Europe

Highlights This week, we are reviewing all our current active trades in our Tactical Overlay. As a reminder, these positions (Table 1) are meant to complement our strategic GFIS Model Fixed Income Portfolio, typically with shorter holding periods and occasionally in smaller or less liquid markets outside our usual core bond market coverage (i.e. U.S. TIPS or Swedish interest rate swaps). This report includes a short summary of the rationale behind each position, as well as a decision on whether to continue holding the trade, close it out or switch to a new position that may more efficiently express our view. The trades are grouped together by the country/region that is most relevant for the performance of each trade. Table 1GFIS Tactical Overlay Trades Feature U.S. Short July 2018 Fed Funds futures (HOLD). Long 5-year U.S. Treasury (UST) bullet vs. 2-year/10-year duration-matched UST barbell (HOLD). Long U.S. TIPS vs. nominal USTs (HOLD). Short 10-year USTs vs. 10-year German Bunds (HOLD). The tactical trades that we have been recommending within U.S. markets all have a common theme - positioning for an expected rebound in U.S. inflation that will push up U.S. bond yields. We are maintaining all of them. The drift lower in realized inflation rates since the spring has been a surprise given the backdrop of above-potential growth, low unemployment and a weakening U.S. dollar. On the back of this, markets have priced out several of the Fed rates hikes that had been expected over the next year, leaving U.S. Treasury yields at overly-depressed levels. Back on July 11th, we initiated a recommendation to short the July 2018 fed funds futures contract (Chart 1). This was a position that would turn a profit if the market moved to once again discount multiple Fed rate hikes by mid-2018. The trade has a modest profit of 9bps, but with scope for additional gains if the market moves to discount 2-3 hikes by the middle of next year. Our base case scenario is that the Fed will lift rates again this December, and deliver additional increases next year amid healthy growth and with inflation likely to grind higher towards the Fed's 2% target. With the market discounting 46bps of rate hikes over the next year, there is scope for additional profits in our fed funds futures trade. Another tactical position that we've been recommending is a butterfly trade within the U.S. Treasury (UST) curve, long a 5-year UST bullet versus a duration-matched 2-year/10-year UST barbell. This is a position that would benefit from a bearish steepening of the UST curve as the market priced in higher longer-term inflation expectations (Chart 2). We have held that trade for a much longer period than a typical tactical trade, going back nearly a full year to December 20th, 2016. Yet while the UST curve has flattened since that date, our trade has delivered a return of +18bps. This outperformance can be attributed to the undervalued level of the 5-year bullet at the initiation of the trade. Chart 1Stay Short July 2018##BR##Fed Funds Futures Chart 2Stay Long The 5yr UST Bullet Vs.##BR##The 2yr/10yr UST Barbell While that valuation cushion no longer exists (bottom panel), longer-term TIPS breakevens are back to the levels seen last December (middle panel), thanks in no small part to much higher energy prices (top panel). This leaves the UST curve at risk of a bearish re-steepening on the back of rising inflation expectations. Add in a U.S. dollar that is -2.5% weaker from year-ago levels (Chart 3, middle panel), and a solid U.S. economic expansion that should eventually translate into rising core inflation momentum (bottom panel), and the case for a steeper UST curve over the next 3-6 months is a strong one. The above logic also supports our trade recommendation to go long U.S. TIPS vs. nominal USTs, which is up +248bps since inception on August 23, 2016. We have been holding this trade for much longer than our usual tactical recommendations, but we will not look to take profits until we see the 10-year breakeven (now at 186bps) return back to levels consistent with the Fed's 2% PCE inflation target (i.e. headline U.S. CPI inflation back to 2.5%). One final tactical trade that will benefit from higher UST yields is our recommendation to position for a wider spread between 10-year USTs and 10-year German Bunds. This trade was initiated on August 9th of this year, and has delivered a profit of +9bps. Yet the UST-Bund spread still looks too low relative to shorter-term interest rate differentials that favor the U.S. (Chart 4, top panel). With U.S. data starting to surprise more on the upside than Euro Area data (middle panel), and with UST positioning still quite long (bottom panel), there is potential for additional near-term UST-Bund spread widening. The upcoming decision by the European Central Bank (ECB) on potential tapering of its asset purchases next year represents a potential risk for the long Bund leg of our recommended trade. Any hawkish surprises on that front would be a likely catalyst for us to close out this position. Chart 3Stay Long U.S. TIPS Vs. Nominal USTs Chart 4Stay Short 10yr USTs Vs. German Bunds Euro Area Long 10yr Euro Area CPI swaps (HOLD). Long 5-year Spain vs. 5-year Italy in government bonds (HOLD). We have two recommended tactical trades that are specifically focused on developments in the Euro Area. We are maintaining both of them. As a way to position for an eventual pickup in European inflation, we entered a long position in 10-year Euro Area CPI swaps back on December 20th, 2016. That trade is now estimated to have a profit of +29bps, as market-based inflation expectations have drifted higher in the Euro Area. The simple reason for that increase is that realized inflation has moved higher on the back of rising energy costs, as there is a very robust correlation between the annual growth rate of oil prices (denominated in euros) and headline Euro Area inflation (Chart 5). More importantly, the booming Euro Area economy, which has eaten up much of the spare capacity in the Europe, has boosted wage growth and core inflation to levels seen prior to the disinflation shock from the 2014/15 collapse in oil prices (bottom panel). With no signs of any imminent slowing of Euro Area growth that could raise unemployment and slow underlying inflation pressures, the trend for inflation expectations in Europe is still upward. The current 10-year Euro Area CPI swap at 1.5% is still well beneath the ECB's inflation target of "just below" 2% on headline CPI, so there is room for inflation expectations to continue drifting higher. ECB tapering of asset purchases is not an immediate threat to this trade, as the central bank is still likely to keep buying bonds next year (at a slower pace), while holding off on any interest rate increases until late 2019. In other words, the ECB will not be looking to act to slow economic growth to bring down Euro Area inflation anytime soon. Our other tactical trade recommendation in Europe is a relative value spread trade, long 5-year Spanish government debt versus 5-year Italian bonds. This trade was initiated on December 13th, 2016 and currently has only a modest gain of +9bps, although the profits were much larger earlier this year. Italian bonds have been outperforming on the back of improving Italian economic growth (Chart 6, top panel) and, recently, a generalized sell-off in Spanish financial assets on the back of the political uncertainty in Catalonia. Chart 5Stay Long 10yr##BR##Euro Area CPI Swaps Chart 6Stay Long 5yr Spanish Government Bonds Vs.##BR##5-Year Italian Debt Our colleagues at BCA Geopolitical Strategy have been downplaying the threat to Spanish political stability from the Catalonian independence movement, given that the polling data shows only 35% for outright independence from Spain. At the same time, the poll numbers in Italy for the upcoming parliamentary elections are much closer, with parties favoring less integration with Europe holding a slight lead over more "establishment" parties (bottom two panels). With the bulk of the cyclical convergence between Italian and Spanish growth now largely completed, and with a greater potential for future political instability in Italy compared to Spain, we expect that Spain-Italy spreads will tighten further back to the lows seen at the beginning of 2017 (-64bps on the 5-year spread). That is a level we are targeting on our current tactical trade recommendation. Canada Short 10-year Canadian government bonds vs. 10-year USTs (TAKE PROFITS). Long Canada/U.K. 2-year/10-year government bond yield curve box, positioning for a relatively flatter Canadian curve (TAKE PROFITS). Short 5-year Canada government bond versus a duration-matched 2-year/10-year barbell (TAKE PROFITS). We have three different Canadian fixed income trades in our Tactical Overlay, all of which were biased towards tighter monetary policy in Canada: a Canada-U.S. bond spread widener, a yield curve box trade versus the U.K. and a curve flattener expressed as a barbell trade (Chart 7) All three positions are in the money, but we now recommend taking profits. We had initiated these recommendations in a very timely fashion earlier in the year at a time when the Bank of Canada (BoC) was sending a relative dovish message. In our view, the Canadian economy was building significant upward momentum that would eventually force the central bank to shift its policy bias. This would especially be true with the Fed also in a tightening cycle, given the typical tendency for the BoC to follow the Fed's policy actions. Several members of the BoC monetary policy committee began to sing a more hawkish tune over the summer, particularly after the release of the Q2 BoC Business Outlook Survey. That robust report, which was confirmed by a 2nd quarter GDP growth rate of nearly 4% (Chart 8), led the BoC to deliver not one by two unexpected interest rate hikes in July and September. Markets reacted accordingly, driving Canadian bond yields higher and flattening the yield curve. Chart 7Take Profits On Bearish Canadian Bond Trades Chart 8Canadian Growth Set To Cool Off A Bit Now, we see the market pricing as having gone a bit too far, too quickly. The Q3 Business Outlook Survey, released yesterday, was still positive but with readings softer than the booming Q2 report. Meanwhile, the commentary from the BoC has become more balanced, with BoC Governor (and BCA alumnus) Stephen Poloz describing the central bank as being more "data dependent" after the recent rate hikes. Markets are now pricing in another 72bps of rate hikes over the next year, even with our own BoC Monitor off the peak (Chart 9). Chart 9Our BoC Monitor Is Peaking From a tactical perspective, the repricing of the BoC that we expected earlier this year is now largely complete. Thus, we are taking profits on all three Canadian trades: Canada-U.S. spread trade: initiated on January 17th, profit of +43bps. Canada/U.K. box trade: initiated on May 16th, profit of +67bps. Canada 2yr/5yr/10yr butterfly trade: initiated on December 6th, 2016, profit of +95bps. From a strategic perspective, we still see a case where the BoC can deliver additional rate hikes and keep upward pressure on Canadian bond yields. The output gap in Canada is now closed, according to BoC estimates, and additional strength in the economy now has a greater chance in translating to higher inflation. Strong global growth, especially in the U.S., will also support Canadian export growth and feed into rising capital spending. While the rate hikes have help boost the value of the Canadian dollar (CAD), the exchange rate (on a trade-weighted basis) also largely reflects a rising value of energy prices and is, therefore, should provide an additional boost to growth via stronger terms-of-trade (bottom panel). In other words, the rising CAD will not prevent additional BoC rate hikes if oil prices remain strong. Thus, we are maintaining our underweight recommendation on Canadian government bonds in our strategic model bond portfolio, even as we take profits on our bearish Canadian tactical trades. Australia Long a 2-year/10-year Australia government bond curve flattener (SELL AND SWITCH TO NEW TRADE). On July 25th of this year, we entered into a 2-year/10-year curve flattener trade for Australia. Though employment was improving and house prices were booming in Australia, the wide output gap, high level of consumer indebtedness and lack of real wage growth was keeping the Reserve Bank of Australia (RBA) inactive. In our view, nothing has changed since then; the RBA remains in a very difficult position. While the yield curve flattened substantially following the initiation of our trade, the global rise in long-term yields since mid-September lifted Australian longer-maturity yields, and the yield curve with it (Chart 10). Now, Australian long-term yields are not reflecting domestic fundamentals but are instead driven by improving global growth. As such, we are closing the trade and initiating a new position - long Dec 2018 Australian Bank Bill futures - as a more focused way to express the view that the RBA will stay on hold for longer than markets expect. Markets are currently pricing in 30bps of RBA rate hikes over the next twelve months. We believe this will be unlikely, for several reasons. Macroprudential measures on the Australian housing market will continue to dampen credit growth. Core inflation is slowly rising but still far below the central bank's target. Additionally, there is plenty of slack in the labor market despite the spike in employment growth. This is evidenced in anemic real wage growth, stubbornly high underemployment rate, low hours worked and high percentage of part-time to full-time workers (Chart 11). Chart 10Close Australian Government##BR##Bond 2yr/10yr Flattener Chart 11RBA Unlikely To Deliver##BR##Discounted Rate Hikes The biggest risk to our new trade would if signs of a tighter Australian labor market started to feed through into faster wage growth, which would likely coincide with faster underlying price inflation and a more hawkish turn by the RBA. New Zealand Long 5-year NZ government bonds vs. 5-year USTs (currency hedged). Long 5-year NZ government bonds vs. 5-year Germany (currency unhedged). Chart 12Stay Long 5yr NZ Government Bonds##BR##Vs. U.S, & Germany We entered two New Zealand (NZ) tactical bond trades on May 30th, going long 5-year government bonds vs. U.S. and Germany (Chart 12). We expected NZ spreads to tighten faster than the forwards based on our more hawkish views on the Fed and, to a lesser extent, the ECB relative to the more dovish view on the Reserve Bank of New Zealand (RBNZ). The outright bond spreads have tightened and, on a currency-hedged basis, both trades are in the money. Our dovish view on the RBNZ came from the central bank's own forecasts, which called for slowing headline inflation on the back of softer "tradeables" inflation and a sharp cooling of domestic "non-tradeables" inflation through a slowing housing market (Chart 13, bottom two panels). Our own RBNZ Monitor has been calling for the need for higher interest rates in NZ, mostly from the strength in the labor market. Yet we have been ignoring that signal, as has the market which has priced out one full expected RBNZ rate hike since the beginning of the year. With business confidence rolling over, and with the trade-weighted NZ dollar still staying at stubbornly strong levels, the case for the RBNZ to deliver even a single rate hike is not a strong one - especially given the soft inflation forecasts of the central bank. Thus, we are sticking with our tactical spread trades for NZ versus the U.S. and Germany. We are maintaining the currency hedge on the U.S. version of the trade, as we typically do for the vast majority of our cross-country spread trade recommendations. Occasionally, however, we will make an active decision to do a spread trade UN-hedged if we felt very strongly about a currency move. We did that for our NZ-Germany spread trade and this has cost us in the performance of the trade, which is down -3.4%. This is because of a surprisingly large decline in the New Zealand dollar (NZD) versus the euro since the inception of our trade. Yet a review of the technical indicators on the NZD/EUR currency cross shows that the currency pair is now very stretched versus its medium-term trend (the 40-week moving average), with price momentum also at some of the most negative levels of the past decade (Chart 14). These measures suggest that the worst of the downturn in the currency is likely over. The relative positioning on the two individual currencies is now neutral, as long positions on the NZD have been reduced (bottom panel). Chart 13RBNZ Dovishness Is Justified Chart 14Keep NZ/Germany Position Currency Unhedged Given these technical indicators, and from these current levels, we see greater upside potential for NZD/EUR in the months ahead. This leads us to maintain our unhedged currency position on the NZ-Germany spread trade so as not to realize the current mark-to-market losses on the trade. Sweden Pay 18-month Sweden Overnight Index Swap (OIS) rate (TAKE PROFITS). We entered into a bearish Swedish rates position back on November 22nd, 2016, paying Sweden 18-month Overnight Index swap rates (Chart 15). At the time, we expected the Riksbank to begin hiking interest rates earlier than what was priced in the markets IF inflation reached the central bank target faster due to a weaker Swedish krona. We also believed that the economy would continue to expand at a robust pace when the economy had no spare capacity, creating additional upside inflation surprises. According to the Riksbank's latest Monetary Policy Statement (MPS), the central bank will likely keep the repo rate at -0.5% until mid-2018, while continuing its asset purchase program until the end of this year - even with an overheating economy. This is because realized inflation has remained below the Riksbank target for a long period of time and, although current inflation is above target, it was not necessary to immediately tighten conditions. More likely, the Riskbank is worried about the potential for the krona to appreciate - especially versus the euro - if rate hikes are delivered. It will only be a matter of time before the central bank is forced to tighten policy with the economy likely to strengthen further, led by solid domestic demand, strong productivity growth, and improving exports. Consumption is also expected to increase as households have scope to cut back their high level of savings. Combining the Riksbank's easing policy with the current strength of the economy and the tightness of the labor market, inflation is very likely to return to the 2% target in the next year or two (Chart 16). Chart 15Close Sweden OIS Trade Chart 16Riksbank More Worried About SEK Than Inflation However, if the Riskbank remains too concerned about the currency versus the euro, as we suspect, then this will prevent any shift to a more hawkish stance before any change from the ECB. That is unlikely to happen over the next year, at least, even if the ECB slows the pace of asset purchases as we expect. Thus, we are closing out our Sweden 18-month Overnight Index Swap position at a small profit of 12bps. We have already kept this trade for longer than the typical investment horizon for one of our tactical overlay trades. We will investigate the potential for more profitable trade opportunities in the Swedish fixed income markets in a future report. Korea Long a 2-year/10-year Korean government bond yield curve steepener (HOLD). We recommended entering into a 2-year/10-year steepening trade in the Korean government bond yield curve on May 30th, 2017. Since then, the yield curve has flattened by 7bps, which was mainly caused by an unexpected rise in the 2-year yield, rather than a decline in 10-year yield (Chart 17). Korea is currently enjoying a solid business cycle upturn. Leading economic indicators are rising, the year-over-year growth in exports has risen to a 7-year high and previously sluggish private consumption has also rebounded recently. The Bank of Korea (BoK) is of the view that the recovery will continue and consumer price inflation will stabilize at the target level over the medium-term. This recovery should cause the 2/10 curve to steepen as longer-term inflation expectations rise. Based on South Korean President Moon's aggressive fiscal plans to increase welfare spending and create jobs in the public sector, at a time when the economy is good shape, we still believe that long-end of the curve (10-year) will rise. In addition, as shown in Chart 18, the 26-week rolling beta of changes in the 10-year UST yield and Korean 10-year bond is very high, nearly 1. Given our bearish view on USTs, this implies Korean yields can follow suit. On the other hand, the correlation between the 2-year UST yield and equivalent maturity Korean yields is much lower (4th panel), as Korean rate expectations have not been following those of the U.S. higher - even with a stronger Korean economy. Most likely, this is due to investors downplaying the potential for the BoK to match Fed rate hikes tick-for-tick given the heightened tensions between the U.S. and North Korea. Chart 17Stay In Korea 2yr/10yr##BR##Government Bond Steepener Chart 18Long-Term Korean##BR##Yields Are Too Low We still believe the Korean curve can steepen as longer-term yields rise, although we will be monitoring the behavior of shorter-dated Korean yield as the situation between D.C. and Pyongyang evolves. If investors begin to demand a higher risk premium on Korean assets, particularly the Korean won, then 2-year Korean yields may rise much faster and our curve trade may not go our way. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights Since the release of our currency hedging report on September 29, 2017,1 we have received an overwhelming positive response from clients around the globe. We thank our clients for their appreciation of our research. Instead of answering client requests individually, we have decided to publish this follow-up report, in which we apply the same methodology to analyze both static and dynamic hedging strategies to hedge a global equity portfolio for the remaining three home currencies (Swiss franc, Swedish krona and Norwegian krone) in our nine-currency global equity universe. For investors based in Switzerland and Sweden, BCA's dynamic hedging framework, based on the proprietary currency indicators from BCA's Foreign Exchange Strategy (FES) service,2 has also outperformed all the static hedging strategies on a risk-adjusted basis since 2001. For Norway-based investors, however, BCA's dynamic hedging strategy does not generate consistently superior performance. Using static hedging, we find that the Swiss franc, together with U.S. dollar and Japanese yen, maintain their "safe-heaven currency" status, in the sense that CHF-, JPY- and USD-based investors should fully hedge foreign-currency exposure to minimize risk. However, our proposed dynamic hedging can achieve a better return/risk profile with less than 100% hedging. Over a four-year moving performance cycle (in line with how most portfolio managers are evaluated), BCA's dynamic hedging adds little career risk to portfolio managers in Switzerland and Sweden, compared to the "least regret" 50% static hedging, but the same cannot be said for Norwegian PMs. We recommend global equity investors based in the U.S., U.K., euro area, Japan, Canada, Australia, Switzerland and Sweden to use the BCA dynamic hedging framework to manage their foreign currency exposure. For Norwegian investors, we suggest "the least regret" 50% static hedging. Feature Dynamic Hedging Vs. Static Hedging We apply the same methodology as described in the previously published Special Report 3 to hedge an identical global equity portfolio into CHF, SEK and NOK using static and dynamic hedging strategies. As shown in Chart I-1, BCA's dynamic hedging strategy, based on the proprietary Intermediate-Term Timing Model (ITTM)4 indicators from the Foreign Exchange Strategy service, outperforms all static hedging strategies on a risk-adjusted basis for the CHF and SEK portfolios, in line with our findings for the other six home currencies. However, the same is not true for the NOK portfolio. Chart I-1Identical Investment, But Different Risk/Return Profiles The Swiss Perspective: On a static-hedging basis, the Swiss franc holds its "reserve currency" status as classified by Campbell et al,5 in the sense that risk-minimizing Swiss-based investors should fully hedge foreign currency exposure. Unlike the other two "safe-haven" home currencies, the USD and JPY, for which a higher hedge ratio results in lower risk and lower return in both the 16-year period from 2001 and the 41-year period form 1976, the CHF-based portfolio has achieved higher return/lower risk in the 16-year period from 2001 as the hedge ratio increases. The ITTM-based dynamic hedging outperforms the best static hedging (100%) in the shorter period, but the simple momentum-based dynamic hedging is inferior to the best static hedging (90%) in the longer period (Chart I-1, top two graphs and Tables II-1 and II-2). Chart I-2Little Career Risk For Swiss ##br##And Swedish Portfolio Managers The Swedish Perspective: On a static-hedging basis, the SEK-based portfolio behaves in a similar way to the euro-based portfolio in both the shorter and longer periods. In the shorter period from 2001, a higher hedge ratio results in higher returns, albeit gradually, but risk decreases until the hedge ratio hits 30% and then starts to increase such that the full hedge has the highest risk. In the longer period from 1976, a higher hedge ratio results in a lower return, while risk decreases until the hedge ratio hits 70% and then starts to rise, such that the unhedged portfolio has the highest risk and the fully hedged portfolio has the lowest return. On a risk-adjusted basis, the best static hedge ratio is 50% for both the shorter and longer periods. Both the ITTM-based dynamic hedging and the momentum-based dynamic hedging are superior to the best static hedge ratio of 50% (Chart I-1, middle 2 graphs and Table II-3 and II-4). The Norwegian Perspective: On a static-hedging basis, the NOK-based portfolio behaves like the GBP-based portfolio in the longer period from 1976, with return increasing and risk decreasing as hedge ratio increases, but it behaves like the euro- and SEK-based portfolios in the shorter period from 2001. On a risk-adjusted return basis, both the ITTM-based and momentum-based dynamic hedging strategies underperformed the best static hedge which is about 80% hedged (Chart I-1, bottom 2 graphs and Tables II-5 and II-6). Little Career Risk for Swiss and Swedish Portfolio Managers: As shown in Chart I-2, on a rolling four-year basis, the ITTM-based dynamic hedging strategy has outperformed the best static hedging strategy for CHF portfolio (which is 100%) and the best static hedging strategy for SEK portfolio (which is 50%). For the NOK portfolio, however, neither the ITTM-based dynamic strategy, nor the "best static hedging" strategy (which is 80%) can consistently outperform the "least regret" 50% hedging strategy. Equal Playing Field: In theory, if hedges were effective, then an identical global investment should have similar returns for all investors, no matter which home currency they hold. While neither the static hedging strategies nor the momentum-based dynamic hedging approach pass this criteria, BCA's ITTM-based dynamic hedging approach has indeed achieved this: it levels out the playing-field for all investors globally. As shown in Chart I-3, in the period from March 2001 to August 2017, if left unhedged, the same global investment exhibits very different annualized returns for investors in different home currencies, with CHF investors at the low end at around 2.8%, and GBP investors at the high end at around 7%. With BCA's ITTM-based dynamic hedge, however, returns for all investors are similar, no matter which currency is their home currency. Chart I-3BCA Dynamic Hedging Strategy Levels Out The Playing Field Bottom Line: We have back-tested the efficacy of BCA's proprietary currency indicators from the Foreign Exchange Strategy team's Intermediate-Term Timing Models to dynamically hedge a global investment portfolio into nine different home currencies. These indicators have proven to add significant value to eight out of the nine home currencies. Granted, back-tests show good results by default. But our FES team will strive to ensure that these indicators continue to work well going forward. We recommend global equity investors based in the U.S., U.K., euro area, Japan, Canada, Australia, Switzerland and Sweden to use BCA's ITTM currency indicator-based dynamic hedging framework to manage their foreign currency exposure. For Norway-based global equity investors, we suggest the "least regret" 50% static hedging. Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com Appendix 1: Dynamic Hedging For Three Home Currencies 1.1 The Swiss Perspective Correlations: For Swiss investors, foreign currencies in aggregate have generally been positively correlated with foreign equities and domestic equities (Chart II-1). In addition, the Swiss franc has strengthened over time, especially after 1999. This explains why, on a static basis, the fully hedged portfolio generates the best risk/return profile. (Table II-1 and Table II-2). Chart II-1Swiss Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Table II-1Risk/Return Profile For Global Equities In CHF (2001-2017) Table II-2Risk/Return Profile For Global Equities In CHF (1976-2017) Historical Performance: Since 2001, ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in CHF. The risk is slightly higher than the best static hedging (which is 100%), but the return is over 200 bps higher, resulting in a 40% increase in the risk-adjusted return (Table II-1). In addition, this is achieved with far fewer hedging transactions than the fully hedged strategy as shown in Chart II-2 panel 2. Over the longer period from 1976, the optimal static hedge ratio is about 90%, almost fully hedged as well, as shown in Table II-2. Chart II-2Swiss Perspective: Dynamic Vs. Static Hedging On a 60-month rolling basis, as shown in Chart II-2, the ITTM-based dynamic risk/return profile also prevails. Current State: Currently our indicators show that Swiss investors should not hedge any foreign currency. Chart II-3 shows how the Swiss investors should have hedged their exposure in U.S. dollar. Chart II-3Swiss Perspective: MSCI U.S. Index Dynamically Hedged 1.2 The Swedish Perspective Correlations: For Swedish investors, foreign currencies in aggregate have little correlation with domestic equities as the average correlation from 1980 is almost 0. This overall average can be misleading, however, as evidenced by the rolling 60-month correlation, which was positive before 1998 and then was negative until recently, and is now in the positive territory again (Chart II-4). This is a typical case where dynamic hedging would outperform static hedging, because the latter assumes constant mean and covariance for the chosen time period (Tables II-3 and II-4) Chart II-4Swedish Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Table II-3Risk/Return Profile For Global Equities In SEK (2001-2017) Table II-4Risk/Return Profile For Global Equities In SEK (1976-2017) Historical Performance: Since 2001, ITTM-based dynamic hedging has produced the highest risk-adjusted return in SEK for a global portfolio. The risk profile looks similar to that of the 50% hedged portfolio, but return is much higher, resulting in a 35% increase in the risk-adjusted return (Table II-3). Over the longer period, the optimal static hedge ratio is also 50%, as shown in Table II-4. On a five-year rolling basis, as shown in Chart II-5, the ITTM-based dynamic risk/return profile also prevails. Chart II-5Swedish Perspective: Dynamics Vs. Static Hedging Current State: Currently Sweden-based investors should be hedging only their exposure in Norwegian krona. Chart II-6 shows how the Swedish investors should have hedged their exposure in Canadian dollar. Chart II-6Swedish Perspective: MSCI Canadian Index Dynamically Hedged 1.3 The Norwegian Perspective Correlations: For Norway-based investors, foreign currencies in aggregate have a slightly negative correlation with domestic equities as the average correlation from 1980 is -0.12. This overall average can be misleading, however, as evidenced by the rolling 60-month correlation, which was above this long-run average before the Great Financial Crisis (GFC), but has been in negative territory ever since. On the other hand, the correlations between foreign currencies and foreign equities, and between foreign equities and domestic equities, have also gone though some regime changes (Chart II-7). Chart II-7Norwegian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Historical Performance: Since 2001, ITTM-based dynamic hedging has produced 7% lower risk-adjusted return for the global portfolio in NOK compared to the best static hedging strategy of 80% (Tables II-5). In the longer period from 1976, the momentum-based dynamic also underperformed the 80% static hedging strategy by 3% on a risk-adjusted return basis (Tables II-6). Table II-5Risk/Return Profile For Global Equities In NOK (2001-2017) Table II-6Risk/Return Profile For Global Equities In NOK (1976-2017) On a five-year rolling basis, as shown in Chart II-8, the ITTM-based dynamic risk/return profile also looks less attractive. Chart II-8Norwegian Perspective: Dynamic Vs. Static Hedging Why does dynamic hedging not work? We do not have a good understanding on this yet. Looking at the individual currency pairs, we notice that our indicators work very well for CAD/NOK, SEK/NOK and JPY/NOK, but not for other pairs, especially during the period between 2011 and 2016 when NOK was strong against most of these currencies. Chart II-9 and Chart II-10 show how JPY/NOK and USD/NOK should have been hedged based on our indicators. The former worked very well, while the latter failed terribly in the period between 2013 and 2016. Chart II-9Norwegian Perspective: MSCI Japanese Index Dynamically Hedged Chart II-10Norwegian Perspective: MSCI U.S. Index Dynamically Hedged 1 Please see Global Asset Allocation and Foreign Exchange Strategy joint Special Report "Currency Hedging: Dynamic Or Static? - A Practical Gide For Global Equity Investors," dated September 29, 2017. 2 Please see Foreign Exchange Strategy Special Report, "In Search Of A Timing Model", dated June 22, 2016 3 Please see Global Asset Allocation and Foreign Exchange Strategy joint Special Report "Currency Hedging: Dynamic Or Static? - A Practical Gide For Global Equity Investors," dated September 29, 2017. 4 Please see Foreign Exchange Strategy Special Report, "In Search of A Timing Model", dated June 22, 2016 5 Campbell, J., K. de Medeiros and L. Viceira, 2010, "Global Currency Hedging," Journal of Finance LXV, 87-122

Highlights Tipping points tend to occur when too many long-term value investors are uncharacteristically behaving like short-term momentum traders. Long IBEX35 versus Eurostoxx50 constitutes a good tactical trade. The underperformance of Spanish equities appears excessively pessimistic. Euro/dollar is technically extended by about 4 cents. The near term event risk is the ECB meeting on October 26, when a taper of asset purchases which extends well beyond 12 months might be regarded as dovish. But in the medium term, euro/dollar will head well north of 1.30. Underweight Basic Materials equities relative to the market as a tactical trade. Feature Spain: Red Herring Or Red Flag? Long Spanish equities is an excellent tactical trade provided that the imbroglio in Catalonia turns out to be a red herring. The IBEX35 index is at a classic tipping point of excessive short-term (negative) groupthink and herding (Chart of the Week). Chart Of The WeekThe Underperformance Of Spanish Equities Seems Excessive But is the imbroglio in Catalonia a red herring? Most likely, yes. As my colleague Marko Papic, BCA Chief Geopolitical Strategist points out, any unilateral declaration of independence from Catalonia would be vacuous if it lacked international legitimacy, or the ability to enforce it with arms. German sociologist Max Weber famously defined a nation's sovereignty as a "monopoly over the use of legitimate force." Unlike the Basque separatists, Catalan separatists have never resorted to force. A descent into violence remains unlikely because the Catalan independence movement is mainly a bourgeois, middle and upper class intellectual vision. The majority of Catalonia's working class are neither Catalan, nor support independence. Any unilateral declaration of independence would also lack political credibility because the opponents of independence largely boycotted the recent referendum to avoid giving it legitimacy. The vote for independence comprised only 37% of the electorate, meaning that popular support for independence remains questionable. The real (and unspoken) reason for the independence referendum was that it was the only glue holding together the Junts Pel Si (Together For Yes) four party coalition forming Catalonia's regional government. Without this glue, the two nationalist parties from opposite sides of the ideological spectrum would not be in bed with each other. And it is unclear whether this unholy alliance can stay entwined. To sum up, Catalan independence is an intellectual vision which at the moment lacks political and implementation credibility. For the imbroglio to become a full-blown crisis, the Catalan government, or militant groups, or the Spanish government would have to escalate tensions with the use of force. We do not expect this to happen. So the underperformance of Spanish equities appears excessively pessimistic, and long IBEX35 versus Eurostoxx50 constitutes a good 3-month trade (Chart I-2 and Chart I-3). Chart I-2The IBEX 35 And Euro Stoxx 50 Have Parted Company Chart I-3The IBEX 35 Has Catch-Up Potential Identifying Tipping Points Of Price Trends Let's take this opportunity to review how we identify such tipping points of excessive groupthink and herding. Tipping points tend to occur when too many long-term value investors are uncharacteristically behaving like short-term momentum traders. Instead of dispassionately investing on the basis of value, long-term investors get sucked into chasing a price trend, and thereby amplify it. These price trends reach exhaustion when there are no more value investors left to suck in, and at the margin, someone wants to get out. The following analysis describes the tipping point of a price uptrend, but exactly the same analysis applies in reverse to the tipping point of a price downtrend. When a financial asset price starts to rise, the momentum trader's natural inclination is to chase the price rise, and buy. Conversely, the long-term value investor's natural inclination, ordinarily, is to lean against the price rise, and sell. The two investors interpret the same information in polar opposite ways because they have very different time horizons. Importantly, their different interpretations of the same information - stemming from their different time horizons - allow the momentum trader and the value investor to trade with one another in very large volume at the current price. This is what creates a healthy market with plentiful liquidity. Now consider what happens when a long-term value investor flips out of character and acts like a momentum trader. With the numerical balance shifting to the momentum traders, the price has to move up to balance buy and sell orders. As more and more value investors defect to momentum trading, the price uptrend gathers steam. This uptrend is exhausted when the long-term value investors have all joined the trend. Regular readers know that we identify these tipping points by comparing the behaviour of investors with 'short-term' 1-day horizons and investors with 'long-term' 65-day horizons. For any financial asset, a near term price reversal is likely to occur when its 65-day fractal dimension hits a lower limit of 1.25 (Chart I-4), which we have found to be the 'universal constant of finance'.1 Chart I-4When The Valuation Framework Changes, It Is More Difficult To Assess Tipping Points At this remarkably consistent limit, the long-term investor reverts back to character, realises the stock is now overvalued and wants to sell. The trouble is that everybody has already joined the trend. To sell, there needs to be a buyer. But who will buy at the current price? Usually, the answer is nobody. The marginal buyer will be a new category of investor: an 'ultra-long term' value investor - let's say, with a 130-day horizon - who stayed true to character and refused to join the uptrend. As this investor knows that the stock is overvalued at the current price, he will only provide liquidity at the 'correct' lower price. So this is the tipping point at which the price trend reverses. Occasionally, there is another possibility. The ultra-long term value investor could also join the trend at the current price. This might happen when the valuation framework for an investment is especially uncertain, leaving long-term value investors extremely disoriented and unable to assess the 'correct' price. An important conclusion is that when the valuation framework for an investment is undergoing a major change, it is much more difficult to assess the tipping point of a price trend. Which brings us to the euro. Is The Euro Overbought? Through the second half of 2014 and early 2015, the euro was in a major downtrend as the ECB first signalled and then implemented its QE program. On several occasions, the 65-day downtrend seemed technically exhausted but after only minor reversals, the downtrend continued (see Chart I-4 again). Even after the 130-day downtrend seemed exhausted at the start of 2015, it persisted into the spring (Chart I-5). The reason was that as the ECB moved into the uncharted territory of QE, ZIRP and NIRP, the valuation framework for the euro also moved into uncharted territory. Without a reliable valuation anchor, longer and longer term investors jumped on the euro bear bandwagon. Chart I-5The Euro Is Overbought, But The Reversal Might Be Minor Today, we face the mirror-image situation. The euro has been in a major uptrend for most of 2017 as the ECB has signalled a recalibration of its extraordinary monetary easing. But though the 65-day uptrend seemed exhausted in the early summer, the uptrend continued as longer term investors joined the trend. Just as in 2014-15, the question today is: at a major turning point in ECB policy, what is the most reliable valuation anchor? For us, the best explanatory model for euro/dollar is the expected difference in ECB versus Fed policy rates 5 years ahead. As this differential compressed from -230 bps to -160 bps, euro/dollar rallied in perfect lockstep from 1.03 to 1.15. However, the subsequent rally has deviated from the expected policy rate differential, suggesting that the euro's uptrend is indeed overdone by about 4 cents. But in the medium term, the much bigger question is: what will happen to the expected policy rate differential? As we explained in Positioning For A Sea-Change2 the differential must eventually compress to around -40 bps, because this is the mid-point of a very well established multi-decade cycle (Chart I-6 and Chart I-7). In which case, euro/dollar must eventually head well north of 1.30 (Chart I-8). Chart I-6The Euro Area - U.S. Average ##br##Interest Rate Differntial = -40 bps... Chart I-7...Because The Euro Area-U.S. ##br##Inflation Differential = -40 bps Chart I-8An Expected Interest Differential ##br##Of -40 bps Means EUR/USD Goes North Of 1.30 To be clear, north of 1.30 is the medium term direction of travel, and the journey will not be a straight line. The near term event risk is the ECB meeting on October 26, when the central bank will very likely announce a recalibration of its monetary policy. A taper of asset purchases which extends well beyond 12 months might be regarded as dovish, as it would delay the timing of policy rate normalisation. In which case, euro/dollar could retest 1.15. Finally, and very briefly, Chart I-9 shows the major equity sector most at risk of a price trend reversal is Basic Materials. Although global growth seems healthy and synchronized, materials equities seem to have run much too far ahead, especially relative to other cyclical equity sectors. We recommend tactically underweighting Basic Materials relative to the market. Chart I-9Tactically Underweight Basic Materials Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report, "The Universal Constant Of Finance," September 25 2014, available at eis.bcaresearch.com. 2 Published on September 7 2017 and available at eis.bcaresearch.com. Fractal Trading Model* As decribed in the main body of this report, this week’s new trade recommendation is to go long Spain’s IBEX35 versus the Eurostoxx50 with a profit target/stop loss of 2.5%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Dear Client, This week, in addition to this regular Geopolitical Strategy Weekly Report, we decided to send you a collaborative report we penned with BCA's Energy Sector Strategy. My colleague Matt Conlan runs the service, which blends BCA's macroeconomic framework with his bottom-up expertise in the energy sector. Matt's service is one of the few that our firm publishes with specific company recommendations. In the report titled "King Salman Goes To Moscow, Bolsters OPEC 2.0," Matt argues that the emerging détente between Russia and Saudi Arabia will strengthen OPEC 2.0 and provide a structural tailwind for BCA's bullish view on energy. I highly recommend that you check out the research Matt and his team produce at nrg.bcaresearch.com. All the very best, Marko Papic Senior Vice President, Geopolitical Strategy Highlights Easier fiscal policy and tighter monetary policy is bullish for U.S. equities; The Dec. 12 Alabama Senate race could be a game changer in U.S. politics; Trump's anti-immigration policies could boost inflation; Our Catalan view is bearing out. Go long Spain's IBEX 35 / short Eurostoxx 50. Separately, book profits on our China volatility trade and our long China big bank trade. Feature "Buy In May And Enjoy Your Day!" has been our mantra throughout the summer. Despite the doom and gloom in the media surrounding the Mueller investigation, North Korea, Trump's legislative agenda, the French elections, Brexit, and so on, the S&P 500 is up 16% and global equities are up 10.8%. Our April 23 Weekly Report bearing the same cheery title focused on three overstated risks:1 European politics - massively overstated; U.S. politics - all noise, no signal; Brexit - irrelevant for global investors. We have also cautioned investors throughout the year to worry, but not to obsess, about North Korea. Yes, it is a risk.2 Yes, it will continue to buoy safe haven assets on occasion.3 But it is extremely unlikely to produce total war and therefore has lost some market relevance as assets have adjusted to the higher geopolitical volatility on the Korean Peninsula under the Trump regime.4 We are not reiterating these calls just to pat ourselves on the back. Rather, our point is to emphasize that there is nothing supernatural about the ongoing bull market. It has not "ignored" geopolitical risks. Rather, geopolitical risks on hand have not developed in a market-relevant way. The bottom line here is that geopolitics is not voodoo. It is not an "error term," a disturbance in an elegant model that can go awry at any moment because "one cannot forecast politics." Investors can systematically analyze geopolitics just as they do the economy or the markets. When geopolitical risks are overstated, as they have been since the beginning of the year, recognizing the mispricing can generate significant alpha. Going forward, however, geopolitics will likely play a headwind for the market. We are particularly concerned with three dynamics: The upcoming party congress in China may signal a shift towards more growth-stalling reforms, as we have been writing all year. The Trump administration could make a hard turn towards a more populist agenda, particularly on trade, if it fails to enact any legislative successes this year. A plethora of political risks in emerging markets (EM) - with the usual suspects of Brazil, South Africa, and Turkey on top of our list - could re-surface in 2018 if China is not firing on all cylinders. We will be focusing on these three risks to markets until the end of 2017 and beyond. This week, however, we focus on upcoming tax legislation in the U.S. First, a reason to be optimistic ("easier fiscal policy, tighter monetary policy" is a winning policy combination). Then, a reason to be pessimistic (Alabama). Finally, a few words about inflation from a political perspective and a quick word on Catalonia. Easy Fiscal, Tighter Monetary Policy Mix - What Does It Mean? If our base case view on tax legislation is correct, U.S. equities should gain double-digit returns from current levels. Our colleague Anastasios Avgeriou, Chief Strategist of BCA's U.S. Equity Strategy, believes that the passage of stimulative tax legislation would serve as a catalyst to further fuel the blow-off phase in equities. In his latest Weekly Report, Anastasios presents empirical evidence suggesting that easy fiscal policy outweighs the drag from Fed interest rate tightening.5 Filtering the post-World War Two era for periods of easing fiscal and tightening monetary policies during economic expansions is revealing. Anastasios defines easy fiscal policy as periods with a positive fiscal thrust and tight monetary policy as a rising fed funds rate. Fiscal thrust is the year-over-year change in the cyclically-adjusted fiscal balance as a percentage of potential GDP (shown inverted on the bottom panel of Chart 1). While such a policy mix is a rare occurrence, it has happened seven times since the mid-1950s (shaded areas, Chart 1).6 All iterations resulted in positive returns, with the SPX rising on average by over 16%. Table 1 details all seven periods that have an average duration of 16 months. For sectoral implications of such an "easier fiscal, tighter monetary" policy mix, we encourage our clients to peruse the work of BCA's U.S. Equity Strategy. On the other hand, the demand for fiscal stimulus usually rises during times of high volatility, unlike today (Chart 2). Investors have become acutely aware of the political difficulties of stimulating the economy late in the economic cycle. We now turn to some emerging risks to our sanguine view on tax policy. Chart 1Easy Fiscal + Tight Money##br## = Buy SPX Table 1SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Chart 2Fiscal Stimulus Usually##br## Comes With High Volatility Bottom Line: If our base case view holds, and Republicans pass mildly stimulative tax legislation, the blow-off phase in equities should continue. "Alabama, You Got The Weight On Your Shoulders" The market continues to doubt that the Trump administration can pass significant tax legislation over the next six-to-nine months. The gap in the probabilities assigned to such an outcome by the market and ourselves has narrowed over the past two weeks, generating alpha on several of our "Trump Reflation" trades (Chart 3). But skepticism abounds. Chart 3Signs Of Life For 'Trump Reflation' Trades We have spent the entire year pushing against the skepticism, but there is now an actual reason to worry. The December 12 Alabama Senate special election - being held to elect a replacement for former Senator Jeff Sessions, now the U.S. Attorney General - has become a premier league event. Former Alabama Chief Justice Roy Moore won the Republican primary against a candidate backed by the Republican establishment and President Trump. The reason the Alabama special election is of global significance is because the Republicans are already down to essentially 50 votes in the Senate. The rhetorical war between President Donald Trump and Senator Bob Corker (R - Tennessee) has reached epic proportions, with the latter insinuating via twitter that the president was an adult baby. Corker has announced his retirement from the Senate, which increases the probability that he will go out by refusing to support the president's agenda across all fronts.7 This now makes two GOP senators that want nothing to do with President Trump's agenda. John McCain (R - Arizona) has harbored ill will since the presidential campaign and has twice played the spoiler in the effort to repeal Obamacare. Further complicating matters is the role of former White House Chief Strategist Steve Bannon, who strongly backed Moore when nobody in the Republican establishment would. If Moore should remain loyal to Bannon beyond the election, it would mean that Trump's former campaign strategist would become the kingmaker on tax legislation. Bannon's departure from the White House was cheered by the markets, as it signaled victory for the "Goldman Sachs clique" and the trio of generals managing President Trump's foreign policy over Bannon's populist "Breitbart clique." We do not think that Bannon is opposed to stimulative tax policy. Yes, he has branded his ideology "economic nationalism," but his media empire, Breitbart, has so far stayed away from attacking the Republican tax plan. Instead, Bannon and Moore could hold out on supporting tax policy until they see movement on other pillars of the populist agenda, namely on immigration policy. As such, Moore's Alabama victory would complicate the horse-trading surrounding tax legislation, and elevate Bannon's standing on Capitol Hill, but it would not be a death knell for stimulus. The actual death knell for tax reform would be if Moore actually lost the December 12 Alabama special election. Moore's views are generally considered to be staunchly conservative, even for Alabama, and therefore a shock defeat cannot be ignored.8 Polls are limited, but most show Moore leading the Democratic candidate Doug Jones by only 5%-8%. This in a state where Republican Senate candidates have defeated their Democrat counterparts by an astounding average of 36% in the last decade! If Jones were to win, Republicans would be down to 51 Senators. Given the staunch opposition to Trump by Corker and McCain, this would effectively end the tax legislation push. Not all is negative for the tax push in Washington. The U.S. House of Representatives has passed a budget resolution that includes steep spending cuts as well as reconciliation instructions for tax legislation. This now sets in motion the reconciliation process by which Republicans can pass tax legislation with merely 51 votes in the Senate. Of the 18 GOP representatives who voted against the budget resolution, only three were from the 31-member Freedom Caucus, which is rhetorically committed to fiscal conservativism. This is very bullish for tax cuts as it means that the Freedom Caucus is toeing the line of its Chair Mark Meadows (R - North Carolina) who has been hinting since the spring that he would have no problem with budget-busting tax cuts. The majority of Republicans who voted against the budget resolution were from highly-taxed "Blue States," suggesting that the real point of contention for Republicans in the House was the proposal to end the state and local tax deduction. Treasury Secretary Steven Mnuchin has already signaled that the White House is willing to compromise on this particular revenue offset. Bottom Line: The December 12 Alabama special election now has global market relevance. A defeat for GOP candidate Roy Moore would be a massive game changer. It would reduce the Republican majority in the Senate to 51 votes, putting in danger President Trump's tax agenda given the staunch opposition from Senators Corker and McCain. What Can Politics Do To Inflation? The greatest surprise to the markets this year has been lackluster inflation data in the U.S. Both headline and core data have been disappointing (Chart 4). This is particularly puzzling as the U.S. has closed its output gap and unemployment has fallen below the low reached in 2007 (Chart 5). Chart 4U.S. Inflation Has Disappointed... Chart 5...Which Is Puzzling At Full Employment One possible explanation is that the U.S. has been importing deflation from abroad. The U.S. imports around 12.5% of GDP worth of goods and 2.8% of GDP worth of services (Chart 6). However, the import price deflator has been growing at 2.7% so far this year and yet inflation has been nonexistent (Chart 6, bottom panel). Export prices have grown by 5% in 2017, from the lows of -15% amidst the commodity bust in 2015 (Chart 7). Chart 6The U.S. Is Not Importing Deflation Chart 7Global Export Prices Are Rising Another explanation is that structural changes in the labor market - globalization and the fall in the unionization rate - have eroded the bargaining power of workers (Chart 8). When combined with the shock of the 2008 Great Recession, workers may simply be happy to have a job and are therefore delaying asking of a raise or switching to a higher-paying, but higher-risk, job. As a result, the economy may have closed its output gap, but with no inflationary effects coming from the low unemployment figures. Chart 8Globalization Suppressed U.S. Wages Further restricting wage gains may be the high number of migrants - legal or illegal (Chart 9). The foreign born population in the U.S. is at an all-time high of 43.2 million, although unauthorized migration has come down from around 12 million prior to the GFC to 11.3 million in 2016. The conventional wisdom is that most immigrants are uneducated, competing with blue collar laborers and suppressing wages at the lower income levels. However, this is a stereotype stuck in the 1980s. Today's migrants are as educated as Americans: 29.7% have a Bachelor's degree or higher, compared with just over 30% Americans in general (Chart 10). Chart 9Immigration Helps Explain Weak Wage Growth Chart 10Immigrants Not Stealing Low-Skill Jobs The point is that immigration has evolved along with the U.S. economy. With 78% of the U.S. economy based in services, the modern migrant has had to keep up with the educational requirements of the American job market. The Trump administration could be a game-changer for the skilled, legal immigration into the U.S. First, President Trump ordered a full review of the high-skilled, H-1B immigration visa in April. Second, President Trump asked Congress in August to curb legal migration by sharply curtailing family reunification while keeping immigration based on job skills roughly the same. Third, anti-immigrant rhetoric - as well as restrictions to family reunification down the line - could influence highly-skilled migrants to choose job opportunities in countries like Australia, Canada, and New Zealand, instead of in the U.S. Bottom Line: Investors often think of fiscal policy as the main vehicle through which politicians can influence inflation. However, the U.S. economy has been enjoying, since the 1980s, the combined effect of rapidly expanding immigration and a parallel increase in the educational attainment of incoming migrants. In a way, the influx of skilled migrants has been an important supply side reform for the U.S. economy. The Trump administration could influence immigration either directly, through policies to curb it, or indirectly, through creating a general atmosphere that redirects some of the flows to other developed economies. Spain: Fade Catalan Risks As we have expected since 2014, the prospects for Catalan independence remain slim.9 As we go to press, Catalan President Carles Puigdemont has backed away from his earlier hints toward a unilateral declaration of independence. Instead, he has succumbed to domestic and international pressure and told the regional parliament that he has "suspended" any declaration in order to begin negotiations with Madrid. Puigdemont's decision to suspend something that has not happened is not only illogical but also ineffectual. The Catalan pro-independence government is trying to force Madrid to be the "bad guy" and refuse negotiations; Spain has refused any discussion of independence. But slight narrative shifts and "gotcha" politics will not work in this case. While Puigdemont is playing checkers with Spanish Prime Minister Mariano Rajoy, the rest of Europe is playing chess. International recognition of Catalan independence is not forthcoming. And without it, Catalonia will not become independent. As we have extensively written, we strongly believe that investors should fade secessionism risk in Spain. First, the independence process in Catalonia falls far short of the democratic ideals established in similar referendums in the developed world, particularly in Scotland (2014), Montenegro (2006), and Quebec (1980 and 1995) (Table 2). The pro-independence government has been unable to significantly boost turnout figures from 2014, no doubt due to interference by the federal authorities. However, even if the pro-independence Catalans were to receive mediation from the EU, the outcome would likely be to strengthen Madrid's hand. For example, when the EU negotiated the 2006 divorce between Serbia and Montenegro, it required a supermajority of 55% in order to recognize the result of the Montenegro independence referendum. As an integrationist project, the EU has an anti-secession bias. Table 2Catalan Independence Demand Exaggerated By Low Voter Turnout Second, the French government has come out forcefully against Catalan independence, as we suspected it would. This is particularly important for Catalonia as it is nestled between Spain and France.10 It is quite likely that, were Catalans somehow to enforce their independence, both European powers would close their borders to Catalan travel and trade. In addition, French European Affairs Minister Nathalie Louiseau has repeated Madrid's assertion that by choosing independence Catalonia would automatically be kicked out of the EU. Third, Madrid is unlikely to make another mistake as the disastrous attempt to disrupt the independence referendum. Images of civilians being dragged through the streets of an advanced European economy while attempting to vote - even if the referendum was constitutionally illegal - shocked the world. Spanish officials have already offered rather tepid apologies for the police action, suggesting that a re-run of the heavy-handed actions is not to be expected. For investors who disagree with us, we suggest an empirical way to test our thesis. Chart 11 shows that only 34.7% of Catalans support independence. These are not pro-Madrid polls. They are the product of the Centre d'Estudis d'Opinió, which is affiliated with the Catalan (currently staunchly pro-independence) government and has been conducting polls on the issue of independence since 2005. Even if the level of support for independence is off in this data, the direction gives us valuable insight into the support for secession. The data clearly suggests that (A) the majority of Catalans have never supported independence and that (B) support for independence peaked in 2013, at the height of Spain's economic crisis, and has been in steady decline since then. That said, Chart 11 also shows that the other 57.5% of Catalans are not necessarily "pro-Spain." In fact, 30.5% support Catalonia remaining in its current form of an autonomous region, with considerable sovereignty devolved to the province. Another 21.7% favor a federal state, which would be a step in the direction of even greater sovereignty. Investors should watch the polls to see whether voters who previously favored federal or autonomous status have begun to shift towards independence, especially in light of the crackdown against the referendum by Madrid. Centre d'Estudis d'Opinió normally releases its third series of polls in October, which would mean that investors will have an update from the official polling agency soon. That said, we are willing to put our geopolitical views on the line. An unwarranted selloff in Spanish equities on the back of increased Catalonia-related geopolitical risk has created an opportunity for a market neutral trade: long Spanish IBEX 35/short Eurostoxx 50. This is a market neutral way to express our view that Catalonia does not pose a grand geopolitical risk as it will remain an integral part of Spain and thus the EU. Importantly, adding a hedge to this pair trade would also make sense for certain investors. Chart 12 shows that EUR/USD and relative Spanish equity performance are joined at the hip. Currently an uncharacteristically wide gap has opened. Thus, putting on this equity pair trade and simultaneously going short EUR/USD on the expectation of a convergence, should generate alpha, as the geopolitical dust settles. Chart 11The Silent Majority Fears Independence Chart 12Expect A Convergence Bottom Line: Fade geopolitical risks in Spain. For those with risk appetite, buy Spanish equities at any sign of geopolitical risk premium. Housekeeping With the Communist Party convening for the nineteenth National Party Congress over the next week, we think the time is opportune to book profits on two trades: our long China ETF volatility index, for a gain of 17.72%, and our long Chinese Big Five state-owned banks versus small and medium-sized banks, for a gain of 11.63%. We will revisit these trades in an upcoming report. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 6 Omitted from the sample are brief periods in the early-1960s, early-1970s, and twice in the early-1980s as they were very close to the end of recessions. 7 We suspect that Senator Corker is planning a centrist challenge to President Trump in the 2020 GOP presidential primaries. 8 "Staunchly conservative" does not do justice to Moore's ideological orientation. He was removed from his position as Chief Justice of the Alabama Supreme Court twice for failing to follow federal law. In both cases, Moore chose to inform his actions as the Chief Justice through Biblical scripture, rather than the U.S. Constitution. 9 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 10 Yes, we are aware that Catalonia also borders Andorra. However, given that French President Emmanuel Macro is the co-prince of Andorra, and that Andorra is a microstate, this fact is largely irrelevant and would in no way aid Catalan independence. However, you have now learned that the French President is automatically a co-prince of another country. And that there is such a thing as a "co-prince." Therefore, this footnote has not been a complete waste of your time.

Highlights Slowing global money growth, export orders, and a downgrade in earnings revisions of cyclical relative to defensive equities points to a mild slowdown in non-U.S. growth. This slowdown is not worrisome, but could become so if the U.S. dollar rallies significantly. This risk should be kept in mind by investors. Short AUD/USD at 0.79 ¢. EUR/USD is trading at a premium and is over-owned. Conditions are emerging for investors to upgrade their view of the Fed relative to the ECB. EUR/USD has downside risk. Feature Chart I-1Global Growth Is Booming The world economy is on a roll. Nearly all of the world's PMI indexes are in expansionary territory, suggesting we are experiencing a rare global synchronized expansion. A key bellwether of global trade, Korean exports, are surging at a 35% annual rate, confirming that the global economy is very strong (Chart I-1). When all looks great, it is the ideal time to wonder what could go wrong. At this point, the greatest risk to this global expansion may be the dollar. A strengthening dollar would tighten global financial conditions, especially for EM borrowers, and exacerbate the impact of yellow flags that have already emerged. Yellow Flags Investors are in an ebullient mood these days, and for good reason: global growth is strong, and global policy is still very accommodative, even if some central banks have begun removing support for their economies. However, three yellow flags have emerged that in our view warrant some caution. To be clear, these are not grave signs and we do not foresee either a U.S. or a global recession until late 2019 at the earliest. With this in mind, what are the worrying signs that investors should monitor right now? The first yellow flag comes from global money supply growth. Narrow money has decelerated from a 12% annual growth rate to 9% today. Historically, this has been a leading indicator of global industrial production, global export growth and commodity prices (Chart I-2). While the surge in money growth in 2016 and 2017 was a key reason behind the rebound in global economic activity, especially outside the U.S., its recent slowdown points to an end of the economic upswing, though admittedly not toward a cataclysm. The second yellow flag comes from the U.S. ISM release. While the general tone of the report remains extremely positive, the export component has been in a downtrend since June. The key determinant of export growth for any country tends to be the vigor of its trading partners. Hence, it is not surprising that softness in the export component of the U.S. ISM manufacturing survey tends to be associated with weakening global trade and industrial activity (Chart I-3). The third yellow flag comes from earnings revisions. The earnings revision ratios of cyclical relative to defensive equities in the U.S. and globally have sharply rolled over. While still in positive territory, this development has historically been an early signal that improvements in global growth metrics are ebbing, a signal being flashed today (Chart I-4). Chart I-2Money And Global Growth: ##br##From Tailwind To Headwind Chart I-3A Blemish In An Otherwise##br## Bright Picture Chart I-4EPS Revisions: Cyclicals Have Turned ##br##Vis-A-Vis Defensives Bottom Line: The global economy is experiencing a synchronized upswing, which has left investors in an ebullient mood. However, slowing global money growth, ebbing export sentiment and weakening earnings revisions for cyclical relative to defensive equities suggest this broad-based upswing has reached its zenith. While a mild deceleration is likely to materialize soon, these indicators constitute yellow flags, not red ones. Conditions are still not in place to expect a major global growth slowdown. The Dollar Holds The Key While the factors above point to a mild slowdown, they do not yet indicate a dearth of growth that could prompt panic among investors, especially in the EM space. For this scenario to become reality, another ingredient is needed. In our view, this ingredient is a strong dollar. To begin with, the relationship between global growth and the dollar is well known in the investor community. When global growth is strong and broad-based, the dollar depreciates; when global growth is weak, the dollar appreciates (Chart I-5). The U.S. is a relatively closed economy, and is less exposed to global growth developments than the euro area, Japan or commodities producers (Chart I-6). Thus, when the global economy is in an upswing, the U.S. garners a smaller dividend than the rest of the world. Conversely, when the global economy hits a soft patch, the U.S. suffers less. Chart I-5Strong Global Growth Coincident ##br##With A Weak Dollar Chart I-6The U.S. Is Less Exposed ##br##To Global Growth Factors But the chain of causation is not only from growth to the dollar. The trend in the dollar also affects the trend in global growth. This is because in aggregate, the world remains short the dollar. According to the BIS, there is $27 trillion dollars of foreign-currency liabilities in the world, $14 trillion of which is denominated in U.S. dollars, with an extremely large proportion issued by EM borrowers. When the dollar weakens, the cost of borrowing among companies and banks that finance themselves in USD decreases, incentivizing further borrowing. This eases global liquidity conditions and decreases the cost of financing global trade, leading to increased economic activity and profits as well as expanding global capex. Meanwhile, when the dollar rises, the balance sheet of those foreign firms and governments that have borrowed in U.S. dollars becomes increasingly illiquid, resulting in strong headwinds for additional borrowing, curtailing economic activity, profits and capex. This explains why the dollar and commodities prices, the latter being extremely sensitive to growth and global capex, have displayed such a strong negative relationship over different time periods (Chart I-7). Chart I-7Rising USD Equals Declining Liquidity And Declining Commodity Prices Thanks to these dynamics, the weakness in the dollar this year has been a major boost to growth for the global economy. As Chart I-8 illustrates, the large easing in EM financial conditions was indeed related to the U.S. dollar's weakness. Therefore, as growth momentum could be peaking, a period of renewed strength in the greenback might inflict further damage to a key buttress of EM growth. Moreover, this time around, Chinese policymakers are unlikely to come to the rescue of the global economy as they did in 2015 and 2016. Back then, China was experiencing a deflationary spiral: producer prices were contracting at a 6% annual pace, profits were in free fall and outflows were growing exponentially. The People's bank of China and the central government pulled all the stops, increasing lending and fiscal expenditures and tightening capital controls. Monetary conditions eased massively (Chart I-9). Chart I-8The Falling Dollar Supported Global Growth Chart I-9Tightening Chinese Monetary Conditions Last weekend, the PBoC announced targeted cuts to reserve requirement ratios for banks extending lending to small companies. According to our China Investment Strategy sister publication, this is not a major easing.1 Instead, these are targeted measures aimed at helping small firms that are currently dependent on the predatory lending rates available in the shadow banking sector. Meanwhile, access to credit by large state-owned enterprises and the real estate sector will continue to be slowly curtailed. The mutation of deflation into inflation and the recovery of profit growth imply that China does not currently need the same shot to the arm that it did in 2015 and 2016. Thus, it is unlikely the country will initiate another round of massive credit easing that will boost investment by SOEs and the construction sector, the two main sources of capex and commodities demand. In an environment where global money growth has rolled over and where China is unlikely to press on the gas pedal as hard as it did two years ago, a strong dollar would thus have a nefarious impact on global financial conditions, global growth, and, in turn, EM currencies and commodities currencies. While we remain very negative on the yen for now, the Japanese currency could benefit from a meaningful slowdown in international growth, as such a slowdown would likely exert downward pressure on global bond yields, including in the U.S. Obviously, the rally in the USD will have to be much more pronounced than what has been experienced in the past month before its negative impact on growth begins to be felt in bond yields and the yen. Thus, we remain long USD/JPY for now. The AUD could prove to be a key victim of the developments highlighted above. The AUD is highly levered to global growth and EM financial conditions. Moreover, it is now very expensive on a long-term basis, having overshot terms of trade by a very significant margin (Chart I-10). Adding to the vulnerability in the Aussie, the Australian economy has been incapable of generating any inflationary pressures. The output gap remains very deep, the level of underemployment is still at a 37-year high, and wages continue to hover near record lows, limiting the capacity of the Reserve Bank of Australia to tilt to a hawkish stance (Chart I-11). Yet, investors expect rates to be 42 basis points higher 12 months from now. Finally, speculators are currently very long the AUD. Thus, we will use any rebound above 0.79 to short the AUD/USD, setting a limit-sell at this level with a target at 0.73. Chart I-10The AUD Is Vulnerable Chart I-11Litle Inflationary Pressures In Australia Bottom Line: While the three yellow flags highlighted do not represent a terminal danger to global growth, a stronger dollar at the hands of tightening global financial conditions, especially in EM economies, would be a much bigger threat to the global economy. We do anticipate the dollar to strengthen over the coming 12 months, but it will take a significant move before the USD puts enough of a brake on global growth to hurt global yields. We therefore remain positive on the USD/JPY. However, with this risk lurking in the background, we are implementing a short position on the AUD, a currency that is both expensive and over-owned, and underpinned by an economy full of slack. An Update On EUR/USD We continue to expect some downside to EUR/USD over the remainder of the year. As we have already highlighted, the euro has greatly overshot its implied interest rate parity (IRP) relationships. Our intermediate-term time model - an enhanced IRP model accounting for short- and long-term real rate differentials, global risk aversion, commodities prices and the trend in the pair - shows that EUR/USD remains near its largest premium to fair value since 2009. Confirming this assessment, the euro has also overshot its equilibrium implied by the level of interest rates five years out (Chart I-12). Valuations offer some insight on the potential size of the euro move, but they offer very little information in terms of timing. Instead, we should rely on technical and macro considerations. On this front, we have already highlighted that speculators are currently net long the euro by the largest margin since 2011. Philosophically, we often look at the euro as the anti-dollar, a highly liquid inverse bet on the dollar. Since EUR/USD constitutes 57.6% of the DXY, a short bet on this dollar index and a long bet on the euro are similar wagers. Currently, the sum of both bets is at a level normally followed by sharp drops in EUR/USD, suggesting that euro buying is hitting exhaustion levels (Chart 13). Meanwhile, with investors having very few short bets on the euro, especially when compared to the large stock of short bets on the DXY, a short squeeze in favor of the USD could emerge if European data disappoints relative to the U.S. (Chart I-13, bottom panel). Chart I-12Downside In EUR/USD Chart I-13Tactical Risk To EUR/USD On the macro front, a few developments have caught our eye. We are entering the window where based on historical lags, the euro area's industrial production is likely to start feeling the pain of the common currency's previous strength (Chart I-14). Compounding this worry for euro longs, euro area earnings revisions are lagging those in the U.S. by the greatest margin since 2014, suggesting the euro's strength has sapped some of the euro area's vigor and is in the process of redistributing it to the U.S. economy. Historically, this has led to a period of weakness in EUR/USD (Chart I-15). Chart I-14The Strong Euro ##br##Will Soon Be Felt Chart I-15Falling Relative EPS Revisions ##br##Equals A Weaker EUR/USD Confirming this insight are relative financial conditions. Euro area financial conditions have been tightening relative to the U.S. since the beginning of 2016 - a move that has become especially pronounced this year. The euro area's inflation outperformance vis-à-vis the U.S. this year was first and foremost a reflection of the previous easing in relative European financial conditions (Chart I-16). Thanks to these strong relative inflation dynamics, investors have brought forward the first rate hike expected from the ECB, while simultaneously removing interest rate hikes out of the U.S. OIS curve. This move has been wildly euro bullish. However, the window of opportunity for this bet is closing; the tightening in European financial conditions now points to a reversal in relative inflation, with U.S. prices set to now take the lead over the euro area. This could force a repricing of the Fed relative to the ECB, implying that monetary divergences could once again play against EUR/USD. Catalonia is not a reason to be bearish on the euro. Marko Papic, BCA's Chief Political Strategist, argues that the northeastern region is unlikely to leave Spain.2 The vast majority of Catalonia still favors remaining part of Spain (Chart I-17). Moreover, the region has received immigrants from the rest of the country for many decades, reflecting its superior economic performance. As a result, only 31% of the population speaks Catalan as a first language. In aggregate, the independentists' victory last weekend only reflects a low turnout rate, as individuals who opposed leaving Spain stayed at home, like they did in 2014. Chart I-16The Fed Will Be Repriced ##br##Against The ECB Chart I-17Will Of The People: ##br##Catalonia Will Stay In Spain Bottom Line: The euro will exhibit downside risk in the coming months. EUR/USD is trading well above its fair value implied by its IRP relationship. Additionally, euro buying has hit nosebleed levels, and the dollar is unloved. Moreover, the euro's recent strength could begin to negatively affect growth, especially as European earnings revisions have collapsed versus the U.S. Finally, financial conditions point to a fall in euro area inflation relative to the U.S., highlighting the risk that the policy path for the Fed could be upgraded against that of the ECB. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see China Investment Strategy Special Report, titled "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, titled "Is King Dollar Back?", dated October 4, 2017, and Geopolitical Strategy Monthly Report, titled "The Geopolitical Risks For The Equity Bull Market", dated May 14, 2014 at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S data has been strong this week: Markit and ISM Manufacturing PMIs beat expectations at 53.1 and 60.8 respectively; ISM Prices Paid rose sharply to 71.5 from 64.0; Markit Services and ISM Non-Manufacturing PMIs also beat expectations at 55.3 and 59.8 respectively; ADP employment change and continuing and initial jobless claims also came out better than expected; The DXY has rebounded meaningfully after a string of stronger data and growing hopes on the fiscal policy front recently. Bond markets have picked up on these developments, with the 10-year yield rising 30 basis points from its bottom last month. However, stronger U.S. inflation is needed in order for the greenback to meaningfully rally. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data has been mixed: The latest headline and core inflation readings for the euro area were weaker than expected, at 1.5% and 1.1% respectively; German retail sales also underperformed expectations, however, German unemployment rate decreased; Euro area manufacturing PMI also underperformed, while the services PMI outperformed; Euro area producer prices beat expectations, coming in at 2.5%. With U.S. data outperforming, the euro has softened versus the greenback, but has not displayed similar movements against other currencies. While it is true that European inflation is higher than a year ago, it is still not near the ECB's target. A stronger euro would further restrict inflationary pressures, which would be a cause for concern for ECB officials. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data has been mixed the past weeks: The jobs/applicants ratio came in at 1.52, underperforming expectations and decreasing from the previous month. Additionally, retail trade and overall housing spending yearly growth both disappointed, coming in at 1.7% and 0.6% respectively. However, on the bright side, Nikkei Manufacturing PMI outperformed expectations, coming in at 52.9. Overall, we continue to be bullish on USD/JPY, as yields in the U.S. will continue to rise vis-à-vis Japanese ones. Economic data has been tepid, and wages continue to contract or remain flat, even if some underlying pressures are slowly emerging. Furthermore we expect that the BoJ will continues its extreme measures of yield curve targeting in order to spur inflation expectations. Nevertheless, the yen could appreciate against carry currencies like the AUD or NZD if Chinese monetary conditions become tight enough. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Markit services PMI outperformed expectations coming in at 53.6, and increasing from last month's reading However, Markit manufacturing PMI came in under expectations at 55.9, and decreased from last month. Moreover Construction PMI unperformed, coming in at 48.1, the lowest level since July 2016. We would lean against any further strength of the pound against the U.S. dollar. The risks associated with Brexit still looms in the background, while data has been mixed, particularly when it comes to consumption and the housing market. Additionally, the market has already fully priced a rate hike by December. Thus, it seems that any good news for the pound are already in the price, as the BoE certainly has little incentives to follow a hawkish policy beyond removing its post-Brexit emergency measures. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was mixed: AiG Performance of Manufacturing Index decreased to 54.2 from 59.8; TD Securities Inflation came in at 2.5%, down from 2.6%; HIA New Home Sales increased by 9.1% MoM in August, up from the 15.4% contraction in July; Building permits are still contracting 15.5% annually, but better than the expected 16.2% contraction. This week, the RBA decided to leave rates unchanged at 1.5%. The monetary policy statement focused on the lack of wage pressures in the Australian economy and on the higher exchange rate, which is "expected to contribute to continued subdued price pressures in the economy", as well as "weighing on the outlook for output and employment", stating further that "an appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast." Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Last week the RBNZ decided to leave rates unchanged at 1.75%. The RBNZ continued with its dovish slant, arguing that monetary policy will remain accommodative for a considerable period. An important development, however, is that the central bank toned down its cautious tone about the kiwi. In previous instances, the RBNZ had been very aggressive in stating that the NZD was too expensive and an adjustment was needed. However, in its most recent statement the RBNZ was much less aggressive in its rhetoric, highlighting the fall in the NZD. Overall, we believe that the NZD will continue to have upside against the AUD, as domestic inflationary pressures are much stronger in New Zealand than in Australia. Meanwhile, global developments, such as a downturn in the Chinese industrial cycle would affect Australia much more than New Zealand. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was mixed: Industrial product price grew at a 0.3% monthly pace, less than the expected 0.5%; Raw materials increased by 1%, above the expected 0.3%; GDP stagnated in July on a monthly basis, below the expected 0.1% growth; Merchandise trade slipped even further into a deficit from CAD 2.6 bn to CAD 3.41 bn. Furthermore, Governor Poloz's September 27 speech sent the CAD tumbling, stating that "monetary policy will be particularly data dependent" and that it could be "surprised in either direction". Probability of a hike in October and December declined from 48% to 23%, and 75% to 63%, respectively. While growth is robust, inflation has been declining since January, which may be a cautious sign for the BoC. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Data in Switzerland has outperformed to the upside: The KOF Leading Indicator outperformed expectations, coming in at 105.8 and increasing from last month's reading. The SVME Purchasing Manager's Index also outperformed, coming in at 61.7 Finally, headline inflation also outperformed expectations, with a reading of 0.7%, increasing from 0.5% on August. This recent strength in the Swiss economy is most likely reflective of the sharp appreciation that EUR/CHF has experienced in recent months. However, despite the increase in inflation, the Swiss economy is still too weak for the SNB to stop intervening in the foreign exchange market or to remove their ultra-dovish monetary measures. Once we see both headline and core inflation climb closer to their historical averages, we will reassess this view. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Data in Norway has been mixed: Register unemployment came in line with expectations at 2.5%, decreasing from last month's 2.7% reading. However the credit growth issued by national institutions in Norway, decreased since last month, coming in at 5.6%. Finally, both retail sales and real retail sales yearly growth came below expectations, coming in at -0.6% and 0.2% respectively. These few data points are interesting given that both retail and real retail sales growth dipped into contractionary territory. This shows that the Norwegian economy is still too weak to sustain a higher krone and higher rates. For this reason we continue to be bullish on USD/NOK. This cross is more correlated with rate differentials than with oil. Thus even if oil continues to rise, rising rates in the U.S. will still put upward pressure on USD/NOK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The 11-year ruling governor of the world's oldest central bank, Stefan Ingves, will now sit at the helm of the Riksbank for five more years, until 31 December 2022. While Sweden's economy is still performing above par with CPIF at 2.3%, our bullish case for the SEK is under threat by the extension of the governor's term, who introduced negative interest rates to Sweden and who is consistently vigilant over the SEK's appreciation, even threatening intervention if needed. EUR/SEK appreciated 0.6% on the news, but has since given up some those gains as economic data in Sweden rebounded sharply. The Riksbank will still likely hike, but the timing is now in question. It is likely that the tightening cycle will now coincide with the ECB's tapering program, which will limit the SEK's appreciation for now. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights Expect Spain's strong growth to fade somewhat as its credit impulse appears to have peaked. The Catalan independence debate is an inconvenience but not a long term tail-risk. Expect Italy's growth to pick up as the Italian banking system is repaired. Brave investors could go long Italian bonds versus Spanish bonds now. More cautious investors might wait until after the Italian election in the first half of next year. France's CAC40 is our preferred mainstream euro area equity market right now. Feature Recent history teaches us that to leave the European Union is inconvenient, but to leave the euro is disastrous. To leave the EU means redefining laws, institutions and trading relationships, but to leave the euro means redenominating the entire banking system's assets and liabilities into different currencies - leading to bank runs and chaotic insolvencies. For this reason, even tiny Greece chose to suffer an extended depression rather than to leave the euro. Chart of the WeekSpain Fixed Its Banks In 2013, Italy Is Fixing Its Banks Now Leaving The EU Is Inconvenient, Leaving The Euro Is Disastrous To leave the EU, there is a broadly defined process but the process is inconvenient and protracted, as the United Kingdom is now discovering. The U.K. will technically leave the EU on March 31 2019, but Prime Minister May has proposed a further transition period of "around two years." Therefore the U.K. will remain in the European single market and customs union - and fully subject to EU laws and regulations - until at least 2021, five years after the U.K. voted to leave the EU. This protraction of the exit process creates a tasty irony. Not long after the U.K. fully leaves in 2021, the Leave vote's 1.25 million majority will have disappeared - counting those who voted in 2016 who are still alive. This is because out of the 0.625 million deaths in the U.K. in each of the coming years, there is a very heavy skew to Leave's much older voters1 (Chart I-2). As the U.K is not in the euro there is no secondary issue of whether to leave the single currency. But this does raise an interesting hypothetical question. If a euro area country - or region like Catalonia - inconveniently left or was ejected from the EU, does it follow that it must also crash out of the euro? No. Several non-EU countries already use the euro. There are the European microstates of Andorra, Monaco, San Marino and Vatican City. More significantly, Montenegro and Kosovo have adopted the euro as their de facto currency. To be clear, we do not expect Catalonia to secede. Polls consistently show a significant majority in Catalonia do not want full independence (Chart I-3). The unionists mostly boycotted the independence referendum because Madrid deemed it illegal. Given the low turnout, the 89% vote for independence equalled just 37% of eligible voters. Chart I-2The Vote For Brexit Was ##br##Driven By Older Voters Chart I-3A Significant Minority In Catalonia##br## Do Not Want Full Independence But even if Catalonia did become independent, this hypothetical eventuality would not involve a catastrophic exit from the euro. Catalonia, in its economic interest, would want to keep the euro, and the EU would let it. The Spain/Italy Conundrum The much bigger threat would be if a major euro area country felt that the single currency was not in its economic interest, and decided to jettison the euro. In this regard, the problem - at first sight - appears to be Italy. Through the 19 years of the euro, Italy's real GDP per head has grown by just 6%, substantially less than any other major economy. If the single currency is to blame for the significant underperformance of its third largest economy with 60 million people, then the euro's long-term viability has to be in question. But it is hard to blame the euro per se for Italy's painful underperformance. For the first half of the euro's life, 1999-2007, Italian real GDP per head performed more or less in line with the United States, Canada and France (Chart I-4) - even without a substantial tailwind from a credit-fuelled boom which the other economies had. Then, in the post-2007 years, there was little to distinguish the economic performances of Italy and Spain until 2013 (Chart I-5). At which point, Spain took off, with real GDP per head subsequently expanding by 15%. Whereas Italy struggled to grow. The conundrum is: what explains this stark recent difference between Spain and Italy? Chart I-4Through 1999-2007, Italy Grew In Line ##br##With Other Major Economies Chart I-5Post-Crisis, There Was Little To Distinguish##br## Italy and Spain Until 2013 The start of Italy's underperformance in 2008 and the start of Spain's strong recovery in 2013 provide the solution to the conundrum. Following the global financial crisis in 2008, Italy has still to repair its banking system. Whereas Spain fixed its banks in 2013. Significantly, Spain ring-fenced bad assets within a bad bank while recapitalising good banks. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. Therefore in 2013, Spanish banks' aggressive deleveraging ended. The result was that Spain's credit impulse - which measures the change in bank credit flows - rebounded very sharply and has remained positive for four years. This explains Spain's remarkably strong recovery (Chart I-6). In contrast, Italy's still dysfunctional banking system means that its own credit impulse has been much more muted and barely positive over the past four years (Chart I-7). Begging the question: why has Italy been so slow to fix its dysfunctional banking system? One reason is that Italy's banking malaise has built up stealthily, generating frequent financial tremors but without an outright crisis. In contrast, the credit booms in the U.S., U.K., Ireland and Spain did eventually cause housing busts and full-blown banking crises, requiring urgent policymaker response. A second reason is that the Italian government is more highly indebted than other governments, making it more difficult to raise public funds to fix the banking system. The good news is that the Italian government, the EU and the ECB are now on the same page and finally progressing to repair the banking system. Italian banks' equity capital is rising (Chart I-8), their solvency is improving, and the share of non-performing loans has fallen sharply this year (Chart of the Week). Chart I-6Spain's Credit Impulse Rebounded Sharply Chart I-7Italy's Credit Impulse Has Been More Muted Chart I-8Italian Banks Are Raising Equity Capital Moreover, the recent smooth winding down of the failing Banca Popolare di Vicenza and Veneto Bank showed that the EU's new rules for resolving failing banks is working. Admittedly, the rules mean that institutional investors could still suffer losses. But a pragmatic solution will permit public funds to protect 'widows and orphans' retail investors. Some Investment Thoughts As the Italian banking system is repaired, there will be a pickup in Italy's growth just as there was in Spain. However, the strong tailwind to Spain's growth that started in 2013 is now fading given that Spain's credit impulse has peaked. This suggests that the yield spread between Italian BTPs and Spanish Bonos - which measures the extra risk premium in Italy - is at a cyclical peak from which it is likely to compress (Chart I-9). Brave investors could go long Italian bonds versus Spanish bonds now. More cautious investors might wait until after the Italian election in the first half of next year. On the face of it, a fading risk of euro breakup should also boost euro area equity relative performance. The trouble is that the relative performance of the broad Eurostoxx50 index is entirely at the mercy of its major sector skews - specifically, a huge underweighting to Technology and an overweighting to Banks (Chart I-10). The way around this dilemma - to like euro area equities but to dislike the overall sector skew - is to steer towards mainstream indexes which have less of a distorting skew. On this basis, the mainstream euro area equity market we would pick right now is France's CAC40 (Chart I-11). Chart I-9The Yield Spread Between Italian And ##br##Spanish Bonds Is At A Cyclical Peak Chart I-10Eurostoxx50 Relative Performance Is ##br##At The Mercy Of Its Sector Skews Chart I-11Prefer the CAC40 To##br## The Eurostoxx50 Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 In the U.K. around 625,000 people die every year and the vast majority of these are aged over 65. But in this older age cohort, 64% voted Leave (source: YouGov). So we can infer that of the 625,000 deaths, about 400,000 voted Leave and 225,000 voted Remain, eroding the Leave majority who are still alive by 175,000 every year. Fractal Trading Model This week, we note that the Canadian 10-year government bond is oversold and due a trend reversal. We prefer to express this as a new relative trade: long Canadian 10-year bond / short 10-year German bund with a profit target / stop-loss of 1% and double position size. In other trades, long USD/CAD hit its 2.5% profit target - the second success in this specific trade in the last three months. We now have three open positions. 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-12 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 Economic Outlook: Global growth will stay strong over the next 12 months, with the U.S. surprising on the upside. Unfortunately, the global economy will succumb to a recession in 2019. Stagflation will become a major problem in the 2020s. Portfolio Strategy: We are sticking with our pro-risk stance for the time being, but are trimming our overweight recommendations to global equities and high-yield credit. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S., euro area, and Canadian government bonds; stay neutral the U.K., Australia, and New Zealand; overweight Japan. Equities: Favor cyclicals over defensives, but look to turn outright bearish on stocks late next year. For now, stay overweight the euro area and Japan relative to the U.S. in local-currency terms. In the EM universe, Chinese H-shares will outperform. Currencies and Commodities: While the recent dollar rebound has further to run, oil-sensitive currencies and the yuan will hold their ground against the greenback. It is too early to buy gold. Feature I. Global Macro Outlook: Reflation, Recession, And Stagflation The economic outlook over the coming years can be summarized in three words: reflation, recession, and stagflation. Reflation A Broad-Based Recovery Global growth is firing on all cylinders. The OECD estimates that all 46 of the economies that it tracks will see positive growth this year, the first time this has happened since 2007. Most leading economic indicators remain upbeat (Chart 1). This has left analysts scrambling to revise up their global GDP growth forecasts (Chart 2). Chart 1Most Leading Economic Indicators Remain Upbeat Chart 2Global Growth Has Accelerated The acceleration in global growth has occurred against the backdrop of tame inflation, which has allowed most central banks to keep interest rates at exceptionally low levels. Not surprisingly, risk assets have reacted positively. These goldilocks conditions should remain in place for the next 12 months. While most economies are growing at an above-trend pace, there is still plenty of spare capacity around the world. This means that inflation in countries such as the U.S. - where the labor market has returned to full employment - is likely to rise only gradually, as excess demand is satiated through higher imports. Such a redistribution of demand from countries with low levels of spare capacity to those with high levels is a win-win outcome for the global economy. Recession Running Out Of Room Unfortunately, all good things must come to an end. Weak productivity growth across most of the world is likely to cause bottlenecks to emerge over time, and this will cause inflation to move higher (Chart 3). Output gaps in the main developed economies would actually be higher today than at the height of the Great Recession had potential GDP grown at the rate the IMF projected back in 2008 (Chart 4). This is a testament to just how exceptionally weak potential growth has been. Chart 3Productivity Growth Has Slowed Across The Globe Chart 4Weak Supply Growth Has Narrowed Output Gaps U.S. growth will surprise to the upside over the next 12 months, leading to an unwelcome burst of inflation in late 2018 or early 2019. Financial conditions have eased sharply this year thanks to lower bond yields, narrower credit spreads, a weaker dollar, and a surging stock market. Changes in financial conditions lead growth by around 6-to-9 months, implying that U.S. growth could reach 3% early next year (Chart 5). This could take the unemployment rate down to 3.5% by end-2018, more than a full point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. The unemployment rate could fall even further if Congress succeeds in passing legislation to cut taxes, as we expect it will. Our geopolitical team estimates that the GOP proposal would reduce federal revenues by $1.1-to-$1.2 trillion over ten years, or about 0.5% of GDP.1 In order to appease moderates, the final bill is likely to scale back the size of the tax cuts and shift more of the benefits to middle class households. Under the current proposal, the top 1% of taxpayers would receive 50% of the tax benefits (Chart 6). Our best bet is that the legislation will be enshrined into law in early 2018. Chart 5Easier Financial Conditions Will Boost U.S. Growth Chart 6Republican Tax Would Disproportionately Benefit The Top 1% Welcome To The Steep Side Of The Phillips Curve The so-called Phillips curve, which depicts the relationship between unemployment and inflation, tends to become quite steep once unemployment falls to very low levels (Chart 7). It is easy to see why: When spare capacity is high, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The 1960s provide a useful lesson in that regard. Just like today, inflation hovered below 2% during the first half of that decade, even though unemployment was trending downward over this period. To most observers back then, the Phillips curve would have also seemed defunct. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 8). The kink in the Phillips curve had been reached. Inflation ultimately made its way to 6% in 1970, four years before the first oil shock struck. Chart 7U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve Chart 8Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Many commentators have questioned the relevance of the sixties template on the grounds that the U.S. economy was less open to the rest of the world back then, trade unions had greater bargaining power, inflation expectations were not as well anchored, and the deflationary effects of new technologies were not as pervasive. We discussed these arguments in a report published earlier this month, concluding that they are not nearly as persuasive as one might think.2 The Difficulty Of Achieving A Soft Landing Rising inflation will compel the Fed to hike rates aggressively starting late next year in order to push the unemployment rate back towards NAIRU. A turn towards hawkishness is especially likely if Janet Yellen is replaced by someone such as former Fed Governor Kevin Warsh, whom betting markets now think has a 40% chance of becoming the next Fed chair (Chart 9). The problem for whoever ends up running the Fed is that it is very difficult to raise the unemployment rate by just a little bit. Modern economies are subject to massive feedback loops. When unemployment begins rising, households lose confidence and reduce spending. This prompts firms to slow hiring, leading to even less spending. The U.S. has never averted a recession in the post-war era whenever the unemployment rate has increased by more than one-third of a percentage point (Chart 10). Chart 9Who Will The Next Fed Chair Be? Chart 10Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Lofty valuations are likely to exacerbate the adverse feedback loop described above during the next downturn. As growth slows, risk asset prices will tumble. This will cause business investment spending to dry up. Given America's dominant role in global financial markets, the U.S. recession will spread like wildfire to the rest of the world. Stagflation The Doves Reassert Control The next recession will probably be more painful for Wall Street than for Main Street. Fed-induced downturns tend to be swift but short-lived. The subsequent recoveries are usually V-shaped, rather than the elongated U-shaped recoveries that follow financial crises. Nevertheless, central banks around the world will undoubtedly start slashing rates again, perhaps even restarting their QE programs. Traumatized by the Great Recession, central bankers will overreact. The hawks will be blamed for the recession and forced to turn tail. The doves will reassert control. Fiscal policy will be significantly eased. This will be particularly the case if the next recession coincides with Trump's re-election campaign, brewing populism in Europe, and the spectre of military conflict in a variety of hotspots around the planet. Structural Forces Will Boost Inflation Meanwhile, millions of baby boomers will be in the process of leaving the workforce. This will lead to slower income growth, but not to slower spending growth - spending actually rises late in life due to spiraling health care costs (Chart 11). An increase in spending relative to income tends to push up prices. A recent IMF research report estimated that population aging has been highly deflationary over the past few decades, but will be very inflationary over the coming years (Chart 12). Chart 11Savings Over The Life Cycle Chart 12Demographic Shifts: From Highly Deflationary To Highly Inflationary All this suggests that the dip in inflation during the next recession will be fleeting. As the recovery from the shallow recession unfolds, inflation will reaccelerate. Of course, at that point, central banks could step in to aggressively quell inflationary pressures. However, they are unlikely to do so. After the next recession-induced burst of fiscal stimulus, debt levels will be even higher than they are now. The temptation to inflate away this debt will intensify. And, in an environment of anemic real potential GDP growth, the means to generate inflation will become available: Central banks will simply need to keep rates below their "neutral" level. Central bankers will rationalize their actions on the grounds that higher inflation will allow them to bring real interest rates deeper into negative territory in the event of another economic downturn. A growing chorus of eminent economists has begun to argue that a 2% inflation target is too low. For example, just this week, Larry Summers stated that "I think we probably need to adjust our monetary policy framework ... to [one] that provides for higher nominal rates during normal times, so there's more room to cut rates during downturns."3 II. Financial Markets As with the economic outlook, the three words reflation, recession, and stagflation guide our views of where financial markets are heading over the coming years. We continue to maintain a pro-risk stance, but are trimming our overweight recommendation to equities and high-yield credit due to the fact that valuations have gotten stretched and we are entering the last innings of the business-cycle expansion (Table 1). Table 1BCA's Tactical Global Asset Allocation Recommendations* Equities Sticking With Bullish ... For Now Recessions and bear markets tend to go hand-in-hand (Chart 13). None of our recession timing indicators are warning of an imminent downturn, suggesting that the cyclical global equity bull market has further room to run (Chart 14). Chart 13Recessions And Bear Markets Usually Overlap Chart 14AThis Business Cycle Has Further To Run Chart 14BThis Business Cycle Has Further To Run Strong growth in corporate earnings continues to underpin the rally in equities. The MSCI All-Country World index has increased by 11.9% in the first 9 months of the year, only slightly more than the 9.1% gain in earnings. As a result, the forward P/E ratio has only risen from 15.7 at the start of the year to 16.1 (Table 2). Table 2Earnings-Backed Price Appreciation Favor Cyclicals Over Defensives Above-trend global growth should boost profits over the next 12 months. We favor cyclical sectors over defensives, and are expressing this view through our long global industrial stocks/short utilities trade recommendation. The trade is up 0.9% since we initiated it last Friday and up 2.3% since I previewed it at BCA's annual New York Investment Conference earlier the same week. Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. Our model predicts that global capex will grow at the fastest pace in six years (Chart 15). This should benefit industrial stocks. On the flipside, rising global yields will hurt rate-sensitive utilities (Chart 16). Chart 15Global Capex On The Upswing Chart 16Higher Bond Yields Will Hurt Utilities Financials should also outperform. Banks, in particular, will benefit from steeper yield curves, faster credit growth, and ongoing declines in nonperforming loans. Energy stocks are also attractive. As discussed below, we continue to maintain a generally upbeat view on the direction of oil prices. Prefer DM Over EM, Europe And Japan Over The U.S. While it is a close call, we see more upside for DM than EM stocks, as the former are less vulnerable to a dollar rebound and an increasingly hawkish Fed. Emerging market equities have had a good run over the past year, and are due for a breather. Our favorite EM equity idea for the fourth quarter is to be long Chinese H-shares. H-shares are heavily tilted toward financials and deep cyclicals, two sectors that we like. They also trade at a mere seven-times forward earnings and one-times book value (Chart 17). Within the DM space, European and Japanese equities should outperform U.S. stocks in currency-hedged terms. The sector composition of both the European and Japanese market is tilted toward stocks that will gain the most from strong global growth and increased capital spending. As our European strategists have documented, the European stock market is dominated by large multinationals whose fortunes are tied more to the global economy than to domestic prospects. This is largely true for the Japanese stock market as well. If our prediction for a somewhat weaker euro and yen comes to pass, profits in both regions will benefit from the currency translation effect. Valuations in Europe and Japan are also generally more attractive than in the U.S, even if one adjusts for different sector weights (Chart 18). Chart 17Chinese H-Shares: A Valuation Snapshot Chart 18U.S. Stocks Look Pricey Small Cap Value Trumps Large Cap Growth Style-wise, we prefer small cap value over large cap growth. Value stocks generally do better in environments where cyclicals are outperforming defensives, while small caps tend to be high-beta bets on global growth (Chart 19). U.S. small caps will disproportionately benefit from cuts to statutory corporate taxes, since smaller companies typically have less ability to game the tax code in their favor. Timing The Next Bear Market As one looks beyond the next 12 months, the skies begin to darken for global equities. The stock market usually sniffs out recessions before they happen, but the lead time is quite variable and generally not that long (Table 3). For example, the S&P 500 peaked only two months before the start of the Great Recession in December 2007. Chart 19Favor Cyclicals And Value Plays Table 3Stocks And Recessions: Case-By-Case Chart 20Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment If the next recession begins in the second half of 2019, global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities are likely to fall 20%-to-30% peak-to-trough. While other global bourses are generally not as expensive, their higher-beta nature means that they will probably face similar if not worse declines. The fact that correlations tend to rise during risk-off episodes will only add to the bloodshed. Stocks And Stagflation If the experience of the 1970s is any guide, equities perform poorly in stagflationary environments (Chart 20). Investors tend to see stocks as a riskier substitute for bonds. When nominal bond yields rise, the dividend yield offered by stocks becomes less attractive. In theory, the increase in the nominal value of corporate net worth resulting from higher inflation should generate enough capital gains over time to compensate for the wider gap between dividend yields and bond yields. In practice, due to "money illusion" and other considerations, that does not fully occur, requiring that stocks become cheaper so that their expected return can rise. The Long-Term Outlook For Profit Margins A complicating factor going into the next decade will be what happens to profit margins. S&P 500 operating margins are close to their all-time highs (Chart 21). While margins will undoubtedly fall during the next recession, their subsequent recovery is likely to be encumbered by a number of shifting structural forces. A slew of labor-saving technological innovations depressed labor's share of income over the past few decades. So did the entry of over one billion new workers into the global labor force following the collapse of the Berlin Wall and China's transition to a capitalist economy. The fixation of central banks on bringing down inflation may have led to higher unemployment than what would otherwise have been the case, thereby undermining the bargaining power of workers. All this may change during the next decade. China's labor force has peaked and is on track to decline by over 400 million workers by the end of the century - a larger decline than the entire U.S. population (Chart 22). A shift towards persistently more expansionary monetary policy could also keep the labor market fairly tight. Chart 21U.S. Profit Margins Are Close To All-Time Highs Chart 22China On Course To Lose More Than 400 Million Workers Technological innovation will persist, but the firms that benefit from it are likely to attract more scrutiny from regulators. Republican voters - the traditional defenders of corporate America's God-given right to make a buck - are growing increasingly wary of big business. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to be liberal on social issues and conservative on economic ones. Very few voters actually share this configuration of views (Chart 23). The Democratic Party's "Better Deal" moves it to the left on many economic issues. This runs the risk of leaving the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. Bottom Line: Investors should stay overweight global equities, but trim exposure from moderate overweight to small overweight due to rising business-cycle risk, and look to get outright bearish late next year. The long-term outlook for equities is poor, especially in the U.S. where valuations are highly stretched. Chart 24 presents a stylized sketch of how we think the major stock market indices will evolve over the coming years. Chart 23An Absence Of Libertarians Chart 24Market Outlook: Equities Fixed Income Above-trend GDP growth and rising inflation are likely to push up long-term bond yields in most economies over the next few quarters, as flagged by our Central Bank Monitors (Chart 25). Bond yields will fall during the next recession and then begin to inexorably rise higher as stagflationary forces intensify (Chart 26). Looking out over the next 12 months, our regional allocation recommendations are as follows: Chart 25Our Central Bank Monitors Point To Growing Pressures To Tighten Chart 26Market Outlook: Bonds Underweight The U.S., Euro Area, And Canada Chart 27Canada Enjoys Robust Growth We remain underweight U.S. Treasurys in a global fixed-income portfolio. The market is pricing in only 44 basis points in Fed hikes between now and the end of next year, well below the 100 basis points of hikes implied by the dots in the Summary of Economic Projections. The U.S. yield curve has flattened since the start of the year. This should change over the next 12 months, as inflation expectations rebound from currently depressed levels. The yield curve in the euro area should steepen more than in the U.S., since the ECB has pledged not to raise rates until well after its asset purchase program is complete - something that is unlikely to happen until the end of next year. This implies that the 2-year spread between the two regions will widen in favor of the U.S., which should be bullish for the dollar. Canadian bond yields are likely to rise further (Chart 27). The unemployment rate has fallen to a nine-year low and the Bank of Canada expects the output gap to be fully closed by the end of this year. The economy grew by 3.7% year-over-year in the second quarter, well above the BoC's estimate of potential real GDP growth of 1.5%. The Bank's most recent Business Outlook Survey points to continued robust growth ahead. The bubbly housing market remains a concern, but delaying withdrawal of monetary accommodation risks exacerbating the problem. Neutral On Gilts And Aussie And Kiwi Bonds In contrast to most other developed economies, leading indicators point to slower U.K. growth in the months ahead (Chart 28). This undoubtedly reflects the ongoing uncertainty over Brexit negotiations, which are likely to drag on for quite some time. Core inflation has surged to 2.7% on the back of the sharp depreciation of the pound, but market expectations suggest that it is about to roll over. Nevertheless, with 10-year gilts fetching just 1.35%, the downside for yields is limited. The cheap pound should also prop up exports, partly offsetting the impact of diminished market access to the rest of the EU. The unemployment rate stands at 4.3%, slightly below the Bank of England's estimate of NAIRU. One way or another, the uncertainty over Brexit will fade, allowing gilt yields to move higher. As with gilts, the outlook for Australian and New Zealand bonds is mixed. Strong global growth should boost commodity prices. This will help the Australian economy. The unemployment rate in Australia has fallen to 5.6%, but involuntary part-time employment is high and wage growth has been stagnant. Industrial capacity utilization remains low, as reflected in a fairly large output gap (Chart 29). The market expects the RBA to deliver 38 basis points in rate hikes over the next 12 months. We think that's about right. New Zealand's 10-year yield stands at a relatively generous 2.96%, which makes it difficult to be too bearish on kiwi bonds. However, we do not see much scope for yields to fall from current levels. Nominal GDP is growing at over 5% and retail sales are expanding at nearly 7% (Chart 30). The terms of trade have risen to their highest level since the 1970s. The output gap is now fully closed and core inflation is edging higher. Despite this good news, the policy rate remains at a record low of 1.75%. We concur with market expectations that the RBNZ will start raising rates next year. Chart 28U.K. Growth Is Slowing Chart 29There Is Still Slack In The Australian Economy Chart 30New Zealand: Upbeat Indicators Overweight JGBs CPI swaps predict that inflation in Japan will average only 0.5% over the next twenty years. As we argued last week, this is far too low.4 The secular drivers of deflation are fading and inflation will begin to surprise to the upside over the coming years (Chart 31). However, the path between here and there will be a choppy one. Considering that deflationary expectations remain deeply entrenched, the Bank of Japan is unlikely to abandon its yield curve targeting regime for at least the next few years. As government bond yields rise elsewhere in the world, 10-year JGBs will be the default winners. Investors thinking of going short Japanese government bonds should focus on 20-year or 30-year maturities, which are not subject to the BoJ's cap. Credit: Still Overweight, But Trimming Back Exposure High-yield credit spreads have fallen back near their post-recession lows after widening in the wake of the global manufacturing recession (Chart 32). We see little scope for further spread compression. Our U.S. Corporate Health Monitor remains in deteriorating territory (Chart 33), and higher Treasury yields will put downward pressure on corporate bond prices even if spreads remain constant. Nevertheless, the default-adjusted spread on U.S. high-yield debt of 212 basis points is still large enough to warrant a modest overweight to credit, especially since banks have started to loosen lending standards again. Chart 31Japan: Fading Deflationary Forces Chart 32High-Yield Spreads Have Narrowed Chart 33U.S. Corporate Health Continues To Deteriorate Our Global Fixed Income Strategists prefer U.S. over European credit, given that spreads are lower in Europe, and the tapering of ECB asset purchases could reduce the demand for spread product. Currencies And Commodities The Dollar: Comeback Kid? Charts 34 and 35 show our expectations about the future path of the major currencies and commodities. Chart 34Market Outlook: Currencies Chart 35Market Outlook: Commodities BCA's Global Investment Strategy service went long the dollar in October 2014. We reiterated our bullish stance before the U.S. presidential elections, controversially arguing that "Trump Will Win And The Dollar Will Rally."5 Unfortunately, we remained long the dollar over the course of this year, which turned out to be a mistake. Strong growth abroad, weaker-than-expected inflation readings in the U.S., and the fizzling of the "Trump Trade" all contributed to dollar weakness. Technicals also played a role. Sentiment was extremely bullish towards the dollar at the start of the year, but extremely bearish towards the euro (Chart 36). The reversal of these technical trends helps explain why the euro appreciated a lot more than what one would have expected based simply on changes in interest rate differentials (Chart 37). Chart 36Euro: Long Positions Are Getting Stretched Chart 37The Euro Has Overshot Interest Rate Spreads Of course, if the spread between U.S. and euro area interest rates continues to narrow, it is likely that EUR/USD will strengthen. We are skeptical that it will. For one thing, financial conditions have eased sharply in the U.S. since the start of the year, but have tightened in the euro area (Chart 38). This suggests that U.S. growth will surprise on the upside whereas euro area growth could begin to disappoint. Chart 38U.S. Versus Euro Area Diverging Financial Conditions The five-year, five-year forward OIS spread between the two regions stands at 87 basis points in nominal terms, and 25 basis points in real terms. The five-year forward spread is even lower if one calculates a GDP-weighted bond yield for the euro area rather than looking at the expected path of interbank rates. Such a small spread is inconsistent with the fact that the neutral rate is substantially higher in the U.S.6 We expect EUR/USD to fall to $1.15 by the end of 2017, and potentially decline further in 2018 as the Fed picks up the pace of rate hikes. The dollar is also likely to strengthen against the yen, as Treasury yields rise relative to JGB yields. We see less downside for the British pound and the Swedish krona against the greenback. This is reflected in our long GBP/EUR and long SEK/CHF trade recommendations, both of which remain in the black. Upside For Oil-Sensitive Currencies Our energy strategists still see further upside for crude oil prices, owing to favorable supply and demand conditions. They point to the fact that official forecasts by the EIA have consistently underestimated oil demand. They also note that compliance with OPEC 2.0 production cuts has been remarkably good, and that estimates of how much new shale output will hit the market over the next 12 months are too optimistic. Additionally, they believe that the decline in production from conventional oil fields around the world - especially offshore fields, where there has been a dearth of new investment in recent years - could be larger than expected.7 Geopolitical risks in Iraq, Libya, and Venezuela could also adversely affect supply. Firmer demand and lackluster supply will lead to further drawdowns in OECD oil inventories, which should be supportive of prices (Chart 39). We recently took profits of 13.8% on our recommendation to go long the December-2017 Brent oil futures contract, but are maintaining exposure to oil through our long CAD/EUR and RUB/EUR positions, as well as through our bias towards cyclical equities. Resilient Chinese Economy Should Support Metal Prices And The RMB Recent Chinese data have been on the soft side, giving rise to fears that the economy is heading towards a major slowdown. We are more optimistic. While growth has clearly slowed since the start of the year, it remains at an above-trend pace, as evidenced by numerous real-time measures of economic activity (Chart 40). Chart 39Falling Oil Inventories Should Lead To Higher Crude Prices Chart 40Chinese Economy: No Need To Be Pessimistic Even the housing market has managed to stay resilient, despite widespread predictions of imminent doom (Chart 41). The share of households planning to buy a new home remains close to all-time highs. The amount of land purchased by developers - a good leading indicator for housing starts - is accelerating. Reflecting these developments, property stocks are surging. Financial conditions have tightened, but so far this has largely bypassed the real economy. In fact, long-term bank lending to nonfinancial institutions has accelerated since the start of the year (Chart 42). The recently announced cuts to reserve requirements for small business loans should facilitate this trend. Chart 41Chinese Housing Market Remains Resilient Chart 42Credit To Real Economy And Profit Rebound Bode Well For Capex Meanwhile, industrial profits have rebounded, as rampant producer price deflation last year has given way to modest price gains this year. Increased retained earnings will give Chinese companies the wherewithal to spend more on capital equipment. A recovery in global trade should also help stoke export growth. (Chart 43). Despite strengthening this year, our indicators suggest the yuan is still in undervalued territory (Chart 44). Buoyant economic growth should alleviate capital flight and reduce the pressure on the authorities to engineer a further depreciation of the currency. This, in turn, should help support metal prices and other EM currencies, even in a setting where the dollar remains well bid. Chart 43Positive Global Trade Momentum: A Tailwind For Chinese Exports Chart 44The Chinese Yuan Is Undervalued Chart 45Gold: Waiting For Drivers Of Sustained Price Appreciation Buy Gold ... But Not Yet Lastly, a few words on gold. Gold does well in situations where real rates are falling and the dollar is weakening (Chart 45). That's not the environment we find ourselves in today. Gold will have its day in the sun, but probably not before the stagflationary era begins in earnest after the next recession. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This revenue loss is measured against a baseline where a number of tax breaks, which are currently set to expire, are extended. Please see BCA Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 3 Summers, Lawrence, H. (@LHSummers). "Great piece by @jasonfurman in today's @WSJ: The U.S. can no longer afford deficit-increasing tax cuts." 01 Oct 2017. Tweet. 4 Please see Global Investment Strategy Weekly Report, "Three Tantalizing Trades," dated September 29, 2017. 5 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016. 6 Please see Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017. 7 Please see Commodity & Energy Strategy, "OPEC 2.0 Will Extend Cuts to June 2018," dated September 21, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Catalonia is a red herring - stay focused on U.S. tax cuts; Tax cuts are on track and will swell the budget deficit; The dollar is poised for a comeback; Believe the Phillips Curve, not the "Amazon effect"; Shinzo Abe's gamble is bullish; go long USD/JPY. Feature Global investors woke up on Monday to shocking news of a mass shooting in Las Vegas and police brutality in Catalonia, where Spain's federal law enforcement attempted to break up the October 1 independence referendum. According to final figures, nearly 92% of those who voted chose to separate from Spain, setting the stage for a unilateral declaration of independence. Our views on the Catalan independence "struggle" are well known to our clients.1 We will only briefly recap them here. Instead, we focus this Weekly Report on the prospects for the U.S. dollar and on Japan's snap election. Catalan Independence: Indignation Is Not A Strategy Why are we so dismissive of the imbroglio in Catalonia? Five reasons: Police "brutality" is overstated: Catalan officials reported that 844 people had been hurt in clashes, but the BBC noted that the "majority had minor injuries or had suffered from anxiety attacks."2 Not the first referendum: The turnout was only 42.34%, as many voters refused to participate. Given that the latest polls show that only 34.7% of Catalans actually want independence, the result was unsurprising (Chart 1).3 Those who oppose independence from Spain stayed home, as they did in 2014. In fact, Table 1 shows that there were about 100,000 less "yes" voters in 2017 than three years ago. Catalonia is not Catalan: According to the latest data from the Institut d'Estadística de Catalunya, only 31% of the population identifies Catalan as their "first language," compared with 55% who identify with Spanish. This is a product of decades of migration from within Spain which has diluted Catalonia's homogeneity. For the most part, the non-Catalans belong to the working class and do not get involved in independence protests or in breathlessly tweeting about the return of dictatorship to Madrid. But if they sense that independence is being imposed on them by an elitist minority, they could let their voice be heard. A declaration of independence means nothing: A unilateral declaration without international support, or the ability to enforce it with arms, is vacuous. U.S. President Donald Trump lent his support to Spanish Prime Minister Mariano Rajoy ahead of the vote, while French President Emmanuel Macron reiterated his support for Madrid following the referendum violence. The EU has made it clear that an independent Catalonia would have to go through the accession process in order to enter the EU, which means it would not have access to the Common Market post-independence. Catalans will not resort to force en masse: Our expectation is that Catalans will not resort to force in order to breakaway from Spain. German sociologist Max Weber famously defined sovereignty as a "monopoly over the use of legitimate force" in a defined geographical territory. If a Catalan minority is unwilling to wrestle control of borders from Spain, its declarations will be irrelevant. Chart 1Catalonia: A Revolt By The Minority Table 1What Has Changed Since 2014? There is more to the referendum than the government in Catalonia is letting on. The Junts pel Sí (Together for Yes) coalition of four parties is unified only by its stance on independence. But the main two nationalist parties that make up the government are on the opposite sides of the ideological spectrum. Without the independence push, the regional government would lose its raison d'être and fall. From the market perspective, the situation in Catalonia would become relevant if the Catalan government, or militant groups in the region, decided to step up tensions by employing force. This could derail Spain's economic recovery, especially since so much of it was centered on manufacturing in the region. We do not see this as likely. First, there are no "militant groups" in Catalonia. Second, throughout the half-century long Basque conflict - which saw over thousand people killed between 1959 and 2011 - Catalonia never experienced violent unrest. Catalan extremists never got inspired by the militant Basque group ETA on any significant scale. Why? Because the independence movement in Catalonia is mainly a bourgeois, middle and upper class, "struggle" for independence that is unlikely to descend into violence. Yes, there are some farmers and blue-collar supporters of independence. But the majority of Catalonia's working class are actually not Catalan. They are either recent migrants from the rest of Europe or migrants from poorer regions of Spain. Not only are they opposed to independence, but they are openly hostile to a bourgeois minority lording their Catalan ethnic superiority over the recently arrived migrants. With Catalan tensions, the ongoing North Korean saga, and the recent tragedy in Las Vegas, there is plenty to distract investors from the most investment-relevant political issue: U.S. tax policy. Bottom Line: As we noted in February, European assets will continue to "climb the wall of worry," which includes Catalan tensions.4 Investors should fade any market reaction to the crisis in Catalonia, which is sure to dominate the news flow for at least the entirety of Q4 2017. Do Republican Voters Want Tax Cuts? The market was shocked at the end of September by President Donald Trump's tax reform plan. After months of doubting whether Republican policymakers can accomplish anything, the market reacted positively to the announcement (Chart 2). And yet a lot of skepticism remains. Primarily, the fear is that fiscally conservative Republicans in the House and Senate will stand in opposition to the plan. After all, Republicans have just failed to repeal and replace Obamacare. Why should tax policy be any different? Chart 2Sign Of Life For 'Trump Reflation' We have argued since November that Republicans in Congress are actually not fiscally responsible.5 Not now and not ever. As if on cue, this spring, the leader of the Tea Party-linked Freedom Caucus, Mark Meadows (R, NC) said that the upcoming tax reform effort did not have to be "revenue-neutral," a claim he repeated on NBC's Meet The Press this weekend. If the leader of the single-most fiscally conservative grouping in Congress is okay with profligacy, who is left to oppose it?!6 Republican voters might have something to say about deficit-busting tax legislation. But GOP legislators are not the only ones willing to compromise on their austerity rhetoric. Republican voters are just as comfortable with profligacy. Chart 3 speaks volumes. It shows that Americans become a lot more comfortable with a bigger government providing more services when Republican presidents are in power. Given Democrats' stable preference for more spending, the movement in the poll is mainly due to Republican and independent voters. There are two ways to interpret the data: Republican voters do not mind a profligate government, as long as the spending is aligned with their priorities. Republican voters do not actually disagree with Democrats on spending priorities, but merely doubt that Democratic policymakers can deliver on those priorities in a fiscally sustainable manner. Whatever the explanation, Chart 3 is clear evidence that the American public grows more comfortable with profligacy when Republicans are in charge. But do voters want tax cuts? The latest polls show that Americans no longer think that they pay too much in taxes (Chart 4). Republican and Republican-leaning voters do not have a problem with how much they pay in taxes, but they do have a problem with the complexity of the tax code (Chart 5). Chart 4American Voters Think Taxes Are Fair... Chart 5...But Republican Voters Think They Are Too Complex The charge that the Trump tax legislation will be a massive tax cut for the wealthy and corporations could stick with some voters, we think primarily with Democrats. Pew research polling consistently shows that Democrats, across the income brackets, agree by 70%-80% that corporations and wealthy people pay too little tax. Republican voters could be susceptible to the same argument, given that around 35%-45% of them agree with Democrats on this issue. To preempt the debate, the Trump administration is focusing heavily on tax complexity. In addition, Trump left the proposed surcharge on the wealthy - a fourth income bracket in the new plan - as yet undefined. This is on purpose. It allows the White House and Congressional GOP legislators to respond to the criticism as it develops. What could be the stumbling blocks going forward? A "Breitbart clique" revolt: A populist revolt against tax cuts for the rich could turn skittish Republicans in Congress against the legislation. The recent electoral defeat for the political establishment in the Alabama Senate primary has shown off the power of the "Breitbart clique" in itself, independent of Trump. However, a quick survey of Breitbart.com shows that the former White House Chief Strategist and Rabble-Rouser-in-Chief Steve Bannon has not unleashed his media machine against the tax plan. In fact, the only prominent Breitbart piece on the tax plan thus far has excoriated the mainstream media for misinterpreting the comments of Gary Cohn, the White House's chief economic adviser, on middle class tax cuts.7 It may be the first time that the website has ever written anything positive about Cohn. Blue State Republicans: There are 29 Republican representatives facing tough reelection campaigns next year who are based in states that voted for Secretary Hillary Clinton in 2016. These Republican representatives will staunchly oppose any proposal to end the state and local tax deduction, given that their voters will be subjected to higher rates of state and local taxes.8 These "Blue State Republicans" could scuttle the current tax blueprint in the House. Anticipating the problem, Gary Cohn has said that the removal of the deduction is not a "red line" for the administration. Senators: Republicans have only a slim margin for error in the Senate. Senators Bob Corker (R, TN) and John McCain (R, AZ) could be the two staunchest opponents to the tax reform effort. The former is a deficit hawk and critic of the president, the latter is a maverick and firmly opposed to the president. On the other hand, the usual thorn in the side of the GOP establishment, Rand Paul (R, KY), could be brought around to support the proposal. Moderates like Susan Collins (R, ME) and Lisa Murkowski (R, AK) should be watched carefully. Investors should expect more Republicans to come out in opposition to certain provisions of the proposed tax legislation. However, the path of least resistance is not for the entire effort to fail, but rather for it to become more profligate. For example, the White House has already gestured towards a compromise with Blue State Republicans on the state and local tax deduction that would increase the deficit. Furthermore, we continue to stress that the failure of the Obamacare repeal and replace bill is not a good guide for what will happen with tax legislation. Taking away an entitlement program is politically challenging. Tax cuts, on the other hand, are generally not. Bottom Line: President Donald Trump is an economic populist. Our research into international comparisons shows that populists tend to get what they want, which is primarily higher nominal GDP growth (Chart 6). We therefore continue to expect the roughly $1.5 trillion tax cut effort - which may or may not deserve the title of tax reform - to pass. Is King Dollar Primed For A Rally? Investors should consider the proposed tax legislation a form of modest stimulus. If we assume that the $1.5 trillion in tax cuts will be offset with a combination of revenue-raising policies to the tune of 50%, it still leaves roughly $750 billion in new deficit spending (stimulus) over the next ten years. A more reasonable figure for total revenue offsets is around $400 billion, which would put the cost of stimulus at roughly $1.1 billion.9 This is not extraordinary large, but even a modest effort this far into the economic cycle could have a significant effect. BCA's Chief Global Strategist, Peter Berezin, believes that inflation is around the corner.10 So why the delay in the data? Peter points out that while the Phillips Curve has gotten a lot flatter over the past four decades (Chart 7), it remains a curve. Once the economy reaches full employment - as it has done in the U.S. (Chart 8) - the curve steepens much faster. As Peter puts it: Chart 6Populists Deliver (Nominal) GDP Growth Chart 7The Phillips Curve Has Gotten Flatter Chart 8U.S. Economy At Full Employment The idea that the Phillips curve steepens at low levels of unemployment is very intuitive: If excess capacity is high to begin with, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The empirical evidence supports this conclusion. Chart 9 shows that U.S. wage growth has tended to accelerate once the unemployment rate falls into the range of 4%-5%. Chart 9Watch Out For The 'Kink' In The Phillips Curve When we present Peter's argument to clients, many retort that "this time is different," namely because of phenomena like the "Amazon effect." To put that argument to rest, our colleague Mark McClellan has penned a Special Report titled, "Did Amazon Kill The Phillips Curve?"11 Mark shows that while e-commerce is undoubtedly increasing its share of retail sales (Chart 10), its contribution to annual headline CPI is modest. For example, Chart 11 shows that online prices fell relative to the overall CPI for most of the time since the early 1990s. However, e-commerce only contributed about -0.15 percentage points to annual CPI in June 2017, and has never contributed more than -0.3 percentage points. Chart 10E-Commerce: Steady Increase In Market Share Chart 11Online Price Index To further test the impact of e-commerce on inflation, Mark focused on the parts of the CPI that are most exposed to it. If online shopping is having a significant deflationary impact on overall inflation, we should see large and persistent negative contributions from these parts of the CPI. He therefore combined the components of the CPI that most closely matched the sectors that have high e-commerce exposure (Chart 12). Again, the contribution of e-commerce-heavy sectors to annual CPI is minimal. Chart 12Electronic Shopping Price Index Chart 13BCA E-Commerce Proxy Price Index Chart 14BCA E-Commerce Adjusted Proxy Price Index Mark finally recalculated the e-commerce proxy using only the sectors displaying the most relative price declines - clothing, computers, electronics, furniture, sporting goods, air travel, and other goods - and assumed that all other sectors actually deflated at the average pace of the entire index. The adjusted e-commerce proxy suggests that online pricing reduced overall CPI by about 0.1-0.2 percentage points in recent years (Chart 13 & Chart 14). We find Mark's work intuitive. The "Amazon effect" is a great example of fitting a broad theory to a particular set of data, a common error in the investment community. The weak inflation print - which is a "Summer of 2017" phenomenon - is being extrapolated into a decade-long theme. But the data is clear: the deceleration of inflation since the Great Financial Crisis has been in areas unaffected by online sales, chiefly energy, food, and shelter costs. High corporate profit margins in the retail sector also argue against the idea that e-commerce represents a large positive macro supply shock. In fact, today's creative destruction in retail may be no more deflationary than the shift to "big box" stores in the 1990s. Putting it all together, the three above views provide a fairly clear signal in terms of asset implications: Geopolitical Strategy Tax Policy View: Tax legislation is a form of modest stimulus enacted by a populist White House in search of higher nominal GDP growth, and it will pass; Global Investment Strategy Phillips Curve View: The Phillips Curve is not dead, just dormant, and will steepen as the U.S. unemployment rate declines further below the equilibrium level; The Bank Credit Analyst "Amazon Effect" View: There is no "Amazon Effect." Pro-cyclical fiscal stimulus in the U.S. should be bullish for the U.S. dollar, bullish for U.S. small caps relative to large caps, and bearish for U.S. 10-year Treasuries. We are already long USD against EUR by recommending that our clients go long Euro Area equities relative to the S&P 500 with a currency hedge.12 We think there may be more upside for the USD against the yen, especially given our view of the upcoming general election in Japan below. What are the risks to a bullish USD view? Continued strong global growth is the main risk (Chart 15). Global data is improving to the point that even moribund Italy is now on fire (Chart 16). However, the positive data may be peaking. European data, in particular, looks like it is reaching its absolute highs (Chart 17). Chart 15Can Global Growth Get Any Higher? Chart 16Italy Is On Fire... Chart 17...As Is Europe Overall Particularly concerning from the global perspective is the ongoing slowdown in the pace of expansion of Chinese money and credit, which we have been arguing for almost a year is policy induced.13 Our colleague Arthur Budaghyan, Chief Strategist of BCA's Emerging Market Strategy has flagged that the official M2, as well as BCA's own custom version of broad money M3, are slowing down to new lows (Chart 18). From the broad money M3, Arthur and his team construct the M3 impulse, which leads both the Chinese leading economic indicator and the well-known "Li Keqiang index" (a growth proxy) by six months (Chart 19).14 Most importantly from the global perspective, the slowdown in Chinese money and credit growth ought to negatively impact demand for imports from China-exposed export sectors in Asia and Europe (Chart 20). Chart 18But Credit Growth In China Is Slowing Chart 19Chinese Credit Leads The Domestic Economy... Chart 20...As Well As Exports To China The policy-induced crackdown against money and credit growth in China should be particularly pertinent in Europe. BCA's Foreign Exchange Strategy has noted how the close trading relationship between China and Europe influences the growth delta between Europe and the U.S.15 Given the potential slowdown in China, and subsequent impact on EM economies, bullishness on Europe could be peaking. Bottom Line: Our view that a modest fiscal stimulus may be afoot is only a small part of a wider BCA bullish-USD narrative. We think it is once again time to turn bullish towards the greenback. We are opening a long USD/JPY recommendation. Our colleague Mathieu Savary, Chief Strategist of BCA's Foreign Exchange Strategy, has been long since USD/JPY hit 109 on August 11. Japan: Abenomics Will Survive Abe Japanese Prime Minister Shinzo Abe's snap election on October 22 took us by surprise. Not because of the timing, which was telegraphed by rumors in the press, but because, for Abe and the ruling Liberal Democratic Party (LDP), the upside risk is limited while the downside is unlimited. Since May 24 we have argued that Abe's political capital has peaked, based on the empirically grounded expectation that his pursuit of constitutional changes to legitimize Japan's defense forces would erode his popular support.16 This view received confirmation in early July, when Yuriko Koike, a former LDP politician, led an insurgency against the LDP in the Tokyo metropolitan elections and dealt them a historic blow in that region. At that time, we argued that Abe would not lose power anytime soon: he maintained his two-thirds supermajority in the lower house (and virtual supermajority in the upper house), did not face an election until December 2018, and could thus double down on reflationary economic policies in order to rebuild popular support.17 Chart 21An Upstart Party Challenges The LDP Now, Abe has made a risky decision to move the general election forward 14 months. He wants to capitalize on Japan's recent strong economic performance, the peaking of North Korean tensions (which are likely to decline by late next year), and an uptick in approval ratings. Last but not least, he wants to take the fight to the political opposition at a time when the rival Democratic Party is in total collapse and Governor Koike, his chief antagonist, is unready to wage a national campaign. The timing was shrewd but comes at a cost. Koike announced a new political party, the Party of Hope, just hours before Abe called the early election. In the first set of opinion polls it has sprung up to 15% approval, only nine points shy of the LDP. True, this is still 14 points short of the ruling coalition (Chart 21). But crucially, the collapse of the Democratic Party prompted its leader, Seiji Maehara, to declare that his party would not contest the new elections. This leaves its members free to join Koike's party; it also partly obviates the problem of the Democratic Party and Party of Hope stealing each other's votes.18 Throughout Abe's term we have compared his approval ratings to those of former Prime Minister Junichiro Koizumi, the LDP's last heavyweight leader, to test whether he retains political capital (Chart 22). According to this measure, he does. Yet, given Abe's long tenure and gradually declining support, this comparison only works as long as there is no viable alternative. That is because Abe's net approval rating, as well as his ability to bring star-power to the LDP, has been fading in recent years (Chart 23). Now he has called an election at the very moment that a possible alternative has emerged!19 Chart 22Abe Losing Favor Over Time Chart 23Abe Becoming A Liability However, we say a possible alternative for a reason: Koike herself, as yet, is refusing to run for the prime minister's slot. She is in a "dilemma of irresponsibility" in which, having just become governor of Tokyo on the pledge to put "Tokyo First," she will be criticized for flagrant ambition and flip-flopping if she abandons that post to run against Abe directly.20 As long as Koike remains on the sidelines, Abe will retain his absolute majority. It would be very difficult for a new party that is struggling to field candidates across the whole country, lacks a clear prime minister candidate, and faces competition with other opposition parties to deprive an incumbent coalition of 85 seats. (Depriving the LDP of its 50-seat party majority alone would be momentous, though conceivable.) The LDP has fallen out of power on only two previous occasions since 1955: once, briefly, in 1993, in the wake of the collapse of Japan's Heisei bubble, and once in 2009, in the wake of the global financial crisis (Chart 24). And the LDP has never lost more than 22 seats in an election year, like this year, in which economic growth is faster than the preceding year. That size of loss would leave Abe wounded but still in control.21 Chart 24The LDP Seldom Loses Elections In Japan On the other hand, if Koike changes her mind and throws herself headlong into competition with Abe, it is possible, albeit still highly unlikely, that she could pull off a historic upset.22 Currently the number of undecided voters is high at about 43%. In recent years, these voters have tended to correlate negatively with LDP support (Chart 25), meaning that LDP voters grew dissatisfied and "undecided" but then came crawling back when the party wooed them. However, Koike could change this dynamic - not only because she apparently has momentum, but also because her background and platform are substantially similar to Abe's, yet with a fresh face.23 Chart 25Undecided Voters Often Return To LDP Koike must make her decision by October 10. It is unlikely that she will join or that her party will field enough competitive candidates - in this respect, Abe gambled correctly in calling the election now. Barring her entrance, what is at stake is Abe's 6-seat "supermajority" in the lower house. Abe is likely to lose this advantage simply based on the Party of Hope's strength in Greater Tokyo and the Kanto Plain, augmented as it is by collaboration with the Democratic Party. A back-of-the-envelope calculation suggests that Koike could easily deprive Abe of this supermajority. Assuming that the Party of Hope performs in line with Koike's performance in the Tokyo/Kanto region in July, gaining 39% of the seats (34% of the popular vote), implies that the Party of Hope could steal as many as 47 seats from the ruling coalition on October 22 (Table 2). This is a generous estimate in giving Koike's party strong support, but a conservative estimate in assuming that it will not win a single seat outside the Tokyo/Kanto region.24 Losing this supermajority would be a big loss of momentum for Abe and the LDP that would carry over into the legislative process (where Abe would struggle to control the LDP factions and fend off corruption allegations) and future elections (where the LDP would be more vulnerable). It would sow the seeds for a leadership challenge against Abe in the LDP next September. But it keeps the LDP in power for the next four years. And its direct impact on passing bills is limited. A lower house majority would still be under the LDP leader's control, and the LDP would still have a near-supermajority in the upper house, removing any risk that it would delay bills. The only initiative likely to suffer would be Abe's treasured constitutional revisions, and yet even those would still have a fighting chance of passing the Diet. The important thing for investors to realize is that a setback or defeat for Abe will not be the death of Abenomics.25 Reflation will continue and Japanese risk assets will continue to outperform on a currency-hedged basis. Why? Table 2The Party Of Hope Threatens The LDP Supermajority From Its Base In The Tokyo/Kanto Region Abenomics is already bearing fruit: Inflation remains weak, but Japan's output gap is closing and unemployment gap is gone (Chart 26). It is only a matter of time before supply constraints put more upward pressure on prices, lowering real rates and easing financial conditions for the economy as a whole. Koike, who styles herself as a pro-business Thatcherite, will not stand in the way of growth. Monetary policy will remain dovish: The dovish shift in the Bank of Japan in 2013 was a regime change within the institution itself. Governor Haruhiko Kuroda was the leader of the change, but since then the entire policy board has been staffed with doves. In fact, in the board's recent minutes, the only dissenting voice argued for more stimulus.26 Kuroda can legally be reappointed for governor for another five years. If not, his replacement will likely perpetuate his legacy, as neither Abe nor Koike have given any hint at wanting more hawkish monetary policy. The market is right to expect barely any rate hikes over the next year and for the BoJ to continue suppressing yields even as other DM central banks become more hawkish (Chart 27). Chart 26Tight Labor Market, But Still No Inflation Chart 27Monetary Policy Will Remain Easy Fiscal policy will ease further: We have shown Chart 28 again and again to clients: the main failure of Abenomics so far has been Abe's own fiscal responsibility. Upon calling the election, he yet again pitched himself to voters on the basis of fiscal irresponsibility. He offered a new 2 trillion yen stimulus package and suspended his pledge to balance the budget by 2020. And while he pledged to pay for education and elderly care by raising the consumption tax from 8% to 10% as scheduled in October 2019, few doubt that he will delay a tax hike (as in 2015) if it threatens to upset his economic recovery. Meanwhile, Koike is running on a platform of easier fiscal policy: she has outright opposed the consumer tax hike, saying that to do so would be to "throw cold water on the still-intangible economic recovery." She wants more earthquake-resistant infrastructure and more social spending (e.g. childcare). She wants measures to boost the female participation rate further (Chart 29).She is hardly likely to boost consumption without continuing Abe's quest to lift wages overall (Chart 30). And in her most significant difference from Abe, she hopes to do away with nuclear power and turn Japan into a renewable energy powerhouse (inevitably requiring large-scale government subsidies and investment). Foreign policy will remain hawkish: Koike is a conservative who is in favor of constitutional revisions to normalize Japan's military. Her Party of Hope could even vote with the LDP on this issue, for a price. While it may be somewhat more China-friendly than Abe (possibly a boon for exports), it would not be willing or able to break Japan's recent trend of rising defense spending and economic diplomacy. Chart 28Fiscal Policy Will Get Easier Chart 29Abe And Koike Want Women Workers Chart 30Abe And Koike Want Higher Wages Moreover, given that Japan has a much higher ratio of public investment to private investment than other comparable countries, and that fiscal spending is limited by a massive debt load, Koike would be committed to boosting private investment just like Abe (Chart 31). Indeed, judging solely by key policy planks, the Party of Hope could almost become an LDP coalition partner. It cannot win a majority without Koike as frontrunner, and even if it did, it would lead to a fractious parliament where it would be forced to cooperate with the LDP in order to pass bills through the LDP-dominated upper house. Koike's sudden emergence does not represent a shift in national trends but rather a confirmation of the post-2011 Japanese political consensus in favor of a dovish central bank, dovish fiscal policy, and hawkish foreign policy. Chart 31Abe And Koike Want Private Investment Chart 32Not Abandoning Nuclear Power Anytime Soon Bottom Line: As things stand, Abe will probably lose his supermajority yet retain his majority in the lower house. This will cause some volatility and policy uncertainty in Japan. Nevertheless, the outlook is still highly reflationary. Koike reveals that the median voter favors pushing Abenomics even further. Should Koike make a dash for the prime minister's slot, she does have a small chance of coming to power. It is hard to put a probability on it until more polling data is available. The biggest policy consequence of a Party of Hope-led government would be her energy agenda of weaning Japan off of nuclear power, which would in the first instance shrink the current account surplus, as during the nuclear shutdown following the Tohoku earthquake in 2011 (Chart 32). However, a Koike majority is unlikely to materialize as things stand, and the LDP in the upper house would be a check on such policies. Go long USD/JPY in expectation of more reflation. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, and BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 2 Please see BBC, "Catalan referendum: Catalonia has 'won right to statehood,'" dated October 2, 2017, available at bbc.com. 3 We are referencing poll numbers collected by the Centre d'Estudis d'Opinió, which is run by the pro-independence government of Catalonia. In other words, if biased, the polls should be biased towards independence. 4 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 6 Apparently, the Democrats! Democratic leaders in Congress oppose tax reform policy that is not revenue-neutral. However, the GOP can ignore them as they plan to use the reconciliation procedure to pass tax policy. 7 Please see John Carney, "Mainstream Media Distort Every Single Thing Gary Cohn Says About GOP Tax Plan," dated September 30, 2017, available at breitbart.com. 8 The announced tax reform plan does not include such a proposal - nor does it provide any detail on how tax cuts would be paid for - but it has been floated as a possibility. This is because it could save the government nearly $370 billion by 2020, according to a report from the congressional Joint Committee on Taxation. 9 For revenue offsets that are likely to pass, we combine the repatriation of foreign earnings ($138 billion over the next decade), the repeal of certain corporate tax breaks ($138 billion), and the repeal of certain individual tax expenditures ($385 billion). We roughly estimate that the offset would total $400 billion, as horse-trading in Congress is likely to reduce the eventual size of overall revenue-offsets. The path of least resistance in Congress is towards more deficit spending, not less. 10 Please see BCA Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017, available at gis.bcaresearch.com. 11 Please see The Bank Credit Analyst Special Report, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017, available at bca.bcaresearch.com. 12 We recently closed our recommendation of being long Euro Area equities relative to the U.S. in an unhedged position for a 7.88% gain. 13 Please see "China: Xi Is A 'Core' Leader ... So What?" in BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016; "China: How Far Will Deleveraging Go?" in Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017; and Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 14 Please see BCA Emerging Market Strategy Weekly Report, "Copper Versus Money/Credit In China - Which One Is Right?" dated September 6, 2017, available at ems.bcaresearch.com. 15 Please see BCA Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 18 The problem still partially exists, as the opposition remains divided by various parties, and left-wing members of the Democratic Party have formed a new Constitutional Democratic Party of Japan that will contest the election and compete with the Party of Hope as well as the ruling LDP. 19 Incidentally, she is one of Koizumi's disciples who can count on his support. 20 According to Shinjiro Koizumi, "If she runs it's irresponsible, if she doesn't run it's irresponsible ... she's in a 'dilemma of irresponsibility.'" Quoted in Robin Harding, "Yuriko Koike hits trouble in Japan election campaign," Financial Times, October 2, 2017, available at www.ft.com. 21 The 22-seat loss referred to above occurred under the leadership of Takeo Miki in 1976. 22 There have been only two occasions in which a multi-term prime minister like Abe lost power due to holding a general election - 1960 and 1972. In the latter, comparable case, Eisaku Sato, who had been in power for eight years, lost power despite the fact that economic growth had recovered from a slight slowdown in 1971. In other words, the lack of enthusiasm for Abe amid a recovering economy is an important warning sign, which we discussed in BCA Geopolitical Strategy Weekly Report, "Insights From The Road - Asia," dated August 30, 2017, available at gps.bcaresearch.com. 23 It will also be important to see if leading politicians continue to defect from other parties and flock to her ranks. Especially politicians from the LDP, and especially those who are not worried, like Mineyuki Fukuda, about losing their seats anyway. 24 It also neglects recent reforms to the electoral system that will eliminate ten seats, only one of which is likely to go to the Party of Hope. 25 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 26 Please see Bank of Japan, "Summary Of Opinions At The Monetary Policy Meeting," September 20-21, 2017, p. 5, available at www.boj.or.jp/en.

Highlights Oil Breakout: Bond markets have been slow to discount the impact of higher oil prices on global inflation, which should lead to steeper yield curves and additional increases in inflation expectations. Trump Trade: The proposed U.S. tax cut plan will result in wider budget deficits and, potentially, faster U.S. inflation with the U.S. economy already near full employment. The Fed is likely to respond to this with even tighter monetary policy, although not by enough to flatten the Treasury curve by as much as is currently discounted. ECB Taper: The ECB will announce a slower pace of asset purchases at the policy meeting later this month, which should bear-steepen European yield curves via widening term premia on longer-dated debt. Feature A More "Normal" Bond Market Chart of the WeekLike Deja Vu All Over Again Global bond yields have bounced very sharply off the September lows. The benchmark 10-year U.S. Treasury yield hit a 3-month intraday high of 2.37% yesterday, while the 10-year German Bund yield touched 0.5% last week. Bond markets have returned to focusing on traditional fundamentals, like growth and inflation, after spending a few weeks worrying about nuclear tensions with North Korea and other political matters. On that note, the global economic news continues to point towards continued solid growth, rising inflation pressures and, in response, less accommodative monetary policy. There is scope for additional increases in bond yields, as markets are still pricing in too much pessimism on inflation and too little hawkishness from central bankers. The latter is especially true in the U.S. where the Federal Reserve is sticking with its plans to deliver another 100bps of rate hikes by the end of 2018 if its growth and inflation forecasts are realized. The odds of that happening would increase substantially if the Trump Administration can successfully deliver tax cuts, which would represent a very rare occurrence of a fiscal stimulus coming at a time of full employment in the U.S. The announcement last week of the Trump tax cut proposals did send a whiff of the old "Trump trade" dynamic through financial markets. The U.S. Treasury curve bear-steepened, the U.S. dollar rallied, inflation expectations rose and the S&P 500 blasted through the 2500 level to hit a new all-time high. Stocks of companies that pay higher tax rates outperformed, just like they did after the election of President Trump nearly one year ago (Chart of the Week). Add in some additional reflationary pressure from Brent oil prices approaching $60/bbl, and it is no surprise that yield curves in most Developed Markets (not just the U.S.) steepened. With this reflationary backdrop, amid tight labor markets and a solid pace of coordinated global growth, we continue to recommend fixed income investors maintain a defensive duration posture, while favoring spread product over government bonds. Yields will continue to rise in the next 6-12 months, but led more by the long-end initially. In particular, we expect government bond yield curves to extend the recent trend of bear-steepening, for three reasons: rising inflation expectations, increased optimism on U.S. fiscal policy and what it means for the Fed, and the upcoming announcement of a tapering of bond purchases by the European Central Bank (ECB). Are Bond Investors Too Complacent On The Inflationary Impact Of Higher Oil Prices? We have received a surprisingly small amount of criticism from the BCA client base about our bearish strategic view on global government bonds in recent months. Perhaps that is because our clients also have a negative opinion on duration risk. At our annual investment conference in New York last week, we conducted polls which showed that a majority of the attendees expect the 10-year U.S. Treasury yield to rise to between 2.5% & 3% by this time next year. At the same time, only 1 in 4 respondents felt that being short duration in U.S. Treasuries was the "contrarian" trade that was most likely to succeed over next 12 months - perhaps because betting on higher yields is not really a contrarian opinion right now! Yet we wonder how aggressively investors in aggregate, and not just BCA clients, are positioned for a rising yield environment. The market is only discounting 40bps of Fed rate hikes over the next twelve months, even as the U.S. economic data flow continues to improve and the Trump Trade is coming back in style (Chart 2). Survey data shows that professional bond managers are running only small duration underweights, yet speculators are still running very net long positions in Treasury futures. In other Developed Markets, there are not a lot of rate hikes priced outside of Canada - where the central bank actually is tightening policy - despite our Central Bank Monitors all calling for policymakers to become less dovish, if not more outright hawkish, as we discussed last week.1 In their defense, bond investors have had a lot of non-economic factors to digest in the past couple of months - not the least of which is judging how much of an "apocalypse premium" to price into bond yields given the nuclear saber rattling between D.C. and Pyongyang. Yet when stepping back away from the headlines and tweets, bond markets have been noting the implications of rising oil prices in a typical manner - higher inflation expectations and steeper yield curves. Oil prices have risen over $10/bbl since the June lows, led by a combination of rising demand on the back of an expanding global economy and a diminished supply response that has seen excessive inventories start to be wound down (Chart 3). BCA's commodity strategists have been expecting such a move to unfold, and prices have already risen into the $55-60/bbl range (on Brent crude) that they were calling for towards year-end. While a move beyond $60/bbl is not currently expected, any additional upside surprises in global growth can only tighten the supply/demand balance in an oil-bullish direction. At a minimum, oil prices can consolidate recent gains, providing a floor to inflation expectations. Already, the breakeven rate on 10-year TIPS in the U.S. have risen 18bps off the June lows, which has prevented the slope of the Treasury curve from flattening even as the 2-year Treasury yield hit an 9-year high last week (Chart 4). We expect to see more bear-steepening of the Treasury curve in the next few months as realized inflation rates begin to grind higher and the Fed will be relatively slow to respond - they'll need to see the inflation pick up first before delivering more rate hikes. This will result in higher market-based inflation expectations (i.e. wider TIPS breakevens) as investors price in a greater chance that inflation will sustainably return to the Fed's 2% target. While oil is not the only factor that matters for U.S. inflation, it is a lot harder for investors to believe that core PCE inflation can rise to 2% without higher oil prices. Chart 2A Revival Of The Trump Trade? Chart 3A Bullish Supply/Demand Backdrop For Oil Chart 4Oil Vs. The U.S. Yield Curve A similar dynamic is taking place in other countries. Inflation expectations (linkers or CPI swaps) are rising alongside rising energy prices in the Euro Area (Chart 5), U.K. (Chart 6), Canada (Chart 7) and Australia (Chart 8). The moves in expectations are largest in countries experiencing stronger growth (the Euro Area and Canada), and more modest where growth is mixed (the U.K.) and where realized inflation is still very low (Australia). Yield curves have generally steepened in response to the reflationary rise in oil prices except for Canada, where the central bank has already delivered two surprise rate hikes over the summer and markets have priced in nearly three more hikes over the next year. Yet even there, global reflation will put steepening pressure on the Canadian yield curve without additional hawkishness from the Bank of Canada. Chart 5Oil Vs. The German Yield Curve Chart 6Oil Vs. The U.K. Yield Curve Chart 7Oil Vs. The Canada Yield Curve Chart 8Oil Vs. The Australia Yield Curve Japan, as always, remains the outlier to global trends. While oil prices have been rising even in yen terms, inflation expectations have remained subdued and the JGB yield curve has stayed flat (Chart 9). With the Bank of Japan targeting a 0% yield on the benchmark 10-year JGB as part of its current monetary policy framework, the link between energy prices, inflation expectations and the slope of the yield curve will remain broken in Japan. This makes JGBs a very low-beta government bond market, and we continue to recommend an overweight stance on Japan given our bias toward a defensive portfolio duration posture. Chart 9Oil Vs. The Japan Yield Curve Net-net, we see oil as continuing to provide a steepening, reflationary bias to global bond yields in the next few months, as the impact of the rise in energy prices feeds through into faster rates of headline inflation. How central banks respond will determine what curves do beyond that but, for now, the bias is towards steeper curves. Bottom Line: Bond markets have been slow to discount the impact of higher oil prices on global inflation, which should lead to steeper yield curves and additional increases in inflation expectations. How Will The Trump Tax Plan Impact The Treasury Curve? Ask The Fed Another factor that will put steepening pressure on global yield curves, especially in the U.S., is the likelihood of the Trump fiscal stimulus coming to fruition. The White House has chosen to refocus its policy efforts on getting aggressive tax cuts implemented. This is low-hanging fruit for a president that needs a legislative victory after fighting a losing battle on health care reform. Last week, the latest Trump tax plan was unveiled, which is centered on delivering large cuts on corporate taxes, reducing the number of personal income tax brackets, eliminating many large tax deductions, allowing companies to fully expense investment spending at an accelerated rate, and introducing a territorial tax system that would exempt U.S. corporate taxes on the foreign earnings of U.S. companies. The Tax Policy Center unveiled its initial assessment of the Trump tax plan last Friday, which is expected to reduce U.S. federal tax revenue by $2.4 trillion over the next ten years and another $3.2 trillion in the following decade.2 The White House is betting on so-called "dynamic scoring" of the tax plan to recoup some of that lost revenue via higher economic growth, although that is filled with unrealistic expectations to prevent an unwanted surge in federal deficits. More likely, the Trump plan would result in a major increase in federal budget deficits over the next decade, similar to the levels estimated by Moody's last year in its own analysis of the Trump fiscal platform.3 In Chart 10, we show how periods of widening federal budget deficits typically coincide with periods of U.S. Treasury curve steepening. Usually, this is merely the business cycle at work, with deficits widening during economic downturns as tax revenues plunge and counter-cyclical government expenditure increases. What is also at work is the monetary policy cycle, with the Fed delivering rate cuts during recessions when the output gap is widening and inflation pressures are diminishing, thus bull-steepening the yield curve. Chart 10Forwards Pricing Too Much UST Curve Flattening Yet the current Trump tax proposal comes at a time when the U.S. economy is operating close to full employment with the output gap essentially closed (middle panel). This means that any impetus to U.S. economic growth from the fiscal easing can cause inflation pressures to build up in a manner different than typical periods of widening budget deficits. This should initially impart steepening pressures on the Treasury curve, but in a bearish fashion via higher longer-term inflation expectations. However, the eventual path for the Treasury curve will be determined by how much the Fed responds to the fiscal easing via tighter monetary policy. Typically, the slope of the Treasury curve is highly negatively correlated to the real fed funds rate (adjusted by headline inflation), with a higher real rate coinciding with a flatter curve and vice versa (bottom panel). Right now, the market is discounting only a modest rise in real U.S. policy rates, looking at the difference between forward Overnight Index Swap (OIS) rates and forward CPI swap rates. That market-implied "real rate" is expected to stay in a modest range between 0% and 1% until well into the next decade. The Fed is also forecasting a rise in the real funds rate to 0.75%, but over a much faster time horizon - within two years - than the market. This is in the context of U.S. core inflation sustainably returning to the Fed's 2% target, which will allow the Fed to eventually raise rates to its current "terminal" rate projection of 2.75%. Thus, when simply eyeballing the relationship between real rates and the slope of the curve in Chart 10, the risk is that real rates will be higher than the market expects over time, and the Treasury curve will be flatter, all else equal. Yet when looking at the slope of the Treasury curve that is currently priced into the forwards, as shown in the bottom panel of Chart 10, a substantial flattening is already discounted over the next decade. Admittedly, the correlation between the real funds rate and the slope of the curve has changed over past decades, and the curve can likely be flatter for a lower level of real yields than in years past. Yet, even allowing for that, the market does seem to be discounting a very aggressive rise in real interest rates over the coming decade - one that is unlikely to be realized unless the Fed delivers a much higher path of interest rates then they are currently projecting. Which brings us back to the Trump fiscal stimulus. If the corporate tax cuts do provide a boost to economic growth next year via increased investment spending and hiring activity, in a way that also overheats the U.S. economy and boosts core inflation, then the Fed may be forced to raise rates at a faster pace than planned. This would result in a much flatter yield curve and would raise the risks of a recession in 2019, which is a scenario we think is highly plausible, especially if there is a change at the top of the FOMC. Late last week, it was revealed that President Trump had interviewed several candidates for the position of Fed Chair. Former Fed governor Kevin Warsh and current governor Jerome Powell were the names that caught the market's attention. Warsh has been a vocal critic of the Fed's slow unwind from the unusual post-crisis monetary policies, and is thus considered a monetary hawk who would want to raise rates higher, and faster, than the current FOMC. Powell is more pragmatic and would likely maintain the status quo at the Fed. The possibility of a more hawkish Fed chair has shown up in online prediction markets, where the "prices" of candidates that are perceived to be more hawkish (Warsh, John Taylor) rose while the prices of the more dovish candidates (Janet Yellen, Gary Cohn) fell (Chart 11). Right now, the online punters have Warsh in the lead, but the intraday "trading" has been volatile. The intersection of U.S. fiscal policy and monetary policy will be critical to determine the future path of U.S. bond yields over the next year. Right now, it appears that there is too much flattening priced into the Treasury curve relative to the expected path of the funds rate and inflation, as the Fed is unlikely to raise real rates much beyond their current projections. That could change if the Trump tax cuts can deliver a faster pace of productivity growth and higher equilibrium real interest rates. Although the post-war history of the U.S. shows that tax cuts by themselves do not raise the potential growth rate of the economy unless they lead to a major increase in investment spending, and even then the impact takes years to be seen (Chart 12). Chart 11Will The Next Fed Chair Be A Hawk? Chart 12Tax Cuts Do Not Always Boost Growth For now, we think it makes more sense to bet against the substantial flattening in the forwards by positioning for a steeper Treasury curve. Bottom Line: The proposed U.S. tax cut plan will result in wider budget deficits and, potentially, faster U.S. inflation with the U.S. economy already near full employment. The Fed is likely to respond to this with even tighter monetary policy, although not by enough to flatten the Treasury curve by as much as is currently discounted. ECB Tapering: Steepening Yield Curves Through The Term Premium The other major factor that should steepen global yield curves in the next several months is the expectation of a change in policy from the ECB. The central bank has been gently preparing the market since the early summer for a shift to a less accommodative policy stance, in response to robust economic growth and slowly rising core inflation (Chart 13). A decision on the changes to the asset purchase program will take place at the October 26th ECB policy meeting. This will involve a reduction in the monthly pace of bond buying and, likely, some guidance as to when the asset purchase program will end. A change in short-term interest rates is highly unlikely before the bond purchases have been fully tapered, as this would go against the current forward guidance from the ECB that states that interest rates will remain at low levels well after the purchases have stopped. As we have discussed throughout this year, we see the ECB having no choice but to begin tapering its asset purchase program. The deflationary tail risks from 2014/15 have faded and, perhaps more importantly, the ECB is running into operational constraints on which bonds it can continue to buy. A likely outcome will be an announcement that the pace of bond buying will slow from the current €60bn/month to least ½ of that pace starting in January 2018. At mid-year, the policy will likely be reevaluated and, if the economy has not slowed materially and/or inflation rolled over, a full tapering of the bond buying would be announced, ending at the end of 2018 or in the first quarter of 2019. A rate hike would not take place until late 2019, which is where the market is currently priced. In the absence of rate hikes, most of the impact on Euro Area bond yields from the tapering will come from a widening of the term premium on longer-maturity bonds. If the pace of growth slows to zero, this could result in the benchmark 10-year German Bund yield returning all the way back to 1% (bottom two panels). This would still be a very low yield by historical standards, in line with structurally lower growth rates and high government debt levels in Europe. But the path to that 1% yield would be very damaging for bond returns as Euro Area yield curves bear-steepen. While the link between our estimates of the term premiums in the major developed markets is not airtight, there has been a loose correlation between them during the post-crisis "quantitative easing" era (Chart 14). If recent history is any guide, a slower pace of ECB bond buying should coincide with steeper global yield curves, all else equal. All else is likely NOT equal, as an unruly response of risk assets and currency markets to a tapering could alter the likely path of growth and inflation expectations and, eventually, interest rates. But, at this moment, an ECB taper is more likely to result in steeper global yield curves. Chart 13An ECB Taper Will Result In##BR##Higher Term Premia In Europe... Chart 14...And Perhaps In Other##BR##Bond Markets, As Well Bottom Line: The ECB will announce a slower pace of asset purchases at the policy meeting later this month, which should bear-steepen European yield curves via widening term premia on longer-dated debt. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "BCA Central Bank Monitor Chartbook: The Less Dovish Rhetoric Is Justified", dated September 26th 2017, available at gfis.bcaresearch.com. 2 http://www.taxpolicycenter.org/sites/default/files/publication/144971/a_preliminary_analysis_of_the_unified_framework_0.pdf 3 https://www.economy.com/mark-zandi/documents/2016-06-17-Trumps-Economic-Policies.pdf Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of September 29th, 2017. The model sharply reduced its allocation to the U.K. to a bare minimum in response to the tightening in liquidity condition as the Bank of England warned of a rate hike in "coming months." The funds are reallocated to the Spain and Germany. Other smaller changes are the reductions in Italy and Australia in favor of Sweden and Switzerland, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 44 bps in September. Both level 1 and level 2 models performed well, with level 2 outperforming its benchmark by 63 bps and level 1 outperforming its benchmark by 9 bps, as the underweight in Australia, U.S. and Japan versus the overweight in Italy, Germany and Netherland worked very well. Since going live in January 2016, the overall model has outperformed the benchmark by 341 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 743 bps. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of September 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model continues to be optimistic on global growth as seen by an increasing allocation to cyclical sectors. Additionally, the model has also reduced its underweight on consumer discretionary stocks, which is currently the only cyclical sector to have a below-benchmark allocation. Finally, the biggest shift was a downgrade in utilities from overweight to underweight. This was primarily driven by momentum. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com