Developed Countries

Overweight The S&P containers & packaging index has been underperforming since the beginning of the year as the spiking input costs of last year materialized in soft Q4 earnings, compounded by fears over a trade war. However, those costs have fallen substantially since the end of the year (second panel) and gross margins should eventually return to normal; trade fears have moderated. In the longer term, we think the focus should remain on the drivers of demand, namely global growth (a key BCA theme for this year). Both volumes and prices have maintained a steady uptrend (third panel) and the sell side has taken notice as relative forward EPS are climbing at the fastest pace in a decade (bottom panel). Combined with the index's weak performance YTD, a sizeable buying opportunity is taking shape; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, PKG, SEE, AVY.

Highlights Two big distortions in the euro area economy arose because Germany depressed its wages for a decade, and then Italy failed to fix its broken banks for a decade... ...but both distortions are now correcting. Long-term property investors in Europe should seek out undervalued gems on the Greek islands, Portuguese Atlantic coast, Italy and German second-tier cities. Steer clear of Scandinavia, France and central London. Stay overweight a basket of German real estate stocks. Maintain a long basket of German consumer services versus a short basket of exporters comprising autos, chemicals and industrials. Feature In Germany and Italy, real house prices are at the same level today as they were in 1995 (Chart of the Week). Germany and Italy share another similarity. Through the past two decades, they have delivered their workers the same subpar real wage growth (Chart I-2). Chart of the WeekThe Mirror Image Journeys Of German ##br##And Italian House Prices Chart I-2The Mirror Image Journeys Of ##br##German And Italian Wages However, while the point-to-point growth rates for both house prices and wages look identical, the journeys that Germany and Italy have travelled have been mirror images of one another. Germany's journey has been a decline followed by rapid ascent; Italy's journey has been a rapid ascent followed by decline. These mirror image journeys encapsulate the two big distortions within the euro area economy. The Euro Area's Two Big Distortions The euro area's first distortion arose from Germany's labour market reforms at the start of the millennium. Germany's labour reforms were putatively to boost productivity. In fact, the reforms' main impact was to depress German wages for a decade. The consequent boost in competitiveness caused symmetrical distortions: a bubble in German exports, and an anti-bubble in German household incomes. Before Germany joined the euro, such a distortion would have been impossible. An appreciating deutschemark would have arbitraged away any rise in export competitiveness. But an exchange rate appreciation could no longer happen once Germany was sharing its currency with other economies that were not replicating Germany's wage depression strategy. Hence, German household incomes - and house prices - have been one of Europe's biggest losers in the single currency era. Conversely, Germany's export-oriented companies - and their shareholders - have been amongst the biggest winners (Chart I-3). Just consider, the Siemens dividend is up almost one thousand percent! The euro area's second distortion arose because Italy failed to fix its broken banks for a decade. After a financial crisis such as in 2008, the golden rule is to nurse the financial system back to health as quickly as possible. Which is precisely what all the major economies did. All the major economies, that is, apart from Italy (Chart I-4). Chart I-3Distortion 1: Germany Depressed##br## Its Wages For A Decade Chart I-4Distortion 2: Italy Failed To Fix Its ##br##Broken Banks For A Decade Italy procrastinated because its government is more indebted than other sovereigns and because its dysfunctional banks did not cause an acute domestic crisis. Nevertheless, Italy's reluctance to fix its banks is the central reason for its decade-long economic stagnation, and declining real house prices. The good news is that the euro area's two big distortions are now correcting. Germany is allowing its wages to adjust rapidly upwards. Meanwhile, in the space of just a year, Italy has raised almost €50 billion in equity capital for its banks. Italian bank solvency and loan quality have improved sharply. This raises an interesting question: do the German and Italian housing markets now offer compelling long-term investment opportunities? European Housing Markets: The Good, The Bad, And The Ugly Property investments offer income via rents. Over time, these rents should increase in real terms. Items such as a litre of milk or a London commuter train journey do not increase in quality. If anything, the London commuter train journey has decreased in quality! By contrast, accommodation does increase in quality. For example, kitchens and bathrooms, home security, and heating and cooling systems should all get better over time. In essence, the quality of accommodation benefits from productivity improvements, so real rents rise. Of course, such improvements require investment expenditure. But a property investor requires a return on this investment. Therefore, property income - even after expenses - should and does increase in real terms. What about capital values? In the long term, we would expect capital values to have some connection to rising real rents. So if real house prices have not increased over several decades, then it signals a very likely undervaluation. Conversely, if real house prices have increased an implausibly large amount over several decades, then it raises a red flag for a likely overvaluation (Chart I-5, Chart I-6, and Chart I-7). Chart I-5German Real House Prices Are No Higher Than In 1995 Chart I-6Scandinavian Real House Prices Have Trebled Since 1995 Chart I-7Italy, Portugal And Greece Offer Good Opportunities For Property Investors On this evidence, we expect the long-term returns from the housing markets in France, Netherlands, Belgium and Finland to be bad. More worrying, we expect the long-term returns from the housing markets in Sweden and Norway to be ugly. Real house prices have more than trebled since 1995. For this, blame the central banks. In recent years, Sweden's Riksbank and the Norges Bank have had to shadow the ECB's ultra-loose policy to prevent a sharp appreciation of their currencies. The trouble is that ultra-low and negative interest rates have been absurdly inappropriate for the booming Scandinavian economies. So the ECB's policy may indeed have generated credit-fuelled bubbles... albeit in Sweden and Norway. Chart I-8London House Prices Have Rolled Over We are also reluctant to own London property. London house prices have rolled over, and headwinds persist (Chart I-8). Theresa May wants to drag the U.K. out of the EU single market and customs union, which cannot be a good thing for London. On the other hand, if parliament forces May to soften her Brexit stance, it could fracture a precarious truce between hard and soft Brexiters in her cabinet and topple the government. Thereby, it could pave the way for a Jeremy Corbyn led Labour government and the spectre of a high-end 'land value' tax. So where are long-term returns likely to be good? We repeat that where house prices have shown no real increase from 25 years ago, it bodes very well for the long-term investment opportunity. This describes the situation for the housing markets in Germany, Italy, Portugal and Greece. To summarise, if you are looking for a long-term investment property in Europe, steer clear of Scandinavia, France and central London. And seek out undervalued gems on the Greek islands, Portuguese Atlantic coast, Italy and German second-tier cities. What Is The Related Opportunity In Equity Markets? Real estate holding and development companies and REITS are the equity market plays on real estate. The trouble is that the stocks are too few and too small for a meaningful investment in Greece, Italy and Portugal. However, in Germany, stay overweight the basket of real estate stocks which we first introduced a few years ago. The basket has outperformed by 50%, but the outperformance isn't over. In Germany, the catch-up of house prices is closely connected to the catch-up of household incomes. As Germany continues to reduce its export-dependence and rebalance its economy towards domestic demand, the catch-up has further to run. Chart I-9German Consumer Services Will ##br##Outperform Consumer Goods It is possible to play this structural theme in the equity market via an overweight in consumer services versus consumer goods. Consumer services tend to have more domestic exposure compared to the consumer goods sector which is dominated by autos. Understandably, during the era of German export-dominance, the German consumer services sector strongly underperformed consumer goods. But in recent years, as the German economy has rebalanced, the tables have turned. German consumer services have been outperforming German consumer goods (Chart I-9). We expect this trend to persist. Our preferred expression is to maintain a long basket of German consumer services versus a short basket of exporters comprising autos, chemicals and industrials. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week's recommendation is a commodity pair-trade: short nickel / long lead. The pair trade's 65-day fractal dimension is at the lower bound which has signalled several reversals in recent years. Set a profit target of 8% with a symmetrical stop-loss. We are also pleased to report that all of the four other open trades are comfortably in profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Underweight Last week we downgraded the S&P consumer discretionary index to a below benchmark allocation on the back of three key factors: a rising fed funds rate, quantitative tightening and higher prices at the pump. One of the charts we published, and are reprinting today, caught the attention of our good friend, who I refer to as the "smartest man in California", and he suggested a few of interesting tweaks to drive a point home. First, he recommended to switch the fed funds rate to the shadow fed funds rate, or the Wu-Xia model, in order to better capture the fact that the Fed was still easing monetary policy below the zero line post December, 2008 and until December, 2015 via QE (top panel). Second, if we were to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the chart would highlight that the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (top panel). Finally, while AMZN has a heavy weight in the broad consumer discretionary index (21%), its earnings weight is quite low (1.5%). Thus, overall consumer discretionary profits are indeed following the Fed's historical tightening path (second panel). Bottom line: We reiterate our underweight stance in the S&P consumer discretionary sector. Category: Consumer Discretionar

Highlights Fed preview: The Fed will hike rates again this week, and may signal a faster pace of future hikes given signs that U.S. inflation is starting to accelerate. Maintain a below-benchmark duration stance and stay underweight U.S. Treasuries in global hedged bond portfolios. Oversold U.S. Treasuries: While most indicators of positioning and momentum for U.S. Treasuries show a deeply oversold market, an analysis of past such episodes shows that it can take 4-6 months before bond yields correct an oversold condition in the absence of slowing growth or inflation - with yields potentially hitting new highs in the interim. ECB Tapering: The ECB strongly believes that the "stock effect" of its asset purchases matters more for European bond yields than the "flow effect". This suggests that the odds of a European "Taper Tantrum" later this year are low, although bond yields there are still headed higher. Feature Chart of the WeekThis Time Is Different? Global bond markets have calmed down after the big surge that started the year. The 10-year U.S. Treasury yield has traded in a relatively narrow 2.80-2.95% range since the VIX spike in early February, despite a string of weaker-than-expected U.S. economic data prints that has triggered sharp downgrades to Q1/2018 U.S. GDP growth forecasts. At the same time, 10-year benchmark yields for other major government bond markets (Germany, France, U.K., Canada) have been drifting lower, but remain above levels that began the year. In the case of U.S. Treasuries, the overall level of yields is being held up by the steady climb at the short-end of the yield curve. Recent hawkish comments from new Fed Chairman Jay Powell and long-time Fed dove Lael Brainard have raised expectations for a rate hike at this week's FOMC meeting, which is now priced as a certainty. The 2-year Treasury yield has climbed to a 10-year high of 2.3%, which is helping keep a floor underneath longer-term Treasury yields despite positioning indicators showing that traders and bond managers already have significantly reduced duration exposure (Chart of the Week). The other factor that is likely holding up global bond yields is the incremental move by the European Central Bank (ECB) towards a tapering of its asset purchases. The market has already repriced both future interest rate expectations and the term premia embedded in European government bond yields, although recent comments from ECB officials suggest that they believe that there will not be a "Taper Tantrum 2.0" in Europe similar to the Treasury market sell-off in 2013. This week, we tackle those two critical issues for bond markets head-on: the implications of large short positions in the U.S. Treasury market versus the ECB taper impact on global bond yields. Our conclusion is that the impact of both is likely overestimated by investors. How To Think About A Technically Oversold Treasury Market The Fed will deliver another rate hike this week. That outcome has already been fully discounted by the market, which should not be considered surprising given the current U.S. economic backdrop: Inflation: Underlying inflation has clearly bottomed out and has begun to accelerate, with the 3-month annualized growth rate of core CPI inflation now up over 3% (Chart 2). That trend should continue in the next several months: our model for CPI Shelter inflation is calling for a pickup (2nd panel), core goods inflation is showing signs of responding to the weakening U.S. dollar (3rd panel), and the big plunge in U.S. wireless phone prices that severely dampened inflation in 2017 is about to wash out of the year-over-year CPI data and boost core services inflation (bottom panel). Growth: Despite some recent signs of softening momentum in the Q1 data, the underlying trend in U.S. growth remains upbeat. Labor demand is accelerating and our payrolls growth model suggests further gains are coming (Chart 3). Corporate profit growth remains solid and the impact of the Trump tax cuts will only boost earnings momentum and business confidence. Leading economic indicators are also accelerating and suggest that any loss of growth momentum in Q1 - which seems to be an annual occurrence despite the seasonal adjustment of data - will be short-lived (bottom panel). Chart 2U.S. Inflation Is Starting To Perk Up Chart 3No Reason For Any Dovish Fed Surprises Financial Conditions: U.S. equity prices have recovered much of the losses suffered during the February VIX-driven correction, while corporate credit spreads remain narrow from a historical perspective (Chart 4). Add in the weaker U.S. dollar - the impact of which is already boosting import prices and potentially following through into the shorter-term inflation expectations of households (bottom panel) - and overall financial conditions remain highly accommodative. Against this positive backdrop, the Fed can feel confident that its growth and inflation forecasts for 2018 will be achieved, and that inflation expectations can continue to climb back to levels consistent with the Fed's inflation target. There is even a chance that the Fed could accelerate its planned pace of rate hikes (Chart 5), particularly if there is an upgrade to the FOMC growth and inflation projections, which will be updated for this week's meeting. Chart 4U.S. Financial Conditions##BR##Remain Accommodative Chart 5All Eyes On##BR##The Dots This Week Yet for all the positive economic, bond-bearish news, one fact stands out - the U.S. Treasury market is deeply oversold from a technical perspective. This should, in theory, limit the ability for bond yields to continue rising and could set up a short-covering bond rally if there is a more meaningful and prolonged slowing of economic growth or inflation. The technical indicators that we regularly monitor for the U.S. Treasury market are all at or near the extremes of the ranges observed since 2000 (Chart 6). Chart 6U.S. Treasuries Are Very Oversold The 10-year Treasury yield is 43bps above its 200-day moving average The 26-week total return of the Bloomberg Barclays U.S. Treasury index is -4.3% The J.P. Morgan client survey of bond managers and traders showed the largest underweight duration positioning since the mid-2000s, although there has been some recent reduction of those positions The Market Vane index of sentiment for Treasuries is now at 49, near the bottom of the range since 2000 The CFTC data on positioning in 10-year Treasury futures shows a large net short of -8%, scaled by open interest Given this degree of investor negativity toward U.S. Treasuries, some pullback in yields seems inevitable. However, a look back at past episodes where Treasuries were this oversold shows that the timing of such a pullback is highly variable - anywhere from one month to seven months. The determining factor is the growth and inflation backdrop in the U.S. To show this, we did a simple study using two series from our list of Treasury technical indicators. Specifically, we looked at "oversold episodes" since 2000 where the Market Vane Treasury sentiment index dipped below 50 and where the 10-year Treasury yield was trading at least 30bps above its 200-day moving average. We then defined the end of the oversold episode as simply the point when the 10-year Treasury yield fell back below its 200-day moving average. We then looked at the duration (in days), and change in bond yields, for each oversold episode. There were eleven such episodes since the year 2000, not counting the current one which has not yet ended. In Table 1, we list them ranked by the number of days it took to complete each episode as we defined it. The longest correction of an oversold Treasury market since 2000 took place between July 2003 and February 2004, where 203 days passed before the 10-year yield dipped back below its 200-day moving average. The shortest correction was in May 2000, where only 28 days were needed. Table 1A Look At Prior Episodes Of An Oversold U.S. Treasury Market To determine what the U.S. economic backdrop was during each episode, we then simply asked if economic growth was rising or falling, or if inflation was stable/rising or falling, using the ISM Manufacturing index and core PCE inflation as the relevant data series. The answers to those questions are found in the final two columns of Table 1. All the positioning and economic indicators used in our historical study, shaded for the oversold episodes, are shown in Charts 7, 8 and 9. Chart 7U.S. Treasury Market##BR##Oversold Episodes 2000-2005 Chart 8U.S. Treasury Market##BR##Oversold Episodes 2006-2011 Chart 9U.S. Treasury Market##BR##Oversold Episodes 2011 To Today The simplest conclusion that we reached from our study is that the shortest corrections of an oversold Treasury market occurred, unsurprisingly, during the two episodes where both growth and inflation were slowing, with an average length of each episode of 42 days. The four episodes where growth and inflation were both rising had a more variable performance, lasting anywhere from 98 days to 203 days, averaging 156 days per episode. The five episodes where growth was slowing but inflation was stable or rising were also of varying length, averaging 140 days. In other words, it has taken around five months, on average, to correct an oversold Treasury market when inflation was stable or rising, and about 1.5 months when inflation was falling. In the current environment, where the ISM Manufacturing index is in an uptrend and core PCE inflation is rising, we should expect a longer period of time before the Treasury market corrects its oversold condition. If we mark the start of the current episode on February 20th of this year, using the definition described above, then the 10-year Treasury yield may return to its 200-day moving average of 2.4% by August (five months from now). A word of warning for traders and investors looking to play for that move by flipping to a long duration position now, though - the primary trend of the market, defined by that 200-day moving average, is currently rising. It was also rising during the two longest oversold correction episodes 2003-04 and 2013-14. The 10-year Treasury yield only declined -14bps and -17bps, respectively, over those entire episodes. During the 2013-14 episode, also a period similar to today when growth and inflation were both rising, yields actually climbed to new cyclical highs before finally peaking. In other words, betting on a reversal of an oversold bond market without any deterioration in growth and inflation dynamics may generate only modest returns over a lengthy period, and with substantial mark-to-market volatility in the meantime. In the current cycle, with leading indicators for U.S. growth and inflation accelerating and the Fed becoming more hawkish, we recommend maintaining below-benchmark duration positions in the U.S. rather than positioning now for a short-covering rally. Bottom Line: The Fed will hike rates again this week, and may signal a faster pace of future hikes given signs that U.S. inflation is starting to accelerate. While most indicators of positioning and momentum for U.S. Treasuries show a deeply oversold market, an analysis of past such episodes shows that it can take 4-6 months before bond yields correct an oversold condition in the absence of a slowing of economic growth or inflation - with yields potentially hitting new highs in the interim. Maintain a below-benchmark duration stance and stay underweight U.S. Treasuries in global hedged bond portfolios. The ECB Is Betting On A Tantrum-Free Taper Several key ECB officials have been giving speeches over the past week, spelling out a consistent message to the markets on the future of euro area monetary policy. Most notably, ECB President Mario Draghi and ECB Chief Economist Peter Praet gave speeches last week at a conference in Frankfurt. Both of them used nearly identical language to highlight how the ECB's main policy tool going forward will no longer be net asset purchases, but instead will be interest rates and forward guidance on changes to rates.1 This echoes the message sent after the ECB's policy meeting earlier this month, when the commitment to increase the pace of asset purchases was dropped from the ECB policy statement. Both Draghi and Praet repeated the ECB's official stance on the end of asset purchases, which requires a "sustained adjustment" in the path of inflation. This was described by Draghi as: Specifically, a sustained adjustment requires three conditions to be in place. [...] The first is convergence: headline inflation has to be on course to reach our aim over a meaningful definition of the medium term. The second is confidence: we need to be sure that this upward adjustment in inflation has a sufficiently high probability of being realized. The third condition is resilience: the adjustment in inflation has to be self-sustained even without additional net asset purchases. Draghi then went on to add these comments on the sequencing of rate hikes after the asset purchases are completed, with our emphasis added: [...] when progress towards a sustained adjustment in the path of inflation is judged to be sufficient, net purchases will come to an end. At that point, next to our forward guidance, appropriate financial conditions will be maintained by our reinvestment policy. [...] as regards the evolution of our policy rates beyond the end of our net purchases, we will maintain the sequencing that is currently set out in our forward guidance, namely our pledge to keep key interest rates at their current levels "well past" the end of net purchases. This time-based element of our guidance is already vital today, in particular to ensure that our policy stimulus is not weakened by premature expectations of a first rate rise, and so financial conditions remain consistent with inflation convergence. That last line can be roughly translated from policymaker-speak as "we want to avoid a Fed-style Taper Tantrum when we stop buying euro area government bonds." Chart 10An Orderly Repricing Of ECB Expectations Praet made similar comments in his speech, discussing how the first rate hike after the end of asset purchases must only take place once there is a "durable convergence" of euro area inflation with the ECB target of just below 2% on headline inflation. So far, the markets have been heeding the ECB's communication and policy guidance. The timing of the ECB's first full 25bp rate hike, taken from our "months-to-hike" indicator, shows that the market does not expect the ECB to adjust rates until November of 2019 (Chart 10). At the same time, the market is only slowly repricing the term premium on longer-dated euro area government bonds, which would be expected if the ECB were to take its time in fully tapering its asset purchases. With realized euro area inflation, and market-based inflation expectations, still well short of the ECB's target, the market appears to be "correctly" following the ECB's guidance on the timetable for future policy moves. This is keeping euro area bond yields at low levels and dampening interest rate volatility. There may be another factor at work holding down bond yields, however. In a speech given at the U.S. Monetary Policy Forum in New York last month - an event attended by numerous academic and Wall Street economists, as well as several current FOMC members - ECB Executive Board Member Benoit Coeure discussed the importance of the "stock" effect of central bank asset purchases compared to the "flow" effect.2 Or as Coeure described it: [...] the "stock effect" - that is, the persistence of the effects of the stock of bonds held by the central bank on its balance sheet under a commitment of reinvestment. If the effects of purchases dissipate quickly, a shorter purchase horizon could lead to term premia rising even as interest rate expectations remain well anchored by forward guidance. Financial conditions would then tighten. But if the effectiveness of asset purchases rises with the stock of assets already acquired - if there is some "crossover point" where the stock effect becomes more important than the continued flow of purchases - then a reduced pace of purchases would not unduly decompress the term premium. This brings up an interesting point about the ECB's policy strategy as it prepares to taper its asset purchase program. If the ECB can effectively communicate that it will continue to reinvest the maturing bonds on its balance sheet after the new asset purchases have stopped, then the market will not price in a bigger term premium on longer-dated bonds since the ECB will continue to own a huge share of the stock of euro area government debt. The stock effect will dominate the diminishing flow effect. Coeure noted in his speech that the experience of the U.S. in 2013, when Ben Bernanke surprised markets with talk that the Fed was planning on cutting back its asset purchases, is different than Europe today. The biggest reason is that the ECB owns a far bigger share of the European bond market than the Fed did at that time. That is because the ECB asset purchases since its bond buying program began in 2015 have dwarfed the net issuance of euro area government debt (Chart 11). At no point during the Fed's quantitative easing (QE) era did the central bank ever buy more U.S. Treasuries than the U.S. government was issuing. According to the logic of Benoit Coeure, the smaller Fed "footprint" in the Treasury market relative to the ECB's ownership share of euro area government bonds (Chart 12) should mean that the Treasury term premium will be more volatile than that for German bunds (and other euro area debt). That is because a greater share of Treasury issuance must be sold to private investors who are more price-sensitive than central banks. In other words, the flow effect dominates the stock effect. Chart 11ECB & BoJ Have Been Absorbing##BR##All Net Government Bond Issuance Chart 12The 'Stock Effect' Of QE##BR##Should Be Bigger In Europe & Japan In Chart 13, we try and visually prove Coeure's thesis. The chart plots the gap between central bank asset purchases and net government bond issuance (the blue solid line proxying the "flow effect", using IMF data) for the U.S., euro area and Japan versus our estimates of the term premium (the black dotted line). The correlation appears to be very strong for the euro area and Japan during the era of asset purchases for those central banks, perhaps due to the "stock effect" dominating the "flow effect". This differs from the experience seen in the U.S. during the Fed QE era, when there was no stable relationship between the term premium and the amount of Treasuries the Fed was purchasing relative to net issuance. Looking ahead, there are important implications of this "stock vs. flow" argument for the future direction of euro area (and Japanese) bond yields, both in absolute terms and relative to U.S. Treasuries. In Chart 13, we also added BCA's forecasts for net government bond issuance over the next two years relative to our projections for the pace of asset purchases from the ECB and BoJ (both new purchases and reinvestments), and the Fed's own projections for the runoff of Treasuries from its balance sheet. Our estimates show that there will still be no new government bond issuance for the private sector to absorb in the euro area and Japan in 2018 and 2019, even with the ECB expected to fully taper new buying to zero by the end of this year and the BoJ dramatically cutting back its pace of buying. This contrasts to the U.S., where the private sector will be forced to absorb an extra US$1 trillion (!) of Treasuries this year and next, thanks to the huge Trump fiscal stimulus and the diminished buying by the Fed. U.S. private investors may require a higher yield (i.e. term premium) to absorb that additional debt, especially if inflation expectations are rising and the Fed is hiking interest rates at the same time. The implication is that the spread between Treasuries and euro area debt (and Japanese bonds, for that matter) could stay stubbornly wide - at least until there is more decisive evidence that the U.S. economy is in a cyclical slowdown that would put the Fed rate hiking cycle on hold (Chart 14). Chart 13The 'Flow Effect' Of##BR##QE Does Still Matter Chart 14The 'Stock Effect' Could Keep The##BR##UST-Bund Spread Wider For Longer From the point of view of euro area debt, however, the existence of a "stock effect" means that those investors expecting a Taper Tantrum 2.0 will likely be disappointed in the size of any upward move in euro area bond yields this year. Bottom Line: The ECB strongly believes that the "stock effect" of its asset purchases (how much they already own) matters more for European bond yields than the "flow effect" (how much they are buying). This suggests that the odds of a European "Taper Tantrum" later this year are low, although bond yields there are still headed higher. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The Draghi speech can be found at http://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180314_1.en.html, while the Praet speech can be found at http://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180314_2.en.html 2 Coeure's speech can be found at https://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180223.en.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Overweight Railroad stocks have recently seen a spike in forward EPS which has eliminated the valuation premium and now the rails are trading on par with the SPX on a forward P/E basis (second panel). The track is now clear and more gains are in store for relative share prices in the coming quarters. Industry operating metrics point to a profit resurgence this year. Importantly, our rails profit margin proxy (pricing power versus employment additions) has recently reaccelerated both because selling prices are expanding at a healthy clip and due to labor restraint (third panel). Demand for rail hauling remains upbeat and our rail diffusion indicator has surged to a level last seen in 2009, signaling that there is a broad based firming in rail carload shipments (bottom panel), particularly the ever-important coal and intermodal segments. Bottom Line: Continue to overweight the broad S&P transportation index, and especially the heavyweight S&P railroads sub-index; please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU.

Highlights Economy: Some of the economic data that feed into GDP have weakened during the past two months, but the fundamental drivers of economic growth remain strong. We continue to expect GDP growth close to 3% in 2018. Markets & Inflation: Bond yields fell during the past few weeks, but so far there is no suggestion that the bond bear market has been derailed. Expect yields to rise in the coming weeks, driven by higher inflation. State & Local Governments: State & local governments still have work to do to repair their fiscal situations. While this process will lead to continued improvement in municipal bond credit quality, it also means that state & local government spending will not provide a significant boost to economic growth. Money Markets: LIBOR/OIS spread widening does not reflect a re-assessment of credit risk in the financial system, but it does present an opportunity for U.S. investors to increase their returns by investing in foreign bonds. Feature Chart 1Growth Scare 2018? A consensus appears to have formed around the outlook for U.S. economic growth. The expectation is that growth, which was already on a solid footing in late-2017, will kick into an even higher gear this year on the back of more stimulative fiscal policy. In fact, Bloomberg consensus forecasts already called for 2018 U.S. GDP growth of 2.3% last October and have ramped up to 2.78% since then. We think it's safe to say that both investors and the Fed have bought into this view, and this makes it concerning that some data have challenged the prevailing narrative in recent weeks. Specifically, a series of disappointing data releases have caused the Atlanta Fed's GDP tracking estimate for first quarter growth to fall to 1.8% (Chart 1). A month ago this same model was calling for growth of 5.4%! Growth Scare 2018? First, we should note that while the Atlanta Fed's GDP tracking estimate for Q1 has declined, as of last Friday, the New York Fed's similar estimate remains at 2.73% (Chart 1). Further, our simple estimate for U.S. GDP growth derived from labor market data shows that growth is tracking close to 3% so far this year.1 Both our simple measure and the New York Fed's model suggest that U.S. growth is running significantly above its 2.2% average since 2010, while the Atlanta Fed's 1.8% estimate suggests it has fallen below its average post-crisis pace. The weakness in the Atlanta Fed model appears to be driven by some hard data - retail sales, durable goods orders and building permits - that have weakened during the past couple months. In general, we note that these measures are still growing more quickly than they were last year, and that the fundamental factors underpinning each component of growth remain strong. We consider each component of growth in turn. Consumer Spending The biggest reason to be pessimistic about consumer spending growth in the first quarter is that core retail sales have been weak for three months in a row.2 Core retail sales contracted in December and January, and increased by only 0.1% in February. However, taking a step back we see that retail sales accelerated sharply between September and November 2017. Even after the recent weakness, the year-over-year growth rate in core retail sales is still above levels observed throughout most of 2016 and 2017 (Chart 2). But more importantly, the fundamentals underpinning consumer spending remain strong and have not corrected at all during the past three months. Disposable income growth is trending higher and recently received a boost from tax cuts. Employment growth has also been strong - averaging +190k during the past 12 months - despite an already tight labor market. These factors have led to a rising trend in our real consumer spending model (Chart 2, panel 2). Finally, while the savings rate is already low and unlikely to fall further, it is also unlikely to rise significantly while consumer sentiment is elevated. The University of Michigan Consumer Sentiment Index hit 102 in March, its highest reading since 2004 (Chart 2, bottom panel). Chart 2Consumer Spending Chart 3Nonresidential Investment Non-Residential Investment Much like with retail sales, new orders for core durable goods have also contracted in each of the past two months, but the year-over-year growth rate is still high compared to the past few years. Meanwhile, our composite indicator of new orders surveys suggests that the recent decline will quickly reverse (Chart 3). Inventories have also been a drag on GDP growth in recent quarters but, according to our model, should increase going forward (Chart 3, bottom panel). Residential Investment The Atlanta Fed model expects residential investment to contribute negatively to GDP growth in the first quarter. This is largely due to the fact that single family building permits declined in January and February. But once again, so far there is no indication that this downtrend will persist. First, housing inventories continue to contract (Chart 4). Inventories typically increase prior to meaningful downturns in residential investment. Second, while higher mortgage rates have certainly dented housing affordability, homes are still much more affordable than prior to the financial crisis, and so far higher rates have not caused mortgage applications to roll over (Chart 4, panel 2). Household formation, the driver of demand for residential investment, is still in a multi-year uptrend and will continue to rise as long as income growth remains strong (Chart 4, panel 3). Fundamentally, it is difficult to see how residential investment can fall meaningfully when household formation is rising and home inventories are already low. Homebuilders appear to agree with this sentiment and are reporting levels of confidence near all-time highs (Chart 4, bottom panel). Chart 4Residential Investment Chart 5Net Exports Net Exports The Atlanta Fed's model projects that net exports will subtract 0.55% from GDP growth in Q1. This is driven mainly by February's sharp deterioration in the trade balance (Chart 5). While net exports are not the most important driver of U.S. growth, this is one area where that could see more downside in the long-run, depending on how much of the government's anti-trade rhetoric turns into law. In the short-run, dollar depreciation should provide at least some positive offset (Chart 5, bottom panel). Financial Conditions Financial conditions are another important driver of economic growth. A few months ago both the BCA Boom/Bust Indicator and the Financial Conditions component of our Fed Monitor were calling for a sharp acceleration in U.S. GDP. This is no longer the case, and the indicators are now consistent with stable or slightly higher GDP growth (Chart 6). However, we should also note that the Financial Conditions component of our Fed Monitor has not actually tightened. It has merely leveled-off at extremely easy levels (Chart 6, bottom panel). Since it is the change in financial conditions that impacts GDP, the leveling-off is consistent with relatively stable GDP growth. Chart 6Financial Conditions Government Spending In a prior report we noted that the combination of tax cuts and the recent spending bill will add 0.8% to GDP this year and 1.3% in 2019. This is a sharp swing from the -0.5% fiscal impulse that was expected prior to the legislative changes.3 Federal government spending will certainly contribute positively to GDP growth this year. But we expect much less of a growth boost (if any at all) from state & local governments. This is discussed further in the section titled "State & Local Governments Still Cautious" below. Bottom Line: Some of the economic data that feed into GDP have weakened during the past two months, but the fundamental drivers of economic growth remain strong. We continue to expect GDP growth close to 3% in 2018. Bond Market Still Taking Cues From Inflation While the outlook for economic growth is always important, recently bond markets have been more driven by inflation, a topic where there is much less consensus in the investment community. Most recently, the 10-year Treasury has fallen 5 basis points since March 9th, with 4 bps of that decline concentrated in the inflation component. The 10-year real yield has fallen by only a single basis point. As we explained in a recent report, the first stage of the cyclical bond bear market is being driven by the re-anchoring of inflation expectations.4 The 10-year TIPS breakeven inflation rate is currently 2.08% and we think it will eventually settle into a range between 2.3% and 2.5%. The decline in the TIPS breakeven rate of the past few weeks is partly explained by a drop in oil prices, but we note that broader commodity indexes have not rolled over (Chart 7). This suggests that weakness in the oil price is not evidence of a broader demand shock and should prove transitory. But even more importantly, the actual inflation data are starting to rebound. Last week's CPI release showed that the 12-month rate of change in core CPI ticked up slightly to 1.85%, but also that the annualized 3-month rate of change jumped sharply above 3% (Chart 8). Further, shelter - the largest component of core inflation - had been trending lower during the past couple years, but leading indicators now suggest a reversal. The rental vacancy rate fell in the fourth quarter of last year for the first time since Q2 2016 (Chart 8, panel 3), and the rate of appreciation in home prices has accelerated (Chart 8, bottom panel). The biggest near-term risk to the bond bear market is that investor over-optimism with regards to the growth outlook leads to a period of negative data surprises. We have previously noted a strong correlation between whether the economic surprise index is above or below zero and whether bond yields rose or fell during the preceding month.5 We also created a model to get a sense of the surprise index's average pace of mean reversion (Chart 9). At the moment, our model forecasts that the surprise index will be close to +20 one month from now. So for now there is no imminent signal that the bond bear market will be derailed, but we will closely monitor data surprises to see if that message changes. Chart 7Breakevens Still Trending Higher Chart 8Inflation Coming Back Chart 9Data Surprises Are Mean Reverting Bottom Line: Bond yields fell during the past few weeks, but so far there is no suggestion that the bond bear market has been derailed. Expect yields to rise in the coming weeks, driven by higher inflation. State & Local Governments Still Cautious As was stated earlier, state & local governments are unlikely to follow the example of the federal government when it comes to spending. In fact, state governments have once again started to raise taxes and reduce budgets. Data for the 2018 fiscal year are shown in Chart 10, and the message is that states have enacted significant revenue increases compared to prior years, and more states are once again raising taxes than are cutting taxes. Further, the National Association of State Budget Officers has noted that of the states that have already announced their 2019 budgets, most have called for another year of slow spending growth and a few states are actually penciling-in declines in general fund spending.6 This should not be too surprising, even nine years into the economic recovery state & local governments are still barely bringing in enough revenue to cover their interest expenses (Chart 11), though they have made considerable progress re-building rainy day fund balances (Chart 12). As for the implications for municipal bond investors, as long as governments maintain focus on improving their fiscal situations than the outlook for credit quality will continue to improve. Our Municipal Health Monitor is still deep in "improving health" territory, a signal that is consistent with ratings upgrades outpacing downgrades for the time being (Chart 13). Chart 10State & Local Government Spending Chart 11Not Much Revenue Buffer Chart 12Rainy Day Funds Rebuilt Chart 13Muni Credit Quality Is Strong Bottom Line: State & local governments still have work to do to repair their fiscal situations. While this process will lead to continued improvement in municipal bond credit quality, it also means that state & local government spending will not provide a significant boost to economic growth. Wider LIBOR/OIS Spread An Opportunity For U.S. Investors Chart 14LIBOR / OIS Spread Widening Explained One trend that has caught investors' attention in recent weeks is the impressive widening in the spread between LIBOR (the cost of unsecured U.S. dollar financing for banks) and the overnight index swap (OIS) rate (the purest measure of the market's fed funds rate expectations). Traditionally, we think of the LIBOR/OIS spread as a measure of credit risk in the financial system. This is because LIBOR is an unsecured agreement between two banks, therefore in theory, it embeds some risk that the counterparty bank will default. But it's important to note that the LIBOR/OIS spread can also rise for idiosyncratic reasons related to the supply and demand for U.S. dollars. For example, when U.S. dollars are scarce, investors are willing to pay more to acquire them and this pressures the USD LIBOR rate higher relative to the OIS rate. In a completely efficient market, competition would then entice counterparties to offer lower LIBOR rates until they eventually only reflect the perceived credit risk of the banking system. However, there is a strong case to be made that strict post-crisis regulations, by making it costly for banks to hold low-margin assets on their balance sheets, have made the market less efficient at arbitraging movements in the LIBOR/OIS spread. This appears to be what is going on at the moment. In recent weeks a confluence of idiosyncratic events have led to both a lower supply and higher demand for U.S. dollars. First, the U.S. government raised the debt ceiling until 2019. The Treasury department is therefore using this breathing room to re-build its cash balance. It accomplishes this by issuing T-bills. As more T-bills are issued U.S. dollars are drained from the market, putting upward pressure on LIBOR. Notice that the spread between the 3-month T-bill rate and the 3-month OIS rate is widening in concert with the LIBOR/OIS spread (Chart 14). Second, companies' new ability to repatriate cash that had been held overseas has a similar impact on LIBOR. That overseas cash had been a source of demand in money markets, but it is now being re-deployed in the form of increased dividends or share buybacks (Chart 14, bottom panel). This is akin to draining U.S. dollars out of the market. Third, the Fed continues to shrink its balance sheet. As this process plays out the Treasury will have to ramp up its issuance, some of which will come in the form of T-bills that will drain even more U.S. dollars out of the market. Going forward, the Treasury department will eventually re-build its cash balance to a level it deems acceptable. This will cause T-bill issuance to taper off, though it will still remain quite strong due to rising deficits and the run-off of the Fed's balance sheet. Similarly, the one-time effect of corporate repatriation will ease over time, though companies may also be less enticed to hold overseas cash balances in the future. All in all, we would expect the widening in LIBOR/OIS to ease in the coming months, but it may take a very long time before it returns to its prior lows, if it gets there at all. A large enough easing of bank capital requirements would likely cause the LIBOR/OIS spread to return to its recent lows, but this does not appear to be an imminent risk. Then, to complicate matters even further, we also have to reckon with the fact that LIBOR is being phased out during the next few years. In fact, the Fed will start publishing its Secured Overnight Financing Rate (SOFR) next month. The SOFR rate will eventually replace LIBOR as the U.S. dollar benchmark for financial contracts, and over time more and more instruments will be tied to SOFR and fewer will be tied to LIBOR. We also would not rule out the possibility that SOFR replaces the fed funds rate as the Fed's target policy rate at some point down the road. The Implication For U.S. Investors Chart 15An Opportunity For U.S. Investors A wider LIBOR/OIS spread has one very important implication for U.S. investors. U.S. investors can take advantage of the scarcity of U.S. dollars in the financial system by swapping their dollars for foreign currencies over short time horizons. In other words, a U.S. fixed income investor can invest in a 10-year foreign government bond, and then increase the received yield by hedging the currency risk. For example, a U.S. investor can receive a yield of 3.3% on a 10-year German bund if they hedge the currency risk on a 3-month horizon. This is a greater yield than they would earn on a 10-year U.S. Treasury note. Without the wider LIBOR/OIS spread the hedged yield would not be nearly as high. If we assume the LIBOR/OIS spread is zero, then the hedged yield on a 10-year German bund falls to 2.80%. Chart 15 shows that as the return from currency hedging increases, U.S. investors earn more from hedged positions in foreign bonds than in domestic bonds. A wider LIBOR/OIS spread gives U.S. investors an extra incentive to put on these global trades. Bottom Line: LIBOR/OIS spread widening does not reflect a re-assessment of credit risk in the financial system, but it does present an opportunity for U.S. investors to increase their returns by investing in foreign bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 For further details on this estimate please see U.S. Bond Strategy Weekly Report, "Brainard Gives The Green Light", dated March 13, 2018, available at usbs.bcaresearch.com 2 Core retail sales exclude building materials, auto dealers and gas stations. 3 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 6 http://budgetblog.nasbo.org/budgetblogs/blogs/brian-sigritz/2018/01/12/governors-begin-releasing-fiscal-2019-budget-propo?CLK=7543618f-810a-4ac4-90e2-01a4b310c649 Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Consumer spending is well supported despite weak readings on household purchases in early 2018. The recent rollover in M&A activity does not signal a top in equity markets nor warns that a recession looms. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. Feature Investors began to worry last week about a slowing U.S. economy sending prices of risk assets and Treasury yields lower. The threat of a wider trade spat with China was also a concern, along with the latest round of political intrigue at the White House. Oil fell more than 1% on supply concerns. While the U.S. economic surprise index moved lower since the start of the year, BCA's view is that the U.S. economy is poised to grow well above potential in the first half of the year. Consumer spending is well supported despite weak readings on household purchases in early 2018. The FOMC will provide a new set of economic forecasts and dot plots at this week's meeting. BCA expects the Fed to raise rates this week and three additional times this year. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. According to our U.S. Equity Strategy service's "buy the dip" cycle-on-cycle analysis, a retest of the recent equity lows typically occurs in the first month following the initial shock, suggesting that the S&P 500 is already out of the woods.1 The return of vol may keep a lid on the SPX for a while longer, but our strategy since February 8 is to buy the dips as we do not foresee an end to the business cycle in 2018. Moreover, the recent weakness in M&A activity is not a sign that the bull market is finished. Despite the dip below 2.90% last week, BCA's U.S. Bond Strategy services pegs fair value for the 10-year Treasury yield at 2.96%.2 Assuming a 3% terminal fed funds rate, our U.S. Bond Strategy team expects the 10-year Treasury yield to peak somewhere between 3.08% and 3.59%.3 Too Cold? Chart 1Weak February Retail Sales At Odds##BR##With Strong Consumers Fundamentals The Tax Cut and Jobs Act put extra cash into consumers' pockets and helped to lift consumer confidence to a cycle high. Household net worth is at a record level, the labor market is strong and wage growth is accelerating, albeit modestly at this point in the cycle. Despite the favorable backdrop, consumers are on the sidelines in early 2018 (Chart 1). Moreover, early March's unusually harsh winter weather in the Northeastern U.S. may prolong consumers' malaise for another month. The retail sales control group, which feeds into GDP calculations, rose a scant 0.1% m/m in February. The reading was well below the consensus of a 0.5% m/m gain. Headline retail sales dipped by 0.1%, well short of expectations (+0.4%). Auto sales (-0.9%) declined for the fourth month in a row in February. It is clear that the surge in auto sales in the wake of last fall's hurricanes pulled up demand. The weakness in February's spending was broadly based, with 7 of 13 major retail sales categories showing month-over-month declines. However, the recent weakness in consumer outlay masks the robust activity in the past 12 months. Overall retail sales are up a solid 4.1% from a year ago, while sales in the retail control group rose by 4.3%. In addition, sales are higher in 12 of the 13 main categories in the past year, led by non-store retailers (+10.1%), miscellaneous store retailers (+7.5%), clothing (+4.9%) and building materials (+4.6%). As a result of the tepid consumer spending readings in early 2018, the Atlanta Fed's GDPNow model has projected Q1 real GDP growth of just 1.8%, adjusted downward from 2.5% on March 9 (Chart 2). At the start of this month, the Atlanta Fed pegged Q1 GDP at 3.5%. Accordingly, some investors are concerned that household spending is nearing a peak and a recession may be imminent. We see it differently. BCA's stance is that consumer spending should continue to grow by at least 2% in 2018. U.S. consumer health has improved markedly in the past year, driving BCA's Consumer Health Indicator into positive territory (Chart 3). Higher equity prices, a stout labor market and an acceleration in real incomes are behind the improvement. Consumer spending growth tends to accelerate when the Health Indicator is rising. The improvement supports BCA's view of a stronger U.S. economy alongside a global synchronized recovery, at least in the next 12 months. Chart 2Q1 GDP Estimates Have Moved Sharply Lower Chart 3The Consumer Is In Good Shape Household net worth in 2017Q4 was at a record high, the result of stable house prices and frothy equity markets, according to the latest Flow of Funds data for 2017Q4 (Chart 4). Moreover, the composition of households' balance sheet is less alarming today than at prior peaks, because equities and real estate relative to household income or total assets are more reasonable. Furthermore, debt levels are tamer today than in 2006. Households may be less vulnerable to unexpected shocks (Chart 4 again) in light of their more resilient balance sheets. BCA's view is that financial vulnerabilities from the household sector are well contained. Household borrowing is increasing modestly at an annual pace of 4%, in sharp contrast with a 12% rate in the middle of the first decade of the 2000s. A broad measure of household solvency, such as the household debt-to-income ratio, is within the range of the past few years and back to pre-recessionary readings. Furthermore, liquidity buffers (liquid assets-to-liabilities) are almost as high as the levels that preceded the equity market boom/bust in 1999-2000 (Chart 5). Chart 4Household Sector Balance Sheet Composition Chart 5Household Sector Buffers Are Solid Nevertheless, risks may dampen the pace of consumer spending. Debt-to-income ratios have bottomed for the cycle (Chart 5 again) and banks are tightening their lending standards. The result is that consumer delinquency rates are on the upswing, notably in credit cards and autos (Chart 6). Moreover, the personal savings rate cannot sustainably remain around its recovery low of 3.2% (Chart 7, last panel). Chart 6Consumer Loan Metrics Chart 7Key Supports For Consumer##BR##Spending Remain In Place At 2.8%, annual wage compensation growth remains sluggish and far from the 3-4% rate per year that the Fed stated would be consistent with an economy closer to 2% inflation (Chart 7, panel 4). Moreover, households are still unlikely to binge on more debt to smooth out their expenditures as they did in the middle years of the first decade of the 2000s. A further acceleration in consumer spending would occur only alongside steady improvement in the labor market and improving household confidence on future employment and income gains. Bottom Line: Consumers' good mood and healthy balance sheets have not translated into firmer spending growth so far in 2018. Nonetheless, even with below-average consumer spending, the U.S. economy is expanding above the Fed's estimate of potential GDP, the labor market is tightening and inflation is grinding higher. The Fed remains on track to hike rates four times this year. The outlook for the U.S. consumer remains bright because of solid fundamental tailwinds such as strong employment growth, stable disposable incomes, frothy household net worth and buoyant confidence. Consumer headwinds to monitor are households' historically low saving rates, still tepid wage inflation and escalating delinquency rates. Too Hot? U.S. merger and acquisition (M&A) volume peaked along with U.S. equity prices in the late 1990s and in 2007. Some investors are concerned that the recent rollover in deal volume is a signal that a recession or an equity market top is nigh. Deal volume in dollars and relative to market cap peaked in 1999, again in 2007, and more recently in mid-2015, before a 13% pullback in the S&P 500 in late 2015 and early 2016. Since then, merger activity has moved lower. The decline in corporate combinations accompanied a sizeable rally in equity markets and robust U.S. and global economies. Although not shown on the chart, deal volume surpassed its late 1980s' pinnacle in 1995, five years before equity markets reached record highs in 2000. The recent peak in corporate takeovers (July 2017) relative to GDP matched those prior highs, but remained below the 1999, 2007 and 2015 tops as a percentage of market cap. Furthermore, last summer's zenith in global or cross-border M&A, a better indicator of market zest than U.S.-only activity, did not eclipse the peaks in 2007. Even at last summer's high, measured against both global GDP and market cap, worldwide corporate combinations remained below their 2015 top and well below their 2007 peak. At just 6.5% in early 2017, the GDP-based metric was significantly under the 2007Q3 pinnacle of 10%. That said, it is difficult to analyze this in context as the time series does not reach back to the late 1990s, which were boom years for M&A. Moreover, Phase I of the Fed funds rate cycle4 (the Fed is tightening, but policy is still accommodative) supports accelerating M&A activity (Chart 8A). Corporate combinations also climb during Phase II (Fed tightening, but policy is restrictive). However, M&A activity peaked at the end of Phase II in 2000 and 2007 (Chart 8B). BCA's view is that we will remain in Phase I until at least the end of 2018 and that Phase II may not be over until the end of 2019 or later. Chart 8AM&A Activity In Phase I Of The Fed Cycle... Chart 8BM&A Activity In Phase II Of The Fed Cycle... Bottom Line: The recent rollover in M&A activity does not signal a top in equity markets nor warn that a recession looms. Overall net equity withdrawal (which includes the net impact of IPOs, share buybacks and M&A) is not out of line with previous economic expansions (Chart 9). Stay overweight stocks versus bonds as the U.S. economic expansions becomes a decade-long phenomenon. Chart 9Comparison Of Corporate Outlays Across Four Economic Expansion Phases Just Right Wage inflation remains in a gradual upward trend, accelerating just enough to nudge up price inflation and prompt the Fed to hike rates four times this year. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. However, the January reading (+2.8 yoy) on average hourly earnings (AHE) stoked fears of the former, while the February reading (+2.6%) raised concerns of the latter. Chart 10 confirms that most measures of labor market slack have returned to normal. Moreover, the latest soundings on the job market from the National Federation of Independent Business suggest that small business owners have the most job openings in at least 18 years (Chart 11, panel 1). In addition, key concerns have shifted to the quality of the job applicants (panel 2) and the cost of labor (panel 3), away from taxes and over-regulation. Chart 10Labor Market Slack##BR##Is Disappearing Chart 11Hiring And Labor Costs A##BR##Key Concern For Small Businesses Those concerns were underscored in the Federal Reserve's January and February Beige books. Table 1 shows industries with labor shortages; in the year ended February, the gain in average hourly earnings in all but 3 of the industries was faster than average. Moreover, in all but 1 of these categories, labor market conditions are now the tightest since before the onset of the 2007-2009 recession. A recent Fed study5 examines the labor shortages in the manufacturing sector in more detail. The Beige Books noted that many businesses are having trouble finding low-skilled (and to a lesser extent, middle-skilled) workers, with a few mentions of the challenges of finding/retaining highly skilled employees, especially in STEM job functions. Chart 12 shows the wage gains for supervisory staff, a proxy for skilled (panel 1) and non-supervisory employees, and an imperfect proxy for low-skilled workers (panel 2). Both metrics are rising, but the skilled worker proxy accelerated more than the low-skilled metric. Moreover, at 3.1%, the latest reading on supervisory employees is nearly double the pace of non-supervisory personnel. The Atlanta Fed's Wage Tracker provides another lens on wage gains by skill level. Chart 13 shows that wage inflation among skilled positions is running well above average. Raises among mid- and low-skilled labor lag far behind. Notably, wages in all three have rolled over since late 2016. Table 1Labor "Shortages" Identified##BR##In The Beige Book Chart 12Supervisory Vs. Production##BR##Wage Inflation Chart 13Wage Inflation##BR##By Skill-Level Chart 14 argues that slightly faster compensation growth is imminent. The top panel shows that more than 80% of U.S. states register unemployment below the Fed's estimate of full employment. In the past, rates over 60% have been associated with wage pressures. The percentage climbed above 60% in January. The bottom panel of Chart 14 demonstrates the relationship between state unemployment rates and wage gains in each state. Chart 1480%+ Of States Have Unemployment Rates Below NAIRU Bottom Line: The labor market is back to normal, but is not overly tight, as shown in Chart 10. Wages and employment costs are in an uptrend, yet firms are still reluctant to give large pay increases to their labor force. That said, against the backdrop of fiscal stimulus, real GDP growth will remain well above potential, which means that the unemployment rate is headed to 3½% or even below. At some point, the labor market will overheat. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Reflective Or Restrictive", published March 12, 2018. Available at uses.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "From Headwinds To Tailwinds", published March 6, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's U.S. Bond Strategy Weekly Report "The Two-Stage Bear Market In Bonds", published February 20, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Lingering In The Policy Sweet Spot," September 26, 2016 and "Stocks And The Fed Funds Rate Cycle," December 23, 2013. Both available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm

Highlights Portfolio Strategy Synchronized global growth, a soft U.S. dollar, our resurgent Boom/Bust Indicator and avoidance of a Chinese economic hard landing, are all signaling that it still pays to overweight cyclicals at the expense of defensives. Economically hyper-sensitive transports also benefit from synchronous global growth and capex. We expect a rerating phase in the coming months. Within transports, we reiterate our overweight stance in the key railroads sub-index as enticing macro tailwinds along with firming operating metrics underscore that profits will exit deflation in calendar 2018. Recent Changes There are no portfolio changes this week. Table 1 Feature The S&P 500 continued to consolidate last week, still digesting the early February tremor. Policy uncertainty is slowly returning and sustained Administration reshufflings are becoming slightly unnerving (bottom panel, Chart 1). Nevertheless, the dual themes of synchronized global growth and budding evidence of coordinated tightening in global monetary policy, i.e. rising interest rate backdrop, continue to dominate and remain intact. Importantly in the U.S., the latest non-farm payrolls (NFP) report was a goldilocks one. Month-over-month NFPs surpassed the 300K hurdle for the first time since late-2014, on an as-reported-basis, while wage inflation settled back down. The middle panel of Chart 2 shows that both in the 1980s and 1990s expansions, NFPs were growing briskly, easily clearing the 300K mark. The 2000s was the "jobless recovery" expansion and likely the exception to the rule. In all three business cycle expansions wage growth touched the 4%/annum rate before the recession hit. The yield curve slope also supports this empirical evidence, forecasting that wage inflation will likely attain 4%/annum before this cycle ends (wages shown inverted, Chart 3). Chart 1Watch Policy Uncertainty Chart 2Goldilocks NFP Report... Chart 3...But Wage Growth Pickup Looms One key element in the current cycle is that the government is easing fiscal policy to the point where both NFPs and wages will likely surge in the coming months as the fiscal thrust gains steam, likely extending the business cycle. This is an inherently inflationary environment, especially when the economy is at full employment and the Fed in slow and steady tightening mode. Last autumn, we showed that the SPX performs well in times of easy fiscal and tight money iterations, rising on average 16.7% with these episodes, lasting on average 16 months (Table 2).1 The latest flagship BCA monthly publication forecasts that the current fiscal impulse will last at least until year-end 2019, contributing positively to real GDP growth. Thus, if history at least rhymes, SPX returns will be positive and likely significant for the next couple of years (Chart 4). With regard to the composition of the equity market's return, we reiterate our view - backed by empirical evidence - that EPS will do the heavy lifting whereas the forward P/E multiple will continue to drift sideways to lower.2 Not only will rising fiscal deficits cause the Fed to remain vigilant and continue to raise interest rates and weigh on the equity market multiple (Chart 5), but also heightened volatility will likely suppress the forward P/E multiple. Table 2SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Chart 4Stimulative Fiscal Policy##br## Extends The Business Cycle... Chart 5...But Weighs On ##br##The Multiple This week we revisit our cyclical versus defensive portfolio bent and update the key transportation overweight view. Cyclicals Thrive When Global Growth Is Alive And Well... While retaliatory tariff wars are dominating the media headlines, global growth is still resilient. Our view remains that the odds of a generalized trade war engulfing the globe are low, and in that light we reiterate our cyclical over defensive portfolio positioning, in place since early October.3 Global growth is firing on all cylinders. Our Global Trade Indicator is probing levels last hit in 2008, underscoring that cyclicals will continue to have the upper hand versus defensives (Chart 6). Synonymous with global growth is the softness in the U.S. dollar. In fact, the two are in a self-feeding loop where synchronized global growth pushes the greenback lower, which in turn fuels further global output growth. Tack on the rising likelihood that the trade-weighted dollar has crested from a structural perspective, according to the 16-year peak-to-peak cycle4 (Chart 7) and the news is great for cyclicals versus defensives (Chart 8). Chart 6Global Trade Is Alright Chart 7Dollar The Great Reflator... Chart 8...Is A Boon For Cyclicals Vs. Defensives Related to the greenback's likely secular peak is the booming commodity complex, as the two are nearly perfectly inversely correlated. Commodity exposure is running very high in the deep cyclical sectors and thus any sustained commodity price inflation gains will continue to underpin the cyclicals/defensives share price ratio. BCA's Boom/Bust Indicator (BBI) corroborates this upbeat message for cyclicals versus defensives. The BBI is on the verge of hitting an all-time high and, while this could serve as a contrary signal, there are high odds of a breakout in the coming months if synchronized global growth stays intact as BCA expects, rekindling cyclicals/defensives share prices (Chart 9). Finally, if China avoids a hard landing, and barring an EM accident, the cyclicals/defensives ratio will remain upbeat. Chart 10 shows that China's LEI is recovering smartly from the late-2015/early-2016 manufacturing recession trough, and the roaring Chinese stock market - the ultimate leading indicator - confirms that the path of least resistance for the U.S. cyclicals/defensive share price ratio is higher still. Chart 9Boom/Bust indicator Is Flashing Green Chart 10China Is Also Stealthily Firming Bottom Line: Stick with a cyclical over defensive portfolio bent. ...As Do Transports, Thus... Transportation stocks have taken a breather recently on the back of escalating global trade war fears. But, we are looking through this soft-patch and reiterate our barbell portfolio approach: overweight the global growth-levered railroads and air freight & logistics stocks at the expense of airlines that are bogged down by rising capacity and deflating airfare prices (Chart 11). Leading indicators of transportation activity are all flashing green. Transportation relative share prices and manufacturing export expectations are joined at the hip, and the current message is to expect a reacceleration in the former (top panel, Chart 12). Similarly, capital expenditures, one of the key themes we are exploring this year, are as good as they can be according to the regional Fed surveys, and signal that transportation profits will rev up in the coming months (middle panel, Chart 12). The possibility of an infrastructure bill becoming law later this year or in 2019 would also represent a tailwind for transportation EPS. Not only is U.S. trade activity humming, but also global trade remains on a solid footing. The global manufacturing PMI is resilient and sustaining recent gains, suggesting that global export volumes will resume their ascent. This global manufacturing euphoria is welcome news for extremely economically sensitive transportation profits (Chart 13). All of this heralds an enticing transportation services end-demand outlook. In fact, industry pricing power is gaining steam of late and confirms that relative EPS will continue to expand (Chart 12). Under such a backdrop, a rerating phase looms in still depressed relative valuations (bottom panel, Chart 13). Chart 11Stick With Transports Exposure Chart 12Domestic... Chart 13...And Global Growth/Capex Beneficiary ...Stay On Board The Rails Railroad stocks have worked off the overbought conditions prevalent all of last year, and momentum is now back at zero. In addition, forward EPS have spiked, eliminating the valuation premium and now the rails are trading on par with the SPX on a forward P/E basis (Chart 14). The track is now clear and more gains are in store for relative share prices in the coming quarters. Despite trade war jitters, we are looking through the recent turbulence. If the synchronized global growth phase endures, as we expect, then rail profits will remain on track. In fact, BCA's measure of global industrial production (hard economic data) is confirming the euphoric message from the global manufacturing PMI (soft economic data) and suggests that rails profits will overwhelm (Chart 15). Our S&P rails profit model also corroborates this positive global trade message and forecasts that rail profit deflation will end in 2018 (bottom panel, Chart 15). Beyond these macro tailwinds, operating industry metrics also point to a profit resurgence this year. Importantly, our rails profit margin proxy (pricing power versus employment additions) has recently reaccelerated both because selling prices are expanding at a healthy clip and due to labor restraint (second panel, Chart 15). Demand for rail hauling remains upbeat and our rail diffusion indicator has surged to a level last seen in 2009, signaling that there is a broad based firming in rail carload shipments (second panel, Chart 16). Chart 14Unwound Both Overbought Conditions And Overvaluation Chart 15EPS On Track To Outperform Chart 16Intermodal Resilience The significant intermodal segment that comprises roughly half of all shipments is on the cusp of a breakout. The retail sales-to-inventories ratio is probing multi-year highs on the back of the increase in the consumer confidence impulse and both are harbingers of a reacceleration in intermodal shipments (Chart 16). Coal is another significant category that takes up just under a fifth of rail carload volumes and bears close attention. While natural gas prices have fallen near the lower part of the trading range in place since mid-2016 and momentum is back at neutral, any spike in nat gas prices will boost the allure of coal as a competing fuel for energy generation (middle panel, Chart 17). Keep in mind that coal usage is highly correlated with electricity demand and the industrial business cycle, and the current ISM manufacturing survey message is upbeat for coal demand. Tack on the whittling down in coal inventories at utilities and there is scope for a tick up in coal demand (third panel, Chart 18). Finally, the export relief valve has reopened for coal with the aid of the depreciating U.S. dollar, and momentum in net exports has soared to all-time highs, even surpassing the mid-1982 peak (bottom panel, Chart 18). Chart 17Key Coal Shipments Underpin Selling Prices Chart 18Upbeat Leading Indicators Of Coal Demand All of this suggests that coal shipments will make a comeback later in 2018, and continue to underpin industry pricing power, which in turn boost rail profit prospects (bottom panel, Chart 17). Bottom Line: Continue to overweight the broad S&P