Developed Countries

Overweight (High Conviction) For most of the past five years, the narrative in S&P energy stocks has been a sad one; underlying energy prices have failed to sustain a rally and stock prices have been stuck in the doldrums. This time looks different; the resilience of the recovery in the global economy has kept a solid floor underneath oil prices, which are pushing up against 3-year highs. The surprising part of the rally in oil prices is the failure of energy stocks to catch up (top panel). Pricing power in energy is rising at its fastest pace this decade and (for now) the sector wage bill is continuing to contract (second panel). The upshot is that margins are rapidly expanding, albeit still from a very weak base (third panel). While the most positive side of the v-shaped recovery in earnings estimates is now behind the sector (bottom panel), profit forecasts are still moving higher at near-record pace; eventually stock prices have to catch up. Stay overweight.

Highlights The current U.S.-China trade skirmish is essentially the beginning of a new cold war. The U.S. and China are engaged in a struggle for supremacy, so trade conflicts will persist. The conflict could evolve into a "game of chicken" - the most dangerous type of game. The U.S. needs Europe's help against China - but an adventure in Iran could cost it that help. Geopolitical risks will cap the rise in bond yields over the next six months, push up oil, and give a tailwind to global defense stocks. Feature The opening salvo of the U.S.-China trade war has caught the investment community by surprise as the market is quickly repricing the odds of a global trade war.1 Nervousness over the breakdown of globalization comes at the same time as our key China view - that Beijing's structural reforms will constrain growth - are beginning to have an impact on global growth (Chart 1).2 Chart 1China Reforms Dragging On Global Growth Fortuitously, we found ourselves in Asia at the onset of "hostilities" and were thus able to see regional investors' reactions in real time. Our clients focused their questions on the economic impact of the announced tariffs (yet to be determined, in our view), constraints facing President Trump (minimal as well), and potential Chinese retaliation (understated). The focus, however, should be on the big picture. The March 23 U.S. announcement of tariffs on around $50 billion worth of Chinese imports is not just the opening salvo of a trade war. Rather the emerging trade war is the opening salvo of a new cold war, a global superpower competition between the U.S. and China that will define the twenty-first century. Put simply, the U.S. and China are now enemies. Not rivals, competitors, or sparing partners. Enemies. It will take the market some time for investors to internalize this idea and price it properly. Meanwhile, in the short term, fears of a full-born global trade war are overblown. The trade tensions are really only about two countries, with uncertain global implications. Investors are right to be cautious, but risks to global earnings are overstated at this time. How Did We Get Here? The ongoing trade tensions are not merely a product of a nationalist Trump administration that decided to call out China for decades of unfair trade practices. They are also the product of the geopolitical context, which we have defined through three "big picture" themes. These three themes allowed us to correctly forecast that the defining feature of the twenty-first century would be a Sino-American conflict. We would be thrilled to see this culminate merely in a trade war. The themes are: Multipolarity (Chart 2)3 Apex of globalization (Chart 3)4 The breakdown of laissez-faire economics (Chart 4)5 Chart 2Multipolarity Is Messy And Volatile Chart 3When Hegemony Declines, Globalization Declines Chart 2 elucidates a key lesson of history: the collapse of British hegemony at the end of the nineteenth century ushered in two world wars. Political science, game theory, and history teach us that periods of multipolarity are rarely peaceful.6 Today's world is not exactly multipolar, as the U.S. remains the preeminent global power. However, regional powers - such as China, the EU, Russia, India, Japan, Iran, and perhaps Turkey and Brazil - have a lot more room to maneuver within their spheres of influence. This means that global rules written by the U.S. at the conclusion of the Second World War are being rewritten for regional contexts. Normatively there is nothing wrong with this process. But practically, multipolarity means that "challenger powers" - such as China today or the German empire in the late nineteenth century - seek to undermine rules and norms of behavior that they had little or no say in setting up. And such rules are necessary to underpin geopolitical stability and grease the wheels of globalization. As Chart 3 shows, trade globalization peaked in the past when the hegemon could no longer enforce global rules. We have therefore emphasized to clients since 2014 that, if we are right that the world is multipolar, then we are essentially at the apex of globalization. A parallel process has seen the breakdown of the laissez-faire consensus, which underpinned the expansion of trade in goods, labor, and capital across sovereign borders. Economic globalization has lifted many boats around the world, but outsourcing - combined with technological innovation - has seen the lower middle class in developed nations face diminishing returns (Chart 4). Chart 4Globalization: No Friend To Developed-Market Middle Class That said, a revolt against globalization and "globalists" is thus far mainly an Anglo-Saxon phenomenon, and particularly an American one. Why? Because the particularities of the U.S. laissez-faire economic model, with its scant social protections, laid its middle class bare to the vagaries of globalization and technological change (Chart 5). However, there is no guarantee that other DM countries will not succumb to the same pressures down the line. Chart 5The 'Great Gatsby' Curve: Or, How Anglo-Saxons Turned Against Laissez Faire This background is important for investors because merely blaming a nationalist Trump administration or a mercantilist Beijing for today's tensions ignores the underlying context. President Trump can change his mind on a dime, but the geopolitical context can only evolve slowly.7 Mercantilism is here to stay; it is a feature, not a bug, of a multipolar world. Contrast today's tensions with those of the 1970s and 1980s between the U.S. and its major trade partners. The 1971 Smithsonian Agreement and the 1985 Plaza Accord ended overt trade protectionism by the U.S. (in 1971), and threats thereof (in 1985), by securing the compliance of these trade partners with Washington's currency and trade demands. Japan further conceded to U.S. demands in 1989 after a two-year trade war. Today, the U.S. and China are not geopolitical allies huddled under the same nuclear umbrella for protection against an ideologically fueled rival. They are ideological rivals. The reason it took a decade for the conflict to erupt is two-fold. First, the U.S. became entangled in the global war on terror after 9/11, which took its focus off of its emerging competitor in Asia. Second, the consensus view - that China would asymptotically approach a Western democracy as it embraced capitalism - has proven to be folly.8 Bottom Line: The China-U.S. trade conflict is a product of today's particular geopolitical context. At heart, it is a conflict for geopolitical primacy in the twenty-first century and thus unlikely to end quickly. Sino-American Conflict Is Intractable The current U.S.-China trade tensions are more of a skirmish than a war. We think that there is considerable room for a step-down in tensions over the next 12 months. First, the Trump administration has not launched an economic war against China. Not only has the U.S. restricted its list of Chinese goods under tariff consideration to just $50 billion of imports - roughly 12% of total Chinese exports to the U.S. - but it has decided to bring a case against China to the World Trade Organization (WTO). The latter is hardly a move by a mercantilist administration dead-set on across-the-board economic nationalism. Second, China has responded almost immediately by offering several concessions, including renewing pledges to open its economy to inward investment and to protect intellectual property (IP) rights. While these may seem like boilerplate concessions that Beijing has floated before, the current context of trade tensions and domestic structural reforms makes it more likely that Chinese policymakers will follow through on their promises. As such, we can see the current round of tensions tapering off, especially after the U.S. midterm elections. However, we doubt that the structural trajectory of Sino-American relations will be significantly altered even if current tensions subside. First, from China's perspective, its extraordinary economic ascent (Chart 6) is merely the return of the millennium's status quo (Chart 7). The last 180 years - roughly from the beginning of the First Opium War in 1839 to today - were the aberration. During this short period of Chinese weakness, the West - with Britain and then the U.S. at the helm - conspired to restructure global rules and norms of geopolitical and economic behavior without input from the Middle Kingdom. Chart 6China's Economic Rise Has Been Extraordinarily Fast... Chart 7China Sees Its Success As A Return To The Status Quo As such, China's influence in key post-WWII economic institutions like the WTO and the IMF is limited while its military has second-class status even in its own "Caribbean Sea," the South China and East China Seas. From the U.S. perspective, China's growth over the past two decades was made possible by U.S. hegemony. The U.S. secured the global rules and norms that enabled China to integrate seamlessly into the global marketplace and then compete its way to the top. Not only did the U.S. allow China to access its credit-fueled markets, but the U.S. Navy protected China's maritime trade, including vital energy supplies transiting from the Middle East. As a thank you for these efforts, China reneged on its WTO commitments, periodically suppressed its currency, stole American intellectual property, and withheld market access from U.S. corporations via tariff and non-tariff barriers to trade. Washington policymakers, and not only Trump's hawkish advisors, are turning against China. There is an emerging consensus among the U.S. foreign policy, defense, intelligence, and economic policy elites that: Sino-American economic symbiosis is over (Chart 8); Chart 8U.S.-China ##br##Symbiosis Is Dead Chart 9The U.S. Is Least##br## Exposed To Trade Chart 10China's Share Of Global##br## Exports Has Skyrocketed The U.S. can afford to confront China over trade because it is the least exposed major economy to global trade (Chart 9); The Chinese have acquired a massive share of global exports without a commensurate opening of their domestic market (Chart 10); Arresting Chinese technology transfer and intellectual property theft is a national security issue (Chart 11); The U.S. can confront China because it has emerged victorious from every global conflagration in the past (Chart 12). Chart 11China Imports Conspicuously Little U.S. IP Chart 12America Is Chaos-Proof Fundamentally, American policymakers want to see China's rapid economic growth slow, they want to see China's capital markets and companies constrained by openness to global competition, and they want to put a leash on China's catch-up in the technological and manufacturing value chain (Chart 13). This is not their stated objective as it would imply that the U.S. wants to see China weakened, and the Chinese leadership miss its decade and century economic development goals. But this is precisely what the U.S. establishment wants. As such, the political and economic visions of American and Chinese policymakers are directly at odds with one another. What does this mean for investors? Over the past several years we have developed a reputation of being sanguine about geopolitics. While many of our peers in the political analysis industry overstate the probability of geopolitical risk, we have (successfully) bet against the worst-case scenario in several prominent crises.9 We like to think that this is because we combine game theory with an understanding of the underlying power dynamics. By emphasizing constraints, we have successfully identified how power dynamics constrain the worst-case outcome.10 When it comes to Sino-American tensions, however, we have always been alarmists. This is because we believe the constraints to conflict are overstated, not understated. Furthermore, the potential market impact of a new cold war is unclear and potentially very large. Both the U.S. and China fundamentally think they can win a trade war. This means that they are engaged in a "regular game of chicken," named after the 1950s practice of racing hot rods head-on in order to prove one's manhood.11 Game theory teaches us that a game of chicken is the most unpredictable game because it can create an equilibrium in which all rational actors have an incentive to keep driving head on - to stick to their guns - despite the risks. In Diagram 1, we can see that continuing to drive carries the greatest risk, but also the greatest reward, provided that your opponent swerves. Chart 13China's Steady Climb Up##br## The Value Ladder Continues Diagram 1A Regular ##br##Game Of Chicken Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. In the current context, this means that the U.S. assumes that China is driven by economic rationality and will not dare face off against the U.S., which has far less to lose given its modest exposure to global trade. Chinese policymakers, however, also think they can win. They look over the Pacific and see a country riven by political polarization (Chart 14) where half of the country thinks the other is "a threat to the nation's well-being" (Chart 15).12 China, meanwhile, has just consolidated its political leadership and feels confident enough in its domestic stability to dabble with growth-constraining economic reforms. Beijing can use any trade tensions with the U.S. to further justify painful reforms. Chart 14Inequality Fuels Political Polarization Chart 15Live And Let Die Who is right? We do not know. And that scares us as it means that the most sub-optimal equilibrium - the bottom-right quadrant of Diagram 1 - is more probable than people think. An important difference maker, one that would alter Beijing's risk calculus considerably, is Europe. Despite being highly leveraged to China's growth, the EU still exports nearly double the value of goods to the U.S. than China (Chart 16). In addition, Europe's trade surplus with the U.S. mostly pays for its deficit with China (Chart 17). Chart 16The EU Exports More To U.S. Than China Chart 17EU Surplus With U.S. Pays For Deficit With China Over the next several months, investors will be able to gauge whether the Trump administration is filled with ideological nationalists who believe in Fortress America or wily realists who know how to get things done. The key question is whether Trump will embrace America's traditional transatlantic alliance with Europe and harness it for the trade war with China. If he embraces it, we will predict that the combined forces of U.S. and Europe will successfully force China to concede to the pressure. If Trump fails, however, we could have a prolonged U.S.-China trade war. Early indications are optimistic. The U.S. gave the EU an exemption from tariffs on steel and aluminum imports on March 22, a delay that will end on May 1. This followed a March 21 meeting between EU Commissioner for Trade Cecilia Malmström and U.S. Secretary of Commerce Wilbur Ross. We suspect, but have no evidence, that the U.S. asked the EU to join in its effort to force China to change its trade practices at the WTO. As an exporting bloc, the EU has a lot more to lose from attacking China than the U.S. But it also has much to lose from unabated Chinese mercantilism and technological theft, and much to gain if China opens its doors wider. As such, we posit that Europe will, in the end, join the U.S. and Japan in a concerted effort to pressure China. This will increase the probability that Beijing ultimately gives in to trade pressure. In the long term, it will also ensure that President Trump does not break the critical transatlantic alliance with Europe, which would be paradigm shifting. But, on the other hand, it will set China and the West on a collision course. China's and the West's suspicions of each other will ossify. Bottom Line: In the short term, trade tensions are likely overstated as U.S. actions against China are largely muted and restrained. In the long term, the U.S.-China trade war could potentially devolve into a "game of chicken," the most dangerous type of conflict. The key variable will be whether the U.S. administration is savvy enough to arrange European collaboration against China. If the U.S. treats the EU harshly and ignores its transatlantic ally on other issues - such as conflict with Iran, discussed below - we could be in for a wild ride in the coming months and years. Either way, Europe stands to gain from a conflict between China and the U.S. Both sides are likely going to try to enlist the EU on their side. As such, we are opening a long Europe industrials / short U.S. industrials trade. Meanwhile, growing trade tensions, policy-induced slowdown in China, and repricing of geopolitical risks in East Asia and the Middle East should cap global bond yields over the next six months. We take 50.4bps and 54.4bps profits on our short U.S. 10-year government bond vs. German bund and short Fed Funds December 2018 futures trades. Iran: The Next Target Of Trump's "Maximum Pressure" Policy President Trump's North Korea policy worked brilliantly in 2017. The policy of "maximum pressure" combined military maneuvers, economic sanctions, and extremely bellicose rhetoric to convince Pyongyang and regional powers that the U.S. has lowered its threshold for full-scale war on the Korean peninsula. China reacted swiftly, starving North Korea of hard currency through economic sanctions (Chart 18). The result was a declaration by Pyongyang in late November that it had finally completed its quest to obtain a nuclear deterrent (an exaggeration at best), an olive branch for the Olympics, and an offer by Supreme Leader Kim Jong Un to meet with President Trump. Chart 18China Gives Kim To Trump The policy of "maximum pressure" yielded such extraordinary results with North Korea that President Trump is now eager to trademark the process and apply it to Iran and potentially other global issues. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has replaced two establishment advisors with hawks. Secretary of State Rex Tillerson has been replaced with CIA Director and noted Iran-hawk Mike Pompeo. Meanwhile, National Security Advisor H.R. McMaster has been replaced by conservative pundit (and former U.S. Ambassador to the UN) John Bolton. Bolton is on record arguing that the U.S. should bomb Iran. The role of the national security advisor varies with the president. Some presidents rely on the position more than others. However, given this administration's inexperience with foreign policy, the role is critical in shaping the White House worldview. The national security advisor manages the staff of the National Security Council (NSC), whose role is to coordinate with the vast network of U.S. intelligence agencies and filter information to the president. Given how large America's foreign, defense, and intelligence establishment is, and given the nature of human and signals intelligence, U.S. presidents often have to act upon diametrically opposing pieces of intelligence. As such, the national security advisor and the NSC can play a critical role in deciding what intelligence makes it to the president's desk and in what context. Staffers in the National Security Council (NSC) are often apolitical. We have been told that several current experts are leftovers from the Obama administration. It is likely that an ideological pundit like John Bolton, who served briefly in the George W. Bush administration, will set out to quickly eliminate non-partisan staffers on the NSC and tilt the information flow away from the empirical to the conspiratorial. With Bolton and Pompeo effectively in charge of U.S. foreign policy it is possible that the U.S. will misapply "maximum pressure" policy to Iran and bungle the complicated coordination with geopolitical allies on China. In particular, the U.S. has to endear itself to the EU if it wants a global economic alliance against China. But the EU also does not want to renegotiate Iran sanctions. Abrogating the 2015 nuclear deal - the Joint Comprehensive Plan of Action (JCPA) - would throw the tentative Middle East equilibrium into chaos. While Iran has played a role in preserving the regime of Bashar al-Assad in Syria, it has largely kept its vast network of Shia militias and allies in check, particularly in Lebanon and Iraq. Ironically, it was the Obama administration's "flawed" JCPA that has allowed Trump to focus on China in the first place. As we argued when the deal was signed, the conservative critics of the deal itself were correct. The JCPA did not degrade Iran's nuclear capability but merely arrested it.13 The point of the deal was implicitly to give Iran a sphere of influence in the Middle East so that the U.S. could extricate itself and focus on China. The Obama administration assessed, in our view non-ideologically, that the U.S. cannot fight two wars at the same time. If the Trump administration decides not to waive sanctions on May 12, it will be in abrogation of the deal. Unlike North Korea, however, Iran has multiple levers it can deploy against the U.S. and its allies' interests in the region. As such, the policy of "maximum pressure" will create much greater risks when applied to Iran. At the very end, it could be as successful as when applied to North Korea, but our conviction view is much lower (and to remind clients, we were optimists about the strategy when applied to North Korea!).14 Furthermore, and again unlike North Korea, Iran is beset with domestic risks. This actually makes it less likely that Tehran will cooperate with the U.S. North Korea is a simple domestic political system where Kim Jong Un can alter policy on a whim without much domestic pushback. In Iran, the dovish and moderate President Hassan Rouhani has to contend for power with hawks who have been critical of the JCPA. Meanwhile, the restive youth population could rise up at the first sign of elite division or weakness. This complicated domestic dynamic is why we cautioned clients back in January that Iran would likely add geopolitical risk premium to the oil markets.15 Bottom Line: It appears that President Trump, motivated by the success of his "maximum pressure" strategy against North Korea, now thinks he can apply it as successfully to Iran. This raises the prospect that Trump will discontinue the waiver of economic sanctions on May 12, effectively re-imposing a slew of economic sanctions against Iran and foreign companies looking to conduct business with it. Geopolitical risks are likely to rise in the Middle East as a result of U.S.-Iran tensions. As we go to publication, Saudi authorities have intercepted another Houthi missile heading towards Riyadh just days after Saudi Crown Prince Mohammad Bin Salman visited Washington, D.C. The White House appears to relish the opportunity to fight a war on two fronts, a trade war with China and a geopolitical war with Iran. Expect volatility and an elevated geopolitical risk premium in oil markets. Stay overweight global defense companies across markets. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 6 Please see John Mearsheimer, The Tragedy Of Great Power Politics (New York: Norton, 2001). 7 Would President Hillary Clinton have avoided a trade war with China? We do not think so. Secretary Clinton was considered a "China Hawk" while at the State Department and pushed for the "Pivot to Asia." Jennifer Harris, the lead architect of Clinton's economic statecraft agenda in the U.S. State Department, recently penned a book that called for greater use of economic tools for geopolitical ends. The book, War By Other Means, introduces the term geoeconomics and calls for the U.S. to use economic instruments to promote and defend national interests. Please see BCA Geopolitical Strategy Blog, "We Read (And Liked)... War By Other Means," dated July 13, 2016, available at gps.bcaresearch.com. 8 In 2000, while campaigning on behalf of China's WTO entry, President Bill Clinton remarked, "economically, this agreement (China's WTO entry) is the equivalent of a one-way street. It requires China to open its markets ... to both our products and services in unprecedented new ways. All we do is to agree to maintain the present access which China enjoys ..." Please see "Full Text of Clinton's Speech On China Trade Bill," dated March 9, 2009, available at nytimes.com. 9 To name just a few: the risk of an Israeli attack against Iran, the risk of a full-scale Russian invasion of Ukraine, the risk of Euro Area collapse, the risk of Saudi-Iranian war, the risk of Russian-Turkish war, etc. 10 For the best example of how game theory is combined with our constraint-based paradigm, please see BCA Geopolitical Strategy Special Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 11 See James Dean in Rebel Without A Cause. 12 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, "North Korea: Beyond Satire," dated April 19, 2017, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, and "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com.

Overweight (High Conviction) U.S. manufacturers are rarely so excited about exports; the latest ISM manufacturing export subcomponent recently hit a three decade high. While the specter of a global trade spat is disconcerting, our sense is that a generalized trade war will most likely be averted or, if the current executive Administration is to be believed, short-lived. The upshot is that air freight & logistics sales momentum will gain steam in the coming months (second panel). Beyond euphoric survey data readings, hard economic data also corroborate the soft data message. G3 (U.S., the Eurozone and Japan) capital goods orders are firing on all cylinders and probing multi-year highs, underscoring that rising animal spirits are translating into real economic activity (third panel). Importantly, relative valuations are discounting a significantly negative profit backdrop, with the relative price/sales ratio at its lowest level since 2002 (bottom panel). The implication is that the group is well positioned to positively surprise. Bottom Line: The S&P air freight & logistics index has a very attractive reward/risk profile and if we were not already overweight, we would take advantage of recent underperformance to go overweight now. Therefore, we are adding it to our high-conviction overweight list; please see this week's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD.

Highlights Fixed Income Asset Allocation: Global growth indicators remain solid, while inflation pressures continue to build. Central banks will remain focused on those factors, and not news-driven market volatility spikes, until the trends change. The cyclical environment still favors a below-benchmark duration stance for bond investors, favoring credit over government debt, but with lower risk-adjusted return expectations. U.K. Gilts: Bank of England hawkishness is increasing, but policymakers will be hard pressed to tighten more than is currently priced. Stay overweight Gilts in hedged global government bond portfolios. Position for a steeper Gilt curve by going long the 5yr in a 2yr/5yr/10yr butterfly trade. Feature Chart of the WeekStill A Bond-Bearish Backdrop Higher financial market volatility remains the most important investment theme for 2018, as investors continue to be fed a steady diet of worrisome headlines. Threats of a U.S. - China trade war, widening LIBOR-OIS spreads in the U.S., the ascent of trade and foreign policy hawks in the White House, troubles at Facebook hitting the market-leading technology stocks - all are just the latest reasons for investors to become more cautious on taking risk. Yet the ability of markets to shrug off, or succumb to, growing uncertainty will be related to two things - the momentum of global economic growth and the future direction of global monetary policy. On the former, the latest data releases have shown some moderation in the strong coordinated global growth upturn witnessed over the past year. Our aggregate measures such as the global PMI and global ZEW indices have dipped lower in the first few months of 2018. These indicators remain at levels suggesting growth is still in decent shape, even with some worsening in expectations (Chart of the Week). On the latter, the BCA Central Bank Monitors are still showing a growing need to tighten monetary policy further in the major developed economies. This continues to put upward pressure on government bond yields through rising inflation expectations and a higher expected path of short-term interest rates. Until there is evidence of a more meaningful downturn in global growth, bond yields will keep on drifting higher. We continue to recommend a below-benchmark overall portfolio duration stance for fixed income investors, favoring spread product over government bonds, while running below-average portfolio risk (i.e. tracking error) given more elevated levels of market volatility. The "TINA Trade" Is Now The "TISNA Trade" - There Is STILL No Alternative Central bankers remain on a path to normalize the extraordinary monetary accommodation of the past several years, led by their steadfast belief in the Phillips Curve at a time of low unemployment in most countries. Against this backdrop, government bond yields cannot fall enough to limit the damage from rapid equity market selloffs without much softer growth or inflation data that would alter the expected trajectory of policy rates. This implies a higher structural level of market volatility now relative to previous years, as we discussed in a recent Global Fixed Income Strategy Weekly Report.1 Yet despite the signs of greater nervousness among investors, there is still a strong level of positive sentiment towards equities and bearish sentiment towards bonds according to the Market Vane indices (Chart 2). The latest edition of the widely-followed Bank of America Merrill Lynch Investor Survey also revealed a disconnect between the opinions of investors (worries over protectionism, trade wars, higher inflation and softer global growth) and actual positions (large equity overweight's favoring cyclical growth stocks).2 Investors seem to be "nervously complacent", staying long risk assets (equities, credit) and underweight safe havens (government bonds) but with a growing list of concerns. For now, this appears to be the most appropriate allocation, for the following reasons: Global growth is still generally strong. Our global manufacturing PMI remains close to the cyclical highs, although there was some pullback seen in the "flash estimates" for March in the euro area, Japan and the U.K. (Chart 3). The breadth of the current cyclical global upturn remains strong, with all eighteen countries in the composite index having a PMI in the "growth zone" above 50 (top panel). Chart 2Pro-Risk Sentiment,##BR##Despite More Volatile Markets Chart 3Global Growth##BR##Still Looks Good The OECD global leading economic indicator continues to accelerate, while the Citigroup global inflation surprise index is also picking up (Chart 4). These are pointing to continued upward pressure on global bond yields through higher real yields and faster inflation expectations, respectively. The global cyclical backdrop is boosting inflation. 75% of OECD countries are operating beyond full employment while capacity utilization rates in the developed economies are approaching 80% - the highest level since mid-2008 (Chart 5, top panel). Global oil prices should continue to grind higher, with BCA's commodity strategists now expecting the benchmark Brent oil price hitting $80/bbl in one year's time (middle panel). Also, global export price inflation is showing no signs of slowing, suggesting that global headline inflation should continue moving higher (bottom panel). Chart 4Upward Pressure On##BR##Real Yields AND Inflation Chart 5A More Inflationary##BR##Global Backdrop Central bankers are still biased towards becoming less accommodative. This was seen last week with the U.S. Federal Reserve hiking the fed funds rate and raising its growth and interest rate projections (Chart 6), while the Bank of England (BoE) gave a strong indication that an interest rate increase was coming in May. This comes as the European Central Bank continues to signal a tapering of its asset purchase program later this year. The latter point is critical for markets, as tighter global monetary policy has diminished the ability for investors to ignore sources of potential uncertainty. Take the current concern over trade tensions between the U.S. and China, for example. A Google Trends search of the phrase "China Trade War" shows, unsurprisingly, a huge recent spike in interest in that topic (Chart 7, top panel). There was also a big increase in such online searches around the time of Donald Trump's election victory in November 2016 and his inauguration in January 2017. At that time, however, global monetary policy was still accommodative, with the real fed funds rate well below the neutral "r-star" estimate (middle panel) and central bank balance sheets in the major developed economies expanding at a 20% annual rate (bottom panel). Chart 6The Fed Will Keep On Hiking Chart 7Expect More Vol Spikes While CBs Tighten The easy monetary settings helped keep market volatility low despite the shock of Trump's election win and what it meant for the implementation of his more aggressive campaign promises, like raising tariffs on U.S. imports from China. Fast forward to today and the real fed funds rate is now at neutral and central banks are buying bonds at a much slower pace. This means that markets will have a tougher time ignoring greater uncertainty, as was witnessed in last week's equity market selloff following President Trump's announcement of $60 billion in Chinese import tariffs. Going forward, without the soothing balm of very low interest rates and plentiful central bank liquidity expansion, volatility spikes like the ones seen in early February and last week will become more frequent. The implication is that volatility-adjusted returns on risk assets will be lower, even if the global growth backdrop remains reasonably supportive. A pro-risk investment bias, but playing with fewer chips on the table, is still appropriate over at least the next six months. Bottom Line: Global growth indicators remain at elevated levels, while inflation pressures continue to build. Central banks will remain focused on those factors, and not news-driven market volatility spikes, until the trends change. The cyclical environment still favors a below-benchmark duration stance for bond investors, favoring credit over government debt, but with lower risk-adjusted return expectations. U.K. Update: Sticking With Our Overweight Call On Gilts Chart 8Mixed Messages On U.K. Growth The BoE kept interest rates unchanged at last week's policy meeting, but sent clear signals that a rate hike would be very likely in May. Two members of the Monetary Policy Committee (MPC), Michael Saunders and Ian McCafferty, actually voted a rate hike last week, which was a surprise. The BoE's increasing hawkishness continues a process that began in autumn of 2017, when policymakers began shifting their language in advance of a November rate hike - the first BoE rate increase since May 2007. The central bank had been worried more about the risks to the U.K. growth outlook since the July 2016 Brexit vote, while ignoring the currency-driven overshoot of its inflation target. Now, the BoE seems a bit more comfortable with the U.K. growth outlook, even amid the ongoing Brexit uncertainty, as was noted in the official policy statement from last week's MPC meeting: Developments regarding the United Kingdom's withdrawal from the European Union - and in particular the reaction of households, businesses and asset prices to them - remain the most significant influence on, and source of uncertainty about, the economic outlook. In such exceptional circumstances, the MPC's remit specifies that the Committee must balance any significant trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity. The steady absorption of slack has reduced the degree to which it is appropriate for the MPC to accommodate an extended period of inflation above the target. We find it a bit of a surprise that the BoE would seek to switch to inflation-fighting mode now, for two reasons: U.K. growth momentum may be slowing. The flash estimate for the March manufacturing PMI fell to an 8-month low, while the leading economic indicators (LEIs) from both the OECD and Conference Board have clearly rolled over (Chart 8). The BoE did highlight the recent pickup in wage inflation, with year-over-year growth in average weekly earnings now up to 2.8% in nominal terms. This has pushed real wage growth back into positive territory (3rd panel), which appears to be feeding through into a slight pickup in consumer confidence (bottom panel). Although the modest increase in February retail sales suggests that a consumer spending revival may be slower to arrive than the BoE is hoping for. U.K. inflation momentum is slowing. The surge in U.K. inflation following the decline in the British Pound after the 2016 Brexit vote is in the process of unwinding. The trade-weighted currency is up 9% from the 2016 low, which has sliced imported goods price inflation from 10% to 2% over the same period (Chart 9). Headline CPI inflation, which rose from near 0% to 3.1% in November 2017, now sits at 2.7%. The upturn in core CPI inflation has also stabilized. While both CPI inflation measures remain above the 2% BoE target, the momentum has clearly peaked and pipeline price pressures continue to decelerate. Investors have listened to the signals sent by the BoE, pricing in 45bps of hikes over the next year and pushing the 2-year Gilt yield to 0.9% - the highest level since May 2011 (Chart 10). At the same time, market-based inflation expectations have dipped a bit and the U.K. data surprise index has fallen back to the zero line (bottom panel). Chart 9U.K. Inflation Has Peaked Chart 10A Rapid BoE Repricing At The Wrong Time? Conflicting signals can also be seen in the slope of the Gilt curve. The nominal 2-year/10-year Gilt curve now sits at 55bps, just above the 2016 post-Brexit lows. The real Gilt curve (the nominal curve minus the 2-year/10-year U.K. CPI swap curve) is sitting at the flattest levels last seen since 2015/16 (Chart 11, top panel) when the BoE base rate was above zero in real terms (2nd and 3rd panels). Now, the real base is deeply negative around -2%, suggesting that the Gilt curve may already be discounting higher real BoE policy rates. At the same time, the U.K. inflation expectations curve is steepening, with 2-year CPI swaps falling faster than 10-year CPI swaps, as was the case during that 2015/16 episode (bottom panel). U.K. money markets are now pricing in an increase in the base rate to 1% over the next year. Given the slowing trends in the U.K. LEIs, the manufacturing PMI and realized inflation rates, we remain doubtful that the BoE will be able to deliver more hikes than are currently discounted. We continue to view U.K. Gilts as a "defensive" overweight within dedicated global government bond portfolios, especially given our recommendation to also stay defensive on overall duration exposure. The primary trend in the performance of U.K. Gilts relative to the Barclays Global Treasury Index, on a currency-hedged basis, is broadly correlated (inversely) to the ratio of the U.K. OECD LEI to the overall OECD LEI (Chart 12, top panel). Thus, we feel comfortable sticking with our call to expect U.K. Gilt outperformance in the next 6-12 months as long as the U.K. LEI continues to underperform - especially with the yield betas of Gilts to U.S. Treasuries and euro area government bonds now well below 1 (middle panel). Chart 11The Gilt Curve##BR##Looks Too Flat Chart 12Stay O/W Gilts & Add Go Long##BR##The Belly On A 2/5/10 Butterfly Given the recent flattening of the Gilt curve, which appears a bit extreme, we are adding a new trade to our Tactical Overlay this week: going long the belly (5-year) of a 2-year/5-year/10-year (2/5/10) Gilt butterfly. The current level of that 2/5/10 butterfly is 9bps, and we are targeting a move down to the -10bp to -15bp range. This trade is mildly negative carry, with -0.75bps of flattening per month already discounted in the forwards over the next year (bottom panel), but we anticipate the 2/5/10 butterfly to compress at a faster rate than the forwards in the coming months. Bottom Line: BoE hawkishness is increasing, but policymakers will be hard pressed to tighten more than is currently priced. Stay overweight Gilts in hedged global government bond portfolios. Position for a steeper Gilt curve by going long the 5yr point in a 2yr/5yr/10yr butterfly trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices", dated March 6th 2018, available at gfis.bcaresearch.com. 2 https://www.bloomberg.com/news/articles/2018-03-20/cracks-in-bull-case-emerge-yet-stubborn-investors-not-moving Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Economy: There is no imminent danger of a significant deterioration in global growth, but the rate of improvement is peaking. The result of the more moderate pace of economic growth and the mounting threat of protectionism is that there is more two way risk in both bond yields and spreads than there has been for some time. Fed: The message from last week's Fed meeting is that the committee recognizes that the outlook for U.S. growth and inflation has improved. Going forward, we anticipate a more hawkish Fed that is somewhat less responsive to tightening financial conditions. This will keep a floor under Treasury yields and impart volatility to credit spreads. Leveraged Loans: Leveraged loans have not yet started to outperform fixed rate junk bonds, but this will change as we approach the end of the credit cycle and loan coupons follow interest rates higher. Feature Yet another down week for risk assets, and all of a sudden 2018 is shaping up to be a pretty miserable year for spread product (Chart 1). High-Yield corporate bonds have underperformed duration-equivalent Treasuries by 29 basis points year-to-date, and investment grade corporates have underperformed by 90 bps. Meanwhile, the sell-off in Treasuries has also paused and the 10-year yield is now 12 bps below its 2018 peak. Chart 1Annual Excess Returns To Credit What exactly is going on? We identify two catalysts for the recent market moves and consider each in turn. Questioning The Synchronized Global Recovery Market moves during the past few weeks have, to some extent, been driven by investors starting to question the sustainability of the so-called "synchronized global recovery". The strong pace of global growth has been a key driver of higher bond yields and risk asset outperformance, and most indicators suggest this trend remains intact. The Global Manufacturing PMI is high compared to recent years, and our PMI diffusion index shows that only 1 out of 36 countries has a PMI below the 50 boom/bust line (Chart 2). Our Global Leading Economic Indicator is similarly elevated, and has a diffusion index that has mostly been in positive territory since mid-2016 (Chart 2, panel 2). But last week we received some evidence that this rapid pace of growth may not persist. Flash PMIs predict that the Eurozone Manufacturing PMI will fall to 56.6 in March, down from a recent peak of 60.6 (Chart 2, panel 3). Similarly, the Japanese PMI is predicted to fall to 53.2 in March, down from a recent peak of 54.8 (Chart 2, bottom panel). There is no Flash PMI data for China, the country with the largest weighting in the Global PMI index, but leading indicators suggest that Chinese PMI will also moderate in the months ahead. This is a risk we have flagged in several recent reports.1 Granted, these are all strong PMI readings that are still well above the 50 boom/bust line, but the pace of improvement has clearly moderated and this sort of marginal change often causes investors to extrapolate weaker growth into the future. This appears to be exactly what is happening. The Global ZEW index, a survey of investors' economic sentiment, fell in March (Chart 3). The BCA Carry Canary Indicator, a composite measure of emerging market currency trades geared to global growth, has also weakened (Chart 3, panel 2). Meanwhile, cyclical equity sectors (excluding technology) have not managed to outperform defensives even as Treasury yields have risen, a break from the prior correlation (Chart 3, panel 3). Of the four market-based indicators that most closely track the 10-year Treasury yield, only our Boom/Bust Indicator is not currently pointing to lower yields in the near-term (Chart 3, bottom panel). As usual, we turn to our 2-Factor Treasury Model to assess the impact of moderating global growth on the 10-year Treasury yield. At present, the model - which is based on the Global Manufacturing PMI and bullish sentiment toward the U.S. dollar - pegs fair value for the 10-year Treasury yield at 2.96% (Chart 4). However, if we assume that Flash PMI readings for the U.S., Eurozone and Japan are accurate, and also that PMIs in the rest of the world and dollar sentiment stay flat at current levels, then the fair value reading from our model will drop to 2.85% when the final March PMI data are released next week. This is not far from the current yield level, and could even be an optimistic forecast if the Chinese PMI starts to roll over, as we expect. Chart 2Global Recovery Still Intact Chart 3Global Growth Warning Signs Chart 42-Factor Treasury Model Of course the global economy also has to contend with the possibility of an escalating trade war between the U.S. and China. Markets reacted last week as the U.S. government ramped up the pressure by announcing a 25% tariff on $50-$60 billion worth of trade with China. While the immediate economic impact of these measures is highly uncertain, our Geopolitical strategists view an escalating trade war as a real possibility during the next 1-2 years.2 Bottom Line: There is no imminent danger of a significant deterioration in global growth, but the rate of improvement is peaking. The result of the more moderate pace of economic growth and the mounting threat of protectionism is that there is more two way risk in both bond yields and spreads than there has been for some time. Stay tuned. A Less Supportive Fed Chart 5Fed Versus Market The second catalyst driving bond markets at the current juncture is that the Fed is providing markets with a less accommodative monetary back-drop. Faced with a firmer outlook for U.S. growth and inflation, the Fed is now somewhat less responsive to tighter financial conditions than it has been during the past few years. This hawkishness will put a floor under Treasury yields going forward, and is also the most immediate risk to credit spreads, as we have explained in several recent reports.3 Chart 6The Fed's Phillips Curve Model Case in point, the Fed went ahead with a rate hike at last week's FOMC meeting despite the recent turbulence in financial markets. Not only that, but FOMC participants generally revised up their projections for both economic growth and the fed funds rate. The same number of participants (6) now expect four rate hikes this year as expect three. Last December only four participants expected four or more rate hikes in 2018. Further, the committee's median projection for the fed funds rate at the end of 2019 rose from 2.7% to 2.9%, the median for the end of 2020 rose from 3.1% to 3.4%, and even the median federal funds rate expected to prevail in the longer run rose from 2.8% to 2.9%. The market has moved a long way towards the Fed's dots in recent months, but is still somewhat more pessimistic. The overnight index swap curve is priced for slightly more than three rate hikes in 2018 (including last week's), but is below the Fed's median projection for 2019, 2020 and the longer run (Chart 5). As mentioned above, the Fed also revised up its projections for economic growth and the pace of labor market tightening. The Fed is now looking for an unemployment rate of 3.6% by the end of next year, well below its estimated 4.5% natural rate. At the same time, however, the Fed left its projections for core inflation largely unchanged leaving some to question whether the Fed is re-assessing its commitment to the Phillips curve. In fact, the following question was asked to Chairman Powell at last week's post-meeting press conference:4 Question: Interesting changes in the forecast. A higher growth forecast [...]. Lower unemployment, [...]. And yet, very little change in inflation. What does that say about what you and the Committee believe about the inflation dynamic? Answer: [...] that suggests that the relationship between changes in slack and inflation is not so tight. [...] It has diminished, but it's still there. In other words, the Chairman refused to dismiss the Phillips curve framework altogether but acknowledged that the slope is very flat. The implication is that the labor market will have to run hot for the next couple of years for the Fed to achieve its inflation target. By our assessment, the Fed's projections for the unemployment rate and inflation seem fairly reasonable. Chart 6 shows an expectations-augmented Phillips curve model of core inflation that we re-created from a 2015 Janet Yellen speech.5 Using the Fed's median projections for the unemployment rate, and also holding relative import prices and inflation expectations flat, the model projects that core inflation will rise during the next two years, but will remain slightly below the Fed's target. In other words, the Fed's inflation forecasts seem to agree with the empirical data. In Search Of A More Robust Phillips Curve One of the reasons that the Phillips curve is so flat is that while core PCE inflation includes some prices that respond briskly to labor market slack, it also includes many prices that are less driven by labor slack and more by idiosyncratic factors. The price of imported goods being a prime example. Recent research from the San Francisco Fed splits out those prices that are more sensitive to labor slack - procyclical inflation - from those that are less sensitive to labor slack - acyclical inflation.6 Interestingly, it is the acyclical components that have caused core inflation to run below the Fed's target in recent years, while procyclical inflation has been well above 2% (Chart 7). This framework is helpful because it allows us to estimate a more robust Phillips curve on just the components of inflation that are most sensitive to tightness in the labor market. For example, when we estimate a Phillips curve relationship on just procyclical inflation (excluding housing), the model shows that this component of inflation will rise by 0.18% for every percentage point decline in the unemployment rate. When we estimate the Phillips curve model on overall core PCE we find that a 1 percentage point decline in the unemployment rate only raises core PCE inflation by 0.09%. The top panel of Chart 8 shows that if the unemployment rate follows the path predicted by the Fed, then procyclical inflation (ex. housing) will rise during the next two years, and should stay above the Fed's 2% target. Our own model of housing inflation also shows that its deceleration should reverse in the coming months (Chart 8, panel 2). Chart 7Acyclical Components A Drag On Inflation Chart 8TCore Inflation Will Move Higher As for the acyclical components of inflation, in a prior report we discussed why health care inflation should rise during the next two years, and this has so far been confirmed by strong producer price data (Chart 8, panel 3).7 For the remaining acyclical components, of which 41% are goods and 59% are services, we would expect that at least the goods component will rise in response to the recent acceleration in non-oil import prices (Chart 8, bottom panel). In conclusion, there is reason to expect some upside in each component of core inflation. We anticipate that core inflation will move higher in the coming months and that the Fed will respond with continued gradual rate hikes. Bottom Line: The message from last week's Fed meeting is that the committee recognizes that the outlook for U.S. growth and inflation has improved. Going forward, we anticipate a more hawkish Fed that is somewhat less responsive to tightening financial conditions. This will keep a floor under Treasury yields and impart volatility to credit spreads. Leveraged Loan Update Chart 9Loan Coupons Will Rise We continue to recommend that investors favor floating rate leveraged loans over fixed rate high-yield bonds in their credit portfolios. The two main reasons for this recommendation are that (i) loans will benefit from higher coupons as the Fed lifts rates and LIBOR resets higher and (ii) loans will benefit from higher recoveries than bonds when the next default cycle occurs. However, somewhat puzzlingly, as 3-month LIBOR has increased during the past few years the coupon return on the S&P Leveraged Loan index has not kept pace. In fact, leveraged loans only started to outperform fixed rate junk a couple of months ago (Chart 9). There are two reasons for this. First, many leveraged loans have LIBOR floors at around 1%, so initial increases in LIBOR in 2016 had no impact on leveraged loan coupons. But 3-month LIBOR is now well above 1%, and yet leveraged loan coupons are still not rising. This is because issuers have been aggressively refinancing loans at lower spreads as LIBOR has increased. This spread compression has kept coupon payments low, but history tells us that this dynamic cannot persist. Eventually, as credit spreads stop tightening near the end of the credit cycle, issuers will not be able to reduce their interest costs through refinancing and will be forced to accept higher coupon payments as interest rates rise. Notice that even though the average price on the S&P Leveraged Loan index was higher between 2004 and 2006 than it is today, that did not prevent loan coupons from rising alongside LIBOR, after some initial lag (Chart 9, bottom panel). Bottom Line: Leveraged loans have not yet started to outperform fixed rate junk bonds, but this will change as we approach the end of the credit cycle and loan coupons follow interest rates higher. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 2 https://gps.bcaresearch.com/blog/view_blog/460 3 Please see U.S. Bond Strategy Weekly Report, "Brainard Gives The Green Light", dated March 13, 2018, available at usbs.bcaresearch.com 4 A full transcript of the post-meeting press conference: https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180321.pdf 5 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 6 https://www.frbsf.org/economic-research/files/el2017-35.pdf 7 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights After the March FOMC Meeting, market pricing for short-term rates is largely consistent with the Fed's forecasts. For investors and the Fed, the health of the economy and earnings matter more than Trump's political woes. However, the U.S. / China trade disputes will now take center stage. How can investors prepare for the trough in Citigroup Economic Surprise Index? Investors remain skeptical that the unemployment rate can fall to 3.5% and wonder what pace of monthly payroll growth would be required to get it there. Feature The S&P 500 fell more than 2% last Thursday after President Trump announced a new round of tariffs aimed at China. Treasury yields drifted modestly lower, and the trade weighted dollar fell 1%. Credit spreads widened. The trade tensions and the softer dollar drove gold up by nearly 3%. Meanwhile, another drawdown in oil inventories drove WTI oil nearly 5% higher. The VIX climbed last week, and has more than doubled since the start of the year. The market largely ignored last week's FOMC meeting. Fed Chair Powell stuck to the script at his first post-meeting press conference, but noted that trade was a topic of discussion. The "...For Inflation" section of this week's report provides more detail on Fed's view of the economy and rates. U.S. risk assets also sold off last week as market participants reacted negatively to Trump's political woes and trade policies. BCA's view is that investors should fade the former and focus on the later. We discuss Trump's political situation, as well as the trade tensions in the second section of this week's report ("...For the Next Tweet"). Nearly all the data in last week's sparse economic calendar exceeded expectations. At 1.8%, the Atlanta Fed GDPNow estimate for Q1 finished the week where it started. An unusual run of harsh winter weather in the Northeastern U.S. in March will keep downward pressure on the Citigroup Economic Surprise Index for the next month or so. We provide more detail on the Citigroup Economic Surprise Index and the performance of risk assets as the index rises and falls in the "...For The Washout" section of this week's report. Moreover, in the final section of the report ("...For The Labor Market"), we discuss how the unemployment rate can get to BCA's target of 3.5% in the next 12 months. ... For Inflation As widely expected, the FOMC last week delivered its sixth rate hike of the cycle and Fed members were more optimistic on the economic outlook. However, U.S. trade policy is a cloud over the outlook. The Fed downgraded its assessment of current economic conditions, but upgraded the outlook. The current pace of economic activity was described as "moderate" and opposed to "solid" in the previous FOMC statement. This reflects some disappointing data releases, which is also apparent in the Atlanta Fed's GDPNow model forecasting just 1.8% growth in Q1. But the Fed does not expect the softness to persist and noted that "the economic outlook has strengthened" (details below in "...For the Washout"). This was reflected in the updated economic projections. GDP growth forecasts were revised to 2.7% and 2.4% for 2018 and 2019, respectively (Chart 1). That's up from 2.5% and 2.1%, and comfortably above the Fed's 1.8% estimate for potential growth. As a consequence, the Fed expects the unemployment rate to drop to 3.6% in 2019, which would be well below the Fed's revised 4.5% estimate of full employment (details below in "...For the Labor Market"). Despite growth being above-trend and the jobless rate falling far below NAIRU, FOMC participants are not forecasting a major acceleration in inflation. From 1.9% in 2018, core PCE inflation is seen fairly steady at 2.1% in 2019 and 2020. To some degree, the upward pressure on inflation will be mitigated by a higher path for the Fed funds rate. Although the median projection remains for three rate hikes this year, the Fed expects slightly faster rate hikes in 2019 and 2020 (Chart 2). The Fed funds rate is now expected to end 2020 at 3.375%, up from 3.125% expected in December. This will put monetary policy on the tighter side of the Fed's 2.875% estimate of the neutral rate. Chart 1The FOMC'S Latest Forecasts Chart 2Market And The Fed In Agreement On Rates Of course, the path of the Fed funds rate will depend on the degree of slack in the economy and the resulting inflationary pressures. The Fed could be underestimating the inflationary pressures associated with a jobless rate that will be nearly 1% below NAIRU. Alternatively, a rising participation rate could slow the decline in the unemployment rate, or the Fed's estimate of NAIRU could get revised much lower. Finally, while the fiscal stimulus is behind the Fed's more optimistic outlook, U.S. trade policy is a growing downside risk (details below in "...For the Next Tweet"). During his press conference, Fed Chair Powell said that FOMC members were aware of the risk, but it was not incorporated into their forecasts. President Trump announced tariffs on China last week. China may then retaliate with its own tariffs. As we've said before, nobody wins from trade wars. Economic activity will be weaker and prices will be higher. A full blown trade war could jeopardize the Fed's rosy forecasts. Bottom Line: Market pricing for short-term rates is largely consistent with the Fed's forecasts. Therefore, the outcome of last week's FOMC meeting is not very market relevant. Investors are more focused on trade policy for now. ... For The Next Tweet BCA is looking beyond any market volatility induced by President Trump's political scandals.1 The decision to impeach President Trump is a purely political decision that rests with the House of Representatives. Under GOP control, Trump will not likely be impeached if he continues to fire his White House aides or members of his cabinet. That is his purview as President. However, relieving Special Counsel Mueller of his duties would probably be a red line for House Republicans and lead to impeachment. That said, it is very difficult to see the impeachment in the House lead to Trump's removal by the Senate, given his elevated approval ratings among GOP voters (Chart 3). Trump's support with GOP voters, our Geopolitical Strategy service's critical measure of whether Trump can stay in power, is back at 2016 election levels with GOP voters (Chart 3). Furthermore, conviction in the Senate (and removal from office), requires 67 votes. If the Democrats take the House, they are likely to impeach Trump in 2019. But even if the Democrats retake the Senate this fall, they would fall far short of that 67-vote threshold for conviction. For investors and the Fed, the health of the economy and earnings matter more than Trump's political woes. Equity markets performed well when the economy and earnings backdrop was favorable during presidential scandals in the 1920s and the 1990s. In the early 1970s, amid soaring inflation and the worst recession since the Great Depression, there was a bear market in equities (Chart 4A). Likewise, surges in equity market volatility amid political scandals were related more to economic and financial events than politics (Chart 4B). Chart 4AFor Markets,##BR##Economy Matters More Than Politics Chart 4BMarket Volatility During##BR##U.S. Political Scandals Today's environment - while not as robust as in the 1920s or late 1990s - provides support for higher stock prices, above-trend economic growth, escalating inflation, three more Fed rate hikes this year, and higher Treasury bond yields. Moreover, none of the issues that investors care about (tax cuts, deregulation, lifting of the spending caps, etc.) can be reversed by Trump's impeachment. Even a Democratic wave in this fall's mid-term Congressional elections will not deliver the opposition party a veto-proof majority (Chart 5). Thus, in the current economic cycle, we expect pro-market forces at the legislative and executive branches of government to persist. Chart 5Democrats's Lead in Generic Congressional##BR##Ballot Has Moved Lower This Year However, Trump's political scandals may cost the GOP the House in this fall's mid-term elections. Table 1 and Chart 6 show that political gridlock is not positive for stock prices after controlling for important macro factors.2 The average monthly return on the S&P 500 is considerably higher when the executive and legislative branches are unified. The worst outcome for equity markets, by far, is when the President faces a split legislature. BCA's Geopolitical Strategy service noted that while the market has cheered the limited scope of tariffs imposed earlier this month, investors may be underestimating the political shifts that underpinned Trump's move. There is little reason to think that protectionism will fade when Trump leaves office. The Administration's decision late last week to introduce sanctions aimed at China represents another escalation of the trade spat initiated in early March. Increased trade tensions with China represent a near-term risk to the markets.3 However, BCA's Geopolitical Strategy team notes that the latest round of tariffs suggests that Trump has made a bid to increase negotiation leverage with China rather than launch a protectionist broadside. This is good news in the short term, relative to the worst fears given Trump's lack of legal/constitutional constraints. But in the long term, Trump's latest move on trade policy support's our view that geopolitical risk is moving to East Asia and the U.S. / China conflict is a high-risk scenario that markets are now going to have to start pricing in.4 Table 1Divided Government Is, In Fact, Bad For Stocks Chart 6A Unified Congress Is A Boon For Stocks Bottom Line: Investors should dismiss the risk of domestic political scandals interrupting the market-friendly policy back drop. However, U.S. / China trade disputes will take center stage. China is motivated to prevent a trade war through significant compromises that Trump can advertise as wins to his audience this November. If Trump accepts these concessions, then the risk of a trade war with China will likely be removed until the next race for President in 2020. ... For The Washout The U.S. economic data have disappointed so far this year, as illustrated by Citigroup Economic Surprise Index (Chart 7). The Index peaked at 84.5 in December 2017 and subsequently has moved lower for 64 days. Since early 2011, there were six other episodes when the Surprise Index behaved similarly. These phases lasted an average of 86 days; the median number of days from peak to trough was 66 days. The implication is that the trough in the Citigroup Economic Surprise reading may be a month or two away. However, the relatively low economic expectations at end-2017 suggest that the disappointment may be truncated. On the other hand, the Tax Cut and Jobs Act of 2017, along with the lifting of budgetary spending caps in early 2018, have likely raised economists' near-term projections. Chart 7U.S. Financial Markets As Economic Surprise Index Declines The performance of key financial markets and commodities since the Economic Surprise Index crested in December 2017 matches the historical record, with a few notable exceptions (Table 2 and Charts 7 and 8). As the Index rolled over in late 2017, stocks beat bonds, credit outperformed Treasuries and the dollar fell, matching previous episodes. However, counter to the historical trend, gold and oil prices have increased and small caps have underperformed in the past three months. Table 2Financial Market Performance As The Economic Surprise Index Falls Chart 8Economic Surprise Approaching A Turning Point Based on BCA's research,5 tactical investors should add to their risk positions as the Citigroup Economic Surprise Index bottoms and begins to climb. As the Economic Surprise Index rises, stocks beat bonds by an average of 8700 bps and in six of the seven episodes since 2011 (Table 3). Furthermore, the performance of stock-to-bond ratio is better when the Economic Surprise Index is accelerating. Table 3 again shows that all asset classes also perform better when the Index climbs. After briefly moving above zero in early 2017 - indicating that inflation data was stronger than analysts projected - the Citigroup Inflation Surprise index rolled over again (Chart 9, top panel) through year end 2017. Reports on the CPI, PPI and average hourly earnings continued to fall short of consensus forecasts despite tightening of the labor and product markets. The disappointment on price data relative to consensus forecasts is not new. Although there were brief periods when prices exceeded forecasts in 2010 and 2011, the last time that inflation exceeded market consensus in this business cycle was in late 2009 and early 2010. In the last few years of the 2001-2007 economic expansion through early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Table 3Financial Market Performance As The Economic Surprise Index Rises Chart 9The Fed Cycle And Inflation Surprise Moreover, the Citigroup Inflation Surprise index escalated during previous tightening regimes when the economy was at full employment and the Fed funds rate was in accommodative territory (Chart 9). The last time those conditions were in place, which was in 2005, the Fed was wrapping up a rate increase campaign that began in mid-2004. An increase in the Citigroup Inflation Surprise Index also accompanied most of the Fed's rate hikes from mid-1999 through mid-2000. In late 2015, as the current set of rate hikes commenced, the inflation surprise index was on the upswing, the economy was close to full employment and the Fed funds rate was accommodative. Bottom Line: The disappointing run of economic data will not end for another few months. The unusually harsh winter weather in March in the Northeastern exacerbates the situation. However, the weakness in the economic data is not a sign that a recession is at hand. We expect that the inflation surprise index will continue to grind higher, as unemployment dips further into 'excess demand' territory (details below in "...For The Labor Market"). After the Citigroup Economic Surprise Index forms a bottom and starts to rise, history suggests that stocks will beat bonds, investment-grade and high-yield corporate bonds will outpace Treasuries, and gold and oil will climb. Stay overweight stocks versus bonds, long credit and underweight duration. ... For The Labor Market BCA expects the unemployment rate to hit 3.5% by late 2018 or early next year, the first time since December 1969. Our base case assumes that the economy will generate 200,000 nonfarm payroll jobs per month and that the labor force participation rate will remain at 63%. The unemployment rate was 4.1% in February 2018 and bottomed at 4.4% in 2006 and 2007; the rate reached a 30-year low at 3.8% in 2000. As noted in the first section of this week's report, at the conclusion of last week's meeting, the FOMC nudged down its view of this year's unemployment rate to 3.8%. The FOMC also slightly adjusted its long-term forecast of the unemployment rate to 4.5%. The implication is that BCA and the FOMC expect the U.S. economy to continue to run below full employment this year. Nonetheless, investors remain skeptical that the unemployment rate can fall to 3.5% and wonder what pace of monthly payroll growth would be required to get it there. In Table 4 we look at various scenarios (monthly increases in payrolls, annual percentage change in participation rate) to show when the unemployment rate will dip below 3.5%. In the past three months, total nonfarm payroll employment increased by 242,000 per month, and in the past year, the average monthly increase was 190,000. The participation rate was 63% in February, little changed from a year ago as an improved labor market offset demographic factors that continue to drive down this rate. Our calculations assume that the labor force will expand by 0.9% per year, matching the growth rate in the past 12 months. Chart 10 shows the history of the unemployment rate and several scenarios in the next two years that assume the participation rate stays at 63%. Table 4Dates When 3.5% Unemployment Rate Threshold Is Reached Chart 10The Unemployment Rate Under Various Monthly Job Count Scenarios Bottom Line: BCA's view is that the FOMC's forecast for the unemployment rate at the end of 2018 (3.8%) is too high and only marginally lower than the current 4.1% rate. This is inconsistent with real GDP growth well in excess of its supply-side potential. The macro backdrop will likely justify the FOMC hiking more quickly than the March 2018 dots forecast. The risks are skewed to the upside. BCA expects the 2/10 Treasury yield curve to steepen through mid-year and then flatten by year-end, spending most of 2018 between 0 and 50 bps. Stay underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Policies Are Stimulative Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report "The South China Sea: Smooth Sailing?," dated March 28, 2017, available at gps.bcaresearch.com. 5 Please see BCA U.S. Investment Strategy Weekly Reports, "Solid Start," dated January 8, 2018 and "The Revenge Of Animal Spirits," dated October 30, 2017. Both available at usis.bcaresearch.com.

Highlights Portfolio Strategy The reward/risk profile of air freight & logistics is extremely attractive. Synchronized global growth, the capex upcycle, a falling dollar and secular advance in e-commerce compel us to add this unloved transportation sub-index to our high-conviction overweight list. Prepare to lock in gains in managed health care. The positive demand and pricing backdrops are already reflected in perky valuations. While homebuilders still have to contend with rising lumber prices and interest rates and the partial elimination of mortgage interest deductibility, the near 20% peak-to-trough drawdown suggests that all of the bad news is baked in relative share prices, warranting an upgrade alert. Recent Changes Add the S&P air freight & logistics index to the high-conviction overweight list. Put the S&P managed care index on downgrade alert. Set an upgrade alert on the S&P homebuilding index. Table 1 Feature Equities lost ground last week and flirted with the bottom part of the trading range established during the past two months, but held the 200-day moving average. Our view remains that the SPX is digesting the early-February swoon, and the buy-the-dip strategy is still appropriate for capital with a cyclical (9-12 month) time horizon as the probability of a recession this year is close to nil. Nevertheless, the recent doubling in the TED spread and simultaneous spike in financials investment grade bond spreads is slightly unnerving (second panel, Chart 1). Junk spreads also widened as investors sought the safety of the risk-free asset. What is behind this fear flare up propagating in risk sensitive assets? First, the Fed continued its tightening cycle last week, raising the fed funds rate another 25bps. As we have been writing in recent research Weekly Reports, rising interest rates go hand-in-hand with increasing volatility (please see Chart 1 from the March 5th Special Report on banks). Thus, as the Fed tightens monetary policy and continues to unwind its balance sheet, the return of volatility will become a key market theme (bottom panel, Chart 1). The implication is that a bumpier ride looms for equities, and the smooth and nearly uninterrupted rise that market participants have been conditioned to expect is now a thing of the past. With regard to the composition of equity returns in the coming year, rising interest rates and volatility signal that the forward P/E multiple has likely crested for the cycle, leaving profits to do all the heavy lifting (Chart 2). Second, rising policy uncertainty (trade and Administration personnel related, please see Chart 1 from last week's publication) is muddying the short-term equity market outlook at the current juncture, and fueling the risk-off phase. However, synchronized global growth, a muted U.S. dollar and easy fiscal policy are a boon to EPS and signal that profit growth will reclaim the driver's seat in coming weeks. Stocks and EPS are joined at the hip and there are good odds that equities will vault to fresh all-time highs on the back of earnings validation as the year unfolds (Chart 3). Chart 1Closely Monitor These Spreads Chart 2EPS Doing The Heavy Lifting Chart 3Profits And Cash Flow Underpin Stocks Importantly, comparing net profit growth to cash flow growth rates is instructive, as SPX EBITDA is not affected by the new tax law. While EPS are slated to grow close to 20% in calendar 2018, the respective forward SPX EBITDA growth rate (based on IBES data) sports a more muted 10% per annum rate (second panel, Chart 4). Similarly, sell side analysts pencil in a visible jump in forward net profit margins, whereas the forward EBITDA margin estimate is stable (middle panel, Chart 4). The recent tax-related benefit is a one-time dividend to profits that will not repeat in 2019. Thus, the market will likely look through this one time effect and start to focus on the calendar 2019 EPS growth number that is a more reasonable 10%, and also similar to next year's EBITDA growth rate. Our sense is that this transition will also be prone to turbulence. Our EPS growth model corroborates this profit euphoria and is topping out near the 20% growth rate (Chart 5). While it will most likely decelerate in the back half of the year, as long as there is no relapse near the contraction zone à la late-2015/early 2016, the equity bull market will remain intact. Chart 4Investors Will See Through The Tax Cut Chart 5EPS Model Flashing Green As we showcased in the early February Weekly Report, four key macro variables are behaving as they have in four prior 20% EPS growth phases since the 1980s excluding the post-recession recoveries (please see the Appendix of the February 5th "Acrophobia" Weekly Report). Therefore, if history at least rhymes, the equity overshoot phase will resume. This week we add a neglected transportation group to the high-conviction overweight list, put a defensive index on the downgrade watch list and set an upgrade alert on a niche early cyclical group. Air Freight & Logistics: Prepare For Takeoff Last week we reiterated our overweight stance in the broad transportation space and today we are compelled to add the undervalued and unloved S&P air freight & logistics index to the high-conviction overweight list. Air freight services are levered to global growth. Currently, synchronized global growth remains the dominant macro theme. Firming export expectations suggest that global trade volumes will get a bump in the coming months (second panel, Chart 6). Importantly, U.S. manufacturers are also excited about exports; the latest ISM manufacturing export subcomponent hit a three decade high. While the specter of a global trade spat is disconcerting, our sense is that a generalized trade war will most likely be averted or, if the current executive Administration is to be believed, short-lived. The upshot is that air freight & logistics sales momentum will gain steam in the coming months (second panel, Chart 7). Chart 6Heed The Signals From Global Growth,##br## Capex And The Greenback Chart 7Domestic Demand##br## Is Also Firm Beyond euphoric survey data readings, hard economic data also corroborate the soft data message. G3 (U.S., the Eurozone and Japan) capital goods orders are firing on all cylinders and probing multi-year highs, underscoring that rising animal spirits are translating into real economic activity (third panel, Chart 6). Chart 8Mistakenly Unloved And Undervalued Tack on the near uninterrupted depreciation of the trade-weighted U.S. dollar and factors are falling into place for a relative EPS overshoot, given the large foreign sales component of this key transportation sub-group (bottom panel, Chart 6). Not only are air freight stocks' fortunes tied to the state of global trade, but this industry is also sensitive to capital outlays. A synchronized global capex cycle is one of the key themes we are exploring in 2018. The third panel of Chart 7 shows that our capex indicator points to a reacceleration in the corporate sales-to-inventories ratio. This virtuous capital spending upcycle, that would get a further lift were an infrastructure bill to be signed into law, is a boon to air cargo services. In addition, as the secular advance in e-commerce continues to make inroads in the bricks-and-mortar share of total retail dollars spent, demand for delivery services will continue to grow smartly, underpinning industry selling prices (bottom panel, Chart 7). As a result, we would look through recent softness in industry pricing power that has weighed on relative performance. Indeed, transportation & warehousing hours worked have recently spiked, corroborating the message from global revenue ton miles (not shown), rekindling industry net earnings revisions (second panel, Chart 8). Importantly, relative valuations are discounting a significantly negative profit backdrop, with the relative price/sales ratio at its lowest level since 2002 (third panel, Chart 8). Similarly, the index is trading at a 10% discount to the broad market's forward P/E multiple or the lowest level since the turn of the century (not shown). Finally, technical conditions are washed out offering a compelling entry point for fresh capital (bottom panel, Chart 8). The implication is that the group is well positioned to positively surprise. Bottom Line: The S&P air freight & logistics index has a very attractive reward/risk profile and if we were not already overweight, we would take advantage of recent underperformance to go overweight now. Therefore, we are adding it to our high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD. Downgrade Alert: Managed Health Care Managed health care stocks have been stellar outperformers not only versus the overall market, but also compared with the broad S&P health care sector. Since the April 2016 inception of our overweight recommendation, they have added considerable alpha to our portfolio to the tune of 21 percentage points above and beyond the SPX's rise (Chart 9). While most of the factors underpinning our sanguine view for health insurers remain intact, from a risk management perspective we are compelled to put them on downgrade alert. Most of the good news is likely baked into relative prices and valuations (bottom panel, Chart 9). In the coming weeks, we will be on the lookout for an opportunity to pull the trigger and crystalize gains and downgrade to a benchmark allocation, especially if defensive equities catch a bid on the back of the current mini risk off phase. Namely, recent inter-industry M&A euphoria is a key catalyst to lighten up on this health care services sub-sector (Chart 10). While regulators have disallowed intra-industry consolidation over the past few years, the M&A premia remained and now the proposed CVS/AET and CI/EXPR deals could be a harbinger of petering out relative valuations and share prices. Chart 9Prepare To Book Gains Chart 10M&A Frenzy True, melting health care inflation is likely a secular theme that is in the processes of reversing three decades worth of health care industry, in general and pharma in particular, pricing power gains. While this is a dire backdrop for drug manufacturers - which remains a high-conviction underweight - it is a clear benefit to HMOs (Chart 11). Health insurance labor costs are also well contained: the employment cost index for this industry is probing multi-year lows (bottom panel, Chart 12). The upshot is that profit margins are on a solid footing. Chart 11Operating Metrics Suggest... Chart 12...To Stay Overweight A While Longer Meanwhile, the overall U.S. labor market is on fire. Last month NFPs registered a month-over-month increase of 300K for the first time in four years and unemployment insurance claims are perched near five decade lows. This represents an enticing demand backdrop for managed health care companies, especially when the economy is at full employment and the government is easing fiscal policy (bottom panel, Chart 11). Despite the still appealing demand and pricing backdrop, the flurry of M&A deals will likely serve as a catalyst to lock in gains and move to a benchmark allocation in the coming weeks as this health care sub-index is priced for perfection. Bottom Line: Stay overweight the S&P managed health care index, but it is now on downgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Upgrade Alert: Homebuilders Showing Resiliency In late-November 2017 when we launched our 2018 high-conviction call list, we downgraded the niche S&P homebuilding index to underweight (Chart 13). Our thesis was that the trifecta of rising lumber prices, mortgage interest deductibility blues and rising interest rate backdrop, a key 2018 BCA theme, would weigh on profit margins and, thus, profits would underwhelm. Since then we have monetized gains of 10% versus the SPX and removed this early-cyclical index from the high-conviction underweight list.1 Today we are putting it on upgrade alert. As a reminder, this was not a call based on a souring residential housing view. In fact, we remain housing bulls and expect more gains for the still recovering residential housing market that moves in steady prolonged multi-year cycles (Chart 14). Keep in mind that housing starts are still running below household formation and the job market is heating up. The implication is that the U.S. housing market rests on solid foundations. Chart 13Bounced Off Support Line Chart 14Housing Fundamentals Are Upbeat While interest rates and rising house prices are denting affordability (second and fourth panels, Chart 15), homebuilders share prices have been resilient recently and have smartly bounced off their upward sloping support trend line (Chart 13). Indeed, interest rates may continue to rise from current levels, but as we have highlighted in recent research, there is a self-limiting aspect to the year-over-year rise in the 10-year yield near the 100bps mark. Put differently, any rise above 3.05% on the 10-year Treasury yield in a short time frame would likely prove restrictive for the U.S. economy.2 Encouragingly, the mortgage application purchase index has well absorbed the selloff in the bond market, unlike its sibling mortgage application refinance index, signaling that there is pent up housing demand (second panel, Chart 16). New home sales are expanding anew as price concessions have likely been sufficient to compete with existing homes for sale (top panel, Chart 16). Chart 15Get Ready To Upgrade... Chart 16...Given Receding Profit Margin Risks On the lumber front, prices have gone parabolic year-to-date courtesy of trade war talk and a softening U.S. dollar. However, lumber inflation cannot continue at a 50%/annum pace indefinitely (third panel, Chart 16). While higher lumber prices are a de facto negative for homebuilding profit margins, we deem they are now well reflected in compelling relative valuations (bottom panel, Chart 15). In addition, if we are correct in assessing that housing demand remains upbeat, this will give some breathing room to homebuilders to partly pass on some of this input cost inflation to the consumer. Bottom Line: The S&P homebuilding index remains an underweight, but it is now on our upgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight Report, "Housekeeping In Turbulent Times," dated February 9, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Underweight U.S. airline stocks hit a patch of turbulence this week when Southwest, usually known for being the price disrupter amongst airline peers, dropped their Q1 revenue guidance "primarily due to the competitive fare environment". We have been flagging a looming price war since United Airlines announced a significant and prolonged capacity expansion plan earlier this year, underpinning our preference to avoid the S&P airlines index. In fact, airfares have been losing share of the customer's wallet for more than a year now and the downtrend is accelerating (second panel). This is further evidenced by airlines' eroded ability to pass through higher jet fuel prices, which have historically been the marginal price setter (third panel). The upshot of declining revenues and rising costs is stalling margins (bottom panel); investors would be wise to skip this flight and stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK.

Special Report

Dear Client, I am visiting clients in Asia this week and working on our Quarterly Strategy Outlook, which we will be publishing next week. As such, instead of our Weekly Report, we are sending you this Special Report written by my colleague Mathieu Savary, BCA's Chief Foreign Exchange Strategist. Mathieu discusses the current economic situation in Switzerland. While the Swiss economy has healed, the Swiss franc continues to exert structural deflationary pressures on the country. The SNB will do its utmost to engineer further depreciation in the franc versus the euro, but will lag behind the ECB when it comes time to increase interest rates. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Chief Global Strategist Feature Switzerland is experiencing a meaningful economic rebound. The Swiss economy is enjoying real and nominal growth of 1% and 1.4%, respectively, and PMIs are hovering near eight-year highs. As a result, after hitting nadirs of -1.4% and -0.95%, headline and core inflation have both recovered and are clocking in at 0.6% and 0.5%, respectively. Moreover, thanks to economic and political improvements in the euro area, capital has begun to make its way back into the euro. As a result, EUR/CHF has rallied, creating a weaker trade-weighted Swiss franc. This means that while global monetary conditions are beginning to tighten, Swiss monetary conditions have eased in 2017 and 2018. As the Swiss economy improves, will the Swiss National Bank follow in the footsteps of many other major central banks and dial down its accommodative monetary policy? Is it time to sell EUR/CHF? In our view, Swiss domestic economic dynamics remain too fragile to let the Swiss franc appreciate meaningfully. Hence, the SNB will not be able to tighten policy much so long as the European Central Bank keeps rates at current levels. Thus, we would continue to bet on an appreciation of EUR/CHF, punctuated with periodic rallies in the Swiss franc when global volatility occasionally spikes. The Domestic Situation Switzerland's current domestic situation can be traced back to the botched abandonment of the currency peg in 2015. On January 15th, 2015, markets were caught off guard by the sudden removal of the 1.20 floor underpinning EUR/CHF. The SNB provided no forward guidance nor any explanation, and the franc surged 20% against the euro in just one day, tightening monetary conditions severely. Fearing a massive deflationary shock to the Swiss economy, the SNB responded with a large-scale injection of liquidity, expanding its assets from 80% of GDP to more than 120% today, the highest ratio in the G10. To enforce an unofficial floor placed under EUR/CHF of 1.08, Swiss foreign exchange reserves grew rapidly. This expansion in liquidity along with negative policy rates caused 10-year yields to decline to -0.6%. A weak franc and falling yields greatly eased monetary conditions (Chart 1). The current strength in the Swiss economy is a direct response to this extraordinarily accommodative policy setting: In response to loose monetary policy, the velocity of money has accelerated over the past three years, supporting nominal growth (Chart 2); Stronger global growth and a healing banking sector have lifted economic activity in the Eurozone. As a large exporter to both Europe and emerging Asia, Switzerland was a prime beneficiary of this development, providing a tailwind to the SNB's reflationary efforts; Swiss real GDP growth has stabilized and is forecast to accelerate further this year, as highlighted by the vigor of the KOF Composite Leading Indicator (Chart 3); Nominal GDP growth has also picked up due to positive developments in inflation and the reflationary boom of 2017; Improving economic activity has caused the Swiss unemployment rate to decline to 2.9%. Chart 1The SNB Eased Monetary##br## Conditions After January 2015 Chart 2The Velocity Of ##br##Money Has Risen Chart 3Swiss Growth Will ##br##Continue To Recover Based on these improvements, it is natural for investors to question whether the SNB needs to remain an aggressive agent of reflation going forward. However, we do still believe that the Swiss franc will continue to hamper the SNB's ability to tighten policy. Bottom Line: When the SNB scrapped its currency cap against the euro in 2015, the action yielded a near-disastrous outcome for the Swiss economy. However, the Swiss central bank soon eased policy massively in response to this self-inflicted shock, limiting its adverse impact on the Swiss economy and ultimately helping growth recover once global growth rebounded. Now that inflation is also perking back up, the SNB could have to tighten policy. However, the Swiss franc will remain the crucial impediment to doing so. The Swiss Franc Is Still Overvalued Chart 4Basic Balance: Providing Long-Term ##br##Support For The Franc Since Switzerland is a small, open economy - total trade amounts to 118.8% of GDP - the Swiss franc is a powerful determinant of domestic monetary conditions. Last year's 9.7% depreciation of the CHF against the euro and 5.3% decline against its major trading partners allowed the economy to climb out of its deflationary funk. However, the Swiss currency has a secular tendency to appreciate, creating a major problem for the SNB. This currency strength puts downward pressure on inflation and impedes the achievement of inflation targets. Officials are therefore forced to fight off any appreciation in order to stave off disinflationary pressures. While its role as a global safe haven contributes to the natural strength of the franc, several important factors supercharge it: First, the country's consistently low rate of inflation puts upward pressure on the CHF's Purchasing Power Parity fair value. This exacerbates demand for the Swiss franc as a global store of value. This creates a virtuous feedback loop of inflows, a stronger currency, lower inflation, and further inflows. Second, Switzerland sports a large positive net international investment position of 125% of GDP, which generates a net positive international income for Switzerland: 5.3% of GDP annually. Not only does this net positive income generate demand for the franc, but countries with much more international assets than liabilities historically experience appreciating real exchange rates. Third, at 8.5% of GDP, Switzerland has the largest basic balance-of-payments surplus in the G10. It has sported a favorable basic balance vis-à-vis the euro area over the past nine years, generating significant upward pressure on the currency (Chart 4). This basic balance-of-payments advantage is set to remain in place as Switzerland runs a current account surplus, and long-term capital continues to be attracted by Switzerland's low tax rates and investor-friendly climate. Brexit jitters are an additional factor favoring FDI inflows into Switzerland. Fourth, the euro area crisis, its associated double-dip recession and long periods of political risk generated a perception that the euro would break up. This stimulated large capital outflows out of the euro area into stable Switzerland. This created a cyclical boost to the Swiss franc beyond the normal structural positives. The strong upward bias to the CHF is not leaving the SNB unmoved. The Swiss central bank has been vocal in expressing its discontent, arguing that the franc is expensive. However this expensiveness does not seem evident when one looks at EUR/CHF against its Purchasing Power Parity equilibrium (Chart 5). EUR/CHF is only trading at marginal discount to its fair value, implying a small premium for the CHF. The reality is that PPP models do not tell the full story for the franc. When looking at Swiss labor costs, the expensiveness of the Swiss franc becomes obvious (Chart 6). By 2015, Swiss unit labor costs converted into euros had risen by 80% compared to 2000 levels. Even after the recent rally in EUR/CHF, Swiss ULCs are still 60% above their 2000 levels, implying a great loss of competitiveness than that experienced by Italy or France over the same timeframe. The Swiss franc may be attractive as a store of value, but this is now hurting the Swiss economy. Chart 5Modest Apparent Overvaluation##br##On A PPP Basis... Chart 6...But An Evident Overvaluation ##br##On A Labor Costs Basis Bottom Line: Thanks to Switzerland's low inflation, large positive net international investment position and basic balance-of-payments surplus, and its safe-haven status, the Swiss franc has been on an appreciating secular trend. Moreover, this long-term strength has been supercharged by the euro area crisis. The CHF has now made Switzerland uncompetitive. Avoiding The Specter Of Irving Fisher If the CHF is expensive, making the Swiss economy uncompetitive, why does Switzerland still have a trade surplus of 11% of GDP, and why is the Swiss unemployment rate not greater than 2.9%? One side of the answer relates to the behavior of Swiss export prices. When the franc is strong, Swiss exporters cut down the price of their products in order to remain competitive abroad (Chart 7). However, the story does not end there. The flexible nature of the Swiss labor market provides an offset to buffer corporate profitability. According to the World Economic Forum, Switzerland has the most efficient labor market in the world, well ahead of other major continental European economies (Chart 8). Swiss employers therefore hold the upper hand in labor negotiations. Chart 7A Strong Swiss Franc Hurts Selling Prices Chart 8The Swiss Labor Market Is Very Flexible In order to contain labor costs, companies have shifted the composition of the labor force. Full-time employment has been contracting since 2016 while all the jobs created have been part-time positions (Chart 9), resulting in elevated labor underutilization. Additionally, employers have been able to exact important concessions from workers, further depressing wage growth, which has averaged 0.5% per annum over the past three years (Chart 9, bottom panel). Low wage growth and labor underemployment have weighed on inflation through two channels: First, the Phillips curve is alive and well in Switzerland, and the current level of unemployment is consistent with low inflationary pressures (Chart 10). Chart 9The Swiss Job Market Is Weaker Than It Looks Chart 10The Swiss Phillips Curve Is Alive Second, low wage growth has translated into subdued household income gains. But at 216% of disposable income, Swiss households have one of the highest debt levels in the OECD. Without income growth, consumption growth has been limited. Swiss real retail sales have been falling more or less in a straight line since 2014 (Chart 11). In essence, the Swiss economy is experiencing a deflationary adjustment similar to the one undergone by Germany in the wake of the Hartz IV reforms implemented in 2005. These reforms put downward pressure on German wages and domestic demand, and fomented deflationary forces. However, 2005 was another era. The negative impact on German demand was buffeted by the extraordinary strength of the global economy, which boosted German exports. Switzerland does not enjoy this luxury: Since the Great Financial Crisis, global growth has been more muted, and global trade is not expanding anymore (Chart 12). Chart 11Regaining Competitiveness ##br##Is Hurting Domestic Demand Chart 12Germany Had ##br##It Easy Because of this lack of a foreign relief valve, weakness in the domestic economy has had another pernicious impact: Switzerland has not experienced any productivity growth since the Great Financial Crisis (Chart 13). As a consequence, the Swiss output gap remains in negative territory, further exacerbating the deflationary pressures created by the expensive Swiss franc (Chart 14). It is unsurprising that despite a massive surge in the central bank's balance sheet, generating inflation remains difficult in Switzerland. Chart 13No Productivity Growth Since 2008 Chart 14Swiss Output Gap Is Negative Finally, even the Swiss price measures theoretically unaffected by the output gap are declining. Owner-occupied home prices are contracting at a pace of 1% per annum (Chart 15). Since 2013, net migration in Switzerland has been declining, weighing on demand for housing. The 2014 referendum to curb immigration, put forward by the right-wing Swiss People's Party, has only added further downward impetus to immigration. Chart 15Real Estate Is Deflationary When deflationary forces are as strong and well-entrenched as they are in Switzerland, and when the economy is burdened by a large debt load - Swiss nonfinancial debt stands at 248% of GDP, the highest in the G10 - a nation runs the risk of entering into the debt-deflation spiral described by Irving Fisher in 1933.1 Falling prices can force a liquidation of debt, which forces further contraction in nominal output, forcing more debt liquidation, and so on. Calling a great depression in Switzerland is too radical, but the country could experience a Japanese scenario of many lost decades if inflation does not return. Therefore, it is no wonder that the SNB is obsessed with keeping monetary conditions as accommodative as possible. Since the exchange rate has a disproportionate impact on monetary conditions for economies as open as Switzerland, this means the SNB is likely to continue to target a weaker Swiss franc for longer. Bottom Line: An expensive Swiss franc has not caused the Swiss economy to experience a trade deficit because the Swiss labor market is so flexible. Instead, an expensive CHF has generated acute downward pressures on wages, domestic demand, and prices. This deflationary environment is especially dangerous for Switzerland as its private sector is massively over-indebted, raising the specter of the debt-deflation spiral described by Irving Fisher. The SNB will keep fighting these dynamics. What's In Store For The SNB? Chart 16Bern Is Tight-Fisted If Swiss fiscal policy was very easy, monetary policy would not have to be as accommodative. After all, Switzerland has fiscal legroom. Government net debt stands at 23% of GDP, the overall fiscal balance is at zero, and Bern enjoys a small cyclically-adjusted primary surplus of 0.3% of GDP. Moreover, after having purchased massive amounts of euros, the SNB is expecting to generate a profit of CHF54 billion in 2017 in the wake of the rally in EUR/CHF. Each canton is set to receive an additional windfall of CHF1 billion in addition to the normal CHF1 billion dividend they normally receive. The country's conservative fiscal management, however, means that the fiscal spigot will not be opened. The so-called "debt brake" rule introduced in 2003 requires a balanced cyclically-adjusted federal budget on an ex ante basis, and in cases of ex post over- and under-spending, offsetting surpluses and deficits in subsequent years as required. As a result, the IMF forecasts that the fiscal thrust will remain near zero for the coming years (Chart 16). Fiscal policy will therefore not come to the rescue. This means the SNB will want to ease monetary conditions further to push demand and inflation back up. Therefore, the SNB will continue to target a weaker CHF in the coming years. Chart 17The SNB Will Keep Rates Below The ECB... Despite this outcome, life for the SNB is getting easier, and its balance sheet will not expand much further. Euro area growth has been recovering, and European political instability has declined. As a result, the probability of a euro breakup has dropped, and rate of returns in the Eurozone have increased. Consequently, hot money flows into Switzerland have abated and the SNB has not had to increase its sight deposits - a key measure of its involvement in the FX market - to push the Swiss franc down. However, to ensure the CHF enjoys a structural downtrend, the SNB will have to keep interest rates across the yield curve below euro area levels, especially as the Swiss leading economic indicator is currently outpacing that of the Eurozone's, which normally coincides with a weaker EUR/CHF (Chart 17). This does not mean that the SNB will cut rates further. European bond yields are moving up and the ECB is slated to increase rates in the summer of 2019. This means that the SNB will not adjust policy until after the ECB does. Doing otherwise would put upward pressure on the Swiss franc - exactly what the SNB wants to avoid at all costs. The SNB is likely to keep this policy in place until the Swiss franc trades at a significant discount to the euro. In our assessment, this means a EUR/CHF exchange rate of around 1.30. Bottom Line: The various levels of the Swiss government have no inclination to ease fiscal policy. The burden of stimulating growth and inflation will continue to rest squarely on the SNB's shoulders, which means it will keep targeting a lower CHF. Thanks to economic and political improvements in the euro area, the SNB can curtail its direct involvement in the FX market. However, creating a negative carry against the CHF will remain the main tool in the SNB's arsenal, so Swiss policy rates will lag the euro area. This policy will remain in place until EUR/CHF trades closer to 1.30. Investment Implications At this juncture, the primary trend in EUR/CHF continues to point upward. The ECB is giving firmer signals that its asset purchasing program will end this September. The implementation of this program was associated with massive outflows of long-term capital out of the euro area (Chart 18). Its end is likely to limit outflows to Switzerland. Additionally, lower Swiss interest rates will continue to hurt the trade-weighted Swiss franc. While the primary trend for EUR/CHF points north, we worry that it will not be a one-way street as it was in 2017. As we have highlighted, Switzerland enjoys a large net international investment position, and its incredibly low interest rates have made the Swissie a funding currency. These attributes also make the CHF a safe-haven currency. Therefore, the franc is likely to rally each time global volatility picks up.2 While BCA expects risk assets to continue to appreciate through most of 2018, prices are likely to become more volatile: China is tightening policy and global central banks are progressively removing monetary accommodation in response to a slow return of inflation.3 These bouts of volatility will cause the occasional selloff in EUR/CHF along the way. The surge in the VIX on February 5th of this year provided a good template for the kind of gyrations that EUR/CHF will likely experience. Nonetheless, despite these occasional surges in volatility, we do expect EUR/CHF to end the year closer to 1.30. In fact, the return of volatility will further ensure that the SNB will lag the ECB in tightening policy. Finally, investors looking to buy EUR/CHF but who worry about these occasional bouts of volatility may hedge this trade by buying put options on AUD/CHF. This cross tends to experience more violent selloffs than EUR/CHF when global volatility rises, and it is furiously expensive on a long-term basis (Chart 19). Moreover, the balance-of-payments picture is very attractive for shorting this pair, as Australia runs a current account deficit of 2.3% of GDP, while Switzerland runs a surplus of 10%. Chart 18...But It Will Be Less Active In The FX Market Chart 19Short AUD/CHF As A Hedge Bottom Line: EUR/CHF is likely to appreciate to 1.30 this year as the SNB will lag the ECB when it comes to removing monetary accommodation. This trend is likely to be punctuated by violent selloffs associated with the return of volatility in global financial markets. Buying puts on AUD/CHF is an attractive way to hedge this risk. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Irving Fisher (1933), “The Debt-Deflation Theory of Great Depressions,” Econometrica, Vol. 1, No. 4 (Oct., 1933), pp. 337 - 357. 2 Please see Foreign Exchange Strategy Special Report, "Carry Trades: More Than Pennies And Steamrollers," dated May 6, 2016, available at fes.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018, available at gis.bcaresearch.com; and Foreign Exchange Strategy Weekly Report, "The Return Of Macro Volatility," dated March 16, 2018, available at fes.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Feature Switzerland is experiencing a meaningful economic rebound. The Swiss economy is enjoying real and nominal growth of 1% and 1.4%, respectively, and PMIs are hovering near eight-year highs. As a result, after hitting nadirs of -1.4% and -0.95%, headline and core inflation have both recovered and are clocking in at 0.6% and 0.5%, respectively. Moreover, thanks to economic and political improvements in the euro area, capital has begun to make its way back into the euro. As a result, EUR/CHF has rallied, creating a weaker trade-weighted Swiss franc. This means that while global monetary conditions are beginning to tighten, Swiss monetary conditions have eased in 2017 and 2018. As the Swiss economy improves, will the Swiss National Bank follow in the footsteps of many other major central banks and dial down its accommodative monetary policy? Is it time to sell EUR/CHF? In our view, Swiss domestic economic dynamics remain too fragile to let the Swiss franc appreciate meaningfully. Hence, the SNB will not be able to tighten policy much so long as the European Central Bank keeps rates at current levels. Thus, we would continue to bet on an appreciation of EUR/CHF, punctuated with periodic rallies in the Swiss franc when global volatility occasionally spikes. The Domestic Situation Switzerland's current domestic situation can be traced back to the botched abandonment of the currency peg in 2015. On January 15th, 2015, markets were caught off guard by the sudden removal of the 1.20 floor underpinning EUR/CHF. The SNB provided no forward guidance nor any explanation, and the franc surged 20% against the euro in just one day, tightening monetary conditions severely. Fearing a massive deflationary shock to the Swiss economy, the SNB responded with a large-scale injection of liquidity, expanding its assets from 80% of GDP to more than 120% today, the highest ratio in the G10. To enforce an unofficial floor placed under EUR/CHF of 1.08, Swiss foreign exchange reserves grew rapidly. This expansion in liquidity along with negative policy rates caused 10-year yields to decline to -0.6%. A weak franc and falling yields greatly eased monetary conditions (Chart 1). The current strength in the Swiss economy is a direct response to this extraordinarily accommodative policy setting: In response to loose monetary policy, the velocity of money has accelerated over the past three years, supporting nominal growth (Chart 2); Stronger global growth and a healing banking sector have lifted economic activity in the Eurozone. As a large exporter to both Europe and emerging Asia, Switzerland was a prime beneficiary of this development, providing a tailwind to the SNB's reflationary efforts; Swiss real GDP growth has stabilized and is forecast to accelerate further this year, as highlighted by the vigor of the KOF Composite Leading Indicator (Chart 3); Nominal GDP growth has also picked up due to positive developments in inflation and the reflationary boom of 2017; Improving economic activity has caused the Swiss unemployment rate to decline to 2.9%. Chart 1The SNB Eased Monetary##br## Conditions After January 2015 Chart 2The Velocity Of ##br##Money Has Risen Chart 3Swiss Growth Will ##br##Continue To Recover Based on these improvements, it is natural for investors to question whether the SNB needs to remain an aggressive agent of reflation going forward. However, we do still believe that the Swiss franc will continue to hamper the SNB's ability to tighten policy. Bottom Line: When the SNB scrapped its currency cap against the euro in 2015, the action yielded a near-disastrous outcome for the Swiss economy. However, the Swiss central bank soon eased policy massively in response to this self-inflicted shock, limiting its adverse impact on the Swiss economy and ultimately helping growth recover once global growth rebounded. Now that inflation is also perking back up, the SNB could have to tighten policy. However, the Swiss franc will remain the crucial impediment to doing so. The Swiss Franc Is Still Overvalued Chart 4Basic Balance: Providing Long-Term ##br##Support For The Franc Since Switzerland is a small, open economy - total trade amounts to 118.8% of GDP - the Swiss franc is a powerful determinant of domestic monetary conditions. Last year's 9.7% depreciation of the CHF against the euro and 5.3% decline against its major trading partners allowed the economy to climb out of its deflationary funk. However, the Swiss currency has a secular tendency to appreciate, creating a major problem for the SNB. This currency strength puts downward pressure on inflation and impedes the achievement of inflation targets. Officials are therefore forced to fight off any appreciation in order to stave off disinflationary pressures. While its role as a global safe haven contributes to the natural strength of the franc, several important factors supercharge it: First, the country's consistently low rate of inflation puts upward pressure on the CHF's Purchasing Power Parity fair value. This exacerbates demand for the Swiss franc as a global store of value. This creates a virtuous feedback loop of inflows, a stronger currency, lower inflation, and further inflows. Second, Switzerland sports a large positive net international investment position of 125% of GDP, which generates a net positive international income for Switzerland: 5.3% of GDP annually. Not only does this net positive income generate demand for the franc, but countries with much more international assets than liabilities historically experience appreciating real exchange rates. Third, at 8.5% of GDP, Switzerland has the largest basic balance-of-payments surplus in the G10. It has sported a favorable basic balance vis-à-vis the euro area over the past nine years, generating significant upward pressure on the currency (Chart 4). This basic balance-of-payments advantage is set to remain in place as Switzerland runs a current account surplus, and long-term capital continues to be attracted by Switzerland's low tax rates and investor-friendly climate. Brexit jitters are an additional factor favoring FDI inflows into Switzerland. Fourth, the euro area crisis, its associated double-dip recession and long periods of political risk generated a perception that the euro would break up. This stimulated large capital outflows out of the euro area into stable Switzerland. This created a cyclical boost to the Swiss franc beyond the normal structural positives. The strong upward bias to the CHF is not leaving the SNB unmoved. The Swiss central bank has been vocal in expressing its discontent, arguing that the franc is expensive. However this expensiveness does not seem evident when one looks at EUR/CHF against its Purchasing Power Parity equilibrium (Chart 5). EUR/CHF is only trading at marginal discount to its fair value, implying a small premium for the CHF. The reality is that PPP models do not tell the full story for the franc. When looking at Swiss labor costs, the expensiveness of the Swiss franc becomes obvious (Chart 6). By 2015, Swiss unit labor costs converted into euros had risen by 80% compared to 2000 levels. Even after the recent rally in EUR/CHF, Swiss ULCs are still 60% above their 2000 levels, implying a great loss of competitiveness than that experienced by Italy or France over the same timeframe. The Swiss franc may be attractive as a store of value, but this is now hurting the Swiss economy. Chart 5Modest Apparent Overvaluation##br##On A PPP Basis... Chart 6...But An Evident Overvaluation ##br##On A Labor Costs Basis Bottom Line: Thanks to Switzerland's low inflation, large positive net international investment position and basic balance-of-payments surplus, and its safe-haven status, the Swiss franc has been on an appreciating secular trend. Moreover, this long-term strength has been supercharged by the euro area crisis. The CHF has now made Switzerland uncompetitive. Avoiding The Specter Of Irving Fisher If the CHF is expensive, making the Swiss economy uncompetitive, why does Switzerland still have a trade surplus of 11% of GDP, and why is the Swiss unemployment rate not greater than 2.9%? One side of the answer relates to the behavior of Swiss export prices. When the franc is strong, Swiss exporters cut down the price of their products in order to remain competitive abroad (Chart 7). However, the story does not end there. The flexible nature of the Swiss labor market provides an offset to buffer corporate profitability. According to the World Economic Forum, Switzerland has the most efficient labor market in the world, well ahead of other major continental European economies (Chart 8). Swiss employers therefore hold the upper hand in labor negotiations. Chart 7A Strong Swiss Franc Hurts Selling Prices Chart 8The Swiss Labor Market Is Very Flexible In order to contain labor costs, companies have shifted the composition of the labor force. Full-time employment has been contracting since 2016 while all the jobs created have been part-time positions (Chart 9), resulting in elevated labor underutilization. Additionally, employers have been able to exact important concessions from workers, further depressing wage growth, which has averaged 0.5% per annum over the past three years (Chart 9, bottom panel). Low wage growth and labor underemployment have weighed on inflation through two channels: First, the Phillips curve is alive and well in Switzerland, and the current level of unemployment is consistent with low inflationary pressures (Chart 10). Chart 9The Swiss Job Market Is Weaker Than It Looks Chart 10The Swiss Phillips Curve Is Alive Second, low wage growth has translated into subdued household income gains. But at 216% of disposable income, Swiss households have one of the highest debt levels in the OECD. Without income growth, consumption growth has been limited. Swiss real retail sales have been falling more or less in a straight line since 2014 (Chart 11). In essence, the Swiss economy is experiencing a deflationary adjustment similar to the one undergone by Germany in the wake of the Hartz IV reforms implemented in 2005. These reforms put downward pressure on German wages and domestic demand, and fomented deflationary forces. However, 2005 was another era. The negative impact on German demand was buffeted by the extraordinary strength of the global economy, which boosted German exports. Switzerland does not enjoy this luxury: Since the Great Financial Crisis, global growth has been more muted, and global trade is not expanding anymore (Chart 12). Chart 11Regaining Competitiveness ##br##Is Hurting Domestic Demand Chart 12Germany Had ##br##It Easy Because of this lack of a foreign relief valve, weakness in the domestic economy has had another pernicious impact: Switzerland has not experienced any productivity growth since the Great Financial Crisis (Chart 13). As a consequence, the Swiss output gap remains in negative territory, further exacerbating the deflationary pressures created by the expensive Swiss franc (Chart 14). It is unsurprising that despite a massive surge in the central bank's balance sheet, generating inflation remains difficult in Switzerland. Chart 13No Productivity Growth Since 2008 Chart 14Swiss Output Gap Is Negative Finally, even the Swiss price measures theoretically unaffected by the output gap are declining. Owner-occupied home prices are contracting at a pace of 1% per annum (Chart 15). Since 2013, net migration in Switzerland has been declining, weighing on demand for housing. The 2014 referendum to curb immigration, put forward by the right-wing Swiss People's Party, has only added further downward impetus to immigration. Chart 15Real Estate Is Deflationary When deflationary forces are as strong and well-entrenched as they are in Switzerland, and when the economy is burdened by a large debt load - Swiss nonfinancial debt stands at 248% of GDP, the highest in the G10 - a nation runs the risk of entering into the debt-deflation spiral described by Irving Fisher in 1933.1 Falling prices can force a liquidation of debt, which forces further contraction in nominal output, forcing more debt liquidation, and so on. Calling a great depression in Switzerland is too radical, but the country could experience a Japanese scenario of many lost decades if inflation does not return. Therefore, it is no wonder that the SNB is obsessed with keeping monetary conditions as accommodative as possible. Since the exchange rate has a disproportionate impact on monetary conditions for economies as open as Switzerland, this means the SNB is likely to continue to target a weaker Swiss franc for longer. Bottom Line: An expensive Swiss franc has not caused the Swiss economy to experience a trade deficit because the Swiss labor market is so flexible. Instead, an expensive CHF has generated acute downward pressures on wages, domestic demand, and prices. This deflationary environment is especially dangerous for Switzerland as its private sector is massively over-indebted, raising the specter of the debt-deflation spiral described by Irving Fisher. The SNB will keep fighting these dynamics. What's In Store For The SNB? Chart 16Bern Is Tight-Fisted If Swiss fiscal policy was very easy, monetary policy would not have to be as accommodative. After all, Switzerland has fiscal legroom. Government net debt stands at 23% of GDP, the overall fiscal balance is at zero, and Bern enjoys a small cyclically-adjusted primary surplus of 0.3% of GDP. Moreover, after having purchased massive amounts of euros, the SNB is expecting to generate a profit of CHF54 billion in 2017 in the wake of the rally in EUR/CHF. Each canton is set to receive an additional windfall of CHF1 billion in addition to the normal CHF1 billion dividend they normally receive. The country's conservative fiscal management, however, means that the fiscal spigot will not be opened. The so-called "debt brake" rule introduced in 2003 requires a balanced cyclically-adjusted federal budget on an ex ante basis, and in cases of ex post over- and under-spending, offsetting surpluses and deficits in subsequent years as required. As a result, the IMF forecasts that the fiscal thrust will remain near zero for the coming years (Chart 16). Fiscal policy will therefore not come to the rescue. This means the SNB will want to ease monetary conditions further to push demand and inflation back up. Therefore, the SNB will continue to target a weaker CHF in the coming years. Chart 17The SNB Will Keep Rates Below The ECB... Despite this outcome, life for the SNB is getting easier, and its balance sheet will not expand much further. Euro area growth has been recovering, and European political instability has declined. As a result, the probability of a euro breakup has dropped, and rate of returns in the Eurozone have increased. Consequently, hot money flows into Switzerland have abated and the SNB has not had to increase its sight deposits - a key measure of its involvement in the FX market - to push the Swiss franc down. However, to ensure the CHF enjoys a structural downtrend, the SNB will have to keep interest rates across the yield curve below euro area levels, especially as the Swiss leading economic indicator is currently outpacing that of the Eurozone's, which normally coincides with a weaker EUR/CHF (Chart 17). This does not mean that the SNB will cut rates further. European bond yields are moving up and the ECB is slated to increase rates in the summer of 2019. This means that the SNB will not adjust policy until after the ECB does. Doing otherwise would put upward pressure on the Swiss franc - exactly what the SNB wants to avoid at all costs. The SNB is likely to keep this policy in place until the Swiss franc trades at a significant discount to the euro. In our assessment, this means a EUR/CHF exchange rate of around 1.30. Bottom Line: The various levels of the Swiss government have no inclination to ease fiscal policy. The burden of stimulating growth and inflation will continue to rest squarely on the SNB's shoulders, which means it will keep targeting a lower CHF. Thanks to economic and political improvements in the euro area, the SNB can curtail its direct involvement in the FX market. However, creating a negative carry against the CHF will remain the main tool in the SNB's arsenal, so Swiss policy rates will lag the euro area. This policy will remain in place until EUR/CHF trades closer to 1.30. Investment Implications At this juncture, the primary trend in EUR/CHF continues to point upward. The ECB is giving firmer signals that its asset purchasing program will end this September. The implementation of this program was associated with massive outflows of long-term capital out of the euro area (Chart 18). Its end is likely to limit outflows to Switzerland. Additionally, lower Swiss interest rates will continue to hurt the trade-weighted Swiss franc. While the primary trend for EUR/CHF points north, we worry that it will not be a one-way street as it was in 2017. As we have highlighted, Switzerland enjoys a large net international investment position, and its incredibly low interest rates have made the Swissie a funding currency. These attributes also make the CHF a safe-haven currency. Therefore, the franc is likely to rally each time global volatility picks up.2 While BCA expects risk assets to continue to appreciate through most of 2018, prices are likely to become more volatile: China is tightening policy and global central banks are progressively removing monetary accommodation in response to a slow return of inflation.3 These bouts of volatility will cause the occasional selloff in EUR/CHF along the way. The surge in the VIX on February 5th of this year provided a good template for the kind of gyrations that EUR/CHF will likely experience. Nonetheless, despite these occasional surges in volatility, we do expect EUR/CHF to end the year closer to 1.30. In fact, the return of volatility will further ensure that the SNB will lag the ECB in tightening policy. Finally, investors looking to buy EUR/CHF but who worry about these occasional bouts of volatility may hedge this trade by buying put options on AUD/CHF. This cross tends to experience more violent selloffs than EUR/CHF when global volatility rises, and it is furiously expensive on a long-term basis (Chart 19). Moreover, the balance-of-payments picture is very attractive for shorting this pair, as Australia runs a current account deficit of 2.3% of GDP, while Switzerland runs a surplus of 10%. Chart 18...But It Will Be Less Active In The FX Market Chart 19Short AUD/CHF As A Hedge Bottom Line: EUR/CHF is likely to appreciate to 1.30 this year as the SNB will lag the ECB when it comes to removing monetary accommodation. This trend is likely to be punctuated by violent selloffs associated with the return of volatility in global financial markets. Buying puts on AUD/CHF is an attractive way to hedge this risk. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Irving Fisher (1933), “The Debt-Deflation Theory of Great Depressions,” Econometrica, Vol. 1, No. 4 (Oct., 1933), pp. 337 - 357. 2 Please see Foreign Exchange Strategy Special Report, "Carry Trades: More Than Pennies And Steamrollers," dated May 6, 2016, available at fes.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018, available at gis.bcaresearch.com; and Foreign Exchange Strategy Weekly Report, "The Return Of Macro Volatility," dated March 16, 2018, available at fes.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades