Policy

Special Report

Markets have been uneasy recently; last month saw the Fed raise rates, combined with language indicating a steeper path for interest rate moves in the coming two years. As of writing, markets are currently assigning a nearly 75% probability of at least two further rate hikes this year alone. However, amidst the Fed's tightening, the government has been embarking on fiscal largess. The recent tax cuts, budget announcements and potential infrastructure bill mean that we have entered a fairly rare period of loose fiscal policy and tight monetary policy; in our October 9th, 2017 Weekly Report, we highlighted seven such periods since the Second World War (shaded in Chart 1). Another two-year period of fiscal easing and tight money is upon us. Bull Markets Don't Die Of Old Age... To complete the adage above, "Bull markets don't die of old age, they are killed by higher interest rates". Thus the focus of roiled markets should be whether tight monetary policy can be offset by loose fiscal policy. In other words, can the government be stimulative enough to cushion the blow from higher interest rates and extend the business cycle? With all seven iterations of simultaneous fiscal easing and monetary tightening noted above resulting in positive stock market returns and the SPX rising by 16% on average, the answer appears to be a resounding yes (Table 1). Chart 1Loose Fiscal Policy Offsets##br## Tight Monetary Conditions Table 1SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Further, the infrastructure bill has not yet become part of the fiscal thrust in this current bull market, meaning that there is still dry powder in the stock market's battle against higher rates. Depending on the timing of the infrastructure bill (and the further away, the better for sustaining the equity market blow off phase), there are good odds that this bull market could be the longest in history (Table 2). Using months without an inverted yield curve as an alternative measure, we are already there as the current streak of 131 months beats the 104 month streak of much of the '90s (Chart 2). Table 2Bull Markets Since World War II Chart 2Longest Positive Yield Curve Streak In 50 Years Look To Earnings For Direction Our view remains that earnings will have to take up the mantle to drive the SPX higher.1 At this stage in the bull market's life, the SPX is no longer discounting many years of future growth and higher rates weigh on this growth rate. The implication is a forward P/E multiple that should drift sideways to lower leaving profits to do all the heavy lifting and largely explaining the S&P 500's return (bottom panel, Chart 3). Importantly, the combination of synchronized global growth and a soft U.S. dollar underpin EPS. Tack on the effect of tax reform (at least this year) and the 20% and 10% EPS growth rates penciled in by the sell side for 2018 and 2019, respectively, are achievable, barring a recession. Considering that stocks and EPS growth move together (top panel, Chart 3), the path of least resistance is higher still for the SPX. This positive equity backdrop warrants a positioning update. Accordingly, we have analyzed the GICS1 industry groups and their average annualized performance in each of the most recent five periods for which we have data of loose fiscal and tight monetary policy. The results presented in Table 3, however, are nuanced. Chart 3Stocks And EPS Are Joined At The Hip Table 3Sector Relative Performance In Tight Monetary/Loose Fiscal Conditions In the left column, our raw data suggests that technology is dominant in the periods we have examined. However, this is skewed by the 1998-99 iteration when this sector went parabolic as the dotcom bubble was inflating, making virtually all other sectors underperform, dramatically in most cases. We have adjusted for this exceptional period in the right column. The adjusted results are telling as cyclicals and positive interest rate sensitive sectors (the S&P financials and energy indexes) are the top performers. Conversely, defensives and negative interest rate sensitive sectors (the S&P utilities and real estate indexes) are the worst performers. Such a result is intuitive; loosening fiscal policy during expansions tends to extend/prolong the business cycle and may also arrive in late/later stages of the cycle where equity returns go parabolic and deep cyclicals roar. In addition, when the Fed raises rates, financials tend to benefit and competing fixed income proxies suffer. Further, there is a positive feedback loop in these actions as loose fiscal policy in good times is typically inflationary, especially when the economy is at full employment, which thus pushes the Fed to continue to or even accelerate its tightening mode. We note that we maintain a preference for cyclicals over defensives in our portfolio, based on our key investment themes for 2018: synchronous global capex growth and rising interest rates. Our analysis here serves to confirm our hypothesis. The purpose of this report is to identify winners and losers in times of easy fiscal and tight money phases, and provide a roadmap of how sector returns may pan out in the coming two year period of fiscal expansion and liquidity withdrawal, if history at least rhymes. Accordingly, what follows is an analysis of the two adjusted top and bottom performers noted above. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. Financials Are A Top Pick Financials benefit from both sides of a monetary tightening/fiscal loosening environment. Rising interest rates are a boon to sector EPS as the increasing price of credit translates directly into top line growth. The higher cost of borrowing should typically result in a slowdown in borrowing and consumption. With fiscal largesse serving to at least offset any natural demand declines, the result should be a banker's dream: simultaneous capital formation and better terms on the existing book of business. The benefits of monetary tightening and fiscal easing are not exclusive to businesses either; such an environment has typically been synonymous with soaring consumer confidence, keeping loan demand high (second panel, Chart 4). Further, low unemployment has historically meant peaking credit quality, implying a margin tailwind to the already-rising top lines of lenders (third panel, Chart 4. Chart 4RS2 Financials Are In A Goldilocks Scenario As operating cash flows are soaring, it is likely that financials will increasingly embark upon shareholder friendly activities. The GFC saw lenders in particular shore up weakened balance sheets with enormous equity issues; the reversal in fortunes (especially given the record number of banks passing Fed stress tests) will see accelerated equity retirement, yet another benefit to EPS growth. In sum, S&P financials should be a core holding during periods of monetary tightening and fiscal easing, (see appendix, Chart 1A); we reiterate our overweight recommendation on financials and our high-conviction overweight on the key S&P banks sub index. Energy Is Just Getting Warmed Up As noted above, one of BCA's key investment themes for 2018 is synchronized global capex, of which the S&P energy sector is a key beneficiary, at least in part fueled by lower taxes and the upcoming infrastructure bill. Recently, the capital expenditures part of the Dallas Fed manufacturing outlook survey hit its highest level in a decade, and capex intentions in the coming six months are also probing multi-year highs. The overall message is that the budding recovery in energy capital budgets will likely gain steam (second panel, Chart 5). Chart 5Energy Should Benefit From High Capex Equally importantly, the recovery in the global economy has kept a solid floor underneath oil prices, which are pushing up against 3-year highs (top panel, Chart 5). Pricing power in energy is rising at its fastest pace this decade and (for now) the sector wage bill is continuing to contract (bottom panel, Chart 5), implying not only top line gains but also a much better margin profile. Still, monetary tightening represents a headwind for the sector. Higher interest rates tend to suppress investment demand and support the U.S. dollar which could put downward force on the price of oil. Our analysis suggests the stimulative effects from fiscal easing should more than offset any pressure from monetary tightening (see appendix, Chart 1B). Accordingly, we reiterate our high-conviction overweight recommendation on the S&P energy index. Be Cautious With Utilities We recently upgraded the beaten-down S&P utilities index to a benchmark allocation, based largely on a modest improvement in operating metrics, lifted by BCA's key 2018 capex growth investment theme; expansionary fiscal thrust should only enhance these metrics. Nat gas prices appear to have mostly stabilized and, as the marginal price setter for utilities, should support the nascent turnaround in industry pricing power (second panel, Chart 6). Further, the rebound in electricity production has peaked but remains comfortably in expansionary territory (third panel, Chart 6). Chart 6Higher Rates Offset Better Fundamentals Notwithstanding the operational positives, we think BCA's key theme of higher interest rates present a hefty offset. Utilities, a high dividend yielding sector, suffer when Treasury bond yields move higher, as competing risk free assets become more appealing (bottom panel, Chart 6). We suspect this fixed income-proxy characteristic is why the S&P utilities sector is historically the worst performer as the Fed is tightening monetary policy (see appendix, Chart 1C). Still, the sector has harshly sold down already and we think the positives and negatives are broadly in balance; we reiterate our neutral recommendation on the S&P utilities index. Real Estate Is Not Immune From Monetary Tightening Much like the S&P utilities index, the S&P real estate sector trades as a fixed income proxy. Accordingly, the anticipated advance in Treasury yields should weigh heavily on REIT prices (top panel, Chart 7), regardless of the underlying fundamentals; fortunately, there is some good news there. Chart 7CRE Prices Are Rising But ##br##How Much Further Can They Go? Lending standards had been tightening from 2013 until the middle of last year; since then, they have been loosening as fears of a second real estate recession gave way to general economic optimism. Given the tight correlation between lending standards and commercial property prices, a loosening of the former bodes well for the latter (second panel, Chart 7). Still, with commercial real estate prices approaching two standard deviations above the 30-year trend (bottom panel, Chart 7), the longevity of the good times should be questioned. Regardless of the modestly improving industry fundamentals, particularly in the context of the fiscal largesse that will certainly be stimulative, monetary tightening headwinds should at least provide an offset (see appendix, Chart 1D). On balance, we reiterate our neutral recommendation on the S&P real estate index. Appendix Chart 1A Chart 1B Chart 1C Chart 1D

Special Report

Highlights Dear Client, This week, we are publishing a Special Report produced by Mark McClellan, author of The Bank Credit Analyst and Mathieu Savary, author of Foreign Exchange Strategy. This report discusses the long-term outlook for the dollar and argues that the greenback is in a structural downtrend. Cyclically too, the dollar is likely to continue to soften. However, despite this negative multi-year view on the USD, BCA still sees a high probability of a dollar rebound in 2018. This move would therefore be a countertrend bounce. Best regards, John Canally, Senior Vice President U.S. Investment Strategy In this Special Report, we review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar. The long-term structural downtrend in the dollar is intact. This trend reflects both a slower underlying pace of U.S. productivity growth relative to the rest of the world and a persistent external deficit. The U.S. shortfall on its net international investment position, now at about 40% of GDP, is likely to continue growing in the coming decades. Fiscal stimulus means that the U.S. twin deficits are set to worsen, but the situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding sustainability. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see little reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are some parallels today with the Nixon era, but we do not expect the same outcome for the dollar. The Fed is unlikely to make the same mistake as it made in the late 1960s/early 1970s. There are risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. While the underlying trend in the dollar is down, cyclical factors are likely to see it appreciate on a 6-12 month investment horizon. Growth momentum, which moved in favor of the major non-U.S. currencies in 2017, should shift in the greenback's favor this year. U.S. fiscal stimulus is bullish the dollar, despite the fact that this will worsen the current account balance. Additional protectionist measures should also support the dollar as long as retaliation is muted. Feature The U.S. dollar just can't seem to get any respect even in the face of a major fiscal expansion that is sure to support U.S. growth. Nonetheless, there are a lot of moving parts to consider besides fiscal stimulus: a tightening Fed, accumulating government debt, geopolitical tension and growing trade protectionism among others. The interplay of all these various forces can easily create confusion about the currency outlook. Textbook economic models show that the currency should appreciate in the face of stimulative fiscal policy and rising tariffs, at least in the short term, not least because U.S. interest rates should rise relative to other countries. However, one could also equate protectionism and a larger fiscally-driven external deficit with a weaker dollar. Which forces will dominate? In this Special Report, we sort out the moving parts. We review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar in the short- and long-term. Tariffs And The Dollar Let's start with import tariffs. In theory, higher tariffs should be positive for the currency as long as there is no retaliation. The amount spent on imports will fall as consumer spending is re-directed toward domestically-produced goods and services. A lower import bill means the country does not need to export as much to finance its imports, leading to dollar appreciation (partially offsetting the competitive advantage that the tariff provides). Tariffs also boost inflation temporarily, which means that higher U.S. real interest rates should also lift the dollar to the extent that the Fed responds with tighter policy. Chart 1At Full Employment,##BR##Import Tariffs Raise Rates That said, the tariffs recently announced by the Trump Administration are small potatoes in the grand scheme. The U.S. imported $39 billion of iron and steel in 2017, and $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. The positive impact on U.S. growth is also modest as the tariffs benefit only two industries, and higher domestic prices for steel and aluminum undermine U.S. consumers of these two metals. A unilateral tariff increase could be mildly growth-positive if there is no retaliation by trading partners. This was the result of a Bank of Canada study, which found that much of the growth benefits from a higher import tariff are offset by an appreciation of the currency.1 Even a short-term growth boost is not guaranteed. A detailed analysis of the 2002 Bush steel tariff increase found that the import tax killed many more jobs than it created.2 Shortages forced some U.S. steel-consuming firms to source the metal offshore, while others made their steel suppliers absorb the higher costs, leading to job losses. A recent IMF3 study employed a large macro-economic model to simulate the impact of a 10% across-the-board U.S. import tariff without any retaliation. It found that tariffs place upward pressure on domestic interest rates, especially if the economy is already at full employment (Chart 1). This is because the central bank endeavors to counter the inflationary impact with higher interest rates. However, a stronger currency and higher interest rates eventually cool the economy and the Fed is later forced to ease policy. This puts the whole process into reverse as interest rate differentials fall and the dollar weakens. The economic outcome would be much worse if U.S. trading partners were to retaliate and the situation degenerates into a full-fledged trade war involving a growing number of industries. In theory, the dollar would not rise as much if there is retaliation because foreign tariffs on U.S. exports are offsetting in terms of relative prices. But all countries lose in this scenario. China is considering only a small retaliation for the steel and aluminum tariffs as we go to press, but the trade dispute has the potential to really heat up. The bottom line is that the Trump tariffs are more likely to lead to a stronger dollar than a weaker one, although far more would have to be done to see any meaningful impact. Fiscal Stimulus And The Dollar Traditional economic theory suggests that fiscal stimulus is also positive for the currency in the short term. The boost in aggregate demand worsens the current account balance, since some of the extra government spending is satisfied by foreign producers. The U.S. dollar appreciates as interest rates increase relative to the other major countries, attracting capital inflows. The currency appreciation thus facilitates the necessary adjustment (deterioration) in the current account balance. The impact on interest rates is similar to the tariff shock shown in Chart 1. All of the above market and economic adjustments should be accentuated when the economy is already at full employment. Since the domestic economy is short of spare capacity, a vast majority of the extra spending related to fiscal stimulus must be imported. Moreover, the Fed would have to respond even more aggressively to the extent that inflationary pressures are greater when the economy is running hot. The result would be even more upward pressure on the U.S. dollar. Reality has not supported the theory so far. The U.S. dollar weakened after the tax cuts were passed, and it did not even get a lift following the Senate spending plan that was released in February. The broad trade-weighted dollar has traded roughly sideways since mid-2017. Judging by the market reaction to the fiscal news, it appears that investors are worried about a potential replay of the so-called Nixon shock, when fiscal stimulus exacerbated the 'twin deficits' problem, investors lost confidence in policymakers and the dollar fell. Twin deficits refers to a period when the federal budget deficit and the current account deficit are deteriorating at the same time. Chart 2 highlights that the late 1960s/early 1970s was the last time that the federal government stimulated the economy at a time when the economy was already at full employment. Seeing the parallels today, some investors are concerned the dollar will decline as it did in the early 1970s. Chart 2A Replay Of The Nixon Years? Current Account And Budget Balances Often Diverge... Chart 3Twin Deficits And The Dollar The two deficits don't always shift in the same direction. In fact, Chart 3 highlights that they usually move in opposite directions through the business cycle. This is not surprising because the current account usually improves in a recession as imports contract more than exports, but the budget deficit rises as tax revenues wither. The process reverses when the economy recovers. The current account balance equals the government financial balance (i.e. budget deficit) plus the private sector financial balance (savings less investment spending). Thus, swings in the latter mean that the current account can move independently of the budget deficit. Even when the two deficits move in the same direction, there has been no clear historical relationship between the sum of the fiscal and current account balances and the value of the trade-weighted dollar (shaded periods in Chart 3). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a booming housing market. ...But Generally Fiscal Expansion Undermines The Current Account Over long periods, a sustained rise in the fiscal deficit is generally associated with a sustained deterioration in the external balance. Numerous academic studies have found that every 1 percentage-point rise in the budget deficit worsens the current account balance by an average of 0.2-0.3 percentage points over the medium term. One study found that the current account deteriorates by an extra 0.2 percentage points if the fiscal stimulus arrives at a time when the economy is at full employment (i.e. an additional 0.2 percentage points over-and-above the 0.2-0.3 average response, for a total of 0.4 to 0.5).4 Given that the U.S. economy is at full employment today, these estimates imply that the expected two percentage point rise in the budget deficit relative to the baseline over 2018 and 2019 could add almost a full percentage point to the U.S. current account deficit (from around 3% of GDP currently to 4%). It could be even worse over the next couple of years because the private sector is likely to augment the government sector's drain on national savings. The mini capital spending boom currently underway will lift imports and thereby contribute to a further widening in the U.S. external deficit position. Chart 4Structural Drivers Of The U.S. Dollar Nonetheless, theory supports the view that the dollar will rise in the face of fiscal stimulus, at least in the near term, even if this is accompanied by a rising external deficit. Theory gets fuzzier in terms of the long-term outlook for the currency. However, the traditional approach to the balance of payments suggests that the equilibrium value of the dollar will eventually fall. An ongoing current account deficit will accumulate into a rising stock of foreign-owned debt that must be serviced. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart 4). The dollar will eventually have to depreciate in order to generate a trade surplus large enough to allow the U.S. to cover the extra interest payments on its growing stock of foreign debt. The structural depreciation of the U.S. dollar observed since the early 1980s supports the theory, because it has trended lower along with the NIIP/GDP ratio. However, the downtrend probably also reflects other structural factors. For example, U.S. output-per-employee has persistently fallen relative to its major trading partners for decades (Chart 4, third panel). The bottom line is that, while the dollar is likely to remain in a structural downtrend, it should receive at least a short-term boost from the combination of fiscal stimulus and higher tariffs. What could cause the dollar to buck the theory and depreciate even in the near term? We see three main scenarios in which the dollar could fall on a 12-month investment horizon. (1) Strong Growth Outside The U.S. First, growth momentum favored Europe, Japan and some of the other major countries relative to the U.S. in 2017. This helps to explain dollar weakness last year because the currency tends to underperform when growth surprises favor other countries in relative terms. It is possible that momentum will remain a headwind for the dollar this year. Nonetheless, this is not our base case. European and Japanese growth appears to be peaking, while fiscal stimulus should give the U.S. economy a strong boost this year and next. (2) A Lagging Fed The Fed will play a major role in the dollar's near-term trend. The Fed could fail to tighten in the face of accelerating growth and falling unemployment, allowing inflation and inflation expectations to ratchet higher. If investors come to believe that the Fed will remain behind-the-curve, rising long-term inflation expectations would depress real interest rates and thereby knock the dollar down. This was part of the story in the Nixon years. Under pressure from the Administration, then-Fed Chair Arthur Burns failed to respond to rising inflation, contributing to a major dollar depreciation from 1968 to 1974. We see this risk as a very low-probability event. Today's Fed acts much more independently of Congress beyond its dual commitment on inflation and unemployment. And, given that the economy is at full employment, there is nothing stopping the FOMC from acting to preserve its 2% inflation target if it appears threatened. Chair Powell is new and untested, but we doubt he and the rest of the Committee will be influenced by any political pressure to keep rates unduly low as inflation rises. Even Governor Brainard, a well-known dove, has shifted in a hawkish direction recently. President Trump would have to replace the entire FOMC in order to keep interest rates from rising. We doubt he will try. (3) Long-Run Sustainability Concerns It might be the case that the deteriorating outlook for the NIIP undermines the perceived long-run equilibrium value of the currency so much that it overwhelms the impact of rising U.S. interest rates and causes the dollar to weaken even in the near term. This scenario would likely require a complete breakdown in confidence in current and future Administrations to avoid a runaway government debt situation. Historically, countries with large and growing NIIP shortfalls tend to have weakening currencies. The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. One could argue that the external deficit represents the U.S. "living beyond its means," because it consumes more than it produces. Another school of thought is that global savings are plentiful, and investors seek markets that are deep, liquid and offer a high expected rate of return. Indeed, China has willingly plowed a large chunk of its excess savings into U.S. assets since 2000. If the U.S. is an attractive place to invest, then we should not be surprised that the country runs a persistent trade deficit and capital account surplus. But even taking the more positive side of this debate, there are limits to how long the current situation can persist. The large stock of financial obligations implies flows of income payments and receipts - interest, dividends and the like - that must be paid out of the economy's current production. This might grow to be large enough to significantly curtail U.S. consumption and investment. At some point, foreign investors may begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We are not suggesting that foreign investors will suddenly dump their U.S. stocks and bonds. Rather, they may demand a higher expected rate of return in order to accept a rising allocation to U.S. assets. This would imply that the dollar will fall sharply so that it has room to appreciate and thereby lift the expected rate of return for foreign investors from that point forward. Chart 5 shows that a 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. Any deficit above this level would imply a rapidly deteriorating situation. A 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040. The fact that the current account averaged 4.6% in the 2000s and 2½% since 2010 confirms that the NIIP is unlikely to stabilize unless major macroeconomic adjustments are made (see below). Chart 5Scenarios For The U.S. Net International Investment Position Academic research is inconclusive on how large the U.S. NIIP could become before there are serious economic consequences and/or foreign investors begin to revolt. Exorbitant Privilege The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The U.S. is also able to get away with offering foreign investors a lower return on their investment in the U.S. than U.S. investors receive on their foreign investment. Chart 6 provides a proxy for these two returns. Relatively safe, but low yielding, fixed-income investments are a large component of foreign investments in the U.S., while U.S. investors favor equities and other assets that have a higher expected rate of return when investing abroad (Chart 7). This gap increased after the Great Recession as U.S. interest rates fell by more than the return U.S. investors received on their foreign assets. Today's gap, at almost 1½ percentage points, is well above the 1 percentage point average for the two decades leading up to the Great Recession. Chart 6U.S. Investors Harvest##BR##Higher Returns Chart 7Composition Of Net International##BR##Investment Position A yield gap of 1.5 percentage points may not sound like much, but it has been enough that the U.S. enjoys a positive net inflow of private investment income of about 1.2% of GDP, despite the fact that foreign investors hold far more U.S. assets than the reverse (Chart 6, top panel). In Chart 8 we simulate the primary investment balance based on a persistent 3% of GDP current account deficit and under several scenarios for the investment yield gap. Perhaps counterintuitively, the primary investment surplus that the U.S. currently enjoys will actually rise slightly as a percent of GDP if the yield gap remains near 1½ percentage points. This is because, although the NIIP balance becomes more negative over time, U.S. liabilities are not growing fast enough relative to its assets to offset the yield differential. Chart 8Primary Investment Balance Simulations However, some narrowing in the yield gap is likely as the Fed raises interest rates. Historically, the gap does not narrow one-for-one with Fed rate hikes because the yield on U.S. investments abroad also rises. Assuming that the yield gap returns to the pre-Lehman average of 1 percentage point over the next three years, the primary investment balance would decline, but would remain positive. Only under the assumption that the yield gap falls to 50 basis points or lower would the primary balance turn negative (Chart 8, bottom panel). Crossing the line from positive to negative territory on investment income is not necessarily a huge red flag for the dollar, but it would signal that foreign debt will begin to impinge on the U.S. standard of living. That said, the yield gap will have to deteriorate significantly for this to happen anytime soon. What Drives The Major Swings In The Dollar? While the dollar has been in a structural bear market for many decades, there have been major fluctuations around the downtrend. Since 1980, there have been three major bull phases and two bear markets (bull phases are shaded in Chart 9). These major swings can largely be explained by shifts in U.S./foreign differentials for short-term interest rates, real GDP growth and productivity growth. A model using these three variables explains most of the cyclical swings in the dollar, as the dotted line in the top panel of Chart 9 reveals. Chart 9U.S. Dollar Cyclical Swings Driven By Three Main Factors The peaks and troughs do not line up perfectly, but periods of dollar appreciation were associated with rising U.S. interest rates relative to other countries, faster relative U.S. real GDP growth, and improving U.S. relative productivity growth. Since the Great Recession, rate differentials have moved significantly in favor of the dollar, although U.S. relative growth improved a little as well. Productivity trends have not been a factor in recent years. Note that the current account has been less useful in identifying the cyclical swings in the dollar. Looking ahead, we expect short-term interest rate differentials to shift further in favor of the U.S. dollar. We assume that the Fed will hike rates three additional times in 2018 and another three next year. The Bank of Japan will stick with its current rate and 10-year target for the foreseeable future. The ECB may begin the next rate hike campaign by mid-2019, but will proceed slowly thereafter. We expect rate differentials to widen by more than is discounted in the market. As discussed above, we also expect growth momentum to swing back in favor of the U.S. economy in 2018. U.S. productivity growth will continue to underperform the rest-of-world average over the medium and long term. Nonetheless, we expect a cyclical upturn in relative productivity performance that should also support the greenback for the next year or two. Conclusion Reducing the U.S. structural external deficit to a sustainable level would require significant macro-economic adjustments that seem unlikely for the foreseeable future. We would need to see some combination of a higher level of the U.S. household saving rate, a balanced Federal budget balance or better, and/or much stronger growth among U.S. trading partners. In other words, the U.S. would have to become a net producer of goods and services, and either Europe or Asia would have to become a net consumer of goods and services. Current trends do not favor such a role reversal. Indeed, the U.S. twin deficits are sure to move in the wrong direction for at least the next two years. Longer-term, pressure on the federal budget deficit will only intensify with the aging of the population. The shortfall in terms of net foreign assets will continue to grow, which means that the long-term structural downtrend in the trade-weighted value of the dollar will persist. Other structural factors, such as international productivity trends, also point to a long-term dollar depreciation. It seems incongruous that the U.S. dollar is the largest reserve currency and that U.S. is the world's largest international debtor. The situation is perhaps perpetuated by the lack of an alternative, but this could change over time as concerns over the long-run viability of the Eurozone ebb and the Chinese renminbi gains in terms of international trade. The transition could take decades. The U.S. twin-deficits situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is anywhere close to the point where investors would begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see no reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are other risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. In 2018, we expect the dollar to partially unwind last year's weakness on the back of positive cyclical forces. Additional protectionist measures should support the dollar as long as retaliation is muted. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 A Wave of Protectionism? An Analysis of Economic and Political Considerations. Bank of Canada Working Paper 2008-2. Philipp Maier. 2 The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002. Trade Partnership Worldwide, LLC. Joseph Francois and Laura Baughman. February 4, 2003. 3 See footnote to Chart 1. 4 Fiscal Policy and the Current Account. Center for Economic Policy Research, Discussion Paper No. 7859 September 16, 2010.

Special Report

Dear Client, This week, we are publishing a Special Report co-produced with Mark McClellan, who writes The Bank Credit Analyst. This report discusses the long-term outlook for the dollar and argues that the greenback is in a structural downtrend. Cyclically too, the dollar is likely to continue to soften. However, despite this negative multi-year view on the USD, BCA still sees a high probability of a dollar rebound in 2018. This move would therefore be a countertrend bounce. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights In this Special Report, we review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar. The long-term structural downtrend in the dollar is intact. This trend reflects both a slower underlying pace of U.S. productivity growth relative to the rest of the world and a persistent external deficit. The U.S. shortfall on its net international investment position, now at about 40% of GDP, is likely to continue growing in the coming decades. Fiscal stimulus means that the U.S. twin deficits are set to worsen, but the situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding sustainability. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see little reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are some parallels today with the Nixon era, but we do not expect the same outcome for the dollar. The Fed is unlikely to make the same mistake as it made in the late 1960s/early 1970s. There are risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. While the underlying trend in the dollar is down, cyclical factors are likely to see it appreciate on a 6-12 month investment horizon. Growth momentum, which moved in favor of the major non-U.S. currencies in 2017, should shift in the greenback's favor this year. U.S. fiscal stimulus is bullish the dollar, despite the fact that this will worsen the current account balance. Additional protectionist measures should also support the dollar as long as retaliation is muted. Feature The U.S. dollar just can't seem to get any respect even in the face of a major fiscal expansion that is sure to support U.S. growth. Nonetheless, there are a lot of moving parts to consider besides fiscal stimulus: a tightening Fed, accumulating government debt, geopolitical tension and growing trade protectionism among others. The interplay of all these various forces can easily create confusion about the currency outlook. Textbook economic models show that the currency should appreciate in the face of stimulative fiscal policy and rising tariffs, at least in the short term, not least because U.S. interest rates should rise relative to other countries. However, one could also equate protectionism and a larger fiscally-driven external deficit with a weaker dollar. Which forces will dominate? In this Special Report, we sort out the moving parts. We review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar in the short- and long-term. Tariffs And The Dollar Let's start with import tariffs. In theory, higher tariffs should be positive for the currency as long as there is no retaliation. The amount spent on imports will fall as consumer spending is re-directed toward domestically-produced goods and services. A lower import bill means the country does not need to export as much to finance its imports, leading to dollar appreciation (partially offsetting the competitive advantage that the tariff provides). Tariffs also boost inflation temporarily, which means that higher U.S. real interest rates should also lift the dollar to the extent that the Fed responds with tighter policy. That said, the tariffs recently announced by the Trump Administration are small potatoes in the grand scheme. The U.S. imported $39 billion of iron and steel in 2017, and $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. The positive impact on U.S. growth is also modest as the tariffs benefit only two industries, and higher domestic prices for steel and aluminum undermine U.S. consumers of these two metals. A unilateral tariff increase could be mildly growth-positive if there is no retaliation by trading partners. This was the result of a Bank of Canada study, which found that much of the growth benefits from a higher import tariff are offset by an appreciation of the currency.1 Even a short-term growth boost is not guaranteed. A detailed analysis of the 2002 Bush steel tariff increase found that the import tax killed many more jobs than it created.2 Shortages forced some U.S. steel-consuming firms to source the metal offshore, while others made their steel suppliers absorb the higher costs, leading to job losses. A recent IMF3 study employed a large macro-economic model to simulate the impact of a 10% across-the-board U.S. import tariff without any retaliation. It found that tariffs place upward pressure on domestic interest rates, especially if the economy is already at full employment (Chart I-1). This is because the central bank endeavors to counter the inflationary impact with higher interest rates. However, a stronger currency and higher interest rates eventually cool the economy and the Fed is later forced to ease policy. This puts the whole process into reverse as interest rate differentials fall and the dollar weakens. The economic outcome would be much worse if U.S. trading partners were to retaliate and the situation degenerates into a full-fledged trade war involving a growing number of industries. In theory, the dollar would not rise as much if there is retaliation because foreign tariffs on U.S. exports are offsetting in terms of relative prices. But all countries lose in this scenario. China is considering only a small retaliation for the steel and aluminum tariffs as we go to press, but the trade dispute has the potential to really heat up. The bottom line is that the Trump tariffs are more likely to lead to a stronger dollar than a weaker one, although far more would have to be done to see any meaningful impact. Fiscal Stimulus And The Dollar Chart I-1At Full Employment,##br## Import Tariffs Raise Rates Traditional economic theory suggests that fiscal stimulus is also positive for the currency in the short term. The boost in aggregate demand worsens the current account balance, since some of the extra government spending is satisfied by foreign producers. The U.S. dollar appreciates as interest rates increase relative to the other major countries, attracting capital inflows. The currency appreciation thus facilitates the necessary adjustment (deterioration) in the current account balance. The impact on interest rates is similar to the tariff shock shown in Chart I-1. All of the above market and economic adjustments should be accentuated when the economy is already at full employment. Since the domestic economy is short of spare capacity, a vast majority of the extra spending related to fiscal stimulus must be imported. Moreover, the Fed would have to respond even more aggressively to the extent that inflationary pressures are greater when the economy is running hot. The result would be even more upward pressure on the U.S. dollar. Reality has not supported the theory so far. The U.S. dollar weakened after the tax cuts were passed, and it did not even get a lift following the Senate spending plan that was released in February. The broad trade-weighted dollar has traded roughly sideways since mid-2017. Judging by the market reaction to the fiscal news, it appears that investors are worried about a potential replay of the so-called Nixon shock, when fiscal stimulus exacerbated the 'twin deficits' problem, investors lost confidence in policymakers and the dollar fell. Twin deficits refers to a period when the federal budget deficit and the current account deficit are deteriorating at the same time. Chart I-2 highlights that the late 1960s/early 1970s was the last time that the federal government stimulated the economy at a time when the economy was already at full employment. Seeing the parallels today, some investors are concerned the dollar will decline as it did in the early 1970s. Chart I-2A Replay Of The Nixon Years? Current Account And Budget Balances Often Diverge... The two deficits don't always shift in the same direction. In fact, Chart I-3 highlights that they usually move in opposite directions through the business cycle. This is not surprising because the current account usually improves in a recession as imports contract more than exports, but the budget deficit rises as tax revenues wither. The process reverses when the economy recovers. Chart I-3Twin Deficits And The Dollar The current account balance equals the government financial balance (i.e. budget deficit) plus the private sector financial balance (savings less investment spending). Thus, swings in the latter mean that the current account can move independently of the budget deficit. Even when the two deficits move in the same direction, there has been no clear historical relationship between the sum of the fiscal and current account balances and the value of the trade-weighted dollar (shaded periods in Chart I-3). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a booming housing market. ...But Generally Fiscal Expansion Undermines The Current Account Over long periods, a sustained rise in the fiscal deficit is generally associated with a sustained deterioration in the external balance. Numerous academic studies have found that every 1 percentage-point rise in the budget deficit worsens the current account balance by an average of 0.2-0.3 percentage points over the medium term. One study found that the current account deteriorates by an extra 0.2 percentage points if the fiscal stimulus arrives at a time when the economy is at full employment (i.e. an additional 0.2 percentage points over-and-above the 0.2-0.3 average response, for a total of 0.4 to 0.5).4 Given that the U.S. economy is at full employment today, these estimates imply that the expected two percentage point rise in the budget deficit relative to the baseline over 2018 and 2019 could add almost a full percentage point to the U.S. current account deficit (from around 3% of GDP currently to 4%). It could be even worse over the next couple of years because the private sector is likely to augment the government sector's drain on national savings. The mini capital spending boom currently underway will lift imports and thereby contribute to a further widening in the U.S. external deficit position. Nonetheless, theory supports the view that the dollar will rise in the face of fiscal stimulus, at least in the near term, even if this is accompanied by a rising external deficit. Chart I-4Structural Drivers Of the U.S. Dollar Theory gets fuzzier in terms of the long-term outlook for the currency. However, the traditional approach to the balance of payments suggests that the equilibrium value of the dollar will eventually fall. An ongoing current account deficit will accumulate into a rising stock of foreign-owned debt that must be serviced. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart I-4). The dollar will eventually have to depreciate in order to generate a trade surplus large enough to allow the U.S. to cover the extra interest payments on its growing stock of foreign debt. The structural depreciation of the U.S. dollar observed since the early 1980s supports the theory, because it has trended lower along with the NIIP/GDP ratio. However, the downtrend probably also reflects other structural factors. For example, U.S. output-per-employee has persistently fallen relative to its major trading partners for decades (Chart I-4, third panel). The bottom line is that, while the dollar is likely to remain in a structural downtrend, it should receive at least a short-term boost from the combination of fiscal stimulus and higher tariffs. What could cause the dollar to buck the theory and depreciate even in the near term? We see three main scenarios in which the dollar could fall on a 12-month investment horizon. (1) Strong Growth Outside The U.S. First, growth momentum favored Europe, Japan and some of the other major countries relative to the U.S. in 2017. This helps to explain dollar weakness last year because the currency tends to underperform when growth surprises favor other countries in relative terms. It is possible that momentum will remain a headwind for the dollar this year. Nonetheless, this is not our base case. European and Japanese growth appears to be peaking, while fiscal stimulus should give the U.S. economy a strong boost this year and next. (2) A Lagging Fed The Fed will play a major role in the dollar's near-term trend. The Fed could fail to tighten in the face of accelerating growth and falling unemployment, allowing inflation and inflation expectations to ratchet higher. If investors come to believe that the Fed will remain behind-the-curve, rising long-term inflation expectations would depress real interest rates and thereby knock the dollar down. This was part of the story in the Nixon years. Under pressure from the Administration, then-Fed Chair Arthur Burns failed to respond to rising inflation, contributing to a major dollar depreciation from 1968 to 1974. We see this risk as a very low-probability event. Today's Fed acts much more independently of Congress beyond its dual commitment on inflation and unemployment. And, given that the economy is at full employment, there is nothing stopping the FOMC from acting to preserve its 2% inflation target if it appears threatened. Chair Powell is new and untested, but we doubt he and the rest of the Committee will be influenced by any political pressure to keep rates unduly low as inflation rises. Even Governor Brainard, a well-known dove, has shifted in a hawkish direction recently. President Trump would have to replace the entire FOMC in order to keep interest rates from rising. We doubt he will try. (3) Long-Run Sustainability Concerns Chart I-5Scenarios For The U.S. Net ##br##International Investment Position It might be the case that the deteriorating outlook for the NIIP undermines the perceived long-run equilibrium value of the currency so much that it overwhelms the impact of rising U.S. interest rates and causes the dollar to weaken even in the near term. This scenario would likely require a complete breakdown in confidence in current and future Administrations to avoid a runaway government debt situation. Historically, countries with large and growing NIIP shortfalls tend to have weakening currencies. The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. One could argue that the external deficit represents the U.S. "living beyond its means," because it consumes more than it produces. Another school of thought is that global savings are plentiful, and investors seek markets that are deep, liquid and offer a high expected rate of return. Indeed, China has willingly plowed a large chunk of its excess savings into U.S. assets since 2000. If the U.S. is an attractive place to invest, then we should not be surprised that the country runs a persistent trade deficit and capital account surplus. But even taking the more positive side of this debate, there are limits to how long the current situation can persist. The large stock of financial obligations implies flows of income payments and receipts - interest, dividends and the like - that must be paid out of the economy's current production. This might grow to be large enough to significantly curtail U.S. consumption and investment. At some point, foreign investors may begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We are not suggesting that foreign investors will suddenly dump their U.S. stocks and bonds. Rather, they may demand a higher expected rate of return in order to accept a rising allocation to U.S. assets. This would imply that the dollar will fall sharply so that it has room to appreciate and thereby lift the expected rate of return for foreign investors from that point forward. Chart I-5 shows that a 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. Any deficit above this level would imply a rapidly deteriorating situation. A 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040. The fact that the current account averaged 4.6% in the 2000s and 2½% since 2010 confirms that the NIIP is unlikely to stabilize unless major macroeconomic adjustments are made (see below). Academic research is inconclusive on how large the U.S. NIIP could become before there are serious economic consequences and/or foreign investors begin to revolt. Exorbitant Privilege The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The U.S. is also able to get away with offering foreign investors a lower return on their investment in the U.S. than U.S. investors receive on their foreign investment. Chart I-6 provides a proxy for these two returns. Relatively safe, but low yielding, fixed-income investments are a large component of foreign investments in the U.S., while U.S. investors favor equities and other assets that have a higher expected rate of return when investing abroad (Chart I-7). This gap increased after the Great Recession as U.S. interest rates fell by more than the return U.S. investors received on their foreign assets. Today's gap, at almost 1½ percentage points, is well above the 1 percentage point average for the two decades leading up to the Great Recession. Chart I-6U.S. Investors Harvest##br## Higher Returns Chart I-7Composition Of Net International##br## Investment Position A yield gap of 1.5 percentage points may not sound like much, but it has been enough that the U.S. enjoys a positive net inflow of private investment income of about 1.2% of GDP, despite the fact that foreign investors hold far more U.S. assets than the reverse (Chart I-6, top panel). In Chart I-8 we simulate the primary investment balance based on a persistent 3% of GDP current account deficit and under several scenarios for the investment yield gap. Perhaps counterintuitively, the primary investment surplus that the U.S. currently enjoys will actually rise slightly as a percent of GDP if the yield gap remains near 1½ percentage points. This is because, although the NIIP balance becomes more negative over time, U.S. liabilities are not growing fast enough relative to its assets to offset the yield differential. Chart I-8Primary Investment Balance Simulations However, some narrowing in the yield gap is likely as the Fed raises interest rates. Historically, the gap does not narrow one-for-one with Fed rate hikes because the yield on U.S. investments abroad also rises. Assuming that the yield gap returns to the pre-Lehman average of 1 percentage point over the next three years, the primary investment balance would decline, but would remain positive. Only under the assumption that the yield gap falls to 50 basis points or lower would the primary balance turn negative (Chart I-8, bottom panel). Crossing the line from positive to negative territory on investment income is not necessarily a huge red flag for the dollar, but it would signal that foreign debt will begin to impinge on the U.S. standard of living. That said, the yield gap will have to deteriorate significantly for this to happen anytime soon. What Drives The Major Swings In The Dollar? While the dollar has been in a structural bear market for many decades, there have been major fluctuations around the downtrend. Since 1980, there have been three major bull phases and two bear markets (bull phases are shaded in Chart 9). These major swings can largely be explained by shifts in U.S./foreign differentials for short-term interest rates, real GDP growth and productivity growth. A model using these three variables explains most of the cyclical swings in the dollar, as the dotted line in the top panel of Chart I-9 reveals. Chart I-9U.S. Dollar Cyclical Swings Driven By Three Main Factors The peaks and troughs do not line up perfectly, but periods of dollar appreciation were associated with rising U.S. interest rates relative to other countries, faster relative U.S. real GDP growth, and improving U.S. relative productivity growth. Since the Great Recession, rate differentials have moved significantly in favor of the dollar, although U.S. relative growth improved a little as well. Productivity trends have not been a factor in recent years. Note that the current account has been less useful in identifying the cyclical swings in the dollar. Looking ahead, we expect short-term interest rate differentials to shift further in favor of the U.S. dollar. We assume that the Fed will hike rates three additional times in 2018 and another three next year. The Bank of Japan will stick with its current rate and 10-year target for the foreseeable future. The ECB may begin the next rate hike campaign by mid-2019, but will proceed slowly thereafter. We expect rate differentials to widen by more than is discounted in the market. As discussed above, we also expect growth momentum to swing back in favor of the U.S. economy in 2018. U.S. productivity growth will continue to underperform the rest-of-world average over the medium and long term. Nonetheless, we expect a cyclical upturn in relative productivity performance that should also support the greenback for the next year or two. Conclusion Reducing the U.S. structural external deficit to a sustainable level would require significant macro-economic adjustments that seem unlikely for the foreseeable future. We would need to see some combination of a higher level of the U.S. household saving rate, a balanced Federal budget balance or better, and/or much stronger growth among U.S. trading partners. In other words, the U.S. would have to become a net producer of goods and services, and either Europe or Asia would have to become a net consumer of goods and services. Current trends do not favor such a role reversal. Indeed, the U.S. twin deficits are sure to move in the wrong direction for at least the next two years. Longer-term, pressure on the federal budget deficit will only intensify with the aging of the population. The shortfall in terms of net foreign assets will continue to grow, which means that the long-term structural downtrend in the trade-weighted value of the dollar will persist. Other structural factors, such as international productivity trends, also point to a long-term dollar depreciation. It seems incongruous that the U.S. dollar is the largest reserve currency and that U.S. is the world's largest international debtor. The situation is perhaps perpetuated by the lack of an alternative, but this could change over time as concerns over the long-run viability of the Eurozone ebb and the Chinese renminbi gains in terms of international trade. The transition could take decades. The U.S. twin-deficits situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is anywhere close to the point where investors would begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see no reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are other risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. In 2018, we expect the dollar to partially unwind last year's weakness on the back of positive cyclical forces. Additional protectionist measures should support the dollar as long as retaliation is muted. Mark McClellan Senior Vice President The Bank Credit Analyst Mathieu Savary Vice President Foreign Exchange Strategy 1 A Wave of Protectionism? An Analysis of Economic and Political Considerations. Bank of Canada Working Paper 2008-2. Philipp Maier. 2 The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002. Trade Partnership Worldwide, LLC. Joseph Francois and Laura Baughman. February 4, 2003. 3 See footnote to Chart 1. 4 Fiscal Policy and the Current Account. Center for Economic Policy Research, Discussion Paper No. 7859 September 16, 2010. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: Headline and core producer prices increased at a 3% and 2.7% annual pace, respectively, outperforming expectations; Headline and core inflation came out at 2.4% and 2.1%, respectively, in line with expectations; However, continuing and initial jobless claims both came out higher than expected. The depressing impact on prices of the fall in mobile-phone service costs is passing, creating a base effect that is lifting inflation. While core inflation is now above 2%, core PCE-the Fed's preferred measure - still sits at 1.6%. However, as CPI is set to accelerate further, so will core PCE. Rising U.S. inflation means that the Fed is unlikely to be as responsive to slower global growth as it was in 2016, pointing to a rally in the dollar this year. Report Links: More Than Just Trade Wars - April 6, 2018 Do Not Get Flat-Footed By Politics- March 30, 2018 Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was disappointing this week: In monthly terms, German exports and imports contracted by 3.2% and 1.3%, respectively. As a result, the trade and current account surplus decreased; French industrial output disappointed expectations; On an annual basis, European industrial production grew at a disappointing pace of 2.9%, less than the 3.8% anticipated by the market. IP contracted in monthly terms. The euro at first rallied this week, but the ECB's minutes revealed sharp debates among members of the Governing Council about the degree of labor market slack in the euro area. This caused a correction in the euro by Thursday. With global growth waning and geopolitical risks, especially in the Middle East, growing, equity volatility is likely to spread to the fixed income and FX space. This should be unfavorable for the euro as investors remain very long the common currency. Investors should position themselves for the euro's current consolidation to morph into a short-term correction. 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 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Labor cash earnings yearly growth outperformed expectations, coming in at 1.3%. Additionally the previous month reading was revised from 0.7% to 1.2%; Moreover, the leading economic indicator also outperformed expectations, coming in at 105.8; However, consumer confidence underperformed expectations, coming in at 44.3. USD/JPY has been relatively flat this week as the yen continues to consolidate previous strength. As global grows is slowing, the Japanese currency will continue to strengthen in the coming quarters. Moreover, geopolitical tensions are set to continue throughout the year, giving an added shine to the yen. That being said, the strength of the yen has already begun to hurt the Japanese economy, thus the BoJ will be forced to lean against this strength. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data has been mixed: Halifax house prices outperformed expectations, coming in at 2.7% on a year-on-year basis; However, industrial production annual growth underperformed expectations, coming in at 2.2%; Moreover, manufacturing production annual growth also underperformed expectations, coming in at 2.5%. GBP/USD has rallied nearly 1% this week, mainly due to the weakness in the dollar caused by trade tensions as well as political grandstanding in Syria between major powers. Nevertheless, we continue to believe that the upside for the pound is limited, given that inflation in the U.K. should begin to slow due to the appreciation of the pound. Moreover, the weak housing market will be another factor weighing on the economy, slowing the BoE in their hiking campaign. 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 Chart II-10AUD Technicals 2 Australian data was mixed: The AiG Performance of Construction Index in March came out better than expected at 57.2, up from 56; NAB Business Confidence disappointed expectations, coming in at 7; NAB Business Conditions came in at 14, less than the expected 17; Westpac Consumer Confidence came in negative at -0.6%. The Australian economy continues to operate below capacity. Although business investment has picked up, consumer spending growth has been limited by low wage increases. Furthermore, the risk of increasing trade tensions between the U.S. and China remains a big risk for the RBA as the Australian economy is highly geared to global trade. Hence, both the domestic and international environment will keep the RBA from raising rates. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has rallied by 1.6% since last week, as the dollar has depreciated amid trade tensions as well as geopolitical tension in the Middle East. Overall, we continue to believe that the trade-weighted NZD will be at risk, particularly against the yen, given that carry and commodity currencies should suffer relative to safe havens in the current environment of slowing growth and rising political risk. That being said, the NZD will probably outperform the AUD. If economic activity slows in China, iron ore prices - Australia's main export - will likely be one of the main victims. On the other hand, dairy products, though affected, will probably hold up better than metals. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was mixed: Housing starts came out stronger than expected, increasing by 225,000; Building permits, however, contracted by 2.6% on a monthly pace; New housing prices increased at a less than expected annual rate of 2.6%; Progress on the NAFTA negotiations and higher oil prices have helped the CAD's performance so far this month, with the loonie outperforming every G10 currency. This trend is likely to continue based on favorable fundamentals relative to the rest of the G10 economies. 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 Chart II-16CHF Technicals 2 Recent data in Switzerland has been neutral: The unemployment rate came in line with expectations at 2.9%. Moreover, it remained at last month's level; Additionally, foreign currency reserves came in above expectations at 738 billion, signaling that the SNB was been actively intervening in currency markets. EUR/CHF has risen by more than 1% this week. Overall, we expect this trend to continue in the long term, given that the SNB want to avoid too-strong a franc. That being said this cross could see some upside on a tactical basis, given that rising geopolitical tensions should boost to the attractiveness of safe-heaven currencies like the franc. 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 Chart II-18NOK Technicals 2 Recent data in Norway has been negative: Headline inflation underperformed expectations, coming in at 2.2%; Moreover, core inflation also surprised negatively, coming in at 1.2%. This represented a significant slowdown from last month's 1.4% annual pace. USD/NOK has fallen by about 1% this week, as the dollar weakened and oil prices rallied in response to growing Middle East tensions. Overall, we continue to believe that the NOK will outperform other commodity currencies like the AUD and the NZD, given that oil should outperform other commodities as oil supply is tighter than base metals' and as global growth slows. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 This week's inflation figures from Sweden disappointed once again, with consumer prices growing at a 1.9% annual clip, slightly below expectations of 2%. While this slowdown in inflation is causing investors to question the resolve of the Riskbank to hike interest rates this year, the main reason behind the SEK's surprising weakness is the emerging slowdown in global growth. Because both Sweden economic activity and price indices are very levered to the global industrial cycle, Sweden could suffer significantly if the floor falls under global growth. However, we do not think that global growth is likely to fall below trend, which suggests that the SEK is becoming a great bargain. However, leading indicators of the global business cycle will have to stabilize before investors buy the krona. 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 Apart from rising geopolitical tensions, our main macro themes remain a growth slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Subsiding NAFTA risks argue for overweighting Mexican stocks within an EM equity portfolio. This is in line with our recent upgrade of Mexican local and U.S. dollar sovereign bonds as well as the peso's outlook versus their EM peers. A new trade: Fixed-income trades should bet on yield curve steepening in Mexico by paying 10-year swap rates and receiving 2-year rates. Close overweight Russian markets positions in the wake of escalating U.S. sanctions. Feature Before discussing Mexico and Russia, we offer an update on our thoughts on the overall market outlook. EM: Looking Under The Hood Investor sentiment remains buoyant on global risk assets, and the buy-on-dips mentality remains well entrenched. On the surface, investors are not finding enough reasons to turn negative on global or EM risk markets. Nevertheless, when looking under the EM hood, we see several leading and coincident indicators that are beginning to flash red. Not only do geopolitics and the U.S.-China trade confrontation pose downside risks, there are also several macro developments that are turning from tailwinds to headwinds for EM risk assets. Specifically: EM manufacturing and Asian trade cycles have probably topped out. The relative total return (carry included) of three equally weighted EM1 (ZAR, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has relapsed since early this year, coinciding with the rollover in the EM manufacturing PMI index (Chart I-1). This currency ratio is herein referred to as the risk-on/safe-haven currency ratio. Chart I-1Risk On / Safe-Haven Currency Ratio And EM Manufacturing PMI The risk-on/safe-haven currency ratio also correlates with the average of new and backlog orders components of China's manufacturing PMI (Chart I-2). The latter does not herald an upturn in this currency ratio at the moment. Share prices of global machinery, chemicals and mining companies have so far underperformed the overall global equity index in this selloff, as exhibited in Chart I-3. Chart I-2China's Industrial Cycle Has Rolled Over Chart I-3Global Cyclicals Have Underperformed, Though Not Tech Potential trade wars, the setback in technology stocks and a resurgence of volatility in global equity markets have recently dominated news headlines. Yet, the underperformance of China-exposed global sectors and sub-sectors signifies that beneath the surface Chinese growth is weakening. Meanwhile, global tech stocks have not yet underperformed much (Chart I-3, bottom panel), implying the selloff has not been driven by this high-flying sector. The combination of weakening global trade amid still-robust U.S. domestic demand bodes well for the U.S. dollar, at least against EM and commodities currencies. U.S. and EU imports account for only 13% and 11% of global trade, respectively (Chart I-4). Meanwhile, aggregate EM including Chinese imports account for 30% of world imports. Hence, global trade can slow even with U.S. and EU domestic demand remaining robust. We addressed the twin deficit issue in the U.S. in our February 21 report,2 and will add the following: If U.S. fiscal stimulus coincides with abundant global growth, the greenback will weaken. If on the contrary, the U.S. fiscal expansion overlaps with weakening global trade, U.S. growth will be priced at a premium and the U.S. dollar will appreciate especially against the currencies of economies where growth will fall short. The majority of EM exchange rates will likely be in the latter group. The relative performance of EM versus DM stocks correlates with the relative volume of imports between China and the DM (Chart I-5). The rationale is that EM countries and their publically listed companies are much more leveraged to China's business cycle than DM. The opposite is true for DM-listed companies. Our view is that China's industrial recovery and growth outperformance versus DM since early 2016 is about to end. This, if realized, should undermine EM equities and currencies versus their DM counterparts. Last week, we published a Special Report on the Chinese real estate market.3 We documented that despite a drawdown in housing inventories over the past two years, both residential and non-residential inventories remain very elevated. This, along with poor affordability and the implementation housing purchase restrictions for investors, will dampen housing sales, which in turn will lead to a contraction in property development and construction activity. Chart I-4Global Trade Is More Leveraged To EM Not DM Chart I-5EM Underperforms When Chinese Imports Lag DM Ones Combined with a slowdown in infrastructure investment due to tighter controls on local government finances, this poses downside risks to China's demand for commodities, materials and industrial goods. This is the main risk to EM stocks and currencies, and the primary reason we continue to maintain our negative stance on EM risk assets. Last but not least, it is widely believed that Chinese households are not indebted and that there is a lot of pent-up demand for household credit. Chart I-6 reveals that this conjecture is simply not true - the household debt-to-disposable income ratio has surged to 110% of disposable income in China. The same ratio is currently 107% in the U.S. Given borrowing costs in general and mortgage rates in particular are higher in China than in the U.S. (the mortgage rate is 5.2% in China versus 4.4% in the U.S.), interest payments on debt account for a larger share of households' disposable income in China than in America right now. In the U.S., the surprise on the macro front in the coming months will likely be both rising wage growth and core inflation. Chart I-7 highlights that average hourly earnings in manufacturing and construction have been accelerating. This underscores that wages are rising fast in these cyclical sectors. This will spread to other sectors sooner rather than later. Core inflation in America is rising and has already moved above 2% (Chart I-8). The rise is broad-based as all different core consumer price measures are rising and heading toward 2%. Chart I-6Chinese Households Are As Leveraged As Americans Chart I-7U.S. Wages Are Accelerating Chart I-8U.S. Core Inflation Is Above 2% While this does not entail that the U.S. is heading into runaway inflation, rising core inflation and wage growth will likely lead many investors to believe that the Federal Reserve cannot back off too fast from rate hikes, particularly when the U.S. fiscal thrust remains so positive, even if the drawdown in share prices persist. This may especially weigh on EM risk assets, where growth will be subsiding due to their links with Chinese imports. Bottom Line: Our main macro themes remain a slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Upgrade Mexican Equities To Overweight In our March 29 report,4 we upgraded our stance on the Mexican peso, local currency bonds and U.S. dollar sovereign credit from neutral to overweight. The main rationale was receding odds of NAFTA abrogation and the country's healthy macro fundamentals. In addition, we instituted a new currency trade: long MXN / short BRL and ZAR. Continuing with this theme, we today recommend upgrading Mexican stocks to overweight within an EM equity portfolio: The odds of NAFTA retraction are rapidly subsiding as the U.S. is shifting its focus to China. Hence, chances are that NAFTA negotiations will be completed this summer, and a deal will be signed off before Mexico's presidential elections on July 1st. A more benign outcome together with an early end to NAFTA negotiations will reduce uncertainty and the risk premium priced into Mexican financial markets. This will help the latter outperform their EM peers. A final note on Mexican politics: The leftist presidential candidate Andres Manuel Lopez Obrador has high chances of winning the presidential elections in July. Yet Our colleagues at BCA's Geopolitical Strategy service believe political risks are overstated.5 The basis is that Obrador will balance the left-leaning preferences of his electorate with the prudent policies needed to produce robust growth. While political uncertainty in Mexico is subsiding, it is rising in many other EM countries such as Russia, China and Brazil. In brief, geopolitical dynamics favor Mexico versus the rest of EM. We expect dedicated EM managers across various asset classes to rotate into Mexico from other EM countries. We outlined two weeks ago that a stable exchange rate will bring down inflation, opening a door for the central bank to cut interest rates no later than this summer. As local interest rate expectations in Mexico continue to subside both in absolute terms as well as relative to EM, Mexican share prices will outpace their EM peers (Chart I-9). Consistently, tightening Mexican sovereign credit spreads versus EM overall should also foster this nation's equity outperformance (Chart I-10). Chart I-9Relative Equity Performance Tracks Relative ##br##Local Bond Yields Chart I-10Relative Equity Performance Tracks Relative ##br##Sovereign Spreads Domestic demand growth has plunged following monetary and fiscal tightening in the past two years (Chart I-11). As both fiscal and monetary policy begin to ease, domestic demand will recover later this year. Chances are that share prices will sniff this out and begin their advance/outperformance sooner than later. Consumer staples and telecom stocks together account for 50% of the MSCI Mexico market cap, while the same sectors make up only 11% of overall EM market cap. Hence, Mexico's relative equity performance is somewhat hinged on the outlook for these two sectors in general and consumer staples in particular. EM consumer staple stocks have massively underperformed the EM benchmark since early 2016 (Chart I-12, top panel), and odds are this sector will outperform in the next six to 12 months as defensive sectors outperform cyclicals. This in turn heralds Mexico's relative outperformance versus the EM benchmark, which seems to be forming a major bottom (Chart I-12, bottom panel). Chart I-11Mexico: Economic Downturn Is Well Advanced Chart I-12Mexican Bourse Is A Play On Consumer Staples Unlike many EM countries, the Mexican economy is much more leveraged to the U.S. than to China. One of our major themes remains favoring U.S. growth plays versus Chinese ones. Finally, Mexican equity valuations have improved quite a bit both in absolute terms and relative to EM. Chart I-13 shows our in-house CAPE ratios for Mexican stocks in absolute terms and relative to the EM overall benchmark: Mexican equity valuations are not cheap but they are no longer expensive. Consistent with upgrading our economic outlook on Mexico, fixed-income investors should bet on yield curve steepening in local rates. We initiated this strategy on January 31 but hedged the NAFTA risk by complementing it with a yield curve flattening leg in Canada. Now, we are closing that trade and initiating a new one: fixed-income traders should consider paying 10-year swap rates and receiving 2-year swap rates. The yield curve is as flat as it typically gets (Chart I-14, top panel). Moreover, 2-year swap rates are not yet pricing enough rate cuts (Chart I-14, bottom panel) but will soon begin gapping down pricing in a large (potentially close to 200 basis points) rate cut cycle. Chart I-13Mexican Equities Are No Longer Expensive Chart I-14Bet On Yield Curve Steepening In Mexico Bottom Line: In line with our recent upgrade of Mexican local and U.S. dollar bonds as well as the currency outlook versus their EM peers, this week we recommend EM dedicated equity portfolios shift to an overweight position in Mexican stocks. Fixed-income trades should bet on yield curve steepening by paying 10-year swap rates and receiving 2-year rates. Investors who are positive on global risk assets should consider buying Mexican local bonds outright. Russia: Geopolitics Trumps Economics Chart I-15Russian Assets Relative To EM Benchmarks:##br## Various Asset Classes The sudden crash in Russian financial markets this week following the imposition of new U.S. sanctions has reminded us that geopolitics can often eclipse economics. Our overweight recommendation on Russian assets versus their EM peers was based on two pillars: (1) healthy and improving macro fundamentals and an unfolding cyclical economic recovery; and (2) easing tensions between Russia and the West. Clearly, the second part of our assessment is wrong, or at least premature. While BCA's Geopolitical Service team maintains that on a 12-month horizon tensions between Russia and the West will subside, the near-term risks are impossible to assess. For this reason we are closing our overweight allocation in Russian financial markets and recommend downgrading it to neutral. In particular, we are shifting Russia to a neutral allocation within the EM equity, sovereign and corporate credit and local currency bonds portfolios (Chart I-15). Consistently, we are closing the following trades: Long Russian / short Malaysian stocks (27.6% gain); Long Russian energy / short global energy stocks (2.8% gain); Long RUB / short MYR (3.1% loss); Short COP / long basket of USD & RUB (16.2% loss); Long RUBUSD / short crude oil (29.1% loss). Sell Russian 5-year CDS / buy South African 5-year CDS (317 basis points gain); Long Russian and Chilean / short Chinese Corporate Credit (12% gain); Long Russian 5-year bonds / short Brazilian 5-year bonds (flat). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We have removed the Russian ruble from the version of this chart shown in March 29, 2018 EMS report to assure that the recent idiosyncratic developments - the selloff triggered by the U.S. sanctions - in Russia's financial markets do not impact the reading of this indicator. 2 Pease see Emerging Markets Strategy Weekly Report "EM Local Bonds And U.S. Twin Deficits", dated February 21, 2018, Page 14. 3 Pease see Emerging Markets Strategy Weekly Report "China Real Estate: A Never-Bursting Bubble?", dated April 6, 2018, Page 14. 4 Pease see Emerging Markets Strategy Weekly Report "EM: Perched On An Icy Cliff", dated March 29, 2018, available at ems.bcaresearch.com. 5 Pease see Geopolitcial Strategy Weekly Report "Expect Volatility... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The ECB admits that its policy is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro will eventually correct. And German consumer services will structurally outperform the consumer goods exporters. Feature Let's begin with some facts, which are difficult to dispute. Fact 1: The euro area is running a €400 billion trade surplus with the rest of the world, equivalent to 4% of euro area GDP. €300 billion of this surplus resides in Germany.1 Fact 2: The trade surplus is a direct result of the undervaluation of the euro (Chart of the Week). This we know, because the surplus has evolved as a perfect mirror image of the euro's undervaluation as calculated by the ECB itself. The central bank admits that the euro is undervalued by around 10%2 (Chart I-2). Chart of the WeekThe Euro Area's Huge Trade Surplus Is Due To The Undervalued Euro Chart I-2The Euro Is Undervalued By 10% Fact 3: The substantial undervaluation of the euro is the unavoidable result of the of the ECB's extreme experiment with bond buying and zero and negative interest rates. This we know, because the euro's undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3 and Chart I-4). Chart I-3The Euro Is Undervalued Because Of The ##br##ECB's Ultra-Accommodative Policy Chart I-4The Euro Has Tracked Expected##br## Relative Monetary Policy Nevertheless, a reasonable riposte to facts 1-3 is that the ECB does not target the euro exchange rate. The ECB sets policy to achieve its price stability mandate, which it defines as an inflation rate of "below, but close to, 2%", the same definition as the Federal Reserve uses. Given that the ECB is further from its price stability mandate than the Fed is, the ECB has to set much more accommodative policy. And there the story might end. 2% Inflation In The Euro Area Is Different To 2% Inflation In The U.S. Except that the story has a twist. The price stability mandates of the ECB and Fed appear very similar, but they are not. The ECB mandate is much harder to achieve, because of two further facts. Fact 4: The definitions of consumer prices in the euro area and the U.S. are quite different. The euro area's Harmonized Index of Consumer Prices (HICP) excludes the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes it at a very substantial 25% weight. The omission of owner-occupied housing costs - which consistently tend to rise faster than other prices - makes it much more difficult for overall inflation to reach 2%. Indeed, excluding shelter, core inflation in the U.S. today is running at 1.2%, the same rate as in the euro area (Chart I-5 and Chart I-6). Chart I-5Core Inflation Is Higher##br## In The United States... Chart I-6...But On A Like-For-Like Basis, Core Inflation##br## Is Not Higher In The United States Fact 5: The ECB has a single mandate of price stability, whereas the Fed has a dual mandate of price stability and maximizing employment. Some people even argue that the Fed has a triple mandate which includes financial stability. The point is that for Fed policy, price stability is only one of several considerations, creating flexibility; whereas for ECB policy, price stability is the only consideration, creating inflexibility. Nevertheless, a reasonable riposte to facts 4-5 is that we must just accept that the ECB and Fed operate within different frameworks. If the ECB's framework necessitates ultra-accommodative monetary policy today, then so be it. And there the story might end. Why Should Americans Pay For European Integration? Except that the story has another twist. The ECB framework wasn't always what it is today. Fact 6: On May 8 2003, the ECB changed its definition of price stability from "inflation below 2%" to "inflation below, but close to, 2%". Thereby, the addition of three small words transformed the flexibility of a 0-2% inflation range to the inflexibility of a 2% point target. Why did the ECB change its objective and make it so much more difficult? Here is the answer, straight from the horse's mouth: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%" - Mario Draghi So there you have it - the ECB admits that it changed its objective to ease the integration burden on weaker euro area economies. The undisputed consequence is structurally easier monetary policy than would be the case without the integration burden. The ECB also admits that an unavoidable result is a structurally undervalued euro, meaning a substantial competitive advantage for the euro area versus its major trading partners, including the United States. To which President Trump might rightly ask: why should American competitiveness shoulder the burden for European integration? Trump's crosshairs may be trained on Germany, which is running the largest export surplus. But he should redirect his focus to the ECB. The majority of German export hyper-competitiveness is no fault of Germany, it is due to the structural undervaluation of the euro (Chart I-7). Moreover, while an undervalued euro benefits exporters, it hurts euro area household real incomes by raising the prices of dollar-denominated energy and food imports, whose demand is inelastic. German households are also deeply unhappy about the negligible interest on their savings. Chart I-7The Majority Of Germany's Hyper-Competitiveness Is Due To The Undervalued Euro The Way Forward, And Some Investment Considerations Ultra-accommodative policy was not the game changer that is sometimes claimed. The euro area's strong recovery started more than a year before the ECB even mooted its extreme accommodation. The turning point came in 2013 when euro area banks stopped aggressively de-levering their balance sheets ahead of the bank stress test (Chart I-8). Chart I-8The Euro Area Recovery Started In 2013 When Banks Ended Their Aggressive De-Levering Mario Draghi admits that policy today is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The ECB has a legal obligation to achieve price stability as its sole objective, but the precise definition of price stability is up to the central bank. To reintroduce some flexibility, it has two options: 'cross-sectional' flexibility, by reintroducing an inflation target range; or 'longitudinal' flexibility by a more relaxed interpretation of the 'medium term' timeframe required to achieve its point target. Of these two options, we expect a gradual move to greater longitudinal flexibility, especially as 'medium term' is already open to considerable interpretation. This will create three structural investment opportunities. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro - as calculated by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually corrects, the decade-long outperformance of consumer goods exporters versus consumer services will reverse, especially in Germany (Chart I-9 and Chart I-10). Overweight German consumer services versus consumer goods exporters. Chart I-9Consumer Services Have ##br##Underperformed In Europe... Chart I-10...But Are Starting To Turn ##br##Around In Germany Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Q4 2017 at an annualised rate. 2 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model* This week, we note that the rally in the Spanish 10-year government bond is extended and ripe for a countertrend reversal. Implement this as a pair-trade: short the Spanish 10-year bond, long the German 10-year bund. The profit target and symmetrical stop-loss is 1%. Lever up to increase potential return. We are also pleased to report that our short Helsinki OMX / long Eurostoxx600 trade achieved its 3% profit target and is now closed. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##Br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights There is more downside risk ahead as the geopolitical calendar is packed in May; Protectionism remains in play, but markets could also fall on Iran-U.S. tensions, military intervention in Syria, and Russia-West confrontation; Investors should expect volatility to go up as we approach a turbulent summer; We were wrong on Russia-West tensions peaking and are closing all of our Russian trades for now, but may look for new entry points soon; Go long a basket of NAFTA currencies versus the Euro and expect reflation to remain the "only game in town" in Japan. Feature "I'm not saying there won't be a little pain, but the market has gone up 40 percent, 42 percent so we might lose a little bit of it. But we're going to have a much stronger country when we're finished. So we may take a hit and you know what, ultimately we're going to be much stronger for it." President Donald Trump, April 6, 2018 Chart 1Teflon Trump There are times when conventional wisdom is spectacularly wrong. Last week was such a moment. Since Donald Trump became president, the "smart money" has believed that he was obsessed with the stock market. Therefore, the view went, none of his policies would threaten the bull market. We have pushed back against this assumption because our view is that geopolitical risks - specifically the lack of constraints on the executive branch in foreign and trade policy - would become investment relevant.1 This view has been correct thus far: we called the volatility spike and trade protectionism in 2018. Not only have President Trump's tariff pronouncements produced stock market drawdowns, but his popularity appears to be unaffected. Astonishingly, President Trump's approval rating collapsed as the stock market went up in 2017 and recovered as the stock market went in reverse this year (Chart 1)! It is therefore empirically incorrect that President Trump is constrained by the stock market. His actions over the past month, as well as his approval ratings, suggest that he is quite comfortable with volatility. There are two broad reasons why we never bought into the media hype. First, there is no real correlation, or only a weak one, between equity declines of 10% and presidential approval ratings (Chart 2). Generally, presidential approval rating does decline amidst market drawdowns of 10% or greater, but the effect on the presidency is only permanent if the momentum of the approval rating was already heading lower, otherwise the effect is minimal and temporary. Second, the median American does not really own stocks (Table 1). President Trump considers blue collar white voters his base and they care more about unemployment and wages, not their equity portfolios. At some point, equity market drawdowns will affect hard data and the real economy. This is the point at which President Trump will care about the stock market. Given that the market is already down 10% from the peak, we are not far away from this pain threshold. But in this way, President Trump is no different from any other president. Chart 2AThe Stock Market Mattered For Eisenhower, JFK, Bush Sr., And Obama... Chart 2B...But Not For Johnson, Nixon, Ford, Carter, Reagan, And Bush Jr. The pessimistic view on trade protectionism risk, that there is more downside to equities ahead, is therefore still in play. Investors should be careful not to overreact to positive developments, such as President Xi's speech at the Boao Forum where he largely reiterated previous Beijing promises to open up individual sectors to foreign investment. In fact, it is the investment community itself that is the target of President Trump's rhetoric. In order to convince Beijing that his threat of protectionism is credible, President Trump has to show that he is willing to incur pain at home, which explains the quote with which we began this report. Table 1Stock Ownership Is Concentrated Amongst The Wealthiest Households This is not dissimilar to President Trump's doctrine of "maximum pressure" which, when applied to North Korea, produced a significant bond rally last summer. The 10-year Treasury yield topped 2.39% on July 7 and then collapsed to a low of 2.05% in September.2 The vast majority of the yield decline, at the time, came from falling real yields as investors flocked into safe-haven assets amidst North Korean tensions and not lower inflation expectations. It is therefore dangerous to rely on conventional wisdom when assessing the limits of volatility or equity drawdowns. Any buoyant market reaction may in fact elicit a more aggressive policy from Washington. As if on cue, President Trump shocked the markets on April 7 by suggesting that he would impose another round of tariffs on a further $100bn worth of Chinese imports, bringing the total under threat to $160 billion. The announcement came after the market closed 0.89% up on April 6. Perhaps President Trump was irked that the market was so dismissive of his trade threats and decided to jolt it back to reality. In addition to trade, there are several other reasons to be bearish on risk assets as we approach May: Chart 3Inflation Will Pick Up In 2018 Chart 4Service Sector Wage Growth Is At A Cyclical Peak Inflation: Unemployment is low, with wage pressures starting to build (Chart 3). Meanwhile, teacher strikes in Red States like Oklahoma, Kentucky, West Virginia, and Arizona are signalling that public service sector wage pressures are building in the most fiscally prudent states. Service sector wages cannot be suppressed through automation or outsourcing and are therefore likely to add to inflationary pressures (Chart 4). The Fed remains in tightening mode, despite the mounting geopolitical risks. "Stroke of pen risk:" Another sign that President Trump is comfortable with market drawdowns is his increasingly aggressive rhetoric on Amazon. There is a rising probability that the current administration decides to up the regulatory pressure on the technology and retail giant, as well as a possibility that other technology companies like Facebook and Google face "stroke of pen" risks. Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions.3 Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has staffed his cabinet with two hawks, new Secretary of State Mike Pompeo and National Security Advisor John Bolton. Meanwhile, tensions in Syria are building with potential for U.S. and Iranian forces to be directly implicated in a skirmish. The U.S. is almost certain to militarily respond to the alleged chemical attack by the Syrian government forces against the rebel-held Damascus suburb of Douma. Throughout it all, investors appear to remain unfazed by the rising probability that Iran's 2 million barrels of oil exports come under renewed sanction risk, mainly because the media is ignoring the risk (Chart 5). Chart 5The Media Is Ignoring Iran As A Risk Russia: As we discuss below, tensions between the West and Russia appear to be building up anew. Particularly concerning is the aforementioned chemical attack in Syria, which Moscow considers a "false flag operation." The Russian government hinted in mid-March that precisely such an attack may occur and that the U.S. would use it as a pretext to attack Syrian government forces and structures.4 Our view that tensions have peaked, elucidated in a recent report, therefore appears to have been spectacularly wrong. Chinese reforms: Now that Xi Jinping has finished setting up his new government, his initiatives are starting to be implemented. While some slight tax cuts are on the docket, and interbank rates have eased significantly, there is no sign of broad policy easing or economic recovery (Chart 6). Rather, both Xi and his economic czar Liu He have continued to stress the "Three Battles" of systemic financial risk, pollution, and poverty - the first two requiring tighter policy. Xi has stated that deleveraging will focus on state-owned enterprises (SOEs) and local governments. SOEs will have debt caps and will not be allowed to lend to local governments. Instead, local governments will have to borrow through formal bond markets, giving the central government greater control. Meanwhile, the Ministry of Housing says property restrictions will remain in place. All in all, the risk of negative surprises in China this year remains significant, with a likely negative impact on global growth.5 There is also a fundamental reason for equity market weakness: the market is likely coming to grips with a calendar 2019 EPS growth of a more reasonable 10% annual rate compared with this year's near 20% peak growth rate. This transition, which our colleague Anastasios Avgeriou of BCA's U.S. Equity Strategy has highlighted in recent research, will be turbulent.6 In addition, Anastasios has pointed out that stocks are reacting to a more bearish mix of soft and hard data (Chart 7), suggesting that not all of the market volatility is due to headline risk. Chart 6China Will Slow Down Further In 2018 Chart 7Trade Is Not The Only Risk To The Market How should investors make sense of these budding risks? Going forward, we would fade any enthusiasm or narratives of "peak pessimism" on trade protectionism. It is in the interest of the Trump administration that investors take his threats seriously. President Trump literally needs stocks to go down in order to show Beijing that he is serious. The summer months could be volatile as market confusion grows amidst the upcoming event risk (Table 2). This may be a good time to be risk-averse, with the old adage "sell in May and go away" appropriate this year. Table 2Protectionism: Upcoming Dates To Watch There are several reasons why protectionism is a much bigger deal than it was in the 1980s when investors last had to price a trade war between two major economies (Japan and the U.S. at the time): Chart 8This Time Is Different... Because Of Supply Chains... Chart 9...Globalization... Supply chains are a much bigger deal today than thirty years ago (Chart 8); The share of global exports as a percent of GDP is much higher today (Chart 9); Interest rates are much lower, leaving little room for policymakers to ease (Chart 10); Stock market valuations are higher, leaving stocks exposed to drawbacks (Chart 11); Unlike 1981-88, when Japan and the U.S. waged a nearly decade-long trade war while remaining allies in the Cold War, China and the U.S. are outright rivals. This increases the probability that Beijing's reprisal, given its constraints in retaliating against U.S. exports (Chart 12), could take a geopolitical turn. Chart 10...Policymaker Ammunition... Chart 11...And Valuations Chart 12China May Run Out Of U.S. Exports To Sanction Investors should therefore prepare for volatility of volatility. Amidst the confusion, there could be some not-so-positive news that the market overreacts to with optimism, and some not-so-negative news that the market reacts to with pessimism. In our six years of publishing geopolitically driven investment strategy, we have not seen a similar period where a confluence of risks and tensions are building up at the same time. May should therefore be a busy month. Mexico: A Silver Lining Amidst Mercantilism Risk? Mexico began the year with clouds over its head due to the Trump team's tough negotiating line on NAFTA. The third round of negotiations, in September 2017, ended on a bad note. The peso tumbled and headline and core inflation soared, portending both tighter monetary policy and weaker domestic demand.7 Today, however, the odds of renewing NAFTA have improved significantly. We have reduced our probability of Trump abrogating the trade deal from 50% to 20%. The administration appears to be focused on China and therefore looking to wrap up the NAFTA negotiations quickly over the summer. This would give time to send the new deal to the Mexican and U.S. congresses prior to the September changeover in Mexico's legislature and January changeover in the U.S. legislature. The U.S. has reportedly compromised on an earlier demand that NAFTA-traded automobiles have a U.S. domestic content of 50%.8 Meanwhile, inflation has peaked and the peso has firmed up (Chart 13), which will help buoy real incomes and boost purchasing power. Economic policy has been prudent, with central bank rate hikes restraining inflation and government spending cuts producing a primary budget surplus (and a much-reduced headline budget deficit of -1% of GDP) (Chart 14).9 Chart 13Mexico: Peso & Inflation Chart 14Mexico: Improved Macro Fundamentals In this more bullish context, the Mexican elections on July 1 are market-neutral. True, it is hard to present a strong pro-market outcome. The public is shifting to the left on the economic spectrum while the outgoing "pro-market" administration of Enrique Pena Nieto has lost credibility. The latest polling suggests that Andres Manuel Lopez Obrador (AMLO) is polling in the lower 30-percentile (around 33%), above his next competitors, Ricardo Anaya (PAN) at 26% and Jose Antonio Meade (PRI) at 14% (Chart 15). However, the latest data point of the admittedly volatile polling gives AMLO a much less commanding lead of 6-7% over Anaya than he had before. AMLO is polling around his performance in the 2006 and 2012 elections (35% and 32%, respectively), has increased his lead over the other candidates, and his National Regeneration Movement (MORENA) and "Together We'll Make History" coalition are also polling with double-digit leads (Chart 16). The general shift to the left is also apparent in the fact that Ricardo Anaya's PAN has been forced to combine with the left-wing PRD in order to garner votes. Chart 15AMLO's Lead Is Not Insurmountable Chart 16Likely No Majority In Congress Nevertheless, political risk is overstated for the following reasons: AMLO is not Hugo Chavez:10 True, he is a leftist, a populist, and has a reputation for egotism. He is Mexico's fitting anti-Trump. Nevertheless, he is also a known quantity, having run for president and engaged with the major parties for over a decade. While he elevates headline political risk, we would fade the risk based on the fact that Mexico is a relatively right-wing country (Chart 17), and his movement will probably not garner a majority in Congress (see next bullet). Notably, AMLO's rhetoric on Trump and NAFTA has been restrained, and his personnel decisions have been competent and orthodox. He has not suggested he will revoke new private Mexican oil concessions, under the outgoing government's privatization scheme, but only halt the auctions. AMLO will be constrained by Congress: The trend in Mexico is towards "pluralization" or fragmentation in Congress (see Chart 18), meaning that ruling parties will have to share power. This is not a negative development. As we recently pointed out, political plurality engenders stability by drawing protest parties into centrist coalitions and by allowing establishment parties to coopt protest narratives without having to actually protest or revolt.11 At this point in time, it is difficult to see how AMLO's MORENA garners enough support to get a majority in Congress. AMLO's closest challenger is right-wing and pro-market: If AMLO loses the election, Ricardo Anaya of PAN will not be scorned by financial markets. In 2006, AMLO looked like he would win the election but then lost to Felipe Calderon (PAN). Of course, a victory by Anaya is not very market positive either, as PAN is in an unstable coalition with the left-wing PRD and would also be constrained in Congress. Still, there would be a lower probability of reversing the outgoing PRI administration's policies than under AMLO. AMLO is unlikely to repeal NAFTA: Mexico's exports to NAFTA partners comprise 30% of GDP, and it would be exceedingly dangerous for a Mexican leader to provoke Trump on the issue. A plurality of the Mexican public (44%) supports the ongoing NAFTA negotiations as they have been handled by the current government (Chart 19), as of late February polling by the Wilson Center. The same polling shows that Mexicans are generally aware of how important NAFTA is for their economy. This is despite the polls showing that a majority of Mexicans have a negative view of the U.S., due largely to Trump's rhetoric (though that majority has fallen considerably since last year to 56%). In other words, anti-American sentiment is not turning the Mexican public against compromising on a new NAFTA deal. Chart 17Mexicans Lean Right Chart 18Mexico's Rising Political Plurality Finally, Mexico is more exposed to U.S. growth (which is charged with fiscal stimulus), and to BCA's robust outlook on oil prices (as opposed to our weaker metals outlook), while it is less exposed to weakening Chinese demand than other EMs (such as South Africa or Brazil).12 The peso looks particularly attractive relative to the latter two currencies (Chart 20). Chart 19Mexicans Want NAFTA To Survive Chart 20A Major Bottom In MXN's Cross? None of the above should suggest that the Mexican election will be a smooth affair. The rise of AMLO will create jitters in the marketplace, particularly as he faces off against Trump, who will continue to try to pressure Mexico over immigration and border security even once NAFTA negotiations are squared away. Nevertheless, the cyclical backdrop has improved while the major headwind of NAFTA abrogation seems to be abating. Bottom Line: Mexico's presidential campaign, election, and aftermath will give rise to plenty of occasion for volatility, particularly as President Trump and a likely President Obrador will not shy from a war of words. Nevertheless, Mexico's economic policy is stable and the NAFTA headwind is abating. We recommend going long Mexican local currency bonds relative to the EM benchmark. We also recommend that clients go long a NAFTA basket of currencies - the peso and the loonie - versus the euro. Our currency strategist - Mathieu Savary - has recently pointed out that the euro has moved ahead of long-term fundamentals and is ripe for a near-term correction.13 Japan: Abe Will Survive Japanese Prime Minister Shinzo Abe has come under rising public criticism in recent that is dragging down his approval ratings (Chart 21). Three separate scandals are weighing on his administration: one relating to the government's sale of land at knockdown prices to a nationalist school, Moritomo Gakuen, tied to Abe's wife; another relating to the discovery of "lost" journals of Japan Self-Defense Force activity during the Iraq war; another tied to the mishandling of statistics in promoting the government's new revisions to the labor law. Abe's popularity has tested lower lows in the past, but he is approaching the floor. And while Abe is still polling in line with the popular Prime Minister Junichiro Koizumi at this stage in his term (Chart 22), nevertheless he is approaching his 65th month in office when Koizumi stepped down. Chart 21Abe's Approval Testing The Floor Chart 22Abe Holding At Koizumi's Levels Of Support More importantly, the all-important September leadership election is approaching. The challenges arising today are at least partly motivated by factions within the LDP that want to challenge Abe's leadership. Koizumi stepped aside in September 2006 because he could not contend for the LDP's leadership due to party rules that limited the leader to two consecutive three-year terms. Abe is not constrained on this front. He has already revised those rules to three terms, giving him until September 2021 to remain eligible as party leader. He wants to run again and incumbents are heavily favored in party elections. Abe also secured his second two-thirds supermajority in the House of Representatives, in October 2017. This was a remarkable feat and one that will make it difficult for contenders to convince the rank and file in Japan's prefectures that they can lead the party more effectively. While Abe's 38% approval is now slightly below the psychologically important 40% level, and below the LDP's overall approval rating (Chart 23), there is no alternative to the LDP heading into July 2019 elections for the House of Councillors. This is manifest from the October election result. Chart 23Still No Alternative To LDP What happens if Abe's popularity sinks into the 20-percentile range? Financial markets will selloff in anticipation that he will be ousted. He could conceivably survive a scrape with the upper 20% approval range, but markets will assume the worst once he dips beneath 30% in the average polling on a sustainable basis. Markets will also assume that the remarkably reflationary period in Japanese economic policy is coming to an end. Even when Abe's successor forms a government, investors may believe that the best of the reflationary push is over. We think that the market would be wrong to doubt Japan's inflationary push. First, if Abe is ousted, the LDP will remain in power: it has until October 2021 before it faces another general election that could deprive it of government control. (A loss in the upper house election in 2019 can prevent it from passing constitutional changes but not from running the country.) This ensures that policy will be continuous in the transition and that any changes in trajectory will be a matter of degree, not kind. Second, the phenomenon of "Abenomics" is not only Abe's doing but the LDP's answer to its first shocking experience in the political wilderness, from 2009-12. This experience taught the LDP that it needed to adopt bolder policies. The result was dovish monetary policy under Haruhiko Kuroda, who just began his second five-year term on April 9 and whose faction has the majority on the monetary policy board. Looser fiscal policy was another consequence - and ultimately it came to pass.14 It will be hard for a new LDP leader to tighten policy. Factions that are criticizing Abe or Kuroda today will find it harder to phase out stimulus once they are in office. Abe's successor will, like him, have to try policies that boost corporate investment, wages, the fertility rate, immigration, social spending and military spending.15 Without such initiatives, Japan will sink back into a deflationary spiral. As for BoJ policy, over the next 18 months the biggest challenges are meeting the 2% inflation target while the yen is rising due to both China's slowdown and trade war risks.16 Tokyo is also ostensibly required to hike the consumption tax in October 2019. This is more than enough to convince Kuroda to stand pat for the time being.17 In the meantime, Abe's push to revise the constitution is a significant factor in encouraging persistently loose monetary and fiscal policy. The national referendum on the matter could be held along with the early 2019 local elections or the July 2019 upper house election. It will be hard to win 50%+ of the popular vote and nigh impossible if the economy is failing. What should investors look for to determine if Abe's downfall is imminent? In addition to Abe's approval rating we will watch to see if the ongoing scandal probes produce any direct link to Abe, or if top cabinet ministers are forced to resign (like Finance Minister Taro Aso or Defense Minister Itsunori Onodera). It will also be a telling sign if Abe's "work-style" reforms to liberalize the labor market, which have received cabinet approval, wither in the Diet due to lack of party discipline (not our baseline view).18 But even granting Abe's survival, we would expect that China's slowdown and the U.S.-China trade war will keep the yen well bid. We are sticking with our tactical long JPY/EUR trade, which is up 2.6% thus far. Bottom Line: Shinzo Abe is likely to be re-elected as LDP leader in September and to lead his party in the charge toward the 2019 upper house election and constitutional referendum. Should he fall into the 20% of popular approval, the markets should sell off. His leadership and alliances have been remarkably reflationary and the policy tailwind could dwindle. We would fade this risk, but we still think the yen will remain buoyant due to China's internal dynamics and the U.S.-China trade war. We remain long yen/euro until we see signs that Washington and Beijing are able to defuse the immediate trade war. Russia: Tensions With The West Have Not Peaked Our view that tensions between Russia and the West would peak following President Putin's reelection has been spectacularly wrong.19 We still encourage clients to review the report, penned in early March, as it sets out the limits to Russia's aggressive foreign policy. The country is geopolitically a lot more constrained then investors think, and thus there are material limits to how far the Kremlin can take the rivalry with the West. What we did not account for is that such weakness is precisely the reason for the tensions. Specifically, the Trump administration - riding high following the success of its "maximum pressure" doctrine in the Korea imbroglio - smells blood. President Trump is betting that the view of Russian constraints is correct and therefore the time to pressure Putin - and prove his own anti-Kremlin credentials - is now. But has the market gotten ahead of itself? The expanded sanctions target specific individuals and companies - EN+ Group, GAZ Group, and Rusal - and yet the broad equity market in Russia has tumbled.20 Sberbank, which is nowhere mentioned in the sanctions, fell by an extraordinary 16% since the announcement. On one hand, there does appear to be a material step-up in sanctions. Despite being focused on specific companies, the new restrictions are designed to make the entire Russian secondary bond market "not clearable." The targeting of specific companies, therefore, was merely a shot-across-the-bow. The implication for the future - and the reason that Sberbank fell as much as it did - is that U.S. investors could be forbidden - or the compliance costs could rise by so much that they might as well be forbidden - from participating in Russian debt and equity markets in the future. On the other hand, our Russia geopolitical risk index has not priced in the renewed tensions (Chart 24). This means that either our currency-derived measure is wrong or the sell off in equity and debt markets is not translating into bearishness about the overall economy. Given our bullish oil outlook and our view of the limits of Russian aggression investors should expect, the index may actually be signaling that these tensions are an opportunity to buy Russian assets. Chart 24The Russia GPI Says No Risk That said, we have learned our lesson. There is no point in trying to catch a falling knife as the Kremlin and the White House square off over Syria and other geopolitical issues. As such, we are closing all of our Russia trades until we find a better entry point to capitalize on our structural view that there are material limits to geopolitical tensions between the West and Russia. The long Russia equities / short EM equities has been stopped out at 5% loss. Our buy South African / sell Russian 5-year CDS protection is down 20 bps and our long Russian / short Brazilian local currency government bonds is up 1.07 bps. Investment Implications In April 2017, we penned a report titled "Buy In May And Enjoy Your Day!," turning the old "sell in May and go away" adage on its head.21 At the time, investors were similarly facing a number of geopolitical risks, from the second round of French elections to concerns about President Trump's domestic agenda. However, we had a very high conviction view that these risks were overstated. This time around, we fear that the markets are mispricing constraints on President Trump. Geopolitical risks ahead of us are largely in the realm of foreign policy, where the U.S. Constitution gives the president large leeway. This includes trade policy. As such, it is much more difficult to have a high conviction view on how the Trump administration will act towards China, Iran, and Russia. Furthermore, the success of the "maximum pressure" doctrine has emboldened President Trump to talk tough, worry about consequences later. Investors have to understand that we are the target of President Trump's rhetoric. There is no better way for the White House to show China, Iran, and Russia that it is serious - that its threats are credible - than if it strongly counters the view that it will do nothing to harm domestic equities. We therefore expect further volatility in the markets. We propose that clients hedge the risks this summer with our "geopolitical protector portfolio" - equally-weighted basket of Swiss bonds and gold - which is currently up 1.46%, although adding 10-Year U.S. Treasurys to the mix may make sense as well. We would also recommend that clients expect both a spike in the VIX and a rise in the volatility of the VIX (volatility of volatility). Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com; and Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 4 Please see "Russia says U.S. plans to strike Damascus, pledges military response," Reuters, dated March 13, 2018, available at reuters.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 8 Please see "US drops contentious demand for auto content, clearing path in NAFTA talks," Globe and Mail, March 21, 2018, available at www.theglobeandmail.com. 9 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Perched On An Icy Cliff," dated March 29, 2018, available at ems.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Should Investors Fear Political Plurality?" dated November 29, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 Please see BCA's Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. 15 Please see "Japan: Abe Is Not Yet Dead, Long Live Abenomics," in BCA Geopolitical Strategy Weekly Report; "The Wrath Of Cohn," dated July 26, 2017; and "Japan: Abenomics Will Survive Abe," in Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018; and "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 17 Please see Cory Baird, "BOJ Chief Haruhiko Kuroda Begins New Term By Vowing To Continue Stimulus In Pursuit Of 2% Inflation," Japan Times, April 9, 2018, available at www.japantimes.co.jp. 18 Please see "Work style reform legislation gets Abe Cabinet approval," Jiji Press, April 6, 2018, available at www.the-japan-news.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com. 20 Please see Department of the Treasury, "Ukraine Related Sanctions Regulations - 31 C.F.R. Part 589," dated April 7, 2018, available at treasury.gov. 21 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com.

Highlights Q1 earnings season looks robust, but trade policy is an uncertainty. Sizeable shifts in equity technicals and sentiment since the start of the year; valuation still stretched. Global growth may have peaked but fiscal, monetary and legislative backdrop remains supportive. The market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. Feature Chart 1Despite Setback In March, ##br## U.S. Labor Market Remains Strong U.S. equity prices fell last week as trade policy remained on the front pages. Gold was one of the few beneficiaries of the tariff talk. Investors hope to turn the page this week as the Q1 2018 earnings season kicks into high gear, but trade-related market volatility is here to stay. The bar is high for 2018 earnings growth, and the focus may shift to the prospects for 2019 sooner rather than later. The modest selloff in the S&P 500 since late January led to a shift in sentiment, but the technical picture for U.S. equities is mixed. Global growth may be rolling over, but we find that risk assets perform well anyway, if fiscal, monetary and legislative policy is aligned. Trump's actions on tariffs do not mean that we are necessarily headed for a trade war. The tariffs proposed but both sides have not yet been implemented and there is still time for compromise. We do not see March's modest 103,000 increase in non-farm payrolls as signaling a weaker labor market. First, the monthly data can be volatile. The soft increase in March follows an outsized 326,000 gain in February. The 3-month average, more reflective of the underlying trend, is a solid 202,000. Second, average hourly earnings increased by 0.3% m/m, which nudged the annual wage inflation rate to 2.7% from 2.6%. Firming earnings growth is a sign of a strong labor market (Chart 1). Despite the soft increase in March payrolls, the U.S. labor market and economy are on a firm footing. Aggregate hours worked increased by 2.0% at a quarterly annualized rate in Q1. Such a pace is consistent with about 3% GDP growth. Firm growth will allow inflation to head back to the 2% target and allow the Fed to continue with its gradual rate hikes. S&P 500 Earnings: Q1 2018 The consensus expects an 18% year-over-year increase in the S&P 500's EPS in Q1 2018 versus Q1 2017, and 20% in 2018. Energy, materials, financials and technology will lead the way in earnings growth in Q1, while real estate and consumer discretionary will struggle. Excluding the energy sector, the consensus expects a stout 17% increase in profits. The robust profit environment for Q1 2018 and the year ahead reflects sharply higher oil prices compared with early 2017 and the impact of last year's Tax Cut and Jobs Act. Moreover, improved global growth and still modest labor costs will support the Q1 results. Trade policy will likely replace tax cuts as a key topic when corporate managements report Q1 outcomes and provide guidance for Q2 and beyond. While no tariffs have yet been imposed, analysts will want to understand the impact that the proposed actions will have on input costs and margins. Moreover, investors must gauge to what extent trade policy-related uncertainty is weighing on business sentiment (details below in "Trade Skirmish...Or Trade War?"). Market volatility, rising interest rates and the modest upswing in U.S. labor costs will also be discussed during the Q1 earnings calls. As always, guidance from corporate leaders for Q2 2018 and ahead are more important than the actual results for Q1 2018. The markets probably have already priced in a robust 2018 earnings profile due to the Tax Cut and Jobs Act, and are looking ahead to 2019 (Chart 2). Investors typically stay focused on the current calendar year's EPS through to at least Q3 before turning their attention to the next year. However, this year may be different. The consensus is looking for 10% EPS growth in 2019, a sharp deceleration from the 20% increase expected this year. Chart 2The Bar Is High For 2018 EPS, But The Focus Is On 2019 Chart 3 shows that elevated readings on the ISM provide a very favorable backdrop for EPS in 2018. As indicated in Chart 4, industrial production (IP), a proxy for S&P 500 sales, is poised to advance in 2018 and lift corporate profits. Industrial production growth may be peaking, but we don't expect it to soften much on a year-over-year basis. Chart 3Elevated ISM Good News For 2018 EPS Growth Chart 4Stout Readings On IP Support S&P 500 Revenue Gains Global GDP growth estimates for 2018 and 2019 continue to move steadily higher in sharp contrast with prior years when forecasters relentlessly lowered GDP estimates (Chart 5). Chart 5U.S. And Global Growth Estimates Are Still Accelerating... ##br## But For How Much Longer? Chart 6The Dollar Should Not Be A Big Concern ##br## In Q1 Earnings Season The greenback should not be an issue for corporate results in Q1 2018 based on minimal references to a robust dollar in the past six Beige Books. This significantly differs from 2015 and early 2016 when there were surges in Beige Book mentions (Chart 6). The last time that six consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically focused corporations versus globally oriented ones. In recent quarters, a modestly weaker dollar has allowed profit and sales gains of global firms to rebound and outpace those of domestic businesses (Chart 7). Margins for U.S. companies have been steady at record heights since 2014, while margins for global businesses dipped along with oil prices in 2014-2016, but rebounded last year and are higher than margins of domestic companies. Nonetheless, a slowdown in growth outside the U.S. may reverse these trends (Please read below, "Global Growth Has Peaked, Now What?"). Investors are skeptical that margins can advance in Q1 2018 for the seventh consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters. However, the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate. Chart 7Global EPS, Margins Outpacing Domestic Chart 8Strong S&P Growth Ahead, Will Start To Slow Soon Bottom Line: BCA expects that the earnings backdrop will be supportive of equity prices in 2018 (Chart 8). However, investors may have already priced in the benefits of the Tax Cut and Jobs Act on corporate results and are focused on 2019 figures. EPS growth will be more of a headwind for stock prices as we enter 2019 (Chart 8). Stay overweight stocks versus bonds. Technical, Sentiment And Valuation Update BCA's Technical Indicator is not at an extreme (Chart 9, panel 1) and the 7.8% pullback in the S&P 500 since January 26, 2018 leaves the index in the middle of its recovery trend channel (panel 2). The failure of the index to break out of this channel earlier this year suggests that a period of consolidation for equities awaits. Moreover, the upward slope in the NYSE advance/decline line (panel 3) is in jeopardy. The final panel of Chart 9 shows that stocks are no longer extremely overvalued, but they remain overvalued nonetheless. Stretched valuations say more about medium- and long-term returns than near-term performance.1 Chart 9Technicals And Valuations For U.S. Equities Chart 10Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated The shift in the equity sentiment since the market top in January is notable. BCA's investor sentiment composite index, which hit an all-time high at the end January, has pulled back in the past few months (Chart 10, panel 1). However, this metric has not yet returned to its long-term average (solid line on top panel of Chart 10). The drop in sentiment is broadly based; individual investors and advisors who serve them (panels 2 and 4) along with traders (panel 3) have lately curtailed their bullishness. Recent shifts in several other sentiment surveys are also worth noting: The American Association of Individual Investors, a contrary indicator of sentiment, turned bullish in recent weeks. The percentage of respondents who were bearish moved above 30%, while the percentage of bulls dipped to 32%. Neither measure is at an extreme (Chart 11). The National Association of Active Investment Managers (NAAIM) says that active managers have reduced equity risk since the beginning of Q4 2017 (Chart 12). At 52%, the average equity exposure of institutional investors is at the lowest level since March 2016 and is nearly half the 102% exposure at the start of 2017. In contrast, the March 2017 reading was the highest since 2007, just before the S&P 500 peak in October 2007. As in previous bear markets, BCA's equity speculation index moved into "high speculation" territory in early 2017 and has remained there. The index is at its highest point since the 2000 market peak (Chart 13, panel 1). Moreover, net speculative positions of S&P 500 stocks are roughly in balance, but have turned net short in recent weeks. Nonetheless, this metric is not at an extreme (panel 3). Chart 11Individual Investors Have Turned More Bearish Chart 12Active Managers Still Overweight Equities... Chart 13Equity Speculation Is High... Chart 14Pullback Has Relieved Some Technical Pressure The S&P 500 is close to its 200-day moving average. In late 2017, this indicator was at the upper end of its post-2000 range (Chart 14, panel 1). BCA's composite technical measure is in the middle of the 2007-2017 range and is not a concern (Chart 14, panel 5). Moreover, the percentage of NYSE stocks above their 10- and 30-week highs are below average and at the low end of their recent ranges. Furthermore, new highs minus new lows is at neutral (panel 2). Bottom Line: The 7.8% pullback in the S&P 500 since January 26 has relieved some technical pressure on the market, and sentiment levels are less stretched than at the late January 2018 peak. Moreover, institutions have cut their equity exposures. Nonetheless, stock speculation is rampant and valuations are elevated, which suggests lower returns in the coming decade. Moreover, a slowdown in global growth in ongoing trade tensions suggest that the risk/reward balance for equities has deteriorated. Global Growth Has Peaked, Now What? Chart 15Is Global Growth Peaking? In last week's report we stated that while BCA expects global growth to be solid this year, there are signs that global growth may near a top.2 March's PMI data support that view. Chart 15 shows that the Markit Global PMI dipped to 53.4 in March from 54.1 in February; the 0.7 drop was the largest since February 2016 (panel 2). Last month,3 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. BCA expects the ongoing era of pro-growth policies to end next year as the Fed raises rates into restrictive territory. However, some investors wonder if the peak in global growth changes our view of how risk assets will perform during periods of harmonized policy. We do not expect the peak in global growth to lead to a recession this year or next. Chart 16 and Table 1 show the performance of U.S.-based financial assets, gold, oil, the dollar and S&P 500 earnings when Fed, fiscal and legislative policies are stimulative and global growth is rolling over but still positive. There has been only a handful of such episodes, so investors should be cautious when interpreting these results. The S&P 500 beats Treasuries, investment-grade and high-yield credit outperforms Treasuries, and small caps outpace large caps. Gold and oil perform well in these periods, perhaps aided by a weaker dollar. S&P 500 earnings are positive. Chart 16Positive Policy Backdrop As Global Growth Is Rolling OverTable 1Three Periods Where Global Growth Rolled Over But Policy Backdrop Was Stimulative Bottom Line: A peak in global growth reduces the risk/reward balance for risk assets, and provides another reason to be cautious. Equity valuation, although improved recently, is still stretched. Central banks are slowly removing the punchbowl, margins have limited upside and the economic cycle is at a late stage. Long-term investors should already be scaling back on risk. Short-term investors should stay overweight risk for now, on the view that fiscal stimulus will provide a tailwind for earnings for the remainder of the year. Trade Skirmish...Or Trade War? BCA's Geopolitical Strategy service notes4 that the market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. U.S. equities are down by 5.7% since the White House announced tariffs on steel and aluminum and 2.34% since it declared impending levies against China. Although we have cautioned clients since November 2016 that protectionism is a real risk to global growth and risk assets, the U.S. demands on China justify the moniker of a trade skirmish, rather than a full-on war. In view of our position, we think the 5.7% drawdown is appropriate, if a bit sanguine. President Trump remains unconstrained on trade policy, giving him leeway to be tougher than the market expects. Therefore, it is appropriate for the market to price in a 20%-30% probability of a trade war developing. Given that the market drawdown in such a scenario could be 20% or more, the market is appropriately discounting the risks. Why would a trade war between the U.S. and China elicit a bear market in U.S. equities when a similar confrontation in the 1980s between Japan and the U.S. did not? First, the overvaluation of stocks is much greater today. Secondly, interest rates are much lower, restricting how much policymakers can react to adverse risks. Thirdly, supply chains are much more integrated, both globally and between China and the U.S. The U.S. Administration's trade policy is not haphazard. President Trump and U.S. Trade Representative Robert Lighthizer are on the same page: they have made China, and not NAFTA trade partners or South Korea, the target of U.S. protectionism (Chart 17). Chart 17China, Not NAFTA, In The Crosshairs Table 2U.S. Gradually Exempting Allies From Tariffs The rapid pace at which the Administration pivoted from global tariffs to targeting China is an indication of what lies ahead. The U.S. uses the threat of tariffs to cajole its allies into tougher trade enforcement against China (Table 2). This strategy can work, as outlined last week,5 but there is plenty of room for mistakes. Trump also wants to change the U.S. policy on immigration and he may use NAFTA negotiations to gain leverage over Mexico. Therefore, there is a slight probability that Trump may trigger Article 2205 to leave NAFTA, but we believe the risk has declined substantively since our 50% estimate in November 2017. Bottom Line: The Trump Administration has pursued a well-considered but tough trade policy toward China. Nonetheless, Trump's actions do not mean that we are necessarily headed for a trade war. The tariffs proposed by both sides have not yet been implemented and there is still time for compromise. The U.S. Treasury will release a list of exemptions on May 1. On May 21, Treasury will reassess its list of China's investments in the U.S. and China will likely retaliate. June 5 marks the end of a 60-day negotiation period when the Administration must decide whether to implement the announced tariffs. There still is a 30% chance that the trade skirmish will morph into a trade war. Trump could significantly escalate matters if he declares a national emergency on trade in June. Expect more trade-related volatility in U.S. financial markets until that time. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Global Asset Allocation Special Report, "What Returns Can You Expect?", dated November 15, 2017, available at gaa.bcaresearch.com. 2 Please see BCA U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", dated April 2, 2018, available at usis.bcaresearch.com. 3 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Line Up", dated March 12, 2018, available at usis.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China", dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan", dated March 30, 2018, available at gps.bcaresearch.com.

Highlights R-star is higher in the U.S. than in most other large economies. This includes China, where an elevated savings rate has depressed the neutral rate of interest. Countries with relatively high neutral rates like the U.S. will tend to run structural current account deficits, whereas countries with relatively low neutral rates will tend to run surpluses. The failure of the Trump administration to understand this basic economic lesson could inflame the ongoing trade spat between the two countries, at a time when populism is on the rise and China is challenging the U.S. for global influence. Fortunately, trade protectionism is less attractive when jobs are plentiful, as is the case in the U.S. today. Thus, we continue to see a market-friendly resolution to the ongoing conflict. Our base case remains that another global recession is still about two years away, which should keep the bull market in global equities intact. However, with global growth decelerating, financial conditions tightening at the margin, and the near-term signal from our proprietary MacroQuant model stuck in bearish territory for the second month in a row, the tactical picture for stocks remains rather murky. Feature Blame It On The Neutral Rate If the world of macroeconomics were set in a superhero universe, the real neutral rate of interest, otherwise known as R-star, would undoubtedly be cast as an arch-villain. R-star is the interest rate consistent with full employment and stable inflation. A depressed R-star has made the zero lower-bound constraint on nominal rates a vexing problem for central bankers. Not long after the Global Financial Crisis began, policy rates fell to ultra-low levels. But even this was not enough to engender a strong recovery. Most economies needed negative real rates. However, with inflation stuck at low levels, there was a limit to how far below zero real rates could go. Japan, of course, has been no stranger to this problem. Policy rates have been close to zero for over 20 years, yet inflation remains stubbornly low (Chart 1). Some commentators have dismissed this issue, noting that real per capita GDP has still managed to grow at a reasonably healthy clip. Unfortunately, this misguided optimism ignores the fact that Japan was only able to keep the economy from sinking into a depression by relying on massive budget deficits. With Japanese monetary policy rendered impotent, fiscal policy had to pick up the slack. High levels of excess private-sector savings were absorbed with continued government dissavings (Chart 2). The result is a gross government debt-to-GDP ratio of 240%. A low R-star has also been a major problem in the euro area. Before the European sovereign debt crisis erupted, Germany was able to export its excess savings to the peripheral countries, who were more than happy to load up on cheap debt so that they could live beyond their means (Chart 3). Chart 1Japan: Even Zero Interest Rates ##br##Were Not Enough To Spur Inflation Chart 2Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 3The European Periphery Is No Longer ##br##Absorbing Germany's Excess Savings Those days are over. Today, Germany's current account surplus stands at a gargantuan 8% of GDP, but much of Germany's savings are exported to the rest of the world. Consequently, the euro area current account balance has gone from roughly breakeven in the pre-crisis period to a surplus of 3% of GDP. This likely means that the neutral rate in the euro area has fallen further. R-Star In China Chart 4China Saves A Lot What about China? One might think that China's fast trend GDP growth rate would translate into a high neutral rate. However, the neutral rate is not just a function of trend growth. Most economic models state that the savings rate also affects the neutral rate.1 The more income people wish to save at any given interest rate, the lower the neutral rate will be. For a variety of institutional and cultural reasons, the Chinese save a lot (Chart 4). The national savings rate has averaged 50% of GDP for the past decade. In fact, despite an investment-to-GDP ratio of 44%, China still manages to run a current account surplus (remember the current account balance is just the difference between savings and investment). A Simple Thought Experiment The earth does not trade with Mars. As a result, the global current account balance must be zero; current account surpluses in one set of countries must be offset by current account deficits in another set of countries. Interest rates and exchange rates play a vital role in ensuring that this identity is satisfied. Imagine a bunch of island economies - all with different neutral rates - that do not trade with one another. Now suppose a technological breakthrough occurs that permits free trade and capital mobility. What would you expect to happen? Standard economic theory says that capital will flow towards the islands with relatively high interest rates. As shown in Chart 5, the flood of capital will push down the interest rate in those economies. A lower interest rate, in turn, will discourage saving and encourage investment, leading to a current account deficit. Capital inflows will also drive up the currency, while higher spending will push up consumer prices. Such a "real appreciation" of the exchange rate is necessary to ensure that increased spending falls primarily on foreign-made goods.2 Chart 5Interest Rates And Current Account Balances In An Open Economy On the flipside, capital will flow out of economies with low neutral rates, putting upward pressure on interest rates. A higher interest rate will lead to more savings and less investment, translating into a current account surplus. Countries with relatively low neutral rates will also see a real depreciation of their exchange rates. If there is complete free trade and capital mobility, the final equilibrium will be one where interest rates are equalized across all islands and the current account deficits of the islands with relatively high neutral rates are exactly offset by the current account surpluses of the islands with low neutral rates. In addition, countries with relatively high neutral rates will end up with exchange rates that appear somewhat overvalued relative to their fair value, while those with low neutral rates will have exchange rates that appear somewhat undervalued. U.S.-China Trade Tensions: An Inevitable Conflict There are many structural reasons why the U.S. and China are at loggerheads over trade these days. We predicted that Trump would win the presidency largely because we thought the political/media establishment was underestimating the importance of the populist wave sweeping across the U.S. and much of the world. Our geopolitical analysts share this view. They have also argued that China's growing economic, military, and technological prowess will inevitably put it into conflict with the U.S., which has been the world's sole hegemon ever since the Soviet Union collapsed.3 This week's report adds another structural reason to the list. While R-star in the U.S. is fairly low by historic standards, it is higher than in most other countries, reflecting America's favorable demographics, large fiscal deficit, and relatively spendthrift culture. This means that the U.S. must run a structural current account deficit. This, of course, is at odds with the Trump administration's stated objectives. Efforts by China or any other country to "talk up" their currencies in the hopes of placating Trump will fail. The U.S. economy is already operating at close to full employment. A weaker dollar would only shift the composition of spending towards domestically-produced goods. The U.S., however, does not have enough spare labor to produce these additional goods. All that would happen is that inflation would rise, rendering U.S. exporters less competitive. More stimulative fiscal policy will further increase the neutral rate of interest in the United States. Chart 6 shows that the budget deficit is set to widen to nearly 6% of GDP by 2019 even if the unemployment rate continues to decline. A larger budget deficit will drain national savings, shifting the savings schedule in the savings-investment diagram discussed earlier to the left. This will result in a bigger current account deficit (Chart 7). Chart 6The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Chart 7A Bigger U.S. Budget Deficit Will Cause The U.S. Neutral Rate To Rise, ##br## Leading To A Larger Current-Account Deficit Investment Considerations The specter of trade protectionism is here to stay, as is the prospect of escalating U.S.-China geopolitical tensions. Fortunately, beggar-thy-neighbor policies are less attractive when jobs are plentiful, as is the case in the U.S. today. Trump also remains constrained by the stock market's view of his actions. After all, this is a president who likes to measure the success of his economic agenda by the value of the S&P 500. As such, we expect both the U.S. and China to follow a two-pronged approach to trade issues over the coming months. Publicly, they will snipe at one another, threatening each other with tariffs and other trade barriers. Privately, they will seek out a compromise that avoids a full-out trade war. China's announcement this week that it will retaliate in kind to the U.S. decision to impose tariffs on $50 billion in Chinese imports should not have taken anyone by surprise. The Chinese government had repeatedly said that they would do precisely this. Importantly, U.S. tariffs do not kick in until June. Between now and then, negotiators from both sides will try to hammer out a deal. Just as with the steel and aluminum tariffs, the final set of tariffs will be a watered-down version of the original proposal. Political theatre will be the name of the game. As discussed in last week's Q2 Strategy Outlook, our base case remains that another global recession is still about two years away, which should keep the bull market in global equities intact.4 We warned investors to "Take Out Some Insurance" on February 2nd, one day before the VIX spike began.5 Now that the S&P 500 is 7% off its highs, our bet is that the path of least resistance for global equities over the next 12 months is up. Nevertheless, with global growth decelerating, financial conditions tightening at the margin, and the one-month ahead signal from the beta version of our forthcoming proprietary MacroQuant model stuck in bearish territory for the second month in a row, the tactical picture for stocks still looks rather murky (Chart 8). For the time being, short-term investors should sell the rallies and buy the dips. Chart 8MacroQuant Model: Tactical Picture For Stocks Still Looks Rather Challenging Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 2 The real exchange rate can be thought of as the volume of foreign goods and services that can be acquired by selling a basket of U.S. goods and services. Mathematically, the real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in domestic prices relative to foreign prices. 3 Please see Geopolitical Strategy Special Report, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015; and Global Investment Strategy Special Report, “The Looming Conflict In The South China Sea,” dated May 29, 2012. 4 Please see Global Investment Strategy Q2 Strategy Outlook, “It’s More Like 1998 Than 2000,” dated March 30, 2018. 5 Please see Global Investment Strategy Weekly Report, “Take Out Some Insurance,” dated February 2, 2018, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The U.S. and China have a roughly 60-day period to prevent the current trade "skirmish" from metastasizing into a full-blown trade war; The revised U.S.-Korea trade deal suggests that Trump's trade negotiators are credible and are targeting China, not U.S. allies; The U.S. will demand that China's recent RMB appreciation is backed by a long-term reduction in foreign exchange intervention; Tariff reciprocity is not significant, but market access and investment reciprocity are; China will offer concessions first, and will only go to a trade war if Trump imposes sweeping tariffs anyway; Short Chinese technology stocks; remain short China-exposed S&P500 stocks in expectation of further volatility. Feature The market is coming to terms with the fact that President Trump is willing to put his policies where his campaign rhetoric was, at least on trade policy. U.S. equities are down 5.7% since the White House announced Section 232 tariffs on steel and aluminum and 2.34% since it announced forthcoming Section 301 tariffs against China. Although we have cautioned clients since November 2016 that protectionism is a real risk to global growth and risk assets,1 we believe that the current set of U.S. demands on China justify the moniker of a "trade skirmish," rather than a full-out war.2 That said, the 5.7% drawdown is appropriate, if a bit sanguine. Our "trade skirmish" view is low-conviction. President Trump remains unconstrained on trade policy, giving him leeway to be tougher than the market expects. As such, it is appropriate for the market to price a 20%-30% probability of a full-blown trade war. Given that the market drawdown in such a scenario could be 20% or more, the current market action is appropriately pricing the worst-case scenario. Why would a trade war between the U.S. and China elicit a bear market in U.S. equities if a similar confrontation between Japan and the U.S. did not in the late 1980s? For three reasons. First, the overvaluation of stocks is much greater today. Second, interest rates are much lower, restricting how much policymakers can react to adverse risks. Third, supply chains are much more integrated today, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. As such, we think the current drawdown is appropriate. That said, the administration's policy is not haphazard. President Trump and U.S. Trade Representative (USTR) Robert Lighthizer are on the same page, making China - and not NAFTA trade partners or South Korea - the main target of U.S. protectionism (Chart 1). The rapid pace at which the administration pivoted from global tariffs to targeting China gives a clear indication of what is afoot. The U.S. is using the threat of tariffs to cajole its allies into tougher trade enforcement against China (Table 1).3 We think this strategy can work, as outlined last week, but there is plenty of room for mistakes that could derail it. Chart 1China, Not NAFTA, In The Crosshairs Table 1U.S. Gradually Exempting Allies From Tariffs Trump also wants to change U.S. policy on immigration and could use the NAFTA negotiation to gain leverage over Mexico. There is therefore still some probability that Trump triggers Article 2205 to leave NAFTA, but we believe it has declined substantively since we put it at 50% in November, particularly given the U.S.-South Korea negotiations we discuss below.4 This week we take a look at the revised U.S.-Korea trade deal and what it suggests about the Trump administration's trade agenda more broadly. Then we update the status of the U.S.-China trade frictions, which are only temporarily subsiding, if at all. Lessons From The KORUS Talks The just-completed renegotiation of the U.S.-Korea free trade agreement (the "KORUS FTA") offers some clues to the Trump administration's trade tactics that may be relevant for future negotiations with NAFTA partners, China, and others. President Trump has repeatedly criticized the KORUS FTA, as the U.S. trade deficit with South Korea has ballooned since its implementation in March 2012 (Chart 2). Trump used the threat of withdrawing from the deal to pressure South Korean President Moon Jae-in not to ease sanctions on North Korea too rapidly. Chart 2Why Trump Likes Tariffs Now USTR Lighthizer and his South Korean counterpart, Hyun Chong-Kim, have agreed to the outlines of a revised deal.5 The key points are as follows: Steel tariff waiver for Korea: South Korea will receive a country-level exemption from the U.S.'s recently imposed steel tariffs.6 Going forward, Korean steel exports will be subject to quotas equivalent to 70% of the average annual import volume during 2015-17. Greater market access for U.S. autos: Korea will double the number of autos it imports on the basis of U.S. safety standards, from 25,000 to 50,000 per year from each U.S. carmaker. It can import more subject to its own safety standards. It will refrain from any new emissions-standards tests, will accept U.S. safety standards on auto parts, and will ease ecological policies and the customs process of verifying the origin of exports. Delayed market access for Korean trucks: The U.S. will retain the existing 25% tariff on Korean trucks through 2041, instead of 2021 (Chart 2, second panel). Fair treatment of U.S. pharmaceutical imports: Korea promises not to discriminate against U.S. drugs but to grant them fair treatment under KORUS provisions. Ancillary currency agreement: The two sides appended a "gentleman's agreement" on currency policies, which is not a formal part of the deal and not subject to legislative confirmation. South Korea agreed not to devalue the won competitively, or to manipulate it more broadly, and to provide greater transparency regarding its interventions in foreign exchange markets. There are three main takeaways from the above. First, the U.S. is obviously focusing on non-tariff barriers to trade, the main hindrance to trade in a world with already low tariff rates. The grievances with Korea were primarily due to safety standards, environmental policies, and burdensome administration that hindered U.S. exports despite the reduction of tariffs under the KORUS agreement. Second, USTR Robert Lighthizer - the seasoned negotiator of the historic 1980s trade disputes with Japan, and the man in charge of the current NAFTA and China negotiations - deserves his reputation as a competent policymaker. He apparently makes concrete demands and is capable of compromising to conclude deals. This reduces the risk, overstated by the media, that the inexperienced U.S. president is driving the trade negotiations. Third, the U.S. is not deliberately trying to punish its allies in pursuit of some mercantilist fantasy of closing every single trade imbalance. Strategic logic dictated that Washington and Seoul needed to conclude a deal quickly so as to better coordinate on North Korea, and they did so. It is highly unlikely that the concluded deal will end the U.S. trade imbalance with South Korea, but it will likely improve it substantively. Moon Jae-in continues to be a pragmatist in his dealings with Trump and Trump is joining Moon's "Moonshine" policy of engagement with North Korea. Talk of the U.S. abandoning its allies did not materialize. (Japan and Taiwan are likely to get deals soon.) Most importantly, this deal is a strong indication that the U.S. will continue to pressure China on its foreign exchange practices. It would make no sense for the U.S. to require its allies to disavow competitive devaluation and reduce currency interventions while not demanding similar assurances from China. On this front, China's recent appreciation of the yuan will not ultimately satisfy the U.S., as it is arbitrary. The U.S. will need to extract deeper guarantees, with the implicit threat of tariffs to prevent China from backsliding. Otherwise the U.S. would yield Chinese exporters a foreign exchange advantage relative to American trade partners who agree to stop intervening to preserve a favorable exchange rate with the USD. A simple comparison of these countries currency moves over the past eight years reveals how they have allowed less appreciation relative to the U.S. than in trade-weighted terms, and how China would benefit if the others were forced to stop this practice while it was left off the hook (Chart 3). Chart 3The U.S. Will Demand Currency Appreciation This last conclusion fits with our study of previous cases of U.S. trade protectionism, in which the end-game was dollar depreciation relative to key trade partners.7 The KORUS case can be considered alongside Lighthizer's and the Trump administration's handling of the Section 301 investigation into China's forced tech transfer and intellectual property theft. The Trump administration came out swinging with unilateral 25% tariffs on about $60 billion worth of goods, to be listed on April 6 and enacted sometime in June. But it also signaled that it would allow a consultation period, and initiated a case through the World Trade Organization, thus reinforcing (rather than undermining) the global trading system. These developments give some grounds for optimism in the NAFTA negotiations and (less so) in the China negotiations. While China is preempting U.S. demands on its currency policy, it will be averse to providing any permanent guarantees, or to painful structural demands. This is due to its concerns about overall stability and its suspicion that the U.S. is pursuing a broader strategic containment policy against it. We discuss these issues below. Bottom Line: The preliminary conclusions of the KORUS FTA negotiation suggest that the Trump administration's trade leadership is credible, while Trump himself is looking for quick and concrete trade "wins" that can be presented to his domestic voter base. This is a marginally market-positive sign. But its ramifications are limited with regard to China, where strategic tensions and geopolitical competition will make it much harder to strike a similar deal quickly. U.S.-China: Fade The "Mirror Tax," Focus On Market Access And Tech China announced tariffs on roughly $3-$3.5 billion worth of U.S. goods on April 2 - ranging from fruits and nuts to wine and pork - in retaliation for the steel and aluminum tariffs that the U.S. imposed in March under Section 232 of the Trade Expansion Act of 1962. China used the exact same tariff rates as the U.S. - 25% and 10% - while selecting the product list so as to produce roughly the same net trade impact in USD terms (Chart 4). The implication is that China will retaliate in kind to deter the U.S., but does not wish to "up the ante." This is largely what we expected, but the implication is significant: the U.S. is about to release a preliminary list on April 6 of $50-$60 billion worth of goods on which it will slap tariffs. This second round of tariffs - which is China-specific - follows from the probe under Section 301 of the Trade Act of 1974. China's recent decision suggests that if negotiations fail, it will respond with tariffs worth roughly the same amount, which is a much bigger exchange of fire for these two economies. The actual retaliatory action would most likely occur in June, when the U.S.'s list is finalized and implemented, though China may hint at its product list much sooner, adding to trade fears and market volatility.8 The Trump administration claims that its product list will be chosen by an algorithm to maximize the impact on Chinese exporters while minimizing the impact on the American consumer. Consistent with this aim, some reports indicate that the goods will be advanced technological products set to benefit from China's "Made in China 2025" plan, in which China has laid down aggressive domestic content requirements (Chart 5). Chart 4Tit For Tat Chart 5China's High-Tech Protectionism What is the Trump administration's goal? Treasury Secretary Steve Mnuchin declared at the G20 finance ministers' meeting that he did not want to penalize Chinese imports so much as promote U.S. exports. Is this a credible basis for assessing the administration's policy? Yes and no. We think Mnuchin is telling the truth, but not the whole truth. When it comes to blocking imports or boosting exports, Mnuchin is right: the U.S. goal is not simply to punish Beijing for past unfair trade practices by blocking imports of Chinese goods. True, the Trump administration has focused on a lack of reciprocity in tariff rates. But a "mirror tax" or "mirror tariff" with China, which Trump has referred to, would not make much of a difference to the trade balance: Chart 6AThe U.S. Exports Soybeans And Cars To China Chart 6BChina Exports Phones And Computers To The U.S. Taking a look at the top ten exports of the U.S. and China to each other (Chart 6 A&B), it is quite clear that China imposes higher tariffs on U.S. goods than the U.S. imposes on Chinese goods (Chart 7 A&B). This follows from World Trade Organization rules and the relative level of economic development of the two countries. Chart 7AAmerican Exports To China Face Higher Tariffs... Chart 7B... Than Chinese Exports To America If we equalize these tariffs by raising U.S. tariffs to the same level as their Chinese counterparts for the same good, we wind up with a very small $6.2 billion gain to the U.S. trade balance (Chart 8). If we focus only on the top ten goods that both countries export to each other, and impose a hypothetical mirror tax, we wind up with an even smaller gain for the U.S. of $3.9 billion (Chart 9). This is small fry and cannot be the administration's goal (at least not its main goal). The real goal is to gain greater market access for U.S. exports in China. Here the U.S. may have a case, as China lags both its developed and emerging market peers in sourcing its imports from the U.S. (Chart 10). While China comprises 24% of total EM imports, it comprises only 15% of U.S. exports to EM. Even in commodity exports, where the U.S. has made major inroads in China, Beijing has recently limited the American share (Chart 10, middle panel). Chart 8Equalizing Tariffs Has Little Impact Chart 9Equalizing Tariffs Has Little Impact (2) Chart 10U.S. Grievance Is About Market Access A simple, back-of-the-envelope comparison of the U.S.'s top exports to China and EM ex-China suggests that the U.S. can make a case that its exports are suffering unduly in China: China's share of top U.S. exports is lower than one might expect it to be relative to EM or EM-ex-China (Chart 11 A&B). The U.S.'s market share of China's imports in key goods is lower than it is in EM or EM-ex-China (Chart 12 A&B). The U.S. share of China's top imports is smaller than the DM-ex-U.S. share (Chart 13 A&B). Chart 11AChina Is Not A Large Enough Share Of U.S. Exports (Broad) Chart 11BChina Is Not A Large Enough Share Of U.S. Exports (Detailed) Chart 12AU.S. Is Not A Large Enough Share Of Chinese Imports (Broad) Chart 12BU.S. Is Not A Large Enough Share Of Chinese Imports (Detailed) Chart 13AU.S. Has Less Market Access In China Than Other Exporters Chart 13BU.S. Has Less Market Access In China Than Other Exporters China has granted the legitimacy of U.S. complaints by pledging several times in the last few months to open market access. The latest news from the negotiations suggests that some progress is being made.9 Clearly the above is a very rough measure. Chinese consumers may not want to buy as much stuff from the U.S. as from Europe and Japan. The U.S. doubtless needs to improve its global competitiveness, and even then it may not gain as much market share in China as its DM peers. Nevertheless, Washington sees itself as the power that brought China into the global economy and allowed it to join the WTO. If China wants the U.S. to allow it to play a greater role in running the world, the U.S. is demanding a beneficial economic relationship in return. One way China is offering to deal with the problem is by buying American goods at the expense of U.S. allies' goods. For instance, Beijing has offered to buy more semiconductors from the U.S. and fewer from Taiwan and South Korea. This would alleviate the U.S. trade deficit a little, but at a greater expense to U.S. allies (Table 2). It would open up an opportunity for China to make more strategic acquisitions in those weakened, neighboring industries. It is not clear that the Trump administration will accept such a "concession," unless it is coupled with much greater concessions as compensation for selling out the allies. Table 2China's Trade Concessions To The U.S. Could Impose Costs On U.S. Allies Similarly, China's concessions that have been offered so far - like lowering the 25% tariff on car imports - are tokens in the right direction but not sufficient to satisfy the U.S. at the current juncture. This means that the U.S. will demand structural changes that increase market access, from a stronger RMB to a more consumer-oriented economy, as part of what will be a drawn-out effort to encourage China to rebalance its macroeconomy. Of course, Treasury Secretary Mnuchin was only telling half the truth: the U.S. also wants to prevent China from stealing too much of America's market share too fast. When we look at China's comparative advantage - the goods categories in which China's export growth has been fastest in recent years, weighted by contribution to the total - the U.S. is the country that has the largest global market share in these very goods (Chart 14). For instance, telecoms equipment, car parts, TVs, electrical circuits, etc. The U.S.'s export mix is not as dependent on these goods as that of China's neighbors (Taiwan, Vietnam, Malaysia, Singapore, South Korea), but it is the chief exporter of these goods nevertheless. Because many of China's most competitive goods are still low value-added (toys, plastics, textiles, furniture), China is pursuing tech upgrades, innovation, and intellectual property: it would eat away at the U.S. share of more advanced goods. Chart 14China's Comparative Advantage Threatens U.S. Global Market Share The Trump administration is trying to slow China's advance and put a stop to China's aggressive poaching of foreign tech and IP.10 This will include restrictions on Chinese direct investment and acquisitions to be announced by Mnuchin on May 21. We expect him to intensify an inherently stringent vetting process. The administration has already taken a proactive stance by blocking Canyon Bridge Capital Partners from acquiring Lattice Semiconductor and Singaporean company Broadcom's attempted acquisition of Qualcomm.11 Rumor has it that the administration is now considering invoking the International Emergency Economic Powers Act of 1977, which authorizes the president to take actions "to deal with any unusual and extraordinary threat, which has its source in whole or substantial part outside the United States, to the national security, foreign policy, or economy of the United States, if the President declares a national emergency with respect to such threat." Trump would be able to cite China's use of state-backed companies, corporate espionage, and cyber-attacks in pursuit of technology and IP (Table 3). Table 3Trump Lacks Legal Constraints On Trade Issues... Especially When National Security Is Involved This is entirely aside from legislation pending in Congress, which the White House appears to support, that would provide the Committee on Foreign Investment in the United States (CFIUS) with the ability to block investments across entire industries, rather than on a case-by-case basis, and with a broader definition of national security and sensitive property and technologies.12 While American presidents have historically vetoed similar legislation against China, the Trump administration may not, depending on the outcome of talks. The key point is that the U.S. political establishment - across the spectrum - is alarmed about China's economic mercantilism. As Senator Elizabeth Warren recently declared to a group of top policymakers in Beijing: "Now U.S. policymakers are starting to look more aggressively at pushing China to open up the markets without demanding a hostage price of access to U.S. technology."13 Warren, a staunchly liberal senator from the Democratic stronghold of Massachusetts, is entirely on the same page as Trump. The takeaway for investors? China's tit-for-tat response to Trump's steel and aluminum tariffs should not be dismissed out of hand. The market is sensitive to trade fears and there is a clear avenue for them to get worse if the 60-day consultation period lapses without any major Chinese concessions. True, negotiations are ongoing and Trump's trade team has been shown to be both credible and willing to pursue trade disputes through the WTO. Nevertheless there are substantial measures aimed at China coming down the pike and the usual restraints on U.S. policy, centered on the U.S. business establishment lobbying policymakers, are not as effective as in the past. Bottom Line: The U.S.'s primary economic goal in the China negotiations is not to equalize tariffs but to open market access. The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. As such, Washington will expect robust guarantees to protect intellectual property and proprietary technology. Investment Conclusions Several clients have asked about the constraints on the different players if trade conflict should escalate over the coming months. On the surface the U.S. is in a stronger position because its outsized deficit with China means that measures constricting bilateral trade are inherently more damaging to China's output (Chart 15). Even some of China's best retaliatory options are difficult to put into practice, including selling U.S. treasuries or imposing sanctions on U.S. commodities (Table 4).14 Chart 15China More Exposed To Trade Than U.S. Table 4China's Retaliation Options Are Limited... Even In Agriculture The U.S. also faces a constraint in imposing measures on China because manufacturing value chains today sprawl across various countries and multinational corporations. Tariffs therefore punish countries, including U.S. allies, that provide inputs to China or American companies that profit from them - think Apple. Moreover, tariffs will not in themselves change the U.S.'s fundamental savings-investment balance, suggesting that demand for foreign goods will simply shift to other producers and the trade deficit will be unaffected. However, supply chain risk is ultimately not prohibitive for the U.S. China has long ranked among the most exposed to supply-chain disruptions, while the U.S. ranks among the least (Chart 16). Moreover, U.S. allies in Europe and ASEAN stand to benefit if supply chains are rerouted from China (Chart 17). While the U.S. and allies would suffer higher initial costs as a result, they would gain the strategic advantage of reducing China's centrality to global supply chains. The latter has given Beijing an advantage in acquiring technology and moving up the value chain. Chart 16China Most Exposed To Supply-Chain Risk Chart 17U.S. Allies Benefit If Supply Chains Move While the Xi Jinping administration is weaning China off export reliance and U.S. reliance, the country still employs 28% of its workers in the manufacturing sector, which leaves it more exposed to disruptions than the U.S. if trade frictions should spiral out of control and weaken overall demand (Chart 18). While American workers are intimately familiar with the boom-and-bust cycle of free labor markets, China has not struggled with significant unemployment since 2003 (Chart 19). Its middle class was much smaller then. Chart 18Employment Is A Constraint On China Chart 19China Unfamiliar With Large-Scale Job Loss In short, China will first attempt to appease the Trump administration through market access (and keeping the RMB strong) to maintain its supply-chain centrality and overall stability. If Trump accepts China's concessions, trade frictions will not spiral out of control - at least not this year. China will only accept a full-fledged trade war if Trump rejects its concessions and imposes punitive measures that threaten its stability. At that juncture, Xi would probably find it useful to demonize Trump and execute long-term changes to make China more self-sufficient, blaming the U.S.-initiated trade war for the painful consequences. This is why it matters if Trump's demands go beyond foreign exchange rates, improved market access, and IP enforcement - for instance, if they extend to capital account liberalization, the holy grail of American trade negotiations with China. Thus far, Trump's team has not raised this demand, but it is a subject we will revisit soon as it is likely to be China's red line, at least within the economic sphere. In light of our expectation for further trade-war related volatility, we would recommend shorting Chinese tech stocks15 and remaining short China-exposed U.S. stocks. The latter trade has been in the black by over 5% in just a week, but is currently up only 0.7%. It is a way to hedge the risk of further tensions between U.S. and China. Risks to this view are: if the U.S. reduces the Section 301 tariffs that it is threatening on or after April 6; if Treasury Secretary Mnuchin's investment restrictions due on May 21 are watered down; or if the U.S. makes no structural demands on China's economy but merely accepts temporary RMB appreciation and some big-ticket import orders. Otherwise the risk that trade tensions spiral out of control will remain elevated at least through the U.S. midterm elections on November 6. By then, Trump will need either to have cut a small-scale deal with China that he can tout for voters or to have taken more aggressive trade action pursuant to the Section 301 findings. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 5 A 60-day consultation period with both legislatures will follow but the deal will probably remain in more or less the same form. 6 Aluminum was not included, but South Korea is not a major source of aluminum products for the U.S. 7 Please see footnote 2 above. 8 Please see David Lawder, "Trump to unveil China tariff list this week, targeting tech goods," Reuters, April 2, 2018, available at www.reuters.com. 9 Treasury Secretary Steve Mnuchin spoke with Politburo member Liu He, who is Xi Jinping's top economic policymaker, and they reportedly pledged that they are "committed" to a solution on reducing the U.S. trade deficit. The U.S. is asking for a $100 billion reduction to the trade deficit within the year, as well as some progress on intellectual property enforcement. Supposedly the specific demands involve reducing the Chinese tariff on car imports and raising the foreign ownership cap on Chinese financial companies, the latter of which China has previously promised to do. Please see Andrew Mayeda, "U.S. Pushes China On Cars And Finance In Tariff Talks," Bloomberg, March 26, 2018, available at www.bloomberg.com. 10 Please see the U.S. Trade Representative, "Findings of the Investigation into China's Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation under Section 301 of the Trade Act of 1974," March 2018, available at ustr.gov. 11 In September 2017, the White House and Department of Treasury intervened in the attempt by a group of investors, including the state-owned China Venture Capital Fund, from acquiring Lattice, on the advice of CFIUS. Lattice makes computer chips that are highly versatile and can be used in military functions; the Chinese SOE was suspected of pursuing China's state-backed efforts to improve its semiconductor industry. Separately, in March 2018, President Trump blocked Singapore-based Broadcom's attempt to acquire Qualcomm, which would have been a hugely consequential tech merger due to the two companies' dominance in making processors. The Treasury Department feared that Chinese state entities might get access to Qualcomm's IP or that the merger might otherwise hinder Qualcomm's "technological leadership." Please see "CFIUS Case 18-036: Broadcom Limited (Singapore)/Qualcomm Incorporated," dated March 5, 2018, available at www.sec.gov. 12 Please see Andrew Mayeda, Saleha Mohsin, and David McLaughlin, "U.S. Weighs Use of Emergency Law to Curb Chinese Takeovers," March 27, 2018, available at www.bloomberg.com. 13 She was speaking with Liu He, seasoned diplomat Yang Jiechi, and Defense Minister Wei Fenghe. Please see Michael Martina, "Senator Warren, in Beijing, says U.S. is waking up to Chinese abuses," April 1, 2018, available at www.reuters.com. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Ags Could Get Caught In U.S. Tariff Imbroglio," dated March 15, 2018, and "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, available at ces.bcaresearch.com. 15 Please see BCA China Investment Strategy Weekly Report, "After The Selloff: A View From China," dated February 15, 2018, available at cis.bcaresearch.com. Geopolitical Calendar

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. When the chartbook was last published in September 2017, the main message was that less accommodative monetary policy was required in the developed economies. This was largely driven by solid global growth and diminishing economic slack visible in measures like falling unemployment rates and rising capacity utilization. Since then, there have been multiple rate hikes in the U.S., single rate increases in Canada and the U.K., and a slowing of the pace of central bank asset purchases in the euro area and Japan. No other central banks have made any moves, however, with inflation still struggling to return to policymaker targets in most countries. A new element that central banks are dealing with is the increased financial market volatility seen in 2018. Yet the BCA Central Bank Monitors continue to point to a need for tighter monetary policy in all countries (Chart of the Week). This means policymakers are unlikely to "come to the rescue" of less stable financial markets through more dovish (and bond bullish) policy without evidence that slower global growth was leading to an easing of cyclical inflation pressures. Chart of the WeekGreater Divergences Between Our Central Bank Monitors Now Versus 2016/17 Feature An Overview Of The BCA Central Bank Monitors Chart 2The Cyclical Backdrop Remains Bond Bearish The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Currently, the Monitors are above the zero line for all countries for which we have built the indicator. This implies that the conditions are not yet present to expect a period of declining global bond yields driven by more dovish central banks. Yet differences in the trajectories of the Monitors have opened up. The BoE, RBA and RBNZ Monitors have fallen well off their peaks, while the Fed, ECB, BoC and even the BoJ Monitors are all still at or close to recent highs. In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the Monitors plotted against our 12-Month Discounters, which measure the expected change in interest rates over the following year taken from OIS curves. Fed Monitor: Market Turbulence Not Yet Enough To Change Fed Plans Our Fed Monitor remains in the "tight money required" zone, signalling that cyclical pressures are still pointing toward additional Fed rate hikes (Chart 3A). FOMC officials are now expressing strong conviction that the Fed's growth and inflation forecasts for 2018 will be realized, and even upgraded those projections last month. That increased confidence comes amid signs that core inflation is finally moving higher after last year's surprising slump (Chart 3B). Chart 3AU.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. The growth and inflation subcomponents of the Fed Monitor have both accelerated since our last Central Bank Monitor Chartbook was published last September. In particular, the inflation subcomponent is on the cusp of breaching the zero line for the first time since 2011 (Chart 3C). The Fed Monitor (unlike the other Central Bank Monitors) includes a Financial Conditions component that is rolling over from very elevated (i.e. supportive) levels. Chart 3CSteady Pressure On The Fed To Tighten, But More From Growth Than Inflation The sharp sell-off in U.S. equity markets seen since early February is a development that would typically give the Fed pause on the need to tighten monetary policy further. Yet there are no real signs - yet - that any slowing of U.S. growth is in the cards for the next few quarters. Leading indicators are still climbing, employment growth has been accelerating in recent months, and both consumer and business confidence remain around multi-year highs. The Fed is likely to deliver on its projection of an additional 50bps of rate hikes in 2018, which is already discounted in money markets (Chart 3D). Additional increases beyond that in 2019 are still likely to occur, barring any signs that the current financial market volatility is altering the current rising trends in growth and inflation. Chart 3DThe Fed Will Continue To Hike In 2018 & 2019 BoE Monitor: Diminishing Pressures To Hike The Bank of England (BoE) Monitor is drifting lower, but remains in the "tighter money required" zone as it has since late 2015 (Chart 4A). Despite that persistent signal, the BoE has raised the base rate only once over that period - in November of last year. On the surface, inflation pressures remain strong. The U.K. unemployment rate is well below NAIRU with an output gap that is now estimated to be closed (Chart 4B). Yet realized inflation has peaked, largely because the British pound is now up 9% off the post-Brexit 2016 lows. Rapid declines in pipeline price pressures (PPI, imported goods price inflation) point to additional slowing of CPI inflation in the next several months. Chart 4AU.K.: BoE Monitor Chart 4BTight Capacity In The U.K. Meanwhile, the economic picture looks mixed. Leading economic indicators have rolled over, as have cyclical measures like the manufacturing PMI and industrial production. Yet at the same time, recent readings on both consumer and business confidence have shown modest improvement. Looking at the breakdown of our BoE Monitor, both the growth and inflation sub-components of the indicator are now falling (Chart 4C). Given the decelerating path of leading economic indicators, and with the currency-fueled rise in U.K. inflation now starting to reverse, we think the BoE will be hard pressed to deliver more than the 41bps of rate hikes over the next year currently discounted in U.K. money markets (Chart 4D). Chart 4CGrowth & Inflation Components Of The BoE Monitor Are Slowing Chart 4DThe BoE Will Not Deliver More Hikes In 2018 Than Currently Discounted We continue to recommend an overweight stance on Gilts, which continue to trade as a "defensive" lower-beta alternative to U.S. Treasuries and core European debt, within dedicated global government bond portfolios. ECB Monitor: Tapering? Yes. Rate Hikes? No. Our European Central Bank (ECB) Monitor has been grinding higher over the past couple of years and broke sustainably above zero in July 2017 (Chart 5A). The broad-based cyclical economic upturn in the euro area has continued to absorb spare capacity, with the unemployment rate for the entire region now down to 8.6%, right at the OECD's NAIRU estimate (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BEuro Area Economy Now At Full Capacity Despite strong growth, headline (1.1%) and core (1.0%) inflation remain well below the ECB's target of "just below" 2%. This lack of upward momentum flies in the face of the inflation subcomponent of our ECB Monitor, which has been steadily moving higher for the past three years (Chart 5C). Chart 5CRising Pressure On ECB To Tighten Monetary Conditions The ECB remains on track to deliver some of the monetary tightening that our ECB Monitor is calling for later this year, but it will not be through interest rate hikes (Chart 5D). ECB officials have made it clear that a tapering of asset purchases will take place when the current program ends this September. However, it will take more evidence that inflation will sustainably return to the ECB's target before rate hikes will commence. Chart 5DECB Will Deal With Tightening Pressures First By Tapering Asset Purchases The recent softening of cyclical euro area economic data like manufacturing PMIs, combined with underwhelming inflation prints, justifies the ECB's cautiousness on rates. Although leading economic indicators are still pointing to another year of above-trend growth in 2018. The likelihood of a taper later this year leads us to recommend a moderate underweight stance on core European government bonds, but with a neutral stance on Peripheral European debt which benefits from an expanding economy. BoJ Monitor: Still Far Too Soon To Expect Any Policy Changes The Bank of Japan (BoJ) Monitor has inched into the "tighter money required" zone for the first time since 2007 (Chart 6A), thanks largely to a robust economy. Yet while growth has been enjoying strong momentum, inflation remains stuck below the BoJ's 2% target - even with record low unemployment and a positive output gap (Chart 6B). Chart 6AJapan: BoJ Monitor Chart 6BJapanese Inflation Still Too Low Japanese businesses remain reluctant to boost wages despite robust profitability and a tight labor market. This makes it difficult for the BoJ to hit the 2% inflation target even using extreme policy tools like negative interest rates and asset purchases. Yet even these policies are approaching limits. Liquidity in the Japanese government bond (JGB) market is severely impaired with the BoJ now owning nearly one-half of all outstanding JGBs. This is the main reason why the BoJ shifted from targeting a 0% yield on the 10-year JGB back in September 2016, aiming to target the price of bonds purchased instead of the quantity. With both the inflation and growth components of our BoJ Monitor are now above the zero line (Chart 6C), a case could be made for the BoJ to consider raising its yield target on the 10-year JGB. In our view, any shift in the BoJ yield curve target will only happen if the yen is much weaker (the 115-120 range), core inflation and wage growth both hit at least 1.5%, and global bond yields hit new cyclical highs (i.e. the 10-year U.S. Treasury yield approaching 3.5%). Chart 6CGrowth & Inflation Pressures Have Picked Up In Japan We continue to recommend an overweight stance on Japan, as the BoJ remains a long way from signaling to the markets that interest rate expectations must begin to rise (Chart 6D). Chart 6DThe BoJ Will Not Signal Any Change In Policy In 2018 BoC Monitor: Still Following The Fed The Bank of Canada (BoC) Monitor has stayed above the zero line since the beginning of 2017 (Chart 7A). The BoC has hiked rates three times since last summer, with Canada's robust growth justifying the tightening of monetary policy. Real GDP expanded by 3% in 2017, enough to push Canada's output gap into positive territory and drive the unemployment rate (5.8%) to below NAIRU (6.5%). As a result, both headline and core inflation are now back to the midpoint of the BoC's 1-3% target range (Chart 7B). Chart 7ACanada: BoC Monitor Chart 7BNo Spare Capacity In The Canadian Economy Growth has cooled a bit recently, though, most notably in consumer spending and housing data. In addition, the inflation component of the BoC Monitor has slowed and is diverging from the rising growth component (Chart 7C). These developments may be a sign that previous BoC hikes are starting to have an impact, although overall GDP growth remains well above trend and leading economic indicators are not slowing. Chart 7CA Divergence In The Growth & Inflation Components Of The BoC Monitor Looking ahead, the Trump administration's rising protectionist rhetoric is a potential threat to both Canada's economy and the value of the Canadian dollar. However, Canada was exempted from the recent tariffs imposed on U.S. steel and aluminum imports, suggesting that Trump may only seek a renegotiation, rather than a tearing up, of NAFTA. We continue to recommend an underweight stance on Canadian government bonds. Only 51bps of rate hikes are discounted over the rest of 2018 (Chart 7D), a pace that can be surpassed if the BoC follows its typical behavior of following the policy lead of the U.S. Fed, which is still expected to deliver 2-3 more rate hikes this year. Chart 7DThe BoC Will Continue Its Hiking Cycle This Year RBA Monitor: Lagging Behind While our Reserve Bank of Australia (RBA) Monitor remains in "tighter policy required" territory, it has pulled back considerably over the past four months and is now near the zero line (Chart 8A). This move suggests that there is no imminent need to adjust monetary policy, given tepid inflation pressures. Despite the recent surge in employment growth, labor markets still have plenty of slack. Part time employment as a percentage of total employment and the underemployment rate are both near all-time highs. Wage growth is weak and a substantial recovery is unlikely given that real GDP growth slowed in Q4 and the output gap is still wide (Chart 8B). Chart 8AAustralia: RBA Monitor Chart 8BAustralian Inflation Remains Subdued Looking ahead, consumption is at risk. Real wage growth has been nonexistent, so households have supported their spending by reducing savings. However, the rate of increase for house prices has slowed and prices in Sydney actually declined in Q4. If overall house prices were to decline going forward, then the lack of a wealth effect boost would force already massively-indebted consumers to reverse the savings downtrend and cut spending. Both headline and underlying inflation remain below the RBA's target range of 2-3%, with policymakers expecting underlying inflation to reach 2% only in June of 2019 with just a gradual improvement in labor markets. The inflation component of our RBA Monitor has already declined significantly on the back of collapsing iron ore prices, softening survey-based inflation measures and cooling house prices (Chart 8C). Chart 8CThe Inflation Component Of The RBA Monitor Has Plunged As such, we maintain our overweight position on Australian government debt, as the RBA will not even deliver the one 25bp rate hike in 2018 currently discounted by markets (Chart 8D). Chart 8DThe RBA Will Not Deliver The Discounted Rate Hikes In 2018 RBNZ Monitor: No Inflation, No Rate Hikes Our Reserve Bank of New Zealand (RBNZ) Monitor, which was the most elevated of all our Central Bank Monitors in last September's update, has plunged sharply since then (Chart 9A). Inflation remains stubbornly below the midpoint of the RBNZ's 1-3% target range, even with a tight labor market and no spare capacity in the New Zealand economy (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor Chart 9BNZ At Full Employment, But Inflation Peaking Both the growth and inflation sub-components have fallen sharply, with the inflation measure now down below the zero line (Chart 9C). A firmer New Zealand dollar, the flipside of the weaker U.S. dollar, has played a large role in dampening traded goods price inflation. Chart 9CStrong NZ Inflation Pressures, But Growth May Be Peaking The February RBNZ Monetary Policy Report expressed an optimistic view on growth supported by elevated terms of trade, population growth, fiscal stimulus and low interest rates. Headline CPI inflation, however, is not projected to rise back to 2% level until 2020. Unsurprisingly, the RBNZ is signaling no change in policy rates until then, even with the central bank projecting the New Zealand dollar to weaken in the next couple of years. We have been recommending long positions in New Zealand government debt versus other developed market debt since last May. New Zealand bonds have outperformed strongly over that period, as markets have priced in no change in rates from RBNZ (Chart 9D) unlike other countries where rate hikes were repriced and, in some cases, delivered. With the RBNZ on hold for at least this year and likely much of 2019, we our staying long New Zealand government bonds. Chart 9DRBNZ Will Stay On Hold In 2018 Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns