chief Economist, Peter Praet explain:4 "There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. The credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these purchases are a concrete demonstration of a desire to provide additional stimulus." Or to put it more bluntly, actions speak louder than words. QE is nothing more than actions that make credible the words that promise ultra-low interest rates for an extended period. It follows that as QE ends, the market impact depends almost entirely on what the end of QE implies for the path of interest rates (Chart I-3). Chart I-2The 9-Year Global QE Story ##br##Is Approaching Its Denouement Chart I-3The Expected Path of Interest ##br##Rates Determines Bond Yields Interestingly, the Federal Reserve has now explicitly broken the link between QE (unwinding) and its interest rate policy. In essence, the Fed is communicating that asset sales have no direct bearing on the path of interest rates. So they do not imply monetary tightening. But in the case of the ECB, its asset purchases and the path of interest rates are still closely entwined. So a reduced rate of asset purchases does imply a higher path of interest rates further out along the expectations curve. The question is: how much higher and how much further out? The Glaring Pricing Anomaly We expect a very tentative ECB to leave interest rate policy broadly unchanged for the next couple of years, perhaps to the end of Draghi's term as President in October 2019. But to us, the glaring pricing anomaly is the interest rate expected in the euro area relative to that in the U.S. five years out (or equivalently, the 10-year bond yield spread.) Absent the distortion from QE, the interest rate expected five years out is a reflection of structural fundamentals. For years, or even decades, the interest rates expected five years out in the euro area and the U.S. rarely separated because the structural fundamentals of the world's two largest economies looked very similar. But in 2013, a very sharp divergence started (Chart I-4 and Chart I-5). What happened in 2013? Did the euro area's structural fundamentals suddenly deteriorate vis-à-vis the U.S.? No, on the contrary, the euro area started a strong rebound from its debt crisis. Chart I-4The Expected Path Of Interest Rates Diverged In 2013... Chart I-5...Bond Yields Also Diverged In 2013. Why? The simple answer is that in May 2013 the Federal Reserve announced that it would exit its QE experiment by tapering its asset purchases. Meanwhile, the market was aware that the ECB's own QE experiment was still to come - and Mario Draghi duly announced it in the summer of 2014. Effectively, in the U.S. the interest rate expected five years out broke free from Fed QE's heavy anchor while in the euro area it got weighed down by ECB QE's heavy anchor. Fast forward to today. Absent the distortion from QE, is the record high spread between interest rates expected five years in the euro area and the U.S. still justified? Looking at the structural fundamentals, the answer is a very emphatic no. The euro area employment to population ratio is at an all-time high - meaning both a structural high and a cyclical high (Chart of the Week); real growth per head in the euro area has been exactly in line with that in the U.S. through the 19-year life of the euro (Chart I-6); and inflation rates in the two economies are near-identical (Chart I-7). Chart I-6Long-Term Productivity Growth Is The Same... Chart I-7...Inflation Is Near-Identical... Sceptics might counter that the euro area's impressive statistics have depended on ECB QE, but the evidence contradicts this. The trends were in place years before ECB QE. So objectively, there is little to separate the structural fundamentals of the euro area and the U.S. We conclude that the record high spread between interest rates expected five years out (or equivalently, the 10-year bond yield spread) is nothing more than a QE 'timing distortion' (Chart I-8). And the spread must compress in the coming years, which constitutes an excellent structural position. Chart I-8...Yet The Bond Yield Spread Is Near A Record Wide Bond investors should structurally underweight German bunds versus U.S. T-bonds. Investment Reductionism5 then implies that equity investors should structurally overweight euro area Financials versus U.S. Financials. QE: The Bittersweet Legacy QE has depressed bond yields by signalling an extended period of ultra-low interest rates. However, as we explained last week in The Mystery Of The Risk Premium... Finally Solved,6 when yields drop to ultra-low levels, bonds become much riskier investments. This is because the prospects for capital appreciation rapidly disappear, while the prospects for large-scale capital losses suddenly increase. But if bonds become riskier investments, it reduces the justification for demanding a 'risk premium' (an excess return) on equities. Thereby, when bond yields drop to ultra-low levels, the boost to bond valuations is linear, but the boost to equity valuations is exponential. Consider what happens to a bond price and an equity price when a 10-year bond yield declines by 2%. To generate the lower yield, today's bond price must rise by 2% compounded over ten years - about 20%. And the same applies to the equity price. Now consider what happens when the bond yield declines by 2% to an ultra-low level. Today's bond price must again rise by about 20%, but the equity price gets a double boost. If its annual risk premium also compresses by, say, 2% then the equity price must rise by 4% compounded over ten years - about 50%. So the boost to the equity valuation is non-linear. At a bond yield of 5%, a 2% decline boosts the equity valuation by 20%. But at a bond yield of 3%, a 2% decline boosts the equity valuation by 50%! This means that QE leaves a bittersweet legacy. The sweet part is that depressed bond yields do justify exponentially higher equity valuations provided bond yields stay well below 3%. The bitter part is that once bond yields reach ultra-low levels, the much higher equity valuations necessarily mean that both bond and equity markets go on to generate feeble 10-year returns. This has been the precise experience of both Japan and Switzerland, where bond yields reached ultra-low levels almost two decades ago (Chart I-9). Chart I-9When Bond Yields Reach Ultra-Low Levels, ##br##Equities Become Highly Valued And Generate 10-Year Excess Feeble Returns So what should long-term investors do? We will save the details for future reports, but we believe that the mainstream investments that could produce impressive 10-year returns are now most likely to come from the currency and real estate asset classes. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Federal Reserve, ECB, Bank of Japan and Bank of England. 2 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017. 3 For example, if the market feared bond purchases would cause inflation and thereby imply a higher path of interest rates, QE would push up bond yields! 4 From a speech by Peter Praet on October 11 2017: Maintaining price stability with unconventional monetary policy measures. 5 Please see the European Investment Strategy Weekly Report, "The Law Of the Vital Few," published on September 14, 2017 and available at eis.bcaresearch.com. 6 Published on October 19 2017 and available at eis.bcaresearch.com. Fractal Trading Model* This week, our model suggests that the short-term relationship between copper and tin has become overstretched. The recommended trade is short copper/long tin with a profit target/stop loss set at 5%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model* The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Overweight We upgraded the S&P construction machinery & heavy truck index to overweight earlier this month, based on a fresh capex upcycle fueled by exceptionally positive expectations for global capital outlays, with tentative signs that mining and oil & gas would participate. Caterpillar's earnings results yesterday confirm this thesis, with machine sales to dealers having firmly pulled out of their multiyear contraction on a broad basis and all regions seeing expansion (second panel). The positive data is captured by our construction machinery EPS model, which is pointing to continued earnings gains (third panel), boosted by an export-accommodative U.S. dollar. Despite solid gains yesterday, this earnings momentum is still not fully reflected in valuations which remain well below peak levels (bottom panel). Bottom Line: We think the earnings-led recovery in the S&P construction machinery & heavy truck sub-index still have legs; stay overweight. For more details, please see our Weekly Report from October 2, 2017. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI.