Wednesday, August 30, 2017 www.hilltopsecurities.com 214.953.4000 − 800.678.3792

Key Drivers for September 2017

Foul weather, fiscal deadlines, partisan politics providing market headwinds• Hurricane Harvey response could smooth deep divides at month−end• Monetary authorities could be thwarted in their normalization path• Government shutdown odds have already receded with tides in Texas• Takeaway from Jackson Hole symposium − Yellen may be bowing out• Plunge in dollar index to 16−month lows contrasts surge in gold over $1,300• Yields en route lower, along with curve flattening ahead of October budget• Stock market paused to reflect on state of union, SP500 below 50−day m.a.• Fed still likely to launch balance sheet reduction while pausing on rate hikes• U.S. growth on firmer path, though inflation shortfall continues to needle Fed• Commodity market continued to stabilize, though crude and gasoline diverging• Japan's Q2 GDP outperformance welcome, but may not in fact be sustainable• Canada is primed for an October rate hike after GDP windfall of its own•

Navigating Noah's Dilemma

On August 30, 2017

Foul weather, looming fiscal deadlines, partisan politicsand monetary conundrums have spun together into atoxic rip tide for the financial markets hurtling fast towardsthe fall. Yet it is possible that the national crisis nowmanifested in Texas torrents will force the U.S. to bridgeits deep divides over debt ceilings, budget politics andthe like, and perhaps even tone down the polarizingrancor. If not, monetary authorities may find their urge tonormalize policy coming up against headwinds forged infresh economic and market volatility.

Like the dark clouds of Hurricane Harvey hovering overHouston, the U.S. legislative cycle stalled out inWashington on Healthcare reform by summer's end andreloaded again on tax reforms. Markets took their cuesfrom the lack of progress on promised business−friendlylegislation, however, taking on a more defensive postureas full reorganization of the White House information andcommand structure was orchestrated by chief of staffKelly. At the same time, fissures and frustrations withinthe executive branch widened, after a threat to hold thedebt ceiling hostage to funding for the border wall, inaddition to scrapping NAFTA outright rather than reformit.

House Speaker Ryan initially said that he "completelydisagreed" with tying the debt ceiling to the wall, but latersaid the White House and Congress were on the samepage. Indeed, wall funding may be a moot issue in theaftermath of Hurricane Harvey. Tax reform was a keypromise during the election and Ryan said theRepublicans will keep their word. He also confirmed thedebt limit will be increased before the ceiling is hit, stating"I know we will get this done." On tax reform, he said they

were working hard on it and expects that Congress can"walk and chew gum at the same time" as multiplelegislative components are herded through at the sametime. Ryan said he wanted a permanent reduction in taxrates, but the overhaul may have some temporaryprovisions.

White House economic advisor Gary Cohn said they arelooking to maintain the "holy trinity" of individualdeductions on mortgages, charitable donations andretirement savings, even while eliminating otherdeductions, simplifying the code and getting rid ofdeath/estate taxes. Treasury Secretary Mnuchin alsoconfirmed that he was "100% confident" that the debtceiling would be raised in September and "there is noscenario where the government won't be paying its bills."

Yet, U.S. government shutdown odds were on the riseeven before Trump threw down the gauntlet over theborder wall budget, according to an Axios.com report.Goldman initially marked them at 50/50 (35% afterHarvey), while a "top Republican source" pegged themas high as 75%. At a minimum that could well push taxreform into next year and it may well be better to get theinternal shutdown spat out of the way sooner than later,while Democrats will stonewall and let conservativesduke it out. Dallas Fed's Kaplan said that the Fed ismonitoring a potential shutdown closely, but he didn'twant to pre−judge that event and hopes to move forwardwith balance sheet reduction as scheduled, in remarksfrom Jackson Hole. Related T−bill yields have remainedelevated and continue to price in shutdown risk, whileTreasury yields have been quickly capped as theperverse scarcity/safety premium continues to prevail,especially after the latest salvos of North Korean missilesover Japan.

Debt ratings agency Fitch said the debt limit andgovernment funding will test policy makers and, if notraised in a timely manner prior to the budget expiry dateof September 30th (actual "drop dead" date likely acouple weeks later), would cause it to review the U.S.sovereign rating with potentially negative consequences.A shutdown per se would not have direct impact on theU.S. AAA status, though the political divisions wouldhighlight budgetary challenges ahead. Fiscalconservatives are likely to make support on the ceilingraise conditional on aggressive measures to reduce debt,while a "clean" limit increase may require support fromDemocrats.

An insightful J.P. Morgan Economic Research Note on"The economics of the impending fiscal battles"concluded: "When Congress returns from recess onSeptember 5th, two separate but possibly related issueswill dominate the agenda: passing a budget, andincreasing the debt ceiling. If Congress and the WhiteHouse cannot agree to a budget by the beginning ofOctober then non−essential functions of the federalgovernment will shut down. This has occurred 18 timessince the current budgeting process took effect in 1976;so, the economic effects are easier to judge. Pastexperience suggests a shutdown of a few weeks wouldhave a fairly minor impact on the macroeconomy;perhaps shaving a few tenths off Q4 annualized realGDP growth. There is no similar historical record togauge the economic impact of a failure to raise the debtceiling in a timely manner. There are several reasons tobelieve that such an outcome would present a severe

adverse shock to economic activity and one that wouldbe far worse than a federal government shutdown. We donot think this is the most likely scenario, and that isimplicit in our economic outlook which continues to seepositive economic growth over the forecast horizon."

Meanwhile, central bankers at the Jackson Holesymposium made staunch defenses of both regulatoryintegrity (Yellen) and anti−protectionism (Draghi). NeitherFed's Yellen nor ECB's Draghi revealed much on theircore competency −− monetary policy −− but chose to digin on sustaining post−crisis regulatory reforms in the faceof executive orders to dismantle rather than clean up pastattempts to reign in financial institutions. In doing so,Yellen in particular seemed to distance herself from thepossibility of heading the Fed come 2018, since herviews put her at odds with the White House. Indeed,economic advisor Gary Cohn was on top of Trump's listto replace her at the Fed helm, but was also highly criticalof Trump remarks equating protestors on both sides, butchose to take the high road and continue to be the drivingforce behind tax reform... much to the relief of the stockmarket.

Likewise, yields and equities stalled out in August, whilethe dollar index resumed its corrosive decline, with theU.S. seemingly in the midst of a yawning credibility gap.Gold managed to clear $1,300 late in the month as ahedge against the toxic political tone in DC, concernsabout the damage from Hurricane Harvey and NorthKorean brinkmanship, well up from lows of $1,204 inearly July. In contrast, the dollar index posted 16−monthlows under 92.0. The T−note yield from its peak near2.40% in July has steadily eroded to the 2.10% area bythe end of August. The S&P 500 also retreated below its50−day moving average near 2,450 for the longest periodsince mid−April, despite stock market investors'persistent willingness to suspend disbelief on businessclimate hopes. The VIX equity volatility index showedsome signs of life in August after marking lows of 8.84 inJuly, ramping over 16.0 before subsiding again. A bigshort position in volatility has been a leveraged fundfavorite for much of the year and short−covering on volmay amplify any rebounds going forward.

Fed itching to trim balance sheet

While the FOMC held rates steady in July and gave noindication just when it planned to launch the balancesheet unwind, most are leaning towards a Septemberstart. Indeed, the policy statement indicated the run−offwould begin "relatively soon," versus "this year" in theJune statement, in line with Fed Chair Yellen'ssemi−annual testimony. The Fed confirmed the economyhas been on a moderately rising growth track, while jobgains have continued to be "solid." Yet, the big catchremains inflation shortfalls, which continue to haunt thedoves, while not particularly bothering the hawks. TheFed acknowledge that core prices have "declined and arerunning below 2 percent" and will continue to bemonitored "closely."

The Fed is clearly prepping markets for a balance sheetmove this fall, even while rates are steady for now. As itindicated in the July statement − "For the time being, theCommittee is maintaining its existing policy of reinvestingprincipal payments from its holdings of agency debt andagency mortgage−backed securities in agencymortgage−backed securities and of rolling over maturing

Treasury securities at auction. The Committee expects tobegin implementing its balance sheet normalizationprogram relatively soon, provided that the economyevolves broadly as anticipated; this program is describedin the June 2017 Addendum to the Committee's PolicyNormalization Principles and Plans."

The follow−up FOMC minutes to July 25−26 meetingshowed clear reservations over the softer inflation profilethan would have been suggested by Phillips Curvemodels, however, in line with recent dovish Fedspeak.Most expected inflation to pick up over medium term, butmany saw likelihood for prices to remain soft, citingvarious factors depressing inflation, includingidiosyncratic ones. That gave many policymakers pausein terms of future rate hikes and some noted there wasroom to be "patient" of further "gradual" tightening.However, the Committee appeared quite ready to startunwinding the balance sheet in the meantime, as mostpreferred to defer the announcement to the next meetingin September. Economic growth was deemed to haveturned up after the slow Q1 pace, and moderate growthwas seen ahead, though the aftermath of HurricaneHarvey no doubt will provide yet another speed bumpbefore the rebuilding efforts kick in. For now, the AtlantaFed's Q3 GDPNow estimate is pegged at 3.4%compared to 4.0% initially, while Action Economics ispresently forecasting a rebound to 3.5% in Q3 from 3.0%in Q2 and 1.2% in Q1.

The U.S. Outlook

Inter−meeting market developments: After defyinggravity and the rising chorus of dissent in Washington,ongoing accommodative Fed policy, improving globalgrowth and a banner earnings season helped keep thestock market afloat. But it began to show some fraying atthe edges as doubts crept in about tax reform thatremains the backbone of the conservative platform, alongwith the fast−approaching debt ceiling deadline. Aftermarking a record high of 2,490 in early August, the S&P500 stalled out and briefly retreated below 2,420 beforefinding legs again, but its 2,450 50−day moving averageremains a near−term pivot. The Dow likewise posted a22,179 life high on August 8th, before probing 21,600and the NASDAQ comp also peeled back from historichighs in late−July at 6,460 to probe 6,200 beforestabilizing. The VIX equity volatility index made a coupleof feints back up through 16.0 after marking historic lowsof 8.84 in July, only to drift back below 12.0 again.

Treasury yields have adjusted lower after the FOMCremained sidelined in July, the FOMC minutes confirmedconcerns about the lack of upside follow through oninflation and the likely postponement of infrastructurespending and tax reform measures perhaps into 2018.Similarly, Bund yields have cooled off from July highsover 0.64% back down to 0.37% as ECB's Draghiattempted to put the QE tapering genie back in the bottle.Indeed, the curve has generally been on a bullishflattening tear since yields peaked in July. The 2−yearyield topped out over 1.43% then and briefly pulled backbelow 1.30%, while the 10−year yield stalled out under2.40% and subsequently retreated to 2.12% as HurricaneHarvey appeared likely to retard growth near−term. Withrespect to the curve, the 2s−10s spread narrowed fromthe +97 basis point area in July to trade inside +80 basispoints by month−end.

Inter−meeting economic trends: July nonfarm payrollsgrew 209k, versus 231k in June, and we expectpersistent payroll growth through the remainder of Q3.Forecast risk lies to the upside, as strong claims andproducer sentiment should support headline job growth.The unemployment rate is expected to hold steady fornow from 4.3% in July, before slipping to 4.2% in Q4,while the workweek oscillates between 34.4 from 34.5.Hourly earnings growth is expected to hover around the2.6% y/y area, while hours−worked continue to rise0.1%−0.2% per month.

Initial claims are expected to average 238k in Augustfrom 242k in July and 243k in June, a tightening trendthat bodes well for continued progress on the jobs front,though distortions from Hurricane Harvey remain awildcard near−term. Consumer confidence increased to122.9 in August from 120.0, and the ADP Employmentreport revealed a 237k August rise that left a hearty 223kaverage gain in 2017. Michigan sentiment rose to 97.6 inAugust from 93.4 in July. We tentatively expect Augustgrowth of −0.1% for industrial production, 0.4% forpersonal income, and a flat figure for constructionspending.

GDP grew at a 3.0% rate in Q2 after a lowly 1.2% Q1climb, and consensus forecasts are lining up around our3.5% estimate for Q3. Retail sales staged a revival fromdepressed 2017 levels, jumping 0.6% headline and 0.5%ex−autos in July, and prices should lift the August figuresas well. Inflation remains cemented below the Fed's 2%target, as the July data in particular were disappointing,and seemed to get under the Fed's skin. July PPI sank0.1% headline and core, while CPI followed up with amodest 0.1% gain for both series. That places core CPIinside +1.7% y/y, in a steady erosion from 2.2% early inthe year. Within the personal income report, core PCEprices rose only 1.4% y/y in June, same as May,descending from 1.9% in January. Hence the Fed hassome reason to be frustrated with inflation progress todate, and is really in no rush to normalize interest rates,while awaiting any blowback from instituting the winddown of QE balances perhaps starting as soon asSeptember.

Commodities turn neutral after rebound: The RJ/CRBindex continued to stabilize in and around 180.00 from itslate−June floor near 168.13, with global growth paced bythe recoveries in Asia and Europe taking hold on thedemand side of the commodity equation, even assuccessive OPEC output cut agreements on the supplyside helped create a semblance of calm despite somenon−compliance. A rebound in shale−oil drilling in theU.S. accompanied the firmer price action on WTI crudeoil, which rebounded from 52−week lows of $42.52 bbl tohighs over $50 bbl before subsiding again to the $46 bblarea on Harvey−related demand declines, even as RBOBgasoline prices surged amid lower refining capacity inTexas. With the Fed shuffling its feet on the inflationtarget heading into a likely launch of balance sheetreduction, and the ECB now mulling its own exit fromquantitative easing and negative rates, the scales shiftedback into the euro, which topped 1.2000 for a 14% YTDgain. Yet this FX surge may well provide the ECB with ayellow light on the QE exit as well. Likewise, thecredibility gap on the dollar index brought it down to16−month lows under 92.0. In contrast, gold managed torally as high as $1,325 this week compared to a summerlow of $1,204 in early July.

Is Japan's GDP Surge Sustainable?

Japan's Q2 GDP growth rate came in well aboveexpectations at 4.0%, posting a welcome sixthconsecutive quarter of expansion. A 3.7% run−up inconsumption drove the pick−up in Q2 GDP, withassistance from private investment and public spending.While impressive, the Q2 GDP windfall may not in fact besustainable. Meanwhile, the inflation backdrop remainedvery tame, as the economy slowly reflates. Theimprovement in the economy allowed the Bank of Japan(BoJ) to maintain its current accommodative policysetting, as opposed to piling yet more stimulus on top.The 4.0% leap in real Q2 GDP (q/q, saar) followed anupwardly revised 1.5% gain in Q1 (was 1.0%) and,moreover, the Q2 GDP increase was well in excess ofexpectations in the vicinity of 2.6%.

A 3.7% leap in Q2 consumption spending (q/q, saar) wasthe main driver. Spending grew 1.5% in Q1 and just 0.5%in Q4. Domestic demand surged 5.2% in Q2 (q/q, saar)after the 1.0% pace in Q1 and 0.4% clip in Q4. Totalprivate investment grew 6.0% in Q2 (q/q, saar) after a3.5% pace in Q1. Private non−residential investmentaccelerated to a 9.9% clip in Q2 (q/q, saar) on the heelsof a 3.6% growth rate in Q1. Net exports exerted a smalldrag on Q2 GDP as exports fell 1.9% in Q2 (q/q, saar)after a 8.0% gain in Q1 and 13.2% surge in Q4. A 8.8%rise was evident in Q3 of 2016, which ended a threequarter run of falling exports. Import growth was steady,rising 5.6% in Q2 after a 5.4% pace in Q1 and 5.5%growth rate in Q4. Imports had declined from Q4 of 2015to Q3 of 2016. The pick−up in imports is consistent with alaudable shift to domestic−led growth in Japan'seconomy.

Growth led by domestic demand in Q2 is presumablywelcome news for the BoJ, as it reduces some of the riskassociated with the global backdrop as the importance ofthe trade sector fades for now. The report likely puts alower bound on the BoJ's stimulus efforts, as thedomestic economy improves. Yet the GDP deflator fell0.4% y/y in Q2 after a 0.8% drop in Q1, so the BoJ'sreflation efforts still have a way to go yet before yieldingconsistent positive results. Indeed, core CPI is still wellbelow the BoJ's 2% target, growing at a 0.4% y/y pace inJune after a matching 0.4% y/y clip in May. Granted, coreCPI has moved in the desired direction this year, with theannual comparison shifting to positive territory in January(+0.1%) and accelerating to the recent 0.4% pace. CoreCPI declined or was flat on an annual basis in eachmonth of 2016, bottoming out at −0.5% y/y from July toSeptember of 2016.

Despite recent progress, Japan's economic performancein Q2 does not appear sustainable, with GDP expected toslow to a 1.5% pace in Q3. That would return GDP to the1.3−1.5% area seen from Q2 of 2016 to Q1 of this year.The 3.7% consumption growth pace, in particular, shouldprove temporary. The tepid growth rate of wages doesnot support sustaining such an elevated consumptiongrowth path. The rise in equity values from 2016 to 2017highs (roughly a 33% surge from June 2016 lows to June2017 highs) suggests a wealth effect may have played arole in driving consumption, although this explanation issubject to the usual caveats such as uneven distributionof share ownership across households. With equityvalues seemingly plateaued for now, a pick−up in wagegrowth would appear required to drive further

consumption from here. This leaves the BoJ likelyholding current monetary policy settings in place amiddownside global growth and inflation risks, as NorthKorean missiles passing overhead and safe−haven yengains add to the challenges for Japan's export sector.Hence, the BoJ will continue to support a low−for−longrate trajectory.

Bank of Canada Primed for October Hike after GDPWindfall:

Canada's real GDP growth pace is on track to accelerateto a 4.0% growth pace in Q2 (q/q, saar) following theunexpectedly firm 3.7% growth rate in Q1. A firm growthtrajectory underpins expectations for another 25 basispoint rate increase from the Bank of Canada (BoC) inOctober. But inflation remains sluggish while risk fromabroad is elevated, suggestive of a still measuredapproach to raising interest rates, despite an economythat handily outpaced the Bank's projections through themiddle of this year.

The Canadian consumer maintained a strong pace ofspending in Q2 after the sizable increase in Q1. Themonthly retail sales report revealed a gain in salesvolumes of 0.5% in June after a 1.0% increase in Mayand a 0.3% rise in April. Moreover, sales volumes haveexpanded in every month this year. Total sales volumesgrew 2.1% in Q2 (q/q, sa) after the 2.2% gain in Q1 and1.9% rise in Q4. On an annualized basis, volumes wereup 8.8% (q/q, saar) after the 8.9% pace in Q1. Hence, weproject a 4.0% growth pace (q/q, saar) for the GDPreport's consumption measure after the 4.3% surge inQ1. Consumption made a positive contribution of 2.5%Q1 GDP and another strong contribution is expected inQ2.

Looking beyond the growth data, a positive shift inCanada's terms of trade starting in Q4 of last yearunderpins the outlook for ongoing momentum in GDP.The terms of trade, as measured by the gap between theannual changes (y/y) in the GDP report's chain priceindex and the CPI, flipped to +0.6% in Q4 from the −0.7%in Q3 of 2016 that marked the eighth consecutive quarterin negative territory. An acceleration in the chain priceindex to a 3.1% y/y pace in Q1 from 2.0% in Q4 (it was+0.5% in Q3 and flat in Q2) relative to a 1.9% CPI growthrate in Q1 (was 1.4% in Q4, 1.2% in Q3 and 1.6% in Q2)furthered the pick−up in the terms of trade, leaving a gapof +1.2% between the respective price measures in Q1.While we expect the pull−back in energy prices to knockthe chain price index 0.5% lower in Q2 relative to Q1(q/q, saar), an easy annual comparison will leave a 2.8%y/y growth rate. Given that annual CPI growth slowed to1.3% in Q2, the gap will expand to +1.5% in Q2,consistent with further gains in the terms of trade,advantage Canada.

Hence, Canadian GDP is on track for a 3.0% pace thisyear, doubling the 1.5% seen in 2016. The broadertheme of upbeat growth remains supportive of a 25 basispoint rate BoC hike to 1.00% in October and follow−uprate hikes in the first half of 2018. A September rate hikecan't be ruled out, but we see the risk as limited givenongoing uncertainties surrounding the global backdrop,and perhaps more importantly the U.S. outlook. Thetrade outlook, in particular, remains a big question markas the market gauges the extent to which the Trumpadministration's disparaging NAFTA comments are trade

negotiation posturing or a credible threat to abolish thetreaty. An October rate hike (as opposed to September)would support the view that the upward path of rates willbe gradual. We project two more rate hikes in the firsthalf of next year, leaving the policy setting at 1.50%.

This publication, including the content and any attachments, is not, and should not, be construed as a recommendation or solicitation to buy or sell anysecurity, futures contract, option on futures, or any other financial instrument mentioned in it. This publication has been prepared either from publicly availableinformation or is based on the opinions of the author. Information contained in this document is believed to be reliable but may not have been independentlyverified. Neither Hilltop Securities Inc. nor Action Economics, LLC guaranties, represents or warrants, or accepts any responsibility or liability as to, the

accuracy, completeness or appropriateness of the information contained in this document. Information contained herein may not be current due to, amongother things, changes in the financial markets or economic environment. Opinions reflected in the materials are subject to change without notice. Pastperformance should not be taken as an indication or guarantee of future performance. Forecasts of future performance represent estimates; actualperformance may vary. This document does not constitute, and should not be used as a substitute for, tax, legal or investment advice. If you have anyquestions about this publication, please contact your investment representative.

Copyright © 2017 Action Economics, LLC. All Rights Reserved.