Financial Markets

Highlights Chart 1European Policy Uncertainty Down Macron remains on target to win the French election, but Italy looms as a risk ahead; Fade any relief rally after South Korean elections; Russia is not a major source of geopolitical risk at present; Stay underweight Turkey and Indonesia within the EM universe. Feature The supposed pushback against populism is emerging as a theme in the financial industry. The expected defeat of nationalist-populist Marine Le Pen in the second round of the French election on May 7 has reduced Europe's economic policy uncertainty, despite continued elevated levels globally (Chart 1). We are not surprised by this outcome. A year ago, ahead of both the Brexit referendum and the U.S. election, we cautioned investors that it was the Anglo-Saxon world, not continental Europe, which would experience the greatest populist earthquake.1 The middle class in the U.S. and the U.K. lacks the socialist protections of large welfare states (Chart 2), leading to frustrating outcomes in terms of equality and social mobility (Chart 3). In other words, the gains of globalization have not been redistributed in the two laissez-faire economies. Hence the Anglo-Saxon world got Trump and Brexit while the continent got market-positive outcomes like Rajoy, Van der Bellen, Rutte, and (probably) Macron. Chart 2Given The Qualities Of The##br## Anglo-Saxon Economy ... Chart 3...Brexit And Trump ##br##Should Not Be A Surprise Looking forward, we agree with the consensus that Marine Le Pen will lose, as we have been stressing with high conviction since November.2 Despite a poor start to the campaign, Macron remains 20% ahead of Marine Le Pen with only four days left to the election (Chart 4). Could the polls be wrong? No. And not just because they were right in the first round. Polls are likely to be right because French polls have an exemplary track record (Chart 5) and there is no Electoral College to throw off the math. Chart 4Le Pen Unlikely To Bridge This Gap Chart 5French Polls Have Strong Track Record As we go to press, the two candidates are set to face off in an important televised debate. Given Le Pen's post-debate polling performance in the first round (Chart 6), we doubt she will perform well enough to make a change. Next week, we will review the second round and its implications for the legislative elections in June and French politics beyond. Overall, we think Europe's policy uncertainty dip is temporary, as the all-important Italian election risk looms just ahead in 2018.3 For now, we are sticking with our bullish European risk asset view, but will look to pare it back later in the year. Chart 6Debates Have Not Helped Le Pen Chart 7Commodity Currencies Suggest Global Trade Is At Risk... What about emerging markets? With investors laser-focused on developed market political risks - Trump's policies and protectionism, European elections, Brexit, etc - have EM political risks fallen by the wayside? Chart 8...And Commodities Are At Risk Too Chart 9China's Growth To Decelerate Again We don't think so. According to BCA's Emerging Market Strategy, the recent performance of the commodity currency index (an equally weighted average of AUD, NZD, and CAD) augurs a deceleration of global growth in the second half of this year (Chart 7) and a top in the commodity complex (Chart 8).4 At the heart of the reversal is the slowdown in China's credit and fiscal spending impulse (Chart 9).5 Given China's critical importance as the main source of EM final demand (Chart 10), the slowdown in money and credit growth is a significant risk to EM growth in the latter part of the year (Chart 11).6 Chart 10EM Is Leveraged To China Much More Than DM Chart 11China: Money/Credit Growth Is Slowing At the heart of China's credit slowdown are efforts by policymakers to cautiously introduce some discipline in the financial sector. Chinese interbank rates have risen noticeably, which should have a material impact on credit growth (Chart 12). Given that the all-important nineteenth National Party Congress is six-to-seven months away, we doubt that the tightening efforts will be severe. But they may foreshadow a much tighter policy in 2018, following the conclusion of the Congress, when President Xi has full reign and the ability to redouble his initial efforts at reform, namely to control the risks of excessive leverage to the state's stability. With both the Fed and PBoC looking to tighten over the next 12-18 months, in part to respond to improvements in global inflation expectations (Chart 13), highly leveraged EM economies may face a triple-whammy of USD appreciation, Chinese growth plateauing, and easing commodity demand. In isolation, none is critical, but as a combination, they could be challenging. Chart 12Chinese Policymakers End The Credit Party? Chart 13Global Tightening Upon Us? In this weekly report, we take an around-the-world look at several emerging economies that we believe are either defying the odds of political crisis or particularly vulnerable to growth slowdown. South Korea: Here Comes The Sunshine Policy, Part II South Korea's early election will be held on May 9. The victory of a left-wing candidate has been likely since April 2016, when the two main left-wing parties, the Democratic Party and the People's Party, won a majority of the 300-seat National Assembly. It has been inevitable since the impeachment of outgoing President Park Geun-hye in December - whose removal was deemed legal by the Constitutional Court in March - for a corruption scandal that split the main center-right party and decimated its popular support after ten years of ruling the country.7 The only question was whether Moon Jae-in, leader of the Democratic Party and erstwhile chief of staff of former President Roh Moo-hyun, would finally get his turn as president, or whether Ahn Cheol-soo, an entrepreneurial politician who broke from the Democratic Party to form the People's Party, would defeat him. At the moment, Moon has a significant lead in the polls, while Ahn has lost the bump in support he received after other candidates were eliminated through the primary process (Chart 14). Moon's lead has grown throughout the recent spike in saber-rattling between the United States and North Korea, which suggests that Moon is most likely to win the race. The debates have also hurt Ahn. Moon leads in every region, among blue collar and white collar voters, and among centrists as well as progressives. Also, the pollster Gallup Korea has a solid track record for presidential elections going back to 1987, with a margin of error of about 3%, so Moon is highly likely to win if polls do not change in Ahn's or Hong's favor. The key difference between Moon and Ahn boils down to this: Moon is the established left-wing candidate and has mainstream Democratic Party machinery backing him, a clear platform, and experience running the country from 2003-8. Ahn does not have experience in the executive branch (Blue House) and his policy platform is less clear. His party is a progressive offshoot of the Democratic Party, yet he is bidding for disenchanted center-right voters, a contradiction that has at times given him the appearance of flip-flopping on important issues. Thus Ahn's election would bring greater economic policy uncertainty than Moon's, though Ahn is more business-friendly by preference. Regardless, the new president will have to work with the opposing left-wing party in the National Assembly if he intends to get anything accomplished. The combined left-wing vote is 164, yielding only a 13-seat majority if the two parties work together. Differences between them will cause problems in passing legislation. It would be easier for Moon to legislate with his party's 119-seat base than for Ahn with his party's 40-seat base, unless Ahn can steer his party to cooperate with the center right like he is trying to do in the presidential campaign. Markets may celebrate the election regardless of the victor because it sets the country back on the path of stable government. The Kospi bottomed in November when the political crisis reached a fever pitch and has rallied since December 5, when it became clear that the conservatives in the assembly would vote for Park's impeachment. This suggested an early government change to restore political and economic leadership. The market rallied again when the Constitutional Court removed Park, which pulled the presidential elections forward to May and cut short what would otherwise have been another year of uncertainty until the original election date in December 2017 (Chart 15). Chart 14South Korea: Moon In The Lead Chart 15Korean Stocks Cheered Impeachment Investors can reasonably look forward to an increase in fiscal thrust after the election, particularly if Moon is elected. Table 1 compares the key policy initiatives of the top three candidates - both Moon and Ahn are pledging increases in government spending. Note that South Korean fiscal thrust expanded in the first two years of the last left-leaning government, i.e. the Roh Moo-hyun administration (Chart 16). Table 1South Korean Presidential Candidates And Their Policy Proposals Chart 16Left-Wing Leaders Drive Up Fiscal Spending Beyond any initial relief rally, however, investors may experience some buyer's remorse. South Korea is experiencing a leftward swing of the political pendulum that is not conducive to higher growth in corporate earnings. This is the implication of the April legislative elections and the collapse of President Park's support prior to the corruption scandal; it will also be the takeaway of either Moon's or Ahn's election win over a discredited conservative status quo (both fiscal and corporate). The leftward shift is motivated by structural factors, not mere political optics. Average growth rates have fallen since the Great Recession, yet South Korea lacks the social amenities of a slower-growing developed economy. The social safety net is comparable to Turkey's or Mexico's and wages have been suppressed to maintain competitiveness (Chart 17). Inequality has grown dramatically (Chart 18). Chart 17Keeping Labor Cheap Chart 18Fueling The Populist Fire Therefore the policies to come will emphasize redistribution, job security, and social benefits. Moon's policies, in particular, are aggressive. He has pledged to require the public sector to increase employment by 5% per year and add 810,000 jobs by 2022, and to expand welfare for the elderly regardless of their income level. This will swell the budget deficit and public debt, especially over time, given South Korea's demographic profile, which is rapidly graying (Chart 19). Moon also intends nearly to double the minimum wage, require private companies to hire 3-5% more workers each year, depending on company size, and give substantial subsidies to SMEs that hire more workers. He supports a hike in corporate taxes, though the details of any tax changes have yet to be disclosed. Chart 19Society Turning Gray Ahn's policy preferences are more focused on productivity improvements than social welfare. While Moon panders to middle-aged workers concerned about job security - among whom he leads Ahn by 30 percentage points - Ahn panders to the youth, who are currently battling an unemployment rate of 11%. He would pay subsidies to young workers while they look for jobs immediately after graduation ($266 per month) and for the first two years of their employment at an SME ($532 per month). He would direct budgetary funds to research and development, high-tech industries, and job training. The SME policies speak to the general dissatisfaction with the cozy relationship between large, export-oriented industrial giants - the chaebol - and the political elite. Both Moon and Ahn will attempt to remove subsidies and privileges from the chaebol, potentially forcing them to sell or spin-off branches that are unrelated to their core business, and will seek to incentivize SMEs. Chaebol reform is a long-running theme in South Korean politics with very little record of success, but the one thing investors can be sure of on this front is greater uncertainty regarding policies toward the country's multinationals. Bottom Line: South Korea is experiencing a swing of the political pendulum to the left regardless of who wins the presidential race on May 9. What About Geopolitics? Internationally, Moon, if he wins, will attempt to improve relations with China and North Korea at the expense of the U.S. and Japan. His voter base came of age during the democracy movement of the 1980s and is friendlier toward China and less hostile toward North Korea than other age groups (Chart 20 A&B). Ahn may attempt a similar foreign policy adjustment, but he is less willing to confront the United States. His attempt to woo the youth will constrain any engagement with Pyongyang, since young South Koreans feel the least connection with their ethnic brethren to the north. Given that a Moon presidency would be paired with that of Trump, it would likely precipitate tensions in the U.S.-Korean relationship. News headlines will announce that South Korea is "pivoting" toward China, much in the way that U.S. ally the Philippines was perceived as shifting toward China after President Rodrigo Duterte's election in 2016. This will be an exaggeration, since Koreans still generally prefer the U.S. to China and view North Korea as an enemy (Chart 21). Nevertheless, there is potential for real, market-relevant disagreements. Chart 20Moon's Middle-Aged Constituency Chart 21Constraints On The Sunshine Policy In the short term, the risk is to trade, given the South Korean Left's strain of opposition to the U.S.-Korea free trade agreement (KORUS) and Trump's intention to renegotiate it, or even impose tariffs. Trump is bringing a protectionist tilt to U.S. trade policy - at very least - and he is relatively unconstrained on trade so we consider this a high-level risk over his four-year term in office. Trade tensions could become consequential if South Korea breaks with the U.S. over North Korea, angering the Trump administration. At the same time, South Korea's trade with China (Chart 22) is a risk due to China's secular slowdown, protectionism, and intention to move up the value chain and compete with South Korea in global markets. Chart 22South Korea's Twin Trade Risks In the short and long term, Moon's attempt to revamp Kim Dae-jung's "Sunshine Policy" of economic engagement and denuclearization talks with North Korea could create serious frictions with the U.S. What Moon is proposing is to promote economic integration so that South Korea has more leverage over the North, which is increasingly reliant on China, and also to reduce military tensions via negotiations toward a peace treaty (the 1950-3 war ended with an armistice only). The idea is to launch a five-year plan toward an inter-Korean "economic union." This would begin by re-opening shuttered cooperative projects like the Kaesong Industrial Complex and Mount Kumgang tours and later establish duty-free agreements, free trade zones, and multilateral infrastructure projects that include Russia and China.8 The problem is that any new Sunshine Policy - which is ostensibly a boon for the region's security - will clash with the Trump administration's attempt to rally a new international coalition to tighten sanctions on North Korea to force it to freeze its nuclear and ballistic missile programs. North Korea will want to divide the allies and thus will be receptive to China's and South Korea's offers of negotiations; the U.S. and Japan will not want to allow any additional economic aid to the North without a halt to tests and tokens of eventual denuclearization. How will this tension be resolved? Trump is preparing for negotiations and over the next couple of years the U.S. and Japan are highly likely to give diplomacy at least one last chance, as we have argued in recent reports.9 Eventually, if the U.S. becomes convinced of total collaboration between China and South Korea with the North (i.e. skirting sanctions and granting economic benefits), while the North continues testing capabilities that would enable it to strike the U.S. homeland with a nuclear weapon, some kind of confrontation is inevitable. But first the U.S. will try another round of talks. The "arc of diplomacy" could extend for several years, as it did with Iran (Chart 23), if the North delays its missile progress or appears to do so. Chart 23The 'Arc Of Diplomacy' Can Last For Several Years Despite our belief that the North Korean situation will calm down as diplomacy gets under way, South Korea is seeing rising geopolitical headwinds for the following reasons: Sino-American tensions: U.S.-China competition is growing over time, notwithstanding the apparently friendly start between the Trump and Xi administrations.10 Trump's North Korea policy: The Trump administration has signaled that the U.S. does not accept a nuclear-armed North Korea and the need to maintain the credibility of the military option will keep tensions at a higher level than in recent memory.11 Japanese re-armament: Japanese tensions with China and both Koreas are rising as Japan increases military expenditures and maritime defenses and moves to revise its constitution to legitimize military action.12 The costs of peace: If diplomacy prevails, South Korean engagement with the North still poses massive uncertainties about the future of the relationship, the North's internal stability amid liberalization, whether the transition to greater economic integration will be smooth, and whether the South Korean economy (and public finances) can absorb the associated costs. This is not even to mention eventual unification. Bottom Line: The current saber-rattling around the Korean peninsula is not over yet, but tensions are soon to fall as international negotiations get under way. Still, geopolitical risks for South Korea are rising over the long run. Investment Conclusions The currency will be the first to react to the election results and will send a signal about whether the fall in policy uncertainty is deemed more beneficial than the impending rise in pro-labor policies. Beyond that, the won has been strong relative to South Korea's neighbors and competitors (Chart 24). The Korean central bank is considering cutting rates at a time when fiscal policy is set to expand substantially, a negative for the currency. Chart 24Won Strength, Yen Weakness Therefore we remain short KRW / long THB. Thailand, another U.S. ally, is running huge current account surpluses, is more insulated from U.S.-China geopolitical conflicts, and has navigated tensions between the two relatively well. We expect a relief rally in stocks due to resolution of the campaign and the likelihood of an easing in trade tensions with China. However, this is the only reason we are not yet ready to join our colleagues in the Emerging Markets Strategy in shorting Korean stocks versus Japanese. We will look to put on this trade in future. We do not have high hopes for Korean stocks over the long run due to the headwinds listed above. As for bonds, both Moon's and Ahn's agendas, particularly Moon's, will be bond bearish because they will increase deficits and debt. At the short end of the curve, yields may have reason to fall; but the long end should reflect looser fiscal policy, the worsening debt and demographic profile, and increasing geopolitical risk, whether from conflicts with the U.S. and North Korea, or from the rising odds of a greater future burden from subsidizing (or even merging with) North Korea. Therefore we recommend going long 2-year government bonds / short 10-year government bonds. Russia: Defying Odds Of A Political Crisis Russia has emerged from the oil-price shocks scathed, but unbowed.13 Its textbook macro policy amid a severe recession over the past two years has been exemplary: The government has maintained constant nominal expenditure growth and substantially cut spending in real terms (Chart 25). The fiscal deficit is still large at 3.7%, but it typically lags oil prices (Chart 26). Hence, the recovery in oil prices over the past year should lead to a notable improvement in the budget balance. For 2017, the budget is conservative, as it assumes $40/bbl Urals crude. Chart 25Russia Has Undergone##br## Through Real Fiscal Squeeze... Chart 26...Which Is##br## Now Over Early this year, the Ministry of Finance adopted a new fiscal rule where it will buy foreign currency when the price of oil is above the set target level of 2700 RUB per barrel (the price of oil in rubles at the $40 bbl Urals) and sell foreign exchange when the oil price is below that level (Chart 27). The objective of this policy is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. Chart 27Oil Price Threshold For New Fiscal Rule Chart 28Forex Reserves Have Stabilized The recovery of oil prices and strict macroeconomic policy has allowed Russia to stabilize its foreign exchange reserves (Chart 28), although they remain at a critical level as a percent of broad money supply. However, the GDP growth recovery will be tepid and fall far short of the high growth rates of the early part of the decade (Chart 29). Chart 29Russia: ##br##Recovery Is At Hand Chart 30Inventories Remain Far ##br##Above Average Levels Russian policymakers should be cautiously optimistic. On one hand, they have been able to withstand a massive decline in oil prices. On the other, the situation is still precarious and warrants caution given the delicate situation in oil markets. OECD oil inventories remain elevated and could precipitate an oil-price collapse without OPEC's active oil-production management (Chart 30). From this macroeconomic context, we would conclude that: Russia will abide by the OPEC 2.0 production-cut agreement: While the new budget rule will go a long way in insulating the ruble from swings in oil prices, Russia is still an energy exporter. As such, we expect Russia to play ball with Saudi Arabia and continue to abide by the conditions of the OPEC deal. Thus far, Russia has been less enthusiastic in cutting production than the Saudis, but still going along (Chart 31). Russia will not destabilize the Middle East: While Russia will continue to support President Bashar al-Assad of Syria, its involvement in the civil war will abate. Moscow already began to officially withdraw from the conflict in January. While part of its forces will remain in order to secure Assad's government, Russia has no intention of provoking its newfound OPEC allies with geopolitical tensions. Russia will talk tough, but carry a small stick: Shows of force will continue in the Baltics and the Arctic, but investors should fade any rise in the geopolitical risk premium (Chart 32). It is one thing to fly strategic bombers close to Alaska or conduct military exercises near the Baltic States; it is quite another to act on these threats. In fact, Russia has been doing both since about 2004 and its bluster has amounted to very little with respect to NATO proper. This is because Russia depends on Europe for almost all of its FDI and export demand and it is only in the very early innings of replacing European demand with Chinese (Chart 33). As long as Russia lacks the pipeline infrastructure to export the majority of its energy production to China, it will be reluctant to confront Europe. Chart 31Moscow Will Play ##br##Ball With OPEC Chart 32Fade Any Spike ##br##In Geopolitical Risk Chart 33Russia Relies On Europe;##br## China Not A Replacement As we have posited in the past, energy exporters are emboldened to be aggressive when oil prices are high.14 When oil prices collapse, energy exporters become far more compliant. Nowhere is this dynamic more true than with Russia, whose military interventions in foreign countries have served as a sure sign that the top of the oil bull market is at hand! Bottom Line: We do not expect any serious geopolitical risk to emanate from Russia, despite the supposed souring of relations between the Trump and Putin administrations due to the U.S. cruise-missile strike against Syria.15 And we also do not expect President Putin to manufacture a geopolitical crisis ahead of Russia's March 2018 presidential elections, given that his popularity remains high and that the opposition is in complete disarray. While Russia may continue to talk tough on a number of fronts, investors should fade the rhetoric as it is purely for domestic consumption. Turkey: Deceitful Stability Turkey held a constitutional referendum that dramatically expands the powers of the presidency on April 16.16 The proposed 18 amendments passed with a 51.41% majority and a high turnout of 85%. As with all recent Turkish referenda and elections, the results reveal a sharply divided country between the Aegean coastal regions and the Anatolian heartland, the latter being a stronghold of President Recep Tayyip Erdogan. Is Turkey Now A Dictatorship? First, some facts. Turkey has not become a dictatorship, as some Western press allege. Yes, presidential powers have expanded. In particular, we note that: The president is now both head of state and government and has the power to appoint government ministers; The president can issue decrees; however, the parliament has the ability to abrogate them through the legislative process; The president can call for new elections; however, he needs three-fifths of the parliament to agree to the new election; The president has wide powers to appoint judges. What the media is not reporting is that the parliament can remove or modify any state of emergency enacted by the president. In addition, overriding a presidential veto appears to be exceedingly easy, with only an absolute majority (not a super-majority) of votes needed. As such, our review of the constitutional changes is that Turkey is most definitely not a dictatorship. Yes, President Erdogan has bestowed upon the presidency much wider powers than the current ceremonial position possesses. However, the amendments also create a trap for future presidents. If the president should face a parliament ruled by an opposition party, he would lose much of his ability to govern. The changes therefore approximate the current French constitution, which is a semi-presidential system. Under the French system, the president has to cohabitate with the parliament. This appears to be the case with the Turkish constitution as well. Bottom Line: Turkish constitutional referendum has expanded the powers of the presidency, but considerable checks remain. If the ruling Justice and Development Party (AKP) were ever to lose parliamentary control, President Erdogan would become entrapped by the very constitution he just passed. Is Turkey Now Stable? The market reacted to the results of the referendum with a muted cheer. First, we disagree with the market consensus that President Erdogan will feel empowered and confident following the constitutional referendum that gives him more power. This is for several reasons. For one, the referendum passed with a slim majority. Even if we assume (generously) that it was a clean win for the government, the fact remains that the AKP has struggled to win over 50% of the vote in any election it has contested since coming to power in 2002 (Chart 34). Turkey is a deeply divided country and a narrow win in a constitutional referendum is not going to change this. Chart 34Turkey's Ruling Party Struggles To Get Over 50% Of The Vote Second, Erdogan is making a strategic mistake by giving himself more power. It will focus the criticism of the public on the presidency and himself if the economy and geopolitical situation surrounding Turkey gets worse. If the buck now stops with Erdogan, it means that all the blame will go to him in hard times. We therefore do not expect Erdogan to push away from populist economic and monetary policies. In fact, we could see him double down on unorthodox fiscal and monetary policies as protests mount against his rule. While he has expanded control over the army, judiciary, and police, he has not won over the major cities on the Aegean coast, which not only voted against his constitutional referendum but also consistently vote against AKP rule. Events in Turkey since the referendum have already confirmed our view. Despite rumors that the state of emergency would be lifted following the referendum, the parliament in fact moved to expand it by another three months. Furthermore, just a week following the plebiscite, the government suspended over 9,000 police officials and arrested 1,120 suspects of the attempted coup last summer, with another 3,224 at large. This now puts the total number of people arrested at around 47,000. Investors are confusing lack of opposition to stability. Yes, the opposition to AKP remains in disarray. As such, there is no political avenue for opposition to Erdogan. The problem is that such an arrangement raises the probability that the opposition takes the form of a social movement and protest. We would therefore caution investors that a repeat of the Gezi Park protests from 2013 could be likely, especially if the economy stumbles. Bottom Line: The referendum has not changed the facts on the ground. Turkey remains a deeply divided country. Erdogan will continue to feel threatened by the general sentiment on the ground and thus continue to avoid taking any painful structural reforms. We believe that economic populism will remain the name of the game. What To Watch? We would first and foremost watch for any sign of protest over the next several weeks. Any Gezi Park-style unrest would hurt Erdogan's credibility. May Day protests saw police scuffle with protesters in Istanbul, for example. Given his penchant for equating any dissent with terrorism, President Erdogan is very likely to overreact to any sign that a social movement is rising in Turkey to oppose him. It is not our baseline case that the constitutional referendum will motivate protests, but it is a risk investors should be concerned with. Next election is set for November 2019 and the constitutional changes will only become effective at that point (save for provisions on the judiciary). Investors should watch for any sign that Erdogan's or the AKP's popularity is waning in the interim. A failure to secure a majority in parliament could entrap Erdogan in an institutional fight with the legislature that creates a constitutional crisis. Chart 35Turkey Constrained By European Ties Relations with the EU remain an issue as well. Erdogan will likely further deepen divisions in the country if he goes ahead and makes a formal break with the EU, either by reinstituting the death penalty or holding a referendum on the EU accession process. Erdogan's hostile position towards the EU should be seen from the perspective of his own insecurity as a leader: he needs an external enemy in order to rally support around his leadership. We would recommend that clients ignore the rhetoric. Turkey depends on Europe far more than any other trade or investment partner (Chart 35). If Turkey were to lash out at the EU by encouraging migration into Europe, for example, the subsequent economic sanctions, which we are certain the EU would impose, would devastate the Turkish economy and collapse its currency. Nonetheless, Ankara's brinkmanship and anti-EU rhetoric will likely continue. It is further evidence of the regime's insecurity at home. Bottom Line: The more that Erdogan captures power within the institutions he controls, the greater his insecurities will become. This is for two reasons. First, he will increase the risk of a return of social movement protests like the Gezi Park event in 2013. Second, he will become solely responsible for everything that happens in Turkey, closing off the possibility to "pass the buck" to the parliament or the opposition when the economy slows down or a geopolitical crisis emerges. As such, we see no opening for genuine structural reform or orthodox policymaking. Turkey will continue to be run along a populist paradigm. Investment Conclusions BCA's Emerging Market Strategy recommends that clients re-instate short positions on Turkish assets, specifically going short TRY versus the U.S. dollar and shorting Turkish bank stocks. The central bank's net liquidity injections into the banking system have recently been expanded again (Chart 36). This is a form of quantitative easing and warrants a weaker currency. To be more specific, even though the overnight liquidity injections have tumbled, the use of the late liquidity money market window has gone vertical. This is largely attributed to the fact that the late liquidity window is the only money market facility that has not been capped by the authorities in their attempt to tighten liquidity when the lira was collapsing in January. The fact remains that Turkish commercial banks are requiring continuous liquidity and the Central Bank of Turkey (CBT) is supplying it. Commercial banks demand liquidity because they continue growing their loan books rapidly. Bank loan and money growth remains very strong at 18-20% (Chart 37). Such extremely strong loan growth means that credit excesses continue to be built. Chart 36Liquidity Injections Reaccelerating Chart 37Money And Credit Growth Strong Besides, wages are growing briskly - wages in manufacturing and service sector are rising at 18-20% from a year ago (Chart 38, top panel). Meanwhile, productivity growth has been very muted. This entails that unit labor costs are mushrooming and inflationary pressures are more entrenched than suggested by headline and core consumer price inflation. It seems Turkey is suffering from outright stagflation: rampant inflationary pressures with a skyrocketing unemployment rate (Chart 38, bottom panel). The upshot of strong credit/money and wage growth as well as higher inflationary pressures is currency depreciation. Excessive credit and income/wage growth are supporting import demand at a time when the current account deficit is already wide. This will maintain downward pressure on the exchange rate. The currency has been mostly flat year-to-date despite the CBT intervening in the market to support the lira by selling U.S. dollars (Chart 39). Without this support from the CBT, the lira would be much weaker than it currently is. That said, the CBT's net foreign exchange rates (excluding commercial banks' foreign currency deposits at the CBT) are very low - they stand at US$ 12 billion and are equal to 1 month of imports. Therefore, the central bank has little capacity to defend the lira by selling its own U.S. dollar. Chart 38Turkish Stagflation Chart 39Turkey Props Up The Lira We also believe there is an opportunity to short Turkish banks outright. The currency depreciation will force interbank rates higher (Chart 40, top panel). Chart 40Weak Lira Will Push Interbank Rates Higher Historically, currency depreciation has always been negative for banks' stock prices as net interest margins will shrink (Chart 40, bottom panel). Surprisingly, bank share prices in local currency terms have lately rallied despite the headwinds from higher interbank rates and the rollover in net interest rate margin. This creates an attractive opportunity to go short again. Bottom Line: We are already short the lira relative to the Mexican peso. In addition, we are recommending two new trades based on the recommendations of BCA's Emerging Market Strategy: long USD/TRY and short Turkish bank stocks. Dedicated EM equity as well as fixed-income and credit portfolios should continue underweighting Turkish assets within their respective EM universes. Indonesia: A Brief Word On Jakarta Elections President Joko "Jokowi" Widodo saw his ally, Basuki Tjahaja Purnama (nicknamed "Ahok"), badly defeated in the second round of a contentious gubernatorial election on April 19. Preliminary results suggest that Ahok received 42% against 58% for his contender, Anies Baswedan, a technocrat and defector from Jokowi's camp whose own party only expected him to receive 52% of the vote. This was a significant setback. Jokowi's loss of the Jakarta government is a rebuke from his own political base, a loss of prestige (since he campaigned to help Ahok), and a boost to the nationalist opposition party Gerindra and other opponents of Jokowi's reform agenda. Ahok is a Christian and ethnic Chinese, which makes him a double-minority in Muslim-majority Indonesia, which has seen anti-Chinese communal violence periodically and has also witnessed a swelling of Islamist politics since the decline of the oppressive secular Suharto regime in 1998. Ahok fell under popular scrutiny and later criminal charges for allegedly insulting the Koran in September 2016 by casting doubt on verses suggesting that Muslims should not be governed by infidels. Mass Islamist protests ensued in November. Gerindra exploited them, as did political forces behind the previous government of Susilo Bambang Yudhoyono and trade unions opposed to the Jokowi administration's attempt to regularize minimum wage increases.17 Ahok's sound defeat shows that the opposition succeeded in making the race a referendum on him versus Islam. Despite the blow, Jokowi's popularity remains intact (Chart 41). The latest reliable polling is months out of date but puts Jokowi 24% above Prabowo Subianto, leader of Gerindra, whom he has consistently led since defeating him in the 2014 election. Jokowi remains personally popular, maintains a large coalition in the assembly, and is still the likeliest candidate to win the 2019 election. Jokowi's approval ratings in the mid-60 percentile are comparable to those of former President Yudhoyono at this time in 2007, and the latter was re-elected for a second term. Moreover Yudhoyono slumped at this point in his first term down to the mid-40 percentile in 2008 before recovering dramatically in 2009, despite the global recession, to win re-election. In other words, according to recent precedent, Jokowi could fall much farther in the public eye and still recover in time for the election. However, Jokowi will now have to shore up his support among voters with a strong Muslim identity, which is a serious weak spot of his, as indicated in the regional electoral data in Table 2. Jokowi relies on two key Islamist parties in the National Assembly. He cannot afford to let opposition grow among Muslim voters at large (notwithstanding Gerindra's own problems working with Islamist parties). Chart 41Jokowi Still Likely To Be Re-Elected In 2019 Table 2Islamist Politics A Real Risk For Jokowi He clearly faces a tougher re-election bid now than he did before. Risks to China and EM growth on the two-year horizon are therefore even more threatening than they were. And since a Prabowo victory would mark the rise of a revanchist and nationalist government in Indonesia that would upset markets for fear of unorthodox economic policies, the political dynamic will be all the more important to monitor. These election risks also suggest that traditional interest-group patronage is likely to rise at the expense of structural economic reform over the next two years. Bottom Line: We remain bearish on Indonesian assets. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy Weekly Report, "Signs Of An EM/China Growth Reversal," dated April 12, 2017, available at ems.bcaresearch.com. 5 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Toward A Desynchronized World?" dated April 26, 2017, available at ems.bcaresearch.com. 7 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016; Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017; and Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, all available at gps.bcaresearch.com. 8 Please see "Moon Jae-in's initiative for 'Inter-Korean Economic Union," National Committee on North Korea, dated August 17, 2012, available at www.ncnk.org. 9 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 10 For our latest feature update on what is one of our major themes, please see BCA Geopolitical Strategy and EM Equity Sector Strategy, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 11 Please see footnote 7 above. 12 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 13 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 16 An original version of this analysis of Turkey appeared in BCA Emerging Market Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 17 Please see "Indonesia: Beware Of Excessive Wage Inflation" in BCA Emerging Markets Strategy Special Report, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at ems.bcaresearch.com.

Highlights Ongoing monetary tightening in China poses a substantial threat to EM risk assets. Yet financial markets remain highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Business conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The pillars of the EM business cycle are China, commodities, and their own domestic credit cycle, rather than the U.S. and Europe. Continue shorting/underweighting the Malaysian currency, stocks and sovereign credit. Feature Chart I-1China: Ongoing Liquidity Tightening There is one major underappreciated risk in global financial markets: China's gradual yet unrelenting monetary tightening. Though slow and measured, this policy tightening constitutes a significant risk, particularly for emerging markets. The basis is that it could trigger a disproportionally large negative effect on Chinese growth because it is taking place amid a lingering credit bubble in China.1 Mainland interbank rates and onshore corporate bond yields have risen as the People's Bank of China (PBoC) has reduced its net liquidity injections via open market operations (Chart I-1, top panel). The PBoC's monetary tightening is bound to reduce money/credit growth in China. The bottom panel of Chart I-1 demonstrates that changes in the central bank's claims on commercial banks lead by 3 months asset growth at commercial banks. Diminished liquidity injections by the PBoC will soon push commercial banks to reduce the pace of their balance sheet expansion. Asset growth/loan origination among policy banks2 has already slowed (Chart I-2). On top of this, China's regulatory tightening aimed at curbing speculative (high-risk) financial activity will also curtail commercial banks' loan origination. For example, bank regulators are forcing banks to bring off-balance-sheet assets onto their balance sheets. As a result, money/credit growth is set to decelerate meaningfully. This, in turn, will cause another slump in this credit-addicted economy. It is very probable that the mini-business cycle in China has already reached its peak - our credit and fiscal impulse heralds further drop in the manufacturing PMI (Chart I-3). Chart I-2Commercial Banks And Policy ##br##Banks' Loan Growth To Slow Further Chart I-3China's Growth Has Rolled Over While China's monetary tightening is not a direct risk to domestic demand in the U.S. or Europe, it poses an imminent risk to commodities prices and EM risk assets. Consistent with slowing Chinese manufacturing output growth, commodities prices trading in mainland China have lately tanked. Bottom Line: BCA's Emerging Markets Strategy team maintains that ongoing monetary tightening in China poses substantial risks to EM risk assets and commodities. Yet financial markets remain complacent. Perplexing Complacency It is very perplexing that EM risk assets have so far ignored the risks stemming from China's tightening and renewed relapse in commodities prices. It seems portfolio allocation into risk assets, including those in the EM universe, is pushing prices higher irrespective of a major relapse in forward-looking indicators for both China and EM growth. EM stocks, currencies and credit spreads have decoupled from a number of indicators with which they historically had a high correlation: In recent weeks, we have brought to investors' attention that an unsustainable gap has been opening between the commodities currencies index - an equal-weighted average of AUD, NZD and CAD - and both EM exchange rates and EM share prices in local currency terms (Chart I-4A & Chart I-4B). Chart I-4AHeed The Message From Commodities Currencies Chart I-4BHeed The Message From ##br##Commodities Currencies Not only have commodities currencies decisively rolled over, but also commodities prices have begun sliding. Historically, EM risk assets in general and the sovereign credit market in particular have always sold off when commodities prices have drifted lower (Chart I-5). EM equity volatility is back to its lows (Chart I-6). This corroborates reigning complacency in the marketplace. Chart I-5Commodities Prices And ##br##EM Sovereign Spreads Chart I-6A Sign Of Complacency EM sovereign and corporate spreads have also fallen to their narrowest levels in recent years (Chart I-7). Notably, our valuation model for EM corporate bonds - which is constructed based on our EM Corporate Financial Health Index - posits that EM corporate credit is very expensive (Chart I-8). Chart I-7EM Sovereign And Corporate Spreads Chart I-8EM Corporate Credit Is Expensive Finally, EM local currency bond yield spreads over U.S. Treasurys have also dropped a lot, signifying complacency on the part of EM investors (Chart I-9). Chart I-9EM Local Bond Yield Spreads ##br##Over U.S. Treasurys Are Low Bottom Line: EM financial markets are not cheap, and investors are highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Can EM Decouple From China? An oft-asked and relevant question is whether EM ex-China can decouple from China itself. Not for the time being, in our view. On the contrary, as we argued in last week's report titled Toward A Desynchronized World,3 China's slowdown will weigh on the majority of the EM investable equity, currency and credit markets. As a result, growth conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The three pillars of EM ex-China growth are commodities, China and their domestic credit cycles. The primary link is via commodities. As China's growth decelerates and its imports relapse, commodities prices will plunge (Chart I-10). Latin America, Africa, the Middle East, Russia, Malaysia and Indonesia are set to experience negative terms-of-trade shocks as commodities prices deflate. As a result, their currencies will depreciate and growth will suffer. Although Mexico is leveraged to the U.S., oil prices still matter for it. This leaves non-commodities producing economies in Asia and central Europe. The latter is too small to matter for EM benchmarks. Central Europe correlates with Europe's business cycle rather than EM. In emerging Asia, Korea and Taiwan - the largest equity market cap weights after China in the MSCI EM index - sell much more to China than to the U.S. and Europe combined. Korea's shipments to China account for 25% of total exports while those to the U.S. and Europe combined make up 22%. For Taiwan the numbers are 27% and 20%, respectively. Thailand sells to China as much as it does to the U.S. This by and large leaves only three mainstream EM economies that are not substantially exposed to China: India, the Philippines and Turkey (Table I-1). Indian and Philippine stocks are expensive, and these nations confront their own unique problems. Turkey in turn is facing major political, economic and financial predicaments. Chart I-10Industrial Metals Prices To head Lower Table I-1Export To China And U.S. In short, among mainstream EM countries, there are very few plays not exposed to China or commodities and offer a reasonable risk/return profile. Investors also often ask if commodities importing economies in Asia can rally in absolute terms when and as commodities prices drop. Chart I-11 illustrates the Korean and Taiwanese equity indexes have historically (in the past 20 years) been strongly correlated with oil and industrial metals prices. The reason is that commodity price swings partially reflect global growth conditions. Being heavily dependent on exports, Korea and Taiwan are highly sensitive to fluctuations in global growth. We expect global trade to slow down anew, driven by weakness in China/EM imports, even if U.S. and European demand remains resilient. We elaborated on this theme in last week's report.4 Therefore, Korean and Taiwanese export shipments are set to slow as well. We are not bearish on Korean and Taiwanese domestic demand - we are in fact overweight these bourses within the EM equity universe, with a focus on technology and domestic sectors. That said, consumer and business spending in these economies is relatively small in a global context to make a difference for other EM markets. In addition, given these economies' mature phase of development, the pace of their income and domestic demand growth will be moderate. Many EM countries have experienced excessive credit growth in the past 15 years, but their banking systems have not restructured - i.e. banks have not sufficiently provisioned for non-performing loans. Until they do so, domestic loan growth remains at risk of weakening. There has been modest deleveraging in Brazil, Russia and India (Chart I-12). However, there is no evidence that these economies have embarked on a new credit cycle. Chart I-11Korean And Taiwanese Stocks ##br##Correlate With Commodities Chart I-12Some Moderate Deleveraging ##br##In Brazil, Russia And India Case in point are Indian state-owned banks: their experience shows that deleveraging can be more protracted and painful than one might initially expect. The reason is that it takes time for banks to acknowledge non-performing loans, be recapitalized and get ready to boost loan growth again. In addition, Brazil and Russia are still commodities plays at the mercy of commodities price dynamics. Besides, Brazil needs to undergo painful fiscal adjustment/reforms. In other developing countries, bank loan growth remains elevated and bank loan-to-GDP ratios continue to rise (Chart I-13). In these economies, credit retrenchment and even a mild deleveraging has not yet occurred. Prominently, as EM currencies come under downward pressure, interest rates in many economies running current account deficits will be pressured higher. This will lead to a slowdown in bank credit growth and will depress demand. Finally, if it were not for the pick-up in Chinese imports, the EM ex-China business cycle and commodities prices would not have ameliorated in the past 12 months. Notably, excluding China, Korea and Taiwan, developing nations' retail sales volumes and new vehicle sales remain dormant (Chart I-14). Similarly, there has not been much recovery in capital spending and, consistently, imports of capital goods in EM ex-China, Korea and Taiwan (Chart I-15). Chart I-13No Deleveraging In Many EMs Chart I-14EM Ex-China, Korea And Taiwan: ##br##Stabilization But No Revival Chart I-15EM Ex-China, Korea And Taiwan: ##br##Not Much Of Recovery As credit growth slows or fails to pick up in these economies, domestic demand recovery will be tepid, and will certainly disappoint market expectations. Bottom Line: Given budding divergence between U.S./Europe and Chinese growth, EM ex-China growth will fail to recover and will surprise to the downside. The basis is that the pillars of the EM's business cycle are China, commodities and their own domestic credit cycle, rather than the U.S. and Europe. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November, 23 2016, and January 18, 2017, the links are available on page 16. 2 Policy banks are China Development Bank, Agricultural Development Bank and Export-Import Bank of China. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. 4 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. Malaysia: Not Out Of The Woods Arenewed relapse in Chinese growth later this year coupled with lower commodities prices will once again expose Malaysia's vulnerabilities. Notably, 26% of Malaysia's exports are related to commodities - mainly crude oil, natural gas, petroleum products and palm oil. Another downleg in the ringgit's value along with lower commodities prices will cause domestic interest rates to rise. However, Malaysia is in no position to tolerate higher interest rates. Leverage has risen considerably in the past ten years in Malaysia, and is very high (Chart II-1A). Indeed, the country has one of the highest debt-servicing costs in the EM universe, according to BIS data (Chart II-1B). Chart II-1A...And Debt Servicing Costs Chart II-1BHigh Leverage... If the Malaysian central bank attempts to cap interest rates by injecting local currency liquidity into the system, the ringgit will plunge even further. Chart II-2 shows that in recent years local interbank rates have tended to rise when the central bank curtailed its net liquidity injection. If on the other hand the Bank Negara of Malaysia (BNM) does not inject liquidity into the banking/financial system, interest rates will rise as the currency depreciates. Interestingly, despite strong inflows into EM generally, the BNM has continued to inject local liquidity into the economy - albeit at a slower pace than in recent years - to keep local rates tame (Chart II-2). Additionally, despite the significant growth slowdown that has occurred in the past two years in Malaysia, banks' NPLs have not risen much (Chart II-3). As banks start acknowledging loan losses and setting provisions for them, their profitability will decline, capital will be eroded, and loan origination will fall. Chart II-2BNM Has Been Injecting Liquidity ##br##To Control Interest Rates Chart II-3Malaysian Banks Haven't ##br##Acknowledged Enough Losses Yet Meanwhile, even though global trade and commodities prices have picked in the past 15 months, Malaysia's economy has failed to recover. This reflects the country's underlying economic vulnerability as the borrowing/credit spree of the past decade has come to a halt: Commercial and passenger vehicle sales are shrinking. Retail trade and employment are also still anemic. Property sales volumes and housing construction approvals are collapsing (Chart II-4). Capital expenditures are depressed (Chart II-4, bottom panel). On the external side, the semiconductor/electronics sector has boomed in Asia since early 2016, but Malaysia has failed to benefit much. Indeed, the recovery in Malaysia's electronics sector has been weak compared to other technology hubs such as Taiwan and Korea. This confirms why Malaysia has been losing market share in electronics products to Korea, Taiwan and the Philippines (Chart II-5). Chart II-4Cyclical Growth Remains Anemic Chart II-5Malaysia Is Losing Tech Market ##br##Share To Its Asian Competitors Bottom Line: Continue shorting MYR versus the U.S. dollar and the Russian ruble. Equity investors should continue to underweight Malaysian stocks within an EM equity portfolio. Relative value traders should maintain our long Russian / short Malaysia equity trade. Buy/hold Malaysian CDS or underweight this sovereign credit market within an EM credit portfolio. Ayman Kawtharani, Associate Editor aymank@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights ECB: The ECB is still on track to move to a less accommodative policy stance over the next year. Hints of this will be given at the June policy meeting, while a 2018 asset purchase taper announcement will be made at the September meeting. Rate hikes will follow the taper, unless core inflation surges faster than expected. Position for steeper core Euro Area government curves now, and a narrowing of the U.S. Treasury-German Bund spread in the second half of this year. France-Germany Spreads: France-Germany bond spreads are now too narrow relative to the probability-weighted outcomes of this Sunday's final round of the French presidential election. Even with a Macron victory highly likely, we do not recommend long positions in French OATs versus German Bunds. Feature Investors have navigated a minefield of political headline risks over the past few weeks. From French politics to North Korean missile launches, from Donald Trump's tax cuts to Theresa May's snap U.K election, uncertainty abounds. Yet risk assets remain unscathed. That can be mostly be chalked up to the strength of the global cyclical economic upturn, which has boosted corporate profits in the developed world and lifted equity and credit market valuations. The continued accommodative monetary stance of the major central banks is also helping investors see through the political noise, although the winds there are shifting (Chart of the Week). Chart of the WeekCyclical Upturn Remains Intact In the U.S., financial conditions have eased since the Fed's "dovish hike" in March, and too few rate increases are now discounted with leading indicators pointing to a reacceleration of growth after the soft Q1 print. Across the Atlantic, the European Central Bank (ECB) is having an increasingly open debate about the ongoing need for an exceptionally dovish policy stance given the robust (by European standards) economic expansion. A lack of inflation will keep the Bank of Japan in hyper-easy mode for longer, but the data is presenting a more mixed message for other developed economy central banks like the Bank of Canada and the Bank of England. We continue to see the current level of global bond yields as priced too low given the ongoing cyclical growth and inflation pressures. A pro-growth fixed income investment stance, with below-benchmark portfolio duration and overweight allocations to corporate credit versus sovereign debt (favoring the U.S.), is still appropriate. ECB Outlook: Language Change Coming In June, Policy Change Coming In September Last week's ECB meeting offered few surprises, on the surface. The official statement sounded a cautious note, discussing downside risks to the Euro Area economy from global factors (i.e. trade policy vis-à-vis the U.S. and U.K., geopolitical uncertainty), and that there is still not enough evidence suggesting that inflation was sustainably on course to return to the ECB's 2% target. In the post-meeting press conference, however, the questions aimed at ECB President Mario Draghi turned into an almost farcical dissection of every word in the official statement. Like this exchange, taken directly from the press conference transcript:1 Question: If I got it right, there's one sentence missing in the statement, and this is the sentence, "There are no signs yet of a convincing upward trend in underlying inflation." What is the reason? No? Have I got it wrong? Draghi: No, you're right in a sense that there is one sentence less, but this one is there. On page 2 you have: "Moreover, the ongoing volatility in headline inflation underlines the need..." Constâncio: "...yet to show a convincing upward trend." Draghi: "...convincing upward trend." If you read the end of page 1, beginning of page 2... Question: So there is no change in your assessment of the underlying inflation trend? That was finally the question. Draghi: That is there. No, the one that is not equal exactly like in the last statement is the balance of risks sentence, which repeated twice that the risks remained tilted on the downside in the last statement, and you can find it only once on the second page. That's the difference. Chart 2ECB Policies Are Working... It is clear that the ECB Governing Council is now stuck in a very difficult position. The domestic Euro Area economic data continues to show a very solid pace of expansion that is soaking up spare capacity, supported by the highly accommodative ECB monetary policies of large-scale asset purchases and rock-bottom interest rates (Chart 2). Yet both wage growth and core inflation remain subdued, suggesting that there is no rush to send any signal that a shift in monetary policy settings is on the horizon - even though the market is aware that the current ECB asset purchase program is set to expire at year-end. The political calendar is playing a role here, as the ECB has not wanted to create additional market volatility by discussing any potential tapering of asset purchases or interest rate hikes during the French election campaign. But with the pro-euro candidate now well-placed to win the French Presidency this Sunday, the market's focus will shift away from ''President Le Pen" disaster scenarios towards timing the ECB's next policy move. The latest round of Euro Area inflation data, released last Friday, showed that the sharp drop in inflation in March was a statistical aberration. Headline HICP inflation (on a year-over-year basis) rose to 1.9% in April from 1.5%, while core inflation jumped to 1.2% from 0.7% - the highest level in almost four years. An acceleration in core inflation now would be consistent with the evidence seen in the Euro Area jobs data, with the unemployment rate steadily falling towards the "full employment" level of 8% (Chart 3). This also fits with the ECB's latest projections that show core inflation returning to just under 2% by 2019. Already, markets are starting to get more jittery about a potential change in the ECB's policy stance in the coming months. Realized bond volatility at the front-end of the German yield curve has risen to the highest level since 2013, although our "months-to-hike" measure is still at 25 months, suggesting that the next ECB rate hike will not occur until 2019 (Chart 4). That pricing makes sense, in our view, as the ECB is likely to taper its asset purchases before considering any interest rate increase. Chart 3...Perhaps Now Too Well? Chart 4Tightening Pressures Building Draghi and other senior members of the ECB (like Chief Economist Peter Praet) have reiterated that exact forward guidance of sequencing - tapering before rate hikes - in recent weeks, citing a desire to not cause an unwanted tightening of financial conditions too soon. That sounds to us like code language for "we do not want to hike rates and cause the euro to appreciate sharply", which is more likely to happen, with greater magnitude, after an increase in policy rates than a taper of bond purchases. We continue to expect that the ECB will move toward a less accommodative monetary stance over the next year, starting with a tapering of asset purchases followed by rate hikes. The initial signal for that will come at the June meeting where a new set of ECB staff economic projections will be prepared, followed by an announcement in September that tapering will begin in early 2018. Rate hikes will not begin until after the tapering ends, likely not until late 2018 or early 2019. This sequencing could change, however, if core inflation was to rise more rapidly than the ECB currently projects, with a rate hike happening sooner in that case. In terms of bond strategy, we recommend curve steepeners in core European government bond markets as an initial way to position for a less accommodative ECB. We anticipate moving to an underweight allocation stance to core Europe (both Germany and France) at some point before the June ECB meeting. We would like to see higher U.S. Treasury yields before making that change, as we expect Treasury-Bund spreads to narrow as the ECB tapers. With the market not pricing in enough rate hikes into the U.S. curve, in our view, we see the Treasury-Bund spread moving wider first as Treasuries reprice, before narrowing after the ECB taper is announced. Bottom Line: The ECB is still on track to move to a less accommodative policy stance over the next year. Hints of this will be given at the June policy meeting, while a 2018 asset purchase taper announcement will be made at the September meeting. Rate hikes will follow the taper, unless core inflation surges faster than expected. Position for steeper core Euro Area government curves now, and a narrowing of the U.S. Treasury-German Bund spread in the second half of this year. OAT-Bund Spreads Are Now Fairly Valued Last week, we closed our recommended long 10-year French OAT vs. 10-year German Bund Tactical Overlay trade following the first round of the French presidential election, at a profit of 1.3%.2 While we view the chances of Marine Le Pen winning this Sunday's run-off vote versus Emmanuel Macron as remote, betting on additional spread tightening from the current level of 53bps does not offer an attractive risk/reward opportunity. To judge this, we performed a scenario analysis to determine a probability-adjusted level of the OAT-Bund spread under the two tail events of a Macron or Le Pen victory. In the first scenario, we assigned a 15% probability to Le Pen winning the election, as currently indicated by online betting markets (Chart 5). In the second, we increased the probability to a more pessimistic 40%, which is Le Pen's current level of support in head-to-head opinion polls. We then came up with OAT-Bund spread projections for a victory by either candidate. If Le Pen were to pull off the upset and win the presidency, this would re-ignite fears of a potential Eurozone breakup given her anti-euro stance. Fears of a "Frexit" would likely push the OAT-Bund spread up to at least the same level (around 190bps) reached during the peak of the Euro debt crisis in late 2011 when euro breakup risk was at extreme levels. Even that spread level, however, may not adequately compensate for France's worsening fiscal backdrop, with France's debt/GDP ratio now 40% larger, relative to Germany's, than during the Euro debt crisis (Chart 6). Chart 5Macron Is The Favorite To Win Chart 6No Value In Staying Long France Vs Germany As a simple way to account for this, we increased the spread target for a Le Pen victory scenario by 1.4 times to account for the increased stock of French sovereign debt, which is all denominated in euros, that would be at risk of default if France was to pull out of the euro. This gives an upside spread target for a Le Pen victory of 266bps. In the event that the poll numbers prove correct, as they did in the first round of the election, and Macron wins as expected, this market-friendly result would prompt the OAT-Bund spread to decline further. Our estimate for a downside spread target after a Macron win is 36bps, which is the average level during 2015-2016 before the rise in uncertainty surrounding the elections. Again, this is adjusted upward in order to reflect changes in the relative debt-to-GDP ratios for France and Germany, with the former nearly 10% higher versus the latter over the past two years. Table 1Probability-Weighted OAT-Bund ##br## Spread Scenarios Using these spread targets and our base case election odds (85% chance of a Macron victory), we come up with a probability-adjusted spread of 71bps (Table 1). Using the head-to-head probabilities from the polling data (60% chance of a Macron win), the expected spread is 128bps. With the current OAT-Bund spread at 53bps, well below either projection, we conclude that the potential reward of holding onto a long OAT/short Bund position for a Macron victory does not adequately compensate for the non-zero probability that Le Pen pulls out the win this Sunday. Bottom Line: France-Germany bond spreads are now too narrow relative to the probability-weighted outcomes of this Sunday's final round of the French presidential election. Even with a Macron victory highly likely, we do not recommend long positions in French OATs versus German Bunds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Global Fixed Income Strategy patrick@bcaresearch.com 1 https://www.ecb.europa.eu/press/pressconf/2017/html/ecb.is170427.en.html 2 Please see BCA Global Fixed Income Strategy Weekly Report "Global Bond Yields On The Move, Higher", dated April 25, 2017, available at gfis.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

Highlights Chart 1Rate Hikes Lagging Wage Growth Last Friday's GDP report showed that the U.S. economy grew a meagre 0.7% (annualized) in the first quarter of 2017, well below levels necessary to sustain an uptrend in inflation. However, our forward looking indicators still point to U.S. growth of around 2% during the next few quarters. It is likely that faulty seasonal adjustments suppressed Q1 GDP growth. Q1 growth has averaged -0.1% during the past 10 years, while Q2 growth has averaged more than 2%. Q2 growth has also exceeded Q1 growth in 8 of the last 10 years. For its part, the Bloomberg Barclays Treasury index has provided an average return of close to 1% during the past 10 Q1s and an average return of 0.4% during the past 10 Q2s. Treasury returns have been greater in the first quarter than in the second quarter in 6 out of the past 10 years. Investors would be wise to ignore Q1 GDP and stay focused on the uptrends in wage growth and inflation that are likely to persist (Chart 1). With the market priced for only 38 bps of rate hikes between now and the end of the year, there is scope for the Fed to send a hawkish surprise. Stay at below-benchmark duration and short January 2018 Fed Funds Futures. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 23 basis points in April. The index option-adjusted spread tightened 2 bps on the month and, at 116 bps, it remains well below its historical average (134 bps). While supportive monetary policy will ensure excess returns consistent with carry, investors should not bank on further spread compression as spreads have already discounted a substantial improvement in leverage (Chart 2). In a recent report,1 we noted that net leverage (defined as: total debt minus cash, as a percent of EBITD) is positively correlated with spreads, and also that it has never reversed its uptrend unless prompted by a recession. In other words, the corporate sector never voluntarily undertakes deleveraging, it only starts to pay down debt when forced by a severe economic contraction. We conclude that debt growth will likely continue to outpace profit growth (panel 4), even as profits rebound over the course of this year. If our anticipated timeline plays out, we will be looking to scale back on credit risk in 2018, when inflationary pressures are more pronounced and the Fed steps up the pace of tightening. Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3). Further, our commodity strategists expect OPEC production cuts will be extended through to the end of the year, and that $60/bbl remains a reasonable target for oil prices. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 62 basis points in April. The index option-adjusted spread tightened 12 bps on the month and, at 371 bps, it is currently 27 bps above its 2017-low. Wider junk spreads in recent months appear to be largely related to flight-to-safety flows driven by elevated global political uncertainty. We find it notable that spreads tightened following the market-friendly result of the first round of the French election. While political uncertainty remains, we view current spreads as attractive on a 6-12 month horizon. In a recent report,2 we tested a strategy of "buying dips" in the junk bond market and found that it produced favorable results in a low-inflation environment. With the St. Louis Fed's Price Pressures Measure still suggesting only a 6% chance of PCE inflation above 2.5% during the next 12 months, we think this strategy will continue to work. Moody's recorded 21 defaults in Q1 (globally) down from 41 in the first quarter of 2016, with the improvement attributable to recovery in the commodity sectors. While commodity sectors still accounted for half of the defaults in Q1, Moody's predicts that the retail sector will soon assume the mantle of "most troubled sector." According to Moody's, nearly 14% of retail issuers are trading at distressed levels. Moody's still expects the U.S. speculative grade default rate to be 3% for the next 12 months, down from 4.7% for the prior 12 months. Based on this forecast we calculate the High-Yield default-adjusted spread to be 207 bps (Chart 3), a level consistent with positive excess returns on a 12-month horizon more than 70% of the time. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in April. The conventional 30-year MBS yield fell 10 bps on the month, driven by an 11 bps decline in the rate component. The compensation for prepayment risk (option cost) rose by 2 bps, but this was partially offset by a 1 bp tightening in the option-adjusted spread (OAS). Since the middle of last year the MBS OAS has widened alongside rising net issuance, but this has been offset by a falling option cost (Chart 4). This is exactly the price behavior we would expect to see in an environment where mortgage rates are moving higher and the market is starting to discount the Fed's eventual exit from the MBS market. Higher mortgage rates suppress refinancings, and this will ensure that the option cost component of spreads remains low. However, higher mortgage rates are also unlikely to halt the uptrend in net MBS issuance, since the main constraint on housing demand this cycle has been insufficient household savings, not un-affordable mortgage payments.3 This means that OAS still have room to widen alongside greater net issuance. The winding down of the Fed's mortgage portfolio - a process that is likely to begin later this year - will only add to the supply that the market needs to absorb. How will the opposing forces of low option cost and widening OAS net out? The option cost component of spreads is already close to its all-time low, while the OAS is still 16 bps below its pre-crisis mean. We think it is unlikely that a lower option cost can fully offset OAS widening. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 2 basis points in April, bringing year-to-date excess returns up to 75 bps. The high-beta Sovereign and Foreign Agency sectors outperformed by 8 bps and 1 bp, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors outperformed by 7 bps each. Local Authorities underperformed the Treasury benchmark by 23 bps. Since the beginning of the year, excess returns from the Sovereign sector have been supported by a weakening U.S. dollar (Chart 5). Mexican debt, in particular, has benefited from a 10% appreciation of the peso relative to the U.S. dollar (panel 3). A stronger peso obviously makes Mexico's USD-denominated debt easier to service and has led to year-to-date excess returns of 402 bps for Mexican sovereign debt relative to U.S. Treasuries. Mexican debt accounts for 21% of the Sovereign index. Our Emerging Markets Strategy service thinks that Mexico's central bank could deliver another 50 bps of rate hikes, because inflation is above target, but also maintains that further rate hikes will soon start to squeeze consumer spending.4 Conversely, the Fed has scope to hike rates much further. Sovereigns no longer appear expensive on our model, relative to domestic U.S. corporate sectors. But we still expect them to underperform as the dollar resumes its bull market. Local authorities and Foreign Agencies still offer lucrative spreads on our model, and we remain overweight those spaces within an overall underweight allocation to the Government-Related index. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in April (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio was flat on the month, but has fallen 15% since peaking shortly after the U.S. election (Chart 6). The sparse details of the Trump administration's proposed tax reform plan, released last week, did not include any specific mention of the municipal bond tax exemption, but did call for the elimination of "targeted tax breaks" leaving some to wonder if the tax exemption is in play. It is too soon to tell whether repealing the tax exemption will be part of the final tax reform plan, although its repeal would be at odds with the President's stated desire to spur infrastructure spending. For this reason, we suspect the tax exemption will ultimately survive. Assuming the tax exemption survives, the proposed repeal of the Alternative Minimum Tax and of the state & local government income tax deduction should both increase demand for tax-exempt municipal bonds. However, this positive impact will be offset by lower tax rates. All in all, it is too soon to know how this will all shake out, but the considerable uncertainty makes us reluctant to take strong directional bets in the municipal bond market for now. Meanwhile, Muni mutual fund inflows have totaled more than $9 billion since the beginning of the year, while total issuance is at a 12-month low. Strong inflows and low supply likely explain why yield ratios are testing the low-end of their post-crisis trading range. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve shifted lower in April, with the 2/10 slope flattening by 12 basis points and the 5/30 slope steepening by 6 bps. The 5-year Treasury yield declined 12 bps on the month, while the 10-year yield fell 11 bps. The 2-year yield actually ticked 1 bp higher. Significant outperformance in the 5-year part of the curve means that our recommendation to favor the 5-year bullet over a duration-matched 2/10 barbell has returned 27 bps since inception on December 20, 2016. This 5-year bullet over duration-matched 2/10 barbell trade is designed to profit from 2/10 curve steepening, which has not yet materialized. Instead, the trade has performed well because the 2/5/10 butterfly spread has moved much closer to our estimate of fair value (Chart 7). The 5-year bullet still looks moderately cheap on the curve, but no longer offers an exceptional valuation cushion. For our trade to outperform from here we will likely need to see some 2/10 curve steepening. We continue to hold the 5-year bullet over duration-matched 2/10 barbell trade, because we still expect the 2/10 slope to steepen. This steepening will be driven by wider long-maturity TIPS breakevens which should eventually catch up to leading pipeline inflation measures (see next page). In a recent report,5 we outlined the main drivers of the slope of the yield curve on a cyclical horizon and concluded that wider breakevens can cause the nominal curve to steepen even with the Fed in the midst of hiking rates. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 25 basis points in April. The 10-year TIPS breakeven rate declined 5 bps on the month and, at 1.92%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Our Financial Model of TIPS breakevens - which models the 10-year TIPS breakeven rate using the stock-to-bond total return ratio, the price of oil and the trade-weighted dollar - attributes the recent decline in breakevens to weakness in the stock-bond ratio and the fact that the 10-year breakeven rate was already quite elevated compared to fair value (Chart 8). Both core and trimmed mean PCE inflation dropped sharply in March, and are now running at 1.6% and 1.8% year-over-year, respectively (bottom panel). This decline is likely to reverse in the coming months. Crucially, pipeline inflation measures, such as the ISM prices paid index, are holding firm at high levels (panel 4). We remain overweight TIPS versus nominal Treasuries on the view that growth will be strong enough to keep measures of core inflation on a steady upward trajectory, eventually converging with the Fed's 2% inflation target. In that environment, TIPS breakevens should eventually return to their pre-crisis range. In last week's report,6 we considered the possibility that TIPS breakevens might not return to their pre-crisis trading range, even if measures of core inflation remain strong. The most likely reason relates to structural rigidities in the repo market that have made it more costly to arbitrage the difference between real and nominal rates. For now, we consider this simply a risk to our overweight view. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in April, bringing year-to-date excess returns up to +33 bps. Aaa-rated issuers outperformed the Treasury benchmark by 10 bps on the month, while non-Aaa issues outperformed by 13 bps. The index option-adjusted spread for Aaa-rated ABS tightened 1 bp on the month, and remains well below its average pre-crisis level. Banks are now tightening lending standards on both auto loans and credit cards. While we do not expect this recent development to have much of an impact on consumer spending,7 it is usually an indication that there is growing concern about ABS collateral credit quality. This concern is echoed by the fact that net losses on auto loans are trending sharply higher (Chart 9). Credit card charge-offs remain subdued for now - and we continue to recommend that investors favor Aaa-rated credit cards over Aaa-rated auto loans - but even in the credit card space quality concerns are starting to mount. Capital One reported a 20% drop in earnings in Q1 versus the same quarter in 2016, and noted that it has been tightening underwriting standards against a back-drop of credit card loans growing faster than income. We remain overweight ABS for now, as the securities still offer attractive spreads compared to other high-quality spread product, but we are closely monitoring credit quality metrics for signs of rising stress. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in April, bringing year-to-date excess returns up to +19 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month, and is fast approaching its average pre-crisis level. Apartment and office building prices are growing strongly, but as in the corporate space, the retail sector is a major drag (Chart 10). Tighter lending standards and falling demand also suggest that credit stress is starting to mount, but while office and retail delinquencies are rising multi-family delinquencies remain low (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in April, bringing year-to-date excess returns up to +19 bps. The index option-adjusted spread for Agency CMBS widened 1 bp on the month, and currently sits at 54 bps. The option-adjusted spread on Agency CMBS looks attractive compared to other high-quality spread product: Agency MBS = 35 bps, Aaa consumer ABS = 46 bps, Agency bonds = 17 bps and Supranationals = 20 bps. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.59% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.43%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we are inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. It should also be noted that the fair value readings from both the 2-factor and 3-factor models are calculated using FLASH PMI estimates for April. These estimates will be revised later today when the actual PMI data are released. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.32%. 1 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 4 Please see Emerging Markets Strategy Weekly Report, "A Time To Be Contrarian", dated April 5, 2017, available at ems.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of April 30, 2017. The model has increased its allocation to Spain at the expenses of Germany largely driven by changes in the value and technical indicators, compared to previous month as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, Level 2 model (the allocation among the 11 non-U.S. DM countries) outperformed its benchmark by 99 basis points (bps) in April, largely a result from the overweight of the euro area versus the underweight in Japan, Canada and Australia. Level 1 model, the allocation between U.S. and non-U.S., underperformed by 13 bps in April due to the large overweight in the U.S. Overall, the aggregate GAA model outperformed its MSCI World benchmark by 15 bps in April and by 138 bps since going live. 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. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of April 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The growth component has become more bullish on global growth. The model has now turned overweight on materials & consumer discretionary, and underweight on utilities & healthcare. 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 Patrick Trinh, Associate Editor patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Feature Table 1Recommended Allocation Don't Worry About The Tepid Data Risk assets are likely to continue to grind higher. Two of the catalysts we cited for this in our most recent Quarterly1 have half happened: European political risk is lifting now that Marine Le Pen looks most unlikely to win in the second round of the French presidential election (polls give her less than 40% of the vote); and the Trump administration announced its tax cut plan (which, though details are still sparse, we expect to be passed in some form this year). As a result, the MSCI All Country World Index hit a record high in late April and the S&P 500 is only 1% below its high. But both growth and inflation have surprised somewhat to the downside in the past couple of months. The Citi Economic Surprise Index for the U.S. has fallen sharply, though surprises remain fairly positive elsewhere (Chart 1).Q1 U.S. real GDP growth came in at an annualized rate of only 0.7%. This has pushed bond yields down (with the US Treasury 10-year yield falling back to 2.2%), consequently weakening the dollar. We are not unduly worried about the tepid data. It is mainly due to technical factors. Corporate loan growth in the U.S., for example (Chart 2), mostly reflects just the lagged effect of last year's slowdown on banks' willingness to lend, as well as energy companies repaying credit lines they tapped in early 2016 when short of working capital. The weakness in auto sales (Chart 3) is most likely caused by the end of the car replacement cycle which began in 2010, rather than reflecting any generalized deterioration in consumer behavior. Moreover, there seem to be problems with seasonal adjustment of data caused by the extreme swings in the economy in 2008 and 2009: Q1 has been the weakest quarter for U.S. GDP in six out of the past 10 years, and has on average been 2.3 ppts lower than Q2.2 There were no such distortions prior to 1996. Chart 1U.S. Growth Has Surprised To The Downside Chart 2Weaker Loan Growth Is Mostly Technical... Chart 3...And The Slowdown In Autos Is Just The End Of A Replacement Cycle A consequence of the wobbly data is that markets have become too complacent about the Fed raising rates, with futures markets now projecting only about 40 bps of hikes over the next 12 months (Chart 4). Our view is that wages will gradually move up this year, pushing core PCE inflation to 2% by year end, which will cause the Fed to raise rates twice before end-2017 and once early in 2018 (though the latter rise could be postponed if the Fed starts to reduce its balance-sheet and forgoes one quarter's hike to judge the impact of this on the market). By contrast, we do not see the ECB hiking before 2019 at the earliest, with ECB President Draghi reiterating that he sees core inflation staying low and remains concerned about the fragile banking systems in peripheral European markets and about Italian politics. We also believe Bank of Japan governor Kuroda when he says he has no plans to change the BoJ's 0% target for the 10-year JGB yield. All this implies that the dollar is likely to appreciate further in the next 12 months as interest rate spreads widen (Chart 5). Chart 4Fed Is Likely To Hike Faster Than This Chart 5Interest Differentials Suggest Further Dollar Strength The next catalyst for equities to rise further could be earnings. Q1 U.S. earnings are surprising significantly on the upside, with EPS growth of 11.7% year on year and 75% of companies beating analysts' estimates.3 BCA's proprietary model suggests that S&P 500 operating earnings this year could grow by over 20% (Chart 6). If anything, upside surprises to earnings have been even stronger in the euro zone and Japan. With none of the standard indicators signaling any risk of recession over the next 12 months (Chart 7), we remain overweight equities versus bonds. We continue to warn, though, that the Goldilocks scenario of healthy growth and stable inflation may not last for long. A combination of tax cuts, wage growth accelerating as labor participation hits a ceiling, and the Fed falling behind the curve (perhaps when President Trump - given that he recently confessed "I do like a low interest rate policy" - appoints a dovish replacement for Janet Yellen as Fed Chair) could cause inflation to rise unexpectedly next year, forcing the Fed to raise rates sharply, triggering a recession in 2019. Chart 6U.S. Earnings Could Grow 20% This Year Chart 7No Sign Of A Recession On The Horizon Equities: In a risk-on environment, euro zone equities should continue to outperform, due to their higher beta (averaging 1.3 against global equities over the past 20 years, compared to 0.9 for the U.S.), more cyclical earnings, and modestly cheaper valuations (forward PE is at a 18.9% discount to the U.S.). Japanese equities should also do well as interest rates rise again globally (except in Japan where the BoJ will stick to its 0% yield target on 10-year bonds), which should push down the yen and boost earnings. We remain overweight Japanese equities on a currency-hedged basis. We are underweight EM equities, which are likely to be weighed down over the next 12 months by the stronger dollar, and by a slowdown in China which should cause commodity prices to fall. Fixed Income: We expect the 10-year U.S. Treasury yield to reach 3% by year-end: a pickup in real growth, slightly higher inflation and two more Fed hikes can easily add 70 bps to the yield over the next eight months. Euro zone yields will also rise, though not by as much. This implies a negative return from G7 sovereign bonds for the first time since 1994. We continue to prefer corporate credit, with a preference for U.S. investment-grade debt over high-yield bonds (which have stretched valuations) and over European corporate debt (which will be negatively affected by the tapering of ECB purchases next year). Currencies: As described above, we do not believe that the dollar appreciation which began in 2014 is over, due to divergences in monetary policy. We would look for a further 5-10% appreciation of the dollar over the coming 12 months, though the rise is likely to be bigger against the yen and emerging market currencies than against the euro. Commodity currencies such as the Australian dollar also look vulnerable and overvalued. The British pound will be driven by the vicissitudes of the Brexit negotiations in the short-run but looks undervalued in the long run if, as we expect, the EU eventually agrees a moderately satisfactory trade deal with the U.K. Commodities: We continue to believe that the equilibrium level for oil is $55 a barrel, and that an extension of the OPEC production agreement beyond June and a drawdown in inventories in the second half will bring WTI crude back to that level - with the risk of even $60-65 temporarily if there are any unforeseen supply disruptions. We remain more cautious on industrial commodities, which will be hurt by a mild withdrawal of monetary and fiscal stimulus in China. Following its 6.9% GDP print in Q1, Chinese growth is likely to slow moderately. However, with the Party Congress coming up in the fall, growth will not be allowed to slow excessively - and, indeed, there are signs that central government spending has begun to accelerate recently (Chart 8). We remain positive on gold as a long-term hedge against the tail risk of inflation. As our recent Special Report on Safe Havens demonstrated,4 gold has historically provided good returns during recessions, particularly those associated with high inflation (Chart 9). Chart 8China Is Withdrawing Stimulus - Or Is It? Chart 9Gold Glisters When Inflation Rises Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Global Asset Allocation, "Quarterly Portfolio Outlook: No Reasons To Turn Cautious," dated 3 April 2017, available at gaa.research.com 2 For detailed analysis of the problems with seasonal adjustment, please see U.S. Investment Strategy, "Spring Snapback?" dated April 24, 2017, available at usis.bcaresearch.com 3 So far about half of U.S. companies have reported. 4 Please see Global Asset Allocation, "Safe Havens: Where To Hide Next Time?" dated April 21, 2017, available at gaa.bcaresearch.com. Recommended Asset Allocation

Highlights Portfolio Strategy Upgrade the financials sector to overweight. This year's consolidation phase is drawing to a close as inflation expectations stabilize. Lift the S&P banks index to overweight. Leading indicators of credit creation are signaling a reacceleration as the year progresses. Trim the S&P health care sector to neutral via profit-taking in medical equipment stocks. Recent Changes S&P Financials - Upgrade to overweight from neutral. S&P Banks Index - Upgrade to overweight from underweight. S&P Health Care - Downgrade to neutral. S&P Health Care Equipment - Downgrade to neutral. Table 1 Feature Chart 1Yields Are Not Yet Restrictive The S&P 500 is challenging the top end of its range. A playable breakout looks increasingly probable, albeit the exact timing is difficult. First quarter profit results have been strong, corporate guidance has been solid and monetary conditions are unlikely to become tight enough in the short run to dent renewed profit optimism. The latest string of economic disappointments is seen as providing the Fed with ample leeway, and investors are willing to overlook ongoing sluggishness because earnings are outperforming the economy via margin expansion. As discussed in detail in recent weeks, earnings growth is supported by a broad-based recovery in sales and pricing power. Top-line growth is critical to sustaining the overall equity market overshoot given sky-high valuations. Indeed, the appeal of equities stems from their attractiveness relative to other asset classes rather than in absolute terms. History shows that an asset preference shift can take time to play out, and push valuations higher than seems justified on fundamentals alone as long as recession is not an imminent risk. The Treasury market can provide clues as to when vulnerabilities will intensify. According to BCA's Treasury Bond Valuation Model, yields usually need to be at least one standard deviation above normal before stocks, and the economy, are at risk of a major downturn (Chart 1). At those turning points, inflation concerns are typically running hot, forcing the Fed to tighten enough to slow growth and undermine economic activity. This simple rule of thumb warned of the most recent stock market peaks, as well as equity slumps in the early-1990s, 1987, and the early-1980s, and supported bond vs. equity outperformance. Recently, the 10-year Treasury yield has returned to fair value, and the U.S. dollar has come off the boil. The implication is that there is no monetary roadblock to halt the upward momentum in equities at the moment. There is ample room for yields to rise before becoming restrictive, especially if the primary driver is the real component. In this light, we will continue with our program of transitioning to a more balanced equity portfolio from its previous defensive tilt. This week we downgrade a defensive sector to neutral and redeploy capital into the financials sector. Upgrade The Financials Sector... The financials sector has given back roughly 50% of its post-election surge this year. The main culprits have been a calming in Fed interest rate hike expectations, a flattening yield curve and softening inflation expectations. Moribund credit creation has also created earnings uncertainty (Chart 2). Nevertheless, the corrective phase appears to be drawing to a close, because financials sector profits are increasingly likely to surpass those of the overall corporate sector going forward. Traditionally, the financials sector benefited from a strong U.S. dollar. A strong dollar exerted downward pressure on interest rates, which spurred domestic economic strength, loan demand and a steepening yield curve. However, since the GFC, the opposite has been true. Zero interest rates and intense deflationary risks were exacerbated by U.S. dollar appreciation, as the corporate sector and commodities suffered. In other words, with the economy operating on a knife's edge between deflation and inflation, a strong currency weighed heavily on financial shares. Thus, the hiatus in the U.S. dollar bull market is a significant positive catalyst, if it arrests the decline in inflation expectations. The yield curve is making an effort to stabilize, suggesting that the risks of falling back close to the deflationary precipice are low. There are already signs of a positive reversal in euro area financials, which had led the U.S. financial sector on the way down after peaking late last year (Chart 2). The euro area has been in a deleveraging phase with acute deflationary risks, underscoring that the signal from share price stabilization in this region is worth noting. The key to a sustained recovery in sector profits is economic reacceleration. Corporate sector profits are healing as a consequence of the pickup in global final demand and the peak in the U.S. dollar, which should ensure that labor market slack does not imminently build. That is necessary to sustain credit quality and generate faster credit demand, and can be illustrated through the positive correlation between the output gap and relative share price performance (Chart 3), at least until the gap grows too large to generate inflationary pressures and by extension, tight monetary policy. Chart 2Earnings Uncertainty... Chart 3...But A Narrowing Output Gap... Leading economic indicators are consistent with erring on the side of optimism (Chart 4). Our proxy for the supply/demand balance for C&I loans confirms a positive bias for future loan growth (Chart 4). The upturn in the financial sector sales/employment ratio is encouraging (Chart 4). Productivity improvement has begun prior to a reacceleration in loan creation, suggesting that additional upside looms as balance sheets expand. Any unlocking of the regulatory shackles would be a bonus. Strength in our Financials Cyclical Macro Indicator confirms that profits should best those of the overall corporate sector. The financial sector is contributing more to overall GDP growth than it did even during the credit binge/housing bubble (Chart 5), despite the headwind of ultralow interest rates. Chart 4...And Leading Indicators ##br##Are Positive Offsets Chart 5Market Cap ##br##Gains Loom Even though financials represent an ever increasing share of the broad economy, the sector still garners less than its historic median market cap weight (Chart 5). The upshot is that if the economy stays resilient, the correction in relative share price performance should fully reverse, and we recommend further upgrading allocations to overweight via the heavyweight bank group. ...And Bank On Faster Growth Bank profit growth is supported by three main pillars: the quantity, price and quality of credit. All three are set to improve. While seven out of eight lending categories are experiencing a negative credit impulse, forward looking indicators are sending a more positive message. Business and consumer confidence have skyrocketed (Chart 6). If the revival in animal spirits lifts real economic activity later this year, capital demands could finally break out of their slump and reinvigorate moribund loan growth (Chart 6). Importantly, our U.S. Capital Spending Indicator (CSI) snapped back into positive territory. This primarily reflects both the firming in the ISM manufacturing survey and tightness in the labor market. Credit growth has not yet troughed, but should recover in the second half of the year based on our CSI's reading (Chart 6, top panel). Other leading indicators are heralding a pickup in credit demand. A steepening yield curve and the soaring ISM new orders index have an excellent track record in leading the Fed's Senior Loan Officer Survey for overall credit demand (Chart 6). Solid house price inflation and a tight labor market should ensure that consumer credit growth also firms (Chart 7), pointing to the potential for a broad-based bank balance sheet expansion. Overall household leverage has fallen back to 2003 levels and the household debt-service ratio is at multi-decade lows. Chart 6A Turning Point For Loans... Chart 7...As Demand Recovers Bank deposits are still growing, outpacing nominal GDP by 200bps, and the sector is extremely well capitalized. The loan-to-deposit ratio remains low by historical standards (Chart 8). Bank holdings of risk free securities comprise about 15% of the sector's assets, well above the historic average (Chart 8). The upshot is that there is plenty of firepower to crank up credit creation. True, a rundown in Treasury holdings would result in mark-to-market losses, but banks are well positioned to navigate through rising interest rates. According to the FDIC, net interest income as a share of total revenue has climbed steadily at commercial banks with assets greater than $1bn (Chart 9). Thus, if a better economy and rising inflation materialize in the back half of the year, then higher interest rates will boost profitability (Chart 9). Chart 8Banks Have Dry Powder Chart 9A Durable NIM Expansion Table 2 shows a sample of the four largest U.S. banks' earnings sensitivity to interest rate changes. Banks profit from overall rising interest rates in two ways: reinvesting at higher yields and assets repricing at a faster pace than deposits. Table 2Top Four Banks' Interest Rate Sensitivities Thus, a steepening yield curve would signal that bank profit estimates should experience a re-rating, provided the yield lift at the long end of the curve was gradual and did not choke off growth via a sudden spike (Chart 9). In terms of credit quality, non-performing loans and charge-offs are sinking from already low levels. It would take a significant deterioration in the labor market to warn that credit quality was about to become a profit drag (Chart 10). Chart 10Credit Quality Is Not An Issue, For Now Importantly, the reserve coverage ratio has climbed to near 100%, as non-current loans have fallen faster than banks have released reserves. Historically, credit quality improvement has been positively correlated with rising valuations (Chart 10). This message is corroborated by return on equity (ROE). Bank ROE has recouped most of the losses since the GFC on the back of recovering productivity gains. However, valuations do not yet reflect the ROE improvement. History shows that after a financial crisis, it can take a prolonged period of improved ROE before investors reward the sector with a valuation expansion, as occurred in the early-1990s (Chart 7, bottom panel). Bottom Line: Boost the S&P financials sector to overweight from neutral. Lift the S&P banks index to overweight. The ticker symbols for the stocks in the S&P banks index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Take Health Care Equipment Down A Notch We are making room for the financials sector upgrade by trimming the health care sector to neutral. As discussed in recent weeks, a modest shift away from a defensive to a more balanced portfolio has been on our radar and the surge in equities over the past week suggests that the consolidation phase is now ending in a bullish fashion, as expected. At the beginning of the year we added the S&P health care equipment (HCE) index to our high-conviction overweight list for three main reasons: valuations had undershot owing to health care reform uncertainty, domestic sales were set to improve and leading indicators of foreign sourced revenue also painted a rosy picture. What has changed? Relative share prices have undergone a V-shaped snapback, all of which can be attributed to a valuation expansion. A flurry of recent M&A activity has also buoyed relative valuations, as takeover premiums have been significant. Relative performance is now at a natural spot to expect a breather. On the operating front, a number of positive profit drivers are still intact. The industry's shipments-to-inventories ratio remains at multi-decade highs and the backlog of medical equipment orders is robust (top and bottom panels, Chart 11). HCE exports are primed to accelerate in the coming months likely irrespective of the U.S. dollar's move. In particular, Europe matters most to S&P HCE constituents, as roughly half of international sales originate in the old continent. Forward-looking indicators of European demand are upbeat, especially with the surge in German medical equipment orders (Chart 11). However, domestic sales indicators have downshifted. New health care facility construction has dropped sharply, warning that investment in medical equipment may soon follow suit (Chart 12, second panel). Consumables demand growth may also take a breather. Consumer outlays at hospitals have nosedived on a growth rate basis. This suggests that the growth in patient visits has dried up, and may be a warning that medical equipment new order growth will also decelerate (Chart 12). Moreover, as outlined in recent Weekly Reports, the broad corporate sector has regained pricing power, but medical equipment suppliers have lagged. Chart 12 shows that relative selling prices are contracting at an accelerating pace. This is significant, as deflation concerns could undermine revenues, and halt the valuation expansion. If domestic medical equipment demand cools, then it will sustain downward pressure on industry activity (Chart 13). Already, medical equipment industrial production (IP) has collapsed, in marked contrast with the expansion in overall IP. Chart 11Export Prospects Are Positive... Chart 12...But Domestic Blues... Chart 13...Will Weigh On Activity Worrisomely, the HCE new orders-to-inventories ratio has also lost steam, warning that a recovery in future production growth may not be imminent. The implication is that productivity gains are petering out, denting our confidence in a further valuation re-rating. Bottom Line: Downgrade the S&P health care equipment index and remove it from the high-conviction overweight list for an 9% gain. This also pushes the broad health care index to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HCEP: MDT, ABT, DHR, SYK, BDX, BSX, ISRG, BAX, ZBH, EW, BCR, IDXX, HOLX, VAR. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Dear Client, In addition to this abbreviated Weekly Report, I sent you a Special Report earlier today written by my colleague Mark McClellan of our monthly Bank Credit Analyst publication. Following up on many of the themes discussed in our latest Quarterly Strategy Outlook, Mark makes a convincing case that most of the factors that have suppressed global interest rates since the financial crisis could begin to unwind or even reverse over the coming years. Best regards, Peter Berezin, Chief Global Strategist Feature Davos Man Is Happy Chart 1Macron Leading Le Pen Populist forces have been in retreat of late. First came the Austrian presidential elections, which saw voters reject a populist right-wing challenger in favor of a former Green Party leader who pledged to be an "open-minded, liberal-minded, and above all a pro-European president." Then came the Dutch elections, where Prime Minister Mark Rutte won more seats than the maverick Geert Wilders. Last week the pound surged after U.K. Prime Minister Theresa May called for a fresh election. May's announcement was designed to expand the Conservative Party's majority, thus neutralizing the ability of a few hardline Tories to scuttle a Brexit deal. These uncompromising MPs would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. This week we have the results of the first round of the French presidential elections. Despite the media's absurd characterization of Emmanuel Macron as an "outsider," the former government minister was, in fact, the establishment's dream candidate: pro-business and fervently Europhile. Current polls show Macron beating Le Pen in a runoff by 21 points (Chart 1). Finally, on the other side of the Atlantic, Donald Trump has caved on most of his populist campaign pledges. He agreed to drop his requests that Congress pay for a border wall with Mexico and defund Planned Parenthood. The move is likely to avert an imminent government shutdown. In addition, Trump backed off his pledge to scrap NAFTA. This follows on the heels of his decision not to label China as a "currency manipulator," something he had promised to do during the campaign. And to top it all off, Trump released a one-page tax plan with all the goodies the Republican establishment has been craving: Lower corporate and personal tax rates and the abolition of the estate tax. Risk Assets Will Benefit... Not surprisingly, global equities have responded positively to these developments. The MSCI All-Country World Index hit a record high this week (Chart 2). A rebound in corporate earnings is helping to propel stocks higher. Our global earnings model points to further upside for profits over the coming months (Chart 3). Chart 2Global Equities At Record Highs Chart 3More Upside Ahead For Global Earnings The laggard remains the Treasury market. Trump's tax plan will add about $5 trillion to the national debt over the next decade above and beyond what the Congressional Budget Office is already projecting. Yet, the 10-year Treasury yield remains 30 basis points below where it was in early March. The market is pricing in just under two rate hikes over the next 12 months. This is below the Fed's guidance and our own expectations. We went short the January 2018 fed funds futures contract last week (Chart 4). Higher U.S. rate expectations should lead to a further widening of rate differentials between the U.S. and its trading partners (Chart 5). Mario Draghi underscored yesterday that the ECB has no plans to remove monetary stimulus anytime soon. If anything, rising inflation expectations in the euro area on the back of a firming economy could lead to lower real yields there, putting downward pressure on the euro. Chart 6 shows that the market expects real U.S. five-year yields to be only 11 basis points higher than in the euro area in 2022.1 That seems too low to us, given the euro area's bleak demographics and high debt levels. We continue to see EUR/USD reaching parity later this year. Chart 4The Market Is Lowballing The Fed Chart 5Higher U.S. Rate Expectations Will Lead To Further Widening Of Rate Differentials Chart 6The Vanishing Transatlantic Bond Spread ...But Populists Will Triumph In The End Steady growth and falling unemployment will reduce support for populist parties over the coming 12 months. This will help keep global equities in an uptrend. Beyond then, the clouds are likely to darken. We argued in our Q2 Strategy Outlook that global growth could begin to slow in the second half of next year.2 If that happens, support for mainstream political parties will fade. Structural forces will further bolster support for populist leaders. Chart 7 shows that Le Pen won the plurality of voters between the ages of 35 and 59. Young voters tilted towards Mélenchon, while older voters overwhelmingly went for Emmanuel Macron and François Fillon. If recent voting trends are any guide, the elderly of tomorrow will be more sympathetic to Le Pen than the elderly of today. Le Pen's populist message on the economy could resonate more with younger voters (indeed, Le Pen beat Macron among voters between the ages of 18 and 24). Chart 7Who Likes Le Pen? Meanwhile, worries about terrorism will undermine support for the establishment. There are 17,000 people on the French government's terrorist watch list, 2,000 of whom have fought in Syria and Iraq. Macron's feeble pledge to hire 10,000 additional police officers will do little to thwart future attacks. In the U.S., Trump's pivot towards the establishment wing of the Republican Party could prove to be short-lived. Most Republican voters have mixed feelings about Donald Trump the man. They voted for Trumpism, not Trump. Either Trump will start delivering on the promises that endeared him to blue-collar workers in states such as Ohio and Pennsylvania, or he will go down in flames in the next election. Bottom Line: Investors should overweight global equities in a balanced portfolio over the next 12 months, but look to reduce exposure in the second half of next year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Talk Is Cheap: EUR/USD Is Heading Towards Parity," dated April 14, 2017, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Outlook: "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Dear Client, In addition to an abbreviated Weekly Report that you will receive later tonight, I am sending you this Special Report written by my colleague Mark McClellan of our monthly Bank Credit Analyst publication. Following up on many of the themes discussed in our latest Quarterly Strategy Outlook, Mark makes a convincing case that most of the factors that have suppressed global interest rates since the financial crisis could begin to unwind or even reverse over the coming years. Best regards, Peter Berezin, Chief Global Strategist Highlights The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. Feature In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart 1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart 1Global Disequilibria The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart 2Global Shifts In The Saving And Investment Curves The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart 2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart 3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart 3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart 3Demographics Are A Structural Headwind For Global Capex (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart 4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart 2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart 5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart 6). The same is true, although to a lesser extent, in the emerging world. Chart 4Working-Age Population Ratios Have Peaked Chart 5Labor Share Of Income Has Dropped Chart 6Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart 7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart 8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart 7Economic Integration And Falling Capital Goods Prices Chart 8Macro Impact Of Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart 9Working-Age Population To Shrink in G7 and China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart 9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart 10Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart 10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart 11 presents the data for China and three of the major advanced economies. The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart 11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart 11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. Chart 11Income And Consumption By Age Cohort The results are shown in Chart 12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart 12Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Chart 13Demographics And Capex Requirements Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart 13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart 14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart 15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart 14China's Savings Rates Have Peaked... Chart 15...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: Table 1Key Secular Drivers The main points we made in this report are summarized in Table 1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook. Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart 16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Another way of looking at this is presented in Chart 17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart 16Market Expects Negative Short-Term Rates For A Long Time Chart 17Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 It is true that observed household saving rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3, IMF World Economic Outlook (April 2017). 5 In other words, while the household saving rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e., savings across the household, government, and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014).

Special Report

Highlights Uncovered Interest Rate Parity still works for currencies. However, it needs to be based on a combination of short- and long-term real rates. Currencies are also affected by the global risk appetite, as approximated by corporate spreads, and commodity prices. Based on our timing model­s, the countertrend correction in the dollar is toward its tailend. Any additional weakness should be used to buy the greenback. The euro is now expensive based on our timing model. However, it could become slightly more expensive as markets continue to price in the euro area-friendly outcome of the first round of the French election. Feature In July 2016, in a Special Report titled "In Search Of A Timing Model," we introduced a set of intermediate-term models to complement our long-term fair value models for various currencies.1 These groups of models provide additional discipline, a sanity check if you will, to our regular analysis. In this report, we review the logic underpinning these intermediate-term models and provide a commentary on their most recent readings for the G10 currencies vis-à-vis the USD. UIP, Revisited The uncovered interest rate parity (UIP) relationship is at the core of this modeling exercise. This theory suggests that an equilibrium exchange rate is the one that will make an investor indifferent between holding the bonds of country A or country B. This means that as interest rates rise in country A relative to country B, the currency of country B will fall today in order to appreciate in the future. These higher expected returns are what will drive investors to hold the lower-yielding bonds of country B (Chart 1). Chart 1Interest Rate Differentials Remain Useful ##br##Gauges For XR Determination There has long been a debate as to whether investors should focus on short rates or long rates when looking at exchange rates through the prism of UIP. Research by the Fed and the IMF suggest that incorporating longer-term rates to UIP models increases their accuracy.2 This informational advantage works whether policy rates are or aren't close to their lower bound.3 Incorporating long-term rates as an explanatory variable increases the performance of UIP models because exchange rate movements do not only reflect current interest rate conditions, but currency market investors also try to anticipate the path of interest rates over many periods. By definition, long-term bonds do just that as they are based on the expected path of short rates over their maturity - as well as a term premium, which compensates for the uncertain nature of future interest rates. There is another reason why long-term rate differential changes improve the power of UIP models. Since UIP models are based on the concept of investor indifference between assets in two countries, changes in the spreads between 10-year bonds in these two countries will create more volatility in the currency pair than changes in the spreads between 3-month rates. This is because an equivalent delta in the 10-year spread will have much greater impact on the relative prices of the bonds than on the short-term paper, courtesy of their much more elevated duration. To compensate for these greater changes in prices, the currency does have to overshoot its long-term PPP to a much greater extent to entice investors trading the long end of the curve. Bottom Line: The interest rate parity relationship still constitutes the bedrock of any shorter-term currency fair value model. However, to increase its accuracy, both long-term and short-term rates should be used. Real Rates Really Count Another perennial question regarding exchange rate determination is whether to use nominal or real rate differentials. At a theoretical level, real rates are what matter. Investors can look through the loss of purchasing power created by inflation. Therefore, exchange rates overshoot around real rate differentials, not nominal ones. On a practical level, there are additional reasons to believe that real rates should matter, especially when trying to explain currency moves beyond a few weeks. Indeed, various surveys and studies on models used by forecasters and traders show that FX professionals use purchasing power parity as well as productivity differential concepts when setting their forex forecasts.4 Indeed, as Chart 2 illustrates, real rate differentials have withstood the test of time as an explanatory variable for exchange rate dynamics, albeit with periods where rate differentials and the currency can deviate from each other. It is true that very often, nominal rate differentials can be used as a shorthand for real rate differentials as both interest rate gaps tend to move together. However, regularly enough, they do not. In countries with very depressed inflation expectations (Japan comes to the front of the mind), nominal and real rate differentials can in fact look very different (Chart 3). With the informational cost of incorporating market-based inflation expectations being very low, we find the shorthand unnecessary when building UIP-based models. Chart 2Over The Long Run, Real Rate ##br##Differentials Work Best Chart 3Real And Nominal Rates ##br##Can Be Different Finally, it is important to remark that in environments of high inflation, inflation differentials dominate any other factor when it comes to exchange rate determination. However, the currencies discussed in this report currently are not like Zimbabwe or Latin America in the early 1980s. Bottom Line: When considering an intermediate-term fair value model for exchange rates, investors should focus on real, not nominal long-term rate differentials. Global Risk Aversion And Commodity Prices Chart 4The Dollar Benefits From Global Woes Global risk appetite is also a key factor to consider when trying to model exchange rates. Risk aversion shocks tend to lead to an appreciation in the dollar, which benefits from its status as the global reserve currency.5 Much literature has often focused on the use of the VIX as a gauge for global risk appetite. Our exercise shows stronger explanatory power for the option-adjusted spreads on junk bonds (Chart 4). Commodity prices, too, play a key role. Historically, commodity prices have displayed a very strong negative correlation with the dollar.6 This correlation is obviously at its strongest for commodity-producing nations, as rising natural resource prices constitute a terms-of-trade-shock for them. However, this relationship holds up for the euro as well, something already documented by the ECB.7 The Models The models for each cross rate are built to reflect the insight gleaned above. Each cross is modeled on three variables, with the model computed on a weekly timeframe: Real rates differentials: We use the average of 2-year and 10-year real rates. The rates are deflated using inflation expectations. Global risk appetite: Proxied by junk OAS. Commodity prices: We use the Bloomberg Continuous Commodity Index. For all countries, the variables are statistically highly significant and of the expected signs. These models help us understand in which direction the fundamentals are pushing the currency. We refer to these as Fundamental Intermediate-Term Models (FITM). We created a second set of models, based on the variables above, which also include a 52-week moving average for each cross. Real rates differentials, junk spreads, and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a 3-9 month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). The U.S. Dollar Chart 5Dollar Fundamentals Strengthening... Chart 6...But Timing Could Be Better To Buy DXY To model the dollar index (DXY), we used two approaches. In the first one, we took all the deviation from fair value for the pairs constituting the index, based on their weights in the DXY. In the second approach, we ran the model specifically for the DXY, using the three variables described above. U.S. real rates were compared to an average of euro area, Japanese, Canadian, British, Swiss, and Swedish real rates weighted by their contribution to the DXY. We then averaged both approaches, which gave us very similar results to begin with. The FITM for the DXY has stabilized and is now slowly moving upward (Chart 5). The ITTM itself is even pointing upward, arguing that the dollar is at a neutral level and that its previous overshoot has now been corrected. However, historically, the DXY rarely stabilizes at its fair value, overshooting the mark instead. Based on historical behavior, the DXY is likely to undershoot its ITTM by another two percent or so before an ideal entry point to buy the USD emerges (Chart 6). Longer term, we continue to expect the dollar to stay on an upward trend. The U.S. neutral rate remains above that of Europe and Japan. Moreover, U.S. economic slack is dissipating much faster than in Europe, and the U.S. may already be in the process of hitting its own capacity constraints. This suggests that the Fed has much greater scope to normalize policy than the ECB. With the OIS curve pricing in a 25 basis point hike in the U.S. over the next 12 months, this will support the USD versus the euro. Japan, too, exhibits increasing signs of limited slack in its economy. However, with the BoJ committed to an inflation overshoot in order to upwardly shock moribund Japanese inflation expectations, we think that Japanese real rates will lag U.S. ones, putting significant upside on USD/JPY. The Euro Chart 7Euro Fundamentals Are Deteriorating Chart 8The Euro Is No Longer Cheap The FITM for EUR/USD has rolled over and is now pointing south, suggesting that fundamentals are moving against the euro (Chart 7). This reflects large rate differentials between the U.S. and the euro area, but also, the recent softness in some corners of the commodity complex. Last spring, the FITM did a good job forecasting the rebound in the euro, and the fact that it is flagging impeding euro weakness deserves to be highlighted. In terms of entering a short EUR/USD tactical bet, at the current juncture, the ITTM suggests an entry point is soon to emerge (Chart 8). Now that the dueling pair of the second round of the French election has been determined - Macron vs Le Pen - the euro was able to price out nightmare scenarios involving two Eurosceptic candidates. In fact, with the realization that Macron holds a 20% lead over Le Pen in second round polling, the market has begun to completely price out any euro-endangering outcome for the French election. This means that the euro is likely to move toward its historical premium to the ITTM before reverting toward its cyclical downtrend. Practically, this means that EUR/USD could run toward 1.11-1.12 before rolling over, something that may happen by May 8th. On a 12- to 18-months basis, we are comfortable with the current message from the FITM. The European economy may be growing above trend, but there remains enough slack in Europe that wage and core inflation dynamics are still very muted. This contrasts with the U.S. economy, where most indicators we track argue that wages and core inflation should gain some upward momentum this year. This means that rate differentials between the euro area and the U.S. are likely to underperform even what is priced into the relative interest rate curves. This should weigh on EUR/USD as the euro is not cheap enough to compensate for these economic dynamics. The Yen Chart 9A Dovish BoJ Will Weigh ##br##On Yen Fundamentals Chart 10The Yen Is No Longer ##br##Tactically Cheap The FITM model shows that the post-election rally in USD/JPY was overdone as the yen's fundamentals have stopped deteriorating after October 2016 (Chart 9). As we see the growing likelihood of a decreasing deflationary impulse in Japan, the strong dovish commitment of the Bank of Japan should pull Japanese real rates lower vis-à-vis their U.S. counterparts. This underpins why we remain cyclical bears on the yen. Tactically, based on the ITTM, it will soon be time to close our short USD/JPY trade. While the yen had massively undershot any rational anchor in the wake of the Trump electoral victory, this undervaluation appears to have vanished after the yen's sharp rebound (Chart 10). A small overshoot in the yen is likely, but unless one is already short USD/JPY, this move should not be chased. In fact, USD/JPY below 108 should be used as an opportunity to reverse yen longs and play what may prove to be a powerful USD/JPY rally. The British Pound Chart 11GBP: A Long-Term Bargain... Chart 12...But Upside Against USD Is Limited According to the FITM, the pound's fair value has been stable post-Brexit, but it is now beginning to point lower. However, despite this turn of events, GBP/USD is currently trading at such an exceptional discount to the FITM - courtesy of a heightened geopolitical risk premium - that this deterioration in fair value is unlikely to matter much (Chart 11). Nonetheless, the fact that fundamentals have a negative directional bias for cable is prompting us to express our tempered optimism toward the pound by shorting EUR/GBP instead of buying GBP/USD. At a tactical level, the ITTM suggests that GBP/USD could have a bit more upside. GBP/USD is at equilibrium based on our timing model, but undershoots tend to be compensated by subsequent overshoots (Chart 12). That being said, with the ITTM still pointing south - in line with the FITM - any further rebound in GBP/USD is likely to prove to be limited. GBP/USD beyond 1.33 should be used as an opportunity to sell cable. On a multi-year basis, GBP is quite cheap, not only on a PPP basis, but also when incorporating relative productivity dynamics. This means that while we have a positive dollar-bias over the next 12-18 months, our favorite non-USD currency is currently the GBP. The June 8th general election is likely to give Theresa May the parliamentary majority she needs to have a more comfortable negotiating position with the EU, helping her obtain more advantageous terms for the U.K., re-enforcing our positive long-term bias on the GBP. The Canadian Dollar Chart 13Oil And Spreads Are Working##br##Against The Loonie... Chart 14...And So Is##br## Wilbur Ross According to the FITM, the aggregate fundamentals have rolled over and are beginning to point directionally south for the loonie: Oil has lost momentum, and rate differentials are not particularly flattering for the CAD (Chart 13). That being said, the CAD has greatly lagged these same fundamentals, probably as investors have been pondering the potential negative implications for NAFTA and Canada of the Trump administration. Our ITTM suggests that with this handicap taken into account, the CAD may not be a short after all (Chart 14). However, because the CAD is more sensitive to the trend in the broad U.S. dollar and general commodity prices than anything else, we prefer to express a positive bias on the loonie by buying it against the AUD, a commodity currency that does not trade at the same discount to its ITTM. The Swiss Franc Chart 15Inflationary Dynamics Should##br## Continue To Weigh On The Franc Chart 16No Clear Timing##br## Signals Yet Even if flat for the past year or so, the directional fundamentals on the Swiss franc vis-à-vis the USD still seems to be in a long-term bear market (Chart 15). This simply highlights the fact that with the U.S. economy able to generate some inflationary dynamics while Switzerland continues to suffer from pronounced deflationary anchors, U.S. real rates have more room to move upward than Swiss ones. In terms of timing, the ITTM is in the neutral zone, suggesting that there is no particularly compelling reason to buy or short USD/CHF at the current juncture (Chart 16). The SNB is unofficially targeting a floor under EUR/CHF around 1.06 to tame the deflationary impulse in Switzerland. While the Swiss economy is improving, it is not yet strong enough to handle a removal of this policy. In all likelihood, this means that for the rest of 2017, USD/CHF will remain a near-perfect mirror image of EUR/USD. The Australian Dollar Chart 17Iron Ore Prices: From Friend To Foe Chart 18No Valuation Cushion For AUD AUD/USD has not been able to break above 0.77, and the reason simply is that the forces embedded in the FITM have sharply rolled over (Chart 17). Not only have commodity prices stopped appreciating - with iron prices, the most crucial determinant of Australia's terms of trade down 21% - but U.S. short rates and long rates have been going up relative to Australia. Most disturbing for Australia, unlike the CAD it does not possess any cushion when analyzed through the prism of our ITTM (Chart 18). This suggests that the deteriorating Australian fundamentals are likely to be directly translated into a lower AUD/USD. Moreover, historically, previous undershoots in the AUD were followed by an overshoot. We do not think this time is any different; but the dovish slant of the RBA and the drubbing received by iron ore prices suggest that if the AUD overshoots, it will be because it may not fall as fast as its fundamentals at first. If that is the case, we do expect a catch-up later this year. As previously mentioned, the relative dynamics between the Canadian and Australian ITTM suggest that investors in commodity currencies should short AUD/CAD. Moreover, on a longer-term basis, we also favor oil producers over metal ones. The supply dynamics in the oil market are much more favorable than for metals. Not only have many global oil producers cut down their output, our sister publication Commodity And Energy strategy expects the OPEC + Russia agreement to be extended for the rest of 2017.8 Meanwhile, metal production cutbacks have been much more timid. The New Zealand Dollar Chart 19NZD Suffers From ##br##Similar Ills As AUD... Chart 20...However Inflationary Backdrop##br## Is More Favorable The fundamentals for the New Zealand dollar have also rolled over after having pointed to a strong Kiwi since February 2016 (Chart 19). Interestingly, the rollover in the NZD FITM has not been as sharp as the rollover in the Australian Dollar's FITM. The ITTM does argue that as with the CAD, the NZD does have a healthy margin of maneuver before the deteriorating fundamentals become a bidding constraint (Chart 20). In fact, the recent NZD weakness may have exaggerated the underlying deterioration in NZ data. The recent stronger-than-expected inflation data may prompt investors to reconsider their very dovish take on the RBNZ. Our preferred fashion to take advantage of the NZD's discount to its ITTM is also against the AUD. Both currencies are very exposed to EM and China shocks, and both currencies display a similar beta to the USD. As such, it is very rare for the NZD to trade at a discount to the ITTM while the AUD is at equilibrium. With the New Zealand domestic economy in better shape than that of Australia, our bet is that both currencies will have to converge, which should weigh on AUD/NZD. The Norwegian Krone Chart 21NOK Fundamentals Have Worsened ##br##Even With Firm Oil Prices Chart 22Not A Good Time To##br## Buy The Krone Yet Like other currencies, the fundamentals for the Norwegian krone have begun to roll over. The sharpness of that turnaround is particularly striking when one considers that oil prices have remained resilient, despite their recent weakness (Chart 21). NOK has taken the cue from the FITM and has weakened in line with fundamentals. Is it time to lean against this weakness and buy the NOK now? We doubt it. The NOK may benefit against the USD if the euro overshoots in the wake of the French election. However, the NOK has yet to correct previous overshoots, and the fact that it currently trades in line with the ITTM suggests that it provides very little insulation against any further deterioration in its own fundamentals (Chart 22). In the longer term, we are more positive on the NOK. It is cheap based on long-term models that take into account Norway's stunning net international position of 203% of GDP. Moreover, the high inflation registered between 2015 and 2016 is now over as the pass-through from the weak trade-weighted krone between 2014 and 2015 is gone. This means that the PPP fair value of the NOK has stopped deteriorating. The Swedish Krona Chart 23Dollar Strength Has Dislodged ##br##The SEK From Fundamentals Chart 24Taking Momentum Into Account##br## The SEK Is Not Cheap The SEK continues to display one of the highest beta to the USD of all the G10 currencies. As a result, when the USD is strong, even if fundamentals do not warrant it, the SEK is especially weak. The rally in the USD in the second half of 2016 took an especially brutal toll on the krona, which has dissociated itself from its pure fundamentals. If the dollar follows the recent improvement in its own FITM, then SEK too will weaken despite its apparent undershoot (Chart 23). Now, however, the SEK's weakness will follow the deterioration in directional fundamentals. The timing model corroborates this picture. The ITTM takes into account the trend of USD/SEK, and when this is done, the undervaluation of the SEK disappears (Chart 24). Over the next three to nine months, we expect U.S. rates to have more upside relative to European ones than is currently priced in by markets. Therefore, we anticipate the USD to strengthen further, and as a corollary, the SEK will suffer especially strongly under these circumstances. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy / Global Investment Strategy Special Report, "Assessing Fair Value In FX Markets," dated February 26, 206, available at fes.bcaresearch.com and gis.bcaresearch.com 2 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori, "U.S. Dollar Dynamics: How Important Are Policy Divergence And FX Risk Premiums?" IMF Working Paper No.16/125 (July 2016); and Michael T. Kiley, "Exchange Rates, Monetary Policy Statements, And Uncovered Interest Parity: Before And After The Zero Lower Bound," Finance and Economics Discussion Series 2013-17, Board of Governors of the Federal Reserve System (January 2013). 3 Michael T. Kiley (January 2013). 4 Please see Yin-Wong Cheung, and Menzie David Chinn, "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market," CESifo Working Paper Series No. 251 (February 2000); and David Hauner, Jaewoo Lee, and Hajime Takizawa, "In which exchange rate models do forecasters trust?" IMF Working Paper No.11/116 (May 2010) for revealed preference approach based on published forecasts from Consensus Economics. 5 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016). 6 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016). 7 Francisco Maeso-Fernandez, Chiara Osbat, and Bernd Schnatz, "Determinants Of The Euro Real Effective Exchange Rate: A BEER/PEER Approach," Working Paper No.85, European Central Bank (November 2001). 8 Please see Commodity And Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades