Developed Countries

Highlights Monetary Policy: The Fed's inflation forecast will continue to guide interest rate policy. This means that while an announcement about winding down the balance sheet will occur in September, a December rate hike is only in the cards if inflation shows some strength in the coming months. Fiscal Policy: The market is likely too pessimistic on the potential for fiscal stimulus from tax cuts, especially given the recent shift in power within the White House. Corporate Spread Valuation: With the exception of Aaa-rated credits (which appear expensive), investment grade corporate spreads are fairly valued after adjusting for changes in credit rating, duration and the stage of the cycle. Investors should expect to earn excess returns from corporate bonds consistent with carry on a 6-12 month horizon. Feature Several developments during the past two weeks provided a lot of information about the near-term outlooks for both monetary and fiscal policy. On the monetary front, the minutes from the July FOMC meeting elucidated the trade-off faced by the Fed between low inflation on one hand and easing financial conditions on the other. Then, at last week's Jackson Hole symposium, both Janet Yellen and Mario Draghi expounded on the topic of financial stability and how central bankers incorporate it into their frameworks. On the fiscal front, the dismissal of White House Chief Strategist Stephen Bannon has the potential to alter the Trump administration's legislative agenda for the remainder of the year, making fiscal stimulus more likely. In this week's report we reflect on how all of these developments impact our 6-12 month policy and market views. Monetary Policy From The Minutes: Low Inflation Vs. Easy Financial Conditions The minutes from the July FOMC meeting showed that "some participants [...] argued against additional adjustments until incoming information confirmed that the recent low readings on inflation were not likely to persist." Meanwhile, "some other participants were more worried about the risks arising from [...] the easing in financial conditions that had developed since the Committee's policy normalization process was initiated in December 2015." In other words, the Committee is roughly evenly split into two groups. Those that would rather delay rate hikes until inflation moves higher, and those that think easier financial conditions are reason enough to continue tightening. Those in the dovish group could point to Chart 1 for support. That chart shows that the real fed funds rate is approaching at least one popular estimate of its neutral level. In the Fed's mental framework it is crucial that the real fed funds rate stays below its neutral level because monetary policy must remain accommodative if inflation is to rise back to the 2% target. In other words, the Fed does not have "room" for further rate hikes unless inflation rises first, causing the real fed funds rate to fall. We won't re-hash prior arguments about why core inflation is likely to rise on a 6-12 month horizon,1 but we will note that our diffusion indexes for both PCE and CPI inflation have recently swung into positive territory. These indexes have strong track records capturing the near-term moves in year-over-year core inflation (Chart 2), and this development gives us some confidence that the downtrend in inflation will soon reverse. Chart 1Closing In On Neutral Chart 2A Positive Signal On Inflation While the dovish camp wants to see strength in core inflation before delivering another hike, the hawkish camp views the easing of financial conditions as sufficient to forecast stronger growth and higher inflation in the near future. This view is backed by some solid empirical evidence. Chart 3 shows one measure of financial conditions - the financial conditions component of our Fed Monitor.2 This index performs reasonably well predicting near-term swings in GDP, and at the moment it suggests that growth will accelerate further in the back half of the year. This "financial conditions approach" to policymaking suggests that monetary policy impacts financial markets and that financial market performance then translates into economic outcomes. From this perspective, the fact that financial conditions have continued to ease since the Fed started tightening in December 2015 means that, so far, monetary tightening has not had any impact cooling the economy (Chart 4). Chart 3Financial Conditions##br## Lead Growth Chart 4Financial Conditions Easier, ##br##Despite Fed Tightening To us, this is the crucial point about the arguments made by the hawkish camp. This group focuses on financial conditions because it believes that easier financial conditions will soon lead to stronger growth and higher inflation. The group is not making the case that the Fed should abandon its 2% inflation target because of concerns about stability in financial markets. From Jackson Hole: Financial Conditions Vs. Financial Stability The focus on financial stability at Jackson Hole led many commentators to forecast that the Fed might tighten due to concerns about excessive leverage and risk-taking in financial markets, ignoring progress toward its inflation target.3 We think this is incorrect, and would draw an important distinction between when central bankers talk about "financial conditions" and when they talk about "financial stability". While the two concepts are obviously similar, central bankers tend to focus on financial conditions as a leading indicator for the economy. It is not separate from the 2% inflation target, rather, it is an input to the Fed's growth and inflation forecasts. However, when central bankers talk about financial stability, they are typically referring to an assessment of the amount of risk-taking and leverage in financial markets. If the risk-taking and leverage in financial markets is deemed excessive, it could pose a downside risk to future growth. Currently, central bankers in general do not believe that there is an imminent threat from financial stability. But more importantly, no current prominent central banker has proposed tightening policy to deal with financial stability risks while disregarding the inflation target. Here is what Janet Yellen had to say on the topic at Jackson Hole: I expect that the evolution of the financial system in response to global economic forces, technology, and, yes, regulation will result sooner or later in the all-too-familiar risks of excessive optimism, leverage, and maturity transformation reemerging in new ways that require policy responses. And Mario Draghi: [W]hen monetary policy is accommodative, lax regulation runs the risk of stoking financial imbalances. By contrast, the stronger regulatory regime that we have now has enabled economies to endure a long period of low interest rates without any significant side-effects on financial stability[.] The above passages make a couple of points abundantly clear: Neither central banker views financial stability as currently posing an economic risk. The preferred method for dealing with this risk, if it were to arise in the future, would be through macroprudential regulation. That is, regulations that limit leverage and maturity transformation. In fact, Draghi plainly said that a robust regulatory regime is important because it allows central banks to use interest rate policy to manage inflation back to target. Janet Yellen also pointed out in her remarks that financial stability risks in the future will almost certainly emerge in "new ways". This makes these risks much more difficult to detect in real time. Meanwhile, it is comparatively easy for Fed policymakers to look at inflation and judge it relative to the 2% target. This is yet another reason why interest rate policy will continue to be guided by inflationary pressures in the economy, not concerns about financial stability. Put differently, if inflation does not reach the Fed's 2% target before the next recession, that would be an easily quantifiable policy failure. This is an outcome that Fed policymakers will seek to avoid at all costs. Bottom Line: The Fed's inflation forecast will continue to guide interest rate policy. This means that while an announcement about winding down the balance sheet will occur in September, a December rate hike is only in the cards if inflation shows some strength in the coming months. Financial conditions are an important input to the Fed's growth and inflation forecasts, but the Fed will not tighten policy due to concerns about financial stability alone. Fiscal Policy Judging from the performance of a high tax-rate basket of U.S. stocks, investors appear to have completely priced out any possibility of tax reform (Chart 5). This is likely a mistake. Tax reform is a major component of both President Trump's and congressional Republicans' agendas. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Chart 5Too Complacent On Tax Cuts? Further, as was recently discussed in depth by our Geopolitical Strategy service,4 until recently the White House had been divided into two cliques. The "Goldman clique", led by National Economic Council Director Gary Cohn, is pragmatic and un-ideological. It is focused on passing tax reform and pro-business regulation. In contrast, the "Breitbart clique" is populist and nationalist. It also leans to the left on economic matters. The recent removal of White House Chief Strategist (and Breitbart clique leader) Stephen Bannon signals a shift in power toward the Goldman clique. Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross are now firmly in charge of economic policy. Meanwhile, three generals are now in charge of foreign and national policy: Defense Secretary James Mattis, National Security Advisor H.R. McMaster, and Chief of Staff John F. Kelly. Between the six of them, and Secretary of State Rex Tillerson, there is not a drop of populism left in the White House. This likely points to an increased resolve to push through some sort of tax legislation. While the size of any tax cut is still very much in question, given how little is priced in, it will not take much to move the needle on financial markets. Bottom Line: The market is likely too pessimistic on the potential for fiscal stimulus from tax cuts, especially given the recent shift in power within the White House. Corporate Spread Valuation How expensive are corporate bonds compared to history? On its face, a simple question. But one that quickly gets complicated when we dig into the details. Case in point, the top panel of Chart 6 shows the average option-adjusted spread (OAS) on the Bloomberg Barclays Investment Grade Corporate Bond Index going back to 1990. A cursory glance at this chart shows that the OAS is somewhat below its historical average, but also that it has been tighter in the past. But this simple visual obscures a few important factors: The average credit quality of the index has worsened since the financial crisis (Chart 6, panel 2). All else equal, this means the average spread should be wider. The average duration of the index has risen over time as bond yields have fallen (Chart 6, panel). This means that the same change in spreads has a larger return impact today than in years past. The stage of the credit/monetary policy cycle is also important. In the top panel of Chart 6 we see that the OAS does not spend a lot of time near its long-run average. Rather, it tends to be very wide in the negative phases of the cycle and very tight in the positive phases. In past reports we have considered the performance of corporate bonds across the four phases of the Fed cycle (Chart 7). To recap, these phases are defined as follows: Chart 6Corporate Spreads Need To Be Adjusted Chart 7Stylized Fed Cycle Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first rate hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium (or neutral) level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. In phases I and IV, we can expect tight spreads and relatively strong excess returns from corporate bonds. Phases II and III are characterized by wider spreads and lower returns. At the moment we judge that we are firmly in phase I of the cycle. The Fed has begun to tighten policy, but by all accounts monetary conditions remain accommodative and the real fed funds rate is below its neutral level (Chart 6, bottom panel).5 Adjusting Corporate Spreads On the first necessary adjustment, we can easily adjust for differences in average credit rating by looking at the different credit tiers of the corporate bond index rather than the index as a whole. As for the second necessary adjustment, we adjust for changes in duration over time by using a 12-month breakeven spread instead of the OAS. The 12-month breakeven spread is defined as the spread widening (in basis points) required over a 12-month period before the given corporate bond index delivers a negative excess return relative to duration-matched Treasuries. It thus includes both the OAS and the impact of lower duration.6 Chart 8 shows 12-month breakeven spreads for each investment grade corporate bond credit tier alongside its historical average and +/- one standard deviation. In each case we observe that breakeven spreads are well below average. In fact, the breakeven spread makes corporate bonds appear slightly more expensive than does the OAS. The final adjustment we need to make is to consider current spreads relative to other similar phases of the Fed cycle. In Chart 9 we show OAS for each credit tier, with dashed lines denoting the historical average, minimum and maximum OAS seen during prior Phase I periods. Adjusting only for credit rating and the stage of cycle (not for changes in duration), we find that Aaa, Aa and A-rated credits appear quite cheap, while Baa-rated credits appear close to fair value. In Chart 10 we show 12-month breakeven spreads for each credit tier relative to other similar phases of the Fed cycle. In other words, the spreads here are adjusted for credit rating, duration and the stage of the cycle. This chart tells a somewhat different story. Here, Aaa-rated credits appear very expensive. Meanwhile, Aa, A and Baa-rated credits appear close to fairly valued. Chart 8Breakeven Spreads Versus Long-Run Average Chart 9Cycle-Adjusted OAS Chart 10Cycle-Adjusted Breakeven Spreads Bottom Line: With the exception of Aaa-rated credits (which appear expensive), investment grade corporate spreads are fairly valued after adjusting for changes in credit rating, duration and the stage of the cycle. Investors should expect to earn excess returns from corporate bonds consistent with carry on a 6-12 month horizon. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 2 For more details on the Fed monitor, please see U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com 3 https://www.bloomberg.com/news/articles/2017-08-25/el-erian-says-markets-too-sanguine-about-fed-view-on-instability 4 Please see Geopolitical Strategy Weekly Report, "The Wrath Of Cohn", dated July 26, 2017, available at gps.bcaresearch.com 5 As was stated earlier in this report, the gap between the real fed funds rate and its neutral level will widen as inflation bounces back in the coming months. 6 For simplicity we assume no convexity impact on excess returns. The 12-month breakeven spread is then calculated as OAS divided by duration. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Yellen sidesteps monetary policy at Jackson Hole. The Fed raised rates in late 1990s before seeing any inflation. Tax cut deal is still likely... ..but a prolonged debt ceiling battle or government shutdown is not. Inflation surprise has not yet followed economic surprise higher. Earnings and earnings guidance matters more than politics. Feature Fed Chair Yellen's speech on financial stability at the Jackson Hole symposium on Friday, August 25 shed little light on the timing of the central bank's next policy move. Some investors were fearing that Yellen would give a nod to the hawks in her speech. Yellen did no such thing. She simply noted "that the core reforms we have put in place have substantially boosted resilience without unduly limiting credit availability or economic growth". Yellen made no comments to suggest that monetary policy needs to tighten in order to reduce financial froth and foster greater stability. Financial stability1 matters to the Fed almost as much as maintaining low and stable inflation, and full employment. In this week's report, we discuss the FOMC's deliberations when the economy was at full employment in the late 1990s, and note that the Fed was willing to raise rates even before inflation accelerated. Gary Cohn, a potential replacement for Yellen, suggested in an interview last week that tax cut legislation is on the way. We agree and discuss below. The economic surprise index is rebounding, but that has not yet led to positive surprises on inflation as it has in the past. We also examine what history says about earnings guidance, U.S. equities and the stock-to-bond ratios during and after earnings reporting season. Fed Deliberations At Full Employment Chart 1The Fed And Inflation At Full Employment Minutes from FOMC meetings in the late 1990s are instructive in understanding the central bank's reaction function due to a lack of inflation as the economy moves beyond full employment (Chart 1). The Fed cut rates following the LTCM financial crisis in late 1998 and subsequently held the fed funds rate at 4¾% until June 1999. Core inflation was roughly flat during the on-hold period, even as the unemployment rate steadily declined and various measures pointed to significant labor market tightness. The FOMC discussion in the late 1990s of why inflation was still quiescent sounds very familiar. Policymakers pointed to the widespread inability of firms to raise prices because of strong competitive pressures in domestic and global markets. In the Fed's view, significant cost-saving efforts and new technologies also contributed to the low inflation environment for both consumer prices and wages. Moreover, rapid increases in imports and a drawdown in the pool of available workers was also seen as satisfying growing demand and avoiding upward pressure on inflation. One difference from today is that productivity growth was solid at that time. The FOMC decided to hike rates in June 1999 by a quarter point, despite any indication that inflation had turned up. Policymakers described the tightening as "a small preemptive move... (that) would provide a degree of insurance against worsening inflation later". The Fed went on to lift the fed funds rate to 6½% by May 2000. Interestingly, the unemployment rate in June 1999 was 4.3%, the same as the current rate. There are undoubtedly important differences in today's macro backdrop. The Fed is also more fearful of making a policy mistake in the aftermath of the Great Recession and financial crisis. Nonetheless, the point is that the Fed has faced a similar low inflation / tight labor market environment before. Question marks regarding the structural headwinds to inflation will remain in place, but it will not take much of a rise in core inflation in the coming months for the Fed to deliver the next rate hike (most likely in December). Any fiscal stimulus, were it to occur, would reinforce the FOMC's bias to normalize interest rates. Is All Lost For U.S. Tax Cuts? Although tax reform was a major component of President Trump's legislative agenda, investors are skeptical that any fiscal stimulus or tax cuts will succeed (Chart 2). In our view, there is a high probability that at least a modest package will be passed. The reason is that, if it fails, Republicans will return empty-handed to their home districts to campaign for the November 2018 mid-term elections. Historically, Republican Presidents who have low approval ratings ahead of mid-term elections tend to lose a larger number of seats to Democrats (Chart 3). Chart 2Market Has Priced Out Trump's Economic Agenda Chart 3GOP Is Running Out Of Time Now that the border adjustment tax is officially dead, the GOP must either significantly moderate its tax cuts or add to the deficit. BCA's geopolitical strategists argue that regardless of which bill is passed by the GOP, the legislation will expire after a "budget window" of around 10 years.2 Tax cut plans ultimately will be watered down, but even a modest cut would be positive for the equity market. The dollar should also receive a boost, especially given that the Fed would have to respond to any fiscally driven growth impulse with higher interest rates. We expect Trump to ensure that the Fed retains its dovish bias when Chair Janet Yellen's term expires on February 3, 2018. He may favor a non-economist and a loyal adviser, such as Gary Cohn, over any of the more traditional and hawkish Republican candidates. Cohn could not single-handedly affect the course of monetary policy. The FOMC votes on rate changes, but decisions are formed by consensus (with one or two dissents). Cohn could implement an abrupt change in policy in the unlikely event that the Administration stacks the Fed Governors with appointees that are prepared to "toe the line." (The Administration does not appoint Regional Fed Presidents). Stacking the Governorships would take time. The FOMC has been very cautious in tightening policy and we do not see Trump taking an active role in monetary policy. The bottom line is that Cohn's possible appointment to the Fed Chair would not signal a major shift in monetary policy. Raising The Debt Ceiling Recent fights over Obamacare and tax reform have pitted fiscally conservative Republicans against moderates, with the debt ceiling used as a bargaining chip in the battles. While government shutdowns have occurred in the past, the debt ceiling has never been breached. At the end of the day, the debt ceiling will always be raised because government could not withstand the public pressure. Democrats can't be blamed because the Republicans control both chambers of Congress and the White House. Even the Freedom Caucus, the most fiscally conservative grouping in the House, is divided on the issue. This augurs well for a clean bill to raise the debt ceiling because the Republican majority in the House is 22 and the Freedom Caucus has 31 members. Democrats will not stand in the way of passage in the Senate. The worst-case scenario for the market would be a two-week shutdown, between October 1 when the current funding for the government will expire, and mid-October when the CBO predicts that the debt ceiling will be reached. Odds of such a scenario are probably around 25%. We would not expect a shutdown to have any lasting impact on the economy, although it could provide an excuse for the equity market to correct. The good news is that at least the economy is cooperating. Economic Surprise Versus Inflation Surprise Economic expectations are now low enough for the still-tepid activity data to beat, but this trend has not yet spilled over into the inflation data. Elevated economic expectations post-election led to a four-month period (early March-mid June) when the Citi Economic surprise index rolled over3 (Chart 4). In mid-July, the data began to top washed-out expectations and the surprise index accelerated. In the past two months, readings across a wide spectrum of economic indicators (consumer and business sentiment, consumer spending, home prices, manufacturing sentiment, and employment) have outpaced lowered expectations. Even so, inflation readings continue to disappoint relative to forecasts. Chart 4Inflation Surprise Usually Follows Economic Surprise Higher... But Not This Time After briefly moving above zero in early 2017 - indicating that inflation data was stronger than analysts projected- the Citi inflation surprise index rolled over again (Chart 4, bottom panel). Reports on the CPI, PPI, and average hourly earnings continued to fall short of consensus forecasts. This despite the rebound in the economic surprise index and the tightening of labor and product markets. The disappointment on price data relative to consensus forecasts is not new. Although there were brief periods where prices exceeded forecasts in 2010 and 2011, the last time that inflation exceeded market consensus in this business cycle was in late 2009 and early 2010. In the last few years of the 2001-2007 economic expansion through early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Moreover, the disconnect between economic surprise and inflation surprise has never been wider, but the inflation surprise index should follow the economic surprise index upward. In the past 13 years, there have been 15 periods when economic surprise has climbed after a trough. The inflation surprise index has temporarily increased in 13 of those episodes. For example, in the aftermath of the oil price peak in the U.S. in mid-2014, both economic surprise and inflation surprise diminished through early 2015 and then began moving up. However, today's inflation surprise index has rolled over while economic surprise has gained, but remember that inflation is a lagging indicator.4 Asset class performance since the economic surprise index formed a bottom in mid-June has run counter to history as risk assets have underperformed (Table 1). Returns on the S&P 500 have lagged Treasuries since the June 14 trough, driving down the stocks-to-bond ratio. U.S. large cap equities have outperformed Treasuries by an average of 290 basis points in the 11 prior episodes in this expansion as economic surprise climbed. Similarly, both high yield and investment-grade corporate bond returns have lagged Treasuries since mid-June. During previous episodes when the surprise index was climbing, credit outperformed Treasuries. Small caps have also lagged large caps, which is counter to the historical pattern, although oil and gold have both gained since the trough in economic surprise. The evidence is mixed for these two commodities after a bottom in economic surprise. Table 1Performance Of Risk Assets As Economic Surprise Rises BCA's view5 is that a Fed-led recession will begin in 2019. Nonetheless, markets were concerned about a recession occurring this year as the economic data underwhelmed in the first part of the year. Despite market fears, reliable leading indicators of a recession such as the LEI, the yield curve and the 26-week change in claims, are not signaling a recession (Chart 5). BCA does not expect the buildup of the types of imbalances that led to economic downturns in the past. Instead, a recession may be triggered by a Fed policy mistake, or a terrorist attack that disrupts economic activity over large area for an extended time, or a widespread natural disaster. Chart 5Data Suggest Low Odds Of A##BR##Recession In Next 12 Months Bottom Line: There are few imbalances in the economy and a recession in the U.S. is more than a year away. Although risk assets have not outperformed as is typical after a trough in economic surprise, we anticipate that stocks will beat bonds in the next 12-18 months. Inflation will surprise to the upside in the coming months, pressuring the Fed and the bond market. Stay short duration. Is Trump To Blame For The Stalled Stock Market Rally? Corporate earnings, not politics, drive equity prices. The S&P 500 has retreated from its all-time highs in early August despite another terrific earnings reporting season.6 Investors are concerned that Trump's erratic presidency may be to blame, but we take a different view Since the start of the economic expansion, the S&P 500 rose in 83% of the periods when large U.S. corporations provide results for the prior quarter and guidance on subsequent periods. (Table 2, bottom panel) U.S. equities increased only 66% of the time when managements were silent on profitability and future prospects (Table 3, bottom panel). However, there are periods when exogenous events like the 2011 U.S. debt downgrade and the 2015 Chinese devaluation that can disrupt the normal pattern, and we have excluded those from our calculations. Nevertheless, with the Q2 earnings reporting season over, the odds are less favorable for a rising U.S. equity market in the next few months. Table 2S&P 500, Stock-Bond-Ratio And Guidance During Earnings Season Table 3S&P 500, Stock-Bond-Ratio And Guidance Outside Of Earnings Season The stock-to-bond ratio also fares better during earnings season than during corporate quiet periods, and moves higher more often. When companies report profits, the stock-to-bond ratio increases 73% (Table 2, bottom panel) of the time versus just 65% outside of earnings season (Table 3, bottom panel). Since the start of 2010, the median return for the stock-to-bonds ratio is 0.046% per day during reporting season (Table 2, top panel) and 0.037% when it is not earnings season (Table 3, top panel). The implication is that the stock-to-bond ratio over the next two months may move higher, and at a faster rate than it did during the just completed Q2 earnings reporting season. Counter-intuitively, earnings guidance increases more often outside of earnings season (90% of the time and 0.04% per day, Table 3) than during it (77% of the time and 0.019% per day, Table 2). The top panels of Tables 3 and 2 respectively also show that the median daily return on stocks is higher outside of earnings reporting season (0.074% per day) than it is as earnings are being reported (0.054% per day). This is also somewhat counter-intuitive, as over the long term, earnings trends drive stock prices. We intend to examine the shorter term relationship between stock prices, the stocks to bond ratio and earnings guidance in a future Weekly Report. Bottom Line: The path of corporate earnings and not politics, ultimately drive stock prices. In the past eight years, the stocks to bond ratio during earnings season rises more and more often than when there was no new information on earnings. We remain upbeat on the earnings outlook for at least the remainder of this year, which will help the equity market weather the ongoing turbulence emanating from Washington. Next year, the earnings backdrop will not be as supportive. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", dated July 24, 2017. It is available at usis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "Is The Trump Put Over" dated August 23, 2017. It is available at gps.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration", published July 17, 2017. It is available at usis.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?," August 18, 2017. It is available at gis.bcaresearch.com. 5 Please see BCA's Global Investment Strategy Weekly Report, "The Timing Of The Next Recession" published June 16, 2017. It is available at gis.bcaresearch.com. 6 Please see BCA's U.S. Investment Strategy Weekly Report, "The Stage Is Set For Jackson Hole", August 21, 2017. It is available at usis.bcaresearch.com.

Cisco Systems, the communications equipment index heavyweight, reported tough quarterly results that highlighted the issues continuing to strain the industry. Revenues have continued to fall as telecom carriers, the key customer group, remain engaged in a deflationary price war (second panel) which has been exacerbated by U.S. federal government spending uncertainty; management guided to more of the same next quarter. Encouragingly, margins have improved despite sliding sales, evidence of solid cost control. This should (eventually) result in outsized profits when revenues turn the corner. On that front, telecom services providers have made significant progress in slowing the rate of decline in sales (third panel). Still, inventories & production have been diverging in an unhealthy direction (bottom panel) which could herald a liquidation phase, rendering the progress on margins unsustainable. We think the risks to profitability, combined with ongoing top line shrinkage, will keep investors away. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV.

Highlights Mario Draghi will signal the ECB's intention to further taper asset purchases during his Jackson Hole address later today, while cautioning that rate hikes remain a way away. The spread between long-term U.S. and euro area bond yields is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area. The upswing in Japanese growth is unlikely to prompt the BoJ to abandon its yield- curve targeting regime. Japanese stocks are cheap and corporate profits are rebounding smartly. Stay overweight Japanese equities in currency-hedged terms for the next 12 months. As one looks further ahead to the next decade, Japanese inflation will likely break out as labor shortages intensify. This will be part of a broad-based increase in global inflation. Stay long Japanese inflation protection and go short 20-year JGBs relative to their 5-year counterparts. Feature Mario Draghi: Action Jackson, The Sequel? Mario Draghi made shockwaves the last time he spoke at Jackson Hole on August 22, 2014. Draghi used that occasion to lay out the case for additional monetary easing. This paved the way for the ECB's own QE program. From that fateful speech to March 2015, EUR/USD fell from 1.33 to 1.05. Three years later, investors are anxious to hear what Draghi has to say, but this time around the expectation is that he will discuss plans for winding down QE. We agree that Draghi will signal the ECB's intent to further taper asset purchases. Growth is currently strong and the risk of a euro area breakup has all but disappeared. Nevertheless, although he may not publicly admit it, Draghi is cognizant of the fact that euro area financial conditions have tightened on the back of a strong euro, while U.S. financial conditions have continued to ease (Chart 1). Mario Draghi also knows that both inflation and wage growth remain depressed across the euro area, and that labor market slack outside Germany is still 6.7 percentage points higher than in 2008 (Chart 2). In addition, Draghi is undoubtedly aware of the likelihood that the neutral rate of interest is extremely low in the euro area, implying that the ECB would be constrained in raising rates even if the region were close to full employment.1 The spread between the 30-year U.S. Treasury yield and the 30-year GDP-weighted euro area bond yield - a reasonable proxy for the market's estimate of the difference in neutral rates between the two regions - currently stands at 86 basis points in nominal terms and 56 basis points in real terms. This is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area (Chart 3).2 Chart 1Diverging Financial Conditions Favor U.S. Over The Euro Area Chart 2Draghi Is Paying Attention Chart 3The State Of Fiscal Policy In The G4 We expect EUR/USD to pare back its gains, dropping to $1.05 by the end of 2018. However, most of the dollar's rebound is likely to occur next year, when it becomes apparent that the U.S. unemployment rate will fall well below the Fed's 2018 projection of 4.2%. This will force the Fed to step up the pace of rate hikes. For the time being, we see EUR/USD fluctuating within a broad range of $1.10-to-$1.20. BoJ: Time To Remove The Sake Bowl? Could the Bank of Japan follow in the Fed's and ECB's footsteps by signaling the desire to slowly withdraw monetary accommodation? On the surface, there are certainly some reasons to think so. Japanese growth has picked up recently, with real GDP rising at a blistering annualized pace of 4% in the second quarter (Chart 4). The acceleration in growth was driven entirely by stronger domestic demand. Consumer spending increased by 3.7%, while private nonresidential investment jumped by 9.9%. Inflation appears to be bottoming. The national core CPI index, which excludes fresh food prices but includes energy costs, rose for the seventh straight month in June to 0.4% on a year-over-year basis. Corporate goods inflation has reached 2.6%, up from a low of -4.6% in May 2016. Corporate service inflation moved to 0.8% this spring, the highest rate since 1993 (Chart 5). Nominal wage growth has also accelerated. Our Wage Trend Indicator, which uses statistical techniques applied to three separate data series to extract the underlying trend in Japanese wages, is now close to its 2007 highs (Chart 6). Chart 4GDP Growth Has Perked Up In Japan Chart 5Corporate Pricing Power Has Improved Chart 6Japanese Wages Are In An Uptrend The recovery in Japanese wage growth has occurred alongside a tightening of the labor market. The latest Economy Watchers Survey featured a litany of companies complaining of worsening labor shortages (Table 1). This is confirmed by the job openings-to-applicants ratio, which has surged to the highest level since 1974 (Chart 7). Table 1Japan: Evidence Of Shortages Of Workers, Part I Chart 7Japan: Evidence Of Shortages Of Workers, Part II Easy Does It, Kuroda-san Despite the good news on the economy, it is highly unlikely that the Bank of Japan will abandon its ultra-accommodative stance any time soon. There are a number of reasons for this: While inflation is rising, it is coming off a very low base, and is nowhere near the BoJ's 2% target. A deflationary mindset also remains firmly entrenched, as highlighted by both survey data and market expectations (Chart 8). Much of the recent pickup in inflation is attributable to higher energy prices and the lagged effects of a weaker yen. Excluding energy prices, core inflation has barely risen. The increase in corporate goods prices has also closely tracked the price of imports. Considering that the trade-weighted yen has appreciated of late, it is reasonable to assume that import price inflation will dissipate. This spring's annual shunto wage negotiations yielded smaller wage hikes among large companies than in 2016. This suggests that further near-term gains in wages will be hard to come by. Fiscal policy may turn less accommodative. The government passed a supplementary budget last summer (worth 1.5% of GDP according to the IMF). The effects of this package are being felt now. Public fixed investment surged by 21.9% in Q2. Under current law, however, fiscal policy is set to turn contractionary again over the next few years. Leading economic indicators are pointing to a modest slowdown in growth over the coming months (Chart 9). Chart 8Deflationary Mindset Has Been Hard To Shake Off Chart 9LEIs Pointing To Modest Slowdown The BoJ is not the same central bank that it was five years ago. The last two hawkish dissenters, Takehiro Sato and Takehide Kiuchi, both stepped down in July when their terms expired. They were replaced by Goshi Kataoka and Hitoshi Suzuki, neither of whom are expected to oppose Governor Haruhiko Kuroda's dovish approach. As such, it is highly likely that the BoJ will continue to anchor the 10-year yield at close to zero for at least the next 12 months. If bond yields elsewhere rise over this period - as we expect will be the case - the yen will weaken. Good News For Japanese Stocks... For Now A weaker yen is, of course, good news for Japanese stocks. Japanese equities are currently trading at a 16% discount to the MSCI World index based on forward earnings (Chart 10). Moreover, unlike in the past, both earnings and dividend growth have been strong, averaging 19% and 9%, respectively, over the last five years (Chart 11). Corporate governance reform - a key element of Abenomics - can take some credit for this. The share of companies with at least two independent directors rose from 18% in 2013 to 78% in 2016. The number of companies with performance-linked pay increased from 640 to 941, while the number that publish disclosure policies jumped from 679 to 1055. Analysts have been slow to factor in these positive developments. Chart 12 shows that Japan leads all other major stock markets in positive earnings surprises in the second quarter. We remain overweight Japanese equities in currency-hedged terms. Chart 10Good Value In Japanese Stocks Chart 11Solid Earnings And Dividend Growth Chart 12Japan And Positive Earnings Revisions: Follow The Leader . The Longer-Term Outlook: Japan (Eventually) Escapes Deflation As we discussed last week, it is likely that the U.S. will fall into recession in 2019 or 2020, dragging the rest of the world down with it.3 As a risk-off currency, the yen will strengthen, potentially reigniting deflationary forces. This will make it impossible for the BoJ to abandon its yield-curve targeting regime. Does that mean that Japan is condemned to a never-ending cycle of reflation/deflation? Not necessarily. As one looks at a longer-term horizon of 5-to-10 years, it is likely that Japan will finally escape deflation. This is because many of the structural forces that have sustained deflation will have either receded or reversed course by then. The simultaneous bursting of Japan's real estate and stock market bubbles in the early 1990s ushered in a prolonged period of falling property prices and corporate deleveraging. This suppressed both household consumption and business investment, leading to a persistent shortfall in aggregate demand. The latest data suggests that property prices are bottoming and corporate balance sheets have finally improved to the point where further aggressive cost-cutting is no longer necessary (Chart 13). Demographic trends are also likely to fuel higher inflation over the long haul. The deceleration in population growth in the early 1990s reduced the need for everything from new homes to new cars, shopping malls, and factories. This weighed on business capex and consumer durable spending, thereby exacerbating the deflationary forces that were already in place. In addition, a surge in the share of the population in their peak saving years - ages 30 to 50 - led to an increase in desired savings throughout the economy. More savings means less spending, so this also contributed to deflation. Looking out, population growth will remain anemic. However, two important developments will occur. First, the biggest cohort of Japanese baby boomers - those born in 1947-52 - will hit 70, the age at which most Japanese workers retire. Second, the secular rise in female labor force participation will plateau. Chart 14 shows that a larger percentage of Japanese women between the ages of 25 and 54 are employed than in the U.S., a massive shift from 20 years ago. Both these changes will exacerbate labor shortages, while further reducing national savings. Chart 13Deflationary Headwinds Are Abating Chart 14Female Employment In Japan Has Surpassed The U.S. Concluding Thoughts Contrary to popular belief, the Phillips curve remains intact, even in Japan (Chart 15). The market is not at all prepared for the prospect of higher Japanese inflation, as evidenced by the fact that CPI swaps are pricing in inflation of only 0.5% over the next two decades. As inflation picks up in the 2020s, nominal GDP will rise (even if real GDP growth remains anemic due to a shrinking labor force). The Bank of Japan will keep nominal rates low during the first half of the 2020s, ensuring that real rates sink further into negative territory. This will be the way by which Japan reduces its debt burden. Older savers may not like it, but the alternative of pension and health care cuts will be seen as even worse. We are currently long Japanese inflation protection through the CPI swaps market. As of today, we are adding a new long-term trade recommendation: Go short 20-year JGBs relative to their 5-year counterparts. The potential upside from this trade easily compensates for the negative carry of 66 bps. An upswing in Japanese inflation in the 2020s is very much in line with our secular view that global inflation will trend higher over the long haul, as articulated in a recent report.4 This will have a profound impact on fixed-income markets. While Japan's demographic transition has been and will continue to be more extreme than elsewhere, population aging is something that will affect all major economies. Chart 15Japan's Phillips Curve Is Alive And Well Chart 16Demographic Shifts: From Highly Deflationary To Highly Inflationary Chart 16 shows the IMF's estimate of how projected changes in the age structure of the population will affect inflation over the next few decades. The Fund's calculations suggest that demographic shifts will go from being very deflationary to very inflationary in every major economy. This will translate into significantly higher long-term nominal bond yields. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Future Of The Neutral Rate," dated August 4, 2017. 2 We calculate this number by taking the difference between the structural primary budget balance in the euro area (roughly 1.5% of GDP) and the U.S. (roughly -2.5% of GDP). The claim that this will translate into 4% more in aggregate demand in the U.S. implicitly assumes a fiscal multiplier of one. A larger multiplier would generate an even bigger gap in demand. 3 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?" dated August 18, 2017. 4 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Feature Dear client, This week we are publishing a brief Special Report highlighting ten charts that have captured our attention, charts we would like to emphasize before the summer lull ends. We will not be sending a report next week, but we will be resuming our regular publishing schedule on September 8, 2017. Warm regards, Mathieu Savary With both the Manufacturing Council and the Strategy and Policy Forum disbanded, markets have lost faith in the capacity of the Trump administration to pass on any meaningful tax reforms or tax cuts. However, as Chart 1 shows, the imperative for Republicans in Congress to do so before the 2018 mid-term election is in fact growing by the minute: The unpopularity of Donald Trump is becoming a major handicap for the GOP in Congress and the post-Charlottesville debacle is only making matters worse. Legislative action needs to materialize to compensate for this hurdle. The tax cuts or reforms ultimately passed are not likely to be what the administration envisage and are likely to be emanating from Congress itself and not the White House. This situation should also give Republicans an incentive to avoid an unpopular government shutdown around the debt ceiling negotiations, but we expect uncertainty around this question to remain elevated as rhetoric flairs up, which could potentially put our long USD/JPY position at risk. Chart 1If Tax Cuts Don't Pass, Republicans Are Heading For A Huge Defeat In 2018 While automation has received a lot of press, one of the key factors that keeps weighing on inflation on a structural basis is the continuation of a 30-year process: The entry of China and other key emerging markets into the global economy, which has massively expanded global aggregate supply relative to aggregate demand. Through the 1980s and 1990s, this expansion in supply mostly reflected the addition of billions of potential workers to the global labor force. However, as Chart 2 illustrates, since the turn of the millennium, the supply-side expansion has mostly taken the form of a massive increase in the EM and Chinese capital stock, which has lifted the global capital stock. As a result, this has created excess capacity for the world as a whole, which is keeping a lid on prices. As long as China keeps a very high savings rate, global demand is likely to remain inadequate relative to global supply, structurally limiting the upside to global inflation. Chart 2Global Excess Capacity While the structural anchor on inflation remains, this does not mean that cycles in prices are dead. In fact, from a cyclical perspective, U.S. core inflation is likely to bottom and slowly inch higher in the second half of 2017. Inflation remains a lagging indicator of the business cycle. Supported by very easy financial conditions, growth has regained some vigor while the U.S. is now at full employment. Additionally, as Chart 3 illustrates, the U.S. velocity of money has once again picked up, a reliable leading indicator of core inflation over the past 20 years. This supports our thesis that this year's downleg in the dollar is long in the tooth: A stabilization and uptick in inflation could force markets to push up the number of interest rates hikes anticipated from the Federal Reserve. Chart 3Cyclical Inflation Dynamics In 2015, the Chinese economy was losing speed at an accelerating pace. Beijing began to panic and pulled out all the stops to put a floor under growth: Fiscal spending increased at an incredible 25% annual pace by the end of 2015 and credit growth was encouraged. While the fiscal stimulus is long past, the Chinese credit impulse has continued to support economic activity, investment, construction, and imports. However, the People's Bank of China has begun engineering a tightening in monetary conditions and is slowly but surely putting the brakes on the expansion of off-balance sheet instruments in the Chinese financial system. As a result, the amount of financing raised by smaller Chinese financial institutions is decelerating. Historically, without this source of liquidity, total debt growth has tended to slow, adversely impacting the credit impulse (Chart 4). This is likely to weigh on investment and construction, thus negatively affecting the dollar-bloc currencies. Chart 4Key Risk To Chinese Credit Growth The euro has rallied violently this year. Some of this strength has been a reflection of the euro's nature as the anti-dollar. As investors began doubting the capacity of the Fed to stick to its plan of hiking interest rates to 2.9% by the end of 2019, and as political paralysis took over the U.S., the greenback suffered, lifting the euro in the process. In sharp contrast, the European economy and inflation picked up and political risk in continental Europe receded, adding fuel to the fire. Today, buying the euro has become the epitome of the "consensus trade," with investors massively long the common currency. However, while a pickup in U.S. inflation will be required to expect a full reversal of this trade, a correction in the euro is a growing risk: The EUR/USD's fractal dimension - a measure of groupthink - has hit 1.25, a level that in the past has warned of a potential countertrend move (Chart 5). Chart 5Correction In The Euro Betting on the yen remains the FX analogue to betting on bonds. JGB yields display a low beta to global government bond yields; thus, when global rates go up, interest rate differentials move against the yen. The opposite is true when global yields fall. The downside to the yen when global rates rise has now been supercharged by the yield cap implemented by the Bank of Japan, as JGB yields are now prohibited from rising when global bond yields rise. BCA's view is that U.S. bond yields should rise over the next 12 months, which will should prompt a period of pronounced weakness in the JPY. But what if a rise in bond yields causes an EM selloff - wouldn't this help the yen? As Chart 6 illustrates, the correlation between USD/JPY and bond yields is, in fact, stronger than that with stocks. In other words, the pain in EM has to become acute enough to cause bond yields to fall before the yen can rally. This means there is a window of opportunity to short the yen when bond yields rise even if EM assets depreciate. Chart 6The Yen Is A Play On Bonds Dollar-bloc currencies (CAD, AUD and NZD) tend to be prime beneficiaries of expanding global liquidity. This is because in an environment where global liquidity expands, the U.S. dollar weakens and commodity prices strengthen. Moreover, when global liquidity is plentiful, risk-taking and carry trades are emboldened, creating inflows of funds and liquidity into EM nations, which in turn, boosts their economic prospects. This also pushes up the expected returns of assets in the dollar-bloc countries, and thus incentivizes global investors to purchase the AUD, the CAD, and the NZD. This means that historically, the performance of dollar-bloc currencies has been tightly linked to the expansions in global central bank reserves - a good measure of global liquidity growth. This time around, dollar-bloc currencies have massively outperformed the growth in global reserves, leaving them vulnerable to any slowdown in global liquidity (Chart 7). Chart 7Dollar-Bloc Currencies Have Overshot Global Liquidity While commodity currencies are all likely to face headwinds over the course of the next 12 months, all dollar-bloc currencies are not created equal. The AUD looks much more vulnerable than the CAD. First, the AUD is trading at a 10.7% premium vis-à-vis its long-term fair value, while the CAD is only slightly expensive. Second, Canadian terms of trade are governed by dynamics in energy prices, its main commodity export, while Australian export prices are a function of base metal prices. BCA's Commodity And Energy Strategy service is currently more positive on energy prices than it is on industrial metals. The energy market is undergoing an important curtailment of supply that will lead to further drawdowns in oil inventories. Meanwhile, the supplies of metal are not as well controlled as those of energy, and China's desire to slow real estate speculation should weigh on construction activity in the Middle Kingdom. Finally, as Chart 8 illustrates, AUD/CAD rarely diverges from AUD/USD, but right now, AUD/CAD is trading at a large premium to AUD/USD. This means shorting AUD/CAD could be a nice way to benefit from a weakening in dollar-bloc currencies while limiting the direct exposure to aggregate commodity-price dynamics. Chart 8AUD/CAD Is A Short The Swedish economy has been strong and the output gap now stands at 1.26% of GDP. Yet, despite this positive backdrop, the Riksbank is keeping in place one of the easiest monetary policies in the world, with nominal policy rates standing at -0.5% and real rates at a stunning -2.6%. It is no wonder that the SEK trades at a 6.4% discount to its PPP fair value against the euro. Now, two developments warrant selling EUR/SEK. First, Stefan Ingves, the extremely dovish president of the Swedish central, is leaving the institution at the end of this year. While his replacement has yet to be announced, it will be difficult to find someone more dovish than him to take the helm of the oldest central bank in the world. Second, not only has Sweden inflation picked up violently, the Riksbank's resource utilization indicator continues to shoot up, pointing to a further acceleration in inflation (Chart 9). As a result, we expect the Swedish central bank to be the next one to join the Fed and the Bank of Canada in tightening policy, which will give additional support for the Swedish krona, especially against the euro. Chart 9The Riksbank Will Hike Soon EUR/NOK has rarely traded above current levels over the course of the last decade. It has only done so when Brent prices have fallen below US$40/bbl (Chart 10). BCA's base case is that oil is more likely to finish the year between US$50 and US$60 than it is to trade below US$40. With EUR/NOK trading 13% over its PPP fair value, and with Norway still sporting a current account surplus of 6% of GDP, even if the Norwegian economy continues to exhibit rather low inflation readings, there is a greater likelihood that EUR/NOK depreciates from current levels than appreciates. We thus recommend investors short this cross over the remainder of 2017. Chart 10If Brent Doesn't Fall Below , EUR/NOK Is A Short Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Neutral Wal-Mart's (WMT) second quarter earnings provided some insight into a retail landscape that is in the midst of upheaval at the hands of Amazon. While a still-strong consumer (second panel) helped drive a 1.8% same-store sales increase, the real story was the 60% surge in online sales. The retail giant's acquisition of jet.com (and a host of smaller sites) and the recent partnering with Google Home to deliver an Alexa-like offering are clear signals that WMT is committed to the online path; the third panel suggests they have little choice. An increasing share of online sales will dilute margins for two reasons: first, with the visibility and comparability of online shopping, the spike in sales will be biased towards the most heavily discounted items, driving an erosion of gross margins. Second, the online platforms are still being built up, with significant overhead expenses that will impact operating margins. Both of these impacts were evident in the second quarter. Net, while WMT looks reasonably strong gearing up for a fight with Amazon from a sales perspective, profitability is the clear loser in the near term. We prefer to sit on the sidelines until margins can stage a recovery (which may take considerable time); stay neutral. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST.

Highlights Your portfolio cash weighting should be at least in the middle of its range, until the observed volatility of risk assets rises meaningfully from its record low. Cyclically add long SEK/USD to long EUR/USD. Within a European equity portfolio, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Go underweight Swedish real estate equities; overweight Spanish real estate equities. Within a global equity portfolio, overweight euro area banks versus U.S. banks. Feature Great expectations for Mario Draghi's appearance at the Jackson Hole Symposium have been dampened, and understandably so. After the last monetary policy meeting, Draghi emphasised that ECB discussions about policy direction would take place in the autumn. It would undermine this decision making process if Draghi's Jackson Hole speech front ran the ECB discussions. Nonetheless, twitchy markets will inevitably read the tone of Draghi's observations on the global and euro area economies. Chart of the WeekSwedish House Prices Are Up 50% In Just Four Years...Thanks To Negative Interest Rates But the more market-relevant presentation might come five hours earlier on Friday at 3pm London time, when Janet Yellen gives a keynote speech on the market's latest meme - financial stability. Three months ago in Madrid, Draghi delivered a keynote speech1 on the very same topic - The interaction between monetary policy and financial stability - available here https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp170524_1.en.html and well worth reading as a prelude to Yellen's presentation. Draghi explained that ultra-accommodative monetary policy endangers financial stability through three potential channels: Distorting investor behaviour. Generating credit-fuelled bubbles, especially in real estate. Squeezing bank profitability. Do any of these three channels give ground for concern today? Yes. Distorting Investor Behaviour In our view, central banks' distortive impact on investor behaviour is the single biggest source of financial instability today. Yet Draghi devoted only a cursory mention of this danger, noting that investors "could be prone to engage in search-for-yield behaviour and take on excessive risks." The difficulty is that the psychological and behavioural finance biases creating the current distortions lie outside central bankers' natural area of expertise. Nevertheless, we hope that Yellen develops this topic much further at Jackson Hole. Specifically, the behavioural finance distortion known as Mental Accounting Bias describes the irrational distinction between the part of an investment's return that comes from its income, and the part that comes from its capital growth. Rationally, people should not care about this distinction because the money that comes from income and the money that comes from capital growth is perfectly fungible.2 But in practice, many people want a minimum investment income - because they wish to match their known spending outlays with their known income. While they could meet their spending needs by crystalizing capital growth, many people create psychologically separate 'mental accounts': spending from investment income and saving from capital growth. This is especially true for retirees whose main or only income might come from accumulated assets. Traditionally, this psychological mental accounting bias would be unnoticeable because investors could easily match their spending needs with the safe income generated by cash and government bonds. But in recent years, central banks' extended experiments with zero and negative interest rates and QE have forced the 'income mental account' to chase the higher but much more risky income streams from high-yield bonds and equities (Chart I-2 and Chart I-3). To the point where these risk assets no longer offer a sufficient risk premium. Chart I-2A Positive Yield On Equities Can Produce##br## A Negative 5-Year Return... Chart I-3...And Even A Negative##br## 10-Year Return The search-for-yield pushed up the prices of these risk assets. Now add to the mix the phenomenon known as negative skew.3 Risk asset advances tend to be gradual and gentle, and the longer and more established the advance becomes, the lower the observed volatility goes. Some investors then mistakenly interpret lower observed volatility as justification for a lower risk premium, which warrants a further price advance. And so on, in a self-reinforcing feedback. Today, this has left us with a bizarre and unprecedented situation in which the observed volatility of the Eurostoxx50 equity index is a fraction of the observed volatility of the long-dated German bund! (Chart I-4) Chart I-4Unprecedented: The Observed Volatility Of The Eurostoxx50 ##br## Is Now Lower Than That On The German Bund! But given the strong inverse relationship between observed volatility and price, record low observed volatility categorically does not mean that prospective risk of a drawdown is low. Quite the reverse, the lower the observed volatility, the higher the prospective risk. And vice-versa. Investment bottom line: Your portfolio cash weighting should always be inversely proportional to the observed volatility of risk assets. Today, with observed volatility still near a record low, your cash weighting should be at least in the middle of its range. Generating Credit-Fuelled Bubbles... In Sweden Turning to the second channel of financial instability, the ECB sees no evidence of credit-fuelled bubbles. Banks are extending credit, but at a fraction of the rate seen prior to 2007 (Chart I-5). And although house prices are rising, the ECB claims that its ultra-accommodative monetary policy has not created imbalances in real estate markets in the euro area. Taken at face value, this claim might be true. Chart I-5Euro Area Banks Are Extending Credit... But At A Modest Rate But look across the Baltic Sea. Chart I-6Swedish House Prices Accelerated##br## After ZIRP And NIRP Sweden's Riksbank has had to shadow the ECB's ultra-loose policy, to prevent a sharp appreciation of the Swedish krona versus the euro. The trouble is that negative interest rates have been wholly inappropriate for an economy that has recently been growing at 4.5%. One worrying consequence is that Swedish house prices have gone up by 50% in just four years (Chart of the Week), with the bulk of the boom happening after ZIRP and NIRP (Chart I-6). Also, bear in mind that the Swedish real estate market did not suffer a meaningful setback in either 2008 or 2011, meaning the recent boom is not a corrective rebound - like say, in Spain and Ireland. So the ECB's ultra-loose policy may indeed have generated a credit-fuelled bubble... albeit in Sweden! Fortunately, as the ECB ends its ultra-accommodation, it will also liberate the Riksbank to end its incongruous and dangerous NIRP policy. Investment bottom line: Cyclically add long SEK/USD to long EUR/USD. For European equity investors, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Also, go underweight Swedish real estate equities which are now approaching peak price-to-book multiples (Chart I-7). Prefer to overweight Spanish real estate equities which offer much more attractive valuations (Chart I-8). Chart I-7Swedish Real Estate Equities ##br##Are Close To Peak Valuation Chart I-8Spanish Real Estate Equities ##br##Offer Better Value Squeezing Bank Profitability For the third channel of financial instability, the ECB concedes that ultra-loose monetary policy compresses banks' net interest margins and thus exerts pressure on their profitability. "Since banks carry out maturity transformation by borrowing short and lending long-term, both the slope of the yield curve and its level matter for profitability." In turn, lower retained profits means lower accumulation of capital, making banks more fragile. The evidence strongly supports this logic. Since the start of the ECB's asset-purchase program, euro area bank valuations - a good proxy for profitability - have formed a perfect mirror-image of the expected intensity of QE (Chart I-9). Chart I-9Bank Valuations Have Been A Mirror-Image Of QE It follows that as the ECB dials back accommodation, the valuations of euro area banks will continue to recover - at the very least, in relative terms versus banks elsewhere in the world. Investment bottom line: Global equity investors should stay overweight euro area banks versus U.S. banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 At the First Conference on Financial Stability, May 24 207. 2 Assuming the tax treatment of income and capital growth is equal. 3 Please see the European Investment Strategy Weekly Report titled 'Negative Skew: A Ticking Time-Bomb' dated July 27, 2017 available at eis.bcaresearch.com Fractal Trading Model* We are monitoring the Italian stock Tenaris which is approaching a point of being technically oversold. We are also monitoring a commodity pair-trade, short nickel / long silver which is also approaching a potential entry point in the coming days. But we have not yet opened either trade. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Highlights Social unrest and populism are on a secular rise in the U.S.; However, the "Breitbart clique" has suffered a critical defeat in the current Administration; This will make headway for upcoming tax legislation and resolution of the debt ceiling imbroglio; We continue to stress that domestic politics will not hurt U.S. equities, but more downside to USD may exist this year; India-China military tensions are not strategic or market relevant, yet. Feature "Most Americans do not find themselves actually alienated from their fellow Americans or truly fearful if the other party wins power. Unlike in Bosnia, Northern Ireland or Rwanda, competition for power in the U.S. remains largely a debate between people who can work together once the election is over." - Newt Gingrich, January 2, 2001 This is the second time we have begun a report with this classic Gingrich quote from 2001, which now seems to come from a different era. On November 9, 2016 we used it to open our election post-mortem in which we argued that American party identifications were ossifying into tribal markers that could cause run-of-the-mill polarization to mutate into something scarier.1 Chart 1 shows that party identification (Republicans vs. Democrats) is now responsible for the greatest difference in attitudes towards 48 values, something historically determined by race and education. Over the long term, these trends are concerning and may spur further social unrest in the U.S. As we wrote in June, the gulf between America's patricians and plebeians has never been as wide as it is now. It is being complemented by a gulf in ideology and worldview.2 Part of the problem is that migration from the traditionally liberal-leaning coastal America as well as the Great Lakes region have significantly altered the demographic makeup of the American South (Chart 2). The combination of pro-business regulation, low taxes, sunshine, affordable real estate, southern charm, and excellent higher-education institutions has been difficult to resist.3 Thus, an influx of young and educated migrants has altered the political makeup of many traditionally conservative states. There are many cities - much like Charlottesville, Virginia - where these recent migrants will come into conflict with the values and traditions of the south. Chart 1Rise Of A Tribal America Chart 2Internal Migration Is A Risk... Given America's history of internal population movements, these patterns of migration should not be a problem. However, today's polarization is extreme (Chart 3), and it is deepening thanks to radically different information and media streams made available by cable television and especially the Internet (Chart 4). Chart 3... In A Polarized Context... Chart 4... Where 'Fake News' Proliferates What does all of this mean for investors? America is geopolitically very well endowed. It has benign neighbors, strong demographics, and almost all the natural resources it needs. However, hegemons are not born out of plenty, but rather out of need and want. The U.K. built a global empire largely because its rain-drenched island lacked basic materials for superpower status. Spain and Portugal discovered new worlds because stronger empires barred lucrative trading routes. Geography does not preordain hegemony. Strong domestic institutions, luck, and guts and glory do. The USD remains weak despite the fact that the Fed was the first major central bank to start hiking this cycle and despite strong economic data out of the U.S. relative to the rest of the world (Chart 5). Perhaps investors have caught the whiff of something rotten in the American Empire? If so, we may be seeing the beginning of a major USD bear market. Chart 5USD Should Be Outperforming In The Current Global Macro Context BCA's Foreign Exchange Strategy sees the current DXY weakness as temporary. We agree, given that the current trajectory of BCA's ECB months-to-hike measure is discounting way too much hawkishness (Chart 6). The dollar index will likely rally in 2018 as inflation data improves and risks in Europe (Italian election) and Asia (Chinese structural reforms) deepen. Chart 6The ECB Hawkishness Is Overstated The scope and pace of the 2018 USD rally, however, will depend on whether investors have confidence in America's economy and institutions. If the Republican tax reform agenda stalls later this year, and if social unrest continues, sovereign and long-term investors may begin to think about diversifying away from the dollar. The "Trump Put" Continues We do not expect domestic politics to play a role in an equity correction. At least not yet. First, investors seem to be completely discounting any possibility of tax reform judging by the performance of the high tax-rate basket (Chart 7). This is likely a mistake. Tax reform is a major component of both Trump's and congressional Republicans' agenda. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Second, the market fell 1.58% after President Trump's combative press conference on August 15. The move was not a reprimand for Trump's rhetoric, but concern that Gary Cohn, the scion of the "Goldman clique" and likely the next Fed Chair, would resign over the comments.4 These concerns have now been allayed by the firing of Stephen Bannon, the White House Chief Strategist and leader of the "Breitbart clique." Bannon's departure puts Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross firmly in charge of economic policy. Meanwhile, three generals are now in charge of foreign and national policy: Defense Secretary James Mattis, National Security Advisor H.R. McMaster, and Chief of Staff John F. Kelly. Between the six of them, and Secretary of State Rex Tillerson, there is not a drop of populism left in the White House. Chart 7What Tax Reform? Although nationalists and populists may be on the retreat, it is still not clear what form tax legislation will take. The only thing that has certainly changed since earlier this year is that the border adjustment tax is officially dead, which would have raised ~$1 trillion in revenue over ten years.5 This requires the GOP either to moderate its tax cuts by the same amount, or to add more to the deficit, which, according to legislative rules, would make the cuts temporary. It is likely at this point that whatever bill the GOP passes, it will expire after a "budget window" of around ten years. The divergence between the White House and Congress remains the same: the White House wants gigantic tax cuts, while Congress wants tax reform, i.e. to broaden the tax base and reduce inefficiencies and distortions. The White House would blow out the budget deficit by more than would the House GOP. There are two key questions that investors want to know from the upcoming tax legislation. First, how significant will the fiscal thrust be? This will determine the impact to the economy and hence will affect the Federal Reserve's response. The GOP Plan: Both the White House and the House GOP claim that they will reduce the budget deficit over the next ten years despite cutting taxes. They project an average budget deficit of 1.3%-1.4% from 2018-2027, down from a 3%-4% baseline. This projection is rationalized via expectations of faster economic growth as well as "dynamic scoring" to capture the macroeconomic feedback of the tax cuts. The White House and GOP claim that economic feedback will reduce the deficit by $1.5-$2 trillion over the ten-year budget window, which is 26%-37% of the total deficit reduction they are proposing (i.e., likely very optimistic).6 The Tax Policy Center Response: Outside analysis of the budget plan argues the opposite. The Tax Policy Center argues that the White House plan, insofar as the details are known, would add a minimum of $3.4 trillion to the deficit over the next ten years, and that the macroeconomic feedback could even be negative (i.e., add to the deficits). The deficit would rise from 3.2% of GDP to 6.4% by 2026, if we factor in the Congressional Budget Office assumptions that a 4% real growth rate leads to a GDP of $26.9 trillion in 2026.7 The GOP Retort: Republicans claim they will reduce the deficit by means of proposed "revenue offsets," or savings measures, over the ten-year period. The Tax Policy Center highlights the following in particular: $1.6 trillion from repealing personal exemptions; $1.5 trillion from abolishing all itemized deductions (other than the politically sensitive mortgage interest deduction and charity deduction); $622 billion from treating some income from pass-through businesses as dividends; $272 billion from repealing corporate tax breaks; $208 billion from repealing the "head of household" status for tax filers; $49 billion from taxing capital gains upon death (above the $5 million threshold). The total is $4.3 trillion in savings, against $7.8 trillion of losses, for a total deficit that is increased by $3.4 trillion over the ten years. This would amount to around $340 billion of "stimulus" each year, with the biggest thrust felt in 2018-19. We very much doubt that the White House will achieve this slate of proposals. It has not shown an inkling of the ability to coordinate such a difficult legislative feat. Therefore, we expect the tax legislation to be watered down. The budget deficit may rise to something closer to 6%, over the next ten years, than to the gigantic 12% of GDP implied by Trump's proposals on the campaign trail (Chart 8). Chart 8Question Of The Year: Will Tax Reform Be Stimulative? The second question asked by investors is about the impact of tax legislation on assets. It is clearly positive for inflation and growth given that even tepid tax cuts will provide economic stimulus when unemployment is already very low. Our colleagues at BCA already believe, without a tax bill, that inflation is likely to surprise to the upside in 2018-19.8 Fiscal stimulus via tax cuts would obviously add to that. The equity market will cheer any promising developments on tax cuts or reform, especially given that so little is currently priced in. However, whether the USD rallies as it did on hopes of tax legislation earlier this year will largely depend on how the Fed reacts to the legislation. There is a lot of uncertainty, particularly if President Trump decides to go with Gary Cohn as the next Fed chair. Bottom Line: Congressional Republicans cannot gamble with tax legislation. The failure to cut taxes, or reform the tax code, would be a major policy misstep ahead of the midterm elections. If legislation passes, we expect that Congress will have had greater control over the plan than the White House, reducing the eventual magnitude of the tax cut and the fiscal stimulus. Congress controls the purse strings and will reassert that authority in the context of an ineffective executive. Should You Care About The Debt Ceiling? Clients are beginning to fret about the upcoming debt ceiling fight. There is good reason to be nervous. The Republican-held Congress has failed to pass legislation, notably on this year's priority item, Obamacare. The last thing Republicans want is to shut down the government or cause a technical default entirely of their own doing! Clients should note that while government shutdowns have occurred in the past, the debt ceiling has never been breached. This is because the debt ceiling is an anachronism. In other countries, when a budget is passed it automatically contains the implicit authority to issue whatever debt is required to finance the resulting deficit.9 To require separate legislation for a budget and an authorized level of debt is a product of politics and has little bearing on the actual financing needs of the U.S. government. At the end of the day, the debt ceiling will almost inevitably be raised in the U.S. because no government could stand the popular pressure that would result from social security checks not being mailed out to seniors (who vote!) or a halt to other entitlement programs. Only a disastrous chain of events resulting from polarization and brinkmanship, even worse than in the Obama years, would lead to such an outcome. Today, given that Republicans control both chambers of Congress and the White House, there is no way for the Republicans to share the blame with the Democrats, as they did under Obama. Investors are therefore mistaking the game-theoretical paradigm: It is not a "game of chicken," but rather a cooperative game given that Republicans in Congress are largely on the same side. Members of the GOP are starting to "get it," including the fiscally conservative House Freedom Caucus. David Schweikert, influential member of the Freedom Caucus who sits on the House Ways and Means Committee, said last week that he is in favor of a clean bill to raise the debt ceiling. Mark Meadows, North Carolina representative who chairs the group, has also said that he is "bullish" on raising the debt limit, although he added that he preferred to attach some reforms to the bill. On August 2, he said "Either that will get done [some spending cuts attached to the debt ceiling bill] or a clean debt ceiling will get done. We will raise the debt ceiling and there shouldn't be any fear of that." Other members of the Caucus, including its founder Jim Jordan of Ohio, have retorted that no debt limit hike without spending cuts should be contemplated, prompting the media to focus on the brinkmanship. But we note that the Freedom Caucus, the most fiscally conservative grouping in the House, is itself considerably divided on the issue. This augurs well for a clean bill since the Republican majority in the House is 22 and the Freedom Caucus has 31 members. If Schweikert and Meadows are indicative of how the group will vote, the fiscal conservatives may not have enough votes to deprive the GOP of a majority. (The latter would force GOP moderates to go to the Democrats for votes, complicating the negotiations and increasing the risk of mistakes.) What about the Democrats in the Senate? To pass a clean bill on the debt ceiling, Republicans would need at least eight Democrat Senators to get to 60 votes, and probably more given that Rand Paul (R-Kentucky) would likely vote against a clean bill. We doubt that Democrats would remain united in voting against a clean bill. It would allow President Trump and Republicans in Congress to accuse them of hypocrisy and holding U.S. credit hostage, much as Democrats did to Republicans between 2011-2016. As such, the market's fear that Democrats could play the spoiler is a red herring. While some grassroots activists in the Democratic Party are sure to want a confrontation, its median voters tend to be educated and well-informed. The worst-case scenario for the market would be a two-week shutdown, between October 1, when the current funding for the government expires, and sometime in mid-October when the debt ceiling is hit, according to the Congressional Budget Office. Odds of such a scenario are probably around 25%. But the contingent probability of a debt ceiling failure following a government shutdown would be reduced, not increased, given that it would focus public attention on Republican incompetence. In other words, if a shutdown occurs on October 1, we would expect the odds of a debt ceiling crisis to be reduced. Finally, our assessment that the "Goldman Sachs clique" has reasserted control over White House economic policy should also be positive for the likelihood of a clean debt ceiling bill. While we have no evidence that Stephen Bannon was in favor of using the debt ceiling for fiscal cuts (given his opposition to government spending cuts in toto), he did say following his resignation that Trump would be "moderated" by remaining White House staffers. He went on to say "I think he'll sign a clean debt ceiling; I think you'll see all this stuff." The only remaining holdover in the White House on the debt ceiling issue is the Office of Management and Budget Director Mick Mulvaney. Mulvaney has suggested earlier in the year that Republicans should try to tie spending restraint to a debt ceiling bill. However, at a meeting between President Trump and GOP leaders in early June, President Trump said that congressional leaders should take Steven Mnuchin's position as the White House position. "Mnuching is that guy," Trump told party leaders at the meeting, according to GOP sources who spoke to Politico in the summer. Mulvaney's office has also confirmed that the Treasury Department "has point on the debt ceiling," i.e., that Mnuchin is in charge. Bottom Line: Concern over the debt ceiling is natural, given the failure of Republican-held Congress to pass any legislation of note this year. However, it is also overstated. The U.S. government would default on its obligations to its voters, first and foremost. Such a scenario - given Republican control of all branches of government - would put the final nail in the coffin of the Republican-held Congress ahead of the midterm elections. Fade any fear of a U.S. default. Will India And China Fight A War? Clients, particularly in China, have shown considerable concern about geopolitical conflict between China and India. Since early June, a border dispute between China and India has flared up in the Doklam region. Doklam, or rather the India-China-Bhutan border region, is one of three main border disputes in the Himalayas that flare-up from time to time - along with Kashmir and Arunachal Pradesh. The 1962 border war between the two Asian behemoths over the latter two areas marked the biggest flare in recent memory. Today, India is fearful of China's growing military and logistical capabilities and concerned about the long-term security of the Siliguri Corridor, the narrow stretch of land connecting the subcontinent to the Northeast (Map 1). Control of the Doklam Plateau and Chumbi Valley would give China access to Siliguri; they are therefore important areas to monitor.10 India is also threatened by China's improving bilateral relations with neighbors like Pakistan,Bangladesh, Sri Lanka, Nepal, and potentially Bhutan. The latter does not have formal relations with China, has always been under India's sphere of influence, and is at the center of the current dispute. And ultimately, India fears that China seeks to create an economic corridor through Bangladesh to the Indian Ocean, which would, in combination with the Pakistan corridor, surround India. Map 1Too Close For Comfort: Tensions Threaten India's Control Over Vital Siliguri Corridor The current dispute ostensibly began - as many do - with contested infrastructure construction. India built some bunkers at a forward outpost in Lalten in 2012; China allegedly bulldozed them on June 6-8 of this year. The same month, Indian troops confronted Chinese troops building a road along the border with Bhutan that would have connected an existing road to a People's Liberation Army outpost and to the border crossing of Doka La. While the territorial dispute is old, China is expanding its pressure tactics on Bhutan, while India has sent troops into disputed Sino-Bhutanese territory in a more assertive defense of Bhutan. Broadly, China is making inroads with infrastructure as it develops its far-flung western regions and seeks to improve connectivity with neighbors via the One Belt One Road (OBOR) initiative. China is capital-rich and can afford to improve its access to regions of strategic value that yield access to key Indian territories or supply water and hydropower to India. India is capital-poor and downstream, so its ability to respond is often limited to military gestures. India also wants to retain its dominance over Bhutanese foreign policy, in place since 1949 and especially 1960, and this dispute is marked by India taking an active military role on Bhutanese territory on Bhutan's behalf. There are several reasons we do not expect this conflict to be market-relevant. First, the Himalayas are isolated and poor, so that China or India would have to make a very dramatic move that poses a genuine strategic threat (e.g., to the Siliguri Corridor, or Chinese control of Tibet, or Indian relations with Pakistan, or Indian water sources) to trigger a larger conflict. Second, while it is true that nationalism is flaring up on both sides, China has a clear interest in pursuing some "rallying around the flag" strategy amid the standoff over North Korea, and ahead of the Communist Party's nineteenth National Party Congress. That it chose to do so in Doklam, where conflict is more easily contained than in the Koreas or the East or South China Seas, suggests that political opportunism and China's desire to make incremental gains, rather than a sweeping Chinese plan to seize strategic territory, is driving the current episode. Meanwhile, India needs to attract capital to build its manufacturing base, and Prime Minister Narendra Modi has reached out to China for this reason. India will undoubtedly defend its strategic interests if attacked, but otherwise it is not eager to clash with China, which has bulked up its military far more than India has done in recent decades. Chart 9India Would Bolster Containment Of China However, we do see India-China relations as fitting into the larger, negative geopolitical dynamic where the U.S. and its allies encourage India as a balance to China, while China suspects the U.S. alliance of using India and others to encircle and entrap China (Chart 9). Not that the U.S. stirred up the current dispute, but that the U.S. (and Japan) will generally seek to improve relations with India and to strengthen its military and economy, and China will use its regional influence to try to keep India off balance.11 This structural dynamic, in addition to China's territorial assertiveness, is likely to keep generating frictions. Bottom Line: A conflict between India and China is only market-relevant if it extends beyond disputed territories in the Himalayas to affect core strategic interests like the Siliguri Corridor, Tibetan stability, the Indo-Pakistani balance of power, or water supply and hydropower. It could also become market-relevant by worsening U.S.-China relations - and delaying Chinese economic reforms - if China should come to feel embattled on all geopolitical fronts. For instance, should an adventurous, "lame duck" Donald Trump attempt to combine with India and other neighbors in ways that threaten to cause problems in China's western regions as well as in its East Asian periphery. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 3 Hook 'em Horns! 4 We recently argued that the White House is torn between two groups, the "Goldman" and the "Breitbart" cliques. The Goldman clique is led by Gary Cohn, Director of the National Economic Council and is pragmatic, un-ideological, and focused on passing tax reform and pro-business regulation. The Breitbart clique is populist, nationalist, and leans to the left on economic matters. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 6 Please see Congressional Budget Office, "An Update to the Budget and Economic Outlook: 2017 to 2027," June 2017, available at www.cbo.gov and U.S. Office of Management and Budget, "Budget of the U.S. Government: A New Foundation For American Greatness, Fiscal Year 2018," available at www.whitehouse.gov. 7 Please see the Tax Policy Center, "The Implications Of What We Know And Don't Know About President Trump's Tax Plan," July 12, 2017, and Benjamin R. Page, "Dynamic Analysis of the House GOP Tax Plan: An Update," June 30, 2017, available at www.taxpolicycenter.org. Using White House growth assumptions of 4.7% would lead to a deficit of 5.7% in 2026. 8 Please see BCA U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long," dated August 8, 2017, and U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com. 9 Denmark also has a debt ceiling, but it has set it so high that it does not need to be addressed. 10 Please see Sudha Ramachandran, "Bhutan's Relations With China And India," Jamestown Foundation, China Brief (17:6), April 20, 2017, available at Jamestown.org. 11 In fact, Japan already waded into the India-China dispute. The Japanese ambassador to India issued a statement critical of China, which the Chinese Foreign Ministry immediately rebuked.

Macro conditions are ripe to initiate a market neutral trade: long materials/short utilities. This trade provides exposure to the budding shift in underlying portfolio strength away from defensives toward cyclicals1 and also from domestic to global-exposed market areas. The balance of macro evidence is skewing increasingly toward robust manufacturing growth at home and abroad. The ISM manufacturing and global PMI indexes have maintained their recent gains, signaling that the path of least resistance for the relative share price ratio is higher (top panel). Synchronized global growth suggests that a relative earnings-led recovery will buttress this pair trade higher. The second and third panels highlight different ways of depicting coordinated EM and DM economic growth, giving us confidence that materials profits will outshine utilities EPS. The depreciating U.S. dollar is also a boon for commodity prices in general and base metals prices in particular. While natural gas prices are the marginal price setter for utilities pricing power, they represent an input feedstock cost to chemicals producers that dominate the materials sector. Taken together, a relative pricing power proxy suggests that materials stocks have the upper hand (bottom panel). Bottom Line: Initiate a long S&P materials/short S&P utilities pair trade. 1 For a recap of our major portfolio moves since May 1, please see U.S. Equity Strategy Weekly Report "Three Risks" dated August 14, 2017, available at uses.bcaresearch.com