Labor Market

Highlights BCA's call is that the robust labor market will boost wages and incomes, and insulate the consumer from rising energy costs and interest rates. Residential investment will add to GDP growth this year and support housing-related investments. Q1 results for S&P 500 earnings and revenues are exceeding raised expectations amid increase in tariff talk. Feature Last Friday's employment report shows a strong U.S. labor market with moderate wage pressures. The Fed can continue with a leisurely pace of rate hikes, which do not disrupt risk assets. The U.S. economy added 164,000 of net new jobs in April. Taking into account the 30,000 upward revision to the prior months, the increase in payrolls was in line with the consensus forecast of 195,000. With the 3-month moving average at 208,000 the pace of jobs growth is running comfortably above the trend growth in the labor force. This is reflected in the unemployment rate dropping from 4.1% to a new cyclical low of 3.9%. The jobless rate is nearing the 3.8% low seen during the height of the tech bubble in 2000. Even though the pace of jobs growth is strong and the unemployment rate is probing new lows, wage gains remain moderate. Average hourly earnings increased by just 0.1% m/m in April. Moreover, last month's gain was revised down to 0.2% m/m from an initially reported 0.3% m/m. As a consequence, the annual rate of wage inflation has slowed slightly to 2.6% from a recent high of 2.8% in January. The underlying trend in wage inflation is higher, but it is fairly shallow (Chart 1). The April employment report is "Goldilocks" for U.S. equities. The labor market is strong and the economy is growing about 3%. With modest wage and inflation pressures, there is no need for the Fed to turn more aggressive to cool a rapidly overheating economy. The modest trajectory of Fed rate hikes alongside modest income gains and stout consumer balance sheets will insulate the largest segment of the economy from higher interest payments and rising gasoline costs. Residential construction will also benefit from a gradual central bank, and housing-related assets are poised to outperform. Corporate profits can also continue to grow while the Fed maintains a gradual pace of rate hikes. The Q1 earnings and revenue reports for S&P 500 firms are outstanding. BCA's call is that the robust labor market will boost wages and incomes, and insulate the consumer from rising energy costs and interest rates. As we stated in our report on April 2,1 conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 2 shows that at 41.8%, household purchases of essentials as a percentage of disposable income are near all-time lows and have dropped by more than 1% since early 2013. In contrast, spending on necessities rose by a record 3% in the five years ending 2008. This matches levels reached at the end of the 1980s when interest rates, inflation and oil prices all soared. Wrenching consumer-driven economic downturns ensued after both episodes. Chart 1Another Goldilocks##BR##Jobs Report For U.S. Risk Assets Another Goldilocks Jobs Report For U.S. Risk Assets Another Goldilocks Jobs Report For U.S. Risk Assets Chart 2Consumer Is Not Stressed##BR##Despite Higher Energy Costs Consumer Is Not Stressed Despite Higher Energy Costs Consumer Is Not Stressed Despite Higher Energy Costs While investors remain concerned that rising rates and higher energy costs could derail the consumer and slow the economy, we take a different view. Energy represents 3.8% of consumers' spending on essentials while interest costs account for 15.9%. BCA expects that the Fed will continue to raise rates gradually in the next 12 months, in lockstep with the market's stance. However, we anticipate that the Fed will be more aggressive from mid-2019 through mid-2020 as inflation moves beyond the Fed's 2% target. BCA's U.S. Bond Strategy service notes that if we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will occur between 3.35% and 3.52%,2 roughly 35 to 50 bps higher than current levels. In previous research, we stated that a modest rise in rates would not be a burden on consumers.3 BCA's Commodity & Energy Strategy team forecasts that West Texas Intermediate oil prices will average $70/bbl. in 2018 and $64/bbl. in 2019. However, it also notes that tight balances in global oil make it likely those numbers will make excursions to $80/bbl.4 If production in Venezuela deteriorates more than expected or the supply in Iran or Libya is compromised, then oil could move beyond $80/bbl and, depending on the supply disruptions, to $90/bbl. Chart 3 shows that the consumer can easily withstand a rise in oil prices to $90/bbl. BCA's assumption is that natural gas and electricity prices will remain at current readings. Chart 3U.S. Consumer Is Well Insulated From Rising Energy Costs U.S. Consumer Is Well Insulated From Rising Energy Costs U.S. Consumer Is Well Insulated From Rising Energy Costs Bottom Line: Tighter labor markets and rising incomes will overcome rising interest rates and higher oil prices, and allow consumers to contribute to above-trend GDP growth. We see gradual upturns ahead for both oil prices and interest rates, but nothing so significant to trigger the collapse of consumer spending. Housing and housing-related assets will also flourish in the next year. Housing-Related Assets: An Update Residential investment will add to GDP growth this year and support housing-related investments. Chart 4 shows that housing in this cycle lagged previous slow-burn recoveries5 by a wide margin. Inventories of new and existing homes are near all-time lows, and the homeownership rate has turned higher alongside incomes and household formation (Chart 5). BCA's view is that escalating mortgage rates are not an impediment to housing construction. Nonetheless, housing did not contribute to economic growth in Q1 2018, but it did add 0.46% to real GDP in Q4 2017 as construction activity surged following last summer's hurricanes in Florida and Texas. Chart 4Residential Investment's Share##BR##Of GDP Has Lagged Prior Long Cycles Residential Investment's Share Of GDP Has Lagged Prior Long Cycles Residential Investment's Share Of GDP Has Lagged Prior Long Cycles Chart 5Solid Housing##BR##Fundamentals In Place Solid Housing Fundamentals In Place Solid Housing Fundamentals In Place Chart 6 estimates the remaining pent-up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the gap implies an extra 1.35 million housing units. The equilibrium number of housing starts that cover underlying population growth, plus the units lost to scrappage, is estimated at about 1.4 million annually. If the household formation 'catch up' fully occurs in the next two years, which would add another 675,000 units per year, then total demand could be close to 2 million in each of the next two years. This compares with March's housing starts of 1.3 million. Clearly, this is an aggressive forecast, and we doubt starts will advance at this pace in the next few years, but it does suggest that housing construction is likely to perk up. Chart 6A Catch-Up Housing Construction##BR##Will Occur If This Gap Closes A Catch-Up Housing Construction Will Occur If This Gap Closes A Catch-Up Housing Construction Will Occur If This Gap Closes The above analysis suggests that residential investment will contribute to GDP growth this year and next. There are favorable implications for housing-related financial assets. We originally examined the implications of a rebound in residential construction activity in 2012.6 Our approach was to test the historical excess return performance of several financial assets as a function of key housing market variables. We concluded that housing-related financial assets were set to outperform their respective benchmarks in a bullish housing scenario in the following year (and beyond). Our original analysis is updated in this report, with a few modifications. First, we examine the relationship between key housing market variables and excess returns of housing-related assets since the onset of the U.S. economic expansion in June 2009, given the structural change in the housing market that occurred following the Great Recession. Secondly, our analysis is based on a more focused set of housing market indicators, given the relatively poor predictive power of new home sales and the months' supply of houses for sale following the crisis period on housing-related asset returns. Table 1 presents the list of housing-related assets that we examined,7 along with the key housing market variables used to forecast excess returns (and whether they were significant predictors in the post-crisis era). The table highlights that most of the variables contain useful information, with the exception of the two noted above, sales of new homes and inventories of unsold homes. The right-most column presents the share of excess returns explained by a composite model of the factors noted as significant for each asset that varies from a low of 14% to a high of 22%. Table 1Important Predictors Of Housing-Related Asset Excess Returns* (June 2009-December 2017) Stressing The Housing And Consumer Sectors Stressing The Housing And Consumer Sectors Charts 7 and 8 present a set of relatively conservative assumptions for the key housing market variables shown in Table 1, based on a rise in housing starts only modestly above the scrappage rate referred to in the previous section. We assume that house price appreciation and housing affordability are moderate due to further rate hikes from the Fed and mounting inflation. We also suppose that the homebuilders' confidence index stays flat, refi applications remain low linked to the uptrend in mortgage rates, and purchase applications rise in conjunction with housing starts. Chart 7A Set Of Conservative Assumptions... A Set Of Conservative Assumptions... A Set Of Conservative Assumptions... Chart 8...For Key Housing Market Variables ...For Key Housing Market Variables ...For Key Housing Market Variables Finally, Table 2 illustrates the predicted excess returns of housing-related assets in the coming 12 months, along with the annualized excess returns in 2017 and, for reference, in the entire sample period. It is important to note that excess returns of corporate bonds are presented relative to duration-matched government bonds, not a speculative- or investment-grade corporate bond aggregate. Table 2Excess Returns Of Housing-Related Assets* (%) Stressing The Housing And Consumer Sectors Stressing The Housing And Consumer Sectors Investors can draw several important conclusions from our analysis: All but one of the housing-related assets are expected to outperform their respective benchmarks in the next year, even given our conservative assumptions about the pace of gains in the housing market. Our model predicts outperformance for the three corporate bond assets (shown in Tables 1 and 2) relative to their respective corporate bond benchmarks, albeit only marginally in the case of investment-grade banks. Moreover, the model projects modest outperformance for agency MBS. With the exception of S&P 500 banks, the model's predicted excess returns are lower in the coming year than they have been on an annualized basis since the onset of the recovery. This highlights that housing-related assets have moved ahead at least some of the expected normalization in the housing market over the next few years. However, a full rise to our equilibrium estimate of 2 million starts during the next two years could potentially lead to an even larger outperformance than the model forecasts. Moreover, Charts 9A and 9B suggest that valuation will not be an impediment to the outperformance of housing-related assets. Chart 9AValuation Won't Be An Impediment... Valuation Won't Be An Impediment... Valuation Won't Be An Impediment... Chart 9B...For Housing Related Assets ...For Housing Related Assets ...For Housing Related Assets Bottom Line: Investors should look to housing-related assets as a source of potential outperformance in 6-12 months. The historical relationship between key housing market variables and the excess returns of these assets implies the latter is set to outperform, even given conservative assumptions about the housing factors. Stunning Results More than 80% of S&P 500 companies have reported Q1 results, and EPS and sales growth are well ahead of consensus expectations at the start of April. Moreover, the counter-trend rally in margins remains in place. We previewed the Q1 2018 S&P 500 earnings season earlier this year.8 82% of companies have released results so far, with 79% beating consensus EPS projections, which is well above the long-term average of 69%. Moreover, 76% have posted Q1 revenues that topped expectations, exceeding the long-term average of 56%. The surprise factor for year-over-year numbers in Q1 stands at a robust 7% for EPS and 1.5% for sales. The earnings surprise reading is well above the long-term average of 5%, while the sales surprise figure is right at the long-term average. Both the earnings and sales surprise figures are even more impressive given that analysts' views of Q1 results increased between the start of Q1 2018 and the actual Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, in effect lowering the bar for results. Table 3S&P 500: Q1 2018 Results* Stressing The Housing And Consumer Sectors Stressing The Housing And Consumer Sectors We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Even so, the results to date suggest that Q1 will be another quarter of margin expansion. Average earnings growth (Q1 2018 versus Q1 2017) is a stunning 26% with revenue growth at 8%. However, on a four-quarter basis, U.S. margins fell slightly in the fourth quarter. Still, they remain high on the back of decent corporate pricing power. Strength in earnings and revenues is broadly based (Table 3). Earnings per share rose in Q1 2018 versus Q1 2017 in all 11 sectors. EPS results are particularly stout in energy (84%), technology (35%), financials (30%), materials (30%) and industrials (25%). The technology, materials, real estate and industrial sectors likewise all experienced substantial sales gains (16%, 13%, 14% and 11% respectively). Excluding energy, S&P 500 profits in Q1 2018 versus Q1 2017 are still vigorous at 24%. BCA's U.S. Equity Strategy service introduced profit models for all 11 S&P 500 sectors in January.9 Optimistic managements have raised the bar significantly for 2018 results in the past few months (Chart 10). On October 1, 2017, before the GOP introduced the tax bill, the bottom-up estimate for the S&P 500's 2018 EPS growth stood at 11%. The assessment grew to 20% at the start of the earnings reporting season in early April. As of May 4, 2018, the figure climbed slightly to 22%. Moreover, the upward revisions are widespread. Calendar year 2018 EPS growth rate estimates in 10 of 11 sectors are higher today than at the start of October 2017. Chart 10High Bar For 2018... But Focus Will Quickly Turn To 2019 High Bar For 2018... But Focus Will Quickly Turn To 2019 High Bar For 2018... But Focus Will Quickly Turn To 2019 While the ebullience is linked to the tax bill, other factors such as solid global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. However, U.S. trade policy is a concern in several industries. Chart 11 shows that through April 27, 45 companies cited tariffs in their Q1 earnings calls, a jump from 5 in the Q4 2017 reporting season. The Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the latest Beige Book (April 18); there were only 3 mentions in the March edition.10 Analysts expect EPS growth to slow significantly in 2019 (9%) from the anticipated 2018 clip, which matches BCA's stance (Chart 12). However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in early 2020. Chart 11Plenty Of Tariff Talk##BR##In Q1 Earnings Calls Plenty Of Tariff Talk In Q1 Earnings Calls Plenty Of Tariff Talk In Q1 Earnings Calls Chart 12Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Strong S&P 500 EPS Growth Ahead, Will Start To Slow Soon Strong S&P 500 EPS Growth Ahead, Will Start To Slow Soon Bottom Line: EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data) and subsequently decelerate because of a modest margin squeeze as U.S. wage growth picks up (Chart 11). A slowdown in global growth will also crimp profit growth later this year. Incorporating the fiscal stimulus lifted the EPS growth profile relative to our previous forecast. Nonetheless, BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors and so far, corporate managements have exceeded the lofty projections. However, it may be more difficult to maintain in the second half of 2018. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", published April 2, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "A Signal From Gold?", published May 1, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's The Bank Credit Analyst Monthly Report from February 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely", published April 19, 2018. Available at ces.bcaresearch.com. 5 Please see BCA Research's The Bank Credit Analyst Monthly Report from March 2017. Available at bca.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report," U-3 Or U-6?," published February 13, 2012. Available at usis.bcaresearch.com. 7 Note that we have excluded fixed- and floating-rate home equity loan ABS from our list of housing-related assets because of a lack of data, as well as investment-grade REITs because of a very low degree of return predictability from key indicators of the housing market. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", published April 2, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," published January 16, 2018. Available at uses.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Short Term Caution Warranted", published April 23, 2018. Available at usis.bcaresearch.com.

Highlights The U.S. labor market is now at full employment and the plethora of fiscal stimulus coming down the pike could cause the economy to overheat. If the recent rebound in the U.S. dollar reverses, this will only add to aggregate demand by boosting net exports. There are two main scenarios in which the U.S. can avoid overheating while the value of the greenback resumes its decline: 1) The Fed tightens monetary policy by enough to slow growth but other central banks tighten monetary policy even more; 2) the U.S. is hit by an adverse demand shock that forces the Fed to back away from further rate hikes. Neither scenario can be easily discounted, but both seem unlikely. The first scenario assumes that the neutral real rate of interest is fairly high outside the U.S., when most of the evidence says otherwise. The second scenario ignores the fact that adverse demand shocks, even if they originate from the U.S., tend to become global fairly quickly. Weaker global growth is usually bullish for the dollar. This suggests that the dollar rally has legs. EUR/USD is on track to hit 1.15 over the coming months, but a plunge below that level is possible given that the dollar is one of the most momentum-driven currencies out there. For now, investors should favor DM over EM equities and oil over metals. Feature Running Hot More than a decade after the Great Recession began, the U.S. labor market is back to full employment (Chart 1). The headline unemployment rate stands at 4.1%, below the Fed's estimate of NAIRU. Broader measures of labor slack, such as the U-6 rate, the number of workers outside the labor force wanting a job, and the share of the unemployed who have quit their jobs, are also back to pre-recession levels. Most business surveys show that companies are struggling to fill vacant positions (Chart 2). Wage growth is picking up, especially among low-skilled workers, whose compensation tends to be more closely tied to labor slack than their better-skilled counterparts (Table 1). Chart 1U.S. Is Back To Full Employment U.S. Is Back To Full Employment U.S. Is Back To Full Employment Chart 2Survey Data Point To Higher Wage Growth Ahead Survey Data Point To Higher Wage Growth Ahead Survey Data Point To Higher Wage Growth Ahead Table 1Wage Growth Is Accelerating The U.S. Needs A Stronger Dollar The U.S. Needs A Stronger Dollar Despite its recent rebound, the broad trade-weighted dollar is still down nearly 7% since its December 2016 high. According to the New York Fed's macro model, a sustained decline in the dollar of that magnitude would be expected to boost the level of GDP by about 0.5%. This would be equivalent to a permanent 50 basis-point cut in interest rates in terms of its effect on aggregate demand.1 Not that long ago, market participants and numerous pundits expected the dollar to continue its slide. Net short dollar positions reached their highest level in nearly six years in mid-April, before moving lower over the past two weeks (Chart 3). "Short dollar" registered as the second-most crowded trade in the monthly BofA Merrill Lynch survey of fund managers that was conducted between April 6 and 12, behind only "long FAANG-BAT stocks."2 Chart 3Short Dollar Is A Crowded Trade The U.S. Needs A Stronger Dollar The U.S. Needs A Stronger Dollar The Fed's Dilemma This raises an obvious question. If the consensus view that so many market investors subscribed to only a few weeks ago turns out to be correct and the dollar does give up its recent gains, how is the Fed supposed to tighten financial conditions by enough to keep the economy from overheating? One response is the Fed could raise rates by enough to slow growth. If the dollar falls while this is happening, so be it. The Fed can always hike rates more quickly in order to ensure that the contractionary effect of higher interest rates more than offsets the stimulative effect of a weaker dollar. The problem with this answer is that the dollar is only likely to weaken if other central banks are tightening monetary policy as much or more than the Fed. Chart 4 shows that the dollar has generally moved in line with interest rate differentials between the U.S. and its trading partners. Chart 4Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials There is little scope for rate expectations to narrow at the short end of the yield curve if U.S. growth remains above trend for the remainder of the year, as we expect will be the case. This is simply because most other major central banks are in no hurry to raise rates. The ECB has effectively pledged not to raise rates until at least the middle of next year. The U.K. remains mired in a post-Brexit slump. The BoJ is nowhere close to meeting its 2% inflation target (20-year CPI swaps are still trading at 0.6%). There is some room for rate expectations to converge further along the yield curve. However, for that to happen, investors must come to believe that the gap in the neutral rate of interest between the U.S. and its trading partners will shrink. It is far from obvious that they will do so. The Neutral Rate Is Higher In The U.S. Than The Euro Area Consider a comparison between the U.S. and the euro area. A reasonable proxy for the market's view of the neutral rate is the expected overnight rate ten years ahead, which can be calculated using eurodollar and euribor futures. The spread currently stands at about 100 basis points in favor of the U.S., down from 150 basis points at the start of 2017. Taking into account the fact that market-based inflation expectations are somewhat lower in the euro area, the spread in real terms is close to 50 basis points. That is not a lot, considering all the reasons to suppose that the neutral rate is higher in the U.S.: U.S. fiscal policy is a lot more stimulative. The IMF expects the U.S. fiscal impulse, which measures the change in the structural budget deficit, to reach 0.8% of GDP in 2018 and 0.9% in 2019. The fiscal impulse in the euro area and most other economies is likely to be much smaller (Chart 5). While the U.S. fiscal impulse will fall back to zero in 2020-21 barring a fresh wave of tax cuts or spending increases, the difference in the structural fiscal balance between the U.S. and the euro area will still widen to a record high of 6% of GDP by then (Chart 6). It is this difference that determines the gap in neutral rates.3 The U.S. will feel decreasing private-sector deleveraging headwinds in the years ahead. Euro area private-sector debt, measured as a share of GDP, is above U.S. levels and still close to all-time highs. In contrast, U.S. private-sector debt is down by 18% of GDP from its 2008 peak (Chart 7). The demographic divide between the U.S. and the euro area will widen. A rising labor participation rate allowed the euro area's labor force to grow at virtually the same pace as the U.S. between 2000 and 2015 (Chart 8). However, now that the euro area participation rate is above the U.S., the scope for further structural gains in participation in the euro area are limited. Over the past two years, labor force growth in the euro area has fallen behind the United States. If this trend continues and labor force growth in the two regions converges to the underlying rate of growth in the working-age population, it could reduce euro area GDP growth by over 0.5 percentage points relative to U.S. growth. Slower GDP growth typically implies a lower neutral rate. Chart 5U.S. Fiscal Policy##br## Is More Stimulative U.S. Fiscal Policy Is More Stimulative U.S. Fiscal Policy Is More Stimulative Chart 6U.S. And Euro Area: Gap In Fiscal##br## Balances Will Hit Record Highs U.S. And Euro Area: Gap In Fiscal Balances Will Hit Record Highs U.S. And Euro Area: Gap In Fiscal Balances Will Hit Record Highs Chart 7Deleveraging Headwinds Will Be##br## Stronger In The Euro Area Than The U.S. Deleveraging Headwinds Will Be Stronger In The Euro Area Than The U.S. Deleveraging Headwinds Will Be Stronger In The Euro Area Than The U.S. Chart 8Slowing Euro Area Labor Force ##br##Participation Will Weigh On Growth Slowing Euro Area Labor Force Participation Will Weigh On Growth Slowing Euro Area Labor Force Participation Will Weigh On Growth When Things Go Sour If other major central banks find themselves hard-pressed to raise rates anywhere close to U.S. levels, how about the opposite case: The one where an adverse shock forces the Fed to cut rates towards overseas levels? Since interest rates in many other economies remain at rock-bottom levels, there is little scope for their central banks to cut rates even if they wanted to. In contrast, the Fed is no longer constrained by the zero bound, which gives it greater leeway to ease monetary policy. While such a scenario cannot be easily ruled out, it is mitigated by the fact that frothy asset markets in the U.S. have not produced large imbalances in the real economy. This stands in sharp contrast to the last two recessions. The Great Recession was exacerbated by a massive overhang of empty homes. The 2001 recession was aggravated by a huge overhang of capital equipment left in the wake of the dotcom bust. The surging dollar and increased Chinese competition also laid waste to a large part of the U.S. manufacturing base, necessitating a period of painful adjustment. Today, both the housing and manufacturing sectors are in reasonably good shape. This suggests that rates can rise further before growth stalls out. And even if the U.S. economy begins to flounder, it is not clear that this would lead to a weaker dollar. Remember that the U.S. mortgage market was the focal point of the Global Financial Crisis, and yet the dollar still strengthened by over 20% between July 2008 and March 2009. A recent IMF study concluded that changes in U.S. financial conditions have an outsized effect on growth outside the United States.4 Weaker global growth is generally good for the dollar (Chart 9). The old adage "When America sneezes, the rest of the world catches a cold" still rings true. If higher U.S. rates lead to a stronger dollar, this could put pressure on emerging markets. Similar to what transpired in the mid-to-late 1990s, a feedback loop could arise where rising EM stress causes the dollar to strengthen, leading to even more EM stress: A vicious circle for emerging markets, but a virtuous one for the greenback. Chart 10 shows that EM equities are almost perfectly inversely correlated with U.S. financial conditions. Chart 9Decelerating Global Growth Tends ##br## To Be Bullish For The Dollar Decelerating Global Growth Tends To Be Bullish For The Dollar Decelerating Global Growth Tends To Be Bullish For The Dollar Chart 10Tightening U.S. Financial Conditions Will Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Will Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Will Not Bode Well For EM Stocks Investment Conclusions The dollar is bouncing back. This week's FOMC statement caused the greenback to briefly sell off before it rallied back. We do not think the Fed's decision to include the word "symmetric" in describing its inflation target was as important as some observers believe. The Fed has stressed that it has a symmetric target for many years. If anything, the inclusion of the word could mean that the Fed now realizes that it is behind the curve in normalizing monetary policy and thus wants to prepare the market for the inevitable inflation overshoot. That could mean more rate hikes down the road, not fewer. As such, we expect the dollar to continue strengthening. Our Foreign Exchange Strategy team's intermediate-term timing model sees EUR/USD hitting 1.15 in the next three-to-six months (Chart 11). A plunge below this level is possible given that the dollar is one of the most momentum-driven currencies out there (Chart 12). Chart 11Euro Is Poised To Weaken Euro Is Poised To Weaken Euro Is Poised To Weaken Chart 12The Dollar Is A Momentum-Driven Currency The U.S. Needs A Stronger Dollar The U.S. Needs A Stronger Dollar Sterling should also edge lower against the dollar over the next few quarters. Our global fixed-income strategists remain bullish on gilts, reflecting their view that the market has been too hawkish about how many hikes the BoE can deliver over the next year. Over a longer-term horizon, the pound has upside against both the U.S. dollar and most other currencies. If a new Brexit referendum were held today, the "remain" side would probably win (Chart 13). Rules are made to be broken. It is the will of the people, rather than legal mumbo-jumbo, that ultimately matters. In the end, the U.K. will stay in the EU. The Japanese yen faces cyclical downside risks as global bond yields move higher, leaving JGBs in the dust. However, similar to sterling, the longer-term prospects for the yen are brighter. The currency is cheap and should benefit from Japan's large current account surplus and its status as a massive holder of overseas assets (Chart 14). Chart 13Bremorse Sets In Bremorse Sets In Bremorse Sets In Chart 14The Yen's Long-Term Outlook Is Bullish The Yen's Long-Term Outlook Is Bullish The Yen's Long-Term Outlook Is Bullish Emerging market currencies rallied between early 2016 and the beginning of this year, but have faltered lately (Chart 15). BCA's EM and geopolitical strategists expect the Chinese government to expedite structural reforms and take steps to slow credit growth and cool the bubbly housing market. We do not anticipate that this will lead to a proverbial hard landing, but it could put renewed pressure on commodity prices over the next few months. Metals are much more exposed to a China slowdown than oil (Chart 16). Correspondingly, we favor "oily" currencies such as the Canadian dollar over "metallic" currencies such as the Australian dollar. Chart 15EM Currencies Have Been ##br##Wobbling Of Late EM Currencies Have Been Wobbling Of Late EM Currencies Have Been Wobbling Of Late Chart 16Base Metals Are More Sensitive ##br##To Slower Chinese Growth Base Metals Are More Sensitive To Slower Chinese Growth Base Metals Are More Sensitive To Slower Chinese Growth As for risk assets in general, our model still points to near-term downside risks to global equities (Chart 17). However, we expect these risks to fade as global growth stabilizes at an above-trend pace. That should set the stage for a rally in developed market stocks into year-end. Chart 17MacroQuant* Model: Still Pointing To Moderate Downside Risks For Stocks The U.S. Needs A Stronger Dollar The U.S. Needs A Stronger Dollar Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Specifically, the New York Fed model says that a 10% depreciation in the dollar would be expected to raise the level of real GDP by 0.5% in the first year and by a further 0.2% in the second year, for a cumulative increase of 0.7%. A 7% decline in the dollar would thus translate into a 0.7*7 = 0.49% increase in GDP. Using former Fed chair Janet Yellen’s preferred specification of the Taylor rule equation, which assigns a coefficient of one on the output gap, a permanent 0.49% of GDP increase in net exports would have the same effect on aggregate demand as a permanent 49 basis-point decline in the fed funds rate. Assuming a constant term premium, this would also be equivalent to a 49 basis-point decline in long-term Treasury yields. 2 FAANG stands for Facebook, Apple, Amazon, Netflix, and Google. BAT stands for Baidu, Alibaba, and Tencent. 3 Conceptually, changes in the budget deficit drive changes in aggregate demand, whereas the level of the budget deficit drives the level of aggregate demand. One can see this simply by noting that aggregate demand is equal to C+I+G+X-M. A one-off increase in G temporarily lifts the growth rate in demand, but permanently increases the level of demand. The neutral rate is determined by the level of demand and not the change in demand because the neutral rate, by definition, is the interest rate that equalizes the level of aggregate demand with aggregate supply. 4 Please see “Getting The Policy Mix Right,” IMF Global Financial Stability Report, (Chapter 3), (April 2017). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Does the 3% level on Treasuries matter to investors? The 2/10 yield curve is typically much steeper when global growth is strong and pro-growth policies are in place. The imperfect inter-relationship between labor market slack, wages and inflation. Feature In last week's report1 we noted that the risk of weakness in equity markets was elevated in the near term. Risks assets balked as the 10-year Treasury yield climbed above 3% early last week. However, easing tensions on the Korean peninsula and another stronger than expected batch of Q1 earnings reports boosted U.S. equity prices later in the week. We will provide a full update on the Q1 earnings season in next week's report. Investors are getting used to a seasonal dip in Q1 U.S. GDP data, and last Friday's release certainly fits the bill. A recent study by the staff at the Federal Reserve Bank of Cleveland2 suggests that the main culprits in this seasonal anomaly are in the private investment and government consumption components of GDP. Output in both categories slowed significantly in Q1 2018. Consumer spending growth exhibited the most significant slow-down, growing at only 1.1% compared to 4% in the prior quarter. But growth in investment spending on equipment also declined sharply, from 11.6% to 4.7%, as did growth in residential investment, from 12.8% to 0% (Chart 1). The latter is due to the sharply accelerating input costs (e.g. lumber prices) faced by homebuilders at the moment. Federal government spending slowed to a 1.7% rate in Q1 from 3.2% in Q4 2017. Chart 1GDP Growth Remains Below Average, But Above Fed's Long Run Target The 3% Milestone The 3% Milestone At 2.9% year-over-year in Q1 2018, real economic growth was above the Fed's view of potential GDP (1.8%) for the fifth consecutive quarter. Given the recent seasonal pattern and the substantial fiscal stimulus coming on stream, the Fed will likely see through the weaker Q1 growth data for the time being. Chart 2Watch The 2.3% To 2.5% Level On TIPS Breakevens Watch The 2.3% To 2.5% Level On TIPS Breakevens Watch The 2.3% To 2.5% Level On TIPS Breakevens BCA's view is that the 3% level on the 10-Year Treasury yield is not an impediment to higher equity prices. The 10-year yield and U.S. equity prices climbed together in the 1950s. The rise in yields in the '50s primarily reflected better economic growth rather than fears of inflation. The run-up in yields since the lows last year reflect both factors (Chart 2). Nonetheless, investors are concerned that higher yields will flip the positive correlation between bond yields and stock prices. Charts 3 and 4 shows the link between the level of both nominal (Chart 3) and real bond yields and equity prices. The implication is that the relationship between stock prices and bond yields tends to stay positive when the nominal bond yield is below 5%. Furthermore, the correlation between real yields and stock prices remains positive (Chart 4). Moreover, since 1980, a move from 2% to 3% on the 10-year Treasury yield has been accompanied by an average gain of 1.2% in the S&P 500, with a median move of 1.8%.3 On average, the S&P 500 posted a modest decline (24 bps) as the 10-year Treasury elevated from 3% to 4%, but the median return (98 bps) was still positive. Our July 2015 Special Report4 explored the impact of rates and inflation on equity prices. Historically, even the move from 4% to 5% on the 10-year is not an impediment to higher stock prices. Chart 3Stock To Bond Correlations Remain Positive With Nominal Yields Below 5% The 3% Milestone The 3% Milestone Chart 4Both Equities And Real Bond Yields Reflect Growth Both Equities And Real Bond Yields Reflect Growth Both Equities And Real Bond Yields Reflect Growth Bottom Line: BCA's stance is that the stock-to-bond ratio will climb this year. Our U.S. Bond Strategy team pegs fair value on the 10-year at 2.78%, but notes that the yield may peak this cycle at between 3.25% and 3.50%.5 BCA's base case remains that U.S. equities will not be subject to an over-aggressive Fed until at least mid-2019 and that increasing bond yields are not a threat. Yield Curve Dynamics Does BCA's stance on the yield curve change our upbeat view on risk assets beyond the next few months of caution?6 In March,7 we discussed 5 episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policies were aligned to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. Risk assets perform well when these policy tailwinds are in place, but these assets tend to struggle for 12 months after the tailwinds abate. Although global growth has peaked,8 we expect the era of pro-growth policies to end next year as the Fed raises rates into restrictive territory. BCA expects the 2/10 curve to remain around 50bps until the inflation breakevens are re-anchored between 2.3% and 2.5% as upward pressure on the short end from Fed rate hikes is offset by the upward thrust of the breakevens on the long end.9 The curve should resume its flattening trend after that, but will not invert this year. The 2/10 curve stands at 45 bps as of April 27, 2018. Chart 5 shows that the curve has spent very little time in the 0-50 range in the past 35 years when fiscal, monetary and regulatory factors were aligned and global growth was positive. A steeper curve (50 to 100 bps) developed alongside a pro-growth policy and solid global growth only once in the past 35 years, over 1983 and 1984, and never when the 2/10 curve was between 0 and 100 bps (not shown). Chart 5The 2/10 Curve Is Usually This Steep When Pro-Growth Policies Are In Place The 2/10 Curve Is Usually This Steep When Pro-Growth Policies Are In Place The 2/10 Curve Is Usually This Steep When Pro-Growth Policies Are In Place Bottom Line: The backdrop of accommodative fiscal and monetary policy, attended by easing regulatory policy and positive global growth, will continue to provide a tailwind for risk assets through next year. However, the 2/10 yield curve is typically much steeper when these policies are all aligned. Thus, investors should continue to favor equities over bonds and remain underweight duration over the cyclical horizon with a tactical cautious stance over the next few months. The Wage Puzzle Chart 6Economy At Full Employment, Theoretically Economy At Full Employment, Theoretically Economy At Full Employment, Theoretically The move higher in the 10-year Treasury yield to 3% for the first time since 2013 (and the 2-year Treasury to 2.5% for the first time since 2008) has diverted attention to the Fed and inflation. Core CPI is now at the Fed's 2% target and the market is concerned that inflation will shoot past 2% and quickly escalate to 3%. BCA's view is that inflation will remain at the Fed's target this year, but drift above that goal in 2019, which would elicit a more aggressive response from the central bank. Tighter monetary policy will ultimately end the expansion in early 2020.10 Until then, the markets will focus on the drivers of inflation, including wages. Our work11 notes that inflation is slow to turn higher in long expansions. The U.S. economy reached full employment in late 2016 (Chart 6). In short- and medium-length expansions, it takes only a few months before inflation turns up. However, in long expansions (1960s, 1980s, and 1990s) prices did not turn meaningfully higher until 26 months after the economy reached full employment. This suggests that a more significant hike in inflation - led by a tighter labor market - is close and supports the recent rise in Treasury yields. There is mixed evidence that view is warranted. Wage inflation has moved higher in recent months, but the link between wages and prices has weakened. Chart 7 shows that before 1985, the correlation between wage growth and prices was above 90%. Since 1984, the relationship has waned. The post-1985 correlation is just under 30%. BCA expects this weaker relationship to persist. Chart 7Link Between Wage Inflation And Consumer Inflation Changed After 1985 Link Between Wage Inflation And Consumer Inflation Changed After 1985 Link Between Wage Inflation And Consumer Inflation Changed After 1985 The disconnect between labor market tightness and wages has recently widened. Chart 8 shows several measures of wage pressures and labor market slack. Historically, less slack translates into higher wages, but the relationship in this cycle has been muted. Moreover, pay gains for workers who switch jobs are running well ahead of those who stay in their current positions and are either promoted or given merit raises (Chart 9). The gap between compensation gains of job switchers and job stayers tends to broaden as the business cycle ages and slack in the labor market shrinks. Chart 8A Wide Disconnect Between Labor Market Slack And Wage Gains A Wide Disconnect Between Labor Market Slack And Wage Gains A Wide Disconnect Between Labor Market Slack And Wage Gains Chart 9Job Switchers Seeing Better Raises Job Switchers Seeing Better Raises Job Switchers Seeing Better Raises Demographics and wage rigidity dynamics are also at play. Chart 10 shows that the labor force participation rate is headed lower due to demographics, but recent trends suggest there may be improvements in the coming years. BCA's view is that the participation rate will be flat in the next 12 months and move lower in the coming decade. Chart 10Decline In Labor Force Participation Is Mostly Demographics Decline In Labor Force Participation Is Mostly Demographics Decline In Labor Force Participation Is Mostly Demographics Wage inflation is an early career phenomenon. Recent research from the Federal Reserve Bank of New York12 shows that across all education cohorts, rapid real wage growth occurs early in a worker's career, with positive real wage growth ending in his/her forties. This is followed by a period of flat to declining real wages. By age 55, all education categories experience negative real wage growth, on average (Chart 11). Chart 11Wage Inflation Is An Early Career Phenomenon The 3% Milestone The 3% Milestone Wage rigidity in this cycle suggests that there will be an upward correction in labor compensation. Chart 12 shows that 14.5% of workers did not have wage increases in 2017. Moreover, 18.9% of hourly workers and 9.2% of non-hourly workers saw no increase in pay in the year ending in December 2017 (Chart 13, top panel.) The bottom panel of Chart 13 shows that more than 20% of workers with less than a high school education received no pay increases in the past year; only 10% of college-educated workers experienced the same end. It is important to note that on balance, measures of wage rigidity have increased over time and are not overly sensitive to the business cycle. Chart 12More Than 14% Of Workers Didn't See A Raise In 2017 The 3% Milestone The 3% Milestone Chart 13Wage Rigidity By Type Of Employee Wage Rigidity By Type Of Employee Wage Rigidity By Type Of Employee Bottom Line: BCA recommends that investors monitor a broad range of inflation indicators. Historical evidence suggests that when the labor market tightens, inflation eventually accelerates. However, wages do not always lead inflation at bottoms and maybe a lagging indicator in this cycle.13 In long economic cycles (1980s and 1990s), wage inflation was a lagging indicator. Most of these indicators show that inflation pressures are building, but only gradually. We expect the Fed to raise rates gradually in the next 12 months, but it may turn more aggressive in 2019 as pressures on inflation, driven in part by a tighter labor market, begin to mount. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "Short-Term Caution Warranted," published April 23, 2018. Available at usis.bcaresearch.com. 2 https://www.clevelandfed.org/newsroom-and-events/publications/economic-commentary/2017-economic-commentaries/ec-201706-lingering-residual-seasonality-in-gdp-growth.aspx 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Yellen's Last Week," published February 5, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Special Report, "Stock-To-Bond Correlation: When Will Good News Be Bad News?", published July 6, 2015. Available at usis.bcaresearch.com. 5 Please see BCA U.S. Investment Strategy Weekly Report, "It's Still All About Inflation", January 16, 2018. Available at usis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Short-Term Caution Warranted," published April 23, 2018. Available at usis.bcaresearch.com. 7 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Line Up", March 12, 2018. Available at usis.bcaresearch.com. 8 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Peril?", April 9, 2018. Available at usis.bcaresearch.com. 9 Please see BCA U.S. Bond Strategy Weekly Report, "Back To Basics", April 17, 2018. Available at usbs.bcaresearch.com. 10 Please see BCA Research's Global Investment Strategy Weekly Report, "Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000", published March 30 2018. Available at gis.bcaresearch.com. 11 Please see BCA Research's The Bank Credit Analyst Monthly Report, March 2017. Available at bca.bcaresearch.com. 12 FRBNY: Liberty Street Economics, "U.S. Real Wage Growth: Slowing Down With Age," September 28, 2016. 13 Please see BCA Research's The Bank Credit Analyst, September 2017. Available at bca.bcaresearch.com.

Dear Client, Alongside this week's report we are also sending you a fascinating short Special Report written by Jennifer Lacombe of our Global ETF Strategy sister service. The report, which demonstrates the use of ETF flows as a leading indicator of FX trends, points to downside for the EUR/USD and GBP/USD this year. I trust you find the piece informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights A debate over slack is raging within the ECB. We tend to side with President Draghi, and believe there is more labor market slack in the euro area than suggested by the OECD's measures. Arguing in favor of this case is the presence of hidden labor market slack, the paucity of wage gains, even in Germany, and the potential for NAIRU to decline in many large economies. With global and European growth slowing, this will limit how hawkish the ECB can be in the short term, and thus limits the euro's gains in 2018. However, on a long-term basis, the presence of slack today argues that the euro area's potential GDP is higher than if there were no slack, and therefore policy rates and the euro have more long-term upside. Feature The recent release of the European Central Bank's account of its March policy meeting was very revealing. The ECB is currently torn between two camps: one believing there is little slack in the euro area labor market, and the other, led by ECB President Mario Draghi and chief economist Peter Praet, arguing that the continent's job market is still replete with excess capacity. This debate has enormous implications for the path of the euro. If there is no slack left in the euro area, this would point to an immediate need for higher rates and a higher euro, but it would also suggest the scope for the terminal policy rate in Europe to rise is limited. The long-term upside in the euro would therefore also be small. If there is still a large amount of slack in the euro area labor market, this implies that policy rates do not have much scope to rise over the next 18 months, and that the euro will find it difficult to appreciate much over this time frame. However, it also suggests that the potential growth rate of the euro area is higher than would otherwise be the case and that terminal policy rates can rise more in the long-run - implying that on a long-term basis the euro still has meaningful upside. We side in the latter camp. Chart I-1No Slack In Europe? No Slack In Europe? No Slack In Europe? Hidden Labor Market Slack... The question of slack in the euro area has been ignited by a simple reality: both the OECD's measure of the European output gap and the difference between the official unemployment rate and the equilibrium unemployment rate calculated by the OECD (NAIRU) are close to zero (Chart I-1). This observation would vindicate the desire of some ECB members to increase rates sooner than later, since the absence of an unemployment gap should lead to both higher wages and higher inflation. But before making too prompt a judgment, the U.S.'s recent experience is illuminating. Only now that the unemployment rate is 0.5% below NAIRU are U.S. wages and core inflation showing some signs of life (Chart I-2). In the U.S., we observed that while the headline unemployment rate has been consistent with accelerating wages as early as in 2015, discouraged workers back then represented 0.4% of the working age population, and were in fact willing participants in the job market. Only now that this number has fallen back to 0.27% - levels associated with full-employment in the previous business cycle - are employment costs perking up. There is little reason to believe that the eurozone economy is very different from the U.S. in this respect. In fact, the euro area suffered a double-dip recession, the second leg of which ended only in 2013, suggesting Europe suffered a severe enough shock to also fall victim to the symptoms of hidden labor market slack. A simple comparison helps illustrates that Europe is likely to still be experiencing labor market slack. Chart I-3 shows various measures of total and hidden labor market slack in the U.S. and the euro area. To begin with, despite a sharp rise in the female participation rate, the euro area's employment-to-population ratio for prime-age workers is not only well below the level that currently prevails in the U.S., it is also below its 2008 peak by a greater extent than is the case on the other side of the Atlantic. This suggests there is greater total labor market slack in Europe than in the U.S. Additionally, discouraged workers and long-term unemployment remain much closer to post-crisis highs in the euro area than in the U.S. In the latter, these ratios have mostly normalized close to levels consistent with full employment. Chart I-2The U.S. Experience WIth##br## Hidden Labor Market Slack The U.S. Experience WIth Hidden Labor Market Slack The U.S. Experience WIth Hidden Labor Market Slack Chart I-3The Euro Area Still Has ##br##Plenty Hidden Slack The Euro Area Still Has Plenty Hidden Slack The Euro Area Still Has Plenty Hidden Slack Looking at some euro area-specific variables also dispels the idea that the European job market is near full employment and about to generate inflation: The ECB's labor underutilization measure1 still shows a high level of slack, especially in the European periphery (Chart I-4). Another problem for Europe is irregular work contracts. Europe, like Japan, is plagued with a dual labor market. On one hand, permanent employees are still protected by generous employment laws. On the other hand, employees under temporary work contracts are not. In Japan, this same disparity has been blamed for keeping wages down, as temporary employees are often willing to switch to positions offering the protection of regular job contracts for no wage increases. These workers are a form of hidden labor-market slack. Temporary employment in Europe remains at elevated levels, and contract work represents a record share of employment in Italy and France (Chart I-5), suggesting the same disease present in Japan also lingers in vast swaths of the European economy. Chart I-4The ECB's Metrics Also Show ##br##Elevated Labor Underutilization The ECB's Metrics Also Show Elevated Labor Underutilization The ECB's Metrics Also Show Elevated Labor Underutilization Chart I-5A Dual Labor Market Weighs ##br##On Wage Growth A Dual Labor Market Weighs On Wage Growth A Dual Labor Market Weighs On Wage Growth Labor reforms could also be creating labor market slack in Europe. As Chart I-6 shows, after Germany implemented its Hartz IV labor reforms in 2004, NAIRU collapsed. Spain, which has implemented equally draconian measures, could also witness its own equilibrium unemployment rate trend sharply lower over the coming years (Chart I-6, bottom panel). In France, timid reforms were implemented during the Hollande presidency, but President Macron is pushing an agenda of deep job market reforms. While Italy remains a laggard and its current political miasma offers little hope, the reality remains that much of Europe could also be experiencing a decline in NAIRU like Germany did last decade. Even Germany shows limited signs of an overheating labor market, despite an unemployment rate of 5.3%, the lowest reading ever in re-unified Germany: not only have German wages been unable to advance at a faster pace than the experience of the past 15 years, recent quarters have seen a slowdown in wage growth (Chart I-7). The presence of slack in the rest of Europe therefore appears to be limiting wage pressures even in that booming economy. Chart I-6The Impact Of Labor Reforms##br## On Full Employment The Impact Of Labor Reforms On Full Employment The Impact Of Labor Reforms On Full Employment Chart I-7No Wage Growth##br## In Germany No Wage Growth In Germany No Wage Growth In Germany Bottom Line: The euro area is likely to be under the same spell as the U.S. was a few years ago. Traditional metrics portend a labor market at full employment, but broader measures in fact highlight that there is still plentiful slack. Additionally, the implementation of labor market reforms in key European economies in recent years could imply that Europe's NAIRU is lower than the OECD's estimate and may further decline in coming years. ... And Slowing Global Growth It is one thing for Europe to be experiencing hidden labor market slack, but if growth is set to accelerate further, this would mean that this slack could nonetheless dissipate fast enough to allow for a more hawkish ECB in the short run. However, this is not the case. The European economy is very sensitive to global growth gyrations, and signs are accumulating that the global synchronized boom is petering out. As we have already highlighted, the diffusion index of the OECD global leading economic indicator has plummeted well below the boom/bust line, pointing to a sharp slowdown in the LEI itself (Chart I-8, top panel). EM carry trades have been underperforming, which normally leads a slowdown in global industrial activity (Chart I-8, middle panel). Additionally, Japanese export growth is decelerating sharply (Chart I-8, bottom panel). In a previous report we attributed major responsibility for this slowdown to monetary, fiscal and regulatory tightening in China. Europe is not immune to this malaise. European exports growth and foreign orders are all slowing sharply, but interestingly domestic factors are also at play. As the top panel of Chart I-9 illustrates, the European credit impulse is now contracting, suggesting domestic demand is set to slow. In fact, this has already begun as the growth of German domestic manufacturing orders is in negative territory (Chart 9, bottom panel). Chart I-8Global Growth Is Slowing Clouds##br## Hanging Over Global Growth Global Growth Is Slowing Clouds Hanging Over Global Growth Global Growth Is Slowing Clouds Hanging Over Global Growth Chart I-9Euro Area Domestic##br## Growth Is Flagging Euro Area Domestic Growth Is Flagging Euro Area Domestic Growth Is Flagging No matter the source, the end result for Europe is the same: the torrid pace of European growth is set to slow, not accelerate. Not only have European economic surprises fallen precipitously (Chart I-10, top panel), but the Ifo survey - a key bellwether of German activity - has also peaked. Moreover, the Sentix survey points to a sharp slowdown in the manufacturing PMIs (Chart I-10, bottom panel). Because there is slack in the European economy and growth is set to slow, there is a good reason for the Draghi-led ECB to remain very cautious in the coming quarters before sounding hawkish. As a result, the euro faces strong headwinds over the next six months or so, especially as the Federal Reserve faces milder handicaps than the ECB: U.S. economic slack has dissipated and U.S. inflation is rising. These inflationary pressures could even intensify thanks to U.S. President Donald Trump's late-cycle fiscal stimulus. Relative growth dynamics also support the dollar this year as euro area industrial production is already lagging behind the U.S. (Chart I-11). This trend is set to continue for the coming quarters because the U.S. economy is less exposed to a global growth slowdown and U.S. households' are experiencing sharply accelerating disposable income growth, a support for domestic demand. Chart I-10Weakening European ##br##Growth Outlook Weakening European Growth Outlook Weakening European Growth Outlook Chart I-11European Growth Will ##br##Underperform The U.S. Further European Growth Will Underform The U.S. Further European Growth Will Underform The U.S. Further Bottom Line: Not only is there still slack in the euro area labor market, global growth is showing signs of a slowdown. This is likely to have a deleterious impact on European growth as the eurozone credit impulse is already contracting. As a result, European growth is likely to lag that of the U.S., an economy where there is no more slack, and where inflation is perking up. This combination represents a potent headwind for the euro over the next six months or so. The Euro Cyclical Bull Market Is Far From Over The combination of slowing global growth and labor market slack in the euro area suggests the euro may depreciate by six to eight cents over the next six months, but it does not sound the death knell of the euro's cyclical rally. To the contrary, the presence of slack in Europe suggests the euro still has significant cyclical upside. Historically, the euro performs well when the U.S. business cycle enters the last two years of expansion (Chart I-12). This is because European growth begins to outperform U.S. growth in the late stages of the economic cycle, allowing investors to upgrade their assessment of the path of long-term monetary policy in the euro area relative to the U.S. This time an additional impetus could emerge. If there is more slack in the euro area than traditional unemployment metrics imply, the euro area's potential GDP is also higher than these traditional metrics would submit - i.e. trend growth in Europe could be higher than once thought. The impact of labor market reforms in France and Spain further bolster this possibility. A consequence of a higher trend growth rate would also be a higher than originally assessed level for euro area neutral interest rates, or the so-called r-star. The European five-year forward 1-month OIS could therefore have significant upside from current levels (Chart I-13, top panel). This would also imply that expected rates in Europe have room to increase versus the U.S., lifting the euro in the process (Chart I-13, bottom panel). Chart I-12The Euro Rallies Late##br## In The Business Cycle The Euro Rallies Late In The Business Cycle The Euro Rallies Late In The Business Cycle Chart I-13European Slack Today Means ##br##Higher Rates Tomorrow European Slack Today Means European Slack Today Means European Slack Today Means European Slack Today Means Bottom Line: The presence of slack in Europe suggests that its potential GDP is higher than once thought. Hence, Europe could still have a few more years of robust growth in front of her. The following paradox ensues: if the presence of slack limits the upside for European interest rates today, it also suggests that European policy rates can rise much more in the future than if there was no slack today. Therefore, while this limits the capacity of the euro to rise further this year, the euro cyclical bull market has much more upside than if there was no slack in Europe today. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 This underutilization measure is based on the number of unemployed and underemployed, those available to work but not seeking a job and those seeking a job but not available for one. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was decent: Retail sales ex. Autos increased at a 0.2% monthly pace, in line with expectations; Housing starts and building permits both beat expectations, coming in at 1.319 million and 1.354 million, respectively; Industrial production grew by 0.5% at a monthly pace, beating expectations; Capacity utilization also increased to 78%; Continuing and initial jobless claims both came out higher than expected; U.S. data continues to generally beat expectations, especially when contrasted with European data, representing a sharp reversal from last year's environment. The yield curve has flattened which has weighed on the greenback preventing the USD from rallying despite an outperforming U.S. economy. Report Links: U.S. Twin Deficits: Is The Dollar Doomed? - April 13, 2018 More Than Just Trade Wars - April 6, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data has been disappointing: German Wholesale price index increased by only 1.2%, less than the expected 1.5%; European industrial production grew at a 2.9% yearly pace, less than expectations of 3.8%; The ZEW Economic Sentiment and Current Situation Survey for Germany disappointed; European headline inflation disappointed, coming in at 1.3%, while core was in line with expectations of 1%. Signs of a slowdown are now emerging in European data, however the euro has yet to follow. The euro area's leading economic indicator is rolling over, suggesting that cyclical factors could drag the euro down in the coming months. The waning of inflationary pressures across the euro area is likely prompt a dovish tone in upcoming ECB communications, which will induce a downward revision in rate expectations by investors. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been negative: Exports yearly growth underperformed expectations, coming in at 2.1%. Moreover, imports yearly growth also surprised to the downside, coming in at -0.6%. Finally industrial production yearly growth also disappointed, coming in at 1.6%. USD/JPY has remained relatively flat this week. Overall, we expect that the yen will continue to appreciate, as global geopolitical risks are on the rise and a potential slowdown in China's growth could will likely lead to a pick-up in FX market volatility. On the other hand, the yen remains at risk in the long term, given that economic data continues to underperform due to the strong yen and Japan's great exposure to global growth. This means that the BoJ will have to keep policy easy in order to support the economy. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Headline inflation underperformed expectations, coming in at 2.5%. Moreover, core inflation also surprised negatively, coming in at 2.3%. Retail prices yearly growth also underperformed, coming in at 3.3%. However, the ILO unemployment rate surprised positively, coming in at 4.2%. After being up nearly 1.4% this week, GBP/USD fell more than a percentage point following the disappointing inflation numbers. Overall, the data follows our prediction from a couple of weeks ago: inflation in the U.K. is set to decline substantially despite a tightening labor market. This is because inflation in the U.K. is mainly driven by previous currency movements. Therefore, given the steep appreciation of the pound since 2017, prices will likely fall, causing the hawkishly-priced BOE to tighten less than expected, hurting the pound in the process. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The Aussie has traded in a wave pattern against the greenback since the beginning of 2016. This week, AUD once again rebounded off the trough of the wave, catalyzed by higher prices in the metals space. Recent announcements by Anglo-Australian group BHP Billiton about curtailing production forecasts provided a boost to iron ore prices. This was coupled with the PBOC's decision to cut banks' reserve requirements which is raising the specter of a potential reflation wave in China. While, for now, external factors are proving to be positive for the Antipodean economy and its currency, the domestic story remains the same: labor market slack, high debt loads, and not enough wage inflation. Recent employment figures confirm this reality: employment grew by only 4,900, driven by a decline in full-time employment of 19,900. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: The food price index month-on-month growth came in at 1%. Meanwhile, headline inflation came in at 1.1%, in line with expectations. NZD/USD has fallen by nearly 1.3% this week. Overall, we expect that the NZD will suffer in the current environment of rising volatility and geopolitical risks. Moreover, on a long term basis, the kiwi continues to be at risk, given that the new populist government is set to decrease immigration and implement a dual mandate for the RBNZ; both factors would lower the real neutral rate. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 This year's disappointing first quarter GDP growth of 1.7% QoQ growth was regarded as an important factor in the BoC's decision this week to hold interest rates unchanged. The statement recognized the weaker housing market and flailing exports as the two culprits in this development. Bank officials denoted the tight capacity utilization as a constraint to further export growth, stating that growth will not be sufficient "to recover the ground lost during recent quarters". While this was an overall dovish policy statement, the Bank still continues to see robust growth going forward, revising their 2019 growth forecast from 1.6% to 2.1%. Importantly, this revision widened the output gap as the potential growth rate was revised higher. In terms of monetary policy, investors still predict two more rate hikes this year, bringing the benchmark rate to 1.75%, which is still below the Bank's estimated neutral rate of 2.5% - 3.5%. This means that if NAFTA is not abrogated in any major way - our base case scenario for the current negotiations - there is still plenty of upside for Canadian rates, and therefore, the CAD. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has gone up by 1% this week. Overall, we continue to believe that the franc will continue to depreciate on a cyclical basis, given that Swiss inflationary pressures remain too weak and economic activity is still highly dependent on the easy monetary conditions brought about by the weak franc and low rates. Therefore, the SNB will remain very dovishly enclined in order to keep an appreciating franc from hurting the economy. Moreover, the Swiss franc continues to be expensive, putting further downward pressure on this currency. On a tactical basis however, this cross could have some downside in an environment of rising volatility and rising geopolitical risk. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has been relatively flat this week. We continue to be negative on the krone against the U.S. dollar, even in an environment of rising oil prices. This is because this cross is more correlated to real rate differential than it is to crude. Therefore, in an environment where the Fed hikes more than expected, real rates should move in favor of the U.S., helping USD/NOK in the process. That being said, the krone will likely outperform other commodity currencies like the AUD, as oil has a relatively lower beta than industrial metals to global growth and Chinese economic activity. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 A slight economic slowdown is still being felt in the Scandinavian economy. As leading economic indicators in both Sweden and the euro area roll over, disinflationary winds continue to batter Swedish shores. As a result, EUR/SEK continues to trade at lofty levels, especially as global investors remain nervous about the risks of a global trade war. The Swedish yield curve has flattened 53 bps since January highs, which is one of the most severe moves in the G-10. It seems that Stefan Ingves' extreme dovishness is again being taken seriously by investors, especially as core CPI is at a mere 1.5%, despite CPIF clocking in at 2%. This core measure and global reflation will need to pick up for Ingves to change his view. While the SEK is cheap, and thus have limited downside from current levels, this economic backdrop suggests it is still risky for short-term investors to buy the SEK. Long-term players, however, should use current weaknesses as a buying opportunity. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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

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

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

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

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