Developed Countries

Highlights Portfolio Strategy The S&P hotels, resorts and cruise lines index will suffer from a profit margin squeeze, which should weigh on valuations. Cut exposure to underweight. A cyclical capex recovery is a boon for software outlays and coupled with reviving animal spirits, signal that it no longer pays to underweight the S&P software index. Augment positions to a benchmark allocation. Recent Changes Downgrade the defensive/cyclical portfolio bias to neutral. Downgrade the S&P hotels, resorts and cruise lines index to underweight today. Lift the S&P software index to neutral. Table 1 Feature Chart 1Weak Dollar Positive Contributor##br## To EPS Growth Equities broke out in a bullish fashion last week, as geopolitical fears subsided and the backlash from hurricane Irma was less severe than initially feared. Beneath the surface, non-inflationary synchronized global growth remains the dominant macro theme. While the latest U.S. CPI print was better than anticipated the Fed would have to see a couple more perky inflation reports before an uptrend is established, cementing the December hike. Until then, the path of least resistance is higher for equities. In our last Weekly Report, we noted that our four-factor S&P 500 operating EPS model has recently accelerated.1 This week, Chart 1 isolates the U.S. dollar as the sole regression variable on SPX earnings and the fitted value suggests that profits will likely surprise to the upside in the back half of the year despite difficult comparisons. Importantly, as we posited earlier this summer, irrespective of where the trade-weighted U.S. dollar ends the year, delayed FX translation effects will act as a tonic for S&P 500 profits. Since late-December's peak, the broad trade-weighted dollar has deflated by 9%. Regression analysis shows that a 1% fall in the U.S. dollar boosts operating EPS by 0.98%, with our dataset going back to the early 1970s. If, however, we narrow the interval of estimation starting in 1994 when NAFTA come into effect then the greenback's sensitivity on SPX EPS increases to 1.6%. While every cycle is different, a fresh all-time high in quarterly EPS - driven by a weak dollar - would not surprise us in Q3 and Q4. At some point, the deflating currency should show up in selling price inflation, again as a lagged effect (middle panel, Chart 2). This is encouraging for our firming operating leverage thesis, as a modest inflationary backdrop would reinforce top line growth (bottom panel, Chart 2). The implication of a sustainable revenue growth outlook is a profit margin-led flow through to EPS, especially for high fixed cost businesses. Already, sell side analysts' overall S&P 500 net earnings revisions are benefitting from the U.S. dollar's decline, and so is sector EPS breadth (trade-weighted dollar shown inverted, Chart 3). Chart 2Will The Dollar's Fall Show Up In Inflation? Chart 3EPS Breadth Improvement Moreover, U.S. dollar-based liquidity (defined as the sum of the Fed's balance sheet and foreign central bank U.S. Treasury holdings) has finally arrested its fall and has recently ticked higher above the zero line. This even mild increase in U.S. dollar-based liquidity represents a de facto easing in global monetary conditions, and historically has been synonymous with S&P 500 EPS acceleration (Chart 4). The upshot is that profits are on a solid upward trajectory. Chart 4Dollar Based Liquidity Also On The Rise The equity market's sensitivity to the greenback has been increasing as the percentage of foreign sourced earnings has been rising over the decades. Globally-exposed goods-producers are in the driver's seat. This raises the question: what to do with our long held preference for defensives versus cyclicals? We are taking our cue from the U.S. dollar-induced shifting macro backdrop, and locking in gains of 11% since the mid-2014 inception in our defensive over cyclical sector tilt, and moving to the sidelines. As a reminder, since the beginning of the spring we have been tweaking our portfolio adding cyclical exposure and, at the margin, removing defensive protection.2 Thus, a defensive over cyclical sector preference is no longer in place. Synchronized global growth, reviving emerging markets, a stable China, and a deflating U.S. dollar are all giving us confidence that it no longer pays to play defense (Chart 5). Finally, following a sling shot recovery, relative valuations are on a more even keel, as is our relative Technical Indicator which is hovering in the neutral zone (Chart 6). Chart 5Book Gains And Move##br## To Neutral Chart 6Valuations And Technicals##br## In The Neutral Zone This week we are making an early cyclical downshift and deep cyclical upshift to our portfolio. Hotels Update: Check Out Time This year has been a good one to be overweight the S&P hotels, resorts and cruise lines index which has outperformed the S&P 500 by a wide margin. However, earnings expectations have moved broadly in line with the market in 2017, meaning that the index's outperformance has been entirely valuation multiple driven. Normalizing earnings to smooth out profit volatility reveals a more severe picture with valuation multiples at decade highs, above the historical mean and at a 40% premium to the broad market (Chart 7). The index's strength has been most pronounced since the beginning of the summer and, unsurprisingly given the cyclical rotation into highly discretionary stocks, has been exclusive to the cruise line operator segment of the index. The two relevant stocks (RCL and CCL) now represent nearly half of the S&P hotels, resorts and cruise lines index's market capitalization. Cruise line operators' margins have climbed to 10-year highs (top panel, Chart 8), justifying soaring stock prices. Profit gains have come on the back of healthy unit revenue as unit costs have remained mostly unchanged (third panel, Chart 8). Chart 7Very Expensive Beneath The Surface Chart 8Cruise Lines Leading The Pack Cruise line occupancy rates corroborate this firm demand backdrop. They have risen in line with margin gains (second panel, Chart 8), a result of improving passenger growth and constrained capacity (bottom panel, Chart 8). This has been the industry's largest margin lever, i.e.: incremental passengers per room come with much higher incremental margin. As cruise lines cannot increase their occupancy ad infinitum (occupancy rates above 100% already imply more than two occupants of a double-occupancy berth), further margin gains of this magnitude seem doubtful. In fact, if cruise operators are to continue growing profits, a capacity growth cycle will eventually have to begin anew, meaning margin contraction rather than expansion. Thus, extrapolating profit growth far into the future is fraught with danger, warning that sky-high valuation multiples are vulnerable to even a modest de-rating. The outlook is even less bright for hotels, an industry that has been losing its share of the consumer's wallet for some time (Chart 9, second panel). Specifically, the low/non-corporate end of the market seems increasingly exposed to competition from Airbnb and other room share competitors; cutthroat competition is pricing power negative with industry selling prices sinking into outright deflation (Chart 9, third panel). Hoteliers are trying to compensate for low prices with huge capacity additions, adding a sense of permanence to recent pricing power declines. However, just as pricing has fallen, the accommodation related employment cost index has gone vertical (bottom panel, Chart 9). The implication of soft pricing power and a rising wage bill is a profit letdown. Our newly introduced S&P hotels, resorts and cruise lines EPS model (comprising the U.S. dollar, employment, PCE and confidence measures) does an excellent job encompassing all these moving parts and confirms our bearish industry profit stance. In fact, it is pointing to significant relative declines vis-à-vis the S&P 500 (Chart 10). Chart 9Mind The Deflationary Impulse Chart 10EPS Model Says Rush For The Exits Putting it together, shrinking margins and increased capital deployment mean lower return on capital and hence lower valuation multiples. This implies that the index's relative gains are in the past. Bottom Line: Take some chips off the table and reduce exposure to underweight in the S&P hotels, resorts and cruise lines index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, HLT, WYN. Software: A Capex Upcycle Winner? Software stock relative performance has returned to its long-term uptrend, but remains far from the two standard deviations above-the-mean peak reached during the tech bubble (top panel, Chart 11). The structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Traditional hardware tech sectors, like communications equipment, are also suffering from the "virtualization" threat as software is making inroads into hardware and blurring the lines between the two. Beyond this constructive backdrop, cyclical forces are also painting a brighter picture for software equities. Importantly, there is tentative evidence that a fresh capex upcycle has commenced (see Chart 3 from last Monday's Weekly Report 3), and if software commands a larger slice of the overall spending pie, industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand have returned to a level last seen prior to the Great Recession, underscoring that software related outlays will likely follow them higher. Recovering bank loan growth is also corroborating this upbeat spending message: capital outlays on software are poised to accelerate based on rebounding bank loans. The latter signals that businesses are beginning to loosen their purse strings anew (third & fourth panels, Chart 11). Reviving animal spirits also suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs. Such ebullience is positive for a pickup in software investments (second panel, Chart 12). It has also rekindled software M&A activity, with the number of industry deals jumping in recent months (bottom panel, Chart 13). Chart 11Back To Trend Chart 12Capex Upcycle... Chart 13... And Reviving Animal Spirits Are Key Drivers Supply reduction presents a bullish backdrop for software selling prices that have exited deflation at a time when overall corporate sector inflation is decelerating. The upshot is that revenue growth will likely reaccelerate (middle panel, Chart 14). But before getting too carried away, there is some cause for concern. The S&P software index is priced to perfection fully reflecting most, if not all, of the positive drivers (bottom panel, Chart 14), warning that any sales/profit mishaps will likely knock relative performance over. Moreover, productivity dynamics are waving a yellow flag. Business sector productivity growth troughed in early 2017. Historically, this output per hour worked metric has been inversely correlated with software outlays (productivity shown inverted, third panel Chart 15). Importantly, even shown as a deviation from the long-term trend, productivity gains have troughed, suggesting that relative profit growth will likely remain muted (productivity shown inverted, bottom panel Chart 15). Keep in mind that, historically, software spending has been countercyclical (second panel, Chart 15) and given that we are not at the end of the line yet, relative outlays on software may not rebound to the same extent as our other aforementioned indicators suggest. Chart 14Impressive Pricing Power, ##br##But Fully Priced Chart 15Productivity Dynamics##br## Are A Sizable Offset Adding it up, enticing structural software forces aside, a cyclical capex recovery is a boon for software outlays and, coupled with reviving animal spirits, signal that it no longer pays to underweight this tech sub-sector. Bottom Line: The S&P software index does not deserve an underweight. Lift exposure to a benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, EA, INTU, ADSK, SYMC, RHT, SNPS, CTXS, ANSS, CA. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see Chart 5 of the U.S. Equity Strategy Report titled "Still Goldilocks", on September 11, 2017, available at uses.bcaresearch.com. 2 Please see the August 14, 2017 U.S. Equity Strategy Report titled "Three Risks" for a quick recap of most of our portfolio moves, available at uses.bcaresearch.com. 3 Please see the September 11, 2017 U.S. Equity Strategy Report titled "Still Goldilocks", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Overweight A neglected aspect of the catastrophe of Hurricane Harvey was the shutdown of nearly 40% of ethylene production, the key ingredient in plastics packaging for foodstuffs, still the largest customer for the containers & packaging index. While production is gradually coming back on line, near-term capacity constraints have driven a 50% spike in ethylene prices (not shown). In the end, we expect Harvey to be a transitory margin blip that is outweighed by the current global economic resurgence driving increasing global exports, particularly U.S. food exports (second & third panels). Moreover, chemical producers have committed capital for approximately 15% more capacity of ethylene production coming on stream in the next two years, meaning this price spike should prove fleeting. We think investors should stay focused on the rebound in containers & packaging pricing power and the industry's disciplined productivity focus (bottom panel). Taken together these factors should generate profit growth that will significantly outlast a hurricane-related dip. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, PKG, SEE, AVY.

Special Report

Feature Valuations, whether for currencies, equities, or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced this year, it is always useful to pause and reflect on where currency valuations stand. In this context, this week we update our set of long-term valuation models for currencies that we introduced in February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 The models cover 22 currencies, incorporating both G10 and EM FX markets. Twice a year, we provide clients with a comprehensive update on all of these long-term models in one stop. These models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning, or middle of a long-term currency cycle. Second, by providing strong directional signals, the models help us judge whether any given move is more likely be a countertrend development or not, offering insight on potential longevity. Finally, they assist us and our clients in cutting through the fog and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1The Dollar's Overvaluation Is Gone After its large 7.5% fall in trade-weighted terms since the end of 2016, the real effective dollar is now trading at a 2% discount vis-à-vis its fair value based on its principal long-term drivers - real yield differentials and relative productivity between the U.S. and its trading partners (Chart 1). The U.S. dollar's equilibrium - despite having been re-estimated higher earlier this year due to upward revisions by the Conference Board to its U.S. productivity series - has flattened as of late, as real rate differentials between the U.S. and the rest of the world have declined. While 2017 has been an execrable year for dollar bulls, glimmers of hope remain. First, the handicap created by expensive valuations has been purged. Second, the excessive bullishness toward the greenback that prevailed earlier this year has morphed into deep pessimism. Third, U.S. real interest rates have fallen as investor doubts that the Federal Reserve will be able to increase interest rates as much as it wants to in the face of paltry inflation have surged. However, the U.S. economy is strong and at full capacity, suggesting that inflation will hook back up at the end of 2017 and in the first half of 2018. This should once again lift the U.S. interest rate curve, the dollar's fair value, and the dollar itself. That being said, this story is unlikely to become fully relevant over the next three months. The Euro Chart 2The Euro's Fair Value Is Now Rising On a multi-year time horizon, the euro is driven by the relative productivity trend of the euro area with its trading partners, its net international investment position, terms-of-trade shocks and rate differentials. Thanks to its powerful rally this year, the euro's discount to its fair value has narrowed from 7% in February to 6% today (Chart 2). This narrowing is not as great as the rally in the trade-weighted euro itself as its fair value has also improved, mainly thanks to continued improvement in the euro area's net international position - a development driven by the euro zone's current account of 3% of GDP. Nonetheless, the EUR's current discount to fair value is still not in line with previous bottoms, such as those experienced in both early 1985 or in 2002. We do expect a new wave of weakness in the EUR to materialize toward the end of the year and in early 2018 as markets once again move to discount much more aggressive tightening by the Fed than what will be executed by the European Central Bank: U.S. inflation is set to move back towards the Fed's target, but European inflation will remain hampered by the large amount of labor market slack still prevalent in the European periphery. What's more, euro area inflation is about to suffer from the lagged effects of the tightening in financial conditions that have been created by a higher euro. However, the fact that the euro's fair value has increased implies it is now very unlikely for the EUR/USD to hit parity this cycle. The Yen Chart 3The Yen Is Very Cheap, But It May Not Count For Much The yen's long-term equilibrium is a function of Japan's net international investment position, global risk aversion, and commodity prices. The JPY discount to this fair value has deepened this year, despite the fall in USD/JPY from 118 to 108 (Chart 3). This is mainly because the euro and EM as well as commodity currencies have all appreciated against the Japanese currency. Low domestic inflation has been an additional factor that has depressed the Japanese real effective exchange rate. While valuations point to a higher yen in the coming year, this will be difficult to achieve. The Bank of Japan remains committed to boosting Japanese inflation expectations. To generate such a shock to expectations, the BoJ will have to keep policy at massively accommodative levels for an extended period. As global growth remains robust, global bond yields should experience some upside over the next 12 months. With JGB yields capped by the Japanese central bank, this will create downside for the yen. However, because the yen is so cheap, it is likely to occasionally rally furiously each time a risk-off event, such as any additional North Korean provocations, puts temporary downward pressure on global yields. The British Pound Chart 4The Pound Is Attractive On A Long-Term Basis The pound has fallen 6% against the euro this year, the currency of its largest trading partner. This has dragged down the GBP's real effective exchange rate to a large 11% discount to its fair value, the largest since the direct aftermath of the Brexit vote (Chart 4). Because Great Britain has entered a paradigm shift - the exit from the European Union will change the nature of the U.K. relationship on 43% of its trade - assessing where the pound's fair value lies is a more nebulous exercise than normal. However, signs are present that the pound is indeed cheap. British inflation remains perky, the current account has narrowed to 4% of GDP, and despite large regulatory uncertainty, net FDI into the U.K. has hit near record highs of 7% of GDP. Movements in cable are likely to remain a function of the gyrations in the U.S. dollar. However, at this level of valuation, the pound is attractive against the euro on a long-term basis. We had a target on EUR/GBP at 0.93, which was hit two weeks ago. This cross is likely to experience downside for the next 12 months. The biggest risk for the pound remains British politics - and not Brexit itself but its aftershock. The EU has made clear the transition process will be long, leaving time for the British economy to adjust. However, the conservative party has been greatly weakened, and Jeremy Corbyn's popularity is increasing. This raises the specter that, in the not-so-distant future, a Labour government could be formed. Under Corbyn's leadership, this would be the most left-of-center administration in any G10 country since François Mitterrand became French president in 1981. The early years of the Mitterrand presidency were marked by a sharp decline in the franc as he nationalized broad swaths of the French private sector, increased taxes and implemented inflationary policies. Keep this in mind. The Canadian Dollar Chart 5The CAD Has Lost Its Valuation Advantage The loonie's fair value is driven by commodity prices, relative productivity trends, and the Canadian net international position. In February, the CAD was trading in line with its fair value. However, after its blistering rally since May, when the Bank of Canada began to hint that policy could be tightened this year, the Canadian dollar is now expensive vis-à-vis its long-term fundamental drivers (Chart 5). In a Special Report two months ago, we argued that the BoC was one of the major global central banks best placed to increase interest rates.2 With the Canadian economy firing on all cylinders, and with the output gap closing faster than the BoC anticipated in its July Monetary Policy Statement, the two interest rate hikes recorded this year so far make sense, and another one is likely to materialize in December. However, while the CAD could continue to rise until then, traders have moved from being massively short the CAD to now holding very sizeable net long positions. Additionally, interest rate markets are now discounting more than two hikes in Canada over the next 12 months, while expecting less than one full hike in the U.S. over the same time frame. If this scenario were to pan out, the tightening in monetary conditions emanating from a massive CAD rally would likely choke the Canadian recovery. Instead, we expect U.S. rates to increase more than what is currently embedded in interest rate markets, thus limiting the downside in USD/CAD. We prefer to continue betting on a rising loonie over the next 12 months by buying it against the euro and the Australian dollar. The Australian Dollar Chart 6The AUD Is Very Expensive The fair value of the Aussie is driven by Australia's net international position and commodity prices. Even with the tailwind of stronger metal prices, the AUD's rallies have been beyond what fundamentals justify, leaving it at massively overvalued levels (Chart 6). This suggests the AUD is at great risk of poor performance over the next 24 months. Timing the beginning of this decline is trickier, and valuations offer limited insight. One of the key factors that has supported the AUD has been the large increase in fiscal and public infrastructure spending in China this year - a move by Beijing most likely designed to support the economy in preparation for the 19th National Congress of the Communist Party of China, where the new members of the Politburo are designated. As this event will soon move into the rearview mirror, China may abandon its aggressive support of the industrial and construction sectors - two key consumers of Australia's exports. The other tailwind behind the AUD has been the very supportive global liquidity backdrop. Global reserves growth has increased, dollar-based liquidity has expanded and generalized risk-taking in global financial markets has generated large inflows into EM and commodity plays.3 While U.S. inflation remains low and investors continue to price in a shy Fed, these conditions are likely to stay in place. However, a pick-up in U.S. inflation at the end of the year is likely to force a violent re-pricing of U.S. interest rates and drain much of the global excess liquidity, especially as the Fed will also be shrinking its balance sheet. This is likely to be when the AUD's stretched valuations become a binding constraint. The New Zealand Dollar Chart 7No More Premium In The NZD Natural resources prices, real rate differentials and the VIX are the key determinants of the kiwi's fair value, highlighting the NZD's nature as both a commodity currency and a carry currency. Both the fall in the VIX and the rebound in commodities prices are currently causing gradual appreciation in the New Zealand's dollar equilibrium exchange rate. However, despite these improving fundamentals, the real trade-weighted NZD has fallen this year, and now trades in line with its fair value (Chart 7). Explaining this performance, the NZD began 2017 at very expensive levels, even when compared to the already-pricey AUD. Also, despite a very strong New Zealand economy, the Reserve Bank Of New Zealand has disappointed investors by refraining from increasing interest rates, as the expensive currency has tightened monetary conditions on its behalf. Going forward, the recent weakness in the real effective NZD represents a considerable easing of policy, which could warrant higher rates in New Zealand. As a result, while a tightening of global liquidity conditions could hurt the NZD in addition to the AUD, the kiwi is likely to fare better than the much more expensive Aussie, pointing to an attractive shorting opportunity in AUD/NZD over the next 12 months. The Swiss Franc Chart 8The CHF Is Cheap, The SNB Is Happy Switzerland's enormous and growing net international investment position continues to be the most important factor lifting the fair value of the Swiss franc. The recent sharp rally in EUR/CHF has now pushed the Swissie into decisively cheap territory (Chart 8). The decline in political risk in the euro area along with the lagging economic and inflation performance of the Swiss economy fully justify the discount currently experienced by the Swiss franc: money has flown out of Switzerland, and the Swiss National Bank is doing its utmost to keep monetary policy as easy as it can. For a small open economy like Switzerland, this means keeping the exchange rate at very stimulative levels. The continued growth in the SNB's balance sheet is a testament to the strength of its will. For the time being, there is very little reason to bet against SNB policy; the CHF will remain cheap because the economy needs it. However, this peg contains the seeds of its own demise. The cheaper the CHF gets, the larger the economic distortions in the Swiss economy become. Already, Switzerland sports the most negative interest rates in the world. This directly reflects the large injections of liquidity required from the SNB to keep the CHF down. These low real rates are fueling bubble-like conditions in Switzerland real estate and are threatening the achievability of return targets for Swiss pension plans and insurance companies, forcing dangerous risk-taking. But until core inflation and wage growth can move and stabilize above 1%, these conditions will stay in place. The Swedish Krona Chart 9The Swedish Krona Has More Upside Even after its recent rebound, the Swedish krona continues to trade cheaply, even if its long-term fair value remains on a secular downward trajectory (Chart 9). Yet the undemanding valuations of the SEK hide a complex picture. It is approximately fairly valued against the GBP and expensive against the NOK, two of its largest trading partners. However, the SEK is cheap against the USD and the euro. We expect the SEK to continue appreciating. While Swedish PMIs have recently softened, the Swedish economy is running well above capacity, and the Riksbank resources utilization indicator suggests the recent surge in inflation has further to run. Moreover, Sweden is in the thralls of a dangerous real-estate bubble that has pushed nonfinancial private-sector debt above 228% of GDP. With many amortization periods on new mortgages now running above 100 years, the Swedish central bank is concerned that further inflating this bubble could result in a milder replay of the debt crisis experienced in the early 1990s. The shift in leadership at the Riksbank's helm at the beginning of 2018 is likely to be the key factor that prompts the beginning of the removal of policy accommodation in that country. We like buying the krona against the euro. The USD/SEK tends to be a high-beta play on the greenback, and thus is very much a call on the USD. However, EUR/SEK displays a much lower correlation, and thus tends to be a more effective medium to isolate the upcoming tightening in monetary policy we expect from the Riksbank. The Norwegian Krone Chart 10The NOK is The Cheapest Commodity Currency The Norwegian krone remains the cheapest commodity currency in the world, along with the Colombian peso (Chart 10). The slowdown in Norwegian inflation and a very negative output gap of 2% of GDP implies that the Norges Bank will remain one of the most accommodative central banks in the G10. Thus, the NOK should remain cheap. However, we continue to like buying the krone against the euro. EUR/NOK has only traded above current levels when Brent prices have been below US$40/bbl. Not only is Brent currently trading above US$50/bbl, but the outlook for oil remains bright: production is in control as the agreement between Russian and OPEC is still in place. Additionally, the recent carnage and refinery shutdowns caused by hurricane Harvey should result in large drawdowns to finished-products inventories in the coming months. This will contribute to an anticipated normalization in global excess petroleum inventories, which have been the most important headwind to oil prices. Finally, the fact that the Brent curve is now backwardated also represents a support for oil prices, as this creates a "positive carry" for oil investors. The Yuan Chart 11The Yuan Can Rise On A Trade-Weighed Basis Despite the recent strength in both the trade-weighted RMB and the yuan versus the U.S. dollar, the renminbi still trades at a discount to its long-term fair value (Chart 11). Confirming this insight, China continues to sport a sizeable current account surplus, and its share of global exports is still on an expanding path. With the RMB being cheap, now that China is once again accumulating reserves instead of spending them to create a floor under its currency, the downside risk to the CNY has decreased significantly. Thus, since the People's Bank of China targets a basket of currencies when setting the yuan's value, to legitimize any bullish view on USD/CNY one needs to have a bullish view on the USD. While we do anticipate the dollar to rally toward the end of the year, our expectation that it will remain flat until then implies that we do not see much upside for now to USD/CNY. However, our bullish medium-term USD view, along with the cheapness of the CNY, suggests that the RMB could continue to appreciate on a trade-weighted basis going forward. While Chinese policymakers have highlighted their desire to make their currency a more countercyclical tool, the recent stability in Chinese inflation implies there is no need to let the CNY depreciate to reflate China. In fact, at this point, elevated PPI readings would argue that the Chinese authorities do have a built-in incentive to let the CNY appreciate on a trade-weighted basis for the coming six to 12 months. The Brazilian Real Chart 12The BRL is Vulnerable To A Pullback In Global Liquidity Hampered by poor productivity trends, which weigh on the Brazilian current account balance, the fair value of the real remains quite depressed, even as commodity prices have sharply rebounded since early 2016. In fact, the violent rally in the BRL over the same timeframe has made it one of the most expensive currencies tracked by our models (Chart 12). This level of overvaluation points to poor returns for the BRL on a one-to-two-year basis, however, it gives no clue to timing. The strong sensitivity of the Brazilian real to EM asset prices implies that the BRL is unlikely to weaken significantly so long as EM bonds remain well-bid. Moreover, because the BRL still offers an elevated carry, until U.S. interest rate expectations turn the corner, U.S. market dynamics will continue to put a floor under the real. However, this combination suggests the BRL could become one of the prime casualties of any rebound in U.S. inflation. Such a development would cause global liquidity to fall, hurting EM bonds in the process and making the BRL's high-risk carry much less attractive. Confirming this danger, the fact that the USD/BRL has not been able to breakdown for more than a year despite the weakness in the USD suggests momentum under the BRL is rather weak. The Mexican Peso Chart 13Mexican Peso: From Bargain To Luxury In the direct aftermath of Trump's electoral victory, the Mexican peso quickly became one of the cheapest currencies in the world. However, the peso's 25% rally versus the U.S. dollar since January has eradicated this valuation advantage to the point where it is now one of the most expensive major currencies in the world (Chart 13). As the peso was collapsing through 2016, the Mexican central bank fought back, increasing interest rates. The massive surge in the prime lending rate points to a protracted period of weakness in the growth of nonfinancial private credit, which should weigh on consumption and investment. Actually, the growth in retail sales volumes has already begun to weaken. This could force the Banxico to cut rates, especially as inflation will slow in the face of peso's rebound this year. Lower Mexican rates, in the face of stretched long positioning in MXN by speculators, could be the key to generating a weakening in the peso over the next 12 months. To see real fireworks in the peso, one would need to see a resumption in the U.S. dollar bull market. Mexico has external debt equivalent to 66% of GDP, the highest among large EM nations. This makes the Mexican economy especially vulnerable to a strong dollar, as such a move would imply a massive increase in debt servicing costs. Thus, while the MXN may not be as vulnerable as the BRL, it could still suffer greatly if global liquidity becomes less generous next year. The Chilean Peso Chart 14CLP Needs HIgh Copper Prices The Chilean peso real effective exchange rate is driven by the country's productivity trend relative to its trading partners and the real price of copper - which proxies Chilean terms-of-trade. Thanks to the CLP's rally since the winter of 2015, the real peso is at a four-year high and is now in expensive territory (Chart 14). We expect copper to see downside from now until the end of the year, pulling down the CLP with it. Current dynamics in the Chinese real estate market and the Chinese credit cycle, which tend to be leading indicators of industrial metals prices, point to an upcoming selloff. Moreover, Chinese monetary conditions have begun to tighten, and are set to continue doing so. This will weigh on Chinese credit growth and capex, creating headwinds for copper and the peso. That being said, the CLP will likely outperform the BRL and the ZAR. M1 money growth is back in positive territory after contracting last year, while industrial activity seems to have hit a bottom and is now picking up. Moreover, since Chile's economy does not have the credit excesses of its other EM peers, we expect the CLP to show more resilience than other currencies linked to industrial metals. The Colombian Peso Chart 15COP: A Rare Bargain Among EM The real COP's fair value is driven by Colombia's relative productivity trends and the price of oil, the country's main export. The fall in oil prices since the beginning of the year have caused a small decline in the fair value of the COP. Nevertheless, the peso is still one standard deviation below fair value (Chart 15). This partly reflects the premium demanded by investors to compensate for Colombia's large current account deficit of 6.3% of GDP. Overall the COP looks attractive, particularly against other commodity currencies. Historically a discount of 20% or more, like what the peso has today, marks a bottom in the real effective exchange rate. Furthermore, our Commodity and Energy Strategy Service expects Brent prices to climb to US$60/bbl towards the end of year, as OPEC's and Russia's production controls translate into oil inventory drawdowns. This should further increase the value of the COP against the ZAR and the BRL. Domestic dynamics also point to outperformance of the peso against other EM currencies. As opposed to countries like Brazil, where private debt stands at nearly 85% of GDP, Colombia has a more modest 60% leverage ratio - the byproduct of an orthodox banking system. Thus, the peso should be able to withstand a liquidity drawdown in EM better than its peers. The South African Rand Chart 16Lack Of Productivity And Politics Are The Greatest Risk To The Rand South Africa's dismal productivity trend continues to be the greatest factor pulling the rand's long-term fair value lower. Due to this adverse trend, while the ZAR has been broadly stable this year, it is now slightly more expensive than it was in February (Chart 16). Not captured by the model, the political risks in South Africa remain elevated, creating a further handicap for the rand. The story behind the ZAR is very similar to the one underpinning the gyrations in the BRL. Both currencies, thanks to their elevated carries and deep liquidity - at least by EM currency standards - will continue to be buoyed by very generous global liquidity conditions. However, global real rates seem dangerously low and could move sharply higher, especially when U.S. inflation picks up at the end of the year and in early 2018. Such a move would cause the currently very supportive reflationary conditions to dissipate. This would put the expensive ZAR in a very precarious position. An additional danger for the ZAR is the price of gold. Gold and precious metals have also benefited from these generous global liquidity conditions. This has helped the South African terms of trade. However, gold is likely to be a key victim if U.S. interest rates rise because it is negatively correlated with both real interest rates and the U.S. dollar. Thus, while we do not see much upside for the expensive ZAR for the time being, it is likely to suffer greatly once U.S. inflation turns around, suggesting the ZAR possesses a very poor risk/reward ratio. The Russian Ruble Chart 17The Ruble Is Expensive But Russia Has The Best EM Fundamentals The RUB is currently trading at a very large premium to fair value (Chart 17). The risk created by such an overvaluation is only likely to materialize once U.S. inflation turns the corner and U.S. interest rates pick up - a scenario we've mentioned for late 2017 and early 2018. This risk is most pronounced against DM currencies, the U.S. dollar in particular. The RUB remains one of our favorite currencies within the EM space, especially when compared to other EM commodity producers. The Russian central bank is pursuing very orthodox policy, despite the fall in realized inflation, and is maintaining very elevated real interest rates in order to fully tame inflation expectations. Moreover, oil prices are likely to experience upside in the coming months as oil inventories are drawn down. This could result in an increase in the ruble's equilibrium exchange rate, which would help correct some of the RUB's overvaluation. The Korean Won Chart 18KRW Is Where You Can Really See The North Korean Tensions The fair value of the Korean won continues to be lifted by the combined effect of lower Asian bond spreads and Korea's current account surplus. Yet, the KRW is trading at an increasingly large discount to its equilibrium (Chart 18). At first glance, this seems highly surprising as global trade is growing at its fastest pace in six years - a situation that always benefits trading nations like South Korea. Instead, political developments are to blame. Not only is North Korea ramping up its tests of intercontinental ballistic missiles and nuclear devices, but also Seoul is within range of Pyongyang's conventional artillery. BCA's Geopolitical Strategy service does not expect the current standoff to result in military conflict. Ultimately, North Korea is no match for the military might of the U.S. and its allies. Moreover, the capacity for Pyongyang's actions to shock financial markets is exhibiting diminishing returns. This suggests the risk premium imbedded in the won should dissipate. However, the won will remain very exposed to dynamics in the USD, global liquidity and global trade. Instead, a lower-risk way for investors to take advantage of the KRW's cheapness is to buy it against the Singapore dollar. While just as exposed to global liquidity as the won, the SGD is currently trading at a premium to fair value. The Philippine Peso Chart 19The PHP Has Over-Discounted The Fall In The Current Account The fair value of the Philippine peso is driven by the country's net international investment position and commodity prices. After falling 6% this year, the real effective PHP now trades at a 13% discount to its fair value (Chart 19). A deteriorating current account, which is now in deficit, has fueled a selloff in the peso, making the Philippine currency one of the worst performing in the EM space. Worryingly, this has occurred alongside faltering foreign exchange reserves. However, the deficit is mainly the mirror image of large capital inflows, fueled by the government's ambitious infrastructure spending. Remittances are growing again and, with a weaker peso, will support consumer spending going forward. Employment had a setback last year, but is growing again. Higher investment and consumer spending will likely push rates up. As inflation rebounded alongside commodity prices last year, it is now at its 3% target. Bangko Sentral ng Pilipinas will need to rein in inflationary pressures to avoid overheating the economy. While the Philippines economy should expand further, the 'Duterte Discount' remains in place. Negative net portfolio flows reflect negative investor sentiment, as policy uncertainty remains elevated. The Singapore Dollar Chart 20SGD Remains Expensive The fair value of the Singapore dollar is driven by commodity prices. This is because the exchange rate is the main policy tool used by the Monetary Authority of Singapore. As a result, when commodity prices rise, which leads to inflationary pressures, MAS tightens policy by spurring appreciation in the SGD. The opposite holds true when commodity prices weaken. Based on this metric, the SGD is currently 4.2% overvalued (Chart 20). Domestically, dynamics are quite mixed. Retail sales have picked up. However, both manufacturing and construction employment are contracting and labor market slack is increasing, pointing to continued subdued wage growth. Additionally, property prices are contracting and vacancy rates are on the rise, led by the commercial property sector. Thus, the recent pickup in inflation could soon vanish, especially as it has been driven by the rebound in oil prices in 2016. This combination suggests that Singapore still needs easy monetary conditions. USD/SGD closely follows the DXY. While the Fed will be able to increase interest rates by more than the 35 basis points priced over the next 24 months, Singapore still needs a lower exchange rate to maintain competitiveness and alleviate deflationary pressures. The Hong Kong Dollar Chart 21The Fall In The USD Has Helped The HKD The HKD remains quite expensive. However, being pegged to the USD, its valuation premium has decreased this year (Chart 21). The fall in the greenback has driven the HKD - which itself has fallen 0.75% versus the U.S. dollar - lower against the CNY and other EM currencies. If the U.S. dollar does resume its uptrend over the next six months, the valuation improvement in the HKD will once again dissipate. However, this does not spell the end of the HKD peg. With reserves of US$414 billion, or 125% of GDP, the Hong Kong Monetary Authority has the firepower to support the peg, which has been one of the cornerstones of Hong Kong economic stability since 1983. Instead, the HKMA will tolerate deep deflationary pressures that will cause a fall in the real effective exchange rate. This is the path that Hong Kong picked in the 1990s, and it will be the path followed again in the face of any broad-based USD appreciation. This suggests that Hong Kong real estate prices could experience significant downside in the coming years. The Saudi Riyal Chart 22The Riyal Is Still Expensive The Saudi riyal remains prohibitively expensive, even as its valuation premium has decreased this year (Chart 22). The SAR is afflicted by similar dynamics as the HKD: its peg with the USD means the greenback's gyrations are the main source of variation in the SAR's real effective exchange rate on a cyclical basis. However, on a structural horizon, the fair value of the riyal is dominated by Saudi Arabia's poor productivity. An economy dominated by crude extraction and processing and living on one of the most sizable economic rents in the world, Saudi Arabia has not endured the competitive pressures that are often the source of productivity enhancement in most nations. Additionally, Saudi capital expenditures are heavily skewed to the oil sector, a sector whose output growth has been limited for many decades by natural constraints. We do not believe the current valuation premium in the riyal will force the Saudi Arabian Monetary Authority to devalue the SAR versus the USD. Saudi Arabia, like Hong Kong, possesses copious foreign exchange reserves, and growth has improved now that oil prices have rebounded. Additionally, the KSA is also likely to tolerate deflationary pressures. Not only has it done so in the past, but Saudi Arabia imports most of its household products, especially its food needs. A fall in the SAR would cause a large amount of food inflation, representing a massively negative price shock for a very young population. This is a recipe for disaster for the royal family of a country with no democratic outlet. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 3 For a more detailed discussion on the global liquidity environment, please Foreign Exchange Strategy Weekly Report, "Dollar-Bloc Currencies: More Than Just China", dated August 18, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Overweight As the concern over hurricanes Harvey & Irma related catastrophes transitions to repair & rebuilding, it is worth examining the home improvement retail (HIR) space. HIR stocks have barely budged since the hurricanes as the market tries to figure out the earnings impact. Reconstruction is displacing renovation demand which will drive near term sales higher; the price of lumber is the usual leading indicator for sales growth in HIR and it is reaching five year highs (second panel). However, said higher prices will mean that some of the deferred renovation demand will be destroyed, implying the hurricanes simply pulled some sales forward rather than create new demand. Still, the HIR space was firing on all cylinders before the hurricanes with roaring sales and efficiency (third panel) driving margins higher. This is not reflected in valuation multiples which are surprisingly touching ten-year lows. Surging mortgage applications (top panel) should keep renovation demand on a solid footing, despite a likely near-term hiccup; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.

Highlights The law of the vital few states that a small number of causes have a disproportionate impact on your overall investment performance. Get the bond yield direction right and your equity sector allocation, equity country allocation and currency allocation should end up outperforming too. Expect the euro area versus U.S. bond yield spread to continue compressing. This means euro area banks will outperform U.S. banks and EUR/USD has cyclical upside. But within a European equity portfolio, banks should be at neutral weight. This implies upgrading Italy's MIB and Spain's IBEX to neutral and downgrading Germany's DAX to underweight. Feature "Less is more, and usually more effective" - Nassim Taleb The law of the vital few states that a small number of causes usually have a disproportionate impact on any overall result. Familiar examples of the law - also known as the Pareto principle or the 80/20 rule - are that a minority of bugs cause a majority of software problems; and that the top few salespeople in any company tend to be responsible for most of its sales. With investment research costs now coming under intense scrutiny, the law of the vital few has become highly significant for the investment management industry too. Every day, investors are bombarded with a seemingly endless stream of research, email alerts and newsfeeds. Yet most of the hundreds of choices that investors have to make reduce to getting just a handful of fundamental decisions right. We call this investment reductionism. The message from investment reductionism is to identify the few decisions that really matter, and to focus your time, effort and resources on these vital few rather than the trivial many. Because the vital few will have a disproportionate impact on hundreds of positions across different asset-classes in your investment portfolio. Bond Yields Are One Of The Vital Few Right now, one of the vital few decisions is the direction of high-quality government bond yields. Get bond yields right absolutely and relatively and you will get at least four investment decisions for the price of one. Not only will you get fixed income right, but your equity sector allocation, equity country allocation and currency allocation should end up outperforming too. In the most recent mini-cycle, the bond yield has driven the bank equity sector's relative performance almost tick for tick both in Europe (Chart I-2) and globally (Chart of the Week). There are two reasons. Higher bond yields fatten banks' net interest margins. They also signal an improving growth outlook and thereby a reduction in bad debts. Lower bond yields imply the exact opposite. Chart of the WeekGet Bond Yields Right And You"ll ##br##Get Banks Right Too Chart I-2Get Bond Yields Right And You"ll ##br##Get Banks Right Too In turn, the bank sector's relative performance has a major influence on equity country allocation. Investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. For example, the defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks. So unsurprisingly, MIB and IBEX relative performance reduces to: will banks outperform the market? (Chart I-3 and Chart I-4) Which itself reduces to: will bond yields head higher? The bond yield - relative to those in other economies - is also a major driver of the exchange rate (Chart I-5). As we detailed in Who's Afraid Of A Stronger Euro?1 the transmission mechanism is the so-called fixed income portfolio channel. In a nutshell, a higher bond yield in one jurisdiction relative to others attracts international fixed income portfolio flows into that jurisdiction, pushing up its currency - until a new higher level of the currency repels any further bond inflows. Chart I-3Get Banks Right And You"ll ##br##Get Italy Right Too Chart I-4Get Banks Right And You"ll ##br##Get Spain Right Too Chart I-5Get Bond Relative Performance Right And##br## You"ll Get EUR/USD Right Too Follow Your High Convictions Still, it is impossible to have a high-conviction view on a macro call at all times. A golden rule of investing is to have a big position only where and when you have a high-conviction view. Chart I-6When Unemployment Is Plunging, Real Wage ##br##Inflation Should Be Rising, But It Isn"t At the moment, our high-conviction view on bond yields is a relative view. Specifically, the euro area versus U.S. yield shortfall will continue to compress one way or another. This is because the polarisation of monetary policy expectations in the euro area relative to the U.S. remains at odds with growth and inflation data that have been, are, and will continue to be near-identical. Using investment reductionism, a high-conviction view that the euro area versus U.S. yield spread will compress necessarily means overweighting European banks versus U.S. banks. And it means staying cyclically long EUR/USD. On the absolute direction of bond yields we have less conviction. On the one hand, major economies are growing well and unemployment rates are coming down. Yet as we explained in Why Robots Will Kill Middle Incomes,2 the current wave of technological progress is especially disinflationary for wages, and one of the reasons why the Phillips curve relationship between unemployment and wage inflation isn't working (Chart I-6). Even the Federal Reserve Bank of Philadelphia, in a recent research paper,3 "finds no evidence for relying on the Phillips curve". The upshot is that we are cyclically neutral on bonds, but structurally positive. Using investment reductionism again, a cyclically neutral stance on bonds necessarily means a cyclically neutral weighting to European banks versus other European sectors. In turn, this means a cyclically neutral weighting to Italy's MIB and Spain's IBEX versus the Eurostoxx600. Sector Skews Are One Of The Vital Few To reiterate, the key consideration for European equity country allocation is always: how to allocate to the vital few sectors that feature most often in the skews: in addition to Banks, this means Healthcare, Energy and Materials (Box I-1 and Appendix). Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Within a European equity portfolio, our cyclical stance to Banks is neutral. Healthcare's cyclical relative performance reduces to its defensiveness and low beta. This means that Healthcare tends to underperform in a strongly advancing market. But it tends to outperform when the market is doing no better than advancing weakly (Chart I-7). As this is our central expectation, our cyclical stance is to remain overweight Healthcare. Chart I-7Healthcare"s Cyclical Relative Performance Reduces To Its Defensiveness And Low Beta Regarding Energy, Materials (and Industrials), euro area equity markets with a large exposure to these export-heavy sectors will be under pressure, given our cyclical view on the euro. Mostly, this is because the translation of multi-currency international earnings into a strengthening base currency hurts index profits. Hence, underweight these sectors. Finally, to arrive at a country allocation, combine the cyclical view on the vital few sectors with the country sector skews shown above. Even if you disagree with our sector views, the sector-based approach is the right way to pick European equity markets. If you agree with our sector views, the result is the following updated European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Italy, Spain, and Netherlands. Underweight: Germany, Sweden and Norway. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Published on August 3, 2017 and available at eis.bcaresearch.com 2 Published on August 10 and available at eis.bcaresearch.com 3 https://www.philadelphiafed.org/-/media/research-and-data/publications/… Chart Appendix Chart I-8Germany (DAX) Is Overweight Chemicals, ##br##Underweight Banks Chart I-9France (CAC) Is Underweight Banks ##br##And Basic Materials Chart I-10Italy (MIB) Is Overweight Banks Chart I-11Spain (IBEX) Is Overweight Banks Chart I-12Netherlands (AEX) Is Overweight Technology, ##br##Underweight Banks Chart I-13Ireland (ISEQ) Is Overweight Airlines (Ryanair)##br## Which Is, In Effect, Underweight Energy Chart I-14The U.K. (FTSE100) Is Effectively##br## Underweight The Pound Chart I-15Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Chart I-16Sweden (OMX) Is Overweight ##br##Industrials Chart I-17Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Chart I-18Norway (OBX) Is##br## Overweight Energy Chart I-19The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks Fractal Trading Model* Our model successfully captured the early August technical bounce in USD/CAD, and is signalling another opportunity now. The profit target / stop loss is 2.5%. 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-20 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. * 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 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 ##Br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights U.S. product inventories - particularly gasoline and distillates - will show sharp declines over the balance of September, as refining capacity continues to trail demand in the wake of Hurricane Harvey. U.S. crude inventories will accumulate as refineries slowly come back on line. This will keep the Brent vs. WTI spreads and crack spreads elevated, as refiners outside the U.S. Gulf scramble for crude (Chart of the Week).1 Global product storage facilities will be drained to more normal levels responding to this imbalance. It is understandable that the significance of the increased frequency of messaging from OPEC 2.0's leadership re its willingness to extend production cuts beyond March 2018 would be secondary to hurricane recovery. Nonetheless, we advise investors to stay focused on OPEC 2.0's evolution, particularly next year, as it develops a modus operandi for providing forward guidance to markets and investors. Energy: Overweight. Brent futures are backwardated to January 2018, reflecting a tight market as refiners, particularly in Europe, scramble for barrels to meet U.S. and Latin American product demand. We remain long Brent and WTI $50/bbl vs. $55/bbl call spreads in Dec/17, which are up 183.8% and 30.2%, respectively, since inception. Base Metals: Neutral. Our tactical COMEX copper short initiated last week is up 3.4%. Precious Metals: Neutral. The Dec/17 COMEX Gold contract gapped lower earlier in the week, as a strengthening USD, and a 15 - 0 vote Monday by the UN Security Council to adopt sanctions proposed by the U.S. against N. Korea took some of the luster off the metal. Our long strategic portfolio hedge is up 8.0% since it was initiated May 4, 2017. Ags/Softs: Underweight. Grains appear to be finding support around current levels. We are bearish, but do not advise shorting the complex, especially with erratic weather as a backdrop. Feature Chart of the WeekBrent - WTI Spread,##BR##Cracks Reflect Refining Scramble The Kingdom of Saudi Arabia (KSA) and Russia, the putative leaders of what we've dubbed OPEC 2.0, are taking every opportunity to signal their willingness to consider an extension of their production-cutting agreement beyond March 2018, when it is scheduled to expire.2 We believe this to be part and parcel of an evolving forward guidance strategy, which KSA and Russia will deploy to signal their production intentions over the near term. This is consistent with our view such a strategy is necessary to keep the producer coalition durable, and to work out an even larger plan to begin messaging firms and institutions allocating capital to oil and natural gas markets globally. This is critical for KSA, which will be looking to IPO Saudi ARAMCO next year, and Russia, which is preparing for elections in March and still relies heavily on hydrocarbon exports to fund its government.3 The last thing either needs is out-of-control oil production tanking the market, as it almost did at the beginning of 2016. Other members of the OPEC 2.0 coalition seeking foreign direct investment (FDI) - e.g., Gulf Arab producers and non-OPEC states like Mexico and Kazakhstan - benefit from an oil-production-management framework as well. The significance of OPEC 2.0's emerging forward guidance strategy could be lost amid the devastation of hurricanes Harvey and Irma, which is understandable. But it will be critical to understanding the coalition's strategy regarding how it intends to manage its own production, now that U.S. shale is the marginal barrel in the world, even after Hurricane Harvey disrupted production and refining in Texas, and U.S. crude and product exports from the Gulf. Thus far, OPEC 2.0 continues to deliver on its production cuts, and global demand - which we expect will dip by less than 1mm b/d over the next few weeks due to the hurricanes - remains strong. In a month or two, we expect hurricane recovery efforts will restore lost refining capacity and product demand. As rebuilding goes into high gear, we expect product demand to get a significant boost. OPEC 2.0 Maintains Discipline We will be updating our oil supply/demand balances next week, but so far it appears KSA and Russia are honoring their commitments to restrain production. This allows them to maintain credibility with their respective OPEC and non-OPEC allies within OPEC 2.0, and with the market in general (Chart 2). KSA, in particular, has led the way among OPEC members of the coalition, according to a tally done by S&P Global's Platts, which put KSA's average crude oil production over the January - August 2017 period at 9.97mm b/d vs. its quota of 10.06mm b/d. This is up slightly over the 9.93mm b/d average production for January - June 2017 reported by JODI. KSA's August production reported in the September OPEC Monthly Oil Market Report was 9.95mm b/d. For the January - August 2017 period, Russia's total crude and liquids production averaged 11.22mm b/d, according to U.S. EIA estimates. For the May - August period, it averaged 11.16mm b/d, putting total output 300k b/d below its October 2016 level, against which OPEC 2.0 benchmarks. Russia committed to reducing output by 300k b/d under the OPEC 2.0 Agreement as part of an overall effort to remove 1.8mm b/d of production from the market to end-March 2018. Russia's crude oil production averaged 10.38mm b/d over the January - June 2017 period, according to JODI data, vs. an October level of 10.51mm b/d. For 2Q17, Russia's average production reported to JODI was 10.31mm b/d, or 200k b/d below its Oct/16 output. Overall OPEC compliance of members with quotas was 112% of agreed volumes last month, meaning OPEC members with quotas under the OPEC 2.0 Agreement are producing 630k b/d below agreed volumes, according to Platts.4 Seven of the OPEC states still covered by the Agreement are producing below quota. Iraq leads in over-production at 4.46mm b/d on average in the January - August period, or 82k b/d over quota. Overall, however, production discipline is holding (Chart 3, panel 2). Chart 2KSA, Russia Leading##BR##OPEC 2.0 By Example Chart 3Production Discipline, Strong Demand##BR##Will Continue To Support Prices Bottom Line: OPEC 2.0's forward guidance to markets, firms and institutions allocating capital in the energy sector has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018, when their Agreement is due to expire. We believe this reflects the desire of OPEC 2.0's leadership to maintain the coalition as a long-term production-coordinating body. This will allow the major oil producing nations to communicate production plans and allay investor fears of out-of-control production in the future. Global Demand Will Remain Strong We have noted repeatedly global economic growth has been firing on all cylinders, which will keep global oil demand robust for at least the balance of 2017, and likely into 2018 (Chart 3, panel 3). This is particularly evident in global trade data, which we also will be updating next week.5 Global economic data continue to support this thesis: All 46 countries monitored by the OECD are on track to grow this year, the first time this has happened since 2007, according to BCA's Global Investment Strategy (GIS).6 In addition, BCA's Global Investment Strategy notes U.S. growth projections have been broadly stable, but these likely will be revised higher. The easing in U.S. financial conditions since the start of the year should boost real GDP growth over the next few quarters, which, along with the expected boost to product demand coming on the back of hurricane-recovery efforts, will continue to be bullish for refined product demand. Global Product Inventory Draws Will Accelerate OPEC 2.0's efforts to draw global inventories - particularly in the OECD - received an unexpected assist from hurricanes Harvey and Irma. We expect the trend of drawdowns seen over the past few months to accelerate (Chart 4). This will return global product inventories to more normal levels, and, with crude oil inventories accumulating, favor refiners as they scramble to meet demand. Our colleagues at BCA's Energy Sector Strategy upgraded U.S. refiners last week to overweight in line with their view Harvey has the "potential to finally normalize bloated refined product inventories. Over two weeks since the hurricane made landfall, the industry still has 1.0 MMb/d of refining capacity shut down (5 refineries), 2.15 MMb/d of capacity not operating but working on restarting operations (6 refineries), and 1.4 MMb/d of capacity operating below full capacity (5 refineries). Over the past 16 days, at least 55 million barrels of refined product have not been generated, which will result in increased crude inventories and shrinking refined product inventories, benefitting refiners" (Chart 5).7 Chart 4OECD Oil Inventory Declines Will Accelerate Chart 5Refinery Outages From Harvey Persist Over the short term, Brent crude - and related streams pricing off Brent - and products will remain bid, keeping refiner crack spreads elevated, as operations return to normal, and Florida emerges from the economic damage and dislocations caused by Irma. Typically, product demand falls immediately after severe storms, and recovers as rebuilding begins and progresses. We will be updating our balances model next week to reflect the effects of hurricanes and the continued indications of strong global growth. Bottom Line: Demand for refined products will dip slightly - likely less than 1% of global demand - as hurricane-ravaged markets recover. As rebuilding progresses, product demand likely will be boosted. This will drain OECD product inventories in the short term, providing an unexpected assist to OPEC 2.0's efforts to bring global stocks down to five-year average levels. This evolution will favor refiners, as well. OPEC 2.0's forward guidance to markets continues to evolve. In recent weeks, it has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018. We believe this messaging is designed to allay fears of another production-free-for-all of the sort that threatened to take global benchmark crude oil prices below $20/bbl last year. It is too early to expect OPEC 2.0 will replace the original OPEC Cartel. But, we believe KSA and Russia are signaling their common desire to make OPEC 2.0 a durable feature of budgeting and investment considerations over the medium term. Actions speak louder than words, in this regard. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 A "crack spread" refers to the difference in refined-product prices and crude oil prices. It takes its name from the "cracking" long-chain hydrocarbon bonds in crude oil required to produce refined products like gasoline and diesel fuel. The Brent - WTI spread is the price difference in USD/barrel ($/bbl) between the global benchmark crudes. 2 Please see, for example, "Saudi Arabia Says It's Open to Another OPEC Cuts Extension," updated on bloomberg.com September 11, 2017; "Saudi, UAE agree extension of oil cuts may be considered - statement," published on the same day on reuters.com's U.K. service; and "Russia's Novak says to consider extension of oil cut deal if glut persists" published on reuters.com September 6, 20107. We have repeated noted markets are looking for OPEC 2.0 to provide forward guidance, if the principals to the deal intend to maintain a durable coalition. Please see, e.g., "KSA's Tactics Advance OPEC 2.0's Agenda," published by BCA Research's Commodity & Energy Strategy Weekly Report August 10, 2017, and available at ces.bcaresearch.com. 3 The U.S. CIA estimates Russia exported 5.1mm b/d of crude oil in 2016, roughly half of crude production. This squares with exports reported by the Joint Organizations Data Initiative (JODI), a transnational agency headquartered in Riyadh, Saudi Arabia. Last year, Russia also exported 223 billion cubic meters of natural gas. KSA exported 7.65mm b/d of crude oil last year, according to JODI, or close to 75% of KSA's production. 4 Please see S&P Global Platts OPEC Guide published September 7, 2017, online. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Trade And Commodity Data Point To Higher Inflation," published on July 27, 2017. It is available at ces.bcaresearch.com. 6 Please see BCA Research's Global Investment Strategy Weekly Report "Central Bank Showdown," published on September 8, 2017. It is available at gis.bcaresearch.com. 7 Please see BCA Research's Energy Sector Strategy Weekly Report "Rebalancing Recommendations," published on September 13, 2017. It is available at nrg.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Overweight Managed health care has been on a tear for the past five years, but 2017 has seen an acceleration, for good reason. Profit growth has been steady and the formula for a further pick up in earnings is in place, making a powerful tonic for the index. The rate of increases in drug prices, which had been a key pain point earlier this decade, has been falling since the end of 2015 (second panel) as generics continue to gain share. Further, consumer spending on health care has been declining as a share of the American household's budget (third panel), which should signal fewer claims ahead and put industry cost pressures into remission. At the same time as health care is losing share of the wallet, pricing power has remained remarkably healthy (third panel), emphasizing the profit resilience of the sector and its ability to deliver outsized earnings growth when costs are falling. Continued earnings growth is now a requirement to be able to maintain the index's upward trajectory as valuations have crept higher this year (bottom panel). We think they are up to the task; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC.

Overweight In early July, we lifted refiners to neutral but refrained from turning outright bullish for three reasons: all-time high refining production, high refined product stocks and breakneck pace refinery runs were offsetting the nascent recovery in gasoline consumption, rising crack spreads and a mini V-shaped recovery in industry shipments. Hurricane Harvey has significantly changed this calculus; severe refinery shutdowns are likely to represent a major, albeit temporary, setback. This production curtailment will result in sizable petroleum products inventory drawdowns and a significantly positive pricing backdrop. Indeed, refining margins have jumped recently and will likely remain elevated as the Brent/WTI spread is widening anew (second panel). Nevertheless, the refining supply disruptions only tell half the story. Refined product demand is exploding higher, pushing all-time highs and signaling that a substantial supply/demand imbalance is in the works. Typically this gets resolved via higher gasoline prices, further boosting industry EPS prospects (bottom panel). As a result, we expect a re-rating phase in relative valuations in the coming months, reversing the year-to-date deflation in the relative price-to-sales ratio. Bottom Line: A playable rally in refiners is in the offing on the back of a budding profit recovery. Boost the S&P oil & gas refining & marketing index to overweight. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV.

Highlights Bonds As A Safe Haven: Global bond yields have been driven lower by safe haven buying, despite ample evidence of faster global growth and central bankers that are still biased to shift to a less easy policy stance. There is now considerable upside risk for global bond yields over the next 6-12 months from these current depressed levels. ECB: The ECB is giving strong indications that a decision on tapering its asset purchase program will be made next month. With the Euro Area economy growing at a solid pace, and with inflation creeping higher, a reduction in the pace of bond buying in 2018 is highly probable. Canada: The Bank of Canada will continue to deliver on rate hikes without decisive signs that the current booming Canadian economy is slowing down, which leading indicators do not suggest is imminent. Stay underweight Canadian government debt, with a curve flattening bias. Feature Fade The Doomsday Trade Investors have had a lot of depressing news to process over the past several weeks. From threats of nuclear war with North Korea, to fears of a U.S. government shutdown over the debt ceiling, to the potential of Biblical flooding from hurricanes in Texas and Florida, the environment has not been conducive to risk-taking. This has triggered a flight into safe-haven assets like gold and U.S. Treasuries as investors have looked to protect portfolios from "existential" risks (Chart of the Week). Yet despite this rapid run-up in the value of save-havens, risky assets like equities and corporate credit have performed relatively well since the most recent peak in bond yields in early July (Table 1). Chart of the WeekFalling Yields Reflect Save Haven Demand,##BR##Not Slower Growth Table 1Changes In Risk Assets Since##BR##U.S. Treasury Yields Peaked On July 7th This move toward safety and risk aversion has widened the disconnect between global bond yields and economic fundamentals - specifically, growth momentum and central bank guidance - to extreme levels. Investors are now underestimating the potential for additional rate hikes in the U.S. in 2018, and are not fully appreciating the likelihood that the European Central Bank (ECB) will slow the pace of its asset purchases next year. Investors plowing money into government bonds now can only be rewarded if global monetary policy was set to ease, which would only be the case if global growth was slowing. That is not happening right now, even in the U.S. where the most apocalyptic headlines have been occurring. While the impact of Hurricanes Harvey and Irma will likely weigh on U.S. growth in the next few months, the underlying trend remains one of steady above-potential growth that is boosting both corporate profits and household incomes. More globally, depressed investor sentiment, indicated by measures such as the global ZEW survey, has helped drive bond yields lower despite the steady upturn in leading economic indicators (Chart 2). When looking at indicators of actual economic activity, like manufacturing PMIs, the growth story looks far stronger. As a sign of how much this "sentiment versus reality" divergence has distorted bond yields, look no further than our own valuation model for the 10-year U.S. Treasury yield. This model, which only uses the global manufacturing PMI and sentiment towards the U.S. dollar as inputs, indicates that the current "fair value" of the 10-year Treasury yield is 2.67%, nearly 60bps higher than market levels seen as this publication went to press (Chart 3). This is a level of overvaluation that even exceeds the extreme levels seen after the U.K. Brexit vote in July of 2016. Chart 2Bond Investors Are##BR##Ignoring Strong Growth Chart 3U.S. Treasuries Are##BR##Now Extremely Overvalued In Table 2, we present a decomposition of the 10-year yield changes in the major Developed Markets since that recent peak in U.S. Treasury yields on July 7th. As can be seen in the first two columns of the table, yields declined everywhere but Canada where the central bank has been hiking interest rates (as we discuss later in this report). Yet the vast majority of the yield decline has come from falling real yields and not lower inflation expectations. This has also occurred via a bull-flattening move in government bond yield curves (again, ex-Canada where the curve has bear-flattened), which suggests it is risk-aversion that has driven yields lower. Table 2Developed Market Bond Yield Changes Since U.S. Treasury Yields Peaked On July 7th The relative lack of movement in inflation expectations is a bit surprising given how strongly global oil prices have risen, denominated in any currency (see the final column of Table 2). When plotting the Brent oil price (in local currency terms) vs. the 10-year market-based inflation expectations (from inflation-linked bonds or CPI swaps), some notable divergences stand out. Inflation expectations in the U.S., U.K., Australia and even Japan look around 10-20bps too low relative to where they were the last time oil prices were at current levels (Charts 4 & 5). Meanwhile, inflation expectations are largely in lines with levels implied by oil and currency levels in the Euro Area and Canada. Most importantly, expectations are depressed in all countries, largely because actual inflation has stayed stubbornly low. Chart 4Inflation Expectations Vs. Oil Prices (1) Chart 5Inflation Expectations Vs. Oil Prices (2) The lack of realized inflation in places with allegedly "full employment" economies like the U.S. has led to questions over the usefulness of frameworks like the NAIRU (non-accelerating inflation rate of unemployment) in predicting inflation. A reduced link between the NAIRU and inflation does appear in many countries, but not necessarily in all countries when viewed in aggregate. Chart 6The NAIRU Concept Is Not Dead Yet In Chart 6, we present an indicator that shows the percentage of OECD economies (34 in total) that have an unemployment rate below the NAIRU rate. Currently, there are 67% of the countries in this list with unemployment rates under the OECD estimate of NAIRU, which is back to levels seen before the 2009 Great Recession. During that pre-crisis period, global inflation rates were accelerating for both goods and services inflation (bottom two panels). While the correlation between this global NAIRU indicator and realized inflation rates declined in the years after the recession, the linkages have improved over the past couple of years. This may be a sign that there is a "global NAIRU level" (or global output gap) that is more important in determining global inflation rates than individual country NAIRU measures. Or put more simply, investors are downplaying the NAIRU concept just at the time when it could be expected to strengthen. If that were the case, inflation expectations around the world would be too low, although it will take some evidence of faster realized inflation (especially in the U.S. and Europe) before the markets begin to discount that in bond yields. In the meantime, markets have become even too pessimistic on growth prospects and the implications for bond yields. Investors have driven down rate hike expectations in the U.S. and U.K. (and, to a lesser extent, the Euro Area) during this latest bond market rally, dragging longer-term bond yields down with them (Chart 7). Yet growth in the developing world is showing little signs of slowing down outside of the U.K., with leading economic indicators still pointing to a continued steady expansion (Chart 8). Even if central bankers are starting to question how fast their economies can grow before inflation pressures pick up in a meaningful way, they are unlikely to stand by and see faster growth prints without responding with less stimulative monetary policies. Chart 7Not Much Tightening Priced##BR##(Except For Canada)... Chart 8...Despite Improving Growth##BR##In Most Countries Net-net, bond markets are now discounting too pessimistic of an outcome for both global growth and inflation. We continue to see more upside risks for global yields on a 6-12 month horizon, although it will take some signs of faster global inflation (not just growth) before bond yields respond. Bottom Line: Global bond yields have been driven lower by safe haven buying, despite ample evidence of faster global growth and central bankers that are still biased to shift to a less easy policy stance. There is now considerable upside risk for global bond yields over the next 6-12 months from these current depressed levels. September ECB Meeting: All Systems Go For A 2018 Taper Last week's ECB meeting provided no changes on interest rates or the size of asset purchases, but plenty of clues on the central bank's next move. A reduction in the size of the ECB's asset purchase program in 2018, to be announced next month, is now highly probable - even with a strengthening euro. The ECB's GDP forecast for 2017 was revised higher from the June forecasts (2.2% vs. 1.9%), while the projections for 2018 (1.8%) and 2019 (1.7%) were unchanged. Meanwhile, the inflation forecast for 2017 was left unchanged at 1.5% and the forecasts for the next two years were only revised slightly lower (2018: 1.2% vs. 1.3%, 2019: 1.5% vs. 1.6%). The fact that the 14% rise in euro versus the U.S. dollar seen so far in 2017 was not enough to move the needle much on the ECB's projections speaks volumes about the central bank's confidence in the current European economic expansion, as well as its comfort level with the rising currency. That makes sense when looking at the euro rally more broadly, as the currency has only gone up 6% in trade-weighted terms year-to-date. Simply put, the ECB does not yet seem overly worried that the strengthening euro represent a serious threat to the economy that could cause a more prolonged medium-term undershoot in Euro Area inflation. ECB President Mario Draghi did make references to currency volatility as being something that should be closely monitored with regards to the growth and inflation outlook. Right now, the realized volatility of the euro has been quite subdued, even as the currency has steadily appreciated (Chart 9). At the same time, our Months-to-Hike indicator has also fallen as the market has pulled forward the date of the next ECB rate hike. That hike is still not expected until late 2019 - pricing that we agree with. However, the fact that the euro can appreciate with such low volatility alongside a slightly-more-hawkish repricing of ECB rate expectations suggests that the market thinks that a move towards reduced monetary stimulus in the Euro Area is credible. That will remain true until the rising euro starts to become a meaningful drag on the economy or inflation, which is not evident in the broad Euro Area data at the moment (Chart 10). Chart 9A "Credibly Hawkish" ECB? Chart 10No Impact (Yet) From A Stronger Euro Draghi did note that the "bulk of decisions" regarding the ECB's asset purchase program would likely take place in October. That means a reduction in the size of the monthly purchases starting in January of next year, but without any changes in short-term interest rates (the ECB reiterated that rates will stay at current levels until after the end of the asset purchase program). Nonetheless, the ECB is incrementally moving towards a less accommodative policy stance that will continue to put upward pressure on the euro and, eventually, trigger a move toward higher longer-term Euro Area bond yields. Bottom Line: The ECB is giving strong indications that a decision on tapering its asset purchase program will be made next month. With the Euro Area economy growing at a solid pace, and with inflation creeping higher, a reduction in the pace of bond buying in 2018 is highly probable. Maintain an underweight medium-term stance on Euro Area government debt. Bank Of Canada: Shock Hawks The Bank of Canada (BoC) continues to confound investors with a surprisingly hawkish policy bias. Another 25bp rate hike was delivered at last week's monetary policy meeting, a move that was not fully discounted by the market, bringing the BoC Overnight Rate up to 1%. The Bank cited the impressive strength of the Canadian economy, as well as the more synchronous global expansion that was supporting higher industrial commodity prices, as reasons for the rate hike. With Canadian real GDP growth surging to a 3.7% year-over-year pace in the 2nd quarter, in a broad-based fashion across all components, perhaps policymakers can be forgiven for feeling that interest rate settings are still too stimulative for an economy with a potential growth rate of only 1.4% (the most recent BoC estimate). In the statement announcing the rate hike, it was noted that the level of Canadian GDP was now higher than the BoC had been expecting after the last Monetary Policy Statement (MPS) published in July. The BoC was already projecting that the output gap in Canada would be closed by the end of 2017. Thus, a higher realized level of GDP suggests an output gap that will be closed even sooner than the BoC was forecasting. This alone would be enough to move sooner on rate hikes for a central bank that focuses so much on its own measures of the output gap when making inflation projections. However, at the moment, there is not much inflation for the central bank to worry about. Chart 11The Great White North Headline CPI inflation sits at 1.2%, well below the midpoint of the BoC's 1-3% target band, while the various measures of core inflation that the BoC monitors are between 1.3% and 1.7%. Annual wage growth accelerated to the faster growth rate of the year in August, but still only sits at 1.7% even with the unemployment rate now down to a nine-year low of 6.2%. Meanwhile, the Canadian dollar has appreciated 13% vs. the U.S. dollar, and 10% on a trade-weighted basis, since bottoming out in early May. This move has been supported by growth and interest rate differentials that favor Canada. This is especially true versus the U.S. where the 2-year gap between Overnight Index Swap (OIS) rates is now positive at +21bps - the highest level since January 2015 (Chart 11). The BoC acknowledged this in last week's policy statement, suggesting acceptance of a strong loonie as a reflection of a robust Canadian economy that requires higher interest rates. The strength in the Canadian dollar will likely weigh on import price inflation in the coming months, and act as a drag on overall inflation. This will not trigger any move by the BoC to back off from its hawkishness unless there is also some weakness in the Canadian economic data. For a central bank that focuses so much on the output gap in its assessment of its own policy stance, the inflationary impact from a booming economy will far outweigh the disinflationary effects of a stronger currency. It remains to be seen if the BoC will be proven right on delivering actual rate hikes with inflation well below target. This is a problem that many central banks are facing at the moment, but the robust Canadian economy is forcing the BoC's hand. An appreciating currency may limit the number of rate hikes that the BoC eventually undertakes, but given its own assessment that that terminal interest rate is around 3%, there are plenty of additional hikes that the BoC can deliver before getting anywhere close to "neutral". The key risk will come from the spillover effects on the overheated Canadian housing market from the interest rate increases. Already, house prices are coming off the boil in the most overheated markets like Toronto, where median home values are down 20% since April due to regulatory changes aimed at reducing leveraged speculation in Canadian housing. It remains to be seen how much the BoC hikes will exacerbate the latest downturn in house price inflation and, potentially, have spillover effects on consumer confidence given high levels of household indebtedness. For now, we do not recommend fighting the BoC, with Canadian leading economic indicators still accelerating and the BoC's own business surveys showing that the economy is likely to remain strong. While there are already 50bps of rate hikes priced next twelve months, this would only take the Overnight Rate to 1.5% - still a stimulative level in the eyes of the central bank. This could also create additional strength in the loonie, although that impact should be lessened if the Fed comes back into play and delivers additional rate hikes in 2018, as we expect. We continue to recommend a below-benchmark duration stance on Canadian government bonds, with yields likely to surpass the relatively modest increases currently priced into the forwards (Chart 12, top panel). We also continue to advise an underweight allocation to Canadian government bonds in hedged global fixed income portfolios (middle panel). We also are staying with our winning Canadian trades in our Tactical Overlay portfolio, where are positioned for wider Canada-U.S. bond spreads and a flatter Canadian yield curve (Chart 13). Chart 12Stay Underweight##BR##Canadian Government Bonds Chart 13Sticking With Our Tactical##BR##Canadian Bond Trades Bottom Line: The Bank of Canada will continue to deliver on rate hikes without decisive signs that the current booming Canadian economy is slowing down, which leading indicators do not suggest is imminent. Maintain an underweight stance on Canadian government debt, with a curve flattening bias. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Monetary Policy: A prominent Fed Governor has acknowledged that inflation expectations have become un-anchored to the downside. This is an important signal and suggests that the Fed will keep policy easy enough for inflation expectations to recover. TIPS: The combination of a Fed that communicates a desire for higher inflation expectations and an end to the current downtrend in realized core inflation will send TIPS breakevens wider. Yield Curve: Higher inflation expectations will cause the yield curve to steepen on a 6-12 month horizon. Although steepener trades no longer appear cheap on our model, we remain overweight the 5-year bullet versus a duration-matched 2/10 barbell. Feature Chart 1Flight To Safety Focused In Real Yields Bond markets digested two important events last week. The first was a politically driven flight to safety. The 10-year yield fell 10 bps (Chart 1) and the average junk spread widened 8 bps as the daily U.S. Policy Uncertainty index1 averaged 121 for the week, its second-highest reading since February. As we have noted in past reports,2 historically the best strategy has been to fade politically driven flights to safety. The second, and more significant, event was a speech3 given by Fed Governor Lael Brainard in which she suggested that inflation expectations have become un-anchored to the downside. As is explained below, this acknowledgement represents an important change in tone from the Fed. One that reinforces our outlook for higher Treasury yields, a steeper yield curve and wider TIPS breakevens on a 6-12 month horizon. You Had One Job The key passage from Governor Brainard's speech is the following: Nonetheless, a variety of measures suggest underlying trend inflation may be lower than it was before the crisis, contributing to the ongoing shortfall of inflation from our objective. To understand the significance of this statement we need some background on how the Fed thinks about inflation. FOMC members tend to apply an expectations-augmented Phillips curve framework to the task of forecasting inflation (Chart 2). Fed Chair Janet Yellen explained this approach in a September 2015 speech.4 In Yellen's words: ...economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from a longer-term trend that is ultimately determined by long-run inflation expectations. [...] An important feature of this model of inflation dynamics is that the overall effect that variations in resource utilization, import prices, and other factors will have on inflation depends crucially on whether these influences also affect long-run inflation expectations. In other words, the Fed's model distinguishes between core inflation's long-run trend and its cyclical fluctuations. Cyclical fluctuations are driven by: Resource utilization (usually measured as the unemployment rate minus its estimated natural rate) Non-oil import prices Idiosyncratic shocks In contrast, core inflation's long-run trend is purely a function of long-term inflation expectations. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, then inflation's long-run trend would be altered and monetary policy would become less effective. In a sense, the worst possible outcome would be if inflation expectations became un-anchored to the downside. Once again, in Janet Yellen's own words: Anchored inflation expectations were not won easily or quickly: Experience suggests that it takes many years of carefully conducted monetary policy to alter what households and firms perceive to be inflation's "normal" behavior, and, furthermore, that a persistent failure to keep inflation under control - by letting it drift either too high or too low for too long - could cause expectations to once again become unmoored. This describes precisely the conventional wisdom as to why the Japanese economy has experienced two decades of deflation despite reasonably high levels of resource utilization. Policymakers did not act quickly or strongly enough following the burst stock market bubble of 1989-91, and this allowed deflationary expectations to become entrenched. In this sense the Japanese experience provides a roadmap for what could happen in the U.S. if the Fed doesn't act quickly to bring inflation expectations back up to target levels. It is true that not all measures of U.S. inflation expectations currently display weakness. For example, the measure we used in our expectations-augmented Phillips curve in Chart 2 - median 10-year PCE expectations from the Survey of Professional Forecasters - appears stable in recent years. However, Governor Brainard pointed to several measures that suggest inflation expectations have already declined (Chart 3). Chart 2The Fed's Inflation Model Chart 3Still Well Anchored? Comparing the three-year period ending in the second quarter of this year with the three-year period ended just before the financial crisis, 10-year-ahead inflation compensation based on TIPS [...] yields is ¾ percentage point lower. Survey-based measures of inflation expectations are also lower. The Michigan survey measure of median household expectations of inflation over the next five to 10 years suggests a ¼ percentage point downward shift over the most recent three-year period compared with the pre-crisis years, similar to the five-year, five-year forward forecast for the consumer price index from the Survey of Professional Forecasters.5 Investment Implications In our view, there are two important facts to keep in mind: In the Fed's model of inflation it is crucial that long-term inflation expectations do not fall. Otherwise, the odds of replicating the Japanese scenario start to increase. A prominent Fed Governor has now suggested that U.S. inflation expectations have become un-anchored to the downside. Chart 4The Market's Rate Hike Expectations Taken together, these two facts have important investment implications. First, the two facts suggest that TIPS breakevens will move wider. While the Japanese experience has taught us that "open mouth operations" become less effective once deflationary expectations are entrenched, they should still have some impact in the States. Notice that the decline in Treasury yields that followed Brainard's comments last week was concentrated in the real component. The 10-year TIPS breakeven inflation rate actually rose 2 bps (Chart 1). The combination of a Fed that communicates a desire for higher inflation expectations and an end to the current downtrend in realized core inflation (see "Economy & Inflation" section below) will be enough to send long-dated TIPS breakevens wider on a 6-12 month horizon. Second, a Fed that is committed to staying accommodative for as long as is necessary to ensure that inflation expectations move higher will cause the yield curve to steepen (see section titled "Inflation Expectations Drive The Curve" below). Third, a Fed that is more committed to fighting deflation should bias Treasury yields lower. However, inflationary pressures in the U.S. economy are strong enough that the Fed will be able to move inflation expectations higher while still delivering more rate hikes than are currently priced into the curve. At present, the overnight index swap curve is discounting that the next 25 basis point rate hike will not occur until November 2018 (Chart 4)! Bottom Line: A prominent Fed Governor has acknowledged that inflation expectations have become un-anchored to the downside. This represents an important signal about the future path of policy and reinforces our view that the Treasury curve will bear-steepen during the next 6-12 months, led by wider TIPS breakevens. Inflation Expectations Drive The Curve Our research6 shows that inflation expectations are the most important driver of changes in the slope of the yield curve. This runs counter to the conventional wisdom which states that the curve flattens when the Fed hikes rates, and steepens when it cuts rates. While the correlation between Fed rate moves and the slope of the curve is undeniable, the relationship results purely from the fact that the Fed responds to changes in inflation. The link between inflation expectations and the yield curve is the dominant relationship. To see this we look at Charts 5 and 6. Both charts show monthly changes in the 5-year, 5-year forward TIPS breakeven inflation rate plotted against monthly changes in the nominal 2/10 slope. Chart 5 shows all available historical data, and we observe a strong positive correlation. In fact, 63% of monthly observations fall into either the top-right or bottom-left quadrants indicating that wider breakevens correlate with a steeper curve and vice-versa. Chart 52/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year / ##br##5-Year Forward (February 1999-Present) Chart 62/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year / 5-Year Forward ##br##During Fed Tightening Cycles (June 1999 To May 2000 & June 2004 To June 2006) The more important question, however, is whether this correlation still holds when the Fed is raising rates. Chart 6 focuses only on prior rate hike cycles and still shows a strong positive correlation. 73% of the monthly observations fall into either the top-right or bottom-left quadrants, although in this case there are more observations in the bottom-left quadrant because typically the Fed lifts rates with the goal of sending inflation and inflation expectations lower. In this respect the current rate hike cycle is unique. The Fed is in the process of lifting rates, but as Brainard's speech shows, it still critically needs inflation expectations to rise. We conclude that the Fed will stay easy enough, long enough, for long-dated TIPS breakevens to return to their pre-crisis trading range between 2.4% and 2.5%. An upward adjustment to this range will occur alongside a steeper 2/10 curve. Unit Labor Costs And The Yield Curve The logic presented above also suggests an inverse relationship between the slope of the curve and wage growth. In a world where inflation expectations are well anchored, stronger wage growth encourages the Fed to tighten policy more quickly, this causes the yield curve to flatten. Conversely, softer wage growth leads to a steeper curve. Our research shows that unit labor costs are the measure of wage growth that correlates most closely with the slope of the curve. The reason is that unit labor costs actually measure both wage growth (compensation per hour) and labor productivity (output per hour). Put differently, the yield curve can flatten because labor compensation is rising and the Fed is tightening policy (bear flattening) or it can flatten because productivity is falling and investors are discounting a slower pace of potential growth and a lower terminal fed funds rate (bull flattening). Unit labor costs capture both of these dynamics. Last week saw second quarter productivity growth revised higher from 0.9% to 1.5% and unit labor cost growth revised down from 0.6% to 0.2% (Chart 7). We expect that productivity will continue to experience a modest late-cycle bounce. Usually, payroll growth starts to moderate late in the business cycle as the labor market tightens. The cost of labor typically rises and encourages firms to substitute capital for workers. This late-cycle boost in capital spending tends to correlate with stronger productivity growth (Chart 8), and this dynamic looks to be in full swing at the moment. Payroll growth has been decelerating since early 2015, and durable goods orders have picked up sharply since the end of last year (Chart 8, bottom panel). Chart 7Weakness In Unit Labor Costs Chart 8Productivity: Look For A Late-Cycle Rebound A modest late-cycle upswing in productivity growth will put downward pressure on unit labor costs and lead to curve steepening. How To Position For Steepening We have been expressing our yield curve view via a long position in the 5-year bullet and a short position in a duration-matched 2/10 barbell since last December.7 So far that trade has returned +28 bps, even though the 2/10 slope has flattened more than 50 bps since its inception. The reason our curve steepener has outperformed even as the curve has flattened is that, when we initiated our trade, the 2/5/10 butterfly spread was discounting an even larger curve flattening. Put differently, the 5-year bullet looked extremely cheap on the curve (Chart 9).8 Chart 92/5/10 Butterfly Spread Fair Value Model This state of affairs has now changed. Our fair value model shows that the 5-year bullet appears slightly expensive compared to the barbell, or alternatively, that the 2/5/10 butterfly spread is priced for a 20 bps steepening of the 2/10 slope during the next six months. According to our model, the 2/10 slope will have to steepen by more than 20 bps during the next six months for our trade to outperform from current levels. Bottom Line: Higher inflation expectations will cause the yield curve to steepen on a 6-12 month horizon. Although steepener trades no longer appear cheap on our model, we remain overweight the 5-year bullet versus a duration-matched 2/10 barbell for now. Economy & Inflation Updates received during the past few weeks indicate that U.S. growth is running solidly above trend, and may even be accelerating. Real second-quarter GDP growth was revised higher from 2.6% to 3%. Second quarter labor productivity growth was also revised higher, as was discussed above. Even following a lackluster August employment report, our back-of-the-envelope tracking estimate for U.S. growth - the sum of year-over-year growth in aggregate hours worked and average quarterly productivity growth since 2012 - is running at 2.7%, well above the Fed's 1.8% estimate of trend (Chart 10). Survey measures also suggest that growth has further upside in the second half of the year, at least according to a simple growth model based on the ISM non-manufacturing survey, our own BCA Beige Book Monitor and a composite of new orders surveys (Chart 11). Chart 10Growth Tracking Above-Trend... Chart 11...And Surveys Suggest Further Upside But bond markets are not getting the message. The 10-year yield is stuck at 2.12%, and the markets seem to be saying that the link between stronger growth and rising inflation has been permanently broken. We disagree and think that investors are simply underestimating the often long and variable lags between economic growth and inflation. Chart 12Inflation Lags Growth Chart 12 shows that real GDP growth has tended to lead core inflation by about 18 months, while changes in year-over-year core CPI (the second derivative of prices) have tended to follow the ISM Manufacturing index with a lag of about 12 months. All signs suggest that the recent downtrend in inflation is nothing more than a reaction to the growth deceleration seen between mid-2015 and mid-2016. Now that growth has re-accelerated, inflation is poised to move higher. Bottom Line: Bond markets are priced as though the link between growth and inflation is broken. We expect they will be proven wrong as inflation regains its uptrend during the next few months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 The daily policy uncertainty index measures the number of news items related to economic uncertainty. For further details please see www.policyuncertainty.com 2 Please see U.S. Bond Strategy Weekly Report, "What We Know About Uncertainty", dated July 12, 2016, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/speech/brainard20170905a.htm 4 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 5 https://www.federalreserve.gov/newsevents/speech/brainard20170905a.htm 6 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 8 For further details on how butterfly trades respond to changes in the yield curve, and on how we use our fair value yield curve models please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification