Developed Countries

Highlights EUR/USD is in a blow off phase. Treasury secretary Mnuchin's comments added fuel to a fire already lit by worries of twin deficits and the inherent responsivity of the dollar to momentum. It is dangerous to short EUR/USD when momentum is so strong; while we expect EUR/USD to correct over the next three months, it is safer to short the euro against the yen. The rebound in Australia's national income will peter off, this will hurt inflows into the country. The RBA will not surprise markets to the upside in 2018. Most of the drivers of AUD/USD point south. Stay short the AUD against the CAD and NZD, shorting AUD/JPY is attractive. Feature By somewhat abandoning the "strong dollar policy" in Davos, U.S. Treasury Secretary Steve Mnuchin sent the dollar in yet another tailspin this week.1 The weakness was further compounded by the seeming lack of concern vis-à-vis the euro's strength expressed by European Central Bank President Mario Draghi during the European Central Bank's press conference in Frankfurt yesterday. Mnuchin's comments rightfully worried investors, as they echoed President Trump's own rhetoric from a year ago that a strong dollar was negative for the U.S. economy, at least in terms of trade competitiveness. However, it is important to remember that words are only words, and for these utterances to have any durable impact, they need to be backed by policy instruments. The 1985 Plaza Accord was able to drive down the dollar not just because finance ministers said that the greenback was too strong, but also because the Federal Reserve cut interest rates in half between July 1984 and October 1986. This drove 2-year yield differentials between the U.S. and Japan, the U.K., and Germany down by 454 bps, 630 bps and 407 bps, respectively. Compounding this punch, the USD was trading at prodigiously expensive levels in early 1985. Today, the Fed is not cutting interest rates, it is raising them. In fact, BCA expects at least three rate hikes this year. The current weakness in the dollar is also easing U.S. financial conditions further, which is giving more ammunition for the Fed to tighten policy. Meanwhile, President Draghi reiterated that the ECB was very unlikely to increase rates in 2018; thus rate differentials between the U.S. and the euro area are widening, not narrowing. There is also the nagging question of the twin deficit in the U.S. The Trump stimulus package is expected to increase the fiscal deficit, and also feed through to a higher current account deficit. We have sympathy for this view. While such a twin deficit was associated with a weakening USD at the beginning of the millennium, in the first half of the 1980s it was not. Thus a twin deficit is no guarantee of a weaker dollar. The behavior of the Fed is likely to once again dominate. In the early days of the millennium, the Greenspan Fed was easing policy aggressively. In the early 1980s, while the Fed was cutting rates, it was cutting rates at a slower pace than had been anticipated because it realized that President Ronald Reagan's tax cuts and increased military spending were inflationary. Volcker wanted to make sure inflation expectations would stay well anchored, and not spike up. It thus seems that once again, the behavior of U.S. inflation is paramount. If U.S. inflation picks up as we expect (Chart I-1), the dollar is likely to appreciate as the Fed will hike. If U.S. inflation stays moribund, the twin deficit will likely tank the dollar. What to do practically? We have posited that the expected terminal rate spread between the euro area and the U.S. has been the interest rate spread driving EUR/USD rate over the past 12 months. Yet, even by this metric, the move in the euro to 1.25 is out of bound, as the euro has completely diverged from the recent trends in terminal rate differentials (Chart I-2). This suggests the euro is vulnerable at current levels. Chart I-1U.S. Inflation Will Pick Up Chart I-2Mind The Gap! It is also important to remark that the dollar's weakness is generalized. Moreover, the dollar is oversold and likely to experience a rebound (Chart I-3). However, timing this rebound is a made harder by the nature of the greenback. As we highlighted in a Special Report in December, the U.S. dollar is one of the two currencies exhibiting the strongest response to momentum factors.2 This is because the dollar is a very important macro variable, which is both responsive to global growth but also a key input to global growth. As global growth strengthens, this tends to weigh on the USD, but the USD's weakness tends to also boost global growth, as it eases global financial conditions. This creates a strong feedback loop that favors momentum trades in the USD. Chart I-3The Time To Bet On A Rebound Is High The greenback is currently entangled in such dynamics. Global growth improved after China massively stimulated its economy in 2015 and early 2016, which hurt the dollar. The weakness in the dollar is now helping global growth, which further hurts the dollar. It is thus a mugs game trying to time a reversal in the USD. As a result, even if we think EUR/USD is likely to experience a sharp correction in the coming weeks, we prefer shorting EUR/JPY. EUR/JPY is expensive, and positioning is just as extreme. However, by shorting the euro against the yen, we are not as exposed to the dollar cycle, and if global growth were to weaken in response to increasing tightening in Chinese policy, the yen would benefit in this environment. As such, the risk-reward ratio for this trade is higher. Bottom Line: Mnuchin comments on the USD were only an excuse for the dollar to sell off. The true culprit for the dollar's weakness is the greenback's own extreme sensitivity to momentum. As a result, timing a dollar reversal is nearly impossible. Only once the dollar begins to turn around can we begin betting on a tactical USD rally, even if it dooms us to miss the early parts of the move. Shorting EUR/JPY continues to offer a more attractive risk-reward tradeoff than shorting EUR/USD. Feature: Hard Times Ahead For The AUD The Australian dollar has rallied by a stunning 18.3% since its February 2016 trough. Improvement in global trade, surging Chinese stimulus, the resurgence in commodity prices, the rally in EM stocks, and the fall in the U.S. dollar have all aligned to transform the AUD into a high flyer. Not only have these factors encouraged risk-taking, creating an environment that is helping high-beta Australian assets perform well, they also have had a direct positive outcome on the Australian balance of payments, thus creating real improvements in the AUD's fundamentals as well. With AUD/USD now back above the key 0.80 threshold, it is important for investors to ask themselves: Can the AUD continue on its upward trajectory or is it time to bet against it? While the short-term outlook remains clouded by the USD's downward momentum, the AUD is likely to weaken on a cyclical basis. Playing AUD weakness against the NZD, CAD, and JPY seems like safer bets at the current juncture. Australian Economic Developments Australia's real GDP growth has slowed from 2.8% in Q3 2016 to 2.2% in Q3 2017, and currently stands below the lows recorded in 2015. However, this hides some very significant improvements, as nominal GDP growth has surged - from 1.4% in Q3 2015 to 6.5% in Q3 2017 (Chart I-4). Consumption has not been the crucial source of variations in Australia's economic activity. Instead, the source of change has emanated from net exports, which have moved from slicing off nearly 2% to GDP growth in late 2015 to adding more than 3% in the most recent quarter. The fluctuations in Australian growth have in large part reflected the dynamics in commodities prices. Australia has undergone massive fluctuations in its terms-of-trade as iron ore, copper and coal prices experienced a bust, followed by a subsequent boom that has pushed base metals prices up by 76% since their nadir. These movements in commodity prices not only explain past gross domestic product performance, they also explain the swings in both national income and corporate profits (Chart I-5). Chart I-4Australian Growth Decomposition Chart I-5The Positive Shock: Commodities In response to the improvement in national income and profits since the winter of 2016, the basic balance of Australia has surged from a deficit of 3% of GDP to a surplus of 3% (Chart I-6). While higher commodities prices contributed to higher exports, lifting the current account, portfolio flows moved up by more than 4% of GDP. This was simply because the surge in Australian corporate profits also made investing in Australia much more attractive for investors around the world. This combination caused a lot of investors to buy Australian dollars in the process, generating a severe upward bias in favor of the AUD. But how these trends are likely to evolve remains uncertain. To begin with, the rate of change of the Reserve Bank of Australia's commodity index has already rolled over, plunging from a high of 47% six months ago to -1% today. The historical lead times of this variable on GDP, GNI and profits suggests that each of these three variables are set to decelerate meaningfully in the coming quarters. This could weigh on inflows into Australia. China too plays a key role. Exports to China were subtracting 0.5% from Australia's growth as of the end of 2016 and are now adding 1.5%. Swings in Chinese activity could amplify the impact of the rollover in commodities price inflation. In fact, the slowing Li Keqiang index already paints this exact picture (Chart I-7). The growth rate of railway freight, one of the index's components, has already collapsed from 20% in August 2017 to 1%, and iron ore stockpiles in Chinese ports are hitting record highs. The tightening of the monetary and fiscal screws in China are therefore likely to exert a negative impact on Australia's national income, and thus on inflows that have been so important in supporting the AUD. Chart I-6From Income Shock To ##br##Balance Of Payment Shock Chart I-7China's Boost Is Dissipating ##br##The Boost To Trade Is Dissipating But what about real economic activity? Here again, the picture does not shine particularly bright. Fiscal policy has been a drag on GDP since 2011, and 2018 will be no exception, as the fiscal thrust will be -0.3% of potential GDP (Chart I-8). A potential rollover in aggregate profits could limit corporate capex in 2018. Mining projects in Australia are expected to continue to decline as a share of GDP in 2018, thus mining capex will remain a drag on growth (Chart I-9). Moreover, imports of capital goods have been a leading indicator of Australian capex, and they too have rolled over after a recent surge, suggesting that non-mining capex growth will also experience limited upside. The Australian consumer is also unlikely to come and save the day. To begin with, the savings rate has additional upside. As net worth has increased, Australian households have curtailed their savings rate to 3% of disposable income (Chart I-10). Moreover, debt levels have increased significantly, rising to an eye-opening 200% of income. The problem is that Australian housing is now much overvalued (Chart I-11). While this does not guarantee a fall in house prices, it is highly unlikely that net worth will continue to increase at its heady pace. Thus, with high debt loads and a limited wealth effect, the probability is high that the savings rate will increase. Chart I-8Fiscal Policy: Still Contractionary ##br## Fiscal Policy Is Still A Drag Chart I-9Mining Capex##br## Still Falling Chart I-10Households Savings ##br##Rate Should Rise Put together, the Australian economy is unlikely to accelerate this year. As Chart I-12 illustrates, business confidence has been weakening throughout the year, new orders are at high levels but are rolling over, and real consumer spending has not been able to gain any traction - despite job growth reaching a 3.8% annual pace. Job growth is unlikely to accelerate from such high levels, limiting the potential for household income growth to undo the damage of a rising savings rate. Chart I-11House Price Gains Will Slow Chart I-12No Boost To Real GDP Growth Bottom Line: The Australian dollar has benefitted from a major nominal improvement in the economy. As terms of trade rebounded, so did nominal GDP, national income and profits. This caused a surge in inflows into the country. However, the best of the positive terms-of-trade shock is ebbing, and the slowdown in Chinese industrial activity also points to weakening national income growth. In terms of real activity, the Australian fiscal drag continues unabated, capex will not accelerate, and households are likely to increase their savings rate, which will weigh on consumption. While Australia is not on the verge of recession, it will not experience much of a boom either. But How Fast Can The RBA Hike Anyway? Chart I-13The RBA Is Limited By Economic Slack The RBA is also still facing a tough environment. On one hand, job creation was very robust in Australia last year, and core CPI has accelerated. However, wage growth remains depressed at 2%. Even more disturbing is the fact that Australian wages have decoupled from a reliable driver: exports to China (Chart I-13). This underscores the extremely large degree of slack present in the Australian labor market. As the middle panel of Chart I-13 displays, the underemployment rate remains near twenty five-year highs and is congruent with the current level of wage growth. Moreover, Australia's output gap is still -2% of GDP and is not expected to close until after 2020. Thus, the underemployment rate will continue to act as an anchor on policy (Chart I-13, bottom panel). The strength in the AUD since 2016 will play into these dynamics. The lack of traction on wages is likely to be compounded by the tightening in monetary conditions resulting from an expensive AUD. As such, we would expect core CPI to weaken again in the coming quarters, which will comfort the RBA that its dovish stance remains appropriate. Finally, the high indebtedness of Australian households along with the fact that house price appreciation has slowed also suggests that household balance sheets are not capable of withstanding much of an increase in interest rates right now. The RBA is unlikely to toy with such a deflationary risk while the output gap is still negative and labor utilization is so low. The market is currently pricing in 40 basis points of hikes in 2018. A hike in 2018 is possible, as the global economy has healed from its deflationary nadir of 2016, but the economic backdrop of Australia will not let the RBA test the waters more than once this year. We thus anticipate that the RBA will continue to lag the Bank of Canada and the Federal Reserve - two central banks we expect to raise rates three times in 2018. The RBA will also most likely lag behind the RBNZ. Bottom Line: The Australian economy is replete with excess capacity, which is limiting the ability of the RBA to push up its policy rate. Moreover, the elevated indebtedness of Australian households suggests the RBA is loath to generate a deflationary shock while the output gap is already negative. The RBA will therefore lag the Fed, the BoC and the RBNZ. Implications For The AUD AUD/USD is currently trading at a 15% premium to its purchasing power parity equilibrium versus the U.S. dollar, making it one of the rare currencies expensive against the still-pricey greenback (Chart I-14, top panel). Moreover, Australia's real effective exchange rate also trades above its long-term average (Chart I-14, bottom panel). While the AUD is not wildly expensive, its current premium to fair value does suggest it would not be immune to adverse cyclical dynamics. What do the cyclical drivers currently say about the AUD? As we have highlighted, Australian national income and profit growth are likely to decelerate sharply in 2018, which is likely to undo some of the improvement that has materialized in the basic balance and thus remove one of the key supports that has underpinned the AUD. In this optic, the fact that the AUD has been able to strengthen despite a significant deceleration in Australian exports of iron ore to China raises a yellow flag against the AUD's strength (Chart I-15). Chart I-14No Valuation Cushion In AUD Chart I-15AUD Disconnect However, when investors expect strong growth from EM economies, the AUD does well. Thus, if the outlook for EM growth remains healthy, current weaknesses in commodities shipments can be safely ignored. Under this framework, the recent sharp upgrade by global investors of long-term earnings growth of EM equities sheds light on the AUD's strength, despite slowing iron ore exports (Chart I-16). Yet, this growth expectation is now the highest on record. This suggests the expectation hurdles in EM are very elevated. Even if EM growth does not crater, any disappointment could leave the AUD in a vulnerable position. The rollover in the annual performance of EM/JPY carry trades point to a growing risk of such disappointments.3 Financial markets are also sending interesting signals. Australian equities are underperforming global indices in local currency terms, suggesting the growth outlook for Australia is weakening relative to the rest of the world. These developments are true even when financial stocks are removed from the equation. Moreover, AUD/USD has historically traded in line with the relative performance between Australian and U.S. equities. Not only is the AUD currently quite above the level implied by the relative stock performance, but also the underperformance of Aussie stocks is deepening. This is another poor omen for AUD/USD (Chart I-17). Chart I-16Investors Love EM, ##br##This Helps The Aussie Chart I-17Listen To Equities If stocks are sending a message regarding the path of the Australian economy vis-à-vis the U.S., and thus about the outlook for AUD/USD, so are various key drivers of policy. First, AUD/USD normally broadly tracks the gap in the five-year moving average of nominal GDP growth between Australia and the U.S. This growth differential is moving in the opposite direction of AUD/USD, and based on the IMF's forecast, it is only expected to widen. AUD/USD has also been responsive to the relative utilization of labor, as measured by the spreads between the U.S.'s U-6 unemployment rate and Australia's labor underemployment measure (Chart I-18). Currently, this spread is not ratifying the rally in AUD/USD - and is pointing toward a much more hawkish Fed than RBA. This too paints a somber picture for the Aussie. This picture is echoed by the trend in Australia's employment-to-population ratio for prime age workers relative to the U.S. Again, Australia's large labor market excess supply points to a weaker AUD (Chart I-19, top panel). What's more, Australia's employment-to-population ratio is set to fall further vis-à-vis the U.S. This relative labor utilization measure has tracked the share of investment as a percent of Chinese GDP. This is because the investment-heavy period of development that China has undergone over the past 30 years has been very commodities intensive, forcing full labor utilization in Australia. However, based on the IMF's forecast, the role of investment in the Chinese economy is set to decline further (Chart I-19, bottom panel). Chart I-18Labor Market Slack Points To Weak AUD Chart I-19Labor Market And China Additionally, Xi Jinping's reforms are about decreasing pollution and leverage while increasing the role of consumption and services in the economy. This points to a risk of an even greater fall in the share of capex in China's economy. This would deepen the decline in labor utilization in Australia relative to the U.S., and thus increase downside risk for the AUD. Another risk emanates from U.S. financial markets themselves. The AUD tends to perform well when volatility in financial markets is on the decline, or at very low levels. This describes the current state of financial markets. On the other hand, a higher VIX is associated with a declining AUD. The VIX's current low level is not enough to flash an imminent sell signal, but the risk of a spike in risk aversion increases significantly if the spot VIX is low and the VIX futures curve is "too flat." Since there is a strong inverse relationship between the VIX futures curve slope and the spot VIX, the curve is "too flat" when its steepness is below the degree implied by the line of best fit linking the slope to spot VIX. As Chart I-20 shows, when the slope of the VIX is below this implied fair value, the subsequent 12 months of returns in the AUD/USD have been negative 84% of the time. The current reading in this relationship suggests that the AUD could depreciate by a large amount over the coming year. Chart I-20Flat VIX Term Structure = Lower AUD In 12 Months Bottom Line: Australia's national income growth is set to decline, and the RBA is unlikely to increase rates more than is currently priced into the curve. Moreover, the Australian dollar is trading on the expensive side. These factors point to vulnerability for the AUD. Moreover, key variables are suggesting this vulnerability could materialize into actual weakness: investors are pricing in too much growth in the EM space, Australian equities point to growth underperformance, labor market utilization measures suggest relative policy will hurt the AUD, China's long-term policy tilt is becoming increasingly AUD-negative, and any spike in asset volatility would hurt the Aussie. Strategy Considerations The arguments highlighted above all point to a weakening AUD. However, the picture is never that clear-cut. In fact, there is one major risk to our view: commodities prices and the USD itself. As Chart I-21 illustrates, commodities prices have a stronger inverse relationship with the USD than they have a positive link to Chinese economic conditions. Thus, if the greenback were to weaken further, the AUD could delay its moment of reckoning even further. This suggests that playing AUD weakness on its crosses, while potentially less rewarding, is a safer strategy. Our long-term valuation models continue to highlight the positive risk/reward tradeoff to shorting AUD/NZD: Not only is the New Zealand economy less exposed to shifting away from investment in the Chinese economy, AUD/NZD is trading at valuation levels that are historically followed by periods of pronounced weakness (Chart I-22). Moreover, the Kiwi economy is displaying a much higher level of resource utilization than Australia, suggesting there is more scope for the RBNZ to increase rates than there is for the RBA. Chart I-21Risk To The View: The Weak USD Chart I-22Improve Your Reward To Risk: Short AUD/NZD The same can be said about AUD/CAD. AUD/CAD also trades at a significant premium to its fair value. As we argued two weeks ago, like New Zealand, labor and capacity utilization in Canada are both very tight, thus we foresee three BoC rate hikes this year, which is at least two more than we anticipate in Australia. Additionally, our commodity strategists continue to like energy more than they like metals. Thus, terms-of-trade dynamics will play in favor of the CAD. That being said, this trade is much more correlated with the movements in AUD/USD than the AUD/NZD bet is. Shorting AUD/JPY is also an attractive trade right now. AUD/JPY is trading at a 30% premium to purchasing power parity, and the risk represented by a potential removal of over-exuberance currently evident in the pricing of growth in EM markets would likely be amplified in this cross. Additionally, as we highlighted two weeks ago, the risk of a tactical rally in the JPY is growing significantly. Bottom Line: The outlook is negative for AUD/USD, but if the USD's bear market can gather force from current levels, this would dampen the attractiveness of shorting the Aussie. While potentially less profitable but also considerably less risky, shorting AUD/NZD and AUD/CAD remain attractive expressions of our negative AUD bias. We also like going short AUD/JPY as it plays both on our positive tactical view on the JPY and on the risks of a slowdown in EM earnings growth expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Even if he somewhat retracted his comments later during the day. 2 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets," dated December 8, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: The Chicago Fed National Activity Index underperformed expectations of 0.44, coming in at 0.27; The Richmond Fed Manufacturing Index came in at 14, well below the expected 19; Manufacturing PMI came in at 55.5, above the consensus of 55; Existing Home Sales contracted by 3.6% on a monthly pace; New Home Sales contracted by 9.3% on a monthly pace; Continuing jobless claims underperformed at 1.937 million, while initial jobless claims outperformed expectations at 233,000. The greenback has experienced notable downside this week owing to a slew of disappointing data and significant technical breakdowns. Treasury Secretary Steven Mnuchin's comments concerning a weaker dollar being beneficial for growth only added fuel to the fire. We have a neutral view on the greenback against the euro as emerging inflation in the U.S. later in the year should help alleviate some of the gains in the euro. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 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 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data this week was stellar: German Current Situations and Economic Sentiment ZEW Surveys came in at 95.2 and 20.14, outperforming the expected 89.8 and 17.8; Overall euro area Economic Sentiment ZEW Survey came in at 31.8, outperforming the expected 29.7; European consumer confidence also beat expectations of 0.6, coming in at 1.3; German IFO Business Climate and Current Assessment outperformed expectations, while the Expectations survey underperformed; German Gfk Consumer Confidence came in at 11, also surpassing expectations of 10.8. Mario Draghi affirmed his positive outlook on European growth and inflation. However, we believe that the most recent move to 1.25 is unsustainable as the euro continues to decouple from relative terminal rates. We believe that signs of weakening global growth should translate into a weaker euro in the short term. Report Links: The Unstoppable Euro - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Even if they decelerated relative to the previous month, imports yearly growth surprised to the upside, coming in at 14.9%. Moreover, the Nikkei Manufacturing PMI also outperformed expectations, coming in at 54.4. The All Industry Activity Index month-on-month growth also outperformed, coming in at 1%. However, exports yearly growth, surprised to the downside, coming in at 9.3%. The Bank of Japan left the reference rate unchanged at -0.1%. In their Outlook for Economic Activity and Prices, the BoJ stated that it expects inflation to reach the 2% target by 2019. Moreover, the committee highlighted that the output gap will move further into positive territory in 2018 and 2019. Overall, we expect for the yen to appreciate in coming months, particularly against the Euro, given that financial conditions have tightened much more in Europe than in Japan. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Retail sales and retail sales ex-fuel yearly growth both underperformed expectations, coming in at 1.4% and 1.3% respectively. Both of these measures also declined relatively to last month. Moreover, the claimant count change surprised negatively, coming in at 8.6 thousand. However, average earnings excluding bonus yearly growth outperformed expectations, coming in at 2.4%. This number also increased from 2.3% last month. GBP/USD has surged by almost 4% this week, partly due to the fall in the dollar. However the pound has also rallied against the euro, with EUR/GBP falling by almost 2%. Overall, the ability for the BoE to raise rates relative to other central banks will be limited, as the strengthening currency should create a drag on inflation and the economy displays underlying weaknesses. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Australian dollar has benefitted from last year's stellar growth period, now above the crucial 0.80 level. Slowing Chinese industrial activity and a domestic fiscal drag will handicap Australian growth this year. We believe the AUD is expensive amongst various metrics and the RBA is unlikely to hike any time soon given the negative output gap. Additionally, substantial labor market slack remains as the concentration of employment has been in part-time growth. We believe markets are overpricing hikes at 40 bps, and the AUD will suffer once this becomes priced in. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data In New Zealand has been mixed: The ANZ Activity Outlook was unchanged from last month, coming in at 15.6%. However, headline inflation surprised to the downside, coming in at 1.6%. It also declined significantly from last month's 1.9% value. Intraday, the kiwi fell by almost 1.5% following the weak inflation number. However even amid this drop NZD/USD has rallied by almost 1% this week, as the dollar has weakened to its lowest level in 3 years. Overall, we are positive on this cross relatively to the AUD, given that Australia is more sensitive to a slowdown in China than New Zealand. However, the New Zealand dollar will likely have downside against the yen. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada was mixed: Wholesale sales monthly growth missed expectations of 1%, coming in at 0.7%; Headline retail sales missed expectations of 0.7%, coming in only at 0.2% on a monthly basis; Core retail sales (ex. Autos) outperformed the expected 0.8% greatly, coming in at 1.6% month-on-month; We remain bullish on CAD as strong employment and higher wages will augur well for inflation this year. Higher oil prices will continue to power the Canadian economy and help close the output gap in line with expectations. The Bank will therefore continue to tighten policy. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen this week by almost 0.5% even as the euro has rallied. Nevertheless, as long as the SNB continues with its ultra-dovish monetary stance, upside for the franc is limited, as the Swiss National Bank will continue to intervene in the currency markets. Indeed, on Monday SNB president Thomas Jordan once again reiterated that he believed that the franc was "Highly Valued". As of now, while inflation is slowly picking up, wage growth and house price growth are too anemic for the SNB to have a significant change in their monetary stance. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has depreciated by 2.2% this week, as it has been struck by a double whammy of higher oil prices and a very weak dollar. Meanwhile, on Wednesday, the Norges Bank decided to keep its key interest rate unchanged at 0.25%. The bank decided that monetary policy should stay accommodative for the foreseeable future, as inflation is likely to stay under target. Furthermore they stated that inflation, the economy, and the currency were evolving according to their December 2017 expectations. Overall, we expect the krone to appreciate relative to the Canadian dollar, as the BoC is fully priced this year, while the Norwegian interest rates could still have some upside amid rising oil prices. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 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 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Data out of Sweden was mixed: Consumer confidence decreased to 107.2 from 107.7, under expectations of 107.4; The unemployment rate increased to 6% from 5.8%, but beat expectations of 6.1%; Producer prices increased in December at a 1.6% monthly pace, and a 2.3% yearly pace. The SEK has appreciated noticeably given the recent hawkish comments by Riksbank officials about the policy path. While the consensus does seem to be changing in the Bank, we remain cautious given Ingves' dovish leanings. SEK could weaken against EUR for the rest of the year given Europe's stellar growth momentum. Report Links: 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 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report co-authored by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst, and Brian Piccioni of Technology Sector Strategy. Mark and Brian argue that the deflationary impact of robot automation will not prevent inflation from rising as the labor market tightens. I hope you will find their report interesting and informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Our cyclically overweight stance on global equities/underweight stance on bonds is working. Stick with it. U.S. Treasury Secretary Mnuchin's comments about the dollar are unlikely to have any lasting effects. EUR/USD has decoupled from terminal rate expectations since the start of this year. Tactical trade recommendation: Go short EUR/USD while simultaneously going long 30-year U.S. Treasurys/short 30-year German bunds. Feature Global Equities Enter A Blow-Off Phase Valuations do not matter on the way up, but they sure do matter on the way down. Once the market reaches that Wile E. Coyote moment - the one where the poor sap runs off the cliff, pauses in mid-air, looks down, and sees the ground below - all hell will break loose. On every valuation measure, U.S. stocks, and increasingly global stocks, have become very expensive (Chart 1). Chart 1AU.S. Stocks Are Expensive... Chart 1B...While Global Stocks Are Getting There That moment, however, is unlikely to arrive until the global economy and earnings growth begin to stall out. As we have argued in past reports, this probably will not happen until late next year. Historically, it has not paid to get defensive until six months before the start of a recession (Table 1). This suggests that stocks could continue to rally right through 2018. Beep beep. Table 1Too Soon To Get Out Granted, the timing of our recession call could turn out to be wrong, which is why we are watching a wide number of leading variables for signs that a slowdown is around the corner (Chart 2). In the U.S., these include credit spreads, the slope of the yield curve, financial conditions, business and consumer confidence, ISM new orders minus inventories, building permits, core capital goods orders, and initial unemployment claims. We have consolidated these variables and dozens of others into our MacroQuant model. The model is still pointing to a reasonably rosy cyclical outlook for stocks (Chart 3). Chart 2Leading Cyclical Data Still Strong Chart 3Cyclical Outlook For Stocks Is Still Rosy The Dollar Takes A Pounding While our cyclical bullish view on stocks and bearish view on bonds has paid off this year, our expectation that the dollar would recoup some of last year's losses has not worked out. Time will tell if December 2016 marked the beginning of a secular dollar bear market. The dollar tends to suffer when global growth accelerates. This happened last year. The dollar also tends to weaken when the composition of growth shifts away from the United States. That also happened in 2017. The remainder of this year could be different. We expect global growth to remain solidly above-trend in 2018, but ease from the torrid pace of 2017. This is already being foreshadowed by the decline in our Global LEI diffusion index to below 50%, a slowdown in Korean and Taiwanese exports, a deceleration in the Chinese Li Keqiang Index, and the loss of momentum in EM carry trades (Chart 4). Meanwhile, the composition of global growth should shift back in favor of the U.S. The fact that the U.S. Economic Surprise index has recovered in recent months relative to other economies suggests that this reversal of fortunes is already underway (Chart 5). The end result for asset markets could be slightly reminiscent of the late 1990s, a period when both equities and the dollar rallied. Chart 4Global Growth Will Remain Above-Trend ##br##But Ease From Blistering Pace Chart 5Composition Of Global Growth Will Shift ##br##Back In Favor Of The U.S. Talk Is Cheap Chart 6Trade-Weighted Dollar No Longer Pricey We do not put much weight on the remarks concerning the dollar made by Treasury Secretary Steven Mnuchin at Davos this week. While Mnuchin did say that "obviously a weaker dollar is good for us as it relates to trade and opportunities," he added that "longer term, the strength of the dollar is a reflection of the strength of the U.S. economy and the fact that it is and it continues to be the primary currency in terms of the reserve currency." More importantly, history suggests that verbal interventions in currency markets are only effective beyond the near term when backed by a supporting change in monetary policy. Many people remember the success that then-Treasury Secretary James Baker had in driving down the dollar following the Plaza Accord in 1985, but what is often forgotten is that the Federal Reserve steadily cut rates from 11.8% in July 1984 to 5.8% in October 1986. As a result, the 2-year interest rate differential fell by 454 bps against Japan, 630 bps against the U.K., and 407 bps against Germany over this period. It is also worth noting that the Fed's real broad trade-weighted dollar index is now 27% below its 1985 peak and 3% below its long-term average (Chart 6). This makes any effort to talk down the dollar all the more difficult. ECB Sending Mixed Messages About The Euro Chart 7Market Has Brought Forward ECB Rate Hikes ECB officials continue to send mixed messages about the resurgent euro. Earlier this month, ECB Vice President Vitor Constâncio and Bank of France Governor François Villeroy both expressed concern about the euro's strength, as did Ewald Nowotny, the fairly hawkish President of Austria's central bank. In contrast, Mario Draghi refused to wade into the debate during yesterday's press conference. The lack of angst in his tone sent the euro higher. Draghi's reluctance to say anything concrete about the euro was partly motivated by the desire to avoid the sort of "beggar thy neighbor" criticism that greeted Mnuchin's remarks. Like other central banks, the ECB gives a lot of weight to financial conditions in setting monetary policy. A stronger currency has tightened euro area financial conditions. This is something that must concern the ECB, at least behind closed doors. Ultimately, any effort by the ECB to knock down the euro will only work if it convinces the market to soften its expectations about the future pace of rate hikes. The likelihood of such an outcome is certainly higher now than it was in 2016. Our "months to hike" measure for the ECB has plummeted from over 60 months in mid-2016 to 19 today (Chart 7). Given that the ECB has made it clear that it intends to delay raising rates for some time after asset purchases end later this year, it is hard to see the central bank hiking rates before the summer of 2019. That is not far from where market pricing now stands. In contrast, if euro area growth were to surprise meaningfully on the downside or if core inflation in the peripheral economies continues to fall - it is already close to zero in Italy - the ECB could be forced to bide its time longer than the market currently expects. A Safer Way To Short EUR/USD Chart 8EUR/USD And Rate Decoupling ##br##Will Not Last Long Still, the euro has a lot going for it. Unlike the U.S., the euro area is running a current account surplus. This means the region does not need to attract foreign capital for there to be excess demand for euros. All it needs to do is keep net capital outflows roughly below 3% of GDP. The ability of the euro area to retain and attract fresh capital has become easier as political risk has ebbed and the ECB's pledge to do "whatever it takes" to preserve the euro has solidified. The euro's share of global central bank reserves currently stands at 20%, well below the 60% share enjoyed by the U.S. dollar. If capital continues to gravitate towards the region, the euro could strengthen further. All this makes shorting the euro a risky bet. With that in mind, investors should consider hedging short EUR/USD positions by wagering that the terminal rate spread between the euro area and the U.S. will narrow. Chart 8 shows that the spread in expected policy rates ten years out has decoupled from EUR/USD since the start of the year. The same is true for the 30-year spread between Treasurys and bunds - another good proxy for the terminal rate spread. While spreads have widened in favor of the dollar, the greenback has nonetheless plunged. Such decoupling rarely lasts long, which makes this a highly attractive trade. With that in mind, we are going short EUR/USD as a tactical trade while hedging the risk of a stronger euro by going long 30-year Treasurys/short 30-year bunds (a bet on further spread compression). Given that the first leg of the trade is more volatile than the second, we are scaling up the latter by a factor of 1.5. We will aim to close the trade for a gain of 5% (EUR/USD of about 1.18), assuming no change in the current spread of 160 bps. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Underweight United Airlines spooked the market this week when they announced their plans to grow capacity by 4-6% per year until 2020; the stock fell by 11% that day and took the S&P airlines index down with it. Capacity additions of this magnitude force competitors to choose between matching or ceding market share. Either choice bodes poorly for airfare pricing, probably unwisely considering how consumer spending on airfares has already fallen off a cliff (second panel). Meanwhile, input prices have shot upward and have diverged sharply from airlines’ ability to pass through fuel costs (third panel). This means a reversal of the downward trend in margins remains well beyond the horizon (bottom panel). Investors should avoid the turbulence; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK.

Highlights U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, recent market action is beginning to resemble a classic late cycle blow-off phase. The fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. The S&P 500 could return 14% or more this year. Unfortunately, the consensus now shares our upbeat view for 2018. Valuation is stretched and many indicators suggest that investors have become downright giddy. This month we compare valuation across the major asset classes. U.S. equities are the most overvalued, followed by gold, raw industrials and EM assets. Oil is still close to fair value. Long-term investors should already be scaling back on risk assets. Investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but a risk management approach means that they should not try to squeeze out the last few percentage points of return. In terms of the sequencing of the exit from risk, the most consistent lead/lag relationship relative to previous tops in the equity market is provided by U.S. corporate bonds. For this reason, we are likely to take profits on corporates before equities. EM assets are already at underweight. We still see a window for the U.S. dollar to appreciate, although by only about 5%. A lot of good news is discounted in the euro, peripheral core inflation is slowing and ECB policymakers are getting nervous. Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. The economy and inflation should justify four Fed rate hikes in 2018 no matter the makeup. The bond bear phase will continue. Feature Chart I-1Investors Are Giddy U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, though, recent market action is beginning to resemble the classic late cycle blow-off phase. Such blow-offs can be highly profitable, but also make it more difficult to properly time the market top. Our base case is that the fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. Unfortunately, the consensus now shares our upbeat view for 2018 and many indicators suggest that investors have become downright giddy (Chart I-1). These indicators include investor sentiment, our speculation index, and the bull-to-bear ratio. Net S&P earnings revisions and the U.S. economic surprise index are also extremely elevated, while equity and bond implied volatility are near all-time lows. From a contrarian perspective, these observations suggest that a lot of good news is discounted and that the market is vulnerable to even slight disappointments. It is also a bad sign that our Revealed Preference Indicator moved off of its bullish equity signal in January (see Section III for more details). Meanwhile, central banks are beginning to take away the punchbowl as global economic slack dissipates. This is all late-cycle stuff. Equity valuation does not help investors time the peak in markets, but it does tell us something about downside risk and medium-term expected returns. The Shiller P/E ratio has surged above 30 (Chart I-2). Chart I-3 highlights that, historically, average total returns were negligible over the subsequent 10-year period when the Shiller P/E was in the 30-40 range. Granted, the Shiller P/E will likely fall mechanically later this year as the collapse of earnings in 2008 begins to drop out of the 10-year EPS calculation. Nonetheless, even the BCA Composite Valuation indicator, which includes some metrics that account for extremely low bond yields, surpassed +1 standard deviations in January (our threshold for overvaluation; Chart I-2, bottom panel). An overvaluation signal means that investors should be biased to take profits early. Chart I-2BCA Valuation Indicator Surpasses One Sigma Chart I-3Expected Returns Given Starting Point Shiller P/E As we highlighted in our 2018 Outlook Report, long-term investors should already be scaling back on risk assets. We recommend that investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but we need to be vigilant in terms of scouring for signals to take profits. A risk management approach means that investors should not try to get the last few percentage points of return before the peak. U.S. Earnings And Repatriation Before we turn to the timing and sequence of our exit from risk assets, we will first update our thoughts on the earnings cycle. Fourth quarter U.S. earnings season is still in its early innings, but the banking sector has set an upbeat tone. S&P 500 profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS growth estimates have been aggressively ratcheted higher (from 12% growth to 16%) in a mere three weeks on the back of Congress' cut to the corporate tax rate.1 U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Our short-term profit model remains extremely upbeat (Chart I-4). The positive profit outlook for the first half of the year is broadly based across sectors as well, according to the recently updated EPS forecast models from BCA's U.S. Equity Sector Strategy service.2 The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. Studies of the 2004 repatriation legislation show that most of the funds "brought home" were paid out to shareholders, mostly in the form of buybacks. A NBER report estimated that for every dollar repatriated, 92 cents was subsequently paid out to shareholders in one form or another. The surge in buybacks occurred in 2005, according to the U.S. Flow of Funds accounts and a proxy using EPS growth less total dollar earnings growth for the S&P 500 (Chart I-5). The contribution to EPS growth from buybacks rose to more than 3 percentage points at the peak in 2005. Chart I-4Profit Growth Still Accelerating Chart I-5U.S. Buybacks To Lift EPS We expect that most of the repatriated funds will again flow through to shareholders, rather than be used to pay down debt or spent on capital goods. Cash has not been a constraint to capital spending in recent years outside of perhaps the small business sector, which has much less to gain from the tax holiday. A revival in animal spirits and capital spending is underway, but this has more to do with the overall tax package and global growth than the ability of U.S. companies to repatriate overseas earnings. Estimates of how much the repatriation could boost EPS vary widely. Most of it will occur in the Tech and Health Care sectors. Buybacks appear to have lifted EPS growth by roughly one percentage point over the past year. We would not be surprised to see this accelerate by 1-2 percentage points, although the timing could be delayed by a year if the 2004 tax holiday provides the correct timeline. This is certainly positive for the equity market, but much of the impact could already be discounted in prices. Organic earnings growth, and the economic and policy outlook will be the main drivers of equity market returns over the next year. We expect some profit margin contraction later this year, but our 5% EPS growth forecast is beginning to look too conservative. This is especially the case because it does not include the corporate tax cuts. The amount by which the tax cuts will boost earnings on an after-tax basis is difficult to estimate, but we are using 5% as a conservative estimate. Adding 2% for buybacks and 2% for dividends, the S&P 500 could provide an attractive 14% total return this year (assuming no multiple expansion). Timing The Exit Chart I-6Timing The Exit (I) That said, we noted in last month's Report and in BCA's 2018 Outlook that this will be a transition year. We expect a recession in the U.S. sometime in 2019 as the Fed lifts rates into restrictive territory. Equities and other risk assets will sniff out the recession about six months in advance, which means that investors should be preparing to take profits sometime during the next 12 months. Last month we discussed some of the indicators we will watch to help us time the exit. The 2/10 Treasury yield curve has been a reliable recession indicator in the past. However, the lead time on the peak in stocks was quite extended at times (Chart I-6). A shift in the 10-year TIPS breakeven rate above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We are likely to take some money off the table if core inflation is rising, even if it is still below 2%, at the time that the TIPS breakeven reaches 2.4%. We will also be watching seven indicators that we have found to be useful in heralding market tops, which are summarized in our Scorecard Indicator (Chart I-7). At the moment, four out of the seven indicators are positive (Chart I-8): State of the Business Cycle: As early signals that the economy is softening, watch for the ISM new orders minus inventories indicator to slip below zero, or the 3-month growth rate of unemployment claims to rise above zero. Monetary and Financial Conditions: Using interest rates to judge the stance of monetary policy has been complicated by central banks' use of their balance sheet as a policy tool. Thus, it is better to use two of our proprietary indicators: the BCA Monetary Indicator (MI) and the Financial Conditions Indictor. The S&P 500 index has historically rallied strongly when the MI is above its long-term average. Similarly, equities tend to perform well when the FCI is above its 250-day moving average. The MI is sending a negative signal because interest rates have increased and credit growth has slowed. However, the broader FCI remains well in 'bullish' territory. Price Momentum: We simply use the S&P 500 relative to its 200-day moving average to measure momentum. Currently, the index is well above that level, providing a bullish signal for the Scorecard. Sentiment: Our research shows that stock returns have tended to be highest following periods when sentiment is bearish but improving. In contrast, returns have tended to be lowest following periods when sentiment is bullish but deteriorating. The Scorecard includes the BCA Speculation Indicator to capture sentiment, but virtually all measures of sentiment are very high. The next major move has to be down by definition. Thus, sentiment is assigned a negative value in the Scorecard. Value: As discussed above, value is poor based on the Shiller P/E and the BCA Composite Valuation indicator. Valuation may not help with timing, but we include it in our Scorecard because an overvalued signal means investors should err on the side of getting out early. Chart I-7Equity ScoreCard: Watch For A Dip Below 3 Chart I-8Timing The Exit (II) We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in subsequent months. A drop below three this year would signal the time to de-risk. Table I-1Exit Checklist To our Checklist we add the U.S. Leading Economic index, which has a good track record of calling recessions. However, we will use the LEI excluding the equity market, since we are using it as an indicator for the stock market. It is bullish at the moment. Our Global LEI is also flashing green. Table I-1 provides a summary checklist for trimming equity exposure. At the moment, 2 out of 9 indicators are bearish. Cross Asset Valuation Comparison Clients have asked our view on the appropriate order in which to scale out of risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the ones that are most overvalued are at greatest risk, and thus profits should be taken the earliest. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time period? Since there is no widely accepted approach, we include multiple measures. More than one time period was used in some cases to capture regime changes. Table I-2 provides out 'best guestimate' for nine asset classes. The approaches range from sophisticated methods developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (oil), to simple deviations from a time trend (real raw industrial commodity prices and gold). Table I-2Valuation Levels For Major Asset Classes We averaged the valuation readings in cases where there are multiple estimates for a single asset class. The results are shown in Chart I-9. Chart I-9Valuation Levels For Major Asset Classes U.S. equities stand out as the most expensive by far, at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads come next at 0.7, followed closely by U.S. Treasurys (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are quite expensive in absolute terms based on the fact that government bonds are expensive. Oil is sitting very close to fair value, despite the rapid price run up over the past couple of months. This makes oil exposure doubly attractive at the moment because the fundamentals point to higher prices at a time when the underlying asset is not expensive. Sequencing Around Past S&P 500 Peaks Historical analysis around equity market peaks provides an alternative approach to the sequencing question. Table I-3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table I-3Asset Class Leads & Lags Vs. Peak In S&P 500 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, Tech stocks, or small-cap versus large-cap relative returns. Sometimes they peaked before the S&P 500, and sometime after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyse due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time is long and variable. The most consistent lead/lag relationship is given by the U.S. corporate bond market. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio in advance of scaling back on equities. But the 'return of vol' that we expect to occur later this year will take a toll on carry trades more generally. We are already underweight EM equities and bonds. This EM recommendation has not gone in our favor, but it would make little sense to upgrade them now given our positive views on volatility and the dollar. An unwinding of carry trades will also hit the high-yielding currencies outside of the EM space, such as the Kiwi and Aussie dollar. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over to the EM economies as we expect. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of the Chinese economy in the coming months. Oil is a different story. OPEC 2.0 is likely to cut back on supply in the face of an economic downturn, helping to keep prices elevated. We therefore may not trim energy exposure this year. As for equity sectors, our recommended portfolio is still overweight cyclicals for now. Our synchronized global capex boom, rising bond yield, and firm oil price themes keep us overweight the Industrials, Energy and Financial sectors. Utilities and Homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. That said, our sector specialists are already beginning a gradual shift away from cyclicals toward defensives for risk management purposes. This transition will continue in the coming months as we de-risk. We are also shifting small caps to neutral on earnings disappointments and elevated debt levels. The Dollar Pain Trade Market shifts since our last publication have largely gone in our favor; stocks have surged, corporate bonds spreads have tightened, oil prices have spiked, bonds have sold off and cyclical stocks have outperformed defensives. One area that has gone against us is the U.S. dollar. Relative interest rate expectations have moved in favor of the dollar as we expected at both the short- and long-ends of the curve. Nonetheless, the dollar has not tracked its historical relationship versus both the yen and euro. The Greenback did not even get a short-term boost from the passage of the tax plan and holiday on overseas earnings. Perhaps this is because the lion's share of "overseas" earnings are already held in U.S. dollars. Reportedly, a large fraction is even held in U.S. banks on U.S. territory. Currency conversion is thus not a major bullish factor for the U.S. dollar. The recent bout of dollar weakness began around the time of the release of the ECB Minutes in January which were interpreted as hawkish because they appeared to be preparing markets for changes in monetary policy. The European debt crisis and economic recession were the reasons for the ECB's asset purchases and negative interest rate policy. Neither of these conditions are in place now. The ECB is meeting as we go to press, and we expect some small adjustments in the Statement that remove references to the need for "crisis" level accommodations. Subsequent steps will be to prepare markets for a complete end to QE, perhaps in September, and then for rates hikes likely in 2019. The key point is that European monetary policy has moved beyond 'peak stimulus' and the normalization process will continue. Perhaps this is partly to blame for euro strength although, as mentioned above, interest rate differentials have moved in favor of the dollar. Does this mean that the dollar has peaked and has entered a cyclical bear phase that will persist over the next 6-12 months? The answer is 'no', although we are less bullish than in the past. We believe there is still a window for the dollar to appreciate against the euro and in broader trade-weighted terms by about 5%. First, a lot of euro-bullish news has been discounted (Chart I-10). Positive economic surprises heavily outstripped that in the U.S. last year, but that phase is now over. The euro appears expensive based on interest rate differentials, and euro sentiment is close to a bullish extreme. This all suggests that market positioning has become a negative factor for the currency. Chart I-10Euro: A Lot Of Bullish News Is Discounted Second, the chorus of complaints against the euro's strength is growing among European central bankers, including Ewald Nowotny, the rather hawkish Austrian central banker. Policymakers' concerns may partly reflect the fact that peripheral inflation excluding food and energy has already weakened to 0.6% from a high of 1.3% in April last year (Chart I-10, fourth panel). Third, U.S. consumer price and wage inflation have yet to pick up meaningfully. The dollar should receive a lift if core U.S. inflation clearly moves toward the Fed's 2% target, as we expect. The FOMC would suddenly appear to have fallen behind the curve and U.S. rate expectations would ratchet higher. Chart I-10, bottom panel, highlights that the euro will weaken if U.S. core inflation rises versus that in the Eurozone. The implication is that the Euro's appreciation has progressed too far and is due for a pullback. As for the yen, the currency surged in January when the Bank of Japan (BoJ) announced a reduction in long-dated JGB purchases. This simply acknowledged what has already occurred. It was always going to be impossible to target both the quantity of bond purchases and the level of 10-year yield simultaneously. Keeping yields near the target required less purchases than they thought. The market interpreted the BoJ's move as a possible prelude to lifting the 10-year yield target. It is perhaps not surprising that the market took the news this way. The economy is performing extremely well; our model that incorporates high-frequency economic data suggests that real GDP growth will move above 3% in the coming quarters. The Japanese economy is benefiting from the end of a fiscal drag and from a rebound in EM growth. Nonetheless, following January's BoJ policy meeting, Kuroda poured cold water on speculation that the BoJ may soon end or adjust the YCC. Recent speeches by BoJ officials reinforce the view that the MPC wants to see an overshoot of actual inflation that will lower real interest rates and thereby reinforce the strong economic activity that is driving higher inflation. Only then will officials be convinced that their job is done. Given that inflation excluding food and energy only stands at 0.3%, the BoJ is still a long way from the overshoot it desires. On the positive side, Japan's large current account surplus and yen undervaluation provide underlying support for the currency. Balancing the offsetting positive and negative forces, our foreign exchange strategists have shifted to neutral on the yen. The Euro remains underweight while the dollar is overweight. Similar to our dollar view, we still see a window for U.S. Treasurys to underperform the global hedged fixed-income benchmark as world bond yields shift higher this year. European government bonds will also sell off, but should outperform Treasurys. JGBs will provide the best refuge for bondholders during the global bond bear phase, since the BoJ will prevent a rise in yields inside of the 10-year maturity. Our global bond strategists upgraded U.K. gilts to overweight in January. Momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. FOMC Transition Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. An abrupt shift in policy is unlikely. There was some support at the December 2017 FOMC meeting to study the use of nominal GDP or price level targeting as a policy framework, but this has been an ongoing debate that will likely continue for years to come. The Fed will remain committed to its current monetary policy framework once Powell takes over. Table I-4 provides a summary of who will be on the FOMC next year, including their policy bias. Chart I-11 compares the recent FOMC makeup with the coming Powell FOMC (voting members only). The hawk/dove ratio will not change much under Powell, unless Trump stacks the vacant spots with hawks. Table I-4Composition Of The FOMC Chart I-11Composition Of Voting FOMC Members 2017 Vs. 2018 In any event, history shows that the FOMC strives to avoid major shifts in policy around changeovers in the Fed Chair. In previous transitions, the previous path for rates was maintained by an average of 13 months. Moreover, Powell has shown that he is not one to rock the boat during his time on the FOMC. It will be the evolution of the economy and inflation, not the composition of the FOMC, that will have the biggest impact on markets at the end of the day. Recent speeches reveal that policymakers across the hawk/dove spectrum are moving modesty toward the hawkish side because growth has accelerated at a time when unemployment is already considered to be below full-employment by many policymakers. The melt-up in equity indexes in January did little to calm worries about financial excesses either. The Fed is struggling to understand the strength of the structural factors that could be holding down inflation. This month's Special Report, beginning on page 21, focusses on the impact of robot automation. While advances on this front are impressive, we conclude that it is difficult to find evidence that robots are more deflationary than previous technological breakthroughs. Thus, increased robot usage should not prevent inflation from rising as the labor market continues to tighten. The macro backdrop will likely justify the FOMC hiking at least as fast as the dots currently forecast. The risks are skewed to the upside. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. This is inconsistent with real GDP growth well in excess of its supply-side potential. The unemployment rate is more likely to reach a 49-year low of 3.5% by the end of this year. As highlighted in last month's Report, a key risk to the bull market in risk assets is the end of the 'low vol/low rate' world. The selloff in the bond market in January may mark the start of this process. Conclusions We covered a lot of ground in this month's Overview of the markets, so we will keep the conclusions brief and focused on the risks. Our key point is that the fundamentals remain positive for risk assets, but that a lot of good news is discounted and it appears that we have entered a classic blow-off phase. This will be a transition year to a recession in the U.S. in 2019. Given that valuation for most risk assets is quite stretched, and given that the monetary taps are starting to close, investors must plan for the exit and keep an eye on our timing checklist. The main risk to our pro-cyclical portfolio is a rise in U.S. inflation and the Fed's response, which we believe will end the sweet spot for risk assets. Apart from this, our geopolitical strategists point to several other items that could upset the applecart this year:3 1. Trade China has cooperated with the U.S. in trying to tame North Korea. Nonetheless, President Trump is committed to an "America First" trade policy and he may need to show some muscle against China ahead of the midterm elections in November in order to rally his base. It is politically embarrassing to the Administration that China racked up its largest trade surplus ever with the U.S. in Trump's first year in office. A key question is whether the President goes after China via a series of administrative rulings - such as the recently announced tariffs on solar panels and white goods - or whether he applies an across-the-board tariff and/or fine. The latter would have larger negative macroeconomic implications. 2. Iran On January 12, President Trump threatened not to waive sanctions against Iran the next time they come due (May 12), unless some new demands are met. Pressure from the U.S. President comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by threatening to close the Straits of Hormuz or by boarding foreign vessels in international waters. The domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. For the time being, however, we expect only a minor geopolitical risk premium to seep into the energy markets, supporting our bullish House View on oil prices. 3. China Last month's Special Report highlighted that significant structural reforms are on the way in China, now that President Xi has amassed significant political support for his reform agenda. The reforms should be growth-positive in the long term, but could be a net negative for growth in the near term depending on how deftly the authorities handle the monetary and fiscal policy dials. The risk is that the authorities make a policy mistake by staying too tight, as occurred in 2015. We are monitoring a number of indicators that should warn if a policy mistake is unfolding. On this front, January brought some worrying economic data. The latest figures for both nominal imports and money growth slowed. Given that M2 and M3 are components of BCA's Li Keqiang Leading Indicator, and that nominal imports directly impact China's contribution to global growth, this raises the question of whether December's economic data suggest that China is slowing at a more aggressive pace than we expect. For now, our answer is no. First, China's trade numbers are highly volatile; nominal import growth remains elevated after smoothing the data. Second, China's export growth remains buoyant, consistent with a solid December PMI reading. The bottom line is that we are sticking with our view that China will experience a benign deceleration in terms of its impact on DM risk assets, but we will continue to monitor the situation closely. Mark McClellan Senior Vice President The Bank Credit Analyst January 25, 2018 Next Report: February 22, 2018 1 According to Thomson Reuters/IBES. 2 Please see U.S. Equity Sector Strategy Special Report "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com 3 For more information, please see BCA Geopolitical Strategy Weekly Report "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. Also see "Watching Five Risks," dated January 24, 2018. II. The Impact Of Robots On Inflation Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. Technological advance in the past has not prevented improving living standards or led to ever rising joblessness over the decades, but pessimists argue that recent advances are different. The issue is important for financial markets. If structural factors such as automation are holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. We see no compelling evidence that the displacement effect of emerging technologies is any stronger than in the past. Robot usage has had a modest positive impact on overall productivity. Despite this contribution, overall productivity growth has been dismal over the past decade. If automation is increasing 'exponentially' and displacing workers on a broad scale as some claim, one would expect to see accelerating productivity growth, robust capital spending and more violent shifts in occupational shares. Exactly the opposite has occurred. Periods of strong growth in automation have historically been associated with robust, not lackluster, wage gains, contrary to the consensus view. The Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. This and other evidence suggest that it is difficult to make the case that robots will make it tougher for central banks to reach their inflation goals than did previous technological breakthroughs. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. Recent breakthroughs in technology are awe-inspiring and unsettling. These advances are viewed with great trepidation by many because of the potential to replace humans in the production process. Hype over robots is particularly shrill. Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. In the first in our series of Special Reports focusing on the structural factors that might be preventing central banks from reaching their inflation targets, we demonstrated that the impact of Amazon is overstated in the press. We estimated that E-commerce is depressing inflation in the U.S. by a mere 0.1 to 0.2 percentage points. This Special Report tackles the impact of automation. We are optimistic that robot technology and artificial intelligence will significantly boost future productivity, and thus reduce costs. But, is there any evidence at the macro level that robot usage has been more deflationary than technological breakthroughs in the past and is, thus, a major driver of the low inflation rates we observe today across the major countries? The question matters, especially for the outlook for central bank policy and the bond market. If structural factors are indeed holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. However, if low inflation simply reflects long lags between wages and the tightening labor market, then inflation may suddenly lurch to life as it has at the end of past cycles. The bond market is not priced for that scenario. Are Robots Different? A Special Report from BCA's Technology Sector Strategy service suggested that the "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity and the microchip.1 GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time. The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks," and this encompasses a broad range of machines: From the Jacquard Loom, which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. Our Technology Sector report made the case that there is nothing particularly sinister about robots. They are just another chapter in a long history of automation. Nor is the displacement of workers unprecedented. The industrial revolution was about replacing human craft labor with capital (machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing and maintaining the machinery. Agriculture offers a good example. This sector involved over 50% of the U.S. labor force until the late 1800s. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," contributed to a massive rise in output-per-man hour. The number of hours worked to produce a bushel of wheat fell by almost 98% from the mid-1800s to 1955. This put a lot of farm hands out of work, but these laborers were absorbed over time in other growing areas of the economy. It is the same story for all other historical technological breakthroughs. Change is stressful for those directly affected, but rising productivity ultimately lifts average living standards. Robots will be no different. As we discuss below, however, the increasing use of robots and AI may have a deeper and longer-lasting impact on inequality. Strong Tailwinds Chart II-1Robots Are Getting Cheaper Factory robots have improved immensely due to cheaper and more capable control and vision systems. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Most importantly, robots are already able to do more than just routine tasks, thus enabling them to replace or aid humans in higher-skilled processes. Robot prices are also falling fast, especially after quality-adjusting the data (Chart II-1). Units are becoming easier to install, program and operate. These trends will help to reduce the barriers-to-entry for the large, untapped, market of small and medium sized enterprises. Robots also offer the ability to do low-volume "customized" production and still keep unit costs low. In the future, self-learning robots will be able to optimize their own performance by analyzing the production of other robots around the world. Robot usage is growing quickly according to data collected by the International Federation of Robotics (IFR) that covers 23 countries. Industrial robot sales worldwide increased to almost 300,000 units in 2016, up 16% from the year before (Chart II-2). The stock of industrial robots globally has grown at an annual average pace of 10% since 2010, reaching slightly more than 1.8 million units in 2016.2 Robot usage is far from evenly distributed across industries. The automotive industry is the major consumer of industrial robots, holding 45% of the total stock in 2016 (Chart II-3). The computer & electronics industry is a distant second at 17%. Metals, chemicals and electrical/electronic appliances comprise the bulk of the remaining stock. Chart II-2Global Robot Usage Chart II-3Global Robot Usage By Industry (2016) As far as countries go, Japan has traditionally been the largest market for robots in the world. However, sales have been in a long-term downtrend and the stock of robots has recently been surpassed by China, which has ramped up robot purchases in recent years (Chart II-4). Robot density, which is the stock of robots per 10 thousand employed in manufacturing, makes it easier to compare robot usage across countries (Chart II-5, panel 2). By this measure, China is not a heavy user of robots compared to other countries. South Korea stands at the top, well above the second-place finishers (Germany and Japan). Large automobile sectors in these three countries explain their high relative robot densities. Chart II-4Stock Of Robots By Country (I) Chart II-5Stock Of Robots By Country (II) (2016) While the growth rate of robot usage is impressive, it is from a very low base (outside of the automotive industry). The average number of robots per 10,000 employees is only 74 for the 23 countries in the IFR database. Robot use is tiny compared to total man hours worked. Chart II-6U.S. Investment In Robots In the U.S., spending on robots is only about 5% of total business spending on equipment and software (Chart II-6). To put this into perspective, U.S. spending on information, communication and technology (ICT) equipment represented 35-40% of total capital equipment spending during the tech boom in the 1990s and early 2000s.3 The bottom line is that there is a lot of hype in the press, but robots are not yet widely used across countries or industries. It will be many years before business spending on robots approaches the scale of the 1990s/2000s IT boom. A Deflationary Impact? As noted above, we view robotics as another chapter in a long history of technological advancements. Pessimists suggest that the latest advances are different because they are inherently more threatening to the overall job market and wage share of total income. If the pessimists are right, what are the theoretical channels though which this would have a greater disinflationary effect relative to previous GPT technologies? Faster Productivity Gains: Enhanced productivity drives down unit labor costs, which may be passed along to other industries (as cheaper inputs) and to the end consumer. More Human Displacement: The jobs created in other areas may be insufficient to replace the jobs displaced by robots, leading to lower aggregate income and spending. The loss of income for labor will simply go to the owners of capital, but the point is that the labor share of income might decline. Deflationary pressures could build as aggregate demand falls short of supply. Even in industries that are slow to automate, just the threat of being replaced by robots may curtail wage demands. Inequality: Some have argued that rising inequality is partly because the spoils of new technologies over the past 20 years have largely gone to the owners of capital. This shift may have undermined aggregate demand because upper income households tend to have a high saving rate, thereby depressing overall aggregate demand and inflationary pressures. The human displacement effect, described above, would exacerbate the inequality effect by transferring income from labor to the owners of capital. 1. Productivity It is difficult to see the benefits of robots on productivity at the economy-wide level. Productivity growth has been abysmal across the major developed countries since the Great Recession, but the productivity slowdown was evident long before Lehman collapsed (Chart II-7). The productivity slowdown continued even as automation using robots accelerated after 2010. Chart II-7Productivity Collapsed Despite Automation Some analysts argue that lackluster productivity is simply a statistical mirage because of the difficulties in measuring output in today's economy. We will not get into the details of the mismeasurement debate here. We encourage interested clients to read a Special Report by the BCA Global Investment Strategy service entitled "Weak Productivity Growth: Don't Blame The Statisticians." 4 Our colleague Peter Berezin makes the case that the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, radio, indoor plumbing and air conditioning. He argues that the real reason that productivity growth has slowed is that educational attainment has decelerated and businesses have plucked many of the low-hanging fruit made possible by the IT revolution. Cyclical factors stemming from the Great Recession and financial crisis are also to blame, as capital spending has been slow to recover in most of the advanced economies. Some other factors that help to explain the decline in aggregate productivity are provided in Appendix II-1. Nonetheless, the poor aggregate productivity performance does not mean that there are no benefits to using robots. The benefits are evident at the industrial level, where measurement issues are presumably less vexing for statisticians (i.e., it is easier to measure the output of the auto industry, for example, than for the economy as a whole). Chart II-8 plots the level of robot density in 2016 with average annual productivity growth since 2004 for 10 U.S. manufacturing industries (robot density is presented in deciles). A loose positive relationship is apparent. Chart II-8U.S.: Productivity Vs. Robot Density Academic studies estimate that robots have contributed importantly to economy-wide productivity growth. The Centre for Economic and Business Research (CEBR) estimated that labor productivity growth rises by 0.07 to 0.08 percentage points for every 1% rise in the rate of robot density.5 This implies that robots accounted for roughly 10% of the productivity growth experienced since the early 1990s in the major economies. Another study of 14 industries across 17 countries by the Centre for Economic Performance (CEP) found that robots boosted annual productivity growth by 0.36 percentage points over the 1993-2007 period.6 This is impressive because, if this estimate holds true for the U.S., robots' contribution to the 2½% average annual U.S. total productivity growth over the period was 14%. To put the importance of robotics into historical context, its contribution to productivity so far is roughly on par with that of the steam engine (Chart II-9). It falls well short of the 0.6 percentage point annual productivity contribution from the IT revolution. The implication is that, while the overall productivity performance has been dismal since 2007, it would have been even worse in the absence of robots. What does this mean for inflation? According to the "cost push" model of the inflation process, an increase in productivity of 0.36% that is not accompanied by associated wage gains would reduce unit labor costs (ULC) by the same amount. This should trim inflation if the cost savings are passed on to the end consumer, although by less than 0.36% because robots can only depress variable costs, not fixed costs. There indeed appears to be a slight negative relationship between robot density and unit labor costs at the industrial level in the U.S., although the relationship is loose at best (Chart II-10). Chart II-9GPT Contribution To Productivity Chart II-10U.S.: Unit Labor Costs Vs. Robot Density In theory, divergences in productivity across industries should only generate shifts in relative prices, and "cost push" inflation dynamics should only operate in the short term. Most economists believe that inflation is a purely monetary phenomenon in the long run, which means that central banks should be able to offset positive productivity shocks by lowering interest rates enough that aggregate demand keeps up with supply. Indeed, the Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. Also, note that inflation is currently low across the major advanced economies, irrespective of the level of robot intensity (Chart II-11). From this perspective, it is hard to see that robots should take much of the credit for today's low inflation backdrop. Chart II-11Inflation Vs. Robot Density 2. Human Displacement A key question is whether robots and humans are perfect substitutes. If new technologies introduced in the past were perfect substitutes, then it would have led to massive underemployment and all of the income in the economy would eventually have migrated to the owners of capital. The fact that average real household incomes have risen over time, and that there has been no secular upward trend in unemployment rates over the centuries, means that new technologies were at least partly complementary with labor (i.e., the jobs lost as a direct result of productivity gains were more than replaced in other areas of the economy over time). Rather than replacing workers, in many cases tech made humans more productive in their jobs. Rising productivity lifted income and thereby led to the creation of new jobs in other areas. The capital that workers bring to the production process - the skills, know-how and special talents - became more valuable as interaction with technology increased. Like today, there were concerns in the 1950s and 1960s that computerization would displace many types of jobs and lead to widespread idleness and falling household income. With hindsight, there was little to worry about. Some argue that this time is different. Futurists frequently assert that the pace of innovation is not just accelerating, it is accelerating 'exponentially'. Robots can now, or will soon be able to, replace humans in tasks that require cognitive skills. This means that they will be far less complementary to humans than in the past. The displacement effect could thus be much larger, especially given the impressive advances in artificial intelligence. However, Box II-1 discusses why the threat to workers posed by AI is also heavily overblown in the media. The CEP multi-country study cited above did not find a large displacement effect; robot usage did not affect the overall number of hours worked in the 23 countries studied (although it found distributional effects - see below). In other words, rather than suppressing overall labor input, robot usage has led to more output, higher productivity, more jobs and stronger wage and income growth. A report by the Economic Policy Institute (EPI)7 takes a broader look at automation, using productivity growth and capital spending as proxies. Automation is what occurs as the implementation of new technologies is incorporated along with new capital equipment or software to replace human labor in the workplace. If automation is increasing 'exponentially' and displacing workers on a broad scale, one would expect to see accelerating productivity growth, robust capital spending, and more violent shifts in occupational shares. Exactly the opposite has occurred. Indeed, the report demonstrates that occupational employment shifts were far slower in the 2000-2015 period than in any decade in the 1900s (Chart II-12). Box II-1 The Threat From AI Is Overblown Media coverage of AI/Deep Learning has established a consensus view that we believe is well off the mark. A recent Special Report from BCA's Technology Sector Strategy service dispels the myths surrounding AI.8 We believe the consensus, in conjunction with warnings from a variety of sources, is leading to predictions, policy discussions, and even career choices based on a flawed premise. It is worth noting that the most vocal proponents of AI as a threat to jobs and even humanity are not AI experts. At the root of this consensus is the false view that emerging AI technology is anything like true intelligence. Modern AI is not remotely comparable in function to a biological brain. Scientists have a limited understanding of how brains work, and it is unlikely that a poorly understood system can be modeled on a computer. The misconception of intelligence is amplified by headlines claiming an AI "taught itself" a particular task. No AI has ever "taught itself" anything: All AI results have come about after careful programming by often PhD-level experts, who then supplied the system with vast amounts of high quality data to train it. Often these systems have been iterated a number of times and we only hear of successes, not the failures. The need for careful preparation of the AI system and the requirement for high quality data limits the applicability of AI to specific classes of problems where the application justifies the investment in development and where sufficient high-quality data exists. There may be numerous such applications but doubtless many more where AI would not be suitable. Similarly, an AI system is highly adapted to a single problem, or type of problem, and becomes less useful when its application set is expanded. In other words, unlike a human whose abilities improve as they learn more things, an AI's performance on a particular task declines as it does more things. There is a popular misconception that increased computing power will somehow lead to ever improving AI. It is the algorithm which determines the outcome, not the computer performance: Increased computing power leads to faster results, not different results. Advanced computers might lead to more advanced algorithms, but it is pointless to speculate where that may lead: A spreadsheet from 2001 may work faster today but it still gives the same answer. In any event, it is worth noting that a tool ceases to be a tool when it starts having an opinion: there is little reason to develop a machine capable of cognition even if that were possible. Chart II-12U.S. Job Rotation Has Slowed The EPI report also notes that these indicators of automation increased rapidly in the late 1990s and early 2000s, a period that saw solid wage growth for American workers. These indicators weakened in the two periods of stagnant wage growth: from 1973 to 1995 and from 2002 to the present. Thus, there is no historical correlation between increases in automation and wage stagnation. Rather than automation, the report argues that it was China's entry into the global trading system that was largely responsible for the hollowing out of the U.S. manufacturing sector. We have also made this argument in previous research. The fact that the major advanced economies are all at, or close to, full employment supports the view that automation has not been an overwhelming headwind for job creation. Chart II-13 demonstrates that there has been no relationship between the change in robot density and the loss of manufacturing jobs since 1993. Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. Interestingly, despite a worsening labor shortage, robot density among Japanese firms is falling. Moreover, the Japanese data show that the industries that have a high robot usage tend to be more, not less, generous with wages than the robot laggard industries. Please see Appendix II-2 for more details. Chart II-13Global Manufacturing Jobs Vs. Robot Density The bottom line is that it does not appear that labor displacement related to automation has been responsible in any meaningful way for the lackluster average real income growth in the advanced economies since 2007. 3. Inequality That said, there is evidence suggesting that robots are having important distributional effects. The CEP study found that robot use has reduced hours for low-skilled and (to a lesser extent) middle-skilled workers relative to the highly skilled. This finding makes sense conceptually. Technological change can exacerbate inequality by either increasing the relative demand for skilled over unskilled workers (so-called "skill-biased" technological change), or by inducing companies to substitute machinery and other forms of physical capital for workers (so-called "capital-biased" technological change). The former affects the distribution of labor income, while the latter affects the share of income in GDP that labor receives. A Special Report appearing in this publication in 2014 focused on the relationship between technology and inequality.9 The report highlighted that much of the recent technological change has been skill-biased, which heavily favors workers with the talent and education to perform cognitively-demanding tasks, even as it reduces demand for workers with only rudimentary skills. Moreover, technological innovations and globalization increasingly allow the most talented individuals to market their skills to a much larger audience, thus bidding up their wages. The evidence suggests that faster productivity growth leads to higher average real wages and improved living standards, at least over reasonably long horizons. Nonetheless, technological change can, and in the future almost certainly will, increase income inequality. The poor will gain, but not as much as the rich. The fact that higher-income households tend to maintain a higher savings rate than low-income households means that the shift in the distribution of income toward the higher-income households will continue to modestly weigh on aggregate demand. Can the distribution effect be large enough to have a meaningful depressing impact on inflation? We believe that it has played some role in the lackluster recovery since the Great Recession, with the result that an extended period of underemployment has delivered a persistent deflationary impulse in the major developed economies. However, as discussed above, stimulative monetary policy has managed to overcome the impact of inequality and other headwinds on aggregate demand, and has returned the major countries roughly to full employment. Indeed, this year will be the first since 2007 that the G20 economies as a group will be operating slightly above a full employment level. Inflation should respond to excess demand conditions, irrespective of any ongoing demand headwind stemming from inequality. Conclusions Technological change has led to rising living standards over the decades. It did not lead to widespread joblessness and did not prevent central banks from meeting their inflation targets over time. The pessimists argue that this time is different because robots/AI have a much larger displacement effect. Perhaps it will be 20 years before we will know the answer. But our main point is that we have found no evidence that recent advances in robotics and AI, while very impressive, will be any different in their macro impact. There is little evidence that the modern economy is less capable in replacing the jobs lost to automation, although the nature of new technologies may be affecting the distribution of income more than in the past. Real incomes for the middle- and lower-income classes have been stagnant for some time, but this is partly due to productivity growth that is too low, not too high. Moreover, it is not at all clear that positive productivity shocks are disinflationary beyond the near term. The link between robot usage and unit labor costs over the past couple of decades is loose at best at the industry level, and is non-existent when looking across the major countries. The Fed was able to roughly meet its 2% inflation target in the 1990s and the first half of the 2000s, despite IT's impressive contribution to productivity growth during that period. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. The global output gap will shift into positive territory this year for the first time since the Great Recession. Any resulting rise in inflation will come as a shock since the bond market has discounted continued low inflation for as far as the eye can see. We expect bond yields and implied volatility to rise this year, which may undermine risk assets in the second half. Mark McClellan Senior Vice President The Bank Credit Analyst Brian Piccioni Vice President Technology Sector Strategy Appendix II-1 Why Is Productivity So Low? A recent study by the OECD10 reveals that, while frontier firms are charging ahead, there is a widening gap between these firms and the laggards. The study analyzed firm-level data on labor productivity and total factor productivity for 24 countries. "Frontier" firms are defined to be those with productivity in the top 5%. These firms are 3-4 times as productive as the remaining 95%. The authors argue that the underlying cause of this yawning gap is that the diffusion rate of new technologies from the frontier firms to the laggards has slowed within industries. This could be due to rising barriers to entry, which has reduced contestability in markets. Curtailing the creative-destruction process means that there is less pressure to innovate. Barriers to entry may have increased because "...the importance of tacit knowledge as a source of competitive advantage for frontier firms may have risen if increasingly complex technologies were to increase the amount and sophistication of complementary investments required for technological adoption." 11 The bottom line is that aggregate productivity is low because the robust productivity gains for the tech-savvy frontier companies are offset by the long tail of firms that have been slow to adopt the latest technology. Indeed, business spending has been especially weak in this expansion. Chart II-14 highlights that the slowdown in U.S. productivity growth has mirrored that of the capital stock. Chart II-14U.S. Capex Shortfall Partly To Blame For Poor Productivity Appendix II-2 Japan - The Leading Edge Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. The popular press is full of stories of how robots are taking over. If the stories are to be believed, robots are the answer to the country's shrinking workforce. Robots now serve as helpers for the elderly, priests for weddings and funerals, concierges for hotels and even sexual partners (don't ask). Prime Minister Abe's government has launched a 5-year push to deepen the use of intelligent machines in manufacturing, supply chains, construction and health care. Indeed, Japan was the leader in robotics use for decades. Nonetheless, despite all the hype, Japan's stock of industrial robots has actually been eroding since the late 1990s (Chart II-4). Numerous surveys show that firms plan to use robots more in the future because of the difficulty in hiring humans. And there is huge potential: 90% of Japanese firms are small- and medium-sized (SME) and most are not currently using robots. Yet, there has been no wave of robot purchases as of 2016. One problem is the cost; most sophisticated robots are simply too expensive for SMEs to consider. This suggests that one cannot blame robots for Japan's lack of wage growth. The labor shortage has become so acute that there are examples of companies that have turned down sales due to insufficient manpower. Possible reasons why these companies do not offer higher wages to entice workers are beyond the scope of this report. But the fact that the stock of robots has been in decline since the late 1990s does not support the view that Japanese firms are using automation on a broad scale to avoid handing out pay hikes. Indeed, Chart II-15 highlights that wage deflation has been the greatest in industries that use almost no robots. Highly automated industries, such as Transportation Equipment and Electronics, have been among the most generous. This supports the view that the productivity afforded by increased robot usage encourages firms to pay their workers more. Looking ahead, it seems implausible that robots can replace all the retiring Japanese workers in the years to come. The workforce will shrink at an annual average pace of 0.33% between 2020 and 2030, according to the Japan Institute for Labour Policy and Training. Productivity growth would have to rise by the same amount to fully offset the dwindling number of workers. But that would require a surge in robot density of 4.1, assuming that each rise in robot density of one adds 0.08% to the level of productivity (Chart II-16). The level of robot sales would have to jump by a whopping 2½ times in the first year and continue to rise at the same pace each year thereafter to make this happen. Of course, the productivity afforded by new robots may accelerate in the coming years, but the point is that robot usage would likely have to rise astronomically to offset the impact of the shrinking population. Chart II-15Japan: Earnings Vs. Robot Density Chart II-16Japan: Where Is The Flood Of Robots? The implication is that, as long as the Japanese economy continues to grow above roughly 1%, the labor market will continue to tighten and wage rates will eventually begin to rise. 1 Please see Technology Sector Strategy Special Report "The Coming Robotics Revolution," dated May 16, 2017, available at tech.bcaresearch.com 2 Note that this includes only robots used in manufacturing industry, and thus excludes robots used in the service sector and households. However, robot usage in services is quite limited and those used in households do not add to GDP. 3 Note that ICT investment and capital stock data includes robots. 4 Please see BCA Global Investment Strategy Special Report "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 5 Centre for Economic and Business Research (January 2017): "The Impact of Automation." A Report for Redwood. In this report, robot density is defined to be the number of robots per million hours worked. 6 Graetz, G., and Michaels, G. (2015): "Robots At Work." CEP Discussion Paper No 1335. 7 Mishel, L., and Bivens, J. (2017): "The Zombie Robot Argument Lurches On," Economic Policy Institute. 8 Please see BCA Technology Sector Strategy Special Report "Bad Information - Why Misreporting Deep Learning Advances Is A Problem," dated January 9, 2018, available at tech.bcaresearch.com 9 Please see The Bank Credit Analyst, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June 2014, available at bca.bcaresearch.com 10 OECD Productivity Working Papers, No. 05 (2016): "The Best Versus the Rest: The Global Productivity Slowdown, Divergence Across Firms and the Role of Public Policy." 11 Please refer to page 27. III. Indicators And Reference Charts As we highlight in the Overview section, the earnings backdrop for the U.S. equity market remains very upbeat, as highlighted by the rise in the net earnings revisions and net earnings surprises indexes. Bottom-up analysts will likely continue to boost after-tax earnings estimates for the year as they adjust to the U.S. tax cut news. Our main concern is that a lot of good news is now discounted. Our Technical Indicator remains bullish, but our composite valuation indicator surpassed one sigma in January, which is our threshold of overvaluation. From these levels of overvaluation, the medium-term outlook for equity total returns is negligible. Our speculation index is at all-time highs and implied volatility is low, underscoring that investors are extremely bullish. From a contrary perspective, this is a warning sign for the equity market. Our Monetary Indicator has also moved further into 'bearish' territory for equities, although overall financial conditions remain positive for growth. It is also disconcerting that our Revealed Preference Indicator (RPI) shifted to a 'sell' signal for stocks, following five straight months on a 'buy' signal. This occurred because investors may be buying based on speculation rather than on a firm belief in the staying power of the underlying fundamentals. For now, though, our Willingness-to-Pay indicator for the U.S. rose sharply in January, highlighting that investor equity inflows are very strong and are favoring U.S. equities relative to Japan and the Eurozone. This is perhaps not surprising given the U.S. tax cuts just passed by Congress. The RPI indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Our U.S. bond technical indicator shows that Treasurys are close to oversold territory, suggesting that we may be in store for a consolidation period following January's surge in yields. Treasurys are slightly cheap on our valuation metric, although not by enough to justify closing short duration positions. The U.S. dollar is oversold and due for a bounce. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights One of the biggest mistakes in finance is to equate risk with volatility. The correct measure of risk is the negative skew in payoff distributions. If 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. This would be the point at which to scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Feature It is the crucial question that all investors should ask at all times. What is the relative risk of the two major asset classes - bonds and equities - and are their relative return prospects commensurate with the relative risk? Chart of the WeekBelow A 2% Yield, 10-Year Bonds Are Riskier Than Equities But first, there is an even more fundamental question: what do we mean by risk? Conventional wisdom says that the risk of an investment is captured by its volatility. Indeed, through instruments such as the VIX futures and currency volatility options, volatility has become a multi-trillion dollar asset-class in its own right. Therefore, volatility must measure the risk of an investment, right? Wrong. The Biggest Mistake In Finance As a measure of risk, volatility is clearly wrong. Volatility regards price gains in exactly the same way as it regards price losses. But investors don't mind gains, they only mind losses! Consider an investment whose price moves alternately sideways and sharply higher. The maths would say that the returns have high volatility, implying that the investment is very risky. In truth though, the investment is highly desirable and 'risk-free' - because its price never declines. At our recent New York conference, Nobel Laureate Daniel Kahneman warned that one of the biggest mistakes in finance is to equate risk with volatility. After decades of empirical and theoretical studies - which culminated in the 2002 Nobel Prize for Economics - Kahneman proved that investors are not concerned about the symmetrical fluctuations in investment returns. Instead, they are concerned about the asymmetry - or skew - in payoff distributions. Kahneman explained the underlying psychology. "People are limited in their ability to comprehend and evaluate extreme probabilities, so highly unlikely events are overweighted." If the payoff distribution is symmetric, the overweighting of unlikely events in the loss tail and the gain tail exactly cancels out. But if the distribution is asymmetric, the longer tail determines the perceived attractiveness of the payoff. Where the longer tail is on the gain side, the distribution is said to have positive skew (Figure I-1). The classic example is a lottery. When people play the lottery, their loss is limited to the ticket price, but their gain could be tens of millions. People perceive the positive skew as attractive because they overweight the minuscule probability of becoming a millionaire. As a result, they overpay for the lottery ticket versus its expected value. Where the longer tail is on the loss side, the distribution is said to have negative skew (Figure I-2). This is like a lottery in reverse. The gain size is relatively limited, but the loss could be very large. People perceive the negative skew as unattractive because they overweight the probability of a large loss. As a result, they demand overpayment to take it on. Figure I-1People Like Positive Skew Figure I-2People Dislike Negative Skew For investments with negative skew, this overpayment takes the form of an excess return demanded from the market - a 'risk premium' - versus investments with less negative skew. Are Bonds A Greater Risk Than Equities? We are now in a position to tackle the question in the title. To determine whether bonds are riskier than equities or vice-versa, we must compare the skews of their return profiles.1 The important point is that for a bond, the skew of its return profile changes with its yield. At yields above 2.5%, 10-year bond returns show no skew. Worst losses broadly equal best gains. However, when yields drop below 2%, returns start to exhibit negative skew (Chart I-2). And at yields below 1%, the negative skew becomes extreme. Chart I-2Bond Risk Increases At ##br##Low Bond Yields Chart I-3Equity Risk Does Not Increase At##br## Low Bond Yields The reason is obvious. Central banks accept that there is a 'lower bound' for policy interest rates - perhaps slightly negative - below which there would be an exodus of bank deposits. The limit also marks the lower bound for bond yields. Close to this lower bound for yields, bond mathematics necessarily creates a negatively skewed return profile. Simply put, prices have little upside, but they have a lot of downside! Chart I-4A 40Bps Rise In Yields Would Make Global ##br##Bonds Riskier Than Equities Turning to equities, the empirical evidence shows that equity returns always exhibit negative skew. Worst losses are typically around 1.5 times the size of best gains (Chart I-3). But the negative skew of equity returns is largely independent of the bond yield. The upshot is that there is a crossover bond yield below which the negative skew on 10-year bonds exceeds that on equities. This crossover bond yield is around 2%. In negative skew terms, we can say that at a 10-year bond yield below 2%, 10-year bonds are riskier than equities. And at a yield above 2%, equities are riskier than 10-year bonds (Chart of the Week). So in negative skew terms, 10-year bonds are riskier investments than equities in Europe and in Japan. But equities are riskier investments than 10-year bonds in the United States. Still, given that developed financial markets tend to move en masse, the relationship that is most significant is the aggregate one. At a global level, 10-year bond yields are 40bps below the crossover yield at which equities become riskier than bonds (Chart I-4). QE Distorted The Relative Valuation Of Equities Versus Bonds Which segues us neatly to today's ECB monetary policy meeting. Many people, worried about the end of QE, point out that the $10 trillion of bonds that the 'big four'2 central banks have bought is not far short of the size of the euro area economy. However, in the context of a global fixed income market of $220 trillion,3 $10 trillion of buying is small change. For the $220 trillion global bond and bank loan complex, the much more significant driver of yields has been the expected path of policy interest rates. As ECB Chief Economist Peter Praet put it, serial QE has been nothing more than "a signalling channel which reinforces the credibility of forward guidance on (ultra-low) policy rates." Chart I-5A Promise To Keep The Policy Rate Ultra-Low ##br##Pulls Down Bond Yields Central bankers know that QE depressed bond yields by signalling an extended period of ultra-low interest rates (Chart I-5). They also know that if the prospective return on bonds drops, so must the prospective return on competing investments such as equities. Thereby, the absolute valuations of bonds and equities both rise. However, one largely overlooked impact of QE - even by central bankers - has been the effect on the relative valuation of equities versus bonds. To repeat, when 10-year bond yields drop below 2%, their return distribution becomes more negatively skewed than that for equities. But if bonds become riskier investments, the 'risk premium' (excess return) on equities must disappear. Meaning equity valuations and prices get a second boost, compressing the prospective 10-year equity return to become 'bond-like'. Is this the case? Unlike for 10-year bonds, we do not know the 10-year prospective return from equities with certainty. However, we can get a good estimate from today's starting valuation. But which valuation metric to use? We are cautious of using profit based metrics as these will be flattered by the advanced position in the business cycle as well as the structural uptrend in profit margins. Instead, at an aggregate level, world equity market capitalisation to world GDP has been an excellent predictor of the prospective 10-year return on world equities. Today, this valuation metric is at the same level as in 2000 and 2007, and implies a prospective return of less than 2% a year (Chart I-6). Chart I-6World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return Nevertheless, while the global 10-year bond yield stays below 2%, this is a sustainable valuation for equities. Effectively, equities and bonds are offering broadly similar negative skews, and therefore should offer broadly similar prospective returns. However, if 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. Though not there yet, this would be the point when we would scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 One simple way to quantify this skew is to find an extended period of time in which the price ended where it started, and then to calculate the period's worst 3-month loss as a multiple of the best 3-month gain. We define skew = -ln(worst 3-month loss / best 3-month gain) using log returns for 3-month loss and 3-month gain. 2 The Federal Reserve, ECB, Bank of Japan and Bank of England. 3 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017. Fractal Trading Model* This week's trade is to position for an underperformance of the Japanese energy sector (led by JXTG Holdings And Inpex) versus the overall Japanese market. This is a longer trade than normal with a maximum duration of 26 weeks. Set a profit-target at 8% with a symmetrical stop-loss. 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-7 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Overweight A key beneficiary of a tight job market are managed health care providers who see lifts in both employer-sponsored health plans and newly-affordable individual and family health plans. With the unemployment rate touching new lows and small-business hiring plans hitting new highs (unemployment rate shown inverted, second panel), the direction for premium revenue for this niche health care sub-index is clearly higher. At the same time as the top line is moving higher, cost inflation has dramatically decelerated, driven by collapsing pharma price inflation (third panel). The implication is outsized earnings growth this year. The market has clearly taken notice, rewarding the S&P managed health care index with a premium valuation (bottom panel). While this is an improvement from the discount multiple of much of the past decade, it remains a far cry from previous cyclical highs. We think an exceptional earnings growth phase should make this valuation expansion durable; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC.

As noted in the previous Insight, relative margin declines for small caps seem more likely than gains. Meanwhile, small cap balance sheets have never been less prepared for such a downturn than they are right now. The relative net debt-to-EBITDA ratio has gone parabolic and is making all-time highs (middle panel). Rising small cap indebtedness, at a time when cash flow growth is anemic, suggests that the S&P 600 is increasingly vulnerable. Not only are interest payments eating into income, but also refinancing risk is a threat in an era of rising interest rates. The recently passed tax reform legislation caps interest expense tax deductibility at 30% of EBITDA this year. Nearly 30% of Russell 2000 constituents had an interest expense greater than 30% of EBITDA, compared with 3% of the S&P 500. The upshot is that stretched small cap balance sheets are delivering an additional P&L headwind that large cap peers don't face. Bottom Line: Factors are starting to line up for small cap underperformance in 2018. We are adding a downgrade alert to small caps vs. large caps. Please see Monday's Weekly Report for more details.

Small businesses have been in an ebullient mood since the Trump administration took power as key concerns, including reducing regulation and lowering corporate taxes have been aggressively addressed. However, recent readings from the Atlanta wage growth tracker and a survey of small business planned wage increases have suddenly diverged (second panel). The implication seems to be that small businesses are struggling to retain talent to a degree the greater economy is not experiencing. This looks to be borne out by the relative operating margins of the S&P 500 and 600 where the former is nearing cyclical highs and the latter remains distantly below the levels of only 5 years ago (third panel). At the same time, small caps continue to trade at a premium valuation to their large cap peers (bottom panel). We think this understates the true valuation gap as nearly 15% of S&P 600 component firms have negative or no forward EPS estimates. Bottom Line: Small caps seem overvalued relative to large cap earnings growth potential. Please see the next Insight for more details.

Highlights The U.S. government shutdown showed that the path of least resistance is for more fiscal spending; President Trump is turning to trade and foreign policy amid a lack of popularity at home; North Korean diplomacy is on track, but U.S.-China relations and Taiwan are potential black swans; Iran and the U.S. are playing a risky double game that will add geopolitical risk premium to oil; NAFTA will be a bellwether for Trump's future actions on issues that carry greater constraints, like Iran and China; Book profits on French vs German industrials and China volatility; close U.S. curve steepener and long PHP/TWD. Feature This weekend, investors woke up to the nineteenth government shutdown since 1976, a product of "grand standing" on both sides of the aisle. Our low-conviction view, which we elucidated last week, is that President Donald Trump will be forced to migrate to the middle on policy as the midterm election approaches.1 Chart 1Trump Hitting (And Building!) A Wall Despite a roaring stock market, strong economic fundamentals, and decade-low unemployment, President Trump's popularity continues to flounder. There is now even a perceptible decline in his support among GOP voters. Key problems for Trump have been the failure to repeal the Affordable Care Act and the intensification of the Mueller investigation (Chart 1). We suspect that he will try to preempt an electoral disaster in November by means of bipartisan deal-making and more orthodox policies. The government shutdown, although not entirely unexpected, undermined the view that President Trump is thinking about moderating his stance. That said, the Democrats are as much, if not more, to blame. With the Republicans in charge of Congress and the White House, it is clear that the Democrats thought that voters would ultimately see the shutdown as the GOP's fault. This was a dangerous assumption given that current polling suggests the Democrats have more to lose. One positive about the short-lived imbroglio is that it was the first government shutdown in twenty years that had little to do with government spending, whether the appropriations bill explicitly or entitlements. While immigration is an intractable issue, the disagreement between Republicans and Democrats is not about dollars. This is good news for the markets as it means that more spending will likely be necessary to grease the wheels of compromise. Our mantra continues to be that the political path of least resistance will lead towards profligacy. While the media's focus is on domestic politics, the real risks remain in the international arena. The two are connected. As political science theory teaches us, policymakers often play "two-level games," with the domestic arena influencing what is possible in the international one. As Donald Trump loses political capital on the domestic front, his options for affecting policy will become constrained. However, the U.S. constitution places almost no constraints on the president when it comes to foreign policy. To this arena we turn, starting with China-U.S. relations and the other potential risks in Asia (the Korean Peninsula and Taiwan). We also briefly turn to Iran and NAFTA. What binds all these risks is that it is essentially up to President Trump whether they become market-relevant or not. Korean Diplomacy Is On Track In mid-September North Korean tensions peaked (Chart 2).2 Leader Kim Jong Un chose to demonstrate known missile capabilities rather than escalate the crisis. Chart 2Markets Have Called Kim's Bluff Chart 3North Korea Is Running Out Of Cash We expected this choice given Pyongyang's considerable military constraints. Kim is a rational actor following his father Kim Jong Il's nuclear negotiations playbook.3 Just as brinkmanship reached new highs, Kim Jong Un declared victory and offered to play nice. Specifically, he launched his most advanced missile yet on November 28 (the Hwasong-15) and immediately thereafter North Korean state media declared that North Korea has "finally realized the great historic cause of completing the state nuclear force," complete with a fireworks celebration in Pyongyang.4 Kim confirmed this message personally on January 1 while offering an olive branch to South Korea for the New Year. Apparently, then, Kim is responsive to the United States' threats of devastating military retaliation against any attack. Kim is also responsive to the fact that China's President Xi Jinping has joined the U.S. coalition imposing sanctions on the North (Chart 3), squeezing North Korea's economy. The deep drop in exports to China suggests that the North will run into foreign-exchange problems if it does not adjust its posture - not to mention shortages of goods like fuel that China is gradually cutting off (Chart 4). In short, the U.S. established a credible military threat in 2017, just as it did with Iran in 2012 (Chart 5). China responded to the U.S. and established a credible economic threat of its own. Kim has de-escalated. Kim said in his New Year declaration that he would only use his nuclear deterrent if the U.S. committed an act of aggression. Rhetoric about destroying American cities is gone. Meanwhile Kim has engaged South Korea in direct negotiations, with military-to-military talks possibly to follow, and both sides will make a display of friendship at the Olympic Games in South Korea in February. Chart 4China Is Enforcing Sanctions Chart 5Credible Threat Cycle: North Korea Mirrors Iran While our view that diplomacy will reduce tensions is on track, we caution that the underlying disagreement is driven by North Korea's weapon capabilities and remains unresolved. The North Korean issue is not a red herring and the diplomatic route may continue to be bumpy from time to time.5 Markets could still be rattled by surprise North Korean provocations. Nevertheless, we do not expect a replay of the 2017 level of "fire and fury" that caused the U.S. 10-year treasury yield to drop from 2.31% to 2.05% between June and September 2017. If the North should jerk back toward a belligerent posture and decisively throw away this opportunity for diplomacy, then we will watch closely to determine whether its provocations truly alter the status quo and whether the U.S. shows any sign of greater willingness to respond with force. Otherwise we will simply monitor the diplomatic talks and watch for any signs of internal stress in North Korea as global sanctions tighten.6 Bottom Line: Korean risks remain market-relevant as the crisis is not resolved and talks are just beginning. Nevertheless, diplomacy is taking shape. We remain long the Korean two-year government bond versus the ten-year on the back of global trends and continued de-escalation. China-U.S. Relations May Sour Anyway Over the past year we have warned clients that U.S.-China tensions are the fundamental source of geopolitical risk globally and in Asia Pacific; that North Korea is a derivative of this fact; and that China's cooperation in policing North Korea would only temporarily dissuade the Trump administration from imposing punitive measures on China over trade. Despite China's assistance with North Korea, Trump will be driven by domestic American politics to slap tariffs on China in addition to those levied on January 22.7 First, Trump is committed to an "America First" trade policy and to economic nationalist voters. Thus he may need to show more muscle against China ahead of the midterm elections. This is particularly true for the key rust-belt states that handed him the election in 2016, where four Democratic senators' seats are in competition in November (not to mention nine other senate seats that could be swayed for similar reasons) (Chart 6). It is politically embarrassing to Trump that China racked up its largest trade surplus ever with the U.S. in his first year in office and is on track to continue racking up surpluses (Chart 7). While Beijing has vowed to open up market access and import more goods and services, these promises have yet to impress (Chart 8). Chart 6Trump's Base Expects Protectionism Chart 7China's Exports To U.S. Are Growing... Administrative rulings on several trade disputes early this year will give Trump ample opportunity to take additional trade action against China. The critical question, however, is whether Trump will continue to focus on item-by-item trade remedies (perhaps at an accelerated pace), or whether he goes beyond previous administrations and demands that China make progress on structural and systemic issues. The latter is more politically difficult and would have greater macro consequences. The U.S. has recently suggested that it made a mistake by bringing China into the WTO. This comes after the December WTO meeting in which the administration was able to secure a joint statement with Japan and Europe that increased the pressure on China.8 At the same time, Trump is weighing a significant decision (due by August, but possible any day now) on China's alleged systemic intellectual property theft, which Trump says is likely to require a "fine" (penalty). And comments by White House officials suggest that the administration may be going after China's promotion of state-owned enterprises (SOEs) as well as forced technology transfers (Chart 9).9 These are structural demands on China that will create much bigger frictions than tariffs on a few sub-sectors. Chart 8...While Imports Remain Tepid Chart 9Foreign Firms Forced To Transfer Tech Second, assuming that the U.S. and international community reach some kind of deal to reduce Korean tensions over the next six-to-eighteen months - for instance, a missile-test moratorium and corresponding easing of sanctions. It is likely still to be a complicated and ugly deal, as Pyongyang has no intention of giving up its nuclear and missile capabilities. The U.S. will have to make unpopular compromises with a rogue regime, comparable to the Iranian nuclear deal of 2015. The deal will leave a bitter taste in Trump's mouth and the administration will likely blame China for failing to prevent the North from achieving its nuclear status. It will rotate to address other long-standing disagreements with China, and may well look for compensation for Korea by taking a harder line on trade. Bottom Line: Korean diplomacy may delay or soften Trump's trade policies but cannot change his domestic political calculus. The Trump administration is more, not less, likely to impose further punitive trade measures on China as the midterm election draws near. We expect Chinese equity volatility to remain high. We are closing our recommendation to go long the CBOE China ETF Volatility Index, which has appreciated by 26.5%. This is not an investable index but an indicator of volatility in ETFs. A Fourth Taiwan Strait Crisis? The rumor is going around that China and Taiwan are on the verge of a "Fourth Taiwan Strait Crisis." Clients all over the world - from Hong Kong to San Francisco to Toronto - are asking us about cross-strait tensions and the risk of war. As we go to press, Taiwanese President Tsai Ing-wen has just publicly acknowledged that war is possible. Taiwan could indeed be a geopolitical "black swan." It was one of our top five black swans for 2016,10 and several extraordinary events that year suggested that our concerns are warranted: China cut off all communication with the island; the Taiwanese navy accidentally fired a missile towards the mainland on the Communist Party's birthday; and a U.S. president-elect spoke directly with a Taiwanese president for the first time since 1979, creating an uproar in Beijing.11 Today, in the wake of Xi Jinping's concentration of power at the nineteenth National Party Congress,12 and Beijing's heavy-handed crackdown on Hong Kong throughout 2017,13 there is renewed concern that China is about to stage a major intervention to rein in Taiwan. There is even talk that China could be preparing to mount a surprise attack.14 The rumors are arising from a confluence of events. On the mainland side, Xi is personally powerful and has made it a priority to lead China into a "New Era" of greater Chinese influence globally. This means that a decision to take bolder action on Taiwan could come from individual whim rather than a collective decision within the party (which would tend to maintain the status quo). Xi has also taken personal control of the military through promotions, and reasserted that the "party controls the gun," making it less likely that he would meet institutional resistance in any major foreign policy initiative. Finally, Xi has hardened Communist Party policies toward Taiwan, reflected in increased military drills, controversial new air traffic routes, and tougher language in the five-year policy blueprint that he presented to the party congress. On the Taiwanese side, the Democratic Progressive Party (DPP), which is the party that leans toward independence from the mainland, dominates the country's politics. The DPP not only won the presidency but also won legislative control for the first time in the January 2016 election.15 The DPP is also the leading party on lower levels of government. And young Taiwanese people increasingly identify as exclusively Taiwanese.16 While President Tsai has been relatively pragmatic so far, her party has fewer domestic political constraints than in the past - leaving room for the party's more radical side to have more influence or for Tsai to overreach. Internationally, Tsai has allies in Trump and Prime Minister Shinzo Abe of Japan - both nationalists who favor Taiwan and harbor deep suspicions about the reviving communism emanating from Beijing. Hence we still see Taiwan as a potential black swan event in the coming years. However, we would put a near 0% subjective probability on the likelihood that China will spring a massive surprise attack in the near future. Why? Xi is not yet breaking the status quo: Xi has not yet shown himself to be a reckless revisionist. China's foreign policy assertiveness is a gradual process that began in the mid-2000s - it traces the country's growing economic importance and need for supply-line security (Chart 10). Xi has trod carefully in both the East and South China Seas, and both of these strategic thrusts are connected with China's security vis-à-vis Taiwan, as well as vis-à-vis the U.S. and Japan. There is no reason to think that China is ready to launch a multi-front attack against the combined forces of the U.S., Taiwan, Japan, and the rest of the American alliance system. North Korea's new missile capabilities do not tip the scales in China's favor either. Incidentally, even Xi's tougher rhetoric at the party congress echoed the 2005 "Anti-Secession" law, so that more evidence would be needed to conclude that a drastic policy shift is under way.17 China may even want to avoid antagonizing the Taiwanese ahead of local elections later this year. Trump is not yet breaking the status quo: Trump's Asia policy has been consistent with that of previous administrations.18 And Trump's moves to assure Taiwan of U.S. commitment to its defense are status quo. After all, the Democratic Party is historically more enthusiastic about supplying Taiwan with arms (Chart 11). Trump has assured Xi Jinping he will adhere to the "One China" policy; and it is rarely observed that Trump's controversial phone call with Taiwanese President Tsai followed the first-ever tête-à-tête between a Chinese president and his Taiwanese counterpart.19 As long as Trump upholds the norm, the U.S. remains committed to Taiwan's defense yet will refuse to let Taiwan lock it into excessive tensions with China. This policy actually reduces the probability of a miscalculation by Beijing or Taipei. By contrast, the probability would rise if China and Taiwan perceived that the U.S. was withdrawing from its commitments, as Taiwan might want to suck the U.S. back in, or China might see Taiwan as vulnerable. Incidentally, if the Trump administration is not rushing into conflict over Taiwan, then Japan's Abe administration certainly is not. Tsai is not yet breaking the status quo: President Tsai has so far played a pragmatic role. While she is dissatisfied with the "1992 Consensus," which holds that there is only "One China" but two different interpretations of it, she has not rejected the status quo, and she has not implied that Taiwan should be its own state (either of which would cause a huge reaction from the mainland). And there is no serious prospect of a popular independence referendum ("Twexit"?) on the horizon, which would assuredly prompt Beijing to aggressive measures. Chart 10China's Assertiveness Grows With Trade Chart 11Trump Has Not Changed Status Quo In order for us to increase the probability of a Taiwanese war, we would have to see one of these three players start behaving in a way that truly violates the status quo that has prevailed since the U.S. and China normalized relations in 1979. The real risk for Taiwan comes if the U.S. and China fail to arrest the secular decline in relations that began in the mid-2000s. A serious misunderstanding between these two would have a range of global repercussions, and could lead to miscalculation over Taiwan. Unfortunately, a miscalculation is conceivable within Trump's and Tsai's terms, which last until 2020. Consider the following scenario as an example. The U.S. is currently demanding that China assist with the North Korean problem, and may believe that it can compensate China by delaying any punitive trade measures. However, China may be expecting something else - it may be expecting the U.S. to downgrade relations with Taiwan. (In other words, China says, we diminish the North Korean threat to the U.S. mainland, you diminish the Taiwanese threat to the Chinese mainland.) Instead of giving China what it wants, the U.S. may provide Taiwan with new weapon capabilities in response to China's militarization of the South China Sea. In this way, U.S.-China competition could shift to the Taiwan Strait in the aftermath of any Korean settlement. In the meantime, we see Taiwan as vulnerable to China's discrete economic sanctions, which China has not hesitated to use in this or other diplomatic spats (Chart 12).20 Chart 12Mainland Tourists Punish Rebel Taiwan Bottom Line: What is clear to us is that U.S.-China tensions continue to grow and Taiwan could become more frightened, or more emboldened, in the "security dilemma" between them. But until we see signs that any of the relevant powers are actively attempting to break the status quo, we see war as a distant prospect. More likely, today's robust trade between China and Taiwan could suffer a hit due to politics, and tit-for-tat cross-strait sanctions could be imposed. We are closing our tactical trade of long Philippine peso / short Taiwanese dollar for a loss of 5%. This was a speculative play on the divergence in diplomatic relations with China. Taiwan has allowed its currency to rise to avoid antagonizing President Trump, while China and Taiwan have so far avoided the diplomatic crisis that we expect eventually to occur, as outlined above. Iran: Could America Pivot Back To The Middle East? BCA's Geopolitical Strategy correctly forecast the U.S.-Iran détente two years before the nuclear deal was agreed in the summer of 2015.21 At the heart of this call was our read of global forces, namely the paradigm shift in the global distribution of power away from American hegemony towards multipolarity (Chart 13). As the U.S. pivoted its geopolitical focus towards China, Iran became a thorn in its side, forcing it to maintain considerable presence in the Middle East. Without a formal détente with Iran - of which the Joint Comprehensive Plan of Action (JCPOA) is the fulcrum - such a pivot to Asia would be extremely difficult. On January 12, President Trump imperiled our forecast by threatening not to waive sanctions against Iran the next time they come due (May 12).22 To avoid that fate, President Trump wants to see three major changes to the JCPOA: An indefinite extension of limits on Iran's uranium enrichment; Immediate access for inspectors to all nuclear sites; Adding new provisions to limit development of ballistic missiles. These additions are likely to kill the deal, although Trump appears to have directed his comments to the European signatories only. This could potentially create a loophole in the crisis, by allowing Europe to agree to new thresholds for re-imposing sanctions outside of the deal's framework. Pressure from the U.S. president comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. In a surprising statement, President Rouhani said, "it would be a misrepresentation and also an insult to Iranian people to say they only had economic demands ... people had economic, political, and social demands." He went on to say that "We cannot pick a lifestyle and tell two generations after us to live like that ... The views of the young generation about life and the world is different than ours." We agree with President Rouhani. First, 49% of Iran's population is under the age of 30 (Chart 14). Meanwhile, the Supreme Leader and the twelve members of the "Guardian Council" - which has the power to veto parliamentary legislation and to vet presidential candidates - have an average age of 73.23 As with the 2009 Green Revolution, which was brutally repressed, Iran's demographics provide the kindling for a potential regime change. Chart 13American Hegemony Ended,##br## Global Multipolarity Ascending Chart 14Iran's Youth:##br## A National Security Risk Second, Iran's economy is clearly not the main reason for the angst. While unemployment is elevated at 12%, it is only slightly above its two-decade average. Meanwhile, inflation is well below its average, with real GDP growth at 5.8% by the end of 2016 (Chart 15). Considering that inflation peaked at 44%, and real GDP growth bottomed at -16% during the most severe sanctions, the current situation is not dire. What has irked the population is that while the private sector suffered throughout the sanctions ordeal, government spending remained elevated (Chart 16). This is not merely because of automatic stabilizers amidst a deep recession. Instead, Iran has elevated its military spending as new geopolitical opportunities presented themselves in the region (Chart 17). It currently spends more on its military as a percent of GDP than any peer in the region (save for Saudi Arabia, its chief rival). It is openly engaged in military conflict in both Syria, Iraq, and Yemen, while it continues to support allies militarily, economically, and diplomatically across the region, particularly Hezbollah in Lebanon. Chart 15Economic Situation Poor But Not Dire Chart 16Government Felt No Pain During Sanctions Chart 17Iran Overspends On Military Third, Chart 18 shows that Iran is becoming "dangerously wealthy." Both the 1979 Islamic Revolution and the 2009 Green Revolution occurred at, or near, the peak of Iran's wealth. The 25 years preceding each event saw the country's GDP per capita triple and double, respectively. Chart 18Wealth Is Also A National Security Risk Political scientists Ronald Inglehart and Christian Welzel have empirically shown that wealth changes people's basic values and beliefs, from political and economic beliefs to religion and sexual mores.24 This is the process of modernization. Economic development gives rise to cultural changes that make individual autonomy, gender equality, and even democracy likely. Iran has essentially come full circle since 1979. We suspect that the conservative hardliners in the regime understand the revolutionary context well. After all, they were themselves in their 30s when they rebelled against the old corrupt regime. As such, they will welcome President Trump's pressure as it gives them a raison d'être and an opportunity to undermine the moderate President Rouhani who staked his presidency on the success of the nuclear deal. The risk in this scenario is that the domestic arena of the ongoing "two-level game" will prevent both the U.S. and Iran from backing away from a confrontation. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by rhetorically threatening to close the Straits of Hormuz - as they did repeatedly in 2011 - or by boarding foreign vessels in international waters.25 Geopolitical tensions would therefore serve to undermine President Rouhani's embrace of diplomacy and to de-legitimize any further protests, which would be deemed treasonous. For Trump, a belligerent Iranian response to his pressure would in turn legitimize his suspicion of the nuclear deal. What about the global constraints of multipolarity that compelled the U.S. to seek a détente with Iran in order to pivot to Asia? They remain in place. As such, President Trump's simultaneous pressure on Iran and China runs counter to U.S. strategy, given its limited material resources and diplomatic bandwidth. It is therefore unsustainable. What we cannot forecast, however, is whether the White House will realize this before or after it commits the U.S. to a serious confrontation. Bottom Line: Domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. The two countries are playing a dangerous two-level game that could spiral out of control in the Middle East. For the time being, however, we expect merely a minor geopolitical risk premium to seep into the energy markets, supporting our bullish BCA House View on oil prices. NAFTA: Of Global Relevance On a recent client trip through Toronto and Ottawa we were unsurprisingly asked a lot of questions regarding the fate of NAFTA. The deal is not just of importance to Canada but to the world. It is a bellwether for our low-conviction view that President Trump is going to moderate to the middle on policy issues ahead of the midterm elections. We encourage clients to read our November Special Report titled "NAFTA - Populism Vs. Pluto-Populism."26 In it, we cautioned clients that the probability of NAFTA being abrogated by Trump is around 50%. Why so high? Because there are few constraints: Economic: The U.S. economy has been largely unaffected by NAFTA (Chart 19) and would likely experience no disruption if Trump abrogated the deal and began negotiations on bilateral trade agreements with Canada and Mexico. Political: Investors and the media are overstating the importance of the Midwest automotive and agricultural sectors to Trump's base. Trump's Midwest voters knew well his view on NAFTA when they voted for him. In fact, they voted for him because of his NAFTA view. Investors have to realize that Americans do not support unbridled free trade (Chart 20). Constitutional/Legal: There is an argument that Congress could stop President Trump from withdrawing from NAFTA, but the only way to do so would be to nullify his executive orders or legislate a law that prevents the president from withdrawing. However, given the point from above, Congress is afraid to go against the median voter. The immediate implications for investors are that both the CAD and MXN could face downside pressure following the Montreal round of negotiations ending January 29. Both fell by 1.2% and 1.9% respectively in the week of trading following the third round of negotiations in September (Chart 21). Chart 19U.S. Economy:##br## Largely Unaffected By NAFTA Chart 20America Belongs To##br## The Anti-Globalization Bloc Chart 21NAFTA Negotiations##br## Are FX-Relevant More broadly, NAFTA is an important bellwether for the direction of Trump's policy. He has practically no constraints to abrogating the deal. If his intention is to renegotiate two separate deals - or simply reactivate the 1988 Canada-U.S. Free Trade Agreement - then it makes sense for him to end NAFTA and score political points at home. As such, if he does not, it will indicate that the White House is not truly populist but has been captured by the Republican establishment. Bottom Line: If President Trump does not abrogate NAFTA, which comes with few constraints, then he has clearly decided to throw his lot in with the U.S. establishment, which has consistently been more pro-trade than the American voter. This would be highly bullish for investors as it would suggest that the (geo)political risk premium would dissipate going forward. In fact, the decision on NAFTA could be a broad indicator for future decisions on trade relations with China, Iranian sanctions, and policy writ large. For if Trump sides with the establishment on an issue with minimal constraints, then he is more likely to do so on issues with greater constraints. This month, we are closing our 2/30 curve steepener recommendation, which is down 90bps since inception. The two alternative ways we have played rising U.S. growth and inflation prospects - shorting the 10-year Treasury vs. the Bunds and shorting the Fed Funds December 2018 futures - are in the money, 27bps and 46bs respectively. We are keeping both open for now. In addition, we are closing our long French industrial equities relative to German industrials for a gain of 10.26%. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 3 The playbook is really Nikita Khruschev's. 4 Please see "NK celebrates completion of nuke arsenal with fireworks," The Korea Herald, December 2, 2017, available at www.koreaherald.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 7 Trump decided to impose tariffs on solar panels and washing machine, mostly affecting China and South Korea, on January 22. On steel and aluminum, Trump has until late April to decide, i.e. 90 days after reports from the Commerce Department due Jan. 15 and Jan. 22. Please see Andrew Restuccia and Doug Palmer, "White House preparing for trade crackdown," Politico, dated January 7, 2018, available at www.politico.com. 8 The U.S. Trade Representative's latest edition of an annual report to Congress over China's compliance with World Trade Organization (WTO) commitments declares that the U.S. "erred in supporting China's entry into the WTO on terms that have proven to be ineffective in securing China's embrace of an open, market-oriented trade regime." Please see "Joint Statement by the United States, European Union and Japan at MC11," December 2017, and "USTR Releases Annual Reports on China's and Russia's WTO Compliance," dated January 2018, available at ustr.gov. 9 Please see Lesley Wroughton, "Trump administration says U.S. mistakenly backed China WTO accession in 2001," Reuters, January 19, 2018, available at www.reuters.com. 10 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 11 Please see "China cuts communication with Taiwan," Al Jazeera, June 25, 2016, available at www.aljazeera.com; "Taiwan mistakenly fires supersonic missile killing one," BBC, July 1, 2016, available at www.bbc.com; Mark Landler and David E. Sanger, "Trump Speaks With Taiwan's Leader, An Affront To China," New York Times, December 2, 2016, available at www.nytimes.com. 12 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 13 Please see "U.S.-China: From Rivalry To Proxy Wars" in BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 14 Xi Jinping is rumored to have told Communist Party leaders in 2012 that the country would invade Taiwan by 2020. Please see Ian Easton, The Chinese Invasion Threat: Taiwan's Defense and American Strategy in Asia (Project 2049 Institute, 2017). 15 Please see BCA Geopolitical Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 16 National Chengchi University's long-running data series on Taiwanese identity shows that 58% of Taiwanese people identify as Taiwanese, and 70% under the age of 40. However, 77.5% of twenty-year olds also support the political status quo, i.e. do not seek political independence. Please see Marie-Alice McLean-Dreyfus, "Taiwan: Is there a political generation gap?" dated June 9, 2017, available at lowyinstitute.org. 17 Please see Richard C. Bush, "What Xi Jinping Said About Taiwan At The 19th Party Congress," Brookings Institution, October 19, 2017, available at www.brookings.edu. 18 Even the North Korea threat portfolio was bequeathed to him from former President Barack Obama, and it is being managed largely by the Pentagon and navy. 19 In other words, the incoming Trump administration implied that if China's leader Xi Jinping can speak directly to Taiwan's leader Ma Ying-jeou, then U.S. President Donald Trump can speak to Taiwanese President Tsai Ing-wen. This is a sign that alliances are alive and well, and that there are tensions, but it is not a harbinger of war. 20 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 22 The JCPOA did not actually legislate the removal of sanctions against Iran as the Obama administration was unable to get the Republican-controlled Senate to agree. Instead, the president has to use his executive authority to continue waiving sanctions against Iran. 23 That is only two years away from the average life expectancy in Iran. 24 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change, and Democracy, Cambridge: Cambridge University Press, 2005. 25 Iranian military personnel - almost always the Navy of the Iranian Revolutionary Guards - seized British Royal Navy personnel in 2007 and U.S. Navy personnel in 2016. 26 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com.

Highlights Duration: The modest bond-bullish message from our technical indicators does not yet outweigh the bond-bearish forces we expect to prevail on a 6-12 month horizon. Maintain below-benchmark duration. 10-Year Yield: The 10-year Treasury yield has risen a lot, but still has considerable upside on a 6-12 month horizon. The 10-year TIPS breakeven inflation rate is still 35 bps below its fair value range, and it is difficult to craft a realistic scenario where a higher cost of inflation protection is offset by lower real yields. Risk Premiums & Treasury Returns: Despite the recent increases in short-dated Treasury yields, Treasuries with 1-2 years remaining until maturity still do not offer adequate compensation for the likely future path of rate hikes. Negative risk premiums in 1-year and 2-year hold-to-maturity Treasury positions are also likely to coincide with very low Treasury index total returns during the next 1-2 years. Feature Chart 1The Long End Catching The Train The sell-off in U.S. bond markets continued last week with the 10-year yield breaking above its previous peak of 2.62%. Of course yields at the short end of the curve made new cyclical highs long ago and have increased even further during the past few weeks (Chart 1). In this report we look at both the long and short ends of the yield curve and ask whether yields are finally fairly priced. But first, a quick re-cap of our cyclical investment stance. In our prior two bulletins we noted that the cyclical outlook for bonds remains bearish, and this continues to be the case. The main reason is that, despite recent increases, the long-term cost of inflation protection is still below levels consistent with the Fed's 2% inflation target. However, we have also warned that the message from some near-term technical indicators is starting to shift. Specifically, net speculative positions in 10-year Treasury futures are now 2% net short. Positioning at these levels has historically been consistent with a modest decline in the 10-year yield during the subsequent three months (Chart 2). Also, the U.S. Economic Surprise Index (ESI) sits at a lofty +65 and is poised to mean revert as investor expectations grow increasingly optimistic. Our simple auto-regressive model of the ESI projects that it will decline to +28 during the next month.1 A positive value on the ESI is consistent with a continued increase in Treasury yields (Chart 3), but we will be watching closely for signs that the ESI is about to break below zero. Chart 2Message From Our Near-Term Indicators (I) Chart 3Message From Our Near-Term Indicators (II) Taken together, the modest bond-bullish message from our technical indicators does not yet outweigh the bond-bearish forces we expect to prevail on a 6-12 month horizon. We therefore maintain our below-benchmark duration bias. We also maintain our overweight allocation to spread product versus Treasuries. Though inflationary pressure in the economy is starting to build, it is still not sufficient to spur significant spread widening. We will elaborate further on our spread product views in next week's report. How High For The 10-Year? In the current environment we find it instructive to split the nominal 10-year yield into its two main components - the compensation for inflation protection and the real yield - and consider each in turn. Inflation Chart 4TIPS Breakevens Are Still Low As was mentioned in the first section of this report, the 10-year TIPS breakeven inflation rate has risen a lot. From a trough of 1.66% last June to 2.05% as of last Friday. But this is still somewhat too low (Chart 4). Historically, the 10-year TIPS breakeven rate has traded in a range between 2.4% and 2.5% when realized inflation is well-anchored around the Fed's 2% target. With inflation almost certain to move back to the Fed's target before the end of the cycle, and indeed our Pipeline Inflation Indicator shows that inflationary pressures continue to build (Chart 4, bottom panel), there is still another 35 bps to 45 bps of cyclical upside in the 10-year breakeven rate. Real Yield As for the 10-year real yield, a simple model introduced in a report last month shows that it is driven by a combination of: The fed funds rate. The expected change in the fed funds rate during the next 12 months, as measured by our 12-month Fed Funds Discounter. Implied rate volatility as measured by the MOVE index. Included as a proxy for the term premium embedded in 10-year yields. The model is shown in Chart 5, where we also incorporate very conservative assumptions for each of the three independent variables. We assume that: The fed funds rate is raised three times this year, in line with the FOMC's median projection (Chart 5, panel 2). The 12-month discounter falls to 25 bps by year end. In other words, we assume that by then investors will only be looking for one rate hike only in 2019 (Chart 5, panel 3). The MOVE volatility index stays flat at historically low levels (Chart 5, bottom panel).2 Chart 5A Simple Model Of The Real 10-Year Treasury Yield The key message from Chart 5 is that it is very difficult to craft a reasonable scenario where the 10-year real yield has meaningful downside from current levels. Even using the benign assumptions described above, our model projects that the 10-year real yield will increase 4 bps in the next 11 months. From current levels that suggests a 10-year real yield of 0.61% by the end of the year. Summing it all up, on a cyclical horizon we project another 35 bps to 45 bps of upside in the inflation component of the 10-year Treasury yield, and at least 4 bps of upside in the real component. This suggests that the 10-year nominal Treasury yield should move into a range between 3.01% and 3.11% by the time that inflation reaches the Fed's target. Bottom Line: The 10-year Treasury yield has risen a lot, but still has considerable upside on a 6-12 month horizon. The 10-year TIPS breakeven inflation rate is still 35 bps below its fair value range, and it is difficult to craft a realistic scenario where a higher cost of inflation protection is offset by lower real yields. Is The Front End Fairly Priced? At this time last year the 1-year Treasury yield was 0.84% and the fed funds rate was 0.66%. During the past 12 months the fed funds rate rose from 0.66% to 1.42%, equating to an average fed funds rate of 1.10% during this period (using monthly compounding). An investor who bought a 1-year Treasury note last year and held to maturity would have earned a risk premium of -26 bps relative to a position in cash. Not a great return by any means, but yields have moved a lot since then. The 1-year yield is now 1.79% and the 2-year yield is 2.05%. Is it possible that front-end yields now provide adequate compensation for the path of rate hikes during the next 1-2 years? And more importantly, does the risk premium earned on short-maturity notes tell us anything about the total returns we can expect to earn from the overall Treasury index? These are the two questions we consider in this section. Calculating The Ex-Ante Risk Premium In Short-Maturity Yields Table 1 shows three different scenarios for the path of Fed rate hikes during the next two years. The median FOMC scenario assumes that the funds rate rises in line with the Fed's median projection. That is, the rate is lifted three times this year and twice next year. The hawkish scenario assumes that the funds rate is raised once per quarter between now and mid-2019, and the dovish scenario assumes that after hiking rates in March and June of this year the Fed is forced to go on hold. Table 1Fed Rate Hikes Scenarios & The Implied Risk Premium We see that the 1-year yield is priced exactly in line with the FOMC's median projection. That is, if the fed funds rate is hiked three times in 2018, then 12 months from now an investor will have been indifferent between a position in a 1-year note and a position in cash. In this same scenario an investor holding a 2-year note to maturity will end up losing 4 bps relative to a position in cash. Unsurprisingly, the hawkish scenario leads to much more negative realized risk premiums for both 1-year and 2-year hold-to-maturity trades. The dovish scenario leads to a small positive risk premium on a 2-year horizon, but a small negative risk premium on a 1-year horizon. This is because our dovish scenario still assumes there are two rate hikes this year. Our initial conclusion is that despite the recent increases in short-dated Treasury yields, Treasuries with 1-2 years remaining until maturity do not offer adequate compensation for the likely future path of rate hikes. Especially since a position in a 1-year or 2-year note is somewhat riskier than a position in cash, due to the additional duration risk. Short-Maturity Risk Premiums And Treasury Returns But there is one more possible application for the above analysis. We calculated the actual risk premiums earned in 1-year and 2-year hold-to-maturity positions going back to 1973, and found that these risk premiums correlate quite well with changes in the average yield for the Bloomberg Barclays Treasury index for the same time horizon. In other words, 12-month periods in which an investor in a 1-year note would have earned a positive risk premium relative to an investor in cash tend to coincide with a falling Treasury index yield, and vice-versa (Chart 6). The correlation is even stronger on a 2-year horizon (Chart 7). Chart 61-Year Risk Premium & 12-Month Change ##br## In Treasury Index Yield Chart 72-Year Risk Premium & 24-Month Change ##br## In Treasury Index Yield Using the relationships from Charts 6 & 7 we are able to calculate the expected change in the average index Treasury yield in each of our three scenarios for Fed rate hikes. We can then translate those yield changes into expectations for total returns from the Treasury index. Those projected total return figures are shown in the final column of Table 1. Our calculation shows that the median FOMC scenario translates into a projected Treasury index 1-year total return of 2.7%, and an annualized 2-year return of 1.7%. The annualized 2-year return in the hawkish scenario is only 84 bps, while it is 2.3% in the dovish scenario. Chart 8Very Low Returns On The Horizon Of course, these figures come with a good deal of uncertainty. Nowhere in the calculation do we consider possible price changes in longer-maturity bonds, which of course are a significant part of the index. In fact, Chart 8 shows that while the total return projections derived from this exercise give a good sense of the general direction in Treasury index returns, there is still considerable variability from year to year. Perhaps the most accurate statement we can make is that with 1-year and 2-year risk premiums likely to be negative - or at least very close to zero - during the next 1-2 years, we should also expect very low total returns from the overall Treasury index. Bottom Line: Despite the recent increases in short-dated Treasury yields, Treasuries with 1-2 years remaining until maturity still do not offer adequate compensation for the likely future path of rate hikes. Negative risk premiums in 1-year and 2-year hold-to-maturity Treasury positions are also likely to coincide with very low Treasury index total returns during the next 1-2 years. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 For further details on the model please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 2 For further details on the model please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification