Developed Countries

Highlights The Fed still wants to hike in December and thrice next year, but euro area inflation could roll-over versus the U.S. This could cause some weakness in EUR/USD. Long USD/JPY remains a cleaner way to capitalize on the Fed and on higher U.S. bond yields. U.K. trend growth is falling, this will limit how high the BoE will push interest rates up. While the pound can rebound further until year-end, it is not as cheap as it may currently look. AUD/NZD could move back toward parity, but be patient before shorting this cross. Feature The Fed Is On, The Dollar Will Strengthen The dollar bear market is likely over for now, but in our view, U.S. inflation still needs to bottom meaningfully for the DXY to be able to move above 95, and for EUR/USD to trade below 1.15. We expect inflation to bottom late in the fourth quarter, and noticeably re-accelerate in 2018. For now, markets will have to fully price a December rate hike from the Federal Reserve and handle the fallout of a potential slowdown in euro area inflation in the coming months. Moreover, the European Central Bank's tapering announcement next month has been well telegraphed, and is likely to be fully priced in a euro already trading well above levels implied by interest rate differentials. Fed Chair Janet Yellen and the Fed's economic projections have been unequivocal: Governor Lael Brainard has not convinced the rest of the FOMC that U.S. inflation expectations are becoming unmoored to the downside. As a result, the Fed still plans to hike in December and still expects to lift U.S. interest rates thrice next year. The committee also continues to foresee inflation returning to 2% in 2019. The market got the message: on Wednesday, the dollar experienced its strongest rally in eight months, and bond yields moved higher. New evidence is also accumulating that U.S. core CPI will soon trough. This week, U.S. non-oil import prices, a key input to non-oil goods prices continued to increase and the Philly Fed survey's prices-paid and price-received components both showed improvement - corroborating the message from the ISM price paid, which has shot up to 62. This should give Wednesday's message from the Fed more credence among investors. Meanwhile, euro area growth remains very strong, but there are early signs that core inflation may be peaking. BCA's euro area core CPI diffusion index has rolled over and fallen below 50%, normally a precursor sign to a top in core CPI (Chart I-1). Moreover, the strength in EUR/USD is redistributing previous U.S. deflationary pressures into the euro area. As Chart I-2 illustrates, the tightening in euro area financial conditions relative to the U.S. points to a rollover in relative inflation trends. Chart I-1Euro Area CPI Peaking? Chart I-2Euro Area Core CPI Peaking Against The U.S. The market is still pricing far too little in the way of rate hikes in the U.S. over the next two years, while it is pricing the ECB appropriately, anticipating a 2019 lift-off of euro area policy rates (Chart I-3). This leaves the EUR/USD quite vulnerable if the market reassesses the Fed's capacity to lift rates, as this pair continues to trade at a level of premium to interest rate parity models last recorded in 2009 (Chart I-4) - premia that have historically been followed by declines over the following six months, averaging 6%. Chart I-3The Potential For A Repricing Of The ##br##Fed Relative To The ECB... Chart I-4..Will Hurt ##br##EUR/USD The yen too remains at risk. The yen might be cheaper than the euro, trading in line with its interest rate-implied fair value, but it is also burdened by a central bank inclined to leave policy as easy as possible for as long as possible. In fact, new Bank of Japan board member Goshi Kataoka dissented this week because, in his view, Japan needs more easing, both fiscal and monetary. Thus, in an environment where the Fed is trying to lift interest rates and where U.S. Treasury yields trade well below fair value (Chart I-5), the yen could suffer greatly as interest rate differentials move in favor of the USD, since the BoJ will still cap JGB yields for an extended period. Moreover, on the political front, an October election is becoming increasingly possible. Japanese Prime Minister Shinzo Abe's popularity has rebounded, and the opposition is in disarray, pointing to a very likely win for the LDP. Abe is seeking a new mandate as he wants to set a referendum to amend the Japanese constitution, removing its pacifist bias in order to increase military spending, which has greatly lagged that of rival China (Chart I-6). The North Korean crisis is obviously beneficial to this goal, and Abe wants to capitalize on it. Chart I-5Biggest Problem For The Yen Chart I-6Abe Wants To Rectify This Gap In order to increase the likelihood of a successful referendum, we anticipate Abe to push for more stimulus to goose the economy. Additionally, when Japanese wages are adjusted for the change in the breakdown between full-time and part-time positions, wage growth has already picked up significantly - well above 3% compared to a paltry 0.4% annual rate for the headline measure. This combination of potential fiscal stimulus, improving underlying wage growth and a staunchly dovish central bank could ultimately put upward pressure on inflation expectations, and thus downward pressure on Japanese real yields. This could further augment the negative impact of rising U.S. bond yields on the yen. Bottom Line: The dollar is set to appreciate against the euro and the yen in the coming weeks. The Fed has not deviated from its message and it still intends to follow the path set in the "dot plot." Meanwhile, euro area inflation could roll over, limiting how close to today markets can bring forward the first hike from the ECB. The euro is too expensive to withstand this eventuality. The BoJ in unwilling to abandon its current extremely dovish policy, setting the stage for additional yen weakness in the face of higher U.S. bond yields. GBP: As Cheap As It Seems? GBP/USD is currently trading at a large 20% discount to its purchasing parity equilibrium rate, and the trade-weighted pound is 10% below our long-term fair value estimate (Chart I-7). Since valuations have been strong predictors of currency returns on a two- to five-year horizon, this begs the following question: Is the pound a buy? Tactically, yes, the GBP still offers upside for the next three months or so, especially vis-à-vis the euro. The Brexit negations are likely to lead to long transition periods for FTAs after the U.K. leaves the EU. Moreover, interest rate markets currently assign a 65% probability of a hike by the Bank of England in November. However, recent communications from BoE Governor Mark Carney and his colleagues suggest the British central bank will hike that month. House prices have regained some composure and wage growth has rebounded to 2.2% after hitting a low of 1.7% six months ago, explaining some of the recent strength in retail sales. Inflation remains sticky at 2.9% per annum, and even the non-tradeable sector, where the pound's movements should bear little influence, continues to experience elevated inflation readings. This would support Carney's recent assertion that the U.K.'s output gap is closing faster than the BoE originally anticipated. It also raises question marks as to whether long-term inflation expectations in the private sector are beginning to become unanchored - something that would justify removing monetary accommodation from the system. Beyond this time horizon, the picture becomes more complex. The problem for the pound arises from the fact that the earlier-than-expected closure of the output gap is first and foremost a reflection of falling trend growth, a phenomenon that will continue well into the future. It is one of the inevitable consequences of last year's Brexit vote. Brexit principally impacts trend growth by depressing the U.K.'s labor force growth. As Chart I-8 illustrates, pre-Brexit, the U.K. experienced much more robust labor force growth than its EU peers thanks to a steady inflow of immigrants. However, at its core, the Brexit vote was a referendum on immigration. The U.K. government's hard stance on rejecting free movement of people going forward demonstrates that the Conservatives understand this, and it will remain a key pillar of their strategy going forward. Chart I-7Is The Pound Really That Cheap? Chart I-8U.K. Trend Growth Will Fall Problematically, leaving the EU will not improve the British trade balance, despite the fall in the pound. It may even hurt it. The fall in the pound can marginally help the U.K.'s goods balance with the EU, which currently stands at a deficit of 5% of GDP. However, this deficit is structural and reflects the U.K.'s lack of competitive advantage in manufacturing vis-à-vis the rest of the EU. Thus, a fall in the pound will do little to fully redress this gap. Meanwhile, the U.K. runs a surplus of 1.3% of GDP in the services balance (Chart I-9). However, by leaving the EU, the U.K.'s service sector is likely to lose much access to the continent as trade in services is heavily regulated, and creating new trade deals on services between the U.K. and the EU will prove a difficult process. Moreover, this services balance seems insensitive to the gyrations in EUR/GBP. Thus, while leaving the EU might marginally help the goods balance thanks to a lower pound, this exchange rate benefit will be nullified by a loss of access to EU markets by U.K. service sector firms. Why does a lower trend growth matter for the pound in the long run? The U.K. has been running a large current account deficit for 20 years. Even at 3.9% of GDP, this deficit does not have to be a problem if it can be financed. Thankfully, the U.K. has benefited from a higher level of neutral interest rates, itself a function of Britain's higher trend GDP growth. This higher neutral rate means the U.K. has been able to enjoy higher interest rates in general than the EU or the U.S. (Chart I-10). These higher returns have attracted the necessary capital to finance the current account. Chart I-9A Lower Pound Will Not Undo##br## The Pain Of Leaving The EU Chart I-10Lower Trend Growth Equals##br## Lower Terminal Rate Going forward, lower trend growth will lower the neutral interest rate, which will limit both the terminal rate hit by the BoE this cycle as well as the average level of rates in the U.K. In this context, the U.K. will need a permanently cheaper pound to finance its current account deficit. As a result, the apparent cheapness of the pound on long-term valuation metrics may prove to be nothing more than an illusion. Chart I-11Will Higher GBP Volatility Hurt London? The other problem that could negatively affect the pound is that the U.K. remains a global financial center. Historically, having low exchange rate volatility has helped financial centers achieve the pre-requisite level of stability needed to attract foreign capital (Chart I-11). However, the pound's volatility has increased in the aftermath of Brexit. If realized volatility was computed from 2000 to 2015, the standard deviation of the pound's returns rank below that of the Swiss franc and the Norwegian krone; if the sample is expanded to today, its volatility ranks above that of the CHF and the NOK. Not only does this point to a large increase in the relative volatility of the pound in the interim two years, but this trend could continue in the future, especially if as our Geopolitical Strategy sister service argues, the leftward-shift in the U.K.'s median voter could lead to a Corbyn Premiership down the road.1 Bottom Line: The pound still has upside in the short-term as markets re-assess the path of the BoE toward a rate hike this year, removing the emergency easing implemented in the wake of the last year's referendum. However, the long-term outlook for the pound is trickier. The GBP's apparent cheapness is warranted. The U.K.'s potential growth rate is falling, which will drag down the country's neutral interest rates. As a result, the BoE will not be able to increase interest rates much over the course of the cycle. This means that financing the U.K.'s current account deficit will require the pound to remain cheap for an extended period of time. AUD/NZD: The RBNZ Can Tighten More Than The RBA The AUD/NZD is likely to experience a move toward parity over the next six months. Currently, AUD/NZD trades approximately 10% above its long-term fair value (Chart I-12, left panels), a level that has historically resulted in sharp reversals. This cross is also trading at a significant premium to our Intermediate-Term timing model (Chart I-12, right panels), further highlighting the medium-term downside risk for the aussie/kiwi. Chart I-12AAUD/NZD Is Expensive Chart I-12BAUD/NZD Is Expensive Valuations are not the only consideration raising a red flag for AUD/NZD. Relative monetary policy dynamics could also weigh on this cross going forward. As the Reserve Bank of New Zealand has been trying to talk down the kiwi, interest rate markets are pricing in 34 basis points of hikes over the next 12 months, while they expect the Reserve Bank of Australia's Cash Rate to increase by 41 basis points over the same timeframe. We think the RBNZ has more room to tighten policy than the RBA, especially as our central bank monitor is much more hawkish on New Zealand than Australia (Chart I-13). Corroborating the message of this indicator, the New Zealand output gap is now at 0.9% of potential GDP while it stands at -1.6% in Australia, suggesting more pronounced underlying inflationary pressures in the smaller economy. Moreover, New Zealand's growth is outpacing Australia's by nearly 1%, and relative LEIs suggest no end in sight for this trend. Thus, the relative output gap between the two countries will continue to move in favor of a tighter RBNZ than RBA. Additionally, Australia house prices have been in a cyclical downtrend versus New Zealand, depreciating nearly 15% in relative terms since 2011. This is resulting in a large underperformance of Australia's credit growth against New Zealand, which points to downside risk in AUD/NZD (Chart I-14). Mirroring these two factors, Aussie retail sales are lagging their neighbors by a near-record 3% annual pace. Beyond domestic conditions, terms-of-trade dynamics are also a negative for AUD/NZD. This cross tends to mimic movements in the prices of metals relative to dairy prices, reflecting the composition of the two nations' exports. Since May this year, metals have been outperforming milk, but AUD/NZD has massively overshot this driver (Chart I-15), exposing the cross to a reversal in relative commodities prices. Going forward, with Chinese monetary conditions tightening, with Chinese fiscal stimulus waning, and with EM money growth sharply decelerating, metals prices, which are much more sensitive to global industrial activity, are likely to underperform the less growth-sensitive dairy prices. Chart I-13The RBNZ Needs To be More##br## Hawkish Than The RBA Chart I-14Disconnect Between AUD/NZD##br## And Relative Credit Growth Chart I-15AUD/NZD Out Of Line ##br##With Terms Of Trade Technically, it is too early to enter this bet with any degree of certainty. Short-term momentum metrics are deeply oversold, and AUD/NZD, currently trading at 1.085, could rebound once it moves to 1.08 - the next key support level and slightly above the 50% retracement of the rally begun in June. This rebound could lift AUD/NZD close to the 1.11 neighborhood. Thus, we will wait for a better entry point to begin shorting this cross, especially as this weekend's election remains too close to call despite a recent rebound in the National Party. A Labour/NZ First coalition could cause a temporary sell-off in the NZD. Bottom Line: AUD/NZD is very expensive, and the market is underestimating the risk that the RBNZ will tighten policy more than the RBA over the next 12 months. The New Zealand economy has much less slack and is growing more strongly than Australia's, pointing to greater inflation risk. Additionally, metals prices are likely to underperform dairy prices, which will hurt Australian terms of trade relative to New Zealand. Technically, a better opportunity to short AUD/NZD is likely to emerge in the coming weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The highlight of this week was the Fed's Monetary Policy meeting, where the FOMC announced the unwinding of the Fed's US$4.5 trillion balance sheet in October. It also intend to boost in interest rates in December, with the probability of a hike that month now at 63%. This is likely to move to 100%. While data continued to be mixed this week - existing home sales slowed but the Philly Fed survey was very strong, the Fed decided to ignore this as well as the potential impact of hurricanes, instead concentrating on the strong fundamentals underpinning the U.S. economy. Interest rates will therefore increase alongside inflation, providing a fillip for the greenback. On the fiscal side, tax cuts seem increasingly likely to be implemented. As investors begin to price out fiscal policy disappointments, the dollar will rally. Nevertheless, inflation is likely to pick up some time in 2018, and the dollar will fully bloom then. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data continues to outperform expectations: Core CPI, unchanged at 1.3%, beat expectations of 1.2%; Headline CPI also remained unchanged at 1.5%; German ZEW Economic Sentiment outperformed greatly coming out at 17.0, while the Current Situation also outperformed at 87.9; German producer prices grew at 2.6% annually, outperforming expectations of 2.5%. While the euro traded positively on the news, it lost most of this week's gains due to the Fed policy decision. We believe that sustained growth in the euro area will sustain the euro between 1.15 and 1.20. However, a pickup in U.S. inflation in 2018 could push EUR/USD toward 1.10. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth underperformed to the downside, contracting by 7.5%. The contraction also accentuated from July to August. Domestic corporate goods price yearly growth also underperformed, coming in at 2.9%. However both export and import growth outperformed expectations, coming in at 18.1% and 15.2% respectively. Additionally the merchandise trade balance in August also outperformed, coming in at 113.6 Billion yen. The Bank of Japan decided to leave their policy rate unchanged at -0.1% on Wednesday on an 8 to 1 vote, with dissenter Goshi Kataoka presenting an even more dovish slant. The BoJ highlighted that the economy continues to expand moderately, and that inflation should continue to slowly grind higher. Overall we are more bearish on the ability of the BoJ to spur inflation without a meaningful depreciation in the yen. Continue to long USD/JPY. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has surprised to the upside: Retail sales growth and retail sales ex-fuel growth outperformed expectations coming in at 2.4% and 2.8% respectively. Manufacturing production yearly growth came in at 2.9%, also outperforming expectations. Furthermore the ILO unemployment rate came in at 4.3%, outperforming expectations. The BoE left rates unchanged in their latest interest rate decision by a majority of 7 to 2. The BoE was more hawkish than expected, commenting that monetary policy could need to be "tightened by a somewhat greater extent over the forecast period than current market expectations". Overall we continue to be positive on the pound relatively to the euro. However on a longer term basis, the outlook for the pound remains tricky, as Brexit could result in a lower neutral rate in the U.K., and thus a lower pound. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD fell sharply following RBA Governor Philip Lowe's speech. Lowe stated that "a rise in global interest rates has no automatic implications for us here in Australia", prompting a repricing of Aussie rates. The high level of household debt was also brought to light, with Governor Lowe highlighting that "household spending could be quite sensitive to increases in interest rates, something the Reserve Bank will be paying close attention to." He also surmised that "there are risks on the horizon, with the Chinese economy going through some difficult adjustments". This speech largely confirms are bearish view on the Australian dollar. While the AUD did rally this summer, this was mostly due to disappointing U.S. inflation. When inflation re-emerges, which we believe will be in early 2018, the AUD could give up most of its gains. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Electronic card retail sales yearly growth increased to 4.4% from 2% the month before. Gross Domestic product yearly growth came at 2.5%, in line with expectations. Meanwhile the current account outperformed to the upside, coming in at a deficit of 2.8% of GDP, compared to expectations of 3%. Finally the Business NZ PMI came in at 57.9, increasing significantly from last month's reading of 55.4. The kiwi has appreciated in the past 2 weeks, as a weak dollar coupled with positive data in New Zealand and falling political risk in that country have helped the currency. At the present, we are bearish on AUD/NZD, as the inflationary backdrop continues to be more positive in New Zealand than in Australia. Meanwhile iron ore prices seem to have peaked. These factors should weigh on this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian consumer sector remains strong, with wholesale sales increasing at a 1.5% monthly pace in July, beating the expected 0.9% contraction. Higher rates are also increasing portfolio inflows, as foreign portfolio investment in Canadian securities jumped to CAD 23.95 bn in July, from the previous outflow of CAD 0.86 bn, also larger than the expected CAD 4.46 bn. While the CAD depreciated against the USD following the Fed's monetary policy meeting, it remained largely flat against other G10 currencies. The CAD will continue to fight headwinds against the USD but to rally on its crosses. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Producer price inflation came in at 0.6%, beating expectations. The trade balance came in at 2.713 billion CHF for the month of August, underperforming expectations. A week ago the SNB left rates unchanged as expected. Most importantly, there was a slight upward revision in the inflation forecast, with the SNB anticipating an inflation rate of 0.4% in 2018 and 1.1% in 2019 compared to the previous forecast of 0.3% and 1%. These forecast assume a 3-month LIBOR of -0.75% through the forecast period. Moreover, the central bank also expects the modest recovery in Switzerland to continue. However, it seems that the floor under EUR/CHF will stay for the time being, as the SNB said that the Swiss Franc continues to be "highly valued" and that that continued intervention in the FX market will continue to be necessary. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Despite a rebound in Norway's economic surprise index, Norway continues to experience a marked lack of inflation: Headline inflation came in at 1.3%, decreasing from last month's reading of 1.5% and underperforming expectations. Core inflation also underperformed expectations, falling from 1.2% last month to 0.9% in the latest data point. Yesterday the Norges Bank decided to keep rates unchanged at 0.5%. The bank released a statement highlighting that capacity utilization is "on the rise, and higher than previously assumed", however they also highlighted that "wage growth will remain moderate". More importantly they signaled that they would likely increase rates somewhat earlier than previously expected. Overall we continue to be bullish on USD/NOK, as interest rate expectations should help the dollar against the krone. That being said, higher oil prices should help the krone outperform its commodity peers and the euro. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has remained flat for a month, as markets are assessing the situation between the two hawkish central banks. Data in Sweden has disappointed recently: Manufacturing PMI went down to 54.7 from 60.4; The current account decreased by SEK 39.5 bn; Industrial production also grew by 5.3% annually, lower than the previous 8.9% figure; New orders are also growing by less than before at 2.1%; Inflation also underperformed the expected 2.2%, coming in at 2.1%; However, the unemployment rate dropped significantly from 6.6% to 6%. While inflation disappointed, it still remains in the target range and the upward trend is still intact. The Swedish economy is performing very well, and the Riksbank is likely to join the Fed and the BoC in hiking rates next year. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights This week's FOMC statement telegraphed another rate hike in December and three more hikes in 2018. The ability of the Fed to deliver on these hikes will depend on whether inflation picks up. We think it will. Stronger GDP growth will push the unemployment rate below 4% next year, the threshold at which the Phillips curve becomes quite steep. The often-cited reasons for why the Phillips curve has become defunct - well-anchored inflation expectations, decreased union bargaining power, a more globalized economy, and technological trends - are less convincing than they appear. Underweight long-term government bonds and overweight equities for the next 12 months. Look to reduce risk exposure late next year. The beleaguered dollar could catch a bid over the coming months. We are closing our long Brent oil trade for a gain of 13.8%. Feature The Fed Delivers A "Hawkish Hold" Going into this week's FOMC meeting, there was some speculation among market participants that the Fed would signal a reluctance to raise rates in December and reduce the number of rate hikes planned for next year. In the end, that didn't happen. Twelve of the sixteen participants indicated that they expected the fed funds rate to rise in December, exactly the same number as in June. The Fed downplayed the effects of the hurricanes, noting that they would not "materially alter" medium-term growth prospects. The median number of rate hikes planned for next year also remained at three. The FOMC kept the long-term estimate of unemployment at 4.6%, despite trimming the forecast for end-2018 unemployment rate from 4.2% to 4.1%. The only substantive dovish changes to the dots came in the form of a cut in the number of hikes planned for 2019 from three to two, and a reduction in the terminal rate from 3% to 2.75%. Not surprisingly, the somewhat hawkish tone of the FOMC statement caused the implied odds of a December rate hike to jump from about one-in-two to two-in-three. The dollar also rallied, with the euro falling a full big figure against the greenback immediately following the release of the statement. Don't Write Off The Phillips Curve Just Yet Last week's higher-than-expected inflation print undoubtedly increased the Fed's willingness to keep raising rates. Nevertheless, despite the tentative rebound in inflation, core CPI inflation is down 0.6 percentage points since January on a year-over-year basis, while core PCE inflation is down 0.5 points over the same period. The failure of inflation to accelerate in response to diminished economic slack has convinced many people that the Fed will not be able to continue scaling back monetary stimulus. It has also prompted numerous commentators to pen obituaries for the so-called Phillips curve. Named after New Zealand economist William Phillips, the curve predicts that falling unemployment will lead to rising inflation. It is certainly true that the Phillips curve has become flatter over the past few decades (Chart 1). However, we think that it is premature to write it off as a useful tool for predicting inflation. This is because the Phillips curve tends to become much steeper once the economy reaches full employment. As we have discussed in the past, a variety of measures suggest that the U.S. is approaching this "kink" in the curve (Chart 2).1 Chart 1The Phillips Curve Has Gotten Flatter Chart 2U.S. Economy At Full Employment The idea that the Phillips curve steepens at low levels of unemployment is very intuitive: If excess capacity is high to begin with, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The empirical evidence supports this conclusion. Chart 3 shows that U.S. wage growth has tended to accelerate once the unemployment rate falls into the range of 4%-to-5%. Chart 3U.S. Wage Growth Accelerates Once The Unemployment Rate Falls To Low Levels The Absence Of Evidence Is Not Evidence Of Absence The past three U.S. business-cycle expansions never reached the stage where the economy had the chance to fully overheat. The 1982-90 cycle was cut short by the spiraling effects of the Savings & Loan crisis, while the 2001-2007 cycle was short-circuited by the housing bust. The closest the economy came to boiling over was during the 1990s expansion. However, that cycle was also prematurely terminated by the dotcom bust and the adverse knock-on effect this had on business investment spending. Moreover, the late 1990s expansion occurred against the backdrop of a soaring dollar, turmoil in emerging markets, and plummeting commodity prices. These external deflationary forces arguably overwhelmed the inflationary impulse stemming from an overheated domestic economy. The tendency of financial imbalances to metamorphize into full-blown recessions before inflation has had a chance to take off means that the U.S. has spent the past 30 years on the flat side of the Phillips curve. One can see this point analytically: Between 1964 and 1980, the unemployment rate was below the Fed's estimate of NAIRU 79% of the time, compared to only 29% of the time since 1980. It is thus no wonder that the Phillips curve looks dead - it has not been given a chance to come alive. This makes us sceptical of studies such as the recent one by the Philadelphia Fed which purported to show that the Phillips curve is no longer useful for forecasting inflation.2 The Kinky Sixties We argued several weeks ago that the next recession could resemble the "classic recessions" of the post-war era, which were caused by the Fed's decision to raise rates aggressively after realizing it was behind the curve in normalizing monetary policy.3 The 1960s provides a useful lesson in that regard. Just like today, inflation hovered below 2% during the first half of that decade, even though unemployment was trending downward over this period. To most observers back then, the Phillips curve would have also appeared defunct. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 4). The kink in the Phillips curve had been reached. Inflation ultimately made its way to 6% in 1970, four years before the first oil shock struck. One might challenge the 1960s comparison on four grounds: First, inflation expectations are allegedly better anchored today; Second, trade unions play a much smaller role in the wage bargaining process; Third, globalization has purportedly made both product and labour markets much more competitive than they were back then, thus severely limiting the scope of firms to raise prices and wages; Fourth, the deflationary impact of new technologies such as robotics and online commerce has become more pervasive. We think all four of these explanations leave much to be desired. As far as inflation expectations are concerned, it is certainly true that central banks did not pursue explicit inflation targets during the 1960s. However, this does not mean that inflation expectations were necessarily poorly anchored. Ten-year Treasury yields averaged 4.1% in the first half of the sixties, well below the 6.6% pace of nominal GDP growth. Investors back then were clearly quite relaxed about inflation risk. This is not that surprising, given that the U.S. had not seen a period of sustained inflation since the Civil War. A decline in unionization rates is also often cited as a reason for why the Phillips curve may be flatter today. The problem with this argument is that it is very U.S.-centric. For example, while the U.S. has experienced a pronounced drop in unionization rates since the 1960s, Canada has not (Chart 5). Yet, the sensitivity of inflation to economic fluctuations has fallen in both countries by roughly the same magnitude. Likewise, the increased use of inflation-linked wage contracts in the 1970s appears mainly to have been a response to rising inflation rather than the cause of it (Chart 6). Chart 4Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Chart 5Inflation Fell In Canada Despite A High Unionization Rate Chart 6Wage Indexation Was Mainly A Response To Rising Inflation Globalization And The Phillips Curve The extent to which globalization has flattened the Phillips curve remains the subject of intense debate. The empirical evidence is mixed, with most studies leaning towards the conclusion that globalization has had only a limited impact on the slope of the curve in large economies such as the U.S. This makes perfect sense, considering that the import share in U.S. personal consumption stands at less than 15%.4 Supporting this conclusion is the fact that wage growth appears to be just as sensitive to changes in the unemployment rate in industries that are highly exposed to trade as those which face little import competition. Upon deeper inspection, many of the arguments for why globalization has led to a flatter Phillips curve are really arguments for why globalization has limited the degree of movement along the Phillips curve. In a highly globalized world, a decline in slack in one country - unless matched by reduced slack in other countries - will lead to higher interest rates in that country and a stronger currency. A stronger currency, in turn, will choke off growth, preventing the unemployment rate from falling as much as it otherwise would. Clearly, such a sequence of events has not applied to the U.S. dollar since the start of the year. This suggests that the unemployment rate will either keep falling towards the steeper part of the Phillips curve, or the Fed will be forced to turn more hawkish. The Effects Of Technology What about the possibility that technological advances have led to a flatter Phillips curve? The problem here is that the data do not fit the story. As my colleague Mark McClellan has pointed out, almost all of the decline in inflation since the Great Recession has occurred in categories of the CPI - such as energy, food, and rent - that have little to do with e-commerce (Table 1).5 Also keep in mind that while online sales have grown rapidly during the past two decades, they still account for only 8.9% of total retail sales and less than 5% of the U.S. Consumer Price Index. Amazon's recent growth has actually lagged behind what Walmart experienced during its heyday (Chart 7). Table 1Comparison Of Pre- And Post-Lehman Inflation Rates Chart 7Amazon Vs. Walmart: Who's More Deflationary? The proliferation of big-box retailers pushed up productivity growth in the retail sector to 3.9% between 1992 and 2007. Productivity growth in this sector has fallen to 2.1% since then. This undercuts the notion that the explosion in e-commerce has produced major efficiency gains for the broader economy, thus contributing to deflationary pressures.6 Investment Conclusions U.S. inflation is likely to trend higher over the coming months as a variety of one-off factors that depressed inflation earlier this year fall out of the equation. The effects of the hurricanes complicate the picture, but history suggests that both inflation and growth tend to renormalize fairly quickly after such disasters. Hence, the markets will look through any near-term noise in the data, focusing instead on the cyclical growth outlook, which remains reasonably upbeat. Chart 8 shows that fluctuations in the ISM manufacturing index have often predicted changes in inflation. The current level of the ISM implies that core inflation will rebound to about 2% by the second half of next year. Risk assets are unlikely to suffer if inflation rises towards the Fed's target against the backdrop of stronger growth. However, if inflation moves above the Fed's target due to brewing supply bottlenecks, the Fed will have little choice but to pick up the pace of rate hikes. This could unsettle markets and sow the seeds for the next recession, which we tentatively expect to occur in the second half of 2019. What should investors do? Right now, none of our leading indicators are warning of an imminent economic downturn (Chart 9). Thus, we continue to recommend a cyclically overweight position in equities. However, we would not fault longer-term investors for starting to take money off the table, especially in light of today's lofty valuations. Chart 8ISM Has Often Predicted Changes In Inflation Chart 9No Warnings Of An Imminent Downturn The Fed is likely to raise rates in December and three or four more times in 2018. We are positioned for this by being short the December 2018 Fed funds futures contract, a trade that has gained 22 basis points so far. Considering that the market is pricing in only 42 basis points of hikes between now and the end of next year, there is plenty of juice left in this trade. A more aggressive-than-expected Fed could give the beleaguered dollar a much-needed lift. We see EUR/USD falling back to 1.15 by the end of the year and USD/JPY moving to 115. We are less bearish towards the British pound and the Swedish krona. Our short EUR/GBP and long SEK/CHF trades are up 2.6% and 5.4%, respectively, since we initiated them. Finally, we are closing our long December 2017 Brent oil futures contract for a gain of 13.8%. We still see modest upside for oil prices, and are expressing this view by being long the Canadian dollar and Russian ruble against the euro. Both currency trade recommendations remain in the money. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and "What's the Matter With Wages?" dated August 11, 2017. 2 Michael Dotsey, Shigeru Fujita, and Tom Stark, "Do Phillips Curves Conditionally help To Forecast Inflation?"Federal Reserve Bank of Philadelphia, Working Paper no. 17-26 (August 2017). 3 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?" dated August 18, 2017. 4 Galina Hale and Bart Hobijn, "The U.S. Content of "Made in China"," FRBSF Economic Letter 2011-25 (August 8, 2011). 5 Please see The Bank Credit Analyst, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017. 6 Ironically, if technological change has made the Phillips curve more flat, it may be because it has reduced competition rather than fostered it. The shift to a digital economy has allowed more companies to dominate their markets by virtue of network and scale effects. The expansion of such "winner-take-all markets" helps explain why industry concentration has risen over the past few decades, boosting profit margins in the process. A recent NBER working paper by Jan De Loecker and Jan Eeckhout found that the average U.S. publicly-listed firm set prices 67% above marginal costs in 2014 compared to 30% in 1990 and 18% in 1980. Economic theory suggests that firms with significant market power will tend to raise prices by less than highly competitive firms in response to costs increases. This would make the Phillips curve more flat. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

The dominant theme this week in U.S. Equity Strategy has been the acceleration in global trade. South Korea, the archetypal global trade bellwether, saw its exports grow by 16% in the first seven months this year with a 31% increase in the first three weeks of September. Such growth reinforces our thesis that we are in the early stages of a global capex resurgence. Global industrial machinery is heavily levered to changes in DM capital goods orders; the recent modest shift to growth in the latter has driven a surge in highly cyclical global machine orders (second panel). Paired with strong domestic demand (third panel) and an export-accommodative currency, U.S. industrial machinery manufacturers should be particularly well positioned to see earnings growth outpace the rest of the S&P 500. The market has been somewhat less sanguine than both us and the sell-side community; earnings estimates have been outpacing the index, resulting in a fall in valuation multiples year-to-date. Validation of those estimates seems likely to be the key catalyst for the index; stay overweight industrial machinery. The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, IR, SWK, PH, FTV, DOV, PNR, XYL, SNA, FLS.

Highlights A major investment theme for the coming years will be the resynchronization of developed economy monetary policies. Expect substantial further convergence between U.S. T-bond yields and both German bund yields and Swedish bond yields. This yield convergence necessarily supports the currency crosses EUR/USD and SEK/USD. Underweight U.K. consumer services versus the FTSE100. Overweight German consumer services versus the DAX. The September 24 German election and October 1 proposed referendum on Catalan independence are not major catalysts for the financial markets. Feature A major investment theme for the coming years will be the resynchronization of developed economy monetary policies. As monetary policy resynchronizes, it will become clear that the extreme desynchronization of monetary policies over the past few years was the great anomaly (Chart of the Week and Chart I-2). This anomaly reached its peak in 2014 when policies at the ECB and the Federal Reserve moved in diametrically opposite directions. The ECB signalled the start of its quantitative easing just as the Fed began to end its own. Chart of the WeekThe Desynchronization Of Monetary##br## Policy Was An Anomaly Chart I-2The Desynchronization Of Monetary##br## Policy Was An Anomaly Why Did Monetary Policy Desynchronize? The extreme desynchronization of monetary policy would not have happened if it was just about economics. On the basis of the hard economic data, the ECB could have emulated the unconventional policies of the Fed, BoJ and BoE years before it eventually did in 2015. If it had, ECB policy would have been much more synchronized with the other major central banks. However, unconventional monetary policy wasn't, and isn't, just about economics. The ECB faced, and still faces, much tougher political and technical hurdles than other central banks. The euro area does not have one government, it has 19. The ECB had to convince sceptical core euro area governments that zero and negative interest rate policy and bond buying were not just a bailout for the periphery, especially with the euro debt crisis so fresh in the mind. Likewise, the euro area does not have one sovereign bond, it has 19. To design and implement an asset purchase program in the euro area is much more complicated than in the U.S., Japan or the U.K. But by mid-2014 it had become clear that each wave of unconventional monetary easing - through its impact on exchange rates - had allowed other major economies to 'steal' some inflation from the euro area (Chart I-3). With the ECB still undershooting its inflation mandate, it was becoming a dereliction of duty for the ECB not to do what the Fed, BoJ and BoE had already done several years earlier. As the saying goes, it is better for a reputation to fail conventionally, than to succeed unconventionally. Chart I-3Currency Depreciations "Steal" Inflation From Other Economies Why Will Monetary Policy Resynchronize? Three years and several trillion euros later, the ECB can feel it has had a fair crack at unconventional easing (Chart I-4). At the same time, the central bank must contend with fresh political and technical hurdles. How many more German bunds can it realistically buy without irking Germany's policymakers? Chart I-4The ECB Has Had A Fair Crack At QE The ECB is also aware that ultra-loose monetary policy - by compressing banks' net interest margins - endangers banks' fragile profitability. This impairs the bank credit channel which is the mainstay of private sector credit intermediation in the euro area.1 Meanwhile, the euro area's configuration of solid economic growth, solid job growth and subdued inflation is common to most large developed economies (the exception is the U.K. which we explain below). Putting all of this together, the theme for the coming years has to be monetary policy resynchronization, one way or the other. One way is that the more hawkish central banks will become less hawkish, as subdued inflation limits the scope for monetary policy tightening. The other way is that the more dovish central banks will become less dovish as the benefits of ultra-accommodation diminish and the costs rise. Or, both ways will happen together. Nowhere are negative bond yields more absurd and more inappropriate than in Sweden (Chart I-5). In just three years the economy has grown 12% and house prices have surged 50%. Furthermore, unlike in other parts of Europe, the housing market in Sweden did not suffer a meaningful setback in either 2008 or 2011. Yet Sweden's negative interest rate policy means that it stills pays people to borrow and further bid up house prices. If anywhere is at risk of a bubble from ultra-accommodative monetary policy, Sweden must be it. For bond yield spreads and currencies - which are relative trades - it doesn't really matter how the resynchronization of monetary policies occurs. We expect substantial further convergence between U.S. T-bond yields and both German bund yields and Swedish bond yields. And this yield convergence necessarily supports the currency crosses EUR/USD and SEK/USD (Chart I-6). Chart 5A Negative Bond Yield ##br##In Sweden Is Absurd Chart I-6If The Swedish Bond Yield Shortfall ##br##Compresses, The Krona Will Rally The Myth Of The Beneficial Currency Devaluation Sharp depreciations in a currency result in an economy 'stealing' inflation from its major trading partners. Chart I-7 and Chart I-8 suggest that absent the post Brexit vote slump in the pound, the gap between U.K. and euro area inflation would be almost 1% less than it is. Chart I-7The Weaker Pound Lifted ##br##U.K. Headline Inflation... Chart I-8...And U.K. ##br##Core Inflation So the Brexit vote explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. Which means that the pound's weakness has choked households' real incomes. Against this, textbook economic theory says that a currency devaluation should make a country's exports more competitive and thereby boost the net export contribution to economic growth. But in the textbook the only thing that is supposed to change is the exchange rate. The textbook assumes that the country's trading framework with its partners remains unchanged. In the case of the U.K. leaving the EU, this assumption clearly does not apply, mitigating the concept of the 'beneficial currency devaluation'. A lot of the benefits of the textbook devaluation come because firms can trade in markets that were previously unprofitable to them. This process requires investment - for example, in marketing and distribution. If Brexit means that many of those markets are no longer available, or come with tariffs, then firms will hold off making the necessary investments - unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. We also hear the myth of the beneficial currency devaluation applied to the weaker members of the euro area. As in, why don't these countries just break free from the euro, and devalue their way to prosperity? The simple answer is that if they left the euro, they would also risk losing access to the largest single market in the world - defeating the whole purpose of the beneficial currency devaluation! A Tale Of Two Consumers Chart I-9A Good Pair Trade: Long German Consumer ##br##Services, Short U.K. Consumer Services For the time being, hawkish comments from the BoE have given the pound a boost. But U.K. consumer spending now faces one of two headwinds. If the BoE follows through with a rate hike, household borrowing is likely to fade as a driver of spending. Alternatively, if the BoE backs off from its threat, the pound will once again weaken, push up inflation and weigh on real incomes. So for the time being, stay underweight U.K. consumer services versus the FTSE100. In Germany, the opposite logic applies. Stay overweight German consumer services versus the DAX. Euro strength helps German consumers in as much as it reduces the prices of imported food and energy. But for German exporters, the strong euro hurts the translation of their multi-currency international profits back into local currency terms. A good pair trade is to be long German consumer services, short U.K. consumer services (Chart I-9). Finally, regarding two upcoming political events - the September 24 German election and the October 1 proposed referendum on Catalan independence, we do not see either as a major catalyst for the financial markets. In the case of the German election, it is because no likely outcome is especially malign (or benign). In the case of the Catalan referendum, it is because it will be hard to draw any meaningful conclusion from the result, given that Madrid has ruled the referendum illegal - and many 'unionists' are unlikely to participate. Please note that there is no Weekly Report scheduled for next week as I will be at our New York Conference. I hope to see some of you there. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 In the euro area, small and medium sized companies tend to access credit through banks rather than through the bond market. Fractal Trading Model This week, we note an excessive underperformance of U.K. personal and household goods (dominated by BAT, Unilever, Reckitt Benckiser) versus U.K. food and beverages (dominated by Diageo and Associated British Foods). Go long U.K. personal and household goods versus U.K. food and beverages with a profit target / stop loss of 4.5%. In other trades, short nickel / long silver hit its 8% profit target, while short MSCI China / long MSCI EM hit its 2.5% stop loss. This leaves three open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 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

Special Report

The Federal Reserve faces unprecedented turnover in its Board of Governors over the coming year. The recent resignation of Stanley Fischer occurred when three of the Board's positions were already vacant and there is the additional issue that Janet Yellen's term as Chair ends in January. It remains far from clear that she will be offered another term or would even choose to stay if given the chance.1 Even Governor Lael Brainard's position could change - her willingness to stay on at the Fed may depend on who is the next Chair and on the other Board appointments. The point is that President Trump has the opportunity to choose the people who will run the nation's monetary policy for years to come. The first Board appointment will be Randal Quarles, nominated to be vice-chair for supervision, a position created by the 2010 Dodd-Frank Act to oversee the banking industry. His nomination was recently cleared by the Senate Banking Committee and he should soon be accepted by the full Senate. Quarles has indicated that his position on financial regulations is much softer than that of Yellen. Not surprisingly, there are widespread concerns about the looming changes to the Fed's Board. There are fears that new appointments may lack appropriate expertise and/or that they will have an intellectual bias that could result in overly tight or overly easy policies. Most Fed Chairmen have been highly-regarded economists with extensive experience in policymaking. One notable exception was G. William Miller, who served as Fed Chair from March 1978 until August 1979. Mr. Miller, appointed by President Jimmy Carter, came from a business background - he was CEO of the conglomerate Textron Inc. His short tenure at the Fed was regarded as a failure because he did not take tough action to deal with a growing inflation problem. That challenge was left to his successor, Paul Volcker. Many names have been touted as possible successors to Janet Yellen, including former Fed Governors Kevin Warsh and Larry Lindsey, Professors John Taylor and Glen Hubbard, and former bank CEOs Richard Davis and John Allison. Media reports suggest that the previous front-runner, Gary Cohn, is out of consideration following his criticism of President Trump's response to the Charlottesville clash between right-wing extremists and their objectors. How much will it matter to the economy and markets which person is chosen? The Fed's Scorecard Monetary policy is important because its sets the short-term price of a very important commodity - money! If the price is set too low, then financial excesses are virtually inevitable and if the price is set too high then economic activity is choked off. Yet knowing exactly where to set that price is no simple matter. The appropriate level of short-term interest rates is not observable and is a function of many variables, including the amount of slack in the economy, inflationary pressures, the level of financial conditions, and international factors. The Fed uses different economic models to help its decision making, but these have proved to be of dubious value. As we highlighted in an earlier report this year, the Fed has failed to forecast every recession during the past 60 years (Table 1).2 Yes, the Fed has been successful in achieving low and relatively stable inflation, but only after major policy errors during the 1960s and 1970s allowed inflation to spiral out of control. Table 1Fed Economic Forecasts Versus Outcomes The Fed's Open Market Committee (FOMC) is not run as a dictatorship, yet the person at the helm does have real power. Weak leadership was partly responsible for the inflationary policy errors of the 1960s and 1970s and the strong hand of Paul Volcker was important in launching the attack on inflation in the 1980s. The aura of invincibility surrounding Alan Greenspan during the second half of his tenure as Fed Chair cowed opposition from other FOMC members and contributed to the major error of weak regulatory oversight during a massive buildup of financial imbalances in the 2000s. Central bankers have long believed that price stability is a key prerequisite for maximizing an economy's potential. If we judge the effectiveness of post-WWII Fed leaders solely by the performance of inflation during their tenure, then Chart 1 shows we must give failing grades to those in charge during the 1950s, 60s and 70s - William McChesney Martin (1951-1970), Arthur Burns (1970-78) and G. William Miller (1978-79). Subsequent Chairs get passing grades - Paul Volcker (1979-87), Alan Greenspan (1987-06), Ben Bernanke (2006-2014) and Janet Yellen (2014-). However, it is not quite as simple as that. The Fed has a dual mandate - the Federal Reserve Act requires that policy achieves maximum employment as well as stable prices. And the Fed also plays an important regulatory role in maintaining financial stability. Chart 1The Fed's Record With Its Dual Mandate If we also take account of trends in the labor market and financial stability, the performance of Fed Chairs alters a bit. The second panel of Chart 1 shows the difference between the unemployment rate and its full employment level (based on estimates by the Congressional Budget Office). The Chairs who presided over rising inflation also managed to keep unemployment low for most of the time. And the cost of Volcker's attack on inflation was a deep recession and spike in unemployment. On average, Greenspan's record on growth and thus unemployment was good, but as we noted, he allowed an unprecedented buildup of financial excesses. This helped to create the conditions for the deepest economic and financial downturn since the 1930s but it was his successor, Ben Bernanke, who had to deal with that problem. Another way to assess the Fed's record is to compare the actual funds rate to the level implied by the Taylor Rule. Professor John Taylor's rule calculates the appropriate funds rate based on the deviation of inflation from 2% and the gap between real GDP and its full employment level. The starting point is the assumption that the real equilibrium rate is 2%. If, for example, inflation was above target and the economy was operating above potential, then the rule would require a real funds rate above 2%. There is a widely-accepted view that the real equilibrium rate declined after the 2007-09 downturn so, in our calculations, we use a level of 0.5% after 2007.3 Chart 2 shows that rising inflation of the 1950s, 60s and 70s coincided with the funds rate being kept below the level implied by the Taylor Rule estimate. Not surprisingly, Volcker had to push the funds rate far above normal to start the disinflation process. Subsequently, both Greenspan and Bernanke kept the funds rate relatively close to the Taylor-implied level. Yellen has kept the rate below our estimate and Taylor has been a critic of the Fed's easy money policies. However, some studies suggest that the real equilibrium rate may be even lower than the 0.5% we have assumed. Chart 2The Fed Funds Rate: Actual Versus The Taylor Rule Which Fed Chair was best for investors? Chart 3 shows real return indexes for bonds and equities. Not surprisingly, bond returns performed poorly during the periods of rising inflation and Volcker's reign coincided with the start of a long-term bull market. The equity market rose strongly under Martin, helped by a healthy economy, but in terms of annualized returns during the various Chairs, Volcker takes first place. The real returns for both markets are summarized in Table 2. Although the market did well under Greenspan, the severe bear market of 2000-02 occurred under his watch and, as previously noted, his regulatory lapses set the scene for the 2007-09 market debacle. Yellen had the second-best returns among the Fed Chairs listed for both bonds and stocks, highlighting the power of zero interest rates and quantitative easing! Chart 3The Fed And Market Returns Table 2Fed Chairs And Market Returns So What? The errors made by policymakers to some extent reflect the biases created during their formative years. For example, for those in charge during the 1950s and 60s, fears of renewed depression probably outweighed those of inflation. And the experience of runaway inflation in the 1970s cemented a powerful anti-inflation bias in those central bankers who gained experience during that time. Volcker was in the Fed before inflation took root, but one could argue that whoever had taken over from William Miller would have been forced to take tough action. Inflation was such a severe problem that no Fed Chair could have allowed it to continue. While Volcker deserves a lot of praise, it should be noted that inflation declined in virtually all industrial countries during the 1980s and beyond, even in cases where central banks had not yet achieved independence. The U.S. was in the vanguard of fighting inflation, but the trend in inflation rates was broadly the same in the U.S. and in the median of 18 other industrial countries (Chart 4). Chart 4The Fed Was Not Unique In Driving Down Inflation At the swearing-in ceremony for Fed Chair Arthur Burns, President Richard Nixon reportedly said "I respect his independence. However, I hope that independently he will conclude that my views are the ones that should be followed". Burns did indeed take an overly soft line on inflation. It is widely assumed that President Trump would prefer someone who will maintain a low interest rate policy in order to support economic growth. It would be a particular concern if the U.S. Administration were to fill the Fed Board with people who had little or no economic and/or policy experience. With the looming departure of Stanley Fischer, there already is a worrying dearth of policy expertise and institutional memory on the Board. President Trump has shown a predilection to favor successful businesspeople for senior cabinet posts and the William Miller's record is not encouraging in that regard. However, it is doubtful that the Senate would approve a full slate of new Board members that is completely devoid of appropriate experience. Moreover, some of the people being touted as possible successors to Yellen, most notably John Taylor, Kevin Warsh and Glenn Hubbard are respected economists who would not be political puppets in pursued of irresponsible policies. If Quarles joins the Fed Board he will push for an easing in bank regulations and will likely get the support from the Chair if a former bank CEO replaces Yellen. However, there would be severe pushback from the staff and other Governors. With memories of the 2007-09 downturn still relatively fresh, Congress also may be wary of a major rollback of regulations. Some Dodd-Frank regulations may be eased - especially for community banks - but we do not anticipate a return to a systemically-dangerous lax regime. What about the Fed's vulnerability to attempted interference from the Administration? Even if President Trump managed to install a new Chair that he deemed loyal and who shared his policy visions, this person would face challenges. The Fed staff is powerful and would make strong arguments against policies they believed to be inappropriate. Importantly, the policymaking process is a lot more transparent now than in the days when Fed Chairs Burns and Miller bowed to political influence. The publication of Fed economic forecasts and detailed meeting minutes would quickly highlight internal policy disagreements and financial market pressures would come into play. And while the Administration gets to nominate people to the Fed's Board, it is not able to remove them. A bigger concern is the possibility that Congress could pass legislation to audit the Fed, including its policy decisions. Earlier this year, the House Committee on Oversight and Government Reform approved the Federal Reserve Transparency Act of 2017, a bill sponsored by Rand Paul, a frequent Fed critic. The bill "directs the Government Accountability Office (GAO) to complete, within 12 months, an audit of the Federal Reserve Board and Federal Reserve banks. In addition, the bill allows the GAO to audit the Federal Reserve Board and Federal Reserve banks with respect to: (1) international financial transactions; (2) deliberations, decisions, or actions on monetary policy matters; (3) transactions made under the direction of the Federal Open Market Committee; and (4) discussions or communications among Federal Reserve officers, board members, and employees regarding any of these matters." Attempts to pass similar legislation in the past have failed, but President Trump is apparently in favor, as are many in Congress. The Fed Chair already faces twice-yearly interrogations by the House and Senate Banking Committees and that has not impacted policy decisions. Nevertheless, any politicization of Fed decisions would be a problem. At the moment, detailed transcripts of Fed meetings are released with a five-year time lag. Publication of internal Fed deliberations within a year of the bill's passage could compromise the willingness of FOMC participants to take unpopular decisions. The Policy Outlook The reality is that Fed policy will largely be constrained by economic environment, regardless of who is the Chair. A lackluster economic expansion and softer-than-expected wage growth and inflation have supported the maintenance of accommodative policies. But, in the absence of a new downturn, the Fed will stick to its plan of winding down its balance sheet and slowly raising interest rates. If anything, market expectations of a fed funds rate of only 1.5% by the end of 2018 seem too low. Dollar weakness and a strong stock market have meant an easing in overall financial conditions and the fiscal environment is set to become more stimulative. Whoever is leading the Fed next year will be under pressure to communicate a more hawkish stance to the markets. The long-run outlook for monetary policy is a more open question. There will be another recession - possibly as soon as 2019 - and that could be quite a deflationary affair. The next generation of central bankers will have spent more of their formative policy years in an environment when inflation was not a major economic problem and they will have come to terms with the extreme monetary actions needed during the 2007-09 collapse. And with massive quantitative easing failing to deliver the high inflation that many feared, any barriers to even more desperate measures may be limited. Thus, the next downturn may sow the seeds of a return to much higher inflation. Given that demographic trends and a political failure to reign in entitlements will lead to rapidly growing public sector debt, higher inflation would be welcomed by the political establishment. The bottom line is that looming changes in the composition of the Fed's Board of Governors is important, but we doubt that the overall integrity of the Fed will be seriously compromised by bad appointments. However, at this stage, it is futile to guess who the Administration will choose. Regardless of who controls the Fed, there always will be the potential for errors because their economic models (along with everybody else's) are imprecise, data can be unreliable, and the policy tools are crude. Some uptick in inflation is likely and would even be desirable, but it will not be allowed to get out of control. The bigger uncertainty is what will happen after the next economic downturn because even the most hawkish policymakers may be forced to embrace inflationary policies that will make the past cycle's actions pale by comparison. Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 Yellen's renomination chances may have been undermined by her recent Jackson Hole speech defending the current financial regulatory regime because that puts her at odds with the Administration's desire to unwind some of the Dodd-Frank rules. 2 This table was originally shown in our Special Report "Beware the 2019 Trump Recession", March 7, 2017. 3 There are several variants of the Taylor Rule, depending on smoothing co-efficients and the choice of the real equilibrium rate. We base our estimates on the formula used by the Federal Reserve Bank of Atlanta, with the one change of lowering the real equilibrium rate to 0.5% after 2007. The FRB Atlanta data can be accessed at https://www.frbatlanta.org/cqer/research/taylor-rule.aspx

We raised the S&P air freight & logistics group to overweight earlier this year based principally on the index being a chief beneficiary should green shoots in global trade proliferate. Since then, global export expectations have shot higher and global ton miles have staged the best recovery since the GFC (second panel). Anecdotally on its earnings call this week, FedEx called this year the "best year for global trade in years". Despite the overwhelmingly positive backdrop, the air freight & logistics index has barely budged. The result is that valuation multiples have collapsed to a fifteen year low (bottom panel). We continue to think the positive earnings momentum in this index can be ignored for only so long; the air freight & logistics group should see a long-overdue rerating. We reiterate our high-conviction overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD.

Highlights U.S. Treasury yields should continue to rise as investors price-out doomsday risk; Tensions surrounding North Korea will continue, but there are signs that negotiations have started and that China is playing ball on sanctions; Meanwhile, our view that tax cuts are coming is finally coming to fruition; Fade renewed European risks regarding Brexit and Catalan independence; But the independence push by Kurds in Iraq could have market impact. Feature Early in the second quarter, BCA's Geopolitical Strategy made two predictions. First, we said that summer would be a time to stay invested in U.S. equities and largely ignore domestic politics.1 Second, that North Korea would become an investment-relevant risk and buoy safe-haven plays but would not lead to a full-scale war (and hence not cause a global correction).2 The summer proved lucrative for both risk-on and risk-off trades, best emblemized by solid returns for both the S&P 500 and 10-year U.S. Treasury (Chart 1 A & B). Chart 1ARisk Assets Have Rallied... Chart 1B...At The Same Time As Safe Havens Can this continue? We do not think so. Geopolitics can influence the 10-year Treasury yield via two mechanisms: safe-haven flows and fiscal policy. On both fronts, we see movements that should support a pickup in yields over the rest of the year, a view corroborated by our colleagues on the fixed-income team. First, investors finally have progress on tax legislation that we have been forecasting since President Trump's election. Given the markets' collective pessimism on corporate tax reform (Chart 2), we expect any good news to change the current narrative. While it is still difficult to envision tax legislation that massively stimulates the economy, it is also difficult to imagine tax legislation that is revenue-neutral. As such, fiscal policy in the U.S. should be at least mildly stimulative in 2018, supporting higher yields. Second, we remain concerned that North Korea could escalate the ongoing tensions in East Asia.3 However, Pyongyang is constrained by its military capacity, which limits what it can realistically do to threaten its neighbors. As we discuss below, there are emerging signs of both diplomatic negotiations and Chinese pressure, key signposts that we have passed the peak on our "Arc of Diplomacy." As such, investors should prepare for the bond rally to reverse and the broader risk-on phase to extend through the end of the year. We expect the "Trump reflation trade" - USD appreciation, yield-curve steepening, and small-cap outperformance (Chart 3) - to restart if our views on the U.S. legislative agenda and North Korean tensions hold. Chart 2Investors Remain Pessimistic On Tax Reform... Chart 3...And On Trump's Policy In General U.S. Treasuries: Fade The Doomsday Trade Our colleagues at BCA's fixed-income desk have shown that flows into safe havens over the summer have widened the disconnect between global yields and economic fundamentals (Chart 4).4 Chief Fixed-Income Strategist Rob Robis points out that BCA's own valuation model for the 10-year U.S. Treasury yield indicates that "fair value" sits at 2.67%, nearly 55bps higher than current market levels (Chart 5).5 This is a level of overvaluation that even exceeds the extreme levels seen after the U.K. Brexit vote in July of 2016. Rob believes that the summer bond rally is about safe-haven demand, depressed investor sentiment, and underwhelming inflation, in that order. It is certainly not about growth expectations, which remain buoyant (Chart 6). Chart 4Falling Yields Reflect Save Haven Demand,##br## Not Slower Growth Chart 5U.S. Treasuries ##br##Are Overvalued Chart 6Global Growth##br## Remains Buoyant To prove that underwhelming inflation has not spurred the latest rally in Treasuries, Rob decomposes developed market bond yield changes since the July 7 peak in U.S. yields. The benchmark 10-year U.S. Treasury yield has risen 20bps off those September lows as investors have priced out doomsday risk. Table 1 shows that yields declined everywhere but Canada (where the central bank has been hiking interest rates). Yet the vast majority of the yield decline has come from falling real yields and not lower inflation expectations, which have actually stabilized over the summer. This has also occurred via a bull-flattening move in government bond yield curves, which suggests it is risk-aversion that has driven yields lower. Table 1Changes In DM Bond Yields Over The Summer (From July 7th Peak In U.S. Treasury Yields) The conclusion of our fixed-income team is that there is now considerable upside risk in global yields. We agree. While North Korea could retaliate against the just-imposed UN sanctions in various ways, it is difficult to see the market reacting with the same vigor as it did in July and August. Investors are becoming desensitized to North Korean provocations, especially as the latter remain confined to "expected and accepted" forms of belligerence, even in the current context of heightened tensions. Future North Korean safe-haven rallies will be of shorter amplitude and duration. The September 15 missile launch over Japan (the fourth time this has happened) has shown this to be the case. Chart 7Position For A Tactically Wider UST-Bund Spread Bottom Line: BCA's bond team remains short duration, a position that our political analysis supports. We will keep our 2-year/30-year Treasury curve-steepener trade open, despite it being in the red by 34.3bps. In addition, we are closing our short Fed Funds January 2018 futures position (for a gain of 0.51bps) and opening a new short Fed Funds December 2018 position. Any sign of emerging bipartisanship should also favor higher fiscal spending, as policymakers almost always come together to spend money rather than cut spending. In addition, we are recommending that our clients put on a U.S. Treasury-German Bund spread widening trade.6 Rob has pointed out that this is a way to profit directly from higher fiscal spending in the U.S., particularly since there is no sign that Germany will change its government spending following its unremarkable election campaign. The data also supports a tactical widening of the Treasury-Bund spread, which is correlated with the relative data surprises (Chart 7). U.S. Politics: From Impeachable To Ingenious The crucial moment for the Trump presidency was the White House purge of the "Breitbart clique" following the social unrest in Charlottesville, Virginia on August 11-12.7 That move has made headway for upcoming tax legislation and resolution of the debt ceiling imbroglio. While some investors saw the racially motivated rioting in Virginia as a harbinger of a major risk-off episode, we saw it essentially as a "Peak Stupid" moment in U.S. politics. We may not know precisely what goes on in President Trump's mind, but we know that he likes polls. And his polling with Republican voters suffered appreciably following the Charlottesville fiasco (Chart 8). Strong Republican support for President Trump is the main source of his political capital. He can use it to cajole and influence Republicans in Congress via the upcoming Republican primary process ahead of the midterm elections. If he loses that support, his political capital will erode and he could become the earliest "lame duck" president in recent U.S. history. Worse, if support among Republicans were to fall below 70%, Trump could embark upon a Nixonian trajectory that could indeed lead to impeachment (Chart 9). Chart 8Trump's Support With GOP Voters Suffered... Chart 9... But Remains Well Above Nixonian Levels Many clients have asked us about the debt ceiling deal that President Trump made with Democrats and whether it signals a radical shift towards bipartisanship. We do not think so. In fact, we think the deal is mostly irrelevant. As we argued throughout the summer, the idea that there would be another debt ceiling crisis this year was always a figment of the media's imagination. There was never any evidence that a sufficient number of members of the House of Representatives wanted to play brinkmanship with the debt ceiling. First, Democrats in both houses of Congress have been clear throughout the year that they would not play politics with the debt ceiling. Second, investors and the media continuously overestimate the strength of the Freedom Caucus, the fiscally conservative grouping of Tea Party-linked representatives. There are 41 members of the Freedom Caucus, whereas 55 Republicans in the House sit in districts that are at least theoretically vulnerable to a Democratic challenge (Table 2).8 The danger for House Speaker Paul Ryan is not that the Freedom Caucus abandons the establishment line, but that the 55 Republicans listed in Table 2 abandon the Republican line. This, in fact, happened throughout the Obama presidency, with centrist Republicans voting with Democrats in the House on a number of key legislative bills (Chart 10). Table 2Plenty Of Vulnerable Republican Representatives Chart 10The Obama Years: A Governing 'Grand Coalition' This is why Speaker Paul Ryan largely ignored the Freedom Caucus and proposed an eighteen-month extension of the debt ceiling. He was never going to allow the Freedom Caucus to play brinkmanship. That President Trump picked the shorter Democrat version is significant only in so far as it signaled that he was willing to work with Democrats. In other words, the move was a "shot across the bow" of Republicans, a message that they had better get started on tax legislation, or else ... What should investors watch now? There are three main issues to follow: Tax legislation outline: House Speaker Paul Ryan has set the week of September 25 as the deadline for Republicans to outline their tax policy plan. The good news for investors is that the outline will supposedly include an already agreed-upon framework by both the House Ways and Means Committee - Chaired by Representative Kevin Brady (R, TX) - and the Senate Finance Committee - Chaired by Senator Orin Hatch (R-UT). Brady and Hatch are serious players and their comments on tax policy should be followed closely. Both favor legislation that would be retroactively applied to FY 2017, even if the bill is actually passed in 2018. They are also part of the Republican "Big Six" group on tax policy, along with Speaker Ryan, Senate Majority Leader Mitch McConnell, Treasury Secretary Steven Mnuchin, and National Economic Council Director Gary Cohn. Reconciliation instructions: The House Budget Committee passed a FY 2018 budget resolution in late July that included "reconciliation instructions" for tax legislation. These instructions allow Republicans to use the reconciliation procedure - a process that allows the Senate to pass legislation without needing 60 votes.9 However, the House version of the budget resolution also included over $200 billion of spending cuts, which is unlikely to pass in the Senate. As such, investors have to carefully watch for the House and Senate Republicans to pass a final budget resolution in order to kick off the reconciliation process. This process will likely happen in October, after the tax legislation package is presented by the Big Six. At that point, the Freedom Caucus will have the ability to extract concessions from establishment Republicans as their votes are needed to pass the budget resolution. We suspect that no Democrats will support the budget resolution given that they have not been involved in the tax policy process thus far. Trump's involvement: President Ronald Reagan's personal support and lobbying for the 1986 tax reform proved critical in getting the bill through Congress.10 President Trump's focus and energy will have to be on par with that of Reagan's if he plans to accomplish the same. A headwind for Trump is the lack of legislative experience in his White House (Chart 11). However, since the appointment of Chief of Staff General John F. Kelly, there has been a clear shift of focus on the legislative process. Chart 11Trump Administration Is On The Low End Of Congressional Experience Bottom Line: We expect investors to start gleaning the outlines of tax policy by late September, with the budget resolution containing reconciliation instructions being passed by both houses of Congress by the end of November. It may be too much to ask Congress to have an actual bill ready to pass by the end of the year, as we originally expected,11 particularly as there is now a potential immigration deal to negotiate with Democrats and last-minute effort to repeal and replace Obamacare. As such, we still think that it will take until the end of Q1 2018 for tax legislation to pass Congress (Q2 in the worst-case scenario for Republicans). Investors, however, will begin to price in a higher probability of tax policy as soon as the outline of the bill emerges in October. As such, we are reiterating our recommendation that investors go long U.S. small caps relative to large caps. Tax policy should overwhelmingly benefit small caps, which actually pay the 35% corporate tax rate. In addition, we would expect the USD to arrest its decline and rally by the end of the year. North Korea: At The Apogee Of "The Arc Of Diplomacy" To illustrate the current North Korean predicament to readers, we have referred to an "arc of diplomacy" (Chart 12), which we illustrate by referencing the rise and fall of U.S. tensions with Iran from 2010-15. The pattern is for the U.S. to increase tensions deliberately in order to convince its enemy that the military option is "on the table." Only once a "credible threat" of war has been established can the negotiations begin in earnest. Chart 12A Lesson From Iran: Tensions Ramp Up As Nuclear Negotiations Begin We are at or near the peak of this process. First: what is the worst-case scenario for markets if the North causes a crisis short of a devastating war? Using our short list of geopolitical crises (Table 3),12 our colleague Anastasios Avgeriou, chief strategist of BCA's U.S. Equity Strategy, notes that while the average peak-to-trough drop of a major crisis is 9%, equity returns also tend to rise 5% within six months and 8% within twelve months after the crisis. To illustrate the trend, Anastasios has constructed an S&P 500 profile of the average geopolitical crisis, and the picture is encouraging (Chart 13). It shows that the market is likely to grind higher even if North Korea does something truly out of the box. Table 3Geopolitical Crises And SPX Returns Nor is a geopolitical incident (again, short of total war) likely to cause a U.S. or global recession. Aside from direct shocks to oil, such as in 1973 and 1990, only the U.S. Civil War (that is, a war waged on U.S. turf) caused a recession at the outset. Other major wars (WWI, WWII, the Korean War) caused recessions when they concluded because of the sharp drop in federal spending as a result of reduced military spending. What makes us think we are at or near the peak of North Korea's belligerent threats? China appears to be enforcing sanctions: at least according to China's official statistics (Chart 14). There is no doubt there are discrepancies and black market activity, but it makes sense for China to dial up the pressure (while never imposing crippling sanctions) and that appears to be occurring. China and Russia agreed to reduce fuel supplies. Both sides agreed to new UN sanctions on September 11 that would partially cut off North Korean fuel. This is a significant step, given that Chart 14 indicates China is already moving in this direction. The U.S. and North Korea have begun diplomatic talks. According to Japan's NHK press on September 14, former U.S. diplomat Evans Revere met with Choe Kang-Il, the deputy director general of the North American bureau of North Korea's foreign ministry in Switzerland over the past week. The U.S. State Department spokeswoman Heather Nauert all but confirmed that some kind of communication is underway, and Secretary of State Rex Tillerson has described his diplomatic initiative as highly active. The last efforts at negotiations, via the longstanding New York channel, were discontinued in June after the death of a U.S. prisoner in North Korea. Those were focused on retrieving U.S. citizens, whereas the new talks allegedly centered on the latest UN sanctions, i.e. a crux of the relationship. The implication is that North Korea is responding to pressure now that its critical fuel supplies are at risk. South Korea is offering aid. South Korea's new government is looking to give the North humanitarian aid, as expected, and will decide on September 21 about a special package for pregnant women and infants. It is suggesting that such aid has no conditionality on the North's behavior. At the same time, the U.S. administration is talking down Trump's recent threat to discontinue the U.S.-South Korean free trade agreement - meaning that the U.S. may even condone the South Korean administration's more diplomatic approach to the North. Chart 13Who Is Afraid Of Geopolitical Crises? Chart 14Is China Finally Playing Ball? At the same time, North Korea is running out of options for provocations that it can commit without provoking a costly response from the U.S. and its allies. The September 15 missile test over Japan was essentially the fourth of its kind, and the market shrugged it off. Here are some options, drawn from our list of scenarios and probabilities (Table 4): Table 4North Korean Scenarios Over The Next Year More of the same: Nuclear and missile tests could continue, or be conducted at higher frequencies or simultaneously. While technical advances may become apparent, they will not change the game. U.S. Territory: The North could create a bigger risk-off move than we saw in July-August if it shot ICBMs toward Guam, or other U.S. territories, as it has suggested it might do. This is especially risky because the U.S. Secretary of Defense James Mattis has repeated Trump's warning to North Korea to not even threaten the United States. However, as long as no such missile actually strikes U.S. territory, the U.S. is unlikely to respond with an attack, and thus such a scare seems likely to fade like the others. Attacking South Koreans: The North has a history of state-backed terrorist actions and military actions. An attack limited to South Korea will cause a shock, in the current context, but the military consequences are still likely to be contained given the extensive history of such attacks. If it is an attack against South Korean civilians in a non-disputed territory, it will leave a bigger mark than it otherwise would, but the South is still likely either to retaliate in strict proportionality, or to refrain from action and use the event as a way of galvanizing international sanctions. Attacking Americans or U.S. allies: The true danger in the current climate is an attack that kills U.S. citizens, or U.S. allies who are not as, shall we say, understanding as the South Koreans (such as the Japanese). This could cause the U.S. or Japan or another ally to take a retaliatory action. Even if limited, this could cause a deep correction in the market. The U.S. response would likely still be limited and proportional. Then the question would be whether the North Koreans can afford to escalate. They can't. The military asymmetry is excessive. This is not the case of the Japanese in 1941, who believed they had the potential of defeating the U.S. if they acted quickly enough and the U.S. was distracted in Europe (Diagram 1). Diagram 1North Korea Crisis: A Decision Tree As the foregoing demonstrates, there could still be big ups and downs between now and the resumption of formal international negotiations, let alone a satisfactory diplomatic accord. The tensions could yet reach another peak. Nevertheless, our sense is that the pieces are falling into place for the North to moderate its behavior, sending the signal that it is ready to engage in real negotiations. Since the U.S. has consistently shown its readiness to talk directly with the North - coming from both Trump and Tillerson - we think we could see shuttle diplomacy taking place as early as this winter. Here are some dates and events to watch: Military exercises: Will the U.S., South Korea, and Japan stop or slow down the pace of military exercises? This could open space for North Korea to offer an olive branch in return. October 10 - anniversary of the Worker's Party of Korea: The North may take an extraordinary action, no action, or familiar actions like missile tests. October 11-25 - China's party congress: The North could fall silent ahead of the big event, or could attempt to disrupt it. China, in turn, could take action around this time (particularly afterwards) to send a signal to the North to tone down the belligerence. In previous periods of tension, China has reputedly drawn a harder line on North Korea in the month of December, when end-of-year quotas made certain trade measures more convenient. Late October - Japanese snap election? Rumor has it that Shinzo Abe is thinking of calling a snap election as early as this month. We normally dismiss such rumors but this time there is a certain logic: two North Korean missiles have flown over Hokkaido in as many months, while the Japanese opposition is in total disarray. If Abe calls early polls, it suggests that he thinks Korean fears are peaking. If he delays, and exploits these fears by pushing constitutional revisions through the Diet (our base case), then he may provoke a North Korean response, given that the revisions pave the way for Japan to "re-militarize." November 1 - APEC and Trump's visit to China: Trump is supposed to head to Vietnam for the APEC summit and to China to visit President Xi Jinping. Xi has recently shown his sensitivity to such summits by concluding the Doklam dispute with India just days ahead of the BRICS summit in Xiamen, China in order to ensure that Indian President Narendra Modi would attend. Xi may have also wanted to advertise his ability to negotiate solutions to international showdowns for the world (and U.S.) to see. Thus, progress on North Korea before or after Trump's arrival could improve Xi's authority both with Trump and the rest of the world. November 23 - U.S. Thanksgiving: North Korea likes to be "cute," so we cannot rule out attempts to unsettle the Americans on Thanksgiving or Christmas Day, as with the July 4 ICBM launch. Trump's visit is very consequential and it is more likely under the circumstances that China will receive him warmly, like Nixon, rather than coldly, like Obama last year. Trump is holding serious trade negotiations (via Commerce Secretary Wilbur Ross) and at the same time threatening to sanction Chinese companies and imports (via Treasury Secretary Steve Mnuchin). There are many reasons for Beijing to cooperate on North Korea in order to get advantageous treatment on the economic front. Bottom Line: The market is already discounting North Korea. We may be wrong temporarily if the North ups the ante yet again, but we are very near the peak of the latest round of tensions. The North is running out of options short of instigating a fight it would lose, while China is enforcing sanctions more seriously (including fuel), and Washington has apparently opened direct talks with Pyongyang. We will maintain our portfolio hedge of Swiss bonds and gold, for now. We are also re-opening our long CBOE China ETF volatility index to account for potential rising political uncertainty surrounding the coming October Party Congress and possibly for further North Korea related risks. However, we are closing our short KRW / THB trade for a gain of 5.33%. Europe: More Red Herrings Brexit is no longer market-relevant. Its economic effect was fully priced in when Prime Minister Theresa May announced on January 17 that the U.K. would not seek membership in the Common Market. Since then, the pound has effectively bottomed against both the dollar and the euro, as we argued it would (Chart 15).13 This does not mean that investors should necessarily go long the pound. Rather, we are pointing out that the moves in the U.K. currency have ceased to be Brexit-related since we called its bottom in January. Going forward, investors should make bets on the pound based on macroeconomic fundamentals, not on the U.K.-EU negotiations. The one political risk to the pound going forward is the potential for the Labour Party, headed by opposition leader Jeremy Corbyn, to come to power in the U.K. in the near term. Corbyn is the most left-of-center leader of a developed world economy since French president François Mitterrand in 1981. And he symbolizes a leftward shift on economic policy by the median voter. Nevertheless, the risks to PM May are overstated, for now. A key test for the Prime Minister, the EU (Withdrawal) Bill, passed its first parliamentary hurdle in Westminster on September 12. No Conservatives rebelled, with seven Labour politicians defying Corbyn's instructions to vote against the bill. The bill still faces several days of amendments, but it largely gives May a free hand to negotiate with Europe going forward. Bremain-leaning Tory backbenchers could have posed problems for May had they decided to obstruct the bill. That they did not tells us that nobody wants to challenge May and that she will likely remain the prime minister until the eventual deal with the EU is reached. Our clients often balk at our dismissal of Brexit as an investment-relevant geopolitical event. However, the crucial question post-Brexit was whether any other EU member states would follow the U.K. out of the bloc. We answered this question in the negative, with high conviction, the day of the U.K. referendum.14 Not only did no country follow U.K.'s lead, but the effect of Brexit was in fact the exact opposite of the conventional wisdom, with a slew of defeats for populists around Europe following the referendum. For the U.K. economy and assets, the key two Brexit-related questions were whether the economy's service sector would have unfettered access to the European market via membership in the Common Market (Chart 16); and whether the labor market would have access to the European labor pool (Chart 17). Both questions were answered by May during her January 17 speech in the negative, which is why we continue to cite that moment as the date when U.K. assets fully priced in Brexit. Chart 15Is Brexit##br## Still Relevant? Chart 16U.K. Needs A Free Services Agreement##br## With The EU, Not An FTA! Chart 17Intra-EU Migration Boosts ##br##Labor Force Growth What could change our forecast? We would need to see the negotiations with Europe become a lot more acrimonious. Disputes over the amount of the "exit bill" or the status of the Irish border simply do not count as acrimony. We need to see the threat of a "Brexit cliff" - where the EU-U.K. trade relationship reverts to "WTO rules" - emerge due to a conflict between the two powers. However, this is unlikely to happen as the EU greatly values its trade relationship with the U.K. And London's demand for an FTA actually plays to the EU's strengths, since FTAs normally privilege trade in goods (where Europe is competitive) relative to trade in services (where the U.K. has an advantage). Bear in mind, as well, that the U.K. and EU are negotiating an FTA from a starting point of a high degree of economic integration: this is not the equivalent of two separate economies pursuing an FTA for the first time. Similarly overstated as a risk is the upcoming Catalan independence referendum. As we argued this February, the referendum is a non-event.15 Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 18). And as we argued in our net assessment of the issue in 2014, a surge in internal migration since the Second World War has diluted the Catalan share of the total population.16 In fact, only 31% of the population identifies Catalan as their "first language," compared with 55% who identify with Spanish.17 Another 10% identify non-Iberian languages as their first language, suggesting that migrants will further dilute support for sovereignty, as they have done in other places (most recently: Quebec). Chart 18Catalans Do Not Want Independence We expect the turnout of the upcoming referendum to be low. Given that Madrid will not recognize it, the only way for the Catalan referendum to be relevant is if the nationalist government is willing to enforce sovereignty. What does that mean precisely? The globally recognized definition of sovereignty is the "monopoly of the legitimate use of physical force within a defined territory." To put it bluntly: the Catalan government has to be willing to take up arms in order for its referendum to be relevant to the markets. Without recognition from Spain, and with no support for independence from fellow EU and NATO peers, Catalonia cannot win independence at the ballot box. Bottom Line: Fade Brexit and Catalonia risks. Iraq: An Emergent Risk In 2014, we wrote the following about the future of Iraq:18 "Furthermore, the recent Kurdish occupation of Kirkuk - nominally to secure it from ISIS, in reality to (re)claim it for the Kurdish Regional Government (KRG) - will not be acceptable to Baghdad. In our conversations with clients, too much optimism exists over the stability of Kurdistan and its expected oil output. While we are broadly positive on the KRG, there are many challenges. First, three-quarters of Iraqi production is, in fact, located in the Southern part of the country, far from Iraqi Kurdistan. Second, Kirkuk and its associated geography has the potential to boost production, but the Kurds (and their ally Turkey) will eventually have to face-off against Baghdad (and its ally Iran) for control over this territory. Just because the KRG secured Kirkuk today does not mean that it will stay in their control in the future. We are fairly certain that once ISIS is defeated, Baghdad will ask for Kirkuk back." In 2016, we followed up again on the situation in Iraq by pointing out that a series of defeats for the Islamic State were raising the probability that a reckoning was coming between Baghdad and Iraqi Kurds.19 Now that the Islamic State threat is in the rear-view mirror, our forecast is coming to fruition. On September 25, Kurds in Iraq will hold an independence referendum. Opposition to the referendum is uniform across the region, with the U.S. - Kurds' strongest ally - requesting that it not take place. Why should investors care? First, there is the issue of oil production. There are no reliable figures regarding KRG production, but it is thought to be around 550,000 bpd, although KRG officials have themselves downplayed their production. This figure includes production from the Kurdish-controlled Bai Hassan and Avana fields in the Kirkuk province, which is not formally part of the KRG territory but which Kurds nominally control due to their 2014 anti-ISIS intervention. A conflict over Kurdish independence could impact this production, particularly if war breaks out over Kirkuk. However, the bigger risk to global oil supply is what it would do to future efforts to boost Iraqi production. Iraq is the last major oil play on the planet that can cheaply and easily, with 1920s technologies, access significant new production. If a major war breaks out in the country, it is difficult to see how Iraq would sustain the necessary FDI inflows to develop its fields to boost production, even if the majority of production is far from the Kurdish region. Given steady global oil demand, the world is counting on Iraq to fill the gap with cheap oil. If it cannot, higher oil prices will have to incentivize tight-oil and off-shore production. Second, there are problematic regional dynamics. There are about six million Kurds in Iraq, about 20% of the total population. The Kurdish Regional Government controls the northeast corner of Iraq, but fighting against the Islamic State has allowed the Kurds to extend their control further south and almost double their territory (Map 1). Turkey has largely supported the KRG over the years, as the ruling party in the autonomous province is relatively hostile to the Kurdistan Workers' Party (PKK), which Turkey considers a terrorist organization. However, Turkey is opposed to the independence of the KRG due to fears that it would start the ball rolling on the independence of Kurds in Syria and potentially one day in Turkey as well. Also opposed to KRG secession are Iran (Baghdad's closest ally) and Syria (which is dealing with its own Kurdish question). Map 1Kurdish Gains Threaten Conflicts With Iraqi Government ... And Turkey On the other hand, the KRG does have international support. Russia just recently concluded a major oil deal with KRG, promising to buy Kurdish oil and refine it in Germany. Moscow will also invest US $3 billion in KRG territory. Russia also supplied the KRG Peshmerga - armed forces - with weapons during their fight against the Islamic State. From Russia's perspective, any conflict in the Middle East is a boon. It stalls investment in the region, curbs its oil production, and potentially adds a risk premium to oil prices. In addition, a close alliance with the KRG would allow Russia to gain another ally in the region. Bottom Line: While it is difficult to see how the independence referendum will play out in the short term, we have had a high-conviction view that Iraq's stability will not improve with the fall of the Islamic State. For investors, rising tensions in Iraq are significant because they could curb investment in the long term and potentially even impact production in the short term. Unlike the Islamic State, which never threatened oil production in the Middle East in any significant way, Iraq and the KRG are both oil producers. In fact, their main conflict is over an oil-producing region centered on Kirkuk. Tensions in the region support BCA Commodity & Energy Strategy's bullish view on oil prices.20 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017; "North Korea: No Longer A Red Herring" in BCA Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was," dated March 8, 2017; and "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 5 BCA Global Fixed Income Strategy 10-year Treasury yield model only uses the global manufacturing PMI and sentiment towards the U.S. dollar as inputs. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Duration 'Hot Potato' Shifts Back To The U.S.," dated August 8, 2017, available at gfis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Is The 'Trump Put' Over?" dated August 23, 2017, available at gps.bcaresearch.com. 8 We use the Cook Political Report for their assessment of how U.S. electoral districts lean. Charlie Cook is Washington's foremost election handicapper with a long record of accomplishment. Anyone interested in closely following the U.S. midterm elections should consider his research, which is found on http://www.cookpolitical.com/ 9 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 10 Please see Joseph A. Pechman, "Tax Reform: Theory and Practice," The Journal of Economic Perspectives 1:1 (1987), pp. 11-28 (15). 11 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 12 Please see footnote 3 above. 13 The GBP/USD bottomed then and there. The GBP/EUR has recently hit a new low, for reasons other than Brexit. This bottom is only slightly below its previous lows in October 2016, when May confirmed that her government would seek to leave the EU in accordance with the referendum result, and in January 2017, when May admitted what the GBP/EUR had already reflected, that this meant leaving the Common Market. Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World," dated January 25, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, and Geopolitical Strategy Special Report, "The Coming EXITentialist Crisis," dated June 24, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 16 Please see Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 2014, available at gps.bcaresearch.com. 17 Please see "Language Use of the Population of Catalonia," Generalitat de Catalunya Institut d'Estadustuca de Catalunya, dated 2013, available at web.gencat.cat 18 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift (Update)," dated July 9, 2014, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 20 Please see BCA Commodity & Energy Strategy Weekly Report, "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance," dated September 14, 2017, available at ces.bcaresearch.com.

Highlights EM EPS growth is set to decelerate significantly and will likely turn negative in 2018 based on the China/EM money/credit indicators. All measures of Chinese broad money growth have fallen to a record low signifying a major growth slump. The two pillars of the EM currency rally - strong growth in China that manifests in higher commodities prices and lower U.S. bond yields- are set to reverse. EM equities and credit markets relative performance versus their DM peers is about to relapse. A new fixed-income trade: receive 2-year swap rates in Mexico / pay 2-year swap rates in the U.S. Feature Last week we were on the road, meeting with some of our U.S. East Coast clients. This week we address some of the common questions we received. Q: Why do you think EM profits will relapse in the next six-to-nine months, given both global and EM growth continue to show strength? A: Our reluctance to change our view on EM risk assets in general and equities in particular has to do with EM/China business cycle/corporate profit indicators. Several indicators for EM profits - which have exhibited very good track records - presently forecast a material slowdown and possibly a contraction in EM EPS starting late this year and well into next year. In particular, China's broad and narrow money impulses lead EM EPS by about nine months, and are currently signaling that EPS growth is set to peak and begin to decline in the next nine months (Chart I-1). What's more, a few business cycle indicators from Korea and Taiwan, such as nominal manufacturing production and manufacturing shipments-to-inventory ratios, corroborate a peak in EM EPS growth (Chart I-2). Chart I-1EM EPS Is Set to Decelerate ##br##And Probably Contract Chart I-2More Signs Of Relapse##br## In EM EPS Growth Importantly, the EM corporate earnings slowdown will not occur in a vacuum. It will transpire amid a slowdown in Asian trade and lower commodities prices. In particular: China's broad money M3 impulse leads domestic industrial orders, nominal manufacturing production and imports (Chart I-3). Even though Asian export data were strong in August, China's container freight index signals a slowdown in Asian trade lies ahead (Chart I-4). Chart I-3China: M3 Impulse And Domestic Demand Chart I-4Asian Export Growth To Slow The Chinese broad money impulse also points to a rollover in Korean, Taiwanese, other EM as well as DM countries' shipments to the mainland (Chart I-5). This is how the slowdown in China's money/credit will hurt corporate profits in EM as well as in DM sectors with substantial exposure to Chinese growth. Besides, China's broad money impulse leads industrial metals prices in general and iron ore prices in particular (Chart I-6). This signifies downside risks to commodities producers. Finally, China's yield curve suggests that mainland manufacturing PMI will roll over after its recent ascent (Chart I-7). Chart I-5Shipments To China Are At Risk Chart I-6Industrial Metals Prices Have Peaked Chart I-7China: The Yield Curve And Manufacturing PMI In short, China has been gradually tightening monetary policy, which has already manifested in record-low broad money growth. The next phase is evidence of a material deterioration in sales and profits among China-exposed plays. The EM stock markets are unlikely to ignore it. Q: It seems you are putting a lot of emphasis on China's broad money M3 measure. Why do you look at your version of Chinese broad money M3 and not at official M2 and total social financing (TSF)? A: Over the past several months we have done a lot of research and analysis on China's money and credit, and believe that our broad money M3 measure and private and public credit aggregate calculated by BIS are presently better measures of money and credit than official broad money M2 and TSF: First, the TSF data have become distorted because of the local government financing vehicles (LGFV) debt swap program. Specifically, according to the LGFV debt swap mechanics, starting in 2015 provincial governments began issuing bonds that have been purchased by banks. The amount of bonds issued was RMB 3.2 trillion in 2015, RMB 4.9 trillion in 2016 and expected to be RMB 4.8 trillion in 2017. This amounts to total issuance of RMB 12.9 trillion since the commencement of the program. As the next step, local governments were supposed to transfer the proceeds from these bond issuances to their LGFVs, with the latter using the money to pay down their debt. The ultimate goal of the program is to shift the debt from LGFVs to provincial governments, as the latter's creditworthiness is much better than the former. This has also reduced interest rates on the debt as provincial governments borrow at lower interest rates than LGFVs. All that said, it is unclear how much of their debt LGFVs have repaid. The main problem with using TSF data is knowing the amount of proceeds from the issued debt swap bonds that were used to pay down LGFV debt. If the entire amount of these bonds issued by provincial governments was used to pay down LGFV debt, there would not be an impact on economic activity, and only a very short-term impact on money supply. When banks buy bonds from non-banks (including governments), they create new money. When debtors (including governments and their entities) pay down debt to banks, money is destroyed. Nevertheless, both official M1 growth and our measure of broad money (M3) were too strong in 2015 and 2016 – i.e., they remained strong much longer than would have been justified by the LGFV debt swap. Furthermore, private and public credit, M2 and M3 money measures have decoupled from TSF since the middle of 2015 (Chart I-8A). TSF adjusted for the LGFV debt swap – the latter is added to TSF – has also diverged from official M2, our broad money M3 and BIS’s private and public credit measures (Chart I-8B). This corroborates that TSF data can no longer serve as a reliable measure of credit/money origination. Chart I-8AChina: TSF Has Diverged From ##br##Other Money/Credit Measures Chart I-8BChina: TSF Adjusted For LGFV Debt Swap Has Also Decoupled From Money/Credit Measures Markedly, paying down debt by LGFVs should have reduced corporate debt outstanding by RMB 12.9 trillion, which would represent a 12% drop from the RMB 112 trillion outstanding at the end of 2015. However, corporate debt has continued to expand rapidly, even as government debt has surged. Given all of the above, we doubt all of the proceeds from bonds issued within the LGFV debt swap program were immediately used to repay LGFV debt. Instead, we suspect the proceeds from the bond issuance might have been at least partially invested into the economy in 2016, in defiance of the rules of LGFV debt swap operation. We played down the rise in M1 in late 2015 and early 2016 because we regarded it as temporary, reflecting the LGFV debt swap program. In retrospect, it was a mistake - this was one of the main reasons we did not heed the message from recovering money growth in early 2016 to turn cyclically positive on China's growth, and consequently on commodities and broader EM. Provided we do not know what portion of LGFV debt was repaid and when, corporate credit and total social financing data have become difficult to interpret. Chart I-8A and Chart I-8B demonstrate that TSF with and without the LGFV debt swap has diverged from private and public debt since the middle of 2015 when the LGFV debt swap program commenced. Apparently, one no longer can rely on TSF or adjust it by the amount of LGFV debt swap to gauge money and credit creation in China. In this context, the aggregate of private and public credit is a much more appropriate measure of credit provision and debt creation than TSF. The basis is because it includes both private and public debt. Indeed, the reshuffling of debt between local governments and LGFVs (the latter are treated as enterprises in China's banking statistics), does not affect either aggregate borrowing or amount of debt held in the economy. Second, when credit numbers are distorted, one needs to resort to money supply measures to judge credit dynamics. The reason is because financial engineering and, in the case of China, the LGFV debt swap program, can obscure the amount of outstanding credit, but they cannot conceal the amount of money banks create when they lend or purchase bonds or any other asset. Money is created when a bank originates claims on non-banks, and money is destroyed when a debt is paid back to the bank. Accordingly, money traces debt creation by banks. Banks can disguise their assets, and corporations and governments can conceal their liabilities, but none of them can camouflage the amount of money in circulation. In short, we trace money to gauge the amount of private and public sector borrowing from banks. This is why we have calculated various measures of money in China to overcome the shortcomings of the TSF. Specifically, we have calculated broad money M3 (see details of our calculation below) and credit-money. The latter is the sum of commercial banks' assets such as claims on non-financial institutions, claims on other financial institutions, claims on government and claim on other resident sectors and commerical banks' as well as the central bank's foreign currency assets. Chart I-9 demonstrates various measures of broad money and outstanding credit: official M2, our measure of broad money M3, our credit-money measure, and private and public debt (source BIS). Importantly, all measures of money and private and public credit suggest that credit origination/money creation was very strong in 2015 and 2016, and that it has slowed substantially in 2017. In brief, the message from various measures of money/credit is consistent. Chart I-9China: Money/Credit Growth Has Decelerated To New Lows Interestingly, broad money M3 rose by RMB 21 trillion in 2015, RMB 20 trillion in 2016 and by only RMB 16.5 trillion in the past 12 months through end of August. This is why the M3 impulse - a change in money flows - has turned negative since early this year. Third, we prefer our broad money measure M3 to official M2 because it is more consistent with the BIS's measure of private and public credit. It has also served as a better tool in forecasting the 2016-2017 recovery in Chinese growth. As can be seen in Chart 1, 3, 4, 5 and 6 on previous pages, the M3 impulse - its second derivative - has a great track record in forecasting China's business cycle dynamics. The acceleration in M2 growth in 2015-16 was milder than one would expect in order to achieve meaningful acceleration in nominal economic activity. M2 growth was more subdued than a rise in both private and public debt (Chart I-9). We suspect that M2 is no longer an encompassing measure of broad money in China, and therefore we have calculated other measures of broad money to gauge true money/credit creation. Chart I-10China: Consumer Price Inflation Is Rising Broad money consists of various liabilities of commercial banks. While the official M2 includes many of their liabilities such as corporate demand deposits, corporate time deposits and personal deposits. It does not include some others. We have added the following commercial banks' liabilities - transferable deposits and other deposits which are not included in M2, liabilities to other financial corporations and other liabilities - to M2 to produce a more all-inclusive measure of broad money M3. Q: Why can't the Chinese authorities stimulate and revive growth again, like they have done many times in the past? A: Of course, they can. However, if the authorities begin easing monetary/credit and fiscal policies now, it will affect growth six to nine months down the road. Based on money and credit indicators shown in the charts above, growth is set to slow over the next nine months because of the time lag that money/credit has on the economy. In the next six to nine months, economic activity and corporate profits are likely to decelerate considerably, based on the monetary/credit tightening that has already occurred in China. Provided China-related financial markets in general and EM risk assets in particular have so far not discounted the slowdown suggested by China's money/credit indicators, they are very vulnerable. Finally, the magnitude of the impending growth slump is likely to be large, as evidenced by the substantial decline in these money and credit indicators that has already occurred. In brief, policymakers have been tightening credit/money creation, and it has not yet impacted financial markets. Furthermore, inflation is rising in China (Chart I-10) and policymakers are unlikely to start easing before they witness a major growth slump. Until the latter becomes visible in economic data and on the ground, financial markets leveraged to mainland growth will sell off notably. Q: There is no indication that the Federal Reserve will turn hawkish. This will be especially true if global growth slows - as you argue it will because of China. Why do you expect the EM currency rally to peter out amid a dovish Fed? Historical empirical evidence suggests that EM currencies are often driven by commodities prices, not the interest rate differential over U.S. rates. Let's take the BRL and the ZAR as examples. Charts I-11A and Chart I-11B illustrate that the BRL and ZAR exchange rates versus the U.S. dollar have historically been closely correlated with commodities prices, not the level of or change in their interest rate differential over the U.S. Chart I-11ABrazil: What Drives The Currency? Chart I-11BSouth Africa: What Drives The Currency? This has also been true over the past 18 months. The rally in EM currencies since early 2016 can be largely attributed to the rise in commodities prices. As and when commodities prices roll over - as we expect to occur - the trade balances of commodities-producing nations will deteriorate, as will their currencies. Remarkably, there are tentative signs that the drop in U.S. bond yields and the greenback's depreciation are late and overdone. Two-year U.S. bond yields have bounced from their 200-day moving average (please refer to the middle panel of Chart II-1 in the Mexican section). Typically, such a technical profile leads to new highs. Our sense is that U.S. bond yields will rebound in the coming months, which will also weigh on EM currencies. Importantly, one of the drivers behind the U.S. dollar selloff since early this year has been the rise in banks' excess reserves at the Fed (Chart I-12). The latter was due to the debt ceiling, as the U.S. Treasury was running down its account at the Fed by issuing less paper. In short, since the beginning of this year the U.S. Treasury did not issue bonds/bills and deposit them at its Treasury General Account (TGA) at the Fed - meaning it was not destroying banking system reserves as it typically does. This boosted the supply of U.S. dollars - banks' excess reserves at the Fed rose by US$ 300 billion. More dollar supply depressed both the exchange rate and U.S. interest rates. Chart I-12 demonstrates that in the post-QE era, banks' excess reserves at the Fed have correlated with the U.S. dollar's exchange rate. The debt ceiling has been resolved for now, and the Treasury will now begin accumulating dollars in its TGA account again. It has already announced that its TGA will rise from $73 billion now to $400 billion at the end of this year. The Treasury will issue more paper, and deposit U.S. dollars in the TGA. This will shrink banks' excesses reserves. This, in tandem with the reduction in the Fed's balance sheet, will diminish banks' excess reserves. The latter will reduce U.S. dollar supply in off-shore markets and will likely trigger a U.S. dollar rebound. On the whole, the two pillars of the EM currency rally - strong growth in China that manifests in higher commodities prices and lower U.S. bond yields - are set to reverse. In turn, a potential EM currency selloff along with deteriorating EM corporate profits will likely weigh on EM equities and EM sovereign and corporate debt. Q: Does this mean EM stocks will relapse in absolute terms, or simply underperform the DM equity markets? Our strongest conviction at the moment is on EM relative equity performance versus DM equity markets. Odds are that a relapse in relative performance is imminent as and if U.S. bond yields rise (Chart I-13). Chart I-12U.S. Banks' Excess Reserves ##br##And The U.S. Dollar Chart I-13U.S. Stocks Outperform EM Ones When ##br##U.S. Bond Yields Are Rising In addition, U.S. stocks' underperformance versus the global equity index in common currency terms is at a technical support (Chart I-14, top panel), and will likely reverse as the dollar firms up. Historically, when U.S. stocks outperform the global benchmark in common currency terms - denoted by shaded periods in Chart I-14, EM stocks typically underperform the global equity index. The dynamics of EM equity absolute performance depends on investor's risk appetite. It will be hard for EM share prices to drop meaningfully as the DM rally persists. Global stocks are still trading well, and it is very difficult to pinpoint any trigger that will lead to a reversal. As our readers well know, we do not forecast triggers for the simple reason that the chances of getting it right are much lower than a coin toss. That said, in the medium term, the reason for a correction in DM stocks could well be EM/China growth, as it was in 2015. In such a scenario, EM risk assets will sell off first. As to timing, it is hard to find indicators that lead share prices, but aggregate EM narrow (M1) money growth has historically been coincident or leading with EM share prices - and it presently points to a considerable drop in EM equity prices (Chart I-15). This EM M1 aggregate is equity market-cap weighted making it relevant to investors. Chart I-14EM And U.S. Equites Typically Do Not Outperform Global Stocks Simultaneously Chart I-15EM M1 Growth And EM Share Prices Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com A New Trade: Receive Mexican / Pay U.S. 2-Year Swap Rates Mexico's 2-year bond yield has recently fallen through a technical support line while the U.S. 2-year bond yield has recently bounced off a major support level (Chart II-1). Our bias is that the 2-year yield in Mexico will fall relative to 2-year U.S. yield (Chart II-1, bottom panel). We recommend a new trade: receive 2-year swap rates in Mexico and pay U.S. 2-year swap rates. Historically, the domestic demand cycle in Mexico was synchronized with the business cycle in the U.S., mainly due to the fact these two economies are heavily integrated. However, the two economies have recently become desynchronized. This is evident by the fact that the Mexican export sector - which is leveraged to U.S. - is booming while the domestic demand in Mexico is slowing down (Chart II-2). Chart II-12-Year Bond Yields: Mexico And U.S. Chart II-2Divergence Within Mexican Economy The culprit behind this desynchronization is the previous collapse in the peso. Falling oil prices and excessive money/credit expansion in Mexico led to a major peso depreciation in 2014 and 2015. The election of Trump pushed it off the cliff in 2016. Inflation in Mexico spiked due to the massive currency depreciation. Consequently, the Mexican central bank has hiked interest rates by 400 basis points since the end of 2015. This, along with fiscal tightening, has choked domestic demand growth in Mexico. At this point, our bias is that the short-term interest rate differential between Mexico and the U.S. is unjustifiably wide and is about to narrow. Going forward, we expect inflation to fall in Mexico and interest rate expectations will at minimum not rise. Inflation in Mexico will roll over soon and moderate because of the following: A large part of the rise in inflation was caused by the depreciation in the peso. The peso's material appreciation this year will reduce the inflation rate (Chart II-3). Consumer spending and capital expenditure are set to continue slumping as the impact of higher interest rates continues filtering through the economy (Chart II-4, top and bottom panel). Chart II-3Mexico: Exchange Rate And Core Inflation Chart II-4Mexico: Domestic Demand To Disappoint Further Domestic vehicle sales are shrinking signifying no revival in interest rate-dependent sectors. Fiscal policy has been tightening and this will continue to be a headwind on economic growth (Chart II-5). Hence, despite flourishing exports to the U.S., very weak domestic demand will dampen inflation in Mexico. Finally, there were several one-off effects to inflation such as the gasoline subsidy removal that took place at the end of last year, and the minimum wage hike that was implemented at the beginning of the year. As the base effect of these fade, the inflation rate will moderate. In the U.S., our bias is that interest rate expectations are too low given the tight labor market, reasonably strong growth, and the U.S. dollar depreciation this year. Odds are that the U.S. interest rate expectations will rise as core inflation moves up (Chart II-6). Chart II-5Mexico: A Major Improvement In Fiscal Position Chart II-6U.S. Core Inflation To Rise Investment Recommendations We recommend fixed-income traders to receive Mexican / pay U.S. 2-year swap rates. The main risk to this trade lies in the event of an abrupt sell-off in the peso against the U.S dollar that could push up the 2-year swap rate differential. While we expect EM currencies, including the peso, to depreciate, this trade is still favorable in terms of risk-reward because of the starting point in interest rate differential and peso valuations: Despite the rally this year, the peso is still cheap (Chart II-7). Furthermore, its current account and fiscal balances have improved dramatically. So, the peso should depreciate less than many other EM currencies. Chart II-7The MXN Is Still Cheap In fact, the interest rate spread between Mexico and the U.S. is already historically high, and the peso depreciation might not push it much higher. We would not be recommending this trade if the peso was fairly or overvalued, or if interest rates in Mexico were not this high. Entering this position under these current circumstances reduces the downside risk and, therefore, makes the risk-reward attractive. As to Mexican financial markets in general, we remain constructive on the peso versus other EM currencies. More specifically, we continue to recommend long positions in MXN versus ZAR and BRL. Mexican local currency bonds and sovereign credit offer good value relative to their EM counterparts. Fixed income investors should continue to overweight Mexican local currency and sovereign credit within their respective EM benchmarks. Finally, the outlook for Mexican stocks in absolute terms is poor as domestic demand will slump, further hampering corporate profits. Within an EM equity portfolio we recommend neutral allocation to this bourse mainly due to our expectations of the peso outperforming other EM currencies. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

The National Association of Home Builders released their housing market index (HMI) which, while still high, took a step downward. Importantly, the softness in the HMI had already commenced earlier in the summer prior to the hurricane season (second panel). Moderating housing starts confirm the weaker industry sentiment (third panel). This is hardly surprising given lumber prices, currently bumping up against five year highs (bottom panel), which will cut materially into profit margins. As a result, the S&P homebuilders index has been tightly range bound since our early summer downgrade to neutral. Conversely, home improvement retailers benefit from high lumber prices as retailers typically earn a fixed spread such that a high dollar value sold will boost profitability. With hurricane-related rebuilding driving lumber demand (and prices) higher in the near-term, the margin spread between home improvement retailers and homebuilders should be amplified in the back half of 2017. Accordingly, we reiterate our neutral homebuilders and high-conviction overweight home improvement retailers recommendations. The ticker symbols for the stocks in the S&P homebuilders index are: BLBG: S5HOME - DHI, LEN, PHM. The ticker symbols for the stocks in the S&P home improvement retailers index are BLBG: S5HOMI - HD, LOW.

Neutral Software stock relative performance has returned to its long-term uptrend, but remains far from the two standard deviations above the mean peak reached during the tech bubble (top panel). The structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech subsector. Beyond this constructive backdrop, cyclical forces are also painting a brighter picture for software equities. Importantly, there is tentative evidence that a fresh capex upcycle has commenced, and if software commands a larger slice of the overall spending pie, industry profits should enjoy a healthy rebound (middle panel). Supply reduction presents a bullish backdrop for software selling prices that have exited deflation at a time when overall corporate sector inflation is decelerating. The upshot is that revenue growth will likely reaccelerate (bottom panel). Adding it up, enticing structural software forces aside, a cyclical capex recovery is a boon for software outlays and, coupled with reviving animal spirits, signal that it no longer pays to underweight this tech sub-sector. Bottom Line: The S&P software index does not deserve an underweight. Lift exposure to a benchmark allocation, and refer to yesterday's Weekly Report for additional details. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, EA, INTU, ADSK, SYMC, RHT, SNPS, CTXS, ANSS, CA.