transportation index, and especially the heavyweight S&P railroads sub-index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights Financial market volatility in general and FX market volatility in particular is set to increase because of the following three factors: Rising U.S. inflation will make the Federal Reserve increasingly hawkish, and the European Central Bank is moving away from maximum accommodation; The Chinese economy is not accelerating; And geopolitical tensions are growing. While EM and commodity currencies will suffer, safe havens like the yen and Swiss franc will benefit. The euro may correct at first, but it remains on an upward trajectory. Feature Chart I-1Low And High Growth Sentiment##br## Are Linked A defining feature of global financial markets over the past two years has been the outright collapse of volatility. However, in late January the VIX rebounded, recording readings not seen since 2015. Currency volatility also hit three-year lows before the same wake-up call, causing a sharp but temporary increase in FX volatility. It is important to understand whether this recent rebound in volatility was just a blip or a symptom of something more profound - a sign that volatility is back on an uptrend and will continue to rise as it did from 1996 to 2002, or again from 2007 to 2009. This matters because volatility is an important determinant of FX returns. High-yielding carry currencies perform well when volatility is low. While low-yielding funding currencies like the Swiss franc or the yen suffer in periods of calm, their returns improve once volatility rises. Moreover, low-volatility environments are often associated with buoyant expectations about global growth among international investors (Chart I-1). Thus, a return of volatility could fray the edges of global growth sentiment, which is currently ebullient. This would hurt EM and commodity currencies. Our view is that volatility is making a comeback as global monetary policy is becoming less accommodative, China's path is becoming rockier and global geopolitical risks are rising. These dynamics will hurt EM and commodity currencies, while at the margin, help safe-haven currencies like the yen and Swiss franc. Monetary Policy In DM Economies Monetary policy in the advanced economies is not yet tight, but is moving away from the large accommodation implemented in the wake of the Great Financial Crisis. Historically, a removal of accommodative policy tends to be associated with rising volatility, especially in the FX space. The link is not that clear-cut though. Policy tightening tends to lead to higher volatility. However, it only does so once we enter the latter innings of the business cycle. Only when inflation begins to gain enough momentum to force the Fed to increase rates fast enough to raise the specter that policy will soon begin to hurt growth, does volatility start rising durably. We are getting closer to this moment in the U.S. The U.S. is increasingly showing signs of late-stage business expansion. For one, the yield curve has flattened to 53 basis points. This level of slope has historically been associated with full employment and rising wage pressures. Surveys corroborate this picture. The NFIB survey of U.S. small businesses shows that the gap between the difficulties of finding qualified labor versus demand problems is close to record highs. This normally marks rising wage pressures, the hallmark of full employment (Chart I-2). Moreover, the ISM manufacturing survey shows that companies are paying more for the price of their inputs and experiencing delays with suppliers. Normally, this also describes a late-cycle environment marked with rising inflationary pressures (Chart I-3). Chart I-2Late Cycle Dynamics##br## In The U.S. Chart I-3Firms Are Facing Budding##br## Inflationary Pressures Other variables are generally pointing toward an acceleration of U.S. inflation. Because aggregate U.S. capacity utilization - which incorporates both labor market conditions and the Fed's own capacity utilization measure - highlights a notable absence of slack, and because the change in the velocity of money in the U.S. is accelerating, our models forecast a sustained uptick in U.S. core inflation to 2% and above (Chart I-4). U.S. CPI excluding food and energy data for February is also pointing toward budding inflationary pressures. While the annual core inflation rate was flat compared to January, the annualized three-month rate of change has surged to 3%. The muted year-on-year comparison is being depressed by some base effect. In 2017, inflation started to weaken significantly in March. Therefore, beginning in March 2018, consumer price inflation in the U.S. will likely accelerate more noticeably than it has until now. Shelter inflation too is moving from a headwind to a tailwind. Shelter inflation represents 42% of the core CPI basket, and it has been on a decelerating trend for 14 months. However, the model developed by our U.S. Bond Strategy colleagues shows that U.S. shelter inflation is now set to start bottoming (Chart I-5, top panel). Chart I-4Core Inflation Will Rise Chart I-5Other Inflationary Pressures Core goods prices are also regaining some vigor. This is not much of a surprise. The strength of the global economy along with the weakness of the U.S. dollar have filtered through to higher import prices. Historically, import prices tend to lead core goods prices in the U.S. (Chart I-5, bottom panel). We could see rising inflationary pressures on the services front as well. The employment cost index - the cost component used to compute unit labor costs - is still displaying a tight positive correlation with the employment-to-population ratio for prime-age workers (Chart I-6). BCA estimates that employment gains above 123,000 new jobs a month will push this ratio up, and consequently labor costs. But as Chart I-7 illustrates, the strength in the Conference Board Leading Credit Index highlights that employment growth in the U.S. is likely to remain robust. This suggests the key driver of service inflation - wages - will continue to improve. Chart I-6Wages Will Keep Rising... Chart I-7...As Employment Growth Will Stay Strong Thus, it seems the stars are already aligning to foment a rise in U.S. core CPI. The Trump administration throwing in some large-scale fiscal stimulus into the mix is only akin to throwing fuel on a fire. Accordingly, we expect the Fed to upgrade its interest rate forecasts for 2019. Markets are not yet ready for this scenario, anticipating only five rate hikes between now and the end of 2019. Thus, the most important central bank for setting the global cost of capital will likely surprise in a hawkish fashion over the coming 21 months. But what about the other big DM central bank, the ECB? The ECB too has begun to remove monetary accommodation, as it has started to taper its purchases of securities. It aims to be done this in September. Moreover, the narrowing gap between the unemployment rate and NAIRU in the euro area points to budding inflationary pressures (Chart I-8). This would argue that the ECB will begin lifting interest rates toward the summer of 2019. In fact, the shadow policy rate for the euro area has already begun to turn higher (Chart I-9), suggesting European policy is already starting to move away from its accommodative extremes. This combination is very important for volatility. As Chart I-10 illustrates, the average shadow policy rate for the U.S., the euro area, the U.K., and Japan leads financial markets and FX volatility. While Japanese rates may remain at low levels, the path for Europe and the U.S. is clearly up, suggesting volatility will rise. Chart I-8Growing Wage Pressures In Europe Chart I-9ECB Policy Is Already Less Accommod Chart I-10Tighter Global Policy Leads To Higher Volatility Bottom Line: The U.S. is increasingly displaying symptoms that its business cycle expansion is at an advanced stage. With inflationary pressures growing more intense, the Fed will need to ratchet up its tightening path. The ECB too has begun removing accommodation. This means that two of the three most important price setters for the cost of money are either fully tightening policy or beginning to remove accommodation. This has historically marked the point when global financial market volatility begins to rise. China Uncertainty China is another factor pointing toward a rise in global financial volatility. China has exerted a benign influence on global growth from the second half of 2016 and through most of 2017. In response to a large easing in monetary conditions and a hefty dose of fiscal stimulus, Chinese growth had until recently regained vigor, with the Li Keqiang index - our preferred measure of Chinese industrial activity - swinging from -2.6 sigma to 0.5 sigma in 15 months. A key gauge of Chinese activity - the average of the new orders and backlog of order subcomponents of the PMIs surveys - captured these dynamics very well. This indicator also explains the gyrations in various measures of asset markets volatility well (Chart I-11). Currently, it points to a rise in global financial market volatility. Going forward, the key question for investors is whether or not Chinese orders continue to deteriorate, flagging a further rise in volatility. We are inclined to say yes. Chinese monetary conditions have continued to deteriorate, and administrative measures to slow down the growth of total social financing are starting to bite. Chart I-12 shows that the issuance of bonds by small financial intermediaries has slowed significantly. Based on this message, the early slowdown in total debt growth should continue over the coming months. Optimists about China often highlight that this should have a limited impact on economic activity. After all, 62% of fixed asset investments in China are financed by internally generated funds. However, the biggest problem for China is the misallocation of capital. As Chart I-13 shows, construction as a percentage of total capex has been linked to population growth. However, after 2008, these two series decoupled: population growth has been stagnating while construction activity has been skyrocketing, despite a slowdown in the rate of migration from rural to urban areas. This suggests that post-2008, China has been building too many structures. Chart I-11China To Affect ##br##Volatility Chart I-12Administrative Tightening Will ##br##Weigh On Chinese Credit Chart I-13After The GFC, Chinese ##br##Construction Took Off When capital is misallocated, even if the share of debt financing is low, tight monetary conditions and administrative measures to limit excesses in the economy can bite sharply. This raises the risk that Chinese growth will not pick up much going forward, and that in fact, capex and industrial activity will struggle. Jonathan LaBerge, who writes BCA's Chinese Investment Strategy, has built a list of some of the key indicators he follows to track the evolution of the Chinese economy. Table I-1 shows that all but the Caixin/Markit manufacturing PMI index are in a downtrend, and that 11 out of the 14 variables have been deteriorating in recent months.1 Moreover, as Chart I-14 illustrates, the strength in the Caixin PMI is likely to be an aberration. When the spread between the Caixin and the official measure is as wide as it currently is, the following quarters tend to be followed by a fall in the average of the two series. Table I-1No Convincing Signs Of An Impending##br## Upturn In China's Economy Chart I-14The Caixin PMI Is Probably##br## The Noise, Not The Signal We would therefore expect Chinese economic momentum to slow further. Since Chinese policymakers still want to engineer some deleveraging, the Chinese industrial sector will decelerate. This will contribute to the rise in financial market volatility for the remainder of the business cycle, especially as global monetary policy in the G-10 is becoming less accommodative. Bottom Line: The Chinese economy contributed to low levels of volatility in financial markets from 2016 to late 2017. However, China still suffers from a large misallocation of capital, which is making its economy vulnerable to both monetary and administrative tightening. With most key gauges of Chinese economic activity still pointing south, industrial activity could deteriorate further. This will contribute to a rise in global financial market volatility, especially as DM central banks are removing monetary accommodation. Rising Geopolitical Tensions The last factor pointing toward rising financial market volatility are growing global geopolitical tensions. As Marko Papic has highlighted in BCA's Geopolitical Strategy service, the world's unipolar moment under the umbrella of U.S. dominance is over. The world is increasingly becoming a multi-polar environment, where multiple powers vie for local dominance. As the early 20th century and the 1930s showed, when the world becomes multi-polar, geopolitical risks rise (Chart I-15). Chart I-15Geopolitical Risk Is The Outcome Of Global Multipolarity Today's increasingly multi-polar world may not be headed for an imminent global war, but tensions are likely to increase. This means policies could become more erratic. Additionally, domestic politics are under stain as well. Rising inequality and social stagnation in the U.S. are fomenting public discontent (Chart I-16). Moreover, U.S. citizens are not champions of free trade; in fact, they view unfettered trade with a rather suspicious eye, as do the citizens of Italy, Japan or France (Chart I-17). Chart I-16The U.S. Is Unequal And Ossified Chart I-17America Belongs To The Anti-Globalization Bloc Practically, this means tensions such as those experienced two weeks ago around the imposition of tariffs on steel and aluminum imports into the U.S. are likely to continue. The White House is already discussing the possibility of imposing a 15% tariff on Chinese imports to the U.S. totaling US$60 billion. As we highlighted last week, alleged intellectual property theft by China will likely remain a hot-button topic that could result in painful sanctions, prompting swift retaliation by Beijing. Additionally, NAFTA negotiations are not over, pointing to continued headline risk in the space. Moreover, relations with Russia are tense, and the Iran deal looks increasingly fraught with uncertainty. These two spots could easily morph into yet another source of risk. Bottom Line: The global geopolitical environment has become a multi-polar system - an environment historically prone to serious tensions. The rise of populism in the U.S. only makes this risk more salient, especially with respect to global trade. As a result, the threat of a trade war, especially between the U.S. and China, is increasing. This means shocks to global trade and global growth could become more frequent. This will likely create another source of financial market volatility, compounding the impact of economic fundamentals like global monetary policy and China's economic risks. Investment Implications Carry trades should fare especially poorly in this environment, as they abhor rising volatility.2 Hence, the performance of EM high-yielders like the BRL, TRY, and ZAR could progressively deteriorate. Moreover, because rising volatility often hurts economic sentiment, this increase in volatility could weigh on growth-sensitive currencies like the KRW in the EM space or the AUD and the NZD in the DM space. The SEK would normally suffer when global growth sentiment deteriorates. Yet this time may play out differently. Swedish short rates are -0.5%, making the SEK a funding currency. If carry trades do suffer, the need to buy back funding currencies could put a bid under the SEK. In this context, the JPY and the CHF could be the great winners. Both currencies have been used as funding vehicles. Moreover, both Switzerland and Japan sport outsized net international investment positions equal to 126% and 65% of their respective GDPs. If volatility does rise, some Swiss and Japanese investors will likely repatriate funds from abroad, generating purchases of yen and Swiss francs in the process. Moreover, from an empirical perspective, both these currencies continue to react well when global volatility spikes. Chart I-18The Euro Is Vulnerable To Higher Vol However, both Japan and Switzerland are still experiencing weak inflation. The BoJ and the SNB will therefore try to lean against currency strength caused by exogenous volatility shocks. The JPY and the CHF could be caught between these forces. The currency depreciation these central banks try to engineer will be occasionally interrupted by sharp rallies when financial market volatility spikes. This means that monetary policy in these two countries will have to stay extremely accommodative. For now, it is still too early to bet against the yen's current strength. Finally, the impact of rising volatility on the euro's outlook is more nebulous. The euro is neither a carry currency nor a funding currency, but it generally appreciates when global growth sentiment improves. Thus, since long positioning in the euro is very stretched, a renewed spike in volatility would likely hurt the euro, especially as European economic surprises are plummeting relative to the U.S. (Chart I-18). Nonetheless, this pain will be a temporary phenomenon. The euro is still cheap, and one of the factors driving global volatility higher is the ECB abandoning its accommodative monetary policy stance. Moreover, as terminal interest rate expectations in Europe are still well below their historical average relative to the U.S., there is still ample room for investors to upgrade their assessment of where the European policy rate will end up vis-à-vis the U.S. at the end of the cycle. Bottom Line: Any negative impact of rising global financial markets volatility will be felt most acutely by carry and growth-sensitive currencies like the BRL, TRY, ZAR, AUD, and KRW. Contrastingly, funding currencies underpinned with large positive net international investment positions such as the JPY and the CHF will be beneficiaries. The impact on the euro may be negative at first, as speculators are massively long the euro despite a collapse in euro area economic surprises. However, the long-term impact should prove to be more muted as the euro's fundamentals are still improving. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation", dated March 7,2018, available at cis.bcaresearch.com. 2 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was generally positive for the dollar: Headline and core CPI came in line with expectations, growing at 2.2% and 1.8% annually, respectively; NFIB Business Optimism Index was hit 107.6, beating expectations of 107.1; Continuing jobless claims came in at 1.879 million, beating the expected 1.9 million; Initial jobless claims came in line with expectations at 226,000; However, retail sales came in weaker than expected, contracting by 0.1% monthly. Despite this generally positive tone to the data, the dollar was still soft this week. However, downward momentum has slowed, paving the way for a short-term counter trend rally. This is consistent with a global growth slowdown. Report Links: Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Dollar Deserves Some Real Appreciation - March 2, 2018 Who Hikes Again? - February 9, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was disappointing: Industrial production contracted in monthly terms by 1% and also grew at only 2.7% yearly, less than the expected 4.7% pace; German CPI grew at a 1.4% yearly pace, with the harmonized index growing by 1.2%, both in line with expectations. In a speech on Wednesday, President Draghi clarified that "monetary policy will remain patient, persistent and prudent" as there is still a need for "further evidence that inflation dynamics are moving in the right direction". As global growth is downshifting, the euro could experience a significant correction before resuming its bull market. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth came in at 2.9%, outperforming expectations. However, domestic corporate goods inflation surprised to the downside, coming in at 2.5%. Moreover, the tertiary industry Index month-on-month growth also underperformed expectations, coming in at -0.6%. Finally, labor cash earnings yearly growth came in line with expectations at 0.7%. Last Friday, the BoJ decided to leave its interest rate benchmark unchanged at 0.1%. In its minutes, the board members shared the view that CPI will reach their 2% in fiscal 2019. Overall, we expect that rising global interest rates will cause a rise in currency volatility. This will result in a positive environment for the yen for now, but one that could prevent Japanese inflation from hitting that 2% objective in 2019. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial production yearly growth underperformed expectations, coming in at 1.6%. Manufacturing production also underperformed expectations, coming in at 2.7%. However, the trade balance outperformed expectations, coming in at -3.074 billion pounds. The pound has been relatively flat this week against the U.S. dollar. Overall, we believe that the upside to the British pound against the dollar is limited, as there are already 40 basis points of interest rate hikes priced for the BoE this year. Given that inflation is set to ease following last year's rally in the pound, it is unlikely that the pound will raise rates more than what is currently priced. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was mixed: Home loans fell by 1.1%; Investment lending for homes increased by 1.1%; The NAB Confidence survey declined to 9 from 11 but was in line with expectations; The NAB Conditions survey increased to 21, outperforming expectations; The Westpac Consumer Confidence increased from -2.3% to 0.2%. Elevated Household debt and the absence of wage growth are still at the forefront of Australian policymaker's minds. The RBA is reluctant to raise rates in order to avoid a deflationary spiral which would set the economy back severely. The AUD will most likely suffer this year because of this. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: The current account surprised to the downside, coming in at -2.7% of GDP. Moreover, GDP yearly growth also underperformed expectations, coming in at 2.9%. However, it did improve from last quarter growth of 2.7%. Finally, Food Price Index monthly growth decline from last month, coming in at -0.5%. The New Zealand dollar has been flat this week against the U.S. dollar. We believe that NZD/USD and NZD/JPY are likely to suffer moving forward, as financial markets volatility is set to rise in the coming months due to the rise in global interest rates and the possibility of a slowdown in China. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian employment figures remain strong, with the ADP employment change coming in at 39,700, above the 10,700 experienced last month. Canada's export growth should improve further as the White House is adding large amounts of fiscal stimulus in the U.S. economy, Canada's largest trading partner. This will help the BoC stick to its hiking path. However, risks are high. While Canada has so far been able to avoid the U.S. steel and aluminum tariffs, NAFTA negotiations still remain a danger for the Canadian economy. Furthermore, the housing market still remains overheated and the debt load is at risk of spiraling when mortgages begin to be refinanced at higher rates. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The SNB left its reference rate unchanged at -0.75%. The Swiss central bank reiterated that the negative rates as well as foreign exchange intervention "remain essential". Moreover, the SNB decreased its inflation forecast for this year form 0.7% to 0.6%. The SNB also changed its forecast for 2019 from 1.1% to 0.9%. Overall, the SNB is likely to maintain a very dovish stance, given the headwinds to Swiss inflation. This will continue to put upward pressure on EUR/CHF. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Headline inflation surprised to the upside, coming in at 2.2%. It also increased from 1.6% the previous month. Meanwhile, core inflation also outperformed expectations, coming in at 1.4%. It also increased from 1.1% the previous month. USD/NOK has depreciated by roughly 1.4% this week. On Thursday, the Norges Bank left its policy rate unchanged at 0.5%. In its monetary policy report the central bank highlighted that the outlook for the Norwegian economy suggests that "it will soon be appropriate to raise rates". Overall, we believe that the krone is likely to outperform other commodity currencies, given that there are only 18 basis points priced for the next 12 months, which is less than is warranted given the strength of the economy and BCA's outlook for oil prices in 2018. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 While Swedish inflation came in line with expectations, with consumer prices growing at a 0.7% monthly pace and a 1.6% yearly pace, Sweden's unemployment came in at a much lower level than anticipated. The krona is finally strengthening after EUR/SEK traded above the critical 10.00 level. This trend should continue as the euro weakens from overbought levels. Furthermore, the eventual resurgence of inflation in Sweden will propel the SEK to stronger levels as markets reprice the Riksbank's likely policy path. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades