Market Returns

GAA DM Equity Country Allocation Model The model significantly reduced the weight of France by six percentage points due to change in liquidity condition, the other downgrade, albeit much smaller, was the U.S. All other countries had been upgraded as a result, with Germany being the largest beneficiary. Japan and U.K. remain the two largest underweights (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed the MSCI World benchmark by 27 basis points (bps) in October, driven completely by the Level 2 model (as U.K and Australia underperformed the euro area). The Level 1 model was in line with the benchmark. Since going live, the overall model performed slightly better than its benchmark. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Table 3Allocations Table 4Performance Since Going Live Chart 4Overall Model Performance For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model". http://gaa.bcaresearch.com/articles/view_report/18850 GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of October 31, 2016. The momentum component has shifted Financials from underweight to overweight. For mode details on the model, please see the Special Report "Introducing the GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

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Highlights Defaults: The default outlook is improving alongside a brighter forecast for economic growth. The corporate default rate will fall from 5.4% to close to 4% during the next 12 months. Valuation: The low starting point for spreads means the risk/reward trade-off in junk bonds remains poor, despite a more encouraging default outlook. Strategy: In addition to a poor longer run risk/reward trade-off, the risk of a Fed rate hike in December makes us extremely cautious on junk in the near term. Maintain a maximum underweight allocation to high-yield and await a better entry point for spreads in the New Year. Feature This year's rally in High-Yield has been nothing short of impressive. The average spread on the Barclays High-Yield index has narrowed to 467bps from a February high of 839bps, and excess junk returns have now recovered all the ground lost since the mid-2014 peak (Chart 1). Chart 1Back In The Black When considering the potential for further spread tightening we first observe that, despite this year's rally, the average junk spread remains 144bps above the cycle lows reached in June 2014. However, the credit cycle is also two years older, corporations are more highly levered and the default rate has started to increase. The dramatic sell-off and subsequent recovery in the price of oil has also had a large impact on junk bond performance since mid-2014, but now that the average spread on energy debt is within 100bps of the overall index (Chart 1, bottom panel), its influence will be much smaller going forward. In this week's report we consider the potential for further junk bond outperformance through three different analytical approaches. We conclude that: Junk spreads already discount a significant improvement in capacity utilization Junk spreads do not adequately reflect the risks from higher implied equity volatility Although the outlook for default losses has improved, current spreads do not offer adequate compensation Growth Rebound Is In The Price As we anticipated,1 last Friday's preliminary Q3 GDP print exceeded expectations. Further, we expect that a number of headwinds which have held back U.S. growth in 2016 will give way next year, generating 2.5% - 3% real GDP growth in 2017.2 This should bode well for junk bond performance, except that a relatively large growth acceleration has already been incorporated into high-yield spreads. Of all economic indicators high-yield spreads correlate most closely with capacity utilization (Chart 2), which bottomed in March of this year shortly after the peak in junk spreads. But capacity utilization has not kept pace with the tightening in junk spreads since then. Historically, a 100bps tightening in junk spreads during a 12-month period has coincided with a 0.4% improvement in capacity utilization. This would suggest that even if junk spreads remain flat, capacity utilization should reach 77.2% by next February (Chart 2, bottom panel). While industrial production will continue to improve, in large part because of rebounds in the oil price and rig count (Chart 3), it will be difficult for any rebound to surpass the expectations that have already been baked into the high yield market. Chart 2Junk Spreads & Capacity Utilization Chart 3Drag From Energy Has Dissipated The Risk From Rising Vol Is Understated Another well-known correlation is between junk spreads and the VIX. As was observed by Robert Merton in 1974,3 corporate bond investors effectively bear the risk from equity investors who own portfolio insurance against downside tail risk (see Box). In other words, an increase in the price of volatility can be thought of as a transfer of default risk from equity holders to bondholders. Unusually, junk spreads have tightened during the past three months while the price of volatility (VIX) has risen (Chart 4). Box - Merton Model Of Corporate Debt Robert Merton pointed out that holding a corporate bond is equivalent to holding a risk-free security plus a short put option on the value of the assets of the corporation. For a corporation with zero default risk, the option is worthless and the bondholder owns a risk-free security. However, the closer a corporation comes to default, the put option (which the bondholder is short and the equity holder is long) increases in value. If the value of assets of the corporation falls below the value of the debt outstanding, then the equity holders are better off defaulting on the debt than repaying it. The act of defaulting on debt is analogous to exercising the put option in that the shareholders put the assets of the corporation to the debt holders rather than repay the debt. Higher volatility increases the value of this put option, effectively reducing the value of corporate debt relative to equity. In other words, higher asset price volatility increases the risk of default. Similarly, a drop in volatility makes default less likely and so increases the value of corporate debt. Although asset volatility and equity volatility are not identical, they are closely related. Therefore, declining equity implied volatility is positive for corporate bonds since it reduces the value of the implicit short put option embedded in corporate debt. This divergence is not sustainable, and the near-term risks clearly favor a convergence via wider spreads rather than a lower VIX. A Trump victory in this month's election would obviously surprise markets and prompt a flight to safety. But the polling data suggest this is a low probability event. More likely is that the VIX rises in anticipation of a Fed rate hike in December. This process could begin as early as tomorrow afternoon, if the Fed teases a December rate hike in the statement from this week's meeting. We anticipate a December rate hike and would expect investors to bid up the price of vol between now and then. As a rate hike becomes more likely, investors will become increasingly worried about a repeat of last year when a Fed rate hike precipitated a large sell-off in risk assets. The trend in equity volatility is also biased higher in the longer run. While it is impossible to accurately forecast all of the wiggles in the VIX index, its long-run underlying trend tends to be driven by corporate health and monetary conditions (Chart 5). Chart 4Higher Vol A Near-Term Risk Chart 5Long Run Vol Drivers Easier monetary conditions tend to reduce investor risk aversion and send the VIX lower. But easy money also encourages the corporate sector to take on debt. Initially, a virtuous circle is created between a lower VIX and a re-levering corporate sector. To the extent that corporate credit growth fuels aggregate demand, risk aversion will decline even further leading to even lower volatility. Eventually, the virtuous circle is broken when either monetary conditions are tightened or leverage increases so much that investors question the sustainability of corporate balance sheets. Chart 5 suggests that the current level of the VIX does not reflect the reality of tightening monetary conditions or deteriorating corporate balance sheets. Bottom Line: A sizeable improvement in capacity utilization and persistently cheap equity volatility are required to sustain junk spreads at current levels. A Brighter Outlook For Defaults Around this time last year we called the beginning of the default cycle,4 and our view remains that we are one year into a prolonged grind higher in corporate defaults. Typically, once corporate defaults start to trend higher they do not peak until the next recession and we do not expect this cycle to be any different. This is because firms tend not to engage in voluntary de-leveraging. Rather, they tend to continue to add leverage until the economy forces retrenchment upon them. One exception to this trend is the small increase and subsequent reversal in defaults that occurred in the mid-1980s (Chart 6). In this instance it was not an improvement in corporate balance sheets that caused the uptrend in defaults to reverse. Instead, it was a dramatic easing of monetary conditions that gave banks the necessary confidence to keep the credit taps open, despite worsening corporate health. This episode can be contrasted with the mid-1990s cycle when corporate health continued to deteriorate but monetary conditions did not ease. This resulted in a persistent grind higher in defaults. Chart 6Defaults Will Moderate Next Year, But Long-Run Uptrend Is Still Intact In our view, the current cycle has the most in common with the mid-1990s. Corporate balance sheets are deteriorating and no monetary relief should be expected with the Fed in the midst of a rate hike cycle, albeit a shallow one. However, the prolonged nature of the recovery also means that the rise in corporate defaults will also be shallow and drawn out, with some fluctuations around an upward trend. Chart 7The Reason For Low Recoveries On that note, we forecast that the default rate will moderate during the next twelve months. Our default rate model is shown in the top panel of Chart 6. This model is based on industrial production growth, corporate profit growth, times-interest earned and lending standards. We forecast that both industrial production and corporate profit growth will improve next year, in large part due to the end of the drag from falling oil prices. The red line in the top panel of Chart 6 shows the Moody's baseline forecast for future defaults. This forecast calls for the default rate to be 4.09% during the next 12 months, down from 5.4% during the past 12 months. This forecast is consistent with our own base case expectation that calls for a return to modestly positive growth in both industrial production and corporate profits (on the order of 5% annualized). The thick grey line in the top panel of Chart 6 shows what the default rate would be in a pessimistic scenario where industrial production and corporate profit growth are held flat at current levels. This forecast has the default rate rising to 6.5% during the next 12 months. In order to forecast default losses we also need a forecast for the recovery rate. In the past we have modeled recoveries using the output from our default rate model. This simple observation that recoveries tend to fall when defaults rise, and vice-versa, had been sufficient to capture the major swings in recoveries, but has not performed well during the current cycle (Chart 7). In fact, recoveries have lagged well below levels that would be expected given the number of corporate defaults we have seen. The reasons for the low recovery rate are not well known, but we have collected some bottom-up data that may offer a partial explanation. The bottom two panels of Chart 7 show the Tobin's Q and net debt-to-assets ratio for the bottom decile of firms in our sample going back to 1990.5 We note that the Tobin's Q - the ratio of market value to replacement value of a firm's assets - has fallen to recessionary levels. Meantime, while net debt-to-assets is in a clear uptrend, it does not appear stretched relative to the early stages of past default cycles. This suggests that low recoveries are not the result of too much debt being supported by too few assets, but are the result of a low market value being placed on the assets in question. More fundamentally, we suspect that low recovery rates are actually explained by the divergence between the monetary and credit cycles (Chart 8). In past cycles, Fed tightening has tended to occur alongside a deterioration in corporate health. However, in this cycle corporate balance sheet re-leveraging is well advanced compared to monetary tightening. If we accept the premise that defaults themselves are caused by tighter money and tightening lending standards, while recoveries are more related to the state of corporate balance sheets at the time of default, then it makes sense that recoveries would be lower in this cycle since corporate balance sheets had been aggressively levering-up for several years before monetary conditions began to tighten and defaults started to rise. Chart 8The Diverging Credit And Monetary Cycles In both our baseline and pessimistic forecasts we assume that the recovery rate increases somewhat (from 28% to 35%), but remains low relative to where we would expect it to be based on the default rate alone. Adding it all up, our base case scenario calls for default losses of 266bps during the next 12 months. This results from a default rate of 4.09% and a recovery rate of 35%. Our pessimistic scenario calls for default losses of 423bps during the next 12 months. This results from a default rate of 6.5% and a recovery rate of 35%. The Default-Adjusted Spread & Expected Returns Individually, neither the average junk spread nor future default losses offer much explanatory power when it comes to forecasting high-yield returns. Rather, it is the combination of both - the default-adjusted spread - that explains the bulk of variation in junk returns. The top panel of Chart 9 shows 12-month high-yield returns in excess of duration-matched Treasuries alongside the average option-adjusted spread from the Barclays index, advanced by 12 months. The chart shows that there is some correlation between today's average junk spread and excess returns during the following 12 months, but the correlation is very weak. Chart 9Default-Adjusted Spread Predicts Lower Excess Returns The second panel of Chart 9 adjusts the average junk spread by realized default losses. Here we see a much stronger correlation. In fact, the starting spread on the High-Yield index less realized default losses during the next 12 months explains more than 50% of the variation in excess junk returns. This means that with knowledge of today's junk spread and an accurate forecast of future default losses, we can have a reasonably good idea about what excess junk returns will be during the next year. The bottom panel shows the results of a regression of excess junk returns versus the default-adjusted spread. It also shows what the default-adjusted spread implies in term of excess junk returns using both our base case and pessimistic default loss scenarios. In our base case scenario where the default rate improves during the next year, excess junk returns are predicted to be close to zero. In other words, the anticipated improvement in defaults is not sufficient to offset the low level of starting spreads. In our pessimistic scenario, where the default rate rises to 6.5%, excess returns during the next 12 months are predicted to be deeply negative. Bottom Line: The default outlook is improving alongside a brighter outlook for economic growth, but wider spreads are still required to make the risk/reward trade-off in junk bonds attractive. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 Please see The November 2016 Bank Credit Analyst, dated October 27, 2016, available at bca.bcaresearch.com 3 Merton, Robert C. 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates." Journal of Finance 29, pp. 449-470. 4 Please see U.S. Bond Strategy Weekly Report, "The Rising Risk Of Corporate Default", dated October 20, 2015, available at usbs.bcaresearch.com 5 We create a sample consisting of all the firms included in either the Barclays Corporate or High-Yield index (excluding financials) for which bottom-up data are available from Bloomberg. Data are retrieved on a quarterly basis and the sample is adjusted once per year based on changes in the composition of the Barclays indexes. The lowest sample size in any quarter is 53 firms, the largest is 101. On average, the sample size is 68 firms. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights A poor fundamental backdrop for high yield is being offset by easy monetary conditions. A prolonged shallow uptrend in corporate defaults - and therefore spreads - is most likely. The relative performance of equities versus corporate credit has not been distorted by monetary policy: the high-yield debt market will remain a reliable indicator for equity market vulnerability. A December rate hike will not be problematic for the residential real estate market. Plenty of pent-up demand for housing exists, and this will provide long-term support, so long as the labor market remains robust. Feature High-yield (HY) corporate bond spreads have dramatically narrowed throughout 2016 (Chart 1). This trend should not go unnoticed, since beyond being an important asset class in its own right, we have long viewed the high-yield debt market as an early warning system for equities. The current message suggests an all-clear for stocks. Chart 1Dramatic Spread Narrowing In 2016, But... We have had a cautious stance on U.S. high yield since August 2015, based on the view that corporate balance sheet health has deteriorated to the point where defaults would continue to rise on a cyclical basis. This week, we explore whether this remains the right strategy, and also whether junk bond spreads are still a relevant leading indicator for the equity market. Our answer to both questions is: Yes. In our view, the HY comeback can be explained by three main factors. First, the recovery in energy-related junk bonds has led the rally, as rising oil prices have helped diminish the default risks among U.S. shale issuers. Second, the 2015 spike in junk bond yields - mainly due to contagion from energy-sector bankruptcy fears - created tactical value in high-yield. Throughout most of 2016, we have seen an unwinding of these previously oversold positions. And third, the high-yield market benefits from an ongoing and intense search for yield in a world of unattractive higher-quality interest rates. Looking ahead, the first two forces are unlikely to play much of a role in the outcome for junk bonds. Oil prices are likely to trade in narrow range, allowing energy-related company fundamentals to stabilize. The rally in junk bonds over the past several months has removed any perceived value in this sector. Thus, it is only the search for yield/accommodative monetary policy that still supports a narrowing in spreads. Over time, we believe junk bond performance will once again be aligned with balance sheet fundamentals, i.e. high-yield spreads will gradually widen. A Review Of Our HY Indicators Our fixed income strategists have developed three key indicators to gauge major turning points in corporate spreads (Chart 2): Corporate Health Monitor (CHM): An aggregate indicator of non-financial corporate balance sheet health. The CHM deteriorated further in the second quarter, and has reached levels that historically tend to only be seen during recessions. Of the indicator's six components, most of the weakness has occurred in measures of corporate profitability (Chart 3). One caveat is that our measure of leverage in the CHM remains low, but this understates the risks because it measures total debt as a percent of market value of equity. Leverage looks decidedly worse if measured using net debt/book value. Chart 2Key Corporate Credit Indicators Chart 3Corporate Health Monitor Components C&I bank lending standards: A Fed survey that measures how easy/difficult it is for the corporate sector to access bank loans. According to this gauge, banks have already been tightening credit conditions for the past three quarters. Deviation in monetary conditions from equilibrium: We use our Monetary Conditions Index (MCI), which incorporates movements in both the dollar and interest rates. Due to a very accommodative Fed, monetary conditions remain very easy according to this measure. At present, two of these three indicators are sending negative signals for corporate spreads. Our corporate health monitor is decidedly bearish, as are lending standards. Indeed, focusing on corporate balance sheets and fundamental credit quality metrics would almost unanimously lead investors to recognize that the credit cycle is in its late stages and to expect spreads to move wider. After all, spreads have widened in every episode of deteriorating balance sheet health since the mid-1990s. Or to put it more simply, a default cycle - leading to spread widening - has occurred each time that year-on-year profit growth has gone negative since 1984 (Chart 4). Chart 4Profit Contraction Spells Trouble For Junk Bonds Our Bank Credit Analyst service came to the same conclusion earlier this year. In a Special Report, our colleagues analyzed financial ratios for 770 companies from across the industrial and quality spectrum. Their work uncovered that the corporate re-leveraging cycle is far more advanced than is widely believed and that key financial ratios and overall corporate health look only mildly better excluding the troubled energy and materials sectors. Of course, there is an important salve this cycle at work and it is captured in our third indicator - monetary policy. As shown in Chart 2, easy monetary conditions have never persisted for this long and low rates have driven a colossal search for yield, causing high-yield bonds to become ever more divorced from fundamentals. This divergence between corporate bond spreads and balance sheet fundamentals is likely to persist for as long as monetary conditions remain supportive. Adding it up, a poor fundamental backdrop for high-yield is being offset by easy monetary conditions. This combination argues for a cautious long-term bias toward lower-quality corporate credit because a prolonged shallow uptrend in corporate defaults (and spreads) is most likely. Nimble investors may look to tactically buy junk bonds when spreads overshoot our forecast of default losses, although such an opportunity is not present at the moment (Chart 5). The equity market is suffering from the same dynamic. Chart 5No Value Here Will Junk Bond Yields Still Warn Of Stock Bear Markets? Junk bond yields have long been one of our early warning indicators for equity bear markets. Since the 1980s, junk yields (shown inverted in Chart 6) have consistently broken out to new highs 3-6 months before stock bear markets take hold. This is because in a typical cycle, junk yields tend to respond more quickly to an erosion in corporate health fundamentals and/or a credit event. Chart 6Junk Bonds Provide Early Warning For Stocks Chart 7Typical Behavior Here But, as we note above, in the current cycle, the reaction to worsening corporate health fundamentals has been far more subdued than historical relationships would have predicted, due to the salve effect of easy monetary policy. If corporate bonds are in a "bubble", does it mean that the behavior of junk bond spreads will no longer be an early predictor of stocks returns? We believe corporate bonds will still be a useful timing tool for equities. If equities are experiencing the same divorcing from fundamentals, courtesy of central bank largesse, then it stands to reason that what pops the bond bubble will also burst the equity balloon. The search for yield has affected the behavior of investors, and therefore returns, in a fairly systematic way. Due to the current extended period of ultra-low interest rates and central bank asset purchases, government bond prices have been pushed sky high (yields have sunk to rock-bottom lows). As a shortage of government bonds has taken hold, investors have sought to invest in "Treasury-like" products, first seeking out the safest corporate bonds, but eventually reaching further out on the risk spectrum to include high-yield bonds and (dividend yielding) stocks. Indeed, asset prices of all stripes have been distorted by the search for yield, which has fueled a broad inflation in all asset classes. The behavior of stocks relative to corporate bonds is telling (Chart 7). Since 2010, and until very recently, stocks outperformed junk bonds on a total return basis. Junk bonds outperformed investment-grade bonds over roughly the same period (although junk underperformed investment-grade in most of 2015 due to the collapse in energy prices and related energy company defaults). This is exactly what has occurred during every recovery phase since the 1980s. Over the past forty years, investment-grade bonds tended to outperform junk bonds and equities during economic recessions. Junk bonds beat equities during the early phases of recovery (i.e. when economic growth turns positive) and for as long as companies continue to repair balance sheets. And equity returns trump both investment-grade and high-yield corporate bonds when our Corporate Health Monitor is deteriorating, i.e. in the latter half of the economic cycle, such as now. This suggests that the relative performance of equities versus corporate credit has not been distorted by monetary policy. One key takeaway is that, although very easy monetary conditions mean that corporate credit performance is becoming divorced from fundamentals, monetary policy has had a similar effect on equity prices (we have written at length in past reports about equity market performance diverging from profit indicators). As in past cycles, once the monetary cover fades, it is most likely that corporate credit markets will once again respond most quickly to balance sheet fundamentals. The bottom line is that we believe the high-yield debt market will remain a reliable indicator for equity market vulnerability. The current message is that a bear market in stocks will be averted, although as we have written in recent reports, earnings disappointments amid dollar strength represent a potential trigger for a near-term correction. Housing Outlook: Room To Expand Over the past quarter, residential real estate data has been slightly disappointing. September housing starts slipped to the bottom end of the range that has held this year and are only marginally above year-ago levels. House price inflation, as measured by the Case Shiller index, is negative on a 3-month basis. Despite this mild disappointment, we continue to believe the housing market is a relative bright light and will continue to be a significant positive contribution to GDP growth. Most indicators show that the housing market continues to recover along the typical path of the classic boom/bust real estate cycle (Chart 8). Chart 8Housing And Its History Chart 9First-Time Homebuyers Entering The Market Moreover, both supply and demand conditions are supportive of further construction activity and upward pressure on house prices over the next several quarters. On the demand side, household formation and a pick-up in interest from first-time buyers are the largest positives. Household formation: The number of households being formed is the most basic measure of marginal new demand for housing units. Household formation was suppressed during the Great Recession and early recovery years, because very poor job prospects and restricted access to credit sorely limited prospective new households from entering both the rental and ownership market. From 2007-2013, the annual household formation rate was 625,000, compared to over 1.1 million in the pre-crisis period.1 Now that the unemployment rate is at 5% and job security is improving, household formation rates are accelerating, particularly among young adults who have hitherto delayed moving out on their own. Monthly numbers are choppy, but household formation could easily run on average at 1.1 million per year for the next few years, simply to make up for muted rates post-housing crisis. First-time buyers: After years of putting off purchases, first-time buyers appear to be finally coming back to the housing market (Chart 9). According to the National Association of Realtors, the proportion of first-time homebuyers for existing home sales has reached its highest mark since July 2012 (34%). But there is still room for this share to improve, as prior to 2007, first-time homebuyers averaged about 40% of total purchases. Once again, persistent income gains and job security will be the driving factors behind first-time homebuyers' decisions. Could a Fed interest rate rise slow housing demand? We don't think so. Mortgage payments relative to income will remain well below their long-term average even if rates are increased by 200bps, an extreme case scenario. Even under this scenario, housing affordability would still be above average, conservatively assuming that income is held constant (Chart 10). Income and employment prospects will continue to trump mortgage rates for consumers making housing decisions; the current employment backdrop is positive for continued housing market activity. Chart 10December Rate Hike Won't Bother The Housing Market Chart 11Supply Is Tight From a supply perspective, conditions remain ripe for more robust construction activity. As Chart 11 shows, the supply of new homes remains low both in absolute, and in terms of months of supply. The bottom line is that we do not fear that a December rate hike will be particularly onerous for the residential real estate market. Plenty of pent-up demand for housing still exists, and this will provide long-term support, so long as the labor market remains robust, as we expect. The recent soft patch in housing will give way to stronger home building activity in the coming months, helping to boost real GDP growth in 2017. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 The State Of the Nation's Housing 2016, Joint Centre For Housing Studies of Harvard University http://jchs.harvard.edu/research/publications/state-nations-housing-2016

Recommended Allocation Central Banks Still In The Driving Seat Markets continue to obsess about every move from the three major DM central banks. With two of them (the Fed and the ECB) likely to withdraw accommodation cautiously over the coming 12 months, the upside for risk assets is limited. The Fed is signaling that it will probably hike in December and the futures market is pricing in a 70% probability of that happening (roughly the probability one month before the rate rise in December last year). Inflation expectations have picked up recently (Chart 1) and core PCE inflation ticked up to 1.7% in August, within "hailing distance", as Fed vice-chair Stanley Fischer put it, of the Fed's 2% target. There is a political angle, too: having forecast four rate rises for the year, the Fed would endanger its credibility (and risk an audit from Congress) if it failed to deliver even one. At the same time, with growth in the Eurozone running a little above trend, the ECB is likely to announce in December an extension to its asset purchase program beyond March 2017 but eventually at a slower pace (a "tapering"). Reflecting these factors, government bond yields have moved up in recent months (Chart 2), and the trade-weighted dollar has strengthened by 4% since mid-August. None of these moves are good for risk assets, which have consequently moved sideways since August. But neither do they presage a big selloff since central banks will err on the side of caution. Inflation in the U.S. is unlikely to jump: wage growth will be kept under control by a gradual rise in the participation rate, which will prevent unemployment falling much further (Chart 3). The Fed's leaders continue to sound dovish. Janet Yellen even raised the question in a recent speech of "whether it might be possible to reverse these adverse supply-side effects [from the 2007-9 Global Financial Crisis] by temporarily running a 'high-pressure economy'", though she emphasized this was a suggestion for further economic research not her view. More practically, the FOMC will have a more dovish tilt in 2017, as the three regional Fed presidents who voted for a hike in September rotate out. Chart 1Have Inflation Expectations Bottomed? Chart 2Bond Yields Moving Higher Chart 3Core Workers Reentering The Labor Force Meanwhile, economic data remain somewhat sluggish. The U.S. manufacturing and non-manufacturing ISMs both rebounded sharply in September, suggesting that the very weak August prints were, as we suggested, an anomaly. Q3 U.S. real GDP growth come in at 2.9%, but the New York Fed's NowCast points to a slowdown to 1.4% in Q4. The Citi Economic Surprise Index (Chart 4) has also turned down again recently, with notable weakness in consumer spending and housebuilding. We expect this sluggish pace to continue through 2017: consumption should hold up as wage rises come through, but it is hard to forecast a strong recovery in capex, given the low capacity utilization rate (Chart 5), even if investment in the mining and energy sectors bottoms out next year. Eurozone growth could stutter too. It is driven substantially by credit growth, but historically European banks have tended to curtail lending after their share prices have fallen, as has been the case recently (Chart 6). Chinese growth has stabilized (at least in the GDP data, which seems to come in regularly at 6.7%, bang in the middle of the government's target range), thanks to the government's reflation policy from earlier this year. While the Chinese authorities have now reined back a little on stimulus, given their worries about the run-up in house prices,1 they offer an option since they would undoubtedly reflate again should growth slow. Chart 4Data Surprising Negatively Again Chart 5Hard To See More CAPEX Indeed Chart 6Share Prices Influence Lending All this suggests that returns from investment assets will be low, but positive, over the coming 12 months. With economic growth anemic but stable, bond yields prone to drift up, and equities expensive (but not as expensive as bonds), we expect risk-adjusted returns from the major asset classes to be broadly similar. We continue to recommend therefore a neutral weighting between bonds and equities, and suggest that investors look to pick up extra return through tilts to investment-grade corporate credit, inflation-linked over nominal bonds, and alternative assets such as real estate and private equity. Equities: Our preference remains for U.S. equities over European ones in USD terms. The dollar is likely to strengthen further, and the worst is not over for Eurozone banks - the time to buy into them will be at the point of maximum pain, which may come if German or Italian banks have to be bailed out by their governments. We continue to recommend a small (currency-hedged) overweight on Japan. The Bank of Japan's new policy to cap 10-year government bond yields at 0% has worked so far: the yen has weakened to JPY 104 to the dollar and equities have risen moderately. We expect further fiscal or wage-control measures from the government to give inflation an extra push. We remain wary of EM equities: earnings growth is negative, loan growth has started to slow (with the credit impulse having a high correlation with earnings and economic growth), and there is still little sign of structural reform. Some sectors in EM - notably IT and Healthcare - are attractive, however. Fixed Income: U.S. Treasury bond yields are likely to rise further - our model suggests fair value is a little below 2% (Chart 7) - and so we remain underweight duration. A moderate pickup in inflation suggests that TIPs will outperform nominal bonds (as described in detail in our recent Special Report).2 We lowered our recommendation in high-yield corporate debt to neutral last month because, at 65 BPs, the default-adjusted spread no longer offers sufficient return to justify the risk. At the start of the year it was 400 BPs (Chart 8). We continue to like investment-grade debt, where the spread over government bonds is 120 BPs in the U.S. and 100 BPs in the Eurozone, higher than at any point in 2005-2006 during the last expansion. Chart 7Treasury Yields Could Rise Further Chart 8Junk No Longer Offers Enough Return Currencies: We expect the U.S. dollar to continue to appreciate given the differential in growth and monetary conditions between the U.S. and other developed economies. The dollar looks expensive, but is nowhere near the over-bought levels it got to at the peak of previous rallies in 1985 and 2002 (Chart 9). China seems likely to allow a further weakness of the RMB against the dollar, repegging it to a trade-weighted currency basket. This could push down other emerging market currencies too particularly if, like Brazil recently, they try to cut rates to boost growth. Chart 9USD Not As Overvalued As In The Past Commodities: Oil has probably overshot in the short-term on expectations that Saudi Arabia and Russia will cap, or even cut, production. We think this talk has been overhyped and that the OPEC meeting in November could prove a disappointment. Nonetheless, we still see the equilibrium level for crude over the next two years at USD 50 a barrel, the marginal cost for U.S. shale producers. Industrial commodities are likely to fall further (they peaked in June) if we are right that the dollar appreciates. We continue to like gold as an inflation hedge, but short-term are nervous because it, too, is negatively correlated with the dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see China Investment Strategy "Housing Tightening: Now And 2010" dated October 13, 2016, available at cis.bcaresearch.com 2 Please see Global Asset Allocation Special Report "TIPS For Inflation-Linked Bonds," dated October 28, 2016, available at gaa.bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)

Special Report

"That as the only possible policy in our day for a conqueror to pursue is to leave the wealth of a territory in the complete possession of the individuals inhabiting that territory, it is a logical fallacy and an optical illusion in Europe to regard a nation as increasing its wealth when it increases its territory, because when a province or state is annexed, the population, who are the real and only owners of the wealth therein, are also annexed, and the conqueror gets nothing." 1 Norman Angell's "The Great Illusion" posited in the early 1910s that war would be futile for developed nations, especially given the rising importance of economic and financial ties. Nevertheless, the arms race from the late-1800s gained momentum and eventually led to the Great War, dealing a devastating blow to his arguments. The European armament dynamics of the late-19th century/early 20th century are eerily reminiscent of the current post-Great Recession global arms race. Back then Germany, Austria-Hungary and Italy on one side, and Britain, France and Russia on the other, were fiercely trying to outpace each other in military expenditures. The crumbling Ottoman Empire along with the newly created smaller states in Greece, Serbia, Bulgaria and Romania were also eager weapons purchasers. Today, a fresh military expenditure-related development pops up almost daily. Not only are the U.S. and China boosting military spending, but also Japan, Australia, India, Vietnam, Saudi Arabia, Turkey, Russia, etc (Chart 1).2 The list goes on and on. The driving factor is "multipolarity," i.e. the emergence of multiple competing great powers, which BCA's Geopolitical Strategy service has shown to be a key investment theme.3 Chart 1U.S. Defense Spending Is More Than The Rest Of The World Combined While we are not arguing that WWIII will erupt in the coming years, the purpose of this Special Report is to identify the winning global equity sectors from the intensifying global arms race (Chart 2): global defense stocks come atop of our list, but also global space-related equities and cyber security firms would be beneficiaries of the secular increase in military outlays. On a regional basis, the U.S. defense stocks are the only game in town, but undiscovered Chinese, and to a lesser extent Russian, defense stocks are intriguing as are Israeli defense and tech stocks (please refer to the Appendix below for ticker symbols). Chart 2Intensifying Global Arms Race Late 19th/Early 20th Century: Militarism, Globalization & Finance Back in the late-1800s, the ascendancy of Germany was challenging the hegemony of Britain, fueling a European-wide arms race. Smaller newly formed states were also on the hunt for the latest and greatest weaponry. During the Balkan Wars of 1912-13 airplanes were deployed in combat for the very first time, highlighting the importance of new technology. Behind this explosive European rearmament were a few large British companies (Vickers Sons & Maxim Ltd, Armstrong and Whitworth, and Coventry Ordnance Works). "By 1905, its capital of £7.4 million ranked Vickers sixth amongst British companies; Armstrong Whitworth, with 5.3 million pounds capital was eleventh".4 Basil Zaharoff, who acted as general representative for business abroad for Vickers,5 was reputedly one of the richest men in the world.6 Moreover, globalization was on the rise in the late 19th century, as evidenced by global imports as a percentage of GDP (Chart 3). Industrialization coupled with imperialism and the colonization of Asia and sub-Saharan Africa along with population growth and rising demand for commodities were key drivers behind the jump in 19th century globalization. Finally, all of this was made possible by cross-boarder finance. Trade finance and credit growth skyrocketed in the late-1800s and the rising interconnectedness of global financial centers was most evident in the 1907 stock market panic that originated in the U.S., but spread like wildfire to the rest of the world. Chart 3Twin Peaks Of Globalization? Chart 4Heeding The Early 1960s Parallel What About The 1960s? The idea of militarily outspending opponents was very evident in the early-1960s when U.S. defense spending surged by 20% on a year-over-year basis (Chart 4), bolstering demand once again for military contractors. The mutually assured destruction (MAD) doctrine of military strategy and national security policy declared overtly in the early-1960s by U.S. defense secretary Robert McNamara and the Space Race competition between the Cold War rivals also have striking similarities with today, as far as investment implications are concerned. Parallels With Today China's ascendency to a world power large enough to challenge the hegemony of the U.S. is a sea change.7 The rearmament of East Asia is reminiscent of late 19th and early 20th century Europe and involves Japan, Australia, South Korea, Vietnam and India. All of the Middle East, along with Turkey and Russia, are on a structural military spending spree. European NATO fringe states are also arming furiously (Chart 5), trying to thwart Russia's regional ambitions. In the U.S., despite the Budget Control Act of 2011 (sequestration), the CBO projects that defense spending will rise gradually from $586 billion in 2015 to $739 billion by 2026 (Chart 6). This is before any push for a fiscal spending thrust that both presidential candidates have proposed, which would include increased defense outlays. While as a percentage of GDP defense spending may drift sideways, in absolute terms it will likely rise, and thus boost demand for defense contractors. Chart 5Stealthy Rise In Defense Outlays Chart 6CBO Estimates New Defense Spending Highs Globalization has hit an apex recently (Chart 3).8 The world is still licking its wounds from the recent GFC, where U.S. financials stocks were so intertwined with their global peers that the crisis effectively brought down to its knees the global financial system and gave birth to unorthodox monetary policy that Central Banks are still currently deploying. Global Rearmament Beneficiaries If our hypothesis that a global arms race will continue to heat up in coming years pans out, then owning global defense stocks as a structural bet will pay handsome dividends. The global push away from austerity and toward more fiscal spending should also support aggregate defense demand. Thus, there are high odds that global defense stocks are primed to deliver absolute positive returns, irrespective of where the broad global equity market drifts in the next five years. Similar to Vickers and Armstrong and Whitworth making impressive stock market strides early last century, global defense stocks should continue to be high flyers. The early-1960s U.S. aerospace & defense (A&D) stocks are the only close stock market parallel we have come across in our analysis (given data constraints) and comparing this index's available metrics of that era with today is in order. A big pushback to the U.S. Equity Strategy service's constructive view on the U.S. defense index (since the late-2015 inception) has been that the valuations of these stocks are already full, leaving no valuation cushion for any mishaps (Chart 7). True, defense stocks are on the expensive side, but not if they manage to grow into their valuations, as we expect. Relative performance was up over 100% in a span of four years in the 1960s (Chart 8), as U.S. aerospace & defense industrial production (IP) swelled to a 20% per annum clip with utilization rates running at 95% (Chart 8). A&D factories were humming, racing to fulfill orders as U.S. military expenditures were thriving (Chart 4). Chart 7Buy Global Defense Stocks Chart 8In The 1960s A&D Factories Were Humming... This demand surge translated into a jump in sector sales momentum (Chart 4), and given the industry's high operating leverage, earnings and book values soared. From trough to peak, sector EPS rose more than 400%, margins expanded from sub 2% to nearly 8%, and book value doubled (Chart 9). That stellar performance justified initial valuation premiums at the time. Using that period as a guide would imply that there is ample upside left for relative performance of the global defense index (that is a pure play on global defense spending). For comparison consistency, we use U.S. A&D figures. Currently, U.S. A&D IP is contracting, with resource utilization running at 80%. U.S. A&D relative performance has risen a mere 30% since the Great Recession (Chart 10). Chart 9...Boosting The Allure Of ##br## A&D Stocks Chart 10If History At Least Rhymes, ##br## There Is Still Ample Upside... Likely, the advance is still in the early innings, and analysts have been very slow to upgrade their EPS estimates accentuating the apparent overvaluation. Importantly, 5-year forward relative EPS growth estimates are deep in negative territory which is very perplexing given the upward trajectory of industry demand (Chart 11). Given that we only have access to data for MSCI All-Country World aerospace & defense long-term EPS expectations the caveat is that some of the poor expectations and performance could be because of the waning aerospace delivery cycle. Unlike the deteriorating health of the broad corporate sector, profit margins are expanding and net debt-to-EBITDA is a comfortable 1.2x. Similarly, interest coverage ratio is near an all-time high of 8x (Chart 12), while the overall markets EBIT/interest expense ratio is half that. Chart 11...Especially ##br## Given Depressed Analysts' Expectations Chart 12Defense ##br## Wins Championships Global defense sector return on equity (ROE) is almost 30% and rising (Chart 13), whereas global non-financial corporate (NFC) ROE is hitting multi-year lows, with the U.S. NFC ROE plumbing all-time lows (Chart 14). Free cash flow is also growing briskly and the industry is making greenfield investments, with capex growing 9.5% year-over-year, the mirror image of the global NFC sector that is pruning capital outlays (middle and bottom panels, Chart 13). Chart 13Defense Flexing ##br## Its Muscles... Chart 14...Vs. The Atrophy In The U.S. ##br## Non-Financial Corporate Sector On the valuation front, modest overvaluation exists, as portrayed by the high relative price-to-cash flow and price-to-book multiples. However, the global defense stocks forward P/E ratio and EV/EBITDA multiple are on an even keel with the broad market (Chart 15), and if our thesis that a secular uptrend in defense-related demand looms proves accurate, then these stocks are not expensive, but on the contrary still represent a buying opportunity. Chart 15Mixed Signals On The Relative Valuation Front Chart 16Defense Is The Best Offense The Rise In Terrorism, Global Space Race And Cyber Security Threat The unfortunate structural increase in terrorist activity will also embolden governments around the world to step up defense spending (top panel, Chart 16).9 The latter tends to move in long cycles. U.S. defense industry revenues have already begun to outpace those of the overall S&P 50010, and a prolonged upturn lies ahead, based on the message from the previous upcycle. From a cyclical perspective, the defense capital goods shipments-to-inventories ratio is outpacing the overall manufacturing sector (second panel. Chart 16), reinforcing the case for ongoing earnings outperformance. The same also holds true in Europe. Western European terrorist attacks have increased, heralding further relative gains for the euro area aerospace & defense index (bottom panel, Chart 16). Beyond the disastrous spike in terrorism, the global space race is also gaining traction, with China spearheading the charge. There is a good chance that China will attain geosynchronous orbit satellites (residing more than 20,000 miles above the earth), challenging U.S. space dominance. India's space aspirations are grand and it is slowly and stealthily rising up the ranks on the space race. Moreover, as more countries aim to have manned space missions, that translates into higher space budgets and thus firming demand for space-related expenditures (Chart 17). Chart 17Space, The Final Frontier Finally, the number of cyber-attacks is also on the rise globally. Defending against attacks is a challenge. Not only does the cyber space domain definition remain elusive, but tracking hackers down is also increasingly difficult given the vastest of the internet, lack of global uniform policing methods and physical country borders. Crudely put, it is a lot easier for a Chinese or Russian hacker to deal a blow, for example, to U.S. nuclear infrastructure rather than physically deliver an attack. All of this suggests that investment in anti-hacking and counter cyber-attack capabilities is necessary around the globe in order to thwart cyber-terrorism. Risks To Our View While there is conceivably a risk that China will abruptly halt its intense militarization and make a U turn in its long-term strategy of becoming a military superpower, we assign a very low probability to such a turn of events. The global push for more fiscal spending may not materialize, which would be a risk to our sanguine global defense spending view. As Paul Volcker and Peter Peterson recently opined in a NY Times article11 - offering a different view from the always-articulate Larry Summers - prudent and fiscally responsible spending is in order given the excessive debt-to-GDP ratio that is probing war-like levels (Chart 18). This excessive debt overhang is not only a U.S. phenomenon, but also a global one spanning both advanced and emerging economies. Chart 18Excessive Debt Is A Risk To Bullish View On Global Defense Stocks One final risk is that the world will enter a prolonged peace phase and global terrorism will get quashed, with conflicts dying down in the Middle East, Russia reining in its imperialistic ambitions and China ceasing to stir the waters in the South and East China Seas. We would also assign low odds to this optimistic "no conflict phase" scenario, but it would indeed be welcome. Investment Conclusion Factors are falling into place for a structural outperformance period in the global defense index. The early-1900s and early-1960s parallels, coupled with the trifecta of terrorism, space race and cyber security all point to upbeat demand for defense-related goods and services. Expressing this buoyant view can be done from a bottom up perspective. The Appendix below highlights all the companies in the global defense index we track from Datastream and the alternative one from Bloomberg. An investable proxy is the U.S. aerospace & defense index as the U.S. dominates global A&D indexes and aerospace outfits also sport significant defense corporate segments (please see the Appendix below for relevant tickers). There are also three fairly liquid ETFs mimicking the U.S. A&D index: ITA:US, PPA:US & XAR:US. Moreover, below are a few more speculative investment ideas. Given China's dominance of global defense spending (ex-U.S.) we are confident that Chinese A&D stocks will also be eagerly sought after and deliver alpha in the coming years (please refer to the Appendix below for a list of China plays). If one has the resilience and the stomach to invest in Russian equities given high political and currency risk, then Russian A&D stocks may be a desirable vehicle. Russia remains a massive weapons exporter with a large sphere of influence. We would not underestimate the returns in local currency of some Russian A&D stocks (the Appendix below lists some Russian A&D listed firms). Finally, Israel A&D and IT companies either listed on NASDAQ or domestically in Tel Aviv offer some great opportunities for investors that can handle riskier investments. Not only Israel's geography, but also its intense IT/military focus and entrepreneurial culture imply that a number of these companies will be long-term winners (please see the Appendix below for relevant tickers). While most of the drones, space-related, and highly specialized IT companies are private, there is a drone and an anti-hacking ETF (IFLY:US & HACK:US). On the space front, we are tracking an index that comprises a number of space-related constituents that we show in the Appendix below. Nevertheless, most of these companies are categorized under A&D. Bottom Line: We are initiating a structural overweight in the global defense index with a longer-than-usual five year secular investment horizon. The re-rating phase in this index is still in the early innings. The re-rating phase in this index is still in the early innings. We also reiterate our overweight in the BCA U.S. defense index (LMT, GD, RTN, NOC, LLL). Anastasios Avgeriou, Vice President Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Angell, Norman (1911), The Great Illusion: A Study of the Relation of Military Power in Nations to their Economic and Social Advantage, (3 ed.), New York and London: G.P. Putnam’s & Sons. 2 Please see BCA Geopolitical Strategy Monthly Report, “The Great Risk Rotation,” dated December 11, 2013, available at gps.bcaresearch.com 3 Please see BCA Geopolitical Strategy Monthly Report, “Multipolarity And Investing,” dated April 9, 2014, available at gps.bcaresearch.com 4 Angell, Warren, Kenneth (1989), Armstrongs of Elswick: Growth In Engineering And Armaments To The Merger with Vickers, London, The Macmillan Press Ltd. 5 http://www.oxforddnb.com/index/38/101038270/ 6 https://www.britannica.com/biography/Basil-Zaharoff 7 Please see BCA Geopolitical Strategy Special Report, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, available at gps.bcaresearch.com 8 Please see BCA Geopolitical Strategy, “The Apex Of Globalization - All Downhill From Here,” in Monthly Report, “Winter Is Coming,” dated November 12, 2014, available at gps.bcaresearch.com 9 Please see BCA Geopolitical Strategy Special Report, “A Bull Market For Terror,” dated August 5, 2016, available at gps.bcaresearch.com 10 Please see U.S. Equity Strategy Weekly Report, “Wobbling,” dated December 7, 2015, available at uses.bcaresearch.com 11 http://www.nytimes.com/2016/10/22/opinion/ignoring-the-debt-problem.html?_r=0 Appendix Table A1BI Global Defense Primes Competitive Peers Table A2World Defense Index (DS: DEFENWD) Table A3S&P 500 Aerospace & Defense Index ##br## (S5AERO Index) Table A4China ##br## Aerospace & Defense Table A5Russia & Israel Aerospace & Defense Table A6Kensho Space Index

Special Report

Highlights With inflation probably having bottomed, especially in the U.S., investors are starting to worry about inflation tail-risk and wonder whether inflation-linked bonds (ILBs) are an efficient way to hedge this risk. This Special Report explains how ILBs work in different countries and analyzes their performance characteristics over time. We find that ILBs, a rapid growing asset class, can be a beneficial addition to a balanced global portfolio even though recent history does not show as strong portfolio diversification benefits as a longer history. The lower nominal duration of ILBs is a useful feature for portfolio duration management. ILBs have proven to be a good inflation hedge in a rising inflationary environment, but they underperform nominal bonds in a disinflationary environment. As such, the balance between ILBs and nominal bonds should be managed tactically based on an investor's views on inflation dynamics and valuation. Overweight U.S. TIPS; avoid U.K. linkers. Australian TIBS are a cheap yield enhancer, but higher yielding Mexican Udibonos are a dangerous yield trap. Feature BCA's view is that the 35-year bull market in bonds is ending and that the path of least resistance for bond yields globally is up.1 Even though the level of inflation in the U.S. is still below the Fed's target of 2%, we think it's clear that U.S. inflation has bottomed for this cycle. Globally, loose monetary policy together with the likelihood of more fiscal stimulus, present the risk of higher inflation down the road. Global Asset Allocation has recommended investors to overweight U.S. TIPS (Treasury Inflation Protected Securities) relative to nominal U.S. government bonds throughout 2016. Many clients have asked for details on how TIPS work, whether there are similar securities in other countries, and how ILBs fit into a balanced global portfolio. In this Special Report, we take a detailed look at inflation-linked bond markets globally and recommend some strategies for asset allocators to use them to help navigate a world of low returns and possibly higher inflation. 1. What Are Inflation-Linked bonds (ILBs)? Inflation Protection: Inflation-linked bonds are designed to hedge inflation risk by indexing the bonds' principal to the official inflation index in the issuer country. While the methodology and what the bonds are called differ from country to country, the underlying concept is the same: the holders of ILBs will get the stated real return even in an inflationary environment since both the nominal face value and the nominal coupon payments change based on an official inflation measure. Deflation Floor: In the case of sustained deflation such that the final nominal face value falls below the initial face value, however, the repayment of principal at maturity is guaranteed in the majority of the countries, but not, for example, in the U.K., Canada, Brazil, or Mexico (Table 1). Table 1Basic Information Of Global ILB Markets Inflation Measure: ILBs are linked to actual inflation with a time lag. As shown in Table 1, the inflation measure used varies slightly by country: in the U.S. it's the non-seasonally adjusted CPI; in the U.K. it's the retail price index (RPI); while in the euro area, France and Italy both have ILBs linked to local CPI ex tobacco and EU HICP ex tobacco, with the former primarily for domestic retail investors. The time lag is three months in most countries, but can vary from one to eight months as shown in Table 1. A Rapidly Growing Asset Class: The earliest recorded ILBs were issued by the Commonwealth of Massachusetts in 17802 during the Revolutionary War. Finland introduced indexed bonds in 1945, Israel and Iceland in 1955. Brazil introduced its indexed bonds in 1964 and has become the largest ILB market in the emerging markets and the third largest globally. When the U.K. issued its first "linkers", it originally used eight months of inflation lag to make sure the next coupon payment is known at the current coupon payment date. In 1991 Canada issued its first ILBs and the "Canadian Model", which uses a three-month lag to the inflation index and calculates a daily index ratio using linear extrapolation, has been adopted widely since; even the U.K. adopted it in 2005. The largest ILB market now is the U.S. TIPS with a market cap of USD 1.2 trillion. TIPS were first issued in 1997, using the Canadian model. Chart 1 shows the evolution of the ILB markets globally. Since the Bloomberg Barclays Universal Government Inflation-linked Bond Index was constructed in July 1997, the market cap has increased to over USD 3.2 trillion from a mere USD 145 million at the end of 1997. It's worth noting that the actual amount of ILBs outstanding globally is slightly larger than this because not all debts are included in the index.3 Even though many countries have issued ILBs, and emerging markets (EM) grew very fast in the 2000s, the global market is still dominated by the top three countries (the U.S., U.K., and Brazil) with a combined share of 70% of global market cap. Chart 1ILBs: A Fast Growing Asset Class Chart 2U.S. BEI Vs. Inflation Expectations Country Differentiation: Nominal government bonds come with different features in different countries, and the same is true with ILBs. Table 2 shows that even though the U.S. accounts for 43.6% of the developed markets (DM) index in terms of market cap, it contributes only 28.8% to overall duration while the U.K. accounts for 53% of the overall duration, because the U.K. linkers have much longer duration than the U.S. TIPS. The Canadian real return bonds (RRBs) have the second longest average duration at 16 years. Table 2Key Features of the Bloomberg Barclays Government ILB Indexes* 2. How Do ILBs Compare To Nominal Bonds? Break-Even Inflation (BEI) And Inflation Expectations: The difference between the yield on a nominal bond and the yield on a comparable ILB (a comparator) is defined as the BEI, the market-based inflation rate at which an investor is indifferent between holding a real or a nominal bond. If realized inflation over an ILB's life turns out to be higher than the BEI at purchase, then holding the ILB is better than holding its nominal counterpart. BEI on its own is not an accurate gauge of inflation expectations, because it is the sum of inflation expectations, the inflation risk premium, and the liquidity premium. One of the long-term inflation expectation measures that the U.S. Fed keeps track of is the five-year forward five-year inflation calculated using the Fed's own fitted yield curves.4 Even this measure, however, contains the inflation term premium and the relative supply/demand of 10-year BEI vs 5-year BEI. Three important observations from Chart 2 for investors to pay attention to when assessing the inflation outlook are: U.S. breakeven inflation rates have been consistently below the Fed's inflation target of 2% since 2014 (panel 4); The CPI swaps markets priced in a much higher inflation rate than the TIPS market and the Fed's measure derived from fitted curves (panels 2 & 3), largely caused by the supply and demand imbalance in the inflation swaps market: there is excess demand to receive inflation, but no natural regular payer of inflation other than the U.S. Treasury via TIPS, therefore a higher fixed rate has to be paid to receive inflation; The 10-year inflation expectation from the Cleveland Fed's model5 (panel 1), exhibits very different behavior from the other measures. It has been below the 2% target since 2011. This model attempts to combine survey-based inflation expectations and that derived from the CPI swaps market. It's intended to be a "superior" measure of inflation expectations from a monetary policy perspective.6 For investors, however, it's advisable to take into account all these measures when assessing inflation dynamics. Duration and Yield Beta: Duration is measured as the bond price change in relation to the yield change. Chart 3 shows that ILBs have higher duration than their nominal counterparts. These two durations, however, are not directly comparable because ILB duration is related to "real yield" while nominal bond duration is related to "nominal yield". The conversion from one to another is not straightforward because the relationship between real and nominal yields can be complex.7 In practice, however, we can run a simple regression to get ILB's yield beta to change in nominal yield.8 Some practitioners simply assume 0.5 in the emerging market.9 Our research shows that in the developed market the relationship between real yield and nominal yield can vary over different time periods and in different countries, but the moving 3-year and 5-year yield betas are always less than 1 and mostly above 0.5, which is the full sample average.(Chart 4). This is a useful feature for duration management and curve positioning. For example, everything else being equal, 1) replacing nominal government bonds with comparable ILBs can reduce portfolio duration, and 2) replacing a short-dated nominal bond with a longer-dated ILB could maintain the same duration. Chart 3Average Government Bond Duration Chart 4ILBs' Yield Beta Total Return: By design, ILBs should do well in an inflationary environment and they should outperform their nominal bonds when realized inflation is higher than the break-even inflation rate. How have ILBs performed in the real world? Unfortunately, we do not have a long enough data history to cover different inflation cycles. Chart 5 confirms that in nominal terms ILBs outperform their nominal counterparts when inflation rate trends higher. What's interesting, however, is that it is disinflation, rather than deflation, that hurts ILBs the most. Within the available data history, only 2009 experienced a brief deflation scare globally, yet the rebound in ILBs actually led economies out of the deflationary environment. Over the long run, U.K. linkers have underperformed nominal gilts since their first issuance in 1981 when inflation was running at 12%. Since 1997 when the Bloomberg/Barclays ILB indexes were constructed, however, ILBs have performed slightly better than their nominal comparable bonds in most countries, with the exception of the euro area where ILBs have fared slightly worse (Chart 5). Risk-Adjusted Return: On a risk-adjusted basis, the available data history shows that ILBs performed slightly better in the U.S. and Australia, and also the DM aggregate on a hedged basis, but slightly worse in the euro area, the U.K. and Canada. It's worth emphasizing, however, that in either case the difference is not significant (Table 3). Chart 5ILB Performance Vs Inflation Table 3ILBs Approximately Equal To Nominal Bonds 3. What's The Role Of ILBs In A Balanced Portfolio? Bridgewater Associate showed that adding ILBs to a balanced euro zone stock/bond portfolio significantly improved the efficient frontier over the very long run, from 1926 to 2010.10 Since there were no ILBs in the early part of that history, ILB returns were calculated based on inflation. Our research, based on data from the Bloomberg/Barclays Inflation-Linked Government Bond Index with a much shorter history, however, does not yield the same results, probably because the much shorter recent history does not include any highly inflationary periods from which ILBs benefit the most. Table 4 shows the statistics of replacing a certain portion of the nominal bonds with comparable ILBs in a DM 60/40 stocks/bonds portfolio. On a standalone basis, the hedged USD DM ILBs are less volatile and have the best risk-adjusted return of 1.3 in the sample period (Portfolio 8). When combined with equities, however, the nominal bonds are a slightly better diversifier than the ILBs. Why? The answer lies in the correlation. Chart 6 shows that the ILBs have much higher correlation with equities than the nominal bonds do with equities. This makes sense because equities could rise in an inflationary environment if the higher inflation were driven by stronger growth, while inflation is always bad for nominal bonds. Again, the differences in risk-adjusted returns are not significant, varying from 0.77 to 0.7 (Portfolios 2-6) in line with the findings in Section 2. Table 4Balanced Global Portfolio Statistics* Chart 6Global Stocks-Bonds Correlations 4. Inflation Has Bottomed BCA's Fixed Income Strategy team has written extensively about the outlook for U.S. and global inflation.11 We concur with their view that, even though inflation in most DM countries is still below the targets set by their central banks (Chart 7), in most countries it has probably bottomed (top three panels in Chart 7), and especially in the U.S., where all indicators point to rising wage pressures as labor market slack diminishes (Chart 8). Chart 7Inflation Still Below Target Chart 8Accelerating Wage Pressure 5. Investment Implications Overweight U.S. TIPS Over Nominal Treasuries: We have shown that ILBs outperform comparable nominal bonds in a rising inflation environment and have argued that inflation has bottomed in the U.S. These views support our recommendation to overweight U.S. TIPS relative to nominal U.S. Treasuries. In addition, our TIPS valuation models (Chart 9) show that breakeven inflation rates in the U.S. are still below fair values based on underlying economic and financial drivers. Being the largest ILB market with a market cap of over USD 1.2 trillion, TIPS are very easy to trade. Currently, only five-year TIPS have a negative yield, so there are plenty of opportunities for investors to preserve real purchasing power by holding longer maturity TIPS. Avoid U.K. Linkers: The U.K. linkers market is the second largest after the U.S., with a market cap of about USD 810 billion. Unfortunately, these linkers are among the most expensively priced real return bonds, with negative yields at all maturities (Chart 10, panel 3). For example, 10-year linkers are currently yielding -1.98%, which means that investors are guaranteed to lose 18% of real purchasing power in 10 years by holding the bonds to maturity. Granted, the U.K. linkers have always traded at a premium to U.S. TIPS and many other ILB markets due to the nature of the U.K. pension schemes which link pension liabilities to inflation (CPI or RPI). With insatiable appetite from pension funds, demand greatly exceeds what the linkers and inflation swaps markets can supply. U.K. real yields have been driven lower and lower, causing an increasing funding gap which in turns drives yield further down.12 In addition, our fair value model (Chart 10, panels 1 and 2) shows that the U.K. linkers' current breakeven rates are above fair value. The collapse in the linkers' yields after the Brexit vote is also consistent with a skyrocketing in the CPI swaps rate, indicating that the probable rise in inflation due to the collapse of the GBP has now largely been priced in (panel 4). Investors who are not constrained by U.K. pension regulations should avoid U.K. linkers. Chart 9Overweight U.S. TIPS Chart 10Avoid U.K. Linkers Yield Enhancement From Australia, Not From Mexico: The U.S. TIPS market is liquid but yields are low, albeit higher than U.K. linkers. Among the smaller markets with higher yields, we prefer Australian Treasury Indexed Bonds (TIBS) over Mexican Udibonos, even though the 10-year Udibonos have a higher yield of 2.8% compared to the 10-year TIBS yield of 0.62%. As shown in Chart 11 and Chart 12, the Australian TIBS are very cheap while the Mexican Udibonos are very expensive. The BEI in Mexico is above the central bank's target of 3% while in Australia it's still at the lower end of the target range of 2-3%. Chart 11 Australian TIBS: A Cheap Yield Enhancer Chart 12 Mexico ILBS: Too Expensive 6. ETFs Some of our clients always want to know if there are ETFs for the asset classes we cover. For ILBs, the most liquid ETF is the iShares TIPS Bond ETF with an AUM of USD 19 billion and an expense ratio (ER) of 20 bps. For non-U.S. global ILBs, the SPDR Citi International Government Inflation-Protected Bond ETF has an AUM of USD 620 million and an expense ratio of 50bps. The Appendix on page 14 gives a sample list of the exchange traded ILB funds. For more information about ETFs, please see BCA's newly launched Global ETF Strategy service. AppendixSample List Of ILB ETFs*** Xiaoli Tang Associate Vice President xiaolit@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "The End of the 35-year Bond Bull Market," July 5, 2016, available at gis.bcaresearch.com. 2 Robert Shiller, "The Invention of Inflation-Linked Bonds in Early America," NBER Working Paper 10183, December 2003. 3 Barclays Index Methodology, July 17, 2014. 4 Refet S. Gurkaynak et al., "The TIPS Yield Curve and Inflation Compensation," May 2008, Federal Reserve publication. 5 Joseph G Haubrich et al., "Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps," Working Paper 11-07, March 2011, Federal Reserve Bank Of Cleveland. 6 Joseph G. Haubrich And Timothy Bianco, "Inflation: Nose, Risk, and Expectations," Economic Commentary, June 28, 2010, Federal Reserve Bank Of Cleveland. 7 Francis E. Laatsch and Daniel P. Klein, "The nominal duration of TIPS bonds," Review of Financial Economics 14 (2005). 8 Mattheu Gocci, "Understanding the TIPS Beta," University of Pennsylvania, 2013. 9 Thor Schultz Christensena and Eva Kobeja, "Inflation-Linked Bond from emerging markets provide attractive yield opportunities," Danske Capital, May 2015. 10 Werner Kramer, "Introduction to Inflation-Linked Bonds," Lazard Asset Management, 2012.

Dear Client, This week, I am currently on the road visiting clients across Europe. We are sending you an abbreviated weekly report as well as a Special Report from our Geopolitical Strategy team entitled “U.S. Election: Final Forecast & Implications”. Not only does this report encompass a detailed analysis of the upcoming U.S. presidential election and its implications for the future of U.S. politics, it also introduces GPS’s poll-plus model, a model which currently forecasts a Clinton victory. I trust you will find this piece very informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights The U.S. dollar is consolidating its recent gains, but it offers more upside in the months ahead A Trump victory would supercharge any dollar strength, but is likely to hurt the dollar in the long-term. In Japan, no more fiscal drag and a tightening in the labor market will ultimately result in a lower yen, courtesy of higher inflation expectations and falling real rates. The Australian labor market points to weaknesses in the domestic economy. Any EM turmoil could launch an AUD bear phase. Feature The U.S. dollar continues to consolidate its recent gains. While the dollar is expensive, it still offers upside potential. Monetary divergences remain in favor of the U.S. economy. U.S. labor market slack is disappearing and the rising share of salaries and wages in the national income pie is likely to further support consumption. Shifting the distribution of economic gains toward workers signifies that the middle class is gaining ground relative to households at the summit of the income ladder. This process should help consumption because the middle class has a much higher marginal propensity to consume than the top 1% (Chart I-1). If consumption growth remains healthy, job creation is likely to fan additional wage pressures, creating a virtuous circle for U.S. households and consumption. This virtuous cycle is likely to help the Fed increase rates over the next two years, providing a source of support for the dollar (Chart I-2). Chart I-1Shifting Income To The Middle Class Will Support Consumption Chart I-2A Virtuous Cycle For The Dollar In terms of the presidential election outcome, the shift of the median voter to the left signifies that redistributionist policies are likely to become an ever growing part of the U.S. political discourse. This reality is likely to provide another source of support for the U.S. dollar, at least for now. While a Clinton victory will not halt these trends, a Trump victory would likely supercharge any dollar bull market. While vague in details, Trump's economic plan involves much more infrastructure spending financed with debt issuance, i.e. a large amount of fiscal stimulus that would remove the need for any dovish tilt to the Fed's stance. Moreover, by raising the specter of protectionism, a Trump victory could revive inflationary forces in the U.S. economy. Protectionism, while negative for profits, would decrease the trade deficit, temporarily lifting U.S. GDP. Since the supply side of the economy has been hampered by tepid levels of investment (Chart I-3), we could see a situation where demand is in excess of supply. This would prompt an even more hawkish Fed. However, although a Trump victory would be a dream for dollar bulls, caution is warranted. In the long-term, a Trump administration implies a falling fair value for the dollar. For one, by lifting inflation, a Trump victory would hurt the PPP value of the greenback. Second, a Trump victory would also ultimately lead to a degradation of the USD's role as the global reserve currency, making the -40% of GDP net international investment position of the U.S. more difficult to sustain (Chart I-4). Finally, by shielding the economy from the competitive pressures of globalization, a Trump victory would likely result in a deterioration of U.S. productivity vis-à-vis the rest of the world. Chart I-3Low Capital Stock Growth Would Crystalize The##br## Inflationary Effect Of A Trump Presidency Chart I-4The Dollar Needs Its ##br##Reserve-Currency Status Yen Signs pointing toward a strong wave of yen weakness are slowly coming together. In recent years, the yen has closely followed real rates differentials (Chart I-5). With the BoJ guaranteeing a limit on the upside for nominal rates, any improvement in the economy is likely to cause inflation expectations to increase, and thus real rates, to fall. What are the signals pointing toward higher inflation expectations and a lower yen? First, the labor market is tightening. The job-opening-to-applicants ratio is at a 15 year high and employment growth remains healthy (Chart I-6). Meanwhile, the participation rate of women in the labor force is at all-time highs, and at 73.5%, the employment-to-population ratio for prime-age women is already above U.S. levels. In fact, it is at similar levels to those experienced in the U.S. during the boom years of the late 1990s. Thus, the declining likelihood that more women will enter the labor force eliminates a wage-suppressing factor. Chart I-5USD/JPY: A Function Of##br## Real Rate Differentials Chart I-6Japan: Female Labor Participation Now Exceeds ##br##The U.S. Japanese Wages Can Now Rise Second, the Japanese shipment-to-inventory ratio is improving. Thanks to lean-inventory techniques, this ratio tends to be most elevated at the bottom of economic slowdowns, reflecting depressed sales rather than bloated inventories. Historically, growing shipments relative to inventories are associated with rising inflation expectations (Chart I-7). Third, the drag from fiscal policy is dissipating. Budget tightening is leveling off, lifting a big brake on domestic demand (Chart I-8). Moreover, we expect fiscal stimulus to gather momentum in 2017, especially in the form of wage policy. This provides an additional support for Japanese inflation expectations. If no further fiscal stimulus comes to fruition in Japan, we expect USD/JPY to rally toward 110-115 in the next 18-months. If aggressive fiscal stimulus and a wage policy are implemented, the upside for USD/JPY could be much greater, in the order of 120 or more. Chart I-7Japanese Shipment-To-Inventory##br## Ratio And CPI Expectations Chart I-8The Dissipating Japanese ##br##Fiscal Drag Yet, while the cyclical outlook for the yen is bearish, the shorter-term outlook is more nuanced. Any EM-selloff triggered by tightening global liquidity conditions could prompt downward pressures on Japanese inflation expectations. This would mechanically lift Japanese real rates and the yen. Hence, we recommend investors sell the yen on a long-term basis but hedge this position by buying JPY volatility over the next 3-6 months. Australian Dollar The Australian dollar is at a tricky spot. Technically, the AUD has been forming a tapering wedge, a pattern that often heralds a large move in this currency. How will this pattern resolve itself? We expect a bearish outcome. The domestic economy is displaying some worrying signs. Not only is full-time employment contracting, but so are total hours worked (Chart I-9). This is likely to weigh on household income and on consumption. This is especially problematic as Australian gross fixed capital formation continues to contract at a 4.5% annual pace. The result is that inflationary pressures in Australia will be kept at bay. In the process, the RBA could adopt a more dovish bias. Chart I-9Australian Domestic Conditions ##br##Are Deteriorating Chart I-10Australian Exports To ##br##China Are Still Falling... Additionally, despite a stabilization in Chinese growth, Chinese imports from Australia continue to contract (Chart I-10). Not only has this happened as iron ore prices have rebounded, but also, as economic conditions have improved in EMs that are highly levered to the Chinese cycle (Chart I-11). Our expectation is that the Chinese industrial sector is likely to experience a slowdown in the months ahead, courtesy of a falling fiscal impulse (Chart I-12), which begs a question: What does the future hold for Australian exports? Chart I-11...Despite Rising Taiwanese##br## Industrial Production Chart I-12Tightening Global Liquidity Is A Headwind##br## For EM Financial Conditions And Growth Finally, our bullish U.S. dollar stance is a tough hurdle for commodity prices to overcome (Chart I-13). Weakness in commodities would represent a negative terms-of-trade shock for Australia and the AUD. Moreover, the PBOC continues to use a lower RMB as an engine of reflation, and we stand by our bearish JPY forecast. Because of these two developments KRW, SGD, and TWD, are very likely to experience further downside. Historically, Asian currency weakness correlates closely with a weak AUD (Chart I-14). Chart I-13Commodities And The Dollar:##br## Joined At The Hip Chart I-14AUD Performs Poorly When ##br##Asian Currencies Sell Off We are already shorting AUD/USD in the context of a short commodity currencies trade. We are considering buying EUR/AUD, as the euro is less sensitive to the dollar, EM spreads, and commodity prices versus the AUD. Also, EUR/AUD is more attractive from a valuation perspective, trading 5% below its PPP fair value. This cross is also supported by a favorable balance-of-payments backdrop, with the euro area registering a 7.7% of GDP current-account differential relative to Australia. Buying EUR/AUD represents a way for investors to bet on a weaker AUD while decreasing their exposure to the U.S. dollar risk factor. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "There are risks of hanging around zero too long. And if the economy can withstand [a hike], I think it's appropriate to move" - Philadelphia Fed President Patrick Harker (October 26, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "In the euro area, we have a long way to go before we exhaust the productivity improvements that have already taken place in the U.S" - ECB President Mario Draghi (October 25, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: ""Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights Chart 1Model Weights In October, the model outperformed global equities in USD and local-currency terms; it also outperformed the S&P 500 in local-currency terms, while performing in line with the S&P in USD terms. For November, the model trimmed its allocation to cash and stocks and boosted its weighting in bonds (Chart 1). The model increased its weighting in French, Dutch, and Swedish stocks at the expense of the U.S., Japan, Germany, Switzerland, New Zealand, and Emerging Asia. Within the bond portfolio, allocation to New Zealand and the U.K. was increased, while the allocation to U.S., Australian and Spanish paper was reduced. The risk index for stocks deteriorated in October, while the bond risk index improved noticeably. Feature Performance In October, the recommended balanced portfolio gained 0.6% in local-currency terms, and was down 1% in U.S. dollar terms (Chart 2). This compares with a loss of 1.4% for the global equity benchmark, and a 1% loss for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we do provide recommendations from time to time. The higher allocation to EM stocks in October was timely, but the boost to bonds was a drag on the model's performance. Weights The model cut its allocation to stocks from 67% to 66% and increased its bond weighting from 21% to 26%. The allocation to cash was decreased from 12% to 8%, while commodities remain excluded from the portfolio (Table 1). The model reduced its allocation to New Zealand equities by 3 points, Emerging Asia by 2 points and U.S., Japan, Germany and Switzerland by 1 point each. Meanwhile, it increased allocation to Dutch, French and Swedish stocks by 4 points, 3 points and 1 point, respectively. In the fixed-income space, the allocation to U.K. and New Zealand paper was increased by 6 points and 5 points respectively, while allocation to Australia, Spain and the U.S. was cut by 3 points, 2 points and 1 point, respectively. Chart 2Portfolio Total Returns Table 1Model Weights (As Of October 27, 2016) Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The dollar appreciated in October and investors should position for additional dollar strength. Our Dollar Capitulation Index seems to be breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators Our model continues to exclude commodities from the portfolio. The risk index for this asset class remains at the highest level in over two years (Chart 4). For the first time since June 2014, the risk index for global equities is above the neutral line (Chart 5). The higher overall risk reflects deteriorating liquidity and momentum readings. Our model cut its weighting in equities for the third month in a row. Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk The value component of the risk index for U.S. stocks improved in October, but this was overshadowed by worsening liquidity and momentum readings. The model slightly trimmed its allocation to U.S. equities (Chart 6). Even after the latest small uptick in the risk index for Dutch equities, it remains one of the lowest among the model's universe. The allocation to this bourse was increased. (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Netherlands Stock Market And Risk The risk index for U.K. stocks declined slightly in October, but remains firmly in high-risk territory both compared to its own history and its global peers. This asset class remains excluded from the portfolio (Chart 8). The model slightly upgraded Swedish equities, despite a worsening risk index. The continued favorable liquidity backdrop remains a boon for Swedish stocks (Chart 9). Chart 8U.K. Stock Market And Risk Chart 9Swedish Stock Market And Risk After declining for four consecutive months, the overall risk index for bonds is not at extreme high-risk levels anymore. The increase in yields has helped completely unwind overbought conditions, as per our momentum indicator. The model used the latest selloff to increase its allocation to bonds (Chart 10). The risk index for U.S. Treasurys declined markedly in October, but a few other markets also feature improved risk readings. As a result, the model downgraded U.S. Treasurys (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk The selloff in New Zealand bonds has pushed the momentum indicator into oversold territory, boosting the allocation to this asset class (Chart 12). The risk index for euro area bonds remains firmly in the high-risk zone even after a notable decline. However, there are select bond markets in the common-currency area that have relatively more favorable risk readings (Chart 13). Chart 12New Zealand Bond Yields And Risk Chart 13Euro Area Bond Yields And Risk Within the euro area, Italian bonds feature a risk reading that has fallen below the neutral line. While the cyclical indicator continues to move into more bond-negative territory, it is currently being offset by the oversold reading on the momentum indicator (Chart 14). U.K. gilt yields moved up as the post-Brexit inflation backdrop became gilt-unfriendly and growth surprised on the upside. Now, with momentum moving from overbought to oversold over just a couple of months, any negative economic surprises could potentially weigh on gilt yields. The model has added this asset class to the portfolio (Chart 15). Chart 14Italian Bond Yields and Risk Chart 15U.K. Bond Yields And Risk A more hawkish Fed could push the dollar higher. The 13-week momentum measure for the USD remains above, but close to the neutral line. The recovery of the 40-week rate of change from mildly negative levels which have represented a floor since 2012 would suggest that a new leg in the dollar bull market is in the offing (Chart 16). Both the 13-week and 40-week momentum measures for the euro are below the neutral line (Chart 17). Growing monetary divergences could continue weighing on EUR/USD before the technical indicators are pushed into more oversold territory. Fears of hard Brexit knocked down the pound. The 13-week rate of change is now close to its post-Brexit lows, while the 40-week rate of change measure is at the most oversold level since 2000 (excluding the great recession). At these technical levels the pound seems overdue to find a temporary bottom (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Euro Chart 18Sterling Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Highlights The perceived shape of Brexit is the single most important driver of the pound and most U.K. assets. The U.K. Courts are due to deliver landmark legal rulings, which have huge implications for the perceived shape of Brexit. Expect an eventual soft Brexit if the Courts decide against the U.K. government and deem that triggering Article 50 requires parliamentary approval. Expect a much harder Brexit if the Courts decide in favour of the U.K. government. Tactical investors should consider owning some very short-term call options on pound/dollar or a combination of call and put options. Feature Within the next two weeks, the U.K. High Court will deliver a landmark legal ruling which will have huge implications for the future of the U.K. and Europe. Chart of the WeekDifferent Levels Of Brexit Mean Different Levels Of The Pound The U.K. High Court will rule whether Prime Minister Theresa May can start the legal process to exit the EU using the so-called 'royal prerogative' - the power granted to governments to make decisions without a vote from parliament. If May cannot use the royal prerogative, she will require an Act of Parliament to trigger Article 50 of the Lisbon Treaty. The High Court judgement hinges on a fundamental issue. Triggering Article 50 necessarily means that the current government will overturn previous parliamentary decisions - the European Communities Act (1972) and European Union Act (2011). Does the constitution permit a government to overturn parliamentary decisions, take away treaties, and remove the population's legal rights without obtaining parliamentary approval? Although we are not legal experts, the court could regard that as overstretching government authority. If the High Court's judgement does go against the U.K. government, expect pound/dollar to rally immediately by about 4-5 cents. Conversely, a judgement in favour of the government could see the pound sell off by about 1-2 cents. Given the possibility of this gapping, tactical investors should consider owning some very short-term call options on pound/dollar, or a combination of call and put options. Nevertheless, the story will not end with the High Court. Whichever side loses will appeal the decision and take the case to the Supreme Court, which is expected to respond by the end of the year. This ultimate pronouncement of law will have a landmark bearing on the shape of Brexit and, thereby, the future of the U.K. and the other EU 27. Where Is The Pound Headed Longer-Term? For investors, the spectrum of Brexit possibilities - no Brexit, 'soft' Brexit, 'hard' Brexit, or 'very hard' Brexit - will be the single-most important driver of the pound, and by extension, other U.K. assets. Of course, U.K. asset prices ultimately depend on economic and financial fundamentals. But Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7 illustrate that by far the most important fundamental for all U.K. assets right now is the perceived hardness of Brexit, as captured in the pound's value. Chart I-2Harder Brexit Means The Eurostoxx600 ##br##Underperforms The FTSE100... Chart I-3...And The FTSE250 ##br##Underperforms The FTSE100 Chart I-4Harder Brexit Means U.K. ##br##Goods Exporters Outperform... Chart I-5Harder Brexit Means ##br##Retailers Underperform... Chart I-6...Travel And Leisure Underperforms... Chart I-7...And Real Estate Underperforms Pound/dollar has (so far) traded at three distinct levels, based on three distinct levels of perceived Brexit severity: near 1.50 before the Brexit vote; near 1.30 after the Brexit vote but perceiving a soft Brexit; and near 1.20 after Theresa May announced that she would trigger Article 50 by next March and was contemplating a hard Brexit (Chart of the Week). Hence the (post-appeal) outcome of the legal case against the government carries great significance. If the government loses, and requires a parliamentary vote to trigger Article 50, several consequences follow. Theresa May's end-March deadline for firing the Brexit starting gun would become very difficult to meet, severely delaying the whole process. Would the government even win a parliamentary majority? If in doubt, would the government call a snap General Election to try and beef up its majority? The current batch of parliamentarians has a strong bias for staying in the EU, but it would be difficult to fly in the face of the referendum result. On the other hand, the checks and balances of parliament are there precisely to stop the country walking over the cliff-edge that a very hard Brexit would be. All the while, with investment slowing and higher inflation from the weaker pound squeezing household real incomes, the economic headwinds from the U.K.s limbo status would be becoming more apparent. Given the high stakes and likely irreversibility of the formal legal process, parliamentarians would rightfully want to examine and approve the U.K.'s negotiating hand. It seems that Parliament would almost certainly water down or delay Brexit before voting it through. Hence, if the government loses its legal case after appeal, Brexit will likely end up in a soft form. And pound/dollar will ultimately elevate to 1.35. Conversely, if the government wins its legal case after appeal, Theresa May will be on course to trigger Article 50 early next year, as promised. At which point, the EU 27's optimal game-theoretical first play is to be very aggressive - effectively opening with a very hard Brexit offer as described in the next section. Whereupon, pound/dollar would find its fourth, even lower, new level: near 1.10. Two Myths About Brexit It is important to debunk a couple of common myths about Brexit. First, that the U.K.'s current position as the EU 28's second largest economy will force the remaining EU 27 to give the U.K. a special status - allowing access to the three freedoms of goods, services, and capital but with controls on the fourth freedom of movement: people. This belief is misplaced. The biggest worry for the EU 27 is that a special status for Britain could catalyse other countries, under populist pressure, to ask for equivalent deals. The EU 27 does not want to give Marine Le Pen the opportunity to say "let's follow the Brits, they've negotiated a great deal." Hence, the U.K. will not get special treatment. Quite the contrary, it must be seen to be paying a substantial price for Brexit. Even for Anglophile Angela Merkel, protecting the indivisibility of the four freedoms and the integrity of the EU is the overriding priority. If the U.K. restricts free movement of people, it almost certainly means a hard Brexit: substantially restricted access to the single market. The U.K. would then have to negotiate a free trade agreement (FTA) with the EU. Given the current difficulty that Canada is experiencing in negotiating a FTA, this might not be a straightforward process for the U.K either. Furthermore, as a FTA does not usually cover services, it would handicap the services-heavy U.K. economy, while perfectly suiting the goods-heavy German economy. A second common belief is that the pound will act as an automatic economic stabilizer. That irrespective of a very tough deal from the EU 27, a weaker sterling will soothe the pain of a very hard Brexit by making British exports more competitive. Granted, the weaker pound will boost the demand for the U.K.'s goods exports. But total U.K exports are much less sensitive to devaluations compared to when the pound tumbled out of the Exchange Rate Mechanism in 1992. Then, just a quarter of the U.K's exports were services; today that proportion is approaching a half (Chart I-8) With the exception of tourism, these services tend to be high value-added financial and business services. Cutting their price will not significantly boost the demand for them. Chart I-8Almost Half Of U.K. Exports Are Services Meanwhile, U.K. consumers will feel distinctly poorer as the sterling prices of food and energy rise (Chart I-9), squeezing real household incomes and spending. In turn, this will leave the Bank of England with a major headache. How best to support real spending: defend the plunging pound to keep a lid on food and energy prices, or cut interest rates? Chart I-9Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Investment Reductionism For U.K. Assets The charts throughout this report show that the strategy for many U.K. investments reduces to an overriding question. Will the U.K largely retain access to the single market, defining a soft Brexit? Or will the U.K. largely lose access to the single market, defining a hard Brexit? In a soft Brexit: Sterling would rally 10%, taking pound/dollar to 1.35. The Eurostoxx600 and S&P500 would outperform the FTSE100. Within U.K. equities, sterling earners would outperform dollar earners, favouring small and mid-cap over large cap. The FTSE250 would outperform the FTSE100. The heavily domestic-focused retailers, travel and leisure, and real estate sectors would outperform the market. Goods exporters, such as the apparel sector would become less competitive and underperform the market. In a hard Brexit, expect the exact opposite of the above. Pound/dollar would slump 10% to 1.10, and so on. To determine which strategy to follow, await the post-appeal Supreme Court judgement on how Article 50 must be triggered, due at the end of the year. If Article 50 requires parliamentary approval, expect a soft Brexit. If it doesn't require parliamentary approval, expect the Brexit game theory to become hard and aggressive. Right now this is a coin toss, but forced to choose, we expect events may eventually prevent a damaging hard Brexit. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* This week's trade is another commodity pair trade: long copper / short tin. 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 10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com 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. 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