Global

Special Report

Highlights Bitcoin and other virtual currencies have sold off sharply in recent days. However, as the turn of the millennium dotcom boom and bust illustrates, wild swings in asset prices can sometimes mask important structural changes that new technologies have unleashed on the global economy. If the proliferation of virtual currencies continues, it will have real macroeconomic effects. Globally, the volume of currency in circulation - the largest component of base money - has grown by 5.5% year-over-year. However, the growth rate would be 7% if virtual currencies were included in the tally. The indirect increase in global liquidity coming from virtual currencies should provide a modest boost to spending. This is somewhat bearish for bonds but bullish for equities. The implications for gold and the dollar are mixed. Governments derive significant "seigniorage revenue" from their ability to issue fiat currency. This is likely to impede the widespread adoption of virtual currencies, ultimately capping their prices. Feature Bitcoin And Beyond The price of bitcoin has been extremely volatile lately, falling by more than 10% last week after the Chinese government announced a ban on so-called Initial Coin Offerings. The downdraft continued into this week, spurred on by JPMorgan CEO Jamie Dimon's description of bitcoin as a "fraud." The recent selloff followed a dizzying ascent which saw the price of the upstart currency surpass $5000 earlier this month (Chart 1). Despite the pullback, one thousand dollars of bitcoin purchased in July 2010 would still be worth $58 million today. Such mind-boggling returns have caught the public's attention. There were more Google searches for "bitcoin" in August and September than for "Donald Trump" (Chart 2). Public appetite is so high that the Bitcoin Investment Trust, though officially an open-ended vehicle, has traded as high as twice its net asset value in recent months. Chart 1Bitcoin Prices: It's Been A Wild Ride So Far Chart 2President Trump: Bitcoin Is More Popular Than You! Other virtual currencies have also seen staggering returns. Ethereum is still up more than 3000% year-to-date, giving it a market cap of $23 billion. Dogecoin, a currency that was started "as a joke" according to its founders, commands a market cap of $114 million. Wider Effects? The run-up in bitcoin prices bears a close resemblance to classic bubbles (Chart 3). Yet, as the turn of the millennium dotcom boom and bust illustrates, wild swings in asset prices can sometimes mask important structural changes that new technologies have unleashed on the global economy. This raises the question of whether the explosion in virtual currencies is relevant for the broader investment community, including those investors who would never consider buying bitcoin. We would answer yes, albeit in a limited form thus far. The market capitalization of all virtual currencies currently stands at $120 billion (Chart 4). Globally, there is about $6 trillion in currency outstanding, so the value of virtual currencies is now 2% that of traditional cash and currency. That's not huge, but it's no longer trivial either. Chart 3Bitcoin Bubble? Chart 4Virtual Currencies: Market Cap Is Now Non-Trivial The importance of virtual currencies increases if we look at rates of change. The global stock of currency in circulation has risen by 5.5% over the past 12 months. However, if we add virtual currencies to the mix, the rate of growth jumps to 7%. The contribution of virtual currencies to the rate of growth of the broad money supply - which includes such items as bank deposits - is still fairly small. However, economists focus on currency in circulation for a reason: It is the largest component of base money (also known as "high-powered" money). The stock of base money helps determine the total money supply through the magic of the money multiplier and fractional reserve banking. The Monetary Hot Potato For the time being, the macro impact of virtual currencies has been constrained by the fact that most people are buying them as a store of value, rather than as a medium of exchange. It is no coincidence that up until recently, a disproportionately large amount of demand for virtual currencies has come out of China, an economy that suffers from a plethora of savings and a dearth of safe investable assets (Chart 5). In addition to squirrelling away their wealth in overpriced condos, the Chinese are now snapping up bitcoins. Chart 5Bitcoin Trading Volume By Top Three Currencies Over time, the public may begin to regard virtual currencies as legitimate substitutes for dollars, euros, yen, and yuan. This could lead people to want to hold fewer of these traditional currencies, causing them in turn to either spend their excess cash holdings or deposit them in commercial banks. The first outcome would obviously be inflationary, but so would the second if rising deposit inflows caused banks to increase lending. What would happen if people began transacting more in virtual currencies? At that point, the Fed and other central banks would need to decide whether to take some traditional paper money out of circulation in order to make room for the growing share of private virtual currencies. The merits of doing so would depend on the state of the business cycle.1 When inflation is low, as it is today in most of the world, central banks would gladly welcome anything that boosts spending and liquidity. Indeed, in some ways, the issuance of private currencies could have similar effects to helicopter drops of money. However, if inflation were to accelerate too rapidly, central banks would have to begin withdrawing their own currencies from circulation, or push for the withdrawal of private currencies. Governments Want Their Cut Chart 6U.S. Seigniorage Revenue The former outcome would not please the fiscal authorities. When the U.S. Treasury issues a $100 bill, it gains the ability to buy $100 of goods and services with it. The government's cost is whatever it pays to print the bill, which is close to zero. This so-called "seigniorage revenue" is quite large, averaging close to $70 billion per year for the U.S. government alone over the past decade (Chart 6). Why would the U.S. or any other country that issues its own currency want to part with this revenue? The answer is that it wouldn't. Instead, governments are likely to introduce their own competitors to bitcoin. The blockchain technology on which bitcoin is built is ingenious but completely within the public domain. Central banks are already thinking about how to issue their own virtual currencies. The creation of such parallel electronic currencies would allow people to send funds to one another and purchase goods and services without the need for an intermediary, a potentially negative development for banks and other financial institutions. These government-sponsored virtual currencies are unlikely to offer the full anonymity of bitcoin, but for most people, that may not be such a bad thing. As our Technology Sector Strategy service has emphasized, private virtual currencies suffer from numerous deficiencies which expose their users to fraud.2 When thieves stole 6% of all outstanding bitcoins from the Mt. Gox exchange in 2014, the victims had nothing to fall back on. A government-sponsored virtual currency could at least offer some protection to its holders, thereby making it more valuable to use. It would also allow central banks to fulfill their responsibilities as lenders of last resort. The Free Banking Era in the U.S., which at one point saw 8000 different currencies in circulation, experienced multiple banking crises. A world with myriad private currencies all competing with one another would be similarly unstable. Bitcoin: A Solution In Search Of A Problem? Chart 7The Boom In Cryptocurrencies This gets to a more fundamental issue, which is that bitcoin often comes across as a solution in need of a problem. People can already transfer money fairly easily when it is legal to do so. If the main practical advantage of bitcoin is to overcome capital controls and empower tax cheats, junkies, and hackers, it is hard to see how this does not beget a government crackdown. Ironically, the "mining" of additional bitcoins requires significant investment in specialized computers and dollops of electricity. Virtual currencies may exist in bits and bytes, but real resources must be expended to create them. In contrast, governments can create money with simply the stroke of a pen. Granted, if governments used this power to devalue the value of money - as they have periodically done from time to time - the virtues of bitcoin as a store of value would become more evident. The algorithms that power bitcoin limit the total number of coins that can ever be created to 21 million. Bitcoin is not the only game in town, however. Dozens of competitors have sprung up (Chart 7). While each may cap the number of coins in circulation, collectively they represent a potentially significant (and possibly unlimited) addition to the monetary base. Thus, it is not clear how well virtual currencies would perform as inflation hedges compared to more traditional instruments such as gold and land, let alone modern hedges such as inflation-linked securities. Investment Conclusions The role that money plays in modern economies is one of those things that people tend to tie themselves into pretzels thinking about. It's actually not that complicated. For the most part, inflation occurs when the demand for goods and services outstrips the supply of goods and services. Outside of extreme situations, the choice of monetary regime does not affect the supply-side of the economy (that's determined by productivity and the size of the labor force, neither of which central banks have much control over). Thus, it really is just a question of how the monetary regime affects aggregate demand. As noted above, there are reasons to think that the proliferation of virtual currencies will boost the demand for goods and services, either through the wealth effect channel (people who acquired bitcoin in its early days feel richer today), or via the currency substitution channel (if people start transacting in bitcoin, they may try to dispose of their excess dollars, euros, yen, and yuan either by spending them or depositing them in banks, leading to higher loan growth). Neither of these effects is terribly significant right now, but both have the potential to increase in importance over time. At some point, governments will take steps to rein in virtual currencies. However, until then, their existence is likely to spur inflation in the fiat currencies in which most prices are measured. That's bad for high-quality government bonds, but potentially good for stocks. The implications for gold are mixed. On the one hand, if the growth of virtual currencies translates into an increase in the global money supply and rising inflation, that is good for bullion. On the other hand, if people see bitcoin as a competitor to gold as a store of value, they may wish to hold less of the yellow metal. The dollar could lose out from the proliferation of virtual currencies if central banks allocate some of their USD reserves into these new currencies. However, it is doubtful this will happen to any significant degree since most central banks are likely to see virtual currencies as unwanted competitors to their own monies. In the meantime, stronger global demand growth could put disproportionately more upward pressure on U.S. inflation, given that the U.S. is closer to full employment than most economies. This could cause the Fed to raise rates more aggressively than it otherwise would, leading to a firmer dollar. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 To appreciate this point, ponder the question of who suffers when someone goes shopping with counterfeit currency. If the economy is operating at full potential, the answer is that everyone else suffers because they have to pay higher prices for the things that they buy. However, if there are plenty of idle workers, the additional spending is unlikely to raise prices. Rather, it will translate into higher output and income. 2 Please see Technology Sector Strategy, "Blockchain and Cryptocurrencies," dated May 5, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights U.S. product inventories - particularly gasoline and distillates - will show sharp declines over the balance of September, as refining capacity continues to trail demand in the wake of Hurricane Harvey. U.S. crude inventories will accumulate as refineries slowly come back on line. This will keep the Brent vs. WTI spreads and crack spreads elevated, as refiners outside the U.S. Gulf scramble for crude (Chart of the Week).1 Global product storage facilities will be drained to more normal levels responding to this imbalance. It is understandable that the significance of the increased frequency of messaging from OPEC 2.0's leadership re its willingness to extend production cuts beyond March 2018 would be secondary to hurricane recovery. Nonetheless, we advise investors to stay focused on OPEC 2.0's evolution, particularly next year, as it develops a modus operandi for providing forward guidance to markets and investors. Energy: Overweight. Brent futures are backwardated to January 2018, reflecting a tight market as refiners, particularly in Europe, scramble for barrels to meet U.S. and Latin American product demand. We remain long Brent and WTI $50/bbl vs. $55/bbl call spreads in Dec/17, which are up 183.8% and 30.2%, respectively, since inception. Base Metals: Neutral. Our tactical COMEX copper short initiated last week is up 3.4%. Precious Metals: Neutral. The Dec/17 COMEX Gold contract gapped lower earlier in the week, as a strengthening USD, and a 15 - 0 vote Monday by the UN Security Council to adopt sanctions proposed by the U.S. against N. Korea took some of the luster off the metal. Our long strategic portfolio hedge is up 8.0% since it was initiated May 4, 2017. Ags/Softs: Underweight. Grains appear to be finding support around current levels. We are bearish, but do not advise shorting the complex, especially with erratic weather as a backdrop. Feature Chart of the WeekBrent - WTI Spread,##BR##Cracks Reflect Refining Scramble The Kingdom of Saudi Arabia (KSA) and Russia, the putative leaders of what we've dubbed OPEC 2.0, are taking every opportunity to signal their willingness to consider an extension of their production-cutting agreement beyond March 2018, when it is scheduled to expire.2 We believe this to be part and parcel of an evolving forward guidance strategy, which KSA and Russia will deploy to signal their production intentions over the near term. This is consistent with our view such a strategy is necessary to keep the producer coalition durable, and to work out an even larger plan to begin messaging firms and institutions allocating capital to oil and natural gas markets globally. This is critical for KSA, which will be looking to IPO Saudi ARAMCO next year, and Russia, which is preparing for elections in March and still relies heavily on hydrocarbon exports to fund its government.3 The last thing either needs is out-of-control oil production tanking the market, as it almost did at the beginning of 2016. Other members of the OPEC 2.0 coalition seeking foreign direct investment (FDI) - e.g., Gulf Arab producers and non-OPEC states like Mexico and Kazakhstan - benefit from an oil-production-management framework as well. The significance of OPEC 2.0's emerging forward guidance strategy could be lost amid the devastation of hurricanes Harvey and Irma, which is understandable. But it will be critical to understanding the coalition's strategy regarding how it intends to manage its own production, now that U.S. shale is the marginal barrel in the world, even after Hurricane Harvey disrupted production and refining in Texas, and U.S. crude and product exports from the Gulf. Thus far, OPEC 2.0 continues to deliver on its production cuts, and global demand - which we expect will dip by less than 1mm b/d over the next few weeks due to the hurricanes - remains strong. In a month or two, we expect hurricane recovery efforts will restore lost refining capacity and product demand. As rebuilding goes into high gear, we expect product demand to get a significant boost. OPEC 2.0 Maintains Discipline We will be updating our oil supply/demand balances next week, but so far it appears KSA and Russia are honoring their commitments to restrain production. This allows them to maintain credibility with their respective OPEC and non-OPEC allies within OPEC 2.0, and with the market in general (Chart 2). KSA, in particular, has led the way among OPEC members of the coalition, according to a tally done by S&P Global's Platts, which put KSA's average crude oil production over the January - August 2017 period at 9.97mm b/d vs. its quota of 10.06mm b/d. This is up slightly over the 9.93mm b/d average production for January - June 2017 reported by JODI. KSA's August production reported in the September OPEC Monthly Oil Market Report was 9.95mm b/d. For the January - August 2017 period, Russia's total crude and liquids production averaged 11.22mm b/d, according to U.S. EIA estimates. For the May - August period, it averaged 11.16mm b/d, putting total output 300k b/d below its October 2016 level, against which OPEC 2.0 benchmarks. Russia committed to reducing output by 300k b/d under the OPEC 2.0 Agreement as part of an overall effort to remove 1.8mm b/d of production from the market to end-March 2018. Russia's crude oil production averaged 10.38mm b/d over the January - June 2017 period, according to JODI data, vs. an October level of 10.51mm b/d. For 2Q17, Russia's average production reported to JODI was 10.31mm b/d, or 200k b/d below its Oct/16 output. Overall OPEC compliance of members with quotas was 112% of agreed volumes last month, meaning OPEC members with quotas under the OPEC 2.0 Agreement are producing 630k b/d below agreed volumes, according to Platts.4 Seven of the OPEC states still covered by the Agreement are producing below quota. Iraq leads in over-production at 4.46mm b/d on average in the January - August period, or 82k b/d over quota. Overall, however, production discipline is holding (Chart 3, panel 2). Chart 2KSA, Russia Leading##BR##OPEC 2.0 By Example Chart 3Production Discipline, Strong Demand##BR##Will Continue To Support Prices Bottom Line: OPEC 2.0's forward guidance to markets, firms and institutions allocating capital in the energy sector has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018, when their Agreement is due to expire. We believe this reflects the desire of OPEC 2.0's leadership to maintain the coalition as a long-term production-coordinating body. This will allow the major oil producing nations to communicate production plans and allay investor fears of out-of-control production in the future. Global Demand Will Remain Strong We have noted repeatedly global economic growth has been firing on all cylinders, which will keep global oil demand robust for at least the balance of 2017, and likely into 2018 (Chart 3, panel 3). This is particularly evident in global trade data, which we also will be updating next week.5 Global economic data continue to support this thesis: All 46 countries monitored by the OECD are on track to grow this year, the first time this has happened since 2007, according to BCA's Global Investment Strategy (GIS).6 In addition, BCA's Global Investment Strategy notes U.S. growth projections have been broadly stable, but these likely will be revised higher. The easing in U.S. financial conditions since the start of the year should boost real GDP growth over the next few quarters, which, along with the expected boost to product demand coming on the back of hurricane-recovery efforts, will continue to be bullish for refined product demand. Global Product Inventory Draws Will Accelerate OPEC 2.0's efforts to draw global inventories - particularly in the OECD - received an unexpected assist from hurricanes Harvey and Irma. We expect the trend of drawdowns seen over the past few months to accelerate (Chart 4). This will return global product inventories to more normal levels, and, with crude oil inventories accumulating, favor refiners as they scramble to meet demand. Our colleagues at BCA's Energy Sector Strategy upgraded U.S. refiners last week to overweight in line with their view Harvey has the "potential to finally normalize bloated refined product inventories. Over two weeks since the hurricane made landfall, the industry still has 1.0 MMb/d of refining capacity shut down (5 refineries), 2.15 MMb/d of capacity not operating but working on restarting operations (6 refineries), and 1.4 MMb/d of capacity operating below full capacity (5 refineries). Over the past 16 days, at least 55 million barrels of refined product have not been generated, which will result in increased crude inventories and shrinking refined product inventories, benefitting refiners" (Chart 5).7 Chart 4OECD Oil Inventory Declines Will Accelerate Chart 5Refinery Outages From Harvey Persist Over the short term, Brent crude - and related streams pricing off Brent - and products will remain bid, keeping refiner crack spreads elevated, as operations return to normal, and Florida emerges from the economic damage and dislocations caused by Irma. Typically, product demand falls immediately after severe storms, and recovers as rebuilding begins and progresses. We will be updating our balances model next week to reflect the effects of hurricanes and the continued indications of strong global growth. Bottom Line: Demand for refined products will dip slightly - likely less than 1% of global demand - as hurricane-ravaged markets recover. As rebuilding progresses, product demand likely will be boosted. This will drain OECD product inventories in the short term, providing an unexpected assist to OPEC 2.0's efforts to bring global stocks down to five-year average levels. This evolution will favor refiners, as well. OPEC 2.0's forward guidance to markets continues to evolve. In recent weeks, it has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018. We believe this messaging is designed to allay fears of another production-free-for-all of the sort that threatened to take global benchmark crude oil prices below $20/bbl last year. It is too early to expect OPEC 2.0 will replace the original OPEC Cartel. But, we believe KSA and Russia are signaling their common desire to make OPEC 2.0 a durable feature of budgeting and investment considerations over the medium term. Actions speak louder than words, in this regard. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 A "crack spread" refers to the difference in refined-product prices and crude oil prices. It takes its name from the "cracking" long-chain hydrocarbon bonds in crude oil required to produce refined products like gasoline and diesel fuel. The Brent - WTI spread is the price difference in USD/barrel ($/bbl) between the global benchmark crudes. 2 Please see, for example, "Saudi Arabia Says It's Open to Another OPEC Cuts Extension," updated on bloomberg.com September 11, 2017; "Saudi, UAE agree extension of oil cuts may be considered - statement," published on the same day on reuters.com's U.K. service; and "Russia's Novak says to consider extension of oil cut deal if glut persists" published on reuters.com September 6, 20107. We have repeated noted markets are looking for OPEC 2.0 to provide forward guidance, if the principals to the deal intend to maintain a durable coalition. Please see, e.g., "KSA's Tactics Advance OPEC 2.0's Agenda," published by BCA Research's Commodity & Energy Strategy Weekly Report August 10, 2017, and available at ces.bcaresearch.com. 3 The U.S. CIA estimates Russia exported 5.1mm b/d of crude oil in 2016, roughly half of crude production. This squares with exports reported by the Joint Organizations Data Initiative (JODI), a transnational agency headquartered in Riyadh, Saudi Arabia. Last year, Russia also exported 223 billion cubic meters of natural gas. KSA exported 7.65mm b/d of crude oil last year, according to JODI, or close to 75% of KSA's production. 4 Please see S&P Global Platts OPEC Guide published September 7, 2017, online. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Trade And Commodity Data Point To Higher Inflation," published on July 27, 2017. It is available at ces.bcaresearch.com. 6 Please see BCA Research's Global Investment Strategy Weekly Report "Central Bank Showdown," published on September 8, 2017. It is available at gis.bcaresearch.com. 7 Please see BCA Research's Energy Sector Strategy Weekly Report "Rebalancing Recommendations," published on September 13, 2017. It is available at nrg.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Dear Client, I have been visiting clients in Europe this week, so today's report is somewhat shorter than usual. We will be back next week with an exciting Special Report on the macro effects of bitcoin and other virtual currencies. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Global growth remains strong and broad-based. U.S. GDP growth will accelerate over the next few quarters thanks to the easing in financial conditions so far this year. The market is pricing in only 20 basis points in cumulative rate hikes between now and the end of next year. This is far too low. Go short the Dec-2018 fed funds futures contract. The euro has strengthened more this year than one would have expected based solely on the change in interest rate differentials. Positioning shifts are the likely culprit. In real terms, the terminal rate in the U.S. based on 5-year, 5-year forward OIS rates is currently only 13 bps higher than in the euro area. We will automatically open a tactical short EUR/USD position if the euro moves above $1.22 any time over the next three weeks. Feature Global Economy Firing On All Cylinders The global economy continues to chug along. All 46 countries monitored by the OECD are on track to grow this year, the first time this has happened since 2007. Usually, economists are too optimistic about growth prospects. This has not been the case over the past 12 months. Consensus global growth estimates for 2017 and 2018 have marched higher during this time, led by the euro area, Japan, and a number of emerging economies (Chart 1). U.S. growth projections have been broadly stable, but these too are likely to be revised higher. Both the manufacturing and non-manufacturing ISM indices improved in August. The same goes for core capital goods orders, consumer confidence, retail sales, and homebuilder sentiment. The employment report was on the weak side, but it was probably distorted by seasonal factors - August payrolls have now fallen short of expectations for seven years in a row, a suspiciously long streak. Hiring intention surveys and perceptions of job availability both remain strong. The net share of households who see jobs as "plentiful" as opposed to "hard to get" rose further in August. It is now well above its pre-recession peak (Chart 2). Chart 1Higher And Higher Chart 2A Healthy U.S. Labor Market Fed Rate Expectations Are Too Dovish The Treasury market remains oblivious to these developments, focusing only on the failure of inflation to rise. This could prove to be a fatal mistake. Inflation is a highly lagging indicator. It typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 3). Trying to infer the true level of economic slack from today's inflation rate is like trying to read the speedometer of an automobile when there is a 30-second delay between what the dial says and when you step on the accelerator. Many market participants and a number of Fed officials have argued that interest rates are already close to neutral, implying little need for further rate hikes. We agree that the neutral rate is lower than in the past, but their argument misses a crucial point. Even if the Fed knew what the level of the neutral rate is - which, of course, it doesn't - it would still need to get the timing right. If the Fed waits too long to bring rates up to neutral, the unemployment rate will end up falling below NAIRU. This could force the Fed to raise rates more aggressively than it (or the markets) would like. Such an outcome now looks increasingly likely. The easing in U.S. financial conditions since the start of the year should boost real GDP growth over the next few quarters (Chart 4). This could cause the unemployment rate to fall to 3.5% by next summer, leaving it below its 2000 lows and more than a full point below most estimates of NAIRU. If this were to happen, it would prompt the Fed to turn up the hawkish rhetoric. Chart 3Inflation Is A Lagging Indicator Chart 4Easing Financial Conditions In The U.S. Bode Well For Growth The market is not giving enough weight to such an outcome. The December-2018 fed funds futures contract is pricing in only 20 basis points in cumulative rate hikes between now and the end of next year. That is much too low. We recommend that clients short this contract and are initiating a new tactical trade to this effect. ECB Will Take It Easy In contrast to the U.S., euro area financial conditions have tightened this year. During his press conference, Mario Draghi expressed confidence in the growth outlook, but acknowledged the risks to the region from a stronger currency. He noted that "the recent volatility in the exchange rate represents a source of uncertainty which requires monitoring with regard to its possible implications for the medium-term outlook for price stability." As we predicted last week, the ECB trimmed its 2018 inflation forecast from 1.3% to 1.2%, and its 2019 forecast from 1.6% to 1.5%. Chart 5 shows the market's estimate of the gap in terminal interest rates between the U.S. and the euro area using 5-year, 5-year forward OIS rates. The gap has narrowed by around 50 bps since the start of the year. However, EUR/USD has strengthened more than one would have expected based solely on the movement in interest rate differentials. Specifically, the market now expects U.S. five-year yields to be 78 basis points higher in 2022 than in the euro area. This is precisely the same gap that prevailed last October. Yet, EUR/USD was $1.10 back then. Today, it is $1.20. Shifts in positioning help explain why the euro has strengthened so much. Traders were heavily short the euro at the start of this year. Today, they are heavily long (Chart 6). Looking out, with few euro shorts left, EUR/USD is likely to trade off the interest rate gap between the two regions. Chart 5U.S. Vs. Euro Area: Interest Rate Gap Has Narrowed Chart 6Euro Positioning: From Deeply Short To Long Chart 7Fiscal Policy Is More Stimulative In The U.S. In real terms, the terminal rate in the U.S. is currently only 13 bps higher than in the euro area. That seems rather low to us. Trend growth is faster in the U.S., the banking system is in better shape, and fiscal policy is more stimulative (Chart 7). All this suggests that the real neutral rate is substantially higher in the U.S. As such, we will automatically open a tactical short EUR/USD position if the euro moves above $1.22 at any time over the next three weeks, with a stop of $1.24 and a year-end target of $1.15. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Beijing's continued focus on reducing excess industrial capacity in the lead-up to the 19th National Congress of the Communist Party will keep iron ore and steel markets buoyant for the balance of the year. The trajectory of prices further out the curve will, however, depend greatly on how quickly China's reflationary policies wane next year. Energy: Overweight. U.S. gasoline inventories could fall by 7-10mm barrels in the first week following the storm (data to be reported today by the EIA), and another 5-10mm barrels (or more) over the next month, depending on how long it takes to restart all of the refineries knocked offline by Hurricane Harvey, according to estimates in BCA Research's Energy Sector Strategy. Current gasoline inventories sit about 20 million barrels above the 2011-2015 average, which, based on our calculations, could be completely evaporated within a month, materially changing the U.S. gasoline market and related crack spreads.1 Base Metals: Neutral. Following our analysis last month, we are recommending a tactical short Dec/17 COMEX copper position at tonight's close, expecting the market to correct in line with the fundamentals we highlighted.2 Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge. The metal will be supported by low real interest rates and safe-haven demand. The position was recommended May 4, 2017, and is up 8.7%. Ags/Softs: Underweight. Another bumper crop is being priced into corn this year. Expectations for higher corn yields this year - ranging from 166.9 bushels/acre (bpa) to 169.2 bpa vs. 169.5 bpa expected by the USDA - will keep prices under pressure. We remain bearish.3 Feature In reaction to Chinese economic and environmental policies, iron ore and steel each rallied by ~78% in 2016. While steel continued its ascent in 2017 - gaining a further ~20% in the year-to-date (ytd), iron ore broke away from this trend and plummeted by more than 40% between mid-February and mid-June (Chart of the Week). Chart of the WeekSteel And Iron Ore Diverged Earlier This Year Although iron ore has since reversed its path and regained most of the loss, the divergence between steel and the ore from which it is produced comes down to a difference in fundamentals. Increased supplies of iron ore at a time of healthy inventories were bearish in H1. On the other hand, closures of both steel capacity as well as coal capacity kept the steel market tight. While China's supply-side policies have been the force behind the strength in both to date, Chinese demand - which accounts for ~50% of global iron ore and steel consumption, and steel production - will take center stage next year. The speed at which China's reflationary policies wane will determine the long-term trajectory of steel and iron ore markets. Granted while there are some early signs of a potential slowdown in China's economy, we do not expect this to hit metals generally in the near term. As Beijing continues its focus on reducing excess capacity in the steel sector, and as policymakers prepare for the 19th National Congress later this year, we expect steel and iron ore to remain buoyant in H2. China's Steel Production Paradox Eliminating Excess Steel Capacity At The Forefront Of Reform Agenda... The National Development and Reform Commission (NDRC) - China's top economic planning authority - has made clear that reducing overcapacity is at the forefront of its reform priorities. More concretely, Beijing aims to cut steel capacity by up to 100-150mm MT over the five-year period between 2016 and 2020. It has already made progress towards that end - shuttering a reported 65mm MT last year - and is on track to meet its targeted 50mm MT of steel capacity cuts by the end of 2017. Additionally, in January the central government announced its intention to eliminate all steel capacity from intermediate frequency furnaces (IFF) by the end of June 2017. So it is no surprise that steel has been performing so well. However, this narrative is inconsistent with Chinese data. ...Yet Chinese Production Is At All-Time Highs Steel production from China this year has been soaring, growing by more than 5% year-on-year (yoy) in the first seven months of 2017. In fact, latest production data from July came in at 74mm MT, marking a more than 10% yoy increase, and an all-time record high for monthly production (Chart 2). And since ~50% of global steel is produced in China, this has translated into strong global steel production figures in 2017. Production grew by 4.75% yoy in the first seven months of 2017, the most since 2011 and almost five times as much as the five-year average yoy increase for that period. In fact, the China Iron and Steel Association recently announced that the strength in steel prices does not reflect underlying fundamentals and is instead due to speculation and a misunderstanding of the market impact of China's policies. In an effort to deter speculation, China's commodity exchanges implemented several restrictions in August, including increasing margins on futures contracts and limiting positions (Chart 3).4 Chart 2Record Steel Production##BR##Amid Chinese Capacity Cuts Chart 3Pure Speculation Or Not?##BR##Beijing Cracking Down On Market Speculation It Comes Down To The Nature Of IFFs This paradox of record high production at a time of capacity closures comes down to the nature of IFF capacity that was shutdown. While for the most part, old, outdated and unproductive facilities were targeted for closure last year, the shift in focus towards IFFs had a different effect on the market in 2017. IFFs use scrap steel, rather than iron ore, as a raw material, which is melted through an induction furnace to produce low-quality steel. Because this steel fails to meet government specifications for high-quality steel, it is considered "illegal" and, although it is used to satisfy steel demand, it is not included in official production data. Thus, efforts to shut-down these producers are not evident in China's production figures. However, IFF steelmaking capacity is estimated to be 80-120mm MT a year, and accounts for ~10% of steel production capacity in China. In terms of output, this substandard steel accounts for almost 4% of Chinese production. Thus, traditional steelmaking facilities have been required to fill the supply void caused by IFF closures, raising the official production figures. Steel Exports Take A U-Turn As "Illegal" Capacity Is Shuttered Moreover, Chinese exports have reversed their trend and are on the decline. Steel exports registered a ~30% yoy fall in the first seven months of this year (Chart 4). This is further evidence that the capacity closures have had a real impact on actual steel production, and that domestic consumers have turned to steel that is typically exported, in order to fulfill their demand for the metal. Furthermore, as authorities crack down on IFFs, demand for scrap steel - the main raw material in IFFs - has declined. Amid waning demand, scrap steel prices fell by 9% in H1 before regaining almost 6% in July. This follows a ~70% rally last year (Chart 5). Chart 4Exports Are Down As##BR##Capacity Is Shutdown Chart 5Scrap Steel Rally Takes A Break##BR##As Demand From IFFs Eliminated Coking Coal Cost Push As part of its environmental protection plans, China's policymakers announced plans to replace 800mm MT of outdated coal mining capacity with 500mm MT of "advanced" capacity by 2020. Last year, coal-mining capacity closures exceeded the 250mm MT target, reversing the slump in coal prices and leading an almost 225% rally in coke futures. Coking coal, or metallurgical coal, is a key ingredient in the steelmaking process. Although coke dipped since its December high, it has rallied by 34% in the past two months. Thus, Chinese steel mills are now producing in an environment of higher input costs, which will translate to higher prices for the finished good. China's Capacity Closures Likely Peaked Given that China has set June 30, 2017 as the target for eliminating induction furnace-based steelmaking, we do not expect IFF shutdowns to continue impacting the steel market. Additionally, while excess steel capacity is conventionally estimated to be 325-350mm MT in China, the Peterson Institute for International Economics (PIIE) argues that this estimate does not account for the need for a certain amount of excess capacity. Instead, they cite 130mm MT as a more reasonable figure of Chinese excess steel capacity. According to PIIE estimates, this means that by the end of the year, China will have eliminated almost all of its excess capacity, and will be very close to the quantity of capacity closures it aims to achieve by 2020. Consequently, we do not expect shutdowns to continue driving up steel prices. However, plans to halve blast-furnace production at Northern China mills to reduce pollution during the winter will weigh on near term Chinese production and the steel market. Bottom Line: Chinese authorities are closing in on their targeted capacity shutdowns. We do not expect this reduction in capacity to continue impacting steel markets in the long term. Near-term supply dynamics will be driven by efforts to reduce winter pollution. IFF Closures Spur Demand For Iron Ore Chart 6Mid-Year China Inventories At Record High With the elimination of IFFs, which take in scrap steel as the main input, we expect greater demand for iron ore from traditional steel mills as they work toward filling the supply gap left by the loss of the so-called illegal steel. While steel prices have been on a consistent uptrend since 2016, iron ore - which usually moves in tandem with steel - diverged from its main demand market earlier this year, before resuming its rally in Q2. The deviation earlier this year was due to increased supplies from Australia and Brazil amid record levels of Chinese inventories (Chart 6). This has reversed, and iron ore has resumed its climb. Stronger demand for iron ore is consistent with import data, which shows that China has been hungry for Australian and Brazilian iron ore. However, since the average iron ore production cost in China - estimated at more than 60 USD/MT, or roughly three (3) times the cost of iron-ore production in Brazil and Australia - is greater than in other regions, many Chinese mines go offline during periods of low prices. By the same token, elevated prices tempt high-cost Chinese producers back online, increasing global supply. Bottom Line: Since the closure of induction furnaces has shored up demand for iron ore, pulling prices up with it, we do not anticipate further drops in prices. However, if prices remain elevated, increased production from China amid well stocked global markets will keep a tight lid on iron ore prices. Chinese Appetite Will Determine Long-Run Market Performance While steel and iron ore are currently well supported, their near term strength is in large part due to China's reflation policies which have revived demand. Given that it is a sensitive political year, we do not foresee downturns in the Chinese economy this year. Authorities will want to go into the 19th National Congress of the Communist Party in mid-October with solid economic data as a backdrop. However, waning Chinese growth would be a long-run negative for the markets (Chart 7). Specifically, official government data indicate: 1. There are early warning signs that the property market in China may be losing momentum. New floor space started, and new floor space completed contracted in July, while growth in floor space under construction and floor space sold have been easing. Furthermore, while total real estate investment has been growing at an average monthly rate of almost 9% yoy since the beginning of the year, July figures show a marked slowdown, at less than 5% yoy growth. We would not be surprised to see the property market winding down as China begins to tighten its real estate policies. 2. Chinese automobile production has slowed significantly from all-time highs recorded at the end of last year. The monthly average 4% yoy growth in the five months to July is a significant deceleration from the 10% yoy average witnessed during the same period last year. 3. However, infrastructure investment has been strong, recording its all-time high in June, and a 20% yoy increase in July. With the National Congress scheduled in October, we do not expect a slowdown in infrastructure spending this year. In addition, August manufacturing PMI data in China came in above expectations, and registered a slight increase from the previous month (Chart 8). The index has remained relatively stable since the beginning of the year, after gaining strength last year. Chart 7Despite Signs Of Fizzling,##BR##Slowdown Not Expected In 2017 Chart 8Accomodative Policies Will##BR##Keep Near Term Demand Solid Bottom Line: Although we expect China's appetite for steel will begin to wane as the economy unravels from its reflationary policies, steel demand will remain strong in 2017. Chinese authorities will want to ensure solid growth in the run-up to the National Congress scheduled for mid-October. Thus, the near-term focus will remain on supply, and the impact of its reforms on ferrous metals. Post-Harvey Rebuilding Will Spur Steel Demand Hurricane Harvey is expected to impact steel markets in three main ways: 30-35% of all U.S. steel imports come through Port Houston. However, the port resumed operations as of September 1 and there is no longer a threat posed on steel imports. The disruption in freight service resulting from Harvey is expected to temporarily push up trucking rates in the next few weeks. This will give U.S. steel firms, which have long been suffering from cheaper Chinese imports, an advantage and opportunity to fill the demand void which will be bullish for U.S. steel. Harvey will have a longer-run positive impact on steel markets through the demand that will be generated from the infrastructure rebuilding process. Still, increased demand for steel will be partially mitigated by a rise in scrap steel supply, in the aftermath of destruction. While it is still too early to measure the extent of damage and the impact of the rebuilding process on steel markets, estimates from the storm's damage run as high as USD 120 billion. Texas's governor estimated the damage to be much greater - between USD 150-180 billion. This compares to USD 110 billion from Hurricane Katrina, the most devastating storm to hit the U.S. prior to Harvey. Bottom Line: While it is still too early to determine the full extent of destruction, the infrastructure rebuilding phase will spur demand for steel. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's Energy Sector Strategy Weekly Report "Upgrading Refining Sector As Harvey Clears Out Inventories," published September 6, 2017 It is available at nrg.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," published August 24, 2017. It is available at ces.bcaresearch.com. 3 Please see "GRAINS - Corn lower as U.S. yield forecasts rise; soy, wheat climb," published by reuters.com on September 1, 2017. 4 Please see "Shanghai exchange urges steel investors to act rationally, hikes fees" published by reuters.com on August 11, 2017. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Feature Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report written by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst. Mark makes a compelling case that the deflationary effects of the "Amazon economy" are overstated. I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Chart 1September Is Generally ##br##Not A Good Time Of Year For Stocks My colleagues and I convened a meeting earlier this week to discuss whether to abandon our long-standing cyclically bullish view towards risk assets. Several of them felt it was time to turn more cautious. I am sympathetic to their concerns: Valuations are stretched, volatility is low, and geopolitical risks (most notably North Korea) are on the rise. Profit growth is likely to decelerate later this year, as the easy comps stemming from the depressed level of earnings in the first half of 2016 vanish. Meanwhile, stocks are entering the volatile early autumn months, a period which has historically seen poor returns (Chart 1). Nevertheless, at times like these, it is useful to fall back on our time-tested indicators. Bear markets have almost always coincided with economic recessions, with the latter usually causing the former (Chart 2). None of our recession-timing signals are flashing red: To cite just a few examples, ISM manufacturing new orders are strong, initial unemployment claims are low, core capital goods orders are accelerating, and the yield curve is not in any immediate risk of inverting (Chart 3). Chart 2Recessions And Bear Markets Usually Overlap Chart 3No Warnings Of Recession Here U.S. financial conditions have eased sharply this year, which should support growth over the next few quarters (Chart 4). A recent IMF report highlighted that easier U.S. financial conditions tend to generate positive spillovers onto other countries.1 The fact that all 45 countries monitored by the OECD are on track to grow this year - the first time this has happened since 2007 - is a testament to the strong fundamentals underpinning the global economy. Chart 4Easing Financial Conditions Bode Well For Growth The Fed's Dot Problem In this light, the Fed's projection that the unemployment rate will end this year at 4.3% and only fall to 4.2% by end-2018 no longer looks credible. If U.S. GDP growth remains above trend, as we expect, the unemployment rate could fall below its 2000 low of 3.8% by next summer. That will be enough to prompt investors to price in a few more rate hikes. Considering that the market expects just 22 basis points in hikes through to end-2018, this is not a high bar to clear. A bit more fiscal stimulus would add to the pressure to tighten monetary policy. While any meaningful progress on tax reform will be difficult to achieve, the odds are good that Congress will agree to cut statutory corporate and personal tax rates, with the latter focusing mainly on middle-income earners. Failure to raise the debt ceiling or extend federal spending authority beyond the current budget window could scuttle the benefits from lower tax rates. Fortunately, the risks of such an outcome have receded. If there is a silver lining from Hurricane Harvey, it is that the disaster could at least temporarily overcome the political impasse in Washington. Congress will need to appropriate additional disaster relief funds over the coming weeks. Politicians who are seen as creating roadblocks to such funding will face the electorate's wrath. The odds of an infrastructure bill passing through Congress have also risen. All recoveries eventually run out of steam, but this one can last at least until the second half of 2019, which will make it the longest U.S. expansion on record. As we discussed several weeks ago, the next recession is likely to be triggered by the Fed scrambling to hike rates in response to rising inflation.2 This is not an immediate concern, given that it usually takes a while for an overheated economy to generate inflation - especially since the U.S. currently can satisfy rising domestic demand with higher imports. However, the risks of overheating will increase as unemployment falls further and excess capacity elsewhere in the world is absorbed. Draghi After Jackson Hole Chart 5A Stronger Euro Is Deflationary Textbook economic theory states that a shift in consumption towards imported goods requires a real appreciation of the currency. The dollar, of course, has done exactly the opposite of that, depreciating by 6.6% in trade-weighted terms since the start of the year. The euro, in particular, has gained significant ground against the greenback, rising above $1.20 at one point this week. Mario Draghi's failure to express concerns about the resurgent euro during his Jackson Hole address was construed by many market participants as a green light for further currency strength. We are skeptical of this "saying nothing means you are saying something" interpretation. Draghi wanted to acknowledge (and partly take credit for) the recovery across the euro area, but he is cognizant of the problems posed by a stronger euro. The ECB's June forecast showed inflation rising to only 1.6% in 2019. In the period since those forecasts were compiled, the trade-weighted euro has appreciated by 3.9%, bringing the year-to-date gain to 6.2% (Chart 5). ECB staff calculations, which Draghi has approvingly quoted, show that a 10% appreciation in the euro would reduce inflation by 0.2 percentage points in the first year and 0.6-to-0.8 points in the subsequent two years.3 Better-than-expected growth since the June forecasts will offset some of the deflationary impact from the stronger euro, but probably not by much, given that the Phillips curve is quite flat at high-to-moderate levels of spare capacity. With labor market slack across the euro area still 3.2 percentage points higher today than in 2008 (and 6.7 points higher outside of Germany), it will be a while before stronger growth generates markedly higher inflation. We expect the ECB to reduce its 2018/2019 inflation forecast by 0.1-to-0.2 percentage points next week. It would be awkward for the central bank to play up the prospect of monetary policy normalization while it is simultaneously trimming its inflation projections. This suggests that the ECB's communications could turn more dovish, thereby limiting further upside for the euro. EUR/USD is currently trading near the top of the $1.10-to-$1.20 range that we foresee lasting for the next 10 months. Thus, our expectation is that the euro will weaken over the next few months, ending the year near $1.15, and potentially moving back towards its 2017 lows in the second half of next year, as an overheated U.S. economy forces the Fed to pick up the pace of rate hikes. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, (Chapter 3), (April 2017). 2 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery to Retro-Recession?" dated August 18, 2017. 3 Please see European Central Bank, "March 2017 ECB Staff Macroeconomic Projections For The Euro Area." APPENDIX 1 Tactical Global Asset Allocation Monthly Update To complement our analysis, we use a variety of time-tested models to assess the global investment outlook. At present, these models favor global equities over bonds over a three-month horizon (Appendix Table 1). Appendix Table 1BCA's Tactical Global Asset Allocation Recommendations* Our business cycle equity indicators remain in bullish territory, as reflected in strong global growth and rising corporate earnings. Our monetary and financial indicators are also generally supportive. In contrast, our sentiment readings are sending mixed signals. On the one hand, implied equity volatility remains low and institutional exposure to stocks is quite high. On the other hand, surveys of retail investors show a healthy skepticism towards the bull market, which is a positive contrarian indicator. As has been the case for some time, our valuation measures are signaling that stocks are expensive, but these are typically useful only over horizons beyond one or two years. As we flagged last month, stocks tend to do poorly in August and September, which may hurt returns over the next few weeks. The stronger euro will negatively impact earnings in the euro area. This has caused our models to suggest a slight downgrade to European equities. However, we are inclined to fade this signal, given our expectation that the euro will give up some of its recent gains. Japanese stocks continue to score well on our metrics, buoyed by strengthening corporate profits and attractive valuations. Emerging market equities are fairly valued, although China still appears cheap. The rally in U.S. Treasurys has caused the gap between the 10-year yield and our model's fair value estimate to widen to around 50 basis points, the highest since last September. European and Japanese bonds also look somewhat overvalued, although the latter will continue to receive support from the BoJ's yield curve targeting operations. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 30th, 2017. The model has continued to reduce its allocation to the U.S. driven by worsening liquidity condition, and it's the second consecutive month that the U.S. allocation is the largest underweight. Australia is downgraded to neutral on concern of valuation. Germany and Netherland continued to receive more allocation and Canada's underweight is reduced as well, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 18 bps in August, entirely due to the 43 bps outperformance of Level 2 model where the overweight in Italy and Germany versus the underweight in Japan, Spain and Canada worked very well. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of August 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model is optimistic on global growth and maintains in cyclical tilt. However, the magnitude of overweight in cyclical sectors has reduced on the back of momentum indicators. The biggest change has been utilities which has moved from a 2% underweight to a 1.7% overweight. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Feature Shrugging Off The Political Noise All the political noise of August (White House resignations, Charlottesville, North Korean missile launches, the looming U.S. debt ceiling) could do no more than trigger a minor market wobble: at the worst point, global equities were off only 2% from their all-time high. The reason is that global cyclical growth remains strong, earnings are accelerating, and central banks have no immediate need to turn hawkish. In such an environment, risk assets should continue to outperform over the next 12 months. The political risks will not disappear (and will no doubt produce further hair-raising moments), but they are unlikely to have a decisive impact on markets. BCA's geopolitical strategists think eventually there will be a diplomatic solution to the North Korean situation - albeit only after a significant further rise in tension forces the two sides to the negotiating table.1 It is hard to imagine the debt ceiling not being raised, since Republicans control both houses of Congress and the White House, and they would be blamed for any disruption caused by a failure to raise it. Recent personnel changes in the White House have left - for now - a more pragmatic "Goldman Sachs clique" in charge. We believe there is still a reasonable likelihood of tax cuts, not least since the Republicans are on track to lose a lot of seats in next year's mid-term elections unless they can boost the administration's popularity (Chart 1). Recent growth data has been decent. U.S. Q2 GDP growth was revised up to 3% QoQ annualized, and the regional Fed NowCasts point to 1.9-3.4% growth in Q3. If anything, growth momentum in the euro area (2.4% in Q2) and Japan (4%) is even better. Corporate earnings growth continues to accelerate too, with S&P 500 EPS growth in the second quarter coming in at 10% YoY, compared to a forecast of just 6% before the results season started. BCA's models suggest that, in all regions, earnings growth is likely to continue to accelerate for a couple more quarters (Chart 2). Chart 1Republicans Need A Popularity Boost Chart 2Earnings Continue To Accelerate The outlook for the dollar remains the key to asset allocation. The market currently assumes that the dollar will weaken further, as U.S. inflation stays low and the Fed, therefore, stays on hold. Futures markets currently price only a 38% probability of a Fed hike in December, and only 25 BP of hikes over the next 12 months. If markets are right, this scenario would be positive for emerging market equities and commodity currencies, and would mean that long-term rates would be likely to stay low, around current levels. But we think that assumption is wrong. Diffusion indexes for core inflation have begun to pick up (Chart 3). The tight labor market should start to push up wages, dollar deprecation is already coming through in the form of rising import prices, and some transitory factors (pre-election drugs price rises, for example) will fall out of the data soon. The Fed is clearly nervous that it has fallen behind the curve, especially since financial conditions have recently eased significantly (Chart 4). A moderate stabilization of inflation by December would be enough to push the Fed to hike again - and to reiterate its plan to raise rates three times next year. Chart 3Inflation To Pick Up? Chart 4Financial Condition: Easy In The U.S., Tight In Europe Meanwhile, long-term interest rates in developed economies look too low given growth prospects (Chart 5). As inflation picks up, the Fed talks more hawkishly, and the dollar begins to appreciate again, rates are likely to move up in the U.S. and in the euro zone. Our view, then, is that the Fed will tighten faster than the market expects, long-term rates will rise and the dollar will appreciate. Equities might wobble initially as they price in the tighter monetary policy but, as long as growth continues to be strong, should outperform bonds on a 12-month basis. Our scenario would be positive for euro zone and Japanese equities, but somewhat negative for EM equities. Equities: We prefer DM equities over EM. Emerging equities have been boosted over the past 12 months by the weaker dollar and Chinese reflation. With the dollar likely to appreciate (for the reasons argued above), and a slowdown in Chinese money supply growth pointing to slower growth in that economy (Chart 6), we think EM equities will struggle over coming quarters. Meanwhile, there is little sign that domestic growth momentum is improving in emerging economies (Chart 7). Within DM, our underlying preference is for euro zone and Japanese equities. Our quants model now points to an underweight for the U.S. We haven't implemented this yet because 1) of our view that the USD will strengthen, and 2) we prefer not to make too frequent changes to recommendations. We will review this in our next Quarterly. Chart 5Rates Lag Behind Global Growth Chart 6Slowing Chinese Money Growth Is A Risk For EM Chart 7EM Domestic Growth Anemic Text below Fixed Income: BCA's model of fair value for the 10-year U.S. Treasury yield (the model incorporates the Global Manufacturing PMI and USD bullish sentiment) points to 2.6%, almost 50 BP above the current level (Chart 8). We therefore expect G7 government bonds to produce a negative return over the next 12 months, as inflation expectations rise and monetary policy continues to "normalize". We still find some attraction in spread product, especially in the U.S. (Chart 9). While spreads are quite low compared to history, U.S. high-yield spreads remain 119 BP above historic lows, while euro area ones are only 65 BP above. Chart 8U.S. Rate Fair Value Is Around 2.6% Chart 9Credit Spreads Not At Record Lows Currencies: The euro has likely overshot. Long speculative positions are close to record levels (Chart 10) and the currency has returned to its Purchasing Power Parity level against the USD (Chart 11). An announcement of a "dovish" tapering of asset purchases by ECB President Draghi in September could persuade the market that the ECB will continue to be much more cautious about tightening than the Fed. The yen is also likely to weaken against the US dollar as global rates rise, since the BoJ will not change its yield curve control policy despite the better recent growth numbers, given how far inflation is still from its target. Chart 10There Are A Lot Of Euro Bulls Chart 11Euro Is No Longer Undervalued Commodities: Our forecast that a drawdown in crude inventories will push the WTI price back up is slowing coming about. U.S. crude inventories have fallen by 25.3 million barrels since the start of the year. The after-effects of Hurricane Harvey might affect the data for a while but, as long as global demand holds up, the crude oil price should rise further, with WTI moving over $55 a barrel by year-end. Metals prices have moved largely sideways year to date, and future movements depend mostly on the outlook for Chinese growth, which may begin to slow. In particular, the recent run-up in copper prices (which have risen by 20% since early June) seems unsustainable. The bullish sentiment was mostly due to short-term supply/demand imbalances caused by labor disruptions at some major mines. However, Chinese copper demand, especially for construction, is likely to weaken over coming months.2 Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Can Pyongyang Derail The Bull Market," dated 16 August 2017, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated 24 August 2017, available at ces.bcaresearch.com Recommended Asset Allocation

Highlights Copper's impressive rally leaves prices out in front of fundamentals. We are expecting a correction going forward, given our view that reduced mine output results from transitory disruptions, and China's growth appears to be stalling: industrial output, investment, retail sales, and trade all grew less than expected last month. Energy: Overweight. Crude oil prices remain fairly well supported this week on signs U.S. production growth may not be as strong as expected, and continued production discipline by OPEC 2.0 keeps global inventories from building too rapidly. We remain long Brent and WTI $50/bbl vs. $55/bbl call spreads in Dec/17, which are up 99.1% and 18.9%, respectively. Base Metals: Neutral. Copper prices appear to be getting out ahead of fundamentals, particularly as regards Chinese demand, which could stall on the back of slower economic growth. Precious Metals: Neutral. In line with our House view, we expect the Fed to remain dovish on the inflation front, which, over time, will mean the central bank finds itself behind the curve on inflation. This means real rates remain relatively low for the foreseeable future, which will be supportive of gold. Ags/Softs: Underweight. We remain bearish, although we are not aggressively shorting any of the ags. Feature Chart of the WeekCopper 2017H1: Exceptional Performance Copper futures traded on COMEX rallied by almost 10% from the beginning of May, when spot was trading just under $2.50/lb, until late July, then shot up by an additional 9% on news of a potential ban on scrap imports by China; 4% of that increase was recorded on July 25 alone (Chart of the Week). Spot copper settled at $2.9865/lb Tuesday. Part of this rally can be put down to a renewed focus on China's environmental policies, which we expect to continue following the 19th National Congress of China's Communist Party later this year, and the better-than-expected performance of the Chinese economy in 2017H1. This occurred as supply side disruptions at some of the world's largest copper mines caused markets to discount possible near-term shortages, along with rumors of an import ban on so-called Category 7 scrap metals. These stories supercharged the copper market. Supply/Demand Imbalances Are Transitory While labor-related disruptions at major copper mines led to a production cutback in 2017H1, supply has, for the most part, recovered. Furthermore, these are one-off events that we do not foresee persisting or having a lasting impact on markets.1 Production of copper ores and concentrates fell a negligible 0.1% year-on-year (yoy) in H1, following a 6.7% yoy increase in global output in 2016. Year-to-date (ytd) production growth lies significantly below the 5.63% average for the same period 2013-2016 (Chart 2). Similarly, in a marked slowdown from the four-year average growth of ~ 4% yoy in refined copper production, output remained largely unchanged in the first 4 months of 2017 compared to last year. However, there is evidence of relief in May and June, which registered a 6.08% yoy increase in output. The slowdown in production is mainly driven by supply-side shocks at some of the world's largest mines in Chile, Peru, and Indonesia. Contract Renegotiations and Weather Disruptions in Chile: The respective 1% and 6.6% yoy fall in global ores and concentrates output in February and March can be attributed to a corresponding year-on-year 17% and 23% declines in production from Chile - the world's leading copper producer. At BHP Billiton's Escondida mine, the world's largest, 2,500 workers staged a 43-day strike over contract renegotiations, which ended without resolution in late March. Although the end of the strike has brought relief to copper output, talks will resume in 18 months, raising the possibility of another strike - and an accompanying production cut - in a year's time. However, President Marcelo Castillo has somewhat calmed these worries, expressing his intent to revise the mine's operating model so that it will be minimally impacted by such disputes in the future. The decline in Chilean output was compounded by heavy snow and rain in May, which forced the Caserones mine to halt production for three weeks. This was reflected in a ~ 1.7% yoy decline in national output in May. Caserones has since resumed production and is now reported to have reached 90% of capacity. Nationwide Strikes in Peru Not Expected to Show up in July Data: Labor reforms proposed at the end of July led to a three-day walk-out by unionized workers across Peru. The strike impacted operations at major deposits including Antamina, Cerro Verde, Cuajone among others. However, according to the National Society of Mining, Petroleum and Energy, absenteeism was insignificant and the impact on copper output was limited. This followed a five-day strike at Cerro Verde - Peru's second largest mine - in March due to dissatisfaction with labor conditions. Peru ramped up output by almost 25% in 2015, surpassing China as the second largest producer of copper, and accounted for 11.4% of global output in 2016. Dispute Over Export Rights and Worker Dissatisfaction at Grasberg: In an effort to promote its domestic smelting industry, Indonesian authorities imposed a temporary ban on exports of copper concentrates in January. However, in April, Freeport McMoRan was granted an eight-month license to resume exports from its Grasberg mine - the second largest in the world. Furthermore, CEO Richard Adkerson expressed confidence that Freeport will succeed in securing an agreement by October, allowing it to implement a major multi-billion-dollar underground mine development plan. Labor unrest remains a problem for the company, nonetheless. Angered by redundancies and enforced furloughs, a strike by 5,000 workers was extended for a fourth month, until the end of August. Output data until May shows production remained largely unchanged compared to last year and follows a 3.82% yoy increase in Q1. Indonesian output accounted for 3% of global copper production in 2016. This will have to be resolved for the company's development plans to proceed unchallenged. Despite these supply-side shocks and ensuing Q2 inventory draw, copper remains well stocked at the major warehouses (Chart 3). Furthermore, COMEX inventories are at their highest level since 2004. As long as the global market remains well stocked, we expect it will be capable of withstanding volatility induced by labor markets and government policy with minimal impacts on prices. Chart 2Supply Disruptions Subsiding,##BR##Copper Market Back In Balance Chart 3Copper Inventories##BR##Can Withstand Volatility Scrap Imports Kick In Amidst Elevated Prices Chart 4China Copper Demand Weakening A dip in Chinese demand was also partly to blame for the minimal impact of the production cutbacks on inventories. Chinese consumption single-handedly makes up ~ 50% of global copper demand. The 1.46% yoy decline in global refined copper consumption during 2017H1 is, in large part, due to a 4.57% yoy drop in Chinese consumption (Chart 4). In fact, consumption during February and April fell 10% and 11%, respectively. Weak demand is also evident in China's import of copper ores and concentrates data. Although imports grew by 2.72% yoy in 2017H1, this is a marked slowdown from the 33.66% growth rate witnessed during the same period last year, and the average H1 growth of 22.6% since 2012. Similarly, China's imports of refined copper, copper alloy, and products fell 18.32% yoy in 2017H1 before increasing by 8.33% yoy last month. However, it appears that scrap copper may have helped fill the void - China's imports of copper scraps and wastes increased by 18.56% in the first half of this year compared to the same period last year. This marks a turning point in the trend, as copper scrap imports have been on the decline since 2013, and is likely a direct result of speculation over the impact of China's environmental policies on base metals. China's Scrap Import Ban: Overplayed Last week, China confirmed intentions to ban some forms of scrap copper imports beginning as early as the end of the year. This is part of measures taken to support sustainable growth and environmental protection. While rumors swirled in late July suggesting "Category 7" (i.e. old) scrap copper would be included in the import ban, the list of banned waste imports released last week by the Ministry of Environmental protection did not include copper. However, copper scrap from automobiles, ships and electronic devices were included in a "limited import" category, with no further details of the import constraints to be imposed on these products. Scrap impacts the copper market in two main ways: It provides smelter-refineries an alternative input, in addition to ores and concentrates, thus enhancing total refined copper supply. The International Copper Study Group (ICSG) estimates global production of refined copper increased by 2% in January due to increased production from scrap, which rose by 13% yoy. It acts as a substitute for refined copper, providing first-stage manufacturers a lower-cost alternative input. This means that when prices are up, as they have been since late 2016, the impact on refined copper production is somewhat muted because scrap usage kicks in (Chart 5). Furthermore, because of this response, the effect of supply-side shocks on refined copper output are - to some extent - restrained. Chart 5Scrap Imports Kick In When Prices Are Up This explains why the market has been in somewhat of a frenzy since late July after hearing that the Chinese authorities will likely implement an import ban on some types of scrap copper, which caused copper prices to jump to levels last seen in 2015Q2. Copper futures traded on COMEX have rallied by 10% from the beginning of May to late July, then shot up an additional 9% on rumors of an import ban; 4% of that increase was recorded on July 25 alone. Markets are clearly buying into the news, and are optimistic the ban will hike demand for other forms of copper. However, we believe this optimism is unfounded, and that the impact on copper markets is overplayed. Although the ICSG estimates that ~ 30% of annual copper usage comes from 'secondary' or recycled sources, a much smaller ratio originates from 'old' scrap copper. This type of scrap is derived from end-of-life electronics, households, cars, and industrial products. While data on old-scrap copper supply is not readily available, researchers at Antaike estimated that out of the 3.35mm MT of scrap copper imports in 2016, old-scrap copper imports made up ~ 0.3mm MT of copper-equivalent. This accounts for a very small fraction of China's 17.05mm MT of imports of copper ores and concentrates and 4.94mm MT imports of refined copper last year. Thus, even if a ban on all old-scrap copper were to materialize, we do not believe it will create a supply deficit, or even threaten one. In addition, there has been speculation that a ban would reroute old scrap metal to other countries for dismantling and processing before being imported by China, diminishing its impact on the copper market. Given that the market's reaction to news of the ban has been favorable, we expect to see a correction as the market responds to information that the ban is less bullish than expected. Chinese Demand Will Ease As Tailwinds Die Down In 2017H1, China surprised with better-than-expected economic performance, which supported copper prices. China's infrastructure and equipment industries are especially important to the copper market, consuming, respectively, 43% and 19% of the red metal domestically. However, as our colleagues on BCA Research's China desk foresaw, recent data gives some early-warning signs of a slowdown in growth.2 Industrial output, investment and retail sales figures came in below expectations amid a cooling property market. Furthermore, restrictions on riskier types of lending will continue slowing credit growth going forward. The property market - residential and commercial construction - accounts for ~ one-third of copper consumption. After reaching three-year highs late last year, the official manufacturing PMI and the Keqiang index - both used as key measures of the state of China's economy - show evidence that the economy is stabilizing (Chart 6). In fact, the Keqiang index has come down significantly from its peak earlier this year. In particular, signs of cooling in China's property sector are playing into the possibility of weaker industrial metals generally. Steel-making commodities and base metals have been in high demand ever since China relaxed housing policies, reviving the property market. However, in an effort to cool this market, Chinese authorities announced measures to raise down payments and control speculative buying in 20 cities last September. These measures are beginning to show up in property-market construction and sales data (Chart 7). Chart 6Early Warning Signs Of China Slowdown Chart 7China Property Sector: Cooling New floor space started contracted by almost 5% yoy in July, potentially signaling early warning signs of what could come ahead. It marks a reversal of a 10.55% expansion in 2017H1. New floor space completed declined in July, registering a 13.54% fall yoy. This follows 5% growth in 2017H1 - a marked slowdown from the 20.05% pace of growth in 2016H1. Furthermore, floor space under construction has been steadily easing, growing just 3.17% yoy in July. In terms of floor space sold, July's yoy growth of 2% follows a 21.37% yoy growth rate in June, and marks a pronounced slowdown from the 15.82% average yoy growth rate in 2017H1. Chart 8China's Economic Structure##BR##Deviates From Trend While near term growth does not appear to be threatened, earlier this month the IMF warned against China's "reliance on stimulus to meet targets," and a "credit expansion path that may be dangerous," which could cause a medium-term adjustment. When this eventually weighs down on industrial activity - as we expect - it will reverberate throughout the economy, discouraging investment projects, and eventually taking its toll on commodities generally, base metals in particular. Even so, in a small change of pace, China's share of secondary sector (i.e. manufacturing) as a percent of GDP crept up in July (Chart 8). This is a deviation from the trend in the evolving structure of China's economy, where the tertiary sector (services) has been making up an increasing share of GDP. While it is still too early to determine whether this is the beginning of a change in trend, or a one-off case, this development is positive for metals short term, since manufacturing activity is industrial-metal intensive. Bottom Line: We expect a correction in copper prices near term, as markets adjust to revelations that the market impact of China's environmental policies is less than expected. Our longer-term outlook is neutral: The synchronized economic upturn in global demand will partially offset waning economic activity in China, as tailwinds from accelerating export growth and easing monetary conditions die down. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 We discuss some of these developments during 2017Q1 in BCA Research's Commodity & Energy Strategy Weekly Report "Copper's Price Supports Are Fading," published by March 23, 2017. It is available at ces.bacresearch.com. 2 Please see BCA Research's China Investment Strategy Weekly Report titled "China Outlook: A Mid-Year Revisit", dated July 13, 2017, It is available at cis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Strong corporate earnings growth will drown out worries about North Korea. Stay cyclically overweight global equities. Underlying wage growth in the U.S. is stronger than the official data suggest. Surveys point to a further acceleration in U.S. wages, as do pay gains at the lower end of the income distribution. Labor's share of income will resume its cyclical recovery. This will lead to more consumer spending, and ultimately, higher price inflation. Wage growth elsewhere in the world will also pick up as labor slack declines. Global fixed-income investors should underweight duration and increase exposure to inflation-linked securities. Feature Focus On Corporate Earnings, Not Korea Chart 1EPS Estimates Have Remained ##br##Resilient This Year Global equities dropped over the past few days on the back of rising risks of conflict in the Korean peninsula. Our geopolitical strategists believe that neither the U.S. nor North Korea will launch a preemptive strike.1 Despite its bluster, North Korea has a history of rational action. It wants a nuclear deterrent and a peace treaty. The U.S. has forsworn regime change as a policy goal. China has recommitted to new sanctions and the South is pro-engagement. This raises the likelihood that a diplomatic solution will be found. Unfortunately, getting from here (open hostilities) to there (negotiated solution) will take time, which leaves the door open to increased market volatility. Nevertheless, we expect any selloff to be short-lived, owing to the positive earnings picture. More than anything else, strong profit growth has underpinned the cyclical bull market in stocks, and we expect this to remain the case over the coming months. More than 80% of S&P 500 companies have reported Q2 results. Based on these preliminary numbers, EPS appears to have increased by 11% over the previous year, marking the fourth consecutive quarter of margin expansion. The strength has been broad based, with all eleven sectors reporting positive growth. U.S. earnings estimates for both 2017 and 2018 have remained steady since January, bucking the historic pattern of downward revisions throughout the course of the year (Chart 1). The picture is even more impressive outside the U.S., where earnings estimates continue to move higher. The Euro STOXX 600 is now expected to deliver EPS growth of 12.6% this year. EPS of stocks listed on the Japanese Topix is expected to rise 14.8% this year and 7.3% next year, giving them an attractive 2018E P/E of 13.6. We recommend overweighting euro area and Japanese stocks over their U.S. counterparts in currency-hedged terms. EM stocks have seen the strongest positive earnings revisions this year. We continue to worry about some of the structural headwinds facing emerging markets (high debt levels, poor governance, etc.). However, the cyclical picture remains more upbeat. Chinese H-shares remain our favorite EM market, trading at just 7.5 times 2017 earnings estimates. The U.S. Labor Market Gets A JOLT, But Where's The Wage Growth? The Job Openings and Labor Turnover Survey (JOLTS) released on Tuesday provided more good news about the state of the U.S. labor market (Chart 2). The number of job openings rose to 6.2 million in June. There are now 28% more unfilled jobs in the U.S. than at the prior peak in April 2007. The number of unemployed workers per job opening fell to 1.1, the lowest level in the history of the series. One might think that with numbers like these, wage growth would be skyrocketing. Yet, it is not. While monthly average hourly wages did surprise to the upside in the June payrolls report, the year-over-year change remained stuck at 2.5%. This week's productivity report showed that compensation per hour increased by only 1% in Q2 relative to the same period in 2016. Other measures of wage growth generally point to some softening this year (Chart 3). Chart 2More Good News For The U.S. Labor Market Chart 3U.S. Wage Growth Remains Soft Many commentators regard the lackluster pace of wage inflation - coming at a time when the unemployment rate has fallen below its 2007 lows - as a "mystery" that needs to be solved. As we argue in this report, there is less to this mystery than meets the eye. Properly measured, underlying wage growth in the U.S. has been rising for some time, and may actually be stronger than the "fundamentals" warrant. Wage inflation elsewhere in the world is more subdued. However, this is largely because progress towards restoring full employment has been slower outside the U.S. Is Wage Growth Being Mismeasured? How can U.S. wage growth be characterized as "strong" when it is still so weak by historic standards? Part of the answer has to do with that old bugbear: measurement error. Low-skilled workers have been re-entering the labor force en masse over the past few years, after having deserted it during the Great Recession. This has put downward pressure on average wages, arithmetically leading to slower wage growth. Most of the official wage series, including the Employment Cost Index, do not adjust for this statistical bias.2 In a recent research report, economists at the San Francisco Fed concluded that "correcting for worker composition changes, wages are consistent with a strong labor market that is drawing low-wage workers into full-time employment."3 In addition to cyclical factors, demographic shifts have depressed official measures of wage inflation. Historically, population aging has pushed up average wages because older workers tend to earn more than younger ones. The retirement of millions of well-paid baby boomers over the past few years has reversed this trend, at least temporarily. Chart 4 shows that the median age of employed workers has fallen for the past three years, the first time this has happened since the 1970s. Weak Productivity Growth Dragging Down Wages Unfortunately, there is more to the story than measurement error. Today's young workers are not better skilled or educated than those of previous generations. This, along with other factors that we have discussed extensively in past reports, has dragged down productivity growth.4 Nonfarm productivity has increased at an average annualized pace of less than 1% over the past few years, down from 3% in the early 2000s (Chart 5). Slower productivity growth gives firms less scope to raise wages. In fact, for all the talk about how wages are stagnant, real wages have risen by more than productivity since 2014. This has pushed labor's share of income off its post-recession lows. Chart 4Median Age Of Workers No Longer Rising Chart 5Real Wages Have Increased Faster ##br##Than Productivity Over The Past Few Years It remains to be seen whether the structural downtrend in the share of income going to labor will be reversed. One can make compelling arguments for both sides of the issue.5 But over a cyclical horizon of one-to-two years, it is highly likely that labor's share will rise. Labor's share of income is fairly procyclical. It increased significantly in the late 1990s and rose again in the years leading up to the Great Recession. Considering how low unemployment is today, it is not unreasonable to assume that it will maintain its cyclical uptrend. If so, this will lead to more consumer spending, and ultimately, higher inflation. Surveys Point To Faster Wage Growth... Surveys such as those conducted by the National Federation of Independent Business, Duke University/CFO Institute, National Association for Business Economics, and various regional Federal Reserve banks suggest that employers are becoming increasingly willing to raise compensation in order to fill vacancies (Chart 6). Workers, in turn, are becoming more choosy. This can be seen in an improving assessment of job availability and a rising quits rate. Both of these measures lead wage growth (Chart 7). Chart 6ASurveys Show Employers More Willing To Raise Compensation Chart 6BSurveys Show Employers More Willing To Raise Compensation Chart 7Workers Are Feeling More Confident ...As Do Wage Gains Among Low-Income Workers Median weekly earnings of low-income workers have accelerated this year, even as wage gains among higher-income workers have hit an air pocket (Chart 8). For example, restaurant workers have seen pay hikes of nearly 5% this year, up from 1% in 2014. Wage growth among lower-income workers tends to be less noisy than for higher-income workers. The incomes of better-paid workers are often influenced by bonuses and other variables that may be driven more by industry-specific or economy-wide profit trends rather than labor slack per se. Less-skilled workers are usually the first to get fired and the last to get hired. Thus, wage pressures at the lower end of the skill distribution often coincide with an overheated labor market. This makes the trend in lower-income wages a more reliable gauge of underlying labor market slack. Wage Inflation Will Slowly Pick Up As Global Slack Diminishes We expect U.S. wage growth to rise over the next few quarters by enough to allow the Fed to raise rates in line with the dots. However, a more rapid acceleration - one that forces the Fed to raise rates aggressively - is improbable, at least over the next 12 months. This is mainly because the relationship between domestic labor market slack and wage growth is not as tight as it once was. Trade unions have less clout these days, which means it takes longer for a tight labor market to produce larger negotiated pay hikes. The labor market has also become less fluid, as evidenced by the structural decline in both the rate of job creation and job destruction (Chart 9). Wages tend to adjust more slowly when there is less hiring and firing going on. Chart 8Better Pay For Low-Wage Earners: ##br##A Sign Of A Tighter Labor Market Chart 9Structural Declines In Job Creation##br## And Destruction Perhaps most importantly, an increasingly globalized workforce has given firms the ability to move production abroad in response to rising wages at home. This suggests that wage growth in the U.S. is unlikely to increase significantly until falling unemployment begins to push up wages abroad. Wage Growth Around The World For now, wage growth in America's trading partners remains subdued. Euro area wage inflation is stuck between 1% and 1.5%, although with important regional variations (Chart 10). Wage inflation has accelerated to over 2% in Germany, but is still close to zero in Italy and Spain. Considering that unemployment in both countries remains well above pre-recession levels, it will be difficult for the ECB to tighten monetary policy to any great degree over the next few years. Japanese wage growth has picked up since 2010, but is still below the level consistent with the BoJ's 2% inflation target (Chart 11). Wage inflation is likely to ratchet higher over the next few years, now that the ratio of job openings-to-applicants has risen to the highest level since 1974 (Chart 12). In a sign of the times, Yamato Transport, Japan's largest parcel delivery company, recently told Amazon that it would not be able to make same-day deliveries due to a shortage of available drivers. Chart 10Euro Area Wage Growth Remains ##br##Weak Outside Of Germany Chart 11Modest Pickup In Japanese Wages Wage growth in Canada has actually declined since 2014. However, that is likely to change given that the unemployment rate has fallen close to nine-year lows. Falling unemployment rates should also boost wage inflation in the U.K., Australia, and New Zealand. Chinese wage growth also remains brisk. Chart 13 shows that urban household future income confidence has picked up notably of late, as growth has improved and the labor market has tightened. Chart 12Job Openings Ratio Will Push Wages Higher Chart 13Optimism Over The Labor Market In China Faster Wage Growth Will Ultimately Lead To Higher Inflation Chart 14The Decline In Inflation Expectations ##br##Have Weighed On Wage Growth Going forward, the combination of falling labor slack abroad and an overheated labor market at home will cause U.S. wage inflation to increase more rapidly starting in the second half of 2018. This will be a break from the past. Lower longer-term inflation expectations have tempered nominal wage growth over the past eight years (Chart 14). Both market-based inflation expectations and inflation expectations 5-to-10 years out in the University of Michigan's survey have fallen by about half a point since the financial crisis. The recent decline in headline CPI inflation from 2.7% in February to 1.6% in June may also explain why wage growth has dipped this year even as payroll gains have rebounded. Rising wage growth could begin to feed on itself. As we have discussed before, the Phillips curve tends to steepen once an economy reaches full employment (Chart 15). If the unemployment rate falls from 7% to 6%, this is unlikely to have a huge effect on wages. But if it falls from 4.5% to 3.5%, the effect could be substantial. A recent Fed paper concluded that "evidence strongly suggests a non-linear effect of slack on wage growth and core PCE price inflation that becomes much larger after labor markets tighten beyond a certain point."6 The implication is that once inflation does start rising, it could rise more quickly than investors (or the Fed) expect. Concluding Thoughts The past three U.S. recessions were all caused by the unravelling of financial sector and asset market excesses: The housing bust lay the groundwork for the Great Recession; the collapse of dotcom stocks ushered in the 2001 recession; and the failure of hundreds of banks during the Savings and Loan crisis paved the way for the 1990-91 recession. Unlike the last few recessions, the next one may end up being more akin to those of 1960s, 70s, and 80s. Those earlier recessions were generally triggered by aggressive Fed rate hikes in the face of an overheated economy and rising inflation (Chart 16). Chart 15The Phillips Curve Appears To Be Non-Linear Chart 16Are We Heading Towards A "Retro-Recession"? The good news is that neither wage nor price inflation is likely to soar over the next 12 months. This means that the bull market in global equities can continue for a while longer. The bad news is that complacency about inflation risk is liable to cause central bankers to fall increasingly behind the curve. Rising inflation will force the Fed to pick up the pace of rate hikes in the second half of 2018. This is likely to lead to a stronger dollar and higher Treasury yields. The resulting tightening in U.S. financial conditions could trigger a recession in 2019 or 2020. Investors should remain overweight risk assets for now, but prepare to scale back exposure next summer. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy Special Report titled "North Korea: Beyond Satire," dated April 19, 2017. 2 Unlike the widely followed average hourly wage series published every month in the payrolls report, the quarterly Employment Cost Index (ECI) does control for shifts in the weights of different industries in total employment. Thus, an increase in the relative number of low-paid hospitality workers would depress average hourly wages, but would not affect the ECI. Nevertheless, the ECI does not control for the possibility that the composition of the workforce within industries may change over time. The Atlanta Fed's Wage Tracker does overcome this bias because it uses the same sample of workers from one period to the next. However it, too, is subject to a number of methodological problems. 3 Mary C. Daly, Bart Hobijn, and Benjamin Pyle, "What's Up with Wage Growth?" FRBSF Economic Letter 2016-07 (March 7, 2016). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016; and The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education and Growth In The 21st Century," February 24, 2011. 5 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; and The Bank Credit Analyst Special Report, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June, 2014. 6 Jeremy Nalewaik, "Non-Linear Phillips Curves With Inflation Regime-Switching," Federal Reserve Board, Finance and Economics Discussion Series 2016-078 (August 2016). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades